Quantifying the potential of utilizing technology to integrate EU Financial Markets An Insights Paper prepared by the Smart Payment Association
April 2019
shaping the future of payment technology
Table of Contents
1. Executive Summary ...... 3
2. Financial Market Integration Background ...... 6 2.1. SEPA ...... 6 2.2. The FedPayments Improvement Program ...... 6 2.3. The Role of International Card Payment Schemes ...... 7 2.4. Emerging Economies and Payment Market Integration ...... 7 2.5. In Summary ...... 7
3. Making the case for Technology in Financial Market Integration ...... 8 3.1. General Considerations ...... 8 3.2. Distributed Ledger Technologies ...... 8 3.3. Common Open Banking Interfaces ...... 9 3.4. Maximizing Financial Market Integration Potential: Combining Advanced IT Technologies 9 3.5. Assessing the Potential of Technology as an Enabler for Financial Market Integration ... 10 3.6. Creating Incentives for Payment Market Integration ...... 10
4. Financial Market Integration, Technology and Regulation ...... 11 4.1. Fintech and Regulatory Sandboxing ...... 11 4.2. The Need for Further International Coordination ...... 12
5. Conclusions ...... 13
Quantifying the potential of utilizing technology to integrate EU April 2019 2
Financial Markets
shaping the future of payment technology
1. Executive Summary
The potential advantages to be gained by bringing about the integration of financial infrastructures is currently a hot topic in the banking industry. The financial services sector has experienced dramatic technology-led changes over the past years, but new cutting-edge technologies now offer the promise of further transformation: enabling the integration of financial infrastructures for future business integration scenarios such as bank mergers, the vertical integration of a bank’s services, or enabling new payment schemes.
This paper explores the potential beneficial impact of technology for further financial market integration, focusing on the integration of financial infrastructures by integrating existing technological platforms through common interfaces (API-Centric Integration or Hub-Centric Architecture) or developing shared processing platforms with a decentralized governance (Distributed Ledger Technologies/Blockchain-based Architectures).
Note: In this paper the terms ‘Distributed Ledger Technology’ and ‘Blockchain’ are used interchangeably.
Quantifying the potential of utilizing technology to integrate EU April 2019 3
Financial Markets
shaping the future of payment technology
Definitions
Financial technology innovation: IT technology that reduces risk and cost and enables financial service providers to offer improved financial services (speed, security, control over own financial assets) to end-users (consumers, merchants, corporations).
Financial services industry integration1: Any event that joins two or more financial services organizations or combines two or more dimensions of the production or distribution of financial services, within or between traditional financial services sectors: Banking, Insurance and Securities.
Financial infrastructure (FI): Technical architecture designed to support transaction and post- transaction services for electronic payments, securities, insurance, derivatives and other financial products.
Fintech: A small-sized organization that is a technology‐enabled financial services market incomer.
Fully integrated financial market2: Market characterized by participants that (1) face a single set of rules when they decide to deal with specific financial instruments and/or services; (2) have equal access to the above-mentioned set of financial instruments and/or services; and (3) are treated equally when they are active in the market.
Introduction
This SPA Insights Paper is focused primarily on the integration of the retail payment market for three key reasons:
1. Payment market integration is an enabler: the cross-border purchasing of financial products benefits from an efficient integrated payment market. The integration of payment markets will increase the provision of trade finance and cross-border corporate banking services, thereby intensifying existing trade and investment links within the EU.
2. The life cycle management of a payment is straightforward (authorization and accounting) compared to the complete lifecycle of a security trade, which is a much more complex business process involving income, tax withholding, corporate actions and a payment.
3. Because SPA members’ main business activity is in the retail payments industry.
SPA believes that innovative technology would help drive the integration of different banking products and services including, but not limited to, electronic payments. Technology enables the development
1 Perspectives on Financial Integration and Financial System Architecture in Emerging Markets, Solomon Tadesse (2005) http://webuser.bus.umich.edu/stadesse/FinancialIntegration.pdf 2 Financial Integration in Europe, European Central Bank, May 2018 https://www.ecb.europa.eu/pub/pdf/fie/ecb.financialintegrationineurope201805.en.pdf
Quantifying the potential of utilizing technology to integrate EU April 2019 4
Financial Markets
shaping the future of payment technology
of new processing platforms, operated according to disruptive governance principles (eg. blockchain), and/or the interconnection of existing ones to provide a broader reach to both end-users and financial service banking providers. Scalable technology for financial service platforms generates an obvious interest in the industry; Distributed Ledger Technology (DLT) and Smart Contracts (SC) are examples of this. While these technologies still lack the necessary maturity, continuous proof-of-concept (POC) efforts are successfully testing more robust implementations.
This lack of maturity has been highlighted by the European Central Bank3: “At its current stage of development, Distributed Ledger Technology (DLT) does not yet provide a solution for central-bank- operated financial market infrastructures. Many elements of a DLT-enabled financial market must be designed and assembled before DLT adoption may be considered a realistic possibility, including standards required to allow technical interoperability between different DLT solutions and with non- DLT systems, as well as standards required to ensure the interoperability of business processes”.
The term ‘platform’ in this document refers to the IT computing facility able to process different financial services (a cluster of products and services) through a common business process. This platform is an enabler for financial market integration but requires an investment effort for development, certification and operational purposes.
In this paper we explore how cost considerations can act as a disincentive for banks to participate in market integration efforts. Many costs are certain and often immediate when developing a platform from scratch and/or when a new financial service provider joins an operational scheme, yet the benefits are very often unclear in the short term. In this post-financial crisis time, investing to achieve a political objective fixed by a regulator is hard-to-make decision.
In this context, the role of technology in the financial market integration process is analyzed from three perspectives:
1. The intrinsic ‘market integrating potential’ of different IT technologies.
2. The real incentives for the financial industry to adopt these technologies.
3. The new risks that these technologies may generate; this aspect could also be considered as a disincentive investment factor.
With these questions in mind, this paper has been structured as follows:
Chapter 2 reviews a variety of financial markets integration approaches and the role played by policy makers and technology.
Chapter 3 focuses on criteria used to quantify the potential of technology to enable market integration.
Chapter 4 provides insight into business models and the governance of shared infrastructures.
Chapter 5 advances suggestions to optimize financial regulation.
Finally, a set of conclusions that summarize the arguments discussed in these chapters is provided.
3 Financial Integration in Europe, European Central Bank (May 2018) https://www.ecb.europa.eu/pub/pdf/fie/ecb.financialintegrationineurope201805.en.pdf
Quantifying the potential of utilizing technology to integrate EU April 2019 5
Financial Markets
shaping the future of payment technology
2. Financial Market Integration Background
2.1. SEPA
The integration of the EU financial system is a political decision, not a market-driven one. In the EU, the introduction of the euro has eliminated exchange rate risks and the cost of exchange rate transactions within the euro zone, removing one main barrier to EU financial integration.
The next logical step was the SEPA program which introduced common payment instruments or payment methods in euros, enabling frictionless low-cost cross-border payments. For the SEPA program implementation, the EU policy makers fix the objectives, but the payment industry decides on the technical standard and the migration plans to a certain extent and it is anticipated that this flexibility will boost EU cross-border trade and investment activity without imposing a significant investment burden on banks and other payment service providers. However, there are still significant differences in the speed at which money circulates in cross-border transfers. This is probably the reason why EU policy-makers are now promoting new cross-border instant payment systems.
Overall, SEPA is considered as a highly-integrating financial market effort, driven by regulation. But it has also generated skepticism within the banking industry, because investments appear insufficiently justified from a pure business perspective.
SPA notes that that the SEPA program is being followed with great interest overseas, yet at present it’s premature to evaluate the impact of SEPA on financial industry performance.
2.2. The FedPayments Improvement Program
The US financial industry launched the FedPayments Improvement initiative4 to promote faster US payment systems, which are currently considered to be slow and inefficient. In our opinion, US financial regulators consider FedPayments as a necessary step forward that they support but won’t necessary catalyze. With an internal banking system that is so highly fragmented and subject to a broad range of regulations, it’s difficult to see how US policy makers could be more prescriptive.
Even if some of the challenges that EU and US banking industry face are common, there’s not a SEPA-comparable effort in US nor a roadmap for compliance with laws such as the PSD2. Furthermore, despite the fact that US corporations such as Google, Apple, Facebook and Amazon (GAFA) are heading the technological revolution, US payment systems are notoriously outdated and their databases appear vulnerable to cyberattacks.
In all, the FedPayments Improvement Program should promote a certain amount of evolution in the market structures of the US financial industry, starting with payments. However, the huge level of fragmentation of the US market is considered a source of inefficiency, which is why the outcome of the SEPA program in Europe is being followed with such interest.
4 https://fedpaymentsimprovement.org/
Quantifying the potential of utilizing technology to integrate EU April 2019 6
Financial Markets
shaping the future of payment technology
2.3. The Role of International Card Payment Schemes
By contrast, international card schemes are good examples of industry-driven successful payment market integration. VISA and Mastercard are prime instances of global card payment networks interconnecting with banks worldwide; banks exchange financial-related data (such as a payment order) using these networks and these exchanges result in the transfer of funds through a Clearing & Settlement facility. Factors for success include the existence of common standards for interoperability and certification around a core technology, the payment card. The market of international card payment networks is highly integrated and constitutes a stable oligopoly that has operated for decades.
This picture is complemented by the existence of several dynamic domestic card payment schemes that have a highly dominant local market position. However, the IT processing infrastructures of domestic and international schemes are not integrated. The payment card technology itself makes it possible to initiate a payment to be processed by either the domestic or the international processing system; even if both processing systems are independent, from the end-user point of view they’re perceived as integrated.
The card payment business model is robust: the interchange fee incentivizes card issuance and the volume of transactions is high enough to generate revenue that funds technological innovation and a better quality of service. The existence of a clear business case drives market integration by the card payments industry itself (self-regulation). In this context the role of the financial regulators is to monitor and correct possible abuses of market dominant positions.
2.4. Emerging Economies and Payment Market Integration
In a paper released in 2014 by the SWIFT Institute5 elaborates on a certain number of initiatives in emerging economies - such as the Association of Southeast Asian Nations (ASEAN), the Common Market for Eastern and Southern Africa (COMESA) and the West African Economic and Monetary Union (WAEMU) - intended to develop regional financial markets.
Deeper financial integration may also foster financial inclusion. By cultivating credit and capital market development and boosting competition and efficiency in financial intermediation, financial integration could in theory improve access to financial services. However, according to an International Monetary Fund report6, the socio-economic outcomes are inconclusive and better criteria to assess the impact of regional financial integration on financial inclusion are needed.
2.5. In Summary
In developed countries, financial market integration is typically driven by policy makers, especially when there is not a clear business case. An exception to this model is the integration of the card payment market, led by a banking industry that succeeded in finding a robust business model.
5 Cross-Border Low Value Payments and Regional Integration – Enablers and Disablers (2014), SWIFT Institute Working Paper No. 2014-005, https://www.swiftinstitute.org/wp-content/uploads/2014/11/SWIFT-Institute- Working-Paper-No-2014-005-Cross-border-LVP-Regional-Integration-Lipis_v4-FINAL.pdf 6 WP/17/1 IMF Working Paper Benefits of Global and Regional Financial Integration in Latin America Prepared by Luc Eyraud, Diva Singh, and Bennett Sutton, January 2017
Quantifying the potential of utilizing technology to integrate EU April 2019 7
Financial Markets
shaping the future of payment technology
In developing countries, financial inclusion policies also act as a driver for financial integration. Emergent economies have been often underserved by banks, which have been replaced by other IT actors such as mobile telco operators in some African countries. The situation is changing rapidly however, and central banks are driving the creation of financial markets where commercial banks play a more prominent role as financial inclusion progresses.
3. Making the case for Technology in Financial Market Integration
3.1. General Considerations
SPA believes that it’s possible to calculate an ‘arrow of time’ for technological IT progress. Because of the traditional early adoption by banks of IT innovation, this arrow of time physical concept could also apply to progress in the way the financial industry offers new products and services. In his 2012 book ‘Nine Algorithms That Changed the Future’, John MacCormick describes in detail nine core algorithms7 that are powering the IT revolution.
While none of these technologies are specific to the financial industry, all constitute the foundational bricks for deploying a new generation of technologies that will enable the next digital revolution in finance: blockchain, big data, cloud computing and virtual platforms, cyberattack-resilient IT technology, machine learning, artificial intelligence, internet of things and advanced cryptography. In the end it is the continuous real-time flows of trusted data that will prove a powerful financial market integration technology-driven tool.
All these technologies may act as enablers for the integration of financial infrastructures of market incumbents with new incomers. At present, however, they are combining to act as innovation differentiators for new incomers in a strong competition context.
Fintech companies are using their own in-house big data algorithms for credit scoring, with input information coming directly from banks through open APIs (for example, account information aggregation) or social networks in a way that is not the norm for banks. Moreover, financial market incomers don’t necessarily have the same security background and are not subject to the same security certification constraints as incumbents. This creates a risk potential; by integrating financial infrastructures, vulnerabilities are added and security undermined. Policy makers might be more prescriptive to ensure that risks are properly monitored, especially when unproven technologies are combined. SPA believes that it is a fundamental issue if regulation specific to Fintech is considered in the future.
3.2. Distributed Ledger Technologies
The appropriate integration of distributed IT systems requires trust on computers, user devices, servers, databases and communication networks. The classical way to provide trust is by creating a Central Trust Authority. If IT financial infrastructures are designed without a central trusted authority, consensus protocols must provide this trust. For instance, trust that a certain assertion is true and
7 Nine Algorithms That Changed the Future: The Ingenious Ideas that Drive Today’s Computers, John MacCormick, Princeton University Press 2012
Quantifying the potential of utilizing technology to integrate EU April 2019 8
Financial Markets
shaping the future of payment technology
that the corresponding transaction is legitimate will be the result of executing a consensus protocol. This disruptive principle is implemented by Distributed Ledger Technologies (DLT) using consensus algorithms to generate trust that a block of transactions is legitimate.
Use cases for DLT include both ‘pure’ financial applications (such as clearing and settlement) and non-financial applications; a third type of DLT use case can bridge financial and non-financial applications.
For instance, DLT may serve for the public verification of securely recorded personal/legal identity details so that customer enrollment and KYC (know your customer) by incomer financial service providers will be facilitated. Federating technologies, such as DLT that links two worlds (legal identities issued by EU members states and financial services provided by the industry) will play a role in near future of contributing to a further level of financial market integration. This case has been recently described by the European Banking Authority8.
3.3. Common Open Banking Interfaces
Application Programming Interfaces (APIs) are a set of routines, protocols and tools that enable communication between distributed software applications to provide a service. Regulated by PSD2, the open banking API enables bank customer to share their current account information securely with other third-party providers (TPP). Once a TPP is authorized by the customer, it can access their data and interact with their bank account through APIs offered by their bank. The Regulatory Technical Standard on Strong Customer Authentication specifies the operational and security requirements needed to develop TPP business models that protect end users of TPP services.
Use cases for services initiated through an API by a TPP includes payment account aggregation, expenditure analytics and financial product comparisons. If the level of information made available for TPPs is significant enough, the data delivered will enable innovation on financial services and facilitate partnerships between banks and Fintechs.
3.4. Maximizing Financial Market Integration Potential: Combining Advanced IT Technologies
One advantage of DLT-based architectures is the fact that they enable financial integration for a diversity of financial products, along with the promise of cost savings, efficiency gains and better control of risks.
What’s more, APIs within a DLT-based system can enable the addition of new features or enhancements not native to the distributed ledger protocol itself and provide user-friendly customized interfaces. This means applications can be personalized to meet the needs of specific asset types or markets and monetized.
If a common messaging standard is used (ISO 20022), APIs can play a critical role in improving usability and interoperability between different protocols and between protocols and legacy systems. Integrity and/or confidentiality is ensured by developing a security architecture that provides the
8 EBA Report on the Prudential Risks and Opportunities Arising for Institutions from Fintech, European Banking Authority (July 2018)
Quantifying the potential of utilizing technology to integrate EU April 2019 9
Financial Markets
shaping the future of payment technology
financial messages exchanged with ‘good’ security properties thanks to acute cryptography. As already mentioned, this inbuilt security eliminates barriers that get in the way of integrating financial infrastructures.
3.5. Assessing the Potential of Technology as an Enabler for Financial Market Integration
SPA suggests creating a simple mathematical tool to assess the potential of a technology for financial market integration purposes. This tool does not have to be very complex or take into account many variables. Instead, a more pragmatic approach is recommended whereby a technology could be evaluated against a set of criteria that qualifies it as an effective ‘enabler’ for market integration purposes.
For example, a DLT could have a good score because of its ability to support a diversity of financial products, or a lower one with respect to other criteria – such as its lack of maturity or the existence of IP. The model must also enable the consideration of different technologies that are implemented together in a financial infrastructure.
This assessment exercise would help to preselect technology that could be explicitly recommended in a legal context.
3.6. Creating Incentives for Payment Market Integration
One major market barrier against the integration of retail payment infrastructures is the fact that an overwhelming majority of retail payment transactions are still domestic. Consequently, innovative payment services such as mobile person-to-person (P2P) payments are operated by domestic schemes for a local market.
To invest and expand a domestic scheme’s reach is risky because only a modest increase in terms of new cross-border transactions would be expected. This point has been debated in the SEPA Mobile Proxy Forum9, a new SEPA initiative to create a cross-border EU scheme for mobile person-to-person payments.
Because of the limited incentives to invest, a simple functional architecture around a proxy look up platform, to which existing domestic mobile P2P systems may connect, has been specified. In principle, this architecture adds value to domestic schemes because it gives their EU customers global reach with little investment effort. It’s been assumed that this fact alone will be enough to ignite the interest of stakeholders to join the new scheme and contribute to the payment market integration effort.
Other than design simplicity, a certain number of market trends may also change perceptions and speed up recognition of the existence of a business case:
The steady increase in the number of cross-border transactions resulting from a boom of e- commerce transactions, the reduction of cross-border fees and the increase of the EU internal remittance market.
9 SCP2P 018-16 v1.1 Rules for operating, joining and participating in the Standardized Proxy Lookup (SPL) service (published December 2017), European Payments Council
Quantifying the potential of utilizing technology to integrate EU April 2019 10
Financial Markets
shaping the future of payment technology
The easy enlargement of the initial mobile P2P payments scope of the scheme to support mobile person-to-business payments (securities trading for example) without significant engineering efforts.
Mobile P2P payments are an enabler for the online peer-to-peer (P2P) lending market, a recent financial innovation pushed by some Fintechs.
All these factors may speed up the progress from a promising proof-of-concept use case to a real business case. Without a clear business case, innovative transactional schemes with a high potential for financial market integration and facilitated by successful consumer technology (in this case, the smartphone) will fail to be adopted.
For both retail payment and securities trading scenarios, incentives to speed up financial market integration requires the creation of a viable business case within an acceptable timeframe. The completion of the TARGET 2 Platform for the EU securities settlement has taken 10 years, despite the availability of mature technology, the full support of the European Central Bank and the existence of an appropriate regulatory framework. None of these highly incentivizing factors currently exist for the implementation of DLT-based systems that could compete with TARGET 2. With regards to the business aspects of financial market integration, insight may be found in the World Bank’s 2014 guidelines10 for the successful regional integration of financial infrastructures.
4. Financial Market Integration, Technology and Regulation
4.1. Fintech and Regulatory Sandboxing
Fintech is a global market phenomenon that is and will be reshaping the landscape of the financial services industry in both developed and emerging markets. Technologies for financial integration are always designed for global adoption, but the level and speed of adoption is largely determined by local market conditions.
Significant differences between EU member states exist in (1) regulation applied to the provision of financial services (securities market regulation, the degree of investor protection, the quality of the insolvency law, auditing and accounting standards) as well as in (2) their national market structures (existence of legacy systems, dominant position of local financial service providers, socio-economical context and cultural factors, such as risk appetite). These differences are, of course, expected to be dampened because of the EU legal framework. SEPA will also further align national market conditions, facilitating the adoption of shared platforms and common standards.
EU policy makers publish directives and regulations that are ‘technology-agnostic’. Yet to achieve their financial integration objectives, policy makers ideally need to be less neutral and promote more actively technology serving integration policy purposes. SPA defends the position that the EU regulators should be more prescriptive in terms of technological innovation choices, following an evaluation of their potential for financial market integration purposes.
10 Guidelines for the successful regional integration of financial infrastructures, The World Bank (2014), http://documents.worldbank.org/curated/en/553331468182345838/Guidelines-for-the-successful-regional- integration-of-financial-infrastructures
Quantifying the potential of utilizing technology to integrate EU April 2019 11
Financial Markets
shaping the future of payment technology
Legal sandboxing for Fintech developing technology promoting market integration is an option that could be seriously considered by financial regulators. However, SPA considers that security and customer protection should be excluded from any exemption regime. In regard to security, financial institutions and Fintech should be subject to the same requirements, including compliance with AML/CFT directives.
4.2. The Need for Further International Coordination
Regional regulation, globalization and rapid technological progress will continue to foster greater integration in both products and organizations within the financial sector. However, as the European Central Bank recognizes “The evidence presented in this chapter does not suggest that all the economic benefits that might be expected from financial integration are already materializing”11. A closer collaboration with similar global initiatives to evaluate socio-economic impact and ‘fine-tune’ financial integration policies could be beneficial.
Standardization and interoperability catalyze the integration of financial infrastructures. Yet paradoxically, one of the major barriers for the global integration of financial infrastructures is the flexibility provided by the standards which has led to different implementations - and not interoperability between them.
Payments are currently seeing another period of rapid innovation and transformation. The strong competition between traditional actors and new entrants in the market of financial services is primarily reflected in the way technology is being marketed. As a side effect, the need to differentiate an offer in the financial supply-side incites the deployment of non-interoperable proprietary solutions leading to market fragmentation.
In the EU a good example is the existence of different proprietary specifications for Open Banking APIs to comply with PSD2. These specifications provide a first level of market integration at national level. In our opinion policy makers could play a more driving role to push for convergence of these API towards a single EU API standard. This standard API should provide entry points to support the exchange of data needed for a diversity of TPP financial services, authentication modes and the risk management systems of banks.
Simultaneously, a global standardization initiative has been launched by ISO TC68 SC9 for an Open API. If adopted, this API will contribute to the integration of banks and TPP infrastructures and enable market integration by facilitating the creation of schemes or pools of banks, TPPs and other actors (dispute resolution services, KYC, ID management). A coordinated action by international regulators, led by the EU, in favor of the uptake of an API standard that could result from merging ‘the best of’ those APIs designed for a large scale adoption (such as the Berlin Group API and STET API) rather than bound to the local needs of the financial industry.
11 Financial Integration in Europe, European Central Bank (May 2018)
Quantifying the potential of utilizing technology to integrate EU April 2019 12
Financial Markets
shaping the future of payment technology
5. Conclusions
The integration of regional or global financial markets can follow different collaborative patterns between policy makers and the financial industry. It is therefore important to understand the key elements and resulting benefits of the integration of financial infrastructures.
Financial market integration means investment efforts for financial service providers, without an obvious payback. For this reason, the existence of a sustainable business case is a core criterium for success. A trade-off is likely to be found in the form of a combination of political drive and market incentives that create a context for the migration of banking IT infrastructures towards a more integrated financial market.
Incentives can be accomplished through legislation (regulatory technical standard), a common system design (a scheme developing detailed technical and governance specifications), or in a more realistic way by the prospect of being able to increase revenues through new financial products and services.
These new products and services may be enabled by advanced IT processing platforms with scalable computational power, appropriate quality of services and secure database storage facilities that are resilient against cyberattacks such as ‘financial cloud’, blockchain and ‘broadband’ open banking APIs.
Technology is a powerful enabler for shaping the financial and banking landscape. Yet SPA considers that technology will help market integration objectives only if supported by common standards that are massively adopted by the industry and explicitly promoted by the financial policy-makers
Yet overruling is considered as detrimental for innovation and innovation in finance is a catalyzer for the EU economic growth. A trade-off is needed.
With respect to the next steps to promote financial integration through technology, SPA outlines four directions:
1. The development of an appropriate tool to evaluate the potential of technology to promote financial integration could be a starting point, as suggested in Section 3 above.
2. The active promotion of federating processes (such as authentication methods and end-to-end security) based on best security industry practices by EU policy makers moving beyond their traditional agnosticism in terms of technology.
3. To adopt a regulatory sandboxing approach to promote innovation, with a focus on consumer protection and the integrity of IT processing facilities run by Fintech.
4. The agreement of a set of criteria to quantify the success of financial market integration efforts and the degree of evolution in the structure of the financial markets resulting from technology uptake. This would include the adoption of shared new platforms and volumes of transactions generated, cost savings, migration plans to innovative infrastructure.
Quantifying the potential of utilizing technology to integrate EU April 2019 13
Financial Markets