While the outlook for real-time payments in the US market remains fragmented and uncertain for the time being, in Europe the pace of development and usage is quickening and real-time payments (or “instant payments”) is clearly a key strategic topic for today.
Instant payment schemes for retail payments based on bank transfer are now present in around 10 markets worldwide, depending on your definition.1 Volumes on these new networks remain modest to date, given that few of them involved wholesale migration from the legacy ACH network counterpart. However, expectations are high. Within this article, we evaluate the potential along with the challenges for the business development of real-time clearing networks in Europe – writes Jip de Lange, Senior Consultant, innovative payment solutions, First Annapolis.
Need for improvement – legacy clearing networks are not ideally aligned to today’s business practices
ACH payments traditionally take time to clear and generally have no corresponding function for obtaining real-time authorizations. Clearly, this makes such networks deficient for retail payments and other use cases in which instant certainty is a requirement.
ACH networks are simply not built to operate in real-time rather they are built around batch processing, which typically takes place overnight. Similarly, the core bank interfaces which consumer ACH payments were also not built for real-time or retail payments. Additionally, batch processing is less expensive and naturally more resilient than real-time, which by default, relies upon robust resilience at all times and for all individual transactions. ACH networks are built for a specific purpose for which they are highly effective and efficient (pre-scheduled payments), but this purpose is not real-time payments.
The processing limitations of traditional ACH networks do not completely restrict their use for retail payments. iDEAL, the primary method of payment for e-commerce in The Netherlands, operates on general SEPA infrastructure, but still enables real-time guaranteed payments for merchants. It does so by operating an alternative set of tools and processes to authorized transactions. Similarly, bank buttons (pay-by-link) as can be found in many markets are a way to communicate authorizations in real-time when funds are cleared asynchronously.
Do we need really need real-time?
Ideally, the workarounds native to iDEAL or bank buttons would not be necessary. In a perfect world, the bank transfer message itself is a single message and clears instantly, because the alternative requirement for work-arounds limits the practicality of using the network. The promise of real-time clearing is that with an instant payments backbone in place, front-end applications built to facilitate retail payments and other use cases will proliferate allowing the network itself to scale.
The counter-argument is simply that the investment and costs required to build and maintain real-time clearing networks rely on a flimsy business case; that either the work-around option is perfectly fine, or simply that the front-end applications and use cases envisioned to propel network scale will never develop (in the face of competition from card networks for example). Let’s look at the current fact base on this debate based on existing real-time clearing networks in Europe.
What we see today in European real-time clearing
There are currently five real-time bank transfer networks operating in Europe (as shown in figure 1).
Figure 1: Examples of Real-Time Clearing Networks in Europe
Source: First Annapolis Consulting research and analysis.
Of these five networks, the UK and the Swiss solutions have seen the highest volumes, although this can largely be explained by the migration of certain volumes from legacy networks (UK) or even the closure of an entire legacy network (Switzerland). The most visible new use case that is enabled with real-time clearing is P2P and although we see large numbers of subscribers in the Nordic markets, it is still too early to speak of real success.
Table 1: Real-Time Networks Across Europe
Source: Company websites and First Annapolis Consulting research and analysis.
Based on these examples, P2P apps appear to have some traction, but it is too early to tell if the migration into C2B payments will be successful. And, generally speaking, few of these new networks displaced old networks which arguably increases the overall cost of the combined systems. Finally, it is interesting that networks developed to date are purely domestic, which runs contrary to the objectives of the European Commission and the European Central Bank to consolidate and to make interoperable payment networks across Europe (which is by the EBA Clearing’s stated real-time initiative carries significant weight).
Real-time payments require collaboration
As payment services are relying on collaboration between market participants, no one bank can create a scaled payment scheme on its own. Banks therefore must collaborate on the development of the network infrastructure (processing, payments settlement, risk/collateral management) itself and on the corresponding bank systems to accommodate real-time insight in balances, messaging and risk management. Establishing real-time clearing requires broad participation and coordination, which is why we generally observe these new instant payment schemes within relatively consolidated banking markets.
Figure 2: Components of Real-Time Payments Across the Value Chain
Source: First Annapolis Consulting research and analysis.
Four reasons to invest now, believing in the promise of real-time clearing
Despite the relative lack of overwhelming business case proof, and the challenges (e.g., broad collaboration), there are good arguments for banks to develop such networks in Europe.
1. Defend the relevance of the current account
A real-time payments infrastructure allows banks to more easily develop front-end applications that raise the prominence of their deposit accounts with consumers. Technical innovators such as Apple, Google, Samsung, and Facebook are coming into the market with new payment front-ends. Simultaneously, PSD2 will encourage other third-party payment providers to enter by making it easy to access the bank account. Within this environment, banks are afraid of being disintermediated in payments and relegated to operating accounts which have little relevance or revenue, but too much corresponding cost. Of course, banks still have the challenge to develop and to market such front-end applications which is not an easily achieved ambition.
2. Mobile apps are an additional weapon in the war on cash (and cheques)
Cash, less so cheques, is still prominent across many European markets. And, cash is expensive to accept and to process (certainly relative to a bank transfer). Thus, a real-time backbone which again could drive customers towards alternative form factors should generate a positive cost replacement business case for banks.
3. Creates an alternative to card networks for retail payments
A real-time payment infrastructure offers a banking community the opportunity to develop retail payments solutions that are an alternative to cards. Smart phones and possibly even biometrics, provide a form-factor on which new front-end applications can be developed riding on the new real-time rails. Although cards are often still preferred by banks, the card networks’ continual drive to own more of the card chain economics makes building alternative networks a sound strategy. For example, in Poland, scheme fees paid by the acquirer and issuer now exceed interchange, creating a clear economic argument to replace Visa and MasterCard. This rationale is not without challenges, however. Getting consumers to change payment behaviors is notoriously difficult as is building a merchant acceptance network.
4. To innovate and be seen as innovative
Banks increasingly see innovation as a key strategic objective; BBVA for example believes that innovation is the bank’s number one success criteria and that it will succeed by offering its customers the most innovative digital services. Real-time clearing networks create a platform on which innovation can easily develop.
Four Reasons to be Discerning and Patient
1. Bad business case
SEPA batch ACH payments are incredibly cheap, often costing banks small fractions of a cent. New real-time networks typically have higher variable cost than the legacy networks they are intended to replace (particularly absent the scale that must come from a wholesale migration). And, fixed costs for development are high while volumes on real-time networks appear slow to develop. This all suggests long break-evens and challenging medium-term business cases. At a time when banks have to be careful where to deploy their capital and are challenged to improve profitability, the Payments Infrastructure may not be the first priority.
2. Banks are challenged to win the battle to own front-end applications
Banks are generally not market leaders on mobile applications, online services, and other modern, technology-led solutions relative to competitors such as Apple and Google. Banks often have strong brands and distribution networks, but they must work hard to foster innovation and to demonstrate nimbleness in developing front-end applications. Of course, the banks don’t necessarily have to win the battle for the front-end applications in order to make the network a good platform for new applications that support the bank’s objectives to maintain account relevance and to replace card networks. Even if the application is owned by Google, if the account inside is the banks, and the infrastructure is lower cost or otherwise more profitable than cards, then the benefit is still there.
3. It will require significant migration effort within the bank
In order to drive a superior business case outcome, banks must embrace more wholesale change (i.e., new networks must replace old networks); migrations must occur. This is a hard pill to swallow for banks with stuffed IT queues and a reluctance to risk major setbacks. Banks seem to want to dabble in use of real-time clearing (routing only incrementally new volumes to the instant payment networks) which simply drives us back to the business case challenges observed in #1.
4. True network scale requires broad participation and alignment among network participants
Clearing networks are, by default, communities. These communities must be aligned around a common set of objectives and investments if the proposition is to be successful. In the Netherlands, iDEAL succeeded because the Dutch banks aligned around supporting the product. MyBank, on the other hand, has failed to gain traction because the community was too broad and not cohesive. Obtaining and maintaining the alignment necessary to build a successful new real-time clearing network is difficult in a market in which there are many banks.
So, what’s the answer – should we invest in the development of new, real-time clearing networks?
It depends, is the easy answer:
- It depends on the complexity of the market community and the alignment around objectives and commitment to invest. In markets where participation is highly complex due to the sheer number of banks (e.g., Germany, U.S.), then a business case that requires collaboration is fundamentally challenged.
- And it depends on the customer behaviors. Markets which are conditioned to using bank transfer as a primary means of transacting are better suited to expand this behavior onto new mobile applications (i.e., the Nordics).
- It also depends on the card network landscape. In markets in which there is already a viable alternative to Visa and MasterCard (e.g., France), hedging Visa and MasterCard via a real-time bank transfer network may be unnecessary.
Banks which see the merits of building such networks should move quickly. Five years from now technical powerhouses, innovators, and others introduced to the market because of PSD2 will crown the market for front-end payment applications making it more difficult for banks to own the front-end. Real-Time clearing networks offer great potential, but also present certain business case risks. We will watch closely as these networks evolve in Europe in pursuit of the broad objective to potentially reshape retail payments.
1 This number depends on your definition of both real-time and retail payments. Real-time can range from hours to seconds and may refer to notification, clearing and availability of funds or ultimately settlement. With retail payments, we generally refer to lower value transactions, but the cost structure or usability of a service could result in usage that is limited to very specific use cases, i.e. express payments.
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