ECB’s Search For ’Holy Grail’ Of Cross-Border Payments

August 4, 2022
A European Central Bank (ECB) study to look into the future of cross-border payments gives high praise to instant payments linkages and central bank digital currency, while it ranks Bitcoin and stablecoins the worst of all worlds.

A European Central Bank (ECB) study to look into the future of cross-border payments gives high praise to instant payments linkages and central bank digital currency (CBDC), while it ranks Bitcoin and stablecoins the worst of all worlds.

In a new working paper in which the ECB searches for the “holy grail” of cross-border payments, bitcoin and stablecoins are found to come up short, while interlinked instant payment systems and CBDCs come out on top.

The paper considers six potential candidates that could evolve to assume holy grail status within the next decade — a feat the ECB considers not only possible, but likely.

The candidates include modernised correspondent banking, cross-border fintech solutions, bitcoin, global stablecoins and interlinked instant payment systems or CBDC with an FX conversion layer.

Each candidate is then assessed based on the key attributes of immediacy, cost, universality and secure settlement (compared to the benchmark of central bank money).

“Several solutions are suitable for improving cross-border payments significantly, and some could even be the holy grail,” the report notes.

Towards the grail

The most promising two candidates, according to the ECB, are interlinked domestic instant payment systems and interoperable CBDCs.

The ECB defines “instant payments” as transactions that are posted and funds made available to the payee in real time or near-real time, and which operate as close to 24/7 as as possible.

Following a lacklustre review of correspondent banking solutions, which often involve lengthy transaction chains and truncated data standards, the ECB praises instant payment systems for their ability to allow financial institutions to interact directly via linked infrastructures.

In theory, then, instant payment linkages should be able to avoid the multiple layers of compliance faced by correspondent banks, such anti-money laundering/counter-terrorism financing (AML/CTF requirements, and their attendant high costs and legal risks.

Moreover, with the integration of an instant FX conversion layer through bilateral or multilateral agreements, instant payments linkages should in principle allow cross-border and cross-currency payments to be completed in central bank money. Avoiding commercial bank money would also help avoid credit and liquidity risks.

However, for instant payment linkages to succeed, the ECB notes that several preconditions must first be met.

The first is the addressability of accounts for cross-border transactions. For the ECB, this would ideally be achieved through global standardisation of unique bank account identifiers (such as IBAN), and this would ensure an efficient and secure routing of a cross-border payment to the payee.

The ECB suggests an even more seamless solution would be the addressability of accounts via a proxy.

For example, if payees could be addressed via a unique email address or phone number, this would reduce the need for additional standardisation, but would also require a global proxy look-up.

Instant currency conversion would effectively entail “decomposing” one cross-border transaction into two domestic instant payments: one to the payee in one currency; and one to a market maker in another.

“Market makers would consist of banking groups having accounts in instant payment systems on both sides — i.e., in the two relevant domestic instant payment systems,” the report notes.

Finally, to ensure integrity and efficiency, the ECB argues that instant payment linkages would require “straight-through” AML/CTF checks.

“AML/CFT compliance checks should be made automated and instantaneous by relying on positive ex ante criteria,” the report notes.

“Of course, ‘suspicious’ payments would have to be rejected or re-routed to a non-instant processing to allow for additional non-automated analysis.”

The ECB gives praise to several instant payment linkages that have already taken place, such as last year’s EBA Clearing-TCH collaboration or the BUNA-TIPS experiment, as reported by VIXIO.

Scaling up such linkages would offer a more efficient, open and competitive system for cross-border payments than correspondent banking and would persevere monetary sovereignty by preventing currency substitution.

How does it compare with interlinked CBDCs?

In the same way as domestic instant payment systems can be interlinked, so too can future CBDCs.

The main difference between instant payment systems and CBDCs is that the former already exist, and only require interlinking, whereas the latter do not yet exist and must be built from scratch. However, there are advantages here.

“Cross-border CBDCs could offer the opportunity to start with a ‘clean slate’ and address the frictions inherent in current cross-border payment systems and arrangements from the outset,” said the ECB, quoting from a 2021 Committee on Payments and Market Infrastructures (CPMI) report.

“The enhancements could be made by offering secure settlement, reducing costly and lengthy intermediation chains throughout the payment process, and eliminating operating hour mismatches by being accessible 24/7.”

As all CBDC payments are settled in central bank money, this ensures payments are not exposed to credit and liquidity risks.

Similar to the instant payment models described above, monetary sovereignty would be preserved by preventing currency substitution and the overall system could not be dominated by a handful of issuers.

The ECB also suggests that interlinking CBDCs could be even easier than interlinking instant payment systems, given the lack of data format discrepancies and the reduced role of commercial banks.

The report adds that central banks should discuss interoperability issues at an early stage of CBDC development.

Crypto-based options fail to impress

At the bottom of the ECB’s holy grail heap are the two crypto-based options: bitcoin; and global stablecoins.

As an unbacked crypto-asset, the ECB does not consider bitcoin as suitable for cross-border payments.

Bitcoin’s “reliance on an independent third asset” in the case of most cross-border transactions means it is neither the currency of the payer or payee and a fiat conversion will typically be required on both sides.

This also means that third-party service providers, such as a broker or crypto exchange, will be required to perform such a conversion, introducing credit and liquidity risks to the overall transaction. This is in addition to platform and regulatory risks.

Bitcoin’s extreme volatility means its price in both the payer and payee’s currency is permanently fluctuating, resulting in a high risk of loss to both parties, while its proof-of-work consensus mechanism is “inherently expensive and wasteful”.

On the plus side, the ECB gives praise to bitcoin’s single, global network that can operate “as is”, and its lack of intermediaries should the payer and payee be happy to transact only in bitcoin.

However, the lack of intermediaries also means that neither party is required to perform know your customer (KYC), AML/CTF checks, which the ECB said will ultimately be cracked down by regulators.

Stablecoins fare slightly better in the ECB’s estimations, given their stable purchasing power, higher efficiency and technology-agnostic qualities.

However, the ECB identified similar risks and frictions as with bitcoin. For example, the payer and/or payee may require fiat conversion in a cross-border stablecoin transaction, and may require a third-party platform to send and receive the funds.

Asset-backed stablecoins without audits or supervision also pose reserve and liquidity risks, in addition to currency substitution risks.

Even with additional regulation, it would be difficult to safeguard against a “run” on a stablecoin in the event of heavy selling by current holders.

In turn, this could also cause large sales of the collateral assets backing the stablecoin, and depending on the size of the stablecoin, this could have an impact on financial stability.

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