Forex payments are a complete racket. If you need to wire money to someone in another region and currency, you typically have to suffer two blows from your bank, delivered like two cheek slaps: whap! a lame exchange rate well below their interbank rate, then backhand whap! a hefty processing fee. Together these usually reach 3-5% of the transfer sum.

Large institutions also suffer from banks’ stranglehold on cross-currency payments. BNY Mellon currently faces a lawsuit from state pension funds claiming nearly a billion dollars in losses from fraudulent forex price execution.

Enter TransferWise, a London-based money transfer service that just closed a $1.3 million equity-based seed round from an absolute Who’s Who of fintech funding and innovation. Lead by Roger Ehrenberg’s IA Ventures (who now takes a board seat), the group includes Index Ventures, Robin Klein, and Saul Klein of The Accelerator Group, Pay Pal co-founder Max Levchin, Wonga co-founder/CEO Errol Damelin, ex-CEO of Betfair David Yu, and Simple co-founder Shamir Karkal.

Launched just over a year ago, and running Euro/GBP transfers only at this point, TransferWise bypasses the traditional international money wiring systems entirely. Like single currency payment startup Dwolla (which also just announced a financing round), TransferWise aims for a more or less direct transaction between payer and recipient, avoiding the exorbitant traditional bank and credit card costs.

How much cheaper is TransferWise? They’ll process a £1,000 payment into Euros for 35-40 EUR less than the major banks, and over 100 EUR less than Western Union. They do so by both applying a far better exchange rate and drastically lowering the processing fee to just 1GBP on transfers up to 300GBP. (See their dynamic cost/comparison calculator.)

To fulfill payments, TransferWise simply sets up its own accounts in each region it serves. So if Lane in London needs to pay Sal in Rome, Lane sends his GBP to TransferWise’s UK account, then TransferWise instructs its continental EUR account to pay Sal’s. Through the end of February, the company has processed over €10 million in transactions.

TransferWise’s founders are two Estonians, Taavet Hinrikus and Kristo Käärmann. Taavet was part of the original Skype team, and Kristo is a former Deloitte manager with financial systems architecture expertise.

They’re addressing a massive market, of course: cross-border payment flow for goods and services reached $150 billion a day in 2010, Taavet says, based on UNCTAD figures. Taavet runs some numbers: “If you assume the average fee is now 5%, that means our industry is $1.925 trillion per year (5% of the $38.5 trillion/year total). Disrupt that down to 1% and you have $385 billion/year.”  98% of the market outside of remittance providers like Western Union, he believes, is handled by the banks, “so it’s really about expanding that 2%.”

I spoke with Taavet about regulation, which is clearly one of the biggest challenges they’ll face to scale. In February, the company received authorization by the UK Financial Services Authority (FSA), which allows it to process all European transfers with no volume cap. (It cannot, however, hold deposits).

TransferWise plans to add more currencies in about a month, starting with three European nations. Then they plan to add regions adjacent to Europe — possibly Russia, the Mideast, or Africa. At that point, they’ll tackle the great American regulatory monster.

“There are two possible solutions for us in the U.S.,” says Taavet. “We could either get a banking license or get a state by state transmitter license. We’re looking at both, as well as partnering with an existing licensor.” It’s also possible, he adds, that offering India or China would make more sense ahead of the U.S.

Sequoia-backed Xoom offers a cross-border payment service closest to TransferWise’s. As Taavet sees it, “Xoom is the one peer of ours that’s not ripping people off. But they focus on the classic remittance corridor, U.S. to India. We could possibly charge less than Xoom, but in any case Xoom is a very good option — we see them on our side against the outrageous traditional bank fees for this service. There’s room for a dozen companies like ours, Dwolla and Xoom.”

On the other hand, Taavet sees PayPal’s business model as far different: “PayPal does things very much like the banks, charging 2-4%, which is absurd. They see cross-border transfers as a revenue driver, while we say that it fundamentally doesn’t cost anything, so there’s no reason to charge for it. We want to be completely transparent and massively drive down costs across the industry, as Skype did against the traditional call carriers.”

What about the credit card providers, and payment startups like Square and Stripe that use the Visa and MasterCard backbone? “I see us as complementary to credit cards. There are many use cases still when a credit card is the best method of making payment, for example, mobile payments. We could at some point start taking credit card payments, though that almost certainly wouldn’t be as cost efficient as our current model.”