Distributed ledger technology and blockchain can help countries faced with the closure of correspondent banking accounts, but coordination, cooperation and governance will matter more than technology.
For many banks, businesses and individuals—from the Pacific Islands to the Caribbean—transferring money across international borders has become more difficult. This is the result of a phenomenon known as ‘de-risking’, defined as the closure of correspondent accounts maintained with large international banks in the name of local banks from low and middle-income countries. The latter need correspondent accounts to process cross-border transactions in a foreign currency for their clients, which include businesses, individuals, non-profit organizations and money-transfer operators.
According to our research, The Decline in Access to Correspondent Banking Services in Emerging Markets: Trends, Impacts, and Solutions, the impact of de-risking has been felt unevenly. Nearly all jurisdictions surveyed have observed cases of de-risking. The situation is particularly acute in small island states, several of which face the possibility of being cut off from the global financial system. Even if the impact is not so drastic, any reduction of correspondent banking relationships (CBRs) is likely to have a negative impact on local markets. Fewer correspondents means lower competition, which leads to higher fees charged by the remaining correspondent banks. While these higher fees are largely absorbed by the financial institutions themselves, we have recorded cases where they have been passed on to the customer. Reliance on a single correspondent bank may also introduce potential systemic risks to the local market.
De-risking is most often associated with more stringent requirements for compliance checks and customer due diligence (CDD) information. For instance, some correspondent banks require that their respondents ‘know their customers’ customer’ (KYCC). The Financial Crimes Enforcement Network (FinCEN) and the Financial Action Task Force (FATF) have expressed strong views against ‘blanket de-risking’. FATF has confirmed that there is no obligation to perform KYCC checks. However, many financial institutions have concluded that the time and cost of providing regulators with detailed information about the correspondent banking business and making necessary adjustments based on their guidance far outweighs the modest revenue of CBRs.
International migrants remitting funds to their home countries are most impacted by de-risking. Since most migrants do not have bank accounts or consider bank transfers too costly, they rely on money transfer operators (MTOs) to send and receive money. MTOs, however, are often affected by ‘blanket’ de-risking because of perceptions that they are inherently risky. To maintain low prices, MTOs prefund their accounts in various currencies and use correspondent accounts for periodic netting operations. Further, the remittances are often disbursed in cash. Consequently, banks maintaining MTOs’ accounts cannot reliably associate their cross-border transfer to any particular remittance transaction or source of funds.
Could FinTech be a Solution to De-risking?
Customers, bankers and policymakers affected by de-risking have looked to FinTech as a potential solution to their problems. The early attempts, however, were not entirely successful.
Great hopes were associated with crypto-assets such as bitcoin. One of the first successful use cases of bitcoin was instant money transfers. Capital controls and systemic banking problems restrict traditional cross-border transaction channels and have led to consideration of crypto-assets as a ‘bridge currency’.
For example, a person transferring money from the United States to India could use their holdings in dollars to buy the equivalent in bitcoins. The bitcoins could then be seamlessly transferred using a cryptographic signature from the electronic wallet of the sender to the wallet of the recipient. The recipient would then exchange the bitcoins into rupees. Enthusiasts of this approach pointed out that, because of the unregulated nature of the peer-to-peer bitcoin network, transferring funds in this way would be immune to any de-risking measures. In fact, it would make the entire network of correspondent banks redundant and obsolete.
However, as cryptocurrencies are often associated with illicit use, requirements have frequently exceeded those imposed on mainstream financial institutions. While the bitcoin protocol and network are not regulated, this is not the case for ‘cryptocurrency exchanges’—the points where dollars, or any other currency get bought or sold in exchange for crypto-asset holdings. Regulators have quickly understood the need to impose the same or greater KYC requirements, as well as the need to account for financial integrity risks. Certain countries have introduced a complete ban on cryptocurrency exchanges or have prohibited regulated financial institutions from providing services to the crypto-asset ecosystem. A few encouraging examples, such as BitPesa—a service enabling money transfers to and from Nigeria, Uganda and Tanzania using bitcoin and other crypto-assets for the cross-border leg settlement—remain vulnerable to the extension of capital controls and other regulatory measures.
Cryptocurrencies, such as Ripple’s XRP or Stellar’s Lumens, have embedded AML/CFT compliance in their design but have not been able to scale up. Limited pools of liquidity on both the sending and receiving ends, coupled with the high volatility of their exchange rates, further diminished their appeal as a solution to the challenges of cross-border money transfers. This could change though. Solutions based on crypto-assets also remain one of the few possibilities for reducing reliance on global reserve currencies for setting exchange rates between currency pairs of limited trade volume.
While crypto-assets are considered of limited utility, the distributed ledger technology (DLT) underpinning them may offer potential solutions to the de-risking problem. These lay in the inherent qualities of DLT: immutability and the distributed nature of the ledger. Immutability means that data saved into the database cannot be retroactively modified or tampered with. This makes DLT-based solutions a good fit for use cases where an undisputed record of past transactions or other modifications to the state of the ledger needs to be preserved. The distributed nature of the database means that no single party holds complete control of all the data.
A distributed, immutable database may dramatically lower the cost of compliance by providing an efficient method of accessing CDD information—also at the level of individual transactions. It could begin with the launch of a shared CDD information repository, where records of compliance checks performed on businesses and individuals, attested by trustworthy financial institutions, could be saved and shared. In this way, the CDD profile of a person authenticated and approved by Bank A would not have to be re-evaluated by Bank B.
However, while using DLT may ensure that CDD records are not tampered with, the system remains vulnerable at the point of data entry. If agents of an MTO decide to accept fraudulent or incomplete documentation to conduct a transaction, other institutions making use of the same CDD profile will also be compromised. To prevent that, it is vital that the CDD repositories are connected to a digitised national ID infrastructure; this development could also lead to further reduction in the cost of compliance by automatizing the process of checking ID credentials.
Availability of a shared CDD repository could enable sharing of compliance information at the level of individual transactions, enabling participating financial institutions to readily make risk-based decisions on whether a transaction should be approved. For instance, a correspondent bank providing services to an MTO could access the CDD profiles and transaction histories of all the senders and recipients of the international money transfers, as well as the agents facilitating their cash-in and cash-out.
While technology allowing DLT-based shared CDD repositories and connecting CDD profiles to live transactions is available, its implementation depends on the availability of infrastructure, IT talent and robust security precautions to ensure data protection. Any implementation will also need to be complemented by sound governance, institutions and enabling regulations. National authorities will have to make decisions on whether the infrastructure powering such services should be run by private entities, consortia of banks and other financial institutions, or public entities such as central banks. The Bank of Mexico, for example, is launching a database of all foreign transfers performed in and out of the country, which could be queried by all banks for the purpose of client risk profiling. Criteria for participation should be established in a way that maintains high levels of compliance and trust, but does not exclude new entrants from the market. Finally, the choice of information on individual transactions that is to be shared on the DLT should be carefully evaluated so that no financial institution is given undue competitive advantage by being granted access to privileged data.
Any DLT-based solution must foster inclusion. In this context, existing DLT pilots for cross-border transactions must be viewed with caution, as their participants are often limited to large international banks. Regulators should ensure that participation in technological consortia is not leveraged to entrench monopolies. In this context, it is important to recognise initiatives such as the SWIFT global payments initiative (GPI), which plans to integrate the potential of DLT technologies within the framework of systems that are already used by most financial institutions around the world.
The World Bank Group is working to contribute to building inclusive DLT-based solutions for cross-border transfers. Our Technology and Innovations Lab works with the FinTech industry, academic communities, governments and other international organisations to use DLT to tackle the most important development challenges and harness the power of technology to benefit the poor. We expect to see the first results of DLT pilots by the end of 2018.
While DLT will not be a panacea for all problems associated with de-risking, the advent of this new technology offers a great opportunity to rethink the architecture of cross-border payment flows, increasing inclusion while maintaining robust compliance. We are excited to be part of it.
Senior Director, Finance, Competitiveness and Innovation Global Practice