Insights into the digital transformation of the retail payments ecosystem

MIP OnLine - 2018

January 2018

The above quote by Oscar Wilde resonated throughout the conference that the European Central Bank and the Banca d’Italia hosted on 30 November and 1 December 2017 in Rome. Entitled “Digital transformation of the retail payments ecosystem”, this conference looked in detail at the dynamic developments that are currently being observed in the retail payments industry on account of new technologies and changes in consumer demand.

This event brought together nearly 300 participants from 53 countries around the world and featured policy discussions on issues such as innovation, interoperability and the integration of retail payments, as well as cybersecurity in the financial ecosystem. The speakers at this conference included the authors of eight academic papers on virtual currencies, the adoption of instant payments and customer behaviour, who presented their findings to participants.

This article seeks to provide an overview of the key messages conveyed by the event’s various high level guest speakers, who hailed from both the financial industry and academia.

An introduction to the subject of innovation

The conference was opened by Ignazio Visco, Governor of the Banca d’Italia, and Yves Mersch, a member of the Executive Board of the ECB, both of whom emphasised that an appropriate legislative framework and cooperation between all stakeholders was key to supporting innovation and ensuring the security of the retail payments ecosystem.

In his welcome address, Mr Visco described the retail payments landscape as “highly dynamic” and “ever-evolving”. He warned that the rapid digital transformation being observed in the industry posed a number of challenges to central banks, one of which was the need to adapt the regulatory framework in order to support innovation. He argued that, in the European context, the revised Payment Services Directive (PSD2) would pave a stable path towards further innovation. Another challenge concerned the oversight of payment systems and payment instruments that were based on new technologies. Central banks needed to be at the forefront of innovation in order to be able to assess vulnerabilities and ensure cybersecurity in the financial ecosystem, he said.

Drawing on the ECB’s experience with the Single Euro Payments Area (SEPA), Mr Mersch pointed out that another key ingredient when rolling out payment innovations was stakeholder involvement. He cited the example of the Euro Retail Payments Board (ERPB), which had brought together stakeholders from both the supply and the demand side of the market and had been instrumental in the emergence of pan-European instant payments in euro. Mr Mersch urged banks to implement instant payments in order to remain competitive in a real-time digital world. He also shared his conviction that pan-European instant payments would “provide an alternative narrative to the ongoing public debate on the alleged innovation brought about by virtual currency schemes”, which he said were “not robust enough from a legal, operational and governance point of view” to formally qualify as currencies.

How is digital evolution affecting the retail payments ecosystem?

A panel discussion brought together high-level representatives of central banks on four different continents, who offered valuable insights into the latest global developments in terms of digital evolution. They identified four areas where digitalisation was having an impact on the retail payments ecosystem:

• new players and new technologies entering the market;
• the dilution of the various steps involved in the processing of payment transactions;
• increasing demand for universal payment instruments that offer the same speed, efficiency and cost both domestically and globally;
• new risks for infrastructure and settlement assets as a result of new technologies.

What role should central banks play in retail payments innovation?

The panel agreed that the impact of innovative technologies and new market entrants on the retail payments industry was twofold. These new developments could help to increase the security and efficiency of retail payments, but they could also result in financial markets fragmenting again and conflict with central banks’ financial stability objectives.

In this context, the panel argued that central banks should seek to engage the industry in a constructive discussion and adjust the regulatory framework in line with the new digital environment. As regards the development of a cashless economy, panellists said that central banks should promote freedom of choice and allow the market and users to decide whether they preferred cash or electronic payments. In addition, it was felt that central bank-backed digital currencies had not yet been sufficiently explored and could potentially contribute to the emergence of a cashless economy in the future.

How can incumbent banks embrace innovation?

Chris Skinner, a fintech commentator and author, predicted that the banking industry would change dramatically in the next ten years, mirroring the technological transformations that had been observed in a number of other sectors, such as retail and medicine. In this context, incumbent banks would face huge challenges when it came to updating their legacy systems. The digitalisation of back offices had the potential to make millions of jobs redundant and needed to go hand in hand with changes in corporate culture and structure, he said.

Could fintech be the answer? Across the financial industry, many people believe that fintech innovations such as distributed ledger technology (DLT) and artificial intelligence could prove effective in modernising legacy systems and optimising the internal procedures of financial institutions. Others go even further, suggesting that – if widely adopted – these innovations could transform the financial ecosystem as a whole. From today’s perspective, it is hard to predict what the future holds, as most of the current DLT-based solutions are not suitable for broad-based application in the financial industry, being restricted to specific niches.

José María Roldán, Chairman and CEO of the Spanish Banking Association and Vice-President of the European Banking Federation, shared his belief that fintech presents both challenges and opportunities for incumbent banks, explaining that it increases competition, but also allows costs to be reduced and can lead to greater returns on equity. He also emphasised that the banking sector contributed to financial stability and that the rise of fintech companies would not threaten its existence. However, he encouraged banks to gain a better understanding of these new technological developments, to be aware of their own vulnerabilities and to use the information at their disposal to improve the user-friendliness of their services.

A panel looking at the disruptive potential of fintech innovations acknowledged that the nature of competition in the retail payments industry was changing. In order to keep up with fintech innovations, established market players needed to adjust their infrastructure and business models in line with the new environment. Incumbents needed to increase investment in new technologies and cooperate with fintech companies, panellists said.

Instant payments – adoption and interoperability

One of the event’s panellists argued that payments should be “simple, safe and smart”, and the new SEPA Instant Credit Transfer (SCT Inst) scheme is designed to be just that. That new scheme allows funds to be transferred in euro in a matter of seconds, both within and between countries, and gives banks and other payment service providers an opportunity to embrace innovation.

With the “old continent” taking a big step towards pan-European instant payments, a recent comparative study by Monika Hartmann, Lola Hernández, Mirjam Plooij and Quentin Vandeweyer from the ECB asked whether instant payments would become the new normal. That study looked at six countries – both in Europe and elsewhere – where instant payments had been introduced in recent years and identified seven factors which had contributed to their uptake:

• active involvement of relevant authorities;
• cooperation between payment service providers;
• added value in terms of speed relative to legacy systems;
• good pricing conditions;
• presence of complementary services;
• widespread use of internet and mobile data;
• high levels of internet banking.

On the basis of those drivers, the paper concluded that the euro area was in a good position to support instant payments and analysed four different scenarios as regards their adoption.

Looking at the bigger picture, instant payments are becoming increasingly common around the world, and the financial industry now faces the challenge of ensuring international interoperability. Against this background, a panel featuring representatives of three different continents – North America, Asia and Europe – talked about how to overcome this interoperability challenge. Those panellists identified the lack of standardised and harmonised message formats as a major issue, pointing out that this could be solved by aligning legal frameworks and adopting international standards such as BIC/IBAN and ISO 20022. They also recommended increasing international cooperation between regulators, banks and market infrastructures in order to address the inefficiencies of international payments while ensuring privacy and data protection.

Virtual currencies

The subject of virtual currencies – one of the hot topics in the financial industry at the moment – was also addressed, being raised in Mr Mersch’s opening speech and elaborated on in three of the academic papers presented at the event.

In the first of those papers, Christopher S. Henry, Kim P. Huynh and Gradon Nicholls from the Bank of Canada looked at awareness and use of Bitcoin among Canadian citizens. Their empirical study showed that around 64% of Canadians had heard of Bitcoin, but only 2.9% owned it.

Nicole Jonker from De Nederlandsche Bank adopted a different perspective, trying to identify what drives retailers’ adoption of virtual currencies by talking to 43 retailers in the Netherlands. The main reasons for accepting such currencies included a desire to attract extra customers (reported by 42% of retailers that accepted crypto-currencies), a desire to meet specific customer demands (23%) and an interest in new technologies (21%). The main reasons for not accepting them included a lack of familiarity with virtual currencies (58%) and a lack of customer demand (36%).

In her paper, Ruth Wandhöfer from Cass Business School looked at the possibility of introducing a central bank-backed crypto-currency to complement physical banknotes and coins. She examined possible scenarios for the adoption of “euro crypto-cash” and made suggestions regarding its design.

In this context, Professor Silvio Micali from the MIT Computer Science and Artificial Intelligence Laboratory presented a new DLT-based crypto-currency – called “algorand” – which he had developed on the basis of a Byzantine consensus algorithm. Professor Micali felt that this solution boasted real technical advantages in the form of trivial computation and true decentralisation, but its limited speed was considered to be a drawback.

Customer choice and behaviour

The retail payments industry is just one of many sectors where customer behaviour has been shaped by mass access to the internet and mobile phones in recent years. Changes in consumer demand have triggered various new developments, such as user-friendly mobile applications allowing the initiation of payments and innovative customer identification methods.

Two of the academic papers that were presented at this conference looked at customer preferences in different countries as regards payment instruments.

Jan Lukas Korella from the Deutsche Bundesbank compared retail payment behaviour in China and Germany. His study found that banks played an important role in the German payment landscape, as consumers’ preferred payment method at the point of sale was cash (51.3%), followed by card-based payments (45.6%). In China, meanwhile, there was a significant difference between metropolitan and rural areas when it came to preferred payment methods: 56.1% of customers in Chinese megacities used non-bank mobile payments and only 21.5% relied on cash at the point of sale, while cash was still the dominant payment method in rural areas.

Another paper by Tamás Ilyés and Lóránt Varga from the Magyar Nemzeti Bank analysed all payment transactions in Hungary in order to identify the main drivers of card acceptance and usage in the country. Their paper concluded that shops with higher levels of annual revenue were more likely to accept card payments and that customers were more likely to pay by card when the value of the transaction was higher.

Two other academic papers focused on the interplay between regulation and innovation and its impact on the user experience.

With PSD2 requiring payment service providers to apply strong customer authentication methods for remote electronic payments, Guerino Ardizzi from the Banca d’Italia looked at how two-factor authentication methods, such as the 3-D Secure protocol, affect the user experience. Analysing data from Italy, he found empirical evidence of a trade-off between the security of technology and its usability.

Meanwhile, Carin van der Cruijsen from De Nederlandsche Bank looked at the issue of consumer privacy in the context of PSD2, exploring consumers’ attitudes to the use of payment data. The results of a recent survey of Dutch consumers indicate that 60% regard the confidentiality of payment data as important, with most people not wanting to share payment data with non-banks and the majority of consumers regarding the selling of payment data to commercial companies as unacceptable. Her paper concluded that context was important and that details of how data will be used should be clearly communicated to consumers in order to obtain their consent.

Cybersecurity

The increasing digitalisation and interconnectedness of financial services provides opportunities to improve the user experience, but it also poses a threat to cybersecurity.

Cyberattacks have become more frequent and sophisticated in recent years, threatening not only the individual institution in question, but the entire sector and the financial ecosystem as a whole. Against this background, Fabio Panetta, Deputy Governor of the Banca d’Italia, argued that we should “recognise that cyberspace is a global public good” and that responsibility for ensuring its security should be shared between governments, public institutions, private industry and academics. Approaching this issue from a central banking perspective, he said that an effective cybersecurity strategy rested on three pillars: regulation, cooperation and awareness of risks.

In the same vein, a panel moderated by Jan Smets, Governor of the Nationale Bank van België/Banque Nationale de Belgique, agreed that the financial industry needed to show solidarity and cooperate, as cybersecurity was not an issue to compete on. In the course of that exchange of views, a number of suggestions were made as regards the best ways of protecting the retail payments ecosystem and building trust:

• increase spending on security protection (i.e. penetration tests);
• adopt a holistic approach and use dynamic risk management to tackle cyberthreats;
• use new technologies to analyse transaction risk and customer behaviour and manage fraud;
• establish an international forum bringing together experts from the world of cybersecurity;
• take steps to address the shortage of cybersecurity experts in the financial industry.

Copies of the various academic papers and video recordings of the conference sessions can be found on the event’s webpage.