New Payment Rails
The greatest impact of cryptocurrency protocols like bitcoin will likely be their ability to radically streamline the transfer of value
A centralized model, rife with cost and complexity
The basic elements of the current process for value transfer across geographies have been in place for more than 150 years, since telegraph companies began ‘wire transfers’.
Today a similar process is still used for everything from large institutional transfers to settlement of retail payments. Nobody should be surprised that viable alternative networks for value transfer have now emerged in the shape of distributed payment systems, such as Bitcoin and Ripple. Existing intra-institutional systems for international payments and transfers that date back decades could be radically streamlined with significant benefits for individual customers and businesses.
The traditional system can be painful and costly: the sender asks their financial institution to transfer a given sum to the recipient using BIC or IBAN codes; the sending bank then sends a message to the recipient bank requesting transfer of the specified amount; once the recipient bank makes a request for funds, the sending bank will respond with the actual flow of funds. But that is not necessarily the end of the process – if the two banks don’t hold reciprocal accounts, the payment must go through a clearing house or correspondent bank. Funds can take several hours – or even days – to arrive in the receiver’s account.
So what next? Banks could take a forward-looking stance and leverage the source code for Bitcoin.
These factors mean decentralized or distributed currencies and mobile money solutions offer compelling alternatives to traditional value transfer. Distributed payment schemes, led by Bitcoin, don’t rely on a centralized counterparty but operate through cryptographic protocols in a ‘trustless environment’.
They offer an altogether simpler, faster and more efficient process, in which payment and settlement happen simultaneously within a closed system that is highly transparent to both sender and receiver. The complex process relied upon in the traditional method of value transfer makes the whole system potentially vulnerable to fraud.
But with distributed networks such as Bitcoin, it’s possible to trace a transaction back to the creation of each unit of value.
Industry collaboration at global level will be crucial to ensuring seamless connectivity for customers across such networks. Global settlement rails and emerging markets may offer the biggest alternative opportunities due to complex regulatory environments in developed local markets.
Looking to a fragmented future
Mobile money solutions and peer-to-peer value transfer networks do rely on a trusted central party but can be launched by any firm. Notable examples include schemes started by network operators (MPESA) and online retailers (PayPal). Transactions can be made in a fiat currency or another source of value issued by the central intermediary. The usefulness of such schemes depends on widespread adoption but MPESA, which allows users to make transfers via SMS, has shown their potential in developing nations where many people lack bank accounts.
So what next? Banks could take a forward-looking stance and leverage the source code for Bitcoin or adopt a protocol such as Ripple to improve on their current systems and protect their market. While limited user identification may be a weakness of Bitcoin at present, such a move by banks could solve this issue by ensuring only registered individuals could access the service. Financial institutions would then face decisions about whether they could pass on any efficiency savings to customers, after also taking into account potential extra costs associated with new risks.
Specifically, they may have to mitigate risks related to reputation, security and compliance as they utilize systems over which they are not in direct control.
Alternatively, banks could simply stick with their current processes, while decentralized systems grow in their own right as more people use them for P2P transfers and international payments. In this scenario, customers could end up with a choice of two parallel ecosystems and trust in traditional payment intermediaries could fall if newer alternatives prove more accurate and efficient.
The greatest impact of cryptocurrency protocols like bitcoin will likely be their ability to radically streamline the transfer of value.
Implications for financial institutions
Revised margin structure:
Margins on the current payment and settlement transactions will become restructured due to competitive pressure from alternative rails or efficiency gains from adopting those alterative rails, coupled with costs of managing new risks.
Global settlement rails and emerging markets may present the biggest opportunities for the development of alternative rails of payment and settlement given regulatory complexity in developed local markets.
Changing role of trusted intermediaries:
As alternative rails with a higher degree of accuracy and efficiency by design are implemented, the role of traditional intermediaries (e.g., payment networks) as a trusted party may diminish.