The Payments Paradox – eh what?

Wednesday, 18 January 2017 00:00

Banks increasingly need to deliver more, faster for less: the payments paradox.

The payments market is undergoing a dramatic and structural change, driven by a powerful mix of consumer demands, technology changes, new entrants as well as by regulatory changes and industry initiatives. It goes deeper than the evolutionary developments we have had in the recent past. It will impact the many players that constitute the payments value chain. In this paper, we would like to provide a view on how this affects the banks, the traditional players that sit where infrastructural payments rails and innovative customer products meet.

We call this a paradox, that is, an apparent self-contradictory situation; invest in payments for less margin in return. However, we think the contradiction can be resolved by adopting a clear payments strategy and the readiness to search for and adopt new business and delivery models.

We think this amounts to two key challenges for the traditional players that need to be addressed:  how to increase innovation capabilities and optimize sourcing of the payments function.

 In this paper, we will address:

  • Key drivers in the payments market
  • Why this results in the payments paradox
  • What strategic responses banks can provide

 

 Drivers shaking up the market – a cocktail of four

 We see four key market drivers at work:

 

1. The ever-continuing regulatory pressure and new industry initiatives.

The most dominant changes for payments in Europe stemming from regulatory and industry initiatives are of course the PSD2 and Instant Payments.

The PSD2 a.o. strives to open up the payment system to competition, drive innovation and consequently will push payments service provisioning further into the commodity arena.

The industry initiative of 24/7, real time, “Instant Payments”, is strongly supported by the regulators. Although optional we foresee it being adopted by the European (and global) communities at a very fast pace. Two years ago, the Eurozone had no plans, now many are executing programs to deliver this major change near term! We are convinced Instant Payments will be adopted rather rapidly by the market under the right conditions. In markets where Instant Payments is already live we have seen that Instant Payments creates new volumes, but we also expect in the mid to long term convergence from regular SEPA payments to Instant Payments, first from SEPA Credit Transfers, then eventually from Direct Debits as new types like the Request for Instant Payment emerge. A convergence from cards transactions to payments transactions could occur if innovative overlay services are developed on top of Instant Payments for e-/m-commerce and at Point of Sale. A further push (or need) for convergence will come from the fact that ‘legacy’ SEPA rails will become too expensive as volumes decline. Some communities in Europe already acknowledge this trend and talk about the Instant Payments being the “new normal”. Although certain pro-active communities might whip the convergence into a mid-term time scale, it is nevertheless expected that convergence will have a long tail due to the number of communities involved and the slow(er) conversion of SEPA Direct Debits. In the meantime, many banks (and processors) will need to deal with more or less fixed costs at lower volumes during the long tail and will be inclined to find new sourcing options for (non -instant) SEPA Credit Transfer and Direct Debit.

 

2. If you can’t stand the technology get out of the kitchen

Keeping up with technology advances and continued experimentation is important. Advances in technology can rapidly re-define a market. At the recent Payments International conference in London 32% of the delegates stated that this kept them awake at night.

Obviously, in the last decade the capabilities of the smart phone have transformed consumer behaviour, reinforcing the wish and need to pay anywhere, anytime, easily and transparently. On top of this, manufacturers like Samsung and Apple now entered the payments game. Increased computer performance and cloud services (private or not) have lowered infrastructure costs. Traditionally in the heavy-duty payments processing environment this was a significant proportion of the overall payments processing costs. Nowadays the payments processing of a Small and Medium bank can be done on a desk top, the processing of a tier-2 bank on a server that fits under your desk.

Distributed ledger technology (DLT) is obviously the next and new technology that is impacting the industry. Despite initial over-hype the industry has started to experiment to see on what promise it can deliver. At the moment focus is on solving complex naturally distributed processes (i.e with many stakeholders) that will see an efficiency gain form DLT (like cross currency payments and industry reference data) and less on highly efficient  centrally implemented payments infrastructures like e.g. (Instant) Payments clearing and settlement.

 

 

nowadays when a disruption happens, 

the visibility and impact on to the community is much greater than ever before..

with instant payments the infrastructure will become even more critical…

whilst margins are going down and flexibility needs are going up…

a balancing act

 

 

3. The customer demands!

Obviously, payments processing is in essence only a supporting process (and not, sorry payments colleagues, the centre of it all!) and therefore should be adaptable to support the end-to-end use cases simply and efficiently – that’s where the value lies.

Sometimes the payments process should be ‘embedded’, that is almost hidden within an app to simplify use and maximise conversion –  as with Uber and similar consumer applications -   or value is delivered by  supporting automated reconciliation for large corporates.

Having said this, it remains important to deliver to payments users the appropriate sense of control and safety. Payments are of course a key enabler for the economy (yes, payments colleagues), disruptions are a no-no and fraud needs to be kept at an absolute minimum.

Nowadays when a disruption happens, the visibility to the general payment using public is much greater than yesterday for example if an instant payment does not work, the payer (and perhaps the payee) know instantly. Social media then becomes the method of redress and ensures maximum reputational damage to PSPs for any service outage. In essence retail customers are demanding payments services that are ubiquitous, easy to use, available 24/7, instant, transparent and 100% reliable; on the corporate side much of the same holds, but with less emphasis on 24/7 and instant at the moment.

The challenge lays in balancing ultimate flexibility with the need for robust operational excellence. The demands are increasing.

 

obviously payments processing is in essence only a supporting process…

and not, sorry payments colleagues…the centre of it all…

and therefor should be adaptable to support

the end-to-end use cases simply and efficiently

that’s where the value lies.

 

4. New guests arrive at the party

Much has been said about the introduction of SEPA but it has (to some extent) made the market more competitive amongst the traditional providers. Fintechs and competition-fueling-regulation like the PSD2 are certainly adding to the dynamic: digital challenger banks like N26 expanding to 17 European countries and promising an 8-minute sign-up process, KNAB in NL, Atom in the UK and Fidor in Germany; innovative payments players with a bank license like Bunq in the Netherlands are on the rise. Many competitors are entering the market, with a fresh approach and not hindered by legacy, and albeit slowly, are taking away payments volumes from the traditionals. Please note, that although the pace of innovation is really ramping up, pushing a payments service into adolescence still takes 4-6 years!

 

So, what does this all mean?

It plainly means that things are moving faster, margins are going down, customer demands are going up and new competition is entering. In this increasingly competitive field more needs to be delivered, faster, at 100% up time.

To make it simple we think banks have two key challenges:

  1. how to increase my innovation capability (in line with customer demands)?
  2. and how to source my payments processing at the right (lower) cost at high quality?

 

Clear strategic response is needed

So how can banks respond to the payment paradox? We think there are four distinct responses, depending on which type of payments role you want to play. Till recently many banks have embraced a strategy that was reactive, tactical, merging  several, less focused roles with a do-it-all-yourself approach to provisioning. But due to the market pressures we think a clearer, more proactive and more focused response is required.

[...] payments players can adopt one of four distinctive strategic responses:

Payments user,

Payments specialist,

Payments provider,

Payments ecosystem

 

We divide the strategic responses as roles along two axes:

  • The innovation axis: the extent to which a bank wants to provide (a distinct set of) new and flexible payments services ahead of the market standard (following/creating client demands)
  • The operational excellence axis: the extent to which a bank wants to provide (a distinct set-of) (standardized) payments services through an extensive network at low cost

Along these axes we divide the strategic response into four quadrants as indicated in diagram 1: be a payments user, a payments specialist, a payments provider or a payments eco-system. The strategic response of an organisation can differ per payments product set or customer segment.

Diagram 1 PayParadox 

 

The Payments user

This is a bank that considers payments to be either a rudimentary service (a means to transfer customer funds in and out of the bank) or a basic and non-competitive service (to complement its core services); its core strategy focuses on other banking functions than payments.

A Payments user considers payments to be a rudimentary service [...]

or a basic and non-competitive service 

Due to the payments paradox the Payments user bank avoids investing in the payments capability itself (and the continuous stream of change e.g. Instant Payments) and outsources it to a third party, relatively cost effectively and without much loss of focus towards the core strategy; with the ongoing commoditization of payments several banks have considered this to be an optimal response and have consequently outsourced (part of) their payments processing; in some cases smaller banks have taken outsourcing even a step further, they just mandate their customers to use an account from a third party bank for deposits and withdrawals for savings or wealth management services. In the latter case banks let go of the payments altogether, but also of an inherent periodic customer touchpoint that payments provide to a bank!

Several banks have adopted the payments user strategy and we expect more to come, the smaller and medium sized banks at the forefront, but we expect tier 2 banks to follow as the upcoming PSD2 regulation further commoditizes the payments infrastructure while new investment is required for Instant Payments and the convergence to Instant Payments makes the decreasing SEPA batch processing infrastructure less and less attractive. If a Payments user considers (or might consider) outsourcing it will need to assess what preparatory developments are needed to execute this approach. For example, can the payments processing capabilities be separated (efficiently) from the core banking platform? Outsource IT or also operations? Back-office or also front office?  

 

 

Payments specialist

This is a bank seeking leadership in providing payments (value add) service; Bunq is such an example; focus is on providing flexible and state of art services, less on cost competition (eventually). Commodity payments services are probably outsourced, where possible, to ensure focus on innovation; the own technology platform and internal culture facilitates customer focus, flexibility, speed to market, try and test and integration with partners.

A Payments specialist seeks leadership in providing payments value add services.

 

Payments provider

This is a bank that offers a large payments network through standardized services cost efficiently. As the payments rails is becoming a commodity a decreasing number of banks will be large enough to provide the rails in an economically sustainable way. The payments provider brings scale that deliver the economies. It might further grow additional business by attracting volume from other players (Payments users, specialists or ecosystem); banks opting for this strategy should create a separate payments provider business line or entity to ensure focus and clarity of costs as well as to ease competition concerns for parties that consider outsourcing.

A Payments provider has scale and reach to offer

standardized payments services cost efficiently. 

 

Payments ecosystem

Product and process leadership is virtually impossible to combine within one organization; it is a culture clash; this means the response in this quadrant requires a mix and match of payments players that collaborate, i.e. an ecosystem.

A bank can decide to play a leadership role in the ecosystem leveraging their customers, trust, scale, reach and investment capabilities, but it will need to introduce possibilities to more easily interact with the eco-system and adapt. An open architectural approach is important, but also more concretely identifying and separating, organizationally and architecturally, what capabilities are (more or less) standardized (Payments provider like) and what capabilities are subject to innovation (Payments specialist like). This will allow the required differentiated business and organizational approach to optimally address the innovation and operational excellence.

The PSD2 regulation or the open banking initiatives provide a catalyst to consider this strategy. Banks have recently really made an effort to experiment and collaborate with Fintechs, trying to bring the best of both worlds together, achieve a new type of organizational dynamic and integrate innovative capabilities.

An interesting example in this context is the German Solarisbank initiative. Solarisbank provides an open bank, not directly to banking customers, but to Fintech companies needing one or several banking services to complement their value proposition. It is an interesting reversal of purpose that makes one realize how dynamic the market is becoming.

A Payments ecosystem: leveraging trust, scale, reach and investment capabilities

with market openness and collaboration

to provide the optimal mix of

innovation and operational excellence

 

So, what did you say?

The payments market is changing structurally. We think the role of payments players is becoming a very challenging one with innovation up, revenue and timelines down. The traditional players, the banks, therefore need to adopt a clear and distinct payments strategy. The payments landscape will change, but it will not be a sudden disruptive change, but in the mid to long term many of the current players will play a different role, source payments processing differently, collaborate in a different way and new players will have consolidated. It is fair to say and is the feedback we get from the bank payments directors we talk to, that it is a market full of uncertainty with an unclear future state. That justifies an iterative approach, but guided by one of the strategic response types to identify the priorities for the role each bank wants to play.

 

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