In this article, we will look at the second strategy to understand how cross-border payments work: Grasp the

principles of Correspondent Banking and account relationships between banks located in different
currency zones.

In case you have not read the introductory article and the article about the first strategy, I strongly recommend
you to read them so that you can easily connect the dots and understand cross-border payments.

This is probably the most important of all the four strategies because at the end of day, payments is about
moving funds and in cross-border transfers, funds move through correspondent accounts. So grasping the
principles of correspondent Banking and account relationships is absolutely essential. In this article, we will first
look at payment systems in two countries. Then we will see how banks access systems of foreign countries.
After that, we will analyze the account relationship and correspondent network. Then we will look at the different
currencies and how they are grouped. We will conclude by looking at how banks use correspondent accounts
with concrete examples.

Payments systems model for Credit transfers in France

and the USA
Let’s start with the payment systems model for Credit transfers in France that we saw at the end of the previous
article.

Payments Systems in France for Credit Transfers

France belongs to a monetary zone, the Eurozone. EBA systems, CORE and TARGET2 are all denominated in
Euro. If a Bank in France wants to send or receive USD or JPY, it is not possible through these systems. How
then do French banks send and receive funds in other currencies? To understand how they do that, let’s first
consider the payment systems for credit transfers in the USA.

Payments Systems in USA for Credit Transfers

This is a very simplified way to represent the payments systems in the USA. But this representation is enough for
our needs.

As I said in the previous article, open loop payment systems are the most widespread in the world and they have
many similarities. Payments systems for credit transfers in the USA provide an interesting proof.  We see one
RTGS system, Fedwire, which is operated by the Federal Reserve, the central bank in the USA. We also see two
multilateral clearing systems: one is CHIPS which is used for high-value payments and the other is ACH, which
is used for retail payments. These systems are all denominated in USD. Impossible for a bank to send or receive
another currency like EUR or JPY through one of them. In a certain way, we can say that these systems know
only the US Dollar. And like Banks in France, Banks in the USA do need to send funds in other currencies than
the local currency. Banks do share the same needs in both countries.

Now let’s look at two payment systems located in two different countries: France and USA.
 Payments Systems in France and the USA – Banks’ needs to access other systems

If a French Bank wants to send or receive US dollars, then it needs to get access to the USA payments systems.
The same thing applies to a US Bank. If it wants to send or receive EUR, then it needs to get access to the EUR
payments systems. And how do they do that? Simply by becoming a customer of a Bank located in the monetary
zone that they want to access. A bank, customer of another bank? This may sound weird for beginners. But that
is the case. Look at the next figure that introduces correspondent account relationships.

Correspondent account relationships

Payments Systems in France and the USA – Correspondent Relationships

The French Bank (Bank 5 on the picture) asks a US bank offering correspondent account services to open an
account for itself. The US Bank (Bank E on the picture) may do the same, but it is not mandatory. We see on the
picture that Bank 5 becomes an end party of Bank E and Bank E becomes an end party of Bank 5. (It is
assumed that Both Bank 5 and Bank E offer correspondent account services).

[box type=”tick” style=”rounded”]Before opening an account, a bank must perform a vetting or KYC (Know Your
Customer) process to check the identity and background of its future client and assess potential risks of illegal
intentions for the new business relationship.[/box]

When the French bank opens an account with a bank in the USA, both banks enter into what is called a
correspondent account relationship. The bank in the USA becomes the correspondent of the French Bank in
USD currency. The account is opened in the book of the bank in the USA, but it is the account of the French
bank.

Unilateral and bilateral account relationship

If Bank 5 opens an account with Bank E, but Bank E does not open an account with Bank 5, then both enter into
a unilateral account relationship. The relationship is unilateral because there is only one account opened. If each
bank opens an account with the other then they will enter into a bilateral account relationship.

Now let’s consider the unilateral account relationship and its main characteristics.

Unilateral account relationship

Citi calls the BNPP account that it holds Vostro account. BNPP its account at Citi Nostro account. Note that it is
the same account, but considered from different perspectives.

BNPP does open an account in his own book: the mirror account. The mirror account is there just to follow what
is happening on the real account and manage liquidity. It does not contain real money. The BNPP account with
Citi may receive thousands of accounting entries. Why is it called mirror account? Because the account entries
on the real account and on the mirror account are of same amount, but opposite signs. If the real account is
debited, the mirror account is credited and vice versa. We will get back to this later.

[box type=”info” style=”rounded”]In many payment engine softwares, the mirror account is called Nostro account
instead of mirror Nostro. The Nostro account is always in the books of the correspondent bank, never in its own
books. So a bank does not debit or credit its Nostro account. Its correspondent bank does.[/box]

Now let’s consider the bilateral account relationship and its main characteristics.
 Bilateral account relationship

BNPP calls the account of Citi in its book Vostro account and its account at Citi Nostro account. Citi calls the
account of BNPP in its book Vostro account and its account at BNPP Nostro account. BNPP opens the mirror
account of its account at Citi in its own books. Citi does the same for its account with BNPP.  Important is to note
that the same account are called Nostro or Vostro. It depends on the perspective of each bank.

The correspondent network

In the example above, we considered the setting up of an account relationship between two different monetary
zones. A bank must do the same for all the currencies where it wants to have a correspondent account. There
are around 180 currencies in the world. One of the first decisions a bank must make in cross-border payments is
to determine the currencies it will handle. Like individuals and companies, a bank may open many accounts in
the same currency.

[box type=”info” size=”large” style=”rounded”]The total number of currency accounts that a bank possesses in
different currency zones is its correspondent network.[/box]

Correspondent network

Currencies are not equal and are in general classified in three groups, decided by the trading volumes, liquidity
and availability of the currencies: major currencies, minor currencies and exotic currencies (Source –
forextraders.com)

Major currencies
These are the most traded currencies in the world: USD – U.S. Dollar, EUR- European Union Euro, JPY-
Japanese Yen, GBP – U.K. Pound Sterling, CHF – Swiss Franc.

The banks offering cross-border payments services will always have Nostro accounts in all major currencies.
Minor currencies
They are classified into two groups : Commodity Currencies (AUD – Australian Dollar, CAD – Canadian Dollar,
NZD – New Zealand Dollar) and Scandinavian Currencies (DKK – Danish Kroner, NOK – Norwegian Kroner,
SEK – Swedish Krona)

The banks offering cross-border payments services usually have Nostro accounts in all minor currencies.

Exotic currencies
This group consists of all the currencies not belonging to the other two groups. But it is important to understand
that these currencies are called exotic because of the lack of liquidity in their foreign exchange markets, not
because of the country’s location or size. Lack of liquidity means simply that you cannot buy or sell the currency
whenever you want.

Exotic currencies include among others:  BRL – Brazilian ReaL, CLP – ChiLean Peso, CNY – ChiNese Yuan,
HKD – Hong Kong Dollar, INR – INdian Rupee, KRW – South Korean Won, MXN – MeXican Peso, RUB –
Russian Federation RUBle, SGD – SinGapore Dollar,  TRY – Turkish lira, ZAR – South African Rand.

A key factor to consider about an exotic currency is its convertibility, or the ability to easily change that currency
into another one.  There are fully convertible (e.g. MXN), partially convertible (i.e. INR) and non-convertible
currency (e.g. CLP). The convertibility of a currency evolves. It is not static.

This is where you see differences between banks. In general, they will have correspondents in all fully
convertible currencies. But they will choose to have correspondents only in some of the partially and non-
convertible currencies.

Usage of the correspondent accounts

After opening a Nostro account with a correspondent, a direct deposit is required to credit the account. In a future
article, we will see in detail how this happens. For now let’s consider, the account is opened and credited. How
then will the Bank use its Nostro account and for what purpose?

Bank and customers funds are kept on correspondent accounts

The bank obviously puts own money on its Nostro account. But the bank also puts the funds of its customers
who have accounts in the same currency on the same nostro account. There is a key rule in cross-border
payments which states:
[box type=”tick” size=”large” style=”rounded”]The currency never leaves the country of origin.[/box]
When a customer opens an account in USD Dollar with BNPP, BNPP opens an account in its book in USD. But
the (real) funds are kept on the Nostro account(s) in the USA. Again a Bank may open many accounts with the
same or different banks in USD. If a customer or BNPP wants to transfer funds to a party in USD, BNPP will
instruct the correspondent (Citi) to debit its account and credit the beneficiary account in the USA. On the other
hand, if BNPP or one of its customers receives funds, then the BNPP Nostro account(s) in the USA will be
credited. For customers, BNPP will ultimately ensure that the amount credited/debited is reflected on the
customer account.

Let’s take another example: If BNPP sends USD to a German Bank (Deutsche Bank), BNPP will instruct its
correspondent to debit its Nostro account and credit Deutsche Bank’s account with its correspondent in USD, so
the account of another Bank in the USA. And if Deutsche Bank sends USD to BNPP, Deutsche Bank will instruct
its correspondent in the USA to debit its Nostro account and credit the account of BNPP with Citi. These
transfers will go through payment systems in the USA like other domestic transfers.

Now that we understand correspondent banking, account relationships and how accounts are used, the time has
come to look at SWIFT and SWIFTNet; not to consider the message types :-), but to get the big picture. Why is
the SWIFT Network so crucial and why are standards needed? The next article will provide answers to these
questions and much more.