Ending banks’ stranglehold on payments
The Governor of your Central Bank can make your life better with a stroke of his pen.
If he does it, every single day millions of people in your country will save money and hassle. Businesses will dramatically reduce their operating costs and will find it easier to sell stuff. Of course, there is a catch — get the world’s smallest violin ready — banks will make a bit less money.
This post will explain how the Governor can do it, and why he should. I will first need to give some background of the three actors in this play: banks, payment companies, and payment systems.
Bankers
Normally, electronic payments work just fine. But every now and then, and seemingly when it’s most important to you, your bank lets you down. Whether you’re buying a special gift, putting down the deposit on a house, or taking out cash abroad, most of us have experienced that helpless feeling when it just doesn’t work. And the basic reason for this is that banks are not very good at it.
Banks take your money and hold it for you in an account — this is called a deposit. They then use those deposits in order to give out loans worth many times the value of the cash you originally left with them. This is the magic of credit creation. Indeed, this is the definition of a bank in UK law: If you take people’s money, then leverage that cash to give out loans, you are a bank. These days, almost all the money lent by banks is in the form of mortgages: money for individuals buying houses.
So what is a bank? You can take the legal definition, you can analyse the Bank of England’s Credit Condition Reviews, or you can wade through banks’ financial accounts to find their biggest line item of revenue. Whichever way you cut it, a bank is just a Mortgage Company.
A new species
In most developed countries, a new genus has evolved within the Financial Services family. The first species to be widely observed was PayPal in the 1990s. Others have emerged since then: Adyen, TransferWise (I work there), Google Wallet and many more.
These companies are specialists in payments. Adyen helps businesses to accept card payments. TransferWise enables low-cost, high-speed, international money transfers. Google Wallet lets you send and receive money between email addresses. All these businesses are licensed under specific regulations covering payments activities. They make their money from the business of payments. Whichever way you cut it, each one is a Payment Company.
Let’s take TransferWise as one example of a Payment Company that has already brought huge benefits to consumers. Most of the money sent overseas, online, is sent through banks. But the user experience is generally poor and clunky. The costs are high and opaque. The transfer takes days or even weeks. TransferWise has offered a service for the past six years which is both cheaper and better, and the customers who have discovered the service are evangelical about it.
But there is a problem faced by every Payment Company. A limit on how much they can improve the customer experience, and reduce the cost. This is because to make payments, a Payment Company is still ultimately reliant on a Mortgage Company. This is because, primarily due to historical accident, banks control access to most payments systems.
Route 66
There was a time when banks were not simply Mortgage Companies. In the 17th Century, banks existed, and mortgages did not. Much of the early activity of banks consisted of financing industry and war. The Bank of England started life this way, as a privately held bank focussed mainly on lending to the Government. As with other banks, it produced paper notes which were fully convertible for gold it held in reserve, and these were used to facilitate high-value payments (most individuals settled their payments in coins). Over time, through its close connection with Government, it became a trusted institution that took sole responsibility for the production of banknotes as well as becoming banker to the banks. By the 20th century, this Central Bank and others around the world played a crucial role in issuing banknotes and facilitating payments between banks.
Paper notes were easier to move around than wheelbarrows of gold. And in due course, electronic messages were easier to move than paper notes. The Central Bank stayed at the heart of it all, acting as the trusted third-party that would settle payments between banks. The electronic payment systems developed from the 1960s onwards have mostly required participants to hold an account with the Central Bank, to ensure confidence that promised funds would in fact be received. And due to the history of their development, Central Banks only offer accounts to banks. This means that for most of the world’s electronic payment systems, banks are the gatekeepers.
There is an exception to this. Privately developed and owned payment systems, such as those built by card schemes (Visa, Mastercard, UnionPay), have less of a built-in bank bias because these systems were not designed around a Central Bank. This explains why Payment Companies (those with appropriate regulatory licences) are able to become direct members of Mastercard. But these private payment systems are expensive and not suitable for all types of payments (e.g. large payments). If payment systems are the roads that money travels on, Mastercard et al are only accessible through a toll booth. Any Payment Company that wants to offer a compelling proposition needs at a minimum to be able to drive on the normal roads. Access to the premium highways is a nice bonus, but insufficient by itself.
So what’s the problem with having a gatekeeper? There are several problems. Firstly, although mostly focussed on selling mortgages, banks still do payments on the side, and make decent money from it. Payment Companies offer an unwelcome threat to this. Let’s put aside for one moment this clear conflict of interest (although it is an important issue I plan to cover in another post). There are two specific problems for any Payment Company. It will need to:
- Maintain a commercial relationship with a bank, which operates as a quasi-monopolist in the market due to the limited number of banks offering services to Payment Companies. This raises costs and creates operational risk.
- Access payment systems through the technology platform of a bank. Most banks use antiquated technology that is neither fully reliable, nor within a Payment Company’s control. Therefore, a Payment Company’s ability to develop a quality product is limited by the quality of its supplier.
‘Ello Guvnor
Why are we still stuck in this position? Status quo bias plays a role, as can be seen in the different approach taken by payment systems developed privately, without Central Bank involvement — some of these allow direct access by Payment Companies. As well as this, it is worth remembering that regulated Payment Companies are a relatively new invention. The main regulatory framework has only existed in the UK since 2009, whereas the rules governing the national payment systems were developed prior to that.
But change is finally coming. In 2016, TransferWise launched a direct connection with the UK’s most important retail payment system, FPS. This is the closest a Payment Company has come to full independence from banks, and it was enabled by the payment system tweaking its rules to make it possible. The final — and most significant — step in this journey is within sight, as the Bank of England has given a clear signal that it will start to give accounts to eligible Payment Companies. The UK is doing this because the Government and the Central Bank both recognise that every individual and business will benefit from the competition and innovation this will bring: faster, cheaper, more reliable payments.
Governments and Central Banks all around the world are pushing to upgrade their payment systems. Their citizens expect payments to be instant, always available, and cheap. So a long-awaited fast payment system is in the pipeline in the USA. The European Central Bank is expecting pan-European instant payments to go live later this year. Australia is building its New Payments Platform. These countries and more are building beautiful highways. Tell your Governor to open these roads to Teslas — not just Ladas.
