Same day, same settlement?
The Payment Services Directive in Europe mandated next-business-day settlement – D+1 – for payment transactions between EC states from Jan 2012. But with some European countries already using faster operating standards, Neil Burton and Gareth Lodge ask: is D+1 good enough?
For example, the Netherlands operates in 30-minute windows. This is why the UK government insisted that the banks invested in a near real-time system, UK Faster Payments, that has a higher operating standard than the (at that time expected) EC mandate. This reduces settlement risk, highlights the settlement positions (and therefore the capital to be held) much more clearly, and reduces bottlenecks.
So D+1 is likely to be gradually reduced because initially it sets a minimum standard; it is the starting point, not the aspiration.
Countries like India, which are essentially building payments infrastructure from scratch, believe that a faster payments service is a necessity today rather than at some point in the future. For India, while the costs in implementing are huge, the longer term benefits are even more so. The programme covers, among other things:
- Implementing a new and feature-rich RTGS system
- India Card – a domestic debit card
- A 24/7 near real-time faster payments service
- Upgrade of the ACH
- Creation of a dedicated mobile payments settlement network
Any one of these items is typically a once-in-a-generation project. But the scale of the benefit far outweighs the cost. And, unencumbered by legacy systems and participants seeking to protect established positions, payback is fast. McKinsey estimates the initial ROI would be somewhere between 6 months and a year.
This transformation of India’s payment infrastructure will turn into a strong competitive advantage in the years to come.
Easier to build than renovate?
For mature economies, because of the need to adapt to existing systems and processes, payback takes much longer. Many mature economies are therefore frequently continuing to rely on infrastructures developed last century. The challenge is not only in the massive investment required, but also in the demand on scarce resources which are typically already fully deployed on maintenance and mandatory regulatory compliance. This results in a systemic aversion to strategic investment.
Such short-termism may no longer serve well. To quote another McKinsey study, “in 2010, 100 of the world’s largest companies headquartered in mature economies derived just 17% of their total revenue from emerging markets – though those markets accounted for 36% of global GDP and are likely to contribute more than 70% of global GDP growth between now and 2025”.1 As fast-growth nations invest in payments systems which leap-frog those of the mature economies, they will surely compete strongly for the transaction banking business of the world’s largest firms.
A number of countries have taken the view that a faster payments clearing system is absolutely critical, and are acting accordingly. This is the case in Brazil and Mexico, and the process is also being undertaken in Canada. Poland has announced that it will introduce a faster payments system and Singapore is in the final stages of testing its near real-time payment system. Other countries such as Australia, Lithuania and the Hong Kong region are already following suit.
These changes are driven by a number of reasons, including improving risk management in financial systems. Whilst it may raise the bar in terms of operational controls – for example the need to ensure better AML and anti-fraud controls in sending payments – it also means that a bank’s position in terms of central bank settlement accounts is far more transparent. This provides more visibility of potentially failing banks; which in turn makes isolating a failing bank far easier.
So where does this leave the US, the largest payments market?
Statistically, the US is somewhat lagging behind other countries which have already undertaken investments in same day payments at governmental level or because of regulatory pressures, or because their existing systems were due substantial investments. As yet, the regulatory drive does not exist for the US. The question relating to whether there is a need to update their current systems becomes the focus, and can be argued on a number of fronts. Is there a demand from the market for example?
Some forms of same day ACH do exist of course, such as the FedACH SameDay service launched in August 2010 – currently being upgraded. Yet, whilst there are thousands of banks using the FedACH service, the numbers using the same day service count in low double figures, and most of those banks are relatively small.
The biggest challenge to uptake is that banks are unsure whether such a service could cannibalise their Wire revenue. But if the UK’s experience is anything to go by, this concern is misplaced. CHAPS – the UK domestic RTGS – volumes have actually increased since the introduction of Faster Payments (though it isn’t yet clear whether this is linked to the launch of Faster Payments).
So, are things about to change?
In September 2011, Nacha put out a consultation document for a rule change proposal. This proposal sets out the changes required to create a same day processing window, and potentially several processing windows. In order to drive enough scale to realise the economies which are a critical success factor for any clearing and settlement systems, the service was proposed to be mandatory for all participants (the Fed service is opt-in).
The vote took place in Q1 2012, with a majority of banks voting for it, but failing to reach the 75% required to proceed. Rumours abound, but the picture emerging is that some of those who voted against or abstained were concerned about the cost versus the benefit they would bear. Many believe that whilst they all paid for the investment costs of implementing NACHA IAT, 95% of the volume is from only two banks.
But with over 70% of votes in favour, the scale of demand is evident. As evidence continues to emerge, for example from the UK where Faster Payments is evidently replacing cheque and paper volumes, the business case can only strengthen. And a narrow focus on the cost of making the payment itself may be misleading. Banks make far more money from services adjacent to the transaction itself, and from the long term nature of the sticky relationships with their customer, to worry overly about preserving outdated methods. Sooner or later, faced with overwhelming benefits to consumers and businesses and slow action by the industry, the regulators will step in. Had transparency been implemented sooner, perhaps a better and cheaper approach to Dodd Frank Section 1073 could have been found.
Hold on – not so fast …
Not all payments need to, nor should, go faster. When consumers are asked if they’d like things faster, or immediate, the answer is of course yes. Since I can IM someone on the other side of the world immediately, and I can ship a parcel to another country reliably and predictably, and I can pay for my pizza from my mobile phone without waiting for a waiter, what’s so hard about payments?
Indeed. But making payments involves substantial costs and risks, and there are multiple failed projects for every successful one. Market research can easily be misleading, if not thoroughly conducted. If the question was ‘how much would you pay, how much is it worth to you’ then the response is far more granular. For predictable payments, such as bill payments and salaries, certainty at low cost wins hands down over speed at a higher price.
For certain transaction types, separating the consumer experience from the clearing and settlement may even improve it. For example, most consumers would consider credit card transactions to be ‘real-time’; the point-of-sale experience is, but the settlement process takes place much later. Online Banking ePayments also separate the two: OBePs enable a merchant to receive immediate and irrevocable notice that settlement will occur; the settlement itself may happen a day later. The real-time requirement here is the certainty that the money will come; not the receipt of the funds.
Tied up in this requirement is far more than the payment; merchants need to know what a payment is for. It is of little help if the funds arrive more quickly, but cannot be linked to the transaction. In that case the payer will continue to be chased, and may even be penalised for late payment, when all the time the funds were sitting in an unapplied receivables account somewhere. And where consumers seek change, corporates soon follow. Many consumers become SMEs or corporates the second they sit behind the desk in the morning.
Not all payments should be made faster. But, as the UK’s Faster Payments has shown, new services can widen the market – by ‘electronifying’ transactions previously made by cash and cheque and by catalysing the launch of new services.
The evidence is mounting; not only is the absence of a same day settlement scheme an economic inhibitor; the existence of one can be an economic accelerator.