A payments system connects payers and payees for an efficient value exchange. It is, by definition, a two-sided market and must meet the needs of the end users on both sides. A retail payments system needs to be adopted by (or available to) a large enough pool of consumers to appeal to merchants. Similarly, the benefits to merchants for offering a new payment method need to outweigh the costs. Benefits may include access to new customers or a better payment experience leading to lower abandonment rates. Costs are not limited to the set up and operational side; there is also the opportunity cost of pursuing this initiative over something else.
However, once established, payments can create a positive flywheel for growth. More merchants make the payment method more appealing to consumers as it can be used in more places. This in turn leads to more consumers adopting the payment method, and so on.
This need to create critical mass on both sides of the market makes establishing a new payment method notoriously difficult – the level of change required to adopt any new payment method needs to be commensurate with the unmet need. Successful examples include:
- Chip and PIN: This required significant investments on both sides of the market by card issuers, acquirers and merchants. However, fraud was a significant cost and something of an existential threat to card payments, as it undermined trust in the whole system. So, over time, chip and PIN adoption was mandated across most countries, reducing fraud levels. Once customers were used to this new payment method, it sped up the checkout process significantly, providing an additional benefit for some retailers as it increases potential throughput at checkout.
- Contactless: This innovation built on the foundation of chip and PIN in the UK but still required significant incremental investment in POS hardware and cards. Benefits were more nuanced, focusing on checkout speed and displacing cash for smaller transactions. Adoption was initially slow, which meant that card schemes and key banks had to invest to seed this market on the expectation that network effects would kick in eventually. TfL’s adoption of pay-at-gate technology provided a great tipping point to establish the positive flywheel, demonstrating its convenience to customers. From that point, the success of contactless was probably inevitable.
- Mobile contactless payments: Merchant acceptance of ApplePay and GooglePay required more limited investment as it leveraged existing contactless foundations. Customers’ attachment to their phones and demand for this innovative payment method was strong, and the established merchant base meant users had immediate utility – further contributing to the positive flywheel. UK Finance recently announced that over one third of UK adults now use mobile contactless payments.
The development of open banking payments has followed a different path. It required significant investment, with many banks citing investments of billions of pounds for the development of read and write APIs as parts of the legacy infrastructure had to be rewired. An unmet customer need did not drive this investment; rather, it was regulation which was introduced to increase competition among existing banks and stimulate innovation.
This starting point makes it difficult to create a positive flywheel for open banking payments. The market’s payout side typically considers open banking as a compliance obligation, making it difficult to secure investment to further improve and optimise the payment experience. Similarly, challenges arise for the payment acceptance side as the payment experience often results in lower success rates than cards.
The future of open banking payments
It is not all doom and gloom for open banking payments, as there are some areas where benefits are visible on both sides of the market and this new capability has thrived. Successful examples of adoption include topping up savings accounts, paying off credit card balances, transferring funds into investment accounts and paying government taxes. These use cases typically used faster payments in the past, and open banking offers a better payment experience for customers while the recipient benefits from reduced operational and reconciliation costs as mistyped reference fields are eliminated.
So, can open banking payments evolve from a ‘better faster payment’ to a fully-fledged alternative retail payment method? Three key foundations can make this a reality:
1. Incentive alignment
Incentives must be aligned across both sides of the market, but there are some challenges to this:
- Clarity around liability and what happens when things go wrong (with the payment or with the purchase) is essential. The underlying need for specific consumer protection will vary depending on use case, so reaching a consensus view that covers all use cases has been difficult. Paying a utility bill has a very different risk profile to purchasing an air fryer from an unknown merchant via a digital marketplace (the latter has been a source of scams).
- A viable commercial model is required to justify continuous investment. Making and receiving payments is not costless, but it has been challenging to find a solution for price when there is a regulatory requirement for full access at zero cost for payment initiation. In the UK, the industry is yet to find a solution for price and liability for variable recurring payments (VRPs). The SPAA scheme has established a pricing framework in Europe, but the capability to execute payments that sit within the framework does not (yet) exist.
2. Transforming from a regulatory structure to a contractual structure
Regulation is an incredibly powerful tool which can create and shape markets. Therefore, it is paramount to exercise this power with caution and ensure that consequences are properly considered. While regulators use extensive consultation, which results in a slow pace of change, an emerging payment capability must be able to adapt quickly to market conditions.
This is better achieved when participants have a contractual relationship with the payment system, and we cannot think of a successful payment system that is not built on such a foundation. Cash might be the exception, but there is debate as to whether it should be considered a payment system at all.
A contractual structure means that a body (or bodies) needs to be responsible for developing and managing the payment system. This is how payment systems typically operate, with examples including Visa, Mastercard, Faster Payments System, Blik, Swish and LINK.
3. Priming the pumps
We believe that a body should oversee open banking payments and enable the development of a contractual framework. However, given that open banking payments were developed because of regulatory action, an economically self-sustaining body to oversee this new payment system does not currently exist. The JROC consultation talked about a Future Entity (this body could be completely new), an existing payment scheme with established capabilities and market experience, or an evolution of an existing regulatory entity.
A key challenge is that there is no burning platform of unmet needs that open banking payments could address which justifies investment in creating this entity. VRPs certainly provide the market with a new capability, but the potential benefits do not seem large enough to overcome the inertia of creating a new payment scheme landscape at present.
Looking ahead
Open banking payments can evolve into a viable retail payments system, but establishing firm foundations remains challenging.
As a major consumer of payment services, the government may be one route forwards. Much like TfL’s actions drove contactless adoption, the market will take notice if the government signalled its intent to shift a proportion of payments to open banking providers.
But success is not solely the public sector’s prerogative. Private sector organisations wanting to develop a strong market position in this emerging capability could also find ways to establish the foundations highlighted above.
To talk to us about this topic, please contact us.
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