2016 has started as 2015 finished; continuing challenges in the financial markets and no let-up in the various announcements around investments in Fin Tech, new Banks and other disruptive initiatives aimed at the payment industry. At a personal level, I must confess to being surprised at just how many initiatives there are “out there” in this space and how much investment is chasing them. This is particularly the case when you begin to analyse what actually comprises a payment, the scope for actual change within that area and how that can be achieved.
To explain further, it is worth remembering that a payment is simply a transfer of value which, aside from a physical transfer of cash or the writing of a cheque, takes the form of an electronic payment instruction. These are either pushed (eg when a consumer initiates an online payment) or pulled (eg when a Direct Debit is taken from a customer account following an earlier mandate being set up). The instruction (in its simplest form) will then result in a debit and a credit being applied to the Originator and Beneficiary accounts respectively.
There are three layers through which the vast majority of payment instructions will normally be processed and these can be summarised as follows:
- Service Channel: This is the medium through which the payment was initiated. Traditional examples include a bank branch, written mandate and telephone centre. There is then an overlap (at the point of initiation) with the next layer of:
- Systems & Infrastructure: This layer, in turn, comprises of three sub-layers:
- The in-house computer systems and software (through which payment instructions are processed) at both the originating Payment Institution and the beneficiary Payment Institution. Aside from the core Accounting systems (which are debited and credited on behalf of the customers on both sides of the payment transaction), examples of other types of systems that could be involved include those associated with Identity Validation and Anti Money Laundering Checks.
- The underlying national Payment Systems which process the payment instructions submitted between the Financial Institutions.
- The networks that inter-connect the Payment Institutions, the Payment Systems and the Central Banks (both domestically and internationally).
- Settlement: In an earlier post, I covered the concept of Settlement Finality and the legal framework that covered it. All payment instructions need to “settle” in a legally protected manner in order that they may be irrevocable. For the major payment systems in most countries, this will involve the use of Central Bank accounts where the majority of banks hold their reserves. The timing of the point of irrevocability will vary; for a cheque credited to an account within the UK, that is normally six days after it has been paid in (see explanation here), whereas for some real time payment systems it can be on the same day (or within a few hours). If Payment Institutions provide irrevocability ahead of the actual point of legal settlement then they normally take financial risk on between themselves at that point (unless central bank funds have been earmarked to cover potential loss allocation).
Notwithstanding the layers outlined above, what is always key to remember is that a payment simply comprises of two elements; the instruction (either pull or push) which sets out who is being debited and who is being credited (and at which Financial Institutions) and the underlying settlement where the payment becomes irrevocable. Everything else in between is simply infrastructure and processing.
So, what has the above got to do with Fin Tech and disruption? Well, it boils down to the straightforward question of how much further can disruptive technology be successfully applied in the three layers?
Service Channel Disruption
The service channel layer is the place where most disruption has recently taken place. Historically, branches were where consumers performed the majority of their banking operations as they paid cheques in and settled bills. As time passed, additional services and electronic payment systems were added (eg ATMs to withdraw cash and, in the UK, Bacs (and Direct Debit) and CHAPS offering timed and same day urgent payment processing). Most were industry funded initiatives, which all key players participated in. They evolved in a similar but piecemeal fashion in most countries.
Moving the clock forward, the Banks (in their role as Payment Service Providers) began to offer new channels by which their clients could carry out their business. This started with telephone based call centres (which could operate outside of normal banking hours and saved customers needing to travel to a branch). Next came Internet Banking access and the ability to not just perform basic banking operations but, additionally, to subscribe to new products (eg savings accounts). Then came mobile banking allied, in a number of countries, to Faster Payment solutions which meant that consumers could, via their bank, move money to selected beneficiaries both quickly and at a time that suited them 24×7.
Most latterly, disruption has begun to occur where new players have begun to introduce additional/competing channels (or overlays) which piggy-back onto existing infrastructure and services. A good example would be Apple-Pay where an existing payment service (ie a credit, debit or store card) is utilised via a convenient “consumer-friendly” App. No new payment type has been invented, merely a different way of leveraging an existing service. Another example is the emerging breed of digital only banks whose streamlined systems will leverage technology available on a user’s device (eg a smartphone camera for biometric identification) thereby simplifying their own systems and making it still easier for the consumer to initiate payments. The Banks will still utilise existing core infrastructure payment systems, but this will be all but invisible to their customers.
Within the Financial Institutions, the key disruptive influence is the fact that the new banking entrants are able to access new technology and are not weighed down by the variety of legacy, inflexible, difficult to maintain and costly banking systems that are present within the existing players. Instead, their systems are modern, flexible and cheaper to maintain thereby providing cost advantage as well as agility when it comes to reacting to new opportunities.
At the central infrastructure level, there remains considerable appetite to change. However, the pace of change is slow due to the need for the market to move as a whole with any change (eg for ISO20022 migration) and the need for the Payment Systems to remain secure and resilient. It is sometimes easier for wholesale change to take place rather than piecemeal change (eg the recent announcement by The Clearing House and Vocalink re the creation of a new Immediate Payment System in the US). Disruption here is measured in the medium to long term as opposed to the short-term.
At the Network Infrastructure Level, there is even less Disruption. Security and resilience is key and the appetite for change by participating Financial Institutions in this area is limited. SWIFT remains a core trusted provider for these entities. Whilst private trusted networks and the use of the internet for financial transactions using proprietary security techniques continues to evolve, concerns around security remains a key inhibitor for growth. The prevalence of news reports around hacking and the extraction of data does little to encourage disruptive change in this area.
The area where least disruption has thus far taken place is around Settlement. This is primarily due to the fact that, whilst settlement can take place on a bi-lateral basis between parties (as they net out their trades), most Institutions will wish for their transactions to settle in one way or another in Central Bank Money for the reasons outlined above. News, however, continues to circulate around developments in this space (for example, the press report in December 2015 around Goldman Sachs’ patent application for a cryptocurrency settlement system”). However, the disruptive impact to date is very modest.
Coming back therefore to the underlying question of how much further can the Payment market become disrupted, the following are likely to be key factors:
- Whilst there remains considerable consumer appetite for continued simplification and smart connectivity, the experience of Apple Pay in terms of new users continuing to use the service (ie retained traction), highlights consumer fickleness and the challenges that new entrants face.
- Whilst a percentage of consumers are eager to try new technology, surveys continue to indicate that the silent majority of Payment consumers are either comfortable with their existing product providers or are reluctant to change in case they find themselves with a worse provider. Whilst the UK’s Account Switching programme has had success in making it less onerous to move banks, the latest statistics published (see here) highlight that, in Q3 2015, 14% fewer bank switches took place than in the same period the previous year.
- As highlighted in an earlier post, timed payments (ie those due to take place on a certain future date) make up the majority of all payments initiated (in the UK, it is over 80%). As such, it could be argued that the scope for consumer driven disruptive progression is less than 20% of the market (unless substantive underlying change to the timed market was to take place).
- Regulation acts as a natural inhibitor in terms of how streamlined Payment Service Provider infrastructure and services can become given the need for security, resilience, audit, sanctions and AML checking. The text backing the US Financial Crimes Enforcement Network (FinCEN)’s fine on Ripple Labs in May 2015 (see here) highlights that “Innovation is laudable but only as long as it does not unreasonably expose our financial system to tech-smart criminals eager to abuse the latest and most complex products.” It is also worth noting that regulation can also act as an enabler. In Europe, the second Payment Services Directive (PSD2) mandates that existing Payment Service Providers will need to open their systems for Third Party Provider access. Member EU states must be compliant with this new Directive by the end of 2017.
Whilst there is capacity for innovation and change (either disruptive or via natural evolution), in conclusion, I would suggest that:
- Within the Service Channel layer, there will be a limit to how much further innovation/disruption can make a straightforward payment instruction even simpler and easier to initiate. What this means for the number of new initiatives being announced and how many of them will therefore falter and fail through lack of critical mass take-up remains to be seen.
- Within the Infrastructure Layer, more innovation and change is likely at both the Financial Institution and Payment System level. Traditional Banks will continue to improve and streamline their legacy systems to compete more effectively with the new breed of Payment Service Providers whilst, centrally, new Payment Systems and initiatives such as ISO20022 will undoubtedly move this Layer forward. However, this will not be an area of rapid change given the substantive change it entails.
- At both the infrastructure and settlement layers, Distributed Ledger Technology has the potential to be a substantive disruptor in the longer-term. Well publicised Use Cases include domestic and cross-border post-trade processing. Additionally, its inherent ability to mitigate key areas of operational risk (via its potential benefit around resilience with multiple data instances present) is attractive. The fundamental question is the degree to which this new area of technology will gain regulatory traction and widespread adoption. For me, this is therefore the key “wait and see” disruptor.