Committee on Payment and Settlement Systems Working Group on Innovation in Retail Payments
"To be, or not to be, that is the question:
Whether 'tis Nobler in the mind to suffer
The Slings and Arrows of outrageous Fortune,
Or to take Arms against a Sea of troubles,
And by opposing, end them:"1
Shakespeare was obviously not the reason for the Committee on Payment and Settlement Systems (CPSS2) to look deeper into the subject of payment innovation. In common, however, with Shakespeare's tragedy, the good, the bad and the followers are facing a new environment. Several developments - in technology, market structures and regulation - change or could change the way payments are made. And quite a number of people believe that we are approaching a tipping point which could turn the whole industry and the role of banks as major players in the market, upside down. These developments, and their effect on the safety, soundness and effectiveness of retail payments, prompted the CPSS to conduct a study on 'Innovation in Retail Payments'. A first article on the activity of the CPSS Working Group (the Working Group) was published in the July 2011 edition of the Newsletter (see link below). Since then, the Working Group has finalised its report, which was published recently (see 'related link' below).
Overview of major trends
Based on a fact-finding exercise among 30 central banks, 122 innovations were identified and categorised. From that exercise, the Working Group derived five major trends:
1. The market is dynamic, but only a few innovations have had any significant impact so far.
2. Most of the innovations were developed for domestic purposes only.
3. Non-banks have become important players in the payments industry.
4. Speed is becoming more essential in the payments industry.
5. Innovations play a key role in facilitating financial inclusion.
Figure 1: Scheme owner of the innovation
The role of non-banks, in particular might attract some attention. Banks are still dominating the scene since they represent the owner in four out of ten innovation schemes. That said, non-banks follow close behind, owning three out of ten innovations and are overwhelmingly dominant in the categories of internet and mobile payments. In some countries, central banks also play an important role in reflecting the strong efforts of emerging countries to build new, state-of-the-art payment systems for their fast-growing economies.
Some take the findings as evidence that non-banks are the real drivers of innovation in payments, whereas others might conclude that this is the result of an uneven playing field in terms of regulation or that success is enjoyed at the expense of security. In this respect, it should be mentioned that the report is descriptive and analytical, rather than evaluative. It was never the intention of the CPSS' work to give guidance or develop recommendations regarding what the various stakeholders, including providers, users and regulators, should do to foster innovation. Nevertheless, the report contains a number of elements geared to assessing what an innovation-friendly environment should look like. The factors which may drive or impede innovation can be grouped into two categories, depending on whether they are outside (exogenous) or inside (endogenous) the payment ecosystem.
Figure 2: Drivers and barriers affecting innovation
Technological developments necessary, but not sufficient
Technological developments are the basis for new or improved services in payments. Examples are the chip technology used in payment cards, the use of mobile phones - or more sophisticated smartphones - as a tool to access internet or mobile channels, and the proliferation of internet infrastructure. Currently, huge expectations have arisen with regard to contactless payments, utilising Near Field Communication (NFC) technology. One thing is clear however; technology is only an enabling factor for innovation and is of no help if there is no user demand. Payment users will only switch to a new service or a new product if it better serves their personal needs when compared to existing solutions. Convenience, cost, speed, security and availability are among the most important factors determining the consumer's choice of payment services. Viewed from that angle, NFC certainly has the potential for significant growth. It is convenient for users, particularly when added to well-established solutions (e.g. card payments) and speeds up the check-out process at the point-of-sale (POS). At the same time, acceptance will very much depend on the degree of security, as perceived by consumers. Since NFC payments are mainly used for low-value transactions, they will have to compete with cash, also in terms of cost.
Regulation - not just a European issue
From discussions in Europe, it might sometimes be concluded that regulation in the area of payments is very much a European peculiarity, or to put it more bluntly, a misadventure. The report clearly demonstrates however, that regulation has become an important topic of focus in a number of CPSS countries. Although concrete approaches differ depending on the regulatory frameworks in the various countries, some general trends can be discerned. Firstly, in a number of countries, the entry barriers to the payments market were lowered to spur competition and innovation. Secondly, in several countries regulation was adopted with a view to increasing the transparency of fees or intervening by redistributing costs and revenues between different stakeholders, i.e. through multilateral interchange fees. Thirdly, governments might also promote innovative payment services by facilitating financial inclusion. This could be done, for example, by setting an appropriate legal framework for e-billing solutions or by relaxing requirements on certain low-cost payment accounts. Irrespective of whether regulators take an ex ante or ex post approach, the speed of innovation is a major challenge here as it renders the payments market a moving target.
Cooperation and standardisation - key factors for successful innovation
Cooperation has always been key to the payments industry, as innovations often entail high fixed investment costs. In view of the fact that the payments business is a network industry, cooperation helps to make innovative products or services available to a high number of potential customers. Cooperation is also the response to a higher degree of complexity in the value chain of innovative payment solutions, as evidenced by mobile payments. Consequently, more than half of the innovations reported in the findings involve some kind of cooperation between the different parties involved. Cooperation between banks and non-banks is the most prominent model, with a strong focus on internet payments, mobile payments and Electronic Bill Presentment and Payment (EBPP) solutions. Not very surprisingly, cooperation between non-banks does not play a significant role. Roughly 40 percent of all innovations however, do not imply any form of cooperation.
Recent discussions in Europe have shown that cooperation in the field of payments is an especially challenging task because it has to comply with the relevant competition-related legislation. It can be concluded from the CPSS report that an innovation-friendly environment requires a proper balance between competition and cooperation of market players. Thus, it is of utmost importance that legislators give clear guidance on how cooperation can be achieved without provoking fears of anti-trust investigations.
In the same manner, the report concludes that standardisation is an important factor behind innovation. It helps to achieve a critical mass and avoids any proliferation of incompatible, smaller-scale systems which lack the necessary acceptance. It can also create a solid foundation for new players wishing to enter a new market. Moreover, standardisation avoids the costs and risks attached to overcoming the absence of standards. At the same time, standardisation could hamper innovation, for example if the standard-setting process has the disadvantage of restricting participation to incumbent players, or if standards become obsolete but are still widely used. In any case, experiences with mobile payments clearly demonstrate the benefits of standardisation. Different payment models and different standards have developed into incompatible solutions, often limited to market niches and hardly viable over the longer term. In this respect, widespread standardisation should ensure that innovation is not locked up in market niches. One remarkable development in the payments industry is the greater reliance on the International Organization for Standardization (ISO). Furthermore, the payments industry has shown that market-driven solutions, such as SWIFT, are able to deliver efficient standardisation results.
Pricing and pricing structure
Pricing strategy is essential for innovation because on the one hand, it has to ensure that sufficient revenues are raised for the payment service provider to support the business case while, on the other hand, it also has to ensure that innovations are accepted by payment service users, taking into account the real or perceived benefits compared with established solutions. A central characteristic of the market for retail payments is the difficulty which exists in setting prices in a two-sided market, comprising consumers and merchants. Therefore, the debate frequently focuses on the pros and cons of multilateral interchange fees, a topic which has been addressed by several regulators across the globe in recent years. Another important aspect in this regard relates to the question of whether merchants should be allowed to pass the cost differences between different payment instruments on to consumers (a practice known as surcharging). The report remains quite silent on this sensitive topic - for good reasons. Firstly, it is very difficult to predict how pricing affects payment innovation since it depends on a number of factors, such as cost structure, degree of competition and elasticity of demand. This means that a case-by-case evaluation is very often the best approach. Secondly, little can be found in theoretical and empirical literature that provides clear evidence on how, for example, interchange fees and innovation interrelate. Thirdly, not enough experience has been gathered regarding the impact of recent regulatory efforts on the market. Generally speaking, central banks favour transparency of the cost of payment instruments, or improvements in price signals, as a way of motivating users to choose the most efficient one.
Security - a major challenge for innovations
Security aspects deserve special attention from payment service providers as inadequate security, whether real or perceived, has the potential to undermine public confidence in a new payment solution, and consequently its business case. Innovations might also replace established payment instruments which have inferior security and higher cost of fraud. Without doubt, the migration process to chip (EMV) and personal identification number (PIN) technology is one of the most important innovations to have occurred in card payments. Nonetheless, the success in combating fraud at the automatic teller machine (ATM) or point of sale (POS) has been partly offset by a drastic increase in fraud in card-not-present transactions on the internet. Innovations play an important role here, from enabling strong two-factor authentication procedures (e.g. 3D-Secure), to generating one-time card numbers (which avoid the need for disclosure of card payment details during e-commerce transactions) and to developing online banking-based solutions that forward customers from the merchant's website to the online banking application. The latter solution highlights the need for banks to provide their customers with an adequately protected online banking environment. For mobile payments, the main issue at stake is the security of the payment application installed on the mobile to guard against cross-contamination, protect sensitive customer data and prevent 'tele-pickpocketing' (the risk of a transaction being carried out without the knowledge of the mobile phone holder).
Changed risk profiles pose a key challenge for central banks. Consequently, central banks might choose to adjust their oversight policies or their oversight tools. Responding to the growing role of non-banks and to the arrival of more complex business models, coordination with other authorities at a national and international level is strongly recommended to avoid inconsistencies in regulatory approaches, to reduce any potential duplication of efforts and to utilise the available know-how (e.g. with regard to the impact of technology). The establishment of the Forum on the Security of Retail Payments (SecurePay Forum) in Europe sets a good example in this respect.
Observations from a European perspective
The findings of the report are broadly consistent with the specific developments in Europe and with the outcome of the European Central Bank's approach e- survey. In many cases, there are also links with the issues taken up by the European Commission in its Green Paper 'Towards an Integrated European Market for Card, Internet and Mobile Payments'.
- There is no indication that Europe is facing an efficiency gap or fall-back in terms of global competition. By contrast, in some areas - such as the decision to migrate to ISO 20022 - Europe is considered a role model. Even so, this does not mean that Europe is at the forefront of innovation.
- Innovative card payments and internet payments play a more prominent role in Europe than at the global level. This is partly a reflection of its well-developed communication and payments infrastructure. For this reason, it is also less likely that new entrants will be able to succeed in setting up, for example, mobile payment schemes based on e-money.
- The issue of integration is a very Europe-specific factor at present. Creating a conflict between integration and innovation however, is not a particularly compelling scenario. Instead, these two aims should complement one another.
- There has been lot of discussion at a global level concerning the definition of appropriate governance in order to foster innovation - not just in Europe. Recent information from Australia3 and the UK4 shows a trend towards setting strategic objectives through an appropriate public body and by broadening the membership of the respective industry bodies in order to better represent the interests of all stakeholders. Both approaches regard the industry as being best placed to implement the recommendations. Only if expectations are not met will further action be considered (e.g. in the form of regulation or - as in Australia - through the provision of services by the central bank itself).
One big question remains: how will the payment landscape develop? Will it be a revolution or an evolution? In Europe, there are factors speaking in favour of the latter: the infrastructure is already well developed, many innovations are, therefore, incremental improvements of well-established products and banks are still benefiting from the trust of customers. But that is by no means a certainty or eternal truth. Specifically, demographic changes or new non-bank competitors might lead to more profound changes. In such a situation, it is of utmost importance that European regulators set up a clear, transparent and reliable framework for future developments in the field of payments. Last but not least, it should guarantee a level playing field between all payment service providers, whether within or outside the banking area, and should strike a balance between competition and cooperation as well as between economic freedom and consumer protection.
Dirk Schrade is Deputy Head of the Department Payment and Settlements Systems at the Deutsche Bundesbank (German national central bank) and chaired the CPSS Working Group on Innovation in Retail Payments.
The views expressed in this text are those of the author and do not necessarily reflect the views of the CPSS or the Deutsche Bundesbank.
Related articles in this issue:
What Happens Next? European Authorities to Communicate Their Vision for SEPA 2.0 by End 2012. EPC looks forward to learning more about the authorities' views on the continued merit of creating harmonised payment schemes and frameworks in the cooperative space of payments
'Towards an Integrated European Market for Card, Internet and Mobile Payments': Striking the Balance - Interoperability and the Access Dilemma. European Commission publishes feedback report on its Green Paper
Related article in previous issue:
A Closer Look at Innovation in Retail Payments. Central bank research in preparation: a report on first findings of working group established by the Committee on Payment and Settlement Systems ( Newsletter, Issue 11, July 2011)
1 "To be or not to be" is the opening phrase of a soliloquy in William Shakespeare's play Hamlet.
2 The CPSS serves as a forum for central banks to monitor and analyse developments in domestic payment, settlement and clearing systems as well as in cross-border and multicurrency systems. The CPSS Committee also focuses on standard-setting activities. The CPSS consists of the Reserve Bank of Australia, National Bank of Belgium, Central Bank of Brazil, Bank of Canada, The People's Bank of China, European Central Bank, Bank of France, Deutsche Bundesbank, Hong Kong Monetary Authority, Reserve Bank of India, Bank of Italy, Bank of Japan, Bank of Korea, Bank of Mexico, Netherlands Bank, Monetary Authority of Singapore, Sveriges Riksbank, Swiss National Bank, Central Bank of the Russian Federation, Saudi Arabian Monetary Agency, South African Reserve Bank, Central Bank of the Republic of Turkey, Bank of England, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York.
3 RBA: Strategic Review of Innovation in the Payments System: Conclusions, June 2012
4 HM Treasury: Setting the strategy for UK payments, July 2012
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