the journal of financial transformation #12

journal 12/2

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12

the journaloffinancialtransformation

Emerging models

Transition

Future

Payments

Recipient of the APEX Awards for Publication Excellence 2002-2004

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Editor

Shahin Shojai,DirectorofStrategicResearch,Capco

Advisory Editors

Predrag Dizdarevic,Partner,Capco

Bill Irving,President,Capco

John Owen,Partner,Capco

Editorial BoardFranklin Allen,NipponLifeProfessorofFinance,TheWhartonSchool,UniversityofPennsylvaniaJoe Anastasio,CEO,CrossBorderExchange,andPartner,CapcoPhilippe d’Arvisenet,GroupChiefEconomist,BNPParibasJacques Attali,Chairman,PlaNetFinanceRudi Bogni,FormerChiefExecutiveOfficer,UBSPrivateBankingBruno Bonati,MemberoftheExecutiveBoardandDivisionHeadTechnology&Operations,CreditSuisseFinancialServicesDavid Clark,NEDontheboardoffinancialinstitutionsandaformersenioradvisortotheFSAGéry Daeninck,formerCEO,RobecoDouglas W. Diamond,MertonH.MillerDistinguishedServiceProfessorofFinance,GraduateSchoolofBusiness,UniversityofChicagoElroy Dimson,ProfessorofFinance,LondonBusinessSchoolNicholas Economides,ProfessorofEconomics,LeonardN.SternSchoolofBusiness,NewYorkUniversityMichael Enthoven,ChiefExecutiveOfficer,NIBCapitalBankN.V.José Luis Escrivá,GroupChiefEconomist,GrupoBBVAGeorge Feiger,ExecutiveVicePresidentandHeadofWealthManagement,ZionsBancorporationGregorio de Felice,GroupChiefEconomist,BancaIntesaWilfried Hauck,ChiefExecutiveOfficer,AllianzDresdnerAssetManagementInternationalGmbHThomas Kloet,SeniorExecutiveVice-President&ChiefOperatingOfficer,FimatUSA,Inc.Herwig Langohr,ProfessorofFinanceandBanking,INSEADMitchel Lenson,GlobalHeadofOperations&Technology,DeutscheBankGroupDavid Lester,ChiefInformationOfficer,TheLondonStockExchangeDonald A. Marchand,ProfessorofStrategyandInformationManagement,IMDandChairmanandPresidentofenterpriseIQ®

Colin Mayer,PeterMooresProfessorofManagementStudies,SaïdBusinessSchool,OxfordUniversityRobert J. McGrail,ChairmanoftheBoard,OmgeoJeremy Peat,GroupChiefEconomist,TheRoyalBankofScotlandJos Schmitt,Partner,CapcoKate Sullivan,ChiefOperatingOfficer,e-CitiJohn Taysom,Founder&JointCEO,TheReutersGreenhouseFundGraham Vickery,HeadofInformationEconomyUnit,OECDNorbert Walter,GroupChiefEconomist,DeutscheBankGroupDavid Weymouth,ChiefInformationOfficer,BarclaysPlc

TABlE oF conTEnTs

noBEl lAuREATE ViEw

6 nash’s theories and their impact on economics and financeAdiscussionwithProf.JohnF.NashJr.,SeniorResearchMathematician,DepartmentofMathematics,PrincetonUniversity,andJoint-WinnerofTheBankofSwedenPrizeinEconomicSciencesinMemoryofAlfredNobel1994

EmERging modEls

12 opinion: Bringing broadband banking to iraqKathleenTyson-Quah,ChiefExecutive,GranularityLtd

16 opinion: unifying the European payments landscapePhilippeMenier,ChiefOperatingOfficer,VisaEuropeLtd

21 opinion: credit card security on the net: where is it today?SankarsonBanerjee,SeniorArchitect,Mphasis

24 opinion: Broadening the value proposition around payments outsourcingThomasHalpin,VicePresident,JPMorganTreasuryServices

26 opinion: Bringing payments togetherMichelAkkermans,ChairmanandCEO,Clear2Pay

31 Payment systems and regulationHansGeiger,Professor,TheSwissBankingInstitute,UniversityofZurichFritzKlein,IndependentConsultant,andChairman,CLSHoldings/CLSBankInternational

39 why has stored-value not caught on?SujitChakravorti,SeniorEconomist,FederalReserveBankofChicago

49 online payments systems for e-commerceCarolinePaunov,Consultant,OECDGrahamVickery,HeadoftheInformationEconomyUnit,OECD

55 six smart moves when playing the smart card gameLeoVanHove,AssistantProfessorofEconomics,VrijeUniversiteitBrussel(FreeUniversityofBrussels)

TRAnsiTion

64 opinion: Payments policy in the information ageRonaldJ.Mann,BenH.&KittyKingPowellChairinLaw,Co-Director,CenterforLaw,Business&Economics,TheUniversityofTexasSchoolofLaw

68 opinion: creating a profitable infrastructure — The payments challenge for banks AnnCairns,GlobalHead,WorkingCapital,ABNAMRO

71 opinion: Payments in transition: where have all the changes gone?MarkWebster,Partner,Capco

74 opinion: Electronic payments: The drive towards a competitive, customer service driven utilityRodDew,MarketingDirector,DistraPtyLtd

79 simulation: A powerful research tool in payment and settlement systemsHarryLeinonen,AdvisertotheBoard,BankofFinlandKimmoSoramäki,PolicyExpert,EuropeanCentralBank

85 European payment systems and monetary unionFranciscoJ.CalladoMuñoz,AssistantProfessor,UniversityofGironaNataliaUtreroGonzález,VisitingProfessor,UniversitatAutonomadeBarcelona

93 Technological innovation in retail payments: Key developments and implications for banksKarenFurst,PolicyAnalyst,OfficeoftheComptrolleroftheCurrencyDanielE.Nolle,SeniorFinancialEconomist,OfficeoftheComptrolleroftheCurrency

FuTuRE

104 opinion: innovation on networks: coordination, governance, and the case of VisAMatthewCardillo,AssistantEconomist,FederalReserveBankofKansasCityAntoineMartin,Economist,FederalReserveBankofKansasCityMichaelJ.Orlando,SeniorEconomist,FederalReserveBankofKansasCity

108 opinion: The evolution of currencyJamesTurk,founder,GoldMoney.com

110 opinion: Automating payment processes to reduce working capital KurtCavano,ChairmanandCEO,TradeCard

112 opinion: new agenda for payment service providersTerryDirienzo,Director,GroupPayments&Settlements,BarclaysPlc.MarkHale,HeadofPaymentsStrategy,GroupPayments&Settlements,BarclaysPlc.

116 opinion: new models of collaboration in transaction bankingWolfgangGaertner,ChiefInformationOfficer,GlobalBankingDivision-GlobalTransactionBanking,DeutscheBank,and,Director,SWIFT

120 opinion: European payment service providers: A race to market and the nature of future victory?JulianWakeham,Partner,CapcoAndrewHogan,ManagingPrincipal,CapcoHectorNelson,Consultant,Capco

125 network-based payments and e-settlementHarryLeinonen,AdvisertotheBoard,BankofFinland

131 Banks’ strategies for payment services: which role for debit cards?FrancescoSaita,AssociateProfessor,FinancialMarketsandInstitutionsDepartment,UniversitàBocconi

141 delivering migrant workers’ remittancesRogerBallard,Director,CentreforAppliedSouthAsianStudies,UniversityofManchester

155 check 21 and the migration to electronic paymentsAdamDener,Partner,Capco

Overlookedandignoredforyears—ifnotdecades—atatime,thepaymentsindustryhasbeeninaconstant

stateoffluxasoflate.Paymentsservicesproviders,suchasuniversalbanks,havehadtocopewiththenotion

thatabusinesspossiblygeneratinghandsomereturnshasnowmoreoftenthannotbecomeacostcenter.In

myopinionthereis,therefore,nobettermomenttodedicateanentireissueoftheJournaltopaymentsinall

itsfacets.

Aswithallother transitions in the financial servicessector,change in thepayments industry isaglobal

phenomenonwithlocalorregionalflavoring:InEuropetheintroductionofthesinglecurrencyaslegaltender

in2002wasimmediatelyfollowedbyadecreeforcingpaymentsserviceproviderstoequalizethecostborne

byusersofmakingacross-bordereuropaymenttothecostofmakingadomesticeuropayment:zero.The

customofpaper-checkpayment intheUnitedStates—abusinessestimatedtogenerateU.S$25billion in

customersupportaccountfeesandU.S.$34billionindeposit/floatfees—isonacontinuedcourseofchange

toelectronictransactionprocessing,enhancedbytheCheckClearingforthe21stCenturyAct.Asia’svarious

developedandestablishedeconomiesseean increasedpresenceofcreditanddebitcardprovidersasan

alternativetocashpayments,and‘secondary’paymentssystemsusedbymigrantworkerstosendfundsback

home.

Thesedevelopmentshelpdramaticallychangepayments’traditionallowvisibilityandstrategicimportancein

banks,andensurethatthecostimplicationsofmaintainingapaymentscapabilityin-houseandthevalueof

theannuityrevenuetheydevelopbecomeincreasinglyrecognizedasimportant.Conceptswhichsincemany

yearshavedominatedtheagendaofsecuritiestradingandprocessingproviders—sharedservicecenters,

outsourcingandoff-shoring,tonamebutafew—arenowalsofirmlycaughtintheimmediateattentionspan

of many payments providers, often piggybacking on previous experience obtained in the financial instru-

mentsdomain.

InthisJournalIwouldliketodrawyourattentioninparticulartotheTransitionsection,whereanumberof

operationalplaysforpaymentsservicesprovidersareshowcased.AtCapcowehavebenefitedgreatlyfrom

ourinfrastructureprojectworkforrespectedproviderstofurtherourthinkingaboutthefutureofthepay-

mentsindustry.Itrustthatyouwillfindthiseditionofouraward-winningpublicationinspiringforyourown

insightanddecisionmakingprocesswhenfacingpaymentschallenges.Enjoy!

RobHeyvaert,

Founder,ChairmanandCEO,Capco

Payments finally hits the boardroom table

It is quite remarkable how payments, be they instruments or mechanisms, are generally viewed, even by

financialinstitutions,asnothingmorethanameanstoanend.Aservicethatneedstoexistinordertomake

sureindividualsandinstitutionsareabletopayforthegoodsandservicestheypurchasefromoneanother.

Itis,ifyouwill,thenotsoexcitingpartofthebusiness.Thebitthathappenswhenalltheotherexcitingevents

havetakenplace.Consequently,paymentsserviceproviders,betheybanksorotherthird-partyinstitutions,

haveallto loseandnotmuchtogain. Ifthetransactionsaresettledsmoothlythenthemechanismshave

donetheirjob,butifthereisanydelayorproblems,theyhavefailedinthissimpletask.But,howsimpleis

thistask?

Basedonthearticlesinthisissue,itisnomeantasktomakesureindividualsandorganizationswhoknow

littleabouteachothercanmakepaymentstooneanother.Thearticlesinthisissuealsohighlightthefact

thatittakesmorethansmarttechnologiesandgoodwillfromfinancialinstitutionstomakeanewpayment

mechanismwork.Wewillfindoutwhyindividualandinstitutionalbehaviorscanmakeorbreaknewpayments

instrumentsormechanisms.And,moreinterestingly,whydespitethefactthatpaymentsareoftremendous

importancetofinancialinstitutions,intermsofcostsandrevenues,theyremainsofarbelowtheradaroftop

managementandstrategists.

However,beforewediscussthecontentsofthethreesectionsthatmakeupthis issueoftheJournal,we

wouldliketoexpressourtremendousexcitement,pride,andhonoratthefactthattheNobelLaureateView

forthisissuehasbeenkindlyprovidedbyProf.JohnNashJr.ofPrincetonUniversity.

Insectionone,wefocusonthetopicofemergingpaymentsmodels.Herewelookatthenewpaymentinstru-

mentsandmechanismsthathavebeenintroducedanddiscusswhysomehavebeenmoresuccessfulthan

others.Theauthorsdescribehownewpaymentmethods,suchasdebit,creditand,smartcards,areaiming

tohelp individuals improvethewaytheymanagetheirfinancesandmakethewholeprocessofpayments

moreefficient.Theyalsoexplainhowcardpaymentstechnologiesarenotonlyprovidinguswithguidanceon

howtomakeourcurrentpaymentmethodsmoreefficient,buthowtheycanbeessentialwhencreatinga

wholenewbankingsystemforawar-torncountry,suchasIraq.

Section two discusses how payment systems have evolved in recent years. The authors look at the chal-

lengesfacedbythebankingsectorinimprovingtheefficiencyofpaymentsprocessesandexplainhowthey

were able to overcome them. This section also covers how simulation tools can help test new payment

mechanismswithoutbringingthewholepaymentssystemundertheriskoffailure.Sectionthreelooksatthe

futureofpayments, includingnewpayments toolsandmethodologies.Thearticlesexamine thepotential

benefitsoffocusingonthoseareasinwhichbankshavespecificcorecompetenciesandhowoutsourcingto

otherbanksorthird-partyproviderscanhelpinthateffort.Thelonglistofnewregulationsintroducedhas

dramaticallyincreasedthecostofbeinginthisspace,andthepapersinthissectionlookatwhatoptionsare

opentobanksfacingthem.

Wehopethatwehaveachievedourobjectiveofprovidingathoroughreviewofthemajorissuesimpacting

thepaymentsworld.Wealsohopethatyouenjoyreadingthisissueandcontinuetosupportthejournalby

submittingyourbestideastous.

Onbehalfoftheboardofeditors

making payments work

8 - The Journal of financial transformation

THE NOBEL LAuREATE VIEW

nash’s theories and their impact on economics and financeA discussion with Prof. John nash, Jr.Senior Research Mathematician, Department of Mathematics, Princeton university, and Joint-Winner of The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 1994

Weareveryhonored thatJohnNash,Jr., themancredited

withoneofthemostprofoundcontributionstotheworldof

economics,haskindlytakenthetimetohelpusgetabetter

understandingofhistheoriesandhowtheyapplytotheworld

ofeconomics.Below,youwillfindthequestionsposedandthe

answerskindlyprovidedbyProf.Nash.

understanding of the theoriesQ: One of the most interesting facts about economic theo-

ries that I have come across is the number of people, includ-

ing myself, who feel that they have a good understanding of

a given theory when in reality they do not. Do you believe

that most people who refer to your theories fully under-

stand them?

Prof. Nash: No, indeed, the majority — even, say, among

economists—wouldhaveonlyanincompleteor‘casual’famil-

iaritywithmycontributions.

NowI justhappentothinkofaverygoodreferencesource;

thisisthebook‘EssaysonGameTheory’publishedbyEdward

Elgar(aBritishpublisherspecializingineconomicsandrelat-

ed fields). Elgar contacted me about publishing a book like

this soonafter thenewsofmyNobelLaureate recognition.

Thisbookhaseverythingthatwaspublishedduringthetime

ofmystudiesinthe50’sinamajorpublication.

Q: Of course, many of our readers either do not have the

time to read that book or will have a tough time understand-

ing its complexities. In order to help our readers get a better

understanding of your theories can you kindly describe your

biggest contribution in a sentence or two?

Prof. Nash: It is not, really, a meaningful issue of whatever

might seem to be my ‘biggest contribution’, when learning

andcultureareviewedfromsometimemuchfurtherintothe

future.Rightnow,Icanonlygowithconventionalopinionand

suggestsimplyaquotationofthecitationatthetimeofthe

Nobelceremonieson10December1994.

Q: Is that a quotation from your own speech at the awards

ceremony?

Prof. Nash:No,thereisamisconceptionhere!Thefactisthat,

quiteexceptionally, Ididnotgivea lecture inStockholmon

the occasion of my being awarded the prize (with Harsanyi

andSelten).Instead,Prof.HaroldKuhn,ofPrincetonUniversity,

gave a lecture about the work I had done which was being

recognizedandaboutconnectionsandapplications,etc.This

organizationalformatwasarrangedbecauseIhadnotbeen,

formanyyearspriorto1994,actuallystudyingandworkingin

economics and game theory. And this circumstance was

relatedtomyhistoryofhavingbeenunder‘mentalillness’for

manyyears,althoughatthattime,in1994,Icouldhave,well

enough,givenalecturemyself,ifthathadbeenrequested.So

whileinSwedenIgavealectureatUppsalabutthiswasnot

ongametheoryoroneconomics.Inyearssubsequentto1994

and1995Ihavebeen,again,activelystudyingintheseareas,

withnewresearchprojects.

Q: In order to help our readers get a better understanding of

Prof. Nash’s contribution, we will use three quotes from the

panel chaired by Prof. Kuhn in honor of Prof. Nash’s Nobel

Prize in Sweden.

‘Nashprovedbypage6ofhisthesisthateveryn-personfinite

non-cooperative game has at least one (Nash) equilibrium

point.Thisisaprofileofmixedstrategies,oneforeachplayer,

whichissuchthatnoplayercanimprovehispayoffbychang-

inghismixedstrategyunilaterally.’Kuhn(1994)1

‘[The Nash] equilibrium is without doubt the single game

theoreticsolutionconceptthatismostfrequentlyappliedin

economics. Economic applications include oligopoly, entry

and exit, market equilibrium, search, location, bargaining,

product quality, auctions, insurance, principal-agent [prob-

lems], higher education, discrimination, public goods, what

haveyou.On thepolitical front,applications includevoting,

arms control and inspection, as well as most international

political models (deterrence, etc.). Biological applications all

1 Kuhn,H.W.,1994,“NobelSeminarinhonoroftheworkofJohnNashinGame

Theory,”December8

9

deal with forms of strategic equilibrium; they suggest an

interpretation of equilibrium quite different from the usual

overtrationalism.Wecannotevenbegintosurveyallofthis

literaturehere.’

Aumann(1987)2

‘Intheshortperiodof1950-53,JohnNashpublishedfourbril-

liantpapers3,inwhichhemadeatleastthreefundamentally

importantcontributionstogametheory:

1. Heintroducedthedistinctionbetweencooperativeand

non-cooperativegames.Theformeraregamesinwhich

theplayerscanmakeenforceableagreementsandcan

alsomakeirrevocablethreatstootherplayers.Thatisto

say,theycanfullycommitthemselvestospecificstrate-

gies.Incontrast,innon-cooperativegames,suchself-com-

mitmentisnotpossible.(Actually,Nashalsoassumedthat

inanon-cooperativegame,theplayerswillbeunableto

communicatewitheachother.Yet,inmyownview,this

wouldbeaneedlesslyrestrictiveassumption.Forifthe

playerscannotenterintoenforceableagreements,then

theirabilitytocommunicatewillbeofnorealhelptoward

acooperativeoutcome.)

2.Asanaturalsolutionconceptfornon-cooperativegames,

heintroducedtheconceptofequilibriumpoints,nowusu-

allydescribedasNashequilibria.Healsoestablishedtheir

existenceinallfinitegames.(NotethatNashequilibria

seemtobetheonlysolutionconceptapplyingbothto

gamesinnormalformandinextensiveform.)

3. Asasolutionconceptfortwo-personcooperativegames,

heproposedtheNashbargainingsolution,firstforgames

withfixedthreats,andlateralsoforgameswithvariable

threats.Healsoshowedthat,inthelattercase,thetwo

players’optimalstrategieswillhavemaximinandminimax

properties.

‘ThebestwaytounderstandtheimportanceofNash’scontri-

butions isbycomparingthestateofgametheory justafter

publicationofVonNeumannandMorgenstern’sbookin1944

withitsstateafterpublicationofNash’sfourpapersin1953.

VonNeumannandMorgenstern’sbookcontainsanexcellent

mathematicalanalysisofoneclassofnon-cooperativegames,

viz.oftwo-personzero-sumgamesandoftheminimaxsolu-

tionforsuchgames.Itcontainsalsoanexcellentmathemati-

cal discussion of one cooperative solution concept, that of

stablesets,formanyspecificgames.Yet,itsohappensthat

theconceptoftwo-personzero-sumgameshasveryfewreal-

lifeapplicationsoutsideofthemilitaryfield.Theconceptof

stablesetshasevenfewerempiricalapplications.

‘Had these twodistinguishedauthorshadNash’snotionsof

cooperative and non-cooperative games available to them,

thenpresumablytheywouldhaveaskedthequestionofhow

toact rationally ina two-personnonzero-sumgameor ina

more-than-two-persongameifthisisplayedasanon-cooper-

ative game, permitting no enforceable agreements and no

irrevocable threats. Perhaps they would have asked also

whether one could not find for cooperative games a more

convincingsolutionconceptthanstablesetsare.Forinstance,

whetheronecouldnotfindasolutionconceptyieldingsharp-

er-predictions about the players’ actual payoffs than the

conceptofstablesetsdoes.’Harsanyi(1994)4

impact on financial marketsEconomistsviewthemarkets,inspecificstockmarkets,tobe

efficient,oneofthemaincomponentsofwhichbeingperfect

competition and perfect dissemination of information, such

thatnoonecanusetheirknowledgetogainsuperiorreturns.

Q: You suggest that transactions fail not necessarily because

participants behave irrationally, but because they do not

know each other’s perspectives of the transaction (i.e. what

is the highest price they are willing to buy at or the lowest

price they will sell at). Does this mean that better informa-

tion can help increase the likelihood of transactions?

Prof. Nash:I,personally,didnotspecificallysuggestthis.But

thisphenomenonisaveryrealandrecognizedone.Recently

the theme of an (economics) Nobel Prize award (shared by

threeAmericans)was‘asymmetricinformation’representing

2 Aumann,R.J.1987,“Gametheory,InThenewPalgraveDictionaryofEconomics,”

editedbyMilgate,M.andP.Newman,460-482.Thisquotewasextractedfromthe

introductoryspeechgivenbyProf.Kuhnatthe1994NobelPrizeseminar.

3 Nash,Jr.,JohnF.,1950a,“Equilibriumpointsinn-persongames,”Proceedings

NationalAcademyofSciences,36,48-49

Nash,Jr.,JohnF.,1950b,“Thebargainingproblem,”Econometrica,18,155-162

Nash,Jr.,JohnF.,1951,“Non-cooperativegames,”AnnalsofMathematics,54,

286-295

Nash,Jr.,JohnF.,1953,“Two-personcooperativegames,”Econometrica,21,

128-140

4 Harsanyi,J.C.,1994,NobelSeminarinhonoroftheworkofJohnNashinGame

Theory,December8

decisionsofanindividualnegotiant.Learningisgoodingen-

eral,theinteractionofspeculatorsandinvestorsis(ofcourse)

game-like,butbeyondthattruismthelevelofpracticalutility

maynotbeeasilyreached.

Q: Can your theories be used to help in determining man-

agement compensation in the u.S., which seems to be going

through the roof?

Prof. Nash:Itis,indeed,aphenomenon.But,gametheoreti-

cally,thereishardlyanyreasonablelimitontheappropriate

compensation for a valuable executive. If Henry Ford, the

founder,deservedtoownthecompany,thenatalatertime,

BillFord,adescendantandnowchiefexecutive(ifanygood

atthatfunction!),mightmeritacomparablelevelofcompen-

sation.Andthere is thegeneralphenomenonof theappar-

ently increasing disparity of incomes and prosperity. One

thingtothinkaboutistheincreasingfactorofmultiplication

applicabletothelaborofafewpersons.Anactoronastage

canbeseenonlybythoseinanaudiencewithinhearingdis-

tance.AnactorinaTVseriescanbeseenandheardbymil-

lionsateachperformance.

PaymentsThethemeofthisissueispayments.Oneofthebiggestprob-

lems that exist in the world today is the lack of trust that

existsbetweenmarketparticipants.Hencetheneedforthe

establishmentofevermoresecuretransactions.

Q: On payments, the inability to know about the motivations

and situations of many individual participants led to the

creation of exchanges and other mechanisms for central

assumption of accountability for completion of transac-

tions. The cost of learning the situation of participants is

often so high that other structures are created to reduce

the need to know. You could look at DVP as being refusal to

learn anything: just pay me when I pay you and life is sim-

ple. Can non-cooperative game theory suggest a way to

improve the way organizations make payments to one

another?

Prof. Nash:Iguessitmusthavebeenalongtimeagothatthe

stockbrokerwasinvented.Andthroughthemoccurpurchase

and sale transactions between parties that would be quite

naturallyveryuntrustingofeachother. Iwouldnotwantto

claimanymagicalpotencyofgametheoryhere,butofcourse

itisnaturallyappropriatefortheconsiderationofsituations

wheretherearepartiesthathaveintereststhatarenotsim-

plyparallel.

Q: Would it help reduce the costs involved in international

transactions?

Prof. Nash:Ifeelthatthecostsofinternationaltransactions

aretypically‘whatthemarketwillbear’.Notlongagoitwas

costlytochangeItalianliramoneyintoFrenchfrancsandvice

versaanda touristcouldpayouta lot thatwayonashort

vacation.Now,with theeuro thatparticularcost isentirely

gone!Telephonechargeshavealsotypicallybeen ‘whatthe

marketwillbear’ratherthanamountsactuallydirectlyrelat-

edtocostscalculableintermsofthetechnology.

world tradeFoundingfathersofeconomicshavesuggestedthatincertain

circumstancesevenifthecostofproductionofoneproduct

ishigherinagivenmarketitmightstillmakemoresensefor

that product to be made in that location if the cost of

exchangeintootherproductsislowerthaninothermarkets.

Q: Can you explain why it is that most countries are still

trying so hard to produce everything?

Prof. Nash:Thereisoftensimplyanationaldefenseconcept.

The Japanese perhaps would feel themselves to be in an

unfortunatesituationiftheycametoactuallygrownoriceat

allwithallriceconsumedbeingimported.

Q: Do you believe that your theories can help improve the

productivity of the world we live in?


the themeofhowonepartymightbebetter (ordifferently)

informedthananother.Andthis,ofcourse,initselfimpliesthe

importance of imperfections of information. The issues of

completenessorincompletenessofinformationareoldtopics

ingametheory.

Q: Can your theory also work when you are dealing with

thousands of participants? Can we really have behavioral

information about so many participants, or do we, can we,

segregate them into groups to make this more viable?

Prof. Nash:Mostdefinitelyyes!Thatis,the‘non-cooperative

game’ concept was always, as I could see immediately, well

suited for application to the multitude of speculators and

investorsthatmightbetradinginthesharesofMSFTonthe

stockexchanges.Yousee,theseindividualtradersareallact-

ing‘incoherently’.

Q: Can the determination of other participants’ values of a

transaction be helpful in increasing the returns we generate

from our transactions (i.e. are the people who are able to

master this able to consistently achieve better rates)?

Prof. Nash:Fromthecompetitivepointofviewitisgenerally

desirabletohavemorerelevantinformation.Fromthecoop-

erativepointofviewitcanalsoimprovemutualbenefitsfor

thepartiestohavemoreinformationaboutthemselves.There

can be paradoxes, however, which can be revealed through

gametheory.IwassurprisedrecentlywhenIwasatagame

theorymeetingand Ihearda talk inwhichanexamplewas

presentedofanauctionsituation,viewedthroughgametheo-

ry, and it turned out that if two bidders in the auction had

different amounts of information about the quality of the

product being sold at auction that it could happen that the

bidderwith less informationwould realize thehigherpayoff

result! IwasquitesurprisedwhenIheardthisandIthought

aboutitinrelationtonon-cooperativegametheory.Andthen

Icouldseethatitwasconsistent.Thenafriendconfirmedthat

itwasafamiliaroccurrenceinexamples.Thethingisthatthe

twobidders, intheauctiongame,arenotsimplyopponents,

oneoftheother,theyarebothcontendingwiththeauction-

eer.

Q: Consequently, are you suggesting that investors/traders

should spend more time determining what the most efficient

level of negotiation would be?

Prof. Nash: Well, first of all, the concept of a ‘minmax’ or

‘minimax’ isaconceptrelatingtozero-sumgamesandthus

properlyrelatingtogamesoftwoplayerswithdirectlyoppos-

inginterests.Thisisnotreallytherelevantcontextforinves-

tors, because all investors can gain, in principle, with good

investments,orallcouldlose,inagreatbubbleoftulipsorof

dotcoms. When the games of speculators can properly be

seenasessentiallyofzero-sumcharacter,withwealthmerely

being transferred but never created, then still the minmax

concept is not of use because these speculative games are

many-person in character (or even games of multitudes)

ratherthangamesoftwoparties.Andnowasidefromminmax

issuesbutrelatingtogametheoryingeneralIcanmakethe

generalremarkthatatheorycanbequitevaluableevenifit

doesnotgiveexplicitlyuseful informationtothepersonsof

the classes to which it would seem to directly apply. Thus

game theory is not very helpful to chess players. And the

medical and physiological theory of muscle functions and

healthwouldnotdirectlyhelpanathlete toprepare for the

Olympics. A player in games or a businessman or financier

may,realistically,needtousetherelevantschoolofcommon

sensetoplaywell,whilegametheoristsmaybeabletoeffec-

tivelyanalyzethebehaviorofclassesofsuchplayers.

J.P.Morgansaiditall,inasense:‘Buylow,sellhigh.’Andthis

isperfectlyvalid,althoughsomewhattautological.

The ‘negotiant’ cannot usually rationally assume that other

negotiantsareplayingaccordingtosomesortofagame-the-

oreticallybasedstrategy.Ifthereisa‘market’thentheadvice

ofMorganisrelevantasaguide.Soagame-theoreticanalysis

basedonwhatotherswouldbedoingiftheywereoperating

according to a game equilibrium (or some other game con-

cept)mightnotbewelljustified,inanindividualcaseforthe

11

Prof. Nash:Itwouldnotbeadirecteffectiftherewouldbea

benefit.WhatIcanseeisthatglobalcooperationinartsand

sciences will naturally increase the economically measured

‘productivity’concepts.

Q: Many suggest that your theories could be used to help

protect the environment in a way that benefits all. Why do

you feel it has not been fully utilized?

Prof. Nash: At the meeting in Marseilles devoted to game

theorywhichIattendedinearlyJuly2004Isawaposterby

aJapanese theorist relating to theKyotoprotocolsand the

themeofglobalwarming.Thethemewasdevelopedinterms

ofcooperativetheorybutasIthoughtaboutitIfeltthatthere

wouldbeamajor issuederivingfromthepossibilityofnon-

cooperativebehaviorbynationswithdifferentnatural inter-

ests.Perhapsingeneral,theenvironment,asaninterestofall

humans, can be most favorably or most easily protected by

concertedhumanactionsandplanningifthereisanappropri-

ateandgoodlevelofcooperationoftheworlddirectedtothat

objective.Globalcooperation,itself,isanaturaltopicforgame

theoreticstudies.

Q: Prof. Nash, thank you very much for giving us this time.

We hope that our readers have benefited from your insight.


Emerging models

Bringing broadband banking to iraq

unifying the European payments landscape

credit card security on the net: where is it today?

Broadening the value proposition around payments outsourcing

Bringing payments together

Payment systems and regulation

why has stored-value not caught on?

online payments systems for e-commerce

six smart moves when playing the smart card game

Bringing broadband banking to iraqKathleen Tyson-QuahChief Executive, Granularity Ltd

salesexecutiveconfirmedtheirsuccessfuluseofR-BGANin

three banking installations in Africa and the Middle East. In

responsetomyinquirysheletmeknowthatNSSLwasthen

supporting solutions to several clients operating in Iraq. At

thispointIaskedwhetherNSSLwouldliketobuildabanking

networkat80locationsinIraq.Afteralongpause,shesug-

gested that she would arrange a conference call with col-

leagues.NSSLhassinceconfirmedthataninternaldebateon

whetherIwastoocrazytobetakenseriouslyoccurredprior

totheconferencecall.

Imusthaveacquittedmyself rationallyon thecall, because

fromthatdateNSSLwasonmyteam.Theyjustifiedmycon-

fidence in their project management skills by coming back

with a project specification and initial quotation for an

80-nodenetworkwithin48hours.

Because NSSL was already operating within Iraq, they were

abletosimplifymanyofthelogisticschallenges.Theyagreed

to take responsibility for procurement, configuration, and

deploymentofthelaptopPCsaswellason-siteinstallationof

thesatellitemodems.Theirexistinghelpdeskoperationsand

Baghdad-basedengineerswouldhandlealldownstreamsup-

port. NSSL would later assume responsibility for in-country

trainingofhundredsofbankstaffwhohadneverbeforeseen

acomputermouseorusedMicrosoftapplications,andalsofor

hostingtheCentralBankofIraqwebsite.

Mammoth mainframes spring to mind when payments are

discussed among central bankers — not laptop PCs. Massive

securityandresiliencytosafeguardtheintegrityofthepay-

mentsprocessandpaymentsdataareessential.Laptopsare

viewed as inherently risky and insecure. I have read every

Basle Committee report on payment systems and knew all

this, but in Iraq it seemed tome that laptopshaveanedge

fromaresiliencyperspective. Ifa laptopgetslost,stolen,or

blownup,wecanputafullyconfiguredreplacementoutwith

thenextconvoy.

Forstate-of-the-artlaptopsecurityproveninbankingapplica-

tions,however,IreturnedtoGoogle.Applyingthesamecrite-

riaofprovenbankdeploymentandchallengingprojectgeo-

graphy, Iwas led toPointsecMobileTechnology.Their solu-

tions,basedondisk levelencryption,hadbeendeployedfor

thousands of bank laptops in the U.K. and U.S. and proven

secureworldwide.

I picked up the phone and dialed the U.K. representative.

AgaintherewasapauseandasuckingofbreathwhenIsug-

gestedarapiddeploymenttoanetworkoflaptopsoperating

inIraq.Thenhesaid,‘Sure.Howsoondoyouwantdelivery?’

Anotherpieceofthepuzzlefellintoplace.

NowIhadthenetworksolution,Istillneededthefunctionality

which would make it worthwhile. This time I did not need

Google.Iknewwhotocall,VisaInternational.Thechoicewas

based on the belief that Visa could pop Iraqi Dinar on its

NationalNetSettlementSystemasanadditionalcurrencyand

process nationwide payments without major incremental

investmentoftimeandcapitalinprojectdevelopment.Using

an existing, proven, high capacity system was essential to

meeting the tight timeframe for enabling the currency

exchange.

VisaInternational’sNationalNetSettlementSystemoperates

domesticsettlementsofcardandelectronicpaymenttransac-

tions for many countries, including countries in the Middle

East and transformation economies in Eastern Europe. The

system provides secure payment processes, backed by the

VisaNetsecuritysafeguardsessentialtoauthorizingtransac-

tionsandcontainingtheriskoffraud.

ConnectingtoVisawouldalsohaverealadvantagesforinte-

gratingIraqwiththeglobaleconomy,allowingIraqisabroadto

send money to Iraq for investment and enabling Iraqi busi-

nesses to make efficient payments to foreign suppliers.

Importantly, it would embed a global data standard, the

16-digitcardnumber,aspartofpaymentoperationsinIraq.

IcalledStuartBrocklehurst,SeniorVP-PaymentsDevelopment


15

One of the benefits of staying current with emerging tech-

nologiesisthatitengendersabeliefinthepossible.Lastyear

Iwaschallengedwith theseemingly impossible, todesigna

bankingnetworkandpaymentsystemforpost-warIraqwhich

couldbefullyoperationalin10weeks,andfoundthatsatellite

data networks and web-based processes made it practical,

quick,secure,andmorefunctionalthananyoneexpected.

InJuly2003thetelecomswerestillknockedoutinmostof

central Iraq, theelectricitynationwidewaspatchy,with fre-

quent blackouts, and only a handful of bank branches had

reopened following widespread post-war looting of banks.

Meanwhilethesecuritysituationwasdeterioratingasinsur-

gents organized and gained access to weapons and explo-

sives.

Despitethesechallenges,theCoalitionProvisionalAuthority

wasdeterminedtoreplacetheoldcurrencyfeaturingSaddam

withanewcurrency.Thechangeoverwasscheduledtobegin

on 15 October 2003, and last for three months. The banks

nationwide would have to reopen to operate the currency

exchange.Inacountrywheremanypeoplekeepboxes,even

rooms,fullofcashintheirhomesinpreferencetothedubious

securityofbanks,theexchangewasgoingtobeamajorlogis-

ticalchallengeforeveryone.

Atan informal summerbarbeque,AndrewBailey (Executive

Director—BankingandChiefCashier)oftheBankofEngland,

tookmetothevegetablepatchatthebackofhisgardenand

askedmetothinkabouttheproblem.TosayIwas‘ledupthe

gardenpath’wouldbeunfair,ashewasfrankindescribingthe

chaos. The urgent need was a network which would enable

communicationsamong80branchesof theCentralBankof

Iraq, Rafidain Bank, and Rasheed Bank so that they could

reopen throughout Iraq, and a system to process electronic

paymentsamongthem.

Icouldhavelaughedawaytherequest,butIfeltIhadtomake

anefforttoaidacountryandapeopleattackedandinvaded

bymyown.

I bounced the problem off a friend specializing in wireless

telecomsandheimmediatelye-mailedbacksuggestingthatI

evaluate data services provided via satellite by Inmarsat.

Some intense Googling led me to the Regional Broadband

Global Area Network (R-BGAN). Portable R-BGAN modems,

whichareaboutthesamesizeandshapeaslaptopPCs,pro-

videbroadbandconnectivitytotheworldwidewebviadown-

linktoanearthstationatFucino,Italy.R-BGANcouldbeused

to provide real-time access to any web-enabled application

operatingremotelyonserversoutside Iraq.Crucially, Iraq is

centrallylocatedwithinthefootprintoftheInmarsatsatellite

supportingR-BGAN.Anaddedadvantageofthiswebconnec-

tivitywouldbetheeaseoftransferringservicestoasecure,

domesticInternetProtocolnetworkwhenitbecomesavailable

inIraq.

OnceIhadbroadband,IknewIcouldfindasolution!Ibegan

to sketch it out as laptop PCs connected by the R-BGAN

modemstoaback-endserverprovidingthecommunications

network,e-mail,andpaymentsapplications.Boththelaptops

andmodemscouldoperateoffbatterypowerduringthefre-

quentblackouts.

AtthispointIreinedinmyenthusiasmandgotpractical.Iset

myself some guidelines on technology and suppliers which

accordedwith thescaleof thechallenges inpost-war Iraq. I

decidedIwouldonlyconsidersuppliersofferingtechnologies

proveninbankdeploymentsinchallenginggeographies.Iraq

wasnoplacetotestnewtechnologiesorunseasonedproject

managers.Ialsodeterminedtokeepasmuchoftheback-end

servers and operational processes as possible outside Iraq,

although all processes should support the Arabic language

andbe transferable toamoresettleddomesticbankingsys-

tem.

GoingbacktoGoogle,IkeptsearchingonR-BGANuntilIfound

acasestudyondeploymenttomajorglobalbanksatbranches

inthelessdevelopedregionsofAfrica.Thedeploymenthad

beenmanagedbyNSSL,asatellitesolutionscompanybased

convenientlyinRedhill,England.WhenIfirstcalledNSSL,the

forCentralEurope,theMiddleEast,andAfrica.Iexplainedthe

challenge, thetimescale,andthesolutionarchitecture Ihad

developed so far, and asked if Visa would provide the pay-

mentsfunctionality.Stuartaskedafewquestionsandprom-

isedtogetbacktomewithinthehour.

A half-hour later he called to confirm the president’s view,

subjecttoapprovals,thatVisacoulddeliver.Overthefollow-

ingweekendallboarddirectorsapprovedVisaInternational’s

commitment to the Iraqibankingnetworkandpaymentsys-

tem. Given that we were in high holiday season, and many

directors were tracked down to beach cottages and boats,

theirunanimoussupportdemonstratedamarvelousenthusi-

asm.Visaevenofferedtocoverthesubstantialsetupcostsin

Iraq.

Connecting Visa to the Iraqi banking network was not the

technology ‘no-brainer’ Ihadhoped.Visausesaproprietary

networkanddatastandard.NSSLquicklywenttoworkwith

Visa’snetworksuppliertoovercomethis,enablingthetrans-

missionof transactiondata from Iraqover Internetprotocol

using a web-based connection and data transformation for

interoperability with the Visa network. It was an impressive

cooperation, displaying a ‘Blitz spirit’ toward engineering a

rapid,workablesolution.

My initial collaborative proposal was sent to the CPA in

Baghdadthefollowingweek.TheCPAhadnotreallyexpected

anyonetosolvetheproblem,sowasabitsurprisedtoreceive

afully-scopedsolution.Itconfrontedthemwithanotherprob-

lem.Theycouldnotawardacontractwithoutatenderpro-

cess,sotheIraqiBankingNetworkandPaymentSystemhad

tobeputoutforbid.Fourteencompaniesresponded,butno

other proposal provided high security and resiliency with

equivalentconfidenceindeliveryonthetimescalerequired.

Ourswasalsothelowestcost.

InthefirstweekofAugust2003,Stuartandtwoexecutives

fromNSSLflewintoBaghdadinanRAFHerculestransportto

negotiatethecontracts.Partofmewantedtobewiththemas

Ihadinvestedalotofmyselfinthesolution,buttherestofme

was happy to be sunning poolside at a villa in Greece, con-

nectedtotheteambyanR-BGANmodemloanedtomeforthe

purpose.TheyreturnedtoLondoneightlong,hotdayslater,

the day before the bomb at U.N. headquarters in Baghdad

which marked the most significant escalation in insurgent

violence.

Thesolutionwent liveontimeandtobudgeton15October,

2003,prettymuchasdesigned inmy initialproposal. Itwas

enhancedbyeightlevelsofsecurity:physical,logical,network,

data,access,andmore.Sincethenithasbeenusedtocoordi-

natethebankingoperationsofthecentralbank,Rafidain,and

Rasheed,bringingthebankingsystembackon-lineandmov-

ingittowardnormaloperations.

This summer, 2004, the system embraced the 26 private

banksoperatinginIraq,enablingthemtoofferVisatransac-

tions and make settlements through the central bank and

globally.

There is still a long, long way to go before Iraq becomes a

moderneconomywithamodernbankingsystem.Thesolution

wedesignedanddeployedwasaimedatmeetinganurgent

need indifficult times. Itprovidesastartingpointona long

pathofmodernizingtheIraqibankingsystem.

All solutions tocomplexproblems looksimple in retrospect.

ThesolutiondeployedinIraqmayappearobviousrevealedas

a completed whole, but there was twenty years of applied

expertiseonwhatapaymentsystemis,howitneedstooper-

ate,howbanksmustinteract,andhowtheprocessesmustbe

protected which went into specifying the solution last sum-

mer.Combiningpaymentsexpertisewithworkabletechnology

andsupplierswhocoulddeliverinIraqgaveoursolutioncred-

ibilitywiththebankersresponsibleforusingitindailyopera-

tions.

TheIraqibankingnetworkandpaymentsystemcanbecount-

edamongthefewsuccessesofthepastyearinIraq.Evenso,


17

Ilearnedsomevaluablelessonsthathavenothingtodowith

technologyorbanking.Firstlesson:nocontract,noclient.In

my zeal to get the job done, self-interest took a back seat.

NexttimeIwouldsortsomeagreementstoensureIgetpaid.

Second,corruptioncanfrustratethebesttechnology,andthe

Iraqi banking sector has been a magnet for returning exile

carpetbaggers.Evenwiththeoverwhelmingsupportofhighly

professional and enthusiastic native Iraqis who are deter-

minedtorebuildtheirnation,oursystemwasnearlyderailed

bythemalign influenceofafewinterlopers.Finally,there is

nothingmorepermanentthanatemporarysolution.Ournet-

work,originallytobereplacedbyaterrestrialsystemwithin6

months,isstilloperatingtoconnectthe81branchesinstalled

onit,andNSSLandVisaarecooperatingonaworldwidenet-

workleveragingthesuperiorresiliencyandsecurityfeatures

developedforIraq.

Itwasamad,exhilaratingsummerproject.Ihavenothingbut

respectforthepeopleintheCPA,CentralBankofIraq,NSSL,

andVisaInternationalwhomadearealityoftheideasIspun

frommydesktop.Astrongbankingsectorisessentialtoany

economicnormalizationinIraq,andweshouldallwishthem

successgoingforward.

unifying the European payments landscapePhilippe MenierChief Operating Officer, Visa Europe Ltd

example, Santander Central Hispano’s acquisition of Abbey

appearstobeheadingforasuccessfulconclusion.And,with

every passing week there is more speculation about yet

anothermega-merger.Clearly,partofthebusinessrationale

istoachievemorescaleandscope—optimizingthecostbase,

andeliminatingduplicateinfrastructures.

Asarelatedpoint, there is the fateof theshared,domestic

payment processing infrastructures. Everyone agrees that

Europecannotsupportaparallelinfrastructureineverysingle

country,sotheseincumbentsareactivelyhuntingforanew

remit.Intheworldofpaymentcardprocessing,forexample,

Interpay,Banksys,andSSBhavepooledtheirscalebycreating

the SiNSYS joint venture. Then of course there’s the SEPA

visionitself—allthosering-fencednationalsilostobesuper-

sededbyonebigdomesticmarket.

Thebankingindustrymayhavebeenreluctanttochange.But

the first round of regulation and the formation of the

European Payments Council (EPC) proved that this really is

not going to be a matter of choice. Coinciding with this we

havetheemergenceofanewlegalframeworkforpayments,

theCommission’sschemetoharmonizethelegislativecontext

for all payments, not just across the euro-zone, but all E.U.

countries. Covering transparency and liability, security and

fraudprevention,andrevocabilityandrefunds,itwillcreatea

levelplayingfieldacrossthecontinent.

Lookingmorecloselyatourownsector,cardpayments,there

is the European migration to EMV chip technology. This is

significantformanyreasonsbutinthiscontextitisthefirst

timethatEuropeisunitingaroundasinglecardstandard.The

casualobservermaythinkofthecardmarketashighlystan-

dardized.But,scratchbelowthesurfaceandyouseeamass

ofnationalidiosyncrasies.EMVrepresentsabigsteptowards

convergence.

So, yes, many different examples of convergence. I suppose

wehavebeenusingthisword‘convergence’foryearsnow—

toying with the possibilities, but mostly on a hypothetical

level.ItisabitlikethefamousoldquotefromStAugustine:

‘Lord,helpmetobegood—butnotjustyet.’

Nowweseem,finally,tohavereachedthemomentoftruthand

themindsetoftheindustrydoesappeartobeshifting.Evenso,

weare still at the startofavery long,difficultprocess, and

therearesomeverycomplex,emotiveissuestoresolve.

The future of processing studyAgainstthisbackground,VisaEuropecommissionedPayment

SystemsEuropetoundertakeamajorresearchstudyamong

Europeanbanksandprocessors—andsomereadersmayhave

participated in this. We asked for their opinions on today’s

cardprocessingmarket.Weaskedthemhowtheythoughtit

mayevolve.Thefindingsmakeforveryinterestingreading.

Intermsofthebigpicture,thereareprobablynottoomany

surprises. Yes, everyone agrees that SEPA is a worthy aim.

And yes, everyone agrees that it makes sense to move

towards a common payments architecture. In other words,

thereiscompleteconsensusonwhatandwhy.Whereitgets

moretricky iswhenwediscusswho,how,when,andwhere.

Theysaythedevilisinthedetail,andyoudonothavetogo

veryfarbeforeyoumeethimheadon!

But the important thing to acknowledge is this: no one is

happywiththestatusquo.Notthebanks,notthecommercial

processors, and not even the inter-bank processors. Even if

SEPAwerenotontheagenda,therewouldberealpressureto

change, and to move toward more openness, transparency,

standardization,andcompetition.Indeedthestudyshowsus

thatitisnotevenSEPAthatisthebiggestforceforchange.

NorisittheCommission’scompetitionintervention.Insteadit

is the needs and demands of the big pan-European banks

whichisregardedastheprimarychangedriver.

Withregardtothebanks,andlookingatissuerprocessingin

particular,arealdilemmaisrevealed;namely,what,when,and

howmuchtooutsource.Formanybanks,itseemstobecon-

stantlyontheagenda.Forexample,oneofthe20largebanks


19

Asmanyreaderswillbeaware,oneofthecentralobjectives

oftheEuropeanUnionhasbeentocreateasingleEuropean

market where there are no barriers to trade or commerce

across any of the member states. Although the European

Unionhasmadehugestridesinthisdirection,severalobsta-

clescontinuetostandinthewayofthevision,inparticular,

cross-borderretailpaymentshavebeenseenasundulyslow

andexpensive.

Anumberofcommentatorshaveenjoyedpointingthefinger

ofblameatEurope’sretailbanks,butthefactofthematteris

thatE.U.countries(justlikecountrieseverywhereelseinthe

world) have independently created a patchwork of parallel,

incompatiblepaymentnetworks.Giventhatthevastmajority

ofpaymentshasalwaysbeen,andcontinuestobe,domestic,

therehasneverbeenacompellingbusinesscaseforbringing

moreunity to thenational infrastructures.Thenetresult is

that,yes,cross-borderpaymentshavebeenslowandexpen-

sive.Andthisisgenerallyreflectedinthepriceandthequal-

ityofserviceexperiencedbybusinessesandconsumersalike.

Theonenotableexceptionisthecardpaymentsector.Since

its inception, the card systems have effectively ‘overlaid’ a

seriesofdomesticpaymentschemeswithinternationalfunc-

tionality and interoperability. In doing so, it has enabled

highly convenient, highly secure, generally instantaneous

cross-borderandmulti-currencypayments.And ithasdone

soatminimalcost.

Frustratedatthelackofprogressacrossothertypesofretail

payments, the European Commission is taking a tougher

stance.Ithasalreadyintroducedpayment-relatedlegislation

andhasinsistedthatEurope’sbankingcommunitymustnow

progresstowardsaSingleEuropeanPaymentsArea(SEPA),

where any regional payments can be made as easily and

cheaplyasinthelocalmarket.Giventhesuccessofthepay-

mentscardindustryinmitigating,ifnoteliminating,anum-

beroftheaforementionedissues,itmightbeworthassessing

whetherthecardpaymentsector,eitherdirectlyorbyexam-

ple,canplayaroleinhelpingtheindustryachieveitsobjec-

tives.

our perspectiveIt should be noted from the onset that we are not a single

entity,rathertheVisaorganization,likeourpeers,isaninter-

nationalassociationofbanks,unitingmorethan5,000banks

in Europe, and 21,000 worldwide. In Europe, these member

bankshaveissued230millionVisacardswhich,during2003,

wereusedtoconduct824billionworthoftransactions,rep-

resentingclosetotenpercentofpersonalconsumerexpendi-

tureacrossEurope.Memberbanksalsosignupmerchantsto

acceptVisa,orother cards issuedbyourpeers, inorder to

benefitfromfast,efficient,guaranteedcashlesspayments.We

actasthegluewhichbindseverythingtogether.Forexample,

wemanagethebrand,providetheprocessinginfrastructure,

andworkwithbanksandregulatorstoagreeandenforcethe

operatingrulesandregulations,definingtheprecisewaythat

paymentsmustwork,andtheresponsibilitiesofeachpartici-

pantineverytransaction.

Europeanbankswerethefirstnon-Americanparticipants in

Visa.Theywerealsothefirsttoregardit,notasacreditcard

system,butagenericpaymentmechanism.Accordingly,they

werethefirsttoissueVisadebitcards,andthevastmajority

ofourEuropeancardscontinuetobedebit.Sincethesedebit

cardsarethedominantpaymentmeansandthepivotalpoint

ofthebankingrelationship,theytendtohaverealstrategic

significanceforanyretailbank.Accordingly,effectivegover-

nanceandcontrolofthepaymentsystemisatoppriorityfor

European banks, and a highly pertinent issue for European

regulators.Itis,therefore,worthadmittingtoavestedinter-

est—byacknowledgingthatVisahasaverybigstakeinthe

waytheEuropeanpaymentsindustryevolves.And,onbehalf

ofourmemberbanks,weareworkinghardtoinfluencethat

evolution.

convergence across banking and paymentsBefore looking at the specifics of the European retail pay-

ments sector, it is perhaps worth considering the broader

context, by which I mean the multiple convergence trends

acrossthebankingandpaymentssectors.Firstly,themergers

and acquisitions continue apace. At the time of writing, for

cultsituation.Theysaythatthebankshaveanew-foundpre-

occupationwithcostsandefficiencies,oftenattheexpenseof

revenue generation and profitability. Consequently, all they

wantfromtheprocessorsisvanilla-stylecommodityservices.

Clearly,itisnotatalleasyforanyprocessortoexcelinthese

circumstances, particularly when you have to upgrade your

systems,themarketishighlyoversupplied,andtherearebar-

rierstointernationalgrowth.

Ultimately,oneisdrawntotheconclusionthat,with80-plus

commercialandinter-bankprocessorssomethinghastogive.

The banks said, yes, the market has to shrink substantially,

andtheconsensuswasthattheremayberoomfor20to30

players.Theprocessorsagreed,theytoosaidtherewasroom

for20to30playersandsuggestedthatwouldbethesizeof

themarketjustsevenyearsfromnow.

other cross-border retail paymentsItshouldbestressedthatwhatwehavebeendiscussingsofar

is the payment card market and payment card processing.

This is a payments market which is commonly perceived as

themostuniform,theonethatisclosesttotheSEPAideals,

andhasthefewestadjustmentstomake.Sowhataboutthe

prospectsforothertypesofpayment?

Visa has also spent some time analyzing the ACH market.

Specifically, we conducted some very detailed, structured

discussions with our members, and also with the national

ACHs.Incidentally,ouraimwasnottodefinehowVisacould

replaceexistinginfrastructuresandmarketplayers,rather,we

wantedtoexaminewhetherourprocessingcapabilitiescould

enhance thecapabilitiesof incumbentplayers—perhapsby

providing complementary, value-added processing services,

which could result in reduced costs and increased revenues

forbanks.

Again, the findings are extremely interesting. Firstly, it was

thoughtinevitablethatpan-Europeanclearinginfrastructures

will emerge to replace the existing, local ACHs. Moreover, it

wasrecognizedthatthescaleandthefunctionalityofVisaNet

couldaddvaluetobanksandtheprocessing infrastructures

theyareusingtoday.Consequentlymostbankshadaccepted

that,yes,theywouldhavetoinvest—atsomestage.Butwith

alackofclarityregardingthefuturelandscape,itwasgener-

ally thought that now was not the time to make such an

investment.Itwasalsothoughtthat,yes,inanidealworldit

wouldbebesttohaveachoiceofcompetitivePEACHes.But,

ofcourse,thisisnotanidealworld,andtherewasnoappetite

toco-investinanalternativePEACHinfrastructure.

Finally,weaskedtheselargebanksabouttheenvironmentten

yearsfromnow.Theyallagreedontwopoints.Firstly,theyall

agreed that, ten years from now, there would not be more

than4to5wholesalepaymentclearers.And,secondly,all12

bankswespoketoagreedthattheywouldbeoneofthefour

orfivesurvivors!

where to from here?Evenifwearetoconfineourconsiderationstothepayment

cardsector,itisclearthatEurope’sbankshavesomedifficult

choices to make. Let us look at some of the criteria that I

believewillbeimportantinthedecision-makingprocess.

grasping the EmV opportunityAsIhavediscussed,there isdefiniteconsistency intheway

thattheEuropeancreditcardmarketfunctions,andthisalso

extendstochargecardsandsometypesofdebitcard.This,

however,isnotthecaseforalargechunkofthedebitmarket,

particularly in central Europe. Indeed, there are 15 different

domestic card implementations, each of which has its own

particular rules, regulations, and processing infrastructures.

Thecasualobservercouldsuggestthatthecreditcardmodel

shouldsimplybeexportedacrossEurope.Given thehistory,

andthefactthatthedebitcardissoverypivotalinthebank-

ingrelationship,theindustryinsiderwouldlabelsuchasug-

gestionasnaïve.

However, with the implementation of EMV chip technology

right across the region, there is an historic opportunity to


wespoketosaidtheywouldoutsourcealloftheirissuerpro-

cessing immediately, ifonlya suitableprocessorwereavail-

able.Anotheronehadjustchangeditsprocessor.Anothertwo

were in the process of changing, and yet another had just

moveditsprocessingbackin-house.

Sowhatisgoingonhere?Thesebankssaytheyarefrustrated

by the lack of choice and flexibility, they do not like to be

dominated by inter-bank processors, and they are not

impressedwithwhatisonofferfromthethird-partyproces-

sorseither.Yes,theyhavegotanelementofchoicewhenit

comestotheircreditcardprocessing,but,forbanksinmain-

landEurope,thepriorityisinvariablydebit.

Buthowdotheybreakthedeadlock?Again,itisagreedthat

thelargerbankswillbetheonestodecide.Onbalancethese

bigbankssaythat,yes,theywouldliketoseecloseddomestic

markets opened up to competition. They are in a situation

where they are supporting a different inter-bank scheme in

everycountrywhere theyoperate,andeachscheme ispre-

sentingthemwithabigbilltoreplaceanagingdeliveryplat-

form.

Buttherearenotanyeasyexitstrategies.Oneoptioncouldbe

torenewtheirsupportfortheseincumbents,helpingthemto

pursuepan-Europeanstrategies,towincross-bordervolumes

andtherebydrivedowncost.Alternatively,theycouldorches-

tratethesaleoftheseinter-bankprocessors,dismantlinglocal

defensive barriers, and effectively opening the door to the

U.S.-stylethird-partyprocessors.Bothstrategieshavedefinite

drawbacks,sothemorelikelyscenarioisgradual,market-by-

marketliberalization,aswehavebeguntoseeinScandinavia.

Barrierscouldgraduallybe lifted,andstep-by-stepcommer-

cialprocessorscouldbe invitedandencouragedtocompete

withtheinter-bankconsortia.Inthisway,competitionwould

begintochangethemarketdynamicsandimprovethequality

andrangeofservices.

Formany, this isamorepalatableoption.But,evenso, it is

slow,unpredictable,andstillnotacompletesolution.Whatthe

bigpan-Europeanbanksreallyneedismulti-countrysolutions

forissuing,acquiring,andATMs.Today,fewifanyprocessors

couldofferacredibleservice.

So, how about the processors themselves? These organiza-

tionsfallintotwobroadcamps,thecommercialprocessors,or

TPPs, many of which are owned and/or operated by large

Americanmultinationals,andthemutuallyownedinter-bank

processors. It is interesting to note that, although the U.S.-

stylethird-partyprocessorsareadmiredfortheircommercial

focus they do not seem to have adjusted to the realities of

Europe.Bankssaytheyareunhappywiththeirstyleandcom-

plainthatthesolutionstheyareofferedtendtobebasedon

theU.S.orAnglo-Saxonmodel.Theyarefrustratedbyalack

of understanding of the specific requirements of individual

banks in different European countries. It is even suggested

that by simply getting out on the road more often senior

executives could do much to address the skepticism. Also,

thankstotheirfileconversionexpertise,theyhaveaparticu-

lar opportunity in cross-border processing. And, as I said

before, the bigger banks are actively looking for such solu-

tions.

Ishouldstressthatthisisnotanexerciseinanti-Americanism.

Manyofourhomegrownprocessorswereseverelychastised.

Banks tend to believe they get higher quality services from

theirin-houseoperations,andthisreflectsbadlyontheentire

sector.

Movingtotheinter-bankprocessors,thesurveysuggeststhat

theymaybefacinganuncertainfuture.Therewassomecriti-

cismover thequalityofserviceand thecostsof redevelop-

ment. However, no one should underestimate the level of

supporttheyretain.Severalbanksbelievethereisdefinitelya

futureforcooperativeplatformdevelopmentandsharedser-

vices.Theconclusionisclear,solongasitadaptstothereali-

tiesofalarger,moreuniformEuropeanmarket,theinter-bank

cooperationmodel isaliveandwell. It shouldalsobenoted

thatmanyoftheprocessors,irrespectiveofwhethertheyare

thirdpartiesorinter-bankconsortia,faceanimpossiblydiffi-

21

unite, and possibly even converge, around a common plat-

form.Whatwearetalkingabouthereisthecreationofanew

AlwaysChip—AlwaysPINdebitproductforEurope.Inafew

years, Europe will be a mature chip market — indeed, more

than90%ofterminalsandcardswillbeEMV.Inotherwords,

the environment will accommodate fully secure cards, debit

cards inparticular—forwhichconsumers’securityexpecta-

tionsarenotfullymettoday,especiallywhentheytravelout-

side of Europe. To the extent that there is a consensus, it

appears to be that Europe’s banks should aim for a fully

securedebit solution,whichat thepoint-of-salewillbechip

andPINonly.

With no exception items, no skimming of the magstripe, no

fraud,andtheopportunitytooperateoff-lineinselectedenvi-

ronments,suchaproductwouldresultinlowerunitcostsfor

all participants, which would in turn lead to increased mer-

chant and consumer confidence. Our own proposal is for a

product which is fully owned and controlled by Europe’s

banks,andwhichoperatesunderitsownacceptancemark.It

wouldbeabletocoexistwithdomesticdebitschemes,aslong

asthebankswhoowntheseschemesfinditappropriate.Of

course, it would also be an ideal point-of-convergence for

theseschemes.Althoughtherearedifferingviewsaboutthe

timingforsuchconvergence,withinandamongcountries,no

one isarguingwith the fact that itwillandmusthappenat

somepoint.AtVisaEurope,weare,therefore,eagertowork

witheachofourmemberstoseehowsuchaproductcould

help them evolve towards a more secure, more convenient,

andmorecost-efficientEuropeandebitscheme,toppedupby

aEuropean-onlygovernancestructure.

maintaining European ownership and controlWhatsomeobserversfailtoappreciateisthatownershipand

controlofthecardpaymentsystemisahighlyemotivesub-

ject for European banks. Thinking back to chip cards, for

example, theEMVspecification itselfwashammeredout in

Europe,andEuropeistheclearworldleaderinimplementing

it.ThenatureofthecardsissuedhereinEuropeisverydif-

ferentfromelsewhereintheworld,andtheirusagepatterns

arealsoquiteunique.Additionally,nootherbanks face the

challenge of migrating from separate, multi-country infra-

structures to a more unified regional infrastructure. The

recentconstitutionalchangesatVisaEuropeareareflection

of this situation. Traditionally, we operated as a branch of

VisaInternational.But,asofJuly2004,wecreatedasepa-

rately incorporated company called Visa Europe. In effect,

thismeansthatEurope’sbanksarethejoint-ownersofadis-

tinctEuropeanpaymentsbusiness,andtoreflecttheirpropri-

etary interest each one holds a nominal, non-transferable

shareinthecompany.Yet,tomaintainourinternationalism,

VisaEuropeexistsasagroupmember—andco-owner—of

VisaInternational.

Inbusinessterms,incorporationmeansthatwecanaccelerate

ourEuropeandevelopmentwork.Italsomeanswecandevel-

op more technology services and have the freedom and

opportunity toenter intocommercialpartnershipsand joint

ventures. Incorporation also has profound symbolic signifi-

cance.ItdemonstratesthatEurope’sbanksaretheexclusive

owner-operatorsoftheirownregionalpaymentsystem.With

an unambiguous European focus, and pan-European repre-

sentation, we can express their views and represent their

interestsmoreforcefullywithEuropeanassociations,regula-

tory bodies, and forums. In particular, we want regulators,

industry bodies, and working groups to regard us as a wel-

comeandauthoritativepartner.

This issueofownershipandcontrolalsoextendstothepro-

cessinginfrastructurewhichtiestogetherthevariouspartici-

pants. Our various surveys suggest that Europe’s banks are

unwillingtocedecontroltothird-partytechnologycompanies.

PerhapstheyhaveglancedacrosstheAtlanticandseenthe

weightofinfluencewhichsuchcompanieshaveontheterms

andthecostsoftheentirepaymentmarket.

In summary, I believe that Europe’s banks have a deep and

enduring appreciation of the strategic significance of elec-

tronicpayments.Icontend,therefore,thatanycompaniesor

organizationswhichseek to representor serve thesebanks


23

credit card security on the net: where is it today?Sankarson BanerjeeSenior Architect, Mphasis

Internetcommerceisheretostay.Ithasbecomeacommon

methodofpurchaseforawiderangeofproducts,andcontin-

uestogrowatagoodclip.Thedominantpaymentvehicleon

theInternetis,andhasalwaysbeen,thecreditcard.Indeed,

thetwoareinseparable.E-commercedoesnotdowellwhere

creditcardusage isnotprevalent,andthe Internethascer-

tainlygivenaboosttocardspending.

WhenInternetcommercefirstcamealong,creditcardissuers

were woefully under-equipped to handle the security issues

that emerged from this new way of doing business. Credit

cardsweremeanttobephysicallypresentedatthepointof

thesale,sothatthemerchantcouldvalidatethetransaction

andobtainasignaturethatrepresentedalegallybindingcon-

tract to pay between cardholder and merchant, with the

creditcard intermediariesactingasfacilitators.TheInternet

introducedawholenewparadigm,wheresellersandbuyers

did not come face-to-face, could easily hide their identities,

andrequirednosignature.Thisledtohighratesoffraudthat

oftenleftmerchantsreelingandcustomersunhappy.

Thecreditcardindustryhasrespondedwithmanymeasures

aimedatloweringtherateoffraudtoacceptablelevels.Some

measureshave,overtheyears,becomequitewidespread.This

articlestudiesfiveschemesthatwerelaunchedbythecredit

card industry in the last few years, and how well they have

servedtheirpurpose.

card Verification Value (cVV2)One of the earliest measures dates back nearly a decade.

Also called the Card Validation Code (CVC2) or Card

IdentificationNumber(CID),itisa3-digitnumber(4-digitfor

Amex)printedonthecreditcardthatisnotinraisedlettering

andnotpresentinthemagneticstrip.Itdoesnotshowupon

creditcardreceiptseither.ThesenumbersarepresentinVisa,

MasterCard, Discover, Amex, and Diners cards. MasterCard

has had it on every card issued 1997. The way it works is

simple; websites ask the user for the CVV2 along with the

cardnumber.Itdoesnotverifytheidentityofthecardholder;

itjusttriestoensurethatthepersonhasthecardphysically

availabletohimorheratthepointofpurchase.

Thoughthetechnologyhasbeenavailableforthebetterpart

ofadecadenow,implementationeventodayispatchy.Credit

card companies will not refuse transactions where the CVV

doesnotmatch;onlyaflagissentbackandthemerchantis

allowed to decide if CVV match should be enforced. More

importantly,exceptinthecaseofAmericanExpress,collecting

andmatchingaCVVnumberdoesnotprovideamerchantwith

any additional protection against charge-backs. A purchase

canbedisputedandchargedbacktothemerchantevenifthe

CVVnumberwascorrect.Therateofcharge-backislowerthan

theratesatwhichCVVmatchesfail,soevenlegitimatecard-

holdersareenteringtheirCVVwrongsomeofthetime.

CVVdoesnotreallypreventtrustedpartyfraud.Thewaiteror

grocerystoreclerkentrustedwithswipingthecardcancopy

theCVV justaseasilyas thecardnumber. Iteliminates the

situationswhereadiscardedcharge-sliporstatementcanbe

usedtolocatethecreditcardnumber,althoughgettingcredit

carddetailsfromtheformerisalreadybecomingmorediffi-

cult as most now mask part or all of the number. It does,

however,seemtolowerthepercentageoffraud;theeffectis

possiblythatofapsychologicaldeterrent.

3d security3D, or Three Domain security, is an Authenticated Payment

Solution.Thismeansthatthepersonmakingthepaymentis

authenticated,astheholderofthecreditcard,inadditionto

thepayment itselfbeingauthorized.Visa’ssolution iscalled

‘VerifiedbyVisa’.ThewayitworksisthatVisaasksthecus-

tomerataparticipatingmerchant’ssitetoconfirmboththe

creditcardnumberandenterapre-decidedPINorpassword.

IfthePINisnotenteredcorrectly,thetransactionisrefused.

ItisveryunlikelythatacreditcardthiefwillknowthePIN,so

the transaction should be safer. Further, the PIN cannot be

accessed by someone in temporary possession of the card.

MasterCardhasasimilarprogram,calledSecureCode.

Thesuccessofthesystemisdependentontwofactors,that

thecreditcardcustomerswillenrollthemselvesintheVerified

forVisaprogramandcreateaPIN for themselves,and that

the merchants will participate in the program. Customer

acceptancedoesnotseemtohavebeenpoor;Visaestimates

thatnearly40%ofitscustomersintheU.S.arenowenrolled.

Merchants,however,havebeenfarlessenthusiastic.Barelya

handful of Internet sites support the mechanism, and most

majorretailershavenotshownenthusiasm.

The question here is the kind of protection this program

affords, and who it protects. Assuming that the cardholder

takes reasonable care with the PIN, this affords protection

against misuse on the sites that support it. However, two

pointsmustbemade.Firstly,mostconsumersarealreadywell

protectedfromunauthorizedchargesontheircreditcardsby

the card issuer. Except for the inconvenience of having to

dispute a charge, the cardholder is usually not liable for a

fraudulent transaction. Secondly, unless the card covers a

largemajorityofmerchantseverywhereontheInternet,there

isverylittletodeteracardthief.Thereasonwhymerchants

havenotshownenthusiasmisthattheystandtogainlittleby

thisprogram.Adoptingtheprogramdoesnotgetthemlower

interchangefeesreflectingtheloweredriskofdoingbusiness.

It does not even protect them against the cost of bearing

charge-backs.Customerscanstilldisputechargesand,justas

inthecaseofCVV2,noextraconsideration isgiventomer-

chants.Mostmerchants,therefore,arereluctanttomakethe

change,whichmeansimplementationcostaswellascustom-

erissues(1-clickordering,forinstance,willnolongerwork).

Address Verification systems (AVs)The theory behind address verification is that the billing

addressofacreditcardismoredifficultforathieftogather.

Awaiteratarestaurantcaneasilynotedownthecardnumber,

buthasnowayofobtainingthebillingaddress.Furthermore,

merchantscaninsistthathighvalueproductsbeshippedonly

tothebillingaddress,makingitlesslikelythatsomeoneother

thanthecardholdercanbenefit fromthepurchase.Address

Verification is todayavailable forallcardholders in theU.S.,

andinsomeothercountriesliketheU.K.

Addressverificationrequiressubstantialinvestmentbycredit

cardissuers.Issuersaretheonlypersonswithaccesstothe

customer’s billing address and their ability to publish this

informationreal-timetopaymentprocessorsiscriticaltothe

AVS method. Countries outside the U.S. have been slow to

adapt to AVS, so this method is usually not available for

Internationalcustomers.BillingaddressevenwithintheU.S.is

not guaranteed reliable. Some users do not update their

addresseswiththecreditcardcompanywhentheymove,rely-

inginsteadonforwardingservicesofthepostoffice.Byand

large,however,billingaddressestendtobecurrentandusing

themasverificationcanbequiteeffective.

Therearesomeproblems,however.Forexample,creditcard

thievesdonotfinditsodifficulttolocatethebillingaddress

of a person; these are routinely stored with the merchant

along with the credit card number. It can also be obtained

from a person’s discarded statements. In this respect, it is

muchweakerthan3DSecure.Someoftheseproblemscanbe

addressed by insisting that goods (especially high value

goods)beshippedonlytothebillingaddress,thuspreventing

thethieffrombenefitingeasilyfromthepurchases.However,

thiscreatesmore issues. Itdoesnotworkforsoftproducts,

suchassoftwarelicensesorporn,andmakesitmoredifficult

forpeopletosendgifts,whichformalargepercentageofthe

commerce. Additionally, many people send their credit card

statementstotheirownortheiraccountant’soffice.Because

oftheseissues,AVSisusedmoreasacheckthanamecha-

nismtoguaranteeatransaction.

surrogate numbersOne clever way to avoid exposing credit card numbers to a

merchantistousedisposablecreditcardnumbersgenerated

foraspecifictransactionandvalidonlyforafixeddurationor

withaparticularmerchant.

Two companies lead in this technology, which has been

adoptedbysomeoftheworld’slargestcardissuers.American

ExpresscallsitPrivatePaymentsandMBNAcallsitShopSafe.

Theprocessissimple.Whenmakingapurchase,thecustomer


25

uses a small application to generate a one-use credit card

numberwithafixedvalueandashortvalidityperiod(usually

twomonths).Thiscardnumberisvalidonlyforonetransac-

tion,or forrepeatedtransactionswithinthevalidityperiod.

The credit card company maps these temporary numbers

backtothecardholder’soriginalcard.

Thetechnologyisveryeffectivewhenusedagainstunknown

merchants,especiallyonauctionsitesorforpurchasingone-

offservicesfromsmallsites.Itisprettymuchimpossiblefor

themerchanttodefraudonthetransactionoutsidethescope

definedbythecustomer.

Issues still remain. This approach negates the huge conve-

nienceof 1-click shopping, requiring thecustomer to fill the

card details each time. Furthermore, for services which are

bookedwithacardbutrequiretheproductionofthatcardat

thetimeoftakingdelivery,suchaswithmovieticketsorair

tickets,thisapproachcausessignificantheadaches.

Anotherissueisthatifthismethodisadoptedforwidespread

use,therewillsoonbeashortageofnumbers.Ofthe16digits

onacreditcard,only10aretrulyvariableforasingleissuer,

leadingtoapproximately10billionpossiblecards.Thatisnot

aproblemwhenphysicalcardsarebeingissued,butitiscer-

tainly not a large limit if each transaction uses a different

temporarycardnumber.

chip cards and smart cardsCredit cards with embedded chips were supposed to be the

ultimatesecuritymechanism.Suchcardsareverycommonin

Europe,wherealargenumberofMasterCardbrandedcredit

cards have them. In the U.S. American Express is the only

major issuer to offer them, on one of their cards (The Blue

card).

Ifallthepiecesofthecreditcardtransactionweresmart-card

enabled, the transactioncould indeedbemadeverysecure.

This,however,involvestheuseofasmartcardreaderanda

computer with the appropriate software; both prove to be

troublesome.Whilecardreaderhardwareisoftendistributed

free,fewusersgothroughthetroubleofhookingthemupand

installingthem.Thereadersareinconvenientforlaptopusers,

whomaynotevenhaveaslottoplugtheminto.Furthermore,

most households in America have multiple computers, and

usuallyonlyonereader issuppliedfor freewitheverycard.

Becauseoftheseandotherissues,usageofthesmartcapa-

bilitiesofthesecreditcardsisverylow.Mostpeoplejustuse

themasregularcreditcards.Merchantstoodonotinvestin

fullysmart-cardenabledpurchasingmechanisms.

conclusionNone of the new measures studied really provide the silver

bullet,theonewaytoensureacompletelysafetransactionon

the Internet for both merchants and consumers. Most offer

somelevelofincreasedprotection,butdonotreallyaddress

theissueofexcessivecharge-backs,anissueofprimarycon-

cernwithmerchantsandissuers.Thisisdirectlyreflectedin

the reluctance by VISA and MasterCard to lower the inter-

changefeeschargedforInternettransactionsevenifoneof

thespecifiedmethodsisadopted.

Credit card usage on the Internet is clearly on the way up.

Fraud rates, though higher than with other channels, have

heldsteadyforsometime.Muchofthis isthepsychological

assurance that these measures, often well publicized, have

contributed to better security. It increases consumer confi-

denceinthesystemandpromotestheperceptionthatfraud

isdifficult.

Amoreimportantreasonisprobablytheincreasedabilityof

merchantstotrackandprosecutethebigoffenders,andtheir

increasedabilitytodetectandpredictfraudulentbehaviorso

thattheycancarryoutmoredetailedchecks(possiblyoffline)

onindividualtransactionsthatseemsuspicious.Thatisprob-

ablythewayitisgoingtocontinue—betterpolicing,smarter

detectionofpossiblefraud,andconfidencebuildingviaindus-

try-widemeasures.

Broadening the value proposition around payments outsourcingThomas HalpinVice President, JPMorgan Treasury Services

advice-to-receive MT 210 matching tools that improve trea-

sury and receivables management, as well as Web-based

toolsthatimprovecustomerserviceandinformationreport-

ing(i.e.fasterinquiryresponseandtheabilitytoproactively

steminquiries).Suchcapabilitieshelpthebuyersofanout-

sourcingsolutiontodifferentiatetheirpaymentserviceswith

theirowncustomerbase. Institutionsconsideringmigrating

toanoutsourcingsolutionshouldlearnaboutthevalue-add-

edcapabilitiesthatpotentialoutsourcingprovidersincludein

theirsolutions.

Such features help broaden an outsourcing solution’s value

propositiontoonethatpotentiallyimprovesclientsatisfaction

and creates new revenue streams that support a model of

businessgrowth.Atthesametime,abuyerofpaymentsout-

sourcingretainsitsdirectclearingmembershipforcontinued

visibilityinthemarket.

core competency or competitive advantage?Distinguishing between core competency and competitive

advantageiscentraltothedecisionofwhethertopurchasean

outsourcing solution. Potential buyers should ask, ‘How can

weobtaincompetitiveadvantageinservicesthatourclients

expectustodeliver?’Corecompetencyissomethinganinsti-

tution does well, but competitive advantage is what a firm

mustestablishtodifferentiateitselfinthemarketandcreate

long-termsustainablewealth.

The new reality for the financial services industry includes

industryconsolidation,newregulatoryrequirements,increas-

ing business-resiliency measures, evolving client needs, and

changing technology. Today financial institutions must hon-

estlyassesstheirbusinessstrategytoensuretheyaredirect-

ingresourcesinamanneroptimalforgeneratingsustainable

profitability.

Whenconsideringoutsourcingpayments, institutionsshould

assess the impact of maintaining their current model and

evaluatethefuturedirectionofthemarketandthechanges

requiredtostaycompetitive.Theyshoulddistinguishbetween

corecapabilityandcompetitiveadvantageandconsider the

outsourcingoptionfromabroadenedperspective.


27

Historically,paymentsoutsourcinghasbeenviewedasacost-

savings measure. Today, financial institutions are searching

for alternatives to maintaining their own infrastructures for

deliveringtransactionservices.Institutionsarerealizingthat

apaymentsoutsourcingsolutionhasabroadervalueproposi-

tionthancostsavingsalone.Therightsolutioncanbeastra-

tegic decision that drives revenue growth, deepens client

relationships,andsupportssustainedprofitability.

Key to this broadened value proposition is finding the right

outsourcing provider, one with the scale to drive efficiency

alongsiderobustproductcapabilitiesandbestpracticesthat

improve quality while providing superior controls. Further-

more, a provider should demonstrate a long-term commit-

ment to maintaining a best-of-breed capability, which helps

the solution’s buyers gain a competitive edge in delivering

paymentsservicestotheirowncustomerbase.

Tipping the scale towards profitable growthInstitutions without the scale of business to compete effi-

cientlymust findviablealternatives to theirownpayments

infrastructure. Many are looking for ways to leverage the

scale of other providers in order to stay in the payments

space.Anoutsourcingmodelisemergingasastrategicsolu-

tionthatenables institutionstocontinueservingtheirmar-

ketswithpaymentsservices.Andtherightoutsourcingpro-

vidercanhelpitsclientsincreasetheirexistingcapabilitiesso

astodifferentiatetheirservicesforcompetitiveadvantage.

choosing an outsourcing modelA number of today’s outsourcing vendors, including banks,

serveasapplicationserviceproviders (ASP).Amoreselect

fewalsoofferabusinessprocessservicesmodel(BSP).With

theASPmodel,thevendorhostsafundstransfertechnology

solutiononbehalfoftheinstitutionalclient,whiletheclient

continues to provide the resources for pre-processing and

post-transactionserviceactivities.With theBSPmodel, the

vendorprovides transactionprocessingandserviceactivity

— including investigations, repairs, and other day-to-day

operationsthatsupporttheclient’spaymentclearingactivity

—inadditiontohostingthetechnologyplatform.

ThekeytoaBSPapproachisthatthesolutionneverlimitsthe

client’sabilitytocontrolitspaymentflows.Rather,itgivesthe

client options and choices for how to manage their funds

transferactivity.Forexample, theclient canelect tohandle

the payment release, repair, and settlement, or choose to

engageinbalancemonitoringtoensurethattheircustomers

haveenoughfundstoauthorizepaymentrelease.Thebuyer

oftheoutsourcingservicemaintainscontroloverthebusiness

processesanddecidesitslevelofinvolvementinthecontinu-

umofprocesses.

Potential buyers of outsourcing services should consider

whether a vendor offers both ASP and BSP models or pro-

vides a technology platform only (ASP) and outsources the

BSPcomponent,asavendorthatactsasanapplicationser-

viceprovider,butalsooffersbusinessprocessservices,may

beoutsourcingthatcomponenttoyetanotherprovider.

maintaining excellence for the long-term Buyersofpaymentsoutsourcingshouldbesurethatpotential

providers have a vested long-term interest in maintaining a

leadingcapabilitythatincorporatesbestpractice.Thislevelof

commitment can be a differentiator when distinguishing

among outsourcing providers. Demonstrated market leader-

shipoftenreflectsaclear long-termcommitment.Whenthe

underlyingpaymentsbusiness ismission-criticaltoaprovid-

er’soverallfranchise,itmeansthattheproviderhasavested

interestinmaintainingabest-practiceenvironmentandstay-

ingattheforefrontofthepaymentindustry’sfuturedirection.

Consequently,best-in-classprovidersshouldenableclientsto

benefitfromstraight-through-processingratesofcloseto97

percent on their pre-processing activities, which lowers the

numberofprocessrepairs.Ofcourse,alowererrorrateand

improvedpaymentprocessingefficiencytranslatesintomore

timelypaymentsand improved liquiditymanagement.Best-

in-class providers should be expected to have invested in

value-addedfeatureslikee-mailnotificationofpaymentsand

Bringing payments togetherMichel AkkermansChairman and CEO, Clear2Pay

theever-changingdemandsofthecustomer.Paymentsplat-

formsthatareinexistencetodaywerejustnotbuilttocater

forthismodel.

Totacklethe issuesof loweringcost, improvingservice,and

supportingnewproducts,banksneedtoembarkonatechnol-

ogy refresh. This technology refresh cannot simply be a

replacement.Theneedforoptimizationofbusinessprocesses

isasbig, ifnotbigger,thanthedeploymentofsystemsthat

make wide use of the Internet and associated technologies.

Theansweriscertainlynottotakethe‘big-bang’approach.It

isnotpracticaltobelievethatthereisamagicaloff-the-shelf

solution to this problem. Though payment systems seem to

caterforthesameneedstheworldover,thedifferencesfrom

onebanktothenextaresignificant.

Whenconsideringthisproblem,itiseasytolosesightofone

ofthemostfundamentalissues,thebusinessprocess.Whilst

allthesilosthathavebeendevelopedaretocaterfordifferent

typesofpayments,whenbrokendowntothelowestcommon

denominator, a payment, irrespective of type, involves the

debitingofoneaccountwithanamountandthecreditingof

another account with that same amount. We need to bring

paymentstogetherbygoingbacktothebasics.

There is a wayAbankshouldtakeacorporateviewofpaymentsasanenter-

prise-wideissue.Theyshouldlookforasolutionthatabstracts

thepaymentprocessfromthechannelsandthatoptimizesthe

businessprocessesirrespectiveofpaymenttype,recognizing

thatwhetherapaymentisalow-valuebatchACHtransaction

orahigh-valuecross-borderpayment,thecoreprocessesare

mostly similar. Common processes are, for example, balance

and limit checking, account number validation, deadline and

cut-offverification,branchidentifierorsortcode.Thesepro-

cessesareimplementedinthemainprocessflowsirrespective

ofpaymenttype.Itbecomesimportanttounderstandthedif-

ferences,isolatethosedifferences,andprocessthemaccord-

inglyoutsidethemainprocessflowsinbusinessprocessesthat

handlethoseuniqueexceptions.Thisistheroutetoradically

reduceprocessduplication,reducinginturntheneedfordupli-

cateinfrastructureandultimatelyleadingtolowercost.

Thesecondpartofthereflectioncentersonhowtoestablish

the roll-out of a payment hub while respecting legacy pay-

mentsystemsandarestilloperatingtothefullsatisfactionof

allconcerned.Mostofthesearetypicallyconnectionstolocal

domestic and international payment networks. A phased

approachmovingawayfromthesiloedpaymentprocessesis

an appropriate route, as it significantly reduces the risk of

failure in building the next generation payment processing

platform. Phasing involves establishing an inventory of the

systemsinplaceandmappingthemagainstthenewservices

thatneedtobeprovided,whilemaintainingtheendgoalofa

component-basedpaymentinfrastructure.

Thestepsofestablishingthephasingfortheroll-outare:Map

the existing bank payment systems against the optimized

component-basedpaymentinfrastructure,prioritizebyidenti-

fyingurgentneedsandselectingkeycomponentsagainstthe

optimizedinfrastructure,andimplementthenewservicesand

initiate gradual migration to the new infrastructure of the

legacysystems.

Over time the payment type independence, the component

re-use, and the volume growth will be achieved, ultimately

leadingtoefficientstraight-through-processing,singleviewof

customer, integrated liquidity and risk management, all-

encompassingfrauddetection,andglobalpaymentmanage-

mentsolution.Allthiswithalowcostapproachofimplement-

ingthepaymenthubinfrastructure,becauseabankcangrow

its payment center in a value-based and affordable manner

overtime.

The solutionA bank payment hub is the most practical and future-proof

systemtomatchabank’sobjectivesandrolloutapproach.It

isacomponent-basedpaymentsarchitecturecompliantwith

thelatesttechnologystandards.Thedifferentelementsofthe

architecturearebusinessprocessmanager,businessservices,


29

Over the past 30 years the payments industry has grown

increasingly more complex, creating unwieldy silos within

banks. In the developed world Automated Clearing Houses

(ACH)werecreated toprocess low-valuepayments thatare

enteredthroughavarietyofchannels, includingchecksand

other paper instruments, telephone, file transfer, branch,

Internet,ATMandso forth.Oftenthesechannelshavetheir

own infrastructure to process these payments correctly

before they are forwarded to the Clearing House for settle-

ment.Furthermore,theseACHpaymentsvaryfromcountryto

countryandusedifferentproprietaryformats.

Theintroductionofhigh-valuepaymentssystems,calledReal

TimeGrossSettlement,madeitpossibleforpaymentstobe

cleared in real-time or near real-time. Although they have

significant overlap with ACH payments, with regard to the

processesthatareapplied,ithasunfortunatelynotprevented

banksandClearingHousesfromcreatinganotherwholenew

setofinfrastructures,tohandle,forallintentsandpurposes,

thesamepayment.AswiththeACHpayments,multiplechan-

nelsareusedtoenterRTGSpaymentsintothesystem.

BothACHandRTGSaredomesticpaymentsystemsandwere

notcreatedtohandlecross-bordertransactions.Inresponse,

anumberofthebankscreatedSWIFT,TheSocietyforWorld

International Funds Transfer, which is a secure messaging

infrastructurethatworksontheprincipleofcorrespondents.

ASWIFTmemberbankoffersaccessto localclearingfor its

overseas correspondent banks, and vice versa. Once again,

although in essence a cross-border payment enables an

accounttobedebitedandananothertobecredited,albeit,

foraccountsthatareheldindifferentcountriesanddifferent

currencies,acompletelyseparateinfrastructurehasbeencre-

atedwithinbankstohandlecross-borderpayments.Aswith

ACH and RTGS payments, there are a variety of channels

available to thecustomer to initiatecross-borderpayments,

whichonceagainduplicatedmoreinfrastructures.Inaddition,

duetothenatureandcomplexityofthepaymentinstructions

oftenalargebackofficestaffwasneededtomanuallyenter

andrepairpayments.

Whilst the world of bank payments was evolving from low

valuethroughtohighvalueandcross-border,atotallydiffer-

entindustryandinfrastructurewasforminginparallel,cards.

Initially card associations were limited to processing credit

transactions, but that has been extended to include debit

transactions attached to a debit account. Within a financial

institution,itistypicalforthecardsdivisiontobecompletely

separatefromanyoftheotherpaymentsdivisions.Thisledto

thecreationofotherseparateinfrastructurestohandlepay-

ments via credit and debit cards, using other standards for

processingofthecardpaymenttransactions.Whenonecon-

sidersthispictureitisnothardtounderstandthatalthough

banksgenerate35%ofallrevenuesthroughpayments,they

also incur around 40% of their total cost, according to the

BostonConsultingGroup.

The challengeTheend-resultofthisevolutionisthatpaymentssystemsare

siloed, resulting inahugeamountof infrastructureduplica-

tion, both hardware and software, and becoming a severe

maintenance headache. Systems are dated, difficult to sup-

port,andinmanycasesrunningontechnologyplatformsthat

areunsupportedorwillbe inthenearfuture. Infrastructure

duplication has not been limited to technology, but also

involvesstaffemployedtoensuresmoothprocessingofnon-

STPpaymentsandtomonitorandmaintaintheinfrastructure.

Theseissuestranslateintoavarietyofchallengesforbanks,

suchasmakingchangestopaymentsystemsquickly,provid-

ingcustomerswith informationaboutthepayment lifecycle,

to process payment related information such as purchase

orders,invoices,andremittanceadvices,tohaveanintegrated

viewofthecustomer,andbeingabletotrackpaymentsend-

to-end.Silosrequiresimilarchangestobemadeinmorethan

oneplaceandincreasethecostofownership.

Intoday’sworldoffranticcompetition,banksneedtheflexibil-

itytobeabletooffernewcompetitiveproductstotheircus-

tomersquickly.Moreandmore,thisrequiresthebankstech-

nologyplatformstobeconfigurable,flexible,andadaptableto

dations that occur prior to a payment being passed to the

payment hub and passes them to the BPM with flags that

indicate what rules have been applied to the payment. This

allows the BPM to determine the workflow entry point and

businessservicesthatneedtobeappliedtothepayment in

ordertocompletetheprocessingofthepayment.

ByusingthisapproachofCAAs,itiseasiertomigrateexisting

functionality from existing channels into the payment hub.

Whenfirstimplementingapaymenthub,itislikelythatexist-

ingchannelsalreadyperformsomeoftherequiredpayments

processing.

Inthisscenariothepaymenthubeitherdoesnotneedtopro-

videallpaymentprocessingortheworkflowcanbeconfigured

suchthattheprocessingalreadyperformedinthechannelsis

notperformedagaininthepaymenthub.Inthelongerterm,

itisrelativelyeasytomigratethefunctionalitypresentinthe

channelintothepaymenthub.Thefunctionalityinthechan-

nelcanbeswitchedoffandtheworkflowinthepaymenthub

canbeextendedtoincludetheprocessingpreviouslycarried

outinthechannel.

channel aware submitterChannelawaresubmitters(CAS)aresimilartoCAAs.Thedif-

ferencebeingthattheysubmitpaymentsfromthepayment

hub to external systems for processing. These external sys-

temsrangefromotherbanksystems(suchasthehost),truly

externalsystems(suchasthelocalACHorRTGSsystem),the

SWIFT gateways, and the customer delivery channels. The

submittersareresponsibleformappingthepayments intoa

formatexpectedbythetargetsystemandtheyalsohavetobe

abletoaddordeleteinformationthatisexpectedbythedeliv-

erychannel.Agoodexampleofthisisanysecurityhandshake

thatwouldneedtooccurforauthenticationpurposesbetween

twoexternalsystems.

conclusionUsingacorepaymentsengine,abankachievesitsobjective

to operate an intelligent central transaction hub that man-

ages all payments transactions originating from all of the

bank’se-channelsandbranches.Byadoptingasystemthatis

services as well as components-based, they migrate over

timeandattheirownpacetoafuture-proofplatformthatis

thecenterofallpaymentflowsindependentofwherethedif-

ferentcomponentsoperateorwhowroteordevelopedthem.

Abstractingandrationalizingthebusinessprocessfromthe

channelsyieldsimmediatebenefitsthatimproveoperational

efficiency.Thechannelawareprocesses,bothadaptersand

submitters,allowthebanktoshieldtheunderlyingprocesses

fromthechannelsand tobecomeflexible inacceptingnew

channels. Future developments are not only made at their

ownpacebutarealsovendorindependent,becausethesolu-

tionallowsthebanktodeveloptheirchangesandnewcom-

ponents in-house. Thus making it easier to react to new

developingbusinessneedsthatpresentafavorablebusiness

case.


dataaccesslayer,channelawareadapter,andchannelaware

submitter.Standardcomponentsmustbedeliveredtogether

withatoolkitthatabankcanusetoextendthefunctionality.

Business process managerAbstracting the workflow and business process from the

underlying business services, offers the necessary flexibility

requiredtorolloutacomponent-basedpaymentarchitecture.

The business process manager (BPM) is at the heart of the

paymenthubandperformsthekeyrolesofworkflowandbusi-

nessprocessmanagement.TheBPMhasnoprocessingcapa-

bility.Whenapayment is receivedby thepaymenthub, the

BPMidentifiesthetypeofpaymentandcallstheappropriate

workflowandrelatedbusinessprocesses.

Ifanewbusinessprocessstepneedstobeaddedtothework-

flow,forexamplecateringforanewregulation, it isdoneat

the BPM layer without any change to the existing business

services.Likewise,ifabusinessservicewritteninanoldtech-

nology needs to be replaced, this is done so without any

changestotheBPM.Havingthiscapabilityinsulatesthepay-

mentsystemarchitecturefromfuturechangesthatcannotbe

plannedforatthedesignanddevelopmentstage,trulyoffer-

ingtheoftencalledfortime-to-marketandflexibilitybenefits.

Business servicesBusinessservicesarediscretecomponentsthatexecuteunits

ofwork.Thecomponentsareservicestobeusedwhenpro-

cessingmanydifferentpaymenttypesviadifferentchannels.

TheBPMinvokescomponentsorprocessestoperformcertain

tasksintheorderdeterminedbytheBPM.Thesecomponents

arecontextless,whichmeansthattheyhavenoknowledgeof

theworkfloworprocess.Theyreceivearequestwithassoci-

atedparameters,performtheirtask,andreturntheresultto

theBPM.Providedthattheexistingbankapplicationsadhere

totheinterfacelayerdefinedbytheBPM,itispossibletore-

useexistingcomponentsthatarealreadyutilizedwithinthe

bank’s environment. Similarly, it is possible to use existing

third-party components if they support the interface of the

BPMoriftheycanbewrappedtosupportit.

data access layer Thedataaccesslayer(DAL)isthelogicalinfrastructurelayer

that the payment hub sits on. The business services access

thedatathroughtheDAL,whichdescribesthedataelements

thatresidewithinoneormorephysicaldatabases.TheDAL

usesdataresidentwithinthepaymenthubandaccessesinfor-

mation retrieved from sources outside. There can be data

elementsthatarenotdirectlypayment-relatedthatneverthe-

lessneedtobeaccessibleinordertoprovideforend-to-end

paymentsprocessing.

Ifpartofthebusinessprocessistocheckthelimitsandthe

account information is held on a host, the business service

invoked by the BPM will retrieve the account limit for the

specified account number. The business service expects a

standard logical data model, part of the payment hub that

defineswherelimitsdataisretrievedfrom.TheDALservices

thedifferentbusinessserviceswiththedatatheyrequire,and

performs the actions required to get information from the

outsideworlditself.

AswiththeBPMlayer,theDALneedstobeabstractedfrom

itsphysicalimplementationinordertoprovideinsulationfrom

future changes and from diverse implementation environ-

ments.Inevitablytherearechangestothephysicaldataloca-

tionanditisimportantthattheydonotnecessarilyhavean

effectontheBPMandbusinessservices.Similarlyitisneces-

sarytoallowchangestotheBPMandbusinessservicesthat

have no effect on the logical or physical deployment of the

DAL.

channel aware adapters Thechannelawareadapters(CAA)manageontheonehand

thespecificsof thechannel,which range fromaweb-based

channel,anIVR,message-basedreal-timepaymentsorlarge

file-based batch payments, basically across all the different

communicationand transportprotocols thatexist in today’s

fragmentedpaymentsworld.

Ontheotherhand,theCAAmanagesthepre-processingvali-

31

Emerging models


Hans geigerProfessor, The Swiss Banking Institute,

university of Zurich

Fritz KleinIndependent Consultant, and Chairman,

CLS Holdings/CLS Bank International

Abstract

Paymentsandpaymentsystemsareanimportantfunctionof

banksandthebankingsystem.Financial intermediation, the

coreroleofthebankingindustry,canbedividedintocapital

andpaymentintermediation.Alothasbeenanalyzed,written,

andsaidaboutcapitalintermediation,itsbalancesheetrelat-

ed risk management and regulation. Risk management and

regulationrelatedtopaymentsystemsisanewertopic.This

article points out sources of risk in payments and payment

systemsandanalysestheapproachtoregulation.

33


Thetermfinancialintermediationisgenerallyusedtodescribe

thefinancialserviceindustry’sroleasamiddlemanbetween

theultimatesaversandborrowers.Wecallthisfunctioncapi-

tal intermediation. In addition, a second sphere of financial

intermediation exists, which can be described as payment

intermediation. It stands for the financial function of the

middlemanbetweenthepayerandthepayeeasthemonetary

componentinamarkettransaction.AccordingtoMertonand

Bodie,‘clearingandsettlingpayments’isoneofthesixcore

functionsperformedbyafinancialsystem.Althoughpayment

intermediationisalesspopularsubjectthancapitalinterme-

diation,itplaysanequallyimportantroleinoureconomy.Itis

thegoalof thispaper tomakeacontribution toourunder-

standingoftherisksandrewardsofpaymentintermediation,

andtodiscusswhetheritshouldberegulatedandsupervised,

andifso,howthisshouldbedone.

Paymentintermediationishighlyimportantfortheeconomic

wealth of the world. Without the use of effective payment

mechanisms,today’sdivisionof laborthroughmarkettrans-

actions would be impossible, Adam Smith’s invisible hand

couldnotperformitsvitalrole,andtheworldwouldremain

stuckinaprehistoric,self-supplyingeconomy.Inthiscontext

itisinterestingtolookbackontheoriginofbankinginEurope.

The driving force behind the development of the financial

system of pre-industrial Europe was not lending per se, but

payments[Kohn(2001)].Inthemedievaleconomy,mosttrade

tookplacewithinlocalcommunitiesofpeoplewhoknewone

another well, and such trade was largely conducted on the

basisof trust.Thesubsequentdevelopmentof tradeamong

strangersindifferentlocationsintroducedanewchallenging

task,whichwastoovercomeanonymityandthedifferencesin

time and distance. This task required new methods of pay-

ment that did not depend on spatial proximity and mutual

acquaintancebetweenthepayerandthepayee.Thetwoprin-

cipalfinancialinnovationsofpre-industrialEurope,thedepos-

itbankandthebillofexchange,evolvedtoaddressthisneed

and moved the banks into their present intermediary role,

substitutingthecounterpartyinthepaymentprocessbothfor

thesellerandthebuyer[McAndrewsandRoberds(1999)].

Becauseamultitudeofbanksexist intoday’sword,allnon-

cash payments for transactions, where the buyer and the

sellerdonothavetheiraccountswiththesamebank,trigger

secondarytransactionsbetweenthebanksofthepayerand

the payee. These secondary transactions are processed

throughstreet-sideorinter-banksystems.Today,street-side

systemsareattheveryheartofeffectiveandefficientpay-

ments. There are three basic architectures for organizing

suchsystems,thenetwork,whereallbanksmaintainbilateral

accountrelationshipswitheachother(aspecialcaseofthe

network is the correspondent banking system, where some

banks act as special nodes in the network and serve other

banks),thecentralizedclearingandsettlementorganization,

which serves as a hub for all the banks (the clearinghouse

collects the payment transactions of all the banks over a

certainperiodoftimeandcalculatesanetpositionforevery

bank. Upon settlement the clearinghouse debits or credits

the participating banks with the net amount of all transac-

tions),andthereal-timegrosssettlementsystem,analterna-

tive central solution, where the payment transactions are

continuouslychargedandcreditedtotheaccountsthatthe

participatingbanksmaintainwiththecentralsystem.Thetwo

systemswithacentralizedarchitectureareoftenoperatedor

closelysupervisedbyacentralbankandserveasatransmis-

sionmechanismformonetarypolicy.Thecentralizedsystems

havetraditionallybeenorganizedbyeachindividualcountry

andbycurrency,whichmade internationalpayments ineffi-

cient, costly, and risk-prone. International payments still

depend largelyonthedecentralizedcorrespondentbanking

system.

Theenormousinnovationsininformationandtelecommunica-

tiontechnologiesoverthelastfewdecadesledtothecollapse

oftimeanddistance,thetwophysicaldimensionsthatareat

thehistoricrootsofthebankingsystem.Yet,thecollapseof

distancedoesnotmeanthatgeographydoesnotmatterany

more.Besidesdistance,geographyhasmanydimensionsthat

affecttradeandpayments,suchaslaws,customs,language,

anonymity or familiarity, education, and history or path

dependence.Technologicalinnovationswillresultinafurther



35

reduction of transaction costs and may even include the

emergenceofanewtypeofmoney,digitalmoney.Suchdevel-

opmentscouldchallengetheveryroleofbanksaspayment

intermediaries.

Paymentsandtheirregulationarethusnotonlyimportantfor

theeconomyasawhole,butalsoforthefutureofbanks,both

inaglobalandlocalcontext.Paymentservicesareonearea

wherebanksstillenjoysignificantadvantagesoverothercom-

petitors,not leastbecauseof theiraccess to thestreet-side

systemsandthecentralbank.Sincebanksarechallengedat

many fronts in capital intermediation, their role in payment

systemsmightbecomeanimportantfactorforfuturesuccess

or failure. It would be dangerous to assume that the past

advantagesofbanksinpaymentserviceswillsurvivenaturally

and remain unchallenged [Llewellyn (1999)]. Banks, both as

individual firms and as an industry group, must, therefore,

clarifyandpossiblyredefinetheirroleandstrategyinthearea

ofpayment intermediation.Suchastrategymustdetermine

the role of cooperation and competition within the industry

andtowardsthecustomersandnewcompetitors.Indoingso,

itwillheavilyinfluencetheroleofregulationandself-regula-

tionintheareaofpaymentintermediation.

Similarlythegovernments,centralbanks,andbankingsuper-

visors must make sure that regulation or deregulation pro-

motestheworkingsoftheinvisiblehandbyfurtherreducing

the costs and risks of exchange transactions, while at the

same time maintaining and enhancing the soundness and

stabilityofthepaymentsystems.

Risk and risk management in payment systemsThe risks of modern payment systems stem from the chal-

lenge that trade between strangers in different locations

introducedintotheworldoftrade.Riskanalysisinpayments

andpaymentsystemsmustgoalong the lineof the trading

andpaymentprocess.Ingeneral,theprocesscanbesimplified

asfollows.Thepaymentprocessisinitiatedwiththeunderly-

ingdealingphasebeingconcluded.Fromthispointonwards

fivetypesofriskarise.

market risk — The risk that market prices change until the

business transaction is fullyconcluded.This isprimarily the

resultofthebusinesspracticethatatransactionisconcluded

ondayA(‘tradeday’T)andsettled(fulfilled)ondayB,sev-

eral days later (T+x). Of course, there is no guarantee that

settlement will really take place. Such a gap quite naturally

existsinforwardtransactions,butthereisalsoagapoftwoor

threedaysinnormalcashtrading[usuallytwodays(x=2)in

foreignexchangespotdealingandthreedaysincashsecuri-

tiesdealing].Thistypeofmarketriskdoesnotconstitutepart

of the payment phase, but rather of the preceding dealing

phase.ItcanbereducedbyintroducingaCentralCounterparty

(CCP)intothebusinessprocessorbyeliminatingthetimegap

betweendealingandpayment.TheCCPwithitsriskmitigating

structurewillsignificantlyreducetheriskthatsettlementwill

notsubsequentlyoccur.Thereductionofthetimegapreduces

theprobabilityandtheextentofmarketpricechanges.

credit risk —Theriskthatonepartyfulfillsitssideofthebusi-

nesstransaction(delivers)andtheotherpartydoesnot(coun-

terpartyorsettlementrisk).Counterpartyorsettlementrisk

canbeeliminatedbyintroducingdeliveryversuspayment,a

paymentprocesswherebothsidesoffulfillmentareconduct-

edsimultaneously.Ifonesidedoesnotdeliver,theotherdoes

notpayandviceversa.

liquidity risk —Ifonepartyfulfillsontimeandtheotheronly

withdelay,thenliquidityriskarisesintheformofthecostof

financing the resulting gap. For the payment system as a

wholetheliquidityriskisparamount.

operational risk — During the whole dealing and payment

process a variety of other risks exist which we summarize

undertheterm‘operationalrisk‘.Thisincludeshuman,techni-

cal,process,aswellaslegalrisk.

Reputational risk — Problems in the payment function can

also be the source of reputational risk for a bank, which

manifestsitselfinareductionoffuturegrowthandearnings

potentials.

Therisksinthelaterstagesofthedealingprocessarerelated

directlytopaymentsystems,theirstructureandtheirdesign.

Thepaymentprocesscanonlyberegardedasfullyconcluded

once the receipt of the payment is reconciled. This is the

point-in-time where the recipient has full knowledge of the

payment received. In managing all the risks involved, there

arethethreebasicoptions,eliminatingtherisk,mitigatingit,

or passing it on to another party. The general operational

natureofrisksinpaymentsisunderlinedbythefactthatthere

isanoptionofeliminatingrisk.Thisdistinguishestheserisks

from other business related risks, such as loan granting,

whereeliminationisonlypossiblebynotconductingthebusi-

nesstransactioninthefirstplace.Figure1detailsthedifferent

risksandthepracticalpossibilitiestomanagethem.

Inaddition,inpaymentsystemsthephenomenonofsystemic

riskisimportant.Itresultsfromthefactthatanyoftheabove

riskscanspreadacrossapaymentsystemfromonepartici-

panttoanother,infectingparticipantsofthepaymentsystem

thatwerenotconductingbusinesswiththeoriginalsourceof

a problem. The structures and processes of the street-side

systemsaredecisivefortheprobabilityandtheconsequences

ofsystemicfailuresthatexhibitsimilaritieswiththespreadof

diseasesthroughcontagioninbiologicalsystems.



management action Elimination mitigation Pass-on

credit risk

Riskofone-sidedpayment •Deliveryversuspayment •Settlementlimits •Paymentafterconfirmedreceipt

•Settlementmonitoring •Paylate

•Fastreconciliation

Riskofrevocationofpaymentreceived •Legalconceptoffinality

Riskofaparticipantnotmeetinghisoverallpayment •Real-timesettlement •Morefrequentsettlementcycles •Carefulselectionofdirectmembership

obligationattheendofasettlementcycle •Settingofparticipantlimits inpaymentsystem

•Meetingthe‘Lamfalussyprinciples’for

netpaymentsystems1

Riskoflossofbalancecreatedbypaymentreceived •Settlementincentralbank •Nostrolimits

money •Nostromonitoring

Countryrisk/transferrisk •N/a •Countrylimits •Inter-marketswaps

•Countrymonitoring

liquidity risk

Riskofinsufficientliquidity •Fastaccesstoliquidity

(e.g.duetounexpectedpaymentoutflows) (i.e.intradayrepoprocedures)

•Maintenanceofreservecollateral

Riskofnotreceivingincomingpaymentsplannedfor •Monitoringofpaymentflow

•Real-timeinformation

•Fastreconciliation

Riskofstrainofliquiditybylargesettlementvalues •Nettingconcepts

Riskofstrainonliquiditybylargepayments •Splittingofpayments

Riskofdeadlock(blockingofcross-directional •Circlesprocessing(simultaneous

paymentsduetolackofliquidityingross settlementofcompensatingpayment

paymentsystems) flows)

legal risk

Riskofrevocationofpaymentsreceived •Legalconceptoffinality

Riskofconflictsoflaw(netting) •Grosssettlement

Riskofconflictsoflaw(cross-border) •Carefulwordingofcontracts

•Externallegalopinions

Riskofcontractsnotbeingupheldincourt •Carefulwordingofcontracts

•Externallegalopinions

1 ReportoftheCommitteeonInterbankNettingSchemesofthecentralbanksof

theGroupofTencountries,BIS1990.


372 Paymentsystemsrequireagreementsbetweenfinancialinstitutionsthatcompete

witheachotherforcustomersinthepaymentmarket.Theseagreementsmaybe

inconflictwithcompetitionlaw.

3 Thismayespeciallybethecasecombinedwithconflictswithcompetitionlawor

whenrisksarecontractuallypassedontoclients.

4 Operationalrisksusuallyexistbothonthelevelofthestreet-sidesystemandof

criticallyimportantparticipantsofthepaymentsystem(theinterruptionofacriti-

callyimportantparticipantmaybringtheentiresystemtoahalt).

Figure1:Riskandriskmanagementinpaymentsandpaymentsystems

Riskofconflictwithcompetitionlaws2 •Eliminationofvolumediscounts

•Openaccesscriteria

•Vettingofcontractualagreements

Riskofconflictwithconsumerprotectionlaws3 •Vettingofcontractualagreements

•Transparentproductdescriptions

•Simpleandtransparentpricestructure

operational risk4

Riskofsystembreakdown •Dualdesignofalltechnicalcomponents •Contractualpass-ontoclients

•Businesscontinuityprocedures

•Regularrehearsals

Riskoflossofdatacentreoroperationalcentre •DualsitesforIT&operations •Contractualpass-ontoclients

(e.g.terrorism,epidemic) •Inter-bankalarmorganization

•Businesscontinuityprocedures


Riskoflossoftelecommunicationlinks •Dualtelecomlinesfromdifferentproviders •Contractualpass-ontoclients

•Replacementcommunicationprocesses


Riskofcorrupteddataand/orsoftware •Independentreplacementsoftwarewith •Contractualpass-ontoclients

reducedfunctionality

•Permanenttechnicalcontrolprocedures

•Softwaredevelopmentprocedures

•Testing

Riskofunforeseenevents •Operationalproceduresforexception •Contractualpass-ontoclients

handling

•Inter-bankalarmorganization


Riskoffraud(external) •Technicalmessageauthentication •Insurance

•Useofstrongencryptiontechniques •Contractualpass-ontoclients

•Authorizationchecks

•Measuresagainstcounterfeiting

•Vigorousprosecution(includingthe

internationallevel)

•Provisionof7x24hotlinestocustomers

•Customerawarenesscampaigns

Riskoffraud(internal) •Four/sixeyeprocedures •Insurance

•Vigorousprosecution

Riskofclericalerrors •Technicalplausibilitychecks •Insurance

•Four/sixeyeprocedures

compliance/reputational risk

Riskofprocessingpaymentswitha •Knowyourclientprocedures •n/a

criminalbackground •Technicalmonitoringofpayments

(e.g.fortriggerwords)

Riskofbreachofconfidentiality •Dataencryption •n/a

•Definitionofrulesforhandlingofdata

•Contractualpass-ontoclients

Riskofconflictwithcompetitionlaws •Eliminationofvolumediscounts •n/a

•Openaccesscriteria

•Vettingofcontractualagreements

Riskofconflictwithconsumerprotectionlaws •Vettingofcontractualagreements •n/a

•Transparentproductdescriptions

•Simpleandtransparentpricestructure

Riskofnegativepressreports •CarefulPR •n/a

management action Elimination mitigation Pass-on

why regulation?Banksareregulatedandsupervisedinpracticallyeverycor-

neroftheworld,althoughthereisnoconsensusinacademia

onwhyandhow.Thegeneralargumentonanabstractlevel

is thatregulationshouldcompensateforthemarket failure

thatwouldprevailinasituationwithoutregulationandsuper-

vision. Market forces alone will not necessarily achieve the

objectiveofefficiencyandsafetysufficiently,becauseapar-

ticipantdoesnotnecessarilybearall thecostsandrisksor

thereisatimelagbetweenthebusinessopportunity(profit)

andtherisk(cost)arising[BIS(2001)].Theothersideofthe

coinistheriskofgovernmentfailure.Regulationofeconomic

activities always faces the challenge of balancing between

thetwoextremesofmarketorgovernmentfailure,orinthe

languageofthenewcomparativeeconomicsbetweendisor-

deranddictatorship[Djankovetal.(2003)].

Thethreespecificmotivationsforregulatingbanksarethe

protection of individuals, primarily the banks’ customers,

guaranteeingthefunctioningofthesystem,andprotection

againstsystemicrisks.Thenotionofsystemicriskstandsfor

the danger that problems in a single financial institution

mightspreadandthat,inextremesituations,suchcontagion

coulddisruptthenormalfunctioningoftheentirefinancial

system.Inspiteofthefactthatsystemicriskandcontagion

aresuchimportantmotivesforregulation,itisstrikinghow

littlethis isreflectedinregulatorysystems.Regulationand

supervisionarestillprimarilydirectedatavoidingthefailure

of individual banks. An illustration of this fact is the new

Baselproposaloncapitaladequacy,BaselII,whichstatesas

itsprimarygoaltostrengthenthesoundnessandstabilityof

thebankingsystem.TheBaselproposaltriestoachievethis

by exclusively regulating one aspect of individual banks:

Solvencyintheformofcapitalrequirements.Liquidityisnot

evenmentionedintheBaselproposal.Usingtheanalogyof

the health system, solvency can be viewed as the physical

fitnessofthepeoplewithinapopulation,whereasliquidity

plays the role of vaccination. To protect a society against

theriskofadisease,vaccinationismoreimportantthanfit-

ness.

Itisobviousthatprudentialregulationandfinancialstability

are still two very different spheres with little connections

between the two, other than that the second serves as an

argumentforthefirst.Thefactthatcreditandliquidityrisks

inherentinpaymentandsettlementsystemshavethepoten-

tial to contribute to systemic problems makes the third

motiveforregulatingbankssoimportantforoursubject.

How to regulatePayments can be regulated on the three levels, payers and

payees, banks, and inter-bank systems. Regulation is by its

very nature a national task, although the international or

cross-border dimension has become a major concern with

respect to effectiveness and systemic risk of payment sys-

tems.Onthefirstlevelwelookatthetwooriginalpartiesofa

markettransaction,i.e.thebuyerandtheseller,orthepayer

and the payee. Such regulation affects all natural and legal

personsinajurisdiction.Theserulesarealsorelevantforthe

actors on the second and third level, discussed below. The

most important legal frameworks are property rights, the

criminal code, the commercial and bankruptcy law. These

basic legalframeworksarenotspecifictopaymentsystems,

but they are most important for the functioning of an

exchange economy, which is based on market transactions

and payments for such transactions. Examples of activities

thatareregulatedinthecriminalcodeandthatarecrucialfor

paymentsarefraudandmoneylaundering.

Importantaspectsofpaymentsthatareregulatedinthecom-

merciallawarethedefinitionoftime,place,identification,and

themeansofpaymentthatareessentialforapaymenttrans-

action. Where has the transaction to be completed, at the

location of the payer or the payee? Is the payment legally

completedatthetimethepayerhastransferredthevalueor

atthetimethepaymenthasreachedthepayee?Hasthepay-

mentobligationbeendischargediftheamountiscreditedto

theaccountatthepayee’sbank?Anaspectthathasbecome

decisive for the realization of the Continuous Linked

Settlementsystemfortherisk-freesettlementofforextrans-

actionsisthequestionoffinalityandconditionality,whichis




39

influencedbybankruptcyregulationsinallcountriesinvolved

inapaymenttransaction.Alltheseregulatoryframeworkson

the first level are supposed to be clearly defined and well

establishedinthelegalsystemofdevelopedcountries.They

arenotalwaysworkingwellindevelopingcountries,andcon-

flicts still arise in cross-border payments between countries

with different legal systems and commercial practices. The

decreeofthefinalitydirectivebytheEuropeanUnionin1998

wasanimportantsteptowardsanopenpaymentareawithin

the E.U.5 Internationally, the establishment of the United

NationsCommissiononInternationalTradeLaw’s‘UNCITRAL

ModelLawon InternationalCreditTransfers’ in 1992wasan

essentialstepformakingfirstlevelrulescompatiblebetween

differentcountries.

Regulation on the second level concerns the banks in their

roleaspaymentintermediaries.Itcantaketheformofpublic

regulation or ruling by the government or a supervisory

authority,oralternatively the formof self-regulationby the

bankingcommunity.Thereareanumberofreasonsforbanks

toregulatetheiractivitiesthemselves.Oneistoavoidpublic

regulation. Other important incentives for self-regulation in

theareaofpaymentsresultfromthefactthatpaymentsys-

temsexhibitstrongnetworkexternalities.Theneedtoprocess

andchannelpaymentsefficientlythroughdifferentbanksand

thestreet-sidesystemrequirestechnicalandbehavioralstan-

dards, both for transactions between different banks and

betweenbanksandtheircustomers.Self-regulation,andpub-

licregulation,alwayspossessesacertainriskofmonopolistic

impacts.Thusantitrustlegislationisoneimportantaspectof

regulation on the second level. At the same time, contracts

concludedbybankswiththeircustomersmaycontainaspects

of abuse of power, thus leading to demands for consumer

protection.

Today, the regulation of payment systems is predominantly

basedontheprudentialregulationofthebanks,althoughthe

arguments for banking regulation and supervision are not

primarilyorientedtowardthepaymentfunction.Contraryto

deposit taking, the payment function does not constitute a

legalreasonforsupervision.InSwitzerland,asinmanyother

European countries, the public postal service is the market

leaderinretailpayments,butitisnotsubjecttosupervision

bythebankingauthorities.Ingeneral,theregulationofpay-

mentscanbeseenasaby-productofgeneralbankingregula-

tion.Someexceptions to thiscanbe found in theEuropean

Union.Onewastheearlyadoptionofacommonpositionby

theE.U.fortheintroductionofaseparateprudentialsupervi-

sory regime for electronic money institutions in 19996.

Anotherarea is the regulationoncross-borderpayments in

the Euro-zone, which has so far not (yet) achieved a single

paymentareafornon-cashpaymentsintheinternalmarket,

despitetheexistenceofacommoncurrencyarea.TheE.U.has

takenandiscontinuingtotakeregulatoryactionstoachieve

thisimportantgoalbecausethemarketforcesdonotprovide

incentivesforafastandeffectivemodernizationoftheE.U.-

widepaymentinfrastructures.

Capitaladequacyrulesarethefirstpillarofprudentialsuper-

vision,andtheregulationofliquidityplaysasecondaryrole.

Theliquidityaspectofregulationismorecloselylinkedtothe

role of the central bank than to the prudential regulator. In

manycountriesthecentralbankhasnotonlythecontrolover

money,butalsotheultimateauthorityoveraccessofbanks,

andother intermediaries, tocentralbankmoneyand to the

national inter-bank system.Theprovisions in thenewSwiss

NationalBankLawthatmandatesthecentralbank‘toprovide

forthe liquidityoftheSwissFrancmoneymarket, tosupply

theeconomywithcash,tofacilitateandsecurethefunction-

ingofthepaymentsystem,andtocontributetothestability

ofthefinancialsystem’areanexampleforsuchanextended

role.7

The third level of regulation, relating to the inter-bank or

street-side systems, covers the most important aspect of

financialstabilityrelatedtopayments.Inordertobeeffective,

regulationandsupervisiononthethirdlevelmustcoverboth

national and international aspects, because contagion does

notstopatnationalborders.In1990thecentralbanksofthe

group of ten, G10, countries created the Committee on

5 Directive98/26/EConSettlementFinalityinPaymentandSecuritiesSettlement

Systems.

6 CommonPosition(EC)No8/2000,adoptedbytheCouncilon29November1999.

OfficialJournaloftheEuropeanCommunities,28.1.2000,p.C26/1.

7 NBGofOct.22003,Art.5.


PaymentandSettlementSystems(CPSS)withtheaimofana-

lyzingdevelopmentsindomesticandcross-borderpayments,

and settlement and clearing systems. In its analysis, the

Committeepaysparticularattentiontofinancialstability,and

therebytothelinkagesbetweeninstitutions, infrastructures,

andmarkets.TheCommitteehasdefinedsevenareasofwork,

among them the core principles for systemically important

paymentsystems,theuseofcentralbankmoneyinpayment

systems, and retail payment instruments and systems. With

regardtofinancialstability,thedevelopmentofthe‘coreprin-

ciples’ is themost importantactivityof theCommittee.The

workontheprinciplesstartedin1998andwascompletedin

January2001[BIS(2001)].Thecoreprinciplesdonotconsti-

tute legallybinding regulation; theyare intended foruseas

guidelinestoencouragethedesignandoperationofsafeand

efficient payment systems worldwide. They define the key

rolesandtheresponsibilitiesofcentralbanksinapplyingthe

principles. The principles have a similar role as the Basel

frameworkonInternationalConvergenceofCapitalMeasure-

ment and Capital Standards for prudential supervision. And

thecentralbanksaretheorchestratorswhowillpromotetheir

implementation.

Thecentralbanksshouldensurethattheirownsystemscom-

plywiththecoreprinciplesandtheyshouldhavetheabilityto

overseecomplianceofthosepaymentsystems,whichtheydo

notoperatedirectly.Itisalsotheresponsibilityofthecentral

bankstocooperatewithoneanotherinpromotingthesafety

andefficiencyofpaymentsystems.Thetenprinciplesstate,

among other points, that the assets used for settlement

shouldpreferablybeaclaimonthecentralbank,whichfacili-

tates the role of central bankers to fulfill the expectations.

Another principle states that payment systems should have

clearly defined procedures for the management of the two

mostimportantrisks,creditandliquidity.Coreprinciplenum-

ber IV requires finality on the day of value, preferably even

duringtheday.ThisisaclearindicationthattheCPSSprefers

themodel‘Real-TimeGrossSettlement’(RTGS)withcontinu-

oussettlementtothe‘ClearingHouse’modelwithmultilateral

nettingandfundingattheendoftheday.PrinciplenumberIX

demands objective and publicly disclosed access criteria, to

secureacompetitivemarketfortheparticipatingbanks.Itis

alsoevidentthattheCPSSrecommendationsfavorpayment

systemsthatprocessdebitandcredittransferselectronically

ratherthanmanuallyandonpaper.Forsystemsusingpaper-

based instruments, such as cheques, there are difficulties

involvedinsatisfyingsomeofthecoreprinciples.

It canbeconcluded that theCommittee’s recommendations

are highly dependent on recent technological innovations.

RTGSandelectronicpaymenttransferswerenotyetavailable

justtwodecadesago.Technologyisattheveryheartofprog-

ressinpaymentsystems.Understandingandusingnewtech-

nologies properly seems more important for the efficiency

and stability of payment systems than the formalities of

whether oversight is implemented by legislation, by regula-

tors,bytheauthorityofcentralbanks,orbyself-regulation.

Masteringtherisksresultingfromthedifferencesintimeand

spacerequirestheskilleduseofnewtechnologies,overcom-

ingtherisksofanonymityandbuildingasolidfoundationof

confidenceandtrustrequiresstandards,rules,andauthority

thatwarranttheproperuseofthattechnologybythepartici-

pants.

References• BankforInternationalSettlements,CPSS(2001),CorePrinciplesforSystematically

ImportantPaymentSystems,Basel.

• Djankov,S.,E.L.Glaeser,R.LaPorta,F.Lopez-de-Silane,andA.Shleifer,2003,The

NewComparativeEconomics,NBERWorkingPaperSeries,WorkingPaper9608.

• Kohn,M.,2001,PaymentsandtheDevelopmentofFinanceinPre-IndustrialEurope,

Hanover,NH.

• Llewellyn,D.T.,1999,TheNewEconomicsofBanking,Amsterdam:SUERFSociété

UniversitaireEuropéennedeRecherchesFinancières.

• McAndrews,J.,andW.Roberds,1999,PaymentIntermediationandtheOriginsof

Banking,FederalReserveBanksofNewYorkandAtlanta.


Emerging models


sujit chakravorti1Senior Economist,

Federal Reserve Bank of Chicago

Abstract

Why have general-purpose stored-value cards been unsuc-

cessfulinpenetratingtheU.S.market?Threenecessarycon-

ditions for a payment instrument to be successful are dis-

cussed:consumersandmerchantsneedtobeconvincedofits

advantages over existing payment alternatives for at least

sometypesoftransactions;paymentprovidersmustconvince

consumers and merchants simultaneously of its benefits to

achievecriticalmass;andassurethemthatadequatesafety

and security measures have been implemented. This article

discussesthecreditcardindustry’ssuccessinmeetingthese

necessaryconditionsandgeneral-purposestored-value issu-

ers’failuretomeetthemtodate.

411 IthankVictorLubasiandLeonardoMayerfortheirexcellentresearchassistance.

Theviewsexpressedaretheauthor’sandshouldnotbeattributedtotheFederal

ReserveBankofChicagoortheFederalReserveSystem.


wepay.Thesefourmajorinnovationsare:coins(4,000years

ago), checks (800yearsago),papermoney (more than 100

yearsago),andthepaymentcard(over50yearsago).

Threeimportantconditionsmustbemetbeforestoredvalueis

widelyused.Firstly,consumersandmerchantsneedtobecon-

vincedthatstoredvalueissuperiortoexistingpaymentinstru-

ments forcertain typesofpayments.Generally,storedvalue

paymentssubstituteforcashpayments.Storedvaluehasbeen

asuccessfulalternativetocashinclosedloopsystems,suchas

transportationservicepurchases,coffeepurchasesatcertain

popular coffee chains, and for purchases on university cam-

pusesandmilitarybases.Nilson(2003)estimatesthatprepaid

cards, which include stored-value cards for limited use and

phone cards, accounted for U.S.$55 billion in 2003 and pre-

dictsthatthisfigurewillgrowtoU.S.$146billionin2007.

Secondly,aswiththeintroductionofanynewpaymentinstru-

ment, to achieve critical mass, consumers and merchants

needtobeconvincedsimultaneously.Thatis,consumerswill

notusestoredvalueunlessasufficientnumberofmerchants

accept it and merchants will not accept it until a sufficient

numberofconsumersuseit.Anexampleoftheinabilityofa

payment instrumenttoovercomethechicken-and-eggprob-

lemistheSusanB.Anthonydollarcoin.Becausecoinsremain

incirculationmuchlongerthanbills,theyarelessexpensive

for currency issuers toprovide in the long run.Unlikemost

countries,theUnitedStateshasbeenunsuccessfulinreplac-

ing lower denomination bills with coins. McAndrews (1997)

arguesthatCanada,likeothercountries,waseventuallysuc-

cessfulwithitsdollarcoinbecausethecentralbankstartedto

withdrawnotesfromcirculation.

Thirdly,withanypaymentinstrument,consumers,merchants,

andfinancialinstitutionsareconcernedwithcreditandfraud

risk.Forourpurposes,creditriskistheriskthatthepayeeis

unabletoconvertapaymentintogoodfunds.Theinabilityto

acquire good funds may result from the payer, a payment

intermediary,ortheissuer’sinabilitytoprocessormakegood

onitsobligationtodeliver.Fraudriskistheriskthatanunau-

thorizeduserisabletousethepaymentsystemforfinancial

gains or a participant in the payment process presenting a

monetaryclaimthatisnotbackedbythevaluestated.

Animportantissuewithcreditandfraudriskistheallocation

ofmonetarylosseswhenitoccurs.Consumersandmerchants

preferthattheliabilitylieswiththepaymentserviceprovider.

Paymentinstrumentswiththischaracteristicmayalsopene-

tratethemarketquicker.Inthecaseofcreditcards,govern-

ment regulations determine the maximum liability to the

consumerifthecardisusedbyanunauthorizeduser.Today,

thecardnetworkshavefurtherreducedtheconsumer’sliabil-

ityforunauthorizedusetozero.

is it better? Fornewpaymentproductstosucceed,theyneedtoprovide

benefitstobothconsumersandmerchants,whileatthesame

timebeingprofitableforpaymentprovidersinthelongrun.3

Issuersofnewpaymentinstrumentsusuallytargetasegment

ofthepaymentservicesmarketwheretheirproductissupe-

rior toexistingalternatives.Arecentexampleofapayment

productthathasbenefitedbothconsumersandmerchantsis

thepaymentproductprovidedbyPayPal.comtobuyersand

sellersfortransactionsononlineauctionssitessuchaseBay.

Because many relatively small merchants were not usually

equipped to process credit and debit card transactions and

checkswereassociatedwithhighsettlementrisk,apayment

enablerlikePayPal.comwasabletointermediatethesetrans-

actionsresultinginbothpartiesbeingbetteroff.

credit cardsIn the early 1970s, some financial observers predicted that

creditcardswerenotviableinthelongrun.Onesuchobserv-

er argued that credit cards were ‘a temporary but probably

unavoidable retreat in the campaign to develop an efficient

domesticpaymentsmechanism’[Hester(1972)].Today,credit

cardtransactionsranksecondbehindchecksintermsofthe

numberofnon-cashtransactionsintheUnitedStates.4There

were 17.86 billion general-purpose charge and credit card

transactions accounting for U.S.$1.608 trillion in the United

2 General-purposestored-valuepaymentcardsaredefinedasthosethatarewidely

adoptedbymerchantsandconsumerswherethevalueresidesonthecardandis

transferredtothemerchant’sterminalatthetimeofpurchase.Unlessotherwise

stated,stored-valuecardswillbeshortforwidely-acceptedstored-valuecardsin

thisarticle.



43

Advancesincomputingpower,electronics,andtelecommuni-

cations have improved the way we live. Now such advances

have started to change the way we pay. Technological

advancements now make it possible for consumers to pur-

chasegoodswithelectronicbitsofinformationrepresenting

money,commonlyreferredtoasstoredvalue.Thevaluemay

bestoredonmicrochipsembeddedinplasticcardsthatlook

similar to credit cards. This type of stored value device is

calledasmartcard.Accordingtoanarticlesevenyearsago,

‘Smart cards are set to revolutionize payment systems and

provideaplethoraofnewopportunities’[TalmorandTimewell

(1997)].Anotherarticleinthepopularpressstatedthat‘Cash

isdirty,inefficient,andobsolete.Smartcards,digitalcashand

ahostofelectroniccurrencieswillsoonreplacepocketmoney’

[Gleick(1996)].Thisarticleasksthequestion:Whyhavegen-

eral-purposestored-valuecardsnotbeenwidelyadoptedas

someanalystshadexpected?2Iwillcomparethecreditcard

industry’ssuccessinmeetingthreeconditionsnecessaryfor

widespreadadoptionwiththestoredvalueissuers’failure in

meetingtheseconditionstodateintheUnitedStates.

Financialanalystshavepredictedthedeathofcashandother

paper-based payment instruments for many years. Cash

usage has started to decline. According to an American

BankersAssociation/DoveConsultingStudy,cashusagehas

declinedfrom39percentto32percentforin-storepayments

[Sapsford (2004)]. Part of this decline results from greater

acceptanceofpaymentcards,suchascreditanddebitcards,

at merchant locations that traditionally had not accepted

them.IntheUnitedStatesandmostpartsoftheworld,limit-

ed-usestored-valuecardshavebeensuccessfulascashsub-

stitutesforsomenichemarkets,suchastransportationsys-

tems,universitycampuses,andmilitarybases.

Smart card issuers along with producers of the technology

havemadesizeableinvestmentstoestablishsmartcardsasa

viablepaymentinstrument.Themigrationtochipcardsfrom

magneticstripeoneshavebeenaidedbythereductioninthe

cost of producing smart cards. Payment card organizations,

such as MasterCard and Visa, along with banking and non-

financial institutions have invested significant amounts of

money into stored-value technology in an effort to provide

electronic substitutes for government-issued physical cash.

MasterCardreportedlyhad investedoverU.S.$150millionto

purchase 51 percent of Mondex International, an electronic

cash system developed in the United Kingdom by National

Westminster Bank [Hansell (1998)]. National Westminster

spentmorethanU.S.$100milliondevelopingMondex[Stouffer

(1996)].

Stored-value issuershope toearn interest fromoutstanding

stored-valuebalances,earnfeesfrommerchants,andpossibly

revenuesfromadvertisingonthephysicalcard.However,issu-

erswillhavetoconvinceconsumersandmerchantswhythey

should use stored value. Issuers argue that their product

wouldbemoreconvenientforconsumersandreducecostsof

processingpaymentformerchants.

MostanalystsagreethatthetwolargestU.S.stored-valuetri-

als, theAtlantaOlympicGamesandtheUpperWestSideof

Manhattan,failedinconvincingconsumersandmerchantsof

thebenefitsofusingstoredvalueoverexistingpaymentalter-

natives.TheEconomist(1998,73)concludedthat,‘Electronic

money has thus turned out to be a solution in search of a

problem.’ While general-purpose stored-value has not been

successful in the United States, many European countries

have implemented such payment instruments with varying

degreesofsuccess.Thisarticlewilladdresssomefactorsthat

haveleadtoadoptionofstored-valuepaymentinstrumentsin

somecountriesbutnotothers.

The necessary conditionsConsumersandmerchantsarereluctanttochangetheirpref-

erencestowardspayment instruments. Inthecontextof the

issuance of new coinage, Jevons (1875) wrote, ‘No one can

possiblyunderstandmanysocialphenomenaunlesshecon-

stantlybearsinmindtheforceofhabitandsocialconventions.

This isstrikinglytrueinoursubjectofmoney.’Furthermore,

EvansandSchmalensee(1999)observethatinthelast4000

yearstherehavebeenonlyfourmajorinnovationsintheway

3 ChakravortiandKobor(2003)arguethatpaymentproductsmaynothavetobe

profitableasastand-aloneproduct,butsufficientlyaddvaluetoabundleofbank-

ingandpaymentservices.

4 Incertainpaymentsegments,suchasin-storepurchases,creditcardshavesur-

passedchecks.Inothermarketsegments,suchasInternetpayments,creditcards

continuetobethepreferredpaymentinstrumentalthoughsignature-baseddebit

cardshavestartedtocatchup.However,forrecurringbillpaymentandbusiness-

to-businesspaymentscheckscontinuetomakeupthelion’sshareofpayments

[ChakravortiandMcHugh(2002)andChakravortiandDavis(2004)].

5 ChakravortiandEmmons(2003),ChakravortiandShah(2003),andChakravorti

andTo(1999)discusstheincentivesforconsumerstousecreditcardsandmer-

chantstoacceptthem.

6 Inadditiontosecurityconcerns,foreigntravelersmayneedtoconverttheircash

intolocalcurrencypriortomakingpurchasesandconverttheremainingforeign

currencybacktohomecurrencyattheendoftheirtrips.However,sometypesof

transactions,especiallysmallones,mayrequirecashforpayment.

7 Foradiscussionofpaymentinstrumentcost,seeFoodMarketingInstitute(2000).


Consumers are unlikely to use stored value for purchases

wheretheyusechecks,creditordebitcardsbecausetheyrisk

losingmonetaryvalueifthestoredvalueislostorstolenand

forgo the opportunity to earn interest on their funds before

theyspendthem.8EvidencefromScandinaviancountriessug-

gests that greater penetration of debit cards especially for

low-value transactions has resulted in greater reluctance to

use stored value products [Van Hove (2004)]. Thus, stored

value may only replace a shrinking number of cash transac-

tions.

Oftensuccessfuladoptionofastored-valuecardisassociated

witheliminatingalternativepaymentmethodscompletely. In

theDutchcitiesofPrumerend,Nijmegen,andRotterdam,the

useofChipknip,ageneral-purposestoredvaluepaymentsys-

tem, became the only way to pay for street parking. As a

result,parkingaccountedfor31percentofthetotalnumberof

Chipknip payments [Van Hove (2004)]. Stored-value cards

mayalsobecometheonlypaymentoption forsomeFrench

parkinglots.

Merchantsmaybenefitfromalowervolumeofcashtransac-

tionsbecausetheyaremorepronetosafekeepingconcerns

and on average take longer to perform than stored-value

ones.Lucas(1994)statesthatemployeetheftcanaccountfor

upto4percentofcashsalesforprimarilycash-basedtransit

systems. In addition, some merchants would benefit from

quickertransactionsbecausethetransferbetweenthemer-

chant’sstored-valuemachineandtheconsumer’ssmartcard

would be faster than alternative payment forms [Poon and

Chau(2001)].

However,merchantsmaybethemostreluctanttousestored-

valuetechnology.Merchantsmayfacelargetransitioncostsin

acquiringthenecessaryhardwaretoacceptstoredvalueand

trainingtheirstaff.Someanalystsarguethattheinitialinvest-

mentmayberelativelysmallcomparedtothepotentialcash

savings,especiallysinceacceptanceterminalsforotherpay-

mentcardswouldneedtobereplacedovertime.Whenthese

terminalsarereplaced,theycouldbefittedforacceptanceof

storedvalueatrelativelylowcost.

44


Statesin2002[Nilson(2003)].

General-purposechargeandcreditcardshaveexistedforover

40years.Unlikechargecards,creditcardsallowedconsumers

to pay their monthly charges in installments. Today, credit

cardsbenefitconsumersandmerchantsandareprofitableto

paymentproviders.5Creditcardsservetwoprimaryfunctions

forconsumers,theyallowconsumerstopurchasegoodsand

services (serves as a payment instrument) and they extend

credit to consumers lacking sufficient funds even if they

choosetopaytheirbalancesinfull(servesasacreditinstru-

ment). Consumers may also prefer to use their credit cards

becauseoffrequent-useawardsordispute-resolutionservic-

es.Furthermore,consumerscanusethemalmostanywherein

theworld.Asaresult,creditcardsmaybepreferredtocash

or travelers’ checks as a secure, widely accepted payment

instrumentforforeigntravelers.6

Although the credit card is the most expensive payment

instrument to accept, merchants benefit from credit card

acceptance, justifying their relatively high cost.7 For charge

and credit card purchases, most merchants enjoy payment

guaranteesfromcardissuersiftheytaketheproperauthori-

zation steps. Merchants also benefit from greater sales and

profits.Inasurveyofretailers,83percentthoughtaccepting

credit cards increased sales and 58 percent thought their

profits increased from accepting them [Ernst and Young

(1996)]. These greater sales are generated in part because

consumersmaynothavesufficientcashonhand.

Financial institutions earn revenue from the merchant dis-

count, interest income from consumers who borrow beyond

the payment cycle, and other fees from additional services

provided. However, there are risks that financial institutions

take when issuing credit cards. Investment in new payment

productsmaynotimmediatelygenerateapositivereturn.In

thecaseofBankofAmerica,fifteenmonthsafter launching

itsBankAmericard,itofficiallylostU.S.$8.8milliondollars.If

hiddencosts,suchasadvertisingandoverhead,wereincluded

thelosswasclosertoU.S.$20million[Nocera(1994)].

stored-valueLimited-use stored value systems have been successfully

adopted for transportation systems, such as the Bay Area

RapidTransitsystemintheSanFranciscoBayAreaandthe

Metro intheWashingtonD.C.area.Sometransitauthorities

have introducedsmartcards thatcanbeusedasproximity

paymentdevices.InHongKong,thetransitauthoritieshave

introducedsmartcardsasthesolepaymentdeviceandhave

foundthatmorepassengerscanbeprocessedinagiventime

spanresultinginreducedqueues[PoonandChau(2001)].

TwonotableU.S.general-purposesmartcardtrialswerecon-

ductedduringthelast8years,UpperWestsideofManhattan

andtheAtlantaOlympicGames.Bymostaccounts,thesetri-

alswerenotsuccessfulbasedontheusageratesandthelack

of long-term adoption in the United States. However, some

lessons can be learned. In both trials, consumers and mer-

chants were given incentives to use the product. In the

Manhattan trial, converted laundrymachinesaccounted for

30percentofalltransactionsconductedwiththestored-val-

ue cards [Van Hove (2001)]. In Atlanta, stored-value cards

were more successful when merchants did not previously

acceptpaymentcards,suchasfast-foodrestaurantsandcon-

venience stores [Bank Systems & Technology (1996)].

Therefore, stored value cards are popular with consumers

andmerchantsatmerchant locations thathad traditionally

acceptedonlycash.

Similartocreditcards,forstoredvaluetobesuccessful,con-

sumersandmerchantsalongwith financial institutionmust

allperceiveabenefit fromitsuse.A lucrativenichemarket

segment forstored-valuecardsareunmannedpointofsale

purchases, such as vending machines, parking meters, and

faresfortransportationservices.Akeyissueforconsumers

in such purchases is the availability of exact change. Coca-

Cola estimates that a significant portion of their potential

salesnever tookplacebecausecustomersdidnothavethe

exactchange[Clemons,Croson,andWeber(1997)].Inother

cases,consumersmayoverpayforservices,suchasparking

andtolls.

458 Forageneraldiscussionaboutthepreferredpaymentinstrumentbyconsumers

andmerchants,seeChakravorti(1997)andHumphrey,Pulley,andVesala(1996).

9 ForadiscussionabouttheinterrelateddemandforpaymentservicesseeBaxter

(1983).

10 SeeEconomidesandHimmelberg(1995)foradiscussionofcriticalmassinthe

contextofnetworkgoods.


and issued cards to applicants if they had a job. Because

cardholdersinitiallydidnotincuranyofthecostsassociated

withcreditcardtransactions, theywereeasilyconvincedto

usethecards.

Cardissuershadmoredifficultybringingmerchantsonboard

becausethemerchantswerechargedafractionof thepur-

chaseprice.DinersClubmanagedtoconvincetwelverestau-

rantownerstoaccepttheircardatthetimeoflaunch.Bank

of America started with 300 merchants. Larger merchants

wereunwillingtopaythemerchantdiscount.Thefirstlarge

departmentstorechaintoacceptthird-partycreditcardswas

J.C. Penney in 1979 and widespread acceptance by grocery

storeshasonlyoccurredrecently.Ontheotherhand,smaller

merchantsthatgrantedtheircustomerscreditwerewillingto

paythefeetoreducetheiraccounting,collection,andbilling

costs.

To expand the geographic coverage of its cards, Bank of

America began to license the BankAmericard through Bank

America Service Corporation to out-of-state banks. Banks

wouldpayaU.S.$25,000entryfeetoBankofAmericaanda

small royalty to support a national advertising campaign to

becomemembersofthenetwork.Eachbankwouldenlistits

ownmerchantsandcustomers.Themaingoaloftheselicens-

ing agreements was to increase the number of consumers

using the card and the number of merchants accepting the

card.BankofAmericabenefitedfromBankAmericardholders

fromotherstatesmakingpurchasesfromtheirmerchantsand

from their customers making purchases from merchants of

theirlicensees.

Card issuers used innovative ways to simultaneously con-

vince consumer and merchants of the cards’ benefits. The

moreconsumersthatcardissuersconvinced,themoremer-

chantswerewillingtoaccept it.Althoughcreditcardswere

eventually successful in overcoming the chicken-and-egg

problem, Osterberg and Thomson (1998) argue that critical

masswasonlyachievedinthelateeightieswhenitsgrowth

exploded.

stored-value Topromoteusage,paymentinstrumentprovidersenticeboth

consumersandmerchantswithincentives.Inthetwolargest

U.S.general-purposestored-valuetrials,issuersgaveconsum-

ersmonetaryvaluetopromoteitsuse.AttheAtlantaOlympic

Games,somestored-valuecardsweregivenawaywithfivedol-

lars of purchasing power, but cardholders preferred to keep

themassouvenirs. InNewYork,Citibankemployeeshanded

out cardswithU.S.$5ofvalue topassersby.Merchantsalso

received the necessary equipment at subsidized rates and

maynothavepaidthefullmerchantdiscount.

Toincreaseawarenessofsmartcardtechnology,somefinan-

cialinstitutionsinothercountrieshavestartedtouseexisting

payment instruments, suchasATMandcreditcards, topig-

gybackstoredvaluebyplacingmicrochipsonthesecards.For

example, financial institutions in Belgium and Finland have

started to put microchips on ATM cards. In these countries,

consumersmustusestoredvaluetopayforparkingmeters,

calls from public phones, and bus tickets [The Economist

(1998)].Theseusesofstoredvaluemayincreaseconsumers’

awarenessandcomfortlevel.

is it safe and secure? The sustainability of a new payment instrument is critically

dependenton thecontainmentofcreditand fraudrisk.The

success of any payment system is related to the faith and

confidence that participants have in it. Payment providers

shouldconvinceconsumersandmerchantsthattheycancon-

verttheirclaimsintogoodfundswithminimalrisk.Ifthepay-

ment provider becomes bankrupt and has payment obliga-

tions outstanding, consumers and merchants may face sig-

nificantlosses.Tolimitcreditrisk,someEuropeanregulators

have argued that stored value should be only provided by

regulatedfinancialinstitutions.

Alongwithcreditrisk,paymentprovidersareconcernedwith

containing fraud risk. Roberds (1998) describes two major

formsoffraud.Inthefirstcase,thebuyerpresentsamone-

taryclaimthatisnotbackedbythevaluestated.Forexample,

46 - The Journal of financial transformation 11 Foranexcellentdiscussiononwhythedebitcardhasbeenslowtopenetratethe

marketplaceseeCaskeyandSellon(1994).

12 Recently,around5millionU.S.retailerssettledacaseagainstMasterCardand

Visaoverthetyingofassociationcreditanddebitcardproducts.Aspartofthe

settlement,thecardassociationscannolongertietheircreditanddebitcard

products.FormoreaboutthiscaseseeChakravorti(2003).


Financial institutions should also benefit from the shift to

stored-value from cash. The migration to electronic substi-

tutes for cash may provide greater profit opportunities for

financial institutions in terms of cost reductions associated

withsecurityandtransportation.Inaddition,financialinstitu-

tions may benefit from income generated from issuing and

distributing the stored value and the interest income from

outstandingstoredvalue.

can it achieve critical mass?Paymentinstrumentshavetwodistinctsetsofusers,consum-

ers and merchants, that simultaneously demand payment

services. Consumers benefit more from an increase in the

number of merchants that accept the payment instrument

thanfromanincreaseinthenumberofconsumersthatuseit.

Similarly, merchants benefit more from an increase in the

numberofconsumersthatarewillingtouseitthanthenum-

berofmerchantsthatacceptit.Inotherwords,theconsum-

er’sandthemerchant’sdemandforthepaymentserviceare

interrelated.9 These types of services are often called two-

sidedbecauseusageoftheseservicesisdependentonboth

sidesbeingonboard.

Paymentservicescanbeviewedasnetworkgoods.Agoodis

definedasanetworkgoodifauserbenefitsfromanincrease

in the number of users of that good [Farrell and Saloner

(1985),andKatzandShapiro(1985)].Forexample,telephones

andfaxmachinesarenetworkgoodsbecauseexistingusers

benefit froman increase in thenumberofpeople that they

can communicate with. Furthermore, a sufficient number of

usersisrequiredforthenetworkgoodtosurvive.Economists

definethissufficientnumberasacriticalmass.10Bothcredit

cards and stored value exhibit characteristics of network

goods.

Theproblemofanetworkgoodachievingcriticalmasscanbe

described as a chicken-and-egg one. An example of a good

that required a long time to overcome the chicken-and-egg

problemisthedebitcard.Althoughthefirstdebitcardpilot

wasconductedin1966,onlymanyyearslaterdiddebitcard

transactionsstarttogainpopularity.11Onetypeofdebitcard,

commonly referred to as PIN-based, uses ATM networks to

processtransactionsatthepointofsaleandisalsoanATM

card. Issuerswere initiallyunsuccessfulatconvincingasuf-

ficientnumberofmerchantstoparticipateprimarilybecause

oftheadditionalcostofinstallingcardreadersandthelack

ofinteroperabilityamongthedifferentATMnetworks.Today,

oneinthreemerchantshaspoint-of-saleterminalsneededto

processPIN-baseddebitcards[Nilson(2003)].Furthermore,

consolidation of ATM networks and the introduction of

sharednetworksalsoincreasedtheappealofPIN-baseddebit

cardstomerchants.

Another debit card innovation that allowed greater market

penetrationwastheintroductionofthesignature-baseddebit

cards issued by the credit card associations. These debit

cardsuse theexistingcredit cardnetwork infrastructure to

processandsettletransactions.Becausecreditcardnetworks

were already extensive and merchants faced no new setup

costs, thesecardswereable topenetrate themarketmuch

quicker.Inaddition,topromoteacceptanceofthesignature-

based debit cards, the card associations required all mer-

chants accepting their credit cards to accept their debit

cards.12

Toovercomethechicken-and-eggproblem,debitcardprovid-

ers used existing technologies that were familiar to both

merchants and consumers. To increase consumer usage

many financial institutions started to issue ATM cards that

werebothPIN-basedandsignature-baseddebitcards.Thus,

with the ATM customer base and the use of the existing

credit card network by signature-based debit cards, debit

cardswereabletoovercomethechicken-and-eggproblem.

credit cardsCharge and credit card issuers used various techniques to

overcomethechicken-and-eggproblem.Toachieveacritical

massofconsumers,BankofAmericamailedactivecardsto

their existing customers. Not having a customer base to

solicit,DinersClubinitiallyhandedoutleafletsdoortodoor

47

13 Today,NBIisknownasVisa.

14 AnotableexceptionistheMondexsystemwhichallowsconsumerstoexchange

valueamongthemselveswithoutthird-partyintervention.Formoredetailsabout

MondexseeClemons,Croson,andWeber(1997).


stored-valueThe most powerful deterrent against fraud in stored-value

systems is the technology. Smart card technology may be

moresecurethancashformerchantsandofferissuersgreat-

erprotectionfromcounterfeitersthanmagneticstripetech-

nology.TopreventtheftofcoinsfrompublicphonesinFrance,

callers were required to use smart cards. The major credit

cardcompaniesareconsideringsmartcard technologyasa

replacementformagneticstripestoreducecreditcardfraud.

Stored-value issuers want to limit or perhaps eliminate the

possibility that outsiders can replicate the underlying value

andinjectitintothesystem.Oneofthelargestknowncases

where a stored-value system was compromised occurred in

JapaninvolvingPachinkoparlors,wherethelesssecuremag-

neticstripetechnologywasused.Criminalorganizationswere

abletocreatestoredvaluethattheydidnotpurchase.Asa

result stored-value issuers are said to have lost at least

U.S.$600million[Pollack(1996)].

Realizing that themostsophisticated technology toprevent

fraudmaynotbeimpenetrable,stored-valueissuersarecon-

sidering other preventive measures. While online real-time

verification would defeat the purpose of stored value, most

issuersrequireredemptionoftheunderlyingvalueaftereach

use.14Inthesesystems,fraudcouldbedetectedsoonerthan

in systems where stored value is redeemed less frequently.

However,giventherelativelysmallamountofmonetaryvalue

transactedwithstoredvalue,theremaybelittleincentiveto

commitfraud.

will stored-value succeed?Giventhecomfortandconveniencethatconsumershavewith

existingpayment instrumentsandongoing improvementsto

reducethecostofacceptingthem,consumersandmerchants

in the United States may perceive little benefit from stored

valueasastandalonepaymentinstrument.Thus,unlesscon-

sumersareforcedtouseitbymerchants,thewidespreaduse

ofstoredvalueasastandalonepoint-of-salepaymentinstru-

mentisunlikelyintheUnitedStates.However,microchipsare

beingaddedtoidentificationcardsorexistingpaymentinstru-

mentswherevaluecanbestoredandusedtomakepurchases.

Suchtypesofcardsexistinclosedsettings,suchasuniversity

campuseswherestudentsmayusethestored-valuefeatureto

makephotocopieswhereotheralternativesarenotasconve-

nient. Alternatively, merchants using stored value in closed

systems, such as transportation systems, could enter into

agreementswithothermerchantstobroadentheacceptance

ofthepaymentinstrument.

Toachieveacriticalnumberof consumers for storedvalue,

financialinstitutionsmayofferastored-valueenhancementto

theirexistingdebitandcreditcards.Similartothedebitcard,

whereissuersusedtheexistingATMandcreditcardnetworks,

bypiggybackingonexistingpaymentcards,storedvaluecould

benefit from economies of scope. While in many European

countries, financial institutions replacedexistingdebit cards

with ones with stored value capabilities, Van Hove (2004)

states thatmanyof theseunsolicitedstoredvalueenhance-

mentsremainlargelyunused.Therefore,whilesuchastrategy

maybehelpfulinachievingacriticalmassofpotentialusers,

itisclearlynotasufficientconditionforwidespreadadoption.

Experiences in Europe suggest that government mandates

may increase theacceptanceofsmartcards.However,even

withsuchintervention,usageratesofthestored-valuecom-

ponentremainsmallasapercentageoftotaltransactions.As

with the introduction of other payment instruments, stored

valuecardswillrequiresometimebeforetheyachievecritical

mass.WhileVanHove(2004)arguesthatstoredvaluehasnot

todateachievedthedesiredmarketpenetration,heidentifies

certain types of merchants as ideal candidates for stored

value.Thesetypesofmerchantshaveatleastoneofthefol-

lowing characteristics: payments are time-critical (public

transport), there are high cash handling costs (vending

machines),ortherearevandalismproblems(parkingmeters

andpayphones).



inachecktransaction,theconsumermaywritecheckswith

insufficient funds in his account. The other type of fraud

involvesthebuyerusingamonetaryclaimbelongingtosome-

oneelse.

Whilecreditandfraudrisksaredifficult,ifnotimpossible,to

eliminate,adequatedisclosureofwhichparticipantbearsthe

lossiscriticaltothesustainabilityofanypaymentinstrument.

Ifpaymentproviderscannotadequatelyguardagainstunau-

thorized use, resulting losses may lead them to leave the

industry and lead consumers and merchants to lose confi-

denceinusingthattypeofpaymentinstrument.Furthermore,

ifconsumersandmerchantsperceivethattheyaremorelia-

bleforpaymentsmadewithanewinstrument,theymaybe

lesswillingtouseit.

credit cardsHistorically,creditandfraudriskshavebeenchallengingfor

creditcardissuerstocontainandhaveledtoanumberofissu-

ers leaving thebusiness.Technological advancementsalong

withgovernmentregulationssignificantlyreducedtheserisks.

However,creditcardnetworkscontinuetoimproveandintro-

ducenewmeasurestomitigatetheserisks.

Creditrisksarecontainedbyguidelinesandrulesatvarious

levelsinthecreditcardnetwork.Theriskthatafinancialinsti-

tution isunabletomeet itspaymentobligation iscontrolled

primarilybythecardassociations.Becausethecostoflosing

theirreputationissohigh,theassociationsimposeguidelines

governingthedistributionoflossesifamemberinstitutionis

unabletomeetitsobligations.Creditriskattheconsumerand

merchantlevelisprimarilycontainedbypoliciesofthefinan-

cial institutions involved. Today, financial institutions use

more rigorous methods to determine creditworthy consum-

ers.Inaddition,partoftheinterchangefeeschargedbycard-

issuers to merchant banks covers the credit risk the issuer

facesfromconsumersunabletopaytheirobligations.

Fraud was a major factor in the early years of charge and

credit cards. Evans and Schmalensee (1993) report that in

1960,BankofAmerica’slossesfromfraudanddefaultswere

nearlyU.S.$9millionor15percentoftheirvolume.Fraudwas

committedinvariousways,includingconsumersusingcards

tomakepurchasesthattheydidnotintendtopayfor,cards

beingstolenfromthemailandusedtomakepurchases,and

merchantssendingincreditslipsfornonexistentpurchases.

Banksimplementedseveralpoliciestolimitfraudulentuses.

Banksrequiredthatmerchantscalltheirfinancialinstitution’s

creditcenterswhenpurchaseswereaboveacertainamount,

knownas floor limits.Manybanksprovidedmerchantswith

hot lists that identified delinquent accounts. Eventually,

Congressoutlawedthemailingofunsolicitedcreditcardsby

financial institutions in an effort to limit fraudulent use.

However,thesemeasureswerenotsufficient.

Theuseofcomputersandtelecommunicationsintheautho-

rizationprocessallowedcreditcardorganizationsandtheir

memberstocontainfraud.In1972,NationalBankAmericard,

Inc. (NBI), thecreditcardorganizationspunoffbyBankof

America,introducedanationwidenetworklinkingcomputers

via telephone lines toauthorizecreditcard transactionsat

thepointofsale.13AlthoughthesystemcostU.S$3millionto

build and implement, it saved members of NBI at least

U.S.$30million in the firstyear [Nocera (1994)].The initial

authorization system still involved humans checking com-

puter screens for the status of the customer’s account.

Today,theprocessiscompletelyautomatedandmosttrans-

actions are authorized prior to purchase. Further improve-

mentstothephysicalcard,thenetwork,andthemonitoring

of charges have led to significant reduction in losses from

fraud.

Althoughcreditandfraudriskhavenotbeeneliminated,suf-

ficientstepshavebeentakentoassureconsumersandmer-

chantsthattheyfaceminimalliabilitywhenusingandaccept-

ing credit cards. The adoption of system wide guidelines

alongwiththeaidofreal-timeonlineprocessinghasgreatly

reducedtheserisksinthecreditcardnetwork.

49


conclusionThisarticleexploredthreenecessaryconditionsfortheviabil-

ityofanewpaymentinstrument.Anewpaymentinstrument

maytakelongerforconsumerstoacceptbecauseofthecom-

plexsetofinteractionsthatoccuramongparticipants.Itmust

provide benefits not provided by existing ones for at least

certaintypesoftransactions.Consumersandmerchantsmust

beconvincedsimultaneouslyof itsbenefitsandmayrequire

incentives to change their behavior. Finally, the payment

instrumentshouldberelativelysafeandadequatemeasures

againstcreditandfraudriskshouldbeadopted.

While credit cards were successful in meeting these three

necessary conditions, stored-value cards have yet to meet

them. However, in markets where limited-use stored-value

cardshavebeensuccessful,theyaregenerallyasubstitutefor

cash.Theyarepopularwithconsumerswhenexactchangeis

required. In some cases, as with the dollar coin, significant

market penetration may not occur unless consumers are

forcedtoadoptstoredvalue,suchaspaymentoftransporta-

tion services and parking fees. They are popular with mer-

chantswhencashhandlingcostsarehighandotheralterna-

tivesarenotavailableforpayment.Today,themostsuccessful

limited-use stored value operators have started to leverage

theirexpertisetoexpandacceptanceoftheirproductbeyond

itsinitialuse.TheOctopusstored-valuesysteminHongKong

was expanded from payment for transportation services to

includepurchasesatnon-transitrelatedmerchants.Theintro-

ductionofanewpaymentinstrumentrequiressufficienttime

to educate consumers and merchants of the benefits of

migratingfromexistingpaymentoptions.Ifstoredvalueisto

succeed,bothconsumersandmerchantsmustbeconvinced

ofitsbenefits.

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Emerging models

online payments systems for e-commerce1

caroline PaunovConsultant, OECD

graham VickeryHead of the Information Economy unit, OECD

Abstract

Withtheslowuptakeofe-commerce in thebusiness-to-con-

sumer(B2C)sector,theinitialhighlyoptimisticgrowthpredic-

tions of e-commerce soon came to be revised downwards.

Withthegaininmaturityofe-commercetherehasbeenarise

insuitableproductsforonlinesalesandsometrendtowards

increased consumer confidence. For these positive develop-

ments to finally lead to the long-expectedgrowth inmarket

share,thingswillcruciallydependupontheexistenceofwell-

developed online payment solutions for e-commerce. This

articleaimstobrushsomebroadconclusionsonthisissue.

Afirstobservationisthatdespitetheexistenceofavarietyof

payment means credit cards are the dominant system for

online money transfers. This is a consequence of advanta-

geouscharacteristics,most importantlythe long-established

51

networks and wide user-bases. However, traditional credit

cardpaymentshavedeficitsintheareasofsecurityandano-

nymity. Moreover, the payment means is not ideal for auc-

tions and micropayment markets. Alternative systems in

somecountriesaredebitcardsandpaymentsviaonlinebank-

ing.Givenlimiteduserbases,electroniccashisnotafeasible

paymentoption.Incontrast,themediatingservicePayPalhas

been successful particularly in serving the auction market.

Furthermore, largeuserbasesandhighaccessibility render

mobile devices as potentially important future means for

conductingpayments. Inparticular, theymay,togetherwith

Internetoptions,playanimportantroleinprovidingmicropay-

mentsolutions.Forthesepayments,thereisstillawaytogo

toestablishaclearalternative to thenon-optimalsubscrip-

tionmodel.

1 Theviewsexpressedinthisarticledonotnecessarilyrepresenttheviewsofthe

OECDoritsmembergovernments.


ofallanalyzedwebsites.Animportantaspecttobearinmind

is the divergence of importance of payment means across

countries.Figure1showsthatforindividualcountries,asfor

instanceFinland,otherpaymentsystems,notablydebitcards

butalsoe-bankingfacilities,arealsoofimportance.

Advantages of credit cardsThe dominant market position of credit cards is easily

explained by their distinguishing characteristics. The long-

establishednetworkcombinedwithawideuser-baseconsti-

tutesaveryimportantadvantage.Thisfactorgainsparticular

significanceintheonlinemarket,becauseitisinitsnaturea

network infrastructuremarket thatprovidesaplatformthat

permits money transfers between the buyer and seller. As

such, the payment system’s value rises with the size of its

user-base, both on the buyer and the seller sides. Further

benefitsarisefromestablishedpresenceandconsumerexpe-

rience with the payment means as well as established and

clearperspectivesonliability.Afurtherkeyadvantageliesin

the existing international dimension of credit cards, which

permitpaymentsacrossnationalborderseasily.Theseadvan-

tageseffectivelyconstitutethebasisforastrongmarketposi-

tion,whichalternativepaymentmethodswillhavetoprovide

andcompetewith.

security of credit card paymentsDespite their widespread use and acceptance, traditional

onlinecreditcardpaymentshavedeficitswithrespecttothe

securityoftransactionsbecauseofweakauthenticationand

the necessity to transfer detailed financial information for

payment3.Asaresult,fraudratesforonlinecreditcardtrans-

actions are higher than for payments through the offline

channel. Yet the losses to fraud are not currently assuming

alarmingnumbers.However,householdsurveysacrossOECD

countriesconstantlyfindthatsecurityconcernsarekeyfac-

torsexplainingconsumerunwillingnesstouseonlinepayment

instruments.Togiveoneillustration,PaymentOnesurveydata

suggestthatnearlythreeoutoffourU.S.consumersdonot

usecreditcardpaymentsonlinebecauseofsecurity (Figure

2). And this is particularly related to providing credit card

informationonline.

52 - The Journal of financial transformation 2 ThesurveywasconductedbyPricewaterhouseCoopersonbehalfoftheEuropean

Commission.Forthestudy,613websiteswereanalyzedmostofwhichwere(454)

e-commercesitesandtheremaining(159)e-bankingsites.Thefocusoftheanaly-

sisisonsecurityaspectsofpaymentsystemsprovidedone-commercewebsites.


53

Withtheslowuptakeofe-commerce,particularlyinthebusi-

ness-to-consumer (B2C) sector, the initial highly optimistic

growthpredictionssooncametobereviseddownwards.Asa

consequence of these developments, attention started to

focusontheobstaclestoe-commerce.Importantly,astrong

barrier to B2C market growth, which surveys continuously

showed,wasstrongconsumerconcernoveronlinepayments.

Atpresent,withthegaininexperienceearlysignsofatrend

towards increased consumer confidence in online payments

can be seen. Another notable development with the gain in

maturityofe-commerceistheincreasingfocusofsellerson

providingproductssuitabletothisparticularsaleschannel.In

particular,theamountofdigitallyavailableservicesandcon-

tent on the Internet has grown exponentially over recent

years[OECD(2004a)].

Butforthesepositivetrendstofinallyleadtothelong-expect-

edgrowth inmarketsharetherewillbeaneedfortheexis-

tence of well-developed online payment solutions that are

adjusted to the precise payment transaction demands of

e-commerce.Afirstoverviewofthisfinancialtransfermarket

showsa largevarietyofsystems, ranging fromcreditcards,

electroniccurrency,andmobilesystemstopaymentsolutions

viaonlinebanking.However,whenanalyzingactualusagethe

numberoffeasiblepaymentplatforms,particularlyforinter-

nationaltransactions,decreasestojustafew,withaclearlead

forcreditcards.Thus,withthedominanceofcreditcardsand

thesuccessofbutafewalternatives,thequestionarisesasto

whether the online payment market is prepared to serve

e-commerce. In particular, this would demand an ability to

allow secure international payments, to conduct person-to-

person transfers, as well as payments of different amounts

including micro-payments. This article aims to brush some

broadconclusionsonthisquestion.

The dominance of credit cards for online pay-ments Themarkethasbeenfromthestartdominatedbytraditional

financialintermediariesofferingconventionalelectronicpay-

mentservicesaugmentedwithminorinnovationstoadaptto

the Internet. In 2003, 94.1 percent of all worldwide e-com-

mercetransactionswereconductedusingcreditcards[Pago

(2003)]. Furthermore, the current trend suggests that their

importance will remain at least as significant in the near

future.Forexample,fortheyear2003,VisaEuroperegistered

adoublingofrevenues,ascomparedtothe2002results[Visa

(2004)],fromInternetsalesto12.6billion.

AdetailedsurveyofE.U.e-commercewebsites2showsasimi-

larpicture,thatfortheseeconomiesclassiccreditcardsare

alsothemostfrequentlyproposedpaymentsystems,with71

percent.Butthesurveyalsoshowsthatothersystemsareof

importance,notablydirectdebitcards,offeredby45percent

Figure1:Paymentmethodsmostfrequentlyproposedbye-commercewebsites

Source:PwC[2003]

Figure2:FactorsdiscouragingU.S.consumersfromusingcreditcardsonline

Denm

ark

Finlan

d

Germ

any

Austria

Spain

TheNet

herlan

ds

Portugal

Belgiu

mIta

ly

Greec

e

Fran

ce

Luxem

burg

Irelan

d

UnitedK

ingdom

100

90

80

70

60

50

40

30

20

10

0

Creditcardpayment Directdebit E-banking

Factor Percentage

Concernaboutsecurity 70%

Difficultiestoenterinformation 9%

Donothaveacreditcard 7%

Donotlikeinterestcharges 6%

Purchasevaluetoosmall 4%

Exceededpersonallimit 4%

Source:PaymentOne,April2003

3 ForadetaileddiscussiononsecurityofonlinepaymentsseePwC(2003).

4 ForfurtherdetailsseeVisa,2001a,bandMasterCard,2003


Additionally,theestablishedtrustinbanksinsomecountries

may also allow greater confidence of consumers, as is the

caseforcreditcards[Kallioetal.(2003)].However,toorga-

nizethissystemonanationallevelseemstostronglydepend

uponbankingindustryco-ordinationandagreements.Given

themainlynationalorganizationoftheretailbankingsector,

thedevelopmentofinternationalpaymentsislikelytobedif-

ficultandinitiallycostly.Alsoformicro-payments,itdoesnot

ofitselfprovideanidealsolution.

Payment means with only limited success — Electronic cashElectronic currency systems, whether in the form of smart

cardsoronlinecashsystems,aretheelectronicequivalentto

cash.Thispotentiallymakesthemparticularlyimportantfrom

thepointofviewofmicro-paymentsandanonymity.However,

theirintroductionhaslargelyfailedandmostoftheexisting

paymentmeansofthiskindarenotwidelyused.Theirpoten-

tialadvantageshavenotbeenenoughtooutweighanumber

of difficulties, such as the question of liability, the cost and

way of distribution, and most importantly the difficulty of

building up a wide network. Furthermore, through ‘virtual’

credit card numbers offered free of charge, such as those

offeredbyCitibank, credit cards seem toprovideapossible

methodforconsumerstosolvetheproblem.Unlesscombined

withothernetworks,itdoesnotseemthatelectroniccurrency

systemscangainsignificantmarketshareinthenearfuture

asthenetworkconstraintsseemtobestrong.

successful alternative payment systems — mediating services and payments via online bank-ingThemediatingservice,PayPal,hasdemonstratedthat,under

favorable conditions, new payment systems can succeed

despitethedisadvantageofaninitialsmalluserbase.These

systems introduceanadditional intermediary layerbetween

sellerandbuyersothatpaymenttakesplaceviathemediat-

ingserviceprovider.TobeabletousePayPal,thenewcomer

has to create an account with the service, which can be

chargedusing, for instance,creditcards. Inordertopayvia

PayPal the seller only needs to indicate the seller’s email

addressandtheamounttopay.Thesellerwillreceivethepay-

mentonhisorherPayPalaccountandwill not receiveany

furtherfinancialinformationaboutthebuyer.

PayPal’ssuccesslargelycameaboutthroughitspopularityon

Internet auction sites, given that the service permitted per-

son-to-personpayments.SinceitspurchasebyeBayin2002,

itsaspirationstotransformitshighlysuccessfulU.S.business

into a worldwide one have been given a further boost.

Currently,one in threeonlineshoppers in theUnitedStates

has an account with the company, a number which corre-

sponds to one-quarter of Citigroup’s clients [The Economist

(2004)]. Although mostly prominent in online auctions, the

gained popularity of the service particularly in the United

Stateshasledtoitsavailabilityforarangeofotherpayments,

such as tax transactions. The company is also seeking to

adjustpricestocompeteforashareinthegrowingmarketfor

micro-payments[Navaine(2003)].

mobile payments: A promise still to be fulfilled Mobilepaymentscanrefertoavarietyofpaymentsystems.

Foronething,themobiledevicemaybeuseddirectlyforpay-

ment, such as transactions where the telephone bill is

charged.Also,itmaybeusedasadevicetopay,forinstance,

viathebankaccount.AnexampleofthelatteristhePaybox

system,whichiscurrentlyoperatinginAustria.Inthismecha-

nismthemobilephone isusedasasecuredevicetopermit

payment.Thecliententersthemobilenumbertogetherwith

theamounttobepaid.Confirmationtakesplaceviaentering

a personal Paybox PIN. An automatic reply from Paybox

acknowledgesthepayment.Theamountwillbedebitedfrom

thecustomer’sbankaccount.

The potential significant advantage of mobile payments is

that they may provide greater applicability than other pay-

mentmeansbecauseoftheveryhighusageandavailabilityof

mobiletelephones.Mobiledevicesmaythusbedevelopedas

paymentmeansforbusticketstoofflineandonlinepurchas-

es. Accepting mobile payments may become attractive for

54 - The Journal of financial transformation 5 Ina2002surveyofretailers,conductedbyGartnerConsulting,44percentof

retailersclaimedtheyhadnewgoodsandservicestosellifanewmicro-payment

systemexisted[Maguire(2004)].


Responding to this problem, credit card companies have

developedaseriesofmeasuresthateffectivelyremovesecu-

rity risks.An importantproductdevelopment tomention is

Verified by Visa. This is a system which connects the card

owner for each transaction directly with the personal bank

through password authentication and a personal message

verifyingthebankconnection.Anotherimportantstep,which

recognizesthatsecuritymeasuresappliedbymerchantsare

crucial, has been the move to impose obligatory security

standards for merchants4. It remains to be seen whether

these developments will also lead to increased consumer

confidenceorwhetherfurtherinitiativesarenecessary.

Protecting anonymityAnadditionalissuerelatedtoaccount-basedpaymentsgener-

allyisthelackofanonymity.Asopposedtotransfersinvolving

papercurrency,thisformofpaymentallowsforthepossibility

totraceconsumerpurchases,anissuewhichraisessubstan-

tialquestionsonprivacyprotection.Thecurrentabsenceof

onlineequivalents tocashpaymentsmeans thatconsumers

leavemore ‘traces’onpurchasinghabits intheonlineworld

thanintheofflineone.

new payment challenges: micro-payments and auctionsIt should be noted that credit cards are not suitable for all

paymenttransfersrequiredfore-commerce.Forexample,in

onlineauctionsandothermarketsrequiringmicro-payments

—meaninginparticulartransfersofsmallmoneysumseven

oflessthanU.S.$1—creditcardsarenotreallythemostsuit-

able modes of payment. Auction markets, and especially

providereBay,havegainedhighpopularityon the Internet,

mainlybecausetheymakeitpossibleforprivatebuyersand

sellersandsmallmerchants toalsoaccess largeaudiences.

However,thecharacteristicsofauctionsrequiretheabilityto

realizeperson-to-personpayments.Sellerswantingtoaccept

creditcardpaymentsneedtohaveamerchantaccountwith

credit card companies. The costs involved would not make

onlineauctionsalesworthwhileforarangeofsmallsellers.

Furthermore,thedesignofcreditcardpaymentsisnotsuitable

fortransferringsmallquantitiesofmoney.Micro-paymentsare

ofgrowingsignificancefore-commerce5,particularlybecause

theyareakeyconditioninthedigitalcontentmarketwherea

rangeitemshavelowunitcosts.Thepossibilityofonlinerather

thanphysicaldeliveryof items,suchasmusictracksordigi-

tized articles, make the electronic sales channel particularly

attractive. Using credit card payments to realize these small

paymentswouldrenderthesetransactionscostly.Asaresult,

muchof themarket formicro-paymentsdoesnotexistor is

confined to subscription type payments. However, as Steve

Jobs,CEOofAppleComputer,statedinApril2004:‘Thesub-

scriptionservicesarenotsucceeding.Peoplewanttoowntheir

music,notrentit’[Chaffin(2004)].

The contribution of debit cards and online bank-ingIn countries such as Germany, Sweden, and Denmark and

manyotherEuropeancountriesdebitcardsprovideanimpor-

tantpaymentchannelforonlinepayments.Oneadvantageis

theirwideruserspreadparticularlyamonglow-endcustom-

ers who may not fulfill conditions to obtain credit cards as

well as institutional arrangements on credit transactions.

Agreements with credit card institutions often also allow

usageofdebitcardsfor internationaltransactions.Because

thepersonalaccount isdirectlydebitedsomecostssavings

overcreditcardsmayarise.However, thebasicstructure is

thesame.Consequently,debitcardsdonotprovidesolutions

to correct the shortcomings of credit cards, such as in the

area of micro-payments. Additionally, debit card payments

may benefit from weaker legislative protections [OECD

(2002)].Topayviaonlinebankingisawidelyusedalternative

payment option in Finland, Portugal, and the Netherlands.

Among the various payment systems, the most interesting

optionistheonewherethee-commerceselleroffersapay-

mentoptionwherethebuyerisredirectedtohisorherbank’s

website.Thepaymentisthendoneusingtheonlinebanking

facilitiesprovidedby thebank.Particularadvantageof this

system is that existing facilities and security arrangements

installed by banks to permit online banking are used.

556 AnimportantstephasbeentakenwiththecreationofSimpay,anewmobilepay-

mentservicesassociation,whichwasfoundedinFebruary2003byOrange,

TelefonicaMoviles,T-Mobile,andVodafone.Itsaimistocreateanetworkallowing

forinternationalmobilepayments.

7 Paysafecardisaprepaidpaymentservicethatcanbeusedformicro-paymentson

theInternet.Thecardsareofdifferentvaluesbetween25and100andcontain

a16-digitnumber(PIN).

8 Payexisanelectronicwalletforonlineandmobilecommerce.

9 Germanyhastwosuchsystems:FIRSTGATEclick&buyandMicromoney.

10 InDenmark,PBSisaserviceproviderforthreesystems,whichoperatemicro-pay-

ments,Valus,EWire,andCoinClick.Internetmerchantswantingtoacceptoneof

themicro-paymentsolutionshavetomakeanagreementwithoneofoperators.A

customerwantingtomakeuseofmicro-paymentspaysarelativelysmallamount

inadvancetotheoperatorusingordinarypaymentsolutionslikedebitorcredit

cards.


merchants because of the wide spread of mobile phones.

Wireless access has, as recently stressed by the OECD

(2004c),shownthemostimpressivegrowthintelecommuni-

cation infrastructure.Youngpeople, inparticular,whichcon-

stitute an important part of digital content demand (for

instance,ringtonesandgames)maynothavecreditcards,so

paymentviamobilephonebills(orphonecards)maybethe

onlywayforthemtopurchasegoods.Furthermore,itcouldbe

devised so as to allow payments from any mobile phone.

Mobilepaymentsmayparticularlybeusefultopermitdown-

loadingandprovidingmobilecontent,anareaofpotentially

strongestinitialimpact.

Asforpresentusageofmobilepayments,intheareaofdigital

content related to mobile phones, such as downloadable

gamesandringtones,premiumSMSisoftenandfrequently

used[OECD(2004d)].However,atpresentfewconsumersuse

theirmobilephoneasapaymentdevice.Forinstance,survey

results for Finland find that less than 7 per cent of mobile

phoneusersusedtheirphonetopurchaseororder in2003

(Statistics Finland, Survey Results of Autumn 2003). Also,

Paybox,theproviderofthemostelaboratedmobilepayment

system, had to discontinue its operations in Germany, the

UnitedKingdom,andSwedenearly2003,mainlybecauseof

the existing limitations to realize mobile payments.

Furthermore,developingmobilepaymentsasameanstoper-

mitinternationalpaymentssuitablealsoformicro-payments

requiresstepstoensureinteroperability6.

solutions for micro-paymentsMobile payments have already revealed their usefulness for

micro-payments. An example of micro-payments from tele-

phonyistheCoinletsystemdevelopedbyPortalify(Finland),

which provides for premium-rate SMS and premium-rate

voice.Theproblemwiththesepaymentsisthattheyarenot

widelyofferedasyetandthatfrequentlyareonlyavailableon

a national basis. An additional way in which telephony may

eventuallybesuccessfulwouldbeasanalternativewaytoadd

the cost of the transaction to existing monthly bills (most

importantlytelephonebills.)TheGermanClick&Paynet900

micro-billing solution offers the possibility for consumers to

payviatheirtelephoneconnection.

There are also prepaid systems providing possibilities for

micro-paymentsontheInternet(e.g.Paysafecard7andMicro-

moneyinGermany).Thecardisnotreloadableandcontains

nootherinformationthana16-digitnumber(PIN),concealed

under scratch foil. Other countries, such as New Zealand8,

havealsodevelopedthesekindsofinstruments.However,to

the present none of these payment mechanisms have been

widelyofferedbyproviders.

Anotherpotentialsolutiontotheproblemofmicro-payments

hasbeenthedevelopmentofcumulativecollectionservices.

Rather than paying for each individual transaction, overall

expenditure is summed once a month for payment through

the payment infrastructure. It may be offered by a micro-

paymentorganizationconnectingtoavarietyofmerchants.

Examples are Cartio Micro-payments and Clickshare. Such

paymentmechanismshavealsobeenintroducedforinstance

inGermany9andDenmark10.

Growthinthemicro-paymentoptionsviamobilephoneshas

beenpredicted,with‘direct-to-bill’expectedtobeparticularly

important[TowerGroup(2004)].AsforInternet-basedsolu-

tions, the aggregation-based solutions are expected to take

the lead with prepaid systems being the alternative option.

However, given the current weakness of prepaid solutions

(apart from mobile prepaid payments), it is questionable

whether prepaid Internet systems will become a powerful

means for micro-payments. The future seems to lie rather

with cumulative account systems and mobile solutions. This

beingsaid, theactualestablishmentofa leadingsolutionto

micro-paymentsenjoyingwideadoptionisstilltoarrive.

conclusionsThereareanumberofpaymentsystemsforonlinepurchase

thathavebeenproposedandarecurrentlyavailable.Atpres-

entcreditcardsarebyfarthemostpopular,withelectronic

currency systems not an efficiently available option. As for

other payment means, PayPal seems to have been able to

56

Emerging models


leo Van HoveAssistant Professor of Economics,

Vrije universiteit Brussel (Free university of Brussels)

Abstract

We are witnessing a shake-out in the European electronic

pursemarket.Severalcardsthathavebeeninthemarketfor

yearshaveorareabouttodisappear.Ontheotherhand,there

areanumberofschemesthataredoingreasonablywell,par-

ticularlyintheBenelux.Thisarticlelooksatthemixedexperi-

encewithe-pursesinEuropefromapragmaticpointofview

andtriestohighlightthemistakesthatweremadebythelos-

ersandthesmartmovesthathelpedthewinners.Thearticle

triestosummarizethe lessons learned insix 'smartmoves'.

Theselessonsshouldbeofinteresttonewere-purseschemes

elsewhereintheworld,butalsotoothernovelpaymentsolu-

tionsthattargetthemarketforlow-valuepayments.

57


merchantswillbereluctanttoinvestinterminalsunlesssuf-

ficient consumers have shown an interest, while consumers

willnotusethenewmeansofpaymentunlessthereissuffi-

cientmerchantacceptance.

In order to break this vicious circle, therefore, backers of a

new payment instrument have to succeed, in one way or

another,inensuringthattheinstalledbaseofbothmerchants

andcardholdersexceedsthecriticalmasspoint. Intheearly

stages of the product lifecycle, e-purse operators should,

therefore, focusonbuildingthe installedbase.Attractingas

manyearlyadoptersaspossible,onbothsidesofthemarket,

isofcrucialimportancetogetthebandwagonrolling.Indeed,

oncetheadoptionratehassurpassedthecriticalmasspoint,

the success of an e-purse can become self-reinforcing: the

moreconsumersusethecard,themoremerchantswillaccept

it,themoreinterestingitsusewillbecomeforasyetuncon-

vincedconsumers,andsoon.

Lookingback,mostEuropeane-pursesponsorshavetriedto

solvetheconundrumbyfocusingtheireffortsonconsumers

andhopingthatmerchantswouldfollow.Obviously,afastand

massive deployment of cards can be instrumental. It is no

coincidence that some of the more successful European

schemeshavesucceededinputtinge-pursesintothehands

of cardholders very quickly. This is true for miniCASH in

Luxembourg, Quick in Austria, and Chipknip in the Nether-

lands [Van Hove (2004)]. Rather than issuing stand-alone

e-pursecards,issuersinthesecountriessimplyincorporated

theire-pursesintotheexistingdebitcards,andsubsequently

tookadvantageofabigwaveindebitcardrenewal.

However,sucha ‘big-bang’strategy isnoguaranteeforsuc-

cess. In several countries where issuers flooded the market

withunsolicitedcards,manyhaveremainedunused.Germany

isasalientexample.Attheendof2002,somesixyearsafter

itsnationwide launch, thepenetrationrateof theGeldKarte

hoveredaround80%of the totalpopulationbut reportedly

only2%to3%ofcardholderswereactivepurseusers.Partof

theexplanationisclearlythatthebackersofGeldKartewere

not very successful on the acquiring side, the number of

GeldKarteterminalsremainedverylow[VanHove(2004)].

Withhindsight,amassiveroll-outofcardsonlyseemsadvis-

ableinverysmallcountries,wherethemuch-neededconcur-

rent promotional efforts on the merchant side can also be

conductednation-widepreciselybecauseofthe limitedgeo-

graphicalscale5.Luxembourgisacaseinpointhere.Inaddi-

tion,chancesarethatinasmallcountrythenumberofactors,

both issuers of cards and organizations on the acceptance

side,islower,thusreducingcoordinationproblems.Forexam-

ple,itmaybesufficienttoconvinceoneortwooperatorsand/

orauthoritiesinordertoattainadequatecoveragein,say,the

parkingbusiness.Theenvironmentmightalsobemorehomo-

geneous in terms of the technology used in, say, vending

machines.

In this respect it is interesting to underline that although

Belgium is a relatively small country, the Proton card was

neverthelessintroducedinphases,citybycity.IttookBanksys

morethantwoyearstocoverthewholeofthecountry.The

FrenchMoneocard—whichwas launchedseveralyear later

than the firstwaveofEuropeane-purses, thusproviding its

sponsors with an opportunity to learn from the mistakes of

others—wasalsolaunchedprogressivelyrightfromthestart,

withbanksacquiringlocalmerchantsaswellasinstallingload-

ingterminalsbeforelaunchingtheservicewithconsumersin

aparticularregionorcity.

Othere-purseoperatorshaveturnedtogeographicfocusing

aftersometime.EuropaySwitzerlandreconsidereditsstrate-

gyinyear5.Ratherthancontinuetotargetthewholeofthe

territory, in 2001 the ‘Zenterstrategie’ was introduced, as is

evidentfromtheAnnualReportforthatyear:‘Anewconcept

is geographic focusing: efforts will now be concentrated on

so-called ‘Acenters’—orcities,whichhaveconvertedpublic

transportation to CASH’6. In the same year, the marketing

campaignofZKAinGermanyalsostartedtargetingcities.In

2003, Munich was chosen as the ‘GeldKarte-Vorreiterstadt’

(GeldKarte pioneer city). According to Jan Hendrikx, Euro

58 - The Journal of financial transformation 1 Adams,J.,2004,“LeveragingtheEMVplatform,”EuropeanCardReview,11:1,p.20

2 TelekursGroup,AnnualReport2003,p.14

3 Source:EuropeanCentralBank,Euro-denominatedelectronicmoneyincirculation

intheeuroarea,September2004

4 “25jaarelektronischbetalen:tijdvooreenbalans,”Revuebancaireetfinancière/

Bank-enFinanciewezen,Nr.2004/6,September2004,p.302


595 Asanaside,thisalsohelpsexplainwhycitypilotsinvariablyprovetobemoresuc-

cessfulthannationwideroll-outs.

6 Telekurs,AnnualReport2001,p.18.

The second half of the 1990s saw a flood of so-called elec-

tronicpurses—chipcardsthatcanstoremultipurposeprepaid

value — being launched on a nationwide scale, especially in

Europe.Currently,however,wearewitnessingashake-outon

theEuropeane-pursescene.Severale-pursesthathavebeen

inthemarketforyearshaveeitherdisappearedorareabout

todoso.InJanuary2004,theSwedishbanksannouncedthat

they will close down their Cash scheme by autumn. Four

months later, Danish EFT operator, PBS, made a similar

announcement. The Danmønt card, which was launched in

March1993andisgenerallyseenasthefirstreale-purse,will

be discontinued from 31 December 2005. Earlier, the

PortugueseMultibancopurse—anotherpioneer—hadalready

defactodisappeared:in2002onlyafewthousandactivated

cards remained in circulation. Visitors to the Sociedade

InterbancáriadeServiços(SIBS)website,theoperatorbehind

thePortaMoedasMultibanco,willlookinvainforevenaminor

referencetoaconceptthatoncereceivedtremendousmedia

attention.

Thesurvivalofotherpurses isalso inquestion.Finland, for

example,islikelytoreplaceitsAvante-pursewithofflineuse

ofastandardEMVdebitcard,accordingtoEeroVasenius,Vice

President of Nordea Bank Finland, on the basis that ‘elec-

tronic purse does not fly in Europe’1. The following quote

taken from the 2003 annual report of the Swiss Telekurs

Groupisalsonotveryencouraging:‘Sincethepastyear,the

valuecardCASHhasonlybeenmanagedasanicheproduct

andisnolongerbeingsupportedintermsofadvertisingwith

largecampaigns.Thenumberoftransactionsconductedwith

CASHdecreasedinthereportingyearby5.4percent,to19.4

million’2.

Ontheotherhand,thereareanumberofEuropeane-purse

schemesthataredoingreasonablywell,thanksinparttothe

introductionoftheeuro.Theaggregatedstatisticsmaintained

bytheECBshowthattherewasajumpinthevalueofhard-

ware-basedelectronicmoney incirculation in theeuroarea

from 170 million in November 2001 to 208 million in

December2001,on theeveof the introductionof theeuro,

andto240millioninJanuary2002.Theoverallamountof

e-moneyincirculationhascontinuedtoincreaseafterwards,

albeitonlygradually:thefigureforAugust2004is283mil-

lion3.ParticularlyintheBeneluxcountriesusageofthelocal

e-purses — called Proton, Chipknip, and miniCASH, respec-

tively—jumpedsignificantlyfollowingthelaunchofthecom-

moncurrency[VanHove(2004)].InBelgium,partoftheeuro

impact has since evaporated, especially when measured in

termsofactiveusers,andinarecentinterviewBanksysCEO,

Dirk Syx, called Proton a ‘commercial disappointment’ as

transactionvolumesremainsignificantlybelowtarget4.Still,

BanksysisnotgivinguponProtonandwillshortlybelaunch-

inganautomaticreloadfunction.

So,clearly,thefortunesofEuropeane-purseshavebeenvery

mixed.Thisarticle looksat theEuropeanexperiencefroma

pragmaticpointofviewtofindoutwhatcanbelearnedfrom

thesedisparatefatesandtoidentifycharacteristicsthatcan

help us distinguish between winners and losers. The article

putsforwardsixessential ‘smartmoves’,whichshouldbeof

interesttorelativenewcomersonthee-pursesceneoutside

Europe,suchasDexitinCanadaandEdyinJapan,aswellas

providersofmorenovelsolutions,suchasmobilepayments,

thattosomeextenttargetthemarkets,suchaslow-valuepay-

ments,whiche-purseshavefailedtocapture.

smart move number 1: mind the network externalitiesPerhapsthemostimportantproblemoperatorsarefacedwith

when launchinganelectronicpurse istheso-calledchicken-

and-egg deadlock. This is because e-purses are subject to

network externalities; put simply, the utility of the payment

instrument increaseswith thesizeof thenetwork.Stronger

still,ane-purseonlybecomessufficientlyusefulifthesizeof

the network exceeds a certain minimum level, the so-called

criticalmass.Thisistrueforconsumersandmerchantsalike,

althoughtherelevantnetworkdiffers.Whatmattersforcard-

holdersisthenumberofterminalsandwhatisimportantfor

merchantsisthenumberofactivecardholders.Insuchatwo-

sidedmarketthereclearlyisacrucialcoordinationproblem:

7 ECR,2003,“Electronicpurse:LastchanceforGeldKarte”EuropeanCardReview,

10:2,p.5

8 EUROKartensysteme,AkzeptanzderGeldKarteinMünchensteigtdeutlich-

Vorreiterstadt-Kampagneerfolgreich,pressrelease,September4,2003.

9 “Japan’scontactlesscashgoesnationwide,”Itworld.com,July19,2002;emphasis

added.

10 Dexitenablesconsumerstopayforlow-costitemswiththetapofaRFID(radio

frequencyidentification)taglinkedtoapre-paidaccount.TheRFIDtagscomein

theformofkeyfobsoradhesivestickersthatcanbeattachedtocellphonesor

otherdevices.

11 Dexit,InvestorRelations,webpagehttp://investors.dexit.com/overview.

asp?ticker=t.dxt,visitedonAugust12,2004.


trieswherethisseemstohavehappenedwithoutproblems.In

atradepublication,FransBaeyens,generalmanager,domestic

paymentsanddepositsatKBCBankinBelgiumwasquotedas

saying: ‘2002wasthe firstyear thebanksmadeaprofiton

thisactivity.Itrequiredanenormouseffort,butalltheparties

involved kept the faith in the business case for years on

end’12.Ihavealsonotcomeacrossanyevidenceofmajorrifts

betweenbanks inAustriaandFrance, although in the latter

casethenationallaunchofMoneomayhavebeendelayedby

thesearchforacommonsolution.

In Germany, on the other hand, not all banks have been

equally active in promoting the GeldKarte. The cooperative

banks,representedbyBVR,haveaddedthee-pursetoalmost

alltheireccards.TheSparkassen-Finanzgruppe,thegroupof

more than500savingsbanks,hasalsobeenanactivepro-

moter. The private banks, for their part, have been far less

active.TheHypovereinsbank,thesecondlargestprivatebank

inGermany(withsome8.5millionclients),hasneveroffered

the GeldKarte. Dresdner Bank decided to stop issuing the

GeldKarteinJune2002becauseofweakdemand.Unlikethe

savings banks, Dresdner Bank did not automatically include

the e-purse function on its debit cards. Finally, while the

DeutscheBank24(with7.4millionclients)continuestoback

theGeldKarte,sincethestartof2002theyonlyofferitasa

separate card. The result is that, as a survey by InterCard

shows,whileonanationalscalechippenetration(asa%of

the number of ec cards issued) averages 68%, in some

regionsthisfigureisbelow26%—dependingonwhichtypeof

bankshaveahighmarketshareinthoseregions.Thisispar-

ticularly true for former Eastern Germany13. With lesson

number1,ontheimportanceof(local)criticalmass,inmind,

thisisclearlynotbeneficialfortheuptakeofe-purses.

In other countries too, some of the issuers have done little

morethanpayinglipservicetothecommone-purseproject14.

Summing up, the third major lesson appears to be that the

e-pursemarketisactuallyathree-sidedmarket,inthesense

thatane-purseoperatornotonlyhastoconvinceconsumers

andmerchants,butalsoneedstomobilizeissuers.

smart move number 4: Know your foesBefore launching an e-purse it is important to have an idea

aboutwhichpaymentinstrumentswillbeitsdirectcompetitors

andhowtheyarepriced.Thiscandiffersubstantiallyacross

countries. One reason for the lack of success of e-purses in

Nordiccountriesappearstobethatdebitcardscanbeusedfor

lower-valuepayments,unlikemanyothercountries.Jyrkönen

and Paunonen (2003) of the Bank of Finland, for example,

point out that ‘the use of e-money is at a very low level in

Finland. One reason for this is that Finnish consumers are

accustomed to paying with other payment cards, especially

w i t h d e b i t

cards,thatcanalsobeusedforsmallpayments.’Inthisrespect

it is interesting to note that, unlike in Belgium for example,

Finnish debit cards are mainly off-line. Similar explanations

appeartoholdforSweden,Denmark,and Iceland[VanHove

(2004)].Thisobviouslyreducesthemarketfore-purses.

WhereDenmarkisconcerned,averyspecificcircumstanceis

thatdebitcardsare freeofcharge forconsumersandmer-

chantsalike.Asaresult,accordingtoHenrikArntAndersenof

DanmarksNationalbank,‘debitcardsareusedforvirtuallyall

transactions,’ even transactions of1 or2. It is also obvi-

ously important to know how the ‘natural enemy’ of any

e-purse,goodoldcash,ispriced.Inmanycountries,thepublic

hasbeensparedtherealcostofcashusage.Thatis,thedirect

chargesfacedbyconsumerswhenusingcurrency, ifany,do

notcoveritsfullcost.Hence,consumersmistakenlythinkof

currencyasbeingfree.Thisobviouslymakesitmoredifficult

fore-purses,andotherelectronicpaymentsystems, togain

ground.Inothercountries,however,thenumberoffeecharg-

ingATMsisontherise,withtheU.K.beingoneexample.All

other things being equal, in such an environment e-purses

shouldstandabetterchanceofbecomingsuccessful15.Dexit,

forexample,appearstobeinsuchapositionbecauseCanadian

consumersareaccustomedtopayingforATMwithdrawals.

smart move number 5: Know your marketWhensettingoutlessonnumber1,itwasalreadypointedout

thatmanye-purseoperatorshavepiggybackedontheexist-

60


KartensystemeCEO,suchactionsaresuccessful;‘we’vefound

thatwithapush,usagejumps40%-60%andstaysthere’7.In

Munich,GeldKarte transactionseven jumpedby 116% in the

firsthalfof20038.

Interestingly,e-purseschemeselsewhereintheworldalready

seemtohaverealizedtheimportanceofgeographicfocusing.

ThisishowanInternetsourcedescribesthestrategyfollowed

byJapaneseoperatorBitWalletinpromotingitsEdypurse:‘In

addition to going after large retail chains, BitWallet is also

looking to court independent retailers in single locations to

createsomethinglikeEdyhotspotswherealargenumberof

retailers accept the card’9. There are also indications that

Canadian payments firm Dexit Inc., the newest kid on the

e-purse block, is taking that lesson to heart. Established in

October2001,Dexitlauncheditspay-with-a-waveservice10in

September 2003 in downtown Toronto. So far Dexit debit

express is only available in the Greater Toronto Area, but

Dexit's‘objectiveistoexpanditsserviceinkeystrategicareas

acrossCanada,startinginthefallof2004’11.

smart move number 2: mind the network externalitiesThesecondlessoniscloselyrelatedtothefirst:inviewofthe

all-importantnetworkexternalities,theintroductionofseveral

incompatiblee-purseschemesatmoreorlessthesametime

may well prove detrimental for all of them. This is because

incompatibility creates uncertainty among consumers and

merchants,andcutsupthemarket,thusmakingitevenharder

toattaincriticalmass.Forexample,considertheintensecom-

petitionbetweenChipknipandChipperintheNetherlands,or

the fragmentede-pursemarket inSpain,whereno less than

three incompatible schemes (Monedero 4B, Visa Cash, and

Euro 6000) were launched in a matter of eight months.

Tellingly,eventodaySpainhasminimale-purseusage.

Inhisrecentdoctoraldissertation,GottfriedLeibbrandtnotes

that‘therearesomeinterestingexamplesoffirmsthathave

tried to compete on standards in payments, but ultimately

joinedtheindustrynetwork’[Leibbrandt(2004)].Oneofthe

exampleshereferstoispreciselythebattlebetweenChipknip

and Chipper in the Netherlands, where eventually only the

Chipknipschemesurvived.InApril1999,threeyearsintothe

‘standardswar’,thetwoschemessignedanagreementoutlin-

ingacommitment toensure interoperability. InMarch2001,

Postbank and ING Bank decided to abandon their Chipper

technology altogether, phase out the Chipper brand, and

migrate to Chipknip by early 2002. This is exactly what the

theoreticalmodelspresentedbyLeibbrandtpredict.Thestart-

ingpointofhisanalysisisthatpaymentinstrumentsaresub-

jecttonetworkexternalities,asthisarticlehasbeenpositing

allalong.Inhismodels,Leibbrandtalsoanalyzedtheadoption

ofthese,andother,networktechnologiesbyexistingfirmsin

anindustry,suchasbanks,aswellasthecompatibilitydeci-

sions that these firms face. He shows that when there is

‘autarky’ — meaning that transactions take place dispropor-

tionallywithincountries,asisclearlythecasewithe-purses,

—‘thetechnologylandscapecanwellbeheterogeneousacross

countries,[but]itwillbehomogenouswithincountries’.

Giventhat,firstly,onlyonetechnologyislikelytosurviveand

secondly,astandardswarisharmfulforallplayers,thelogical

adviceistopreventsuchawarinthefirstplace.InFranceand

Switzerland,itinitiallyalsolookedlikeseveralschemeswere

goingtocompetehead-to-head,butluckilyinthesecountries

allplayersagreeduponacommonsolutionbeforeanyofthe

schemes were launched on a national scale [Van Hove

(2004)].Interestingly,inFinlandthefirstversionoftheAvant

e-pursewaslaunchedbyasubsidiaryofthecentralbank.By

takinganactivepartinthedevelopmentofthenewpayment

instrument,theBankofFinlandpreciselywished‘toavoidthe

unnecessary emergence of several parallel or overlapping

cardsystemsinFinland’[KokkolaandPauli(1994)].

smart move number 3: Know your friendsBuildingonthepreviouslesson,itisonethingtoagreeona

commonstandard,butforane-pursetobecomesuccessfulall

participating issuers and acquirers must also be completely

committed. This is not evident, as it implies cooperation

betweencompetitors.BelgiumandLuxembourgaretwocoun-

6112 ECR,2003,“Electronicpurse:LastchanceforGeldKarte”EuropeanCardReview,

10:2,p.5

13 InterCard,Chip-Ausstattungderec-Bankkartenfälltaufunter70%,pressrelease,

April2,2003.

14 ExamplesarethePostOfficeinSwitzerlandandSvenskaHandelsbankenandS-E

BankeninSweden[VanHove(2004)].

15 Althoughtherearecurrentlynoe-purseschemesactiveintheU.K.

16 Acaveathereisthatadistinctionhastobemadebetweenthenumberoftrips

registeredandthenumberofactuale-pursepaymentsmade(forsinglefares).

Also,Octopusisonlyslowlymakinginroadsintheretailenvironment.


significant.Compared tocash,however, all theabovedisad-

vantages cancel out. At the same time, e-purses can offer

important improvements over cash. Getting this message

acrossmaybeanotherreasonwhye-purseoperatorsshould

perhapsconcentrate,at least initially,onplaceswhichprevi-

ouslyonlyacceptedcash.

conclusionSimplifying somewhat, the ultimate profile of a successful

Europeane-purseschemeseemstobeaschemethatisactive

inarelativelysmallcountryand/oronethathasoptedfora

phasedintroduction,wheredebitcardsarefairlypopularbut

functioninon-linemodeand/orcannotbeusedforlow-value

payments,whereallplayersquicklyagreeduponacommon

solutionsothattherearenoincompatibilityproblems,where

all major banks participate in the scheme and prove to be

completelycommitted,andwherethee-purseprojectreceives

support fromplayers inat leastoneandpossiblyseveralof

the following sectors: public telephones, parking meters,

vendingmachines,andpublictransport.

Asalreadyalludedtointheintroduction,Iamconvincedthat

therecipefore-pursesuccesselsewhereintheworldissimi-

lar.However,theanalysisoftheEuropeanexperiencehasalso

shownthatcountry-specificcircumstancescanmakeaworld

ofdifference.Thesinglemostimportantlessonis,therefore,

perhapsthatitisdangeroustogeneralize.

Theintroductionalsoclaimsthattheexperiencewithe-purses

holds valuable lessons for newer generations of payment

schemes.However,while I seeclearparallels, therearealso

importantdifferences. It is,forexample,nocoincidencethat

the Dutch banks announced in September of this year that

they will stop some of their current individual Internet pay-

mentsystems—suchasTootz,Way2Pay,andE-wallet—and

thattheywill joinforcestodevelopanewinternetpayment

standard17. The important question is, however, whether a

national standard will be sufficient. Turning to mobile pay-

ments,itisclearthatlessonsnumber2(avoidincompatibility),

3(makesureallGSMoperatorsareinvolved),4(whatabout

pricing?)apply,asdolessonsnumber5and6inonewayor

another. However, there is at least one possible exception:

wheremobilepayments forcontentorgoodspurchasedvia

m-commerceore-commerceareconcerned,thereisbydefini-

tionlessneedforastrategyofgeographicfocusingwhichhas

proved to be very important in the real world. In short, the

caveatis:the‘smartmoves’putforwardhereshouldbetrans-

posedinasmartway.

References• Leibbrandt,G.,2004,“Paymentinstrumentsandnetworkeffects:adoption,harmo-

nizationandsuccessionofnetworktechnologiesacrosscountries,”doctoraldisser-

tation,UniversityofMaastricht,June

• Jyrkönen,H.andH.Paunonen,2003,“Card,Internetandmobilepaymentsin

Finland,”BankofFinlandDiscussionPaperNumber8/2003,March12

• Kokkola,T.andR.Pauli,1994,“Electroniccash,”BankofFinlandBulletin,68:12,

December,9-14

• VanHove,L.,1999,“Electronicmoneyandthenetworkexternalitiestheory:lessons

forreallife,”Netnomics,1:2,137-171

• VanHove,L.,2001,“TheNewYorkCitysmartcardtrialinperspective:aresearch

note,”InternationalJournalofElectronicCommerce,5:2,Winter,119-131

• VanHove,L.,2004,“ElectronicpursesinEuroland:whydopenetrationandusage

ratesdiffer?”SUERFStudies,Nr.2004/4

• VanHove,L.,Aselectedbibliographyonelectronicpurses(andelectronicmoney),

website,1996-2004



ingdebitcardinfrastructure.Incorporatingthee-pursefunc-

tion into debit cards obviously reduces the issuing costs

involved.Itmayalsobetemptingtofollowasimilarapproach

whereterminalsareconcerned,byconvertingdebitcardter-

minals into so-called 'combi terminals,’ terminals that can

handlebothdebitcardsande-purses.Thishas,forexample,

beendoneinAustriaandintheNetherlandsinallprobability

inanattempttoreachacriticalmassofterminals.

However, one has to realize that merchants that already

acceptdebitcardsarenotreallypartofthecoremarketofan

e-purse.Asaresult,suchacceptancepointstypicallydonot

generatehightransactionvolumes.Rathere-purseoperators

should focus on those retail sectors that typically do not

acceptdebitcards,becausetheaverageticket issimplynot

highenough.Also,surveyspointoutthatconsumersseethe

added value of e-purses particularly in unattended applica-

tions,suchaspayphones,vendingmachines,parkingmeters,

and transit systems, because these are the uses for which

cashistrulyinconvenient.

Animportantlessonis,therefore,thatbesidesthequantityof

terminals, their quality matters too. More concretely, the

European experience shows that an electronic purse needs

thesupportofatleastoneandpossiblymoresectorswitha

large number of small cash payments, such as public tele-

phones, parking meters, vending machines and/or public

transport.Althoughtheimportanceofpublicpayphoneshas

been diminishing due to the phenomenal uptake of mobile

phones,thedealwithBelgacomearlyinthelifecycleofProton

was a vital one for Banksys in Belgium. In the Netherlands,

purse-only parking in three cities has been, and still is, an

important driver behind Chipknip usage. Vending machines

aretypicallyalsopopularapplications.IntheNetherlands,for

example,vendingmachinesrepresented5.3%oftheterminal

parkatend-2002,butwith18.4%theirshareinthetotalnum-

berofChipkniptransactionsovertheyear2002wassignifi-

cantly larger. As the Octopus scheme in Hong Kong has

shown16,anotherpotentialvolume-boosteranddooropener

mightbepublictransport.However,allinall,Europeane-purse

operatorshavebeenslowinbringingelectronicticketinginto

their schemes. Part of the explanation for this is that all

Europeanschemesarecontact-based,whereasthepreferred

option for transport applications is obviously a contact-less

card.

smart move number 6: Know (and educate) your customersInJuly2004,theMoney&FinanceResearchGroupandthe

CenterforWork,OrganizationalandEconomicPsychologyof

theFreeUniversityofBrusselstogethersupervisedasurvey

of1,000Belgianconsumersovertheageof15.Thesurveywas

commissionedbyBankys,thenationalEFToperatorandspon-

sorofProton.Thesurveyconfirmedonceagainthate-purse

users on average tend to be younger and better-educated.

Thesamegroupalsoprovedtobemoreopentoawiderange

of, sometimes hypothetical, payment innovations, including

mobile payments. Early in the lifecycle of a new electronic

payment instrument, when lesson number 1 plays to its full

extent, sponsors might, therefore, want to concentrate on

theseinnovatorsandearlyadopters.

Thesurveyalsounderpinnedtheneedforthorough,andcon-

tinuous,consumereducation.ComparedtoProtonusers,non-

usersconsistentlyunderratedProtonacceptance,whileover-

rating the costs involved. Also, more than 8 years after its

launch,therewerestillimportantmisconceptionsconcerning

the degree of anonymity provided by Proton, with 40.1% of

non-usersstatingthatProtondidnotprovideadequatelevels

of anonymity, as compared to 23.9% of users. Conversely,

27.4%ofProtonusersconsiderittobeveryanonymouscom-

pared to only 15.3% of non-users. In general, as was to be

expected, non-users were less convinced of the advantages

offeredbyProton.AsIhavearguedearlier,itisimportantto

ensure that e-purses are not primarily compared to debit

cards.Indeed,comparedtodebitcards,e-purseshaveobvious

disadvantages. They must be reloaded periodically, there is

theriskoflossandtheft,usersmustkeeptrackofthebalance

on their cards, and they lose the float on their money. The

advantageofnotneedingtouseaPINappearstobenotso

6317 “INGstaaktWay2pay,ABNstoptE-wallet,”2004,PlanetInternet,September17

Transition

Payments policy in the information age

creating a profitable infrastructure — The payments challenge for banks

Payments in transition: where have all the changes gone?

Electronic payments: The drive towards a competitive, customer service driven utility

simulation: A powerful research tool in payment and settlement systems

European payment systems and monetary union

Technological innovation in retail payments: Key developments and implications for banks

Payments policy in the information ageRonald J. MannBen H. & Kitty King Powell Chair in Law, Co-Director, Center for Law, Business & Economics, The university of Texas School of Law

processed and cleared in an electronic way, which justifies

ruleslikethosediscussedabove.

Rulesrelatedtoerroraresimilar.Thetypesofeventsthatare

likelytoleadtoanerror,aswellasthemechanismsfordetect-

ing, confirming, and responding to an error are likely to

dependonthetechnologythat isusedtoclearandprocess

payments.Thus,itmakessomesensethattherulefortrans-

actionsprocessedelectronically(coveredbytheEFTA)would

differ from the rule for transactions processed entirely by

paper (conventional check transactions governed by Article

4).At thesame time, thecontinuingshiftof check transac-

tions from paper to electronic processing (probably to be

acceleratedby theCheck21Act)mightundermine thatdis-

tinction.

Rulesthatdeterminewhenapaymentismadearesimilar,in

thattheyareforthemostpartmadebasedonthepracticali-

tiesofaparticularsystem.Thus,inthewire-transfersystem,

wesaythatthepaymentiscompletewhenthebeneficiary’s

bankbecomesobligatedtopaythebeneficiary.Inthecheck-

ing system, we say that the payment is not complete with

respecttoanordinarycheckuntilthecheckispaid,butthat

it occurs with respect to a cashier’s check when the payee

acceptstheinstrument.

Rules related toreversibility,however,arecompletelydiffer-

ent. Rules related to reversibility should depend on the

dynamicsoftheunderlyingtransactioninwhichthepayment

ismade.Inthesimplestcases,paymentsystemsarespecial-

izedforuseinparticularsituations.Thus,forexample,inbusi-

ness transactions, parties often choose to make payments

withlettersofcreditorwiretransfers.Thosesystemsinclude

particular rules designed for the particular transactions in

whichtheyareused,whichdeterminethetimingandcircum-

stancesinwhichpaymentscanberecoveredorstoppedonce

the process has been initiated. Because those systems are

quitespecialized,thesystem-specificrulesworkwellforthem.

Secondly,toillustratethatframeworkinapplication,itisuse-

fultothinkaboutthetwomostrapidlygrowingpaymentsys-

tems in our economy, credit and debit cards. Existing law

drawsa starkdistinction in legalprotectionsbetween those

twosystems.Theapparentbasisforthatdistinctionistheidea

that cognitive problems that afflict borrowing transactions

justify a greater level of protection for consumers that use

credit cards than for those that use debit cards. From that

perspective,theexistingrulesdivideconsumerpaymentsinto

twoclasses.Thefirstclassincludestransactionsinwhichthe

consumer makes contemporaneous payment: cash, checks,

and debit cards. Because the consumer at the time of the

transaction understands that the payment is being made

more or less immediately, the consumer is treated as ade-

quatelyassessingthewisdomofthepaymentinquestion.

Creditcards,however,arequitedifferentfromthatperspec-

tive,becausetheconsumerthatpurchaseswithacreditcard

doesnotmakeimmediatepayment.Rather,althoughthemer-

chant receives contemporaneous payment, the payment by

theconsumer isdeferred,automaticallyuntilastatement is

receivedand,at theconsumer’soption,moreor less indefi-

nitely, as permitted by the strikingly lenient repayment

optionstypicalofthemodernAmericancreditcard.

TheAnglo-Americanlegalsystemhasalongtraditionofpro-

tectingborrowersfromthefollyofimprudentborrowing.The

most famous example surely is the centuries-long effort of

Englishcourts to invalidateaseriesofcreditordevices that

hadtheeffectofgrantingmortgagecreditorsabroadrightto

takereal-estatecollateral fromborrowerswhofailedtoper-

formpreciselyastheyhadpromisedatthetimeoftheloan.

That instinct continues to have broad application today, as

courts steadily broaden the range of devices to which that

invalidatingruleextends.

Althoughitisabitmuchtosuperimposetheinsightsofmod-

ernacademicliteratureonthepolicyinstinctsofthemedieval


67

The point of the longer essay this paper summarizes is to

emphasizesomething that isdeeplywrongwith thecurrent

frameworkofourpaymentspolicy.Theportionofthatpolicy

reflectedintheTruthinLendingActgrantsconsumersavari-

etyofgenerousrightsincreditcardtransactions.Bycontrast,

theElectronicFundsTransferAct,whichgovernsdebitcard

transactions,isrelativelycharyinitsprotections.Today,how-

ever,withthedebitcardmarketincreasinglydominatedbythe

PIN-less debit cards marketed by Visa and MasterCard, the

distinction between the credit card and the debit card is

almostinvisibletoallbutthemostsophisticatedconsumers.

Thecauseoftheproblemiseasytosee,ofcourse:technology

has altered the landscape of private payment institutions

whileCongresshasnothadoccasiontoupdatethestatutes

that regulate those transactions. The solution, however,

seemssufficientlydifficulttowarrantdetailedconsideration.I

startatahighlevelofgenerality,analyzingthegeneralques-

tionofwhattypesofconsiderationsshouldinformasophisti-

cated payments policy. There is of course some substantial

priorthinkingonthesubject,mostobviouslytheUniformNew

PaymentsCode(UNPC)andwriterslikePeterAlceswhocriti-

cizedthatproject.Iwanttomakethreemajorpointshere.

Thefirstpointisthatpreviousanalysishasfailedtorecognize

the importanceoftheunderlyingtransactions inwhichpay-

mentsaremadetoissuesordinarilytreatedinthelegalrules

thatregulatepaymentsystems.Thebasicproblemisthatpay-

ments policy needs to attend more consciously to the con-

texts of the transactions in which payments are made.

Existinglawarticulatesrulesthatareboundedalmostentirely

by the nature of the technology with which the payment is

made.Thus,wehaveseparaterulesforwiretransfers,letters

ofcredit,checks,electronictransfers,andthelike.Thattype

ofboundarymakessenseonlyforissuesdrivenbythenature

ofthetechnology.Itmakesnosense,however,forissuesthat

shouldberesolvedbyreferencetothenatureoftheunderly-

ingtransactioninwhichthepaymentismade.

At its heart, payments law must resolve four fundamental

questions:whobearstheriskofunauthorizedpayments,what

mustbedoneaboutclaimsoferror,whenarepaymentscom-

pleted (so that they discharge the underlying liability), and

whencantheybereversed.Thefirstthreequestionsarecat-

egoricallydifferentfromthe last,becausetheyoftenshould

beresolvedbasedonthenatureoftheunderlyingtechnology.

Thus, for example, with respect to the risk of unauthorized

payments,thefundamentalquestion ishowtodesignasys-

tem that gives adequate incentive to the user to avoid and

mitigate lossesfromunauthorizedtransactions,whilegiving

adequateincentivetothesystemoperatortomakeadvances

intechnologyandsystemdesignthatcanavoidandmitigate

thoselosses.Inourlegalsystem,wehavetakentheviewfor

mosthigh-technologypaymentsthatanalmostcompleteallo-

cation of the risk of those losses to the system operator is

appropriate.

Thepremiseofthoserules(admittedlyunspoken)isthateven

a complete allocation of loss to the network operator will

leavetheconsumerasufficient incentivetoattendtothese

problems.Thatcouldbetruebecauseofthehassleofrevers-

ing unauthorized charges, because of doubts that financial

institutionswillreadilyfulfilltheirobligationsinsuchasitua-

tion,orevenbecauseofignoranceofthelegalprotectionsfor

unauthorizedtransactions.Atthesametime,therulesreflect

theimplicitpremisethatlossesintechnology-drivensystems

are most effectively reduced by technological and system-

designinitiativesthatareexclusivelywithinthecontrolofthe

system operator. Thus, we are not surprised to see major

investmentsinfraud-preventiontechnologyinthecredit-card

and debit-card sectors. Because the justifications for those

rulesrelatetothenatureofthetechnology,itisplausiblefor

federallawtoprescribesucharuleforallelectronictransfers

fromconsumeraccounts.Itislessplausibletoincludeasimi-

larruleforcreditcardtransactionsbasedontheavailabilityof

creditinthetransaction.Itwouldbemoresensible,surely,for

thatruletobejustifiedbythefactthatthetransactionsare

monthlystatement,thetaskofmonitoringexpensestoreview

compliance with a budget (or, perhaps more commonly, to

understandthefailuretocomplywithabudget) isrendered

mucheasier.

Stillanotherfactor,atleastbycomparisontothecheck,isthe

desiretoclosethetransactionrapidly.Althoughthishasnot

alwaysbeentrue,itnowplainlyisthecasethatthecheckis

theslowestofretailpaymentmechanisms.Whenagrocery-

store customer pulls out a check-book to pay for groceries,

thehurriedcustomersinthelinebehindinevitablysigh,know-

ingthattheirwaitwillbeprotractedbytheadditionaltimefor

theconsumertowritethecheckandfortheclerktodecide

whethertoacceptit.Thatisnottosay,ofcourse,thattheuse

ofcreditcardsforborrowingisnotanimportantpolicyissue.

Itistosay,however,thatitisnotsufficientlydominantinthe

decision to use a credit card to exclude other relevant con-

cerns.

Thatargumentleadsto,atleast,twopossibleresponses.The

simplest course would be to repeal the TILA protections as

outdated.Irejectthatapproach.Instead,Ibuildontheframe-

workarticulatedabovetoarguethatthoseruleshavecome

fortuitouslytoserveotherimportantpolicies,specificallythe

transaction-relatedsalespoliciesthatareimportantinissues

ofreversibility.Themostobviousoneistoredresstheimbal-

ance in enforcement capabilities between the typical mer-

chant seller and the typical consumer buyer. If the existing

rules shift the burden of instituting and pursuing litigation

fromtheconsumertothemerchant,theymightenhancethe

likelihood that disputes in retail transactions are resolved

appropriately.Ifthatistrue,thenitjustifiestheTILArules.

Theproblemwiththatjustification,atleastasanexplanation

of existing law, is that the enforcement-imbalance concern

appliestoanypaymentsystemthattheconsumeruses.The

majorpointcuttingagainstbroadapplicationof that rule is

theneedtomaintainpaymentoptionswithdifferentcharac-

teristics,sothatmerchantsandtheircustomerscanchoose

betweenpayment systems thatare finaland those thatare

not.Inthecontextofface-to-facetransactions,Iconcludethat

credit and debit cards should have similar limitations on

reversibility, leavingopenthepossibilitythatdevelopingfor-

matslikeprepaidcardsultimatelymightbeleftonthecash-

equivalent side of the line. In the Internet context, where

creditcardscurrentlydominate,Iconcludethatthesamerule

shouldapply.Tobesure,thatdoeslimittheavailabilityunder

currenttechnologyofanypaymentoptioninthatmilieuthat

is both practical and wholly final. In the end, however, the

distinctionsbetweencreditanddebitcardsdonotseemtome

sufficient,orsufficientlyclear totheuser, to justifyamajor

distinctiononthatpoint.


English judiciary, thatpolicy findsbroadsupport in thespe-

cific concerns of the nascent behavioral economics move-

ment.Scholarsinthatfieldoftenpointtoanoverlappingset

oftendenciesthatgenerallyleadanormalindividualtounder-

estimatethelikelihoodofnegativefutureeventsthathavenot

previously been salient in the experience of the individual’s

circleofpersonalacquaintances.Asimilar,relatedphenome-

nonleadstosystematicunderestimationofthelikelihoodthat

anegativeeventwillhappentotheestimatingindividual,even

iftheindividualaccuratelyunderstandstheoveralllikelihood

of the event. Both of those phenomena are exacerbated by

thelikelihoodthatconsumershavehigherdiscountratesfor

eventsperceivedaslikelytooccurfarinthefuturethanthey

do for events likely to occur in the immediate future. Thus,

thosescholarswouldsay, it isreasonabletoworrythatbor-

rowers entering into credit transactions do not adequately

weighthelikelyharmstothemfromthedifficultiesthatmight

come at the time that repayment is due. Also, with a little

moresubtlety,thosewhopayinadvancemightunderestimate

thelikelihoodthattheywillharmtheirstrategicrelationswith

themerchantbyagreeingtopaynowandreceivethesubject

merchandise(orservices)later.

Finally, that concernworkswell asa lens forunderstanding

TILA.TILAdoes littleornothing toregulateanythingabout

credit card transactions divorced from their credit-related

features. The bulk of its regulations appear to rest on the

concern that crafty credit card issuers will trick consumers

into using credit cards without understanding the costs of

repayment. Thus, the statute relies heavily on a variety of

disclosure rules reflecting the well-intentioned notion that

mandatory disclosures will resolve the cognitive problems

thatafflictthepotentialcreditcarduser.

Thirdly, it seems clear that the normative underpinnings of

the current rules have become outmoded in several ways.

Mostimportantly,itseemslikelythatmany,ifnotmost,credit

cardtransactionsnolongerreflectthekindsoflong-termbor-

rowing transactions that justify the cognitive concerns that

wouldjustifytheexistingpolicy.Inthemodernera,however,

thecreditaspectofthepurchasetransaction is increasingly

obscure.Formanyofus,probablymostofthelimitedsample

of people who will read this article, the credit card is used

muchmoreforconveniencethanforanypurposerelatedto

borrowing.Toputitanotherway,weoftenpullacreditcard

fromourwalletnotbecausewelackthepresentwealthtopay

thepurchasepricefortheiteminquestion,butforsomeother

reasonunrelatedtoacreditdecision.

Ifthereisanythingthatprovesthatpoint,itistheriseofthe

convenience credit card user, who charges amounts on the

cardbutpaysoffthebilleachmonth.Oncearelativelysmall

sectorofthemarket,convenienceusersnowconstituteabout

40% of the market. For those users who consciously limit

theirspendingtowhattheycanrepayoutofresourcesavail-

ablethatmonthitisalmostdeceitfultotreatthetransaction

asoneinvolvingasignificantextensionofcredit.

Rather,weusethecreditcardforalocusofcompletelydiffer-

entreasons.Themosteconomicallyrationalmightpointtoa

desiretogetthefloat, theuseofthefundsduringthetime

thatelapsesbetweenthedateofthetransactionandthedate

thatthecreditcardbillmustbepaidtoavoidafinancecharge.

Buttherapidriseofthedebitcard,whichhasnosuchfloat,

suggests that it is not the dominating market factor in the

choiceofacreditcardovercashoracheck.

Morelikelyfactorsincludesuchthingsasadesirenottohave

tocarryenoughcashtocoverallofthepurchasetransactions

ofourdailylife.Thatisnotjustadesiretolimittheriskofa

loss fromtheft. Italsohastodowiththerelativeeasewith

which credit cards can be used, by comparison to the ease

withwhichwecangetcashfromourbanks:howmanyofus

stand at retail counters thinking something like ‘if I use a

creditcardhereitmeansIwon’thavetostopattheATMto

getmoneybeforeIgotoworktomorrow?’

Anotherconsiderationforsomeofusrelates to theeaseof

record keeping. If most of our transactions can be pushed

ontoasinglecreditcard,whichprovidesasingleconsolidated

69

creating a profitable infrastructureThe payments challenge for banks

Ann CairnsGlobal Head, Working Capital, ABN AMRO

route favored by some scale players, such as Citibank. But

bankswillneedtomaketheirownassessmentsofwhichbest

fitstheirowninstitution.

offshoring is here to stayPartandparceloforganizationaldecisionsarechoicesabout

whether or not to offshore. Whether institutions have the

capabilitytoexecuteoffshoringwithintheirexistingnetwork

ornot,anoffshoring2strategyisacriticalcomponentofany

paymentsstrategywherequality,productivityimprovement,

andreducedmanufacturingcostarekeycompetitivefactors.

Thedirectbenefitsofoffshoringareclear:Upto65%reduc-

tioninpaymentinstrumentunitprocessingcost,withsignifi-

cantqualityenhancementsgeneratingdownstreambenefits

incustomersatisfactionandreducedserviceandcorrective

costs.Additionalbenefitscomefromtheenormouscatalytic

effect of re-engineering processes that enable a relentless

pursuitofcontinuousqualityimprovement.

Somebanks,includingABNAMRO,havebeenabletosignifi-

cantlyenhancedisasterrecoveryandbusinesscontinuityby

introducing ‘load-sharing’ between regional and offshore

processinghubs.Thereducedriskofdisruptionisillustrated

bythefactthatfourpoweroutageandsecurityrelatedsite

denials in Western locations resulted in zero customer

impact,dueto theabilityof theoffshore facility toexecute

processing.Counterintuitivetoa‘Westisbest’outlook,per-

haps,buttruenevertheless.Infact,thekeyoffshoringdeci-

sionforbanksisnotwhethertooffshore,butwhethertodo

so in-house, by building their own facilities, or to select a

trusted provider — either a local company or a Regulated

FinancialInstitutionwithaprovenbusinessprocessoutsourc-

ingoffer.

A payments model appropriate to the parent institution’s strategyPaymentsbusinessgroupswithinbanksneedtodevelopstrat-

egies that maximize value for their parent. In essence, the

paymentschallengeisnodifferentfromthecommercialchal-

lengefacinganyotherbusiness. Ineverybusinessthereare

threecompetingbusinessthemes,customer-relationshipcen-

tric, product-innovation centric, or infrastructure manage-

ment centric. Different industry sectors (pharmaceuticals,

publishing, etc) offer examples of how organizations have

evolvedtounbundleconflictingcoreprocesses.Thebanking

andthepaymentsbusinessisnodifferent.Ittoowillconsistof

these three unique business characteristics which may con-

flictorbesuboptimal.Thechallengeistochoosewhichofthe

three models will add maximum value to clients and share-

holdersinthecontextofthestrategyoftheparentinstitution.

A customer-relationship businessRole:identify,attract,andbuildrelationshipswithcustomers.

Tasks:drawcustomersintothebank,assistthem,andtryto

build personal relationships with them, responding to ques-

tionsandcomplaints,collectingcustomerinformation,etc.

A product-innovation business Role: conceive of attractive new products and services and

commercializethem.

Tasks: research new products, figure out how to bring new

products/services best to the market, find ways to present

newproductstopotentialcustomers,etc.

An infrastructure businessRole: build and manage facilities for high-volume, repetitive

operationaltasks.

Tasks:buildnewbranches,maintaindatanetworks,provide

back-officetransactionalservices,managelogisticnetworks,

etc.3

Excelling at all three at the same time is incredibly difficult

and results in suboptimal contribution to theparent institu-

tion. For example, when we explore the economics we find

thateconomiesof scopeapply to thecustomer relationship

themewherehighcostofcustomeracquisitionandrelation-

shipmaintenancemakesitanimperativetogainlargeshare

of wallet, economies of speed apply to product innovation

aspectsofthebusinesswhererapidtimetomarketequatesto

70 - The Journal of financial transformation1 ArticleinComputerWeekly,13July2004

712 Formoreinformationaboutoffshoringpleaserefertothe8thissueofthis

Journal,whichwasdedicatedtothistopic.

3 Thisconcept,whichisevidentinourbusiness,isidentifiedanddevelopedby

Hagel,J.andM.Singer,1999,NetWorth:ShapingMarketsWhenCustomersMake

theRules,HBSPress

Onthefaceofit,thepaymentsindustryisthrivingasvolumes

continuetorisesteeply.In2003NACHAprocessed10billion

payments(up12%on2002),SWIFTvolumesgrewby9.5%on

2002(paymentsrepresent60%ofallSWIFTmessages),and

TheBankforInternationalSettlementsreporteddailyglobal

turnover in traditional foreign exchange markets of U.S.$1.9

trillioninApril2004,up36%atconstantexchangeratescom-

paredto2001.

But, as every payments executive knows, despite rising vol-

umesoverall,theindustryactuallyfacessomethingofacrisis.

Downwardpressureonpricingandthecostsofdoingbusiness

inanincreasinglycompetitiveandregulatedmarketplaceadd

uptoaverychallengingenvironmentforpaymentsproviders

in2005.

downward pressure on pricingPaymentsare, fundamentally,autilityusersarereluctantto

payfor.So-called‘freebanking’hasbeenthelifetimeexperi-

enceofmostadultsintheretailbankingsectorin,forexam-

ple,theNetherlandsandtheU.K.Businessestoohavebecome

much more demanding buyers of payment services over

recent years; reasonably enough, they negotiate hard with

theirbankersonpricingandtheyalsomanagetheirpayments

needscloselyusingsuchtoolsasinter-companynettingand

domestic non-urgent payment methods in preference to

cross-bordertransfers,andsoon.

Andgradualdownwardpressureonpricinghasbeensharply

accelerated in Europe by the introduction of the Single

EuropeanPaymentsArea.WithintheEuro-zone,cross-border

transfersofupto12,500mustnowbechargedasdomestic

transfers—thecapwillincreaseto50,000in2006.

cost drivers — technology renewal, market complexities, and regulation Meanwhile, the costs of providing the reliable and compre-

hensivepaymentsinfrastructuredemandedbyuserscontin-

ue to rise. Technology costs represent a huge and ongoing

burden,averagingaround20%ofthetotalcostbaseofpay-

ments organizations, according to market estimates. The

global IT investments (i.e. not just payments) of financial

institutions are an estimated U.S.$347 billion, according to

TowerGroup(2004).Atthesametime,thecostsofmeeting

regulatoryrequirementshavespiraled.Knowyourcustomer/

U.S.A.PatriotAct,BaselII,andSarbanes-Oxleytogetherrep-

resent significant costs. HSBC, for example, has calculated

thatthecostofmeetingregulatoryrequirementsis3.125%of

its Ebitda (earnings before interest, tax, depreciation, and

amortization)1.

The high costs of payments infrastructure have been com-

poundedinmostmarketsbylowinterestrates(onfloat)over

recentyears,addingtothedifficultiesforindividualpayment

providersofsupportingtheirpaymentsinfrastructures.While

this cost factor looks likely to improve going forward, the

othersarecertainlywithusforthelongerterm.

scale and size are different Thereceivedwisdomoverrecentyearshasbeenthatmarket

consolidationwillresolvethesechallengesthroughtheemer-

genceofafewmegaprovidersabletoprocesshighvolumes

ofpaymentsefficientlyandprofitably.Yetmergers,especially

cross-border,arehardtoachieveanddifficultinexecution.It

maybeseveralyearsbeforebenefitsstarttoberealized.And

evenifthedesiredscalecanbeacquiredinthisway,willthe

organizational structurebeable toexploit itefficiently?As

anyonewhohasspentmorethanfiveminutesinaverylarge

organizationknows,bigisnotalwaysbeautifulandtheday-

to-day realities of siloed businesses, fragmented infrastruc-

ture,andallocatedoverheadscanquicklydissipatethe‘scale

benefits’ofthetextbooks.

Sogettingtheorganizationalandsalesmodelsrightwillbe

everybitasimportanttoprofitabilityasassemblingthevol-

umebusiness.BostonConsultingGroup’sresearchhasdone

muchtoinformthinkinginthisarea.Ofthreeorganizational

models identified by BCG (infrastructure, customer centric,

andtransaction)thetransactionmodel(amono-line,custom-

er-facingentitywithfullP&Lresponsibility)appearstobethe

premiumpricingand largermarketshare,andeconomiesof

scale apply to any infrastructure business where high fixed

costsrequirelargevolumethroughputtodrivelowunitcost.

in or out: what is a bank to do? Whilechoiceoforganizationalmodelwillbecriticaltoexisting

or aspiring core infrastructure providers, other banks may

makeadifferentfundamentalchoice—thatofoutsourcingor

partneringtoresourcethepaymentsservicesthebankandits

customersneed.

Inmakingthisdecision,paymentsexecutiveswillobviouslybe

lookingtoshedtheinfrastructurecostsreferredtoabove,but

theyshouldalsobethinkingpositivelyaboutthebestwayto

enhancetheircorecapabilitiesandextendtheirreach,aswell

asmanagegrowthandriskforthefuture.

Whicheverpathaninstitutiontakes,thedecisionpointisnow

(or earlier!). Some banks are already incurring significant

lossesacrosstheirpaymentsfranchises,decisionsmadenow

concerning infrastructure changes will take some years for

the benefits to be realized, and banks that hesitate will be

evenmoreuncompetitiveonceearlieradoptersofnewbusi-

nessmodelsstart toreapthebenefitsof, forexample,new

technologyplatformsoroffshoringmodels.

Thosebankschoosingnottobeinfrastructureprovidersstill

have complex decisions to make. There is a spectrum of

choicefromoutsourcingaspecificserviceforaspecificmar-

ketsegmentorgeography(forexample,abankmaychooseto

outsourcealleuroclearingbutcontinuetocleardollarsthem-

selves) to fully private-labeled outsourced structures (for

example,front-andback-endprocessingforallcorporatepay-

ments). In the latter case, the bank would concentrate on

providinganeffectivesalescoverageapproachforpayments

asanadd-ontoother,value-addedfinancialservices.

In other cases, strategic partnerships may be founded on

mutual benefits, as with the partnership between Deutsche

Bank and Postbank4. In this interesting alliance, Deutsche

BankmovedalldomesticpaymentstoPostbankin2003,giv-

ingPostbanka15%shareoftheGermandomesticpayments

market.Thenearlierthisyear,DeutscheBanktookoverhan-

dlingofallPostbank’scross-borderbusiness.

Inthefuture,wecanexpecttoseebanksandfinancialinstitu-

tionspursuingstillmoreinnovativeorganizationalmodelsas

the market segments into core infrastructure providers and

thosefinancialinstitutionsthatchoosetooutsourcetheirpay-

mentsprocessing.Forboth,thechallengewillbetomaintain

organizationalclarityandflexibility,andcustomerresponsive-

ness,astheystrivetobecomeorremainprofitable.

72 - The Journal of financial transformation4 DiscussedinmoredetailbyWolfgangGaertnerinthisissueoftheJournal.

734 DiscussedinmoredetailbyWolfgangGaertnerinthisissueoftheJournal.

Payments in transition: where have all the changes gone?Mark WebsterPartner, Capco

Formanyyears,punditshavebeenpredictingthedawnofa

cashlessandchecklessworldandthedemiseofmoretradi-

tionaltransactionmethods.IntheU.S.specifically,the‘death

ofthecheck’hasbeenheraldedanddiscussedforatleastthe

last thirty years. The reality is, however, that the uptake of

newandimprovedpaymentsproductshasbeenmuchslower

thananticipated.Paper-basedmanualpaymentssystemsare

stillprevalentandmostbanksarestillusingpaymentsplat-

formsandarchitectures thathad theirgenesis in the 1960s

and70s.Giventhebroadspreadacceptanceofpersonalcom-

puters and Internet communication, the question becomes

whyhasthepaymentsindustrybeensoslowtochange?

drivers of changeBytheirnature,financialinstitutionsareinherentlyconserva-

tiveandriskaverse.Barringregulatorydemand,changeusu-

allytakesplaceveryslowly,almostcomingtoacompletehalt

without some strong motivation. The typical drivers for

changeinbankingtendtobecostcontrolorefficiency,cus-

tomer demand (revenue pressure), and risk control. While

eachoftheseareascanbeaffectedbytransformationofpay-

mentssystems,theoverall impactofthesedrivershasbeen

lessthanimpressive,intermsofmandatingchange.

The foundations of much of the current payments system

infrastructurehavebeeninplacesincethe1960s.Asbusiness

andconsumerdemandforfinancialtransactionsincreasedin

apost-WorldWarIIerathepublicandprivatesectors,inthe

formofbanksandcentralbanks,joinedtogethertocreatean

incredibly large and sophisticated infrastructure to manage

the flow of paper-based transactions, primarily checks. As

volumesgrew,existingprocesseswereautomatedtoimprove

efficiencyandentirebusinessesgrewuparoundmeetingthe

needs of the check-processing industry. The end result has

beenthecreationofalargebaseoffixedcostsdedicatedto

processing manual transactions. Electronic transactions are

arguablymorecosteffectivethancorrespondingpaper-based

ones,onapertransactionbasis.However,whenthecostsof

supportingtheexistinginfrastructureareincluded,thebusi-

ness case for change becomes questionable. As will be dis-

cussedlater,thissituationisexacerbatedbythefactthatfew

banks look at payments holistically. Most banks operate in

silosandhavecreatedseparateoperationalentitiesforpaper

andelectronicpayments.Thismakesitdifficulttodetermine

the overall economic impact of changes in transaction pat-

ternsandresultsincontinuedinvestmentinexistingsystems

thathavealreadyreachedscaleeconomy,ratherthaninvest-

inginnewerunprovenpaymentsvehiclesandplatforms.This

situation is changing as maintenance costs for aging pay-

mentsplatformsincreases.Butatthemoment,bankstendto

be more focused on increasing the cost efficiency of their

existing payments products rather than making extensive

investmentsinnewsystems.

Theeconomicsituationiscomplicatedbythesurprisinglack

of customer demand for newer payments products. Con-

sumershavebeenveryslowtomovefrompapertoelectronic

payments.Despiteavarietyofmarketingcampaignsbybanks,

retailers,andtradeassociations, ithasonlybeen inthe last

yearthatthevolumeofretailelectronicpayments,primarily

cardandACH,hasequaledthatofthepaper-basedmarketin

the U.S. Businesses have been even slower to change their

paymenthabits.Tradeorganizations,suchastheAssociation

ofFinancialProfessionals(formerlytheTreasuryManagement

Association),havemadeitveryclearthatchecksarethepre-

ferred method of payment, at least from the disbursement

sideofthehouse.Thislackofdemandhasmadeitdifficultfor

bankstojustifyhugeinvestmentsinnewpaymentsinfrastruc-

ture.Facedwithtakingtheriskthat ‘ifyoubuild it, theywill

come,’ banks have again focused on improving the overall

efficiencyoftraditionalpaymentsplatforms,andonlymaking

limitedinvestmentsinnewersystems.

Thethirdpotentialdriverofchangeisriskcontrol.Thiscan

belookedatfromseveralpointsofview.Firstly,itistheissue

of transactional risk control. Banks and corporations have

spentsignificanttimeandmoneydevelopingtechnologyand

processes to control and manage the risk of check fraud.

Although check fraud is a growing concern for most banks

andmanycorporations,fewconsumersseecheckfraudasa

major issue.Bycomparison,bothbanksandconsumersare

increasingly concerned about credit and debit card fraud.

Bankshavespentlargeamountsoftimeandmoneydevelop-

ingwaystocontroltheriskofcardfraud,butlossescontinue

to climb and consumers’ fears, largely due to growing con-

cernaboutidentitytheft,continuetoincrease.Asaresult,at

leastforthemoment,transactionalriskdoesnotseemtobe

an adequate reason to radically change payments systems.

The second point of view is that of operational risk. The

increasing cost of maintaining existing payments platforms

maybean incentive tomovetowardsnewerandmoreeffi-

cientplatforms.Aspreviouslymentioned,muchoftheexist-

ing payments infrastructure has been in place for thirty to

fortyyears.Althoughthesystemsandtechnologyhavebeen

updatedandmodifiedovertime,theiroverallcomplexityand

the related cost of maintenance continues to grow. Despite

the increasing cost, however, the existing systems do work,

andastheoldadagesays‘ifitain’tbroke,don’tfixit.’

Barriers to changeWhilethedriversforchangemaybemixed,barriersprevent-

ingitaresignificant.Hereagainwecanlookatrisk,revenue

orcustomerdemand,andcostefficiency.Ineachcase,there

arefactorsthatcreatepotentialbarrierstoanychangebar-

ringabsolutenecessity.

Payments are a core function for financial institutions.

Various studies have indicated that payments account for

30% to 40% of total net banking revenue. Understandably,

mostbanksarehesitanttomakemajorchangestocoresys-

temsinabigbangapproachwhensomuchoftheirrevenueis

atstake.Theriskofpotentialfailureisjusttoohigh.Unfortun-

ately, thesamecomplexityandageofexistingsystemsthat

increases maintenance costs also makes it difficult to make

significantchangesincrementally.Asaresult,majorchanges

inexistingsystemstendtobedeferredifatallpossible.

Although referred to earlier as surprising, the lack of cus-

tomer demand for new and improved payments systems is

actually not that surprising at all. Most consumers tend to

resistchangeunlessthere issomestrongincentivetomake

thechange.Inthecaseofpayments,onemightexpectthisto

be an economic incentive, given that electronic payments

shouldbecheaperandmoreconvenientthanthecorrespond-

ingcheck-basedones.Whilethismightbeatruestatementon

an all-in cost basis, most customers, whether consumers or

corporations,donotseeitthisway,mainlybecausethereis

lack of transparency in payments processing costs in the

bankingindustry.Veryfewbankcustomersseetheactualcost

of check writing as a disbursement method. Rather than

charging transaction fees, most banks recover their costs

through a combination of float and exception item service

chargesforcheckwritersanddepositchargesleviedoncom-

mercialcustomers.Infact,manyU.S.bankshaveextensivead

campaigns around variations on the theme of totally free

checking.Evenforcommercialcustomers,theper-transaction

or‘pennyprice’forindividualchecksisrarelyequaltoitstrue

cost.Thisapparent subsidyof checkwritingby thebanking

industry provides customers a strong incentive to stay with

theirtraditionalhabitsofwritingchecks,whilecheckreceivers

burytheircostsinthepricesthattheychargetheend-users.

Thislackoftransparencyisalsoanissuewithinmostbanks.

Aspreviouslymentioned,mostbanksarehighlysiloedwhenit

comestopaymentsplatforms.Veryfewbankshavetheability

tolookatpaymentsasawholeandhavedifficultyapportion-

ingcostsandrevenuesacrossvariouspaymentchannelsand

platforms.Asaresult,decisionsareoftenmadebasedonan

incompleteunderstandingoftheimpactofchangeonallpay-

ments products. While free checking may be viewed as a

neededprerequisitetomaintainingdemandaccountbalances,

electronic transactions are fully charged, resulting in an

added customer disincentive to change. Additionally, invest-

mentdecisionsareoftenmadebasedupontherelativesize

and importanceofthepaymentchannel,ratherthanonthe

long-termstrategic interestsofthefinancial institution.This

tendstofavorexistingpaymentssystemsandplatformsthat

havealreadydevelopedscalevolume.

Finally,fromacostefficiencypointofview,paymentsprocess-


75

ingisahighlycomplexnetworksystem.Thisisespeciallytrue

intheU.S.,sincetherearealargenumberoffinancialinstitu-

tionsthatclearpayments.Inlargesystemsofthistype,par-

ticipantsarehighlydependentupontheactionsofothernet-

workparticipants.Onebankcannotchangetoamoreefficient

methodofprocessingpaymentsunlessasignificantnumber

oftheotherparticipantsmakeasimilarchange.Asaresult,in

a variation on the traditional concept of ‘The Prisoner’s

Dilemma’ingamingtheory,thenetworktendstosuboptimize

anddiscouragechange.Sinceeveryonecanprocesschecks,

we continue to process them and there is little movement

towardsmoreefficientpaymentmethods.

conclusionWhile the economic transparency of our various payments

systems isunlikely to improveany timesoon,end-usersare

findingotherreasonstodemandincremental,ifnotovernight,

change. Decades of such incremental changes have already

hadsignificanteffectsonbothcheckandelectronicpayments

systems. Over time, we have gradually built an electronic

infrastructure that can effectively parallel existing paper-

basedsystems.Theincreasingageoftheexistingsystemswill

eventually force a transition as maintenance and operating

costscontinuetoincrease.Regulatoryissues,suchasCheck

21intheU.S.,imageprocessingmandatesinpartsofAsiaPac,

andpricingharmonizationintheE.U.,willonlyacceleratethe

rateofchange.

Wemayneverseeatotallycashlessandchecklesssociety,but

the transition to more integrated and automated payments

systemsishappening.Ratherthantherevolutioninpayments

thatwasoncepredicted,weareinthemidstofanevolution,

aslowseachangethatwilloccurwithoutmostofuseverreal-

izingthattherehasevenbeenachange.Howwegetthereis

perhapsnotas importantasthefactthatwewilleventually

get there. And by then, the pundits will be predicting even

moreradicalchanges!


OnceuponatimeaBankCEOreceivedaphonecallfromhis

motheronChristmasEve.

—‘Ican’tgetanymoneyoutfromtheATMformylastmin-

uteshopping,theBankbranchhaslongqueuesand

Icouldn’tusemyBankcardatthesupermarket,’she

exclaimed.

—‘Don’tworry,I’lllookintoit’,hereplied,thinkingthiswasa

minorproblemashepreparedforhisannualtalktothe

seniorexecutivesoversherryandmincepies.

He called the operations center; ‘Actually the Bank’s whole

ATMandPOSnetworkisoutofoperationanditisunlikelythat

wecanrecoverthesituationforanothertwohours,’reported

thedutymanager,lumpinthroat.Theimplicationsalmostdo

notbearthinkingabout;theCEOknewthat25%oftheentire

country’selectronicpaymentsnetworkwasoutofactionon

thebusiestshoppingdayoftheyear.

WhydidtheCEOnotknow?Whataretheramificationsfrom

the merchant business customers and card holding clients?

How long and how much will it cost to handle the manual

transactions generated from the outage? What does this

meantotheBank’sreputationandbrand?Thisisabusiness

whoseraisond’êtrehasbeenbasedontechnologytodeliver

convenience;evenhismother reliesonelectronicpayments

mechanisms.

How many times have we heard it? ‘This business needs to

improveclientservicelevels,adapttochangingcircumstanc-

es,increaserevenue,andreducecosts.’Thefinancialservices

industryislitteredwithexamplesofnotheedingtoorexecut-

ingsuccessfullyaround thesecore facets.Forexample,new

entrantsinmortgages,on-linesharetrading,andinsurancein

thelasttenyearshavechangedthemarketpermanently.The

top ten in many lists of vertical product suppliers will have

changedbeyondrecognitioninthelastdecadeinmostdevel-

opedcountries.

However,paymentshavenotbeentestedandthreatenedas

dramaticallyinthatperiod.Whynot?Thebottomlineisthat

payments have to be fulfilled as a core mechanism in our

economies.The risks, scale, security, andcomplexity cannot

be underestimated in delivering a successful payments net-

workwithappropriateregulationtoensurethatthenecessary

robustness,safetymechanisms,andcompetitiveframeworks

are in place. The inertia to change and the high barriers to

entryhavebeendictatedbysophisticatedgroupingsofinter-

ests, includinggovernmentsandregulatorybodies, financial

institutions, large payments processors, large retailers, con-

sumergroups,andserviceandtechnologysuppliers.

The above story actually illustrates only one aspect of the

increasing pressures on payments processing to deliver

improvedandnewservicesatasignificantlylowercost. It is

possible that this Bank had driven costs down through low

investment in aging infrastructure, asset depreciation, and

staffreductions.Astransactionvolumeshaveincreasedand

layer upon layer of complexity introduced, the system has

reacheditscapacityandfailed.

Payments processors are facing a difficult equation. They

havetoassesswhetherthecommercialrisksofnotchanging

theirbusinessprocessesandinfrastructurearegreaterthan

therisksassociatedwithtechnologicalchange inoneofthe

most demanding of all IT and telecommunications environ-

ments.

Outsourcingremainsanotheroptionwherebankshavecon-

tracted either specialist third-party payments processors or

major outsourcing organizations to operate their IT infra-

structure.Evidencesuggeststhattheseoutsourceoperations

actually have the same problems as the original payments

institution, namely; limited differentiation, rigid processes,

ageing infrastructure, and costs levels that do not support

newmarketmodelsandcompetitivedynamics.

Whilst it is relatively straightforward to argue that a bank’s

core business may not be operating a Point of Sale (POS)

terminalfleet,theadvantagestothebankinclude:Revenue/

Electronic payments:The drive towards a competitive, customer service driven utility

Rod DewMarketing Director, Distra Pty Ltd

77

profitability,adirecttouchpointwiththebusinesscustomer,

service differentiation, and cross-selling opportunities. It is

possible that outsourced or central switch initiatives could

dilute the bank’s brand and disintermediate the bank’s rela-

tionship with the merchant customer, as witnessed in the

UnitedStatesandbysmallerfinancialinstitutionsthatutilize

outsourcedpaymentsservices.

merchants demanding moreMerchants have become increasingly dissatisfied with the

levelofserviceofferedbythepaymentsnetwork.Currently,a

typical model includes paying rental for the Point of Sale

devicesandtelecommunicationsline,andafeeforeachtrans-

action processed. The transaction fees cover both the pro-

cessing and support costs of the acquiring operation and

fraudandotherrisksfacedbythecardissuer.

Settlement, the movement of funds from the cardholder’s

accounttothatofthemerchant,cantakedays,andtransac-

tionsthataredisputedcantakeweekstoresolve.Thee-pay-

mentsPOSdevicesaregenerallynotintegratedwithin-house

networks,inventoryandfinancialmanagementsystems.

These factors have led to high rates of churn at the small

retailer end of the market, driven by marginal fee benefits,

andforlargerretailerstodeploytheirowninfrastructure(or

retailer led outsourcing/ consortiums) to negotiate better

transactionfeetermsandlowerinfrastructurecosts.

An opportunity exists for enterprising payments processors

andmerchantacquiringbankstogrowmarketsharebyprovid-

inggreaterinformationvisibility(on-linetransactionreporting

services, self service, dispute reconciliation), reduced settle-

ment times, and improved financial services, examining the

broader business needs, such as cash flow requirements,

supplierchainintegration,insurance,leasingetc.

other significant market changes impacting the status quoWhilstmerchantpressureishavingarealimpactonthepay-

mentsnetwork,thereareanumberofotherforcesofchange

thatareleadingtoare-assessmentofthepaymentsbusiness.

Thefollowingprovidesasummary:

Regulation—anincreasingnumberofregulationsareimpact-

ing payments processing globally. These include Check 21

(check image capture at the Point of Sale in the U.S.), the

Patriot Act (determining disclosure obligations on money

laundering),BasleII(operationriskcapitaladequacy—asper

thestoryreferredinthispaper),reducedpaymentsnetwork

fees, and greater transparency (Reserve Bank of Australia

creditcardreformsandEFTPOSnetworkdesignation,andthe

TreasurySelectCommitteeenquiriesintheU.K.).

Role of card schemes—potentialcentralswitchingmodelsin

Asiancountriesaimtocircumventtheperceivedexpenseof

utilizingthecardschemesasswitchprocessors.Additionally,

U.S.merchantshave fought successfully for the loweringof

debitcardtransactionfeesfortransactionsprocessedthrough

thecardschemenetworks.

Fraud—increasingcardfraudhasledtonationalmandatesto

deploy smart card technology (EMV). This typically requires

the deployment of new terminals and card readers, and

changestothecoreprocessingsoftware.

new channels and transactions—growth inATMandPOS

usagecontinuesunabated.However,newerchannels,suchas

theinternetandmobilenetworks,aregainingsignificantlev-

elsofmarketacceptance.POSdevicescanalsobeextended

to provide banking services, such as funds transfer and bill

payment,andothertransactiontypes,suchasticketing.New

transaction types include health insurance payments, P2P

payments, loyaltyschemes,mass transit systems ticketpur-

chase, etc. Payments processors need to evolve to support

multi-currencyandchannelintegrationcapabilities,andmore

thanjuststandardfinancialtransactions.

communications—ATMandPOSnetworkshavebeendomi-

nated by proprietary, costly communications infrastructure.


TransactionsaretypicallyaggregatedbyTelcosandforward-

edontopaymentsprocessors.Withtheadventofubiquitous

InternetProtocol(IP)thepotentialisfor‘alwayson’devicesto

routetransactionstopreferredprocessors.Thelegacyaggre-

gationservicesarethreatenedandpaymentsprocessorswill

bedriventowardsdifferentiationbeyondterminalconnectivi-

tyandfinancialtransactionprocessing.

Payments convergence—paymentsprocessinghastypically

beenmanagedthroughlinesofbusiness.However,anenter-

priseviewofpaymentscouldleadtogreaterefficienciesand

theproductionofnewproducts/services.Thesameenviron-

mentcouldsupportB2B,P2P,billpayments,highvalue/lower

volume payments, high volume/lower value payments, sup-

plierpayments,etc.

The technology challengeThecomplexityandscaleofthepaymentsswitchingprocess

cannot be underestimated. For example a large payments

processor may handle millions of real-time authorization

transactions a day from in excess of 100,000 POS/ ATMs

devicesplusinternet,mobile,andvoucherchannels.Ithasto

settlefundswithcardissuinginstitutions,cardschemes,and

tensofthousandsofmerchants.Thecostsofmanagingdis-

puteprocessesaresignificant. Inaddition,thesystemshave

toprovide24x7operationstoallowconsumerstotransact

anywhereatanytime.

However, tomeet thedemandsdescribedabove,processors

needtoexaminetheirexisting infrastructureandassessthe

migration risks of moving to new business models, a lower

cost model, and new communications, software, and plat-

forms.

Large payments processors have had very little choice in

selecting the necessary high performance transaction

processing environments needed to drive large payments

networks. Typically, the solutions have utilized in-house or

heavily customized vendor software operating on either

mainframesorhigh-endserversforhighavailabilityandfault

tolerance.

Awaveofsecondgenerationsolutionshasprovidedsoftware

on open platforms (UNIX, NT etc.). However, to provide the

levelsoffaulttoleranceassociatedwiththemainframes/high

end servers, clustering and replication techniques are

deployed.The limitationof thesearchitectureshas included

reducedperformanceandscalabilitydimensionsandextreme-

ly complex recovery issues in the event of a partial system

failure. Whilst these solutions are more flexible and open,

thereisstillaheavyrelianceontheoriginalsoftwarevendor

tocustomizethesoftware.

Thenextgenerationofpaymentssolutionsnowofferatruly

open and adaptable environment, unlimited scalability, and,

importantly,faulttoleranceattheapplicationlevelthrougha

distributedarchitecture.Costsaredrivenoutthroughchoice

ofdeveloper/integrator,useofmarket standard serversand

databases,speedtomarketfornewservices, lowerupgrade

costs, and utility models for license fees and infrastructure.

Transaction information isavailable inrealtimefordistribu-

tion to merchants, banks, and senior management via web

interfaces.Thenextgenerationapplicationdeliversasignifi-

cantly lowercostbase,greaterbusinessagility,andactually

improved reliability through enhanced replication and moni-

toring.

conclusionIndeliveringasecure, trustedpaymentsnetwork,payments

participantshavefocusedonnetworkcentricissuestoexpand

andgrowtheirbusinesses.Thenewdimension is toprovide

client-centric services; value for money, faster settlement

processes, value-added services, new channels, and greater

convenienceandtransparency.

Thecostsandrisksassociatedwithchangingtonewbusiness

modelsandapproaches,coupledwiththepotentialcannibal-

izationofexistingrevenuestreams,havehinderedinnovation

andresponsiveness.Thechallengeforexistingpaymentspro-

cessorsistoeitherreducetheircostsandadaptorbesubject

79

toagradualerosionoftheirbusiness.

However,therealopportunityisforlargeprocessorsandnew

entrantstoexploitthemarketchangesbyprovidingconsoli-

dated services that do not disintermediate the existing net-

workoperators.Thismaybeachievedbyprovidingdifferenti-

atedservicesandrevenuesharingmodelstobanksandmer-

chants within the network on the same infrastructure. The

ultimate vision is to deliver electronic payments as a utility

serviceacrossmultiplechannelsatanational, regional,and

potentiallyagloballevel.Acompetitivedynamicismaintained

by leveraging the infrastructure to support value added

aspectsforparticularnetworkrelationships.

Indefiningthestepstodeliveronnewstrategies,technology

has to be a high consideration. The ability to differentiate

service,adapt,providescale,anddeliverthehighestlevelof

availabilityarecomplexdimensionstoorchestrate.Importantly,

risksmaybemanagedthroughaphasedintroductionofnext

generation technology. The solution needs to meet existing

functionalandservicelevelrequirementsaswellasrealizing

the core benefits; reduced costs, increased business agility,

andimprovedservicelevels.

The payments processor’s challenge is identifying what is

trulyopen,whatwilldelivertoday’srequirements,andwhat

will rapidly adapt to meet an ever changing and dynamic

market.

Transition


Harry leinonenAdviser to the Board, Financial Markets,

Bank of Finland1

Kimmo soramäkiPolicy Expert, Directorate General Payment

Systems and Market Infrastructures, European Central Bank

Abstract

Paymentsystemsarecomplicatedandcontainmanyinternal

andexternaldependencies.Societyisdependentonwellfunc-

tioningpaymentinfrastructuresanditsstabilityandefficiency

bothrequirecontinuousmonitoring.Itisdifficult,ifnotimpos-

sible, to test different kind of risk scenarios and policy or

structural changes in daily production systems. Simulation

models, payment system simulators, provide a powerful

research tool for payment and settlement system analysis.

Thisarticledescribesthegeneralstructuresanddimensions

ofpaymentsystemsandthepossibilitiesofapaymentsystem

simulationapproach.

811 Theviewsexpressedarethoseoftheauthorsanddonotnecessarilyreflectthe

viewsoftheBankofFinlandortheEuropeanCentralBank.


simulation — the possibilitiesThe development of payment and settlement systems often

involves the hands-on work of designing and operating sys-

tems.Theanalyticalworkmusttackletheproblemofhandling

of largeamountsofdataand transactions.Simulation tech-

niquesenabletheconstructionofmodelsthatcloselymimic

therealworld.Thegenericeconometricmodelsaretoolimit-

ed to deal in sufficient detail with the many dimensions of

paymentsystems,whichentailimportantdependencies,both

within and between systems. Decision-making and other

behaviorissuesareheuristicanddependentoncounterparty

andsituation.Forthisreason,paymentsystemmodelsmust

allowfortheembeddingofdifferentkindsofbehaviormodels.

Areality-friendlysimulationmodelprovidesaveritablelabo-

ratorysetting,inwhichonecananalyzetheprobableaffects

of different structural options and decision parameters on

payment flows and system participants. An on-stream pay-

mentsystemissosensitivethatonecannotuseitfordirect

experimentationwithoutendangeringdailyoperations.

Anotherareaofresearchisthestudyofdifferentcrisissce-

nariosandhowtoprepareforthem.Whilerealizationsofsuch

crisisscenariosareextremelyrare,simulationmodelsenable

onetostudynumerouscrisis-likesituationsandthustopre-

pareinadvancefortherealevent.

Nonetheless, simulation models are subject to their own

important limitations. Optimization analysis requires com-

plete enumeration and iteration, so that one may actually

miss the true optimum. There may be problems with the

behavioral models and assumptions, which may not hold in

certainspecial situations. It is fairlysimple tousepayment-

flowtimeseries insimulationstudies,but thismayresult in

thefailuretodetecttheimpactoffuturechangesinpayment

flows.

Basic structures of payment systemsTraditionally,paymentsystemshaveoperatedonthebasisof

batch-processingandsystem-specific timetables.At theend

oftheday,anetpositioniscalculatedfrompaymentflowsfor

eachparticipatingbank.Insuchdeferrednetsettlementsys-

tems(DNS),coveringfundsareusuallytransferred,withalag,

acrossaccountsat centralbanks. Inorder to speeduppay-

menttransfers,especiallyforlargepayments,onlinecontinu-

ous settlement systems (CNS) have been developed. But

because a netting system can give rise to large inter-bank

creditriskpositions,authoritieshavegenerallyrequiredthat

theserisksbelimitedorhaveprovidedintheirsteadreal-time

grosssettlementsystems(RTGS).

Payment and settlement systems are often hierarchically

structured.Thetoplevelcomprisescentralbanks’RTGSsys-

tems,wherelargepaymenttransfersareexecuted,inter-bank

debitsandcreditsaresettled,andothersystems’finaltrans-

fersofcoveringfundsareaffected.Forexample,theBankof

Finland’sRTGSsystem(BoF-RTGS)handles inter-bank trans-

fersofcoveringfundsforcertainotherFinnishsystems:Retail

payment system (PMJ), express and check transfer system

(POPS),andtwosecuritiessettlementsystems(OMforshares

andRMfordebtinstruments).Theinternationaldimensionof

the BoF-RTGS is represented by its continuous linkage with

the European System of Central Banks’ TARGET system,

through which covering funds are transferred for systems

handlingprivatelarge-valuepaymentsinEurope(EURO1)and

internationalcurrencytransactions(CLS).Figure12showsthe

hierarchicalstructureofpaymentandsettlementsystemnet-

worksingeneral.

Risk considerationsLarge inter-bankriskpositionscanarise inanettingsystem

because banks accept incoming payments on behalf of cus-

tomersbeforecoveringfundsaretransferredbetweenbanks.

G10 central banks’ Committee on Payment and Settlement

Systems,initsLamfalussyreport[BIS(1990)],focusedatten-

tion on this type of risk. Authorities then proceeded to

demand that private netting systems employ limits and col-

lateralrequirementsforriskcontrolpurposes.Thereportalso

promotedthedevelopmentofRTGSsystemsbycentralbanks

[BIS(1997)].Andinordertoreducerisks,coreprincipleshave



83

Thelastseveralyearshaveseenagrowinginterestinresearch

anddevelopment in inter-bankpaymentandsettlementsys-

tems. Central banks have allocated effort and resources to

thisspecialarea.Amongthefactorsbehindthemovementare

internationalcooperation,technologicaladvancement,grow-

ingdependencyonsmoothfunctioningpaymentsystems,and

riskperspectives.Cooperationhasbeenaparticularlyimpor-

tant factor in theEuro-zonearea,whichhas seenextensive

linking of payment systems in order to give the region a

totallyintegratedinter-bankpaymentsystem.Thekeyofficial

fora have been payment system committees of G10 central

banks and of the European System of Central Banks, and

workinggroupsoftheEuropeanCommission.

AttheBankofFinland,simulationmethodshavebeenusedfor

severalyearsintheanalysisofpaymentsystems.Thistypeof

researchwasinitiatedaroundthetimeFinlandwasjoiningthe

Economic and Monetary Union and it became necessary to

examinetheimpactthatthenewmethodsoftransferringpay-

ments and covering funds would have on Finnish payment

systems.Outofthisconcernevolvedtheconstructionofthe

firstpaymentsystemsimulator.Thesimulatorprovedtobean

excellent tool for studying liquidity needs and system risks.

Althoughthesimulatorwasnotintendedforoutsideuse,other

centralbanksmadeuseofitwiththehelpofBankofFinland.

ExperiencewiththesystempromptedtheBankofFinlandto

proceedwiththedevelopmentofanewandmorediversified

simulator, designed especially for external use and interna-

tional distribution. The new simulator, BoF-PSS2, was com-

pletedinSpring2004andisavailableforresearchpurposes

freeofcharge.

Thepurposeofthisarticleistointroducethebasicissuesand

research topics related to payment systems that have been

studiedwiththeaidofsimulationmodelsaswellasthepos-

sibilities for using the Bank of Finland simulator. A more

detaileddescriptionofpaymentsystemfeaturesandinterest-

ingtopicsforsimulationstudiescanbefoundinLeinonenand

Soramäki(2003).

RT

gs

lev

elc

ns

lev

eld

ns

lev

el

DomesticcurrencyForeign

currenciesBonds Shares Derivatives

End-of-periodRTGSsettlement


DVP-conditions

DVP-conditionsPVP-condition

RTgs 1 RTgs j RTgs k RTgs mbonds

RTgs nshares

RTgs pderivatives

dns r dns s dns ubonds

dns vshares

dns wderivatives

cns b


cns b bonds

Intradayliquidity

injections

Figure1:Hierarchicalstructureofpaymentandsettlementsystems

2 Figure1illustratesthelinkagesforsimpleandconditionalfundstransfers.Incon-

nectionwithsecuritiessettlementsystems,deliveryversuspayment(DVP)means

thatdeliveryofsecuritiesisconditionalonsimultaneouspayment.Paymentver-

suspayment(PVP)referstocurrencytradinginwhichpaymentinonecurrency

occursonlysimultaneouslywithcorrespondingpaymentintheothercurrency.

DVPandPVPweredevelopedasmeansofreducingsettlementrisk.


settlementprocess.Certaintimingmethodscanalsobeused

forthesepurposes.InFigure2thedottedlineshowsthepos-

siblebenefitsofasettlementalgorithmthatsolvesgridlock

situationsinthesystem.Insuchsituations,theparties’trans-

actionsarequeuedandcannotbesettledindividuallyone-by-

onebutcouldbesettledbynettingorsplitting[Leinonenand

Soramäki(1999)].Atypicalexampleisacircularsituationin

whichparticipantAispayingparticipantB,whoispayingpar-

ticipantC,whoispayingparticipantA;butnoonehassuffi-

cientliquiditytopayandthusbreakthecircle.

In seeking a partial netting solution, one encounters the

‘knapsack’problem.Thisariseswhenliquidityisnotsufficient

tocompleteallthetransactionsinaqueueandonemustcom-

poseasmallergroupoftransactionsforsettlement.Inseek-

ing an optimal combination of transactions to settle, one is

facedwithsomanypossibilitiesthatgoingthroughthewhole

list isan inefficientprocedure.Algorithmsarepubliclyavail-

ablethatfindtheoptimalsolutioniftheorderofpaymentsis

fixed[BechandSoramäki(2001,2002)]andanapproximately

optimalsolutionifpaymentscanbesettledinanyorderfrom

thequeues[Guentzeretal.(1998)].Theproblemofgridlockis

particularly acute in securities settlement systems that

requiredeliveryversuspayment(participantsmusthavesuf-

ficientmoneyandsecurities).

cost elementsSettlement systems entail three structural cost factors that

are partly interdependent: Liquidity, delay, and credit-risk

costs.Liquidity,suchasholdingsoffundsforcompletingset-

tlements,involvescertaincosts.Theseare,asidefromstorage

costs,mostlyopportunitycosts,sincetheinterestrateoneli-

giblecollateralisusuallylowerthanonotherinvestments,due

to the liquidity premium. If settlements and the underlying

payments are late, delay costs arise, mostly in the form of

sanctions. If the payment system operates on the basis of

credit,usersalsoincurcreditriskcosts.Thebasicstructural

interdependenciesofcostelementsaredepictedinFigure34.

Besidesstructuralcosts,everysystemencountersprocessing

costs.Theseare,however,generallyof thesamemagnitude

regardlessofstructuraloptionanddependmainlyontheeffi-

ciencyofunderlyingcomputersystems.

Credit risk costs do not arise if the system operates com-

pletely on the basis of liquidity. If settlement is wholly or

partlybasedon implicitcreditrelationsbetweenthepartici-

pants, the cost of liquidity will be smaller. The difference,

however, is that liquidity costs fall on sending parties while

credit risk costs are reduced for receiving parties. Similarly,

liquiditycostscanbereducedbydelayingoutgoingpayments

so that they are in synchrony with incoming payments and

thusbenefitfromthenettingeffect.

Delaysinsettlementanddeliveryareusuallycausedbylimits

onavailableliquidityandonpermittedcreditrisks.Inpractice,

delays are greater, the less the liquidity available and the

tighter thecontrolofcredit risks. In their roleasoverseers,

centralbankshaveusuallyattemptedto increase liquidity in

ordertoensureadherencetopaymentprocessingtimetables.

Atthesametime,theyhaverequiredreductionsandcompen-

sation via liquidity transfers, especially to avoid large risk

positions.Figure3givesanexampleofasystem(A)basedon

fullliquidityandasystem(B)basedoncredit.

843 Therelationshipbetweenliquidityneedsandsettlementspeedisstudiedin

KoponenandSoramäki(1998)andLeinonenandSoramäki(1999).

Pay

men

td

elay

s

Liquidityavailable

Lowerbound Upperbound

4 2

3

1

Figure2:Relationbetweenliquidityandsettlementspeed


beendrawnup for systemically importantpayment systems

[BIS(2001)].

Insomepaymentsystems,counterpartyriskscanbesolarge

astogiverisetothethreatofadominoeffect.Financialprob-

lemsofoneparticipantcanbetransmittedviapaymentsys-

temstootherparticipantssoastocreateasystemicriskto

thewholefinancialsector.Integrationofpaymentsystemshas

increased the likelihood of contagion of systemic risk situa-

tions across wide areas of the globe. Authorities have

attemptedto limittherealizationprobabilityofsuchriskby,

forexample,requiringgrosstransfersofcoveringfundsand

collateral coverage of all significant counterparty positions.

Systemic risk has also become an important research topic

[Angelini et al. (1995), Kuussaari (1996), and Bech et al.

(2002)].

Liquidityriskisrelatedtopossibleshortfallsoffundsforset-

tlingpaymentobligations.Banksdoattempttoforecasttheir

comingliquidityneeds,butpaymentflowsaresubjecttodiffi-

cult-to-forecast stochastic fluctuations. These fluctuations

may be troublesome, especially in times of market distur-

banceorwhenotherbanksinthesystemarefacingliquidity

problems.Realizationofliquidityrisksmayevencauseatem-

porarydisruptiontoalargepartofthepaymentsflows.

liquidity needsLiquidity needs of payment systems and participants vary

accordingtotimetablesandsystemfeatures.Figure2givesa

generalpictureofliquidityneeds.Thelowerboundappliesto

theendoftheperiod,i.e.,itistheminimumamountofliquid-

ityneededtosettleallpaymentsbytheendoftheday.Ifthe

finalinter-banksettlementandtransferofcoverarenotcar-

riedoutuntiltheendoftheperiod, it issufficientthateach

counterpartyhassettlementfundsavailableintheamountof

its net liability. Settlement in this case is delayed for the

maximum time (point 2). In case payments are settled con-

tinuously with this same amount of liquidity and queued

whenever not enough liquidity is available, the settlement

delayscanbereduced(point3).

The upper bound (point 1) applies to continuous real-time

settlement. Payments are settled immediately and liquidity

needismaximized.Anyliquidityinexcessofthisamountwill

notbeused.Betweentheseextremesituationsisacontinuum

ofoptionsforwhichsettlementisdelayedandpaymentsare

variously queued. The shape of the curve depends on the

extentofthecontinuousnettingeffect.Ifliquidityisreduced

belowpoint3somepaymentswillnecessarilyremainunset-

tled while others are increasingly delayed. If liquidity is

reduced to 0 (point 4) no payment can be settled by gross

settlement.

Interest in intraday liquidity derives from developments in

paymentsystemsandshrinkingdeliverytimes.Paymentsys-

temsarecurrently inakindof interimstage.Earlier,before

the1990s,operationswerestrictlyonthedailylevelandintra-

day liquidity had no significance. As the processing of pay-

mentshasbeenspeededupandcentralbankshaveconverted

toRTGS,intradayliquidityhasreceivedincreasingemphasis.

As speed becomes more important, banks’ liquidity needs

increasetowardtheupperbound3.

If payments are queued, various netting and splitting algo-

rithmscanbeusedtoreduceliquidityneedsandspeedupthe

854 Figure3depictsathree-dimensionalcostminimizationproblemintermsofcredit

risks,liquidity,andpaymentdelaycosts.Allofthecostdimensionsinthechart

canbetradedoffagainsteachother.Therelationshipswithagiventechnology

areusuallyconvexresultinginauniquecostoptimum.

Figure3:Structuralcostsofpaymentandsettlementsystems

Settlement-delaycosts

Liquidity-usagecosts

Credit-riskcosts

System A

System B


Bank of Finland simulatorTheBankofFinlandPaymentandSettlementSimulatorcan

be characterized as a deterministic system with decision-

makingcapability,whichtakesstochasticdataasinput.Fora

giveninputdataandchoiceofalgorithmsandparameters,the

simulatorwillalwaysproducethesameresults.Usuallytime

seriesovermanydaysareinputinordertogetagraspofthe

fluctuationrangesofthevariousresults.Onecancreateand

use algorithms with decision-making capability that enable

payments processing in accord with different settlement

modesandbehaviormodelsforsettlementparties(banks).

Thesimulatorisbuiltfor independentPCusageandiscom-

posed of three subsystems — input generation, simulation

execution,andoutputanalysis.

ThesimulatoroperateswithMicrosoftNT,XPand2000and

requirescentralmemoryofat least256MB.Ausers’guide

andorderandinstallationdirectionsareavailableatwww.bof.

fi/sc/bof-pss.DistributionishandledviaInternet.UsingJava,

theusercanbuildnewsettlementalgorithmsandlinkthemto

thegivenstructures.Thedatabaseisbasedonthecost-free

MySQLdatabase.

using the simulatorTheBankofFinlandSimulatorisamodernresearchtoolthat

has been well received, particularly by other central banks.

Currently,about20centralbanksaroundtheworldareusing

it. These include all the Nordic central banks, European

CentralBank,severalEuropeannationalcentralbanks,Bank

for International Settlements, Federal Reserve Bank of New

York, Bank of England, Bank of Canada, and several central

banks in Asia. The simulator is used inter alia for studying

liquiditypoliciesandcounterpartyandsystemicrisks,making

efficiency comparisons, and developing algorithms, pricing

policies, and settlement modes. The European Central Bank

hasbeenparticularlyhelpfulinadvisingondesignandintest-

ingthenewversionofthesimulator.

Payment and settlement systems have received relatively

littleattentionfromfinancialmarketresearchers.Thesolu-

tions have usually been based on conventions applied by

those in charge of actual payment system operations. A

modernautomatedpaymentsystemisbasedpurelyondata

transferlogisticsexceptforthefactthatevenasmallnum-

ber of bits may contain credit transfers worth billions of

monetaryunits.Onewouldhopeforanexpansionofresearch

inpaymentsystems.

TheBankofFinlandPaymentandSettlementSimulatorpro-

videsnewtypesofopportunitiesinthisarea.Interestingand

sparsely-studiedareasofresearchincludeDVP-basednetting

and queuing algorithms in securities settlement systems.

Relatedtopicsofspecialinterestmightbemodelsofpartici-

pantbehaviorinvariousstressandemergencysituationsand

theconsequencesforsettlementrisks.Variousriskmanage-

mentsystemsthatmaybeincorporatedinpaymentsystems

represents another area that could benefit from further

research(i.e.thereactionsofparticipantsandthesystemto

terroristattacksandtoparticipants’liquidityproblems).

Theintentionistodevelopandexpandthesimulatoronthe

basis of experience and user feedback. It is hoped that an

active group of users will share experiences and ideas for


Transition

European payment systems andmonetary union

Francisco J. callado muñozAssistant Professor, university of Girona

natalia utrero gonzálezVisiting Professor,

universitat Autonoma de Barcelona

Abstract

We make a comparative study of payment systems for E.U.

-fifteencountriesforthe1996-2002period.Specialattention

is paid to the introduction of the new European single cur-

rency.Theoveralltrendinpaymentsisforamovefromcash

tonon-cashpaymentinstruments,althoughelectronicinstru-

mentsarenotwidelyusedyet.We finda significant impact

fromtheintroductionofthenewbanknotesandcoinsoncard

use.

87

InaworldofeconomicglobalizationandITdevelopmentthe

waysinwhichpaymentsaremadeareclearlyevolving.Cash

isnolongertheuniquepossibilityofmakingapaymentandit

sharesthestagewithcreditanddebitcards,directdebits,and

electronicmeans.

Bankersandotherprofessionals1areveryinterestedinknow-

inghowcustomersarepayingfortheirdailytransactionsand

monitoringwhatchangesaretakingplace.Theyarenotalone,

financialauthoritiesarealso interested inthis typeof infor-

mation,sinceoneoftheirresponsibilitiesisthepromotionof

efficiencyandsecurityofbothpaymentsystemsand instru-

mentsinordertosafeguardthemonetarypolicytransmission

mechanismandtocontributetothemaintenanceofsystemic

stabilityandpublicconfidenceinthecurrency[ECB(2002)].

Thepurposeofthispaperistostudythemaintrendsinpay-

mentsystemsacrosstheE.U.-15countriesfortheperiod1996-

2002. The data used in our analysis are derived from the

EuropeanCentralbank(dataonpayments)andtheEuropean

commission (economicdata).Thisanalysis is interestingnot

only to have a portrait of the evolution of payment instru-

ments usage in a general setting2 but also to analyze the

impactoftheintroductionofthenewcurrency,bothamong

thefirst11countriesin19993andthefullintroductionofEuro

notesandcoinsin2002acrossE.U.-15,onthesesystems.

cash useToanalyze the importanceofcashpaymentsweuse twoof

thetypicalproxiesusedbytheBISstudies:cashincirculation

asapercentageofGDPandcashincirculationasapercent-

ageofnarrowmoney4.Figure1offersthesetwomeasuresfor

thecountriesincludedinthesample.Ascanbeseen,thereis

adeclineincashuseforbothindicatorsandforalmostevery

country.TheonlyexceptionistheU.K.,wherethereisaslight

increaseincashusagefortheperiod1996-2001inthepropor-

tionofnarrowmoneyandaround10%for1996-2002inthe

proportionoftheGDP.Withrespecttothedistinctionbetween

euroandnon-eurocountriesapointhastobemade.Theeuro-

zone shows a decrease for the period 1996-2001 and 1996-

2002,butitpresentsanincreaseincashusewiththeintro-

ductionofeurocoinsandnotesin2002,thatisaround35%.

Non-euro countries, on the contrary, decrease their use of

cashandthefiguresfor2002arequitesimilarto2001.

Itcan,therefore,beconcludedthattheusageofcashdeclined

duringtheperiodofstudy,withtheexceptionofthephysical

introduction of the euro in 2002 that made the euro area

moredependentoncash.The‘dualcirculationperiod’5ofthe

neweuronotesandcoinsandtheformernationalcurrencies

together with the flourishing of money from the unofficial

economycouldexplainthisbreakinthetendencyofcashuse

reductionofthepreviousyears.

Retail paymentsAnother way of looking at payments systems would be to

analyzethecompetitionamonginstrumentsatretaillevel.On

theonehand,ATMnetworksallowcustomerstohaveaccess

to cash closer to the point of sale. On the other, EFTPOS

instruments,suchasdebitcards,provideconsumerswithnon-

cashmeansofpaymentrightatthepointofsale.Figures2to

5helpunderstandingtheirevolutioninthelastyears.

1 Companiesdifferentfrombanks(namelyretailstores,insurance,petrolstations

etc.)arenowofferingpaymentservicestotheirclientsmainlytroughcreditand

debitcards.

2 MarkoseandLoke(2000)madeafirstattempttoanalyzepaymentusageforthe

period1990-1998andservedasastartingpointforthiswork.

3 TheintroductionofthesinglecurrencyinGreecetookplacein2001.

4 UsuallyrelatedtoM1,althoughthecorrespondenceisnotalwaysexact.

5 Thespeedofthechangeoverwasnotthesameinallcountries.Thedualcircula-

tionperiodlastedbetweenfourweeksandtwomonths.


88

cash % of narrow money cash % of gdP

1996 2001 2002 1996 2001 2002

Belgium 27.5 11.8 - 5.1 2.8 -

Denmark 10.2 9.2 8.7 3 2.9 2.9

Germany 27.6 11.3 - 6.9 3.3 -

Greece 44.1 30.9 - 6.5 5.5 -

Spain 25 12 - 10.3 6.6 -

France 14 7.4 - 3.3 2 -

Ireland 34 16.5 - 4.7 3.3 -

Italy 16.1 11.3 - 5.3 4.7 -

Luxembourg 14.6 0.8 - 2.9 1.9 -

Netherlands 18 5.7 - 5.3 2.1 -

Austria 22.9 13.9 - 5.8 3.9 -

Portugal 15.3 8.7 - 4.9 3.6 -

Finland 6.6 6.1 - 2.2 1.9 -

Sweden - 4.1 4.5 4.1

U.K. 4.9 5 4.8 3 3.3 3.3

E.U. 13.8 8.6 11.5 5.3 3.5 3.5

Euro-zone 18.1 10.3 14.1 5.8 3.5 4.8

Figure1


WhenlookingattherelativenetworkdensitiesofEFTPOSto

ATMterminalswefindthatthereisnoregularpatternacross

all countries. Greece, Italy, Austria, Sweden, and Portugal

seemtohaveanincreaseinthisperiodalthoughtherateof

growth differs across the countries. Germany, Ireland, and

Spaingrowatthebeginningoftheperiodandthendecrease

inthelateryears,whileFrance,Finland,andLuxembourgare

relativelyunchanged.Denmark,Belgium,andtheU.K.donot

showacleartendency.WithrespecttotheEuroandE.U.coun-

tries,bothgroups increaseatasimilarratealthough,again,

withtheintroductionofthenotesandcoins(2002)theeuro-

zonesuffersaslightdecrease.Thisfactfollowsthesamepat-

ternasthoseobservedinFigure1.

Comparingthepercapitaratioofvalueofcardtransactions

(bothcreditanddebit)tothepercapitavalueofATMrelated

use,wefindthatmorethanhalfofthecountrieshavearatio

greaterthan1,thatis,thevalueofcardtransactionsisbigger

thanthevalueofcash.RemarkablecasesarethoseofFrance

and Sweden that start the period below 1 and end up with

cardsovercashin2002.TheE.U.asawholepresentsalsoa

dominanceofcardinvalueterms.Thisdoesnotholdforthe

Euro-zone since the six countries in which cash is still the

mostimportantpaymentinstrumentarewithinthemonetary

union.Again,in2002,theratioindicatesariseincashusein

thiseuro-zone.

WithregardstotheintensityofcardandcashperEFTPOSand

ATM terminals in terms of value, although no general trend

canbeidentifiedintherelativeimportanceofeachthereisan

increaseintheintensityofcarduse,thatis,eachEFTPOSis

processingagreatervalueof transactions.Thisgrowthpat-

tern holds for almost every country, including the E.U. and

Euro-zonecountries.Interestingly,fortheEuro-zonecountries

thisincreasealsoholds2002.

The intensityofcashusebyATM,onthecontrary,doesnot

follow a clear tendency. Some countries grow, some others

decline, and some remain nearly constant and figures are

morestable inall cases.TheE.U.and theEuro-zoneexperi-

encerelativegrowthuntil2002,whentheincreasebecomes

moreprofound.

It can be concluded then that cards are being more inten-

sivelyusedthancash.Consequently,financialauthoritiesand

bankers could increasemore thanproportionally theaccep-

tanceanduseofcards,andintheprocessdecreasetheuseof

cash, just by increasing the relative number of EFTPOS to

ATMs.

cash and non-cash electronic paymentsWe also looked at the relationship between cash use (as a

percentage of narrow money) and non-cash electronic pay-

ments and their evolution from 1996 to 2002 across these

countries (Figure 2). We found that at the beginning of the

periodalmosteverycountryhadahighcashuseandamore

variableelectroniccomponent.By2002,mostcountrieshad

lowerusageofcashandincreasedtheproportionofnon-cash

electronicpayments.OnlyIrelandremainswithahighdegree

ofcashusage,howevergiven itsstartingpointofveryhigh

cashuseandlowusageofnon-cashelectronicpayments its

89

110

100

90

80

70

60

50

40

30

110

100

90

80

70

60

50

40

30

0 10 20 30 40

Highusageofelectronicpayments

Highusageofcash

Ir

Ir

P

P

Fi

Fi

UK

UK

Fr

Fr

It

EU

EUIt

e

e

S

S

B

B

G

GA

A

D

D

Figure2:Cashuseandnon-cashelectronicpayments

6 Irelandisthecountrywherechequeshavethemostrelevantusebothinvolume

andvalue,butwefindthatitsimportancealsofallsduringthisperiod.

7 ItisimportanttoremarkthatATMandEFTPOSterminalsincrease54%and86%

respectivelyintheE.U.duringtheperiod(computedfromEurostatfigures).


triesandsuggestthatfinancialstructure,aswellastheintro-

ductionofthesinglecurrency,mayhaveaffectedthedecision

to use them. In this section, we want to investigate more

deeplytheempiricalevidenceontheserelationships. Inpar-

ticular,wetestthreehypotheses:

■ Whetherthefacilitiesdevelopedbyfinancialinstitutions

significantlyinfluencetheuseofcardsinstruments?

■ Ifthedegreeofeconomicdevelopmentcanalsoaffect

carduse?

■ Whethertheintroductionofnewcoinsandbanknotes

influencetheevidencedincreasingtrendincarduse?

Specifically,wedistinguishbetweentheuseofcardstowith-

drawmoneyfrombankaccountsandtheuseofcardsaspay-

ment instrumentatpointofsale.Weestimate the following

equations:

Card usei,t = α + β * banking industry facilitiesi,t + γ*gdpi,t

+ψt+εi,t (1)

wherei=1,…,nreferstocountriesandt=1,…,Ttotimeperiods.

Fromaneconometricpointofview,fortheestimationofthe

coefficientsα,β,andγwetakeintoaccountthestructureof

theerrorterms,εit8.Wealsoallowforthepresenceofunob-

servableindividualeffects9.

Thevariables thataccount for thebanking facilitiesare the

number of branches and the number of ATM and EFTPOS

available.Allvariablesarecontrolledforthepopulationofthe

countryinordertoallowcomparisons.Thenumberofbranch-

esisincludedinallregressions.However,weusethenumber

of ATMs when the dependent variable is the use of card to

withdrawmoneyandthenumberofEFTPOSinsteadwhenthe

dependent variable is the payment function of credit/debit

cards.Thenumberofbranchesaccountsfortheproximityof

thebankinginstitutiontocustomers.Theexpectedsignofthis

variableintheuseofcardsisnotobviousexante.Ontheone

hand,closeservicetocustomermightreducecardusebothto

withdrawmoneyandtopay,suchthatcustomershaveaccess

toadirectandpersonalserviceeasily(substituteeffect).On

theother,thecloserserviceassociatedtoalargernumberof

branchescantransmittrustandreliabilityinthebankinginsti-

tutionandfostertheuseofcards(reliabilityeffect).Wewilltry

toshedsomelightastowhicheffectisstronger.

Thephysicalfacilities,namelynumberofATMsandthenum-

berofEFTPOSpositivelyinfluencetheuseofcards.Thelarger

numberofATMs(EFTPOS)thelargertheprobabilityofusing

them.Therefore,theexpectedsignispositive.

To capture the effect of the introduction of the euro, we

includetwodifferentdummyvariables,onefortheyear1999

whentheEuropeansinglecurrencywas introducedandone

fortheyear2002whenthebanknotesandcoinswerephysi-

callyintroduced.Finally,weincludethepercapitaGDPineach

countrytocontrolforthedegreeofeconomicdevelopment.

The expected sign is positive. The use of cards requires a

minimumdegreeofelectronicfacilitiesandcommunications

tooperatecorrectly.Weassumethateconomicdevelopment

isagoodproxyfortechnologicaldevelopment.

Figure3presentstheresultsforthewithdrawalfunctionsof

cards. We estimate the equation using three different mea-

sures of the dependent variable. The cash use of cards is

computedintermsofthetotalvolumeoftransactions,num-

beroftransactionsdone,andtheaveragevaluepertransac-

tioninPanelsA,B,andCrespectively.

ATMnetwork influencessignificantlyandpositivelycarduse

towithdrawmoneybothintermsofvolumeandthenumber

oftransactions,as itcanbeobserved inall runs inPanelsA

and B. However, the average value of transactions is not

affected by ATM network (panel C). Column 1 in each panel

presentstheresultswhenthedummyvariablethataccounts

fortheintroductionofthesinglecurrencyisintroduced.The

1999variableisnotsignificantinanyoftherealizations,that

is in volume, number of transactions, or average value.

However, thedummy for the introductionof thebanknotes



development isoneof themost remarkableofanycountry.

WedonotfindacleardistinctionbetweentheE.U.andEuro-

zonecountries.Althoughtheoriginisdifferent,lesscashuse

inE.U. countries, theybothendup inaprettymuchsimilar

positionby2002.Therefore,intermsofvolume,wefindthat

thereisacleartrendtowardslowercashusageandtogreater

usageofnon-cashelectronicmeansofpayment.

Evolution of non-cash payment instrumentsAsshowninFigure2,thereisatrendfromcashtonon-cash

paymentinstruments,althoughpaper-basedinstrumentsare

stillimportantinmanyE.U.countries.Whatweintendtodoin

thissection is toassess therelative importanceof thenon-

cashpaymentinstrumentsinvolumeandvaluebetween1996

and2002.

We find that the use of cheques decrease significantly

between these two periods6. The use of credit and debit

cardsincreaseconsiderablyduringthisperiod,althoughtheir

relativeimportanceintermsofvalueissmall.Hence,itseems

thatcarduse isprobablymorerelatedtodailyoperations7.

Credittransfersaccountforthemajorityoftotalvaluetrans-

actionsandareimportantintermsofvolumeoftransactions,

although it falls during the period. Direct debits, instead,

remainfairlystableinallcountries.

Althoughonewouldexpectthatelectronicinstrumentswould

experience a significant increase in popularity during this

period,wefindtheirusageremainsquitesmall,particularlyin

valueterms.Belgium,Luxembourg,andTheNetherlandsare

the countries with highest usage of electronic instruments

andexperiencethelargestincrease.Thislackofgrowthtakes

place at a time when access to new technologies and the

Internet has experienced a huge increase in E.U. countries

(876%intheperiod1996-2001accordingtoEurostatfigures).

It seems logical, therefore, that should financial institutions

wishtoincreasetheusageofelectronicmoneyacrossEurope,

theywouldneedtoinvestheavilyinbettersecuritysystems,

transparency,andpublicityinordertoincreaseconsumerreli-

abilityandthesuccessofthesepaymentinstruments.

We also examined the potential impact of the euro on the

usageofnon-cashelectronicpaymentsand instruments,by

lookingatthechangesintheyears1998-1999and2001-2002,

andfoundno‘euroeffect’.Wefoundthattherewasnobreak

in tendency present. On the contrary, results confirm the

trendsandpatterns found in thewholeperiod, inparticular

relativetothevalueoftransactions.Therefore,theintroduc-

tion of the new bank notes and coins do not seem to have

dramatically impacted the relative importance of non-cash

instruments.

Econometric analysisTheprevioussectionsshowthatboththerelativeimportance

of cash and non-cash use and the distribution of non-cash

instrumentsarenothomogeneousacrosstheEuropeancoun-

918 Theerrorterm,εi,j,t isidenticallydistributedanduncorrelatedacrossobserva-

tionsandwithexogenousvariables,butcov(εi,j,t,εi,j,s)maybedifferentfromzero

ift=s.

9 Individualeffectscanbetreatedasfixedorrandom.Theproblemisnotifeffects

arefixedorrandom.Theproblemiswhethertheeffectsarecorrelatedtothe

observablevariables.Whencorrelationispresent,conditionalinferencemustbe

done(fixedeffectestimation)[ArellanoandBover(1990)].TheHausmantest

showthatindividualfixedeffectsarenotcorrelatedwiththeexplicativevariables,

thereforetherandomeffectestimatorisconsistent.However,insomespecifica-

tionstheHausmantestrejectsthehypothesisthattherandomeffectestimatoris

consistent,thereforefixedeffectestimationisused.

Panel A: Total volume of transactions

Thedependentvariable,Cashvalue,isthetotalvolumeofcardtransactionsto

withdrawmoney.FinancialfacilitiesarenumberofATMs(NºATMs)andnumberof

branchoffices(branch)per1000inhabitants.D1999andD2002accountforthe

yearofintroductionofthecommoncurrencyandnotesandcoinsrespectively.

(1) (2) (3) (4)

cash value cash value cash value cash value

Nº ATMs 2679939c 2748867.65c 2779121.05c 1236233.59c

x 1000 inhab [428515] [438,145.177] [436,816.852] [431,538.405]

D1999 -63003.57

[132541.4]

D2002 512,332.699c 543,062.722c 443,695.083c

[133,264.997] [134,744.668] [119,858.977]

Branch 734,546.0198 1788831.82c

x 1000 inhab [562,480.867] [499,017.945]

Per Capita GDP 96,257.126c

[15,444.7848]

Constant 694017.1b 575,140.862b 207,085.4122 -1.6117e+06c

[314588.3] [235,788.986] [366,794.189] [443,397.185]

Obs 95 95 95 90

R-squared 0.4872 0.57 0.58 0.69

Hausman test 0.00 187.85c 32.92c 125.59c

Standarderrorsinbrackets

a—significantat10%;b—significantat5%;c—significantat1%

Figure3:Useofcardstowithdrawmoney


andcoinsispositiveandsignificant,inparticularintotalvol-

umeandtheaveragevalueoftransactions.Therefore,itcan

be claimed that although the changeover to the euro took

place in 1999, it is the introduction of notes and coins that

enhances theuseofcardsatATMs.Hence, the ‘euroeffect’

takesplacein2002.

Whatismostinterestingisthattransactionsdonotincrease

butthevalueofeachtransactionishigher.Onepossibleexpla-

nationcouldbethevalueoftheeurobanknotes;largerthan

the national ones. Moreover, perhaps the increase in prices

duetotheroundingmighthaveaffectedthisresultaswell.As

thedummy1999isnotsignificant,weintroducethedummy

correspondingto2002fortherestoftherealizations.

The degree of economic development affects positively the

cashuseofcards,independentofthetypeofmeasureintro-

duced (Column 4). Hence, the more developed the country,

themoreuseofcashinstruments.Theeffectsofthebranch

networkarenotconclusive.Whenitisintroducedalonewith

the2002timevariable(Column3), itscoefficient isnotsig-

nificant.However,whenitisincludedwiththedegreeofeco-

nomicdevelopment, itscoefficient ispositiveandsignificant

(Column4).Inthiscase,the‘reliabilityeffect’overcomesthe

substitutiveeffectoflargerbranchnetwork.Thefactthatthe

branchnetwork isonly significant jointlywith theeconomic

development may mean that the ‘reliability effect’ is taken

into account by consumers in economically developed envi-

ronments.

Figure4presentstheresultsfortheuseofcardsasapayment

instrument.Again,wemeasure theuseofcards in termsof

total volume, number of transactions, and average value of

transactionsinPanelsA,B,andCrespectively.Inthiscase,we

replacethenumberofATMswiththenumberofEFTPOSavail-

able. The EFTPOS network influences significantly and posi-

tivelycardusetopaybothintermsofvolumeandthenumber

of transactions (Panels A and B of Figure 4). However, the

averagevalueoftransactionsisnotaffectedbytheEFTPOS

network(PanelC).


Panel B: number of transactions

(1) (2) (3) (4)

transactions transactions transactions transactions

x 1000 inhab x 1000 inhab x 1000 inhab x 1000 inhab

Nº ATMs 24005.42c 21598.94c 21423.62c 14271.28c

x 1000 inhab [2460.575] [2858.337] [2897.677] [2998.799]

D1999 78.20867

[705.4583]

D2002 1271.141 1375.165 883.5491

[853.0511] [887.9476] [826.8769]

Branches 1537.869 8420.163c

x 1000 inhab [3637.473] [3418.001]

Per Capita GDP 513.3503c

[104.8599]

Constant 9254.231c 10414.3c 9771.093c -1007.743

[3284.545] [3071.285] [3472.797] [4014.939]

Obs 96 96 96 91

R-squared 0.58 0.59 0.60 0.70

Hausman test 0.000 0.000 0.000 0.000

Panel c: Average value of transactions

Thedependentvariable,transact(respectivelyAtmvaptr),isthenumberofcard

transactionstowithdrawmoneyper1000inhabitants(theaveragevalueofeach

transactioninPanelC).

(1) (2) (3) (4)

Atmvaptr Atmvaptr Atmvaptr Atmvaptr

Nº ATMs 47.3895c 21.73221b 21.1738b 1.984646

x 1000 hab [10.82327] [11.149] [11.252] [12.9219]

D1999 .22863

[3.1227]

D2002 16.36994c 16.91159c 14.5724c

[3.4754] [3.587] [3.8473]

branch 9.372596 22.6672

x 1000 hab [14.008] [14.5687]


[0.4399]

Constant 80.5646c 92.616c 88.4251c 64.1529c

[11.9013] [10.6675] [12.301] [14.794]

Observations 95 95 95 90

R-squared 0.21 0.38 0.38 0.42

Hausman tests 2.42 4.24 0.16 3.97



Figure3(continued):Useofcardstowithdrawmoney


93

Panel A: Total volume of transactions

Thedependentvariable,Cardvalue(transactrespectivelyinpanelB),isthetotalvol-

umeofcardtransactionstopay(numberoftransactionsper1000inhabitantsin

panelB).FinancialfacilitiesarenumberofEFTPOS(NºEFTPOS)andnumberof

branchoffices(branch)per1000inhabitants.

(1) (2) (3) (4)

card value card value card value card value

Nº EFTPOS 156,810.932c 121,445.9548c 123,352.5818c 78,832.6894c

x 1000 inhab [15,586.6287] [17,011.3802] [16,356.7001] [20,965.4774]

D1999 -42,835.8330

[109,146.4338]

D2002 458,201.2561c 400,076.4758c 382,155.4983c

[115,378.6766] [112,836.9966] [110,798.7588]

Branch -1.3803e+06c -977463.0924b

x 1000 inhab [428,152.4659] [410,066.2826]

Per Capita GDP 49,812.2575c

[15,261.9106]

Constant -243328.4348 32,956.2763 683,449.0571b -220039.2793

[276,408.5673] [278,312.3132] [324,643.9854] [404,918.4418]

Obs 105 105 105 100

Number of cntry 15 15 15 15

R-sqd 0.24 0.27 0.40 0.53

Hausman test 2.60 1.54 0.03 5.84

Panel B: number of transactions

(1) (2) (3) (4)

nº trans nº trans nº trans nº trans

x 1000 inhab x 1000 inhab x 1000 inhab x 1000 inhab

Nº EFTPOS 3,056.3032c 2,389.7544c 2,409.6415c 1,779.6621c

x 1000 inhab [300.3363] [330.6613] [328.3495] [468.6010]

d1999 -763.6574

[2,085.3649]

d2002 8,449.3579c 7,673.1950c 7,855.6110c

[2,226.9987] [2,251.3461] [2,376.2326]

Branch -18,881.4428b -11,658.9786

x 1000 inhab [8,683.1587] [9,080.0094]

Per Capita GDP 726.5331b

[348.2890]

Constant -3,146.8811 2,095.4014 11,055.6887 -2,927.7474

[5,903.6937] [5,955.6091] [6,824.2131] [9,377.8244]


R-squared 0.23 0.25 0.39 0.40

Hausman Test 1.86 1.19 0.06 4.53

Panel c: Average value of transactions

Thedependentvariable,posvaptr,istheaveragevalueofcardtransactionstopay.

FinancialfacilitiesarenumberofEFTPOS(NºEFTPOS)andnumberofbranchoffices

(branch)per1000inhabitants.

(1) (2) (3) (4)

Posvaptr Posvaptr posvaptr Posvaptr

Nº EFTPOS 0.0601 -0.1498 -0.1514 -0.7356b

x 1000 inhab [0.1939] [0.2267] [0.2242] [0.2949]

D1999 -0.6359

[1.3386]

D2002 2.6534a 3.0135b 1.7008

[1.5227] [1.5222] [1.4256]

Branch 9.7409 16.9185c

x 1000 inhab [6.0324] [5.6443]


[0.2243]

Constant 53.7210c 55.3227c 50.6277c 34.9544c

[4.2114] [4.2955] [5.2119] [6.3063]


R-squared 0.01 0.02 0.04 0.27

HausmanTest 0.70 0.28 4.63 3.78



Figure4:Useofcardstopay


As in Figure 3, Column 1 in each panel presents the results

whenthe1999dummyisintroduced.The1999variableisnot

significant in any of the realizations. However, the 2002

dummy,whichaccountsfortheintroductionofthebanknotes

and coins, is positive and significant. Therefore, it can be

claimedthatthereisaeuroeffectthatalsoenhancestheuse

of cards as payment instrument. A possible interpretation

couldbethatconsumersprefertousecardstopayduetolack

ofknowledgeandconfidenceinthenewbanknotes.

ContrarytoATMsuse,thenumberofEFTPOStransactionsdo

increase significantly in 2002, although the value of each

transaction isnotalteredsignificantly.This result reinforces

thehypothesisthattheincrementalincreaseinvalueofATM

transactions is causedby the largernewbanknotes, rather

thantheincreaseinpricesaftertheintroductionofthesingle

currency.Ifthelatterwasthecauseitwouldalsohaveimpact-

edthevalueofEFTPOSoperations.

Branchnetworkhasasignificantlynegativeimpactonuseof

cardsforpayment,intermsofvolumeandnumberoftransac-

tions. Therefore, in the case of EFTPOS, it seems that the

substituteeffectisdominant.Resultsfortheaveragevalueof

transactions, however, are not conclusive. When the branch

variable is introducedalonewiththe2002timevariable, its

coefficientisnotsignificant(PanelC);but,whenitisincluded

with the degree of economic development, its coefficient is

positiveandsignificant.Inthiscase,thereliabilityeffectover-

comes the substitutive effect of larger branch network.

Therefore,thetrustinthefinancialsectorisimportantforthe

increaseinthevalueofcardoperations.

Finally, we introduce the degree of economic development.

Thecoefficientispositiveandsignificantinallthreecases,as

expected.Hence,themoreeconomicallydeveloped,themore

useandtrustincards,bothtowithdrawandtopay.

conclusionThispaper illustratesthattheuseofcashdeclinedbetween

1996and2002.Therewasanincreaseinnon-cashpayment

instrumentsduetonewtechnologies, inparticularcarduse.

Accordingly, traditional instruments such as checks experi-

enceadecline,butsurprisinglyelectronicmoneyrelevanceis

still very small. The econometric estimations confirm the

descriptiveanalysisresultsconcerningcashuse.Furthermore,

thereisevidencethattheintroductionoftheeurobanknotes

andcoinsenhancescardusesignificantly,bothatATMsand

EFTPOS.Economicdevelopmentandfinancialsystemsfacili-

tiesaffectcarduseaswell.Hence,reliability inthefinancial

system is crucial for the use of cash less instruments.

Therefore, should financial institutions want to support the

useofthesepaymentinstrumentstheywouldneedtoinvest

insecuritysystems,transparency,andpublicity.

References• Arellano,M.andO.Bover,1990,“Laeconometríadedatosdepanel”,

InvestigacionesEconómicas(SegundaÉpoca),14(1),3-45.

• Eurostat.2004.“Economicdata”.EuropeanCommission.http://epp.eurostat.cec.

eu.int/portal/page?_pageid=1090,1137397&_dad=

portal&_schema=PORTAL

• Greene,W.H.,1998,Análisiseconométrico.Terceraedición,(Prenticemay-Madrid).

• MarkoseS.M.andY.J.Loke,2000.“Changingtrendsinpaymentsystemsfor

selectedG10countriesandE.U.countries1990-1998”.InternationalCorrespondent

BankingReview,Yearbook,2000/2001,EuromoneyPublication

• EuropeanCentralBank,2004.“BlueBook,Paymentandsecuritiessettlementsys-

temsintheEuropeanUnion,Addendumincorporating2002figures”.April

• EuropeanCentralBank,2002.“E-paymentsinEuropetheEurosystem’s

Perspective”.September

• BankforInternationalSettlements,2004,“Statisticsonpaymentandsettlement

systemsinselectedcountries,figuresfor2002,”CommitteeonPaymentand

SettlementSystems,March


Transition

Technological innovation in retail payments: Key developments and implications for banks1Karen Furst

Policy Analyst, Office of the Comptroller of the Currency

daniel E. nolleSenior Financial Economist,

Office of the Comptroller of the Currency

Abstract

TheUnitedStates still hasaheavilypaper-based retailpay-

ment system when compared with many other developed

economies,buttheshifttoelectronicpaymentshasbeenbig-

gerandmoredecisivethancommonlyperceived.Forthefirst

time ever, check use declined in the mid-1990s, and among

electronicpaymentstheadoptionofdebitcardshasoccurred

atanextremelyrapidpace.Thepurposeof thisarticle is to

promotegreaterawarenessofthenatureofrecentchangesin

retailpaymentsintheUnitedStates,andtoexploresomeof

thekeyimplicationsofthosechangesforthebankingindus-

try.Wedescriberecenttrendsinretailpayments,highlighting

thesurprisingdropincheckusage,andconsidertheimpactof

changes in retail payments on bank revenue and costs. We

concludethat,althoughbanksarelikelytorealizesubstantial

long-runpayments-relatedimprovementsinproductivity,they

facegreater-than-commonly-appreciatednear-termchalleng-

es.

951 Theopinionsexpressedinthisarticlearethoseoftheauthorsalone,anddonot

necessarilyrepresentthoseoftheOfficeoftheComptrolleroftheCurrencyorthe

U.S.TreasuryDepartment.TheauthorswouldliketothankDavidNebhut,Mark

Levonian,andJeffreyBrownforhelpfulcomments.


Recent changes in the retail payment landscapeTheUnitedStateshas longbeenconsideredunusualamong

developed economies for its reliance on paper checks, and

henceforitsproportionatelyloweruseofelectronicmeansof

payments.4 The annual publication by the Bank for Interna-

tionalSettlements(BIS)ofpaymentsystemstatisticsforthe

G-10 countries in its ‘Red Book,’ considered to be the most

authoritativesourceforsuchinformation,ratifiedthepercep-

tionofcontinuing,thoughslowing,growthofcheckusagein

theUnitedStates.5Onthebasisofsuchinformation,payment

system officials, practitioners, and analysts commonly

observedthat,althoughU.S.consumersandbusinesseswere

steadily increasing theuseofelectronicmeansofpayment,

theyneverthelesscontinuedtoclingtocheckusage.

Itwasthereforeatremendoussurprisewhen,in2001,theFed

announcedtheresultsof itssurveyof theuseofretailpay-

mentsin2000[GerdesandWalton(2002)].Inparticular,data

onchecksshowedthatcomparedtoprevioussurveyresults

for1995,checkusagewaslowerforthefirsttimeever.Insub-

sequent annual editions of the BIS ‘Red Book’ on payment

statistics, the Fed restated its estimates of check usage for

pre-surveyyears.6AsFigure1illustrates,thoserestatements

show not only a declining trend in check usage, but lower

annualtotalsforeachyear.Fromthisitisclearthatboththe

magnitudeofconsumerandbusinessrelianceonchecks,and

thetrendinthatreliance,hadbeenoffbyafactorof25per-

centormore.

Theimprovementintheaccuracyofthecheckusagedatahas

directimplicationsforourviewofelectronicpayments.These

areclearlyillustratedinFigures2and3,whichfocusonthe

pre-2000period.Figure2showsthattherewasagreaterreli-

anceonelectronicpayments thanhadbeenpreviouslysup-

posed.Inparticular,whereastheold(withoriginalcheckdata)

perceptionwasthatinthelate1990ssomewhatmorethana

quarterofallnon-cashretailpaymentswereundertakenwith

an electronic medium, the true figure (with revised check

data)wascloserto40percent.Figure3illustratesthatforthe

first time ever, electronic payments actually exceeded pay-

mentsbycheckbeginning in2002. In thatyear,42.3billion

consumerandbusinesspaymentswereconductedviacredit

cards, debit cards, or the ACH (automated clearing house)

system,comparedwith40billionpaymentsviacheck.Clearly,

consumers and businesses have decisively shifted payment

patternstowardelectronicmedia.

96

1991e 1992e 1993e 1994e 1995 1996e 1997 1998 1999

Original data 57.47 58.40 60.30 61.67 62.92 64.68 66.09 67.00 68.00

Revised data 43.50 44.63 45.79 46.98 49.5 48.15 46.57 45.17 43.81

Figure1.ChangingperceptionofcheckusageintheU.S.(billionsoftransactions)

Source:OCCusingdatafromstatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears).

Note:1996‘reviseddata’isanestimateconsistentwithrevisionsmadetoRedBookdatafor1997-2000bytheBIS.1991-1994‘reviseddata’areestimatesbasedontheaverageannual

rateofcheckusegrowthbetween1979and1995,asperGerdesandWalton(2002).

1991e 1992e 1993e 1994e 1995 1996e 1997 1998 1999

With original check data 18.64 19.87 20.75 22.30 24.11 25.94 24.43 26.76 29.33

With revised check data 23.24 24.49 25.63 27.37 28.78 32.06 31.45 35.15 39.18

Figure2:Changingperceptionofimportanceofelectronicpayments:Electronicpaymenttransactionsasapercentofallnon-cashpayments

Source:OCCusingdatafromstatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears).

Note:1996‘reviseddata’isanestimateconsistentwithrevisionsmadetoRedBookdatafor1997-2000bytheBIS.1991-1994‘reviseddata’areestimatesbasedontheaverage

annualrateofcheckusegrowthbetween1979and1995,asperGerdesandWalton(2002).

2 Analystsandpractitionersdividepaymentsintowholesaleandretailpayments.

Wholesalepaymentsconsistofverylarge-valuepayments,especiallyinter-bank

paymentsrelatedtobanks’clearingandsettlementrole.Retailpaymentsinclude

consumer-to-businessandbusiness-to-businesspayments.Themajorcomponents

ofretailpaymentsintheUnitedStatesincludecash,checks,creditcards,debit

cards,andautomatedclearinghouse(ACH)transactions.Unliketheotherformsof

retailpayments,reliablerecordsforthenumberandvalueofcashpaymentsare

notmaintained,andhenceexactdataoncashusageisimpossibletoobtain(and

evenestimatesaregenerallyconcededtobeoftheballparkvariety).Forthisrea-

son,mostanalysesofretailpaymentsfocusonnon-cashpayments,aconvention

wefollowinthisarticle.

3 We,andmostothers,refertotheFederalReserve’s(2002)RetailPayments

ResearchProjectasasinglestudy,althoughitisinfactaseriesofthreeclosely

relatedstudiesconductedbytheFedinconjunctionwithseveralconsultingfirms.

Thecomponentstudiesarethe‘DepositoryFinancialInstitutionCheckStudy,’the

‘CheckSampleStudy,’andthe‘ElectronicPaymentInstrumentsStudy.’Gerdesand

Walton(2002)isconsideredanauthoritativesourceforadescriptionandanalysis

oftheretailpaymentsstudy.


97

4 Unlessotherwisespecifiedinthisarticle,theterms‘electronicmeansofpayment’

and‘electronicpayments’refertocreditcard,debitcard,andACHpayments.Our

comparisonsofmeansofpaymentsfocusonthenumberoftransactions,rather

thanthedollar-valueoftransactions.Forinternationalcomparisonsofpayment

systemsseeHancockandHumphrey(1998).

5 Statisticsonpaymentandsettlementsystemsinselectedcountries,Bankfor

InternationalSettlements.Thesourceforeachcountry’sdataisitscentralbank,

whichofcourseistheFederalReserveinthecaseoftheUnitedStates.Itisimpor-

tanttounderstandthatincompilingannualpaymentstatisticstheFedusesvari-

ousestimationtechniques,andreliesonthird-partysourcesinsomeinstances,

becauseitisinfeasibletogetanactualcountofallnon-cashpaymentstransac-

tions,andimpossibletogetanactualcountofallcashtransactions.Notethata

thoroughsurvey,suchastheFedundertookfor1979,1995,and2000,entails

expensesthatfewwouldarguearejustifiedonanannualbasis.

6 TherevisionsintheRedBookincludeddatafrom1997-2000.Toarriveatarevised

figurefor1996,weappliedthesame3percentperyearestimateddeclineincheck

usetheFedusedtore-statethe1997-2000figures.GerdesandWalton(2002)

estimatedthat,onaverage,checkusegrewata2.6percentannualratebetween

1979and1995,amethodweusedtogeneraterevisedcheckusefiguresfor1991-

1994.

Thestunningadvancementsintelecommunicationsandinfor-

mation management in the early-to-mid-1990s profoundly

affectedthefinancialservicesindustry.Newproducts,suchas

credit derivatives were developed, access to credit was sig-

nificantly increased as a result of major improvements in

creditscoringandthedevelopmentofsecuritization,andnew

methods of delivering financial services, especially via the

Internet,emerged.Oneaspectoffinancialservicesprovision

that had, prior to this period, remained below most radar

screenswasretailpayments.2However,beginningintheear-

ly-to-mid-1990s,agrowingnumberofpractitioners,analysts,

andpolicymakersbegantofocusontheimportanceofretail

paymentsonfinancialintermediaries’performance,competi-

tive position, and relationships with third-party payments

servicesvendors.

A key feature of the retail payments landscape is the long-

termshiftawayfrompapertoelectronicmeansofpayments.

Recently, a comprehensive study of retail payments in the

UnitedStateswaspublishedbytheFederalReserveSystem.3

The study revealed a startling, and hitherto unrealized

change:whereasithadbeencommonlyperceived,andannu-

ally reported by the Fed, that check use continued to grow

throughoutthe1990s(albeitataprogressivelyslowerrate),

thenewstudyshowedthatforthefirsttimeever,checkusage

actuallydeclined in themid-1990s.Anecessarycorollary to

thisdevelopmentisthattheshifttoelectronicpaymentswas

moredramaticthanmanyhadimagined.

Theseprofoundchangesinretailpaymentstrendsarelikely

tohavemajor implications for financial intermediaries,par-

ticularly for banks, which are at the heart of the payment

system. The purpose of this article is to promote greater

awarenessofthenatureofrecentchangesinretailpayments

intheUnitedStates,andtoexploresomeofthekeyimplica-

tions of those changes for the banking industry. The next

sectiondescribesrecenttrendsinretailpayments,highlight-

ingthesurprisingdropincheckusage,followedbyanexami-

nationof the implicationsofchanges in retailpaymentson

bank revenue and costs, which concludes that, although

banks are likely to realize substantial long-run payments-

relatedimprovementsinproductivity,theyfacegreater-than-

commonly-appreciated near-term challenges. The final sec-

tionsummarizesandraisesanumberofpaymentsissuesthat

warrant further consideration by bankers and financial sys-

temregulators.

1995 1996e 1997 1998 1999 2000 2001 2002 2003e

Electronic 20.0 22.7 21.4 24.5 28.2 32.7 37.6 42.3 50.7

Check 49.5 48.0 46.6 45.2 43.8 42.5 41.2 40.0 38.0

Figure3.Electronicpaymentsovertakechecks(billionsoftransactions)

Source:OCCusingdatafromStatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears);NACHA;

CardIndustryDirectory2004;andMinehan(2004).

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003e

Credit card 4,7 5 5,6 6,6 9,1 10,4 11,5 12,6 14,2 16,9 18,4 19,7 21,1

Debit card 0,22 0,289 0,71 1,1 1,44 2,3 3,54 4,9 6,49 8,4 10,33 13,22 18,27

ACH 1,71 2,49 2,6 2,93 3,49 4,05 4,55 5,33 6,12 6,94 8,06 88,83 10,02

ATM 6,4 7,21 7,7 8,45 9,7 10,68 10,98 11,16 10,9 12,84 13,58 13,97 14,27

Figure4.Growthofelectronicpayments(billionsoftransactions)

Source:OCCusingdatafromstatisticsonpaymentandsettlementsystemsinselectedcountries(RedBook),BankforInternationalSettlements(BIS)(variousyears);NACHA;Card

IndustryDirectory2004;andEFTDataBook–2004Edition.

7 Onthebankingindustry’slong-termprospectsforrealizingnetbenefitsfrominno-

vationsinretailpaymentssee,forexample,Minehan(2004).


siderable source of revenue. In particular, Radecki (1999)

found thatpaymentsconstitutebetweenone-thirdand two-

fifthsofoperatingrevenueforthetwenty-fivelargestbanking

companies. Furthermore, for banks of all sizes, payment

activities are central to deposit taking and lending relation-

ships.

A largecomponentofpayment revenuederives fromcheck

processing and checking account-related activities. Such

income streams include revenue from cash management

services,suchasprocessingcheckpaymentsatthelockbox,

interestincomefromdepositaccountbalances,andfeesasso-

ciated with insufficient funds.8 Declining check use means

thisrevenueisshrinkingandwillcontinuetoshrink.

Inadditiontothedeclineincheck-relatedrevenue,thereare

severalotherpayments-relatedforces likelytohaveanega-

tive impactonpaymentsrevenueforbanks.Firstly,manyof

the electronic payments replacing paper checks are lower

margin activities for banks. A recent Ernst & Young report

rather gloomily concluded that ‘although many banks have

spentyearsthinkingaboutandplanningforadeclineinpaper

payments,therealizationofthisphenomenonwasstillpain-

ful…Decliningpapervolumeswereseenfor[corporate]con-

trolled disbursements, as well as in check clearing, account

reconciliation,andinbothretailandwholesalelockbox.While

intheorythereshouldbeanupsideforproductssuchasACH,

EDI, and purchasing cards, the revenue declines seen from

paper products are not being offset by the replacing elec-

tronicalternatives’[Ernst&Young(2003,p.4)].Evenamong

electronic payments, banks are seeing slower growth for

thoseformsofpayments,suchascreditcards,withrelatively

higher margins, compared to other forms of electronic pay-

ments,suchasonlinedebit.9

Secondly,recentchangesinfeestructuresforelectronicpay-

mentshavehadanegativeimpactonpaymentsrevenuefor

manybanks.Animportantexampleisthe2003dropininter-

change fees on signature debit card payments (using Visa

checkcardordebitMasterCard),adeclinethatcameaboutas

aresultofshiftingmarketforces.10Themainparticipantsin

the market for signature debit card (and credit card) pay-

mentsarethemerchantsreceivingthepayments;merchant

acquirers,whicharefirms,includingsomebanks,thatbuyor

acquiredebitandcreditcardreceiptsfrommerchants,card-

issuingbanks,andthe twomaincardassociations,Visaand

MasterCard. Merchants sell their card receipts to merchant

acquirersatadiscounttofacevalue.Thesizeofthisdiscount

is largely based on the interchange fee merchant acquirers

mustpaytocard-issuingbankstocompletetheprocessingof

the card payments. In turn, the two card associations are

instrumental in determining interchange fees. A series of

recent events brought about a shift in the relative market

powerofthesemarketparticipants,resultinginasubstantial

decline in some interchange fees earned by card-issuing


1991 1995 1999 2003e

ATM 49.12 40.84 28.89 22.42

ACH 13.09 14.71 16.22 15.73

Debit cards 1.71 6.08 17.22 28.70

Credit cards 36.08 38.36 37.67 33.14

Figure6:Electronicpayments:Shifttodebitcardusage(percentoftotalelectronic

paymentstransactions)

Source:OCCusingdatafromNACHA;CardIndustryDirectory2004;andEFTData

Book–2004Edition.

Figure5:Proportionalgrowthrateofcomponentsofelectronicpayments:

Debitcarduseexplodes1991-2003

Source:OCCusingdatafromNACHA;CardIndustryDirectory2004;andEFTData

Book–2004Edition

Ratio of transactions 2003 to 1991

ATM 2.23

Credit card 4.49

ACH 5.87

Debit card 81.87


An important feature of the greater-than-previously-per-

ceivedshiftfrompapercheckstoelectronicpaymentsisthe

change that occurred in the use of various components of

electronic payments, such as credit cards, debit cards, and

ACH transactions. Figure 4 illustrates trends in credit card

transactions,debit card transactions,ACH transactionsand,

forcomparison,ATMtransactions.Inthefirsthalfofthe1990s

thesecomponentsofelectronicpaymentsrosemoreorlessin

tandem. Beginning in the mid-1990s, however, debit cards,

whichhadbeeninusesincetheearly1980s,suddenlysurged,

overtakingbothACHandATMtransactions.

Figure 5 puts the growth of debit card use in perspective,

showing that while ATM, credit card, and ACH usage grew

substantially, debit card usage increased more than 80-fold

overthe1991to2003period.Asaconsequenceofthischange

in payment practices, debit cards, which had accounted for

only2percentofallelectronicpaymenttransactionsin1991,

hadrisento29percentofallelectronicpaymentsby2003,a

positionrivalingcreditcardusage(Figure6).

The impact of changing trends in retail payments on the banking industryThe greater-than-initially-believed switch away from paper

checkstoelectronicpaymentshashad,andwillcontinueto

have, a significant impact on the banking industry. Conven-

tional wisdom holds that advancements in retail payments

lowerbanks’operationalcosts,makingthembetteroff than

theywere in themorepaper-intensiveera. In fact,however,

thestoryismorecomplex.Althoughpaymentsystemexperts

considerlong-termprospectsforimprovedbankproductivity

promising,itisfarfromcleartowhatextentbankswillrealize

netbenefits fromchanges in retailpaymentpatterns in the

near-term.7 Such a conclusion rests on a consideration of

developmentsonboth the revenueandcost sidesofbanks’

retailpaymentactivities.

Banks’ payment-related revenueTraditionally,bankshavefocusedtheireffortsondeposittak-

ingandlendingactivities,regardingpaymentservicesinthe

same light as other, less glamorous, back office activities.

However,formanybankspaymentsactivitiesrepresentacon-

99

8 Thereissomeuncertaintyassociatedwithinsufficientfundsfee.Feesforbounced

checksandoverdraftfeesoncheckingaccountshavebecomeanimportantgener-

atoroflow-riskincomeforsomebanks.Moebs(2003)citesaMarch2003report

bytheresearchfirmCelentestimatingthatfeesforbouncedchecksgenerated

between25and50percentofalldepositfeesearnedbyU.S.banks.Notethat

recentlysuchfeeshavecomeunderattackbyconsumergroupsandunderscruti-

nybyregulators.Forexample,bouncedcheckfeeswerethesubjectofaJune

1998reportbytheConsumerFederationofAmericaentitled‘BouncedChecks:

BillionDollarProfitsII.’Numerousconsumeradvocacygroupshaveexpressed

theirconcernaboutbounceprotectionprograms,includingtheiruseasavery

expensiveformofshort-termborrowing.Thoseconcernsarenotlimitedtopaper

checks.Thesamegroupshaveurgedthatfinancialregulationstreatfeescharged

bybankswhenanaccountisoverdrawnwithanATMordebitcardasanunfair

anddeceptivepractice,onthegroundsthatnooverdraftwouldhaveoccurredif

thebankhaddeclinedthetransaction.Seeforexamplecommentssubmittedby

theNationalConsumerLawCenter,ConsumerFederationofAmerica,Consumers

Union,NationalAssociationofConsumerAdvocates,andtheWoodstockInstitute

totheFederalReserveSystemontheProposedAmendmentstoRegulationDD

(August6,2004).Forexamplesofregulatoryresponsestothedebate,see,e.g.,

InteragencyGuidanceonOverdraftProtectionPrograms,andproposedchangesto

RegulationDD(whichimplementstheTruthinSavingsAct),whichwerepublished

forcommentonJune7,2004intheFederalRegister(Volume69,No.109at31858

and31760,respectively).

9 In2003,thevolumeofcreditcardandonlinedebitcardpaymentsgrewatannual

ratesof7percentand27percentrespectively.Thesedifferinggrowthrateshavea

largeimpactontherevenueofbanksthatissuethecards,inlargepartbecauseof

differencesin‘interchangefees’receivedbythecard-issuingbanks.Theinter-

changefeeissignificantlyhigherforcreditcardsthanforonlinedebit.Forexample,

onaU.S.$75grocerystorepurchase,theU.S.$0.91(VISA)creditcardinterchange

feewouldbe6timesgreaterthantheU.S.$0.15PINdebitinterchangefee(specifi-

cally,inthiscase,viatheSTARnetwork).Thedifferenceinmarginincreasesasthe

purchaseamountincreases,becausemostPINdebitnetworkscapinterchange

betweenU.S.$0.15toU.S.$0.60pertransaction,whileVISAinterchangeisgenerally

apercentageofthepurchaseamount(generallybetween1.2%and2.6%),plusa

fixedfeethatisusuallybetweenU.S.$0.05toU.S.$0.10pertransaction.

10 Therearetwowaysdebitcardtransactionscanbemade,eitherthedebitcard

holdercompletesatransactionbysigninghissignature(aso-called‘signature’or

‘offline’transaction),orusesapersonalidentificationnumber(PIN)atthepointof

sale(asometimesreferredtoasan‘online’payment).Ingeneral,merchantsprefer

PINdebitcardtransactionstosignaturetransactionsbecauseinterchangefees

tendtobesignificantlylowerforPINdebit,ultimatelyresultinginlessofadis-

countformerchantsonthevalueofthecardreceiptstheyselltomerchant

acquirers.Note,however,thatdifferencesbetweenthetwotypesofdebittransac-

tionsarenarrowing.TheCardIndustryDirectory2004reportsthatinterchange

feestypicallyaccountfortwo-thirdsormoreofaretailer’scostofacceptingbank

paymentcards.

11 Theinterchangefeesmarkethadbeeninturmoilforsometime,asretailerssawa

steadyincreaseinthediscountratestowhichtheircardreceiptsweresubject.

Manyretailersbelievedtheseexceededthemajorcostsofissuingcardsandpro-

cessingtransactionsthattheinterchangesystemwasoriginallydesignedtocover.

Indeed,someretailersthoughtinterchangefeesshouldhavedroppedsubstantial-

ly,aselectroniccardtransactionsreplacedpaper-basedcardpayments.Wal-Mart

andothermajorretailerschallengedthepricingpowerofthetwomajorcardasso-

ciations(VisaandMasterCard)inaclass-actionlawsuit.Thelawsuitchallengedthe

cardassociations’‘HonorAllCardsRule’requiringretailersacceptingonetypeof

cardbrandedbyVisaorMasterCardtoacceptallcardsbearingthatlogo(i.e.,if

thestoreacceptedbrandedcreditcardstheyalsohadtoacceptthecardcompa-

nies’brandedsignaturedebitcard).Thepartiessettledoutofcourtinearly2003;

asaresultofthesettlement,startinginAugustof2003bankissuersofsignature

debitcardsexperiencedaone-thirddropinmerchantacquirer-paidinterchange

feerevenue.Althoughthisdeclinehasbeenoffsetsomewhatbysubsequent

increasesininterchangefeesforsignaturedebit,andbyincreasesoninterchange

feesforPINdebitcardtransactions,industryexpertsestimatethatinterchange

feerevenuehasdroppedbyapproximately20percentfromthepre-settlement

level.ForathoroughdiscussionofthepressuresoninterchangeseeGiesen

(2004).

12 See,forexample,Porter(2004).Histhreepercentfigureisbasedoninformation

fromaPewHispanicCenterreportreleasedinJune2004.Notethatseverallarge

banks,includingCitibank,BankofAmerica,andWellsFargoareactivelymarketing

remittanceservices.Inaddition,FirstData’s2003annualreportindicatesthatits

WesternUnionaffiliateisencounteringexpandedcompetitionfrombanksand

ATMproviders,whichhavebeguntotargetmoneytransferuserswithnewproduct

offerings.

13 WesternUnioncontributed35percent(U.S.$2.94billionin2003)toFirstData’s

totalrevenue(U.S.$8.4billion)andaccountedforapproximately80percentofthe

revenueinFirstData’sPaymentServiceunit,whichin2003hadanoperatingmar-

ginof34percent.

14 PayPalhasrecentlycompletedtechnologicalinnovationsandhasexpandedits

productofferingstobecomeapaymentsprovideroutsideoftheonlineauction

market.Inparticular,itisrevampingitssalesforcetobecomeapaymentsprovider

forretailers.MerchantswithU.S.$100,000ormorepermonthinPayPalvolume

paya1.9percentdiscountfeeandU.S.$0.30pertransaction.SeeInternetRetailer

(2004)andBliss(2004).


The bill payment market is dominated by the CheckFree

Corporation. CheckFree’s electronic commerce division lets

customersreceiveelectronicbillsovertheInternet,paybills

electronically, and make payments not related to bills. The

majorityofCheckFree’scustomersaccessitssystemthrough

banks, including Bank of America, Wachovia, Washington

Mutual,andWellsFargo.FeestoCheckFreeincludeanaverage

U.S.$0.35 charge per transaction for banks that use Check-

Freeforbillpaymentande-billprocessing,andanaverageof

U.S.$0.81 per transaction charge for banks that fully out-

source bill payment to CheckFree [J.P Morgan Securities

(2004)]. It is noteworthy that even though banks pay

CheckFreesuch fees,an increasingnumberofbanksdonot

chargetheircustomersforbillpayment.

Ebay,theleadingonline-auctioncompany,purchasedPayPal,

theleadingonlinepaymentsystem,inOctober2002.PayPal

builtitsonlinepaymentnetworkontheestablishedinfrastruc-

ture of bank accounts and credit cards. During the second

quarter of 2004, PayPal handled U.S.$4.35 billion of gross

paymentvolume(a53percentincreaseoverthesecondquar-

terof2003),generatingU.S.$161.5millionintransactionfees.

Forthesecondquarterof2004PayPal’saveragetransaction

revenue rate was 3.64 percent and its processing expenses

ratewas1.34percent,resultingina63percentmargin.14Note

thatthePayPalsystemhasalsobeguntobeusedforcross-

borderremittances.

Expeditedlatepaymentsaregenerallyfor lastminutetrans-

fers by consumers to pay recurring bills. This is a relatively

newbutrapidlygrowingmarket.Theexpeditedlatepayments

market is led by companies such as Western Union and

MoneyGram. Other non-bank providers of so-called ‘walk-in’

billpaymentserviceshavealsoenteredthismarket,including

AmericanPaymentSystems,whichservicesuptosevenmil-

lion households. Note that American Payment Systems was

acquiredbyCheckFreeinJune2004.

100

2000 2001 2002 2003

Per unit cost — in cents 1.6 1.5 1.3 1.1

ACH volume — billions of transaction 3.81 4.45 4.99 5.59

Figure7:FedACHprocessing:Per-unitcostdeclinesasvolumeincreases

Source:OCCusingdatafromtheFederalReserveSystemandNACHA.


banks.11 Finally, banks are not dominating other higher margin pay-

mentsactivitiesthathaveemergedasaresultof,orreceived

aboostfrom,technologicaladvancements.Chiefamongsuch

paymentsactivitiesaremoney transfer (includingespecially

cross-borderremittances),billpayment,paymentsgearedto

the online market (such as PayPal), and expedited late pay-

ments.Withtheexceptionofexpeditedlatepayments,thereis

one dominant, and non-bank, provider in each of these

increasinglyimportantpaymentsmarketsegments.

Moneytransferisoneofthemostimportantfinancialservices

forunbankedconsumersandisdominatedbynon-bankfirms,

suchasWesternUnion(apartoftheFirstDataCorporation)

and MoneyGram. Industry analysts forecast money-transfer

growthof18percentthrough2010,withmuchofthisgrowth

coming from remittances, a payment process that enables

immigrants to send money from the United States to their

home countries. Some banks have recently shown a some-

what belated interest in the remittance market, but remain

smallplayers.Forexample,bankshandlelessthan3percent

oftheU.S.toMexicoremittancemarket.12Anindicationofthe

high-margin nature of the money transfer business can be

inferred from First Data Corporation’s 2003 performance.

FirstDatareportedanoperatingmarginof33percent,duein

parttoa35percentcontributiontoFirstData’stotalrevenue,

and an 80 percent contribution to First Data’s Payment

Servicesunit,byitsWesternUnionsubsidiary;WesternUnion

hasa75percentshareoftheworldwideremittancemarket,a

marketinwhichtheaverageremittancefeeis7percentofthe

amountofmoneytransmitted.13

101

15 Checkelectronificationcanbeaccomplishedviatwobasicroutes.Inthecaseof

‘checkconversion’apapercheckisusedasasourceofinformationatthebegin-

ningofthepaymentprocesstoinitiateanACHtransaction.‘Checktruncation’is

theprocessofstoppingthepaperduringtheclearingprocess,thuseliminating

additionalphysicalhandlingandtransportationoftheitems.Notethatthesame

economicforcesthathavepropelledcheckelectronificationhavealsostimulated

significantimprovementsintheprocessingofpaperchecks.See,forexample,

Greenspan(2003),andFerguson(2003).

1999 2000 2001 2002 2003

Per unit cost — in cents 3.8 4.0 4.5 4.5 5.1

ACH volume — billions of transaction 17.1 17.0 16.9 16.6 15.8

Figure8.Fedcheckprocessing:Per-unitcostrisesasvolumedeclines

Source:OCCusingdatafromtheFederalReserveSystemandNACHA

16 NACHA(anindustrygroupofelectronicpaymentsystemparticipants)isworking

todevelopamechanismtoaddressthisdisparitybyhavingbanksthatoriginate

unauthorizedACHdebitstoaccountspayareturnentryfeethatwillgotothe

receivingbank.

17 TheFederalReserve’sRegulationEcoversconsumercomplianceissuesformany

typesofelectronicpayments.

18 Infact,theexperienceofthesebankshasbeenthatmanyInternetbankingcus-

tomersconductmoretransactions,acrossmorechannelsthannon-Internetcus-

tomers,andhencearecostlytoserve,despitetheiruseoflowercostdelivery

channels.However,netrevenueforcustomerswhouseInternetbankingtendsto

behigher,becausethesecustomersusemorehighvalue-addedproductsandser-

vices,andbecausetheytendtobemore‘sticky’–thatis,theydonottendtoleave

thebank,inpartbecauseofcosts(intimeandeffort)theyincurinsettingupser-

vicessuchaselectronicbillpayment,accountaggregation,etc.

19 Forexample,aMay2004reportbyCelentestimatesthatinternalinformation

technologyspendingonnon-cardpaymentsystemswillgrow37percentover

2003-2004,morethantwicetheincreaseover2001-2002,andthatmassive

investmentincheckprocessingisdrivingthisshort-termspike.


added, it is frequently not advisable, or even feasible, to

abruptlydiscontinueolderoptions,evenifthoseoptionsare

morecostlyforabank[DoveConsulting(2004)].Thislesson

was most recently learned by banks that successfully inte-

grated Internetbanking into theiroveralloperations. Inpar-

ticular,bankswithwell-establishedandwell-regardedInternet

bankingoperationsanalyzedcustomerbehavior,anddiscov-

ered that customers adopting Internet banking still wish to

use the bank’s other delivery channels, including branches

and call centers.18 The same dynamic holds true for pay-

ments:customersshiftingtogreaterrelianceondebitcards

maystillwishtohavetheoptionofpaperchecks,forexample.

Underthesecircumstances,banksneedtoascertainthemost

profitablebalancebetweenintroducingnewpaymentoptions

and maintaining (and, over time, possibly de-emphasizing)

olderones.Thisbalancingactrequiresmakinginvestmentsin

newpaymentsystems,butalsocontinuingtoincurcostsfor

maintaining older ones.19 A corollary is that banks face

increased risk-management responsibilities in such areas as

security(includingfrauddetectionandprevention)relatedto

allaccesspointsandpaymentsoptions.

conclusionsTheUnitedStatesstillhasaheavilypaper-basedretailpay-

ment system compared with many other developed econ-

omies,buttheshifttoelectronicpaymentshasbeenbigger

and more decisive than commonly perceived. For the first

timeever, checkusedeclined in themid-1990s,andamong

electronicpaymentstheadoptionofdebitcardshasoccurred

atanextremelyrapidpace.Thesechangingpatternsofpay-

mentsmayeventuallyresultinsubstantialpayments-related

costreductionsforbanks,butthestoryonnet,especiallyin

thenear-term,iscomplexandlessthancompletelysanguine.

Payments-relatedrevenue isan importantsourceof income

forthebankingindustry,perhapsmoresignificantthangener-

ally appreciated, and payments undergird both deposit and

lending relationships for banks. A large part of payments-

related revenue comes from check-related activities, and as

checkusedeclinessowilltherevenuefromit.Itisnotclear

thatrevenuefromincreasedprocessingoflowermarginelec-

tronicpaymentswillfillthegap.Inaddition,changingtrends

inretailpaymentshaveresultedinsignificantchangesinpay-

mentfeestructuresforbanks,includinginparticulararecent

declineinsomecard-relatedinterchangefees.Finallyonthe

revenueside,non-banks,ratherthanbanks,dominatemarkets

for some higher margin, non-traditional payments options,

suchasremittancesandbillpayment,whichhavereceiveda

boostfromrecenttechnologicalinnovations.

Onthecostsidethestory isalsocomplex.Whileelectronic

payments are far less expensive to process than paper

checks, some cost-related factors cut the other way. For

example,ascheckusefalls,scaleeconomiesfromprocessing

largevolumesofchecksdecline.Eventechnological innova-

tionsin‘electronifying’checksentailexpensesthatmustbe

102


Banks’ payments-related costsThecommonperceptionisthatchangingretailpaymentspat-

terns have been an important positive development on the

cost side for banks. There is certainly justification for this

view. Electronic payments in general are substantially less

costly to process than paper-based ones. For example,

FederalReserveper-itempaymentsprocessingcosts,which

areillustrativeofindustrytrends,showthatitisalmostfive

times more costly to process a paper check than an ACH

transaction. Furthermore, as the volume of electronic pay-

ments processed increases, economies of scale and addi-

tionalinnovationsarelikelytoenhancethisadvantage.Inthis

vein,Figure7showsthatFederalReserveSystem’sper-unit

ACH processing costs have declined as the volume of ACH

paymentsithandleshasincreased.

However,aswiththerevenuesideofthepicture,thestoryis

morecomplexthancommonlyappreciated.Asaconsequence,

achieving overall payments-related cost-reductions entails

significantchallengesforbanks.Onefundamentalfactoroper-

atingtoconstrainpayments-processingcostimprovementsis

decliningscaleeconomies.Inparticular,ascheckusedeclines

andthescaleofcheckprocessingformanybanksdecreases,

theper-unitcostofcheckprocessingrises.AsFigure8shows

forexample,theFedhasseenasteadyincreaseinitsper-unit

checkprocessingcostsasthevolumeofchecksitprocesses

hasdeclined.

In response to the increasingly unfavorable economics of

papercheckprocessing,industryparticipantshavedeveloped

technological improvements. ‘Checkelectronification’results

insubstantialcostsavings,includingofcoursetheelimination

oftheexpenseandtimeofmovingpaperthroughthesystem,

but also efficiencies such as lower back office costs for

researching past payments.15 Nevertheless, there are sub-

stantialcostconsiderationstotake intoaccounteven inthe

case of such technological advancements. These of course

includeequipment,software,andpersonnel-trainingstart-up

costsforswitchingtonewprocesses.

Inadditiontotheobviousstart-upcostconsiderations,there

aretwopossiblylesswell-recognizedcostsofcheckelectroni-

ficationwithwhichbanksmustdeal.Paymentsecurityissues

poseimportantcostchallengesforbanks.Forexample,many

check fraud protections are currently based on, some even

imbedded in, paper checks. Check electronification innova-

tionsneedtobedesignedtoofferat leastasimilar levelof

fraudprotection,aprocess thatmayentail additional costs.

Additionally,itispossibleforbankstounderestimatepayment

systemupgradecostsbecausetheyfailtorealizetheneedto

properlyintegratepapercheckandelectronic(ACH)process-

es.Inparticular,becausecheckandACHprocessingsystems

have not traditionally been linked, it is possible that, when

checksareconvertedtoACH,cashmanagementriskcontrols

in place for paper check processing may be inadvertently

bypassed,orstop-paymentordersforconvertedchecksmay

notbeactedupon.Banks’checkelectronificationcostcalcula-

tionsneedtotakeintoconsiderationtheproperintegrationof

checkandACHprocessingsystems.

Anadditionalfactoronthecostsidethatwilltendtomitigate

retail payments-related cost improvements for some banks

arisesfromimbalancesinthedistributionofcostsassociated

with some forms of electronic payments. Such imbalances

maybecomemoreonerousasagrowingvolumeofretailpay-

mentsbecomeelectronic.Forexample, in thecaseofunau-

thorizedACHpayments,thecostsarebornebythereceiving

bank(theconsumer’sbank),eventhoughtherevenueassoci-

atedwiththepaymentgoesentirelytotheoriginatingbank

(the merchant’s bank).16 Other ACH-related cost burdens

receiving banks may incur without sufficient compensating

ACHrevenueincludecompliancecosts,forexampleinconnec-

tion with consumer protection, as well as costs associated

withscreeningcross-borderACHtransactions incompliance

withOFAC(theTreasuryDepartment’sOfficeofForeignAsset

Control)requirements.17

Finally,thereisanimportantstrategicissuebanksmustcon-

siderthathasbothcostandrevenuedimensions.Bankshave

learned that when new service options for customers are

103

Future

innovation on networks: coordination, governance, and the case of VisA

The evolution of currency

Automating payment processes to reduce working capital

new agenda for payment service providers

new models of collaboration in transaction banking

European payment service providers: A race to market and the nature of future victory?

network-based payments and e-settlement

Banks’ strategies for payment services: which role for debit cards?

delivering migrant workers’ remittances

check 21 and the migration to electronic payments

1 WethankJamieMcAndrewsforhelpfulcomments.Theviewsexpressedhereare

thoseoftheauthorsandnotnecessarilythoseoftheFederalReserveBankof

KansasCityortheFederalReserveSystem.

innovation on networks:coordination, governance, and the case of VisA

Matthew CardilloAssistant Economist, Federal Reserve Bank of Kansas CityAntoine MartinEconomist, Federal Reserve Bank of Kansas CityMichael J. Orlando1

Senior Economist, Federal Reserve Bank of Kansas City

upproblemlimitsinnovationinaparticularnetworksettingis

critical to identifying ways to enhance network utilization.

Althoughthenetworkeffecthasbeenmorewidelyconsidered

in these environments, solving the hold-up problem may be

thecriticalpathtoincreasednetworkutilization.

The case of VisAThis sectiondescribes theevolutionof theVISAnetwork to

illustrate how network utilization was increased in the pres-

ence of both network and hold-up problems. We argue that

theadoptionofajointownershipstructureintheearly1970s

wascriticaltoVISA’sgrowthandsuccess.

TheVISAcard,asweknowittoday,beganitslifein1958as

theBankAmericard,BankofAmerica'srevolving-creditprod-

uctandoneofthefirstmodernmulti-purposecreditcards.In

the beginning, the BankAmericard program was entirely

underthecontrolofBankofAmerica.Inordertoexpandthe

program,BankofAmericaformedtheBankAmericardService

Corporation,whichallowedlicensedbanksoutsidethestateof

California to issue BankAmericards to consumers in their

regions.Thiscanbeseenasafirststeptowardsmutualown-

ership of network assets, a progression that culminated in

1970withBankofAmerica'sdecisiontotransferownershipof

theBankAmericardprogram,andtheunderlyingnetwork,to

thebanksthathadbeenlicensedissuersundertheprevious

arrangement, creating National BankAmericard Inc. (NBI).

Thus,theassociation,theinnovativeorganizationalstructure

thathasplayedsuchalargeroleinthegrowthofthenetwork,

wasborn.

Apart from joint ownership of network assets, a significant

featureofthisorganizationalstructurewasthatitcalledfor

the centralization of functions that benefited all network

membersjointly.Infact,oneofthemostimportantcentralized

functionsofthenewly-formedorganizationwasthedevelop-

ment of innovative interchange technologies. This coordina-

tionofinvestment—inthiscasetheconsolidationofresearch

anddevelopmentefforts—gaverisetoanumberofkeyinno-

vations, fromBASE1, theworld's firstglobalelectroniccard

authorizationsystem,totheadoptionofthenameandbrand

VISAandacommonfront-endforitsproducts.

WiththeadoptionoftheVISAbrand,theneedtoissueinfor-

mational material and reissue all cards in circulation repre-

sentedsubstantialcosts fortheparticipantstothenetwork.

Suchacostly innovationcouldonlyhavebeenjustified ifall

participantscoordinatedtoinvestinthebrand.Theseinvest-

mentsalsohavethecharacteristicthattheyarespecifictothe

network.Thereisnoobviouswayforaninstitutiondecidingto

leave the network to redeploy the product of this kind of

investmenttoanalternativeuse.Hence,thisexampleisalso

typicalofthekindofinnovationthatisatriskofbeingheldup.

Theefforttoconsolidateresearchanddevelopmentandcoor-

dinateinvestmentscanbeseenasanattempttoaddressthe

network effect. In this network structure, important innova-

tionsshouldbeadoptedbyallparticipantsjointlytoguaran-

teethebestpossiblereturnforagivenamountofinvestment.

However, it could be seen as puzzling that BankAmericard

ServiceCorporationwouldtaketheadditionalstepofsharing

ownershipof thenetwork, since itdoesnotobviouslyserve

thepurposeofbettercoordinationof investment.Given the

valueoftheVISAbrandtoday,onecouldarguethatitwasa

majormistaketosurrendersoleownershipofsuchavaluable

asset.Wearguethatthiswasnomistake,orcoincidence.

Ifonetakesthehold-upproblemseriously,itbecomesappar-

ent that VISA could not be worth what it is today under a

monopolyownershipstructure.Thisisbecausethenumerous

costlyinvestmentsnecessarytoenhancethebrandnotonly

requiretheparticipationofallnetworkparticipantsbutalso

106

107

The‘networkeffect’ isperhapsthemostthoroughlystudied

featureofnetworkenvironments.Participantsareunlikelyto

use a network unless others are already doing so. In many

networksettings,suchastelecommunications,payments,and

software,innovationalsoappearsfundamentaltogrowth.As

such,thenetworkeffectalsostructuresincentivestoinnova-

tionthatdeterminethenetworkdynamic.Thehigherthelevel

ofinnovationonanetwork,themoreparticipantsareattract-

edtoit.Andthemoreparticipantsthereareonanetwork,the

greaterpotentialforinnovation.Butanotherbarriertoinvest-

ment is likely to play a role in network growth. Investment

‘hold-up’generallydescribesthedisincentivetoincurafixed

costwherethevalueofsuchaninvestmentmaybeappropri-

atedbyanotherparty.Thismaybeaproblemforinvestments

ininnovationonownedor‘sponsored’networks,whereaset

of standardsor rulesareestablishedby thenetworkowner.

Indeed,onsuchnetworksinvestmentsininnovationaretypi-

callynetwork-specific.Consequently, it is interesting tocon-

sidertheseproblemsinabstractandaskhowonelargenet-

workwasabletoovercomethem.

Anetworkeffectresultswhenutilizationofanetworkservice

byoneconsumeraffectstheutilizationchoiceofanother.The

telephoneistheclassicexampleofthisphenomena;theben-

efittousingthistechnologydependsonthenumberofother

consumerswhoalreadydoso.Thisproblemfornetworkutili-

zation translates into a similar problem for network innova-

tion. Innovative investment may not be justified if too few

ultimatelyusethenetwork,butmaybejustifiedifmanydoso.

Imagineasituationwhere,ifallnetworkparticipantschoose

to adopt an innovation, the innovation-enhanced network

attractsevenmoreusers.Inthiscase,benefitstoparticipants

associated with the increase in network usage may justify

adoptionandhenceinvestmentintheinnovation.However,if

toofewparticipantsadopttheinnovation,networkusagemay

remain sufficiently low so that the cost of the innovation

exceeds its benefits. Consequently, a network effect is an

important barrier to both utilization and innovation on net-

works.Unlessitispossibletocoordinatethebehaviorofpar-

ticipants,manypotentialnetwork innovationswillneversee

thelightofday.

Theholdupproblempresentsamoregeneralbarriertoinno-

vation.Itplaysamajorroleinlimitinglargeinvestmentsspe-

cifictoaparticularapplication.Thesefeaturesarecharacter-

istic of investment in innovation on sponsored networks.

When an innovation is costly and specific to the network —

meaningthattherearenousesforthisinnovationoutsideof

thenetwork—innovationcanbeheldupbytheownerofthe

network.Consider suchan innovation that isadoptedbyall

participantstoanetwork.Thebenefitsfromtheinnovation,in

the form of increased network usage and/or lower cost, for

example, yield increased profits to network participants.

However,oncethecostoftheinnovationhasbeensunk,the

owner of the network can appropriate these benefits, for

examplebyrepricingnetworkaccess.Potentialadopterswill

bedeterredastheyanticipatetheowner’sbehavior.Potential

innovatorswillholdupinvestmentastheyanticipatenopar-

ticipantswilladopt.

Inordertoovercomethehold-upproblem,thenetworkowner

mustbeabletocrediblycommitnottoexpropriatethevalue

oftheinvestmentfromparticipants.Inprinciple,thiscouldbe

doneinavarietyofways.Forexample,areputationortheuse

of long-term contracts might allow this kind commitment.

Suchmechanismsmaytakealongtimetoestablishorrequire

costlyrevisionsasconditionchange.Aparticularlyeffective

waytoovercomethehold-upproblemisfornetworkpartici-

pantstojointlyownthenetwork.Suchagovernancestructure

insuresthesamesetofinstitutionsreceivesthebenefitsfrom

the innovation,eitherasparticipants inorasownersof the

network.Understandinghowthenetworkeffectandthehold-

arespecific to thenetwork.Hence, inorder toextractmore

valueoutofitsnetworkitwasnecessaryforBankofAmerica

to agree to share it with the other banks that licensed the

creditcards.

Imagineforamomentthat,intheearly1970s,BankAmericard

ServiceCorporationhadproposedtocentralizetheresearch

anddevelopmentfunctionfortheVISAnetworkbutretained

soleownershipofitsassets.Inaworldwheretheonlybarrier

toinnovationisthenetworkeffect,thisstepwouldhavebeen

enoughtospurthegrowthofVISA.However,wehaveargued

thatoneshouldexpectotherparticipantsintheVISAnetwork

torealizethatsuchanarrangementwouldbebadforthem.In

effect, they would be financing costly innovations that

enhance the value of the network but would be unlikely to

partakeinthosebenefits.BankAmericardServiceCorporation,

as the sole owner of the network would be able to reprice

networkaccesstosystematicallyextractallbenefits.Thissug-

geststhattheonlywaytogetothercardissuerstoagreeto

finance network-specific innovations was to allow them to

becomejointownersofthenetwork.

Onemorepointisworthnoting.Atfirstglace,thegovernance

structure of American Express might seem to provide a

counter-example to our story, since, in contrast to VISA,

American Express is not mutually owned. Closer inspection,

however, reveals that there is no contradiction. American

Express,becauseitisaproprietarynetwork,andnotanasso-

ciation,hasnoindependentbanksissuingAmericanExpress

credit cards. Instead American Express functions as its own

soleissuer,meaningthat,unlikeVISA,itischaracterizedbya

verticallyintegratedorganizationalstructure.

conclusionInprinciple,bythelogicofthenetworkeffectargument,coor-

dinationcouldhavesolvedBankAmericard’snetworkproblem.

Inpractice,BankAmericardhadtotakeanextrastepandorga-

nizeunderamutual-ownershipgovernancestructureinorder

to address the hold-up problem. Hence, our argument sug-

gests that there isnomiddlegroundbetween theorganiza-

tionalstructureofVISAandAmericanExpress.Eitherallpar-

ticipantsjointlyownthenetwork,asawaytosolvethehold-

up problem, or a single entity is in charge of a ‘network’,

integratingtheinterestsofdownstreamparticipantsintothe

firm.

As we have pointed out, the hold-up problem is likely to be

particularly serious in cases where costly, network-specific

investmentisnecessarytoimplementinnovationsonaspon-

sored network. Such investment cannot provide benefits to

participantsoutsidethenetworkandthusmakesthemespe-

ciallyvulnerabletobeingexpropriatedbythenetworkowner.



The evolution of currencyJames TurkFounder, GoldMoney.com

Thus,theconceptofamoneysubstituteintroducesanewrisk

intothetransaction,normallycalledpaymentrisk.Itistherisk

that the recipient may not be able to exchange the money

substitutereceivedinatransactionforagoodorservice.The

paymentriskmeansthatthemoneysubstitutemayloseallor

some of its value before it can be exchanged for items of

value.

Formorethan300yearswehavebeenusingmoneysubsti-

tutes.Theirproblemsarereadilyapparent.Papercurrencies

oftenbecomeworthless ifbanks fail,orwhencentralbanks

pursuerecklesspoliciesthaterode,andinsomecasesdestroy,

thevalueofthecurrency.

Furthermore, money substitutes are expensive. They are

based upon credit, and it is costly to monitor credit-worthi-

ness. In addition, substitutes do not circulate efficiently in

onlinecommerce.Therearecostswhenconvertingonecur-

rencytoanother,andmoreimportantly,withnationalcurren-

ciesitisnotpossibletomakeinstantaneousandnonrepudia-

ble 24/7 payments, which have clearly become important

requirements for global online commerce. In short, while

money substitutes have more or less met the needs of the

marketplaceuptonow,theyhavebecomeinadequate.

Importantly,moderncomputerandcommunicationstechnolo-

giesmakepossiblenewformsofcurrency,evenprivatefree-

marketcurrency,suchasGoldMoney.Thedigitalgoldcurren-

cyisdrivenbybottom-lineobjectivestoearnaprofit,incon-

trasttotheoftencapriciousandharmfulpoliticalaimsunder

whichcentralbankersoperate.

Therefore, it is my expectation that currency is about to

evolveyetagain.Globalonlinecommercerequiresit,andso

doesthehighcostofoperatingourpresentcurrencysystem

ofmoneysubstitutes.

BanksintheU.S.earnapproximatelyU.S.$70billionannually,

and it isestimatedthatsome40%oftheirprofit isderived

from their payment systems that enable the money substi-

tutestheycreatetocirculateascurrency.Thatisahighcost

indeedtoconsumersandbusinesses,particularlywhencon-

sideringthatthetechnologyexiststodaytosignificantlylower

thesecosts.

Iexpect,therefore,thatcurrencywillevolveintonewforms.

And, itwillnotbethefirsttimethattechnologyhascaused

profoundchanges.TakethehistoryofPCsasanexample.In

1977corporateITdepartments‘ruledtheroost’andPCswere

ahobbyforahandfulofenthusiasts.Yetintenyears,thePC

hadturnedcorporateITdepartmentsontheirhead.Because

ofdevelopinghardwareandsoftwaretechnology,thePChad

becomeanimportantnewtool,foreverchangingthefaceof

corporatecomputing.Thissamepotentialexiststodayforthe

Internettofundamentallyandforeverchangebankpayment

systems.Asaconsequence,lookfornewcompaniestoexploit

thesenewtechnologies,andintheprocesscreateacurrency

thatonceagainismoney,andnotamoneysubstitute.

111

UntiltheformationoftheBankofEnglandin1694,moneyand

currencywereoneandthesame.Moneywasatangibleasset

andthisassetitselfcirculatedascurrency.

Moneymostoftentooktheformofgoldorsilvercoins,though

historyshowsthatmanyassetshavefromtimetotimeserved

as money. But regardless of what ‘thing’ served as money,

eachsharedonecharacteristic;theywereallatangibleasset.

Consequently,moneyhadvalue in transactionsbecause the

asset being used to represent it was perceived to possess

someinherentusefulnessandwasthereforevaluable.Whatis

moreisthatitwasthistangibleassetthatcirculatedascur-

rency. In other words, though money often took different

forms,withcoinsofpreciousmetalsbeingthemostcommon,

the asset serving as money passed current from hand-to-

hand.

Assetsservingasmoney,however,were inconvenient.Coins

wereheavyandbulky,andthelargenumberrequiredtocom-

pletehighvaluetransactionswasunwieldy.Evenworse,coins

couldeasilybenickedorscratchedinuseandwereworndown

from constant handling, dissipating the precious metal con-

tentthatgavethemtheirvalue.Asaconsequence,goldand

silverwereconsideredtoovaluabletocirculateascurrency,a

realitythatactedanasincentivetodevelopalternatives.And

infacttheselimitationswereovercomebyanimportanttech-

nologicalinnovationfromtheBankofEngland.

It created paper currency, called banknotes, which were a

promissory note obligating the bank to pay the weight of

metalprintedonthenote.Thisnewcurrencyenabledthegold

andsilvertoremaininthebank’svault,withthesepapernotes

circulatingascurrencyinplaceoftheinconvenientandvalu-

ablemetals.

Thisnewcurrencywasthereforeamoneysubstitute,andnot

moneyitself.Thecurrencyallowedtheappropriateweightof

preciousmetaltobepaidondemandwhenthebanknote,on

whichagivenstatedweightofthemetalwasrepresented,was

handed to the bank for redemption. This feature provided

holdersofthenotessomecertaintythattheirmoneywouldbe

returnedtothem,butitalsointroducedarisk,namelythatthe

bankwoulddefaultonitsobligation.

Thisriskofdefaultwasgenerallyperceivedtobeacceptable

giventheadvantagesofferedbythisnewcurrency.Because

bank notes were very convenient and lowered the cost of

transactions, theyofferedsignificantadvantagesovercoins.

Therefore, increasing amounts of bank notes were put into

circulation.Itwasasuccessfulinnovation.However,theessen-

tialnatureofcurrencywasradicallyaltered.

Incontrasttothetangibleassetcommoditiesthatcirculated

ascurrency,banknotesdonothaveanyintrinsicvalue.Their

valueisderivedfromtheassetsbackingthem,thusmakingit

clearthatcurrencyhadbecomeanitemthatrequiresbalance

sheet accounting and double-entry bookkeeping. Currency

wasnolongeratangibleasset,thevalueofwhicharosefrom

theassetitself.Currencywasnowamoneysubstitute,andin

particular,aliabilityoftheBankofEngland,whichpromisedto

paymoneyondemand.

Thereisanimportantdifferencebetweenmoneyandmoney

substitutes, which has its basis in common law, that for an

exchangeinthemarketplacetobeextinguishedassetshave

tobeexchangedforassets.Soifoneusesgoldtobuyahorse,

forexample,anasset(gold) isbeingexchangedforanasset

(the horse), and the instant the assets change hands the

exchangeisextinguished.Therearenolingeringobligations.

Butconsiderthistransactionifoneusesanationalcurrency,

i.e.,amoneysubstitute.

Thenationalcurrency isnota tangibleasset. It isadeposit

liabilityofabank,anditderivesitsvaluefromtheassetsback-

ingit.Therefore,thebuyerinthisexchangewalksoffwitha

horse(anasset)andthesellerwalksoffwithamoneysubsti-

tute (abank’s liability), so theexchange isnotextinguished.

Thereisalingeringobligation,andtheexchangeisnotextin-

guished until the seller manages to exchange the national-

currencymoney-substituteforagoodorservice.


Automating payment processes to reduce working capitalKurt CavanoChairman and CEO, TradeCard

Executivestherewerelookingtoautomatethepaymentdeci-

sioning and scheduling processes. The retailer chose not to

implementsoftwareacrossitsprocurementdivisionandhun-

dredsofsuppliers,butinsteadtouseanon-demandplatform

that works over the web. The platform extracts purchase

ordersfromtheretailer’sERPsystem,andthenautomatically

populates and routes other documents necessary for the

transaction,suchassuppliers’invoices.Italsohandlesallthe

informationgatheringandcompliancecheckingthatgoesinto

paymentdecisioningandscheduling,givingthefinanceteam

thefreedomtothinkstrategicallyaboutpaymentsandtheir

timing.Fromatechnicalstandpoint,whatmakesthispossible

isopendataexchange.Asolution,whetheritissoftwareoran

on-demandproduct,shouldbeabletoacceptnearlyanydata

formatandtransport,fromEDIandAS2toXMLandflatfiles.

Thatway,alltheworkacompanyanditssuppliershavedone

on procurement, fulfillment, payment, and workflow is re-

used.Likewise,bothbuyersandsupplierscancontinuework-

ingwiththeirexistinglogisticsandfinancingpartners.

use procurement and payables data to reduce working capitalPoor visibility into and control over payments shrinks the

capitalacompanyhasavailableforotheruses.Withtheright

solution, companies can track relevant data throughout the

procurementcycle,enablingfinanceteamstopreciselyfore-

castcashmovements,planforFX,andbetterinvestthecom-

pany’smoney.

Forinstance,thefinanceteamofacompanyIknowusestheir

procure-to-payautomationplatformtoleverageadvanceship-

ping notices. Suppliers issue these notices when the pur-

chased goods are ready to ship from their factory or ware-

house. Based on the notices, the finance team begins fore-

castingpayablesmuchearlierthantheycouldwith invoices.

Other companies move even closer to the purchase order.

Manycontinuetorelysolelyoninvoices,withtheaddedben-

efitofanautomatedmechanismforcollectingthedata.

In any case, a dashboard or some other reporting tool is

required to precisely manage and exploit this information.

Suchtoolscanprovideeverythingfromabigpictureviewof

paymentstothestatusofindividualtransactions.Havingthis

informationallowsfinanceteamstolowertheworkingcapital

they keep on hand and, in turn, apply funds to higher yield

investments.Italsoimprovesplanningforcurrencyexchange.

Theresult,inshort,istheabilitytofundtherightpaymentsat

therighttimewiththerightcurrency.

113

When CFOs and other finance executives discuss electronic

payments, the conversation typically centers on optimizing

settlement.Butwhatabouttheprecedingsteps,particularly

payment decisioning and scheduling? Payment decisioning

determineswhetherapurchaseorder’stermsandconditions

arefulfilledandreflectedontheinvoice—andinturn,wheth-

ertheinvoiceshouldbepaidoradjusted.Paymentscheduling

encompasses the payment’s timing. Both areas require pre-

ciseinformation,yetaretypicallyrifewithmanualprocesses

and paper. The result is reduced visibility into payables and

bloatedworkingcapital levels.These issuesareexacerbated

when procurement is decentralized, such as at a company

whose multiple divisions use individual purchasing and

accountspayableprocesses.

In contrast, when payment decisioning and scheduling are

executedefficiently,companiescantightlycontrolwhichsup-

pliersgetpaidonwhatdates,aswellasextendvisibilityinto

upcoming payment requirements. This complements elec-

tronicpayment’sprocesssavingswhileenablingcompaniesto

reduceworkingcapital.Forthesereasons,ananalysisofpay-

mentdecisioningandschedulingprocessesshouldbepartof

electronicpaymentinitiatives.

Many companies determine that an automated approach to

paymentdecisioningandscheduling isasensiblesolution—

particularly if the automation layers over existing business

processesandtechnologies,ratherthanrequiringchangesto

them. Below are three best practices for implementing this

approach. They are based on the practical experience of

financeexecutiveswholedsimilarprojects.

start with the purchase orderPaymentdecisioninginvolvescomparingprocurement,fulfill-

ment,andevenwarehousedocumentstodetermineifasup-

plier’sinvoiceshouldbepaid.Automatingthistediousprocess

givesfinanceteamsfasternoticeofupcomingpayments.By

adding automation of payment scheduling, companies can

thensettleinvoicesatthemostfinanciallyopportunemoment.

Mostcompaniesbeginautomationatthepurchaseorder,and

looktoelectronicallysharethisinformation,aswellaslogistics

and payment information, across their own accounting and

procurementdepartmentsandwithsuppliers.Theadvantages

of starting automation at the purchase order are twofold.

Firstly, this approach contributes to overall process efficien-

cies, as information is disseminated faster and more accu-

rately. Secondly, finance teams gain the option to take pay-

mentvisibilitytoitsverygenesis.Withtherightsolution,pay-

m e n t

visibilitycanevenbeaimedat logisticsareas, suchaswhen

suppliersshipgoodsorwhenawarehousereceivesthem.

There are several software and on-demand products that

automatethese‘procure-to-pay’processes.Nomatterwhich

oneanorganizationchooses,itisimportantthatthesolution

be able to base payment decisioning on the comparison of

multipledocumentsandsetsof information.Afterall,many

factorscanbeinvolvedindeterminingwhetherornotasup-

plierhasmettheirobligation.

Another key feature is dispute resolution and negotiation.

Havingautomatedworkflowandcollaborationcapabilities in

these areas can expedite the handling of non-compliant

invoices or inaccuracies in other documents, saving time in

accountspayableaswellasprocurement. It isaparticularly

important capability for direct goods procurement, as slow-

downs anywhere in the supply chain can impact production

schedulesandthecostofgoods.

Extend the value of ERP and other back-end systemsManycompanieshaveputatremendousamountofresources

intoERPandotherback-endsystems.Toexpediteprocure-to-

pay automation, it makes sense to leverage these invest-

ments.Agoodsolutionwillreusetheirdata,suchaspurchase

ordersorshippingnotices,andcomplementtheirassociated

businessprocesses.

Consider the case of a large retailer I recently visited.

new agenda for payment service providersTerry Dirienzo, Director, Group Payments & Settlements, Barclays Plc.Mark Hale, Head of Payments Strategy, Group Payments & Settlements, Barclays Plc.

support these developments. As customers invest in more

electronically integrated business processes, banks must

ensurethattheirpaymentservicescanbeeasilyintegrated.

Critically,asacustomer’sexpectationofserviceincreasesand

their willingness to pay a premium decreases, banks must

seekto improvetheproductivityof theirpaymentsprocess-

ing,clearing,andsettlement.Thiscreatesdemandsandchal-

lengesforeverypartoftheinternalandexternalsupplychain

fromproduct,throughchannelandoperations,toclearingand

settlement. The ability to process payments electronically

fromoriginator tobeneficiary, straight throughandwithout

expensiveintervention,willbeessentialtodrivingupproduc-

tivityandquality.

Inviewoftheextentof informationtechnologyemployedin

thesupplychaininfrastructure,managersmusttakeaccount

oftheITprocessingandcostbenchmarksofsimilarITenter-

prises,andachieveatleastthesameorsimilarlevelsofasset

utilizationandratesofreturnoncapitalemployed.

Everybankhasadifferentpaymentsserviceandproductmix,

as well as a different marketing strategy, which will largely

determine the process and operational requirements that

needtobesatisfied.Equally,bankswillbeatdifferentstages

of organizational evolution, which will determine the extent

andnaturetowhichanintegratedend-to-endpaymentssolu-

tionisavailabletocustomer-facingbusinessareas.Thecom-

bination of these factors will then help identify the most

appropriate organizational and delivery decisions for actual

productandservicedelivery;inparticular,identifyingtheser-

vices that should be processed internally and those that

shouldbepurchasedexternally.

Thebanksthatwillsucceedandgaincompetitiveadvantage

under these conditions will be those that can develop out-

standingpropositionstocreategenuinecustomervalueand

thatoptimizetheirsupplychainbycombiningacompetitive

unitcostwithexcellentservicedelivery.

organizational philosophyInassessingtheoptionswithwhichtomeetabank’spayments

needs,itisimportanttorememberthatpaymentsisonlyone

elementofabank’sbusinessandthatanyorganizationaldeci-

sionsforpaymentsmusttakeaccountofthewidercontextin

whichtheyoccur.Centraltothisiswhetherabankhasacen-

tralized or a decentralized structure for measuring the suc-

cessofitsproductsandservices,whichincludesthewaythey

aremanagedanddelivered. Ifthestructureiscentralized, it

provides for decisions to leverage shared infrastructure, to

offer a manufacturing service for payments, and to obtain

highratesofassetutilization.Ifthestructureisdecentralized,

thenamoredistributeddeliverycapabilityispossible;trading

higherfixedcostoverheadsforgreaterflexibilityandcontrol.

Theabilitytoadoptamoreexternalizedsourcingmodelwill

alsodependtoaverylargedegreeontheextenttowhichthe

existingpaymentsinfrastructureandoperationsareseparat-

ed,colocated,rationalized,oroptimized.

A bank’s fundamental perception of payments will dictate

how they approach this choice. In particular, for example,

whether payments are regarded as a source of value, an

applicationofcost,oranelementofrisk.Thisdecisionisnot

exclusiveorone-dimensional,sincetheperceptionmaydiffer

depending on which part of the supply chain is being con-

sidered (payments, clearing, or settlement), the customer

segmentbeingtargeted(retail,corporate,orfinancialinstitu-

tion),orthedriveroftheactivity(interoperabilityordifferen-

tiation).

Ifpaymentsareregardedasacost,anon-differentiatedcom-

modity,andahomogeneousproduct,thenthiswilllenditself

to a centralized structure and to more external sourcing.

Whereasamoreprofit-orientedtreatmentofpayments,that


115

The business of making payments should be high on the

executiveagendaofeveryfinancialserviceprovideroverthe

nextfiveyears.However,itisabusinessineverysenseofthe

wordandthismeansthatmanagershavetoreconcileprovid-

ingcustomerswiththemostrelevantandvalueaddingpay-

mentservices,whileat thesame timedoingso in themost

cost-effective and responsible manner that mitigates the

inherentinvestmentandbusinessrisks.

Customersexpecttheirbankstomakepayments,tohavesuf-

ficient payments reach, and to be able to make their cash

management more efficient. The business of payments is,

therefore,acorecompetenceofabank in thesamewayas

lendingmoneyandprovidingsavingvehiclesarecorecompe-

tencies,exceptthat it isthe lynchpinofthethree,sincethe

othertwodependonpaymentstofunction.

The unprecedented change in the business environment,

relentlessincreasesinthelevelaswellasthenatureofcom-

petitioninthemarketplace,andmoresophisticatedcustomer

demands,therefore,createademandingandurgentagenda

forallpaymentserviceproviders.

Payments landscapePaymentsarealsothelifebloodofcommercialactivityandas

such they underpin the operation and the confidence that

makeseveryeconomyfunction.Inaninformationtechnology

era,therefore,itisimperativetoensurethatdeliveryofpay-

ments isefficient, safe,and trusted; irrespectiveofhowthe

paymentsareactuallyprovidedwithinthesupplychain.

Customers have an extremely high expectation of payment

serviceperformanceandavery low tolerance threshold for

paymenterrors.Thisplacesapremiumonthevariousways

that the channel, product, and service strategies of banks

addressthematterofpaymentsandinparticularinhowthese

productsandservicesaresourced.

Theapplicationofinformationcommunicationtechnologyto

enable real-time transfer of value, to support daily transac-

tional values that sometimes dwarf the GDP of many coun-

tries, and to provide international transaction processing

means that the payments business has an extremely high

inherent level of operational risk. Banks, therefore, have to

fullyunderstand,manage,andbeable tomitigate theman-

agementrisksinvolvedintheirpaymentsservices.

Independentlegacysystems,oftenwithproprietarytechnolo-

giesandsystems,arebeingchallengedbytheconsolidation

andglobalization that isoccurring inupstreamclearingand

settlement and in downstream customer treasury and cash

management.Thisisbeingacceleratedbystandardsconver-

genceandtheuseofmoreopenstandards,therebyallowing

greateraccesstonewentrantsandopportunitiesforkeener

competition.

Theeconomicimportanceofpaymentsalsomeansthatmar-

ketmakersandregulatorsareseekingtoachievetheirgoals

and ambitions by homogenizing payments activity within

theirrespectivecountriesandalsocross-border.Thisispar-

ticularlytruewithinEurope,wherewiththeSingleEuropean

PaymentsAreaisbeingusedasameanstoachieveasingle

Europeanmarket.

The challenge for banksThepaymentscontextandlandscapemeansthatbanksneed

to deliver payment solutions that their customers value, in

the manner most attractive to those customers and in the

timescalethatfitstheirownplansandactivities.Ascustom-

ers themselves adopt new technologies, so too must banks

adapttheirpaymentsolutions.Thisisparticularlytrueofthe

Internet,wherecorporatecustomersareusingittoimprove

their own customer experience, to broaden their proposi-

tions,andto improvetheirworkflowandcashmanagement

cycles. It isessentialthatbanksanticipateandarereadyto

howtheserviceisdeliveredtheriskandtheresponsibilitywill

alwaysremainwithinabank.Thecombinationofthesethree

regulatorypillarsmaycausemanybankingexecutivestobe

nervousofallowingthirdpartiestomanagesubstantialpor-

tionsofoperationalriskslikethoseinherentinpayments.

market development conclusionsThe management of the payments supply-side is complex,

risky,andsubjectofsubstantialfuturechange.Anythirdparty

seeking to provide compliant solutions will want to ensure

thattheirpricingincludesapremiumfortheserisksandwill

probablyshyawayfromabsolutewarrantiesandassurances

aboutobtainingcompliance. It isnot thechange that is the

primaryissuehere,butthefactthatchangeiscertain,willbe

mandatory,andyetdifficulttoquantify.

It isclear,however,thatbankswillcontinuetodeveloptheir

outsourcingandoffshoringexperience.Giventhediscussions

above,theshorttermupstreamsupply-sideislikelytodevel-

opinthefollowingways.Bankswillfocusonmakingimprove-

mentstointernalprocessingcapabilitiestoallowmorethird-

party sourcing solutions to be considered. There will be

increasedstandardizationofpaymentsactivitiestofacilitate

migration to different sourcing models. More co-sourcing of

commonprocessingactivitiesinthenon-competitiveareasof

clearing and settlement will be undertaken. There will be

greater consolidation of clearing and settlement activities,

which will be accelerated by the development of the Single

European Payments Area. Selective third-party sourcing of

discreteandnichepaymentsbusinessactivitieswillbecome

moreprevalent; this isanarearipefor jointventuring.And,

third-partysourcingofinfrastructuremanagementandsome

operationsmanagementwillcontinue.

Knowledge management as a separate and managed disci-

plinedoesnothaveanestablishedhistoryinbankingandthis,

aswellasothercriticalpre-requisitedisciplines,willneedto

be established before banks are able to safely migrate sub-

stantialpartsoftheirpaymentsbusinessestothirdparties.

Final commentAnumberofcommentatorstalkaboutbankssimplyoutsourc-

ingtheirpaymentsbusinessestoreducecost,butthisseems

tounderestimatetheoperationalrisksinvolvedandthevalue

ofpayments to thebusinessofbanking.Theyalsooveresti-

matetheabilityof thesupply-sidetomeetthefull rangeof

commercialrequirementsinvolved.Itseemsmorelikelyinthe

long-termthatbankswill,eitherunilaterallyorinpartnership

withothers,establishatransactionalprocessingutilitytopro-

videpayment-processingservicestootherbanks.Intheshort-

term, the focus ismore likely tobeamixedsourcingmodel

withafocusonraisingprocessingproductivityandimproving

servicequality.


perhapsservicesnicheandprofitablepaymentsmarkets,will

lend itself to internalmanufacturing,sellingof transactional

services,andsomedecentralizationofnicheactivities.

sourcing modelsManagersconstantlyaddress thequestionofhowtosource

eachcomponentofthesupplychain.Dependingonthescale

ofthecomponentinquestion,thisrangesfromin-housedeliv-

ery to facilitiesmanagement, jointventure,or fulloutsourc-

ing.Withineachcategorytherearethenotherkeyconsider-

ations, such as packaged or bespoke services, offsite/near-

shoresourcing,orfinallyfulloffshoresourcing.

The considerations within each of these options are fairly

standard and best practices also fairly well established and

understood.Muchofthisiscodifiedandavailableinreference

texts. The issue is principally one of information systems,

infrastructure,andinformationtechnologyservicesmanage-

ment.However,where there ismoreuncertainty,andmuch

lessguidance,isinhowtoapplytheseoptionstothebusiness

ofpaymentsandinsuchawaythatsatisfiestheprudential

requirementsofa regulatedcredit institution.The inherent

and systemic risks involved in the payments business is of

such an order of magnitude different to other business

activitiesinotherindustriesthattheCommitteeofEuropean

BankingSupervisorshasestablishedprinciplesforoutsourc-

ing material activities, made such decisions the subject of

pre-notification, and prescribed the outsourcing of certain

specifiedactivities.

Atamorecomponentlevel,banksalreadyutilizeamixtureof

differentsourcingsolutionstomeettheirneeds.Thismaybe

to take advantage of scale economies or to white label the

delivery of particular software products. In every case it is

essential that the customer is unaware of this and that the

actualsupplieroftheproductorserviceisnottransparentto

them.

Payments is a relatively homogeneous product in isolation

andthereforesubjecttosupplierswitching.Thismeansthat

sourcingfromcompetitorswithoutnon-competeandsecrecy

agreements is particularly fraught and carries the risk of

brandandreputationdamage.Where,forexample,isthecom-

mercial incentive for a competitor supplier to offer a good

serviceiftheyareabletoapproachthecustomerinquestion

andsubsequentlysolicittheirbusiness?

Key sourcing considerationsCommercialconsiderationsalsomakeoutsourcingofthepay-

mentsbusinessparticularlycomplex,andBasleIIexacerbates

this.Therearemanysubstantialcreditexposuresinthepay-

mentssystemsatanytimeduringthedayandthesearesub-

jecttocollateralizationandreserve.Normalbusinesspractice

istomatchriskwithcontrol.But,wherecontrolofpayments

isinthehandsofathirdpartyitishardtoconceivethatthese

exposurescouldeasilybecoveredbyliabilityagreements,itis

easytoseetheinsurancepoolbeingconsumedbyamarketof

several‘pure’paymentserviceproviders,andthereareonlya

feworganizationswithabalancesheetcapableofsustaining

thecontingentliability.

Additionally, given the mission critical nature of payments

processing,thelevelofinherentrisk,andthefixedoperating

deadlinesforclearingandsettlementwhereservicesareout-

sourced,thereisapremiumforexcellentserviceintegration

and issue management capabilities. This is particularly the

case in a mixed sourcing environment. In addition, where a

bank isaccustomed tounderstanding the imperativeofsys-

temicandregulatedstability in issuemanagementandused

toplacingtheseconsiderationsbeforeimmediatecommercial

concerns,therecouldbeariskwhenthereissubstantialthird-

partysourcing.

UnderSarbanes-Oxley,bankexecutivesaremoreclearlyand

directly accountable for the effectiveness and operation of

their internal control environments. Under Basle II more

effective operational risk and incident management will be

required, as well as a much better information reporting

capability.TheCommitteeofEuropeanBankingSupervisors

doesnotallowriskmanagementtobeoutsourced.Nomatter

117

new models of collaboration in transaction bankingWolfgang GaertnerChief Information Officer, Global Banking Division — Global Transaction Banking, Deutsche Bank, and, Director, SWIFT

dollar clearing market has seen the disappearance of 59 of

the 115clearinghouseparticipantsduringthe last tenyears

— more than 50 % of the market players have disappeared

(CHIPS statistics). This supports the hypothesis that as the

consolidationprocessof the transactionbusinesscontinues,

therewillonlybeafewbanksthatwillhavethetransaction

volume,andhencethescaleofeconomyatthelowertransac-

tion revenue margins, to meet the customer demands. The

restneedtothinkaboutnewwaysofdoingbusiness—coming

backtothecarbuilderanalogy,thinkingaboutbreedingcattle

oroutsourcingthefarm.

new ways of partnering between banks Outsourcing to another bank may not only serve to reduce

costs, but can enhance the existing offering to customers

wantingmorecomplexservices.Itmayevenimprovethecost

basisofcertainpartsoftheback-endvaluechain.Thereare

possiblythreewholesalebankingproductsandservicesthat

arepartofthistrend:

■ Whitelabelingoffront-endtechnology—namelyInternet-

basedservices,suchaselectronicbankingplatformsand

nettingsystems.

■ InfrastructureoutsourcingofITandoperationswithtrans-

actionroutingandconversioncapabilities,transaction

settlementoptionsandlockboxservicesbeingpopular

choices.

■ Partnerbankingsolutions,includingaccountandliquidity

managementservices,infrastructureandplatforms

aroundcommonservices,suchassales,implementation,

andcustomerservicemodels.

Fundamentaltopartnershipsistheselectionofasuitablesup-

plier. Key benchmarks are a commitment to quality, price,

reputation,andresources.Clientswouldseelittledifference,

as such banks would provide the same depth of the value

chain, by outsourcing services to larger institutions. Thus,

bankscouldmaintaintheirrelationshipsandclientinteraction

withoutthecostandeffortofmanagingtheentireprocess.It

also frees up banks to move further up the value chain to

meet thedevelopingneedsof theircorporateclients.Banks

can lookathowandwhere theycancontinue toaddvalue,

especially for multinational corporations, by helping compa-

niestomanageliquidityacrosstheirglobaloperations.Thus,

these new business models, with cooperation between all

types of institutions, could allow for more efficiencies and

lowercostsforall.

One example for white-labeling is the cooperation between

Barclays Bank and Deutsche Bank. Such strategic partner-

shipscouldonlybepossibleduetoexcellentITandoperations

capabilities,andshowsthatthesefieldshavebecomekeydif-

ferentiatorsandcriticalsuccessindicators.Themandatefrom

Barclayscamewiththeresponsibilitytoprovidepremierser-

vice,bestqualityandhighestsystemavailabilitytothebank

and its clients. This is the first partnership of its kind in

Europe,wherealeadingprovideroffersitscashmanagement

franchisetoanotherfinancialinstitutiontoserveitscorporate

clients. By leveraging Deutsche Bank’s infrastructure and

technologyinvestments,BarclaysBankcannowofferstate-of-

the-artpan-Europeancashmanagementsolutionstoclients,

including account services, domestic and international pay-

mentsandcollections, liquiditymanagement,andelectronic

banking solutions. They will, of course, continue to provide

accountandpaymentservicestotheircustomerswithinthe

U.K.andretainfullresponsibilityforclientrelationships,while

Deutsche Bank will oversee operations and processing, the

management of its services, and also extends support to

Barclays’sales,implementation,andcustomerserviceteams.

In such a scenario, there are winners all around the table.

Banks unable to maintain a stand-alone cash management

businesscanbuy-inservicestoprotecttheircustomerbase,

reducetheircostandrisk,aswellasgeneraterevenue.The

vendorbankleveragesits infrastructureandsystemsinvest-

ments, as well as its high-volume processing efficiencies, to

create an alternate stream of revenue. Finally, corporations

andinstitutionsstandtobenefitfromaccesstoproductsand


119

Intheworldoftransactionbanking,changehasalwaysbeen

incremental and not fundamental. But not anymore, the

industryistransformingitself,andatgreatspeed.Itishard

to believe, but instituting such fundamental changes will

force some banks and financial institutions to move away

fromtransactionbankingaltogether,whichwasonceregard-

edtobeacorebusiness.Thesenecessarychanges,whennot

totally successfully implemented, can become a costly pro-

cessandinvolvehighoperationalrisks.

Nowwhatexactlyare thedrivers forchange in transaction

banking?Wehaveincreasingcompetitionwithinadeclining

margins scenario, a growing set of demanding regulations,

greatercustomerexpectations,massive IT investmentsand

growingexpertiseasaprerequisite,newmodelsofcollabora-

tioninthefinancialindustrysector,andtheresultingindustry

consolidation. Understanding these drivers is key for the

financedirectorandcorporatetreasurer,astheywillhavean

impactonhowacompanymanagesitsfinancialtransactions.

It istheseverydriversthatwillalsochangethetransaction

bankinglandscapedramatically.

While competition is increasing, the transactionmarketwill

undergoastrongconsolidationasbankstrytocometoterms

withallthechangesthatourindustryisfacing.Theylookat

what services they should and are actually able to offer to

theircorporateandinstitutionalclients.Itwillbeincreasingly

difficultandinvestment-intensiveformanytransactionbanks

tooffer thecompletesuiteof transactionservices in-house

and manage the investment that goes hand-in-hand with

that.Theresult:nothinglessthanparadigmshifts.

Thereistheoldsayingaboutcarmanufacturers,thatatsome

stage their vertical range of manufacturing would get so

extensivethattheywouldeventuallybreedtheirowncattlein

ordertohavetheleatherforcarseats.Whileitisclearthat

thissituationhaschangeddramaticallyinmanufacturing,itis

lessobviousthatthisiswhatbanksaredoingintoday’smar-

ketswhenitcomestotransactionbanking.

Now that transaction banking has become a commoditized

business, with transaction fees decreasing, clients look for

lower prices and increased capabilities. Yesterday’s order-

winningcriteriaarejustnormaltoday,sotherequirementto

deliver truly complex solutions and the ability to process

scalehasincreasedsignificantly.Inaddition,adifficultglobal

economyandaharsherregulatoryenvironmentareputting

morepressureonbanks.Theever-increasingnumberofregu-

lationsisanadditionalcostdriver.Forexample,TARGET2will

resultintherealizationofasinglereal-timesettlementsys-

temforEurope.Similarly,theanti-moneylaunderinglegisla-

tionandtheU.S.PatriotActwillrequirefurtherinvestments.

Andwhilelarge,globalprovidershavethesystemsinplaceto

comply,smallerbankswill find ithard.BoththePatriotAct

andtheSarbanes-OxleyActplaceemphasisoninternalcon-

trols,transparency,andtraceabilityofdata.Furthermore,the

U.S.CheckClearingforthe21stCenturyAct(Check21)means

thatmostchecksnowneedtobeconvertedintoimagesand

manypaymentswilltaketheformofe-checks.Marketforces

andregulatorychanges,suchastheE.U.regulationoncross-

border payments in Euroland, affect transaction processing

profitability.AtthesametimetheestablishmentofSEPA,the

SingleEuroPaymentsArea,resultsinthenecessarydevelop-

ment of new and better systems. IT specialists, better

straight-trough-processing (STP) rates,and investmentgov-

ernanceandcontrolprocessesareneeded.

Astherequirementforoptimizationandpressureonbanksto

achievefastoperationalefficienciescontinues,smallerbanks

must individually evaluate their capabilities. This could

requiresomepainfuldecisionmakingbeforeproceedingwith

capital investment to enhance existing or purchase of new

payment applications to support new IT infrastructures, or

eventoenhanceSTP.

Should banks, therefore, maintain payment processing in-

house,makeastrategicdecisiontosetupatransactionbank

and in-source, or make a strategic decision to outsource to

one of the global payment providers? For example the U.S.

mentinstructionsreceivedfromourcustomers),whichcould

notbeprocessedstraightthroughandrequiremanualinter-

vention.Withthisimplementationallformermanualinterven-

tion functionswill resideononeapplication,enhancingpro-

cessingspeed,STP,andefficiencygreatly.Ineffect,withthis

break-through installation,DeutscheBankwillruntheirpay-

mentsbusinessonthesameplatformglobally,andthisisfor

all processing hubs in all major currencies. This single plat-

formalsomaximizestheimpactofthedesiredglobalopera-

tion model. The architecture behind MTNA is specifically

designed to support the planned key strategic initiatives,

among them the full multi-entity functionality required to

undertake in-sourcing or private label processing, artificial

intelligencecomponentsandlearningcapabilities,makingthe

repair/STP processes more efficient than ever before and

providing the basis for state-of-the-art delivery of advising,

andreconciliationanddecision-supportinformationtoclients.

MTNAcomprisesasinglesystemwithcommoncomponents

foreuro,U.S.dollar,sterling,andmulti-currencyclearingand

comeswithafullarrayofconditionalpaymenttriggers,which

will become increasingly important in a real-time payments

environment. Importantly, customers will not need to adopt

new technology; they interface with MTNA in a number of

ways,amongthemSWIFTorotherproprietaryDeutscheBank

payment offerings. MTNA is an example of how global and

completeITstrategymustdeliverinthedaysofmarketcon-

solidation and new ways of doing business in transaction

banking,andhowITcanhelptodifferentiateabankfromits

competition.

conclusionWhen it comes to transaction banking, large technology

investmentsandtheirunderlyingcontrolprocessesareneed-

edjusttostaycompetitiveandtocomplywithregulations.For

financial institutions, the resultingconsolidation leads to in-

sourcing and outsourcing decisions at the same time.

Especially,banksare in thedualpositionofbeingbothcus-

tomersofotherbanksaswellasserviceprovidersforcorpora-

tions.Therefore, theyhave tobeclear in theirdecisionson

howtopositionthemselveswithinthecontextoftheindustry

drivers.

Financialinstitutionsarerequiringmoreandmorefromtheir

payment service providers because their customers are

demandingmore.Thereforeeachbankhastoaskitself,what

paymentservicescantheyprovideandatwhatcost?Howcan

they make such payment processing competitive and from

wheredotheyprocess?

The ongoing market consolidation is a result of the market

necessitytoofferthefullglobalsuiteoftransactionbanking

productsat competitiveprices.Consequently, large transac-

tion banking providers will be able to provide in-sourcing

activities and white-label services for the mutual benefit of

their strategic partners. This has resulted in consolidation

among transaction bankers and has led to a greater accep-

tanceofoutsourcingasaviableoptionastechnology,regula-

tion, compliance, and contingency. There is also a growing

recognitionthattheneedtomeettheserequirementsraises

thebarontheinvestmentsrequiredforcurrentprovidersto

remaincompetitive.

Today’s transaction banker will have to recognize that the

demands of customers must be met. These demands cover

suchaspectsaslowtransactionprice,responsiveservicelev-

els, fasterprocessingwith theability toaccept transactions

closertopaymentcut-offtimes,provisionofaccuratetransac-

tionprocessingsupportedwithfastresearchofenquiryproce-

dures,andtheprovisionofaddedproductfunctionality.MTNA

coversthesedemands,andisanexampleofhowITcanserve

asadifferentiatorinadifficultmarket.Itisalsoanexampleof

how an effective IT architecture, combined with the use of

globalmodules,andastrictinvestmentcostgovernanceover

underlying processes, have helped enhance the transaction

bankingcapabilitiesofDeutscheBank.


servicestheywouldnototherwisehavebeenabletoprocure

throughtheirhousebank.

Anotherexample,thistimefortheoutsourcingprocesstaking

placeat thesametime, isDeutscheBank’spartnershipwith

Postbank.OnApril6th,2004,DeutscheBankAGandPostbank

signedtheagreementthatthelattertakesovertheprocess-

ingof the former’sdomesticpaymentsaswellas thepaper

handling of Deutsche Bank’s cross-border payment opera-

tions. Postbank now processes the German domestic and

parts of the foreign payment transactions for us. For both

banks, this cooperation is a step in the implementation of

respective strategic objectives. Postbank is continuing to

expanditsdomestictransactionbankingbusiness,leveraging

theirresources,whileDeutscheBankwillbeabletoconcen-

trate on their core transaction banking businesses. For the

banks’ clients, nothing will change. Their accounts will con-

tinuetobekept,asbefore,withtheirrespectivebanks.

Postbank is already one of the market leaders in payment

transactions with approximately 10 million transactions per

day.BasedontheagreementtohandleDeutscheBank’spay-

menttransactions,andthisisinteresting,alongwithDresdner

Bank’spayments,agreeduponinMarch2004,Postbankwill

haveamarketshareofover15%ofthedomesticpaymentsin

Germany. Inreturn,Postbankwill transfertoDeutscheBank

its U.S. dollar clearing business and its worldwide foreign

transactionbankingoutsideoftheE.U.DeutscheBankisthus

strengthening its core competencies in offering global cash

managementsolutionsandthesettlementofforeignpayment

transactions, inparticular for institutionalandcorporatecli-

ents. As a result, both parties are advancing by taking con-

cretestepstoachievejointsynergiesintransactionbanking.

Technology as an enabler Asmentionedbefore,intransactionbanking,IThasbecomea

hugedifferentiator.CuttingcostsbyenhancingSTP,reducing

operational risk, and catering for global platforms have all

become paramount. Major players will need to continue to

invest inplatformsandcapabilities.Betterbackofficecapa-

bilitiesandenhancedSTPratesarepreconditionsforachiev-

ingmarketconcentrationandstandardizationwithinthepay-

mentsbusiness.Thefollowingdriversneedtobefullyunder-

stood when STP and back-office automation are to be

increasedtocompetitivelevels:Assessingbackofficerational-

ization trends; streamlining processes and systems across

regions to deliver benchmark cost transaction processing;

understandingtheupcomingchallengesforcentralandcom-

mercial banks arising from the E.U. accession; restructuring

the back office and delivering benefits through outsourcing

andin-sourcing;examiningthecurrentdriversforSTP,assess-

ingthelatestdevelopmentswithinE.U.paymentsregulatory

requirements; and functional and analytical clarity on effi-

ciencygains,expensecontrol,reducederrorrates,increased

scalability,andoperationalrisk.

Itisahugeandcomplextasktoprovideefficientandrobust

solutionsacrossdifferentregulatoryenvironments,real-time

reporting, investigations and analysis requirements, tax

issues,andformatsandclearingmechanisms,tonameafew

of thechallenges. Forexample, theGlobalMessagingArchi-

tecture (GMA) project addresses these requirements, while

MoneyTransferNewArchitecture(MTNA)isaglobalinitiative

toreplacesegmentedregionalHighValuePaymentsprocess-

ing systems in Germany, the United States, and the United

Kingdomwithglobalmodules.MTNAisanewstate-of-theart,

component-based processing system. The major component

of the U.S. release, which is now up and running, is an

enhanced liquidity management and clearing module. This

managesthegatewaytotheFederalReserveBankandpro-

videstoolstomonitorandmanageintra-dayliquidity,clearing

channelaccounts,andparticipantpositions.ThePartySearch

Engine component is a look-up tool that provides speedy

accesstobankinformationneededtoqualifyandrepairpay-

ments.

The manual entry and repair system module includes func-

tionality to repair and approve outward payments (i.e. pay-

121


Paymentshavelongbeencentraltoabank’svalueproposi-

tion.However,on-goingcustomizationofthepaymentsindus-

try, the advent of the euro, and the emergence of a Single

EuroPaymentsArea(SEPA),arenowforcingEuropeanbanks

toreconsiderexactlyhowtheirpaymentspropositionsshould

evolve.Emerginginfrastructurestandards,suchasSwiftNet

and EMV, payment solutions, such as EBA Step 2 and

VisaDirect,andboth‘e’and‘m’channelsareallforcingpay-

mentsplayers to faceup tosomekeyquestions relating to

theirbusinessstrategyintheyearstocome.

In order to remain competitive, European banks are being

forcedtomakestrategicdecisionsaboutwhereandhowthey

willoperatewithinthedifferent‘valuewebs’currentlyemerg-

ingacrossthe landscape.Theriseofmorecustomer-centric

paymentssystemsareforcingbankstoreexaminetheirpay-

ment value propositions in light of both changes to market

infrastructuresandtheincreasedcompetitivethreatposedby

fast-movingnewentrants.Thetimewouldappearripeforthe

creationofapaymentutilitiesmodel,designedtoallowbanks

to share costs, minimize risks, and better utilize funds that

wouldhavepreviouslybeensunkintopaymentsinfrastructure

purchases.Yet,theevidenceshowsthatveryfewutilitymod-

elsthusfarhavemanagedtogainsignificanttractioninthis

market. While this track record has not impressed the pay-

ments market to date, there are signs that the situation is

changingandthattherealityofasuccessfulutilityisstarting

tomaterialize.

why BsPs have underperformed so farHistorically,thepaymentsmarkethasbeencharacterizedby

highlevelsofcompetitiveconcentration,withasmallnumber

oflargebanksdominatingdomesticpaymentsprocessingand

clearingbusinesses.Thesestructureshavetraditionallybeen

locallybased.Manyexistingnationalpaymentsystems,whilst

oftenefficientatadomesticlevel,arefragmentedandfailto

satisfyE.U.commissionrequirementsforSEPA.Thearrayof

institutionsthroughwhichpaymentsmustcurrentlypasshas

alsobeenabarriertoefficiencyinthismarket.Theseinstitu-

tions also face a trade-off between processing volume and

unit pricing, with higher unit costs often resulting from the

varietyofmechanismsinplace.

Consequently, the demand for a shared payments business

serviceprovider(BSP)platform,withsufficientscaletoobtain

efficientcostparameters,hasemerged.Theseemergingmod-

elsarecreatingamarketforoutsourcinganddrivingfinancial

institutions to invest in innovative, revenue generating new

ventures.TheseBSPsofferfullservicecapabilities,delivering

bothbusinessprocessesandtechnologyservicestothirdpar-

tiesandarerunbypeoplewithexperience inoperating the

business.Suchplatformswouldrequirethecooperationand

collaboration of a number of nationally dominant players,

workinginconcerttowardacommongoal.Todate,franchise

conflict, substantial implementation costs, and a number of

socialchallenges,particularly incontinentalEurope,haveall

provedtobesubstantialbarriersandthusfarthecostofthese

have outweighed the benefits of large-scale bank collabora-

tioninthepaymentsspace.

SomebankshavedippedtheirtoesintotheBSPwaters,but

genuine success stories are few and far between. In fact, a

reviewofpastBSPventuresrevealaresultsspectrumranging

from underperforming attempts like European Transaction

Bank(ETB),Finforce,andArcordia,throughtopartialsuccess

stories likeProponix.Additionally, therearea fewemerging

ventures where the verdict is still unclear. BSPs that have

failedtobuild thenecessarymomentumformarketsuccess

haveessentiallynotsucceededinattractingthelargenumber

of client banks required for such a scale-driven business

model.Infact,theyhaveneverachievedthemarketcredibility

neededtobuildacriticalmassofparticipanttransactionvol-

ume.TheProponixventurehasenjoyedsomemomentum,but

challenges around market pricing have prevented it from

developingintoafull-blownsuccessstory.Thesemixedmar-

ketresultshaveledtopersistentresistancetotheemergence

ofgenuineBSPs.

Inourexperience, this resistance isusuallydrivenbya fear

among potential players that BSP initiatives might actually

European payment service providers: A race to market and the nature of future victory?1

Julian Wakeham, Partner, CapcoAndrew Hogan, Managing Principal, CapcoHector Nelson, Consultant, Capco

1 ThisisarevisedversionofthearticlepublishedinInternationalPayments,

March2004

123

bringaboutmoreharmthanbenefit.Thereasonsandbarriers

for this are multiple. Firstly, many banks still consider their

technologyandoperationscapabilitiesasvaluablesourcesof

competitivedifferentiation.Inthebattleformarketsharethey

arereticenttoletgoofwhatarebelievedtobecoreassetsby

turningtoBusinessServiceProviders(BSPs)asanalternative.

These organizations have failed to recognize that in many

casesproprietaryinfrastructureisnotcoretotheirbusiness,

asitdoesnotsufficientlydifferentiatetheirofferings.Ifany-

thing, this somewhat antiquated mindset is increasingly

becomingacompetitivealbatross.Inourview,thepersistence

of financial institutions to remain infrastructure owners is

neither realistic nor viable, especially for small players. We

continue to advocate the point of view that, regardless of

governancestructure,thecustomerfranchisebusiness,prod-

uct innovationanddelivery,and infrastructureprovisionwill

needtobeunbundledasthepaymentslandscapeevolvesin

theyearstocome.

Secondly, banks have not yet overcome their reticence to

workcollaborativelywithcompetitorswhenitcomestoout-

sourcing non-core activities. Many players are concerned

about the loss of management control and ownership over

outsourcedactivities.However,alternativesexisttothesim-

plecustomer/providermodelandtheseallowmoreflexibility

intermsofgovernanceandcontrol. Indeedthegovernance

modelofaBSPcanofferaco-ownedorco-sourcedservice,

andassuchcanallowmanyproviderstooperateinanenvi-

ronmentofcooperation.Thesegovernanceoptionsprovidea

viablealternativetoanydominant-playercenteredmodels.

Thirdly, despite increasing cost pressures, the traditional

financial incentive to explore and develop alternative pay-

mentgovernancestructureshassimplynotbeensufficientto

inducewholesalebankstobeginthetransformationprocess.

Morerecently,bankshavecometorecognizeandappreciate

thatthecostsassociatedwithowningallthebusiness‘bun-

dles’describedabovearesuboptimal forallbut the largest

providers. Indeed,organizationsarestrugglingtocopewith

the overwhelming maintenance and development costs

requiredtokeepupwithindustrychanges,suchasCLS,T+1,

Basel II, and the E.U. pricing directive, to name but a few.

There are many examples of payments businesses where

maintenanceandsupportofexisting infrastructureexceeds

80percentoftheavailableITbudget.Banksareslowlycom-

ingtodigestthesecostimplications.

Finally,banks fear that therisks toqualityandcontrol that

are involved might outweigh the benefits of outsourcing.

Theyareafraid todelegateservices thatcould impactcus-

tomersatisfaction, thatSLAs in themselveswill notensure

qualityand that theywill lack theweight to influencedeci-

sions and manage the new interface as required. They are

afraid that the nature of BSP itself will impact quality and

customer satisfaction. Lack of exit options from the out-

sourcingmodeloncethedecisionhasbeenmademagnifies

thesefears.

ThelingeringresistancetoBSPsisbasedontraditionalbank-

ing perspectives on the dynamics of competitive markets.

However, it is the very nature of these dynamics that have

undergonesignificantchangeinrecentyears,particularlyin

theEuropeanpaymentsmarket.Thischangehasbeendriven

by regulators with an increasingly European and customer

protection outlook, challenging the historical balance

between regulation, competition, and cooperation that has

developed in each national market. As such, the change in

regulatorystancewillforcebankstore-thinktheirpayments

models,andconsequentlytheycompeteandcooperate.This,

combined with emerging standards, new technologies, and

increasedcompetitionwilldrivebanksto increasinglyques-

tionthevalueofkeepingpaymentprocessingcapabilitiesin-

house.Theemergenceofinfrastructuresthatunderminethe

valueoftraditionalcorrespondentrelationshipsand,forthe

smallerproviders,theinabilitytofollowtheircompetitorsto

low-cost offshore environments, will compound these argu-

ments. As such, the relationships between traditional com-

petitors are evolving toward more collaborative footings

whenappropriate.Theoldmarketparadigmsareslowlyfad-

ing away as value propositions are being redefined around


customers,costpressuresaremounting,and issuesaround

qualitystandardsofexternalpartnersarebeingredefined.

change is in the airAgainst this backdrop, we see the emergence of three pay-

mentBSPmodelsinthenottoodistanthorizon.Thecommon

themeacrossallthreeofthesemodelsiscustomer-centricity,

and if implementedcorrectly theywillhave thepotential to

liberateadimensionofvaluebeyondcostbenefitsandequity

participation.Acceleratedtop-linerevenuegrowthconstitutes

a third dimension of value, and is a direct outcome of the

markedincreaseinqualitythatwillcharacterizewinningBSP

modelsof the future.Higherqualitystandardswill translate

into higher degrees of customer loyalty, and ultimately cus-

tomer-spend, which will be achieved through improved spe-

cializationandmanagerialfocus.

Bank-centric model (Fi insourcing) — Many banks are

acknowledgingthebenefitsoffocusingonscalethroughcen-

tralization, shared services, and efficiency service offerings.

WeseethisinthecurrentmarketwithbothCitibankandABN

Amroaugmentingtheirrespectivepaymentsservicedelivery

tolargecorporatecustomersbycreatingutilities,accesspor-

tals, and support for exchange and marketplaces. Deutsche

Bankisalsoleadingthedevelopmentoffull-servicedistribu-

tion channels, leveraging their strong retail and wholesale

clientbases,aswellastheirabilitytomeetthedemandsfor

unified services across products and markets. These strate-

gies are allowing banks to solidify their market positions as

paymentssystemsbecomeincreasinglyinterconnected.

Joint venture model — Market forces are challenging the

traditional payment system continuum. Non-traditional pro-

vidersarechallengingincumbentsystemsandpaymentmar-

ketsareincreasinglyresponsivetopaymentprovidermodels

thatcombinethestrengthsofworld-classbankswithglobal

solutions and technology providers. The partial success of

AMS’sPROPONIXofferingisatestamenttothisfact.Thesuc-

cessof iPSL— theU.K.-based joint venturebetweenUnisys,

Barclay’s,LloydsTSB,andHSBC,whichseekstocreateeffi-

ciencies and cost reductions by managing routine business

functions—isyetanotherexample.iPSLnowhandlesnearly

70percentofallchecksprocessedintheUnitedKingdomand

istrulytransformingbusinessoperations,allofwhichdemon-

strates thatanumberofbankscancollaborate successfully

withalargetechnologypartner.

infrastructure-centric model—Theemergenceofnewpay-

ment infrastructure platform players — EBA Step 2/3,

VisaDirect,anddomesticplayerswithinternationalambitions

— is demonstrating a trend toward making payments both

moreregionallyorientedandcustomerfocused.Marketinitia-

tivesseekingtodrivecommonmessagingstandards—IBAN&

BIC, MT103, RosettaNet, and TWIST — are becoming more

prevalent,drivingautomation,andallowinginfrastructurepro-

viders to get closer to the end customer. Additionally, many

incumbentsare increasinglyenhancingtheirmarketproposi-

tionstooffervalue-addedservices,bothadvisoryandprocess-

ing.

developing a framework for successNewlyestablishedbusinessstrategiesareshiftingbanksfrom

‘infrastructure compliance’ to ‘business enhancement’ and

drivingtherealignmentofbankoperatingmodelstosupport

thistransformation.Higherservicelevelsandcostsavingsare

being achieved through cohesive sourcing strategies which

support a bank’s operating model through the utilization of

outsourcingandoffshoring.Theframeworkforsuccessthus

lies in developing the case for a BSP solution that demon-

strates substantial long-term benefit while simultaneously

beingviableintheshort-tomedium-term.Thebenefitmust

outweigh the implementation complexity and any related

downsidefromsocialandsystemupheaval.

Thus,beyondacompellingfinancialmodel,non-captiveBSPs

shouldadditionallybedesignedfromtheoutsettoprice ‘at

market’ratherthanbeacost-transfermechanismforincum-

bentinstitutions,haveagovernanceandconsequentlypric-

ing structure that support open and ubiquitous usage, and

fromtheoutsethavecredibility intermsofcapabilitiesand

125

longevity. Evenwiththesecriteriafullysatisfiedthereisafinalhurdle.

ThecomplexityofprovidingapaymentBSP lies inthecom-

plexityofthebroaderserviceproposition.Whilsttheunderly-

ing payment processes are commodity processes, the cus-

tomerservicelayerandsupportingtransactionconditionscan

createsignificantcomplexity.Thiscomplexity is,however,at

theheartofwhatcustomersvalueandthereforeformulates

an important dimension on which banks can differentiate

themselves from their competitors. BSP providers must be

able to either handle these complexities or allow their cus-

tomerbankstohandletheminmoreefficientways.

ThedynamicsofthepaymentsmarketinEuropeareevolving

at increasingly rapid rates.Customer, competitive, technical,

and regulatory pressures are forcing payment providers to

re-examine the basis on which they design and ultimately

deliver customer propositions. Traditional forms of gover-

nance and structure are being replaced with innovative

arrangements,ofteninvolvingeithercompetitorsturnedcol-

laboratorsornon-traditionalpaymentsplayers,orevenboth.

Standingstillandwatchingthesedevelopmentsfromtheside-

lines can no longer be a viable strategy for European pay-

ments providers. Understanding the nature of the changing

gameandpositioningforsuccessonthebasisofadisaggre-

gated value-chain has for many become the only feasible

means for long-term survival in the European payments

space.

Future


Harry leinonenAdviser to the Board, Financial Markets,

Bank of Finland1

Abstract

In order to increase the efficiency of payment systems the

opportunities of new technologies need to be employed.

IntegrationofcustomersICTsystemsandthoseofthebanks

need to be improved in particular. Internet technology pro-

videsnewpossibilitiesfordirectend-to-endcontactsbetween

all participants in the payment processing chain. Making an

e-paymentcouldbemadeaseasyassendingane-mail.This

articledescribesthestepsandchangesthatare, ingeneral,

necessary in order to transform national paper-based pay-

mentconventionsintointernationalnetwork-basedsolutions.

Wewillneedaninternationalaccountaddressingsystemand

anopennetworkbetweenserviceproviderstotransportwell-

standardized payment messages, including the inter-bank

settlement.

1271 Theviewsexpressedarethoseoftheauthoranddonotnecessarilyreflectthe

viewsoftheBankofFinland.


decentralized infrastructureThenetworkenvironmentisdecentralizedandtelecommuni-

cationbuildsbridgesbetweenthedifferent independentbut

interoperable entities in the network. With regards to pay-

ments,thesebridgesmusttransferpaymentmessagesaswell

as inter-bank settlements. This is the main difference with

other messaging systems. In a decentralized network-based

environmentthesettlementmethodalsoneedstobedecen-

tralizedinordertobeefficient.Inthisenvironment,thesettle-

mentmethodwillneedtoentailimmediatefinalitybetweenall

the different participating service-providing institutions

(mainlybanks).Thenewe-settlementmodel introducesnew

automated and electronic possibilities for inter-bank settle-

ments.E-settlementisaproposednewsettlementmethodfor

thenextgenerationofpaymentsystems,whichcannonethe-

lessbeemployednowincurrentpaymentsystems.

Theinter-banksettlementprocessitselfwillhavetobeawell-

integratedpartofthepaymentprocess,withend-to-endcon-

trolfromsendingtoreceivingbank.Inordertosupportrapid

paymenttransfers,thesettlementmethodmustalsosupport

real-timeprocessing.Anefficientsettlementsystemalsosup-

portscontinuousreconciliationforimmediateerrordetection.

Itisalsoimportantthatmostofthesecurityandcontrolfea-

turesbebuiltintothesystem,toenableimmediatereaction.

Thee-settlementprocessisdesignedtosupportandaccom-

plishfinalinter-banksettlementincentralbankmoneyinreal-

timeforend-to-endpaymentsinstraight-through-processing

(STP) mode. It should be seen as one essential part of the

wholepayment(credittransfer)circle(Figure3).

InFigure3, (1) thepayer receivesabill orother instruction

from thebeneficiaryconcerningapayment tobemade. (2)

Thepayerthensendstheinstructiontohisbankforprocess-

ingandroutingtothebeneficiary’sbank.(3)Thisinter-bank

leg includes e-settlement, so that the beneficiary’s bank

receivesboththepaymentmessageandthefinalsettlement.

(4)Thebeneficiary’sbankcantheninformthebeneficiaryas

totheincoming/finalpayment.

128 - The Journal of financial transformation 2 SeeforIBAN-informationThomsonFinancialPublishingwebpage:www.tfp.com/

payment.shtmlandtheEuropeanCommitteeforBankingStandards(ECBS)web-

page:www.ecbs.org

TcP/iP

internet-

network

Bank 1Payment/account

server


server


server

Bank nPayment/account

server

Payment

Payment

Payment

Payment

Figure1:Directinterbankcommunicationinanetwork-basedinfrastructure

Figure2a:Paymentscanbemadeby

transferringfundsbyaddressingdirect-

lythereceivingaccountinacommon

accountnumberspace.

Figure2b:Thecommonaccountnumber

spaceisdividedintosub-spacesbelong-

ingtoserviceproviderswhicharecon-

nectedviainteroperablesystembridges.


129

Current payments clearing conventions, although they now

use electronic automation, have evolved out of paper-based

physical processing and transportation. In order to further

increaseefficiencyandimproveservices,thepaymentsystems

needtobereengineered.Themaindriversforchangewillbe:

■ Thepossibilitiesofmodernnetwork-basedreal-timepro-

cessing.

■ Theneedforaclearanduniversalaccountnumbercon-

vention.

■ Thebenefitsofadirectdecentralizedinter-banksettle-

mentfacility,e-settlement.

Thenew technologyof telecommunications,mainly Internet

technology (TCP/IP) based networks, security facilities like

publickeyinfrastructure(PKI)andhardwaresecuremodules

(chipcardsorsecurePCcards),real-timeprocessing,lowcost

andefficientserverhardware,andmanyothersfactorswillbe

thebasisforthisreengineering.

connecting networksToday everybody is connected via networks. Using Internet

ande-mailwecansenddifferentkindsofmessages,invirtu-

ally real-time, to most of the bank employees in the world.

However,welackthesepossibilitiesforpaymentmessages.By

extendingthedecentralizednetworkconceptoftheInternet

topaymentsusingsecureanddedicatedTCP/IPnetworkslike

SWIFTnet,wecanbuildanewend-to-endandSTPpayment

processwithoutanyinterveningclearingandsortingcenters.

Thenetworksortsthepaymentsbytransportingthemtothe

given network address in the same way that an e-mail is

routedtothegivennetworkserver.Inthee-mailsystembanks

have e-mail/mailbox servers. In a network based payment

systemsbankswillneedpayment/accountservers,otherwise

theconceptisverysimilar.

international account number (iBAn)Inorder to routepaymentmessagesefficiently, innetwork-

basedsolutionsaswellasinanytraditionalsystem,weneed

auniversalaccountnumberconventionthatclearlyindicates

theaddressofanyaccountinthesystem.Thiscouldbecom-

paredtotheaddressofmailboxesontheInternetorinterna-

tional GSM telephone numbers for routing SMS messages

internationally(Figure2a).Aninternationalaccountnumber

(IBAN) seems to have become the preferred option. If all

banksimplementIBANsproperly,thecustomerwillonlyneed

tostatethecorrectIBANandthepaymentwillberoutedto

therightaccount.Thiswillrequirethesystemstohavesearch

tablesfromwhichtherightBIC,bankname,networkaddress,

etc.,canbefoundbasedontheIBAN.Thesekindsofmodules

andsearchtablesareemerging2.Withoutauniversalaccount

number-space,efficientcross-borderSTPcannotbereached.

Interoperablebridgesareneededtoroutepaymentsbetween

theaccountsofdifferentserviceproviders(Figure2b).

Payer’s bank Beneficiary’s bank

Payer Beneficiary

Figure3:E-settlementispartofthecredittransfercircle,whichprovides

efficientelectroniccommunicationsbetweenparticipantsinapayment.

4

2

3

1

including e-settlement

E-billing

E-banking

Bank-to-bank

Customer-to-customer

Customer-to-bank Bank-to-customer statementsreceipts


inter-bank networkAdedicatedinter-banknetworkisneededtolinktogetherall

participatingbanksandthecentralbank, forthepurposeof

processingpayments.Theinter-bankpaymentnetworkisthe

essentialpartofanetwork-basedpaymentsystem.Allbanks

canaddresseachotherdirectlyandsendpaymentstoeach

otherwithoutacentralizedprocessingandroutingsite.Thisis

theessentialnewparadigmintroducedbyInternetcommuni-

cations(TCP/IP-networks).Allparticipantscanoperate inde-

pendently; they only need enough networking capacity to

meettheirownneeds.Systemadministrationisneededonly

foradministrationpurposes,not,say,forpaymentprocessing.

ThenewSWIFTnetnetwork,introducedbySWIFT,isonethat

cansupportdirectcommunicationsbetweenallparticipants.

Therearealsonationaldedicatedpaymentnetworkswiththe

samecapability,suchastheinter-banknetworkPankkiverkko

inFinland.

immediate liquidityFor settlement purposes, banks need liquidity. Liquidity is

transferred by the central bank to the system (i.e. e-settle-

ment modules) at the start of the day. It can be increased

during thedayby thecentralbankvia liquidity transfersor

paymentstothebanks.Attheendoftheday,liquidityistrans-

ferredbacktothecentralbank.Theliquidityinthesettlement

modulesisthuscomposedofpositivebalancesofcentralbank

money,originally inthetraditionalformofreservedeposits,

intraday credits, etc., but transferred from the centralized

systeminthemorningtodistributede-settlementmodulesto

beemployedduringthedayinthee-settlementsystem.Inthe

eveningtheliquiditywillbetransferredbacktothecentralized

accounts for overnight bookings. When inter-bank payment

systems provide at some point in the future a 24hour/7day

service, as has been predicted, the e-settlement modules

couldstarttoruncontinuouslybyonlyreportingthebalance

attheturnofaccountingday.

Inatruereal-timeenvironment,thereisgenerallylittlescope

for the various types of liquidity saving features, based on

delayingorqueuingofpayments.Customersarewaitingfor

direct confirmation of their payments. A bank that is often

obliged to inform its customers that payments are queued,

thatitiswaitingforliquidity,willlosecustomers.Inthereal-

timeenvironment,customersexpectdirectdelivery.

Still, the e-settlement module could contain basic queuing

facilities for situations in which the available liquidity is not

sufficient or customers are willing to accept delays. These

wouldbedecentralizedqueues,designedfordifferent levels

ofcomplexity.Bilateralnettingcouldbeaccomplishedinthe

distributed e-settlement system through bilateral netting

requeststocheckwhethertherearetransactionsalsoqueued

at the other end. Multilateral netting requires a centralized

nettingagent.Differenttypesofnettingandadvancedliquid-

ity saving featureswouldcomplicate thesystem. It isadvis-

able to keep the basic system very simple; possible add-on

servicesshouldbeprovidedseparately.

High security and availabilityThe system's security features must be carefully designed.

The settlement balance and all security keys need to be in

tamper-resistant environments and all the encryption algo-

rithmsmustbehighlyreliable.Thereshouldbenopossibility

ofsystemintrusion,andanytypeofhackingshouldbeimme-

diatelydetectable.Thesystemwillbeclosed,withsettlement

money circulating among a limited number of trustworthy

users. The system will include automated reconciliation at

end-of-day,fromtimetotimeduringtheday,andinconnec-

tionwitheachtransaction. Inanetwork-basedenvironment,

allparts,centralizedanddistributed,mustbewellsecured.A

digital/electronicversionofthefour-eyesprinciplehastobe

implemented.

Twodifferentcontrollingprogramsandtwodifferentencrypt-

ed and tamper-resistant storage devices protect the money

balances. The separate controlling functions are monitoring

each other so that there are no individual IT developers or

developmentteamsthathaveallthenecessaryprogramming

code in their possession. In case of intrusion attempts, all

criticalinformationwillbedestroyedatthatsiteandtherewill

130


Thiscredit-push/credit-transfer typeofpayment is themost

convenientandefficientinthenetworkreal-timeworld.Ithas

fewer processing and transportation legs than electronic

credit/debitcardpayments,directdebits,orelectronicchecks.

In credit transfers, the payer’s bank identifies its customer,

checks the payment instruction, and debits the payer’s

account; the beneficiary’s bank checks the settlement and

creditsthebeneficiary’saccount.Inthefuturereal-timeworld,

paymentswillbeprocessedwithinsecondsinthesamewayas

e-mailandSMS-messagesarenowprocessed.

An e-settlement solutionThee-settlementsolutionshouldbeseenaspartofthefuture

paymentinfrastructurethatwillsupportanincreaseine-com-

merceviatheInternet,real-timesecurityandmoneymarket

deals and transfers, mobile payments (currently GSM-based

butsoonUMTS-based),andcross-bordervolumes.

Thepaymentworld(forallkindofpayments)willbechanging,

aswillallothermessagingsystems,fromslower-pacedbatch

processingtoimmediatereal-timeservice,integrateddirectly

withusersystemsinaglobalnetworkcommunity.

E-settlementprovidesasolutionthatcanbeintegratedinto

currentsystems,usingapartof theexisting infrastructure,

andhenceitfacilitatesagradualchangefromcurrentstruc-

turestonewe-basedones.Thefundamentalideaofe-settle-

ment is attachment of a digital e-settlement stamp to the

currentpaymentmessages.Thee-settlementstampisadded

tothepaymentmessageandservestotransfercentralbank

moneyfrompayer’sbanktobeneficiary’s.Finalsettlementis

part of the payment message, in the form of an electronic

centralbankdraftorcentralbanke-cashforinter-bankset-

tlementpurposes.Theelectronicstampwillaccompanythe

payment on its route through the inter-bank payment net-

worktothereceivingbank.Theelectronicstampcanbeseen

asamodernversionofacentralbankdraft.Itisthecoverin

centralbankmoneyofthepayment(s)itaccompanies.

The stamp is protected by very strong and modern crypto-

graphictechnology(e.g.,PKI).Thesestampsareproducedand

decoded by e-settlement modules situated close to banks’

paymentsystems.

The e-settlement modules are tamper-resistant devices pro-

vided by central banks to each bank. These are closely inte-

grated with banks’ payment systems, for example, directly

integrated with the SWIFTnet access platform (CBT). This

makes settlement transfers a highly automated part of pay-

mentprocessing. Integratingthenewsettlementprocesswill

be quite straightforward, given that it will be done on the

access platform (e.g., SWIFT CBT) level. In traditional RTGS

systems,banks’settlementaccountsarelocatedinthecentral-

ized RTGS system. In the e-settlement system, each bank’s

settlementaccountisdistributedtothebank’sownprocessing

site in a central bank controlled e-settlement module. This

moduleshouldberegardedasacompletelyautomatedcentral

bank branch serving one customer with one account. Each

bank has access to its own account, as before, but is much

morecloselyintegratedinamoreautomatedandefficientway.

Thedistributionofcentralbankmoneyinelectronicformatto

banks’ payment platforms is the essential feature of the

e-settlementapproach.Thedistributinge-settlementmodules

needtobehighlysecureandneedtomeetatleastthesame

security standards as do traditional RTGS systems. The sys-

temshouldalsobegenerallyopenand independent,tosup-

portthevariouspaymentnetworksusedbybanks.

131


beasecurityalerttothesystemadministrator(s).

Highavailabilitymustalsobeensuredinthedistributedsys-

tem. In a distributed system, a malfunction will generally

affectonlyoneparticipantatatimeandonlythosepayments

toandfromthatparticularparticipant. Inorderforthepar-

ticipanttoreestablishnormaloperationsquickly,thereshould

beback-upsandmirroreddevicesforallcriticalcomponents.

Redundantinformationinthee-stampsgivesthepossibilityto

parsetheinformationofcompletelydestroyedIT-sites.Italso

supports a direct switch of functionalities and services to

workingpartsofthenetwork.Thismakesdistributedsystems

morerobustthantraditionalcentralizedsystems.

The benefitsThemainbenefitofe-settlementisthatitenablesredesignof

thewholepaymentsystemprocessinanefficientway,using

newnetworkpossibilities.Ittherebycreatesthenextgenera-

tionofpaymentsystemsinfrastructuresandmakesthesettle-

ment process more efficient. Payment systems will change

considerablyinthenearfutureduetomoderntechnologyand

itwouldbeanadvantage tomodernize the settlementcon-

ventionsatthesametime.

Thedecentralizednetwork-basedmodelfacilitatesdirectreal-

time communication. General standards will result in a STP

process.Thebestexampleisthecurrente-mailsystemandits

standards.Theseareappliedworldwideandgiveareallylow

cost, efficient, and rapid communication system. The e-mail

costs are so low that they are considered to be part of the

generaloverhead;nobodybotherstoreportthemseparately.

Thesametypeof infrastructurewithadditionalsecurityele-

mentsandthesettlementfunctioncouldbedevelopedforthe

paymentsector.

Thecost-advantageofthee-settlementsystemis inthe low

processing costs of adding the e-settlement stamp that

enables instant final settlement in central bank money. The

extraprocessingcostofaddingthee-settlementstampwillbe

practicallyzero.Itwillbeanintegralpartofthepaymentpro-

cessitself.Banksneedonlyinvestinlowcostequipment.The

verylowtransactioncostsofe-settlementwillenablebanksto

alsotransferpaymentflowsfromcentralizedprocessingcen-

ter systems to more efficient decentralized network-based

communications.

The bottlenecks created by centralized resources will disap-

pearandeventhedependenceoncriticalcentralizedresourc-

es will be dramatically reduced. E-settlement could offer a

solutionforintegratingtheeuro-zoneareapaymentsystems,

andamulti-currencyversioncouldserveanevenlargerarea.

Inorder toachieve large-scalebenefitsvia thee-settlement

model, the number of participating banks and the payment

flowsmustbesufficientlylarge.

The e-settlement approach will also reduce settlement risk,

becauseallsettlementsaredoneincentralbankmoneywith

immediatefinality.Thereconciliationandcontrolfunctionsin

thesystemwillalsoreducethepossibilityforerrorsoratleast

speeduptheprocessforfindingthem.Ingeneraldecentral-

izedsystemsaremorerobustthancentralizedsystems.

1323 TheresultsoftheprototypeprojectarepresentedattheBankofFinland’sweb

sitewww.bof.fi/sc/e-settlementandinLeinonen,H.,V-M.Lumiala,andR.Sarlin,

2002,“Settlementinmodernnetwork-basedpaymentinfrastructures–description

andprototypeofthee-settlementmodel,”theBankofFinlandpublicationDP23.

Furtherinformationaboutdevelopmentsinpaymentsysteminfrastructurescanbe

foundinLeinonen,H.,2000,“Re-engineeringPaymentSystemsfortheE-world,”

theBankofFinlandpublicationDP17,andinPaymentSystemsWorldwidemaga-

zine,SpringandSummer2000issues.

Future


Francesco saitaAssociate Professor, Financial Markets and

Institutions Department, università Bocconi

Abstract

Debitcards’role,eitherusedatATMsoratmerchants’point-

of-sale, in payment services provisions by banks has been

studied by many researchers before the development of

Internetbanking.Yet,byanalyzingdataonrecentevolutionof

debitcards’diffusionandusageacrossmajorcountries,debit

cardsshowinterestingevolutionpatterns.Istherestillarole

fordebitcardsinbanks’strategiesonpaymentsystems?This

paperdiscusses thisproblembyanalyzingwhybanksmight

invest indebitcards’developmentandexaminingwhichfac-

torsinpracticemaymakethemverycautiousindoingso.

133

1 Bansal,P.,2002,“KeepYourCostsDown,”TheBanker,March,125

2 Bansal,P.2002,“Multi-mediaDifficulties,”TheBanker,March,124.


newchannelwasslowerthananticipatedandthat itsshort-

termbenefitsforbanks’P&Lshadoftenbeenoverstated.This

hasalsoledsomebankstoconsider,withmuchmorecaution,

investments in new alternative distribution channels, recon-

sidering the benefits deriving from the traditional branch

networks2.Thiscaution,andsometimesthedisenchantment,

aboutnewchannelsalsohasan impacton thestrategies in

thepaymentbusinessandon thewillingness topursueand

introduceinnovationsinthefield.

Inthispaper,Iaimtodiscusstheroleofdebitcardstosupport

abank’sstrategyinthepaymentservicesbusiness.Therea-

sonwhythiscouldbeinterestingisthatwhiletheyhavebeen

amajordriverforchangeandwereatthecenterofthedebate

abouttechnologicalinnovationbeforethebirthoftelephone

andInternetchannels,theirpopularityamongbankmanagers

has fallen in recent years. While telephone and especially

Internet banking were attracting major attention and by far

the largest share of banks’ investments in new distribution

channels,debitcards,togetherwithATMsandPOSterminals,

onlyremainedinthebackground.Atpresent,then,afterreal-

izing that thee-commercegrowthwascertainlynotaspro-

foundasmanyhadthought,andthatasubstantialpartofin-

storepaymentscannotbesubstitutedbypayments through

theInternet,itispossibletohaveadebateaboutwhether,and

uptowhatextent,debitcardsmaystillrepresentasignificant

opportunityforbanksinthepaymentservicesarena.


cards with a cash function cards with a debit function cards with a credit function cards with an e-money function

2001 2002 2001 2002 2001 2002 2001 2002

Belgium 1361 1442 1217 1306 296 294 778 800

Canada Nav nav Nav nav 1510 1653 2 2

France 711 741.5 652 684 Nav Nav 5 14

Germany 1480 1443 1252 1129 381 391 818 819

Italy 429 477 404 459 345 375 1 5

Japan* 2554 2603 Nav Nav 1820 1919 Nav Nav

Netherlands* 1608 1635 1315 1338 312 316 1309 1078

Sweden* 536 643 542 549 419 472 63 55

Switzerland 1191 1232 745 789 452 454 485 502

u.K. 2247 2400 920 1004 951 1066 nav nav

u.S.A. 2886 2996 888 902 4322 4355 nav nav

*Dataoncardswithacreditfunctionincludecardswithadelayeddebitfunction.

Figure1:Numberofcardsperthousandinhabitants

Source:CommitteeonPaymentandSettlementSystems(CPSS),RedBookStatisticalUpdate,March2004.


135

Retail payment services have always been important for

banks,notonlybecausethesupplyofpaymentserviceshas

been fundamental in their development in the Middle-Ages,

butalsobecausepaymentservicescurrentlyrepresentabusi-

ness area with a substantial impact on banks’ profitability.

Accordingtoa2002studybyBostonConsultingGroup, the

payment business accounts for up to 35% of revenues and

40%ofcostsforbanks1.Asaconsequence,manybankshave

overtimedevotedsignificanteffortandinvestmentinorderto

increase revenues and reduce costs deriving from the pay-

ment business. The development of new channels, such as

ATMs, POS terminals, telephone, and Internet banking, has

representedaclearopportunitytopursuethoseobjectives.

Atthesametime,newchannelsdidnotalwaysfulfilltheper-

hapswishfulandoptimisticexpectationsof increasedprofit-

abilitythathadbeenformulatedexante.Aftertheendofthe

period of over-enthusiasm about Internet banking, many

observersagreedthat thedevelopmentof the Internetasa

cAgR of ATms

per country,

1998 2000 2002 1998-2002

CPSS average 648 794 927 9.4%

u.S. 677 967 1220 15.9%

u.K. 421 563 690 13.1%

Switzerland 642 675 706 2.4%

Sweden 281 295 297 1.4%

Netherlands 418 435 466 2.8%

Japan 934 922 895 -1.1%

Italy 487 549 683 8.8%

Germany 556 580 612 2.4%

France 490 580 637 6.8%

Canada 778 1037 1272 13.1%

Belgium 564 657 683 4.9%

Figure2:NumberofATMspermillioninhabitants

Source:CommitteeonPaymentandSettlementSystems,RedBookStatistical

Update,March2004.

Note:CPSSaverageisaweightedaverageofthecountriesincludedinthe

CommitteeonPaymentandSettlementSystemsstudy,andalsocomprises

SingaporeandHongKong.

cAgR of Pos

terminals per

country,

1998 2000 2002 1998-2002

CPSS average 6136 10862 12040 18.4%

u.S.A. 6157 10976 12128 18.5%

u.K. 10462 12533 13691 7.0%

Switzerland 7158 9369 10976 11.3%

Sweden 8406 9822 11439 8.0%

Netherlands 8533 9774 10972 6.5%

Italy 6001 9878 14109 23.8%

Germany 4423 7194 5584 6.0%

France 12047 13848 15620 6.7%

Canada 13024 14231 15737 4.8%

Belgium 9121 11346 13136 9.5%

Figure3:NumberofPOSterminalsformillioninhabitants


Update,March2004.

Note:dataforJapanareunavailable

cAgR

1998 2000 2002 1998-2002

CPSS average 25.4 28.4 25.6 0.2%

u.S. 40.6 45.3 36.7 -2.5%

u.K. 31.7 34.5 38.3 4.8%

Switzerland 11.3 18 21.5 17.4%

Sweden 37.6 36.2 36 -1.1%

Netherlands 27.1 29.5 29.7 2.3%

Japan 3.1 3.2 2.9 -1.7%

Italy 8.5 9.1 10.9 6.4%

Germany 17.1 20.4 19.7 3.6%

France 15.5 17.9 19.8 6.3%

Canada 47.5 48.4 45.6 -1.0%

Belgium 15.6 19.8 23 10.2%

Figure4:NumberoftransactionsatATMsperinhabitant


Update,March2004.


possibletoseethatthedispersionacrosscountrieshaseven

increasedbetween1998and2002,especiallyduetothestrik-

ingly high growth rates of ATM terminals in the U.S. and

Canadainparticular,thathavebeenreplicatedinEuropeonly

bytheUnitedKingdom.Inanycase,allcountriesexceptJapan

show a clear tendency to an increase in the availability of

terminals;overall, thenumberofATMsinthecountriescov-

eredbytheCommitteeonPaymentandSettlementSystems

reportin2002was40%higherthanfouryearsbefore.

ThepictureconcerningtheavailabilityofPOSterminalsalso

shows clear differences between countries, even if in this

case differences seem to be smaller and many European

countries appear to be in leading positions. Among those,

particularlyremarkableisItaly’scompoundedannualgrowth

rate of 23.8%, with POS terminals more than doubling

between1998and2002.

WhilethedatainFigures1,2,and3seemtoprovideaclear

overallpictureofthecountrieswherecardshaveamajorrole,

it isinterestingtolookcarefullyatthedataconcerningcard

usage(Figures4and5).ForATMs,whileCanada,U.K.,andthe

U.S.areamongthecountrieswithmoreATMsperinhabitant

and have a higher usage rate, variations in the number of

transactionspercapitaaremuch lowerthanchanges in the

numberofavailableterminals.Theoppositehappensinstead

forPOStransactions.Asaresult,bycombiningthedata,itis

possible to assess that while ATM productivity in terms of

number of transactions per terminal has generally been

decreasing (with the remarkable exception of Switzerland),

POS terminals have continued to face a significant growth

(Figures6and7).

ByobservingthedatainFigure6and7therearemanyinter-

esting elements that emerge. First of all, the two countries

thatexperiencedthehighestgrowthinATMtransactionsper

inhabitant,SwitzerlandandBelgium,didnotattainthisobjec-

tivethrougharemarkableincreaseinthenumberofavailable

terminals, but by simply increasing their productivity. This

suggeststhatinvestmentoncustomereducationorappropri-

atepricingstrategiesmaybemoreeffectivethanaggressive

strategiesconcerningthenumberofavailableterminals.Itis

alsoworthnotingthatthecountrieswiththemostremarkable

growthinthenumberofATMspermillioninhabitants(Canada,

U.K.,andtheU.S.)notonlyexperiencedasubstantialdecrease

in ATM productivity, but in two cases also registered a net

decreaseinthenumberoftransactionsperinhabitant.

Data on POS productivity are different, since all countries

experiencedsuchasignificantgrowthinthenumberoftrans-

actions per inhabitant that productivity increased every-

where. There is also a positive correlation between the

growthintheterminalsnetworkandthegrowthinthenum-

beroftransactionsper inhabitant(asopposedtothenega-

tive correlation that existed for ATMs). Yet, expanding the

POS network is clearly not the only way to increase debit

cardstransactions:ItalyandSwedenexperiencedthehighest

growthintransactionperinhabitant,butSweden’sgrowthin

thenumberofterminalswasonlyaround30percent.Atthe

sametime,Italyitselfnowhasaterminalbaseperinhabitant

higherthanallotherEuropeancountriesexceptFrance,and

yettheproductivityofitsterminalsislowerthan25%ofthe


cAgR

1998 2000 2002 1998-2002

CPSS average 18.3 27.2 39.1 20.9%

u.S. 20.8 33.8 54 26.9%

u.K. 30.3 40.7 51.7 14.3%

Switzerland 14.9 23.9 30.8 19.9%

Sweden 18.1 28.9 57.1 33.3%

Netherlands 37.9 50.3 66.2 15.0%

Italy 3 5.5 9.5 33.4%

Germany 8.2 12.7 16.7 19.5%

France 43 54.3 66.9 11.7%

Canada 44.8 63.7 76.4 14.3%

Belgium 29.1 39.8 52.1 15.7%

Figure5:NumberoftransactionsatPOSterminalsperinhabitant


Update,March2004.


Ofcourse,whendiscussingthistopicwemustconsiderthat

thediffusionandusageofcardsismarkedlydifferentacross

countries,andsoisobviouslythepotentialforimprovement.

Forthisreason,wewillstartbyanalyzingdataconcerningthe

penetrationofcards,theavailabilityofterminals,andcards’

usageacrossmajorcountries.Wewillthendiscussthepoten-

tialbenefitsbanksmayexpectfromneweffortsincards’dif-

fusion and examine the obstacles that might prevent banks

frominvestingsignificantlyinthedebitcardbusiness.

debit cards diffusion and usage across countries: Key data and trendsThediffusionofcardsacrossdifferentcountriesis,asonemay

expect,significantlydifferent,duetoanumberofreasonsthat

arelinkedpartlytostructuralcharacteristicsofthefinancial

system (i.e. different households’ attitude towards financing

purchases with debt that may help explain differences in

credit cardsdiffusionandusageacrosscountries), partly to

the history of the banking system (i.e. the development of

alternative competing ATM networks that may require the

customertoholdmultipledebitcards,orthedevelopmentof

auniquenationalATMnetwork),andpartlytothecharacter-

isticsofretaildistributionnetworkofgoodsandnon-financial

services(sincethe levelofconcentration, the importanceof

big distribution networks, and the average size of retailers’

facilitiesmayimpactthespeedofadoptionofnewmeansof

payment). The overall recent picture of cards’ diffusion is

reported in Figure 1, where it is possible to note that while

there is a huge difference, as far as credit cards are con-

cerned, between Japan and Anglo-Saxon countries on one

sideandremainingEuropeancountriesontheother,thesitu-

ationissomewhatmoremixedasfarasdebitcardsarecon-

cerned, where countries such as Netherlands, Belgium and

Germanyhaveaclearleadingposition.

Asforcards’diffusion,eventhenumberofterminalsavailable

forcardusageismarkedlydifferentacrossmarkets.Figure2

reportsthenumberofATMspermillioninhabitants,anditis

137

Transactions per terminal Var% Terminals Trans-

cAgR actions/

inhabitant

1998- 1998- cAgR

1998 2000 2002 2002 2002 1998-2002

Belgium 27,660 30,137 33,675 21.7% 4.9% 10.2%

Canada 61,054 46,673 35,849 -41.3% 13.1% -1.0%

France 31,633 30,862 31,083 -1.7% 6.8% 6.3%

Germany 30,755 35,172 32,190 4.7% 2.4% 3.6%

Italy 17,454 16,576 15,959 -8.6% 8.8% 6.4%

Japan 3,319 3,471 3,240 -2.4% -1.1% -1.7%

Netherlands 64,833 67,816 63,734 -1.7% 2.8% 2.3%

Sweden 133,808 122,712 121,212 -9.4% 1.4% -1.1%

Switzerland 17,601 26,667 30,453 73.0% 2.4% 17.4%

u.K. 75,297 61,279 55,507 -26.3% 13.1% 4.8%

u.S.A. 59,970 46,846 30,082 -49.8% 15.9% -2.5%

CPSS average 39,198 35,768 27,616 -29.5% 9.4% 0.2%

Figure6:ProductivityofATMterminals

Source:ElaborationondatafromCPSS,RedBookStatisticalUpdate,March2004.

Transactions per terminal Var% Terminals Trans-

cAgR actions/

inhabitant

1998- 1998- cAgR

1998 2000 2002 2002 2002 1998-2002

Belgium 3,190 3,508 3,966 24,3% 9,5% 15,7%

Canada 3,440 4,476 4,855 41,1% 4,8% 14,3%

France 3,569 3,921 4,283 20,0% 6,7% 11,7%

Germany 1,854 1,765 2,991 61,3% 6,0% 19,5%

Italy 500 557 673 34,7% 23,8% 33,4%

Japan nav nav nav nav nav nav

Netherlands 4,442 5,146 6,034 35,8% 6,5% 15,0%

Sweden 2,153 2,942 4,992 131,8% 8,0% 33,3%

Switzerland 2,082 2,551 2,806 34,8% 11,3% 19,9%

u.K. 2,896 3,247 3,776 30,4% 7,0% 14,3%

u.S.A. 3,378 3,079 4,453 31,8% 18,5% 26,9%

CPSS average 2,982 2,504 3,248 8,9% 18,4% 20,9%

Figure7:ProductivityofPOSterminals

Source:ElaborationondatafromCPSS,RedBookStatisticalUpdate,March2004.

3 Feescanalsobelessevidentincaseswhenthecustomerischargedbythebank

alsoonthebasisofthenumberoftransactionsonhisbankaccount,orthenum-

beroftransactionsoveracertainthreshold.Inthiscaseacustomerthatuseshis

debitcardfiveorsixtimesatPOSterminalsinsteadofwithdrawingcashonceand

payingthemerchantsincashisclearlygeneratingahigheramountoffeesforthe

bank,evenifheprobablydoesnotperceivethedebitcardascostly.

4 Atkins,W.,2004,“IsDebittheNewCash?”TheBanker,June,110-111


may complete autonomously through an ATM instead of

entering the branch could further reduce the workload for

branches.DebitcardandATMsupportersarguethatwhilea

significant cost saving may already have been attained by

mostbanks,a furtherdevelopmentof self-service terminals

eveninsidethebranchmaybefundamentaltokeeptheover-

allcostsofabank’sdistributionnetworksufficientlylowand

toletthebranchberestructuredsoastomaximizeitsselling

potential. On the other hand, however, multifunction ATMs

couldbeusedtodeliverothernon-bankingservices(i.e.pur-

chasing tickets forentertainmentorsportevents) thatmay

produceextrarevenuesforthebankandhelpamortizingthe

costsofitsATMdistributionnetwork.Insomecases,develop-

ingtheseservicesmayalsoprovidecustomersanincentiveto

get more familiar with ATMs. In Italy, for example, banks

started offering customers the opportunity to conveniently

rechargetheprepaidcardsformobilephonesthroughATMs.

Consideringtheextremelyhighdiffusionofcellularphonesin

Italy, thishasbeenasignificantsource fornew incomeand

theopportunitytomakedebitcardsanormalinstrumentfor

a largeshareofcustomersthathaduntil thenprovedtobe

resistanttoalltheeffortsdevotedtoincreasecardusage.

Developmentsine-commercecouldalsohelptoincreasethe

usageofdebitcard,iftheycanalsobecomeasafemeansof

payment for purchases through the net. This could become

possibleifandwhenlow-costcardreadersbecomeavailable,

sothatthebuyerscanusePIN-basedpaymentsconfirmation,

ratherthanhavingtosendtheircarddetailsthroughthenet.

Of course similar card readers could be designed for both

credit and debit cards, which makes determination of their

impactondebitcardusagelesscertain.Thisisnot,however,

somethingthatmayattractbanks’ interestintheveryshort

term,sincethedevelopmentofcheapreadersisatechnologi-

calpreconditionforanyeffortinthisdirection.

what may prevent banks from investing in debit cards?While there are many good reasons why we should expect

bankstospendtimeandeffortinincreasingdebitcarddiffu-

sionandusage,a realisticanalysismustalsocarefullycon-

sider theobstaclesand thedoubts thatmaypreventbanks

fromdoingthat,or,atleast,frominvestingattheratetech-

nology suppliers and innovation supporters would like. The

reasons behind banks’ caution are various, sometimes

extremely well grounded and sometimes purely psychologi-

cal.However,theymustclearlybeconsideredifonewantsto

realistically evaluate the potential for further debit card

expansion.Forclarity,wecangroupthecausesforresistance

intotwodifferentareas,theuncertaintyabouttheattainable

returnoninvestmentsondebitcardsinparticularandonthe

payment business in general, and the (at least perceived)

unsatisfyingperformanceofrecentinvestmentsonnewtech-

nologicalchannels,suchasInternetandPCbanking.

Firstofall, it isverydifficulttoassessthereturnoninvest-

mentfromalternativechannelsprecisely.Whileforinstance

theextrarevenuesgeneratedbyincreaseddebitcardusage

atPOS terminalsmaybeeasy toassess, thepotential cost

savingsderivedfromareductionintheamountofcashbeing

handledbythebankareclearlymuchmorecomplextoquan-

tify.Consequently,whileitmaybeeasytodescribeintheory

thatthismaybeanadvantageabankshouldconsiderwhen

deciding whether and how to promote higher card usage

rates, theuncertaintyabout thesavingsthatcouldactually

beattainedisaclearobstacle.Abankwouldliketobeableto

fullyevaluatetheoveralleconomicconsequencesofeitheran

aggressivepricingstrategyoramarketingcampaignamong

customers before undertaking them, and the difficulties in

understandingtheimpactoninternalcostsisfromthisview-

point a major problem. This problem is common to other

channelsaswell,atypicalexamplebeingtheInternetwhere

evenaclearassessmentofincrementalrevenuesmaybedif-

ficult, since it is not always clear whether a product pur-

chasedon-lineisarealnewpurchaseorsimplyasubstitute

forapurchasethatthecustomerwouldhavemadethrough

moretraditionalchannels.

The problem of evaluating real attainable cost savings is

equally important when critically assessing the benefits of

138


productivityofthesecondworstcountryreported;theresult

isnotexplainedbyalowernumberofdebitcardseither(from

Figure1itispossibletoseethatforthenumberofdebitcards

per thousand inhabitants it is close to countries such as

Sweden and France with a completely different number of

transactionsperterminal).Whiledifferencesinterminalpro-

ductivitymaydependalsoonthestructureofretailers’distri-

bution network across different countries, it is quite clear

thateffortsdevotedtoincreasecardusageratherthansim-

plyincreasethenumberofcardsincirculationorthenumber

ofavailableterminalsmaybeimportant.Ofcourse,providing

incentives to customers to increase card usage by either

adopting aggressive pricing strategies or developing cam-

paignstopersuadethemtograduallychangetheirbehavior

requiresasignificantcommitment. Iwillnowbrieflydiscuss

whyweshouldexpectbankstoseriouslyconsiderinvestingin

thisdirectionandwhich,at thesametime,are thereasons

whytheymaystillbeverycautiousandreluctanttodothat.

why should banks invest to develop debit cards further?Theheterogeneouspictureemergingsuggests that in some

countries there are still large margins for improvement in

termsofdebitcards’diffusionandusage.Whilethepotential

fordebitcards’ furtherdevelopment is testifiedbystillhigh

growthrates inthenumberoftransactionsand isobviously

stressedbynewtechnologysuppliersorbynetworkssuchas

MasterCardorVISA,itisimportanttodiscusswhichbenefits

banksmayactuallyexpectfromfurtherinvestmentsondebit

cards.

Asfaraspotentialbenefitsareconcerned,wecouldconsider

thebenefitsderivingfromgreaterusageatthepoint-of-sales

terminals.Inthiscase,benefitsforthebankmayderivefrom

thefeesthatcanbechargedtocustomers,ifafeeischarged,

and merchants. In any case, direct charges on debit cards

usagewouldclearlybecounterproductiveonthenumberof

transactions3whenrevenuesfrommerchantsdependonthe

marketsharethebankhasamongmerchantsonly(sothat,for

instance, a bank with a large retail customer base but few

merchantshasfromthisviewpointlittleincentivetoinvestto

convinceitscustomerstoincreasecardusage).Agreateruse

ofdebitcardsatPOSterminalsmayalsoimplyareductionin

the costs a bank faces for handling cash, and moving it

betweenbranchesandautomatedtellersinordertomakeit

availabletoitscustomers.Someanalystssuggestthatifmer-

chants’feeswerebasedontherealcoststhebanksbears,the

threshold where debit cards would become a cheaper pay-

menttypeformerchantsthancashwoulddroptoalevelas

low as U.S.$124. While there may be uncertainty about the

exactcostestimatesthatmayhelpidentifythethresholdpre-

cisely, pricing is undoubtedly a critical issue for providing

banks,merchants,andcustomerstherightincentivestosub-

stitutecashwithmoreefficientmeansofpayment.

ApartfromdebitcardusageatPOSterminal,banksmaybe

willingtodevelopusageatautomatedtellersalso,fordiffer-

ent reasons. Increasing the number of cash withdrawals,

request for information, and bill payments that customers

1395 FernandezCaro,S.,2002,“MoreEffortGoesintoBranches,”TheBanker,August

6 Bielski,L.,2003,“HardtoGettheOnlineHabit,”ABABankingJournal,February,

79-86


adequately exploiting this unutilized potential first, rather

than increasing the capacity of other alternative channels

suchas,forinstance,ATMs.Thisisreinforcedbythefactthat

PCandInternetbankingmay,firstly,provideevengreatercost

savings for lowvalue-added transactions, suchasabalance

enquiryorsimplebanktransfers6,andsecondly,offertothe

bankcheaperandricherinformationonthecustomer’strans-

actionsandinterests,whichcouldleadtobettersellingoppor-

tunities. Suggesting new products through the website and

providingfastandadequateinformationontheircharacteris-

ticsispossiblethroughInternetandPCbanking,butitisbasi-

callyimpossiblethroughATMs.Thepayoffbanksmayexpect

from trying to exploit the potential of their previous invest-

mentsonInternettechnology,evenifofcoursetheneedfor

upgradesisevenanissuehere,isthereforesubstantiallydif-

ferentfromtheonethatmaybederivedbyoldertechnologi-

calchannels.

Thesecond implicationofthepoorresultof Internet invest-

mentshasprobablybeentoincreasetopmanagers’riskaver-

sionwhenevaluating investments indistribution technology

ingeneral,especiallyconsideringthedifficultiesfacedinprop-

erlymeasuring,evenexpost,returnsoninvestment.Itmaybe

hardfortheheadofaretailbankingdivisiontopersuadethe

chiefexecutiveofficerthatdespiterecentunfortunateresults,

investing in new channels may be a winning choice for the

bank.Itismorelikelyinsteadtoassumethatabankmayreact

to unsatisfying Internet investments returns by reducing

investments in the retailbankingdivision in favorofothers,

andconcentrateretailbanking investmentsonrestructuring

traditional bank branches that have been proven to be far

moreimportanttocustomersthanmanyInternetsupporters

wouldhavepredictedafewyearsago.

conclusionsDebitcardsthathadbeenforalongtimeconsideredtobea

key innovation inbanks’distributionnetworks—priortothe

adventoftelephone,Internet,andPCbankingchannels—con-

tinue to experience significant growth, especially as far as

usage at POS terminals is concerned, and still represent an

importanttoolforabank’sstrategyintheretailbankingbusi-

ness.Yet,banks’investmentsinthefieldmaybelimitedbythe

difficulties inclearlyunderstandingchannelprofitabilityand

theactualcostsavingsthatmayderivefromincreaseddebit

cardusage. Ifprofitability isnotcompletelyclearandatthe

sametimedebitcardsarenolongerperceivedasasourceof

differentiation,sinceinnovationismainlydrivenbytechnolo-

gyproducersandinternationalcardnetworksthatobviously

try to spread innovation as fast as possible across banks, a

certain caution is understandable. Going forward, banks

shouldnotonlylimittheirinvestmentstohardwareandtech-

nologicalsupport,theyshouldalsotryandinfluencecustom-

ers’behaviorthroughpricingandeducation.



greater debit card usage through ATMs. In this case, one

major issue is represented by the fact that while activity-

based costing techniques may produce an estimate of the

costofalltypesoftransactionsforabankdependingonthe

channel the customer uses, understanding clearly which

partsofthosecostscanbeactuallyreducedoreliminatedby

migratingtransactionstowardsATMsorotherchannelsisnot

simple.Majorsavingscouldderive intheoryfromreduction

in staff costs, especially for cashiers. Yet, while it may be

simpletouseself-servicechannelstoreducethenumberof

cashiers in each branch to one only, dedicated to complex

transactionsortoresistantcustomers,pursuingfurthercost

savingsbyeliminatingthecashiercompletely isnotequally

easy. The risk is, therefore, that cost savings may remain

largelytheoretical,duetothecleardiscontinuityofthecost

function for each branch. While the possibility that some

banksmaystillhaveanincentivetopromoteATMusagecan-

not obviously be ruled out5, potential advantages may be

higherespecially for thosebanks thathadnotrestructured

theirbranchesyet,andmaintainbrancheswithahigherthan

averagesize.

CustomereducationeffortsdevotedtoincreasinglargerATM

usemaybeparticularlydifficulttojustify,especiallyconsid-

eringthatsimilareffortsdevotedtoincreasecards’usageat

point-of-salesorincreaseInternetbankingmaybemorepro-

ductive.WhileagreaterdevelopmentandusageofPOSter-

minalsmightreducetheneedforcashforsmalltransactions

andthereforemakecashwithdrawalsmoreinfrequent,which

might increase the attraction of investments aimed at

increasingPOSusage,otherchannels,suchastelephoneor

PC/Internet banking, allow customers to get information

abouttheircurrentaccountaswellasundertakeotherpay-

menttransactions,suchasbanktransferorders.Whencom-

paredtoanATM,thesechannelsalsoofferthebankabetter

opportunity to sell other products when the customer con-

tacts the bank for a payment transaction. As a result, it is

likely to think that customer education efforts might be

devoted to supporting the development and usage of tele-

phoneorPC/InternetbankingratherthantheusualATM.

Doubtsconcerningthereturnoninvestmentfromdeveloping

ATMsmaynotbelimitedtoonlybasicfinancialservices,they

couldalsobeextendedtofunctionsthatmoresophisticated

ATMsmayperformandthedeliveryofnon-financialservices.

Infact,extendedfunctionalitydoesnotimplyextrarevenues

but clearlyextra fixed costsdue to theupgradeofexisting

terminals,whichmaybenon-trivialespeciallyforlargerATM

networks.Inpractice,itisrealistictoassumethatfunctional-

ityextensionsmayoccuronlyinthosephasesthatabankis

forcedtoinvestinsubstitutingolder-generationATMsdueto

theclearobsolescenceofthenetwork.

Theneedtoundertakemaintenanceandupgradingofexisting

networkisjustanexampleofthekindsofinvestmentthata

bankmayfacesimply inordertomaintainthesameservice

quality as its competitors, and that may certainly influence

their willingness to invest further in more ambitious card

usage development programs. From this viewpoint even a

relevant and important technological change, such as the

migration of debit cards from magnetic stripe to chip card

technology,whileopeningupnewopportunitiesforsaferand

greatercardusage,willnecessitatesignificantinvestmentsin

upgradingmerchants’terminals.Again,immediatecostsmay

be clearer and more evident to both banks and merchants

thanfuturereturns,orthepossibilityofbecominglatemovers

insuchafield.

A second source of resistance to investment on debit card

maybeassociatedwithrecentexperiencesofinvestmentsin

Internet banking. In many countries there had been a clear

overstatement of the growth potential of Internet and PC

bankingchannels.Manybankshad,therefore,investedsignifi-

cantamountsofmoney(perhapspartiallyforasinceretrust

on Internet potentiality, and partially simply for an uncon-

scious ‘me-too’ strategy) that did not generate adequate

returns.Thisfacthashadatleasttwoconsequencesthatmay

berelevantforouranalysis.

ThefirstconsequenceisthatifthereisovercapacitywithPC

andInternetbanking,itlooksnaturaltoconcentrateeffortson

141

Future


Roger BallardDirector, Center for Applied South Asian Studies,

university of Manchester

143

Abstract

Asglobalizationhasledtoeverhigherlevelsoflabormobility,

sothevolumeoffundsremittedtotheirfamiliesbyworkers

employed in countries far distant from their homes has

increased by leaps and bounds. The total volume of such

transfers currently amounts to over U.S.$100 billion per

annum, the greater part of which flows from economically

advancedregionsintheWestandNorthtodevelopingcoun-

tries in the East and South. Delivering those funds swiftly,

reliably,andcheaplytorelativelyremotedestinationsopens

upnewopportunities for the financialservices industry,but

alsorepresentsamajorlogisticalchallenge.

Although many banks and money transfer agencies have

recently begun to consider how they can make the most of

theseopportunities, those thatseek toenter this fieldsoon

findthattheyareupagainstveryeffectivecompetition:the

InformalValueTransferSystemswhichmanymigrantgroups

havethemselvesdevelopedtomeetthischallenge.Inapost

9/11context, therehasbeenmuchfevereddiscussionabout

thethreatwhichsuch‘undergroundbanking’networksalleg-

edlypresenttothestabilityoftheglobalorder.Inaneffortto

replace ill-informed speculation with empirically grounded

detail, this paper demonstrates the extent to which such

informal networks have developed in such a way that they

nowprovideahighlyefficientresponsetothelogisticalchal-

lenge of delivering migrant remittances. In doing so it also

setsthesceneforamore informeddebateabouthowIVTS

networksmightbestberegulated.

1 Ratha,D.“Workers’Remittances:AnImportantandStableSourceofExternal

DevelopmentFinance”.GlobalDevelopmentFinanceReport.WorldBank,

WashingtonD.C.(2003)

2 HouseofCommonsInternationalDevelopmentCommittee.“Migrationand

Development:Howtomakemigrationworkforpovertyreduction”HC79-1.The

StationaryOffice,London(2004)

3 AnoverviewofthegrowthandqualitativecharacteristicsofBritain’sSouthAsian

populationcanbefoundinBallard,R(Ed).“DeshPardesh:TheSouthAsian

PresenceinBritain.”C.HurstandCo.,London(1994).

4 Piore,M.J.“BirdsofPassage:MigrantLabourandIndustrialSocieties.”Cambridge

UniversityPress,Cambridge(1979).


population of migrant workers’ consequent need to find a

safe,speedy,andreliablemeansoftransferringtheirsavings

backtotheirkinsfolk,especiallywhen,aswasveryoftenthe

case,theylivedinrelativelyremoteruralareas.Hencejustas

themigrantsorganizedtheirownmeansofentryintodestina-

tionlabormarkets,whichinmanycasesinvolveriskingtheir

lives, theyalsodevised theirownmeansof sendingsavings

backhome.Whilstthephysicaltransferofcurrencynoteswas

themostobviouswayofdoingso,long-distancemigrants,and

especiallythosewhoseresidencerightswereuncertain,were

unabletomakehomevisitswithanyfrequency.Butasthey

soondiscovered,theformallyconstitutedfinancialsectorwas

ill-equipped to meet their needs. Over and above delivery

problems, the commissions charged by banks, let alone by

specialist money-transmission agencies, such as Western

Union, consumed an alarmingly significant portion of their

hard-earned savings. Hence wherever groups of labor-

migrantsestablishedethniccoloniesofanysize they invari-

ablywentontodeveloptheirownself-constructedstrategies

ofinformalvaluetransmission.

Astheyearshavepassed,mostoftheseinformalalternatives

havebecomesteadilymoresophisticated,aidedbyadvance-

mentsincommunicationtechnology,particularlyintermsof

the development of fax and then the Internet, which have

madeitpossibletoorganizelarger-scalevaluetransferswith

speed, accuracy, and with high levels of reliability. Hence

whilsttheseinformaltransfersystemswentlargelyunnoticed

duringtheirinitialyearsofdevelopment,withtheturnofthe

centurytheysuddenlybecamethefocusofmuchhigherlev-

elsofinstitutionalattention.Thereweretworeasonsforthis

seachange. Inthefirstplaceoncemillionsandthentensof

millions of dollars began to be transmitted through these

InformalValueTransferSystems(IVTS),theybegantobesuf-

ficientlylargeastomakeblipsoninstitutionalradarscreens.

Henceanumberofmajorbanks,ledbythosebasedintheU.S.

with an outreach into Latin American markets, began to

explorewhether itmadecommercial sense tomakeamore

activeresponsetothepotentially-profitablebusinessoffacili-

tating remittance transfers. Secondly, and ultimately even

more importantly, questions began to be asked about the

extenttowhichtheseIVTSnetworkswerebeingusedtopro-

videacoverforlaunderingtheprofitsofdrugsmuggling.And

although initial reports5 were rather skeptical about the

extenttowhichIVTSwasactuallybeingusedasavehiclefor

criminal malfeasance, rather than a convenient means of

facilitating wholly legitimate remittance transfer, the whole

debatewastransformedintheaftermathoftheeventsof9/11.

Even though the greater part of the 9/11 operation was

financedbywiretransfers intopersonalaccountsopenedat

theSuntrustBankinVenice,Florida6,amassofluridly-written

articlessoonappearedinthepresssuggestingthatHawala/

IVTS networks were in fact a wholly unregulated form of

‘undergroundbanking’whichprovideddrugs smugglersand

terrorists a vehicle for financing their evil deeds. Hence,

despitetheabsenceofanysubstantialbodyofevidencesup-

portingsuchaccusations,governmentsthroughouttheworld

have found themselves under ever increasing pressure, for

the most part articulated by the U.S. Treasury, to introduce

regulatorymeasureswhichcouldineffectputallsuchinfor-

maloperationsoutofbusiness.

However,aseveryonewithinthefinancialservicesindustryis

now very well aware, draconian initiatives whose central

objectivesweretocounterbothmoneylaunderingandterror-

istfinancingwerebynomeanslimitedtotheinformalsector.

Suddenlyvirtuallyeveryagencyengagedinanykindoffinan-

cialtransactionsonbehalfofpersonalcustomersfoundthem-

selves required to introduceelaborateKnowYourCustomer

procedures,andalsounderaduty,backedupbyseverecrimi-

nalsanctions,tosubmit‘suspicioustransactionreports’,espe-

ciallyinthecaseofcashtransactionsinexcessofU.S.$10,000.

Whetherthisnewregulatoryenvironmentishavinganyeffect

ontheproblemsitisdesignedtoconfrontremainstobeseen.

What is undoubtedly the case, however, is that as a conse-

quenceoftheseinitiativesitisnotjustIVTSnetworkswhich

havefoundthemselvesunderpressure.Financialinstitutions

of all kinds now find themselves faced with the necessarily

expensivetaskofgatheringandrecordingagreatdealmore

personaldataabouttheirclientsandtheirtransactionsthan

144


1455 Passas,N.,“InformalValueTransferSystemsandCriminalOrganizations;astudy

intoso-calledundergroundbankingnetworks.”http://www.minjust.nl:8080/b_

organ/wodc/publications/ivts.pdf(1999).

6 “The9/11CommissionReport.”GovernmentPrintingOffice,WashingtonD.C.

The growth of migration and remittances in the contemporary worldInthecontextofanevermoreglobalizedlabormarket,many

millionsofpeoplearenowlivingandworkinginlocationsfar

distantfromtheircountriesoforigin,andtowhichtheyregu-

larly remit a substantial proportion of their earnings. The

financialflowsgeneratedbymigrantremittancesinthissense

are by now very substantial. Although accurate figures are

extremelyhardtocomeby,itisnotunreasonabletosuggest

that the current flow of transnational value-transfers cur-

rently generated by migrant workers amounts to at least

U.S.$100billionperannum,andperhapsagooddealmore.

Neverthelessmigrantworkersarefarfrombeingahomoge-

neous socio-economic category. Although the professionally

qualifiedemployeesofmultinationalcompaniesnowtendto

display high levels of spatial mobility during the course of

theircareers,suchhigh-fliersonlymakeupaverysmallpro-

portion of the global stock of migrant workers. Instead the

vastmajorityworkatfarlowerlevelsintheoccupationalhier-

archy.Butalthough theirwagesareonlyasmall fractionof

thoseenjoyedbythehighfliers,mostdisplayamuchhigher

propensity to save, so much so that they frequently send a

substantial proportion of their relatively meager incomes

backtotheirkinsfolkinAsia,Africa,andLatinAmerica.The

size of the resultant transactions, examined one by one, is

verysmall.Thevastmajorityofmigrantsrarelyremitmuch

morethanafewhundreddollarsamonth,merepennypack-

etsinbankingterms.Howeveritisthevolumeofsuchtrans-

actions which gives them their current significance, no less

locally than globally. In many countries of the developing

worldmigrantremittancesnowformthelargestsinglesource

of foreign exchange, comfortably exceeding the sum of all

formsofdevelopmentassistanceandFDI.1

Notonlyhasthescaleoftheseremittanceflowsgrownvery

rapidlyinrecentyears,butso,too,hasthelogisticalchallenge

ofdeliveringthem,notleastbecausesomanyoftheirrecipi-

ents live in remote rural areas, far beyond the reach of the

formalbankingsystem.Howeveragrowingnumberofstake-

holders—stretchingfrommigrantsthemselvestotheirfamilies

andcountriesoforigintotheInternationalDevelopmentCom-

munity—haveaninterestinensuringthatmigrantremittances

areasswift,reliable,andaboveallcheapaspossible.2Itfol-

lows, therefore, that the recent rapid growth in South-North

labor migration, and the concomitant growth of remittance

transfersinthereversedirections,presentsbothamajornew

challengeandanequallysubstantialsetofnovelcommercial

opportunities to the financial services industry. This paper

explores the ways in which those opportunities have so far

beenmet,identifiesthekindsofinstitutionalinitiativeswhich

haveemergedtomeetthem,andonthatbasisseekstolook

forwardtothelikelycourseoffuturedevelopments.

Althoughmigrantshavealwaysplayedamajorpartinprovid-

ing the labor power needed to fuel urban and industrial

growth,anddespitethefactthattheycontinuetobeavital

sourceofmenialworkersinmostpost-industrialsocieties,and

most especially those with plummeting birth-rates, their

arrival has rarely been planned or centrally coordinated.

Moreover all efforts to achieve such coordination invariably

fail,foroneveryobviousreason.Migrantworkersarenotonly

invariably self-selecting, they also behave as self-motivated

entrepreneurs whose principal concern is to advance the

interests of themselves and their kinsfolk.3 Migrants have

always acted thus. No less than the millions of European

migrants who crossed the Atlantic during the 19th and the

20th century, their ever more numerous successors from

Asia,NorthAfrica,andLatinAmericaseekingtheirfortunesin

theaffluentcitiesofothercontinentsarepursuingtheirown

agendasontheirownterms.Indoingsotheynotonlyaimed

tomakethemostoftheincome-earningopportunitiesavail-

able at their destination, but were equally committed to

increasingthewealth,andhencethestatus,oftheirfamilies

andtheircommunitiesbackhome.4

Yetalthoughareverseflowofremittancesfollowsthearrival

ofmigrantremittancesalmostassurelyasnightfollowsday,

until very recently the formally constituted financial sector

madenoorderedeffortstorespondtothisrapidlyexpanding

7 Theempiricaldataaroundwhichthissectionofthepaperisconstructedderives

frommorethanthirtyyears’experienceofethnographicresearchonthegrowth

oftheSouthAsianpresenceinBritainanditstransnationalconnections,which

hasinrecentyearsprovidedaplatformforamuchmoredetailedexaminationof

theactivitiesofHawaladarsoperatingintheU.K.andDubai,aswellasinIndiaand

Pakistan.Between2000and2002IreceivedagrantfromtheE.S.R.C.toconduct

researchonKinship,Entrepreneurship,andtheTransnationalCirculationof

Assets.Awealthofmoredetailedmaterialontheseissuescanbefoundathttp://

www.art.man.ac.uk/CASAS/pages/papers.htm


U.S.$1.8billion)peryearbacktoPakistan.7Apartfromabrief

blip when Customs and Excise arrested a series of major

Hawaladars and charged them with money-laundering, the

greaterpartofthesefundsweretransferredbacktoPakistan

through the informally grounded Hawala system, often

throughdealsfacilitatedinDubai.HoweverPakistanisarenot

alone in using this system. To my knowledge similar Dubai-

centered transfer networks have also been established by

immigrantsfromBangladesh,Pakistan,Afghanistan,Iran,and

Somalia. Such networks also facilitate transfers from immi-

grants who have established themselves across the length

andbreadthoftheE.U.

Thesenetworksdidnotspringintoexistenceoutoftheblue.

Whilstthegrowthofmigrantremittancesmayhavedramati-

cally boosted the scale and scope of contemporary Hawala

networks,therootsoftheseoperationscanbetracedbackto

theancientsystemofcommercialbanking,whichgrewupto

servetheneedsoflong-distancetradersintheIndianOcean

region. IntheiroriginalformatHawalanetworksemergedto

oil the wheels of commercial activity, meeting the needs of

long-distance traders who wanted to transport the bullion

theyneededtofinancetheiractivities.Adepositmadewitha

Hawaladarinonemarketplace(theGujaratiportofSurat,for

example)couldbepickedupasacreditfromthatHawaladar’s

correspondingpartnerinBasra,Mogadishu,orMalacca.

Asaresultofcompletingsuchtransactionsontheircustom-

ers’behalf,correspondingHawaladarswereconstantlyshift-

ing debits and credits between one another. Just as in any

other banking system, Hawaladars were prepared to take

these positions because those within any given network

trustedtheirpartnerstohonoreachother’sinstructions,and

abovealltomakeupanynetdeficienciesasandwhenaset-

tlementwaseventuallyimplemented.Althoughsystemsecu-

ritywasascrucialafeatureoftheseoperationsasitisinany

otherbankingsystem, its foundationsweregrounded in the

cultural and religious context of the times. Medieval

Hawaladars largely eschewed the elaborate clerical and

bureaucratic procedures, such as regular inspection of par-

ticipants’ records by accountants and regulators, around

whichcontemporaryWestern-stylebankingsystemsarerou-

tinely constructed. Indeed the only external authority to

whomHawaladars(thevastmajorityofwhomwereMuslims)

wereresponsiblewasAllahhimself.

But,althoughmostHawaladarstook,andstilltake,thetreatof

Divinesanctionsseriously,nonearesoidealisticastorelyon

thatas theprincipalsourceofsystemsecurity. Insteadthey

reliedonrelationshipsofabsolutetrust.Notonlydidthesys-

tem rely on customers having absolute confidence in their

Hawaladars’reliability,theHawaladarsthemselvesneededto

haveasimilarlycomprehensiveleveloftrustineachother’s

honesty.Thiswasnecessarysincedueto thedistancescov-

eredtherewereimbalancesbetweentheparticipantsforlong

periodsatatime.

Becauseoftheneedforabsolutetrust,itishardlysurprising

to find that each network of corresponding Hawaladars,

together with their customer-base, was normally language,

religion,andhencecommunity-specific.Fromthisperspective

HawalanetworksarebestunderstoodasanIslamicversionof

a much wider range of pre-modern forms of long-distance

value transmission and settlement, to which parallel Hindu

andChineseformsofIVTSalsoemergedduringthemediaeval

period,andlikewiseremaininoperationtothisday.Moreover

itisquiteclearthatwhilsteachsuchsystemhasitsownspe-

cific set of cultural and religious roots, all are constructed

around translocal networks of absolute interpersonal trust.

These not only provide a secure channel of communication

betweenspatiallyseparatedfinancialoperators,butarealso

thefoundationsofawebofbindingreciprocitieswhichpro-

vides,ineachcase,abedrockofsystemsecurity.

Whilst religious and sectarian loyalties provided the basic

foundationsofsuchnetworks, thesewere,andstillare,rou-

tinelyreinforcedbytiesofkinshipandmarriagebetweenthe

participants, so generating an even tighter web of mutual

reciprocities.Henceitisthroughtheoperationofsuchinfor-

mally constituted networks, rather than through the imple-

146


they had hitherto collected, and even then can often find

themselvesinanuneasypositionforfearthattheymightfind

themselveschargedwithcolludingincriminalactivity.

A new opportunity for the financial services industry?Yetdespitethecostlydownsideofthesenew,albeitstillmuch

disputed, regulatory regimes, these post-9/11 developments

may,at leastonthefaceof it,haveopenedupamajornew

opportunityforthefinancialservices industry.Astable,and

indeedasteadilyexpandingflowofvaluetransfertothetune

ofU.S.$100billionperannumiscertainlynotanopportunity

tobesniffedat,mostespeciallywhenregulatoryauthorities

aroundtheglobeareactivelyencouragingtheformalbanking

sector to become much more heavily involved in providing

services in this sphere, thereby providing migrant workers

withanalternativetowhattheburgeoningAML/CFTindustry

regardsasdeeplysuspectIVTSandHawalanetworks.

Yet despite the obvious opportunities that these develop-

ments have thrown up, those players who have sought to

enter this sector of the global foreign exchange market

appear to be finding the going extremely tough. Devising a

commerciallyviableresponsetothespecificcharacterofcus-

tomerdemandsinthissphereisprovingtobefarfromeasy,

not least because their competitors in the ‘informal’ sector

stillappeartooccupyapositionofclearcompetitiveadvan-

tage,despite thehigh levelsofofficialharassment towhich

theyhaverecentlyfoundthemselvessubjected.

Sojustwhatarethefinancialandlogisticalrequirementsofa

successful remittance transfer operation? Overall volume is

notaproblem.Whatdoescausesevereproblemsisthelogis-

tics of such operations. Given that individual transfers are

mostly in penny packets, most transfers require funds to be

converted into relatively obscure currencies, most senders

prefertomaketheirdepositsincash,andrecipientsfrequently

liveinruralareas,andhencewellbeyondthebankingfrontier.

Inviewofthesechallengesitishardlysurprisingthatspecial-

ist cash delivery operations based in the formal sector, of

which Western Union is currently the most salient example,

regularly charge a commission of around 15% for their ser-

vices,andeventhentheirdelivery-coverageislargelyrestrict-

edtomajorurbancenters,especiallyinthedevelopingworld.

Fromtheperspectiveofill-paidmigrantworkersacutof15%

ontheirhard-earnedwagesappearstobequiteoutrageous,

especiallysincethemarginchargedbyoperatorsintheinfor-

malsectorisdramaticallysmaller,often2%orless.Why,then,

doesWesternUnionfinditnecessarytochargesomuch?And

how,bycontrast,dooperatorsintheinformalsectormanage

to offer a service which is just as reliable and with a much

greaterspatialreachwhilstchargingsomuchless?

Theanswer to the firstquestion isobviousenough.Serving

the financial needs of millions of migrant remitters drawn

fromdevelopingcountriesisanaccountant’snightmare.Given

thatthepacket-sizeofeachtransactionissmallandthedeliv-

ery address is so often as remote as it is obscure, not only

must elaborate and expensive arrangements to consolidate

andthentodeconsolidatethesesmallpackagesateachend

ofthetransmissionchainbedeveloped,butaprocessofcur-

rencyexchange,onawholesalebasisofcourse,mustalsobe

implementedsomewherealongtheway.Becauseofthelarge

number of the administrative staff required to implement

theseprocesseswhenconventionalbureaucraticprocedures

areemployed,costsarenecessarilyhigh.Nomatterhowhard

theytrytocutdownonadministrativecosts,WesternUnion

anditsmanyemergingrivalswithintheformalsectorseelittle

prospectofreducingtheircommissionchargesbymuchfrom

theirpresentlevels.Nowondertheircompetitorsintheinfor-

malsectorarecurrentlyhavingafieldday.How,though,are

theymanagingtopullitoff?

The roots of HawalaIntheU.K.thePakistanicommunity,whichiscurrentlyaround

threequartersofamillionstrong,isthemostactivesources

of migrant remittances, and its members are collectively

responsible for sending anywhere between £500 million

(approximatelyU.S.$900million)and£1billion(approximately

147


ofcurrentexchangeratestoprospectivesenders,collectionof

datafromsendersabouthowmuchistobedeliveredwhere

and to whom, and the transmission of delivery data to the

remotedestination.

The second is value transmission and settlement, which

means that they need to organize availability provision of

creditatthepointofdeliveryagainstaccumulateddebitsat

the point of deposit, so enabling the organization of subse-

quentprocessesofsettlement.

Thethirdelementiscollectionanddeliveryofcurrencynotes,

whichinvolvescollectionandconsolidationofsenders’depos-

itsandtheonwardtransmissionofthesefundstosettlement

partners, and the deconsolidation of credits received from

settlementpartnersandtheirdistributiontoassignedrecipi-

entsatavarietyofoverseasdestinations.

Since all remittance agencies, be they formally constituted

banksorHawaladarsoperatingintheinformalsector,facethe

same set of technical and logistical challenges, it is worth

exploringwhichofthetwoisinapositiontoimplementthis

complexsetof taskswith thehighest levelofeffectiveness,

efficiency,andreliability.

A concrete example: the transfer of remittances from the u.K. to Pakistan’s mirpur district Morethanathirdofamillionpeoplewhoseancestralorigins

lie inMirpurDistrictare resident in the in theU.K.,mostof

whomkeepinclosetouchwiththeirkinsfolkbackhome.Not

onlyarevisitsbackandforthextremelyfrequent(PIAoper-

atesnolessthantenflightsintoManchestereveryweek),but

many of the pioneer settlers who arrived in the U.K. forty

yearsagohavenowretired,andarenowtakingtheopportu-

nity touse their accumulated savings tobuild splendidnew

houses for themselves back in Mirpur.8 As a result, remit-

tances from U.K. to Mirpur are currently running at some-

whereintheregionof£250million(approximatelyU.S.$450

million)perannum,thegreaterpartofwhichpassesthrough

Hawala networks. Delivery is routinely achieved within 48

hours,withnosignificantorganizationalfussand100%reli-

ability.Fromthecustomer’sperspectivesendingmoneyback

toMirpurcouldhardlybemorestraightforward.Alltheyhave

todo isapproachtheir localPakistanitravelagent(thevast

majorityofwhomoffersuchservices,eitherintheirownright,

oras theagentofa largerHawalaoperatorbased ina city

which supports a large local Pakistani population), enquire

aboutandagreeuponarateofexchange,provetheiridentity

(arequirementoftherecentlyintroducedanti-moneylaunder-

ingregulations),maketheagreedpayment,andprovidethe

recipient’snameandaddress inMirpur.Within48hoursthe

sumagreeduponwillbereadyforcollectioninMirpur.

Sohowisitallachieved?Asevertheback-officemechanisms

which support these apparently straightforward front-office

resultsareextremelycomplex,somuchsothattheyarebest

consideredinaseriesofstages,allofwhichhavetobefitted

smoothly together for the whole operation to produce the

desiredresult.

The collection of sterling in u.K. and the delivery of rupees in mirpur In front-office terms, Hawaladars engaged in collecting and

dispatchingremittancetransfersnecessarilyworkinclosecol-

laboration with a corresponding partner operating at the

destination(s) to which those remittances are dispatched.

Moreover ifweleavetheissueofsettlementtoonesidefor

themoment,implementingthecomponentofthedealwhich

matterstothecustomer,namelythedeliveryofrupeestothe

recipient,issimplydependentontheswiftandaccuratetrans-

missionof theappropriatedelivery instructions.Howeverto

sendseparatemessagesforeverysingletransactionwouldbe

highlyinefficient,consolidationistheorderoftheday.Hence

each consolidating Hawaladar (and for clarity’s sake let us

identifyhimasHaoperatinginBirmingham9)willmakeupa

list, setting out all daily transactions with over-the-counter

customersandthosepassedontohimbyanetworkofagents

and sub-agents operating in smaller Pakistani communities

elsewhereintheU.K.Thenitisasimpleenoughtasktofaxthe

spreadsheet to his corresponding partner Hb, operating in



mentationof formalbureaucraticproceduresofpaper trails

andauditinspections,thatIVTSnetworkshavecharacteristi-

callyachievedaconditionofself-regulation.Whilstrelianceon

self-regulationinthissensemayseemasold-fashionedasitis

insecure,itisworthrememberingthatsolongasthenetworks

withinwhichthesetransactionsareimplementedhaveanall

encompassing impact on their members’ lives, sanctions

against malfeasance, no matter how informal their founda-

tions, can be as far-reaching as they are severe. Breach of

trust characteristically leads to swift and comprehensive

socialex-communicationnotjustoftheoffender,butalsoof

hisentirefamily;andbecausethesenetworksarenowbecom-

ing ever more transnational in character, flight offers fewer

andfeweropportunitiesforescape.

The gradual eclipse and subsequent revival of HawalaFinancialoperationsonlysurviveiftheycansustainaposition

ofcompetitiveadvantage,andIVTSsystemsarenoexception.

WhenEuropeanadventurersinitiallybrokeintoIndianOcean

tradingsystemsinthe16thcenturytheysoonfoundthatthey

hadlittlealternativebuttomakeextensiveuseoflocallycon-

stitutedfinancialservices,andforstraightforwardcommercial

reasonstheycontinuedtodosountilthebeginningofthe19th

Century. But as Imperial domination became steadily more

comprehensive,Europeanbanksgainedadominantposition

in major trading centers all around the Indian Ocean. As a

result more indigenous providers of financial services were

drivensteadilyoutwardstowardsthesocial,geographical,and

economicperipheryofthesystem.

However, in the post-colonial world four key developments

havefacilitatedtheresurgenceofIVTSoperationsingeneral,

andofHawalainparticular.Firstly,theimpositionofover-tight

exchangecontrols inmanypartsofthe IndianOceanregion

has resulted in the emergence of a vibrant black market in

foreignexchange.Secondly,asthenumberoflabor-migrants

fromallovertheregiontotheGulfandEuro-Americagrewso

did the amount of migrant remittances. Thirdly, the rapid

growthofmanufacturingactivityinEastandSouthEastAsia

hasleadtoanupsurgeinintra-regionaltradeinmanufactured

goods.Finally,radicalimprovementsincommunicationstech-

nology — including fax, internet, cell- and satellite phones —

have made such transfers more efficient. Taken together,

these developments rapidly gave Hawala operations a new

leaseoflife.

How do contemporary iVTs systems actually work?Although Hawala networks and other similarly structured

IVTS operations are often described as providing under-

groundbankingservicestotheirclients,itisworthremember-

ing that Hawaladars do not provide retail banking facilities,

such as current accounts, taking deposits, or making loans.

InsteadIVTSnetworksarebestunderstoodasspecialistforex

agencies whose sole purpose is to facilitate value transfers

overlongdistancesandbetweendifferentcurrencyregimes,

and in so doing specialize in the delivery of relatively small

sumstorecipientsbasedinremotedestinationsinthedevel-

opingworld.

Fulfillingthatspecialistroleisfarfromstraightforward.Even

thoughthegrossannualflowofcredits intoanygivenlabor

exportingcountrymaywellamounttoseveralbillionsofdol-

larsperannum,closerinspectionsoonrevealsthatorganizing

theswift,reliable,andefficientdeliveryofinnumerablesmall

packetsofvalueonaglobal scale isamajor logistical chal-

lenge.Withthatinminditisworthrunningthroughjustwhat

kindofactivitiesthetasknecessarilyentails.

It goes without saying that in meeting this challenge

Hawaladarsrarelybecomeinvolvedinthephysicaltransferof

currencynotesacrossinternationalborders.Insteadtheyuse

familiarbankingprocessesofconsolidation,deconsolidation,

and settlement whenever and wherever they possibly can.

Hence Hawaladars’ collection, transmission, and delivery

operationshavethreecoreelements,allofwhichareclosely

inter-connected.

Thefirstisinformationprocessing,whichdealswithprovision

1498 AdetailedaccountofthehistoryofmassmigrationfromMirpurDistrict,aswellas

oftheimpactoftheinflowofremittancesonthelocaleconomycanbefoundin

Ballard,R.“Acaseofcapital-richunder-development:Theparadoxicalconsequenc-

esofsuccessfultransnationalentrepreneurshipfromMirpur”inGardnerand

Osella(eds.)Migration,modernityandsocialtransformationinSouthAsia,New

Delhi:Sage,2004.

9 IhaveborrowedthenotationfortheidentificationofHawaladarsasHa,Hb,etc.

fromthemodelsetoutinElQorchi,MaimboandWilson“InformalFundsTransfer

Systems:andanalysisoftheinformalHawalaSystem”WashingtonDC:IMF/World

Bank,2003.Howeverasmysubsequentanalysisshows,Hawaladealsveryrarely

taketheformofthesimplebilateralexchangeswhichtheysetforthintheir

model.

10 Ballard,R.‘HawalaTransformed:Remittance-drivenTransnationalNetworksinthe

post-Imperialeconomicorder’inMaimboandRathaeds.Remittances:

DevelopmentImpactandFutureProspects.WorldBankPublications,Washington

D.C.(2004)


Inthesecircumstancestheoutflowofmigrantworkerstothe

Gulf, the U.K, and the U.S, together with migrant workers’

constantsearchforcheaperandmoreeffectivemeansofget-

tingtheirremittancesbackhome,hasgivenapowerfulboost

toKarachi’sinformalmoneymarket.

AscomparedwithHawaladarsserving theneedsofmigrant

workers,theircounterpartsinKarachioperateinaverydiffer-

entkindoffinancialcontext.Notonlyarethemajorityoftheir

customers drawn from the city’s business and professional

elite,butsuchordersforU.S.$areinvariablyonasubstantial

scale.HenceasingleorderforU.S.$inKarachimaywellgen-

erateasufficientquantumofrupeestomeetaweek’sworth

of daily out-payments in penny packages handles by Hb in

Mirpur.Finalsettlementcanonlybeachievedwhenthehard-

currencycreditsheldbyHainBirminghamhavebeentrans-

ferredtothedestinationsspecifiedbythecustomersofHcin

Karachi.

dubai as a settlement hubMostsuchdealsarecurrentlybrokeredinDubai.WhyDubai?

NotonlyhasDubaitakenadvantageoftheboomintheprice

ofoiltoestablishitselfastheGulf’smostimportantcommer-

cialentrepôt,butasaresultofitscloseproximitytoBombay

andKarachi,thestabilityoftheDihramslinktothedollar,and

itsconsequentconditionofunrestrictedaccesstotheglobal

financialsystem,ithasbecomeSouthAsia’spremieroffshore

banking center. So it is that Dubai’s Exchange houses have

cometoplayakeyroleasfacilitatorsofremittanceandcom-

mercially-driven Hawala settlements not just to serve the

financialneedsoftheverysubstantialmigrant-workerpopula-

tion intheoil-richregionswhichsurround it,butalsoonan

ever more global scale. Hence with their newly established

headquarters in Dubai, Hawala networks, which have their

rootsinmediaevalpractices,haveonceagainbeguntooilthe

wheelsoftradeintheentireIndianOceanregion.10

A worked exampleWithall this inmind,aworkedexample,albeitmuchsimpli-

fied,mayprovideaclearerandmoreconcrete indicationof

justhowthewholesettlementprocessoperates.Letussup-

posethatHainBirminghamhastakenordersforthedelivery

ofRs.10millioninMirpur,forwhichhehasreceived£75,000

fromhisU.K.-basedcustomers.MeanwhileHcinKarachihas

a customer who wished to purchase $100,000 in order to

settlethe invoiceforaconsignmentoftelevisionswhichhe

has imported fromChina,whosemanufacturer isexpecting

paymenttobemadeintohisU.S.$accountinHongKong.Ha

andHcseparatelyapproachaspecialistsettlementbrokerin

Dubai,Hd,whocalculates(forthesakeofargument)thatRs.

10million=U.S.$100,000=£75,000,sogeneratinganideal

opportunity toarrangeaback-to-backswap.HenceHdsets

upaHawalasettlement inwhichHabuysU.S.$ 100,000on

Londonmoneymarketthroughhisbankwhichhepromptly

sends by TT to Hd’s account with Bank of America in New

York; meanwhile Hc takes delivery of Rs. 10 million in cash

from his television-importing customer, which he promptly

dispatchesbyroadtoHbinMirpur,therebyrecompensingHb

for the disbursements made in response to Ha’s previously

faxed instructions; and last but not least Hd transfers

U.S.$100,000byTTfromhisaccountinNewYorktothetele-

visionmanufacturer’saccountinHongKong,thusfullyclos-

ingthecircle.

Howeveritgoeswithoutsayingthatthisisonlyahugelysim-

plifiedexample,andthatintherealdealssuchsettlementsare

agreatdealmorecomplex.Henceintheinstancecited,there

is every prospect that Hc in Karachi would approach Ha in

Birminghamdirectly,andhavingfoundaneatmatchbetween

their immediate financial requirements would do a simple

swapbetweenthemselves,suchthattherewouldbenoneed

to looktoHd,whowould inevitablytakeasmallpercentage

cutonthedealtofacilitatesuchasettlement.

Inpractice,opportunitiestoimplementneatlymanagedswaps

involving such large sums are relatively rare, given that

Hawaladarsoperateinsuchawidevarietyofnationalarenas,

fromwhichtheyseektomakedealsinmanydifferentcurren-

ciesintrancheswhichveryrarelymatchupanythinglikeso

neatlyas theydo in theexamplecited. It follows that since



Mirpur,whocanpromptlysetaboutorganizingthelocaldeliv-

eryofrupeestorecipientsasinstructed,andwherenecessary

using his own network of agents and sub-agents to make

deliveriestorecipientsresidentinvillagesinthemoreremote

partsoftheDistrict.Pleasenotethattherehasbeennotrans-

fer of value from Ha to Hb. Corresponding Hawaladars are

readyandwillingtotakeonsuchapositionofindebtedness

given the relationship of trust between them, but at some

stagethatconditionmustofnecessitybedischarged.

organizing settlementBecausethemajorityofmigrantworkersaredrawnfromrela-

tively remote rural areas the most distributing Hawaladars

operateinregionswherethereisnosignificantlocaldemand

forforeignexchange.ThatiscertainlythecaseinMirpur,so

Hbrarelyifeverhaslocalcustomersinterestedinexchanging

rupeesforthesterlingcreditswhichheisconstantlyaccumu-

latingwithHainBirmingham.However,inPakistan’scommer-

cial capital, a thousand miles away in Karachi there is an

almost insatiable demand for access to hard currency, for

whichmembersofthelocalbusinesselitearefrequentlypre-

paredtopaypremiumrate.Hencethe informalmoneymar-

kets in Mirpur and Karachi are effectively mirror-images of

oneanother.Thisprovidesanobviousopportunitytoorganize

and implement complementary back-to-back settlements,

withtheaddedriskofhavingtomovethecashbetweenthese

twocities,whichinmostcasesrequirehiringofarmedguards.

Karachi’s Hawala market Likemanyotherdevelopingcountries,Pakistanhaslongsuf-

feredfromaseveredeficitinitsbalanceoftrade,whichisonly

partiallyremediedbyremittancesandotherinvisibleexports.

SinceKarachi isPakistan’scommercialcapitalaswellasthe

country’s principal entrepôt, a major manufacturing sector,

the city has long supported a pent-up demand for foreign

exchangetosettleinvoicesformanufacturedgoodsimported

fromoverseas,topurchaseeducation,medicaltreatment,and

propertyoverseas,toaidthewealthytoexportcapitaltohard-

currency tax-havens beyond the purview of the Pakistani

authorities,andtoreplenishtheStateBank’sforeign-currency

reserves.

151


Regulation: is Hawala broke? And does it need fixing?Whilst there can be no doubt whatsoever that Hawala net-

works, as well as their Chinese and Latin American equiva-

lents, provide an excellent deal from the perspective of the

manymillionsofmigrantworkerswhoregularlyutilize their

facilities, the prospect that these informal, and currently

almostcompletelyunregulated,systemsmightalsohavesig-

nificant operational down-sides also needs careful consider-

ation.Itis,therefore,importanttodeterminehowsecuresuch

valuetransmissionsare,asfarasitsretailcustomersarecon-

cerned, and how vulnerable such networks are to criminal

penetration?

Effortstoanswerthesequestionshaverecentlybeguntopre-

cipitateadebateabouthow,onwhatbasis,andtowhatends

this increasingly significant corner of the global foreign

exchangemarketmightbestberegulated.Fourequallypress-

ingquestionshavenowbeguntobeposedwithinthatdebate:

■ TowhatextentdocurrentHawalanetworkshaveanyin-

builtguaranteesofsystemsecurity?

■ Iftheseguaranteesareeitherabsentorinadequate,what

measuresmightrealisticallybeintroducedtoimprove

currentlevelsofsystemsecurity?

■ Isthereanywayinwhichadequateandeffectiveregulato-

rymeasurescanbeintroducedwhilststillretainingthe

strengthsofsuchsystems’informalprocedures?

■ Shouldalleffortsbeconcentratedondrivingallthese

dangerouslyinformalfinancialtransfersintotheproperly

regulatedforexchannelsmaintainedbytheformalbank-

ingsector?

How vulnerable are contemporary Hawala systems to criminal penetration? Yet,evenifweacceptthattheseinformalsystemshavebeen

providing an efficient, effective, and above all a reliable

responsetothelogisticalchallengesthrownupbytheexcep-

tionallyrapidgrowthintheNorthtoSouthremittancedeliv-

ery market in recent years, the priorities of the regulatory

authorities have undergone a sea-change since 9/11. Hence

whilstcustomer-protectionstillremainsasignificantcompo-

nent of the regulatory agenda, measures to curb money-

launderingingeneral,andthefinancingofterroristactivities

inparticular,havesuddenlyleapttotheheadofmanyagen-

cies’ concerns. Given that IVTS networks stand beyond the

reach of any kind external regulation, alarmist accounts of

their vulnerability to criminal penetration are now regularly

articulatedinallmannerofofficialreports,mostparticularly

thoseemanatingfromNorthAmerica.

Yetdespitetheseregularlyarticulatedconcerns,whichhave

inturnledtotheintroductionofaswatheofanti-moneylaun-

deringinitiativeswithwhichtheentirefinancialservicessec-

tor, formal as well as informal, is now required to conform,

muchlessattentionhasyetbeenpaidtodeterminingjusthow

fartheinformalsectorhasactuallybeenusedforsuchnefar-

ious purposes. In a similar vein it is also worth noting that

there have been even fewer efforts to explore whether the

raftofanti-moneylaunderinginitiatives,withwhichallinstitu-

tionsintheformallyconstitutedfinancialservicessectorhave

tocomply,havehadanysignificant impactontheirnominal

targets.If,asIstronglysuspect,theirimpactsofarhasbeen

moresymbolicthanreal,itishightimetoconsiderwhatalter-

native initiatives might be expected to produce the desired

result.

Beforeproceedingfurtheritisalsoworthremindingourselves

that money-laundering is a catch-all term covering a wide

varietyofdifferent formsof financialmalfeasance.Notonly

doestheextentandcharacteroftheir‘criminality’varyenor-

mously, but there are excellent reasons for suggesting that

onlyasmallminorityofthetransactionssolabeledareassoci-

ated either with drug-smuggling or with terrorist finances.

Insteadthevastmajorityaretheoutcomeofstrategieswhich

bothindividualsandcorporationsregularlydeviseasameans

of confounding the efforts of national governments to tax

their income,to imposeexcisedutiesongoodstheywishto

importorexport,and/ortoimposerestrictionsontheirability

to export funds into alternative financial jurisdictions. The



mix’n’match settlements are extremely complex to set up,

theyregularlyrequirethelubricatingassistanceofbrokersin

Dubaiifsuchexercisesaretobeswiftlyandsmoothlyimple-

mented.Moreoveralltheevidenceoftheresultantsettlement

transactionswhichIhavesofarbeenabletoobtainsuggests

thattheyareconductedonaverysubstantialscale,sincethe

basic unit of account in making such deals appears to be

U.S.$100,000.

How secure is iVTs/Hawala as far as its retail customers are concerned?Whilstbillionsofdollarsareprocessed throughDubai-based

IVTS/Hawala networks every year, it is striking that despite

theabsenceofanykindofcentralregistry,letaloneacentral

regulator,seriouscustomercomplaintsarevirtuallyunknown.

Howcan thisbe?Thebasicanswer isquitestraightforward:

likethepre-colonialstructuresfromwhichtheyevolved,con-

temporary Hawala networks are best understood as distrib-

utedsystemsinwhichsystemsecurityisrootedinthetrans-

nationally extended relationships of absolute trust which

participating Hawaladars routinely maintain between them-

selves.Giventhatallmembersofthenetworkareactivepar-

ticipantsinthewholeenterprise,systemsecurityisnotonlya

matterofcollectiveconcern,butisalsoarticulatedfromthe

bottom up, in sharp contrast to the top-down patterns of

externalscrutinyandregulationwhichcontemporaryWestern-

stylebankingsystemsroutinelydeployforthatpurpose.

It isalsoworthemphasizing thatsuch informalmethodsof

guaranteeingsystemsecurityarefarfrombeinganoutmod-

ed hangover from by-gone age. Quite the contrary, such

practicesappeartobetheprimesourceofthesystem’scom-

petitive advantage, above all because they allow large

swathesofoperationallyredundantclericalandbureaucratic

activity to be stripped out of the system. By doing so,

Hawaladars are able cut down information transmission to

theminimumlevelrequiredtoimplementthetaskinhand,so

enabling their core business of value transmission to be

implementedwiththemaximumlevelofspeed,reliability,and

efficiency. Moreover having adopted such a lean and mean

approachtothedatawhichtheychoosetotransmitbetween

themselves, Hawaladars have typically taken immediate

advantage of developments in communications technology.

Henceinadditiontolandlinesandmobilephones,Hawaladars

havemovedrapidlyonwardsthroughfax,email,networkpor-

talsandsecureVirtualPrivateNetworksasameansofinfor-

mation transmission amongst themselves, whilst all of the

largeroperators,andanincreasingnumberofsmallerones,

have now begun to plug directly into inter-bank electronic

valuetransfersystems,suchasBACSandSWIFT.

Giventhemanifestcommercialefficiencywithwhichcontem-

porary Hawala systems cope with the logistical challenges

thornupbymigrantworkers’financialservicesrequirements,

as well as the ever-greater technical sophistication of the

transferandsettlementprocesseswhichtheyhavedeveloped

in order to meet those requirements, the use of the term

‘informal’asmeansofcharacterizingthesystemasawhole

needs to be approached with considerable care. In the first

place,anysuggestionthatHawala’sinformalcharactermeans

thatitis‘asystemwithoutrecords,’asthosewhosuspectthat

thewholeexerciseismerelyaconvenientcoverforcriminal

activity frequently argue, falls by the wayside. Despite their

commitment to reducing clerical procedures to a minimum,

thereisnowayinwhichHawaladarscoulddealaccuratelyand

efficientlywithtransactionsofthecomplexitytowhichremit-

tance transferprocessesgive risewithoutextensive record-

keeping.Secondly,andconsequently,‘informality’isnottobe

confusedwithbackoftheenvelopeprocedures.Onthecon-

traryHawaladarshavebeenmuchquickertomakeuseofthe

efficiencygainswhichcanbeextractedfromrecentdevelop-

ments in electronic communications than their rivals in the

formalbankingsector.

Thisimmediatelypromptsafurtherquestion.Coulditbethat

the competitive advantage currently enjoyed by contempo-

raryIVTSnetworksissimilartotheadvantagesInternet-based

retail banks have over their branch-based competitors that

arestrugglingwiththecripplingcostsofmaintainingapres-

enceonthehighstreet?

15311 Robinson,J.TheSink:Terror,CrimeandDirtyMoneyintheOffshoreWorld

Constable.London(2003)

12 PublicAffairs(2004)The9/11CommissionReportNewYork:PublicAffairs.


serious financial arsonists long since perfected the art of

buildingsmokelessfires.Inthesecircumstancesthereareno

shortcuts. Ifthesecurityservicesreallywanttotrackdown

terrorists,andiflaw-enforcementofficersreallywanttotrack

downdrugsmugglers,neithercrackingdownonHawaladars

norevermoreelaborateKYCrequirementsarelikelytobeof

muchuse.Iftheauthoritiesreallywanttocatchterroristsand

drugsmugglers,ratherthantogenerateheadlineswhichsug-

gesttothepublicatlargethatsomethingisbeingdone,there

appearstobenoalternativetothehardslogofdetectivework

in which suspect transactions, no matter how complex and

obscure,aretrackedrightthroughfromoneendtotheother,

and arrests are made. The current scatter-gun approach,

which appears to be as much directed at the formal as the

informalsector,maywellbeavehicleforbringingsuccessful

prosecutionsagainstthosewhohavefailedtoconformtopost

9/11 regulatory requirements. If the ‘war on terror’ goes no

furtherthanthat,suchsurrogatesuccessesappeartobelittle

morethandiversionaryexercises inpublicrelations. Insuch

circumstancesterroristsanddrugsmugglerswillcontinueto

wend their way through the global financial system with no

greaterdifficultiesthantheyhavesofarenjoyed.

conclusion In my experience the vast majority of Hawaladars have no

greatobjection,atleastinprinciple,tosubjectingthemselves

and theiroperations to regulatory scrutiny, especially if the

centralaimofthoseregulationsistoensurethattheirfacili-

ties are not being surreptitiously utilized by terrorists and

drugsmugglers.Afterall,likeallotheroperatorsinthefinan-

cial services sector they have businesses to run, and client

confidencetomaintain.Blithelyprocessingcriminal transac-

tionswould innowaybeworthwhile in straightcommercial

terms.

However, given that they have businesses to run, and that

positionofcompetitiveadvantagearisespreciselyfromtheir

capacitytoimplementlong-distancevalue-transfersonacom-

prehensively lean-and-meanbasis,noHawaladarwouldever

wishtobesaddledwitharequirementtoimplementelaborate

bureaucratic procedures of questionable utility, most espe-

ciallyifthoseproceduresstoodcomprehensivelyatoddswith

thewayinwhichhisbusinessroutinelyoperated.Bythesame

token it also makes little sense to demand conformity to a

regulatoryregimewhichwasdesignedforuse inabusiness

whichiswhollydifferentincharacter13.Nevertheless,itisto

everyone’s advantage, except for committed criminals, that

HawalaandothersimilarIVTSnetworksshouldbebroughtin

outof thecold.But thatwillonlyoccurwhenmuchgreater

cognizanceistakenofthewayinwhichcontemporaryremit-

tance-driven value-transfer systems actually operate, such

that appropriately-grounded and genuinely reality-checked

regulatoryprocedurescanbeintroduced.

Meanwhileonquiteanotherlevelaltogether,therecanbeno

doubt whatsoever that IVTS networks are highly effective

service-providers inan increasinglysignificantcornerof the

globalfinancialservicessector.Moreoveritshouldbynowbe

quiteclearthatinformalinthiscontextshouldnotbeviewed

as either casual or unsophisticated. IVTS networks are in

essence a highly efficient technical response to some very

substantiallogisticalchallenges.Assuchtheyhaveemerged

asverysignificantcompetitorstomoremainline institutions

whichoperateonamore formalbasis.ButasGerryAdams

said of Irish republicanism, ‘it’s not going to go away, you

know.’JustasJapan,andmorerecentlyChina,havereversed

thetermsoftradebetweenEastandWestthroughtheirinno-

vations in the manufacturing sector, we should also not be

surprised if similar challenges from below also begin to

emergeinthefinancialsector.Thisisnottosuggestthatthere

is any likelihood that Hawaladars will be turning the way in

whichtheentireestablishedfinancialservicessectoroperates

on itshead.But, it is tosuggest that in thespecific fieldof

long-distancecrosscurrencyvaluetransfers,theformalsec-

torhasagreatdealtolearnfromitsmoreinformalcompeti-

tors.



resultantcontradictionsareof longstanding.Justas states

havealwaysneededtotaxtheirsubjects inordertofinance

their activities, their subjects have done their best to avoid

them.Consequently,ifHawalanetworksalsoprovidesupport

forsuchevasivestrategies,whichtheyalmostcertainlydofor

peopleofthedevelopingworld,weshouldnotbegreatlysur-

prised.Howeversuchstrategiesareinnosenseuniquetothe

informalsector.Onthecontrary,itseemsquiteclearthatall

thebiggestplayers,aswellasthevastbulkofthefundslaun-

dered inthissense,slipwitheasebetweenon-andoffshore

institutionswhicharefirmlylocatedwithintheformallycon-

stitutedfinancialsector.11

Aml/cFTWhat,though,abouttransactionsatthemuchmoreserious

endofthemoney-launderingspectrum,drugsmugglingand

terroristfinancing?Herewemoveintoevenshadierfinancial

arenas. By contrast with the vast sums of money regularly

transferredaroundtheglobetofacilitatetaxevasioninallits

variousforms,thevolumeofcross-currencytransfersgener-

ated by drug-smugglers seems to be relatively small. For

example,althoughAfghanistanmaycurrentlybethesource

of around 80% of the world’s heroin supplies, it is quite

unreasonabletosupposethatanythingmorethanatinypro-

portion of the profits accruing from its sale in Europe and

North America ever come anywhere near the country in

whichthepoppycropisgrown.Drugsmugglersmayindeed

needtolaundertheirill-gottengains,butitmakesnosense

for themtoseek todosoby investing in theeconomiesof

failed and near-failing states. Meanwhile there is a growing

awarenessthatthesumsrequiredtofinanceterroristatroci-

tiesaresosmall thatmanycommentatorshave likenedthe

taskofidentifyingsuchtransferstolookingforaneedleina

haystack. The FBI estimates that the cost of mounting the

September11attackswassomewherebetweenU.S.$175,000

and U.S.$200,000, very small beer in the context of the

globalforexmarket.Moreoverthebulkofthesefundswere

dispatchedtotheU.S.bywiretransferintoanaccountwhich

two of the perpetrators opened at the SunTrust Bank in

Venice,Florida.12

Thefactthatthosefundsweretransferredthroughtheformal

bankingsystemalsoraisesanotherimportantwiderquestion:

towhatextentaretransfersmadethroughinformalsectors,

as is widely assumed, ‘more anonymous’ than those sent

throughmoreestablishedbankingchannels? Infactthere is

goodreasontosupposethat theopposite is true.Bydefini-

tion, Hawaladars normally know their customers on a per-

sonalbasis.Whensuchcustomerstransfersubstantialsums

ofmoney,theHawaladarswillnormallyhaveaprettyshrewd

ideaofthesourcesofthosefunds,andthepurposesforwhich

theyhavebeendispatched.Moreover,ifheknowsthatthere

isaprospectthatthosefundshavebeenacquiredonaseri-

ously illicitbasis thentheHawaladarwhotakesthosefunds

aboardwillbewellawarethatbyimplementingthatdealheis

implicitlyconfirmingthebonafidesofthewholetransaction

as far as all his partners in that Hawala network are con-

cerned, needlessly putting the integrity of the system as a

wholeatrisk.Inotherwords,notonlyareHawaladarslikelyto

be aware of which of their customers might be engaged in

shadydeals,but theyarealsounderasignificantdegreeof

systematicpressuretokeepclearofsuchtransactions.

Bycontrasttherearegoodreasonsforsupposingthatserious

criminalshaveamuchbetteropportunityofpreservingtheir

anonymitybydealingwiththeformalbankingsector.Post9/11

Know-Your-Customer AML procedures with which all major

institutionsinthefinancialservicesindustryarenowrequired

toconformareexpensiveto implement,andcustomersmay

oftenbeannoyedbytherequirementtoproduceavarietyof

documentstoverifytheirpersonalidentity.Howeverthereis

noreasontosupposethatthosedeterminedtoslipbeneath

thenetwouldhaveanydifficultywhatsoeverindoingso.

Money, it is worth remembering, is merely a medium of

exchange.Itisneitherblacknorwhite,andneitherguiltynor

innocent.Iftheauthoritiesarereallyconcernedabouttrack-

ingdownseriouscriminalactivitiesitisbecomingincreasingly

clearthattodososolelyonthebasisofseekingto identify

‘suspicioustransactions’ishighlyunlikelytoprovidepositive

results.Whilstsmokedoesnotnecessarilyconcealafire,most

15513 IntheNetherlandsandGermany,forexample,currentregulationstreatvalue

transmissionagenciesasbanks,andhencerequirethemtomaintaincapital

reservesandtouseauditproceduresofthekindwhichareentirelyappropriatefor

institutionswhichofferacomprehensivebankingservices.Inthefaceofsuch

requirementshawaladarshavenoalternativebuttoconducttheiroperations

‘underground’.

Future


Adam denerPartner, Capco

Abstract

Thisarticleexploresthe increasingchanges inpaymentand

payment flowsdrivenby regulation,customerbehavior,and

technology.TheimplementationofCheck21legislationinthe

fourthquarterof2004will furtheracceleratethemigration

frompapertoelectronicpayments.Thischangeisexpensive

andwillimpactbanks.Bankinginstitutionswillneedtoinvest

inthefront-,middle-,andback-officeinfrastructureswithtotal

industrycoststoexceedU.S.$10billionoverthecourseofthe

decade.Theincreasingmigrationalsoraisesriskstothebanks

as businesses are better able to gain benefit from changes

andinturnwillbebetterabletocollectfunds.Theaccelera-

tion of collection has significant potential negative conse-

quencesonbankrevenuesfromdepositsandpaymentprod-

ucts.

157


permit and/or likely enable stopping the flow of original

checks in thecollectionand/or returnprocess, reducing the

physical processing and shipping of checks, establishing

agreementtocollectorreturncheckselectronically,andcre-

atingnetworkagreementsfromthousandsofbankstoaccept.

The detailed provisions of The Check 21 Act incorporate a

framework that includes the definition of substitute checks,

the establishment of a new negotiable instrument, and an

agreementthatasubstitutecheckisapaperreproductionof

theoriginalcheckandcanbeprocessedassuch.Thepaper

reproductionmust,however,meetindustrystandardsforsub-

stitutechecks,includeanimageofthefrontandbackofthe

originalcheck,andbeMICRencodedandmachinereadable.

Asubstitutecheckisthelegalequivalentoftheoriginalpro-

videdthatitaccuratelyrepresentsalltheinformationonthe

frontandbackoftheoriginalcheck,bearsalegendstatingit

isalegalcopyofyourcheckandthatyoucanuseitthesame

way you would use the original, and that no agreement is

neededtotransferalegallyequivalentsubstitute.

Check21doesnot,however,specificallyprovideforelectronic

exchangebanktobankalthoughimplicit inthe legislation is

theabilityforthistypeofserviceprovision.

incorporating imaging into check processing — A u.s.$10 billion problemToday’s check processing environment involves a complex

network of processes involving significant labor, expensive

equipmentandsystems,transportation,andinter-partyaffili-

ations. A key element of determining the necessary check

processes is the predicated location of presentation of the

checkbyortoabank,whichasdiscussedpreviously,isalegal

negotiabledocument.Check21complicatesthissituationby

expandingthescopeofcurrentandpotentialprocesseswhile

increasingtheneedfortechnologysupportfortheequipment

andsystemsthatsupportthem.

The short-term impact of Check 21 compliance will be

increasedexpensestosupportredefinedprocesses, incorpo-

ration of imaging and digital conversion into the processes,

andincorporationofimagingtechnologies.Theselegacycosts

will increase cost-per-check processing in the short term.

Initialtransportationcostreductionswillnotadequatelyoff-

set the increased costs, while redundancy costs inherent in

today’sprocessingenvironmentswillsignificantlyincrease.

We estimate that the industry’s near term investment costs

willbeapproximatelyU.S.$10billionoverthenext3to5years.

This figure includes new imaging input hardware, storage,

retrieval,andsoftwaresupportinginput,storage,andretriev-

al. In addition, it includes network connectivity supporting

input,storage,retrieval,andpresentationaswellastheredun-

dancycostsofcurrentcheckprocessingenvironments,includ-

inglabor.



159

RecentlyapprovedCheck21legislationwillbeimplementedin

October 2004, the objective of which is to reduce systemic

riskassociatedwithphysicalcheckmovementandtoprovide

amechanismtoreducethecostsassociatedwithcheckpay-

ment processing. Check 21 creates a newly acceptable pay-

mentinstrumentandprovidesafoundationfortheimagingof

checksasthebasisforcreatingnewpaymentinstrumentsand

theiracceptancebyotherbanks.WhiletheActdoesnotspe-

cifically require that imagesbepresentedbank tobank, the

legalandoperationalfoundationexistsforthisevolution.

However,closerscrutinyofthelegislationpointtosignificant

business risks from both a cost and revenue perspective.

Theseinclude:

■ industry costs —Check21will,overthenext3to5years,

costtheindustryU.S.$10Billiontomanagebankingindus-

trycomplianceimplementationandredundancycosts

associatedwithreductionsinlegacyinvestmentsincheck

processing.

■ cost savings —Post-implementationwillallowforpro-

cessingcostsavingsand,withtheembraceofdigital

presentation,significanttransportationcostsavings.

■ Float and fee revenue loss —Check21posessignificant

revenueriskbymigrationofcheckprocessingtoACHor

digitalchecksatsignificantlylowerfees,changes,and

reductionsincheckfloat.

■ insufficient funds fee loss —Thelegislationalsohasthe

abilitytocreatefundsverificationserviceswhichcould

reduceinsufficientfundsprocessingandfees(NSF).

To date, most observed industry efforts have been compli-

ance, as opposed to business, focused. Given the scope of

both thecostand revenue impact, Iwould recommend that

bankCheck21programsbeaggressivelymanagedasbusiness

programs. There is significant opportunity, as well as risk,

basedonwhichapproachisultimatelypursued.

what is check 21?‘An Act to facilitate check truncation by authorizing substi-

tutechecks,tofosterinnovationinthecheckcollectionsys-

temwithoutmandatingreceiptofchecksinelectronicform,

and to improve the overall efficiency of the Nation’s pay-

mentssystem,andforotherpurposes.’PublicLaw108–100,

108thCongress.

TheCheckTruncationActwassignedintolawonOctober28,

2003 by President Bush. The law, commonly referred to as

Check21,providesalegalframeworkforbankstoacceptsub-

stitute forms of checks effective October 2004. The likely

initial outcomes of the legislation are the reduction of sys-

temic risk of lost checks due to business continuity failure,

suchas9/11,andcostreductionbyallowingbankstoagreeto

electronic presentation, thereby eliminating the need for

physicalpresentationandtransportationofchecksforsettle-

ment.

Itisthebroaderimplicationsofthelaw,however,thatcreate

evenmoresignificantbenefitsaswellasrisksforbanks.The

legislation will likely serve as an enabler that will form the

basisofcheckdigitizationleadingtodigitalpresentationbank

tobank.

Check21createsalegalandoperationalfoundationthatwill

network and servers

depository bank Paying bank

checkprocessing

consumer

Paper checks

merchant

systems & i/F

clients/customer service

systems & i/F

clients/customer service

checkprocessing

imagearchive

Presentation

Process

Dataflow Imageflow Pointofimpact/enhancement

Figure1:ProcesseswhereCheck21’simpactwillneedtobeaddressed


anddisbursingfloat—theyalso lowertransactionrevenues

andmargins.

Corporationshavebeenwillingtoacceptthepositivebenefits

of converting check-based receipts to ACH transactions,

genericallyreferredtoasCheckConversion.Thisisalsoborne

outbytherapidgrowthofcheckconversiontransactions in

the last24months.Todate,checkconversionhashad little

impact on corporate payments, since it has, by regulation,

beenlimitedtoconsumerinitiatedtransactions.Thissituation

is beginning to change, as the U.S. Treasury has recently

issuedproposedregulationsthatwillallowittoconvertcom-

mercialpaymentstoACHtransactionsaswellifitwishestodo

so.TheimplementationofCheck21truncation,whichhasno

similar limitation, will only likely accelerate the movement

towardselectronicpayments.

The result of these customer and regulatory transitions is

decreasingmarginexacerbationincheckprocessing,ascheck

volumedeclines.Bankattemptstomaintainmarginsbyrais-

ingcheckpricescoulddrivemoretransactionstoelectronic

mediaorcompetitors,compoundingtheproblem.Suchevents

couldfurtherstrainthesignificantinvestmentsincheckinfra-

structuresandeconomics.

Point of presentation image capture (PoPic)Another likelychangerelated toCheck21 is lowerrevenues

predicatedbytheretailneedsofcustomersatpointofpresen-

tation and with bank-to-bank presentment. As noted in the

survey,mostbankimagingeffortshavebeenfocusedoninter-

nalprocessing.Whilecertainindustryeffortshavebeencre-

ated that are focused on inter-bank capabilities, such as

archiving, the advent of bank-to-bank presentment capabili-

tiesandimagecaptureatpointofpresentationwillhavesig-

nificantimpactoncheck-processingeconomics.

Thebulkofretailcheckpresentationoccursatbankbranches,

retailmerchants,andcheck-processingmerchants.Suchpre-

sentationisphysicalacrossmultiplechannels(e.g.ATM,teller,

POS)andrepresentsasignificantopportunitytotransferpro-

cessingcosts to thepresenterby incorporating imaging into

presentation processing. This capability will be of benefit to

bankbranchesandretailerswithsignificantcollectionrequire-

ments. It is likely that some retailers, including banks, may

drivebankproviderstoenablecapabilitiesfortheirbenefit—to

expeditetheircollectionandfloatconcentrationcapabilities—

tothedetrimentoflesssophisticateddisbursersanddisburs-

ingbanks.Theincorporationofimagingtechnologyatpointof

presentationwillbothenablesignificantsavingsandopportu-

nityaswellaschangebehaviorsofend-usercustomers.

In addition, bank-to-bank presentation (B2BP) for collection

will drive furthercostefficiencies.By incorporating imaging

POPIC with electronic presentation processing, settlement

canbeenabledbythepresenterautomaticallywithoutdirect

staffing(ortransportation)otherthansupportforthecusto-

dialfunctionofimagedchecks.

Inadditiontobusinesscontinuityrelatedriskreduction,Check

21 implementation will offer significant long-term financial

incentives for the industry, includingreducedtransportation

costs,processstaffing,andlaborrequirements.

Analogue/paper to digital payments: The risk of lost float and revenue reductionsCheck21regulationsenterthebusinesscycleataprecarious

timeforthebankingindustry.Alreadyundereconomicpres-

sureexacerbatedbytherecentrecessionandcreditcycle,the


image capabilities of image enabled banks

statements Rejects Returns Posting

National banks 68% 49% 26% 34%

Regional banks 47% 34% 27% 22%

who would you use as a processor?

3rd Party FRB consortium RPA Another

bank

National banks 27% 4% 0% 4% 12%

Regional banks 45% 35% 32% 25% 11%


The banking industry has the ability to control elements of

this impact through staging, predicated on a redefinition of

processing. However, these impacts could also be driven by

other banks and key customers who could hasten and even

define implementationstagingbypursuing legislativelysup-

portedoperationalbenefits.

Figure1notestheprocesseswhereCheck21’simpactwillneed

to be addressed. These include at point of retail sale (cus-

tomertomerchant),atpointofbranchpresentation(ATMor

teller),checkprocessinginput,checkprocessingsystem,cus-

tomerservicesupport,banktobankpresentation,andimage

archiveandretrieval.

Our2003industrysurveyonpreparednessforcheckprocess-

ing and image automation discovered that only the largest

banks have begun to incorporate imaging technology into

their services. Only 65% of overall respondents indicated

somelevelofimageenablement.Whentherespondentswere

brokendownintonationalandregionalbankswefoundthat

while90%oftheformergroupareimageenabled,only60%

ofthemembersofthelattergroupare.

Thebulkofimagingintegrationisnowfocusedonstatement

processing, with approximately half as much automation in

reject, return, and posting processing. In addition, respon-

dents indicatedabiasagainstsupport fromotherproviders

forimagingenablementthroughincorporationofservicepro-

visions(lessthanhalfofthebanksrespondedinfavor).

cost savings: The payoff from imaging?The manifestations from bank compliance implementation

and the benefits offered by Check 21 have the potential to

significantlyimpactbankcosts,revenues,andevencustomer

behaviors.

AcH adoptionIncommercialpayments,thetransitiontoACHhasaccelerat-

ed with conversion increasing significantly in the past 24

months.TheFederalReservehasnotedACHgrowthrecently

atmorethan15%.WhileACHhastraditionallyofferedlower

directprocessingcosts,commercialpayershavebeenslowto

transfer due to the potentially negative impact on working

capital, in the form of lost float and control over payment

dates. Large, sophisticated companies have historically uti-

lizedinternalandexternalresourcestoanalyzethebenefitsof

usingchecksversusACHpayments,andchangedthosepay-

mentflowstheyfeltbeneficial.

Disbursingcorporationshavethepotentialtolosefloatben-

efitsascollectioncyclescanbereducedthroughutilizationof

Check21-aideddigitizationandelectronicpresentation.Asa

result,companiesutilizingcheckfloatwill likelymodifytheir

processestoneutralizethelostfloatbenefitandcontrol.ACH

mechanisms can enable incorporation of disbursing lags to

attemptcashflowneutrality.

Alternatively, thesecompaniesmayaccept the lost floatas

anaccomplishedrealityandmigratetowards lessexpensive

ACH payments. The impact of this conversion is significant

forbanks.WhileACHservicesofferlowerprocessingcosts—

this transition stranding significant investments in check

processing infrastructuresandsharedbenefitsofcollection

161


traditionalcommercialbusinessisexperiencingclientconver-

sion-basedadoptionofACHwhileconsumerbusinessisunder

margin pressure due to increased competition for account

ownershipamidrisingcostsfornewbranches.Compounding

these challenges, POPIC implementation and bank-to-bank

presentation capabilities have the potential to significantly

reducebankrevenuesviareductionsinfloatrelatedtocheck

collectionandpotentiallyalteringprocessesrelatedtoinsuf-

ficientfunds(NSF)andtransactionfees.

Float revenue reductionDisbursersandbanksbenefitfromcheckfloatinthreedistinct

cycles, mail float, the cycle where the check is in transit to

collector(intransactionswherepresentation isnotatPOS);

Processingfloat,thecyclewherethecheckisbeingprocessed

bythecollectorandbythecollector’sbank;andclearingfloat,

thecyclewherethecheckisbeingmovedfromdepositoryto

payingbankforfinalsettlementandfundsrelease.

Dependent upon the method of presentation, a significant

numberofchecksthatarepresentedviaPOPICincorporating

B2BP would potentially reduce the processing and clearing

cycles.Thiscyclereductionwouldhavesignificant impact in

speedingupavailablecollections,therebyreducingfundsbal-

ancesamongdisbursersandtheirbankingproviders.

Federal Reserve statistics offer significant insight into the

potential impactofCheck21 implementation.Monthlytrans-

actiondepositdata(i.e.non-savings-accountsforcommercial

andretailcustomers)seemtoberelativelyflatoverthepast

13 years. Estimated float revenues generated from those

deposits (i.e. Fed Funds rates) shows the net impact of the

reducinginterestrateenvironment.

These impacts are significant but will be increased through

furtherACHand imagingbasedconversion.Check floathas

beendecreasingasaresultandfurtherproducttransitionand

behavior change is likely to significantly reduce revenue

potential.Analysisoncurrentcollectiontrendssuggestscon-

tinued downward pressure on the collection cycle, further

pressuringfloatopportunityaswell.


guidelines for authors

Inordertoaidourreadership,wehaveestablishedsomeguidelinestoensurethatpublishedpapersmeetthehigheststandardsofthoughtleadershipandpracticality.Thearticlesshould,therefore,meetthefollowingcriteria:

1. Doesthisarticlemakeasignificantcontributiontothisfieldofresearch?

2.Cantheideaspresentedinthearticlebeappliedtocurrentbusinessmodels?Ifnot,istherearoadmaponhowtogetthere.

3.Canyourassertionsbesupportedbyempiricaldata?4. Ismyarticlepurelyabstract?Ifso,doesitpictureaworldthatcan

existinthefuture?5. Canyourpropositionsbebackedbyasourceofauthority,preferably

yours?6.Wouldseniorexecutivesfindthispaperinteresting?

subjects of interestAllarticlesmustberelevantandinterestingtoseniorexecutivesoftheleadingfinancialservicesorganizations.Theyshouldassistinstrategyformulations.Thetopicsthatareofinteresttoourreadershipinclude:

• Impactofe-financeonfinancialmarkets&institutions• Marketing&branding• Organizationalbehavior&structure• Competitivelandscape• Operational&strategicissues• Capitalacquisition&allocation• Structuralreadjustment• Innovation&newsourcesofliquidity• Leadership• Financialregulations• Financialtechnology

manuscript submissions should be sent toShahinShojai,[email protected]

CapcoClementsHouse14-18GreshamStreetLondonEC2V7JETel:+44-20-73671321Fax:+44-20-73671001

manuscript guidelines

AllmanuscriptsubmissionsmustbeinEnglish.

Manuscriptsshouldnotbelongerthan5000wordseach.ThemaximumnumberofA4pagesallowedis10,includingallfootnotes,references,chartsandtables.

Allmanuscriptsshouldbesubmittedbye-maildirectlytotheeditor@capco.cominthePCversionofMicrosoftWord.TheyshouldalluseTimesNewRomanfont,andfontsize10.

Wheretablesorgraphsareusedinthemanuscript,therespectivedatashouldalsobeprovidedwithinaMicrosoftexcelspreadsheetformat.

Thefirstpagemustprovidethefullname(s),title(s),organizationalaffili-ationoftheauthor(s),andcontactdetailsoftheauthor(s).Contactdetailsshouldincludeaddress,phonenumber,faxnumber,ande-mailaddress.

Footnotesshouldbedouble-spacedandbekepttoaminimum.TheyshouldbenumberedconsecutivelythroughoutthetextwithsuperscriptArabicnumerals.

For monographsJensen,M.,CorporateControlandthePoliticsofFinance.JournalofAppliedCorporateFinance(1991),pp.13-33.

For booksCopeland,T.,T.Koller,andJ.Murrin.Valuation:MeasuringandManagingtheValueofCompanies.JohnWiley&Sons,NewYork,NewYork(1994).

For contributions to collective worksRitter,J.R.,1997,InitialPublicOfferings,inLogue,D.andJ.Seward,eds.,WarrenGorham&LamontHandbookofModernFinance,South-WesternCollegePublishing,Ohio.

For periodicalsGriffiths,W.,Judge,G.,1992,‘Testingandestimatinglocationvectorswhentheerrorcovariancematrixisunknown,’JournalofEconometrics54,121-138.

For unpublished materialGillan,S.,andL.Starks.RelationshipInvestingandShareholderActivismbyInstitutionalInvestors.WorkingPaper,UniversityofTexas(1995).

guidelines for manuscript submissions


Theworldoffinancehasundergonetremendouschangeinrecentyears.Physicalbarriershavecomedownandorganizationsarefindingithardertomaintaincompetitiveadvantagewithintoday’strulyglobalmarketplace.Thisparadigmshifthasforcedmanagerstoidentifynewwaystomanagetheiroperationsandfinances.Themanagersoftomorrowwill,therefore,needcompletelydifferentskillsetstosucceed.

ItisinresponsetothisgrowingneedthatCapcoispleasedtopublishthe‘journaloffinancialtransformation.’Ajournaldedicatedtotheadvance-mentofleadingthinkinginthefieldofappliedfinance.

The journal,whichprovidesauniquelinkagebetweenscholarlyresearchandbusinessexperience,aimstobethemainsourceofthoughtleadershipinthisdisciplineforseniorexecutives,managementconsultants,academics,researchers,andstudents.Thisobjectivecanonlybeachievedthroughrelentlesspursuitofscholarlyintegrityandadvancement.Itisforthisreasonthatwehaveinvitedsomeoftheworld’smostrenownedexpertsfromacademiaandbusinesstojoinoureditorialboard.Itistheirresponsibilitytoensurethatwesucceedinestablishingatrulyindependentforumforleadingthinkinginthisnewdiscipline.

Youcanalsocontributetotheadvancementofthisfieldbysubmittingyourthoughtleadershiptothejournal.

Wehopethatyouwilljoinusonourjourneyofdiscoveryandhelpshapethefutureoffinance.

[email protected]

Request for papers — deadline January 28th, 2005

Formoreinfo,seepage162

©2004TheCapitalMarketsCompany.VU:ShahinShojai,

PrinsBoudewijnlaan43,B-2650Antwerp

Allrightsreserved.Allproductnames,companynamesandregisteredtrademarksin

thisdocumentremainthepropertyoftheirrespectiveowners.

165

Design,production,andcoordination:Cypres—DanielBrandtandPieterVereertbrugghen

©2004TheCapitalMarketsCompany,N.V.

All rights reserved. This journal may not be duplicated in any way without the express

writtenconsentof thepublisherexcept in the formofbriefexcerptsorquotations for review

purposes.Makingcopiesofthisjournaloranyportionthereofforanypurposeotherthanyour

ownisaviolationofcopyrightlaw.

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the journal of financial transformation #12

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