Why is liquidity a problem in the financial world?
After all, the forex market is one of the most liquid markets in the world. If not, the most liquid. And yet, it’s actually fundamentally difficult to send your money to someone overseas. It takes days. Sometimes, it gets bounced back. Worse. Sometimes, it gets lost on the way… And then the Banks blame Swift, and you’re out of pocket. Or you have to wait weeks to months to somehow get your funds back via some insurance policy or guarantee your bank may have. Or may not have.
Why is there a lack of liquidity in the financial markets?
When banks transact with each other internationally, it’s not as simple as we think. We think of banks as monstrous overseers with ultimate power and control. It’s not the case. A lot of smaller banks struggle in the shadow of more well-established systems. For a small bank in Malta to send funds to Yemen, a complex messaging system takes over. This is SWIFT, most of the time. Other companies do exist as remittance payment providers that contend with Swift, but their reach is limited.
Understanding the current system.
Swift actually does not settle or transfer money, they simply relay messages about whose money is to go where. In this instance, there is probably no direct relationship between the Malta-Yemen sender-receiver banks. Instead, both transact with a larger bank that has a corridor setup there. Or worse, sometimes the Malta bank will have to let their funds go to a corridor to the USA, or some other neighbouring country who does have such a corridor setup. In this fashion, payments can be bounced around through up to a dozen banks, each snipping their little $15 fee and exchange rate commission along the way.
Delays in modern finance.
Every bank operates their own ledgers. These are their records of all transactions. For established banks to work efficiently internationally, they lock up millions of dollars in what is called “Nostro & Vostro” accounts. In essence, they leave $5,000,000 (example) with another bank in the country they have their main corridor(s) with. Then, when one of their clients wants to send money to that country, they use this Nostro account. Nostro means “Our money at your bank” and Vostro means “Your money at our bank”. They both describe the same thing, but from either perspective. The banks use these Nostro accounts regularly, and will still charge exchange rates at whatever the going rate is on the day to make more money. Ever notice the spread at a bank’s Forex teller is 2-3 cents or more, whereas on the interbank it is in fractions of a cent? Yes, they make good money here too.
The Problems With Nostro/Vostro accounts.
Banks both small and large must leave phenomenal amounts of money locked into overseas accounts to provide basic services to their clients. For them, this is money that could otherwise be invested. It could be saving you costs as a client too. At present, it is just a cost of business that they can’t avoid. Because payment channels between banks, central banks, and countries, is incredibly slow!
Beyond the big banks having these accounts, smaller ones often do not. Because every bank has their own rules, ledgers, and systems in place, they must interact with one another to perform transactions between banks. This is the cumbersome part, where humans takeover and human error can come into play.
Not only that, but with millions (if not billions) of dollars left in overseas accounts, these amounts become subject to Forex fluctuations. Prices do not need to move much to substantiate huge losses (or profits at times) for the banks involved. This exposure is just another cost that have to factor in to their daily running costs. That get passed on to you. Yup. Sorry.
Because of the amount of funds moved every day, at the end of the banking day, a lot of banks will “settle” the ultimate differences. For instance, Australia may have sent $90,000,000 to the USA, but the USA’s clients only sent $45,000,000 to Australia. At the end of the day, Australia would settle the remaining $45,000,000. Meaning, the USA actually never sent a dime, and Australia got to hold on to the $45,000,000 that got sent its way. Whether banks settle like this or rely on their Nostro/Vostro accounts depends on the bank and unique setup along the way. Don’t forget, big banks also have to settle with their correspondent Central Bank on a daily basis.
Why Blockchain can help solve liquidity problems around the world.
You’ve heard it said that if you want to send $10,000 to Europe fast, you’re better off getting on a plane and flying it there yourself. Blockchain companies like Ripple Labs, however, are aiming to bring the financial world into the modern age. Instead of banks locking up their billions of dollars all around the globe, paying exchange rate differences, they can instead keep those funds at home. This prevents paying out forex changes, for one. It means they can access and use those funds as needed. This is important because of how a bank functions with its Central Bank (we’ll cover that in another article).
In this ideal setup, banks instead operate directly with Ripple, or through another third party. When they need to send money overseas, their money is moved through the Blockchain Ledger operated by Ripple, facilitated either by Ripple or another third-party (Such as R3’s Corda Settler). Instead of purchasing EUR with USD, the USD would buy XRP. XRP is the coin/token that is available to transact between all currencies. It is a “bridge” currency. This is especially helpful for smaller currencies that may not have the liquidity larger ones do. As Ripple’s ledger moves and settles in seconds, the banks are exposed to seconds (not days, weeks or months) of Foreign Exchange. The XRP then buys the EUR, and settles in under minutes.
Why is settlement a big deal?
As mentioned above, settlements usually occur at the end of the day, or sometimes after several cumulative days. The settlement is when the money actually arrives in the receiver’s bank. This takes a long time because of all the places funds must bounce through on the way to the receiver. SWIFT, the current giant, “misplaces” quite a few of their payments annually. It may not seem a large deal to them, but for someone sending $8,000 to their parents in a home country, it is a huge deal. SWIFT has also been targeted lately by Hackers taking advantage of their messaging system, and in one case $1.8B to hackers alone. If you check that link, you’ll see a constant stream of SWIFT losing “$10m” “$81m” “$6m” all over the world, from Bangladesh to Taiwan.
Liquidity Solutions are the Key to future Global Financial Stability
By operating on a blockchain system that is verified by decentralised nodes running worldwide, hackers are unable to gain a foothold in the system. With one single central pool (XRP) that operates with not only currencies, but other digital assets, stocks, and anything that can be recorded digitally, we are moving towards a place where money moves like data. You can email someone on the other side of the world in minutes. We can call and video the other side of the world instantly. Yet, to send money is slow and laborious.
Ripple’s XRP token is backed by what is called “RippleNet”. In essence, RippleNet is a network of banks, payment providers (remittance companies) and other associated groups. RippleNet provides a standardized ruleset (or backend) that means they interconnect and operate together efficiently, and more importantly, virtually instantly. Everything is tracked on the blockchain, guaranteeing transparency. In this way, a single gateway is all that is required for one bank to transact globally, lowering the barriers to entry.
Expanding on the global money problem.
By tackling real problems with blockchain solutions, the technology is being brought to the forefront of a new digital age. Imagine a place where you can send money directly to your cousin in seconds? Not only can banks now do this, but the technology takes it another step further. Individuals can transact on the network on their own, without the need of the bank at all as an intermediary. Instead of having your funds with a bank, and a bank sending it and charging you fees, you can control your own money freely. Stored in digital wallets, XRP can be sent globally by you, from you, to whoever you want, as long as they have an account in the same network.
Bringing banking to the unbanked.
For this reason, it brings banking and accessibility to the roughly 3 billion unbanked people in the world. Yes. 3 billion people don’t have access to bank accounts, but most of them do have access to a phone. And that’s all you need. This increase in access and liquidity means that farmers in third world countries can transact with buyers in other countries directly, and receive money faster and with less cost to them. This in turn means more money for that economy, and in turn you can see how that will allow economies to flourish as they never have before.