Blockchain technology reinvents correspondent banking – just not yet

Correspondent banks are in retreat: here is why

As the Bank for International Settlements stated in a recent paper, the number of correspondent banks are in decline. The latest global financial crisis as well as various money laundering scandals have caused regulations to increase dramatically, which in turn has bid up costs of operating correspondent banking services. Especially the burden of disclosure requirements as well as other operative costs has become too great, especially for smaller banks, which is why the number of correspondent banking relationships has gone down in recent years.

From the point of view of a globalised world economy, this is a cause for concern, since correspondent banking systems are essential components of the global payment system that ensures cross-border payment traffic. Intact and numerous correspondent banking relationships are important for globally functioning payment rails because there is currently no uniform and global infrastructure for the clearing and settlement of financial transactions.

Although the number of correspondent banking relationships is decreasing, the complexity of the correspondent banking system has hardly diminished. Interdependencies are still strong and payment rails opaque, making the system as a whole inefficient. Inefficiencies also stem from the fact that – especially in the era dominated by the US – the system is less of a correspondent banking network and more of a pyramid with enormous power asymmetries. Time and again, smaller banks are denied access without any objective justification. For countries that are attached to a single correspondent bank, such a cut-off can be severe.

Will blockchain come to the rescue and represent a new business model for banks?

With these rising challenges in correspondent banking, new approaches and solutions are increasingly being discussed. One of the more prominent of these is blockchain technology. A blockchain can be understood in this context as a decentralised settlement infrastructure that enables real-time clearing and settlement of transactions.

Because of its decentralised, open ledger, transactions on a public and permissionless blockchain can be viewed transparently by anyone at any time. Transactions are not only settled instantaneously and with instant finality, there’s also no direct intermediaries involved in settling value. Establishing trust in the integrity of a counterparty through a dedicated intermediary, as required by the traditional financial system, is not a prerequisite to a blockchain. The traceability and immutability offered by blockchain technology create synergies and efficiency and can reduce dependencies and costs in today’s correspondent banking system.

Instant settlement is going to free up liquidity and make cross-border banking more efficient

What exactly could the efficiency and cost gains look like? Since there is currently no final settlement in real time, unsettled transactions in the traditional correspondent banking system have to be hedged properly. This ties up liquidity but does not prevent participants from being exposed to counterparty risk in the first place. If this liquidity were freed up, it would greatly improve efficiency.

Real-time settlement, as made possible by blockchain technology, can minimise counterparty risks. Moreover, because transactions are executed instantaneously and with instant finality, there is no need for a correspondent bank to park liquidity in order to hedge their activities. This has the effect of reducing complexity and therefore promoting efficiency in the system. Using a blockchain can also increase security in a system with many different non-trusting players, as it entails fewer single points of failure.

Because settlement is instant on a blockchain, relationships between transacting parties is not merely built on book values. This lends itself to a new form of trust built among involved players. Consequently, cost savings on the operational side of business ensue.

Faster, cheaper and more secure on the blockchain

Blockchain technology also has great potential in payment information transfer, specifically in the area of data management. For example, it increases the ability to trace and thus validate data. When considering the high error-proneness of existing systems such as SWIFT, this feature of a blockchain is promising as well.

However, improved payment information transmission is one thing. The other is faster, cheaper, and more secure transactions enabled by blockchain technology. For instance, microtransactions come to mind that open up new business models for banks. Taken together, improved transactions speed as well as enhanced payment information transmission allow for a large increase in efficiency.

Depending on how applications are designed, transactions on a blockchain are easily traceable. As a matter of fact, this makes it possible that correspondent banks can enter new ways of collaborating with regulators. Also, synergies among banks working closely with law enforcement when it comes to KYC and AML can potentially be enhanced. So, in the eyes of regulatory bodies: What’s not to like about this blockchain technology that gives them potentially more collaborative control in the area of money laundering and counterterrorism, one might ask?

What is holding blockchain’s rubber back from hitting the road?

The obvious question that arises: If blockchain is so much better, why hasn’t it caught on yet? One of the main reasons is that it still lacks scalability. Cheaper costs, fast and instantaneous transactions are indeed a property of a blockchain, but not necessarily on its base layer. Current blockchain implementations do not meet the demands of current global payments. The technology is not yet mature enough to handle the tens of millions of payments required each day. However, scaling solutions of all kinds should gradually eliminate this bottleneck over the next few years.

There is not only a technical deficit, but also a knowledge deficit today. Blockchain technology is based on a completely different substructure than the traditional systems people have been working with up until now. A number of functionalities in the area of peer-to-peer payments or custody still need to be understood better by the relevant people in charge. Only then corresponding risks can be adequately assessed and provided for.

Correspondent banking on the blockchain is up against established power asymmetries

One of the main reasons why blockchain technology is having a hard time gaining acceptance is the current power asymmetries present in correspondent banking relations. Although blockchain could break up larger correspondent banking chains into smaller peer-to-peer setups, states, but also the respective banks at the top of the correspondent banking pyramid acting on government’s behalf, do not want to give up their monopoly or oligopoly position. This is why a disintermediating technology like blockchain has an incredibly hard time gaining a foothold in this area.

One concrete example of this power struggle is showcased by what Ripple, a private corresponding banking solution has gone up against. After several players joined this globally rolled out system, they were threatened by the central authorities to have their functioning correspondent banking relationship in the traditional system terminated if they were to continue operating on the Ripple network. This goes to show: Because of challenges like these, current blockchain-based correspondent banking solutions have not caught on.

From a pragmatic point of view, it seems highly likely that if blockchain technology is implemented into correspondent banking systems, they will be introduced in the form of private or consortium blockchains. They offer better control mechanisms as well as privacy, since complete transparency is not in the interest of the participants. While these solutions allow for the implementation of access rights, private blockchain solutions also make it possible to circumvent the scalability issue haunting public blockchains to this day.

Blockchain’s biggest chance of success in correspondent banking is linked to the arrival of CBDCs

The way these private or consortium solutions could be implemented is by introducing so-called central bank digital currencies (CBDCs). It is likely that upcoming innovations in the correspondent banking system, if any, will be driven by new CBDCs and their different implementations. After all, these CBDCs will be promoted by government agencies. This creates trust and makes inclusion into the traditional financial system way more likely.

Trust is something current solutions like private stablecoins are lacking. Also, with stablecoins that ultimately track the currency units issued by central banks, there is always an intermediary involved that needs to be trusted to keep a stablecoin’s value close to the peg – and ultimately will be a driver of costs. CBDCs don’t have this problem as they are directly issued by central banks with no counterparty in-between.

Today’s expectations are that with CBDCs, there will exist the possibility that foreign currencies can be seamlessly and smoothly converted into local currencies via central banks or large banks acting on their behalf. Such a setup can ultimately ensure that controlling and supervisory entities are introduced that can make sure required quality standards are met by all players involved.

This article is based on Jonas Gantenbein’s master thesis “Blockchain as a revolution of the cross-border correspondent banking system” at the University of Applied Sciences OST (formerly UAS St. Gallen).