How regulation is opening up a new era for payments systems in the UK
The UK’s complex regulatory environment is giving rise to a raft of payments innovation. It’s a landscape in which financial institutions and all other participants need to keep up or be left behind.
Otto Benz, Payments Technical Services Director, Global Payments, at Lloyds Bank, takes a look at what innovation means for financial institutions, corporates and consumers. He also talks to Matthew Hunt, Chief Operating Officer at Pay.UK, about what innovation means for financial institutions, corporates and consumers.
Otto Benz: Regulation driving innovation may seem like a contradiction in terms, but the focus of regulation has been shifting from being just about institutional soundness and customer protection to providing conditions conducive to supporting, facilitating and even driving innovation.
This change of focus is about enabling good outcomes for all end users on the basis that an engaged and active customer can choose between suppliers; and that there will be rivalry between competitive providers of services that results in better value, higher quality and more innovative products.
Why does financial regulation exist?
To take a step back, why do we have regulations and regulators at all? Firstly, it protects the wider financial system. Also, in a complex marketplace, many customers could suffer detriment because of the unequal balance of knowledge.
So we have two strands of regulatory activity:
- Prudential regulation, which is largely the domain of the Prudential Regulation Authority (PRA). Payment systems fall under this remit of prudential regulation.
- Conduct regulation, which is largely the domain of the Financial Conduct Authority (FCA).
We now also have the Payment Systems Regulator (PSR), whose goals are to develop and protect competitive markets, as well as create conditions conducive to innovation. Along with its regulatory activities, it has carried out detailed reviews examining key aspects of payment systems markets.
There are five initiatives where we can see regulation driving the innovation agenda.
"29 firms have gone through the FCA sandbox process, they’re on their fourth cohort of firms and are now working with 11 regulators in Europe, the US and Asia."
Otto Benz, Payments Technical Services Director, Global Payments, at Lloyds Bank
1. The FCA ‘sandbox’
Established by the FCA in 2015, this is a safe environment where fintechs and other challenger institutions can test new products and services. The idea is that they can put in place business models, new delivery mechanisms and test their products in a regulatory protective framework.
By the end of 2018, the FCA had 29 firms go through the process. They are already on their fourth cohort of firms and are now working with 11 other regulators in Europe, the US and Asia. You will see firms emerge from this process with new, innovative ideas who start to compete with established players.
2. Cheque imaging
Incorporated into the Small Business, Enterprise and Employment Act 2015, cheque imaging allows UK banks and building societies to scan their cheques and pay them in as images. Cheque imaging speeds up the time it takes to clear a cheque. Whilst it took six working days via the previous system, processing images instead of pieces of paper means that customers get access to their funds by the end of the next weekday after paying a cheque in.
While cheque volumes are decreasing, they are still significant; in 2018, we wrote 346 million cheques in the UK with a value of £442 billion. We are now seeing much faster clearing, improved cash flow and the certainty of funds that were promised.
3. Open Banking and PSD2
The Payment Services Directive, passed by the European Parliament in 2015, acknowledged the arrival of fintechs and other challenger organisations across Europe.
Its ambition is to create a level playing field for payments services, while also ensuring customer security and enhanced protection. Effectively, a customer can provide permission for a regulated third party to access their bank accounts and provide new services. It also delivers a new form of secure customer authentication.
Also driving Open Banking in the UK is the Competition and Markets Authority (CMA). Its competition review of the market has mandated the nine largest banks in the UK to create an API framework to require them to share data and to allow initiation of payments.
The combined result is that the UK has put in place a common set of standards, unlike elsewhere in Europe, and a working framework of infrastructure that supports this API environment and ecosystem. There are already firms making use of these API frameworks and, although it will take time, we’ll see significant changes as a result.
4. The Bank of England Real-Time Gross Settlement (RTGS) programme
This is the system that underpins CHAPS. Launched as a result of the outage in 2014, it is a series of initiatives undertaken by the Bank of England to ensure enhanced resilience in its provision of services.
One of the goals of the infrastructure redevelopment is the move to ISO 20022 messaging, which enhances the messaging format, offering additional functionality that allows for longer references, thus providing more information than any other type of transaction. Along with this, ISO 20022 messaging allows for new services, which may for example include enhanced reconciliation, along with others to be defined over time.
The real innovation is the ability of companies and service providers to make use of the enhanced data the new message format provides. The Bank of England has also taken over the management of CHAPS and has expanded direct access. These things together play to the theme of enhanced access, enhanced competition, new facilities and payments provision, and the new message formats that go with them.
5. The Payments Systems Regulator
Regulatory innovation driven by the PSR includes setting up the Payments Strategy Forum (PSF). The Forum’s final report last year involved a number of initiatives, one of which is the consolidation of UK payments schemes into Pay.UK.
There is also the announcement of the New Payments Architecture (NPA), the proposal to redevelop the UK retail payments infrastructure, alongside and to reinforce what the Bank of England will be doing with RTGS.
Then there are overlay services:
- Confirmation of Payee will allow consumers to verify who they are actually making a payment to.
Request to Pay is an alternative collection mechanism to allow consumers to make a choice on the payment of a bill alongside more traditional mechanisms like direct debit.
All of this shows that the UK regulatory environment has radically changed in the last five to 10 years, providing companies with the platform to take advantage of these regulatory changes to build innovative propositions, bring them to market and compete with the established and existing providers.
Pay.UK is part of this new environment. I asked Matthew Hunt, the organisation’s Chief Operating Officer, about the development of the new payments architecture and how it’s going to transform the environment for end users.
Otto: Matthew, what does the creation of Pay.UK mean for users of the system?
Matthew: Pay.UK is the entity into which the previous retail payment schemes – Bacs, Faster Payments, Cheque and Credit – have been merged. Our vision is to enable a vibrant UK economy by providing a robust, resilient, open and competitive payment system.
The consolidation of the retail payment schemes under Pay.UK will bring substantial benefits to users of the system. We expect to see new products enabled by competition and innovation that better serve end user interests. The first of these, where Pay.UK has played a leading role, are Confirmation of Payee and Request to Pay.
There’s also the issue of costs. Many individuals bank either cheaply or for free and make payments for free. Larger businesses bank and make payments cheaply too. But there’s a group in the middle of medium-sized corporates and small business for whom banking and payments are quite expensive. By facilitating a more competitive, efficient market we hope to enable new providers to come in and drive competition in a way that makes access to banking and payment services more economic across all user groups.
Otto: So what progress is being made on Confirmation of Payee and Request to Pay and how will they affect end users?
Matthew: We have provided the standards for Confirmation of Payee to enable the banks to begin planning their implementation.
When it’s built, users making payments via an app or Faster Payments will type in the account number and the sort code as they do now, plus the name of the person receiving the payment. The receivers’ bank will send one of three messages to let the person sending the payment know whether they’ve got a match or not:
- A green tick when everything matches.
- When there’s no match, but the system identifies the name as sufficiently close and will provide the actual name of the bank account holder to the sender to enable them to check further.
- There’s no match at all, and the sender is advised to check their data and submit again.
This, along with, the Contingent Reimbursement Model (CRM), provides protection from certain types of fraud, such as malicious redirection scams. Users will have protection if they can demonstrate that they’ve taken adequate steps to check where they’re sending the money; getting the green tick under Confirmation of Payee will be one of those adequate steps.
Otto: And how will Request to Pay work?
Matthew: Pay.UK is also providing standards for Request to Pay, which banks and other players will hopefully start building during 2019.
"The UK has put in place a common set of standards – unlike elsewhere in Europe – and a working framework of infrastructure that supports the API environment and ecosystem."
Otto Benz, Payments Technical Services Director, Global Payments, at Lloyds Bank
Request to Pay has been trumpeted as being of particular benefit to those on low incomes and zero hours contracts as it enables them to manage their payment schedules more carefully. Customers may also use Request to Pay if they are in a new relationship with a direct debit provider and they don’t want to give completely unhindered access to their bank account to them.
For payment collectors, Request to Pay provides a new and potentially more efficient way to interact with customers when negotiating a new payments schedule. Currently, billers might have to staff and provide call centre facilities; but Request to Pay will enable them to agree payment schedules with their customers via the payment system. This offers the biller and the customer more choice and is hopefully more efficient for the biller.
Otto: How will the New Payments Architecture transform UK payments?
Matthew: I think the Payment Strategy Forum saw the New Payments Architecture as a way to increase access to new providers of payments and increase competition, reduce barriers to entry and offer enhancements such as richer data via ISO 20022.
Our job in the NPA is to maintain robustness and resilience, whilst supporting a wider ecosystem where banks, challenger banks, fintechs and non-banks are able to plug into the payments infrastructure and offer different services with a faster time to market. At the same time, they can still offer payment products underpinned by the reliable central bank money settlement we provide.
Two terms are used to describe the approaches Pay.UK will consider when developing the NPA:
- Competition ‘for the market’ means something provided by a single provider on behalf of the whole market. Pay.UK’s provision of the clearing and settlement layer of the architecture for the market. We will procure that via a competitive process.
- Competition ‘in the market’ describes an environment where multiple firms compete to provide services to their end customers.
"For payment collectors, Request to Pay provides a new and potentially more efficient way to interact with customers."
Matthew Hunt, Chief Operating Officer at Pay.UK
Pay.UK offers certain fundamental products on a ‘for the market’ basis by competitively sourcing them on behalf of all the industry players.
There are three key reasons why we should source certain elements on a ‘for the market’ basis.
Firstly, we need to be certain of the robustness and resilience of the payment system in our role as guardians of it. This will mean that some elements (e.g. core clearing and settlement) can only be provided on a ‘for the market’ basis.
Secondly, we need to be confident of being able to maintain good end user outcomes; it’s really important that predictable, consistent functionality is maintained for both customers and billers. For the first few years at least, the way we can be confident of these outcomes is if we define a product such as Direct Debit and procure it on a ‘for the market’ basis.
Thirdly, there may be a need for Pay.UK to procure a ‘for the market’ proposition where the market is not yet ready or able to support competing propositions. Over time, if the market dynamics change and competition ‘in the market’ becomes possible, Pay.UK would withdraw and allow competition to take over.
Otto: So there’s a focus on competition, innovation, new access and new entrants. What steps are you taking to make sure the new architecture is secure, robust and resilient?
Matthew: Robustness and resilience are our primary objectives and need to be the platform on which future innovation is built – an innovative payment system is no good if it’s falling over.
The Bank of England has recently published a discussion paper on operational resilience in payment systems, which we responded to. We think a key issue here is increasing our ability to deal with IT issues when they arise, as well as minimising the likelihood in the first place. Unfortunately, Faster Payments had its first outage in 10 years in July 2018. The industry did a good job at minimising the impact on end users, and we learned a lot from that incident. And at a time when we are designing the NPA, this is a really good opportunity to factor in those lessons learnt.
We are also thinking hard about the right way to maintain financial stability and end user confidence in the ecosystem when potentially a wider group of correspondents are plugging into the architecture. As the relevant authority, Pay.UK will continue to set the rules and standards to which all players must adhere if they participate in the retail payments space. Ensuring compliance with these rules will be another way we ensure the robustness and resilience of the payments infrastructure.
About the authors
Payments Technical Services Director, Global Payments, at Lloyds Bank
Chief Operating Officer at Pay.UK
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