How Global Financial Transactions Really Work

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Okay, right.
I’ve got some questions around.
Yes, so I’ve got questions around.
Previously, we’ve talked about banks.
We’ve talked about getting a mortgage.
We’ve talked about fractional reserve lending.
What I want to understand now is physically
when if one bank decides to give another bank money
or let’s start off with a simple thing.
Say I have just transferred money.
I got a parking fine yesterday.
Wonderful.
Because in Norway, all the shops, they have apps.
Everyone has different apps and I’m finding out now
that there’s hardly any free parking in Norway
even though normally I would expect to park in front of a supermarket
or something and be able to just park there for free.
As I found yesterday, I tried doing that and got a parking fine
which is my second one since I’ve been in Norway
which proves I don’t ever learn anything.
However, so I got this and so I tried to get it out of my mind.
So I don’t know why I’m talking about it now
but by paying it straight away.
So I’ve just paid this fine.
So I went into my app on my phone
and in Norway, I had an account number
and then I had something called a kid number.
Now, I think this is Norwegian specific
but I’m going to use this example anyway
because I think most of it will be pretty generic.
So I put that into my phone.
I say I want to transfer some money,
the amount of money, the account number
and then when I put in the account number
it pops up with the name of the organization
that I’m paying this fine to.
And then in Norway, I put this kid number
which I think is a reference ID for the particular fine
and then I hit submit, right?
So what then happens?
How does that company get my money?
Yeah, absolutely.
So once you hit submit and you’ve entered all those details
basically what’s happening behind the scenes
is your bank is going to move that money
over to the other bank that the company is using.
So that kid number that you mentioned
that is basically like a reference number
that tells the company which fine you’re paying
and the account number is obviously the destination bank account.
So once you submit that payment
your bank will move the money electronically
over to the other bank
and it usually happens through the national payment network.
So in Norway, there’s a system called bank accept
that handles a lot of these transactions
and essentially it’s all electronic
so the money just moves digitally from your account to theirs
and they get the funds usually within a day or so.
Right, yes.
So what I want to do is I want to understand that electronic process
in a bit more detail.
So what happens is the bank then communicates
with this other organization that you specified
and what do they act like?
Yeah, can you just explain in a bit more detail how that works?
I guess they have some kind of…
Well, from a technological point of view
I guess they have some kind of API which connects with it
which does some kind of handshaking.
So is this sort of in…
Yeah, so do they have a big database
of all the transactions in Norway
or how does it actually, you know…
How does it create like a trusted system
that this bank knows that the other bank
you know that the transaction has occurred
and all that kind of stuff.
How does a lot work?
Yeah, absolutely.
So let’s break it down a bit.
Basically what happens is when you hit that submit button
where bank takes that transaction information
and it kind of goes through the National Payment Network
or the Clearinghouse system.
So there’s basically an organization that sits in the middle
and they make sure that we’re bank and the receiving bank
talk to each other securely and yeah, they do have…
So you can think of it as kind of a big database
or a ledger that records all these transactions
and East Transacting has a unique reference number,
it’s tracked through the system
and that way when the receiving bank gets that signal
they know it’s coming from a trusted source,
they know the transaction’s legitimate
and they can credit the company’s account.
All right, so my bank,
they basically communicate with this Clearinghouse.
Then the Clearinghouse kind of accepts the funds
and then the third party bank trusts the Clearinghouse
and then accepts the transaction from the Clearinghouse.
Is that kind of how it works?
Yeah, that’s pretty much spot on.
So your bank and then the other banker
both connected to this Clearinghouse,
your bank sends the transaction details there,
the Clearinghouse kind of sits in the middle
and says, yep, this is all good.
And then the other bank, because they trust the Clearinghouse,
they say, okay, we accept this money
and we put it into the company’s account.
So yeah, you got it exactly right.
Right, so the Clearinghouse,
and I guess for…
Is the Clearinghouse owned by the Norwegian government?
Yeah, so in Norway the main Clearing system
is actually run by a company called BITS,
which is owned by the Norwegian banking industry.
So it’s not directly owned by the government,
but it’s sort of this industry owned body
that makes sure that all these transactions happen smoothly.
And of course, they regulate it
and overseen by the Norwegian authorities,
but it’s not a government agency itself.
Okay, so if I then change the scenario
and I want to move money to a French bank account, let’s say,
and I want to do that, what are the steps involved in that?
So I want to move 2,000 Norwegian Kroner
into the equivalent of that in a friend of mine,
say, who lives in France,
and I want it to go to their bank account.
So what steps are required to get there?
Yeah, so when you send in money internationally like that,
it’s a pretty similar process,
but it involves a little bit of extra information
and usually a different network.
So in Europe, there’s something called the SEPA network,
which is the single euro payments area.
And that allows you to send euros pretty easily across European borders.
Now, if you’re sending from Norwegian Kroner to a French account,
your bank is basically going to convert the money into euros
and they’re going to send it through the SEPA network
to your friend’s French bank account.
So you just need a few extra details like the I-Ban,
which is the international bank account number of your friend,
and maybe the BIC or SWIFT code of their bank.
And once you have that, the process is pretty similar.
You just put that in, your bank does a conversion,
and then it goes through that European payment network over to France.
Okay, so basically there’s just three parties involved in that transaction as well.
There’s the two banks and then there’s this clearing house,
but the clearing house is different for Europe
and if it was to America it would be a different clearing house again,
but it would just be three parties, is that correct?
Or does it go to the national clearing house
and then it goes to the European clearing house?
Yeah, that’s a great question.
So essentially you’re right, it’s still basically three parties,
your bank, the receiving bank in France,
and then the clearing system in the middle.
In Europe that’s usually SEPA.
If you were sending it to the US,
it might go through the SWIFT network or a different international payment network.
But generally speaking, it’s not like it has to go through a local clearing house
and then a European one.
It’s just that your bank is connected to the international network
and it will go straight from the international network to the receiving bank.
So it’s really just those three parties,
it doesn’t have to hop to multiple clearing houses.
Okay.
So what happens when somebody wants to send?
So these clearing houses, they are owned,
it sounds like the clearing house is an agreement
between all the banks that this clearing house
is the source of truth for these types of transactions
and they will abide by the clearing house’s rules.
There’s no legal obligation.
Let’s think about this.
So what prevents a bank sending money to the clearing house
and then that money going to my friend in France
but then not actually sending the money to the clearing house
or sending money to the clearing…
Well, not marking on its database that it sent that money to the clearing house.
How do you keep the banks honest in this system?
Because it seems entirely voluntary.
Yeah, that’s a really interesting question
and it definitely gets into how trust and security
maintain in these systems.
So even though it might seem voluntary on the surface,
there’s actually a lot of regulation and oversight involved.
So banks have to be licensed and regulated by financial authorities
and they have to follow pretty strict rules
about how they handle these transactions
and the clearing houses themselves, they’re also regulated
and they have to maintain really accurate records
and the banks are audited.
There’s a lot of oversight to make sure that nobody’s trying to cheat the system.
So it’s not just a voluntary agreement,
it’s really a heavily regulated environment
and that’s how they make sure that the banks stay honest
and that the money that’s supposed to move really does move.
But okay, what I don’t understand is,
so when you say it’s heavily regulated,
that’s going to be regulated within certain countries’ jurisdiction.
But when you’re talking about international payments,
I’m just trying to think of an example.
What about, yeah, what about, this is a good example.
So how was the Russian money able to be held?
So it’s my understanding that there was some bank in Russia,
Russia owned this money and it was in a bank in Europe or somewhere
and then due to the conflict in Ukraine,
the money was prevented from returning back to Russia.
That seems to break the sort of contract that you have with this system.
And I suppose I’m interested in thinking about
when there’s a lot of money involved
and when there’s an international transaction,
how is that able to happen and why was it able to happen there
and not able to happen in other scenarios?
Yeah, that’s a really interesting scenario and a good example.
So in normal circumstances, these international payment networks
are all about trust and they follow the rules.
But when you have a situation like the one you’re describing,
where there are sanctions or geopolitical issues,
what happens is governments step in
and they can actually impose restrictions on those financial institutions.
So even though in normal times, the bank might say,
yeah, we follow the rules, everything’s fine.
If the government says, no, you can’t release these funds,
then the bank is legally obligated to hold onto that money
and that can happen in cases of sanctions or other legal measures.
So it’s kind of an exception to the rule.
It’s not that the whole system bikes down,
it’s just that governments have the power to intervene
if they think there’s a legal or political reason to do so.
Right, so I guess in certain circumstances,
so say if there was a lot of money involved,
say there was something happening financially,
there was some kind of little bank crisis going on
and I suppose a bit like what happened recently in Venezuela, right?
America pumped a whole load of money into Venezuela
to stop the currency from sinking through the floor.
That transaction had to occur.
And when lots of money is involved,
I mean, because like so in that example, right,
they’ve sent a whole bunch of money to Venezuela.
Venezuela, but the money doesn’t actually get sent to Venezuela.
It’s a, you know, this is computer screen stuff.
There’s no money actually, there’s no physical notes
that are going over there or gold or anything like that.
It’s just an entry on a system.
So with Venezuela, for example,
yeah, let’s look at that example.
How did that transaction happen?
What is the clearinghouse that keeps America and Venezuela honest
or what’s the jurisdiction in that situation?
Yeah, so when you’re talking about something like that
where there’s a really large international financial transaction,
especially between governments or central banks,
it’s a little bit different.
So they might be using something like the International Monetary Fund,
the IMF, or another international financial institution.
And those institutions act as the sort of clearinghouse
for those big transactions.
And it’s really about the agreements between those countries
and those institutions.
So the jurisdiction is kind of a global one.
And the trust comes from the fact that these are central banks
or major international organizations.
And they’re all basically agreeing to the same set of roles.
But the jurisdiction is kind of international.
It’s not like one country’s laws are in charge.
It’s really the agreements that all these parties have with each other.
And that’s how they keep everyone honest and keep the system running.
So the IMF is one of its…
What is the International Monetary Fund’s key objective?
What is their purpose as an organization?
Yeah, absolutely.
So the International Monetary Fund, or IMF,
its main purpose is to promote global financial stability.
So they’re there to help countries maintain stable exchange rates
to help in situations where a country might have a financial crisis.
They can lend money. They can provide financial advice.
And they’re really just there to kind of keep the global financial system running smoothly.
So that’s their key objective.
So the IMF, does it sort of receive subscriptions from countries on a yearly basis?
And it’s basically just a fund.
It’s its own bank and it’s topped up with money from contributing countries.
And then its purpose is to help countries iron out potential financial problems.
Is that… have I described it correctly or am I missing something there?
Yeah, you pretty much nailed it.
That’s exactly what the IMF is.
It’s funded by contributions from member countries.
They all kind of chip in and then the IMF has this pool of resources
that they can use to help countries that are in trouble.
And they provide loans. They provide advice.
And their whole goal is just to keep things stable.
So yeah, you got the idea. That’s what they do.
So what last year, what was the… I don’t know, the top 10…
Top 5 contributors and how much did they contribute to the IMF?
So as of 2023, the biggest contributors to the IMF were actually countries like
the United States and China, Germany and France.
And they each put in these big quotas, which are kind of like their membership do, if you will.
And that basically what the IMF uses as its pool of money to help our countries.
And how much is that? How much did each of those countries put in just out of interest?
So in 2023, the top contributors of the IMF were countries like the United States,
which put in the largest share at about 83 billion SDRs.
That’s a kind of IMF currency.
And then you have Japan, China, Germany and France following behind with their own big contributions.
So basically the biggest economies.
Yeah. So would it be true to say that they pay in an amount that’s sort of proportional to their GDP?
Or is it that America is pretty much funding the whole thing?
Yeah, it’s a good question. So it’s actually proportional.
The IMF sets quotas based on the size of each country’s economy.
So it’s not just the US paying for everything.
It’s more like each country pays in according to how big their economy is.
So it’s a shared responsibility and the US just happens to be the biggest contributor.
Right. So that money can be used for making loans, but the IMF also functions as a clearinghouse.
So in the case of this money that America sent to Venezuela, it sent it via the IMF.
So it sent the money to the IMF.
Then the IMF sent it to Venezuela and the IMF kept a record of this transaction that’s happened.
But in this case, because it’s the government, there’s nothing stopping the government from printing more money, I suppose.
So is that what happened or did the IMF give them the money out of their own funds?
Yeah, that’s a good distinction.
So in a situation like that, if the US is sending money to Venezuela and the IMF is involved,
it could be that the US is using the IMF as kind of a middleman, like a clearinghouse,
or it could be that the IMF is actually providing a loan out of its own funds.
It kind of depends on the situation, but either way, the IMF is keeping track of the transaction.
And yeah, governments know it’s for more money if they want to, but when they use the IMF, it’s a little bit more formal and more structured.
So did when America sent the money to Venezuela, did they go through the IMF?
So actually, in that particular case, the IMF didn’t end up facilitating it.
Venezuela did request a big loan from the IMF, but it wasn’t approved because of some political issues.
So in that instance, the money didn’t actually flow through the IMF.
So how did America clear the money?
So in that scenario, the US would have likely used its own federal banking system
or worked directly through its own treasury and through international banks.
So a set of using the IMF as a middleman, they would have just done direct transfer using international banking channels.
And those are regulated by different agreements and different networks like the Swift Network,
which is commonly used for international transfers.
So basically, they just went through the regular international banks.
So they would have probably used the Swift Network.
Yeah, exactly.
They would have most likely used the Swift Network or a similar international payment system to just send that money directly.
So it would have been pretty straightforward.
It’s not involved in the IMF in that case.
So when does the Swift Network in use and when are these other clearing houses in use?
If it’s within Europe, it sounds like you’re using one of these clearing houses.
But then if it’s more international, are the transactions then using the Swift Network?
Is that the way it works?
Or is it more fragmented than that?
Yeah, that’s a good way to look at it.
So basically, within Europe, for example, they’ll use a system like SEPA,
which is more localized in its current euro transactions.
And then you’re doing international transactions outside of that.
That’s where Swift comes in.
So Swift is kind of the global standard for international banking,
especially when you’re going across different currencies and different continents.
So it kind of depends on where you’re sending the money.
If it’s within a certain region, they might use a regional network.
And if it’s global, they know you Swift or something similar.
Right. So is this why Russia is creating its own transaction network?
Because they’ve been barred from using Swift.
Is that correct?
I think that is correct.
And I think they’re setting up their own.
Could you talk about that, please?
Yeah, absolutely.
That’s exactly what’s going on.
So when Russia was barred from using Swift due to sanctions,
they started working on their own alternative network
so that they could still do international transactions with countries that are willing to use it.
So it’s basically a way for them to have more control and not be dependent on a global system
that they can be locked out of.
So yeah, that’s pretty much what’s happening.
And what countries accept their new system at the moment?
So as of right now, there are about 177 financial institutions from around 24 different countries
that are actually using Russia’s alternative system instead of Swift.
Wow. So how many use Swift?
Swift.
So right now, Swift is used by over 11,500 financial institutions
in more than 200 countries and territories.
It’s definitely the big global standard.
So if countries use the Russian alternative,
are there countries that use both that and Swift at the same time?
Yeah, absolutely.
There are definitely countries and banks that use both Swift and the Russian alternative at the same time.
It’s kind of a way for them to keep their options open
and to be able to do business with different partners.
So yeah, it’s not an all-in-nothing thing.
They can use both.
Okay, that sounds great.
Just one thing, just through this conversation,
when you were talking about the IMF,
you mentioned that America sends a certain amount of money in SDR.
I think you said SDR.
What is that?
And yeah, why is it not US dollars or something like that?
Yeah, good question.
So SDR stands for Special Dryer Rights.
And it’s basically a kind of international reserve asset created by the IMF.
And it’s not a currency like the dollar or the euro,
but it’s more like a potential claim on the freely used occurrences of IMF in member countries.
So the reason they use SDRs is because it’s a neutral asset
that represents a basket of major currencies.
And it just makes it easier for the IMF to do business without favoring one currency over another.
So it’s kind of their own little internal unit of account.
So is it more so that it doesn’t create sort of political conversations
around what currency the IMF is using because it’s supposed to be international?
And the second question, how does it value the SDR?
Yeah, you got it exactly right.
The whole point is to be neutral
and to avoid those political conversations about which currency the IMF is favoring.
And the way they value the SDR is actually by taking a weighted basket of major currencies.
So it’s based on the US dollar, the euro, the Chinese Yuan, the Japanese Yen and the British Brown.
And they just mix those together to come up with a value of an SDR.
So it’s really just a neutral stable unit.
But I don’t understand that because all of these currencies are valued in terms of another country,
another currency, they’re all value pairs.
So how do you put 10 different currencies in a bucket and say it’s worth, you know, how do you do that?
Is it some kind of relational index or something?
Could you just add a bit more detail to that because at the moment, I don’t understand how that works.
Yeah, absolutely. So it’s a good question.
Basically, the SDR is like a weighted average of those major currencies.
So they take a certain percentage of the value from the dollar, a certain percentage from the euro and so on.
And they combine them into a kind of index.
So you’re right, each currency is valued in pairs.
But by taking a little piece of each major currency, the SDR becomes a sort of blended value.
And that means it’s more sabial and it doesn’t depend on just one currency’s movement.
So yeah, it’s kind of like a little index that they use to keep things balanced.
Okay. All right.
Well, I think that’s added a whole load of detail to my knowledge of the financial system.
And if any of the listeners are interested in more on this,
then you can leave a leave a message, I guess, on the website.
I’m thinking this might conclude the finance section on the podcast.
But anyway, thank you chat GPT.
You’re very welcome.
I’m glad we could dive into all these details and ask some new layers to your understanding.
And yeah, any time you want to chat about finance or anything else, just let me know.
For show notes and more, go to talking2ai.show.