By Brian Charlick, Principal Consultant at CGI
During the past decade we have witnessed a significant shift in the payments and banking landscape. A drive to mobile banking, fintechs, younger tech-savvy demographics and new global financial instruments have driven up payments volumes. This pattern of increased volumes has coincided with ever increasing demands for payments to be executed and settled in real time. This decade has seen a plethora of developments in payments and FX settlements, including new entrants, new models and changes to existing models.
Despite all this, the introduction of instant FX settlement and international payments has some serious obstacles to overcome; both internal and market infrastructure and vitally, how the two intersect.
Issues to be faced
Operational constraints for domestic and international payments have major issues, ranging from regulatory requirements, operational logistics, risk management and pricing. The regulatory requirements, largest of all being under AML5 and increasing requirements due under AML6, mean that it is currently impossible to be compliant while also guaranteeing instant payments. Under AML5 and AML6, the need to monitor the transaction for potential fraud and check against the sanction lists for not only the payer and payee, but also the ultimate beneficial owner means exceptions that need to be investigated will increase, possibly up to 5% of all transactions falling within the scope of the regulation. Given that level, the guarantee of instant becomes a real problem. Smaller value and crypto currencies will be impacted as they are captured under AML5 and AML6.
Operational logistics such as settlement will need to change, with the current netting model no doubt being dropped, as this stops real time payments. The systems will need to cope with the increase in payments to be made.
Pricing tools and processes will need to change. The principle of revaluation of positions at set times in the day for risk and controls will not work. In place will need to be real–time valuation of positions, mirroring the valuation and pricing seen by traders for many years.
Risk management will also be impacted as risk positions will require real–time valuation. Limits will need to be administered instantly, with trades being blocked real time rather than by reference to an overnight limit update.
A bigger concern is control. The need to monitor and control real time will provide the biggest challenge to financial service organisations. To be able to see trends and breaks in operation, or risk limits being broken, will require an enormous effort.
It is currently impossible to be compliant with AML5 and AML6 while also guaranteeing instant payments
Market infrastructure also has issues to resolve. The model of netting, used by many, will be all but redundant. Payment instructions will need to be transmitted real time. The role of the correspondent bank becomes a question too. Using a middle person slows the process. In this case the market needs to have a payment structure that allows small financial service organisations, as well as non FS firms to enter the network at a cost–effective rate. SWIFT could still be used as the communication channel, although others will also seek to provide that service such as Google, Apple, Amazon, Paypal etc. Finally, with the advent of the tech giants’ payment offerings and developments, the risk of fragmenting the market is real.
However, a newer challenge is DLT and the Central Bank Digital Currency – how might this be used and to what impact? Will CLS use it to provide tokens across central banks, fitting within existing models, or will it be used by firms like Mastercard and become a bigger disruption?
Does that mean real time will not happen?
The market is responding, CLSNow is one starting point, SWIFT gpi and ISO20022 is another. Meanwhile, technology is beginning to enable Instant Payments, UK Open Banking being one example. It is evident, however, that there is much still to be done to facilitate real time; as mentioned, across market infrastructure and internally.
When looking at the potential changes, it is important to realise that in the past we have seen successful change driven by a series of small, iterative, rapid changes in the models rather than a big bang, certainly where the market drives the change rather than a regulation being laid down. I believe this will be the case here. By way of example, we are already starting to see two streams of payments mature with retail consumer and small business payments going through Travelwise, PayPal, Amazon, etc, while the larger banks and client organisations are using SWIFT and the traditional model; CBDC could become a part of the process for CLS, retaining the same market model.
The need to monitor and control in real time will provide the biggest challenge to financial service organisations
Internally, traders will need to see real–time positions, risks and limits. Hedging will become more difficult, potentially using algo or analytics to execute, as real time will reduce the ability to foresee the positions and arising exposure. Risk management will have to become real time and monitoring the limits for clients will have to change. It will need to be done in real time with limits restricting the trading ability immediately. Accounting will need to revalue real time in order to provide risk data for monitoring activity. Settlement systems will have to create immediate settlement instructions that are sent without manual validation, causing a knock on effect for reconciliation. Finally, and as important, is the need to create controls in real time; information, I use the word information rather than data, will be required in real time in order for control to be effective.
On the up side, intelligent automation will enable much of the control to be faster and more prescribed market intelligence to be created.
The growth of FX transaction volumes doesn’t look like slowing and the demand for real-time settlement isn’t disappearing anytime soon either. In the near future we may see some sporadic attempts, but the market in general is still some way off. To get ahead of this challenge, market participants need to review their internal operating models and controls, embrace and leverage new technologies and collaborate with others to ensure a consistent industry approach.