How do we settle foreign exchange in cross-border payments?

The diagram shows the information flow and settlement flow. Bob needs to pay 100 USD to Alice, who can only receive EUR.

Step 1 - Bob sends 100 USD via a third-party payment provider. In our example, it is Paypal. The money is transferred from Bob’s bank account (Bank B) to Paypal’s account in Bank P1.

Step 2 - Paypal needs to convert USD to EUR. It leverages the foreign exchange provider (Bank E). Paypal sends 100 USD to its USD account in Bank E.

Step 3 - 100 USD is sold to Bank E’s funding pool.

Step 4 - Bank E’s funding pool provides 88 EUR in exchange for 100 USD. The money is put into Paypal’s EUR account in Bank E.

Step 5 - Paypal’s EUR account in Bank P2 receives 88 EUR.

Step 6 - 88 EUR is paid to Alice’s EUR account in Bank A.

Now let’s closely examine the foreign exchange (forex) market. There are 3 layers:

🔹 Retail market. Funding pools are parts of the retail market. Paypal usually buys a certain amount of foreign currencies in advance to improve efficiency.

🔹 Wholesale market. The wholesale business is composed of investment banks, commercial banks, and foreign exchange providers. It usually handles accumulated orders from the retail market.

🔹 Top-level participants. They are multinational commercial banks that hold a large number of certificates of deposit from different countries. They exchange these certificates for foreign exchange trading.

When Bank E’s funding pool needs more EUR, it goes upward to the wholesale market to sell USD and buy EUR. When the wholesale market accumulates enough orders, it goes upward to top-level participants. Steps 3.1-3.3 and 4.1-4.3 explain how it works.

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