On innovation and okapis
To try to understand European Union (EU) policy in the area of payments, it is necessary to get a grip on concepts such as integration, standardisation, competition and innovation, as these terms are often used when discussing the Single Euro Payments Area (). A clear understanding of these terms should help to highlight the interdependency between these concepts (if any) and to identify the role of the European authorities (if any) in the advancement of these concepts. This article will use innovation as the basis and yardstick of this analysis, albeit the most elusive of the terms under consideration.
'Innovation is the multi-stage process whereby organisations transform ideas into improved products, service or processes, in order to advance, compete and differentiate themselves successfully in their marketplace'1. Anyone familiar with this definition and some basic knowledge of zoology knows that innovation is best treated as an okapi. The okapi is a mammal native to the Ituri Rainforest, located in the north east of the Democratic Republic of the Congo, in Central Africa. Although the okapi bears striped markings reminiscent of the zebra, it is most closely related to the giraffe2. The okapis are solitary and only occasionally gather. Okapis are shy and will not breed if they feel that they are being watched.
Innovation first takes place when individual businesses seek to differentiate themselves in the marketplace. Innovation will disappear without the right incentives, due to the effort and resources required to transform a new idea into a product or solution. Innovation will also wilt in an environment of heavy and uncompromising regulation and obsessive supervision. This will be exacerbated if such regulation is written by people who have seen business in action as much as they have seen okapis - which we assume is none in the case of most regulators located in Brussels.
The one notable difference between okapis and innovation is that okapis are a near threatened species. In contrast, innovation in the payment sector is alive and kicking. During the Financial Infrastructure Week, which took place in March 2011 in Rio de Janeiro, 121 innovations were reported to the Payment and Settlement Systems Committee in the Bank for International Settlements. The individual projects covered all areas relevant to the payment industry including initiation, processing, exchange and clearing, plus a whole range of products and services. The innovators are active across the entire sector representing central banks, financial institutions and non-financial institutions amongst others.
Innovation incentivised by market demand is happening. To ensure it stays that way, regulatory restraint in this area needs to be adhered to. European authorities should therefore curb their habitual complaining about an imaginary lack of innovation and start to recognise market reality instead.
On innovation and competition
Innovation in the business environment is generally the result of 'selfishness meets altruism', whereby the innovator seeks a reward (more profit) in recognition of the fact that increased profit is subject to delivering additional value to the customer. As pointed out in a previous edition of this newsletter, any payment service provider () active in the market is free to choose a payment strategy and to define services and products which add value to the underlying basic operating principles. Therefore, the product portfolios of differ necessarily and each one sends a distinct message to its customers stressing the differences and value added compared to products and services offered by competitors. As a result of product promotion by competitors in the commercial payments environment, we are already witnessing diversity, differentiation, creativity and specialisation benefiting individual customers.
Competition will happen naturally if the right conditions, such as strategically promising opportunities and incentives, are in place. Innovation is a direct consequence of competition in action.
On innovation and market integration
Integration usually relies on standardisation, harmonisation and the definition of common rules. Development of and migration to the harmonised set of payment schemes is a prime example of the case in point. can be compared to other integration initiatives aimed at creating frameworks, which prescribe standardised processes to be observed by actors operating in network industries. The Credit Transfer () and Direct Debit (SDD) Schemes represent the integration of multiple sets of individual national payment schemes at a European level. Migration to a single set of payment schemes would allow multiple to offer a broad range of diversified payment services and products for euro credit transfers and euro direct debits -wide. Similar examples of standardisation in network industries can be found in the areas of telecommunication, television and radio or transportation. In the area of payments, the introduction of the euro can also be regarded as a means of standardisation.
Standardisation - in payments and other areas - takes place in the cooperative space. The rules and standards which make up a payment scheme are defined by in the cooperative environment - that is the European Payments Council (). As outlined earlier in the article, innovation generally relies on the ingenuity of individual providers, however there are many incidents in the payment industry when market integration, such as standardisation, actually resulted in innovation and vice versa.
To give just one example: the first banks that installed automated teller machines (ATMs) were deemed innovative because they provided new services to their customers so that they could withdraw their funds more conveniently. At the very beginning, this innovation created a competitive advantage. When it became generalised, the community of banks could add more value by connecting ATMs and providing a network of ATMs, therefore making it even easier for customers to access their money. The community acted innovatively when doing so.
This example shows that innovation created at the cooperative level - by the community rather than the individual - is ideally based on a pre-existing value that releases its potential when, through means of standards and common rules, it may get generalised. The cooperative effort is effective by extending reach and expanding the network, based on a set of harmonised operational and technical standards and the agreement of common business rules. This means that the growing network provides additional value to the market.
This example also demonstrates how integration and innovation should ideally happen in subsequent phases, as this way forces the industry to repeat the virtuous cycle. Integration is the best basis for innovative initiatives to be pursued by individual service providers. Only in integrated markets does innovation reach its full potential. Once the market has matured further, the supply side will be moved to act innovatively again - and more integration is then required. The larger the network at the start, the greater the potential benefits, as integration multiplies the incentives for innovation.
The harmonisation exercise is just another example of integration as an expression of innovation. The developed the and SDD Schemes, the latter of which allows both payers and payees for the first time to make and collect cross-border direct debits. Thousands of banks across Europe have implemented these schemes. In doing so, they were the first in the world to deploy the global ISO 20022 message standards developed by the International Organization for Standardization. ISO 20022 message standards are generally recognised as the hottest thing in payment town. Re-engineering financial services, based on payment schemes and ISO message standards, drives forward automation and the dematerialisation of business processes. In other words, European banks have created the network which empowers bank customers to realise significant efficiency gains and fully explore the internal market.
That being said however, is only one example of an integration initiative fostering innovation in the payments market. The concept itself was certainly not invented by the European authorities on a quest to promote EU integration. Self regulation by banks in the area of payments is the long-established approach in all national communities - and now in . Banks created those network conditions, which allow innovation to release its full potential, before the start of the initiative and they will most likely continue to do so in the future.
On regulators' ambitions to mandate 'innovacompegration'
The article so far demonstrates how innovation usually happens first in the competitive business environment. Innovation is used by market participants to differentiate their commercial offerings from the rest. Innovators should not be asked to make their innovations available for free as this would destroy the foundations of competition. Innovation must also be left to market forces to ensure that only those initiatives which meet market demand are the ones that survive and set the benchmark for new 'standard' solutions. Only when individual initiatives have passed that test, should cooperative efforts aimed at generalising such solutions be progressed. It is the market that judges which developments are ripe for further standardisation and generalisation - not the regulator. The authorities that now claim the role of referee to judge which innovative ideas must remain and which should be given up will effectively prevent innovation to materialise. (For more details on the subject please refer to the article 'The Good, the Bad, the Ugly and a Knight in Shining Armour? European Commission requests unprecedented powers to determine payment functionalities, see 'related article in previous issue' below).
To avoid the risk of regulatory hyper activism, the authorities might also reconsider their expectations with regards to the impact of market integration on competition. When the programme was launched some ten years ago there was an understanding that some barriers should be removed to allow cross-border competition in the payments market. It was not perceived that competition was lacking at a national level (national competition authorities would have intervened if that was the case). Replacing the multitude of existing national euro payment schemes for credit transfers and direct debit by a set of harmonised payment schemes is one step further to market integration, but it will not bring, ipso facto, more competition. The expectation that cross-border competition will dramatically increase while integration of the euro payments market is in its infant stages is unrealistic: integrating payment schemes does not provide enough incentives to trigger such a development.
Business is not a sports game and commercial providers run financial risks which may end in failure. The substance of competition is essentially a by-product of two or more providers with the same overarching objectives such as: winning more clients, being more profitable and gaining further market share. As the marketplace has limits, these variables are generally bound to a zero-sum game and what one provider gets is lost by another. There is evidence that banks compete within the national payment markets, which is logical because the vast majority of payments are made domestically. It is difficult to compete in a 'domestic' euro payments market made up of 32 countries, which today exists only in theory. Cross-border competition in will take time to materialise, even once migration to the single set of payment schemes is completed. The removal of national barriers in the payments market will bring value, but not as much as expected and as quickly as desired. It will take time to change ingrained payment habits on both the demand and supply sides. Payments continue to rely on proximity effects: merchants prefer to bank with a nearby institution they can contact easily; consumers still open accounts based on closeness to their home or work and where staff speak their language. Even large corporations make similar considerations when searching for solutions that best meet their needs. Consequently they will regularly choose large banks with an overlapping footprint in the markets where both are present.
The most zealous integrator will not change the fact that payment habits and business models on both the demand and supply sides will only change gradually once is a reality.
It must be re-stated, as many times as necessary, that the integration of the national euro payment markets into a single European one is a process that would have never occurred spontaneously. It requires the political will and mandate to achieve it. It is therefore the task of the European legislator to set the legal and regulatory conditions required to conclude this market integration exercise and to establish end dates for migration to the payment schemes. - or integration - is however not an end in itself. It is an interim stage that should not be judged on the direct outcomes, but on the situation it leaves for the market to reap further benefits. is a seed rather than a fruit. Regulatory action should be restricted to sow that seed and focus on integration, not on 'innovacompegration'. The latter would potentially result in a scenario best described as 'operation successful, patient dead'.
Javier Santamaría represents Banco Santander. Banco Santander is a member of the European Payments Council.
Related articles in this issue:
The SEPA Regulation - A Progress Report. First reactions by European Parliament and Council of the European Union introduce important improvements to European Commission's proposal for a SEPA Regulation
Related article in previous issue:
1Baregheh A, Rowley J and Sambrook S. (2009) Towards a multidisciplinary definition of innovation, Management decision, vol. 47, no. 8, pp. 1323-1339
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