Maximising the profit potential of a bank’s US dollar (USD) payment volume is a complex task that continuously challenges many Asian financial institution buyers. The typical size of USD clearing volume generated by most Asian banks is large, compared to that commanded by banks from other regions. The USD is still the preferred trade currency in most Asian countries, with trade instruments being the preferred method of middle market corporate payments in most South and Southeast Asian economies. In addition, most Asian banks are capable of capturing large volumes of USD retail remittances from immigrant worker communities located in other Asian countries as well as in the US. Lastly, Asian treasury volume still remains stable, as most foreign exchange (FX) deals are USD against local (non-continuous linked settlement, CLS) currencies, minimising the volume reduction effects of CLS on bank-to-bank payments.
While most Asian banks process their USD payments volume through a network of correspondent bank relationships, many also maintain a New York branch or agency with some type of connectivity to one or more USD clearing networks. There are now over 250 branches, agencies, and representative offices of foreign banks in New York1.
While some Asian banks maintain their own USD clearing operations, these payment shops are usually small and are frequently managed as a utility. For most Asian banks, the predominant business line of their New York branch is trade finance. Their USD payment shop in New York primarily services trade-related payments, a small portion of their network’s volume and, sometimes although not commonly, they provide limited international cash management services to a relatively captive local US client base (local corporations with trade links to their head office country or US offices of companies from their head office country).
Yet for many Asian banks that maintain a New York branch or agency, USD clearing and payments is a missed fee-generating opportunity because of the market potential commanded by their network’s volume, as well as opportunities that can be created within their local or regional footprint. Decision-makers in many Asian banks are looking for methods of increasing fee income generated by their New York branches. While many are concentrating on expanding their trade-related revenue, some banks are also investigating methods of expanding the fee-generating capabilities of their New York payment operations. Finding the correct model for organising a payments business that accomplishes this goal is, however, challenging in a mature market that is fiercely competitive and dominated by several large players. The need to keep pace with new technology, increasing regulatory pressures, and competitive pricing in a commoditised industry often compel banks to evaluate their direct participation in USD clearing and look at other strategic alternatives. These include a variety of models, from a simple expansion of current correspondent relationships to more comprehensive partnership and outsourcing models. Those responsible for determining their bank’s strategic direction continuously need to evaluate which model of clearing their USD transactions best meets their client’s needs, while at the same time maximising economic profit for their organisation.
New Market Factors Affecting USD Clearing
The general trend has been for banks to completely exit or significantly downsize their New York-based payments businesses. USD clearing effectively became a business line for banks in the 1970s with the emergence of the New York Clearing House’s Clearing House Interbank Payments System (CHIPS). CHIPS effectively introduced the capability to make cross-border USD payments electronically. For global and larger regional banks, CHIPS allowed the development of a full payment product line within their lucrative correspondent banking businesses. Whether using CHIPS to process their internal network volume, to sell USD clearing services to downstream banks in their home country, or to develop global USD clearing businesses, major banks from around the world joined the network. At a high point in 1985, more than 142 banks were direct CHIPS participants2.
During the 1990s and in the first years of the new millennium, the number of CHIPS participants dramatically dropped. There are now only 54 direct online CHIPS participants. Yet, at the same time, the volume processed by CHIPS continued to grow.
There were two primary reasons for this trend:
- First, the 1990s were a decade of widespread bank mergers. The consolidation of the banking industry worldwide led to the creation of larger and more robust CHIPS participants who gained from increased benefits of scale.
- Second, smaller participants found it too difficult to compete with the larger players arising through bank consolidation. While they were unable to compete with the larger participants in capturing local incountry or regional business, more importantly, they were unable to compete with the larger participants internally, within their own bank. This is because network users and purchasers found that their payments were serviced better and with more favourable terms by external providers than by their own New York branch. Thus, internal volume was increasingly being awarded to external providers instead of being moved through the bank’s own CHIPS participating New York branch.
Certain market developments are now placing new pressures on those banks that continue to maintain a USD payments operation in New York:
- The post-September 11 and Patriot Act environment have created additional regulatory, compliance and contingency requirements for banks maintaining a USD payments operation in New York. Most Asian banks can successfully deal with new “Know Your Customer” requirements since they do not require large capital investments and because the home office usually maintains strong relationships with their in-country client base. However, the need to expand or develop anti-money-laundering monitoring programmes is forcing many banks to increase investment spending for their compliance systems and functions (both for obtaining new monitoring and client relationship management systems as well as for the resources needed to support these systems and tightened procedures). In addition, banks are faced with increased risks of potential fines and a loss in reputation. Lastly, the events of September 11 have also required many banks to evaluate their existing contingency plans and capabilities. In many cases, banks are finding that they need to upgrade those capabilities, requiring additional capital investment. While the scale of these needs is obviously larger with those banks that maintain a significant USD clearing presence, certain minimal requirements have to be met regardless of the size of the payments business. Within many banks, and especially within smaller USD clearing participants, these costs are having a direct negative impact on the economic profit of their payments businesses, or on future forecasts of the business line’s viability.
- In general, banks are reviewing the economic profit of various business lines. Global economic conditions are forcing many financial institutions to concentrate capital into business lines that represent core competencies. For many Asian banks, USD payment processing, even when viewed as part of their international cash management offering, is not a core business. Maintaining a USD payments business requires continuous dedication to investment spending to upgrade capacities; keeping up with mandatory regulatory, SWIFT and clearing system changes; and developing product enhancements.
- Product gaps between market leaders and other participants are increasing. Market leaders (about the top 10 CHIPS or Fedwire participants) have been continuously investing capital in upgrading their product set and capabilities. The same trend is not found among smaller participants. Because of this difference in capital investment, there is an ever-increasing gap between the “haves” and the “have nots”. Asian banks often find that a larger CHIPS participant better services their payments than would their own New York payment shop. Because of this factor, among others, many Asian banks that maintain payment operations within their New York branch will often route only a small percentage of head office or network volume through their New York branch, opting instead to route the majority of volume through correspondents.
USD Payments Structures Found in New York Branches of Asian Banks
Most Asian banks that maintain a branch or agency in New York usually do not connect to all three USD clearing systems (i.e. CHIPS, Fedwire and automated clearing house [ACH]). There are now only 10 Asian CHIPS participating banks. With the exception of these, most Asian banks, especially those that only have an agency in New York, maintain a smaller payment shop with minimal funds transfer and investigation operations. The majority are SWIFT participants using a smaller payment-processing platform that is part of a vendor-based integrated back-office system that also covers their general ledger, demand deposit account, trade and FX-processing needs. They are almost always online Fedwire participants while maintaining a correspondent relationship with one or more of the larger CHIPS participants. They rarely have ACH capabilities. This is especially true for banks from South and Southeast Asia, while certain North Asian banks also maintain a smaller US retail subsidiary that provides services to their local ethnic communities in the US. While these subsidiaries do provide a wider scope of domestic and international cash management services – including low-value, ACH processing – they do not usually process their bank network’s volume.
From a technical standpoint, Asian banks usually face problems maintaining such an infrastructure:
- USD payments shops structured in this fashion are usually plagued with endemic unit cost problems. Regardless of the volume processed, each participant must maintain minimal system infrastructures. As the branch usually does not capture significant volume, system capacity is underused, bringing the unit cost up. It usually cannot be significantly reduced without larger amounts of volume. However, larger volume cannot be handled because the New York payment operation usually does not have the human infrastructure needed to maintain that volume in the areas of repairs, investigations and general servicing. In addition, since only small portions of a bank’s assets would be invested in the US, the New York payment operation may not have the needed intra-day liquidity to support large volumes.
- As certain payments are simply passed from the home country to a CHIPS participant via a correspondent relationship, the New York branch effectively becomes an unneeded intermediary. They will usually add no value, so the simple solution may be to send the home country payment directly to the USD correspondent.
Outsourcing as a Strategic Alternative
A strategic alternative to maintaining this type of a payments shop structure now being considered by some banks is the outsourcing of their New York USD payments operations to a larger USD clearing provider. In such an arrangement, the outsourcing bank (the Asian bank that maintains a New York branch) awards a service provider (a larger USD clearing provider, usually among the top 10 CHIPS participants) with certain or all back-office functions related to payment processing (and potentially other functions). This may take the form of just performing operational functions, or the form of a more classical ‘white-labelling’ solution. Outsourcing could, however, provide the Asian bank with the capabilities needed for its New York branch to stay active in USD clearing by growing fee income from the business line, while avoiding the necessary capital investment to build that business line in-house.
What can an Asian bank with a New York branch or agency gain from an outsourcing solution?
- Through outsourcing, an Asian bank can get access to market leading products without internal development: by outsourcing, the Asian bank will usually be able to tap into the products and services offered by its provider. As the Asian bank’s volume will be processed on the larger provider’s system, the provider can white-label all or some of their payment products and functionalities. At a minimum, the outsourcing bank will be able to apply these services to its own network payments. In a pure whitelabelling format, the outsourcing participant would have the capability to market those to third-party clients as their own products and services.
- Outsourcing will almost always be a more cost-effective solution: by outsourcing, the Asian bank would gain the benefit from processing at the cost charged by the provider. The outsourcing bank can then significantly reduce infrastructure maintained in New York. System maintenance spending is also brought down to minimal levels. Further investments to meet mandatory and regulatory changes in clearing systems will also be minimal.
- Through an outsourcing arrangement, the Asian bank is able to leverage the provider’s robust systems and infrastructure: the outsourcing bank will be able to grow volume without having to worry about reaching maximum capacities and the relevant investment spending required to increase capacity. This includes both technological and human resource capacity.
- The outsourcing bank gains its provider’s payment-processing efficiencies: most large USD clearing providers have very efficient infrastructures with trained staff and efficient procedures. By outsourcing, the Asian bank will effectively be able to leverage these efficiencies. Increases in straight-through processing rates, decreases in compensation payments due to such items as errors can be immediately realised and passed to clients.
- Certain outsourcing models allow the bank to retain its front-end to clients: depending upon the outsourcing bank’s needs, solutions can be structured in a way that the bank retains its front-end with its clients. The Asian bank’s clients see their bank as the provider of services, while in actuality the payments are processed by the USD clearing outsourcing provider. For example, the provider will usually be able to send statements to the outsourcing bank’s clients directly by using the smaller participants’ SWIFT bank identifier code. By the same token, the provider can execute payments using the outsourcing bank’s Fedwire or CHIPS identifiers.
Considering Potential Outsourcing Service Providers
One of the critical factors in successfully implementing a USD payments outsourcing solution is the selection of the most appropriate provider. Asian banks that consider outsourcing their New York payments operations realise that making such a commitment is a major undertaking. Selection of an outsourcing provider that will not meet the bank’s needs could eventually have a large impact on the bank’s reputation and client base. The best outsourcing providers will usually be those banks that have:
- An innovative approach to product development: banks will want to outsource with those providers who have a reputation as being market leaders with regard to product innovation. This will assure that their payments will always benefit from the latest developments in USD clearing.
- Flexible systems: some providers will eventually try to steer the final solution to meet their own capabilities. To not fall into this loophole, any bank considering outsourcing should first gauge the potential partner’s commitment to a thorough analysis of existing and potential infrastructure and needs, as well as the provider’s track record for building customised solutions. Better providers will have a systems infrastructure that will be able to easily connect to any legacy back-office components that may remain in the Asian bank’s New York office, and will also be flexible enough to customise payment services or patterns that are unique to the outsourcing bank.
- Developed delivery channels: while most financial institutions considering outsourcing are SWIFTcapable, many outsourcing models are structured around non-SWIFT communication channels. This is especially the case if the New York branches will also be outsourcing their local SWIFT operations. Some of the major USD clearing providers have built proprietary delivery channels that can be used to communicate with legacy back-office systems.
- Dedicated and well-built analysis and implementation procedures: while certain providers claim to have “plug and play” capabilities (the ability to implement an outsourcing solution with minimal customisation), in actuality the best solutions have been those that have been carefully thought through and structured over time. Major USD clearing providers now have various models for implementing payment-processing outsourcing arrangements. What model works best for a particular bank depends upon how much of the bank’s current back-office functions should be outsourced. For example, it may be prudent to maintain certain functions, such as client services, in-house. Within some banks, it is also impossible to unwind and outsource one back-office function without affecting other functions. This is especially the case when the bank maintains one integrated back-office platform within its New York branch that supports the bank’s trade, treasury, general ledger, and DDA functions. Outsourcing just one piece – payment processing – may not be technically possible, or may not provide the expected cost savings as maintenance of the back-office system may stay at the same level. This makes the solutionplanning phase of establishing a payment-processing outsourcing arrangement ever more important. The best USD clearing providers will work with a potential client on a detailed technical analysis to jointly determine the most optimal structure for the outsourcing arrangement.
- Local home country client service and relationship support: any potential provider will need to provide second line client support to an outsourcing bank. The success of the partnership may very well hinge on how operational and transactional issues are communicated to an outsourcing bank’s own client base. The best providers will have a local country presence in the outsourcing bank’s home country.
- Confirmed commitment to the USD clearing business line: banks simply would not want to partner with an outsourcing provider that may at some point exit the USD payments business. The potential provider’s historic market share, their annual investment spending in maintaining and growing this specific business line, the relevant size of the business line’s revenue in overall transactional services revenue, as well as other factors are usually a sound gauge of the provider’s commitment to the business.
Lastly, any Asian bank considering outsourcing its New York payments operation should look for providers that are not a significant home country competitor. A large USD clearing outsourcing provider who also has a large local presence in the bank’s home country will effectively prevent the bank from growing business based on its new capabilities.
Conclusion
At a time when market conditions are forcing many Asian banks to evaluate both their New York branch presence as well as their overall USD payment routing strategy, strategic alternatives do exist to optimise the economic profit and return of both. If the bank can capture significant volume within its home country or region, a partnering alternative involving outsourcing payment operations to a major USD clearing provider can provide the bank with the strategic infrastructure needed to develop these opportunities. Selecting the correct partner that will work with the Asian bank in developing a customised solution the is key to success.
1 Thompson’s Global Banking Resource, www.tgbr.com.
2 The Clearing House Interbank Payments System, www.chips.org.