Future of Finance Series, episode 1: Paving the road for a diversity of payment options

The Bank of England’s Future of Finance report paints a picture of a future that offers a diversity of payment options that are “efficient, fast, secure, low-cost and cross-border”. It also indicates that all new payment providers will need appropriate regulatory oversight. Here, we explore some key insights the Bank has revealed as to its path to facilitating that outcome. 

This is the first instalment in our Future of Finance Series, which looks at Huw van Steenis’ Future of Finance Report and the Bank’s response to it.

New market entrants

The FoF report identifies that business models are changing - and increasingly fintechs and big-techs are joining banks in the payments space. The Bank of England (the “Bank”) is welcoming the innovation and competition in this market, and believes that a range of payment options can also contribute to financial stability. However, it has made very clear that allowing for new entrants and payment methods, and an unbundling of the value chain, must not leave any gaps in regulatory oversight.

Wider access to the Bank’s balance sheet

A new commitment to consult on broadening access

Given the shifting market, the FoF report recommends that the Bank consider how alternative payment providers such as fin-techs and big techs might access the Bank’s infrastructure, including its balance sheet and payment systems. In response, the Bank has announced its plans to consult on the appropriate level of access in 2020.

New opportunities for alternative payment providers

This is good news for new entrants. Holding an interest-bearing account with the Bank is a privilege that has historically been reserved for “key links in the economy”, which currently extends to banks, certain broker-dealers and CCPs. Access to such an account would allow a payment provider to benefit from the full Bank rate on overnight deposits and avoid the credit risk involved in depositing money with an ordinary bank. Moreover, it would allow it to compete on a more level playing field with these incumbent banks.

The Bank already opened up its Real-time Gross Settlement (RTGS) system to non-bank payment service providers last year – and six non-banks have so far gained membership. Holding an RTGS settlement account with the Bank is a prerequisite to becoming a direct member of any payment system in the UK. Direct membership allows these institutions to settle transactions directly in central bank money rather than having to go via a bank. Again, this allows new businesses to compete directly with the incumbents. 

With great power comes great responsibility

As will all good things, access to the Bank’s infrastructure will inevitably come at a cost. The FoF report acknowledges that “an appropriate package of obligations” would need to accompany these new rights. These obligations may include new capital and reporting requirements, for example. And in his Mansion House speech, Mark Carney made clear that the Bank is looking at strengthening supervision for those applying for settlement accounts – not just overnight accounts. 

Regulatory supervision of this nature is unlikely to suit the model or culture of every tech company, and prospective applicants would need to consider carefully whether they would be willing and able to meet the necessary requirements in exchange for this enhanced access to the Bank’s infrastructure. 

Ongoing focus on improving cross-border payments

Room for improvement

The FoF report identifies that cross border payments are an area where “frictions and inefficiencies continue to exist” and points to research showing payments made cross border are, on average, ten times more costly than domestic ones. It attributes this to the need to interact with multiple different infrastructures through the correspondent banking system in order to process such payments, and to the time spent on manual reconciliation exercises.

An ongoing area of focus

The Bank is already focusing on improving the efficiency of cross border payments. It has been reconfiguring RTGS to lower the costs of cross-border payments, harmonising data standards and promoting KYC utilities, for example. It plans to step up its efforts though. And it has committed to help empower private innovations in cross-border finance by partnering with other central banks to explore how high-value payments systems could be used to deliver instant settlement in different currencies. 

A measured approach to crypto

Some cryptocurrencies “simply won’t cut the mustard”

The report offers some cautionary words around cryptocurrencies, commenting that “cryptoassets that are not backed by currency are an unreliable store of value, inefficient medium of exchange and simply won’t cut the mustard”. And, in relation to digital coins that are backed by fiat currency or a basket of assets, it notes that “so far, the stability of such coins is unproven, and subject to considerable scrutiny”. It also adds that it does not see a compelling case for a central bank digital currency at this time, given numerous uncertainties. 

It does however point to potential benefits of digital currencies and encourage the Bank to remain at the forefront of research on these topics. And we already know the Bank is upgrading RTGS in a way that is interoperable with private payment systems that use distributed ledger technology. 

“An open mind but not an open door” for Libra

The recently unveiled plans for Libra (a digital currency that is intended to facilitate retail payments within the Facebook ecosystem) have caught the attention of the financial markets and policy makers. In his speech, the Governor acknowledged that Libra could “substantially improve financial inclusion and dramatically lower the costs of domestic and cross border payments”. But again, he emphasised that to do so it would have to meet the highest standards of prudential regulation and consumer protection in advance of any launch. 

The benefits of central bank backed coins for wholesale markets

The Governor also spoke to the efficiencies that central bank backed coins, like the Utility Settlement Coin, can bring for wholesale markets – “unlocking billions of pounds in capital and liquidity that can be put to more productive uses” – and their potential to overhaul how those existing markets operate. 

Removing barriers to direct-to-bank payments

Potential for growth in the UK

The FoF report identifies that some countries (such as the Netherlands, Sweden and Denmark) have seen considerable success from models that facilitate payments directly between bank accounts. These payments avoid the card rails and thus card fees. The UK market, on the other hand, has not yet experienced significant growth in this area and is still dominated by cards.

Ongoing efforts to remove barriers

The implementation of PSD2 in the UK has already gone some way to facilitating this type of business model, by allowing payment initiation service providers direct access to consumers’ bank accounts. But there are weaknesses in our payments infrastructure than continue to act as a barrier (for example, the lack of reliable point of sale infrastructure). The Bank has said it will continue to reform its hard and soft infrastructure with the aim of removing barriers to direct-to-bank payments.

Prioritising protection of cash

The FoF report underlines that a key priority for the Bank is ensuring that the decline in cash usage leaves no-one behind. Policy makers “need to ensure that cash distribution across the country is maintained even if cash is used far less to ensure the inclusion of those who rely on cash”. The Bank is already working with stakeholders and the Government to help safeguard cash for those who need it, and has committed to do more.

A need for next generation payments regulation

A move towards a more diverse and complex system requires appropriate regulation – not least to reflect the appropriate prudential standards for new providers referred to above. The FoF report calls for “next generation payments regulation” to reflect the shifting risks. It recommends that the Bank prompt the Treasury to evaluate:

• the appropriateness of the regulatory framework for the risks posed by different payment activities, including tiering of firms;
• how to ensure effective supervision of the overall payments value chain;
• the role of data-sharing between platforms and payment companies; and
• ways to reduce fragmentation and complex regulation in the UK.

The Bank has said it will help drive this review forward and will also support the Payments Strategy Review just launched by the Treasury.

Next up in our Future of Finance Series

In the next instalment of our Future of Finance Series we will look at the Bank’s message on cloud technologies and what this means for financial services. Stay tuned by signing up to our FintechLinks blog.