The US dollar is the world’s premier reserve currency. It is used as a settlement currency for transactions worldwide, and commodities traded on world markets are priced in dollars. Many countries outside the US either use it as their own currency (Ecuador, Panama) or peg their currency to it in some way (China). International payments denominated in US dollars are made all over the world, all the time.
But ultimately, all international payments in US dollars have to be settled through the US, as the issuer of the currency. Specifically, international wire transfers are processed via the Federal Reserve’s Real Time Gross Settlement System (RTGS), known as the “Fedwire Funds Service” or just “Fedwire.”
How does Fedwire work for international payments?
Fedwire is one of a family of central bank RTGS systems that together form what we might call the “hubs” of the international payments network. Broadly speaking, each currency issuer has its own central bank RTGS system. So, for example, the European Central Bank’s (ECB) TARGET2 system is the RTGS for the Euro, and the Bank of England’s CHAPS is the RTGS for sterling. Fedwire, like other RTGS systems, handles international payments instantly (“real time”) and without netting (“gross”). Once the accounting entries are made, they are irreversible (“settled”).1
Central banks operate RTGS systems because, as currency issuers, they can provide unlimited liquidity to the international payments network, eliminating the risk of wire transfer failures due to lack of currency reserves at intermediaries.
In the fall of 2007, international payments systems became stressed due to shortages of certain currencies, including the US dollar. The Fed provided US dollar liquidity to support international payments via temporary swap lines with a number of other central banks. The temporary swap lines ended in 2010, but permanent swap lines have now been established with five major central banks including the ECB and the Bank of Japan, reinforcing the US dollar’s position as the international settlement currency.2
Both US and foreign banks can send and receive payments via Fedwire. If foreign banks are Fedwire participants, they can send and receive payments directly via Fedwire using the SWIFT international messaging service. If they are not, then they can send payments via a US bank or another foreign bank that is a Fedwire participant – this is a form of “correspondent banking.”3
Another route for international payments is the bank-owned, privately operated Clearing House International Payments System (CHIPS). Participants include US banks and US branches of foreign banks. CHIPS is not a RTGS: dollar payments sent via CHIPS are batched and netted before processing. The net transactions are then settled via Fedwire. As the Federal Reserve Bank of New York says, “CHIPS is both a customer and a competitor of the Federal Reserve’s Fedwire service”, since CHIPS relies on Fedwire for settlement but accepts large value payments that could be sent directly via Fedwire.4
An uncertain future for international US dollar payments
Use of the Euro for international payments is growing, and admission of the Chinese Renminbi to the IMF’s SDR basket starting in October 2016 raises the possibility that it could become an important international settlement currency in the future.5 Nonetheless, as yet the dominance of the US dollar in international payments is not seriously challenged. But the way in which international dollar payments may be processed in future could be affected by other factors.
In 2014, the French bank BNP Paribas was fined nearly $9 billion for systematic violation of US sanctions against various countries. Additionally, its access to dollar clearing via CHIPS and Fedwire for certain types of transaction was suspended for a year.6 This is the most severe penalty imposed on a foreign bank for breaking US laws, but it is by no means the only one. Other foreign banks which have suffered penalties for sanctions-breaking and money laundering include HSBC, Barclays, Standard Chartered, ING and Credit Suisse.7
The long line of regulatory and legal enforcement actions against foreign banks trading in US dollars has raised questions about the future of international dollar clearing through the US. Writing in September 2014, Ernest L. Patrikis, a partner at a leading international law firm, warned that excessively heavy penalties could drive foreign banks to exit from dollar clearing altogether, or to set up their own offshore facilities.8 But an unnamed senior banking executive quoted in Euromoney in January poured cold water on the idea that European banks would set up their own US dollar clearing facility, noting that underlying transactions would still need to be settled in New York.9
International payments denominated in dollars are quickly and efficiently processed through the Federal Reserve’s Fedwire system, which can be accessed by financial institutions worldwide either directly or via the US’s extensive network of correspondent banks. Until other currencies can offer similar efficiency of processing and widespread acceptance, US dollar clearing via Fedwire seems likely to remain the world’s premier international payments process.