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SWIFT stands for Society for Worldwide Interbank Financial Telecommunication and is a messaging standard and connectivity hub for facilitating cross-border payments worldwide. More than 8.000 financial institutions and over 200 countries are active in this network. The network is based on correspondent banking which means that a network of “trust” relationships have been set up between banks. These banks communicate with each other using a standard messaging system native to the SWIFT network. That way not all banks need to have agreements in place with all other banks around the world to communicate and send funds, but rather use the trust that has been set up with a mutually trusted bank. For instance, if banks “A” and “C” are not connected in the SWIFT network, payments can be routed through them by exchanging payment messages via mutually trusted bank “B”, hence the term correspondent banking. Note that SWIFT does not actually settle these transactions; rather, SWIFT provides a messaging system for banks to communicate payment and settlement information. Instead, the correspondent banks themselves provide the funds and infrastructure necessary to settle transactions, as explained above.This system was created in 1973 when the internet, of course, was not available for this type of communication. In the present day, executing transactions by means of the SWIFT network and correspondent banking is regarded as expensive, complicated and slow. Although the messaging part is real-time, the actual change of banking positions takes a few days. Below Figure 4.3 presents a diagram which shows how a SWIFT payment is initiated.
Figure 4.3 Current situation SWIFT payment. Source: Ripple Labs (2014b)
Keys
Relationship Management Application (RMA) is the norm for exchanging “keys” in the SWIFT network. All key management is based on the SWIFT PKI that was implemented in SWIFT phase 2. A Bilateral Key allows secure communication across the SWIFT Network. The text of a SWIFT Message Types (MT…) together with this authentication key is used to safely send information across the SWIFT network. These RMAs are setup between banks and managed by the International Markets department of a bank.
Clearing and Settlement
Financial transactions take place through clearing and settlement. Clearing is the whole process from the point in time a trade is initiated till the final settlement is made. Settlement is the last stage in the process where the involved clearing house will transfer the funds. DLPs such as are only a clearing mechanism, and if implemented will rely on the current settlement mechanisms. Settlement is executed by the TARGET2 system within the EURO-area, while clearing currently is performed by clearing houses which can be Equens, EBA Clearing, or also TARGET2.
Channels offered by the EBA Clearing (European Banking Association) are used for clearing funds directly between European banks. EBA Clearing offers three separate payment platforms called EURO1, STEP1 and STEP2 (or PE-ACH) to transfer funds.
EURO1 focuses on Single, High Value and Urgent payments and is operated by SWIFT. Banks are processing payments through the SWIFT network. EURO1 is similar to STEP1.
STEP1 focuses on Single, High Value and Urgent payments for small and medium sized banks and bank to bank transfers. All payments are being processed through the SWIFT network. The process of accepting payments is different due to the nature of the payment admitting party (e.g. Banks and
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Retail). The main difference between EURO1 and STEP1 is that a STEP1-bank settles via a EURO1-bank. The admission criteria for a EURO1-bank are therefore more severe. For example a EURO1 bank needs to deposit collateral to EBA Clearing to gain access to the EURO1-platform. Also EURO1-banks grant limits to each other. These limits together form a minimum and maximum bandwidth in which the actual netted position can fluctuate. Very high value trades, performed by a bank’s treasury desks, involves currency amounts as high as or higher than these minimum and maximum, therefore these trades are made by TARGET2. STEP2 focuses on bulk and non-urgent payments (bulk channels or direct link channels) and is run by SIA S.p.A. In this network all SEPA Credit Transfers (SCT), SEPA Direct Debit Core (SDD Core) and SEPA Direct Debit B2B (SDD B2B) are processed. With this channel no correspondent bank is needed.
Figure 4.4 STEP2 payments. Source: EBA Clearing (2006) Equens
Equens is a Dutch clearing house and also clears SEPA Credit Transfers (SCT), SEPA Direct Debit Core (SDD Core) and SEPA Direct Debit B2B (SDD B2B), therefore directly competing with EBA STEP2. At this point Equens is mainly used for national fund clearing, card clearing and iDeal transactions.
TARGET2
TARGET2 (Trans-European Automated Real-time Gross Settlement Express Transfer System) is an interbank payment system for the real-time processing of national and cross-border transfers throughout the European Union. TARGET was replaced by TARGET2 in November 2007. TARGET2 is the Real-Time Gross Settlement (RTGS) system made by Eurosystem. Payments made by TARGET are immediately settled on a continuous basis in central bank money with no pre-defined limit. TARGET2 settles inter- and intra-bank positions for market making and is mainly used for large volume EURO payments. TARGET2 is operated on a single technical platform. The business relationships are established between the TARGET2 users and their National Central Bank. Due to its design to process large volume payments this system is one of the largest processors in the world in respect to volume. The main objective of TARGET2 is making a more efficient cross-border payment market in the European payment area. Although TARGET2 is in itself real-time, it still depends on the back office systems of the sender and beneficiary bank. Most major banks have automated this process, but some small banks not yet and therefore the point to point payment is still not real-time.