International payment system

What Is an International Payment System?

An international payment system refers to the complex network, rules, and procedures that facilitate the transfer of funds across national borders, forming a critical component of global Financial Systems. These systems enable individuals, businesses, and Financial Institutions to send and receive money in different currencies and jurisdictions. The primary goal of an international payment system is to ensure the secure, efficient, and timely movement of money worldwide, supporting global trade, investment, and remittances. Without robust international payment systems, the seamless flow of capital and the execution of Cross-Border Payments would be significantly hampered.

History and Origin

The evolution of international payment systems reflects centuries of global commerce. Early methods relied on physical transfers of precious metals or bills of exchange. The advent of telegraphy in the mid-19th century marked a significant step forward, enabling faster communication of payment instructions across continents. However, these early systems were often slow, prone to errors, and lacked standardization.¹⁸

A major turning point came with the establishment of the Society for Worldwide Interbank Financial Telecommunication (SWIFT) in 1973 by 239 banks from 15 countries.,¹⁷,¹⁶ Before SWIFT, banks relied heavily on the Telex system, which was manual, lacked standardized message formats, and offered minimal security.¹⁵ SWIFT was created as a cooperative utility to replace these cumbersome processes with a secure, standardized messaging network for financial transactions.¹⁴,¹³ The first SWIFT message was sent in 1977, and the system rapidly expanded, transforming how Commercial Banks communicate internationally.,¹² Concurrently, domestic systems evolved to handle international flows; for instance, the Clearing House Interbank Payments System (CHIPS) in the United States, developed in the late 1960s as an electronic replacement for a paper-based system, became a primary network for large-value domestic and international U.S. dollar payments.,¹¹

Key Takeaways

• An international payment system facilitates the transfer of funds across national borders between different currencies and jurisdictions.
• Key systems like SWIFT primarily transmit payment instructions, while actual money movement often occurs through Correspondent Banking relationships or clearing systems like CHIPS.
• These systems are crucial for global Trade Finance, international investment, and remittances.
• Challenges include regulatory complexity, currency conversion risks, high fees, and a lack of transparency.
• Future developments focus on enhancing speed, efficiency, and transparency, including the interlinking of fast payment systems and exploring Digital Currencies.

Formula and Calculation

International payment systems do not have a single overarching formula or calculation, as they are primarily infrastructures and networks for transmitting payment instructions and facilitating settlement. However, the costs associated with international payments can involve several components:

Where:

• Sending Bank Fee: A fee charged by the originating bank for processing the international transfer.
• Intermediary Bank Fees: Fees charged by any intermediate Financial Institutions involved in routing the payment, which can vary and often lack transparency.
• Receiving Bank Fee: A fee charged by the beneficiary's bank for receiving the international payment.
• FX Spread: The difference between the exchange rate at which the bank buys the foreign currency and the rate at which it sells it to the customer. This spread represents a significant component of the cost for Foreign Exchange transactions.

Effective Liquidity Management within these systems aims to reduce the total amount of funds that need to be physically transferred by using techniques like Multilateral Netting.

Interpreting the International Payment System

Interpreting the effectiveness and performance of an international payment system involves assessing several key factors:

• Speed: How quickly do funds reach the beneficiary? Traditional systems can take 1-5 business days, while newer initiatives aim for near real-time settlement.
• Cost: What are the total fees, including hidden charges and foreign exchange spreads, associated with a transaction? High costs disproportionately affect smaller transactions and remittances.
• Transparency: Can both the sender and receiver track the payment status and ascertain the final amount received? Lack of transparency remains a significant challenge.
• Reach: How many countries and Financial Institutions does the system connect? A broader network facilitates wider international commerce.
• Security and Risk Management: How robust are the measures against fraud, cyber-attacks, and illicit financial flows, including adherence to Anti-Money Laundering (AML) protocols?

Analyzing these aspects helps evaluate a system's efficiency, reliability, and its contribution to global Financial Stability.

Hypothetical Example

Consider a small business, "Global Gadgets," based in the United States, that needs to pay a supplier, "Tech Innovations," in Germany €50,000 for a shipment of electronic components.

1. Initiation: Global Gadgets' Commercial Bank in the U.S. receives the payment instruction.
2. SWIFT Message: The U.S. bank sends a SWIFT message to its correspondent bank in Germany (or directly to Tech Innovations' bank if they have a direct relationship). This message contains all necessary details: beneficiary name, account number, amount, currency, and SWIFT/BIC codes.
3. Currency Conversion: Since Global Gadgets pays in USD and Tech Innovations needs EUR, the U.S. bank or an intermediary bank performs the Foreign Exchange conversion. For instance, if the exchange rate is $1.08 USD per €1.00 EUR, Global Gadgets' account would be debited approximately $54,000, plus any transaction fees.
4. Settlement: The actual transfer of funds occurs between the banks involved. This might happen through CHIPS for the U.S. dollar leg and a European payment system like TARGET2 for the euro leg, or via their Correspondent Banking accounts with Central Banks.
5. Credit: Tech Innovations' bank credits €50,000 (minus any receiving bank fees) to their account, and the supplier receives confirmation of the payment. The entire process, depending on the systems and banks involved, could take anywhere from a few hours to a few business days.

Practical Applications

International payment systems are foundational to numerous aspects of the global economy:

• International Trade: Businesses rely on these systems to pay for imports and receive payments for exports, facilitating the exchange of goods and services across borders.
• Foreign Direct Investment (FDI): Large corporations use these systems for cross-border mergers, acquisitions, and establishing new operations in foreign countries, involving significant capital transfers.
• Remittances: Individuals send money to family members or friends in other countries, which is a vital source of income for many developing economies.
• Portfolio Investment: Investors utilize international payment systems to buy and sell foreign stocks, bonds, and other financial instruments.
• Financial Market Operations: Banks and other financial institutions use these systems for interbank lending, Foreign Exchange transactions, and settling securities trades globally.
• Regulatory Compliance: These systems incorporate mechanisms for screening transactions against Economic Sanctions lists and for reporting suspicious activities to combat illicit finance.
• Data and Analytics: The vast volume of transactions processed through systems like SWIFT provides valuable insights into global financial flows and economic trends. For instance, the global cross-border traditional and crypto payment market approached a value of about one quadrillion dollars in 2024, with payments predominantly concentrated in advanced economies and driven by financial institutions and large transactions.

L¹⁰imitations and Criticisms

Despite their critical role, international payment systems face several limitations and criticisms:

• Cost and Inefficiency: Transactions often involve multiple intermediary banks, leading to cumulative fees and foreign exchange markups that can be opaque and high, especially for smaller payments., The t⁹raditional correspondent banking model can be slow and costly.
• ⁸Speed and Transparency: While faster than historical methods, many international payments are not instantaneous. The lack of real-time tracking can create uncertainty for both senders and receivers regarding the exact time of arrival and the final amount.
• ⁷Regulatory Fragmentation: Each country has its own regulatory framework, leading to a complex web of compliance requirements (e.g., Anti-Money Laundering and Counter-Terrorism Financing checks) that can slow down processing and increase operational burden for Financial Institutions.
• ⁶Accessibility: Participation in some major international payment systems, like CHIPS, is limited to a relatively small number of very large banks, which means smaller institutions and individuals must rely on these participants as intermediaries, potentially increasing costs and reducing direct control.
• Vulnerability to Geopolitical Events: The reliance on centralized messaging networks like SWIFT makes them targets for Economic Sanctions, which can disrupt legitimate financial flows.

Addressing these limitations is a priority for Central Banks and international bodies, with efforts focused on enhancing speed, transparency, and interoperability.

International Payment System vs. Clearing and Settlement

While closely related, an international payment system and Clearing and Settlement represent different stages within the payment process.

An international payment system refers to the overarching infrastructure, networks, and agreements that enable the initiation and routing of payment instructions across borders. Systems like SWIFT are primarily messaging networks that transmit payment orders between banks, instructing them on how money should be transferred. It provides the "pipes" and "language" for global financial communication.

Clearing is the process of exchanging financial transaction information between financial institutions and determining the net obligations between them. For instance, if Bank A owes Bank B $100 and Bank B owes Bank A $70, clearing establishes that Bank A has a net obligation of $30 to Bank B. Systems like CHIPS utilize Multilateral Netting to aggregate and offset payment obligations among participants, reducing the number and value of individual transactions that need to be settled.,

Settlement is the final step where the actual transfer of funds occurs, discharging the obligations determined during clearing. This involves the movement of funds between bank accounts, typically held at Central Banks or through direct bilateral arrangements. A Real-Time Gross Settlement (RTGS) system settles each transaction individually and immediately, while net settlement systems settle the net obligations at designated times. CHIPS, for example, is a net settlement system that settles a large volume of U.S. dollar payments daily.,

In e⁵ssence, an international payment system facilitates the communication of the payment order, while clearing and settlement are the operational steps that calculate and finalize the transfer of the actual funds.

FAQs

How does SWIFT fit into an international payment system?

SWIFT (Society for Worldwide Interbank Financial Telecommunication) is a crucial part of the global international payment system. It provides a secure messaging network that banks use to send and receive information about financial transactions, such as payment orders. SWIFT does not hold or transfer funds itself; it only transmits the instructions. The actual movement of money happens through other channels, often involving Correspondent Banking relationships.

⁴What are the main challenges faced by international payment systems today?

Current challenges include the high cost of transactions due to multiple intermediaries and Foreign Exchange spreads, slow settlement times compared to domestic payments, lack of transparency regarding fees and payment status, and the complexity arising from diverse regulatory requirements across countries, including Anti-Money Laundering rules.

³Are there alternatives to the traditional international payment systems like SWIFT?

Yes, efforts are underway to develop alternatives and enhance existing systems. These include the interlinking of domestic fast payment systems to enable faster Cross-Border Payments, the exploration of central bank Digital Currencies (CBDCs) for cross-border transactions, and distributed ledger technology (DLT) based solutions. For example, the Bank for International Settlements (BIS) has supported initiatives like mBridge, which aims to facilitate real-time transactions using CBDCs and reduce settlement delays significantly.,[¹]²(https://www.fintech.gov.pl/en/component/content/article/bis-published-a-report-regarding-testing-of-a-cbdc-platform-for-international-paymen?catid=19:aktualnosciartykulyen&Itemid=101)