How money moves12 min read

This is another non-AI written post explaining another basic banking activity. In the previous post, we established what happens when you give (deposit) money in a bank. However, now you accidentally find yourself in San Jose, planning a tour to the Poas Volcano, you’re also hungry, and a sloth just stole the last of your cash from your purse while you were being distracted by a monkey! That money sitting in your bank on the other side of the world is a bit useless in your particular case isn’t it? Now you need to transfer it, right? Very easy: you just grab your phone, initiate a money transfer to the tour operator so that you can go see the volcano, and use your Visa or MasterCard (debit or credit) card to pay for a hamburger. Life’s easy.

But have you ever wondered how that is possible? How it works? What parties are involved in this whole ensemble of inter-connected institutions to enable you to do that very (but not really) simple task of instantly transferring money from one side of the world to the other? Probably not. Normal people don’t think and wonder about these kinds of things, they’re busy taking pictures of monkeys in Costa Rica. Well, this is your lucky day! Since you’re here reading this post, you’ll learn a basic overview of how it works.   

As explained in the previous posts, banks are institutions that keep books on who they owe money to. So, when a bank client (you) wants to transfer money to another bank’s client (i.e. friend or someone selling something), there are a series of steps that need to happen. Here’s an oversimplified list of steps that are usually taken:   

• First is you need to give an instruction/order to your bank. ¹This is the coolest part of being a bank client, because it’s like having a personal slave. You order it to do something, and it is obligated to obey!
• Then your bank will check its books, and see whether it owes you more money than that which you are ordering it to transfer.  
• Then your bank must communicate to the recipient’s bank about the amount of money that you intend to transfer to them.  
• Then your bank will change its books to state that it owes you less money.  
• Then the recipient’s bank will change its books to state that it owes the recipient more money.  

There are a few ways that this happens. It is either done through a communication system. Or through a payment system. One obvious thing to understand in this process is that all of this concerns information; more specifically, electronic information. Nowhere in this process does it involve a bank actually getting cash (i.e. coins and banknotes) and stuffing them in an envelope and mailing them across the world. You just need to be aware that our lives are much simpler in terms of money transfers because of the internet. So, when one bank communicates with another bank through a system, it is done via established internet protocols.

How money transfers work very well and are seamless, is because of standardization of communication. The structure of money transfer information has been very well standardized ²and has it’s own ISO standard, and all participants follow that standard; that means, the sender bank and the recipient bank both speak the same language. The benefit of information structured in a set format between participants is to allow them to.automate their systems.   

One of the most famous money transfer communication systems in the world ³that almost everyone that has ever transferred money internationally has heard about is SWIFT. That organisation works so well, it definitely deserves its own dedicated blog post, and I may do it in the future, but for now, just consider it as an institution owned by financial institutions which provides a standardized way of how information is communicated between banks nationally and internationally, and operates a communcation platform through which that information is communicated. Inherently, trusting the SWIFT network is a pre-requisite in enabling money transfers. So, when money is transferred from one bank to another, or more technically, when a ‘message’ is sent (communicated) from one bank to another, then the recipient bank, because it has received the message through the SWIFT system, it relies and acts on it (i.e. changes its books accordingly). Joining the SWIFT communication network is not an easy task for banks, and there are a long list of organisational and technical requirements which must be met, because inherently what is being communicated is not information, but trust.   

The SWIFT system is exclusive to financial institutions. Because of that limiting factor, another type communication system emerged which was built on top of SWIFT, which enabled other participants to move money effortlessly, and that is: the payment card ecosystem. If you have never heard of SWIFT, then you definitely have heard about Visa, MasterCard, American Express, and others. You probably have one of their logos in your wallet right now! The payment card industry has been created to facilitate seamless payments between companies and individuals. So, when your bank is in Denmark, and you’re trying to buy a hamburger at 02:00 AM in Costa Rica with your card, what happens in those 2-5 seconds when you touch the merchant’s payment terminal is:  

• Depending on the amount, you may first be asked to authorize the payment (via Card PIN)
• Then your account is checked whether you have the available funds 
• Then those funds are frozen in your account 
• Then this information is communicated to the merchant.

However, that doesn’t mean that money was transferred from your account to the merchant’s account. That usually happens later, in the next business day (or later), during business hours. That is called ‘settlement’. I’m introducing this additional concept in here before explaining what a payment system is, because you need to understand that money transfer has two aspects: one is communicating the information, and the other is actually transferring the money.

In a payment system, participants (e.g. banks) communicate information about money transfers, as well as actually transfer money (change their books). Payment systems are usually used in a common legislative framework, such as within countries, or the EU ⁴which uses Clearing and Settlement Mechanisms such as STEP2 or STET, and they are used to communicate information as well as to settle transactions. What does settling involve? Well, we must take one step back and think about the last step in first list above, when the recipient’s bank changes its books to state that it owes the recipient more money. For that bank to be able to do that, some other book must be changed somewhere to state that the same amount of money is actually owed to that bank. Banks can’t just create money as much as they want! Only Central Banks can do that. Money has to come from somewhere. Just like you and me are clients of banks, banks are also clients of other banks. So when you transfer money to someone in another bank, besides communicating the information of who is the recipient and what is the amount (the process that happens quick), your bank must also change its books to state that an amount is reduced from your account, and that same amount is increased in the recipient bank’s account (a much slower process). That is what ‘settlement’ is. But this is not done for every money transfer transaction, because many transactions happen during the day, in each direction. This is done in bulk at set periods (e.g. at the end of the day). If 128 clients of Bank A, transfer 512k EUR to 256 clients at Bank B, and in the same day, 768 different clients of Bank B, transfer 1.024m EUR to 64 clients at Bank A, then at the end of the day (or whatever period), Bank A and Bank B check the total amounts transferred between each of their clients, and then come to the conclusion that 512k EUR must be transferred to from Bank B to Bank A, and they change their books accordingly, thus settling the transactions. This is very easy when there are only two banks involved and they each have accounts with each other. Where matters become more complicated and where you need a ‘system’ is when there are more parties involved. In those cases, the most efficient way is for each bank to have a central counterparty ⁵usually a bank, a central bank, or a financial institution that acts like a bank, and then settlement happens there. Effectively, in a country, all the operating banks, have an account with whatever institution that runs the payment system. They transfer and keep a certain amount of money to that institution. Then at clearing and settlement intervals, that amount either increases or decreases depending on how much money each individual banks’ clients transfered. So, if a country has 10 banks, and those banks have thousands of clients who transfer money to the thousands of clients in other banks, the payment system operator at the end of the day checks how much money was transferred in and out of each individual bank, and then comes up with a total, and then changes the amount in its books for each individual bank. E.g. bank A had a total of 12m EUR of outgoing transfers, and had 8m EUR of incoming transfers, then at the end of the day bank A’s account in the system is reduced by 4m EUR. 

This is very easy when the banks are in one country or one payment system, but what about international payments, or in other words, cases when the banks don’t even know each other? That is where ‘correspondent banks’ come into play. According to SWIFT, most of the world’s international transactions⁶ approximately 86% are done through only one intermediary bank. That means, both the sender’s bank and the recipient’s bank have an open account in a mutual bank. I.e. both your bank in Demark, and the recipient’s bank in Costa Rica, have an account with BNP Paribas in New York. What about the other 14%? Well, that is the whole point of having SWIFT, and routing transactions in the most efficient manner. This is kind of like that trivia game of Six Degrees of Kevin Bacon. Most world banks can be connected to each other through two or three intermediaries. E.g. if the recipient’s bank in Costa Rica doesn’t have an account with BNP Paribas in New York, it may have an account with Santander Mexico, who in turn has an account with BNP Paribas in New York.  

So, a less simplified list of tasks that are taken when you want to transfer money from Denmark to Costa Rica is:  

• First is you give an instruction/order to your bank.  
• Then your bank will check its books, and see whether it owes you more money than that which you are ordering it to transfer.  
• Then your bank must communicate to the recipient’s bank about the amount of money that you intend to transfer to them.  
• Then your bank will change its books to state that it owes you less money.  
• Then your bank’s respective correspondent bank will change its books to state that the correspondent bank owes your bank less money. 
• At the same time, the correspondent bank, will change its books to state that it owes the recipient’s bank more money. 
• Then finally the recipient’s bank will change its books to state that it owes the recipient more money.  

Money transfer and clearing through the international payment card scheme operators such as Visa or MasterCard is similar, but those operators play the one of the roles of clearing and settlement institutions. Your bank that issued the payment card that you use usually has an account in a bank that Visa or MasterCard requires, and that amount is reduced or increased depending on how many payments are made by your bank’s clients or how many payments are received by your bank’s clients who are merchants. But how those operators work is a topic for another blog post, because this post is already too long, and they’ve advanced so much with their product offering ⁷including things like crypto, tokenization, etc., so more room is needed to explain how they work. 

At the end of all this, you must take one aspect into account in money transfers: and that is cost. Every action taken by any participant mentioned in this post will levy a cost for their actions. SWIFT itself has a cost, a bank changing its books has a cost, Visa/MasterCard have costs, the bank that gave a payment terminal to the hamburger seller has a cost. Naturally, none of those participants will bear the cost on behalf of someone else, and it is usually the client that pays. You pay when you initiate the money transfer, or the merchant pays when they accept a card payment. That is why sometimes international transfers cost a lot, because most likely, more than one intermediary bank was used. On top of that, when costs are levied, they become avenues to generate profit for banks, which slightly increases prices. That’s how I get paid, and that’s how shareholders increase their wealth.  

Hopefully, you have now learned at least conceptually how money moves in financial institutions. This has become much more complicated in the past few decades, and now we have current account providers (that are not banks), and we have crypto, and other ways to move money. They’re just topics for future blog posts. If you read all of this, you are now more aware of everyone involved when you’re trying to pay for something, and you’ll be less frustrated when it doesn’t work.