Do we need a new EU Network for EU Payments Interoperability?

(1)

Do we need a new EU Network for

EU Payments Interoperability?

Peter Jones

(2)

EU Payments Interoperability

2

Suddenly the payments talk is of EU payments

“technical interoperability” frameworks and new

networks. Key stakeholders are, once again,

promoting common EU acceptance, and radical new

regulations that will dematerialise borders, and

enable third party access to the current account.

Many observers question the basis of the

harmonisation visions. Are they realistic? Have the

lessons of the past ten years been learned? Do

they reflect the real requirements of the payments

business? Or do they reflect fundamental

misunderstandings with great potential to

inadvertently damage the EU’s national

infrastructures?

The EU’s institutional stakeholders (ECB/EC) have struggled to understand the strategic

role that processing networks might play in enabling EU card and electronic retail

payments interoperability. Front end, switches, routing and authorisation clearing

settlement (ACS) are highly complex processes. Across Europe’s 28 nations, there are

many national market variations each supported by a multiplicity of interbank and

commercial processors. Surely, the regulators ask, we can make our networks more

efficient? Why can’t we harmonise payments processes, create a common technical

infrastructure and enable any scheme and any payment acceptance across the EU?

(3)

3

Part 1 - Six Key Retail Payments Interoperability Issues

So let’s examine some of the key issues that must be addressed if the stakeholders’ vision is to be translated into a credible strategy for the EU’s national debit schemes and payments networks.

Fig 1: Six Key Retail Payments Interoperability Issues

First, Europe implemented a version of interoperability over 30 years ago. Visa and MasterCard

(the International Card Schemes - ICS) have provided Europe’s ten+ national debit card schemes with both EU cross border and worldwide acceptance. However, most accept this model is reaching legacy and needs to be reworked. Also, in several national markets, barriers remain. Few, if any, of EU’s largest non-bank acquirers have invested in systems to accept non ICS branded debit in local markets. Many await the implementation of common EPC/EPASOrg standards (or compliant similar) to see whether they prove economic, and popular with merchants. Meanwhile, domestic bank owned acquirers have a local advantage with both ICS and domestic scheme membership and in many cases, ‘on us’ discounting, removing incentives for competitors to enter markets. So full technical interoperability is still some way from being achieved by all players.

Second, what are the interoperability requirements of consumers, merchants, banks and

acquirers? In most nations 95% of payment transactions are locally issued, accepted and acquired, and are debit card based (the same ‘localism model’ is even more true for ACH payments). Most consumers want reliable home card acceptance and cross border when they travel, roam and shop online outside home markets. Merchants, corporates and banks have similar domestically focussed requirements. The exceptions are the small number of Pan EU

Barriers • Pan-EU Merchants • Pan-EU Acquirers • Merchant Steering • Border Dematerialisation Requirements • Consumers • Issuers • Merchants • Acquirers 1 2

National Market Governance

• Debit Schemes • Processing • Clearing/Settlement

4

Network Business Case

• Volumes • Architecture • Cost/Risk 5 6 EU Debit Schemes • Player Exit • New Entrants • Future Visions Network Providers

• Brand Processing Separation • National Clearing Settlement • Best in Class Networks

(4)

4

merchants who perceive benefits from common F2F/e-com systems in their cross border stores. Also, a small number of international non-bank acquirers want to become full players in all markets. Similarly, multi country banks with pan EU operations would like to harmonise their acquiring platforms.

In addition, all larger merchants want lower ICS processing costs and more network competition as they adopt Interchange ++ billing and full transparency. Finally, as a result of the planned cards regulation, national debit schemes realise that the combination of card holder brand selection and merchant steering means they could be displaced by the ICS cobrand on their cards as borders disappear. So, for some, a need to extend their acceptance outside their home markets and seek a scheme or delivery network solution.

Third, what is the supply side of Europe’s Pan EU payment networks? Well, there are surprisingly

few credible providers with reach and full ACS features. Of these, the ICS are the major players, and to a lesser degree the T&E card schemes and niche ATM

players such as Trionis. Both ICS have powerful modern networks (Visa EU has invested over €500m in the past five years) with EU and worldwide monobrand reach and API’s. They also offer a multiplicity of sophisticated network features and multicurrency settlement options. Both have competed aggressively for EU network processing revenues over the past decade. But this has created tensions with the regulators through their use of cross

subsidies and higher interchange to persuade national debit card issuers to migrate to their brand. This has contributed to the case for the interchange caps and resulted in pressure on the ICS to separate their brand and processing entities in line with the original EPC SEPA Cards Framework.

Fourth, can a credible business case be constructed for technical interoperability and a new Pan

EU network? Lack of volume is a key constraint. Debit and credit card cross border transaction volumes are modest and are estimated at between 1,750m-1,850m per annum (4%-5% of total card volumes). Assuming commercial ACS processing fees are between €0.015-€0.02 per transaction, the cross border revenue opportunity is €25m-€35m per annum of which 98% is currently contracted to the ICS. Thus a new network player would struggle for many years to generate sufficient revenue to support a major switching centre. So the accepted view is that an EU network is not sustainable on the basis of cross border card volumes alone. This barrier has long been recognised by the ICS. Over the past 15 years both have targeted domestic ACS linked to the adoption of their brands, generating 20bn+ annual transactions from 10+ nations of which the UK is by far the largest. So a key business case issue for any new network provider is how to generate new volume not already contracted to other players.

Fifth, is the need to resolve the longstanding debate over a “sovereign” EU debit scheme. Sadly,

the early SEPA Cards Framework interoperability concepts may have partly encouraged schemes in Ireland, Finland and the Netherlands to exit the market. Fearing a duopoly, the EC and ECB have pressured banks to build a common debit scheme of which Monnet was the last iteration. If a credible EU debit scheme eventually emerges, the belief is that many national schemes would

“Both ICS have

powerful modern

networks with EU,

worldwide

monobrand reach

and API’s.”

(5)

5

consolidate. But is this the optimum outcome? For a new debit scheme, the costs of contracting with Pan EU merchants are very high as the Monnet modelling showed. Also, new national schemes are now emerging in Bulgaria and Poland. Similarly, in electronic payments, Finland and Malta have decided to build their own ACH’s. It can be argued that in the short term, national card and ACH schemes need to be defended not displaced, if they are to flourish. A recent paper by John Chaplin, Andy Veitch and Jürgen Bott1_{, which surveys 25 national debit card schemes worldwide,} suggests that they are significantly lower cost, better controlled and deliver greater benefits than international schemes. Worryingly, at least ten of the schemes consider their future threatened by regulation and the costs of innovation. A better plan could be to delay Pan EU debit, encourage close scheme cooperation and seek low cost ways of enabling Pan EU acceptance for an eventual EU scheme

.

Sixth, is the pressure by central banks and local banking associations to retain local governance

of payments settlement (cards and ACH) and to avoid offshore or centralised solutions. There will be strong pushback in many markets against any network concept that transfers volume. Fear of loss of control of retail payments settlement and the writing off of a substantial investment in processing assets, is a key factor limiting any initiative to develop a new Pan EU network or card scheme.

1_{National Payments Schemes: Drivers of Economic and Social Benefits? 2014}

“If a credible EU

debit scheme

eventually

emerges, the

belief is that

many national

schemes would

consolidate. ”

(6)

6

Part 2 - Overview and Network Architectures

So to summarise, the EC/ECB’s vision of technical interoperability revisits many issues examined over the past ten years. Consumers, merchants and acquirers have local requirements, given 95% of payment transactions are accepted and settled in national markets. The ICS co-branded interoperability model is reaching the end of its life but they continue to be the dominant providers of EU ACS networking services. Major multi country acquirers cannot easily enable national debit acceptance in many markets. There is no business case for a cross border cards only network and additional volume would be needed to show a return. Excessive competition for national volume has damaged national debit schemes and encouraged regulation. The case for an immediate sovereign EU debit card scheme is growing weaker and the case for defending national debit stronger. Finally, the demand for local governance of clearing and settlement must be considered when new networks are designed.

Fig 2: Examples of Network Topographies

Before potential solutions are assessed, it’s important to understand new network architectures and topography. The two primary options are peer to peer or a central switch. A peer to peer framework was developed by the Berlin Group to support the EAPS debit card scheme. More recently EACHA has trialled peer to peer for ACH payments but concluded such networks are too complex to manage and support. As a result, nearly all players believe that a central switch by architecture (one or multi hub) can best deliver the benefits of simplicity and a common API. EACHA are now considering such a model (CENT) adopting the topography implemented from the outset by the ICS.

Typical Star Central Hub Networks (one or multi hub) Processor Peer to Peer

Linking Networks Bank 1 Bank 3 Bank 4 Bank 2 Processor 1 Processor 3 Processor 4 Processor 2

(7)

7

Part 3 - Potential Scenarios and Solutions

So what are the network development options that the EC/ECB can consider to enable any card acceptance across the EU? Five scenarios are proposed.

Fig 3: Summary of Scenario Benefits and Issues

Scenario 1 is based on improving the Status Quo. The proposal is to continue with the current ICS co-branded card arrangements but provide increased support for domestic card schemes. This would include changing planned regulation and dropping; consumer brand/scheme selection, merchant steering and the dematerialisation of borders. Interoperability as it applies to building a new technical network would be shelved and a “sovereign” EU debit scheme delayed. Implementation of the EPC/EPASOrg common acceptance standards would be mandated as would SEPA Card Clearing standards. In addition, the ICS would be asked to focus on winning cross border processing only and national market ACS would be discouraged.

This scenario is attractive in that domestic debit brands would be protected for several years and clearing and settlement would remain in domestic markets. The downside is it’s too late to change the regulation and several cherished SEPA concepts would be delayed. Key stakeholders may also consider that EU payments markets would remain uncompetitive, network costs would not be reduced and some barriers remain.

Scenario 2 proposes the EC and ECB focus on stimulating network competition. As a result of brand and processing separation both ICS are encouraged to compete, become multi-brand rather than mono-brand and allow universal access to their networks through open APIs. Both would deliver unbundled basic cross border only services with national market clearing and settlement as an option. Also, both would be encouraged to compete to service national EU debit card cross border acceptance and also to interface with domestic market ACHs for cross border electronic payments. The end objective would be to stimulate the development of two utility networks that enable the ACS of multiple card schemes, and benefit from new volumes from cross border electronic, alternative and P2P payments.

Scenarios

Benefits

Issues

1. Improved Status Quo National Markets Protected SEPA Inter Operability Delay 2. Enable Network Competition Lower Cost Utility Network Only Two Players 3. Cross Border Only Hub Links All EU Processors Business Case and Costs 4. Central Universal Payments

Switch

Lower Operating Costs and Real Time

Displacement of National Infrastructures 5. Market Driven Infrastructure

Build

(8)

8

The advantages would be a reduction in ICS processing costs, reduced national market erosion, and networks that would support all payments players, merchants, acquirers, issuers, processors and ACH’s. The downside is that this scenario could result in a duopoly.

Scenario 3 would argue that to achieve a fundamental change in competition a third, more advanced, network is needed. The initial vision would be to support domestic debit cards, ATM and ACH processing. A Cross Border SEPA Payments Hub would be constructed which would act as a gateway into each national market. The hub would be

multi-purpose (Card/ACH) cross border only, multi-scheme and currency, and support all types of card and electronic payments. Issuers Acquirers would continue to be connected in each national market and access the hub for cross border transactions via a common API.

The advantages would be a solution for domestic debit and potentially, real time processing for cross border ACH transactions. This model increases cross border volumes, and also ensures the retention of domestic settlement in each market. The downside is

the potential cost (perhaps €50m-€100m), the risks associated with a complex SEPA development and volumes may not be sufficient to match ICS rates. In addition, not all markets would fit the model and limited efficiency savings would result.

Scenario 4 would be based on a Universal Payments Central Switch which would completely displace national market clearing and settlement for all local debit cards and ACH payments. A single integrated card ACS and ACH network to real time Faster Payments standards (almost a Target model) could result for both domestic and cross border.

The benefits would be substantial. A world leading platform with economies of scale, and the elimination of spare processing capacity in several markets.

The disadvantages are a mixture of politics, cost and risk. This model would create a very low cost service with potential to become a monopoly single provider and displace commercial processors. Loss of sovereignty over national card schemes and settlement is an issue. Also again, a high risk and very complex project, initially just for the Eurozone and ultimately all EU country payments. Solutions would still be needed for worldwide card acceptance.

Scenario 5 argues that a new pan EU cross border network will only develop as a result of market demand and that the ECB/EC should provide leadership only, and avoid designing or mandating technical solutions. As a result the focus would be on persuading the commercial and interbank processing sectors to innovate and build new network constructs. For example, the F2F and e-com Gateway PSP sector, plus schemes such as iDeal and Mybank could be encouraged to extend their payment hubs (ie a multi-bank architecture) to interface with all national card and ACH processors through a common API. Acquirers, banks and corporates could then access these hubs to enable cards acceptance and ACH settlement. Similarly, ideas such as the mandated bank account access API and overlay concepts could result in entirely new models for Pan EU clearing and settlement.

“A Cross Border

SEPA Payments

Hub would be

constructed

which would act

as a gateway into

each national

market.”

(9)

9

This scenario would also encourage the EU Fintech sector to produce novel solutions. The downsides are that demand driven SEPA was the ECB/EC’s preferred model over ten years ago. Markets have so far struggled to deliver network solutions that enable interoperability.

So five technical interoperability scenarios from which the ECB/EC can choose. Staying with the status quo and dropping elements of SEPA is an unlikely choice, but needs consideration. Stimulating ICS network competition has several attractions, provided their new focus is on cross border. A Cross Border SEPA Hub linking domestic processors would deliver interoperability, but would costs fall? A single Central Switch for all Eurozone/EU payments could be politically dangerous, ambitious, high risk but greatly improve efficiency. Finally, as history has shown, market demand driven solutions can lack focus and a clear target architecture.

Fig 4: Analysis of Scenario Options

So to sum up, interoperability visions and revised calls for a technical network may not be the best way ahead for Europe’s payment systems. The key lessons learned over the past 10 years is that the EC/ECB still do not fully understand the dynamics and the forces at play in the markets! They have to avoid falling into the trap of prescribing solutions without modelling the outcomes and realising the potential to damage low cost efficient systems. Practical network solutions must reflect reality and recognise that 95% of payments are local. The stakeholders have to choose between the scale advantages of single solutions and demand for local control. Monolithic Pan EU systems are unlikely to meet the needs of today’s consumers, merchants, corporates and banks. Technical interoperability visions have to be founded on three principles: national market first, cross border second and Pan EU centralisation not yet!

Scenario Credibility/ Feasibility Low Risk/Cost Meets User Requirements Competition Improvements Efficiency Improvements Makes Business Case Scenario 1

Improved Status Quo Scenario 2

Network Competition Scenario 3

Cross Border Only Hub Scenario 4 Universal Central Payments Switch Scenario 5 Market Driven Infrastructure Build

Very High Benefit Low Benefit

“Stimulating ICS

network competition

has several

attractions, provided

their new focus is on

cross border.”

(10)

10 About Peter Jones

Peter Jones has over 35 years business and IT experience, 4 with a major European retailer (C&A Brenninkmeyer), 17 with a UK clearing bank (Royal Bank of Scotland) and 23 as Director and owner of PSE Consulting. He has had operational responsibility for a number of eftpos, bespoke retail systems and credit card related services. He has particular expertise in retailer systems, debit and credit cards, card schemes, interchange and processing. Over the past 23 years he has been responsible for the management of over 1,000 payments assignments for clients within the UK and Europe. He is from a processing and IT background and has led and managed major development projects relating to payments systems. He is well known within European payments business and is a regular writer on payments related issues and a speaker at conferences.

About PSE Consulting

PSE Consulting is a leading European payment business and technology consulting organisation. The company was established in 1991 and operates from offices in London. PSE Consulting is a founder member of the European Payments Consulting Association (EPCA), an association of like consultancies practicing in eleven European countries.

PSE Consulting provides independent advice to major European institutions and to many other players who are

currently shaping the European payments market place.

PSE Consulting

Office:+44 (0)20 8891 6244

Fax: +44 (0)20 8891 6245 [email protected]