Contemporaneous financial intermediation

Merz, Markus Article — Published Version Contemporaneous financial intermediation Digital Finance Provided in Cooperation with: Springer Nature Suggested Citation: Merz, Markus (2021) : Contemporaneous financial intermediation, Digital Finance, ISSN 2524-6186, Springer International Publishing, Cham, Vol. 3, Iss. 1, pp. 25-44, https://doi.org/10.1007/s42521-021-00029-3 This Version is available at: https://hdl.handle.net/10419/287552 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Vol.:(0123456789) Digital Finance (2021) 3:25–44 https://doi.org/10.1007/s42521-021-00029-3 1 3 ORIGINAL ARTICLE Contemporaneous financial intermediation How DLT changes the cross-border payment landscape MarkusMerz1 Received: 18 December 2020 / Accepted: 19 February 2021 / Published online: 8 March 2021 © The Author(s) 2021 Abstract Digital innovations in banking and payments recently have garnered a great deal of attention. Specifically, distributed ledger technology (DLT) has the potential to fundamentally change the roles and responsibilities of stakeholders in the financial sector. DLT is a novel and fast-evolving approach to record and share data, e.g., payment transactions, among members of a decentralized network. Using transaction cost theory, the paper examines how DLT will change the cross-border payment infrastructure. DLT can reduce the overall transaction costs potentially resulting in the disappearance of correspondent banks. Keywords Distributed ledger technology· Cross-border payments· Transaction costs· Correspondent banking· Ripple· Intermediation JEL classification E42 · G21· O30· P51 1 Introduction Banks have long been rationalized by their seemingly essential role as financial intermediaries in an economy. Traditionally, banks are thought to intermediate between non-banks, such as households and firms (Diamond and Dybvig 1983; Diamond 1984). However, less regarded, but equally important banks also provide payment services.1 Cash is ill-suited for large payments, especially over a long distance. In this context, banks allow customers to transfer money in a safe and secure manner. Due to * Markus Merz [email protected] 1 Department ofBanking, University ofTuebingen, Tübingen, Germany 1 Strictly speaking, banks started as providers of payment services and then extended into financial intermediation services (Kohn 1999). 26 Digital Finance (2021) 3:25–44 1 3 the globalization of both business and private transactions, and growing financial integration, transferring money across borders has become a pervasive issue. For centuries, banks have dominantly carried out cross-border payments via correspondents, i.e., interbank intermediaries that complete transactions on behalf of banks in areas where they are not physically present (Society for Worldwide Interbank Financial Telecommunication 2016; Calomiris and Carlson 2017; Committee on Payments and Market Infrastructures 2018). Today, however, this model faces significant challenges. For example, banks must compete with faster, cheaper, and more transparent (online) payment service providers (e.g., PayPal, TransferWise, WeChat Pay, Alipay, Amazon Pay, etc.). Many of these new intermediaries carry out transactions within their own ecosystem, instantly shifting money from one account to another. Surprisingly, according to Denecker et al. (2016), more than 95% of business-to-business and approximately 60% of consumer-to-consumer cross-border transactions are still processed by banks.2 The authors cite proven security of banks for both money and data as the dominant reason. Despite the longstanding dominance of banks, the competition remains fierce as cross-border payments are extremely profitable. About $136 trillion flow across borders annually (Bruno etal. 2019). Although this is only one-sixth of all global payments, it generates about 30% of the revenues that processors collect, totaling more than $230 billion per annum (Bruno etal. 2019). To insure their control, banks are continually working on improvements. For example, the Society for Worldwide Interbank Financial Telecommunication’s global payments innovation (SWIFT gpi) improves the speed, transparency, and traceability of cross-border payments, but still relies on the correspondent banking system. More recently, however, banks have started to explore an innovation that could profoundly transform the cross-border payment infrastructure: Distributed Ledger Technology. DLT is decentralized and the network participants hold identical copies of a shared database that is updated algorithmically. The usage of DLT eliminates the need for third parties, i.e., correspondent banks, to manage and reconcile individual bank accounts. Although there are still significant legal, regulatory, and operational barriers to the global implementation of such a system, DLT already has the potential to replace correspondent banks and dominate cross-border payments. In the presented research, the unconventional but highly pertinent transaction cost model of Breuer (1993) is introduced and adapted to predict how DLT will increase the efficiency and resiliency of crossborder payments. The paper begins by explaining the role of correspondent banks as interbank intermediaries. Subsequently, the potential impact of DLT on the presented market structure is analyzed. It is shown that the use of DLT could reduce the economy-wide transaction costs making correspondent banks superfluous. The presented findings contribute to the nascent literature on technological disruption in the banking sector (see, e.g., Swan (2015),Vives (2019), Boot etal. (2021)) by explicitly examining how DLT changes the cross-border payment market. DLT is highly discussed in the field of cross-border payments (Bank of Canada, 2 More recently, Rice etal. (2020) reinforce this finding stating that the overwhelming majority of crossborder transactions are processed by banks. 27 1 3 Digital Finance (2021) 3:25–44 Bank of England, and Monetary Authority of Singapore 2018; Newman etal. 2018) and has even been implemented (Rapoport etal. 2014). With the exception of Mills etal. (2016), He etal. (2017), and Casu and Wandhöfer (2018), academic reports, however, are limited and incomplete. Mills etal. (2016), for example, only broached the topic in their broader work on payment, clearing, and settlement. He etal. (2017) and Casu and Wandhöfer (2018) provide a more comprehensive analysis of the implementation of DLT in cross-border payments.3 Casu and Wandhöfer (2018) qualitatively evaluated the potential of DLT and several other network models by surveying members of the industry. The findings presented here complement this earlier work by explicitly examining potential effects on the costs and the design of payment infrastructure. In their work, He etal. (2017) offer a conceptual framework to assess the impact of DLT on the cross-border payment market. Although they claim that through its technical characteristics, DLT has the potential to reduce transaction costs, they do not quantify the effect. There are, however, substantial costs associated with migrating from existing longstanding IT systems, operational arrangements, and institutional frameworks to a DLT-based payment infrastructure (Natarajan etal. 2017). A tool to accurately estimate potential costs savings is therefore highly desirable for bank managers, regulators, and central bankers. Here, a theoretical framework is provided that allows a detailed estimation of the transaction costs in the current correspondent banking system and in a DLT-based system. Additionally, the systematic and thorough characterization of DLT will help provide clarity to the often disorganized existing literature on the nascent technology (Perdana etal. 2020). Finally, the presented work is related to the literature on optimal intermediation structures. Craig and von Peter (2014) and Calomiris and Carlson (2017) provide evidence that banks themselves rely on another layer of intermediation for a variety of functions. The presented theoretical framework shows the cost benefit of interbank intermediation using the example of correspondent banks and how a DLT system like RippleNet can not only transform existing cost structures, but also the interbank market. Since the stability of the financial system greatly depends on the interbank network topology (Hüser 2016), the insights here also have important implications for future regulation. 3 The direct use of central bank digital currencies for cross-border transactions is also examined in the literature (Koning 2016; Raskin and Yermack 2018; Auer and Boehme 2020). Although this idea seems promising, economists have several reservations, e.g., privacy issues, or the limited operational capacity of central banks to deal with individuals (see, e.g., Kahn etal. (2019) for an insightful discussion on this topic). Additionally, Boar etal. (2020) found that the overwhelming majority of central banks see themselves as unlikely to issue any type of such a currency in the foreseeable future. Other studies examine the specific example of Bitcoin (Böhme etal. 2015; Narayanan etal. 2016) and its use as virtual currency (Rysman and Schuh 2017). Scalability and transaction speed, however, are limited in the Bitcoin system (Natarajan etal. 2017). 28 Digital Finance (2021) 3:25–44 1 3 2 The foundation ofinterbank intermediaries 2.1 The concept ofcorrespondent banking The ability to safely and securely transfer money both within and across borders is indispensable for a functioning economy. Until the middle ages, banks were municipally chartered institutions and could offer payments services only within their home city (Quinn 2008). As a result, funds had to be physically transferred. A process that was often plagued by theft, confiscation, and loss at sea. As long-distance trade increased, better suited transaction means were needed. The bill of exchange became available as a new payment instrument during the 13th century. Bills of exchange are written instructions from a drawer to a drawee, a correspondent in a different city, to give funds to a payee. Initially, correspondents were often merchants, with time banks were used more frequently due to their ubiquitous network and ample liquidity. Starting in the 17th century, ongoing improvements in interbank relationships and the emergence of new payment instruments simplified inter-regional and cross-border payments (Quinn 1997, 2008). By the end of the 19th century, certain banks began to specialize in mediation of long-distance transactions, i.e., correspondent banks (see, e.g., Calomiris and Carlson (2017) for an overview of the U.S. corresponding banking network at that time). Today, most other banks rely on these correspondent banks to complete transactions on their behalf in areas where they are not physically present (Society for Worldwide Interbank Financial Telecommunication 2016; Rice etal. 2020). The intermediary banking services are controlled by a few large correspondents, i.e., the market is typical for an oligopoly. According to the European Central Bank, in 2016, there were 401 correspondent banks involved in the Euro business that served 9,754 customer banks (European Central Bank 2016). Based on data from the Committee on Payments and Market Infrastructures (2019), it is estimated that the number of correspondent banks had decreased to about 361 by the end of 2018. Although the exact number of correspondent banks globally is publicly unknown (Committee on Payments and Market Infrastructures 2016, 2019), the total number is declining, i.e., the market is increasingly concentrated. In the succeeding sections, for simplification, correspondent banks will only be referred to as correspondents. The modern correspondent banking model consists of an international network of financial institutions, where the sender and the beneficiary bank employ an intermediary (the correspondent) to sort and process crossborder payments. The sender and the beneficiary bank hold Nostro (Italian: ours, which refers to ‘our account with you’) account with the correspondent. Due to the absence of a direct account relationship, the correspondent provides Loro (Italian: theirs, which refers to ‘their account with them’) accounts on behalf of the sender and the beneficiary bank.4 The financial information, to settle transactions by crediting and debiting the accounts, is exchanged via the SWIFT’s network (Grant 1986; 4 Note that this is the most simple structure. In principle, there could be additional correspondents involved on the sending and receiving sides. 29 1 3 Digital Finance (2021) 3:25–44 Society for Worldwide Interbank Financial Telecommunication 2016). The payment instruction flows through an entry posting system, which creates a debit to the sender’s account and either a credit to the beneficiary’s account if this is held with the same correspondent or a posting to the payment system queue for settlement over the national/regional payment system. The payment flows from one bank to another through a central bank clearing system. There are two main types of settlement systems: real-time gross settlement (RTGS) and deferred net settlement (DNS). While in a DNS system (such as the Clearing House Interbank Payments System, CHIPS in the U.S.), all unsettled transactions are gathered and processed in bulk, RTGS systems (such as Fedwire in the U.S. or the Trans-European Automated Real-time Gross settlement Express Transfer system, TARGET2 in Europe) process money in real time. To illustrate the payment processing via a correspondent, consider the following example. An U.S. American importer instructs its regional bank, i.e., the sender bank, to make a payment to a European firm (compare Fig.1). It is important to note that the payment instructions are exchanged separately from the “physical” flow of payments between the corresponding parties. The European firm has an account at Deutsche Bank with which the regional bank, e.g., the Bank of Colorado, has no banking relationship. However, both the Bank of Colorado and Deutsche Bank have a correspondent banking relationship with the Bank of America, i.e., they both hold Nostro accounts at the Bank of America. Like the Bank of Colorado, the Bank of America has an account at the Fed and thus receives the funds through the national payment system, e.g., Fedwire. The Bank of America provides Loro accounts for their bank clients that they can make and receive USD and foreign currency payments. Upon receiving the USD in its Federal Reserve account, Bank of America does a book-entry transfer to credit Deutsche Bank’s USD Nostro account for the amount of the payment. Bank of America then converts the USD to Euro, so it can send the payment to the German supplier’s account at Deutsche Bank. Fig. 1 Correspondent banking system today 30 Digital Finance (2021) 3:25–44 1 3 Correspondents are used, because accounts at the central bank governing the particular currency are required for a transfer. In this example, Deutsche Bank does not have an account at the Fed. As a result, Bank of America cannot “physically” move the USD to Deutsche Bank. Assuming the supplier would like to either withdraw the funds or use them to make a Euro payment, Bank of America must first do a separate foreign exchange transaction to convert the funds to Euro. To do this, the Bank of America will debit Deutsche Bank’s USD Nostro account and then credit Deutsche Bank’s Euro Nostro account for the Euro equivalent. Bank of America then sends the Euro amount via the European Central Bank settlement system, TARGET2, to Deutsche Bank, since Deutsche Bank has a TARGET2 account. Once Deutsche Bank has the funds, it can credit the supplier’s account, and the supplier can make a Euro payment or withdrawal. In terms of costs of cross-border payments, each bank in the payment process charges payment processing fees (Casu and Wandhöfer 2018).5 Each bank also individually conducts know-your-customer, anti-money laundering, and counter-terrorist-financing checks. In addition, network and liquidity costs are involved in maintaining correspondent relationships. Costs arise for each bank that is involved in the process of funding interbank accounts and managing exposures. 2.2 The theory ofinterbank intermediation To better understand the formation of interbank intermediaries in cross-border payments, the model of Breuer (1993) is introduced and adapted. For this model crossborder transactions are defined as the transfer of a fixed amount of money from one currency zone into another. Two banking systems with n domestic banks (D) and m foreign banks (F) are considered, the bilateral network and the corresponding banking system. In the bilateral network (compare Fig.2), on behalf of their clients, each domestic bank must handle the sorting and processing of payments directly with its foreign counterpart. In this system, there are m∗n possible interbank transactions. In contrast, the presence of j intermediary correspondents (B) results in n∗j+m transactions (compare Fig.3). In this case, all institutions forward payment instructions to correspondents that operate solely in a specific region (e.g., in one country, state or jurisdiction, etc.), to sort and process. In this system, the number of interbank transactions is reduced if the number of correspondents is sufficiently low, i.e., j≤ m(n−1) n holds true. In other words, as long as every correspondent j serves more than two foreign banks m, the correspondent system results in a lower number of interbank transactions. Note that the modeled structure implies that each domestic bank has access to all service-providing correspondents. As only “a few key players [account] for the majority of loro account turnover” (Committee on Payments and Market Infrastructures 2016,p.15), this seems to be a reasonable assumption for the cross-border payment market. In contrast, each correspondent limits its service 5 Note that, in the end, these costs are passed on to the payer and/or payee depending on the charge code. The code OUR is used to denote that the payer covers all transaction fees, BEN indicates that the beneficiary bears all the costs, and SHA indicates that payer and payee share the costs. 31 1 3 Digital Finance (2021) 3:25–44 to a few foreign banks in a specific region, jurisdiction, or category of clients due to regulatory requirements and risk management considerations (Committee on Payments and Market Infrastructures 2016).6 To evaluate if the employment of correspondents and the resulting decrease in interbank transactions also reduces costs, further analysis is necessary. Therefore, it is important to consider the different types of transaction costs that arise for the banks when payments are processed. In principle, transaction costs are classified according to their traceability (direct or indirect costs) and/or to their relationship with the transaction volume (variable or fixed costs)—compare Table1. Each market participant faces market entry costs, c1 . These costs are volume independent (i.e., fixed) and cannot be attributed to a specific transaction. In case of cross-border payments, this could be, e.g., costs for a payment processor license. In addition, there are fixed costs that are directly attributable to the transaction, c2 . In the considered use case, these could be costs for establishing and managing counter–party bank relationships, directly with the correspondent or the foreign bank, respectively. There are also direct costs, c3 , which depend on the transferred money volume. Examples are foreign exchange costs or payment processing fees. With increasing payment orders, more processing fees accumulate. Finally, there are general costs that depend on the total volume, but are not attributable to a specific transaction, c4 . An example is the opportunity costs for trapped liquidity that banks are required to hold on their Nostro accounts to settle payments. Every market participant is considered to have the same cost parameters and functions, i.e., is able to process the same amount of payments. This is done to rule out Fig. 2 Bilateral transactions 1 2 ... m 1 2 ... n Fig. 3 Interbank intermediation 1... m j... m− m/j +1 ... m 1 2 ... n 1... j 6 Theoretically, it is also possible to assume that each correspondent j has a relationship with all foreign banks. This would result in m ∗ j + n ∗ j transactions. Depending on the number of correspondents, i.e., if j≤ m∗n m+n , this system could have a lower number of transactions in comparison to the bilateral system. However, such a system is not only inferior to the one depicted in Fig.3, but also at odds with reality. 32 Digital Finance (2021) 3:25–44 1 3 any biases stemming from specialized banks in the systems (i.e., more cost efficient banks). All market participants are banks and face similar regulatory costs (e.g., licensing fees or costs for know-your-customer checks etc.). In addition, all banks involved have volume-dependent costs for funding interbank accounts as well as processing and managing exposures (Casu and Wandhöfer 2018). As a result, the costs for a domestic bank in a bilateral system amount to: where V denotes the volume of all cross-border payments, V mn the volume for each transaction, and V n the volume per domestic bank. Respectively, the transaction costs for each foreign bank are given by: where V m denotes the payment volume per foreign bank. Consequently, in a bilateral system with n domestic and m foreign banks (compare Fig.2), the transaction costs sum up to: In comparison, if j correspondents are involved (compare Fig. 3), each domestic bank has transaction costs of: Instead of directly processing payments to foreign banks, the domestic banks forward payment instructions to the specific correspondents. In turn, the correspondent forwards the payment to the foreign bank. The costs for the foreign bank can be described by: (1) c D=c1+mc2+mc3 (V mn ) +c4 (V n), (2) c F=c1+nc2+nc3 (V mn ) +c4 (V m), (3) c=nc D +mc F c =[m+n]c1+2mnc2+2mnc3(V mn ) +nc4 ( V n) +mc4 ( V m). (4)  c D=c1+jc2+jc3 ( V jn ) +c4 ( V n ). Table 1 Different types of transaction costs This table is adapted from Breuer (1993) and displays the different transaction costs. Transaction costs can either be fixed (volume independent) or variable. Moreover costs can be distinguished into direct and general, i.e., not clearly attributable costs Transaction volume Transaction volume Independent costs Dependent costs Costs not directly attributable to specific transactions c1 c4 Costs directly attributable to specific transactions c2 c3 39 1 3 Digital Finance (2021) 3:25–44 3.2 Implications forthecorrespondent banking system In the following, the transaction cost model of Breuer (1993) is used to illustrate how DLT systems, like RippleNet, affect the correspondent banking system. Instead of relying on several specialized correspondents, domestic and foreign banks use a shared network that is based on a permissioned DLT and transfer funds directly (compare Fig.6). In case of cross-border payments via DLT, the costs for a domestic and a foreign bank reduce to: Instead of maintaining j counter-party relationships, each bank only maintains access to the Ripple network. This reduces the network costs for each bank to c2 . Similarly, due to the fact that less parties are involved, the processing fees c3 can be reduced, too. Instead of processing messages to j correspondents and keeping internal records to capture proprietary aspects of each currency transfer, both banks only face one-time costs, consisting out of the direct transfer costs and costs for validating transactions on the ledger. Like in the correspondent banking system, banks still have to provide sufficient funds in their account to process the payments. Even though a lot of interbank intermediaries can be excluded in this system, at least one administrator (A) for the market place is needed. The administrator faces market entry costs 𝜏1 to set up the system. Additionally, the administrator has to verify all domestic and foreign banks (resulting in costs 𝜏2 ), ensuring that they have the ability to process payments. Once the information is digital, it can be easily verified and shared among all network members. Making use of the distributed exchange capability, cross-border payments are automatically processed among network members, resulting in 𝜏3 . The instant real-time settlement of transactions basically eliminates the time and cost of capital ( 𝜏4 ) that is locked during a cross-border transfer. Still, the administrator faces 𝜏4 costs for the infrastructure, i.e., capacity costs that incur to be able to process all payments. Thus, the costs for the administrator can be described by: (9)  c D=c1+c2+c3 (V n) +c4 (V n). (10) c F=c1+c2+c3 (V m) +c4 (V m). Fig. 6 Intermediation via DLT 40 Digital Finance (2021) 3:25–44 1 3 As a result, in a DLT system, the following transaction costs incur: To assess potential benefits of the DLT system, the economy-wide costs of the DLT system must be compared to those of the correspondent banking system. Subtracting Eq. (12) from Eq. (7) reveals the economy-wide differences between the two systems: Although the initial infrastructure required for a DLT platform is far more costly ( 𝜏1 ) than a simple banking license ( c1 ), in relative terms considering the sheer number of existing correspondents j, the technology is remunerative. While there are little data on the costs of public permissioned DLT systems, Brody etal. (2019) estimate an initial investment equivalent to approximately 26 German banking licenses, i.e., correspondent banks.12 Currently, there are about 361 correspondent banks in the Euro business alone. For a sufficiently large number of correspondents ( ∼ 26), the DLT system results in lower market entry costs. A DLT system reduces networking costs if onboarding ( 𝜏2 ) is less expensive than it is for banks to establish counterparty relationships ( c2 ). There is limited information on both the onboarding costs in a DLT system and the banks’ network costs. It seems plausible, however, that both the administrator and correspondents have economies of scale in establishing additional relationships (Maringer etal. 2019). While an administrator must accumulate (11) cA =𝜏1+(m+n)𝜏2 +n𝜏3 ( V n) +m𝜏3 ( V m) +𝜏4(V) . (12) c=nc D +mc F +c A c =(m+n)c1+𝜏1+(m+n)(c2+𝜏2) +n[c3(V n)+𝜏3(V n)] +m[c3(V m)+𝜏3(V m)] +nc4 ( V n) +mc4 ( V m) +𝜏4(V) . (13) c −c=jc1−𝜏1+jc4 ( V j ) −𝜏4(V) +[2jn +m−n]c2−(n+m)𝜏2 +2jnc3(V jn)−n[c3(V n)+𝜏3(V n )] +m [ c3 ( V m) −𝜏3 ( V m)] . 12 According to Haag and Steffen (2020), the German Federal Financial Supervisory Authority BaFin charges a fee of up to $25,000 for granting a banking license. 41 1 3 Digital Finance (2021) 3:25–44 knowledge about the regulatory environment and how to establish trustworthy relationships, correspondents potentially already possess unique proprietary knowledge. The exact relation between 𝜏2 and c2 is hard to determine. Although c2 may possibly be lower than 𝜏2 , with an increasing number of correspondents, the DLT system can result in lower network costs. Anecdotal evidence indicates that it is simply too costly for correspondents to establish and maintain banking relationship for certain geographic regions (Bräuning and Fecht 2017; Kobayashi and Takaguchi 2018). The number of correspondents has been steadily decreasing over the last years and the remaining correspondents have even pared back their relationships. This resulted in even higher cross-border payments costs in abandoned regions (Rice etal. 2020). In contrast, technologies such as RippleNet enable banks to exchange funds without dedicated pre-established networks for the target location of the transaction as long as both institutions are connected via the system. Payment processing costs can be significantly reduced in the DLT system, because failures of payments are minimized through the automatic real-time settlement (Ripple 2017). In the current correspondent system, complex interbank pricing rules create the need for manual invoicing, claims-handling, and dispute management. This requires substantial manpower and valuable time for transaction execution. In addition, due to the presence of market makers, an universal intermediate currency (e.g., XRP) and cost beneficial path settlements, foreign exchange costs can be reduced. Currently, managing cash reserves in multiple currencies makes optimizing payment flows challenging. The DLT system will reduce operational costs linked to the processing of payments, i.e., 𝜏3( ⋅ )<c3( ⋅ ) holds true. The main challenge for the administrator, e.g., Ripple Labs, is to ensure that the processing power to support an increasing number of transactions per second is available, i.e., the system is scalable. The required computing is energy intensive (Leopold and Englesson 2017; Truby 2018). Brody etal. (2019) cite ongoing maintenance ( 𝜏4 ) as the most significant running cost for a public permissioned DLT system. In the case of correspondents, typically, opportunity costs for trapped liquidity ( c4 ) are a major cost factor. Nonetheless, given the required processing power and energy, maintaining a DLT system might still be more expensive. However, in case of a relatively high number of correspondents, the positive effect of 𝜏1 , 𝜏2 , and 𝜏3 outweighs the additional costs of 𝜏4 . Consequently, in principle, a DLT system results in an overall cost saving. The magnitude of improvement greatly depends on network effects that can only be created by on-board large banks around the world (Iansiti and Lakhani 2017). To achieve this, building and maintaining trust in the new payment system are vital. 4 Conclusion Traditional correspondent banking networks are still prevalent for cross-border payments. Here, transaction cost theory was used to show the amenities of such interbank intermediaries. Subsequently, the effect of a DLT-based system on the cross-border payment market was analyzed. DLT has the potential to replace correspondents and dominate cross-border payments by reducing the overall transaction 42 Digital Finance (2021) 3:25–44 1 3 costs. DLT is a nascent technology that could form the basis of a new cross-border commercial payments network. The speed of acceptance by banks around the world and the rate at which legal concerns are addressed will determine when DLT can be used to support trillions of dollars in payments. Acknowledgements I thank Max Bruche, Werner Neus, Anna Staerz, Sebastian Weitz, the audience at the World Finance Conference 2020, and two anonymous reviewers for their helpful suggestions and comments. Funding Open Access funding enabled and organized by Projekt DEAL. Open Access This article is licensed under a Creative Commons Attribution 4.0 International License, which permits use, sharing, adaptation, distribution and reproduction in any medium or format, as long as you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons licence, and indicate if changes were made. The images or other third party material in this article are included in the article’s Creative Commons licence, unless indicated otherwise in a credit line to the material. If material is not included in the article’s Creative Commons licence and your intended use is not permitted by statutory regulation or exceeds the permitted use, you will need to obtain permission directly from the copyright holder. To view a copy of this licence, visit http://creat iveco mmons .org/licen ses/by/4.0/. References Afonso, G., & Shin, H. S. (2011). Precautionary demand and liquidity in payment systems. 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