What is Prefunding in the Remittance Process?

In the article How to improve the common problems of the remittance companies? FinFan discussed 4 common problems that remittance companies have been encountering and the solutions to solve these problems.

We also discussed that prefunding is the cause of the third problem is the loss of liquidity in remittance businesses. So, what is the prefunding and how does it work? Let’s find out with FinFan in this article.

What is prefunding?

Pre in “prefunding” means before, that is the deposited funds which remittance companies’ correspondent banks give to the banks of their partners before this money comes to the recipients.

What is correspondent banking?

Correspondent banking is an agreement between two banks whereby one bank (correspondent bank) carries on representative services (such as maintaining deposits, offering settlements, etc.) for another bank (respondent bank). That type of often banking was created to solve the problems of currency exchange between countries faster and more convenient.

Why do we need correspondent banking and prefunding?

To explain this, we need to understand the cross-border payment process of banks. That takes 3 steps like the way to send money to Vietnam from India, Australia, Japan, etc. via bank.

• First the sender needs to have his/her present country's bank account and a valid residence card or passport.
• Then, when sending money, the senders need to fully declare the recipient’s information such as account name, ID number, recipient's address, phone number, bank name, bank account number, and bank identification number.
• Third, the deposit must be converted into the recipient’s national currency and sent to the recipient’s bank account by the Nostro account in the correspondent bank.

Although it only takes place within 3 short steps, this process takes almost 7 working days to reach the recipient's bank due to a few regulations of different countries' banks as well as the handling of exchange rates between countries.

Can customers wait so long for remittances that they need twice as much to cover their daily lives?

To shorten that time (almost real-time), remittance companies’ banks connect with banks in countries of remittance recipients to open correspondent bank accounts (call Nostro accounts) to offer settlements, because money transfers between domestic banks happen more quickly than international money transfers.

Limitations of using prefunding

The use of prefunding means that the remittance service provider must always set aside an amount of reserve money in its Nostro bank account.

This can lead to the company's budget not being guaranteed (especially for small technology companies that have to constantly rotate capital for other activities).

More than this, it can lead the remittance company to lose opportunity cost for other areas or areas that need the company's investment (a financial technology company usually doesn't just stop at remittances).

Another limitation of using prefunding comes from choosing the company's business partners. If the selection process is not done carefully, the remittance company’s prefunding money may not fly but be used by the partner for other purposes, not to pay customers of that remittance company.

Prefunding also plays a critical role in minimizing risks associated with payment delays and failures. It can create new credit risks in the financial system, for example, if commercial banks offer loans to support the prefunding in a foreign currency.