Payment (r)evolution, where did this come from?
We hear a lot about the payments revolution and how it’s gathering speed, fueled by technological changes and shifts in market dynamics. In fact, the payment sector could be seen as the archetype of how technological innovation can reshape an industry’s approach and create the need to change. And we touched upon the matter in our previous blog “The payment evolution: a banking perspective”.
In October 2022, we released the “Banking Trends and Figures 2022: The Payment Revolution — an opportunity to enhance Banks’ Digital Transformation” report, which identified three main shifts as underpinning the new payments landscape:
- Demand for instant payments is disrupting the ecosystem and infrastructure;
- Big Tech’s entry presents a new and complex layer of competition within the payments ecosystem;
- Innovation of Business-to-Business (B2B) payments represents the new frontier of payments.
The times sure have changed. Banks once held the monopoly on payments, but they faced tighter regulatory scrutiny than fintechs and big tech peers due to their key contribution to overall financial stability.
Concurrently, regulatory gaps hinder banks from innovating at the same pace as their less regulated and more agile competitors. On top of this, their legacy systems can be an obstacle too, due to cost and complexity.
But the reality is that most of us, through our own personal experience, now prefer instant payments — in fact, more and more we want instant everything, right? And we increasingly have access to innovative ways to pay thanks to those fintech and big tech players.
Artificial Intelligence-enabled integration of financial service offerings within traditionally non-financial platforms has also accelerated the digitalisation of payments and effectively limited the use of physical cash.
As mentioned, one area that we would like to focus on is that of cross-border payments. That’s because in Luxembourg, Europe and the world, there’s still a lot of work to be done. And even though one may be at the point of saying “what’s a bank to do?,” banks can still find opportunities in this changing landscape and do a reset and a re-think.
Right now, however, there still needs to be more of a “behind the scenes” evolution to support a successful banking payments revolution.
Let us begin with a little (almost true) story about a grandfather and the current cross-border transfer situation
Andy Oak, lives in Europe, in country A. He wants to send some money to his grandson living in country B outside Europe so as not to miss the lad’s birthday. He therefore contacts his bank and orders the transfer of 1000 currency units. The day after, when calling his grandson, our Andy is a bit disappointed as no “thank you” comes from him. Well, that’s because he’s still unaware of the gift. Why is it so?
While it’s hard to define and explain with precision every single step of this funds flow, we can try to give you an overview of the traditional cash journey. It’s all about correspondent banking.
Correspondent banking refers to contractual relationships between banks around the globe allowing them to transfer money from institution to institution. They open current accounts — the famous Nostro (our cash in your institution) and Vostro (your cash in our institution) accounts— in several other institutions, to make it simple.
And just like you and us, they need to sign contracts defining the currencies, the limit of overdraft per account, the minimum balance, remuneration, transaction fees, you name it. Once in place, they are able to transfer money from one account to the other and they do so using, among others, a messaging service: SWIFT. Do they have open accounts in all institutions? Well, no. And this is why funds flow can become a real journey.
But let’s go back to Andy’s cash. The order to move cash from his own bank account in Bank 1 to the account of his grandson in Bank 2 has been recorded at 10am, country A time. At the end of the day, the order will be processed with all other transactions recorded that same day.
As Bank 1 has no direct relationship with Bank 2, Bank A will therefore first move the money to Bank 3. Bank 3 will then move it to Bank 4 and Bank 4, having the relationship with Bank 2 will finally transfer the money there. Of course, different time zones, different checks for Anti-Money Laundering (AML) or different regulations will play their part in the game. All in all, this is why money will reach Andy’s grandson’s account only later on.
And to add insult to injury to poor Andy, a roughly speaking 50 currency units fee is applied to that transaction. Yes, every intermediary needs remuneration.
The above illustration is voluntarily simplistic, but in truth we aren’t that far from reality. Indeed, the process can still be time consuming and costly if using the old ordinary banking payment rail, to put it simply.
However, for a couple of years now, we are seeing new solutions for both retails and corporations. They are trying to bring faster, cheaper and more transparent — and secured — payment rails. And where do they come from? Either from the evolution of the existing rails with initiatives coming from SWIFT, or the Single Euro Payments Area (SEPA) instant payment initiative — just to mention some names you’ve probably heard of already, but also from revolutionary technologies such as Distributed ledger technology (DLT).
What are the obstacles to digital innovation for banks?
To be honest, there may be a lot of them, but we can gather them into three key areas:
1. Regulation: Banks, given their operations and their impacts on overall financial stability, are subject to heavier and tighter scrutiny and regulatory oversight than their fintech and big tech competitors.
At the same time, regulation in itself has largely underpinned the digital transformation of payments observed in the payments ecosystem. The PSD2 Directive*, for instance, has played a significant role in promoting innovative competition and enhancing inclusion through standardisation.
This regulation compels banks to allow third-party providers to access clients’ bank accounts through APIs**, underscoring the expansion of fintech and big tech in driving financial management, and payments speed and ease.
2. Legacy system: Not all banks have access to the agile infrastructure required to execute rapid and real-time iterations or facilitate the rapid embedding of modern technologies within their systems.
3. Change in customers’ expectations: We mentioned it already, but we all are, and those who are digital natives even more, shifting our preference for a more seamless payments experience and we expect to be able to carry out all activities conveniently from our mobile devices — including payments. Studies show that sharing personal data to facilitate this process is clearly there as well.
Banks are adapting to the payments revolution by buying and or partnering with big tech, fintech, paytech… or others?
This is good for everyone. Really, which treasurer wouldn’t be happy to see their banking partner proposing free treasury management analytics? Which financial controller would claim that new solutions to manage expenses are useless? Which individual would be dispirited to be offered services such as having all bank accounts in one app, or being able to pay with his phone or watch? And we are just mentioning some obvious evolutions that have now been live for a couple of years.
As Philippe Förster, the Electronic Money Institution/Payment Institutions (EMI/PI) Leader at PwC Luxembourg explains: “Banks and fintechs together are changing the financial services industry. The latter are getting banking licences while the former are partnering or buying fintechs to digitalise or improve their services. Regarding payments, we have identified several trends that range from the proliferation of digital wallets to more emphasis on the customer experience to improved cross-border payments.”
The disruption of the payment ecosystem affords a greater opportunity for banks, fintechs, big tech firms, and regulators alike to re-assess their strategy for greater value yield. More importantly, it’s allowing banks to transform or upgrade — in every sense of the word — to consolidate their position as market innovators and leaders.
In this context, in the “Banking Trends and Figures 2022: The Payment Revolution”, our banking specialists have identified five strategic considerations that will advance banks’ adaptation and set them up for greater value-creation in this new payments segment:
- Differentiate your organisation by leveraging opportunities within the B2B landscape;
- Establish partnerships with fintech will lead to a win-win situation;
- Anticipate further changes in the payments landscape;
- Drive the development of global payments solutions;
- Regulators have a role in levelling the playing field.
Banks have an opportunity to reinvent themselves, in alignment with core and unique strengths, such as long-term business relationships with corporates.
They could strategically focus on providing ancillary services, improving cross-border payments procedures, making life a whole lot easier for people like Andy.
By assessing what differentiation is needed to compete in this technologically-advanced environment and finding improved ways to present their existing services, banks are in a prime position to enhance their value-add potential exponentially.
*The key objectives of the PSD2 Directive are creating a more integrated European payments market, making payments more secure, and protecting consumers.
**Banking API is the process of exposing banking functions as a web service so that they can be accessed by third-party companies.