Mapping the digital payments revolution summary
A SUMMARY AND FULL REVIEW OF THE DISCUSSION AT THE WEBINAR ON 8 JUNE 2020 PART I
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Although factors such as risk, value, access to credit or regulatory compliance are sometimes more important than speed, the world is moving towards faster payments.
Instant payment is now available in more than 50 countries around the world, but instant payment is not real-time payment, and it does not mean the payment has settled.
Because payments have not settled, banks incur the costs of liquidity. This liquidity cost, which was increased by the Basel III capital adequacy regime, also inhibits competition.
Liquidity costs to banks can be reduced by real-time gross settlement, but that requires customers to pre-fund accounts. An alternative is to exchange of digital tokens representing the value transferred.
Cross-border payments, which depend largely on correspondent banks to access central bank operated settlement systems, remain far from instant. Most take three to five days.
Services are being developed to accelerate cross-border payments, notably in the eurozone, but a global service depends on inter-operability between the services, based on agreed standards.
To reduce error-rates in payments, transaction management platforms (such as those provided by SWIFT and Ripple) allow payment details to be checked prior to despatch and repaired en route.
These platforms help to increase competition in payments by collecting data to tell banks and non-bank payment service providers (PSPs) of the most efficient ways to make a payment.
Payments market infrastructures (PMIs) both encourage innovation (by providing reliable plumbing) and discourage it (by limiting access, failing to adopt standards and not modernising systems).
Standardisation of the formats in which information is exchanged between participants in the payments industry increases innovation and competition by facilitating inter-operability.
KYC, AML, sanctions screening and countering the financing of terrorism (CFT) checks have become a major regulatory burden and obstacle to faster payment. Digital Identity is a solution to this.
Digital Identity will be difficult to universalise, but it will spur innovations. It makes instant payment easier, opens the possibility of programmable money and encourages the proliferation of currencies.
However, multifarious currencies might exacerbate liquidity problems in payments, especially in the absence of systems powerful enough to manage issuer risk.
Legacy systems remain an obstacle to innovation in payments, since the challengers own the superior technology but the incumbents own the customers.
Instant versus real-time payments
Instant payment is now a global phenomenon. Since Faster Payments began to offer retail customers instant payment in May 2008, instant payments have spread around the world. According to technology vendor FIS, the number of countries offering some variety of instant payment – by which the firm means any digital payment confirmed to the sender and receiver within 60 seconds – has nearly quadrupled since 2014 to a total of 54.
Though the terms “instant” and “real-time” are often used interchangeably, payment within 60 seconds is not real-time payment. Nor is instant payment the same thing as the final, irrevocable settlement of a transaction. In other words, customers of instant payment services enjoy the illusion of instantaneous settlement but specific transactions have not actually settled. Instead, the banks still net their overall obligations to each other through a clearing house and settle the net amounts through the Real Time Gross Settlement (RTGS) systems operated by central banks.
This means that, although instant payment in central bank money eliminates settlement risk for bank customers, banks assume the credit risk of funding large volumes and values of payments between thousands of different types of entity until settlement finality is achieved. This drives an appetite for intra-day liquidity. This liquidity has always had a cost. But the focus of the Basel III capital adequacy regime on intraday liquidity risk has increased it.
Genuine real-time settlement would reduce that cost to banks, by transferring it to their customers, who would have to pre-fund their accounts. For now, however, banks have to maintain pockets of liquidity with multiple correspondent banks in multiple locations to ensure they can make payments. A typical bank has to maintain and manage liquidity across hundreds of legal entities, hundreds of accounts with correspondent banks, and dozens of currencies. McKinsey estimated in 2016 that US$5 trillion sits idle in these accounts on any given day.
So inefficiency in payment imposes material costs. Those cost limit competition, by making it too expensive for smaller banks to compete. It could be reduced by more effective market-making in liquidity, but that is an old-fashioned answer to the reducing the burden of idle capital. A modern answer is for correspondent banks to access liquidity on demand, by exchanging digital payments tokens to represent the transfer of value or the currencies exchanged.
Tokens allow users to access liquidity when they need it rather than keeping buffer amounts in hundreds of accounts. Ripplenet users are already using the XRP crypto-currency for this purpose, but Stablecoins (tokens backed by currency holdings or other assets that reduce the volatility associated with pure crypto-currencies) or central bank digital currencies (CBDCs, or fiat currency issued by central banks in digital form on to blockchain or other networks) could fulfil the same role.
Payment tokens allow value to be transferred in a matter of seconds. But speed is not everything in the payments industry. Payments are part of an enormously wide range of transactions between individuals, individuals and businesses, between businesses, and between individuals and businesses and government agencies. So the factors driving a specific payment are multifarious. Which means in turn that speed – faster payment – is not always the decisive factor. In many cases, factors such as risk, value, access to credit or regulatory compliance may be more important than speed.
Yet the world is undoubtedly moving towards faster payment. This is obvious in the case of younger consumers, who expect faster services in every aspect of their lives, and for them to be open during the evenings, weekends and bank holidays when old-fashioned payments systems tend to be shut. Likewise, businesses also value instant payment, partly because it offers certainty of payment at lower cost than credit cards, but mainly because it makes it easier and cheaper to manage cash flow.
The same expectations apply to payments across borders and currencies. Yet even with instant payment systems in place in 54 markets, rapid payment remains a largely domestic phenomenon. Cross-border payments still have to traverse domestic payments systems. That means appointing a correspondent bank to comply with local laws and regulations, run Know Your Client (KYC), anti-money laundering (AML), sanctions screening and countering the financing of terrorism (CFT) checks, execute any associated foreign exchange (FX) bargains and, last but not least, access the national RTGS system.
A payment service provider (PSP) might be able to offer its customers instant payment in one market, but it cannot offer the same in another market unless it can accommodate instant payment. Even in markets that do offer instant payment, non-banks are generally unable to access domestic real-time settlement services directly (although the Bank of England has since July 2017 allowed non-bank payment service providers (PSPs) to access its RTGS system directly, most non-bank PSPs continue to work through banks).
In the Single Euro Payments Area (SEPA), meeting the challenge of making cross-border payments instantly is the objective of two services. EBA Clearing launched its RT1 platform for making euro payments instantly across national borders in November 2017. This was followed in November 2018 by the TARGET Instant Payments Settlement (TIPS) service of the European Central Bank (ECB). In the Nordic markets, the big regional banks have developed the P27 infrastructure to achieve instant payments between banks in Denmark, Finland and Sweden.
What is required is inter-operability between these regional infrastructures, so instant payment can be globalised, spreading the benefits of faster and cheaper payment to cash transfers currently suffering from high transaction costs, such as remittances. In other words, the benefits of more efficient payments mechanisms across national borders extend beyond business-to-business payment. Lower transaction costs will also raise living standards in developing economies.
The efficiency and inter-operability needed to deliver such benefits depends on standardisation of the information being exchanged between payers and payees. Standards facilitate inter-operability, reducing friction and increasing levels of automation between organisations based in different jurisdictions. This not only allows payments to be made more quickly but reduces the proportion which fail due to inaccurate or incomplete information. But standards alone cannot mitigate all obstacles to the automation of payments across borders.
The data contained in a standardised payment message still has to be validated. If it contains an error, or crucial information is missing, the payment is likely to fail. Both Ripple (via Ripplenet) and SWIFT (via its global payments initiative (gpi)) aim to minimise delays of this kind by enabling the parties to a payment to pre-validate payments before sending them and, if errors nevertheless persist, rectify the issues while a payment is en route from the payer to the payee.
Competition to provide payment services
These emergent, real-time payment transaction management platforms will eventually foster greater competition, because the information they generate about the efficiency of different banks and PSPs will drive payments down the cheapest and fastest routes. The SWIFT gpi service aims to provide exactly that sort of information, with the goal of raising service performance throughout the global payments eco-system.
But the SWIFT gpi service also strengthens incumbents. In fact, it exemplifies a shift in the SWIFT strategy from point-to-point payments messaging to an always-on payments transaction management platform where all parties to a payment can actively intervene to prevent payments failing. Sparked by changing technology, and especially blockchain, gpi is an example of how incumbents evolve in response to competitive threats. It provides the banks which control SWIFT with capabilities that allow them to compete with new entrants.
There is a view that payments market infrastructures (PMIs) – essentially, the bank-controlled clearing houses that net payments and the central bank-controlled RTGS systems that settle them – could fulfil a similar role. They are certainly essential to competition, in that they provide reliable and resilient networks for competing providers to offer products and services. And the sheer volume of new PSPs entering the payments markets seems to confirm that current market infrastructures are able to support new entrants armed with innovative products and services.
But some believe a PMI that was not controlled by banks, or to which banks were not the gatekeepers, would accelerate innovation in payments. After all, any infrastructure controlled by incumbents is susceptible to the temptation to raise barriers to entry to newcomers. The need to maintain security against cyber-attack and operational resilience can also provide useful cover for anti-competitive practices.
Some if the so-called FAANGs – Facebook, Amazon, Apple, Netflix and Google – are cited as potential infrastructure providers. But a likelier candidate is the mobile telephone networks. They have a signal advantage over the debit and credit card networks supported by the current PMIs, in that almost everybody has a mobile phone, while only merchants have point of sale devices.
So far the mobile telephone industry has tended to entrench incumbents in the payments industry by supporting apps which continue to run on existing PMIs, rather than developing an alternative payments network of its own. However, PMIs may find their dominance tested by one widely predicted development: the Internet of Things (IoT). This is likely to massively inflate the volume of payments they must support, while reducing their value.
It is not clear that the existing PMIs have the capacity to adapt to IoT with their current technology. This means that, in the absence of an alternative, innovation and competition will be slowed down if the incumbent PMIs do not enhance their systems to meet the IoT challenge. Most PMIs run on technology dating back to the 1970s, before the Internet or the mobile telephone became ubiquitous. This is already limiting the ability of incumbents and newcomers to innovate.
But their needs are less influential in driving change than the central banks. The Federal Reserve, the European Central Bank (ECB) and the Bank of England, for example, have all specified that their new RTGS systems will use the ISO 20022 standard. This has prompted the banks that use them to accelerate their own plans to adopt the standard, which will allow them to develop new payment services.
Standardisation of this kind tends to intensify innovation and competition as well as facilitating inter-operability. In India, for example, efforts to replace cash with digital payments saw relatively limited progress despite the introduction in 2010 of the Immediate Payments Service (IMPS), which enabled funds to be transferred electronically through the Internet, mobile telephones, ATMs and bank branches. It was not until the central bank and the PMI introduced the Unified Payments Interface (UPI), a standard set of APIs, that digital payments took off and a series of innovative PSPs emerged to take advantage.
What standards cannot solve, of course, is the regulatory obligation to run KYC, AML, sanctions screening and countering the financing of terrorism (CFT) checks. These take time, making it harder to sustain instant payment. But financial crime is a threat which regulators – through the regularly updated recommendations of the Financial Action Task Force (FATF) – expect banks and PSPs to defeat. To encourage them, they levy fines on individual officers of the firm as well as the institution itself. So banks take financial crime seriously.
Digital identity and payments
In payments, the industry has used a variety of methods to combat financial crime. Cryptographic solutions, such as the randomly generated tokens used by mobile telephone payments apps as an alternative to CHIP and PIN, are familiar. Advanced data analytics and artificial intelligence (AI) are being used to identify criminal activity. Biometrics, capable even of linking the pattern of keystrokes on a mobile telephone to an individual, are being deployed.
Which is what effective KYC, AML sanctions and CFT checks ultimately reduce to: confirming that the payer or the payee is who they say they are. This matters to customers as well as regulators. One reason innovators have found it so difficult to dislodge the incumbents and incumbent technologies in payments – physical cash, bank accounts, and CHIP and PIN systems administered by regulated banks – is that they provide trust. They reassure customers that payers are who they say they are, that they have the money, and that payments will go to the right person.
Blockchain was designed to disintermediate banks by eliminating precisely that competitive advantage. As Satoshi Nakamoto put it: “We have proposed a system for electronic transaction without relying on trust.” But digital identity (Digital ID) is emerging as the most durable solution to the problem of trust. Digital ID requires standardisation to enable databases to inter-operate but it also relies on tried and tested technologies and established methodologies, making it both more robust and easier to adopt.
In India, for example, Digital IDs preceded instant payment, and instant payment progressed more rapidly as a result. In other markets, instant payment is proving harder and riskier to implement because Digital ID is seen as a solution to a problem in instant payment rather than the creator of an opportunity to accelerate payments. It follows that, once Digital IDs are in place, further innovations can be expected, and they are also likely to be adopted more quickly – not least because FATF now sees Digital IDs as the answer to KYC, AML, sanctions screening and CFT checks in digital payments.
In the distant future, Digital IDs may even be derived from payments, in the sense that a long history of licit transactions builds a reputation which reassures counterparts. Payment tokens, derived from the crypto-currency experiment, may proliferate, and allow consumers to express personal values and affiliations through the money which they chose to pay and get paid.
Such new forms of money could even be programmable, initiating payments when conditions are satisfied, sparking negotiations when insufficient funds are available or facilitating requests for payment instead of invoices. It may even be possible to control how money is spent – a prospect that has sinister implications if it is controlled by governments.
However, in the absence of a CBDC equivalent to the fiat currency of today – a long term prospect possibly accelerated by the Covid 19 pandemic – a proliferation of payment tokens of this kind would exacerbate existing liquidity problems in the payments industry. There would be a need not only to establish rates of exchange between them, but to manage the risk represented by the issuer in real-time. The systems do not yet exist to automate either of these functions.
Transition to the future of payments
In fact, one of the problems incumbent payment banks face in competing with new entrants is legacy systems, which are both costly to maintain and limited in capability. They do, however, have much larger customer bases than challengers equipped with superior technology, and adding customers is much harder than replacing technology.
Indeed, the incumbent banks are addressing their legacy technology problems already. They are switching to the Cloud, which enables established banks to adopt new applications more quickly at lower cost, while providing assurance to regulators as well as customers that systems remain resilient and secure from cyber-attack.
Incumbent banks are also purchasing innovative start-ups and third-party systems and buying managed services and applications in areas needing rapid attention from firms such as Vocalink. The boldest are developing entirely new digital capabilities alongside their traditional technology platforms, with a view to migrating clients on to a new platform over time. These (as in the case of Bó at NatWest) do not always succeed.
The larger challenge for incumbents in retaining their current client base may lie in developing new products and services on top of a payments business in which competition is likely to narrow margins. Changing the underlying technology platform is simply a pre-condition for being able to do this. It is their skill in making use of Application Programme Interfaces (APIs) that is likely to determine their ability to survive and thrive.
It is APIs that are turning the ideas of Open Banking – the process by which competing providers can access customer information to offer better payments products and services – into reality. APIs also facilitate new services such as Request to Pay, by which businesses request payment of a bill rather than issue an invoice or initiate a direct debit or accept a standing order. The customer can then either pay or negotiate. In short, APIs are already being used to widen choice in payments, which is driving competition.
In theory, private, permissioned blockchain networks would eliminate the need for APIs, because banks and PSPs that are members of the same network will see all the customer information anyway, in real-time. However, the real, long-term value of blockchain networks almost certainly lies outside the world of payments per se, in the tokenisation of assets, including securities and commodities as well as illiquid asset classes such real estate.
That said, if asset tokenisation is to take off, it needs to solve its payment problems. These include the fact that settlement in fiat currency presently has to take place off the blockchain network, through the existing paraphernalia of correspondent banks, clearing houses and RTGS systems. Another problem is that, without netting or access to credit, users of blockchain networks have to pre-fund their accounts if they are to pay for tokens. And pre-funding is the mirror-image of liquidity costs – still the biggest problem in payments tout court.
(1) FIS, Flavors of Fast Report 2019.
(2) Financial Action Task Force (FATF), Guidance on Digital Identity, 2020.
Questions to be addressed at Payments Part II
1. Payments still create significant costs in capital held for liquidity purposes. In what ways can the cost be reduced?
2. Cross-border payments are still not instant in most cases. How can a genuinely global instant payments network of networks be built?
3. The value of mobile telephone networks in connecting everybody to everybody is rich in further potential value for payments. How can it be realised?
4. What do payments market infrastructures and payment markets participants need to do to be ready for the Internet of Things?
5. What is the optimal method of achieving universal adoption of Digital Identities by consumers and companies?
6. In payments, are blockchain technologies and APIs rivals, complementary or entirely separate technologies?
Future of Finance aims to keep this conversation alive. If you have answers to or comments on any of these questions please share them with me. We will be re-visiting this topic again in the near future, so if you would like to join our panel, get in touch. Equally, if you would like to sponsor a panel on this or a related subject, my contact details are below.
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