Fintech and Cross-Border Payments

IMF News, November 1, 2017

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Fintech and Cross-Border Payments

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• Authors: Dong He
• Published: November 1, 2017

I. The Organization of Financial Services — A General Framework

• Technology affects attributes of services (speed, security, transparency) and the organization of service providers (market structure).
• Adoption driven by targeting unmet user needs ("gap" or "shortcomings" of services); larger shortcomings create stronger incentives for firms to apply technological advances and faster user adoption.
• Possible effects of technology on market structure:
  • (i) reduce the need for financial intermediaries;
  • (ii) push intermediaries to change internal structures (partnerships and acquisitions);
  • (iii) induce entry of new intermediaries while displacing older ones.
• Technology can alter underlying market imperfections:
  • reduce asymmetric information;
  • facilitate matching of transaction parties;
  • reduce transaction costs;
  • change incentives for horizontal or vertical integration;
  • alter barriers to entry.

II. The Current and Future Landscape of Cross-Border Payments

• Cross-border payments differ substantially from domestic payments due to pricing, infrastructure, and international handling requirements; fintech could make a "payment just a payment" irrespective of border.
• End-user priorities: low cost, security, convenience, predictability, transparency, and confidentiality.

Findings — shortcomings of current cross-border payments:

• Cross-border transfers are costly and cumbersome.
• Services are opaque; price is often not known at initiation.
• Cross-border payments are slow because routing through many banks causes delays and fees.
• Shortcomings arise from technology, regulation, and market structure.

Findings — market structure:

• Payments chain segments remain highly concentrated with high barriers to entry.
• Barriers include high fixed and sunk costs (user interfaces, regulatory compliance, trust-building, large back-offices), need for scale to manage liquidity and counterparty risk, and strong network externalities in messaging and settlement (netting lowers costs; access to counterparties facilitates transactions).

Scenarios for fintech (three DLT-centered scenarios, in increasing order of disruption):

• Back-end processes
  • Application: shared permissioned DLT platforms among correspondent banks to automate tracking, optimize liquidity and risk management.
  • Gains: efficiency improvements; little impact on market structure expected.
  • Uncertainties: unclear pass-through of cost savings to end-users; incumbent oligopolistic correspondent banks may retain market power.
• Compliance
  • Application: DLT combined with digital identity and know-your-customer utilities to lower compliance costs (including AML/CFT and sanctions-related controls).
  • Effects on market structure: digital identities could reduce economies of scope from proprietary customer information and ease switching between providers, conditional on data-sharing willingness or regulatory requirements.
  • Benefits/risks for end-users: likely cheaper and more inclusive services; privacy and security concerns for personal information on ledgers and for digital identity theft.
  • Policy constraint: extent to which regulation allows financial institutions to outsource customer due diligence.
• Means of payment
  • Application: DLT-backed virtual currencies shift payments from accounts-based to token-based systems; two DLT means relevant for cross-border:
  • Privately run hub-and-spoke payments networks where fiat is exchanged into tokens (wallets), tokens transferred over the hub, then exchanged back into fiat.
  • (Implicit) Other token-based DLT payment architectures.
  • Market-structure implications: potential shortening of the payments chain; messaging and settlement in central bank money or via correspondent banks may be displaced; virtual currency exchanges and wallet providers could capture significant business.
  • End-user attributes: potentially faster, more traceable, easier to use, cheaper, and more secure — subject to three caveats.

Three caveats to hub-and-spoke virtual-currency networks:

• Caveat 1: Erratic valuation of virtual currencies introduces risks; volatility limits use as stores of value and may constrain adoption for large-value payments.
• Caveat 2: Lack of trust in hub-and-spoke networks could erode value. Trust requires:
  • legal certainty on transfer of ownership of the virtual currency;
  • trust in stability and security of the underlying technology and issuance/backing rules;
  • trust in security of virtual currency exchanges and wallet providers (data security and wallet access).
  • Policy implication: regulators may need regulatory approaches for exchanges and wallet providers to protect consumers and address AML/CFT concerns.
• Caveat 3: Lack of interoperability among networks could keep hub-and-spoke prices high via strong network externalities and market power.
  • Policy implication: regulation aimed at anti-competitive concerns could help alleviate high fees.

III. Central Bank Digital Currencies (CBDCs)

Definition and basic properties:

• A "Central Bank Digital Currency" ("CBDC") is a digital form of central bank money that can be exchanged in a decentralized manner peer-to-peer without need for an intermediary.
• A CBDC would be exchanged at par with the central bank’s other liabilities (cash and reserves) — either through banks or directly at the central bank.

Why central banks might issue a CBDC:

• Efficiency reasons:
  • Counter monopoly power from strong network externalities in private operators or private virtual currencies.
  • Counter inability to ensure full stability and safety of privately coded/maintained currencies.
  • Overcome coordination failure in agreeing on a single new technological standard.
  • DLT-based CBDC could be more secure and resilient than settlement systems exposed to single point-of-failure risk.
• Retail and inclusion reasons:
  • Replacing notes and coins could save state costs of maintaining and replacing cash.
  • Could reduce transaction costs for individuals and small enterprises with little or costly banking access and facilitate financial inclusion.
  • By facilitating small-value payments, could boost adoption and efficiency of decentralized service economy.
• Monetary-policy reasons:
  • Proliferation of private virtual currencies might erode demand for central-bank money and weaken monetary policy transmission; a CBDC could forestall this.
  • Replacing cash (except possibly costly-to-store small denomination notes) with a CBDC could allow the central bank to lower interest rates well into negative territory when necessary — balanced by the need to respect social preferences for the form of money.

Design choices and implications:

• Basic requirements: issued in the same unit of account as fiat money; a liability of the central bank; exchanged at par with other non-equity liabilities (cash and commercial bank reserves).
• Key differentiators from commercial-bank reserves:
  • Whether interest is paid on a CBDC matters:
  • A non-interest-bearing CBDC is a better substitute for cash than for bank deposits.
  • An interest-bearing CBDC is a better substitute for bank deposits and may affect transmission and financial stability more.
• Distribution decisions: how and to whom the central bank distributes CBDC.
• Technology choices: security, speed, and who bears operating/maintenance/development costs (central bank vs. private sector participation).
  • Question of whether central bank remains catalyst or full-scale operator.
• Broader implications: choices affect the nature and regulation of the financial system, conduct of monetary policy, and roles of central and commercial banks.
• Policy recommendation: a gradual approach to introducing CBDCs, if at all, building on experience and evolving fintech.

IV. Policy and Strategic Implications

• Trust remains essential across all fintech developments; lowering some barriers to entry may raise others (e.g., closed networks creating new market power).
• Technology promises to improve cross-border payments, reduce costs of compliance with AML/CFT regulation, and offer better and cheaper services — but downside risks need minimizing.
• Regulatory priorities suggested by the analysis:
  • Address privacy and security concerns for DLT-based compliance and identity solutions.
  • Clarify rules on outsourcing of customer due diligence.
  • Consider regulatory approaches for virtual currency exchanges and wallet providers to protect consumers and address AML/CFT issues.
  • Monitor and, where necessary, address anti-competitive outcomes from network effects and lack of interoperability.
  • Study CBDC trade-offs carefully (efficiency, inclusion, monetary-policy transmission, financial stability) and proceed gradually.
• Call for dialogue: policymakers, investors, financial-services firms, and countries should engage in dialogue to shape outcomes.

This speech is based on “Fintech and Financial Services: Initial Considerations”, IMF Staff Discuss Notes No.17/05.

IMF Communications Department — Fintech and Cross-Border Payments (Speech by Dong He, Deputy Director, Monetary and Capital Markets Department) — Ripple – Central Bank Summit, Carnegie Hall, New York — November 1, 2017.

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