The drive of innovation in payment systems
Article written by JP Fabri. He is an applied economist with amassed local and international experience. Fabri formed part of the private office of the former Prime Minister of Malta and Governor of the Central Bank of Malta. He also has international policy advisory experience having been an advisor to 9 governments on economic resilience and good governance. Fabri is also a visiting assistant lecturer at the University of Malta.
Payment systems are often taken for granted and underestimated. Current generations have seen the emergence of credit cards, debit cards, online payments, mobile phone payments, contactless payments and other innovative methods of payments. Payment services underpin main street, the wheels of industry, the operation of markets and the existence of government. No other banking activity is as important to either society or business as payments.
Technology and regulation are driving innovation in payment systems and creating new sources of value. So significant are the changes, that the future payments market will have a profound effect on the structure of today’s banking sector and other sectors too.
In 2015, the European Union acted to create a ‘digital single market’ for payment services in Europe. This move was championed by the EU’s Second Payment Services Directive (PSD2) which strengthened consumer rights, introduced new security measures, and provided the regulatory infrastructure for its own form of Open Banking (‘OB’). This game-changing Directive opens up consumer bank accounts to third party providers (TPPs), unlocking banks’ data-lakes and providing a level playing field with other financial services providers. As such, it represents a fundamental change in the European banking sector, and a significant step towards Open Finance. PSD2 became law for member states in January 2018, and its measures became active and enforceable in stages through to December 2020. PSD2 is seen as Europe’s response to this rapidly changing domain and was aimed at defining and pioneering the future of payment services.
The future of payment services
There is no doubt that technology and consumer behaviour are continually pushing the envelope with respect to payment services. The experience of COVID has also accelerated the use of alternative payment methods and numerous analysts believe that it will be accelerating the move towards a cashless society. The following are increasingly being seen as the key drivers behind the future of such services:
- Cashless - more cash will be displaced by electronic transactions as payment innovations make it beneficial for customers to use mobile and other alternative means of payments even in small denomination transactions
- Engagement - as payments and mobility become more integrated, the importance of payment transactions as a potential customer interaction point will increase for merchants and financial institutions alike
- Data-driven - with greater adoption of electronic payments, more data will be accumulated from payment transactions, allowing financial institutions, service providers and merchants to gain a greater understanding of customers and businesses
- Increased access to loans - as more payments are processed through electronic rails, financial institutions’ visibility into individuals’ and businesses’ cashflow and spending patterns will increase, improving their ability to extend loans to customers previously less understood
- Reduced costs - since innovative solutions build on the existing infrastructure, which has very low variable costs, the cost of making electronic transactions will fall as electronic payments gain more volume.
These forces, together with regulatory and technology innovations, will usher in a new era of customer empowerment. With the appropriate permissions, customers will be able to centralize their account information and payment options into one unified mobile application, enabling them to conduct day-to-day banking on the platform of their choice, provided by their bank or an innovative fintech. The obvious threat for banks is one of disintermediation, with fintechs potentially owning the customer relationship, while traditional banks simply maintaining the infrastructural architecture. Although banks may choose to treat PSD2 as a mere compliance exercise, I strongly believe that they should actually turn the regulation into a competitive advantage by becoming the customer’s trusted integrator and service provider.
PSD2: success or flop?
As we know, the intentions behind PSD2 were noble but the execution was rushed and incomplete. PSD2 is hampered on two main fronts:
- The restrictive definition of ‘Payment Accounts’ means that TPPs are limited in the nature and quantity of data which they can access from Banks and other ASPSPs.
- The lack of interface standardisation rules has led to the banking sector adopting differing APIs/Modified Interface frameworks, rendering TPP integration unduly cumbersome and costly.
The current framework therefore leaves a lot to be desired and is generally ill-equipped to bring about the full dissemination of Open Banking, and lesser still Open Finance, in the frictionless manner it was first intended. Consequently, prospective TPPs have been forced to explore the possibility of setting up private trust frameworks with selected banks, or otherwise connect with each bank independently according to that Bank’s specific set of rules.
The European Commission is cognizant that PSD2 did not live up to its expectations and its revolutionary scope has been tamed. To this end, in September 2020, it launched a
very comprehensive Digital Finance Package.
Data is king. The future is digital, open and data-driven.
The digital finance strategy sets out general lines on how Europe can support the digital transformation of finance in the coming years, while regulating its risks. The strategy sets out four main priorities: removing fragmentation in the Digital Single Market, adapting the EU regulatory framework to facilitate digital innovation, promoting a data-driven finance and addressing the challenges and risks with digital transformation, including enhancing the digital operational resilience of the financial system. Embracing digital finance would unleash European innovation and create opportunities to develop better financial products for consumers, including for people currently unable to access financial services. It unlocks new ways of channelling funding to EU businesses, in particular SMEs.
Boosting digital finance would therefore support Europe’s economic recovery strategy and the broader economic transformation. It would open up new channels to mobilise funding in support of the Green Deal and the New Industrial Strategy for Europe.
As digital finance accelerates cross borders operations, it also has the potential to enhance financial market integration in the banking union and the capital markets union, and thereby to strengthen Europe’s economic and monetary union.
A strong and vibrant European digital finance sector would strengthen Europe’s ability to reinforce its open strategic autonomy in financial services and, by extension, its capacity to regulate and supervise the financial system to protect Europe’s financial stability and shared values.
The Package launched by the Commission consists of a Digital Finance Strategy, a Retail Payments Strategy, legislative proposals for an EU regulatory framework on crypto-assets, and proposals for an EU regulatory framework on digital operational resilience. The Retail Payments Strategy aims to bring safe, fast and reliable payment services to European citizens and businesses. It will make it easier for consumers to pay in shops and execute e-commerce transactions safely and conveniently, all whilst ensuring a successful roll-out of instant payments across Europe. To this end, it seeks to achieve a fully integrated retail payments system in the EU, including instant cross-border payment solutions. This will facilitate payments in euro between the EU and other jurisdictions. It will promote the emergence of home-grown and pan–European payment solutions. Closely linked is the Digital Finance strategy which is based on a further 4 pillars, with the ‘Promotion of data-driven innovation in finance through common data spaces’ being one such pillar.
One of the primary commitments under this pillar is the ‘Promotion of business-to-business data sharing in the EU financial sector and beyond’. This effectively outlines the EU’s Open Finance Strategy for the coming years. To this end, the Commission intends to issue a proposal for such a framework by 2022 and intends to have it finalized and rolled out by 2024. The framework itself will be structured around:
- A review of PSD2 throughout 2021 – We anticipate that this will include a full review of the scope of the Directive and will seek to rectify the two main stumbling blocks discussed earlier
- The EU’s Data Strategy which, amongst other high-level targets revolves around:
- Creating frameworks which are GDPR compliant;
- A novel EU Data Act (which is to be discussed throughout 2021); and
- A novel EU Digital Services Act
The EU’s Data Strategy is a very ambitious undertaking which seeks to create a single market for data and build new sectors and niches around data sharing. The document is very general in nature and is meant to act as a roadmap for the future for both the private and public sectors. It tackles data-related hurdles currently faced throughout the EU and a high-level strategy of how these can be overcome. The vision goes well beyond financial services as the strategy is highly cross sectorial in nature and looks at healthcare, climate change, public records, etc.
In the financial sector, EU legislation requires financial institutions to disclose a significant amount of data products, transactions and financial results. Moreover, the revised Payment Services Directive marks an important step towards open banking, where innovative payment services can be offered to consumers and businesses on the basis of the access to their bank account data. Going forward, enhancing data sharing shall become a cornerstone in stimulating innovation as well as achieving other important policy objectives at EU level.
The Commission will further facilitate access to public disclosures of financial data or supervisory reporting data, currently mandated by law, for example by promoting the use of common pro-competitive technical standards. This would facilitate more efficient processing of such publicly accessible data to the benefit of a number of other policies of public interest, such as enhancing access to finance for European businesses through more integrated capital markets, improving market transparency and supporting sustainable finance in the EU.
European payment services. Quo vadis?
The Commission recognises that payments are at the forefront of digital innovation in finance. With digitalisation and changing consumer preferences, payment service providers will increasingly abandon traditional payment instruments and develop new ways to initiate payments.
However, the EU payments market is currently highly fragmented along national borders. Other than a handful of major global players – such as worldwide payment card networks and large technology providers – there's virtually no digital payment solution that can be used across Europe to make payments in shops and in e-commerce.
Although there have been encouraging developments such as the European Payment Initiative (EPI) project and work towards common European schemes and rules to facilitate interoperability of instant payment solutions, the Commission recognises the risk of inconsistencies and further market fragmentation.
Looking to the future, the Strategy envisions achieving a fully integrated retail payments system that promotes the emergence of home-grown and pan–European payment solutions. Outwardly, the Strategy sets out the Commission's plan for the EU to make a significant contribution to cross-border payments with non-EU jurisdictions, supporting the international role of the euro and the EU's open strategic autonomy.
Despite the initial setbacks of PSD2, I remain equally convinced that the future is one of an open banking world. PSD2 laid the regulatory foundations of such a new world and the new Digital Finance Strategy and the revised PSD2 will definitely continue contributing to this open future.
The evolution in payments has the potential of kickstarting a revolution, albeit slower than first expected.
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