The Business case for payments using Cryptocurrencies
What is it that cryptocurrencies can really do for cross border transactions ?
A lot of talk around blockchains and cryptocurrencies being used for payments is based on the idea that it will cut costs of transactions. The correspondent banking model where a payment remitter’s bank and the beneficiary’s bank work with their correspondent banks to settle a payment is expensive as each party involved not only have their own fees but the process is prone to operational inefficiencies and errors.
The illustration shows a typical funds flow through correspondent banks for a cross border payment. But how do the costs of a payment transaction stack up ?
The costs stack in the illustration above shows that liquidity and foreign exchange costs make up almost 50% of total cost of a cross border payment. The remaining 50% is made up of operations, compliance and claims related costs. If we consider blockchain platforms like Ripple that banks may be adopting to cut costs, they would most likely cut operational costs only.
The big opportunity and challenge for cryptocurrencies is to cut liquidity costs. This is the cost that settlement banks and dealers (that credit the beneficiary account in a payment transaction) incur by reserving cash for a settlement cycle. This cash reserve (marked as Nostro-Vostro liquidity in the illustration above) has an opportunity cost associated with it, which is passed on to the payment transaction. The opportunity cost would at least be equal to the overnight cost of funds. Either the remitter or the beneficiary pays this eventually. Such pre-financing of settlement accounts required by law is unlikely to go away. And since cryptocurrencies can not be used to pre-finance settlement accounts, the opportunity may be in using cryptocurrencies in offsetting the opportunity cost of setting aside or borrowing for the cash reserve required for pre-financing settlement accounts.
The above illustration shows how a cross border payment gets settled. Here, $125,000 is remitted which is settled in euros at an exchange rate of $1.17 to an euro. Since the amount remitted is not known at the beginning of a day, the recipient bank gets a liquidity provider to set aside a cash reserve, in this case, it is 300,000 euros. As the $124,986 remitted (net of fees by the remitting bank) is credited to the liquidity provider’s account in the correspondent bank, the equivalent amount in euros 1,06,826 is debited from the pre-financed cash reserve of the liquidity provider in the correspondent bank on the receiving side. And finally, 106,812 euros (net of fees charged by the beneficiary’s bank) is credited to the beneficiary account by its bank.
The fees charged for the transaction shown here can vary across different payment service providers. However, whatever the fees may be, a part of it is accounted for by the cost of maintaining the pre-financed account, in this case, 300,000 euros in the liquidity provider’s account. Given low interest rates in many advanced economies, the liquidity costs should be low. However, for economies such as China, India, Mexico and other countries that receive a majority of cross border consumer remittances, liquidity costs may still be high due to higher interest costs.
Now, such costs are common to all payment transactions — both debit transfers and credit transfers. Think of debit transfers as one way payments made, for example, for the payment of goods and services. Credit transfers are payments made for investments in and financing of beneficiaries where an IOU is created and repatriations of returns on investments are expected by the remitter / investor. In the case of credit transfers, exchange rate risks and associated losses may be far higher than the transactional costs themselves.
The case above illustrates how currency depreciation can cause losses in credit transfers. The example considers $30,000 sent in March 2018 to India when the Indian rupee was at INR 65 to USD 1. An equivalent amount of approximately INR 2 million was settled to the beneficiary that could be an investee or borrower. Although interest rates on the credit extended is shown at an attractive rate of 13% per year resulting in interest earnings of INR 127k in six months, the depreciation in the exchange rate to INR 71 to USD 1 by September 2018 causes a net loss of 3%. Net repatriations are only $29,000.
In the case of credit transfers, how can cryptocurrencies possibly cut losses ? There has been a lot of discussion lately around stable coins which are pegged cryptocurrencies. The peg could be to a major reserve currency such as the USD or to a basket of currencies. Can stable coins be possibly used as hedge against such exchange rate risks ? More than just the design of stable coins, the challenge is to integrate the use of stable coins in the way financial markets operate now.
However, it is probably safe to say that in both the case of debit transfers as well as credit transfers, cryptocurrencies need to be able to offset the opportunity cost of using fiat currencies that are used for settling payments and investment related transactions.
Disclosure : I am working on the design and implementation of a cryptocurrency protocol at Verified AG called the Via that imbibes some of these ideas in the article. The Via is a fiat collateralized cryptocurrency that is designed for transferring value between applications running on different blockchain platforms, hence the name Via. Please feel free to connect with me on twitter and subscribe to developments on Via.
