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