Opinion: The Path to Real-Time Payments - Food for Thought

Steve Percy

President, Diolkos Commerce Solutions

June 2020

Trustworthy payment and financial systems are critical to the safety of the world. Think about the anarchy that would occur with the masses in the western world if we didn’t have them. I quote Burl Ives as I shake “Brrrrrrrrrrr”.

Let’s talk about the big banks and payments.

Almost all new solutions in payments are designed and built outside of banks by non-bank Fintech startups. However, the significant portion of financial asset wealth, particularly liquid wealth, is held in bank accounts/ledgers of Financial Institutions. Non-cash payments are completed bank-to-bank via direct account-to-account exchanges between bank ledger systems (Demand Deposit Accounts). Why does the western world continue to trust banks while under-banked and unbanked economies have found newer telecom-based solutions to address retail and person-to-person payments ? Much like wireless telecommunications was transformational for non-G20 economies, when combined with the Internet, wireless has become a platform of transformation of commerce. But hey, visionaries predicted this more than 30 years ago at the onset of wireless telecom. Check your textbooks and business publications.

Cheque volumes peaked in the early 1990’s (25+ years ago) and while many electronic solutions have been built to replace them as a payment solution, industry associations report that cheques still support 40% to 50% of the value exchanged between parties as of 2018. Financial institutions and technology companies have been designing and building new electronic solutions for more than 40 years to eradicate the use of cheques yet have only progressed to match the dollar amounts still supported by paper cheque technology. The primary reason that the conversion to electronic methods is difficult, is that they are built on top of the same exchange and settlement solutions that have existed for more than a century. They all have to work together and the various timelines involved in balancing the system increases the conversion complexity as more are added. And there are many as identified a little later in this paper.

Let’s look into the past a bit more to build an understanding of how we got here. Some can still remember “Banker’s Hours” with the branch closing at 3 PM to manage the daily closing process which consisted of account balancing, book keeping, and central reporting. Cheque exchange and settlement were one the principal operational issues to manage. Even credit card networks originated from the processing of paper. Remember the 3-part paper and card sliders that used to damage the odd card ? They still exist. A little more history, know that computers were introduced into banking in the 1960’s/70’s to make these same processes more efficient. They started as batch processing systems to make inter-branch clearing and settlement more efficient. SNA 3270 type terminals became the installed base in branches to improve the accuracy and turn-around time of these manual processes. 50 years of effort has made tremendous changes to this effort with long standing centralization into regional Clearing Centers, outsourcing of same, and now decentralization back to the branches with mobile capture (camera) and image scanning technology. In truth, as long as cheques play a significant role in the values exchanged, these processes will continue to exist. There are many experts out there and almost all within the banks will agree that legacy and very old platforms receive minor investment in conversion. The focus over the last 20 years has been significant investments in imaging capture and storage technology.

Now please take note, the huge cost to replace the core clearing and settlement systems is not just an expense of the financial services industry, it is also an expense to corporations, governments, and small businesses. Organizations that run on quarterly reporting and annual performance returns do not have an appetite to make major expenditures in share services processes. They run on fixed and declining budgets. We, as either direct or institutional investors, are the culprit as we don’t like to see major shifts in profits and in turn stock prices.

Let’s continue.

The Check 21 initiative in the United States, while completely necessary, electronified the image of the cheque and gave checks continued life. This expensive effort finally brought overnight exchange to the large majority of payments in the United States. In many payment scenarios overnight exchange has become acceptable in the market, providing time to make sure that payments are properly routed between parties, and of course the correction of problematic items. But Check 21 extended the rope life of the massive anchor that is holding all of the current electronic payment technologies back.

Over the last 40 years, issues related to clearing and settlement have been inherited by the various new electronic payment methods and have been necessarily layered onto these core platforms. For Fintech Startups (and their VC investors), the fastest way of getting a new payment method approved is to integrate it into the various jurisdictional low value clearing and settlement platforms. So that is what everyone is doing, integrating into the card processors (primarily) or connecting into a jurisdictional debit network run by local payment associations. And guess what ? The new and improved real-time payment systems under construction around the globe using ISO 20022 as their core standard do not make any changes to this same clearing and settlement methodology, or level of risk. ISO 20022 is a message and communications format, nothing else. It is not a platform or new risk management methodology.

Another issue holding back new globally operating payment methods is biology. Plant and animals operate on circadian rhythms. Humans are not nocturnal. We need to sleep. Our day consists of 2/3 awake and 1/3 asleep. We built our lives and various pieces such as the economy around this fact. Hence, all of our processes and systems have evolved from a need to close out our day and go to sleep assured that the world is settled, at least until we wake up the next day. And countries/jurisdictions operate according to the same set of circadian rhythms. In turn with this subject matter, all of the current and planned payment solutions are built around this concept. And it is believed by experts around the globe that if we all communicate with the same message format (ISO 20022) then we will be able to operate internationally 7/24 and resolve the circadian issues in real-time payment delivery. I don’t agree. Message formats in themselves do not solve timing challenges or reduce risk. I might argue that this is yet another anchor mounted off the stern of the boat of progress.

So what is the list of electronic payment types? There are many different payment methods for retail and commercial customer use.

For retail exchange:

· Cash (beyond barter, as old as the ancient Chinese, Turks, Greeks and Romans)

· Cheques/Checks,

· Point-of-Sale Credit Card - Debit Card – Prepaid Card,

· e-mail transfers (Venmo, Zelle, Interac…) – 10+ years old

· Point-of-Sale Mobile (newest method Square/Apple/Google/Paypal/AliPay/WeChatPay/…),

· eCommerce (Paypal, aggregator gateways,

Note: the last two are just a “layered” interface to the above Card and Mobile methods, or hold balances in a 3rd-party FI Omnibus Account for On Us exchange only),

Plus specialty payment types for corporate/business/government such as:

· Corporate Bill Payment,

· Pre-Authorized Direct Debit (One-Time and Recurring, managed through ACH/Electronic Funds Transfer - EFT’s),

· Payroll (again, ACH/EFT), and

· Mass Payments (again, ACH/EFT’s),

Plus non-currency payments operated on pseudo-regulated private corporate systems including:

· Loyalty Point and

· Token Value Payment services (not large at this time).

Every one of these is a customer-facing front-end solution that processes payments at the clearing/authorization level only. The settlement of all of them eventually routes through to the same core clearing and settlement systems operated by payment associations or card network processors. Of course, clearing is linked to settlement, and adding more electronic payment clearing system types operating on different timelines increases the complexity of settlement. Settlement is the final balancing of these systems, which occurs in a scheduled batch (execution) environment (meaning that aggregated volumes from each of the above methods are aggregated over a period of time and processed en-masse).

Depending on the payment type, a payment is either pushed or pulled from a Payor’s account. A simple view, the processing sequences are designed to:

A. Confirm the transaction is properly authorized by the Payor, and

B. if not properly authorized then it is stopped and returned at some point prior to or after the funds have moved.

C. debit funds from the Payor’s bank account and Credit the same to the Payee’s bank account,

D. Settle any interbank net positions on a daily interval (close the accounting books for the day)

E. ensure that losses due to fraud or errors are minimized.

Adding to this, every independent payment type has the potential to be supported through multiple access channels including in-person branch, ATM, Desktop (via Internet), Mobile, Direct File remittance, and the dying voice/telephone. Each of these requires a unique and separate entry point for customers requiring separate authorization credentials for each and person and a hierarchy of security measures to control access and permissions (a virtual buffet for criminals). They also operate according to different timelines related to when they need to be available for use and end-of-day support. Incredibly complex and challenging.

This complexity has reached a point where terminology such as “payment friction” is now a measurable parameter and is used regularly by payment professionals in their everyday efforts to improve their customer experience.

So let’s outline some of the critical issues and challenges in completing any payment:

1. Did the Payor authorize this payment ?

2. Does the Payor have good funds at the time of payment ? Is pre-authorization available for all payments or just some ?

3. Does an FI have full visibility to all outbound and inbound payment transactions that have been processed or are expected to be processed for any account holder during a payment period (ex. one day) ?

4. Time-of-day: Are the two Financial Institution systems on each side of the transaction available (ex. Circadian issues including End-of-day, weekend or holiday) ?

5. Is there a future date defined for the payment ?

6. Are the sources and destinations of payments vulnerable to change (fraudulent activity)?

7. If there is a problem that requires investigation, is it simple to trace through and resolve ? Who is accountable ?

And then there are payment scenarios that the current low-value clearing and settlement systems cannot address within their core offering:

1. Time Sensitivity – pay at an exact time during the day.

2. Multiple Payor’s sharing a payment.

3. Multiple depositor’s sharing a payment.

4. Retail: Are there loyalty rewards associated with the payment ?

5. If shared per above items 2, 3, and 4 , how can you reverse/refund any specific portion independent of the other portions ?

6. And the biggest question in today’s just-in-time reality, can all of this be done immediately in real-time with a guarantee that funds are good and can in turn be immediately used by the Depositor Payee ?

(not without good credit as it turns out)

Of course, there are many other important contributors to all properly operating payment solutions, including:

1. Jurisdictional Regulatory oversight (Sanctions and AML/ATF – Anti-Money Laundering and Terrorist Financing, Privacy, Deposit Insurance, et. al.)

2. Fraud and theft – Note: the distribution and storage of customer personal financial information (PII) on many corporate ERP systems force monitoring and prevention over many different systems and access points.

3. Service Support – How to support all users and staff on the many systems in tracing and investigating individual payments.

4. Technology costs and upgrades ($ Billions are budgeted annually across the industry).

5. Market changes and the effects of technological disintermediation.

6. Many other stakeholders including Consumer Associations, Law Enforcement, Financial Control, Legal, Operations, Treasury, Audit, Legislation and other regulatory, et al.

We all read in the news about massive data breaches on a monthly basis, and it is a significant concern. Current payment systems, both high and low-value, rely on the distribution, use, and sharing of the payor/payee financial institution names, account numbers, account names and authorization credentials of payment by the Payor/Account Owner. Hackers illegally acquire PII from non-bank corporate servers and sell the information for fraudulent use. As a result, Personal Identifiable Information - PII is a principal data component included in all Privacy legislation.

A key area in payments is the invention and integration of fraud scanning tools. New and improved AI techniques are introduced regularly and the payback is marketed and measurable. Additionally, while many of the new AI tools are built for time-of-sale protection, there are numerous processes to address correction of fraud and theft after the fact. Protection is also governed by recourse timelines depending on the payment type that the customer must oversee and enforce with their Financial Institution. To assure orderly and respectful behaviour, societies have instituted regulating oversight institutions, industry associations, and consumer protection groups that work to define Laws and Voluntary Operating Rules. All of this is to assure that funds will be exchanged between Payor’s and Payees in a controlled and lawful manner. These organizations play an Ombudsmen role in assuring the protection of individuals when there are issues under dispute. Most are enshrined in legislation within the jurisdiction and in turn support commercial treaties between jurisdictions. All is great until there is a problem.

Problem. Payment investigations are costly. Particularly when they cross international borders. The multitude of low-value payment methods delivered through independent systems, each with separate processes and systems, creates delays in retrieving authorization and execution information. Every front-end system requires independent tools and staff training to trace who, when, and where authorizations were given, right through to the common back-end clearing and settlement systems. And reversals are also costly and challenging for the same reasons. Process impact assessments and costs are under constant review as to how to satisfy these requirements and at times different approaches are taken depending on the level of financial risk. Every bank manages these in a slightly different manner and all fall to the bottom line.

What is clear is that the current exchange and settlement methods and platforms have different authentication delays that albeit small, create opportunities for criminals to defraud the system. Because of this, expensive resources are deployed to oversee and correct problems after the fact. Be assured however that the banks protect their customers in virtually all cases. That is why we trust them and in turn need them. Societies cannot afford to have citizen’s watching their financial assets multiple times a day so we need to have a system of oversight. Without it, and without any physical location for recourse, we would have anarchy (again, “Brrrrrrrrrrrrrrrr”).

Over many decades the Financial Services industry has built risk management processes to reduce the time it takes to complete exchange authentications and provide immediate value to the depositor, without holding the payment amount from the depositor until settlement can occur. These risk management processes are spread throughout the bank and layer on top of one another. They ultimately benefit everyone with reduced costs. Very smart.

But the next evolution in payments is “real-time”. Real-time means that funds, once authorized, move bank-to-bank immediately without recourse. The funds are perfectly liquid and can then be moved again, immediately, without recourse.

The clever risk expertise bankers of today give us the impression that we have immediate liquid funds because we generally send and deposit payments without any challenges and unnoticeable holds. But that is for the credit worthy only as the risk management techniques discussed above provide this pseudo-real-time illusion.

True real-time is a different kettle of fish. It really meets the requirement of real-time and is ultimately expected to reduce the risk in payments towards zero. But make note that none of the above systems and risk management methods were originally designed to deliver on a requirement such as this. They were designed to support the existing methods and historical infrastructure.

True real-time introduces many challenges, and every stakeholder discussed above requires attention. Every issue must now be addressed in real-time, which again means immediately. And the current methods, now to be adopted for this requirement, have a lot of issues when you require all banks domestically and eventually internationally, to integrate. It is a lot of work. But consumers and governments don’t care.

The fact that China and India and others have payment services that provide real-time, no recourse payments using systems such as AliPay is something we must have in the west. Even if they are not governed by the same complex protections we require our banks to provide. Over the last 20 years there are have been many political and competitive pressures placed on the banking sector to provide real-time payments to consumers. In a faster moving world demanding Just-In-Time on everything, liquidity is tight, and businesses and individuals want to be paid immediately and be able to immediately use the funds. This is not available today.

Providing ‘instant or real-time value” to meet today’s expectations in growing commerce is not possible with today’s methods and platforms. Every jurisdiction across the globe has recognized this issue and have launched “Payment Modernization Programs” to replace these low-value clearing and settlement platforms. However, because of the complexities of their current systems, all of these initiatives have subdivided their solutions based on payment type and generally target POS and e-Commerce payments only. Most will maintain batch capabilities for mass corporate and government payments or modify their High-Value Transfer systems to provide solutions for this segment.

Real-Time solutions that are currently in development are designed around an open system approach allowing the injection of a payment on one end with routing and authentication information included. No change to the current methodologies hence the same risk items will remain, and the timeliness of the immediate payment requirement will add significant risk to the operators. Without experience, the risks are not fully understood so almost all of these initiatives are planning to require large, possibly 100%, collateral coverage for payments processed through these systems. The financial crisis of 2008 has taught us that 30-day liquidity is critical and the adoption of Basel III and Stress Testing has demanded it. Large amounts of collateral are very expensive and market sensitive requirements, particularly as volumes grow, and grow they will. Recovery following Covid-19 is dependent on growing Small businesses and the growing GIG Economy. They need liquidity and need it in real-time. Treasury leaders in Financial Institutions will only support if their retail and commercial business lines can support the costs. It’s Catch 22.

Let’s add onto the pile. In the current initiatives, there are no independently set real-time control parameters designed into the system that can be independently set by a participating FI, and concurrently react in real-time. Limits will be set and applied to participants on the system by an oversight/regulatory organization, and an end-of-day principle will be used to reconcile and re-balance the accounts of participants at the jurisdictions National/Federal Oversight Bank. Collateral is the protection buffer. Does anyone really believe that this methodology will address a 7/24 global environment, particularly as volumes transfer from batch to real-time execution ? Not without severe metering of payments from one platform to the other. FI’s will need to use transaction pricing to manage these risks so only the most credit worthy and liquid clients will be able to participate in the early stages. Bear witness the Fed in the U.S. who have launched their own Real-Time initiative to support small businesses in the fall of 2019.

But be assured that the experts around the world will need to change their approach if the volume of 7/24 real-time intraday payments is to grow. Particularly if more than retail payment types, which carry larger dollar amounts, are included. And what about non-currency payments operating on private corporate systems ? Customer loyalty incentives have become a key commercial requirement in acquiring/switching customers so every solution must consider the integration of same into their payment execution and refund processes.

So will any of the current Real-Time initiatives provide a path to global Nirvana ? Are the independent crypto-currency solutions running on technology platforms such as Blockchain headed towards the High Volume, Real-Time, Retail, “Camelot” ? Will increasingly protective governments give up their fiat currencies in favour of a global crypto ? Will everyday people feel comfortable with their wealth spread out on a private sector global crypto service, or just a portion ? How do currency holders investigate and get resolution for crypto problems that aren’t fully protected by legislation and regulation ?

Nothing is moving fast in the arrival of true real-time payments. And here’s another bit of information. Many experts in financial services have indicated that e-mail transfers have been the only truly innovative new electronic payment type introduced in the last 20 years. All the others are really just layers on top of current technologies and processes. The largest of these are just massive private ledgers, much like corporate Loyalty Point solutions, but offering individual On-Us exchanges between participants. All of these operate with reduced oversight of jurisdictional regulators and more consumer risk.

It appears to be impossible to understand and satisfy all stakeholders. Unless… you start from scratch and are patient enough to work through the issues understanding who and what is really important.

My opinion. ;)