Cross-border payments can be slow, expensive, and risky. In today’s world of payments, counterparties in different jurisdictions rely on costly trusted relationships to offset the lack of a common settlement asset together with common rules and governance. But imagine if a multilateral platform existed that could improve cross-border payments—at the same time transforming foreign exchange transactions, risk sharing, and more generally, financial contracting.
A common ledger, smart contracts, and encryption offer significant gains to market efficiency, completeness, and access, as well as to transparency, transaction and compliance costs, and safety.
Today my remarks will provide an overview of the current landscape and then present a path forward on how a newly designed multilateral platform could enhance cross-border payments, and eventually stimulate the provision of key international public goods and infrastructures.
Today’s world of payments
Currently at the domestic level, there exist infrastructure and governance structures that allow the private sector to better provide payment and financial services. At the international level, however, lack of coordination creates insufficient provision of these public goods and results in inefficient arrangements for cross-border transactions.
Compounding these issues is the disruption in cross-border payments caused by emerging new technologies that allow transactions to circumvent borders and regulations, as well as the fears of fragmentation that have arisen with ongoing geopolitical conflicts.
Indeed, the need for better cross-border payments has long been recognized by the international community. In the October 2020 Roadmap for Enhancing Cross-Border Payments, G20 Finance Ministers and Central Bank Governors endorsed a set of 19 Building Blocks that aim to achieve faster, cheaper, more transparent, and more inclusive cross-border payment services. These should be safe and secure, and would facilitate economic growth, international trade, global development, and financial inclusion.
With these objectives in mind, the design of a multilateral exchange and contracting platform should improve cross-border transactions in two ways.
First, it should centralize payments and settlement and integrate functionality needed for cross-border transactions, namely, to streamline compliance, to reduce cost of foreign exchange conversion, and to better manage financial risks.
Second, it should leverage new technologies to better organize payments and associated financial markets. These new technologies can alleviate the underlying obstacles to trade. These include common ledgers with unique states, programmability that allows for automated financial contracts (“smart contracts”), and encryption that ensures privacy. Participants can then interact via a multilateral exchange and contracting system where they can truthfully share information with smart contracts but retain privacy relative to other parties.
The current landscape is continuously updated by private and public sector innovation. Fast (retail) payment systems are emerging from private bank clearing associations, and from central banks. FinTechs serving households and small businesses start from digital payment functions but build credit and insurance products on top, with synergies in data and financial products. At the wholesale level, large intermediaries like JP Morgan have been developing blockchain-based solutions for instantaneous digital transfers of Treasury and collateral (US money market funds).
The responsibility for tracking transfers and changes in ownership in this landscape rests on multiple brokers and intermediaries that modify their clients’ accounts to reflect those transactions. As infrastructures and legacy systems were created to facilitate intermediation, the information from transactions is recorded in several ledgers—for each intermediary and each of the clients that enter a transaction. But these ledgers do not guarantee a unique common underlying state. And limited communication makes reconciliation time consuming and costly.
For cross-border payments, many of these infrastructures are insufficient or do not exist. Establishing trust and coping with market failures is more difficult and expensive when transactions must be carried out across borders. At the international level, the lack of common governance across borders makes these public goods scarce or non-existent and leads to high risks, high costs, and high concentration.
First, internationally there is no common and widely available settlement asset. Banks must rely on foreign banks to access foreign central bank money via nostro/vostro accounts (i.e., the same account from the point of view of two different banks) or must set up branches and be regulated in the countries for which they want to have access to central bank reserves.
Second, cross-border transactions usually require that an agent in the payment chain make the conversion across currencies. In many cases, this implies risks and high costs, which are among the main drivers of cross-border transaction costs.
Third, compliance with rules for cross-border transactions is expensive. At the international level, there is a lack of common governance for vetting procedures and monitoring. Not only is it expensive to gather these data on customers, but it can also be risky to trust financial institutions from other jurisdictions as there can be uncertainty on the soundness of their procedures.
Specialization in overcoming these three frictions gives rise to networks of bilateral correspondent banking relationships, international banking, and closed loop solutions in cross-border payments that have high fixed costs and economies of scale. The result is concentrated market structures and large intermediaries that play a central role in cross-border payments.
A number of public and private sector innovations and initiatives in the past have attempted to improve cross-border payments. Standardizing messaging allowed correspondent banking to be faster and safer. Netting and settlement has been improved for some currencies. Regional payment platforms have been developed and experimentation in interlinking domestic payments systems is also ongoing. Payment providers have also been developing new services. Solutions that leverage stablecoins for fast and inexpensive cross-border payments have also grown recently.
Right now, there are related ongoing projects and experimentation that also aim to develop solutions for cross-border payments using Distributed Ledger Technologies. Some of these projects are public and led by a consortium of Central Banks and some are done in collaboration with BIS Innovation Hubs, while others have been launched by the private sector.
We can build on all these initiatives—and go further.
Tomorrow’s world of payments
In a recent Working Paper, we outline a vision for new a platform to facilitate cross border payments, currency exchange, and financial contracting—dubbed the “X-C platform.” X-C has a centralized, multi-currency foreign exchange trading environment on the platform. We also allow for the introduction of contracts and policies to manage foreign exchange risks.
Our focus with X-C naturally goes beyond purely payments as we include other functions that are needed for competitive and efficient cross-border payments outcomes.
The idea is to create markets that are currently missing, establish infrastructures to fill in gaps in financial access, and reduce inefficiencies in cross-border payments. To do so, we are explicit about economic frictions, and we lay out the technological requirements for the solutions we propose. This gives blueprints for the design of the platform, its infrastructures, and its functions.
A first key aspect of the design is that organizing cross-border transactions in a multilateral platform like X-C could improve efficiency by reducing transaction chains, settlement risk, and costs of foreign exchange transactions. This aspect of the design hinges on an architecture that would provide key public goods: (i) a common infrastructure with rules and governance that would shorten transaction chains and would give legal certainty to participating agents; (ii) common settlement assets issued by central banks to reduce settlement risk; and (iii) a trading environment to trade these different settlement assets in the platform.
A second key aspect of the design is combining the separate features of new technologies that X-C would require to address market failures and inadequate contracts. These features of new technologies I mentioned before: one common ledger; programmability, and cryptography.
The X-C platform uses the common ledger to build markets and keep track of ownership of transactions offered by participants. The ledger is built to be able to interact with computer code. Smart contracts can read, execute, and modify entries in the ledger and automatize financial contracts. Cryptography allows smart contracts to be executed without revealing information to relevant parties.
Each of these three features is used to address different fundamental obstacles to trade that limit contracts. Limited commitment caused by potential reneging of contracts can be addressed with cryptographic commitments as atomic swaps (i.e., the exchange of cryptocurrencies from separate blockchains) and automatic transfers. Untrusted messages, where agents are suspicious whether the other party complies with rules, can be tackled with domestic certification combined with cryptography to preserve data sovereignty and privacy. Unobserved states that generate financial risks can be taken care of by aggregating information from privacy-preserving messages. Unobserved actions like front-running can be tackled with contracts executed by programmed rules.
The design is anchored on contract theory and market design: how agents should interact to best overcome market failures; what they should trade; and how markets should be organized for best results.
In the current cross-border payments landscape, large institutions act as dealers and need to cover the cost of holding currency inventories. There are further markups to cover foreign exchange and counterparty risk. The market power from concentration also results in even higher markups. X-C design aims to increase competition, lower spreads, and reduce risks by providing infrastructure, contracts, and markets for just-in-time liquidity transfers for previous contract commitments; a centralized multi-currency market; and instruments and markets for better hedging of risks.
Settlement risk is eliminated by immediate guaranteed settlement at a point in time or guaranteed contracted settlement at future designated dates and states. This is why we call this a “dynamic ledger” in which messaging, settlement, and committing contracts become linked. Digital monies issued by central banks (“certificates of escrow”) on X-C can then be used for programmable final settlement in participant countries’ currencies. Thus, cross-border transactions using X-C are final and irrevocable.
To deal with data, retain privacy, and comply with domestic and international regulations, X-C leverages cryptography to enable regulators and compliance officers to conduct checks, monitor, and audit in a privacy-preserving fashion. Financial integrity checks and capital flow management encompass two sets of rules and regulations that can make cross-border payments slower, riskier, and more expensive. X-C can help to reduce the costs and risks by automatizing compliance with these rules while preserving privacy.
Strong privacy can be retained while preventing untraceable transactions by leveraging “credential providers” and control agencies together with cryptographic proofs and checks. This allows decoupling controls and user authorization from transaction submission and execution.
The functionalities of X-C allow it to manage efficiently—and in a privacy preserving way—the information generated at the local level. They also allow it to identify and vet individuals or firms that X-C’s participants may want to serve. For example, a transaction order can read a list of sanctioned individuals and attach a cryptographic proof that the individuals participating in a transaction were vetted and are compliant with, for example, AML-CFT rules.
Another consideration is how to organize spot and derivative foreign exchange markets to improve market liquidity and better manage risks. Foreign exchange spreads play a large role in the fees for cross-border payments and are usually a result of wholesale market underdevelopment. A better trading infrastructure, better risk management, and a more predictable policy environment can contribute to lower foreign exchange trading risks and better-functioning for foreign exchange markets.
Currently, foreign exchange trade is mostly done through a set of oligopolistic intermediaries who carry different currency inventories. This requires large balance sheets, resulting in imperfect competition and in price distortions. When markets are decentralized or shallower, market power and distortions are usually larger.
The centralization of information and exchange of foreign exchange trading can contribute to improving markets by increasing transparency and by creating incentives to increase competition. It allows for visibility on prices and quantities that are being actively traded. It also allows elimination of settlement risk from transactions.
X-C is distinguished from other proposals by organizing foreign exchange trade in a multi-currency environment that utilizes market design theory. Intermediaries act as broker dealers and compete to attract trade from clients. Also, multi-currency auctions are introduced as a robust solution that generates competitive outcomes and can be implemented entirely through smart contracts where no third-party auctioneer is needed.
X-C is also distinguished by enabling participants to hedge foreign exchange risks via forward or contingent contracts by allowing on-platform foreign exchange derivative contracts and markets for those. Agents can also enter contracts that mutualize idiosyncratic risks but contingent on aggregate shocks. Smart contracts take as inputs the messages of all the agents with private shocks and implements a cross agent allocation
X-C’s dynamic ledger can help control and manage financial stability risks from these derivative contracts without requiring full escrow or collateral. The dynamic ledger goes beyond preventing double spending of funds and avoids the double commitment of the rights to future funds that have been contracted with others. As smart contracts are part of the ledger, these can be made to be consistent with each other.
X-C can be used to implement policies using smart contracts. It also allows the possibility of representing additional assets on the platform’s ledger, which can also be useful for policymaking. This allows for implementing domestic or multilateral safety nets, for creating foreign exchange intervention rules and implementing them on the platform, and for coordinating policies among different central banks.
With escrow accounts on the platform, each central bank can trade in spot auctions and the other markets. This shortens payment chains, reduces balance sheet interconnections, and makes transactions faster, cheaper, and safer than bilateral private claims. Not only can each allow their regulated intermediaries to convert central bank reserves to certificates of escrow, and vice versa, but each central bank can also expand its balance sheet directly by trade on the platform.
Smart contracts can also be used to deploy cross-country liquidity. Participating central banks could establish borrowing and lending arrangements in which they could get certificates of escrow from another central bank that participates in the platform and use those to provide liquidity to its domestic private platform participants. Cross-border liquidity provision arrangements could include liquidity bridges (used on a relatively routine basis), currency swaps (used under exceptional circumstances), or regional financial arrangements.
Cryptography is also needed. This would allow central banks to keep their foreign exchange positions, policy, and reserve goals to themselves but still use that information to tailor swap line contracts and to achieve a degree of policy coordination.
Foreign exchange intervention rules can also be implemented on X-C. Intentions embodied in messages and actual bids from central banks can be aggregated in a privacy-preserving fashion. Each participating central bank can communicate its preference for volatility bands for foreign exchange rates that reflect its policy choices given its risk aversion and reserve commitments. For example, a central bank can input contingent bids in auctions. These input parameters are not known to anyone, but a smart contract can find the best bands that satisfy all central banks and their reserve commitments, and automatically intervene when these volatility limits are reached. This would be an improvement on how swap lines are currently used.
This use of X-C’s multilateral privacy-preserving bidding schemes could provide additional coordination tools and trust building among central banks, thus expanding access to international financial safety nets.
In conclusion, a new multilateral exchange and contracting platform that centralizes payments and settlement and that integrates functionality needed for cross-border transactions, as outlined above, would help in streamlining compliance, reducing the cost of foreign exchange conversion, and better managing financial risks. New technologies can be leveraged to better organize payments and associated financial markets and allow the design of a multilateral exchange system where participants can truthfully share information with smart contracts, but still retain privacy relative to other parties.
While new technology and appropriate economic design can go far in improving cross-border transactions, there are hurdles that require multinational coordination at a legal and political level. These include governance agreements, and aligned AML/CFT, legal, and regulatory frameworks. More reflection will also be needed to ensure the operational stability of platforms, given their systemic nature. Finally, further work is needed to ensure regional platforms are interoperable, which will help counter geopolitical fragmentation.
Other important questions arise in terms of the role of the public sector (both country authorities and international organizations) in operating and developing platforms. The role of the private sector to ensure adoption and sustainable business models should also be further explored.
While these are all difficult issues, the prospect of a solution where technological innovations are leveraged by the public sector for public policy objectives is one that should spur the ingenuity needed to address the challenges.
*Tobias Adrian is the Financial Counsellor and Director of the Monetary and Capital Markets Department of the International Monetary Fund (IMF). In this capacity, he leads the IMF’s work on financial sector surveillance, monetary and macroprudential policies, financial regulation, bank resolution, debt management, and capital markets. He also oversees capacity building activities in IMF member countries with regard to the supervision and regulation of financial systems, bank resolution, central banking, monetary and exchange rate regimes, and debt management.