Transfers of money have largely shifted away from cash over the past decade. Cash accounted for more than 50% of all monetary transactions in Canada ten years ago, but it now accounts for less than a third . The rise of digital money transactions, most of which are controlled by banking institutions, is a major factor in the decline of cash.
As students, we frequently use these digital payment methods, whether it’s to pay for a quick lunch from a food truck or our tuition. When it comes to paying tuition, if you’re an international student, it’s almost impossible to start with a bag of cash in your home currency and exchange it for Canadian dollars. While it might make you think you’re a part of the mafia, you’ll also agree that it’s not very convenient. So, how can banks assist us in making it easier?
Let’s go through the banking procedure one step at a time. Let’s say you want to send 20 Canadian dollars to your friend Justin, and both of you have accounts with TD Bank, a local bank. The bank will debit (deduct) 20 from your account and credit (20) Justin’s account in this scenario. This would only necessitate an electronic balance update because both accounts are held in the same bank. It should be noted that no actual cash was transferred here. This is referred to as a “book transfer.”
Now, what if Justin has an account with a different bank, such as RBC? Banks typically use the central bank for interbank transfers within the same nation. “Correspondent bank accounts” are accounts that each major bank has with the country’s central bank. TD takes 20 CAD from your account and asks RBC to pay Justin 20 CAD in order to transfer the same amount. However, this alone is insufficient; if RBC gave it to Justin, it would lose $20! In order for the transaction to be equitable, TD needs to ensure that RBC receives the 20 Canadian dollars. As a result, RBC’s central bank account receives 20 CAD deposits and 20 CAD debits from the central bank’s account. The central bank could be thought of as a bank for banks.
However, not every bank has a central bank account. The term “clearing” banks refers to banks that have an account with the central bank. The process of re-direction through a clearing bank is more involved and beyond the scope of this article if you wish to conduct business with a non-clearing bank.
Now that we have that out of the way, let’s talk about cross-border banking transactions in different currencies. Let’s say you’re an international student and want to pay your fees through a direct bank-to-bank transfer. Your home bank account has GBP funds in the Bank of London, but my university’s RBC account requires Canadian dollars. The Bank of London must have a “nostro” in RBC in order to facilitate this kind of transaction. Simply put, a “nostro” account is one held by one bank in a foreign currency in another bank . The Bank of London ought to have CAD in a nostro account with RBC, which is known as its reserve.
When you ask your bank to pay the University of Toronto in Canadian dollars, it uses the GBP conversion rate and frequently charges an additional fee. The bank never actually sends money; rather, it sends secure messages to the receiving bank in order to deposit the required amount in the receiving account. The system known as SWIFT (Society for Worldwide Interbank Financial Telecom) is the communication protocol that banks use the most. The sender bank needs specifics, such as the SWIFT code of the receiving bank, account information, and personal information of the recipients, among other things.
When RBC, the receiving bank, receives this message, it takes the funds from the Bank of London’s nostro account and deposits them in the account of the recipient, UofT in our case. Note that the final CAD deposit was essentially a book transfer within RBC, and that the CAD was never transferred between banks! A direct bank-to-bank wire transfer is the name given to this particular transaction.
Nostros can’t be held in every bank in the world, which makes it impossible for banks to do so. You might be able to see how the nostros model could quickly explode as new banks emerge if you enjoy computing algorithmic complexity. A Money Transfer Operator (MTO) serves as an intermediary in other forms of foreign exchange (forex) transactions. MTOs typically have local currency accounts in numerous international banks.
If we wanted to transfer money using Western Union, an MTO example, our scenario would look something like this. For the same amount in Canadian dollars, Western Union sets a price in GBP, usually higher than the current exchange rate, plus an additional fee. The discussed amount is then transferred to Western Union’s GBP account by our bank. Western Union orders money to be transferred from its CAD account to UofT’s RBC account in response to this. What if the CAD account held by Western Union is not in RBC? That’s fine; we already know how transfers between banks work!
The next time you press the send button, keep in mind that a lot is going on behind the scenes. Due to its lack of transparency and centralized control, this behind-the-scenes movement of money has received a lot of criticism in recent years. The rise of decentralized payment methods like cryptocurrency was a byproduct of this criticism. However, that subject is worthy of its own article!
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