Cross-border payments and CBDC: The future of global financial transactions

Cross-border payments refer to financial transactions between individuals, businesses, or institutions in different countries. These transactions involve the movement of funds across international borders and are usually facilitated by banks and payment service providers. Cross-border payments are often a bane for your international customers and drain your institution's efficiency. We all know the problem– slow transfers, horrendous fees, and a tangled web of regulations. But what if there was a way to streamline the process, slash costs, and revolutionize global transactions? Enter Central Bank Digital Currencies (CBDCs) In today's interconnected world, cross-border payments have become an essential component of international trade and finance. As technology continues to advance, the financial industry is exploring new ways to improve the efficiency and security of these transactions. The emergence of Central Bank Digital Currencies (CBDCs) has gained momentum in recent years. Let’s delve into the potential impact of CBDCs on the global financial landscape.

Central Bank Digital Currencies (CBDCs) - A potential game-changer for cross-border payments

Let’s look at some of the key features of CBDCs.

• Digital fiat currency: CBDCs are digital forms of fiat currency issued by central banks. These are digital versions of the government-issued money we already use that is not pegged to a physical good like gold.
• Central bank backing: Unlike cryptocurrencies such as Bitcoin, CBDCs are regulated by central authorities and aim to combine the benefits of digital technology with the stability of traditional fiat currencies.
• Blending innovation and tradition: They are designed to offer the convenience and speed of digital transactions while maintaining the trust associated with traditional currencies.

In the current literature, there is a tendency to confuse CBDC with payment systems like UPI (in India). One is a digital form of money, while the other is a platform to transfer money between accounts in real time.

CBDC is like a digital banknote which can be used by:

• The public (retail CBDC) pay each other and to shops/businesses.
OR
• It can be used between financial institutions (wholesale CBDC) to settle trade transactions.

In this blog, we will focus on CBDC’s effect on the efficiency of cross border payments.

Cross border payment challenges

According to a WTO report, the market for cross–border payments will reach a value of 250 trillion dollars by 2027.With such a huge market, conventional cross-border payments using traditional correspondent bank arrangement often face challenges such as:

• >High costs
• Lengthy processing times
• Complex intermediaries
• Impairment of cross-border fund flow

While significant progress has been made, the cost of cross-border payments has declined considerably. In fact, according to a report by BIS, the global average cost of sending remittances was still around 6.3% in Q2 2021 with delays ranging to around 4-5 days.

Potential of Central Bank Digital Currencies (CBDCs)

According to a World Economic Forum report, on the domestic front, evaluating CBDCs serves multiple objectives, including:

1. Promoting financial inclusion
2. Improving payment systems
3. Minimizing dependence on cash
4. Bolstering monetary policy effectiveness
5. Addressing the challenges posed by private cryptocurrencies

Moreover, the global proliferation of Central Bank Digital Currency (CBDC) pilots for cross-border payments is primarily driven by the goal of reducing transaction costs due to economies of scale and network benefits and improving the efficiency of cross-border payments.

Imagine— no more waiting days for your international payment to clear. Transactions are processed in seconds, just like sending a text message. Several pilot programs for cross-border payments with CBDC are currently running worldwide.

1. Project Aber in the Middle East where they are testing a joint digital currency for both local and international payments.
2. SWIFT, the big bank messaging system, is experimenting with CBDC transfers. The early signs are positive – they have found interoperability between the new digital currencies and existing systems. This paves the way for a scalable solution that is compatible with any domestic payment system and makes CBDC networks fit for cross-border payments.
3. Project Inthanon-Lion Rock, a joint initiative of the Bank of Thailand and Hong Kong Monetary Authority, explored CBDC for cross-border payments and successfully completed a cross-border payment within seconds.

Even though these preliminary tests only involved a limited number of transactions and controlled conditions, they successfully demonstrated the potential for fast cross-border payments with CBDCs. Further research will explore how to maintain this efficiency when handling larger volumes of transactions on a global scale.

Moreover, it's not just about tech; countries tend to take different approaches while setting up CBDCs. While one option is for the central bank to handle everything directly, another option is to involve banks and payment companies. Which approach is best depends on each country's situation.

From an operating model perspective, three CBDC concepts are being considered:

• Direct or single-tier model entrusts all responsibilities are entrusted to the central bank, which has the knowledge and resources to maintain the entire system.
• The indirect or two-tier model, the more popular one, involves commercial banks or payment service providers (PSP) issuing CBDC backed by the central bank.
• The hybrid model involves both the central bank and PSP in CBDC issuance. The model choice depends on the region's social and technological conditions and the market dynamics.

Building a secure and connected future with CBDC

CBDCs offer exciting opportunities but like any other digital currency, a CBDC is vulnerable to cyberattacks, fraud, and operational disruptions that can hinder the functioning of the financial system. To ensure their smooth operation and increase trust, robust security measures and resilient protocols must be a priority.

Currently, there is no universally recognized framework for CBDC interoperability, which is why the development of interoperability frameworks, such as ISO 20022 and common blockchain standards, is happening at a rapid pace. This will steer the implementation of CBDCs in the right direction to work together seamlessly and pave the way to a more efficient and interconnected global financial system. These frameworks have been developed with foreign exchange regulations, settlement procedures, and user privacy, thus ensuring smooth cross-border transactions while upholding compliance.

Furthermore, user privacy is paramount in building trust and adoption of CBDCs and systemsIn addition, protecting user privacy is paramount to building trust and acceptance of CBDCs and systems must be equipped with strong data protection measures. User information must be handled securely, adhering to relevant laws and regulations. This ensures that user data is only shared with authorized parties and is not used for purposes other than those to which users have explicitly consented.

Conclusion

According to the CBDC tracker, around 130 countries, constituting 98% of the global GDP, are actively exploring and advancing in various stages of pilot projects related to Central Bank Digital Currencies (CBDCs). The ongoing CBDC pilots around the world have yielded invaluable lessons that are insights, applicable on a global scale. The key takeaways in these pilots include:

1. Having a clear purpose for CBDC implementation,
2. Making informed choices regarding the underlying technology,
3. Aligning with regulatory frameworks,
4. Ensuring seamless integration with existing payment solutions,
5. Prioritizing user experience and accessibility,
6. Fostering public confidence and trust,
7. Inculcating public-private collaboration in CBDC development, and
8. Emphasizing interoperability.

In this dynamic CBDC landscape, these times are exciting, marking a transformative era in the evolution of global finance. Nagarro, with its team of experienced domain and technology consultants and expertise in areas like design thinking, product lifecycle management, agile development, blockchain, security audits, qauality assurance can help ideate and create applications for commercial banks and PSP’s, conduct interoperability testing and pilots with financial institutions and provide post-deployment support.

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