Cross-border money transfers usually flow through a correspondent banking network that consists of chains of banks, cooperatively working to transfer funds from the payer to the payee. However, this model is problematic, as it adds extra time and cost to money transfers, and demands a lot of operational effort on the banks’ side.
Since real-time, instant cross-border payments are still not achieved, the current system quick-fixes the problem by ‘prefunding’.
Let’s say there is Bank A in Germany, a respondent bank, and Bank B in Singapore, which is Bank A’s correspondent partner. In the correspondent banking model, Bank B holds deposits owned by Bank A. When Bank A wants to transfer money to Singapore on that day, Bank B pays out from the deposits of Bank A, before the settlement is met. ‘Pre’ in the prefunding stands for ‘before’ the actual settlement takes place, which will happen in 3-4 days later due to the shortcomings of the current system. In other words, prefunding is basically keeping balances in relevant accounts in different countries to shorten the time circuit needed for a cross-border payment.
In prefunding, each participant deposits cash to the expected value of its maximum net obligations for the next settlement cycle, eliminating the settlement risk in the payment system. In case a participant fails, they have already provided the funds to cover their liabilities. It also provides intraday liquidity management, which is essential for the payment system to run easily and without failure.
To put it simply, prefunding operates as a ‘patch’ to overcome the shortcomings of the correspondent banking model. And as all patches in financial models, it comes with trade-offs:
These challenges need to be addressed as soon as possible to enhance cross-border payments. It is almost 2022, and cross-border payments are still lagging behind domestic ones in terms of time, cost, and transparency. To achieve instant cross-border payments, the global financial system needs more than just a workaround.