Why is real time payments such a big deal?
In today’s internet-focused world, where we all expect 24x7, instant, on-demand access to resources and services, the clamor for real-time payments systems is growing louder every day. The question with which regulators and the banking industry is wrestling is how to deliver a secure, effective, convenient system to send or receive a payment immediately, even across borders, to or from a deposit bank account.
In a typical real-time payment scenario, a consumer or small business wants to make or receive a low-value payment without using a bank-specific acquiring device (e.g., a card reader such as Square) or a physical debit card. The sender needs to know the recipient’s bank account or an associated alias and to be able to use the bank’s existing channels – generally internet or telephone banking or visiting a bank branch – to initiate a transaction (Note: Alias or proxy services are emerging in a number of countries to provide simplicity for consumers and to protect the recipient’s bank account details. Examples include the Paym in the UK and SWISH in Sweden for mobile transactions). Generally, these systems are not designed to handle bulk transactions such as payroll, rather simply to process single, instantaneous payments.
To make an instant, irrevocable payment without a real-time payment system, the current options are using a debit or credit card (a debit collection-based transaction) or paying in cash. A debit card provides a proxy for the user’s account and effectively is a promise to pay the merchant within X days, via an acquirer connected to the card switch. A credit card, similarly, acts as a proxy for a line of credit with a credit institution and the merchant receives funds days (or sometimes weeks) later. Cash is immediate, but carries its own risks and handling costs.
Although consumers are migrating towards convenience, new non-card payment mechanisms (such as Apple Pay and mobile apps) typically rely on the same debit or credit card infrastructures. The pressure on card interchange models has renewed attention on innovation in the non-card payments space. After all, if a debit card is already a proxy for my account, then why do I need a card to reach it if online I can use another proxy associated with this account?
A number of different business and technical models have emerged in several jurisdictions to achieve a real-time payment system, one which supports a customer experience for a spontaneous payment. From a customer’s perspective, this immediately transfers funds from the sender’s bank account to the recipient’s bank account, where the recipient can see an acknowledgement of the receipt of funds, typically within seconds. There are a number of different, innovative ways emerging to achieve this objective. What is no longer in dispute is that there is demand for such services, both to send and receive payments, and that businesses see the great potential of immediate cash flow and instant payments.
The introduction of Faster Payments in many countries has leveraged what is now “old” technology, commonly used for card switching, and adapted it to deliver a near-real-time or real-time experience (e.g. South Africa RTC, India IMPS). In a small number of countries, the Real Time Gross Settlement (RTGS) system has been adapted to cater for payment types beyond the high-value, systemically important transactions it was designed for, extending RTGS down into the low-value payments where immediate settlement is a critical success factor for that transaction (e.g., in Mexico). Each country has adapted the concept to suit its own market conditions and volumes of daily transactions.
In countries with a low volume of transactions, and particularly where there are a low number of market participants in the central bank’s RTGS system, then it may be most effective to leverage that infrastructure to effect these transactions. In Mexico, the central bank has opened up the RTGS environment to a wider range of participants, including non-banks.
The vast majority of central bank RTGS systems were designed to process a relatively low volume of systemically important, same-day payments intraday across the central bank’s accounting platform (to achieve settlement finality for holders of central bank settlement accounts), and the retail payment systems are typically operated as a separate clearing and settlement mechanism where the net positions of the clearings are transmitted into the RTGS for settlement at predetermined intervals intraday (or at the end of day in some countries). This approach has been taken to manage risks, collateral costs, and funds availability, not to mention enable effective processing and booking of high volumes of transactions.
The U.K. Experience
In the U.K., following market reviews into competition in retail banking, the U.K. banks designed Faster Payments as a new payment system, combining a bespoke adaptation of a card switch for clearing with the risk management and settlement processes typically found in an ACH infrastructure. This gives end customers an immediate experience while reducing the participating financial institutions’ settlement costs. This was in large part possible due to the relatively low number of directly participating financial institutions when it went live in 2008.
The U.K. model has been widely acknowledged as very successful, with ever-rising volumes. It has created a platform for new businesses and products and contributed to conditions for some new business models to thrive, particularly in the digital and online economy.
As internet banking has taken off, the ability to execute transactions instantaneously has driven new customer expectations, behavior, and demand. Faster Payments in the U.K. is now embarking on a journey to open access to the payment system to new participants, new market entrants, and non-bank providers such as aggregators.
The U.S. Experience
The trend towards real-time or Faster Payments is visibly gaining traction in the U.S. and across Europe, the two major currency areas where the traditional payment systems have not provided such services in a ubiquitous way for consumers. In the U.S., discussions on the design of Faster Payments are well underway. The Federal Reserve Bank System has initiated a multi-streamed activity to examine potential improvements and enhancements to the U.S. payment systems, including the concept of Faster Payments. The Federal Reserve has established a task force to examine how this might best be achieved to meet the requirements of competition, collaboration, and reach within the U.S. market.
Simultaneously, The Clearing House, a private-sector operator of payment systems such as CHIPS and EPN, has initiated a Faster Payments project. According to TCH, the intent is to deliver a “real-time payment system to better meet consumer’s and businesses’ expectations in an increasingly digital economy.” (Note: Any organization undertaking a faster payment initiative should contemplate the broad range of stakeholders in order to be able to meet the needs of all sectors and segments within the payment ecosystem. Cybersecurity, identity management, fraud, and simplifying integration and speed of access to the payment systems are areas of increased focus and opportunities for improvement. Any system also will need to consider new requirements in the digital market, new security frameworks to protect consumers and businesses, a range of proxy and alias options, and the potential to adopt international standards and processes).
Enabling Global Payments in Real Time
Global, cross-border interoperability in payment systems is challenging and requires significant harmonization of business processes and standards. The world is witnessing a wave of standardization, with the ISO 20022 electronic data exchange standard seen by many as the best option for a future-proof common framework for the development of almost all financial messaging. In Europe, the Single Euro Payments Area (SEPA) project has seen the largest migration of users to date to ISO 20022, including government, corporations, banks, and non-financial institutions. ISO 20022 is rapidly becoming the standard for payments messaging, but there is still a long way to go to harmonize different systems.
In 2014, the U.S. Stakeholder Group – including The Federal Reserve Bank of New York, The Clearing House, X9, and NACHA – examined the business case for migrating to ISO 20022 in the U.S. payment systems. Work is underway to determine how to best achieve such a migration. The connectivity methodology for Faster Payments is at the forefront of this discussion, as there is a strong desire to enable a framework and format that could lend itself to the development of new, data-rich products and services.
It may appear that this is a simple technology challenge, but the adoption of common business process or messaging standards cannot alone guarantee cross-border interoperability of payment systems. The challenge is not simply one of communication, but primarily of banking and accounting. Cross-border transactions involve foreign exchange (FX) as a basic requirement. In each transaction, the parties can either share the associated spread in the FX fees or one party benefits. In each currency, the settlement of the underlying transaction must take place with legal finality in central bank or commercial bank money. The management of the risk profile in this process is critical.
At all points in the transaction process, client money must be protected from counterparty default or theft and from cyber-attacks, identity theft, account hijacking, and fraud. In credit card transactions, the identity of the card user is protected through Payment Card Industry Data Security Standards (PCI DSS), which is mandatory for all merchants.
The ACH world is moving towards combining multiple solutions. Without international coordination, the adoption of a new solution in one jurisdiction could interfere with regulatory compliance requirements in another, particularly if the third party cannot conduct Know Your Customer’s Customer (KYCC) analysis on the transaction.
The business processes, risk management, and settlement practices within national and currency groups are often slightly different. Ultimately, this is a complex accounting challenge. The funds must be carried into the settlement process in each jurisdiction by a financial institution participating in settlement where finality can be achieved locally. There are a number of third-party market participants that operate similar types of services, namely Earthport for low-value, cross-border transactions and Continuous Linked Settlement Bank (CLS) for foreign exchange and related products. These existing players provide some insight into how such a service might operate.
Regulation and the Contraction of Cross-Border Services
One of the consequences of a retrenchment of cross-border payments and trade activity by globally active banks has been the contraction of international services available to multinational corporations and individuals that provide reach and depth in all local markets. Increased risk management and regulatory requirements have hightened complexity and costs and, in some cases, it is now impossible to reach counterparties in certain jurisdictions in a timely fashion (if at all) to deliver payments via the traditional banking routes. Individuals seeking to send funds overseas in real time are presented with a myriad of regulatory reporting and Know Your Customer (KYC) questions. Charities seeking to distribute aid in emergencies face this challenge regularly.
Creating a framework to ensure that an individual in one jurisdiction can send funds to an individual or small business in another country – in real time at low cost – is not new: the credit card has long been relied upon by consumers and businesses for this purpose. The consumer never sees the lag in actual settlement or any fee structure (whether interchange or merchant fees), which are borne by the merchant to create convenience and ensure global acceptance. Sometimes this is taken for granted, as the complexity of processing that sits behind these activities is not transparent to the user.
Historically, the business opportunity, in terms of the number of actual cross-border transactions, was perceived to be low. Indeed, when contrasted with the volumes transacted in any one jurisdiction, the business case for cross-border transactions is often deemed to be weak. (Typically two to three percent of transactions in SEPA were deemed to be from one country to another.) But the key issue is whether the convenience created by a real-time global payments system would drive more cross-border economic activity. Another question is whether we actually record the volumes of transactions, or whether consumers and small businesses find a workaround to avoid the complexity and charges associated with these transactions. This is where the digital agenda comes into play. The EU Digital Single Market Strategy seeks to encourage the creation of a wider ecosystem to boost GDP within the Eurozone from traditional e-commerce.
If consumer to business payments are the first theme, then the second area is remittances. Many consumers and small business owners struggle to find a secure, cheap, and reliable method to reach their destination when sending payments abroad. In many cases, a worker is sending funds to support family members in another country. The amounts in question are often higher than presumed. Human nature dictates that these transactions will not stop because complex barriers have been put in place, but will simply migrate to other channels, including physical movement of cash across borders at great risk to personal safety. So how do we create a common platform to effectively route transactions across borders?
At this stage, it can be logically assumed that each jurisdiction is likely to develop a national solution, as this appears to be the path of evolution in the vast majority of countries. A lot of attention has been focused on whether these systems can be joined together. This is not as simple as it first appears. Many of the clearinghouses around the world have been seeking methods to do this effectively and efficiently for at least 20 years. We have seen limited success with a number of innovations that address specific corridors and typically utilize a bridging strategy to carry messages and funds across that currency divide (e.g., IPFA). These solutions have proved highly effective for a small number of participants and for a small number of currencies, but appear limited in reach.
Finding a Solution
In order to create a globally ubiquitous service, each consumer needs access to a domestic ubiquitous service, plus either a foreign service alongside the domestic service or a single offering which routes transactions from the domestic currency to a secondary service to carry that transaction to its cross-border destination. If financial institutions wish to remain relevant in this space, they could seek to create a channel to accommodate such funds transfers via their branded access points. The consumer or small business is often less interested in how it happens – they are interested in how fast, how much it costs, and how timely confirmation is that the transaction has reached its destination. Sounds easy.
It should not be forgotten that making credit push payments across borders is currently possible. There are a number of options available that use current mechanisms. They tend to be expensive, slow, point-to-point, and inconsistent in terms of the remittance data that is sent with transactions. These corridors have often grown to service the needs of specific communities, in the case of remittances, or specific industry verticals. Increased regulation and supervision of Anti-Money Laundering (AML) measures and sanctions are testing the capacity of these business models to provide a timely service in many countries. As these transactions speed up, we cannot lose sight of risk-management requirements.
As payments become a standalone activity from banking in many jurisdictions, customer protection gains greater importance. Consumers may perceive that funds are more secure during a transfer than they may actually be. The industry needs to provide greater clarity of security during these payment processes so that users can make educated decisions about the risks they are prepared to take and the nature of the organizations they choose to handle these transactions.
It is worth considering that the Faster Payment systems are typically credit-push and not debit focused. There is a move to introduce new capabilities to facilitate a request for a credit transfer. This would enable a business, for example, to send a message with an outstanding invoice and payment details to ensure that a customer could (preferably within a mobile application) create a payment instruction with pre-populated information and pay that business the correct amount, with the correct reference, and with all the information the business needs to reconcile the transaction. This is a very attractive scenario for merchants, whether at a point of sale or where the customer is not present. It may be possible to integrate the use of such messaging (which does not require the sophistication of direct-debit mandate handling and legal protections) across borders and currencies.
The critical question is whether it makes sense to connect the domestic systems, and if so, how? The vast bulk of transactions are typically very local, and most consumer purchasing behavior is fairly predictable, so the industry is seeking to address the exceptions. The business case is potentially weak for each organization to do this independently and to bilaterally connect to each other. A more practical approach is to have one or more aggregators with fast-switching technology deliver this capability between national clearinghouses. This would be a complex, risk-aware interbank and B2B environment, typically in a domain with short return-on-investment expectations. But, creating such a solution is a long-term infrastructure play.
There are a number of possibilities. A few organizations within the Eurozone already have faster payments-type systems (e.g., U.K., Denmark, Sweden, Poland, and Italy) or are creating Faster Payment services, so this question is there to be solved. Consumers and businesses will increasingly want to reuse this capability across the EU.
A friction could emerge between local versus pan-European or international services if these are developed without a common framework. Banks seeking simplification and a reduction in their clearing and settlement connections are reluctant to return to a situation where they have to maintain a complex architecture with numerous bilateral links and different standards (whether technical or business-model based). There is room for significant simplification in this space. This does beg the question as to whether it is possible to have true competition between payments infrastructures, if effective interoperability is a goal. Each innovation drags away from harmonized standards. If we’re not careful, soon we will need a Single Euro Faster Payment Area (SEFPA), and then a Single Global Faster Payments Area (SGFPA).
Key industry players around the world are engaged in significant dialogue to share experience and learn from each other. Work is ongoing to consider standardization of business processes, messaging standards, and content, in order to ensure that steps are taken to achieve interoperability before functional designs are completed.
Will interoperability be achieved in five to 10 years? Yes, it is possible, but it will require significant global leadership, investment in a clear vision, and then a practical strategy to achieve it. There are a number of paths and options. This is a complex question, and one that could produce a number of responses by a significant number of players in the market. Clear direction is required, as the cost of developing multiple answers could possibly outweigh the benefits of complex, global interoperability with every operator attempting to meet requirements in specific foreign-exchange corridors.
Another possible model to achieve interoperability or reach is one that is more hub and spoke than is currently envisioned. The complexity of the processing that needs to occur in real time means that repeated handoffs in a bilateral framework would not be ideal. Some currencies have multiple operators (particularly in Europe). Therefore, I think it is more likely that there will be the emergence of a single global bridging platform between all of these systems, in a similar architecture context to CLS. Such a platform could create a third-party processor, one that all financial institutions or infrastructure providers could connect to, in order to move funds quickly cross-currency in real time.
The burning question is how to achieve this end result? Who could build it and when? What are the incentives to do so? Perhaps it is time to consider joining some dots and creating a wholesale payments clearing value chain that utilizes bespoke architectures in a more creative arrangement. It might be possible to create a landscape where ClearXchange, CLS, Earthport, and others, including high-volume clearing and settlement mechanisms in each currency (such as U.K. Faster Payments, The Clearing House, and EBA Clearing), could all play critical roles in delivering specific functionality required to deliver speed and security globally in a more complex world. In the current climate of intense regulatory scrutiny on payments, the ultimate question is: How do we achieve a global regulatory regime that makes such a project feasible?