Europe’s quest for payment pricing unity

Five years after the introduction of the euro, the European Union still does not operate fully as a Single Euro Payments Area (SEPA). There remains a differentiation in costs, either to the customer or the banks, depending on whether payments are made within one country’s borders or cross-border.

The banks and utilities that will ultimately build the infrastructure to enable the SEPA have been given until 2010 to operate in a true pan-European fashion, with the looming threat of mandatory requirements by the regulators hanging over them.

In February 2005, the European Commission (EC) and the European Central Bank (ECB) summoned banking group heads for a progress report. Regulators are increasing pressure on the banks that have not yet provided evidence of satisfactory progress. But banks are still debating and there is still no official common position or significant progress. The European Payment Council (EPC) – established by banks to respond to the issues arising from the SEPA – has already designing the euro payments standards. However, European commissioner for internal markets Charles McCreevy said at March’s Eurofi conference, Banking and Finance in Europe, that the road map was behind schedule. “It has been four years since promises were made by the banking system to develop, by no later than 2010, Europe-wide payments infrastructure, standards and products. I now understand from the industry that this target date is likely to be missed. This is, at least, disappointing news for users of payment services and for the EU economy,” he said.

Francesco Burelli, managing consultant and strategist in the financial services team at RSM Robson Rhodes Business Consulting, in London, says: “From the EU’s viewpoint, banks have not been delivering the cost reductions and the process improvements they committed to for the past 12 years. Banks have experienced a public outbreak of criticism, expressing disappointment for the lack of progress to date and for being likely to miss the agreed 2010 deadline.

“Despite the complexity of setting mandatory standards over 12 national payment systems, and Mr McCreevy indicating that self-regulation from banks would still be preferred over EC intervention, banks have been explicitly threatened by the EC to define compulsory standards and include the SEPA road map into legal directives. Discussions between the Commissioner and banks to reinforce the need for action have been taking place but there has been no further public progress report statements made to date.”

Transfer costs

Transactional and payments revenue accounts, on average, for 35%-45% of the total revenues for a European middle-tier bank. However, cross-border bank transfers typically account for between 1%-2% of the total domestic volumes. Of these, about 83% are card payments, 16% are bank transfers and less than 0.5% are cheque payments. Bank transfer systems are expensive and costly to operate, and do not work on a straight-through processing basis. They are mainly based on correspondent-based payment logic (a nostro and vostro account through which payments are settled). The high cost of the system and the low volume of transactions has been one of the arguments used by banks for their high flat fee structure, which is suitable for high value transactions but not for international small-value payments. Mr Burelli adds: “Small banks have had a marginal role in EPC as only the major banks and the interbanking associations are directly represented. Small and medium-sized banks may or may not be directly impacted, depending on their volume and value of cross-border payments and of the standards that will be developed and adopted to comply with the SEPA directive.”

For small and medium-sized banks, the development of a framework based on bilateral exchanges would result in particular disadvantage and these banks would rather see the development of a simpler formalised standard as maintaining bilateral agreements.

Leonard Schwartz, director at ABN AMRO, says: “Although the infrastructure is not there today, although there are entities like STEP 2, banks have got to maintain multiple connections and multiple formats. For pricing of the transactions to be the same, a common delivery structure is needed.”

He believes that getting there will take time and that market forces, rather than regulation, should play a large part in the final shape of the SEPA. He says: “It’s not simply a question of willingness, but efforts and the resources to do it and how fast it can be achieved. For a small to medium-sized bank, only interacting with one or maybe two automated clearing houses [ACHs], the relative impact would be very high and it may well want to resist that change. You see that any time there is regulatory mandated change – the people who are going to gain the least are going to resist that change. It is easier to lay out principles that change a dozen systems.”

Until now some banks have been dragging their heels, perhaps hoping the issue would be forgotten about or slip down on the ECB’s and the Internal Market Directorate-General’s respective priority lists. Despite the years spent debating the issue, both regulatory bodies are pressurising banks to move forward with the SEPA implementation. It must also be considered that this could be very expensive for banks with expected benefits impacting less than 2% of total payment transactions – an argument that banks have used in their objections.

The SEPA issue dates back as far as the early 1990s when the EC and the European Parliament demanded banks take action to make electronic payments across the eurozone more efficient and less costly.

But Robson Rhodes’ Mr Burelli says: “[The] SEPA will not drive banks to outsource more as, for the vast majority of European banks, cross-border payments are mostly managed by third-party (generally inter-banking) organisations. The issue is to define a SEPA standard and then implement it, regardless of the investment required from banks.

“This will impact the role and, if not the very reason of existence, of ACHs and the many domestic payment processors. Mr McCreevy is demanding evidence of progress, a road map, an implementation plan and actual actions; realigning the business behind the scenes is not a feasible option for a bank.”

Regional interlinked ACHs

One possible scenario is the emergence of a limited number of interlinked regional ACHs. These would work on the same logic as a pan-European ACH (PE-ACH) but on a smaller scale.

A PE-ACH would have high costs of transition and low volumes, as it would be aimed at processing only cross-border payments. A single European ACH for all payments (domestic and cross-border) would benefit from huge volumes leading to a very low transaction unit cost.

However, this would reduce competition by becoming a monopoly and would force the write-off of domestic and international ACHs. Currently, the only possibility of two PE-ACH equivalents existing at the same time would be if the international card scheme systems, Visa and MasterCard, added ACH functionalities and also processed cross-border non-card payments.

ABN AMRO’s Mr Schwartz, says: “If you minimise the number of ACHs, whether it is four or one, by the very fact you have done that, the rules of governance have to reflect this. A common format and common pricing for transactions in the eurozone is a requirement of the SEPA, which means rethinking the governance building the links and migrating the infrastructure from the current environment. Banks need to look at increasing consistency in process and governance, as well as understanding the migration process that will accommodate both banks and the corporate users.”

Europe’s ACHs are slowly starting to react. The Spanish banks are in talks with the Euro Banking Association (EBA) and, in May, the seven major Italian banks announced that they would migrate their domestic credit transfers to STEP 2, built by the European Bank Association. Other smaller ACHs are also expected to follow.

Plans of action

Last December, the French banking community clearly indicated its intention of competing at the pan-European level by creating an entity called STET, funded by six leading French banks. This will replace and modernise the French ACH by 2007. In the same vein, the UK’s ACH, BACS, has been relaunched as Voca, with a new governance structure and technology upgrade to help it position itself in the PE-ACH race.

But it is a question of numbers. Each year about 50 billion to 60 billion payment transactions are handled within the eurozone. Each ACH would be required to sustain at least 10 billion transactions annually to survive and have economies of scale, but likewise, there is no reason why one utility could not handle all the transactions. How else would you get the reach needed to make payments in the eurozone work? Banks are not going to be members of more than one or two systems so how would payments work unless there was a link between the PE-ACH operators?

Brendan Reilly, euro clearing senior product manager at JPMorgan Treasury Services, says: “Once we get to the end game of one or two PE-ACH operators, some banks will probably have some very serious questions about their costly branch infrastructure, but we are not there yet and much is still to be done.”

 Brendan Reilly, euro clearing senior product manager at JPMorgan Treasury Services

He believes that an EU Directive would probably take too long to implement and that perhaps the only way mandatory measures could potentially work would be if the ECB regulated the process. He says: “The ECB could license the ACHs in the eurozone, and ensure they comply with certain standards like processing on the basis of an IBAN [International Bank Account Number] and be able to make payments across the eurozone. This could actually be quite successful as it would force the national ACHs to decide whether to invest in these developments and perhaps link with other ACHs, or decide to migrate domestic payments to EBA’s STEP 2, for example. If regulation is done right it could be quite helpful.”

He adds that unless there is some kind of regulation along those lines, it is hard to see how it is going to happen – who is going to go first? And there are still national interests within Europe. With regard to the competitive positioning going on among ACHs, Mr Reilly believes it could just be a case of reinventing the wheel, unless some real functionality is added.

He says: “The French STET, for example, might be viable if it can offer thicker functionality than STEP 2 does at the moment. STEP 2 does not handle returns particularly well. It is not really clear what goes on at the receiving bank country, in terms of charges that get applied to the receiving bank by the entry point bank. STEP 2 is really a thin model at the moment although I think pressure is growing for them to start looking at the handling of returns.

“In the end, you will probably get two pan-European ACHs, just because there will be a thick model and a thin model, but for ultimate consumer interest, the best situation is to have one infrastructure, which is a non-profit-making, member-owned utility.”

JPMorgan prices for a euro-wide wire payment. It makes no difference to the customer whether the payment is cross-border, but it does make a difference to the cost to the bank. Target2, scheduled for 2007 with testing beginning next year, will help banks lower these costs by providing a single platform for real time gross settlement payments across the eurozone.

Current developments

But for now, after the latest statements from Mr McCreevy, banks have no choice but to start proving they have made progress in the development of a road map and of implementation plans. Whatever the ECP decides to do, there will still be a significant number of issues that need to be settled before delivering the SEPA vision, including the ECP governance, because as it stands, the ECP does not have the capability to give bank the mandate for implementation.

Mr Schwartz says: “The biggest challenge is that the scope of SEPA-related discussions seems to be large and growing and we need to focus on what exactly it is that needs to be done to accomplish specific objectives. One of the reasons why there is caution about how to approach SEPA is that we are changing lots of things at once. It is overwhelming.

“It is not just a question around a single pan-European ACH structure. There are all other issues that range from discussions around liability to discussions from the corporate community about tying invoicing and payments together. There is still a lot of information-gathering going on.”