The Payments Revolution

If you’ve ever purchased something with a single click and waited only seconds for your payment to be transferred and for the entire transaction to be verified and approved, you are part of the payment system revolution. Your desire, and that of other ‘end users,’ to make payments as quickly and securely as possible at any time and from any device is a crucial part of what’s driving this revolution forward. Many of us already take buying movie tickets online or transferring funds across the globe via phone for granted, but these mundane transactions are part of a dramatic, increasingly global transformation in the way we pay.

We have entered the brave new world of payment system innovation, where thanks to the spread of innovative new technologies, money is flowing faster than ever among households, businesses, merchants, and banks.  The rise of new P2P systems mobile options, and e-wallets is sparking a shift away from the banking deposit model now underway is creating exciting business opportunities as well as risks for merchants and consumers. But not all countries are moving as quickly in the direction of ‘end to end efficiency’ in payments. At this year’s Toronto Global Forum, experts from which will be featured in an OpenCanada In Depth later this month, CIC President Dr. Jennifer Jeffs sat down with First Vice President of the New York Federal Reserve Christine Cumming, to discuss the ongoing transformation of the U.S. payments system, and why the U.S. is struggling to stay a leader in the payments space.

Jeffs: I’d like to start by talking about the drivers of innovation in the financial services sector. Where is the pressure for these technology-based advances coming from?

Cumming: The big innovations that we are seeing are both consumer driven and merchant driven. It’s both because what we’re seeing is less that consumers are demanding change in an unambiguous way and more that both bank and non-bank innovators have been looking at what attracts consumers or merchants to their products. The non-bank sector has been pretty active – everyone is familiar with PayPal by this point, but there are also a lot more electronic wallets out there, as well as large retailers experimenting with products that look like bank products or credit card products. Much of the innovation in the sector right now deals with merchants trying to find less expensive, more convenient ways to process credit card payments. One good example that’s well known now is Square.

There’s a growing demand for greater ease of payment, which is being perceived by technology innovators. I will really put a big stress on technology as making a huge difference here – technology is what’s creating a situation where innovations can enter the picture and make a big difference for both consumers and merchants.

With so many more transactions being processed, and so much money flowing through the system, is the wholesale payment system becoming more vulnerable and volatile? Can we protect and stabilize it?

In the short run, the wholesale payment system is still a ways away from full exposure to these innovations. But I will talk about where we face increased vulnerability. I think the really vulnerable part of the system, and where the major changes may occur first, is in the retail space – the smaller payment space. The Federal Reserve runs a system call Automated Clearing House system or ACH, which is essentially an overnight batch system – you put in your payment instruction today and the actual payment is made the next morning. We can see from the levels of consumer demand for some of the newer bank products that there’s a real market for P2P or person-to-person, same-day payments, which entail certain risks.  The cyber threat has escalated tremendously in the last few years and fraud remains a serious concern – it’s one of things we try hardest to guard against. In an evolving payment system, the growth of sophistication and technical skill in the criminal community is clearly something to be worried about. The growing world of points and coupons is also a vulnerable space.

A space which itself is the product innovation…

Yes, today we deal a lot more with points, coupons, and discounts. They’re unlike traditional bank deposit products, in that they really don’t reference payment sources at all. And providers are creating products that facilitate individuals managing these as part of their finances. So as I said, the retail payment space is changing dramatically as what customers want is changing.

And in what other areas do you expect to see similarly significant changes?

We still use cheques by the billions in the United States, so that’s somewhere we’re likely to see changes. Innovation in the smaller payments space is also affecting the wholesale system in the sense that it’s creating competition for the bottom end of the distribution of wire transfers – those around $15,000. People like wire transfers because of the high degree of security and the absolute guarantee that it gets to the end point. But I think that the smaller amount wire transfers are probably vulnerable to better payment methods like those transforming the retail space because if you know it’ll get there the same day, you might be really tempted to use something that is much cheaper than a wire transfer, and that can be confirmed that day. For the vast bulk of wire transfers, which are very high value, there are still a lot of advantages to the wire system that I don’t expect to erode in the near future.

Is an opportunity emerging for other types of organizations to get involved in financial transfers?

That is a very big and very interesting policy question. I can speak from the standpoint of how the Federal Reserve looks are our current counterpart banks in the payment system. These banks are regulated. They are supervised. Essentially, we have lot of insight into the credit quality of the banks that we deal with. We are aware when a bank is getting into trouble and therefore we can manage the risk of that before it negatively impacts the system. So a system where all those doing the transferring are banks is a world we know well. Whether we should or could extend beyond that… that’s a major policy question for decision-making bodies like the Board of Governors. Answering it would involve thinking about how we’d extend credit oversight to non-bank participants, thereby ensuring that we and the system remained protected.

Are other countries beside the United States experiencing similar innovation surges in the payments space?

The world is moving very quickly in the payment space, particularly overseas. We’re finding that there is a much more of a drive to innovate in the Eurozone and emerging economies. Part of the reason for that, at least in some countries, is that they don’t have to deal with a legacy system. In others, they do, but they’re focused on rebuilding. Look at the Eurozone – they’re in the process of remaking their system with the Euro in mind. And when you look at what they’re building, they’re really thinking in 21st century in terms.

What about some of the big emerging economies?

They have a huge advantage, of course, because they either don’t have a legacy system or they can more easily put what they do have aside. In emerging economies, we see a lot of interest in not only creating strong payment systems at the retail level and the wire transfer level, but also in the role mobile phones can play. Many of these countries have substantial under-banked populations, so I think there’s a lot of interest in overcoming the logistical issues that come with using a conventional banking system with branches and having to transport things long distance such as currency and cheques.

There really is a huge amount of interest in seeing what the cell phone can do. This is a place where the U.S. is also making efforts to advance in this area, but we come up against the challenge of each bank doing their own thing, which means that their systems can’t talk to each other. We haven’t succeeded in creating a full-fledged, national system.

Emerging markets today have an opportunity to really think through what they want their systems to look like. And then they can borrow the latest technology to build them.

So is the U.S. at a disadvantaged position today when it comes to pushing ahead with payment system innovations because its traditional model is so entrenched?

When we interact with our colleagues overseas, more and more what we hear when it comes to payment system innovations is, “where is the United States?” Take credit cards, for example. Cards that contain a chip are now standard in Europe but in much of the United States, consumers still don’t have them.

Another example can be found in the world of global payment standards. Global standards impact wire transfers and the retail system. Where is the big push to adopt ISO 20022? The United States is a sponsor of this effort to standardize global business communication and we are in the process of examining the business case for 20022, but again, we hear our colleagues overseas saying, ‘where are you?’

At one point the United States was the clear leader in introducing global payments standards and innovations. Now we’re the ones who are being pulled along, at least a little bit, by ISO 20022 standards. Feeling pressure to change – that’s a very different situation for us. And it’s a big motivator of the Federal Reserve’s new strategic plan for payment services.