Non-cash, low-value payment systems, such as international and domestic card schemes, have continued to evolve over the past decade. While these reforms are generally aimed at improving the security, speed and cost of non-cash payments, some reforms have been more effective than others. And while some reforms are designed to embrace and encourage innovation, others preserve the anachronistic and inefficient banking practices that have blocked innovation in this sector.
The old way
Despite some superficial changes to authentication, the clearing and settlement processes employed by the major card schemes and most domestic switches have changed very little in the past 20 to 30 years. As illustrated in the diagram below, when the cardholder swipes or taps their card at a merchant terminal (1), the cardholder’s approval is implicit (not explicit), with the transaction details being “pulled” from the merchant to the card issuer (the cardholder’s financial institution).
The transaction details are initially transmitted (2) to the merchant’s financial institution (the “acquirer”). If the acquirer is also the card issuer, the authorization is internal, but otherwise the acquirer sends the information to the issuer either directly (3) if they have a bilateral agreement) or via a switch (3a) provided by the card scheme. The issuer authorizes or declines the transaction and communicates the information via the acquirer, again either bilaterally (4) or through the switch (4a), back to the merchant (5) and cardholder (6).
Once payments are cleared between financial institutions, they accrue obligations which must be settled. Final settlement of obligations between payments providers is either bilaterally between pairs of institutions (holding “vostro” and “nostro” netting accounts) or multilaterally through a third settlement bank, typically the central bank.
Traditional low-value, non-cash clearing and settlement process
However, access to settlement accounts at central banks, like Australia’s Reserve Bank, is usually limited to financial institutions that satisfy specific criteria i.e. so-called tier 1 institutions. Financial institutions that do not have access to a central bank account settle their payments across the books of one of the tier 1 financial institutions, which, in turn, settles across the books of the central bank.
The point is that the clearing and settlement systems for most card or domestic payment schemes are complex and built on a foundation of bilateral agreements between the major financial institutions and between them and the central bank. These bilateral agreements tend to stifle competition because new entrants are forced to work through one of the privileged tier 1 institutions. The process is also time-consuming and costly. The need for bilateral agreements also tends to block innovation because it is not in the interests of the tier 1 institutions to change the status quo.
The right way
That’s true in many jurisdictions, including Australia, but it’s not true everywhere. The UK’s Faster Payment Service (FPS) is a good example of how clearing and settlement should be done. FPS is a UK banking initiative designed to reduce payment times between different banks’ customer accounts from the three working days that transfers take using the long-established BACS system, to minutes or hours. FPS supports P2P, P2B, B2B and B2P transactions and the funds are settled immediately.
When a payment is transacted using FPS, the information flow is in the opposite direction, from the payer’s financial institution to the merchant or payee. As illustrated below, the payer chooses a channel and instructs their bank to pay an amount from their account to the payee’s account (1). After the usual customer authentication, the payer’s bank checks that the account has sufficient funds and that the request to make a payment is genuine. The payer’s bank sends the transaction to FPS (2). From this point onwards, the payer has an obligation to pay. FPS sends the payment instruction to the payee’s bank (3), who verifies the transaction, and then sends a message back to FPS that it has accepted or rejected the payment (4), who in turn notifies the payer’s bank (5). Once cleared, and unlike most other payment systems, instead of netting the transactions at the end of the day, FPS sends individual settlement files to the central bank for immediate settlement (6).
Faster Payment Service clearing and settlement process
Compared with a traditional pull payment, the FPS transaction is pushed from the payer’s institution to the payee’s institution. And although authorization is still implicit (implied by the payer’s bank sending the payment request to FPS), the transaction is quite secure as it relies on the bank’s (instead of the merchant’s) authentication process. This type of transaction is referred to as “hub-and-spoke” because all communications are passed to and from banks (spokes) through the FPS hub.
Hub-and-spoke settlement means that new entrants only need to establish agreements and work with one party to provide a service to the network. By interfacing with the switch at the hub they can interact with all members. The switch only interfaces with parties who are approved and have been able to demonstrate their security credentials.
It sounds simple, and it is. In fact it is this simplicity that is so revolutionary. It is also very fast. Gone are the complex bilateral arrangements and restrictive practices that stifle competition and innovation.
In the next stage of the UK reforms, the Payments Systems Regulator (PSR) plans to consolidate the operation of the three payments systems (BACS, C&CCC and FPS) into a single organization and advance the development of the New Payments Architecture (NPA). According to the Bank of England, “[the NPA is] an industry-led initiative that aims to increase competition and resilience as well as enhance innovation across the payments and banking industry”. Currently, a new entrant needs to be able to establish their credentials with all three clearing systems. As such, the UK reforms promise a much easier, faster, and less costly path for new entrants wishing to enter the ecosystem and to bring innovative products into the marketplace.
The wrong way
The New Payments Platform (NPP) is Australia’s answer to the UK’s FPS and the NPA for real time transfers. They might sound the same, but the NPP is a very different beast. In the NPP, there are three main types of organizations: NPP Participants (tier-1 banks), Identified Institutions (other banks and financial institutions), and Overlay Service Providers (payment service providers).
The NPP may be faster than the existing clearing and settlement systems, but it is still based on bilateral agreements with and between the tier-1 banks and the RBA. And it still forms a formidable barrier to competition and innovation in the Australian payments ecosystem. Nor does it address the fundamental security flaws in the current system.
NPP clearing and settlement process (source: Reserve Bank of Australia)
Fortunately, Bluechain schemes do not rely on traditional clearing systems for authenticating payment. When a payment is transacted using Bluechain, the information flow can be in either direction. Bluechain supports both push and pull transactions, and, in both cases, the approval is explicit because the details of the payee and payer and the authorization are bound to the transaction. However, once payments are cleared between institutions, settlement of a Bluechain transaction is by whatever the national settlement system is in place: FPS/NPA in the UK and BECS/RITS (or NPP/RITS) in Australia.
Which way will you go?
National regulators, central banks and switches have a clear choice:
- The wrong way: preserve the inefficiencies of an anachroistic banking system with complex and restrictive bilateral settlement agreements, or
- The right way: encourage competition and innovation with simple and fast hub-and-spoke clearing and settlement arrangements.