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Although Ripple has been consistently hit in recent years by SEC-led lawsuits and we don’t know what the final outcome of this lawsuit will be, it’s worth taking a look at Ripple Labs system and products.
For this purpose, it is also necessary to expand the scope in connection with today’s payment systems (e.g. Fedwire,…) and financial messaging networks (e.g. SWIFT) and thus to show a more comprehensible view of Ripple and its possibilities.
The topics of payments and financial messaging are just as relevant as understanding the mechanism that allows money to be transferred internationally from one place to another in the current world.
In this first article, we look at today’s traditional payment systems in the context of domestic and international payments. We will also look at the challenges and related opportunities that arise for the rapidly growing fintech sector.
In the second post, we will focus on Ripple and take a closer look at the business case of Ripple Labs.
Today’s Banking System and Payment Transactions
We do not base ourselves on explaining how the banking system works but on how the current payment system is structured. Here, banks play an important role, as do other components of the economic system such as payment products and -provider, clearing houses, and central banks. Country regulators and forms of payment must also be taken into account in addition to the distinction between national and international payment transactions.
Since one of the first and essential use cases in crypto was the transmission of payments without the involvement of a third trusted intermediary (a bank), it makes sense to think about today’s traditional payment universe.
This is especially true since Ripple has made many efforts in this area to bridge the gap between crypto and the banking world.
Payment Systems
Efficient payment systems are essential for a well-functioning economy.
As mentioned earlier, a distinction must also be made between domestic and international payments. Whereas domestic payments are usually processed using country-specific payment systems and -methods. SWIFT is the current choice for cross-border payments as means of communication to connect two country related payment systems.
An attempt to describe a payment system can be as done by Gary Gensler in one of his MIT lectures, and for me, it is a very plausible as well as generally valid and usable explanation.
” A Method to amend and record entries on Ledgers for Money authorizing, clearing and recording final settlement.”
The parties involved in such payment systems are usually
- Central banks
- Commercial banks
- Commercial and retail clients
with these, payment systems being the domain of the central banks.
A distinction must be made between systems managed by the central bank itself, such as Fedwire in the USA, and those managed by bank consortia, such as SIC and Euro SIC (Swiss Interbank Clearing) or the clearing system of Swiss Post.
However, they have one thing in common. All payment systems are subject to the respective regulation of the corresponding central bank.
But how does a Payment Transaction work?
Consumer instructs his bank (issuing bank) with a payment instruction to transfer a certain amount to a beneficiary. It does not matter if the beneficiary is a merchant or another private person.
Explanation: It does not matter which payment instrument is used for a purchase or a transfer because behind the scenes a payment instruction is always given to the bank to transfer a certain amount from the issuing bank to the merchant bank.
There is a network between the issuing and merchant bank which enables the transfer. These payment service providers could be credit card providers like VISA, Mastercard, or other networks like ACH, SIC, or SEPA.
At the other end is the merchant or consumer, who usually has to be connected to the bank or acquirer through a bank account, POS, or e-commerce gateway.
Value and Time
In addition to the amount debited on one side and credited on the other, the time needed for such a transfer to take place and be available to the beneficiary for further use is also relevant.
In the digital world, there are still delays between debiting and crediting of a sum of money. They can vary depending on the payment method, system. For example, in SEPA, banks have time to process payments within 48 hours. SWIFT can take between 3-5 days for a transaction.
The challenge of getting closer and closer to real-time processing of payments is not trivial and has been occupying the payments world for some time. Cryptocurrencies and their systems, such as Ripple, can help here. But more on this later.
If we now take the above diagram and expand it, we get the following result.
In the last 20 years, the digital wallet layer has been added, as well as cryptocurrencies. This brings me back to the use case I mentioned at the beginning, which is also described in the Bitcoin whitepaper.
At best, cryptocurrencies can compensate for some of the inefficiencies of today’s payment systems.
Three essential elements of payment systems
These three elements are Messaging, Clearing and Settlement (see also the drawing payment systems above).
The following subdivision serves not only to better understand the elements of a payment system but also to differentiate between the many providers in the payment field. Providers can offer one or more elements.
For example, SWIFT is a messaging provider. Neither clearing nor settlement is performed by SWIFT.
CHIPS, STEP1 and STEP2, EURO1 in SEPA provide message processing and clearing.
National Settlement Service provides Settlement in the USA.
CHAPS and Fedwire provide messaging, clearing and settlement
Messaging System
Please find below a graphical landscape of message families and possible categorization in order to get a better overview of messaging.
Clearing System
Settlement System
While clearing refers to reconciliation and netting, settlement is the mechanism that moves funds from one account to another. There are different settlement systems, the Net Settlement System, RTGS, and RTFS. The net settlement has already been explained in connection with the clearing system above. Let’s take a closer look at the RTGS and RTFS.
Real Time Gross Settlements (RTGS)
No netting is done and each transaction is settled individually within RTGS. This System is used for urgent- and also for high-value transfers. Transactions are near real-time (not 100% real time). Settlement can take place relatively quickly. There can’t be an offsetting of incoming and outgoing money flows between two banks due to the proximity to real-time.
RTGS is used for large amounts. Examples of such RTGS systems are:
- Fed Wire, UK CHAPS; Target, CNAPS HVPS (whereas operational hours are limited)
- SWIFT (Society for Worldwide Interbank Financial Telecommunications, facilitates interbank payment messaging)
At this point, we would like to briefly mention ongoing efforts related to Real Time Retail “Instant” Payment Systems. These include:
- Australia NPP, China IBPS, Eurozone TIPS, India NEFT, Japan Zengin, Mexico SPEI, UK FPS
- In USA there are the Projects of ” The Clearing House Real-Time Network” and with Fedwire the “FedNow Service”
Real Time Final Settlements (RTFS)
Cross-Border Payments and SWIFT
Now we have so far looked at the payment systems within a country or defined zone but what about cross-border payments?
It already becomes more complex. In addition to the distances and different currencies, one also has to deal with the issues of trust and the size of the participating instances. Likewise, one must consider how a payment done in a US payment system can be transferred to the payment system used in the Europe in order to pay a beneficiary there. For international payments to work well, the following conditions must be met:
- There must be a network of correspondent or intermediary banks
- The currencies must be freely convertible
- A communication system for the global processing of payments must exist.
Correspondent Bank
The correspondent bank, on the other hand, acts as a middleman for the issuing and receiving bank, including different currencies. The banks involved are also located in different countries. They can also offer more services than an Intermediary Bank.
Free Convertible Currency
The currency must be freely tradable and freely transferable from one country to another. This is not a problem with currencies like USD or EUR. However, this is not the case with every currency. For example, the Chinese have a separate currency for domestic payments and another for cross-border payments. Other examples are the Taiwanese Dollar or the Brazilian Real which are not allowed to be freely imported and exported into the country.
Communication System (e.g. SWIFT)
SWIFT stands for Society for Worldwide Interbank Financial Telecommunication. The SWIFT network was established by banks for the exchange of messages. It enables efficient international payment transactions by exchanging messages quickly and securely between the participating banks and the payments systems in their countries.
Only standardized messages in the form of instructions or information are sent to the recipients bank via the network. No money is transmitted. This means that the settlement is in the responsibility of the banks themselves.
Swift knows two order types “normal priority” and ” high priority” in the area of payments.
SWIFT messages are not only used in the area of payments but also for other areas as briefly listed below.
SWIFT NET FIN (MT messages)
| Message Type | Area/Function |
|---|---|
| MT0nn | System Messages (SWIFT GPA) |
| MT1nn | Costumer payments and Cheques |
| MT2nn | Financial Institution Transfers |
| MT3nn | Treasury Markets- Foreign Exchange, Money Markets and Derivatives |
| MT4nn | Collection and Cash Letters |
| MT5nn | Securities Markets |
| MT6nn | Precious Metals and Syndicated Deals |
| MT7nn | Documentary Letter of Credit |
| MT8nn | Traveler's checks |
| MT9nn | Account Information |
SWIFT NET FileAct
In contrast to FIN where only MT messages are transmitted FileAct allows the transmission of files of any kind and is mostly used to transfer large batches of messages, such as bulk payment files, very large reports, or operational data. Interact will not be discussed in detail in connection with Fin and FileAct.
One could write several posts about SWIFT that dive into all possible depths of detail. However, that is neither the purpose nor the point here, as this is only about understanding national and international payment traffic and how cryptocurrencies, projects, and technologies can at best offer new opportunities for payment systems.
SWIFT was founded in 1973 by banks and is managed by the SWIFT company. Most banks around the world are connected to the network and for this reason, SWIFT is one of the most established and widely used networks in the financial sector. Consider that about 11,000 banks in 220 countries belong to it.
Pain Points of Payment Systems in general
Now there are some pain points with today’s payment systems. These look like the following (non-exhaustive list)
- Chargebacks
- Complexity
- Costs
- Cross boarder payments
- Data Privacy
- Delayed Settlement
- Fraud
- ..
Opportunities
The selection of the above pain points can, however, also serve as an opportunity for fintech and startups. This is strengthened among other things with the openings of the banks resulting from the Open Banking or PSD2 which enable these companies to offer better and different services through API’s by these regulations.
In the next article, we will start by talking about our own experience with expensive and non-transparent cross-border payments and then we will get into the topic of Ripple.
