In this article, we will look at the second strategy to understand how cross border payments work: Grasp the principles of Correspondent Banking and account relationships between banks located in different currency zones.
In case you have not read the introductory article and the article about the first strategy, I strongly recommend you to read them so that you can easily connect the dots and understand cross border payments.
This is probably the most important of all the four strategies because at the end of day, payments is about moving funds and in cross border transfers, funds move through correspondent accounts. So grasping the principles of correspondent Banking and account relationships is absolutely essential. In this article, we will first look at payments systems in two countries. Then we will see how banks access systems of foreign countries. After that, we will analyse the account relationship and correspondent network. Then we will look at the different currencies and how they are grouped. We will conclude by looking at how banks use correspondent accounts with concrete examples.
Payments systems model for Credit transfers in France and the USA
Let’s start with the payments systems model for Credit transfers in France that we saw at the end of the previous article.
France belongs to a monetary zone, the Euro zone. EBA systems, CORE and TARGET2 are all denominated in Euro. If a Bank in France wants to send or receive USD or JPY, it is not possible through these systems. How then do French banks send and receive funds in other currencies? To understand how they do that, let’s first consider the payment systems for credit transfers in the USA.
This is a very simplified way to represent the payments systems in the USA. But this representation is enough for our needs.
As I said in the previous article, open loop payments systems are the most widespread in the world and they have many similarities. Payments systems for credit transfers in the USA provide an interesting proof. We see one RTGS system, Fedwire, which is operated by the Federal Reserve, the central bank in the USA. We also see two multilateral clearing systems: one is CHIPS which is used for high value payments and the other is ACH, which is used for retail payments. These systems are all denominated in USD. Impossible for a bank to send or receive another currency like EUR or JPY through one of them. In certain way, we can say that these systems know only the US Dollar. And like Banks in France, Banks in the USA do need to send funds in other currencies than the local currency. Banks do share the same needs in both countries.
Now let’s look at two payments systems located in two different countries: France and USA.
If a French Bank wants to send or receive US dollars, then it needs to get access to the USA payments systems. The same thing applies for a US Bank. If it wants to send or receive EUR, then it needs to get access to the EUR payments systems. And how do they do that? Simply by becoming customer of a Bank located in the monetary zone that they want to access. A bank, customer of another bank? This may sound weird for beginners. But that is the case. Look at the next figure that introduces correspondent account relationships.
Correspondent account relationships
The French Bank (Bank 5 on the picture) asks a US bank offering correspondent account services to open an account for itself. The US Bank (Bank E on the picture) may do the same, but it is not mandatory. We see on the picture that Bank 5 becomes an end party of Bank E and Bank E becomes an end party of Bank 5. (It is assumed that Both Bank 5 and Bank E offer correspondent account services).
[box type=”tick” style=”rounded”]Before opening an account, a bank must perform a vetting or KYC (Know Your Customer) process to check the identity and background of its future client and assess potential risks of illegal intentions for the new business relationship.[/box]
When the French bank opens an account with a bank in the USA, both banks enter into what is called correspondent account relationship. The bank in the USA becomes the correspondent of the french Bank in USD currency. The account is opened in the book of the bank in the USA, but it is the account of the french bank.
Unilateral and bilateral account relationship
If Bank 5 opens an account with Bank E, but Bank E does not open an account with Bank 5, then both enter into a unilateral account relationship. The relationship is unilateral because there is only one account opened. If each bank opens an account with the other then they will enter into a bilateral account relationship.
Now let’s consider the unilateral account relationship and its main characteristics.
Citi calls the BNPP account that it holds Vostro account. BNPP its account at Citi Nostro account. Note that it is the same account, but considered from different perspectives.
BNPP does open an account in his own book: the mirror account. The mirror account is there just to follow what is happening on the real account and manage liquidity. It does not contain real money. The BNPP account with Citi may receive thousands accounting entries. Why is it called mirror account? Because the account entries on the real account and on the mirror account are of same amount, but opposite signs. If the real account is debited, the mirror account is credited and vice versa. We will get back to this later.
[box type=”info” style=”rounded”]In many payment engine softwares, the mirror account is called Nostro account instead of mirror Nostro. The Nostro account is always in the books of the correspondent bank, never in own books. So a bank does not debit or credit its Nostro account. Its correspondent bank does.[/box]
Now let’s consider the bilateral account relationship and its main characteristics.
BNPP calls the account of Citi in its book Vostro account and its account at Citi Nostro account. Citi calls the account of BNPP in its book Vostro account and its account at BNPP Nostro account. BNPP opens the mirror account of its accout at Citi in its own books. Citi does the same for its account with BNPP. Important is to note that the same account are called Nostro or Vostro. It depends on the perspective of each bank.
The correspondent network
In the example above, we considered the setting up of an account relationship between two different monetary zones. A bank must do the same for all the currencies where it wants to have a correspondent account. There are around 180 currencies in the world. One of the first decision a bank must make in cross border payments is to determine the currencies it will handle. Like individuals and companies, a bank may open many accounts in the same currency.
[box type=”info” size=”large” style=”rounded”]The total number of currency accounts that a bank possesses in different currency zones is its correspondent network.[/box]
Currencies are not equal and are in general classified in three groups, decided by the trading volumes, liquidity and availability of the currencies: major currencies, minor currencies and exotic currencies (Source – forextraders.com)
These are the most traded currencies in the world: USD – U.S. Dollar, EUR- European Union Euro, JPY- Japanese Yen, GBP – U.K. Pound Sterling, CHF – Swiss Franc.
The banks offering cross border payments services will always have Nostro accounts in all major currencies.
They are classified into two groups : Commodity Currencies (AUD – Australian Dollar, CAD – Canadian Dollar, NZD – New Zealand Dollar) and Scandinavian Currencies (DKK – Danish Kroner, NOK – Norwegian Kroner, SEK – Swedish Krona)
The banks offering cross border payments services usually have Nostro accounts in all minor currencies.
This group consists of all the curencies not belonging to the other two groups. But it is important to understand that these currencies are called exotic because of the lack of liquidity in their foreign exchange markets, not because of the country’s location or size. Lack of liquidity means simply that you cannot buy or sell the currency whenever you want.
Exotic currencies include among others: BRL – Brazilian ReaL, CLP – ChiLean Peso, CNY – ChiNese Yuan, HKD – Hong Kong Dollar, INR – INdian Rupee, KRW – South Korean Won, MXN – MeXican Peso, RUB – Russian Federation RUBle, SGD – SinGapore Dollar, TRY – Turkish lira, ZAR – South African Rand.
A key factor to consider about an exotic currency is its convertibility, or the ability to easily change that currency into another one. There are fully convertible (e.g. MXN), partially convertible (i.e. INR) and non-convertible currency (e.g. CLP). The convertibility of a currency evolves. It is not static.
This is where you see differences between banks. In general, they will have correspondents in all fully convertible currencies. But they will choose to have correspondents only in some of the partially and non-convertible currencies.
Usage of the correspondent accounts
After opening a Nostro account with a correspondent, a direct deposit is required to credit the account. In a future article, we will see in detail how this happens. For now let’s consider, the account is opened and credited. How then will the Bank use its Nostro account and for what purpose?
The bank obviously puts own money on its Nostro account. But the bank also puts the funds of its customers who have accounts in the same currency on the same nostro account. There is a key rule in cross border payments which states:
When a customer opens an account in USD Dollar with BNPP, BNPP opens an account in its book in USD. But the (real) funds are kept on the Nostro account(s) in the USA. Again a Bank may open many accounts with the same or different banks in USD. If a customer or BNPP wants to transfer funds to a party in USD, BNPP will instruct the correspondent (Citi) to debit its account and credit the beneficiary account in the USA. On the other hand, if BNPP or one of its customer receives funds, then the BNPP Nostro account(s) in the USA will be credited. For customers, BNPP will ultimately ensure that the amount credited / debited is reflected on the customer account.
Let’s take another example: If BNPP sends USD to a German Bank (Deutsche Bank), BNPP will instruct its correspondent to debit its Nostro account and credit Deutsche Bank’s account with its correspondent in USD, so the account of another Bank in the USA. And if Deutsche Bank sends USD to BNPP, Deutsche Bank will instruct its correspondent in the USA to debit its Nostro account and credit the account of BNPP with Citi. These transfers will go through payments systems in the USA like other domestic transfers.
Now that we understand correspondent banking, account relationships and how accounts are used, the time has come to look at SWIFT and SWIFTNet; not to consider the message types :-), but to get the big picture. Why is the SWIFT Network so crucial and why are standards needed? The next article will provide answers to these questions and much more.