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.

Infrastructure Disruption

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.

Settlement Disruption

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.

Regulation & Legislation

• The key European announcement of the month came from the European Parliament on 8 October with the formal adoption of the second Payment Services Directive (PSD2). Whilst the Directive has still to be signed off via the EU Council of Ministers, this was a key stage towards adoption of the Directive across EU Member States by the end of 2017. The text of the press release can be read here. From this point, the emphasis will now shift to how Financial Institutions will adopt its requirements; in particular, the provision of access to customer accounts (XS2A) and the need for common minimum API and Security standards to facilitate this.
• Following the UK Payment Community event that took place on 17^th September, the first meeting of the UK Payment System Regulator’s (PSR) Payment Strategy Forum took place on 8^th October. As part of the meeting, they considered Strategy Setting principles and priorities including an initial set of items reviewed and weighted at the Community event. All papers for the Payments Strategy forum are available on the PSR’s website here.
• In the US, 1^st October marked the date when retailers and businesses either utilised chip-enabled Credit Cards or became liable in the event of card-presented fraud if they accepted EMV based cards without EMV enabled terminals.

Central Banks

• A key announcement from the world of Central Banks and their interaction with the wider Payment eco-system came from the Peoples Bank of China on 8^th October with the launch of CIPS (China International Payment System). Operated by The Cross-border Inter-bank Payment and Clearing (Shanghai) Corporation, the system will provide clearing and payment services for cross-border and offshore Renminbi transactions. 19 banks were selected to be Direct Participants at launch. 38 domestic and 138 overseas banks are also participating on an Indirect Basis. Further information can be found at the PBoC website.
• On 15 October, the Bank of England issued two consultation papers aimed at the further strengthening of the UK Financial system through structural reform. One paper was on ring-fencing and the other on operational continuity. The consultation closes on 15 January 2016. The backing Bank of England news release can be viewed here.

Immediate / Faster / Mobile Payments

• On 14^th October EBA Clearing published an updated Blueprint setting out the basic principles which would back a pan-European instant payment infrastructure. Over 230 parties contributed to the consultation which sets out a roadmap through to the delivery of the infrastructure in 2018. The text can be downloaded via a form located at this link. Earlier in the month, EBA Clearing also announced it was launching a Request for Proposal (RPF) for the delivery of the infrastructure.
• On 13^th October, STET (a SEPA based Clearing House) announced in Paris that it also planned to create an Instant Payment Infrastructure for European Payment Service Providers. This will be offered to the French Banking Community for early adoption. The announcement can be read here.
• Just 24 hours earlier, Vocalink announced the signing of a letter of intent with NITMX (Thailand’s main Interbank Payments Provider) for a joint study into options for the delivery of mobile payment services in Thailand). The backing article can be read here.
• On 30^th September, NACHA – The Electronic Payments Association announced the release (via its Payments Innovation Alliance) of a white paper entitled “Real Time in Real Life: The Impact of a Real-Time Payments System on its Users”. The paper aims to “provide clarity on what a real-time payment is by exploring what real time means, outlining the challenges to implementing real time, and identifying major use cases and user impact”. A link to download the report can be found here.

Payment Liquidity enhancements

• Earlier in October, two of the UK Payment Schemes (Bacs and the Faster Payments) announced the launch of their respective pre-funding initiatives. Designed to eliminate both intra-day and out of hours liquidity risk, the initiatives work by Direct Participants lodging (via committed interest bearing accounts held at the Bank of England), sufficient liquidity to cover their intra-day netted exposure. This will assist Faster Payments in its ambition to raise its current system imposed maximum limit of £100K per transaction.   At the same time as this announcement, Faster Payments also announced the commitment of three Challenger banks to join the system in 2016.

Standards / ISO 20022

• SWIFT used the opportunity of Sibos to announce the publication of is ISO 20022 Harmonisation Charter. Backed by the cooperation of 20 key Financial Market Infrastructures, the charter seeks to formalise a consistent approach to ISO20022 adoption via the sharing of information around its adoption. The backing document can be downloaded here.

Distributed Ledgers / Blockchain

• Against the backdrop of multiple announcements of Corporate and Fintech investment in Distributed Ledger and Blockchain technology came the announcement from the UK Government of its investment of £10m to launch a research initiative in distributed Ledger Technology. This announcement came as part of a speech given on 14 October by the UK Economic Secretary ahead of the launch of the Alan Turing Institute next month.   The text of the speech can be read here.
• As most know, one of the key challenges around Blockchain technology is its potential capacity limitations. SETL’s announcement on 12 October that it had cracked a billion transactions per day in a test environment was therefore particularly noteworthy given this is approximately the number of worldwide payment movements per day.

Other Publications

Two further research reports with specific reference to Payments have been published in recent weeks:

• The first (jointly published by RBS and Cap Gemini) is the “2015 World Payments Report” examines developments in the global payment landscape. It has a dedicated website that can be linked to here.

• The second (published by McKinsey) is entitled “Global Payments 2015: A Healthy Industry confronts disruption” and can be found here.

Yesterday’s announcement by Earthport Plc of the enhancement of its services to “enable real-time cross-border payments via distributed ledger protocol” via a partnership with Ripple Labs (http://www.earthport.com/pr/earthport-launches-the-first-fully-compliant-gateway-for-real-time-payments-via-distributed-ledger/) has the potential to move things forward in this space given the stated ability for clients to maintain their compliance regimes. The fact that Earthport currently focusses on low value cross-border payments should not take away from the broader opportunities and impact that could arise here.

I must emphasise that I have no relationship with either Earthport or Ripple Labs or any other party in this field.   However, my background in those Market Infrastructures backing the settlement of equities, FX and payments means that I can highlight the potential disintermediation or “disruptive” impact that such advances could bring. For me, the key question is whether we are now seeing the birth of the next iteration of Market Infrastructures and, if so, what happens to the existing ones?

In terms of context, it is less than twenty-five years ago that a raft of Real Time Gross Settlement Systems were built by the major Central Banks (some countries are still in the process of building them) and these provided the foundation stones that permitted settlement systems to access them for real-time, safe, secure settlement (see my last post on Finality in the Payment Chain).   A number of domestic settlement systems were then created, many of which were subsequently subsumed into the major international systems that are around today (eg Euroclear, CLS etc).   It can be argued that these were the first major “disruptors”, creating faster, more cost-effective and more secure means for settlement to take place (either on a domestic or international basis).

New guidelines for their operation were created (under the Bank for International Settlements (BIS) and its subordinate Committee for Payments and Settlement Systems (the CPSS – now renamed the CPMI (Committee on Payments and Market Infrastructures)).   This Committee comprises of the main Central Banks (see www.bis.org/cpmi/membership.htm) and works closely with other key organisations such as the Financial Stability Board (http://www.financialstabilityboard.org/).  It is only three years since the latest set of “Principles for Financial Market Infrastructures” were published (www.bis.org/cpmi/publ/d101a.pdf), which provide the minimum standards across a number of key areas (ranging from Governance to processes around Operational and Liquidity risk) that Financial Infrastructures are expected to comply with and form the basis for assessment by those regulatory bodies responsible for their supervision.   Most key Financial Market Infrastructures are obliged to comply with the PFMIs, with some jurisdictions (eg the Eurozone) only publishing their requirements in this area as recently as last year.

The point of stating the above is to highlight that it is only very recently that the applicable standards and associated regulatory approaches have sufficiently evolved to enable the existing Financial Market Infrastructures to (a) put in place the necessary controls and (b) to be supervised in a consistent fashion to provide the necessary level of comfort to those who are reliant upon them for the safe delivery of settlement services on a daily basis.   These processes move slowly (sometimes by necessity due to the need for legal alignment and sometimes down to the sheer logistical challenge of geography and resources). They now potentially risk being overtaken by the evolution of the next set of “disruptive forces”.

A key question is how large does a new “system” or “combination of systems” need to be before it is considered to be a Financial Market Infrastructure? Are we likely to see those entities who are rapidly moving forward in the payment and settlement space likely to fall within that definition themselves (whether they want to or not) and, therefore, the purview of the international authorities for supervision and oversight (assuming that it is felt appropriate for them to be overseen in the same manner as before)?   Does the nature and manner of their operation mean that the existing regulatory standards need to be reviewed again and, if so, in what timescale?

The latest advances will undoubtedly bring impact in the Market Infrastructure space. That is natural evolution which should be seen as an opportunity rather than a problem.   There is though the final question of what happens to the existing Financial Market Infrastructures?    Do they evolve themselves and become adopters of the new technology or should we expect a natural transition to replacement infrastructures?   That brings with it its own challenge; the cost of running the existing infrastructures should not be underestimated and, in most cases is fixed given the regulatory standards they must comply with.   As such, economies brought to their users is often a volume game and if some of this volume is moved elsewhere (think of a long balloon being squeezed), the cost just goes up somewhere else.  It should also not be forgotten that a lot of the existing Financial Market Infrastructures are “not for profit” industry owned entities which is a very different structure to those driving the pace of change at present.

If ever there was a good reason to “watch this space”, the changes now afoot would be a good justification.

At present in the UK, payments operate on separate ledger mechanisms which echo the past in terms of their structure.   All existing core Payment Systems in the UK operate by settling the obligations from one of their Direct Participants to another across settlement accounts held at the Bank of England.   For those institutions that are Direct Participants in the Payment Systems, their settlement accounts at the Bank of England are normally directly linked to their Reserve Accounts (thus enabling them to participate in the Bank of England’s “Sterling Monetary Framework”).   At present, over 150 institutions hold Reserve Accounts at the Bank of England.  As such, it could be argued that these form the Central Ledger for £ Sterling and the account structures held within each of the participating Banks to keep track of their customers’ balances form separate “nodal” sub-ledgers.   A customer’s “nodal entry” balance may be positive or negative depending upon whether they are in credit, overdrawn or have authorised loans with that institution that exceeds their credit balance.

Collectively (and keeping things simple for illustration’s sake), it could then be stated that the daily payments between Banks on behalf of either themselves or their customers takes place within a Closed Network Group of authorised institutions.   Unless the Central Bank has released “new money”; it remains a “sealed” Group operating within the total value of £ Sterling in existence.   As such, all daily transaction flows between those participating in the “eco-system” therefore net out at the end of the day.   At its widest level, this eco-system encompasses all entities and systems which require the movement of £ Sterling to operate.

Payment Systems are currently the means by which the instructions to move monies from Banking Institution A to Banking Institution B (on behalf of their respective customers) are securely transmitted and processed. We currently have several in the UK which reflect the differing means of money transmission; CHAPS for real-time guaranteed High Value Payments and Cheque and Credit Clearing (for when a paper instrument (the Cheque) is used by a customer as their instruction to credit funds to another party who banks elsewhere in the UK Banking System) are two examples.

These payment systems therefore act as the interface between the “Central Ledger” and the “Nodal Ledgers” held at the Banks and other Financial Institutions who participate in our payment “eco-system”.   They need to be secure, trusted and resilient.   Erroneous or illegal transfer instructions purporting to represent the wishes of a customer to transfer funds elsewhere cannot and must not exist.

The collective needs and wants of the various players participating in the existing UK Payments arena therefore mirror closely the underlying aspirational attributes of a distributed ledger system; a single, secure, trusted ledger mechanism where authenticated transfers between Financial Institutions and their customers take place legitimately and without impediment.

A lot of work and thinking is taking place within the UK Payments Industry at present to determine its future shape and strategy for the next 10 years. In my last post, I highlighted the core objective of the new Payment Systems Regulator around innovation and the aspiration within the payments industry to look to consolidate a number of the payment systems and to operate to common data and message standards.   These remain key objectives.   The question is whether any aspect of the logic backing the distributed ledger process could be brought into use as part of the forward looking payment system design?

This would not be without considerable challenge.   The distributed ledger process present behind Bitcoin requires the full ledger to be present on all nodes with authorised data miners utilised to validate transactions over a specified time period.   The sheer volume of payments initiated in the UK on a given day raises the key obstacle of how a similar mechanism could work.

However, maybe this could be addressed by utilising the current banking structure and considering it in a slightly different vein?   What if the Banks were the authorising “miners” in the Bitcoin analogy? What if full Distributed Ledgers were held at the institutions that held authorised Banking Licenses with legal authority for Settlement Finality still vested with the Bank of England as the repository of the Centralised Ledger?   The two banking parties in a transaction on behalf of their respective customers would provide the authenticated bi-lateral adjustment on the distributed ledgers that would then be adjusted at the centralised ledger in the name of their own institution. The centralised adjustment could be real-time or in netted blocks thereby representing the Deferred Net Settlement status currently present within existing Payment Systems such as Faster Payments.

As I said at the beginning of this post, we already operate a simpler form of discrete ledgers already.   The big step would be to extend the model so that the Banks would not just operate their own ledgers but that for the broader banking community. The Payment System would then become the network and rules mechanism by which the transactions would take place.   The audit trail of transactions conducted through the network could be managed by The Payment System and would become, by default, the UK Payment Transaction Repository which could then be utilised as required by Government and law enforcement agencies in terms of the data that it would hold.

The above is just food for thought.   However, as the various parties in the UK Payments arena formulate their thoughts in the coming months on the future structure of the underlying systems and infrastructure, it would be a pity if thought was not given to whether the UK could somehow leap-frog one or more interim steps to the next level of evolution.