The Financial Times defines liquidity within a transaction as how easy it is to perform an exchange in a particular security or instrument, or the ease of converting an instrument into cash for withdrawal. This takes into account the stability and price of each instrument over the course of a transaction.
If a financial transaction is an engine with moving parts and multiple factors that impact its performance, then liquidity is the oil that makes it move. Good, clean oil in the form of cheap and readily available liquidity means less risk and a faster, smoother transaction.
For routine domestic transactions like a debit card purchase or paper check deposit, liquidity is generally high because financial exchanges normally execute in a single currency and are approved against account balances held by each party in the transaction. But when you assess liquidity for international or cross-border transactions, the oil begins to thin and performance breaks down.
International transactions already face hurdles and delays because of country-specific regulations and currencies. Exchanging one currency for another introduces a price and time variance that could impact pricing on each side of the exchange. This erodes the stability of the transaction – therefore the liquidity – and increases risk and cost.
As a result, financial institutions must pre-fund nostro accounts on each side of a transaction in that country’s native currency. These account balances in a local currency improve liquidity by lowering the risk for the parties transacting.
However, these accounts come at a high cost. According to a 2016 McKinsey Global Payments report, there is approximately $5 trillion dollars sitting dormant in these accounts around the world – tying up capital that could be used in more productive ways. They also must be actively managed to ensure balances are commensurate with transaction volume.
The cost and complexity of holding these accounts around the world is one reason why only a handful of banks can process global transactions. The burden of maintaining nostro accounts worldwide is simply unsustainable for most organizations. Small-to-mid-size banks and payment providers instead pay a fee to use the international transaction systems of their larger brethren.