As was again highlighted this week in a report issued by the trade association Payments UK, the payments market is undergoing a dramatic and structural change. Its main driver is a powerful mix of consumer demands, technology changes and new entrants, combined with regulatory changes and industry initiatives. The change goes deeper than the evolutionary developments; it will impact on the many players that constitute the payments value chain.
How will this affect the banks, the traditional players that sit where infrastructural payments rails and innovative customer products meet?
It’s evident that banks increasingly need to deliver more and faster for less: the payments paradox. The paradox results from an apparent self-contradictory situation: the need to invest in payments but for less margin in return. However, this contradiction can be resolved by adopting a clear payments strategy coupled with the readiness to search for and adopt new business and delivery models.
However, reaching this resolution means successfully addressing two key challenges: how to increase innovation capabilities and optimise sourcing of the payments function?
This article will consider key drivers in the payments market, why they result in the payments paradox and what strategic responses banks can provide
A cocktail of drivers shaking up the market
Today’s payments market is shaped by four key drivers:
Continuing regulatory pressure and new industry initiatives:
The most dominant changes for payments in Europe stemming from regulatory and industry initiatives are, of course, the second iteration of the Payment Services Directive (PSD2) and instant payments, aka instant or real-time payments.
PSD2 strives to open up Europe’s payments system to competition and drive innovation; consequently it will push payments service provisioning further into the commodity arena.
The industry initiative of 24/7, real-time “Instant Payments” is strongly supported by the regulators. Although currently optional, it’s highly likely to be adopted at a very fast pace. We also expect a mid- to long-term convergence from regular single euro payments area (SEPA) payments to Instant, initially from SEPA credit transfers (SCTs) and eventually from SEPA direct debits (SDDs) as new types like the Request for Instant Payment emerge.
A convergence from cards transactions could occur if innovative overlay services are developed on top of Instant Payments for electronic and mobile commerce (e-/m-commerce/point of sale (POS). As this convergence grows many banks – and processors – will need to deal with the fixed processing costs at decreasing numbers of SCT (and eventually SDD) processing. They will look for new sourcing options.
If you can’t stand the heat get out of the kitchen!
Keeping up with technology advances and continued experimentation is important. Advances in technology can rapidly redefine a market. A survey of delegates at last November’s Payments International conference in London, found one in three agreed that staying updated caused them sleepless nights.
Obviously, in the last decade the capabilities of the smartphone have transformed consumer behaviour. Increased computer performance and cloud services – private or not – have lowered infrastructure costs. Nowadays the payments processing of a smaller bank can be done on a desktop for a tier-2 bank on a server that fits under your desk.
Distributed ledger technology (DLT) is the next and newest advance that is impacting an industry focused on making processes efficient for its complex multi-stakeholders.
The customer demands!
While colleagues might have a more elevated view of it, payments processing is essentially a supporting process only and therefore should be adaptable to support the end-to-end use cases simply and efficiently. That’s where the value lies.
Sometimes the payments process should be ‘embedded’; that is almost hidden to simplify use and maximise conversion – as Uber has done for public transport – or value is delivered in increased automated reconciliation numbers for corporates.
It remains important to deliver to payments users the appropriate sense of control and safety. Payments are a key enabler for the economy, disruptions are a no-no and fraud needs to be kept at an absolute minimum. If a disruption happens today, the visibility to the general payment-using public is much greater than yesterday. A glitch in the instant payment system is instantly public knowledge; social media then does the rest. The demands are increasing.
New guests join the party:
Much has been said about the introduction of SEPA but it has increased market competition among banks. Fintechs and competition-fuelling-regulation like PSD2 add to the dynamic. New guests, unhindered by legacy systems are entering the market with a fresh approach and – albeit slowly – are taking away payments volumes from traditional players.
Market drivers are making conditions increasingly competitive, where more needs to be delivered, faster, 100% of time.
To make it simple banks must tackle two key challenges:
- how to increase innovation capability in line with customer demands.
- how to source payments processing at lower cost but maintain quality.
A clear strategic response is needed
So how can banks respond to the payment paradox? There are four distinct responses, depending on which type of payments role a bank wishes to play.
These roles are divisible along two axes:
- The innovation axis: the extent to which a bank wants to provide a distinct set of new and flexible payments services ahead of the market standard; following/creating client demands.
- The operational excellence axis: the extent to which a bank wants to provide a distinct set of standardised payments services through an extensive network at low cost.
Along these axes we divide the strategic response into four quadrants as indicated in Diagram 1: as a payments user, a payments specialist, a payments provider or a payments ecosystem. The strategic response of an organisation can differ per payments product set or customer segment.
The payments user:
This is a bank that considers payments to be either a rudimentary service (a means to transfer customer funds in and out of the bank) or a basic and non-competitive service (to complement its core services); its core strategy focuses on other banking functions than payments.
Due to the payments paradox the payments user bank avoids investing in the (non-distinctive) payments capability itself. Outsourcing it to a third party, relatively cost- effectively, enables focus towards the core strategy. Some smaller banks take outsourcing a step further, they just mandate their customers to use an account from a third party bank for deposits and withdrawals for savings or wealth management services. In the latter case, banks let go of the payments altogether.
Several banks have adopted the payments user strategy; more are likely to follow with the smaller and medium-sized banks at the forefront, although tier 2 banks may join them as PSD2 further commoditises the payments infrastructure while new investment is required for Instant Payments and the convergence to Instant Payments makes the decreasing SEPA batch processing infrastructure correspondingly less attractive.
A bank seeking leadership in providing payments value-added service; Netherlands ‘bank of the free’ Bunq is one example; it focuses on providing flexible and state-of-the-art services, less on cost competition. Commodity payments services are typically outsourced to ensure the focus on innovation; the own technology platform and internal culture facilitates customer focus, flexibility, speed to market, try and test and integration with partners.
A bank that offers an extensive payments network through standardised services cost efficiently. As the payments rails become a commodity a decreasing number of banks will be large enough to provide them in an economically sustainable way.
The payments provider brings scale to deliver the economies; it might further grow additional business by attracting volume from other players, such as payments users, specialists or ecosystem. Banks opting for this strategy should create a separate payments provider business line or entity to ensure focus and clarity of costs as well as to ease competition concerns for parties that consider outsourcing.
Product and process leadership is virtually impossible to combine within one organisation; it creates a culture clash, which means the response in this quadrant requires a mix and match of payments players that collaborate, i.e. an ecosystem.
A bank can decide to play a leadership role in the ecosystem leveraging its customers, trust, scale, reach and investment capabilities, but will need to introduce possibilities to more easily interact with the eco-system and adapt. An open architectural approach is important, but also more concretely identifying and separating, organisationally and architecturally, which capabilities are standardised (payments provider-like) and which are subject to innovation (payments specialist-like). This will allow the required differentiated business and organisational approach to optimally address innovation and operational excellence.
PSD2 and the open banking initiatives both provide a catalyst for considering this strategy.
The payments market is changing structurally. The role of payments players is becoming very challenging with innovation up, margin and timelines down. The banks, as traditional players, need to adopt a clear and distinct payments strategy. The payments landscape will change; it will not be a sudden disruptive change, but in the mid to long-term many of the current players will play a different role, source payments processing differently, collaborate in a different way and new players will have consolidated.
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The only way PSD2 will function effectively and securely, will be through the mobile banking application itself. However, the directive does not specify how secure this access will be, nor, what risks will arise, and for who.
PSD2 heralds a new dawn for mobile payments, as the regulatory technical standards around the upcoming European open banking regulations are expected to put mobile devices at the heart of new payment techniques. But despite the regulatory environment nudging markets towards certain payment types, it is not easy to predict exactly how consumers will adopt the technology.
These are interesting – and uncertain – times for global retail banking, from Trump's desire to remove Dodd Frank to Brexit and new British banking regulations.