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International Payments Systems

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Published : February 26th, 2023
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Today, we will talk about “international payments systems,” which commonly include foreign exchange services. This is intended as a simple tutorial for nonspecialists, such as generalist statesmen or legislators. Probably, it is inaccurate, or incomplete, in some important aspects. But, I think we need to move beyond a state in which “international payments systems” are basically Magic performed by banker-priests. This is not hard to understand.

Let’s take County A, with its domestic floating-fiat currency, Currency A, and a local commercial bank, Bank A, and central bank, Central Bank A. Then there’s Country B, with its domestic floating fiat currency and bank, and central bank. We want to be able to exchange currencies and make payments, for trade and investment purposes.

You are Businessman A in Country A, with a bank account at Bank A. You want to buy some shoes from Businessman B in Country B. Businessman B has two options for payment: accept a payment in Currency A, or a payment in Currency B. Probably, he would prefer Currency B, so let’s go with that.

How does Businessman A in Country A acquire Currency B to pay Businessman B?

At the simplest level, he could pay in the paper currency of Currency B. He could trade Currency A (the paper banknotes) for Currency B at an airport kiosk that handles foreign exchange of paper banknotes, and then deliver the banknotes of Currency B directly to Businessman B, via a local courier. But, this is inconvenient.

So, he goes to his bank, Bank A, where he has a bank account. Using Bank A’s foreign exchange services, he sells Currency A for Currency B on the open market. He then asks Bank A to pay Businessman B’s bank account at Bank B. Bank A pays Bank B, using Currency B. Everybody is happy.

How does this work?

To sell Currency A and buy Currency B, Bank A must, obviously, have some means to hold and accept transactions in Currency B. It needs a “wallet.” This wallet can take two forms: 1) It might have a local subsidiary in Country B, which has an account with the Central Bank B. Then, this local subsidiary can hold Currency B and make payments. 2) Bank A can have a checking account with Bank B. Obviously, #2 is easier, since this takes only an afternoon to set up. You don’t have to set up a whole functioning subsidiary (a bank) in Country B.

To simplify things, let’s have Bank B also have an account at Bank A. Now, Bank A and Bank B are both able to hold both Currency A and Currency B, which means that customers of Bank A and Bank B can also hold and make payments in Currency A or B as they wish. Anybody with an account at Bank A or Bank B can now buy or sell Currency A and Currency B to their hearts’ content.

This can work with just two countries, but it gets complicated when there are, let’s say, fifty countries. There would be (50*49)/2 cross rates, or 1,225 cross rates. If you wanted to Sell Currency A and Buy Currency QX, you would have to wait for someone who wanted to Sell Currency QX and Buy Currency A, in the same quantity. You would have to have some kind of quote system or communication system for all these 1,225 cross transactions. This is a big mess. Basically, it is “currency barter.”

So, you use a “currency of currencies,” a medium of exchange between currencies. This could be a “currency basket” of major currencies, or it could be based on gold, or it could be a domestic floating fiat currency like the USD today. We talked about how to set these up last week:

February 19, 2023: BRICs and Gold

Now, we have only fifty markets for the fifty currencies: Currency A and Gold; Currency B and Gold; and so forth. Now, if you want to get from Currency A to minor Currency QX, you Sell Currency A and buy Gold (a “checking account based on gold,” not bullion itself — it’s all digital). Then, you sell Gold and buy Currency QX. Simple.

Today, you could have some major international banks (Sberbank, the State Bank of India or the Industrial and Commercial Bank of China), that basically have checking accounts at domestic banks in all of the fifty countries. Using these domestic checking accounts, the international banks are able to hold the currencies of all fifty countries. They would thus have access to the foreign exchange markets of all fifty countries. They would also have the “currency of currency,” such as a gold-based checking account. This might be operated by Sberbank. So, the State Bank of India would also have a gold checking account at Sberbank. Someone wanting to go from Russian Rubles to Indian Rupees would sell RUB for Gold; and then sell Gold for IDR.

Now, you can see that all we really need to do is have Bank A and Bank B both have checking accounts with each other, which can take an afternoon. Also, we need a “gold checking account,” or in fact anything, to serve as the “medium of transaction” between two currencies, avoiding the “barter” condition. This is also easy.

So, what are you waiting for? Just start getting things done.

While all these processes are “digital,” or informational, they are also very simple. In the past, they were done with letters carried by ships. Later, they were done by telegraph. You could do it on the phone, in analog voice. You don’t need any fancy information systems that take years to set up.

For example, let’s look at the basic transaction, Bank A sells Currency A and receives Currency B.

Somewhere, there is someone who has some Currency B that they want to trade for Currency A. This is a “market.” This Currency B is held as a bank deposit. It is actually the bank that holds Currency B, in the form of a deposit at Central Bank B. The buyers and sellers of Currency A and B come to an agreement. The person with Currency B sends it to Bank A’s bank account at Bank B (via a transaction at Central Bank B, acting as a bank clearinghouse for Currency B). Then, Bank A sends its side of the trade, Currency A, to some bank account that can hold Currency A (via a transaction at Central Bank A, acting as a bank clearinghouse for Currency A). So, it is basically just two checking account payments, no different than a person today using a bank check, or an electronic means to do the same thing, like an ACH payment or Zelle. We can see that there isn’t that much information involved, and that it could take the form of a paper letter delivered in the post if necessary (which is what a paper bank check is). Probably, these checking accounts would actually both be held by Bank A — in other words, both sides of the forex transaction are customers of Bank A, because Bank A offers the ability for a customer to hold balances in both Currency A and Currency B, which is obviously necessary for both participants in the forex trade. So, the transaction would actually be internal to Bank A.

The point is, we don’t need gigantic amounts of infrastructure, or gigantic amounts of time to set up this infrastructure. The infrastructure — checking accounts at Bank A and Bank B — is already in place.

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Nathan Lewis was formerly the chief international economist of a firm that provided investment research for institutions. He now works for an asset management company based in New York. Lewis has written for the Financial Times, Asian Wall Street Journal, Japan Times, Pravda, and other publications. He has appeared on financial television in the United States, Japan, and the Middle East.
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