By Paddy Ramanathan – Innovation Cafe’s Digital Transformation specialist [Original post here]
The Federal Reserve System (the Fed) in the United States released its report on Strategies for improving the US Payments systems last week. It is the result of extensive analysis done by the Fed in conjunction with “payment system stakeholders” for the past few years. This 58-page report is “calling on all payment system stakeholders to seize the opportunity and join together to improve the payment system”. These changes are likely to generate other digital and mobile offerings as has happened in other countries such as Kaching in Australia, PingIt in the UK and M-Pesa in Kenya to name a few.
The Payment system today is a complex mesh of players and infrastructures that have grown over time. In this post, I have made an attempt to provide an overview of the current state while reviewing the highlights from the report and the opportunities this evolution presents.
The Payment Ecosystem in the US – Current State
The figure above depicts the various electronic money movement schemes (paper based checks represents a fair amount of volume but are not covered) in the US (Fed operated and Private) and the flows as it stands today. There are essentially 4 distinct paths:
- Near-real time processing with FedWire – a near-real time (from the Customer’s vantage point) funds transfer network and settlement system operated by the Fed. Access to this capability is only for banks and depository institutions who expose these services through a variety of channel like Commercial Online/Mobile Banking. For example, a business that has to send funds to its supplier can initiate a wire money transfer through it Bank’s online channel. The supplier usually receives funds in their own bank account within hours
- ACH (automated clearing house) is an electronic network operated by NACHA (a non-profit association of Banks and depository institutions) where funds are settled by the Fed and the Clearing House. ACH transactions are processed using batch and typically settle in 1 to 2 days. For example, a business forwards its payroll payments to its Banks in a file form with specific instructions on when to debit and credit and in a day or two the employee’s accounts are credited.
- Credit Card networks such as Visa, MasterCard and American Express is something we are familiar with. When one swipes their card at a merchant or buys something online there are several steps that occur in the background. First, the point of sale system initiates an authorization to the acquirer (usually the merchant’s bank who provides the credit card accepting capability to the merchant but sometimes it is a reseller). The acquirer/processor routes the transactions through appropriate network to the Issuer bank to authorize the transaction and ensure that funds are available. Processor than settles the transactions with the different financial institutions involved.
- Debit Card networks work like Credit card networks but with a pin, they have an additional step if the merchant and the issuing bank belong to different networks. There is usually a intermediary who routes the transactions (with encrypted pin) between the Debit card network.
International or cross-border payments have separate networks and flows and are not covered in this post.
Highlights from the report
The desired outcomes of US Payment system improvement according to the paper are:
- A faster, near-real-time, and ubiquitous electronic payment system to support a variety of B2B, B2P, P2P and P2B use cases such as supplier payments, bill payment, adhoc p2p etc
- Evolve the security and risk management provision of the payment system to keep pace with the rapidly evolving and expanding threat environment – this topic, in a broader sense than just Payments, is getting a lot of attention these days with the upcoming Cyber security summit in Feb
- Better choices and convenience to send and receive cross-border payments – current options lack transparency and convenience
- More Electronic payments to reduce societal cost of payments and a democratic approach to payments systems improvement with collaboration amongst the various stakeholder
The report describes a set of 5 strategies to achieve the desired outcomes
- Actively engage with stakeholders through the faster payments taskforceand a payment security task force. Firms that want to keep track of this evolution should join these taskforces at the Fed payments website .
- Help coordinate the effort to identify effective approaches for implementing safe, ubiquitous and faster payments. The Fed plans to help facilitate this discussion and would not consider an operational role unless by doing so there is clear public benefit and other providers cannot do so.
- Reduce fraud risk and advance the safety, security and resiliency of the payment system
- Achieve greater end-to-end efficiency for domestic and cross-border payments
- Enhance the Fed’s payment, settlement and risk management services.
Gaps and Proposed Design Option
The analysis looked at unmet needs and gaps of the current capabilities. 5 use cases were identified that are described below that would benefit from faster authorization, clearing, settlement and/or availability of funds. According to the analysis, these represent at least 29 billion transactions or 12% of all US payments annually.
- Person-to-Person – Sample payments: paying a friend or micro business
- Person-to-Business ad hoc remote – Sample payments: emergency bill payment, time-sensitive corrected bill payment
- Business-to-Person ad hoc low value – Sample payments: Wages for temporary workers or time sensitive corrected payroll
- Business-to-Person ad hoc high value – Sample payments: Medical insurance claims, legal settlements, FEMA transfers
- Business-to-Business ad hoc low-value – Sample payments: Just-in-time supplier payments
Several design options were considered including using the Debit/Pin infrastructure (used currently in some vendor products) but the preferred design option is to build a new near-real time clearing infrastructure to address targeted use-cases and use the legacy systems for settlement. The longer-term objective would be to extend this new capability to have functionality from existing ACH and even the FedWire system.
Virtual currencies or Blockchain technology or cryptocurrencies (Bitcoin, Ripple etc) were not considered sufficiently mature to be included as an option although the report alludes to tracking their progress in the future. Initially, I thought the report had totally kept them out as I could not find any references to Bitcoin or blockchain only to find the euphemism “Digital Transfer vehicle”. It is worth mentioning that as a separate and unrelated effort the New York state regulator of financial institutions (DFS) is working on and has published a proposal for regulating all virtual currency.
The Opportunities for Banks and Technology providers
Payment ecosystem has evolved significantly especially in the last few years as is evident with the activity at the Money 2020 conference (Key themes from 2014 Money 2020 ). Technology startups, established technology players, fintech companies and ecommerce providers play alongside financial services providers driven by customer expectations, economics considerations and the integration of value-added services to both the payer and the payee.
Several technology advances will likely play a big role in the payment infrastructure evolution.
- Security technologies such as Biometrics and digital identities at the point of initiation will play a big role. Propagation of security credentials across the payment value chain could yield significant benefits.
- Network analysis of aggregated payment data across institutions, cross analyzed with public and internet data using Big Data analytics has the potential to reduce payment fraud and the cost of fraud prevention and regulatory compliance.
- Secure API’s and Cloud based integration technologies will be a key part of the infrastructure that will have a transformative effort. As I wrote last year on the API opportunity in Banking, secure APIs in payments will transform commerce and allow creative service providers to combine value added services.
- Last but not least, block chain technology and virtual currencies could provide a disruptive jolt to the payment ecosystem not just due to the economics but its speed and traceability characteristics. As one of Fed governors said in the webcast and I paraphrase, technology innovation within a virtual currency may become important for it to be considered as part of the broader payment offering rather than the virtual currency itself. In all likelihood we will see that happen in the next couple of years.
Financial Institutions should carefully track the payment infrastructure evolution and factor it in their cash management and merchant banking roadmaps as well as their technology architecture. Technology firms including startups in Biometrics, Big Data, API management and Cloud integration space should participate in the taskforces and carefully examine the opportunity to be a part of the solution stack.
Paddy Ramanathan is a advisory partner at Innovation Cafe specializing in Digital Transformation in Financial Services.