Ghostwrote for the president of the Americas channel at ACI Worldwide

The Changing Landscape of International Payments

As more and more business is conducted globally, international payments are increasing at an exceptional rate. In the coming years, these payments are expected to climb at the rate of 10.2 percent a year globally and this growth presents phenomenal potential for financial institutions to profit. Financial institutions have a wealth of new opportunities, particularly in new initiatives that are extensions of the growth in payments. These include new initiatives for streamlining payments processing, which result in improved operating efficiencies and ultimately reduced costs. These also include opportunities for new revenue sources with fee income generated both by new types of payments transactions and new delivery channels, as well as fee income for services that to date have been provided by nonbanking entities We are experiencing a payments revolution. At no other time in the last 15 years has there been so much transformation in international payments. With this growth and opportunity come growing pains that financial institutions must learn to alleviate and mediate. Changes in customer needs and expectations are to a degree inevitable but are perhaps now spurred on by greater competition in the marketplace. Add to these regulatory changes especially those which seek to eliminate or reduce risk, consolidation in the banking marketplace, and the threat of disintermediation from new entrants to the banking market, and it is easy to see how financial institutions might quickly feel overwhelmed. Financial institutions are addressing these challenges and opportunities by moving towards enterprise-wide payments systems, as well as implemementing payment hubs and enterprise risk solutions. They are also capitalising on opportunities to increase profits and generate new income from international payments. The Complexities of Cross-Border Payments More than 80 percent of todays cross-border payments are conducted through intra-bank transactions or between inter-bank relationships such as nostro/vostro accounts, for example between a correspondent bank and a respondent bank. Furthermore, financial institutions often treat domestic and cross-border payments the same, using their internal networks to settle and clear both types of payments. Although cross-border payments amount to trillions of dollars annually, they are inefficient and costly for financial institutions and for businesses. Most domestic financial institutions payment systems simply are not designed to handle such payments and thus process them in a slow and cumbersome fashion. The existing payments processing systems were developed in silos relative to the payment instruments. Challenges have arisen with the explosion of delivery channels. In the early 1900s, the branch was the only delivery channel for banking transactions, and payment types were limited to cheques and wire transfers. Payments processing was separate for those transactions: cheques and deposits went into item processing, and wires went through the wire room. This scenario was the beginning of todays payment processing silos. When credit cards were introduced in the 1940s, another processing silo emerged. As low-value payment systems were developed such as the U.S. Automated Clearing House (ACH) in the United States in an attempt to reduce the costs and inefficiencies associated with cheque processing, additional payments processing silos were developed. For low-value payments in particular, these

payment formats were specifically designed for the domestic payments banking systems they served within their respective countries, thereby creating the challenges financial institutions now face with low-value payments instruments that cannot easily cross international boundaries. Todays domestic inter- and intra-bank infrastructures are not designed for crossborder payments. Although many countries have established high- and low-value payment systems, these are based upon proprietary communication and security standards rather than global standards, which are lacking. The current way in which cross-border transactions are processed is expensive and inefficient. Often, financial institutions have subsidiaries, branches and associated banks in multiple countries and move funds to the destination country via an intra-bank transaction. If beneficiaries have accounts with the foreign institution, then they may be credited directly; otherwise, the payment is sent to a beneficiarys financial institution, or it may be sent through a national settlement and clearing system. Although the silo approach may enable institutions to deploy systems to support new delivery channels and financial services faster, the resulting complexity in systems can actually decrease their flexibility and response time overall. Furthermore, the boundaries of the traditional payment silos are becoming less distinct, and the line between high-value and low-value/bulk as a payment processing path criterion is becoming blurred and is no longer sacrosanct. Moreover, regulatory requirements both governmental and private have had a blistering effect on cross-border payments. Implementing processes, procedures and systems to comply with and remain in compliance with such mandates is expensive and generally offers little benefit other than compliance to the financial institution. Finally, although domestic wire payments adhere to common message standards, cross-

border wire payments do not, as they must support the rules and regulations of multiple countries. Because of this, reaching the goal of straight-through processing (STP) is a difficult challenge for approximately 15 percent of businesses trying to do so. The Single Euro Payment Area (SEPA) has posed a unique challenge for non-European banks with customers with European trade activity. SEPA STP requirements call for IBANs and BICs for all wire transfers into the European Union (EU)/European Economic Area (EEA). Problems arise when a system requires an IBAN for a country for which no IBAN has been established. Often clients will try to create an IBAN using the transit routing number and bank account number. However, when these numbers are not recognised, the incoming wire is held for investigation. Then, not only is the wire delayed, but the recipient is also charged for the investigation. A workaround is for the originating bank to initiate the non-European payment through another, non-automated means, which will cost more. Another challenge financial institutions will face beginning September 2009 is the emergence of the international ACH transaction (IAT). IATs are NACHAs response to the U.S. Office of Foreign Assets Control (OFAC) and anti-money laundering concerns associated with existing cross-border ACH SEC codes. Gateway operators will be required to classify payments transmitted to or received from financial institutions outside the U.S. as IATs. Financial institutions will need to update their transaction systems to manage IATs, and systems in all areas including operations, compliance, audit and customer service may be affected, adding to the challenges and complexities of enabling IATs. International and cross-border payments are not totally about complexities and hardship, though. Plenty of opportunity and growth potential exist for financial institutions, and the promise for profit is certainly present.

Remittances, trade finance and globalisation all present tremendous prospect for financial institutions. The Rise of Remittances With 12 percent of the U.S. population consisting of foreign-born immigrants, the highest percentage since 1930, remittances, payments sent back to a workers country of origin, are on the rise. In fact, global worker remittances are expected to top $456 billion by 2010, up from $369 billion in 2007. A 2004 survey by the U.S. government determined that 61 percent of Latin American immigrants that is 10 million people are sending remittances to their home countries. The survey indicated that although remittance amounts varied by the immigrants country of origin, foreign workers in the United States are sending remittances to nearly every country in the world, and in many cases the sender or beneficiary of the remittance does not have a bank account. The chief countries where workers send remittances are China, Mexico, the United States and India. Financial institutions should not ignore the increase in global remittances, for offering this service presents an opportunity for them to make money by charging remittance fees. Although the market has been dominated by money transfer companies specifically the top five: Western Union, MoneyGram, Euronet, Xoom and iKobo financial institutions can win business by charging lower fees and offering better exchange margins than these competitors. Furthermore, banks can cater to a wider customer base and offer expanded services, such as direct payroll deposit to a foreign account. Find Fortune in Trade Finance As more companies seek goods and services overseas, international trade is booming. In fact, international trade is expected to grow at a rate of 10 percent a year over the next few years. The United States is experiencing record export rates due to the week dollar. In FY2007, U.S. exports were $1.62 trillion and imports were $1.953 trillion.

The basics of trade finance are relatively simple: A buyer wants to purchase goods. A seller wants to provide goods. Both parties require trusted mediators to facilitate the transaction and must mitigate risk. The financial institutions role is to provide advice and counsel to the buyer, the seller or both, verify the clients eligibility and mitigate risk. Finally, the financial institution will lend the necessary funds or extend credit to the buyer or seller and execute payment. Letters of credit (LCs) are used to obtain loans and credit for the buyer. For example a buyer will complete an LC form and provide it to his or her financial institution. After reviewing the LC, the buyers financial institution will approve the buyer and send the LC to the sellers financial institution. Then, based on the LC, the sellers financial institution will approve the buyer and may provide a loan to the seller to finance purchasing or manufacturing of the goods. The LC is promising that the buyer will pay the sellers bank, and if he doesnt, then his bank will. The benefits for financial institutions include service fees for the LC. These may take the form of transactional fees, a percentage of the total LC or both. However, LCs are burdensome and expensive, error-prone and risky if buyers fail to pay. Thus, use of LCs has declined and open account trade has gained momentum. Although considered by some to be riskier than LCs, 70 percent of international trade is conducted on open account terms. Although open account trade reduces costs and payment time frames, suppliers and exporters assume all risk and funding may not be as readily available as with traditional LCs. The surge in open account trade has meant a loss of business for financial institutions and poses the threat that they will be disintermediated. LCs are cumbersome, but they generate income from service fees. To regain some of that business, financial institutions are encouraging corporate customer s to use LCs. The key is for financial

institutions to develop an efficient LC process and automate that process wherever possible. Also, issuing LCs locally when possible makes the process less laborious. SWIFT has developed the new Trade Services Utility (TSU), which enables financial institutions to play a role in open account trade. The TSU is a centralised data matching and workflow utility that allows financial institutions to compare all the commercial data they exchange that corresponds to underlying trade between corporations. Financial institutions can then offer valueadded trade services such as supply chain financing to support open account trade globally. The Trend Towards Globalisation Todays advancements in communications and financial technologies enable financial institutions greater geographic reach with less risk and lower costs than ever before. Moreover, demand has grown for financial institutions that can provide not only crossborder payments but also services across borders. These factors have contributed to the globalisation of financial institutions and the expansion of multinational financial institutions. Mergers and acquisitions across geographies are one way in which this globalisation and expansion is occurring. Some examples are the mega-banks created by the combining of banks, such as that which occurred with Bank of America and Nations Bank and with JP Morgan Chase from the merging of Chase Manhattan Bank, Hanover Bank, Morgan Guaranty Bank and Bank One. Furthermore, mega-banks, such as Bank of America, Citibank and HSBC, are creating and operating their own internal global payment networks through which all domestic and cross-border payments flow right at the bank. These systems allow the financial institutions to reduce per-transaction costs, improve their profits and ensure a consistent level of service across all points of delivery.

Inefficiencies are expensive and cut into a financial institutions profits. Thus, along with this globalisation comes the need for operational efficiencies and workflow management solutions. One way in which financial institutions are improving operational efficiencies is to trade in disparate, siloed systems with complex integration for enterprise-wide products that can automate processes and manage payments end to end, eliminating inefficiencies and improving profit margins. Another way financial institutions are optimising operational efficiency is to outsource payment clearing services to other financial institutions and third-party processors. Outsourcing these activities allows financial institutions to not only improve operational performance but also offer products and services they may not be able to provide otherwise and thus enhance the brand value. Mitigating the Risks of International Payments Common risks that occur with international payments are money laundering and criminal activity to fund terrorist activities, such as the attacks on the World Trade Centre in September 2001, as well as terrorist attacks that followed in other countries. To mitigate such risks, governments have designed various mandates and regulations with which financial institutions must comply, and new initiatives include standards and regulations requiring enterprise risk management (ERM) solutions. ERM takes a holistic view of a financial institutions relationship with a customer by collectively viewing every product or service the customer uses. This enterprise-wide approach protects financial institutions from fraud at every level, from money laundering activity to identity theft to deposit fraud essentially any type of fraud that causes an institution or its customers monetary loss or potentially damages the institutions reputation.

ERM is an evolving process, especially since governments have begun implementing and enforcing standards and regulations that are pushing financial institutions towards ERM. Although many institutions particularly the large national and international financial institutions have already adopted ERM approaches, others are still using reactive rather than proactive methods of risk monitoring and detection. Typically, these methods are the traditional silo approaches to fraud risk management and are rapidly becoming insufficient in preventing increasingly sophisticated transaction-based crimes. Over the last decade, governments have imposed increasingly more mandates and regulations on international and cross-border payments to manage the risks associated with such payments. Financial institutions face not only the complexities of learning about these mandates, but also ensuring that their payments systems are in compliance with them. Some of the major mandates with which financial institutions must comply include the following. Sarbanes Oxley Enacted in 2002, Sarbanes Oxley (SOX) is a U.S. federal law that contains 11 titles describing requirements for financial reporting. Also known as the Public Company Accounting Reform and Investor Protection Act of 2002, SOX introduced significant legislative changes to financial practice and corporate governance regulation, including stringent new rules with the objective to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws. SOX also required most public companies to meet the financial reporting and certification mandates for any end-of-year financial statements filed after 15 November 2004; and smaller companies and foreign companies were required to meet these mandates for any statements filed after 15 July 2005. J-SOX In 2006, Japan developed its own version of Sarbanes Oxley, unofficially called

J-SOX, for corporate responsibility of financial reporting as part of the Financial Instruments and Exchange Law. Although JSOX is not exactly the same as Sarbanes Oxley, the two mandates share key similarities. The companies affected by J-SOX are Japans listed companies approximately 3,800 companies, including their significant subsidiaries and affiliates. Based on J-SOX, all listed companies in Japan must prepare and submit internal control reports on a consolidated basis, starting with the fiscal year commencing on or after 1 April 2008. J-SOX also requires all listed companies in Japan to fully and accurately disclose financial information. Basel II Basel II, the second of the Basel accords for the banking industry, is a risk management practice that sets an international standard to regulate the amount of capital banks must set aside to protect themselves against financial and operational risks. The intention of Basel II is to help protect the international financial system from collapse if a major bank or a series of banks fail. Enforcement of Basel II is achieved by establishing rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves in line with the risk to which it exposes itself through its lending and investment practices. Thus, financial institutions holding riskier assets must to have more capital on hand than financial institutions with safer portfolios. Furthermore, Basel II requires companies to publish the details of risky investments and the companies risk management practices. The Basel accords are issued by the Basel Committee on Banking Supervision, which meets in Switzerland. International Financial Reporting Standards (IFRS)/International Accounting Standards (IAS) These standards are established by the International Accounting Standards Board (IASB) and are a principles-based set of standards that

describe broad rules as well as specific standards as part of the IFRS Framework. IFRS/IAS objectives are to standardise financial statements and their content. For example, IFRS/IAS financial statements all contain a balance sheet, an income statement, a cash flow statement, etc. These standards are used in more than 100 countries around the globe, including the European Union, Russia, South Africa, India, Pakistan, GCC countries and Singapore. The IASB and the U.S. Financial Accounting Standards Board are seeking convergence of standards by the end of 2008. EU Directives on Anti-Money Laundering (AML) The EU has established several directives to prevent and combat money laundering. The third EU Anti-Money Laundering Directive requires financial institutions to take a risk-based approach to preventing money laundering, to identify their customers, keep appropriate records, establish internal procedures to train staff and guard against money laundering and to report any indications of money laundering to the competent authorities. Previous EU antimoney laundering directives include a directive on lawyers as gatekeepers and whistleblowers and another that extends the definition of money laundering beyond drug offences to include proceeds from all types of illicit crime. U.S. PATRIOT Act on AML After the terrorist acts of 11 September 2001, Title III of the USA PATRIOT Act was designed to combat money laundering by amending criminal money laundering laws and recordkeeping and reporting statutes for financial institutions. Title III also calls for financial institutions to implement anti-money laundering programmes and customer identification verification procedures. Furthermore, brokerdealers are required to file suspicious activity reports (SARs), and the U.S. Department of Treasury adopted regulations to encourage financial institutions to cooperate with regulatory and law enforcement bodies regarding individuals or organizations reasonably suspected based on

credible evidence of engaging in terrorist acts or money laundering activities. Conclusion Major regulatory pressures, technological advances, and competitors have created a perfect storm for international payments. Banks alone will spend more than $50 billion annually on technology to restructure and transform their card, ACH, wire transfer, trade finance and mobile payments. Implementing end-to-end enterprise payments systems that eliminate silos is one way that financial institutions are streamlining operations and international payments. A payment hub is an open standards-based SOA architecture that provides a comprehensive set of business application services orchestrated to meet specific processing requirements and rationalize middle-office payments flow. The componentized architecture of a payment hub provides banks with the ultimate flexibility to deploy only the components they need, when they need them, thus reducing the initial capital investment as well as the bank's operating costs while still supporting multiple countries and payment types from a single platform. Furthermore, a payment hub provides enterprise services to reduce the redundancy that occurs across the front, middle and back office in the course of processing payments, enabling financial institutions to reduce costs and gain flexibility in introducing new products to market. Finally, financial institutions must mitigate the risks associated with international and crossborder payments. This includes preventing money laundering and complying with a vast array of national and international mandates. An ERM solution is crucial to the business of such payments. Silo-based approaches are reactive and their functions segregated; each silo has its own tools and applications to assist with specific management and reporting requirements. Problems arise because these independent systems do not communicate with one another across business lines.

By capturing a broader view of customer activity, financial institutions gain a complete understanding of a particular customers risk profile. This expanded view allows institutions to better detect and prevent fraud by monitoring transactions and events across the entire range of customer activity. A true ERM model provides financial institutions with the architecture to enhance customer service while reducing infrastructure

costs through better IT integration and providing a strategic advantage in the future. With the appropriate systems in place, financial institutions will succeed in the international payments arena, an area that although undergoing tremendous change is filled with opportunity, growth and the potential for profit.

References European Payments Transformation: Non-European Banks, Beware, Aite Group, 2008 Competing in Money Transfers: A Market Overview, Celent, March 2007 Managing Risk and Compliance: Responding to New Realities: A Review of Trends and Operational Imperatives for the Future, Celent, December 2007 The Inefficiencies of Cross-Border Payments: How Current Forces Are Shaping the Future, by Yoon S. Park, PHD & DBA, George Washington University for Visa Commercial, November 2006 Remittances: International Payments by Immigrants, Congress of the United States, Congressional Budget Office, May 2005