The Solution to Cross Border Payment Inefficiencies?

CBDC ARRANGEMENTS:

The Solution to Cross Border Payment Inefficiencies?

Kokila Alagh Founder, KARM Legal Consultants

Despite the unprecedented rise in cross-border trade and commerce, payments and funds transfers have been slow to catch up. Kokila Alagh Founder of KARM Legal Consultants examines whether distributed ledger technology based Central Bank Digital Currency (CBDC) arrangements between countries may solve issues including fragmented data formats, complex compliance checks and incongruent operating hours of payment systems across multiple jurisdictions

Cross Border Payments – Existing infrastructure and challenges

Current cross border payments infrastructure comprises multiple parties operating at disparate speeds to authenticate transactions. The banking sector remains webbed with the correspondent banks.

Correspondent banks hold deposits owned by other banks (respondents) and execute third party transactions on their behalf. Settlement between these institutions is facilitated by transactional messages transmitted over an encrypted financial network (think SWIFT), then relevant accounts are credited or debited. Such arrangements allow banks to maintain branches in multiple jurisdictions and have the ability to facilitate international payments.

Retail fintech applications created by non-banking institutions such as e-wallet services (HubPay and Tiqmo in UAE, etc.) and schemes such as the Asian WeChat Pay and AliPay, often rely on correspondent banking to provide foreign exchange and settlement services, losing transaction speed. Further, interbank settlement of cross-border card transactions relies on correspondent banking as well.

Challenges and issues

Some improvements are being made. Examples of this are the integration of synchronised domestic Real time Gross Settlement systems and harmonised API protocols for data exchange across payment infrastructures and jurisdictions (for instance, Nium). That said, most transactions are still facilitated through correspondent banks. These transactions face the following issues: 1. Cost: These include compliance costs, FX conversion rates and fees, fees along the payment chain and liquidity cost for prefunding. The

World Bank estimates the global weighted average cost for crossborder remittances of $200 to be 6.51%, making such remittances a costly affair. Additionally, for cardbased payments a fee of up to 10% is

charged as card issuer/ merchant fee and FX margin. 2. Transparency: Several API-centric innovations such as SWIFT GPI have enabled end-to-end tracking of payments. However, the lack of adoption and access to these innovations means that some transfers still suffer from opacity regarding total transaction cost.

Limited transparency also affects

AML/CFT checks.

Speed and synchronization (Liquidity and credit risk linked)

The dependence on several correspondents and intermediaries, asynchronous cut-off and opening times and regulatory checks all contribute to prolonged processing periods. Non-standardized messaging and processing formats slow down crossborder payments, as mapping and format conversions are required. Speed and cost effectiveness are both consequences of interoperability and standardization. The lack of instantaneous atomic settlement

and DvP (delivery versus payment, simultaneous and immediate settlement where transfer of one asset is conditional on the transfer of another asset) also results in counterparty credit risk i.e. the possibility that a loss will be experienced because of a default by the counterparty.

CBDCs and multi-CBDC arrangements

A CBDC can be defined as a digital payment instrument, denominated in the national fiat unit of account, the value of which is guaranteed by the central bank of that country. The conversation around CBDCs has gained momentum due to potential use of blockchain in speeding up transactions, although CBDCs may or not be blockchain based. Conceptually, a digital version of a national fiat currency can only be referred to as a CBDC if it is backed by a central or reserve bank of the said jurisdiction.

Several central banks have already started experimenting with cross border CBDC arrangements (for example: Project Jasper-Ubin between Singapore and Canada and Project mCBDC Bridge between Hong Kong, Thailand, China and UAE). Most of the current projects focus on the interlinking wholesale CBDCs, which are meant only for licensed financial institutions that hold reserve deposits with the central bank. Unlike retail CBDCs, wholesale CBDCs cannot be used for payments by individual users.

The Bank for International Settlements identifies three separate models for payment systems interoperability that can be associated with current CBDC projects:

1. Model 1 (Compatible CBDC

Systems): Revolves around creating uniform regulations and market practises across several jurisdictions.

This in turn reduces the friction present in the cross-border payments system caused due to different

AML/CTF compliances and data messaging standards through which transactional information is passed between financial institutions. From a technical standpoint, it involves reducing barriers to membership

through common messaging standards. Since this model does not require a technical interface to link various CBDC systems together, it is a cheaper albeit slower model when compared to the other m-CBDC arrangement models.

2. Model 2 (Interlinked CBDC

Systems): The most popular model amongst central banks that are currently considering incorporating interoperability features into their CBDC systems. Here, the CBDC systems of various jurisdictions are interlinked through technical interfaces or using common clearing mechanisms. For example, Project Jasper-Ubin uses

Hash Time-Locked Contracts to facilitate atomic transfers between two different DLT systems (Jasper in

Canada and Ubin in Singapore).

3.Model 3 (Multicurrency CBDC

Platform): Here, multiple CBDCs can be run on a single platform (for example: mCBDC Bridge and Project

Inthanon-LionRock). Such models explore the possibility of setting up international settlement platforms where central banks can utilise

CBDC for the execution of wholesale transactions. Such systems eliminate the need for banking relationships between certain countries as a single universal system will facilitate settlement and transfer of value.

Resolution of extant issues and frictions by CBDC arrangements

The advent of interoperable crossborder CBDC systems may help reduce inefficiencies and friction in crossborder payments and also help central banks achieve the targets set out by the G20 roadmap. 1. Cost: The correspondent banking model incurs network management costs and transaction fees charged by intermediaries. With CBDC models, the number of requisite parties in cross border payments reduces. Models 2 and 3 may help with disintermediation as parties can directly interact with each other. Model 1 may also help reduce back-office costs for error handling and reconciliation by prescribing standardized message/data formats.

Costs or premiums associated with counterparty credit risk may be reduced by atomic settlements. 2. Speed (Atomic Settlement): Due to the direct settlements over interlinked

CBDC platforms, payments will no longer need to be routed through several entities. Additionally, the presence of standardized messaging formats will facilitate fully automated processing. CBDCs can operate 24/7, addressing the issue of asynchronous operating hours. Further, atomic settlement could eliminate credit and liquidity risk arising from time lag between transfers. 3.Transparency: The presence of synchronized compatibility capabilities in Model 1, interlinking interfaces in Model 2, and single system of settlement in Model 3 enable enhanced visibility on prospective fees and estimated delivery time of funds prior to making the payment.

The interlinking of various digital ecosystems will enable direct transfer of standardized messages between the initiator and beneficiary, eliminating information gaps in the payment chain. Additionally, CBDCs could settle instantly, reducing the need for status updates.

Conclusion

While the cross-border payments and remittances industry continues to evolve, the underlying system that is used to facilitate these transactions still needs reinvigoration. By creating accessible and completely digital representations of sovereign backed value, most of the frictions can be removed. International integration and cooperation are crucial for the successful deployment of CBDC based international payments. If coordinated successfully, CBDCs in combination with other improvements might improve the cross-border payments ecosystem.

Millennials’ Preferences Driving the Future of Islamic Banking

Zeeshan Awan Head of Islamic Banking, National Bank of Fujairah makes the case for Islamic banks and finance providers as poised to benefit from the positive demographics of the Islamic World, while noting that to truly succeed, they will need to offer more than just technology

Despite the challenges posed by COVID-19, the Islamic economy continues to see robust year-on-year growth, propelled by emerging factors such as the rise of ethical consumption, digital connectivity, participation of top global brands, and the surge in trade among the countries of the Organization of Islamic Cooperation (OIC).

Younger customers are expected to play a crucial role in the growth of Islamic finance in terms of expanding its customer base in years to come. In an effort to appeal to this customer segment, Sharia-compliant banks have stepped up investments in the digital space to better match their expectations for a seamless banking experience.

Growing Customer Base

One of the key Islamic economy drivers is a young, large, fast-growing Muslim population. The Muslim demographic is one of the strongest demand-side drivers for the Islamic economy’s growth. According to the Pew Research Center’s Forum on Religion and Public Life, the global Muslim population reached 1.9 billion in 2019, and is expected to grow twice as fast as the overall world population, reaching 3 billion by 2060 (a 70% increase from 2015) and will represent 31.1% of the global population. The Pew Research Center estimates that the Muslim population will also remain predominantly young in 2050, with 60% aged between 15-59 and 24% under 15 years of age. To put this in perspective, only 16% of the Muslim population will be 60 and above in age in 2050 while the same age group in Europe will represent more than 28% of the region’s population according to a report by the State of the Global Islamic Economy.

Preference for Islamic banking

Islamic banking continues to outpace growth in comparison to conventional banking as Muslims and non-Muslims alike seek more ethical ways to bank and finance projects. According to a report by Fitch Rating in 2021, the UAE remains a key Islamic finance hub. Islamic financing

and deposits accounted for 29% and 26% of total sector financing and deposits, respectively, at end-2020. Growth in Islamic financing continued in 2020 (3.6%) against a contraction in conventional banking.

Accessibility is a key barrier for Millennials

According to a Finance and Faith report 2021, more than half of young Islamic finance customers would adopt Islamic banking if it were more accessible. The report illustrates the growing appeal of Islamic finance services around the world, as over half (53%) of young Muslims would choose Islamic banking, if barriers to entry were removed.

Future growth

To sustain the recent pace of growth, Islamic banks will have to be increasingly competitive in targeting new customer segments in novel ways.

Today’s millennial customers are techsavvy, geared towards ease, accessibility, and functionality and capturing this

discerning and demanding group is critical for Islamic banks in order to sustain their customer base. In a very short time, they will comprise the majority of financial consumers and influencers.

It is expected that Gen Z and millennials are going to be the key catalysts for growth of the banking sector. Millennials are a large demographic in the UAE and most banks are now targeting them.

While conventional banking leads the way in terms of technology adoption, Islamic finance is increasingly leveraging digital banking to reach out to younger customers.

National Bank of Fujairah’s Shariacompliant Islamic window, NBF Islamic, views technology as a key area of innovation and is making a series of investments to improve its services as well as increase its competitive edge. In 2020, NBF invested in new products and services as it looked to increase efficiency, help businesses overcome Covid-19 related constraints, and broaden its customer base. To date, more than 70 percent of the bank’s customers have transitioned from traditional to online banking, and in some processing areas, more than 90 per cent of transactions are now fully automated. NBF’s success in further leveraging technology during 2020 enhanced the group’s responsiveness and adaptability and complemented its growth strategy, especially during the pandemic when access to digital and online channels was key to delivering value.

NBF has been constantly offering innovative solutions to meet young

customers’ demands. As such, in 2018, NBF launched Ajyal, a tailor-made banking service aimed at supporting the financial needs and aspirations of the young Emiratis in the UAE. Built with tech-savvy customers in mind, Ajyal features the best-in-class digital banking experience. Consumers can register and open an account in just three simple steps with the NBF Instant app, taking less than a minute to become an Ajyal customer. Once onboarded, customers can enjoy easy online banking access with the NBF Direct app that’s quicker, more secure and hassle-free.

ACCORDING TO A FINANCE AND FAITH REPORT 2021, MORE THAN HALF OF YOUNG ISLAMIC FINANCE CUSTOMERS WOULD ADOPT ISLAMIC BANKING IF IT WERE MORE ACCESSIBLE

Zeeshan Awan, Head of Islamic Banking, National Bank of Fujairah

Affluent millennials

As an emerging affluent segment, choices made by millennials are expected to shape product development and invigorate innovation within Islamic finance for years to come.

Millennials will be the drivers of spending, investing and growth of the economy.

Many of the traditional Islamic banks recognize the need to innovate, where some are stepping up their investments in the digital space to cater to the crucial changing demographics. But capturing this wallet share will need to go beyond just technology and will need to focus on customer service and experience. Few businesses are sustainable over the long term if they rely on structural advantage alone. Digital banking is an integral component of the future and Islamic banks will need to be as good as others to maintain or increase their customer base and perhaps more importantly customer satisfaction.