Payment Vs Payment (PvP) prevents the transfer of currency between two entities unless both sides of the payment are liquid. The PvP settlement mechanism ensures that the final transfer of a payment in one currency takes place only if and when a payment in another currency takes place. A PvP arrangement reduces settlement risk in foreign exchange (FX) transactions and, depending on the design, can reduce funding costs by reducing participants’ liquidity obligations. Settlement risk is brought about when there is a loss for one party in a transaction when they are liquid, but the partnering bank involved in the transaction is not. This leads to central banks dealing predominantly in credit and not only increases the time settlements take, but also the risks. By implementing a PvP arrangement, no transaction will take place without both sides being liquid, therefore credit dealing is reduced, along with settlement risks.
In order to enable PvP to take place, technology has been evolving in recent times to allow new business models to support this next generational way of settlement. The aim is to develop technology which can support instantaneous PvP settlement for fiat currency today, whilst also supporting and anticipating a future that may include new currencies. While older technologies were successful when used at the time
they were developed, they were not built to support further innovation outside of their own technological
framework – i.e., new currencies, new corridor systems, and different time zones. As a result of technology lacking innovation and the ability to adapt, flaws have emerged. Therefore, the new designs on the market are now being developed to support today’s technology as well as prepare for tomorrow’s needs.
One of the most exciting developments for this technology is that the new designs attempt to cater
towards the needs of the participants. One of the huge issues surrounding the topic of payments today is the issue of time. Payments can take as long as three days to complete which, in a world used to instant digital response, is just not suiting the needs of the modern participant. If one considers domestic payments, for example, they happen instantaneously.
The new technologies in development are working to match this standard. One way in which this is happening is by ensuring the technology supports transfer of funds 24 hours a day, 7 days a week. This will mean that, regardless of time zones, Payment vs Payment transactions can take place.
Today cross-border payments still function using the old correspondent banking model. The correspondent banking model creates a reciprocal relationship between banks. It creates a contractual agreement between banks for them to partake in payment services. It involves each bank opening an account at the other bank for the money to be transferred into. Though the method is effective, there is huge settlement risk as banks often end up dealing in Credit. Several emerging market economies (EMEs) currencies, where trading volumes have grown substantially, are not supported under the existing arrangements. In addition, existing arrangements do not cater to all market participants’ needs or are deemed too expensive. Even though existing PvP arrangements have successfully reduced settlement risk for much of the FX market, certain growing market segments remain vulnerable.
Fit for purpose
In order to be fit for today’s world of payments, PvP technology that is being developed should include an atomic settlement lock, which prevents transactions from taking place until both counterparts are liquid, irradicating credit risk in cross-border payments. Another element developers are focusing on is finding an approach that can cut costs, which have risen as a consequence of prudential regulatory measures implemented following the financial crisis. There are a few reasons that cross-border payments have become notorious for their high cost for banks.
For one thing, the number of intermediaries involved in cross border payments raises the cost inextricably. Each intermediary involved charges the bank for their services, leading to multiple fees on top of that from the bank one is transferring to.
There is also the element of regulatory cost along with fees being charged for FX to convert one currency into another, all add up to making the transactions costly for banks. The Payment vs Payment technology that is being developed reduces intermediaries by providing a direct route for the payment that still ensures liquidity, as well as technology with the ability to work with multiple currencies. The difference here is that the underlying asset transacted is not the prudentially costly commercial bank money, but central bank money instead, which does not attract capital charges for banks. Technologies that combine the use of cloud technologies as well as an API are leading the way towards a resolution in this area. In simpler terms, an API creates a connection between a data provider and a user through an online connector, like ‘The Cloud’.
This reduces the number of intermediaries by creating a direct pathway between bank and bank. The new technologies are using Payment vs Payment methodology because it tackles the key issues in
international payments today. The technology needs to support innovation, tackle settlement risk and reduce the risk of payments across borders. The PvP arrangement must be suitable for its purpose, meaning the counterparties should be able to transfer funds when it serves their commercial and operational needs. As well as mitigating settlement risk, they should be able to adequately monitor their bilateral exposures and optimize liquidity usage.
Private and public stakeholders can work together to address common barriers to broad adoption of PvP to both enhance existing PvP arrangements and develop new solutions. It would be beneficial for private companies to agree on conventions for value dating, to align nostro operating hours, and to promote interoperability between legacy and newer systems.
New PvP providers could use central bank accounts, money and credit facilities to assess operational barriers, and central banks could encourage private sector participation. Payment vs Payment solutions are seeking to do this and are therefore the future of payments in the international settlement industry.
Fintech For Good: RTGS.global