The UN estimates that over 800 million people across the globe regularly receive remittances, and many studies have linked remittances to a broad range of positive effects in recipient households. Unfortunately, the remittance industry is plagued by a range of issues such as high fees and slow processing times, which have persisted despite technological advancements making other financial transactions quicker and cheaper. This blog post examines the major pain points within the remittance industry, and explores potential solutions to them.
Written by Paolo Di Stefano — April 11th 2023
On the 70th anniversary of the United Nations (UN) in 2015, the 193 member states collectively declared the seventeen Sustainable Development Goals (SDGs) aimed at resolving important social, economic, and environmental issues around the globe until 2030 (UN General Assembly, 2015). Goal 10, titled Reduce inequality within and among countries, explicitly refers to lower transaction costs for remittances as one of its few concrete measures.
Contrary to official development assistance (ODA) and foreign direct investment (FDI), remittance flows are made up of many small transactions from migrant workers or benevolent senders abroad who support their friends and families in their home countries (IMF, 2009). Since remittances are most frequently sent from high-income to low- and middle-income economies, relatively small transactions can already significantly impact the recipients’ purchasing power (Ratha, 2013).
The UN estimates that more than 800 million people regularly receive remittances and links them to a broad range of positive effects contributing to more prosperity across the globe (UN General Assembly, 2015). This is supported by a comprehensive cross-country study from López and Fajnzylber (2008) in Latin America showing that higher remittance inflows are associated with lower levels of poverty in recipient economies. Beyond that, studies by Hildebrandt et al. (2005) in Mexico and by De and Ratha (2012) in Sri Lanka concluded that the presence of remittance income in households corresponds to better health conditions, and a study by Edwards and Ureta (2003) in El Salvador even led to the conclusion that remittances positively impact the educational situation of children in recipient families.
While the positive effects of remittance flows are broadly undisputed in the scientific community, the remittance industry is plagued by a range of issues such as high fees and slow processing times (World Bank, n.d.). These issues have persisted for decades, despite technological advancements making many other financial transactions quicker and cheaper. The outdated financial infrastructure and poor market conditions within the remittance industry, therefore, represent a significant legacy inherited from previous generations, one that is in dire need of a replacement for the UN to be able to achieve the SDGs by 2030.
2. What are the challenges?
The World Bank estimates that an astonishing total of USD 781 billion in remittances was sent in 2021, which approximately corresponds to the GDP of Switzerland in the same year (Ratha et al., 2022; Macrotrends, 2023). While the largest outflows of remittances arose from high-income countries such as the United States, the United Arab Emirates, Switzerland, and Germany, the top five recipient countries for remittance inflows in 2021 were India, Mexico, China, the Philippines, and Egypt (Ratha et al., 2022). For most low- and middle-income countries around the globe, remittances represent the largest source of financial inflows as they have reached approximately three times the recorded volumes of ODA and even slightly surpassed those of FDI in recent years (Ratha et al., 2022).
The World Bank has documented the prices of many remittance service providers (RSPs) over the last decade and regularly approximates the global average transaction cost to remit USD 200 (World Bank, n.d.). In the most recently published report, the global average transaction cost increased from 6.01 percent in Q2 2022 to 6.30 percent in Q3 2022. Sub-Saharan Africa was the most expensive region to send money to, recorded at 8.46 percent in Q3 2022 (Ratha et al., 2022). Assuming that an average of 6.30 percent of the total USD 781 billion transferred in 2021 was charged4 would mean that fees of more than USD 49 billion were collected by RSPs over the course of a year. This displays how massive the remittance industry truly is and how much potential for gains in cost efficiency remains. The reasons why fees are so high are manifold according to the World Bank (n.d.). The main issues include the underdeveloped financial infrastructure in most low- and middle-income countries, limited competition among RSPs, regulatory obstacles in many jurisdictions, as well as a lack of transparency.
The World Bank distinguishes between different types of RSPs acting as financial intermediaries on behalf of the senders and recipients. The most important types are banks, post offices, and money transfer operators (MTOs) such as Western Union, which are defined as financial companies specializing in cross-border transfers (IMF, 2009). These RSPs transmit transaction details through specific payment interfaces. Traditional wire transfers are still the most frequently used payment interface and represent electronic transfers of funds based on systems such as SWIFT or Fedwire.
In both cases, the funds are sent across extensive networks of banks and credit institutions (IMF, 2009). Especially when less prevalent currencies are involved, the process can become lengthy and inefficient as direct links between the senders’ and the recipients’ RSPs might not exist (Flore, 2018). Moreover, many MTOs typically need to involve outside agents, such as drug stores or cell phone centers, in the process. Their function is to collect the funds and transaction details from senders or respectively, hand out the funds to the recipients (Western Union, n.d.). These agents still represent the predominant access points for MTOs in most recipient economies and are an additional cost factor (Flore, 2018).
Apart from that, money transfer is a heavily regulated industry. Licensing for every jurisdiction, in which RSPs plan to offer their services, is necessary before they can start to operate. Anti-money laundering and anti-terrorism regulations typically require RSPs to identify customers, keep a record of their transactions, and report suspicious transactions to the authorities (Flore, 2018). The exact regulatory requirements are however not homogeneous across countries, and particularly in low- and middle-income economies, applications to obtain the necessary licensing can take multiple years (IMF, 2009).
Lastly, the World Bank (n.d.) points out that the lack of pricing transparency and the limited degree of competition are closely connected. Foreign exchange margins are usually not displayed openly and thus, customers can rarely compare the exact prices among different providers. The IMF (2009) found that in these cases, customers usually stick to using the providers they already know. This allows more established RSPs to keep large market shares because customers do not detect cheaper alternatives right away. Flore (2018) highlights that for some countries, exclusive rights to a handful of RSPs have been granted by the authorities, restricting competition even more. It is therefore evident that there remains much room for improving the deficient industry conditions and that the UN’s call for lower transaction costs for remittances is definitely legitimate.
3. How can we tackle these challenges?
Since the outlined challenges of underdeveloped financial infrastructure, limited competition among RSPs, regulatory barriers, and the lack of transparency are strongly interconnected with each other and concern a wide range of countries, there is unfortunately no simple action plan to holistically improve the deficient industry conditions. Two major pain points and potential solutions to them shall however be discussed in more detail in the following paragraphs, namely the inadequate financial infrastructure as well as the stiff regulatory environment.
As stated in the previous section, traditional wire transfers are still the most frequently used payment interface used by RSPs and are based on antiquated systems such as SWIFT or Fedwire, which were both established in the last century (IMF, 2009). To start with the most prominent example of financial innovation in recent years, blockchain technology would certainly have the potential to revolutionize the remittance industry by providing a secure and transparent payment interface for international money transfers. Blockchain-based systems allow for decentralized peer-to-peer transactions and could greatly reduce the costs and processing times for cross-border transactions (Nakamoto, 2008; Mazières, 2016).
There are already several blockchain-based remittance platforms in development. For example, Stellar, a US-based non-profit organization born out of the cryptocurrency project Ripple, has been working on a blockchain-based remittance platform that allows for near-instant cross-border transactions at a fraction of the cost of traditional methods (Mazières, 2016). Another example is the fintech start-up BitPesa, which was founded in Kenya and aims at leveraging blockchain technology to facilitate remittances with a specific focus on previously unbanked recipients in Africa (Varghese, 2018).
Another alternative to traditional wire transfers is the approach two European fintech start-ups, TransferWise and Azimo, use. They developed a system that involves both bundling as well as internally matching transactions of users wanting to send funds in the opposite direction. Hence, a substantial part of the funds can simply be transferred within some of the national payment systems and do not necessarily have to travel across borders (Cortina & Schmukler, 2018).
It is therefore evident that alternative technologies to traditional financial systems such as SWIFT and Fedwire already exist. A main hindrance to wider adoption, however, is the unclear and inconsistent regulation across different countries and the long waiting times to obtain licensing. This creates uncertainty for customers and makes it difficult for new companies to enter the market (Mazières, 2016).
To be more concrete, the regulation of blockchain-based money transfers widely varies across different jurisdictions. In a few countries where regulation of so-called decentralized finance is already more advanced, Switzerland for example, blockchain-based remittance platforms are regulated similarly to traditional financial service providers. In these cases, they are required to obtain licenses and comply with anti-money laundering (AML) and know-your-customer (KYC) regulations (PwC, 2023).
In most countries, however, regulatory frameworks for blockchain-based money transfers are still being developed. In the United States, for example, the regulatory landscape for blockchain-based financial services is still evolving, and different states have different laws and regulations. The Financial Crimes Enforcement Network (FinCEN) has previously stated that all money transmitters, including those using blockchain technology, would be treated equally. However, the other two relevant regulatory bodies, namely the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), have yet to issue clear guidance. Many recipient economies such as India and Egypt are in a similar situation, where the regulatory environment is uncertain, and some providers may risk operating in a grey area (PwC, 2023).
Overall, the regulation of blockchain-based money transfers is certainly not a simple issue, and the regulatory landscape is likely to evolve and improve over the next years. However, considering that according to Flore (2018), there exists consent among experts that the small average transaction amounts make remittances inefficient as a money laundering tool, regulators should be urged to move quickly and be as pragmatic as possible. The quicker they issue clear guidance and reduce waiting times for new RSPs to obtain adequate licensing, the sooner innovative competitors can enter the industry, and ultimately, a larger share of the transferred funds can reach those in need.
It was shown that remittances are a vital source of financial support for many recipients in low- and middle-income countries across the globe. Despite the wide range of positive effects associated with remittances, this essay has pointed out that the remittance industry still broadly relies on antiquated financial infrastructure and is plagued by a range of issues. Particularly the high transaction costs, which can be as much as 8.46 percent in Sub-Saharan Africa, represent a significant barrier to achieving the UN’s SDG of reducing inequality within and among countries.
It has been set forth that the issue does not lie in the absence of alternative technologies, but in the lack of regulatory guidance to allow companies utilizing these technologies to compete within the industry. The quicker the regulatory environment can be improved, the sooner innovative competitors can enter the market, and ultimately, a larger share of the transferred funds can reach those in need. The outdated financial infrastructure within the remittance industry as well as the stiff regulatory environment therefore represent a major problematic legacy that has been passed on from previous generations to ours and which needs to be addressed and replaced urgently.