Call to Action – Submit Response to Fed

1 Dec 2013

As most of you know, the Federal Reserve published a paper entitled Payment System Improvement and opened it for comments Responses are due 13 days from Today. My response can be viewed here.

After witnessing the mess that Regulators and Central Banks can create (FFIEC 2 Factor Auth, UK Faster Payments, SEPA, …), you should take time to submit something for your organizations.  We all need a flexible regulatory environment which provides a fertile field for Innovation and technology evolution (of payments and banking).  How should the US payment system evolve? What is Broken? What is working? Who should lead (Government or Industry)? This is the context behind the survey which covers: tokens, real time payments, fraud systems, mobile payments, and approach.

Summary View

  • The Payment System works today for 95% of needs. Let’s NOT force everything to be real time. Just as we have Rail and Ship transport today… some consumers still demand next day air delivery (a business need that consumers will pay extra for).
  • The problem with the payment system is NOT speed, it is control. The American Banker article How Big Banks Killed a Plan to Speed Up Money Transfers speaks to the uneven playing field faced by small banks, MSBs and other service providers.  Why are big banks blocking this real time effort? Because the top 4 are formulating plans to restrict use of bank owned settlement infrastructure and create new semi-open REAL TIME settlement networks (ie ClearxChange) which will only work for the largest institutions (see New ACH Payment System for background on this initiative). The second paragraph of the Fed’s paper

    Industry adoption of new payment services and technology in this country has been driven mostly by market forces rather than government direction

    is incorrect. Industry adoption of CORE payment services is driven COMPLETELY by the top 5 banks. Top 5 Banks created and hold veto power over: Visa, MA, TCH, NACHA, … and most industry infrastructure.

  • There are only 2 regulatory changes I would request: #1 mandate transparency in rule making for both government controlled (FedWire) and private Payment Entities. No more anonymous voting on common infrastructure, the NACHA and TCH voting procedures are a mess.  The WSJ article above demonstrates the obfuscation.. and the subsequent success of this blog. #2 Allow non banks to assume risk and decrease compliance requirements (for banks) surrounding this service. (more on that later)
  • Over 40% of US consumers are no longer well suited for traditional banks and are migrating to new products (pre-paid/GPR cards) that are offered by new intermediaries. Payments are not only critical to the top of the pyramid but to the bottom. Non banks and the unbanked must be able to participate in the payment system. Again the issue is NOT real time payments, but ACCESS (control).
  • The core technical challenges in Payments are #1 Consumer Authentication, and #2 Risk Management. Non banks are best positioned to Authenticate a Consumer, and may also be best suited to manage risk (as Paypal does in Card Not Present). Banks bear the weight of KYC/AML requirements today and therefore look to control the entire process. If we want consumer centered investment, Non Banks must be able to participate, and bear risk. If the central bank commits to technology of yesterday  we will not be able to leverage new capabilities and consumer experiences will be highly fragmented. (ex a new Apple device which would enable real time, irrefutable transaction signing).
  • The core business challenges in payments today are around value. Banks do not want to invest in networks that benefit merchants (ie Debit, DDA) and Merchants don’t want to invest in networks that benefit banks (ie Credit, Contactless). Payments are just the last (easiest) phase of a long Commerce process. No one should force banks to invest in merchant friendly mechanisms, but banks should not be in a position to BLOCK success here.
  • There will be NO INVESTMENT, if there is NO RISK. Payment profitability is driven by risk management (including fraud, authentication, credit risk, …).  We must allow entities that can bear risk to participate and invest.
  • Network efficiencies MUST IMPROVE (see Thomas Phillippon below). The GOAL of payments should be to provide LEAST COST ROUTING to support consumer preferences of where and how they want to pay and authenicate (ex Apple, Google, …). Expanding an existing utility (ie Fed Wire) may provide a faster path to new capability, and develop a higher quality of service, as competition develops among private networks (analogy is Darpanet ).

MCI Interconnect in Financial Services?

The metaphor for change in the payment system may be the 80s MCI interconnect battle (see Wikipedia), combined with a new regulatory regime which would allow non-bank participation in an OPEN settlement network (Connection + Settlement). See my blog How to Deregulate Payments like Telecom. To understand the current state of industry quantitatively,  NYU’s Thomas Philippon published jaw dropping research detailing how Payments and Banking are one of the few network businesses in the HISTORY OF MAN to grow less efficient (rail, telecom, energy, …). Obviously Regulatory Capture is an issue as regulators protect Bank margins and discourage rate competition. The fundemantal flaw to the Fed survey is an underlying assumption that change will be made to existing utilities and existing players. I’d rather take the MCI approach where the government provides for open interconnect and allows other parties to assume risk. This is why Telecom, Airlines, Stock Exchanges, and the Internet work today. There will be no change, or new investment, unless Regulatory Capture and Big bank control over common utilities is broken.

In another example, from my blog Tokens – Merchant Options obviously there is a need to tokenize a direct draft ACH/DDA to hide the consumer’s account number. This is what the TCH upick system (bespoke TCH token system) was developed around. However banks have NO incentive to deliver innovation around DDA tokens as it would decrease risk and increase consumer adoption in a model where they can not charge ANY interchange. Thus innovation is directed toward revenue (a logical imperative), and conversely merchant avoidance is based upon cost/value (hence no adoption of card POS tokens).

The EU’s ELMI model is perhaps the best developed regulatory standard. Perhaps the US pursues something similar which would serve as a federally chartered MSB. Or provide for existing MSBs to operate (and assume risk) on a settlement network (like Fed wire).  This is my core recommendation, rather than taking a 5 year approach, the Fed should create an open settlement service, in which private utilities (ACH, Visa, …) must compete with. Australia (EFTPOS) and Canada (Interac) have both successfully consolidated debit infrastructure as a result of regulatory mandates (and these remain bank owned networks). Today Fedwire competes with TCH in settling payments, but garners much less than 1% of settment (see FedWire Volumes).

The Fed should consider consumer requirements and preferences, after all it is the consumer’s money. Similar to the MCI telecom case, regulators should consider the minimum consumer servicing requirements. If a consumer wants to pay through an intermediary (like PayPal, Amazon, Google, MCX, … ), or have money stored with an intermediary, or want to remain anonymous to the merchant in a transaction, they should be able to do so. As the Visa model evolves, Consumers should be able to INITIATE the payment request with the Bank (as opposed to the Visa/MA model of merchant requesting payment based upon consumer credentials).

Today, ODFIs are responsible for all risk (in ACH and Card Present). The Regulatory burden they face is substantial (Fed, OCC, CPFB, …etc.).  There are very big plans by the banks to gain tighter control over the payment network (see Tokens and Consumer Authentication).  Fundamentally, if we want change, we must improve transparency and allow risk to be assumed by non banks (and consumers).  Consumers should have the choice to take the slow railroad (with guaranteed delivery) or an instant transfer that cannot be reversed.

The FED should be very mindful that their direction does not just impact Innovation at the top end of the consumer pyramid: over 40% of US consumers are unprofitable to US Banks (see Prepaid – Future of Banking?). The Amex/WMT Bluebird product is proving to be an attractive alternative “banking lite” product with ability to direct deposit. The story of MPESA in Kenya may be useful here, as a non-bank was granted an exception which enabled the service to grow from 0 to 10% of the GDP in 3 yrs. Regulators and the Central bank do NOT look favorably on this development, as 10% of the GDP flows out of M1 into a single non-interest bearing settlement account which cannot be leveraged by banks to offset loans (ie liquidity ratio). But consumers love the service…

Key Topics which I believe need to be addressed:

#1 Bank Ownership and Control of the Payment Rails

  • Cost Transparency/Reporting
  • Speed Transparency/Reporting
  • Transparency of Rule Making and Voting in Infrastructure
  • Non Bank Ability to Connect
  • Non Bank Ability to Take Risk
  • Non Bank Participation in Settlement (ex Federally chartered MSB, or non-bank access to FedWire)
  • Consumer Authentication Standards, and Ability for non-banks to assume role (see KYC)
  • Common Reporting/Alert Interface in Transaction Origination and Settlement

#2 Issuance and Value Storage (from How to Deregulate Payments like Telecom)

We need to look no further than BitCoin to see the need for new regulations surrounding issuance. Transfer of funds between entities is covered above, and my view is that non-bank participants should be licensed and agree to abide by current money transfer  regs (ie. Fincen/AML, ..). Issuance of “credentials” and storage of funds is another matter. Long term storage of funds is a banking function, and should be regulated, settlement funds face state escheatment issues (but largely unregulated unless interest is paid), while storage of “Value” is completely unregulated (ie Coupons – a form of legal tender, Pre paid offers, bitcoins)?

From above, if we allow non-banks to participate in real time funds transfer, third parties (ie Sofort) would act as agents (on behalf of consumer, merchant or bank) to direct the funds and assume risk on behalf of consumer. If a good/service is purchased immediately (commerce) then there is no regulation, however if the value is “held” for future use it is generally regulated (hence MSB, eGold, bitcoin issues). Thus the rules under which third party senders operate (as agents), are different from the entities at the end of the transactions (banks, merchants, consumers). See ACH Origination Risk.

As in the MPESA example above, there is an obvious CONSUMER need for issuance to more closely resemble cash in its ease of exchange, verification, anonymity and storage.

Our current need is for simplified laws surrounding account under a given value amount (say $2000). Providers of service should be lightly regulated through self reporting, “transparency”, and the need to keep settlement funds with the Fed. In this proposed model, a bitcoin exchange must ensure that no single individual has processed more than the threshold in a given time period. Hence the need for KYC of exchange participants (when converting to cash).

Summary – new HUB vs evolving existing networks

The current ACH system will never go away (related blog). There were $33.91 TRILLION moved over the network in 2011, compared to total debit and credit volume of around $4.5 Trillion. What path should regulators take?

#1 Improve ACH (primarily speed and fraud management). The highest priority will be around third party senders (TPS), the lowest priority will be regular customer directed debits and payments to billers.

Third party senders (TPS) are a subclass of Third Party Service Providers (TPSP) which originate ACH transactions based on a direct consumer relationship.  Alternatively TPSP are also known as “processors” whose customers are banks (primarily) and have no direct consumer relationship. Banks are not happy with the “free riders” on their network (see  blog). Most bankers view companies like PayPal and Xoom as riding on their rails for free. One of their biggest issues is that they do not have visibility into the actual beneficiary as the settlement account hides where the payment is going to. This impacts their ability to perform risk management and authorization. Take these issues together with the increased regulatory focus on AML and we have a fertile environment for change (HSBC’s See Deferred Prosecution Agreement, and business overview of HSBC’s issues from Reuters). Note that AML concerns are much more relevant to International ACH Transactions (IAT). This blog is not focused on IAT.Token

Banks must therefore architect a solution to evolve ACH while the ship is moving. This is a much better approach than that taken by the UK of mandating faster payments… (one bank was losing 30M GBP a WEEK from fraud when launched). The consensus approach seems to be one surrounding tokens and directory (my blog from last year Directory Battle Phase 1).

#2 Build a new competing network (around Fedwire) which would allow for non-banks to assume risk


Sorry for abrupt end.. I’m sounding repetitive.. .so I’m stopping

“Real Time” Funds Transfer in the US

I’ve had quite a few questions from start ups on this subject, so I thought I would address here. In the past few months we have seen press from Obopay on Star/NYCE integration that would allow for “instant” transfers. Only FedWire offers real time transfers between all financial institutions. All other solutions have sporadic coverage unless balances are held within the same institution (bank, paypal, … ).

8 Feb 2011

I’ve had quite a few questions from start ups on this subject, so I thought I would address here. In the past few months we have seen press from Obopay on Star/NYCE integration that would allow for “instant” transfers, yesterday there was a press release from Cashedge/NYCE on the same subject. In my previous blog on Visa Money Transfers I discussed the top 2 fallacies: Instant and Mandatory. These same issues plague NYCE’s and Star’s PIN Debit “credit push”.

For the non-bankers, there are 5 basic payment networks that surround a typical US DDA account:

  1. PIN Debit/ATM (Interlink, Pulse, Star, NYCE)
  2. Signature Debit
  3. ACH (example The Clearing House, Jamie Dimon Chairman)
  4. FedWire (the US RTGS system run by the Fed)
  5. SVPCo (Check Images)
  6. Optional (ex. SWIFT, Western Union, …)

For further information see the FFIEC’s Examination Guide on Retail Payment Systems.

From a global perspective, we are quite a few years behind the UK and most of EMEA. While consumers in the UK can expect that 98% of domestic payments to clear in “real time”, most ACH “payments” in the US clear in the 3-5 day horizon. This blog is focused on “instant” payments. Important to note that the definition of “instant” is relative to both bank and consumer. For example, each bank has its own policy on funds availability and posting (vs clearing). A consumer could see funds posted to their account, but the funds may not be available for withdrawal. Other banks choose to show the consumers available funds to avoid confusion.

FedWire is a Real Time Gross Settlement (RTGS) system run by the federal reserve. Each bank in the US maintains funds with the federal reserve, and FedWire performs real time exchange of funds between member banks. Consumers and Commercial Businesses know of this service as a “wire”, and it is the only real time payment network in the US with universal adoption. FedWire Fees (~ $.52) are paid by the sending bank.

PIN Debit

The other “real time” payments systems (surrounding a US consumer DDA) are PIN Debit and Signature Debit. PIN Debit Networks evolved from ATMs, connecting ATM nodes to bank run authorization systems. Bank Authorization processes for PIN Debit/ATM systems are rather straight forward: validate the PIN  and funds available (I emphasize this authorization process as it is key to understanding why a “credit” is difficult to process on this debit system). PIN Debit fees are typically paid by the merchant and average around 85bps + $0.10. For ATM use, banks control fees and can assess surcharge for use of bank or foreign ATMs.

ATM Networks grew as groups of banks banded together to monetize ATM infrastructure, and further expand network into the retail POS. This expansion led to further change in structure, from bank ownership to independence. The driver of any independent network is to add volume, nodes and services. ATM Networks evolved into PIN Debit Networks, with Visa’s 1987 contract to operate Interlink  serving as a key milestone. Today, Pulse is owned by Discover, Star by First Data, Interlink by Visa (these 3 make up over 83% of PIN Debit Volume).

PIN debit networks have been working to fill the real time “hole” in DDA payment services for many years. Star’s Expedited Transfer, NYCE’s A2A Money Transfer , Visa’s VMT all attempt to EXTEND their respective PIN Debit networks to handle credit transactions. In EVERY CASE, the networks must sell their members banks and get them to extend a PIN based network (which processed only debits in a simplified authorization process), into a funds transfer service. Who owns fraud? Compliance? Reg E burdens? Consumer Support? Returns? Reporting? Integration into online banking? Statements? .. yep the banks.. Oh and by the way.. the other “benefit” to a bank is that once you implement it you can forget about those expensive wire fees. The result of their efforts is what you would expect… VERY poor adoption.

Today, PIN debit networks are looking at a very bleak future. Signature and PIN debit rates will be moving to a flat fee of $0.21 as a result of the recent Dodd-Frank Act (pending completion of the comment period). As a result, my guess is that we will likely see consolidation and bank ownership of shared PIN network infrastructure as with any commodity payment service.

Signature Debit

Signature Debit varies from PIN Debit in that it evolved from Credit Card (as opposed to ATM). Visa was and has always been the leader in signature debit penetration, a look back at this 2003 article provides much insight into the history here. Most US consumers today don’t understand why their debit card has both a PIN and signature feature… many books could be written on this subject alone… but oddly enough consumers prefer PIN (see Pulse Federal Res Presentation 10/10).

In the signature debit model, transaction authorization is much more complex, with most banks leveraging either network shared infrastructure (example Visa DPS), or their credit card systems. The complexity arises as the lack of PIN requires the banks to risk score transactions in a manner akin to credit card (absent the credit risk). There are limited facilities for a credit transaction within most Signature Debit systems, and most relate to a merchant credit relating to a previous transaction (ex. Overcharge, returned merchandise). DPS, Mastercard IPS, and most other platforms perform usually perform a daily net settlement with member banks (multiple settlement files are sent throughout the day.. but netted just once) .  Just as with PIN Debit, Signature Debit is also designed as a DEBIT ONLY system…

In VMT, Visa is attempting to enhance signature debit network into a quasi RTGS transfer service by leveraging its DPS hosting and authorization role. The QUASI is very important… as DPS, Interlink or any of the debit systems are “real time” ONLY in the instruction, NOT the Settlement.  To suggest that any of these services are an actual RTGS system is a significant stretch of the imagination and thoughtful invention. A payment system cannot be faster than its underlying settlement system.  The PIN and Signature Debit Networks DO NOT SETTLE, but rather depend on existing bank settlement processes (which are daily batch runs). The “message” to post or credit a transaction to the customer can be “instant” but the funds will not clear into the customers account until settlement occurs (dependent upon each bank’s policy).

What does this all mean for real time transfers in the US?

Only FedWire offers real time transfers between all financial institutions. All other solutions have sporadic coverage unless balances are held within the same institution (bank, paypal, … ).

How should you view NYCE, STAR, Visa “credit” Capabilities?

It works at some banks, with many provisions. I estimate that combined coverage of NYCE, Star and VMT “credit” covers less than 5% of all US deposit accounts. As you can see from WSJ graphic below, the top 5 banks account for 80%% of debit volume…. given that these banks have not adopted the credit services (in debit), there is little likelihood of success.

It is likely that independent PIN debit networks will go the way of Canada’s Interac… a bank owned service.

Messages for banks

Keep bank control of transfer facilities.. new services that give consumers real time transfers compete with wire, increase fraud exposure and enable rate hoppers… Why role this out today when you will likely get it from a bank owned network in 2-3 years.. ?