Transcript: Episode 7: Payments regulation – keeping pace with innovation

Sarah Isted: Hello everyone and welcome to the latest episode of our Risk & Regulation Rundown podcast. This is a monthly podcast where we discuss the latest risk and regulatory developments affecting our industry, some insights from our work with clients, and our perspective on industry talking points.

I’m Sarah Isted, your regular host, and as we did last month, we’re recording this episode remotely, so please bear in mind that as a result the sound quality might not be quite as good as usual.

In this episode, we’re discussing the regulation of payments, and I’m delighted to be joined by our first ever external guest Christina Segal-Knowles, who is the Executive Director for Financial Markets Infrastructure (FMI) at the Bank of England, and Jon Maskery, a PwC Partner who leads our payments team.

This is a very timely topic, given the rapid pace of developments in the payment sector and some of the changes we are currently living through.

Jon, could you start by giving us a bit of background on how the payments sector is evolving?

Jon Maskery: Yes, thank you Sarah. We are currently in a time of unprecedented change really across the payments industry, being driven by three major themes or axes. The first one is the continued regulation, including PSD2. Secondly, the global consolidation of standards on to the ISO 20022 standard. And finally, the continued innovation and disruption from FinTechs in the payments arena.

All three of these are inextricably linked and driving the organisations we work with to think about their payments businesses. Now, there are different ends to the spectrum. Some organisations are focusing on payments through operational excellence and resilience, driving out the maximum cost synergies, others are looking to reevaluate their payments businesses and look at how they take advantage of potential revenue streams afforded by open banking, for example. A study that PwC conducted back in 2018 highlighted a revenue opportunity of £7.2 billion created by open banking and that opportunity will be the size of the market by 2022. Banks and FinTechs are sort of feeding in the thinking around that into their business strategies and looking at how they can tap into this market. Through those three lenses, a huge amount of change and thought into how the industry is going to move forward.

Sarah: Thank you Jon, and that revenue opportunity is massive isn’t it, so it’s no wonder that organisations are reflecting on how they get involved in that in a safe and appropriate way. You mentioned the payment services directive, known as PSD2. How has the implementation of that directive impacted the sector and are there any issues that firms are still finding challenging?

Jon: Yes, PSD2 incorporated two of the key parts or key APIs within open banking. It incorporated the account information service provision, where with consent of the customer, banks could provide information to other institutions and also the payment initiation service provision, where banks could initiate payments on behalf of customers with consent.

These services to be provided by banks are at the cornerstone of driving competition into payments and financial services. However, there were risks. Providing these interfaces could have caused risks to customers, and as a result PSD2 incorporated far-reaching safeguards including cybersecurity standards, strong customer authentication, and access, consent management, transaction monitoring and fraud controls, and reporting of any fraud breaches. While some organisations have completed the journey, some are still implementing some of the changes and the strong customer authentication implementation dates for cards have been pushed back into 2021, and some organisations are still challenged with the implementation of these. It may be that some of these challenges have slowed the rise of new opportunities for customers and new competitors, FinTechs, and functionality in the market.

As such, we are seeing that the £7.2 billion market, it is there, but it may not be accessed until later than 2022.

Sarah: Brilliant, thank you Jon. Christina, welcome to the podcast. How do you see the payments sector evolving and innovating from your perspective and what are some of the challenges, but also opportunities that that innovation brings?

Christina: Thanks Sarah. Jon covered a number of the regulatory changes underpinning some of what we've seen very well. I would add maybe a couple of things on top of that, that I think are driving a real change in the way that we make payments, and both the things that we see in front of us when we make a payment, but also the things lying behind that and how the industry is structured and how a typical payment is made.

In addition to some regulatory changes, which Jon has outlined, we've also seen some cultural changes and changes in the way that consumers purchase things and their own expectations around convenience and speed at which they expect to make a payment. We've seen in the ten years from 2008 to 2018, a decline in the use of cash from about 60% of transactions to around 28% of transactions. We’ve also seen a really massive increase in the amount of commerce that's going on online, as well as in many countries a very rapid rise in the use of contactless payments, rather than traditional chip and pin. You put that all together and alongside the regulatory changes that Jon was talking about, and it’s been a real driver of innovation in payments, and in the way a typical payment is made.

So far, a lot of that innovation has been really concentrated in the early part of the payments chain. When I'm talking about the payments chain here, I'm talking about all of the steps that it takes to get from the point of initiation, the point that you walk in the shop and tap your card, to the point at which the payment is made into the merchant’s bank account, so there are a number of steps along the way. There has been a lot of change that we're seeing already in initiation, some of that is visible to people who are walking into shops and seeing different ways of tapping your card – on a laptop, different machines at the initiation point. There is also access and innovation, sitting behind that, around the way that those initiation services are connected to various payment systems.

We have seen a number of non-bank players get involved in those stages of the payment process, partly out of these changes in the way that we culturally expect to make a payment, and partially driven by the changing regulatory environment. All of that comes together and creates number of opportunities. The innovation that we are seeing is already improving customer convenience. It may make access to payment services easier for some small businesses. In some cases, it may act to reduce costs. There is a number of things that come out of this innovation that are very, very positive. But it also is something that as a regulator, we need to be looking at to make sure that it doesn't introduce new risks, that could pose risks to payments systems. We see the ability to make payments securely and with reliability, as something that's quite fundamental to financial stability in the UK. So we will need to make sure that as this innovation happens, we are able to keep up and make sure the regulation is fit for purpose.

Really the regulatory regime that we have here in the UK was designed for a world in which most of the steps in this payment chain, the way the payment gets from point A to point B, used to be conducted either by banks, and large banks who were also involved in payment services, or by core payment systems, so your big payment systems, whether those are card providers or electronic payments providers and processors. And that covered the entirety of the payments chain, and they were all covered by regulation.

Now with these new players coming in, particularly in that front end of the payment chain in those initial stages, both the things you see and the things you don’t see, the challenge for us is to make sure that those steps, which could potentially disrupt the entire payment if they fell apart, are regulated properly.

So there’s lots of opportunity, lots of things that could really improve the situation for businesses and households in the UK and globally, but also some challenges to make sure that the regulation keeps up.

Sarah: Definitely, and the pace of change that you've referred to there in the last ten years is immense. So the impact on regulators is significant and you touched upon there, the way the regulators are thinking about approaching payments. Are there any other aspects that you think regulators need to be considering in terms of managing some of the risks that you've mentioned?

Christina: There are number of things that we need to be thinking about. The first is the one that I've already mentioned, to make sure that all of the entities that are involved in payments and could be potentially important to how payments are made are regulated in a way that not only ensures payments are safe, secure and reliable, that's obviously very important and fundamental, but also in a way that isn't specific to a certain technology and ends up inadvertently dampening innovation by having the regulation based around what type of entity you are, what type of technology you are using, rather than what is the fundamental risk that we are trying to address. Because we want to be in a situation where we are helping to foster innovation, and we're not biasing where innovation goes to fit the regulation. Instead, the regulation should be based around the risk and be something that facilitates all sorts of technologies, all sorts of different types of entities, whether that's a bank or a non-bank, providing a service provider that can be done in a way that's safe and regulated appropriately.

The other thing that we've been looking at very closely is, right now most of the innovation that we've been seeing is really focused on potentially adding new stages or adding new players into payments chains that are pretty well established. The things that we’ve already seen, where payments are generally still either going through the card rails and so going through a debit or credit card system, or they're going bank to bank. I think there is also potential for even more fundamental innovation coming down the line where you go through an entirely different way to pay, and that's something that we're looking ahead to in the future to make sure the regulatory system can keep up.

Sarah: I wanted to touch on that, because one of the fascinating innovations that we hear a lot about, and I know a number of my clients are thinking about, is stablecoins. A number of firms are proposing business models which involve using cryptoassets, which can be known as stablecoins, for transactions that are currently processed by retail or wholesale payment systems, and this will be very different for the industry or could be very different.

In your mind, what questions does that pose for the industry and how its regulated?

Christina: That's a great question. That is the type of thing that I was thinking about when I was mentioning the potential for things to move into an entirely different way to pay. Stablecoins are particularly interesting, in that the proposal is not just as an innovation of how do you get that payment from point A to point B, but stablecoins are proposing to actually change the thing with which you are paying.

That's something that's not necessarily new - we've seen private money and private electronic money in the past, but it's typically been in the form of private bank deposits and that’s what we're transferring in a payment system rather than something that is completely outside the regulatory system. So, stablecoins and the stablecoin proposition not only need a regulatory response that can view the elements that would be replacing a traditional payment system or payment service provider and making sure that stablecoins are regulated in line with that, because they will be providing and posing the same risk as if you were making a payment with a card or making a payment bank to bank. Therefore, if we are trying to be technology neutral, you need to be thinking about how do you capture a stablecoin that's providing those services in the same way that you capture a traditional firm using more traditional technologies to make that same payment. But you also need to be thinking about, these stablecoins are proposing to create the money-like instrument that they're transferring and that's typically been something that requires regulation and requires rules around it to make sure that it provides that stability of value and those protections that customers and businesses have come to expect in the way that they make a payment. It raises all sorts of very interesting questions that regulators will need to grapple with, both regulators in the UK and internationally.

Sarah: Thank you, Christina, and Jon, what's your perspective on these types of innovations and what you're seeing from your work in the industry?

Jon: I certainly think that stablecoins can be a massive step forward for us. We've seen a lot of volatility and instability associated with currencies such as bitcoins but having stablecoins engineered for stability, they offer the same benefits of custodianship and blockchain, but without the volatility. That makes them massively positive and there are really good use cases from a payments perspective. These include things like remittance, settlement, and overseas workers trying to send money home and not having to pay hefty fees, or waiting a considerable amount of time before the money is received. Stablecoins could play a major role in cross-border payments due to the fact that they don't require a middleman. In the world where we are encouraging a lot of innovation, certainly stablecoins are a next step on the journey that really do open up a market and provide so much opportunity for financial institutions and customers.

Sarah: Of course COVID-19 is impacting payments firms as it is for all financial services firms, and the FCA published its business plan in April and highlighted that making payments safe and accessible was one of its four mid-term priorities, and that it was concerned that COVID-19 could impact payment services firms’ financial strength, but also consumers’ ability to access cash and payment services. So Jon, can you talk us through how COVID-19 is impacting firms that you’ve seen, and how they can continue to meet regulators’ expectations in the current situation and beyond?

Jon: I think, as Christina mentioned earlier, COVID-19 has driven and will continue the drive towards electronic payments. Cash has been perceived as a disease vector, further driving customers towards digital contactless payments, and I think that will continue to accelerate the move away from cash and towards these more innovative payment methods.

With regards to the pandemic, across our industry, we saw challenges initially with mobilising remote working, but in reality FS markets moved to these new ways of working incredibly quickly. There were challenges with contact centres, but technology supported the creation of new centres, enabling people to work from home in a contact centre or call centre. That's an important part of a payment journey, for a customer understanding where a payment may be, and what’s happened to a payment.

We've also seen and we've always known that payments have needed to be resilient. In general, the platforms have stood up to the test with very few outages over the period, if any. That said, banks do continue to focus on resilience, both operationally and technically. If we see that continued move away from cash to digital payments, financial services organisations will need to ensure that their systems that process their payments have the capacity to deal with the new volume.

The final thing I would say about COVID-19 is, we have seen an increase in fraud and scams as a result. But the regulatory changes driven by PSD2, especially in the fraud space, will have done more to protect customers than would have previously been there. So, there’s a lot of change and a lot of impact from COVID-19 across the industry.

Sarah: Thank you, Jon, and Christina what are the Bank of England's current priorities in terms of supervising payment firms and financial market infrastructure firms?

Christina: Jon did a good job of highlighting some of the challenges that we've faced, thinking about this current situation and the COVID-19 crisis, we've had the perfect storm in some ways where you've had a combination of real operational challenges in terms of the volumes that are going through payment systems shifting, depending on whether it's a wholesale payment system or a retail payment system. There have been different dynamics for different systems, but definitely changes in the types of payments that are flowing around.

We've had at the same time an economic and financial stress, which impacts payment systems and also very heavily impacts some of the other financial market infrastructures of banks and supervisors, for example central clearing counterparties which are really at the center of financial markets and are very important in the current moment to financial market operations. Then at the same time you've had all of the firms that we supervise have had to move to business continuity plans and working from home.

But given all of that, we've been really pleased at how well things have held up. It's been something that we've continued to focus on how do we support the firms that we supervise in navigating this and really tried to reorient our supervisory activities to be focused on the current challenges that firms are facing rather than thinking about things that are further down the line so that they can really focus on making sure that they are able to continue to be secure and reliable through this challenge. Looking ahead, we will need to continue to work with the firms that we supervise to think about how do ongoing changes and ongoing challenges affect their ability to continue to provide that secure and reliable service. Jon mentioned changes in the way that people make payments and the continuing and potentially accelerated declining use of cash and that is going to be quite important. We're also going to have to think about as we go through the response to COVID-19, whether that is additional stages and additional periods of market volatility, as people adjust to the economic realities of some of the things that have gone on. There will continue to be things that we need to work very closely with firms on. We'll also need to work with them as they think through how do they continue to operate in the changing environment, when it comes to their working from home, coming back into the office, all of those things will be challenges going forward, so lots to think about, lots to look at.

On the other hand, there’s actually a really positive story in terms of how financial market infrastructures have performed so far, and that really underscores - going back to our earlier conversation - the importance of making sure that the things that are key to making a payment, the things that households and businesses are relying on are well supervised, and have the operational or financial resilience and the business continuity planning in place going into future crises. I think all of the performance that we've seen to date is not just due to happenstance, it’s instead because we've worked very closely with firms to make sure that they were ready for a stress and I think so far we've seen that pay off in terms of the resilience we've seen to date.

Sarah: Brilliant. Thank you Christina and Jon for such an interesting discussion, we could continue I’ve no doubt and explore this further. Thank you both very much.

If you’ve found this helpful, please share it with your colleagues, and subscribe to future episodes of the podcast and we'll be back with another episode next month. But in the meantime, do take care and continue to stay safe. Thanks very much everybody.