Plus: OakNorth, Cross River Bank, Stupidity
A few months ago I sold my car. Nothing fancy – just a small VW Polo I’d bought to tootle around in. But after crunching some numbers I realised I was paying two times more per mile to run it than to use Uber, so I put it up for sale.
It turned out to be a useful experience. For a start, I made money on the trade. Even though I’d added to its mileage (and scuffed its hubcaps) I sold the car for more than I’d bought it. Some of that was attributable to unusually high used car price inflation. Some was due to subsidies I creamed off dealers at both ends of the trade. These were unicorn start-ups with a mission to disrupt the used car market, each of them eager to bolster sales numbers ahead of their next funding round.
More fundamentally though – and to the subject of this piece – the sales process demonstrated the economic power unleashed by real-time bank payments. To sell the car, I used the services of a unicorn startup whose online marketplace matches retail sellers with professional buyers. A number of buyers expressed interest and the highest bidder sent a representative round to my home to complete the deal. After a quick check to make sure the condition of the car matched my photos and description, he instructed head office to release payment. Within seconds I saw the money appear in my account via my banking app. I handed over the keys.
Such speed of payment is a relatively new phenomenon. Before 2008, a payment like this would have taken three days to clear in the UK. Unless I wanted to make a business out of buying and selling cars (not such a bad idea given my success on this occasion) and sign up for my own POS terminal, the sales process I went through would have been impossible. I either would have had to take credit risk on the dealer (no thanks) or alternatively invite the dealer’s representative to stay in my house for three days until the payment cleared. Workaround solutions such as a banker’s draft were available to transfer credit risk onto the dealer’s bank, but the amount needed to be pre-agreed, leaving no room to renegotiate on the spot.
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When it launched in 2008, the UK’s Faster Payments Service was one of the first 24/7 real time-payments services in the world. Its development was triggered by a government review identifying demand for shorter clearing cycles for telephone and internet banking payments. At the time, authorities estimated annual net benefits to the UK economy of between £75 million and £134 million – numbers which now look like an understatement given my experience.
The government set up one organisation to oversee the service and it charged another with building it. The problem is that both were controlled by incumbent banks, setting up a conflict of interests – banks are not known for innovating change – and uptake was slow. Rules had to be introduced requiring banks to move standing order payments to the new platform but even then, it took time for the system to gain traction. Seven years after those new rules, the system was still only processing 25% of the UK’s transfers and direct debits.
Over time, government authorities moved control of the system away from the banks. First they moved oversight to a new organisation now known as Pay.UK. This is a not-for-profit company funded through a cost recovery business model. Then the government required banks to sell the company that built and maintains the central payments infrastructure, a company called Vocalink. In 2016, the thirteen banks that owned Vocalink sold it to Mastercard for £700 million.
Today, the UK Faster Payments Service has 40 direct participants, mostly banks. In addition, other entities can plug in via a sponsoring bank. Last year, it processed 3.4 billion transactions worth £2.6 trillion. Pay.UK oversees a couple of other platforms as well but a look at its most recent annual report reveals that it costs around 1.5p per transaction to process these volumes. Given the high value of many transactions – Faster Payments increased its cap to £1 million from £250,000 earlier this year – the cost as a percentage of transaction value is very small (a fifth of a basis point).
Faster payments outside the UK
Since being launched in the UK, 24/7 fast payment systems have proliferated around the world, with currently over 60 jurisdictions having launched them. For consumers and merchants, the benefits are clear: they provide the certainty and cash flow benefits of immediate payment. For banks, they mitigate credit risk. The longer it takes for money to get from one place to another, the more credit risk that builds up in the system. Banks have historically absorbed that risk, but it’s better for the system if it can be eliminated entirely.
While every jurisdiction has its own motivations for launching a faster payments service, each is able to build on the success of the last. The most successful to date is the Brazilian Pix system, operational since November 2020. From a standing start, it did 1.37 billion transactions in the month of February alone, worth R$645 billion. That’s more than the value processed via credit cards. The service is used by 114 million people, equivalent to two-thirds of the adult population. In terms of transactions per capita, it already oustrips the UK.
The traction of the Brazilian Pix system is all the more remarkable in that the improvement over the legacy infrastructure is not as great as it was in the UK. Under the legacy Brazilian TED system, accounts could be credited in under 90 minutes, albeit only during weekday business hours. But the Brazilian authorities’ motivation wasn’t just speed, it was financial inclusion. According to the World Bank, around 30% of Brazilians over the age of 15 do not have a bank account at all, making the 90 minute clearing time moot. In addition, Brazilian authorities had to contend with something the UK authorities didn’t back in 2008 – the spectre of big technology companies. WhatsApp was about to launch a payments feature that worked well, but was restricted to its own users; the government wanted to create a more open ecosystem.
The success of Pix surprised even its backers. At launch, the president of the Central Bank of Brazil projected it would hit 20 million transactions within six months; it got there in a week and a half. Its design is a pretty good blueprint for how to scale up a network with the benefit of government sponsorship. Unlike in the UK, the authorities began by retaining complete control rather than handing it over to banks. The Brazilian central bank assumed the role of rule maker and developer, operator and manager of the settlement infrastructure. Having built the system on this basis, it incentivised usage in a number of ways.
On the consumer side, the Brazilian central bank understood the importance of brand. This was never a feature in the UK where over a decade on, most people still haven’t heard of FPS - the Faster Payments Service. The Brazilian authorities recognised that just as with payment cards and transfer schemes, fast payment systems need a name and a brand. It’s something Visa management identified many years ago. In his book on the company, Electronic Value Exchange, author David Stearns notes, “During my interviews with Visa’s pioneers, I was struck by how often they spoke about the importance of Visa’s marks: the blue-white-and-gold bands design; and the name ‘Visa.’ They considered the marks to be not only key contributors to Visa’s success, but also the most important asset Visa owned.” He concludes that, “value always flows according to a mark. The mark…is established by an authority, and only those who recognize and trust that authority will continue to participate in the payment system.”
The central bank also made the system very easy for consumers to use. In the UK, you need to know the recipient's bank details – name, sort code and account number (fourteen digits in all). The Pix system introduced an alias (e.g. phone number, email address) to serve as a Pix key; it also allows payments to be initiated via a QR code. The idea is that unless making electronic payments is as simple and intuitive as making cash payments, consumers will likely continue to prefer using cash. And cash is still used in over a third of point-of-sale payments, compared with an eighth in the UK, making it a high bar to compete with.
As well as consumers, the authorities also needed to get the banks on board. At launch, S&P estimated that they would lose 10% of their total fees over a twelve month period from forgone money transfers and card payments. “There is nothing I can do to motivate banks,” recognised the president of the Central Bank of Brazil. “What I need to do is to motivate the clients. Banks are motivated by their clients.” Some banks saw this and rushed to get customers hooked up with their favourite Pix keys.
But to speed up the process, the central bank president mandated large banks to get involved. All banks with more than 500,000 transaction accounts were signed up, creating a critical mass for more to follow. There are now 774 participants in the system. His pitch to them was that in spite of the S&P projections, this wouldn’t be a zero sum game – business models would emerge around small transaction values, creating opportunities for new revenue streams elsewhere.
On the merchant side, the system had to fulfil a couple of criteria. It had to be secure and it had to be cheap. Card fees had already been coming down in Brazil over the recent past. Merchant discount rates for credit cards fell from 2.8% in 2014 to 2.2% in 2021, and for debit cards they fell from 1.6% to 1.1%. Pix fees are lower, at around 0.2% for person-to-business transactions. One acquirer, SumUp, even charges a zero rate. Part of the difference stems from lower processing costs. Merchant acquirers typically take a 0.5% fee on a credit card transaction, and the network (Visa or Mastercard) will take 0.1%, with the bank keeping the rest. By contrast, Pix charges fees on a cost-recovery basis at a rate of R$0.001 per transaction.
And a bit of luck
Even with all these design features, Pix needed an additional boost to get it moving and that came via the pandemic. As the chart of fast payment scheme adoption above shows, Mexico launched a scheme in 2019 called Cobro Digital, but its take up has been much slower. Like Pix, the Mexican scheme was controlled by the central bank, which recruited large banks as participants and made it free for consumers to use. The difference is that in Brazil, most Covid relief payments were made through Pix. Now that Pix has established traction, network effects sustain its growth.
While there are clear economic benefits to facilitating faster payments, it’s not all good, as the UK can testify. In October last year, the UK Treasury filed a payments landscape review. It cautions that “unlike other payments networks such as the major card schemes’ chargeback processes, Faster Payments does not have comprehensive scheme rules to deal with how participants should collectively act to resolve disputes and assign liability when a Faster Payment goes wrong.” The industry has added a layer of fraud protection at the user interface, but that slows the process down, limiting its functionality.
This trade-off between security and speed is one the Brazil central bank had to contend with. But it has been able to react. In the first six months of last year, São Paulo witnessed a 40% rise in ‘lightning’ kidnappings – where people are grabbed on the street and forced to transfer money in exchange for their release. Police put this down to the introduction of Pix. The central bank responded by putting in a $200 transfer limit on peer-to-peer payments at night, when most attacks occur, and installed a minimum waiting time for increasing transfer limits.
There’s little doubt that central banking authorities around the world are looking at the Brazilian experience with interest. The emergence of technology companies that dominate payments represents a threat as reflected in policymakers’ responses to Facebook in 2019. Many are coming round to the view that competition is best played out at the user end rather than at the infrastructure end. When the UK authorities insisted banks sell the Faster Payments infrastructure to Mastercard in 2016, they anticipated it would enhance competition at the back end; an alternative response would have been to squash competition at that end and encourage it in the provision of services. The reason is that the best network is a monopoly, but in private hands a monopoly would not be in the public interest.
None of this is lost on Visa. Its regulatory filings contain a risk statement warning that “Government actions or initiatives such as…real time payment initiatives by governments such as the US Federal Reserve’s FedNow or the Central Bank of Brazil’s Pix system may provide competitors with increased opportunities to derive competitive advantages from these business models, and may create new competitors, including in some cases the government itself.”
Through central bank digital currencies, governments are looking to reassert their control over money as transactions become more electronic. Infrastructure systems like Pix get them a lot of the way there.
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For more on Pix, the BIS published a useful bulletin, and two of its architects wrote a piece in the Journal of Payments Strategy & Systems (Volume 15, Number 4).
One country that’s been slow to embrace faster payments is Canada. The reason is a structure not dissimilar to that in the UK in 2008 before the government intervened: Canadian banks control both Interac, the company that provides the payment infrastructure, and Payments Canada, the organisation that oversees it. “My own personal opinion was it felt like there were benefits to some to slow it down,” a former Payments Canada board member told the Ottawa Sun. “The frustration is felt in pretty much every corner, except for the incumbents that have a solution in market.”
The Brazilian Central Bank operates two infrastructure platforms to manage Pix. A Transaction Accounts Identifier Directory (DICT) is a database that links keys to users’ transaction accounts. And an Instant Payments System (SPI) which settles transactions between institutions.