Instant payments: what now?

Many countries around the world have transitioned to or are at least in the process of implementing an instant payments environment. Proponents argue that this model offers consumers and businesses an easy, cost-effective approach to making payments with the certainty expected in the instantaneous, real-time world of the internet. Here, The Banker talks to two industry experts, Isabel Schmidt of Deutsche Bank and Christopher Schmitz of EY, to gauge their views on possible future developments.

The Banker: The topic of the day appears to be ‘instant payments’. Is this a new phenomenon that is going to transform the payments industry?

Mr Schmitz: First of all, the concept of instant or faster payment systems as something new is not correct. If you take the Zengin system in Japan, for example, this is in fact more than 40 years old and as such pre-dates Swift. Even the UK’s Faster Payments system has been in existence for more than seven years. However, what we have seen in the past couple of years is an acceleration of such systems coming into place, in Poland, Sweden, Denmark, Singapore, Australia, etc. A more important, pertinent question is why that acceleration is taking place now.

Generally speaking this is linked to rapid developments in technologies, such as smartphones, becoming ubiquitous and broadband being rolled out across the world. As such, consumers are already accustomed to rapid access to information and the next logical expectation is to conduct transactions in near or even real time. The advancements that have taken place in the aforementioned technologies have not been matched in the transaction processing space. Many financial institutions have ageing legacy systems and, in the past few years at least, resources have been ploughed into other requirements, mainly related to regulation. The relatively slow cycles in the payments world are now being scrutinised as consumers and businesses demand more agile systems.

As to whether this is going to radically transform the payments industry remains to be seen. When we talk about instant payment systems, they are normally associated with retail/consumer payments, but there is scope for more use in cases including business to customers and business to business. The driving force behind instant payment systems, besides consumer expectation for instant money transfers, is the regulators and their aim is to increase the velocity of money through the economy by accelerating the clearing and settlement of payments. Basically, if money is received instantly, goods can be shipped quicker and that speeds up the economy. In that respect instant payments have a positive impact.

When we talk about instant payments as a channel for corporate or institutional payments, there are different sets of circumstances. What impact instant payments have on corporates, especially larger ones, is less clear. Operations of large corporates are based on overnight settlement. Real time has its advantages, no doubt. These would include simpler processing, greater transparency and a reduction in the cost of cash and cheque processing. Corporates could also improve their working capital by accessing funds posted in real time rather than having delays related to the clearing of slower payment types. Intraday liquidity management profits from real-time settlement. In a low interest environment turning around cash at low cost in real-time provides opportunities for market participants to
leverage their cash balances more efficiently in intraday arrangements.

Ms Schmidt: Essentially [I agree], however, I think we need to clarify first what is meant by ‘instant’ or ‘real time’. Does ‘real time’ merely relate to authentication (with irrevocable payment guarantee)? Does it mean funds are made available to the beneficiary account? Or does it mean instant settlement? If you take a look at the various systems around the world, there are different approaches to clearing, posting and settlement. In reality, most, although not all of these, are real time in notification and authorisation, not settlement. For example, the UK and Singapore systems have deferred net settlement, whereas SIX in Switzerland has actual real-time settlement.

As of now, instant or faster payments systems have emerged to deal with domestic demand. Although it is generally recognised that instant payment is one of the most prevalent developments in payments and transaction banking in recent years, the real transformation will come when we start talking about cross-border instant payments. And here there have been some interesting developments lately, especially in Europe.

In response to the increased global attention to real-time payments, the European Central Bank asked the European Retail Payments Board [ERPB], which succeeded the Single Euro Payments Area [SEPA] Council, to develop a vision and way forward on instant payments. In response, the ERPB stipulated that immediate payment solutions should leverage the harmonisation and integration achieved as part of the SEPA implementation. Approaching immediate payments with a ‘SEPA philosophy’ would in turn encourage the development of a single European market for immediate payments in euro. Consequently, they are pushing for the need of at least one pan-European instant payment solution for the euro. It should be noted that the ERPB has agreed to invite the supply side of the industry in close co-operation with the demand side to make an assessment of the issues related to pan-European instant payment solutions. This brings up the issue of having a level playing field when it comes to regulation. Currently [financial technology companies], for example, are not regulated in the same manner as banks.

In March 2015, European Banking Authority clearing announced its intention to offer Europe-wide instant processing services to payment service providers by 2018. However, at the same time, many national initiatives are already under way. Examples include Spain, the Netherlands, Germany and Belgium. That is maybe not surprising given that approximately 95% of payments in such countries are purely domestic. At the same time, this development on a national level has come in response to the threat from providers outside the traditional banking sphere.

Setting up parallel systems does not necessarily appear to be the most efficient way forward and is somewhat in contradiction to the achievements made through SEPA. Of course, these individual systems could be connected to each other with an overarching layer allowing direct participation. Here, parallels can be drawn to the euro payments systems with Target, which was an interlinking of different national networks that has since evolved into what is now Target2. The industry must be mindful of the complexities involved in proceeding in this way and learn from past mistakes. Fortunately, there have been massive technological advancements made within the past 15 years, so interconnection should prove to be easier today than it was at the turn of the century.

TB: Given that systems are being developed on a national level, what solutions are potentially available for the wider interoperability of real-time payment systems?

Mr Schmitz: It was interesting to note that in the study this year from the European Automated Clearing Houses Association entitled ‘Study on Interoperability of Immediate Payment Systems’, [there was a suggestion for] a decentralised model for cross-border immediate payments within the European Economic Area, based on bilateral exchange between members. By its own admission, though, this would at present be limited to those currently in operation such as Faster Payments System [FPS] in the UK, Swish in Sweden, Nets in Denmark and ExpressElixir in Poland. In such a scenario, protocols would follow existing industry practices, and banks would undertake the currency conversion and use the clearing houses for clearing and settlement in a single currency. Banks would of course have to be able to offer foreign exchange conversion in real time. With regards to technical aspects, the payment message would be based on the globally accepted standard of ISO20022.

There is, however, a different option altogether evolving to implement instant payments in multiple currencies, and that is the use of ‘distributed ledger technology’, which allows a digital currency to be used in a decentralised payment system. Any digital record of currency opens up the possibility that it may be copied and spent more than once. With conventional bank deposits, banks hold the digital record and are trusted to ensure its validity. With digital currencies, by contrast, the ledger containing the record of all transactions by all users is publicly available to all. Rather than requiring users to have trust in special institutions, reliance is placed on the network and the rules established to reliably change the ledger.

TB: Is there a lack of a business case for banks and corporates to invest in real time?

Ms Schmidt: Whenever investments are required, the first question that has to be asked is whether there is a current or anticipated market need at all. Instant or faster payment systems are being introduced at different rates around the world and for different reasons. The UK’s FPS was brought in essentially because of the antiquated BACS scheme through which payments took three days to clear. FPS is now seen as one of the front-runners, certainly compared with the US, which currently does not have such a system in place. That said, the Federal Reserve Bank and the Federal Reserve Board are evaluating potential strategies for collaborating with the industry to achieve real-time payment capabilities; the Clearing House, owned by some of the world’s largest commercial banks, has announced plans to undertake a multi-year effort to build a real-time payment system; and Nacha, the industry trade group that sets the rules for the automated clearing house network, has also just announced that it is to adopt same-day [automated clearing].

The view in the US on the need for faster or instant payments is changing. Up until very recently, though, there was still a degree of apprehension about instant payment implementation. The reasons for this were down to costs, a fear of revenue loss and operational challenges. Many banks have already invested in infrastructure-related projects and are reluctant to invest before recovering those investments. There are certainly overhead challenges with operating 24/7, together with the cost of implementing technology platforms, especially in light of the required compliance and fraud avoidance measures. At the very least, those banks using older legacy systems with delayed batch postings would require a major upgrade. Others fear that instant payment services may cannibalise the revenue from existing bank services.

There is undoubtedly a cost issue involved for banks. However, banks must remain flexible to upcoming changes regardless of how real time develops. If they do not, then they risk even stiffer competition from outside the traditional banking sphere.

In contrast to banks, cost is not an issue for corporates. Currently, the topic of instant payments is not high on their list of priorities (in contrast to merchants). That said, if such a system were readily available, they would no doubt be looking to take advantage of its benefits to serve segments of their business needs. It should be pointed out, however, that if instant payments does develop into the corporate space, the problem becomes far more complex as values exchange increases significantly and credit and liquidity matters begin to move to the top of the issue list.

TB: From a banking point of view, how do you see the role of distributed ledger concepts in a cross-currency real-time payments environment?

Ms Schmidt: Banks would be foolish to dismiss this completely but at the same time there has been a lot of hype generated in the market. While advocators are quick to point out that distributed ledger could transform the industry, there are certain risks that need to be considered with regards to the infrastructure and safety and soundness of the financial system.

Looking at Ripple as the most prominent example, it is based on a distributed infrastructure maintained by independent operators (there is no central operator). Therefore, the stability and resilience of the payments network depends upon the availability of the underlying nodes. Additional measures, such as routing payment transaction through legacy networks, will have to be taken to sustain payment functionality.

Additionally, there is the issue of banking regulation. As there is no central operator, the network participants are responsible for implementing local regulatory requirements including know your customer, anti-money laundering, filtering, etc, as required by the respective banking regulators or other authorities.

Utilising emerging infrastructures also brings up the issue of back-office processes to deal with exception handling, investigations and reconciliation, for example. Financial institutions would need to provide back-office integration and training, as well as establish interbank agreements regarding funds exchange. It is difficult to see such emerging infrastructures completely replacing classic ones going forward. Indeed, the infrastructure used today has proven itself when it comes to the reliable settlement of large payments volumes and values. It’s also scalable and has resilient processes and applications. Finally, global reach can be established through existing inter-bank networks.

While the current set-up of Ripple and similar concepts focuses on settlement in commercial money, and through that claim to reduce the complexity of correspondent banking, it would be interesting to see the impact of applying these technologies to settlement in central bank money. This would require more rigour in implementing mechanisms to safeguard the anti-money laundering regulatory requirements, but would also open up new horizons for using distributed ledger architectures for financial institutions and corporates. 

Such providers would argue that they are not positioning themselves as a threat to banks but in fact offering a complementary channel for customers and I agree that ultimately what is likely to emerge is a more differentiated set of solutions that offer distinct service levels for distinct client needs. While it is always prudent to put the existing hype into some sort of perspective, banks will nevertheless need to show open-mindedness to new technologies. Some banks are already experimenting in this space; no doubt others will follow.