Future of Payments

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FUTURE OF PAYMENTS raconteur.net 2 RACONTEUR 24 / 04 / 2016 COMMERCIAL FEATURE New kid on the block is shaking up the system An innovative way of managing financial transactions associated with the bitcoin cryptocurrency, is being adapted and could become mainstream BLOCKCHAIN DAN BARNES O n the island of Yap in the West Pacific, giant stone coins called rai have long been used to ex- change value. Moving them is often impractical, so ownership is proven by repeating the oral history of a stone's ownership. Bitcoins are transferred in a similar, but more secure, way. The history of every transaction is encoded cryptographically in a permanent record called the block - chain. When one person pays another, this payment history, which is distributed and accessible rather than centralised, is auto- matically checked to ensure the person has previously received the amount of bitcoins they want to spend. This clever method of managing trans - actions is now being employed beyond the use of bitcoin as a digital currency. In many ways, blockchain improves upon the current system for payment infrastruc - ture. It creates certainty of ownership and it creates transparency. At present there are centralised ledgers, but these need to reconcile transaction records with the ac - counts and records of anyone using an in- strument, such as cash or shares. Maintaining a centralised ledger is ex- pensive and relatively inefficient. Dis- tributed ledgers like blockchain require a relatively simple technological set-up, just a computer network and some soft- ware, albeit pretty smart software, but the technology is open source allowing many people to use it for other purposes. As people can only spend what they have received, counterfeiting is impossible and there can be no dispute over who has how many bitcoins. A distributed ledger of transactions can conceivably be used for any unit of value, from loyalty points to cash, to complex contracts. Many technol - ogy startups are building their own block- chain-inspired distributed ledgers to take advantage of this. They can be divided into two types: pri- vate, which connect people who have spe- cifically been given permission to join; and public, like bitcoin, which can be accessed by anyone downloading some software. Each has certain qualities. The public blockchain of bitcoin is being used as a transfer system for real currency. BitPay allows a shop to receive payments via bitcoin as a transfer mechanism and receive funds directly to its bank account in the local currency, with lower fees than card schemes. Payment app Circle, which has just launched in the UK, allows con - sumers to make payments with a bank card that are transferred into bitcoin. Consequently, the use of the public block- chain by consumers and merchants could allow them to make payments from and to bank accounts without using card pay- ment systems. "We are really using it as a settlement network, not as a primary currency for consumers, and so consumers never see bitcoin. It's the token that we use because it can be transmitted and transacted and settled in a final and secure way," says Jeremy Allaire, chairman and chief exec - utive of Circle. "There is enough liquidity on that platform to enable the crossing of currencies through it and so it becomes a very efficient global media." Bitcoin is not a regulated currency and so transactions in it are not regulated di - rectly by the Financial Conduct Authority (FCA). However, Mr Allaire says that an e-money issuer licence, which Circle has acquired, covers payment activity, curren - cy exchange and cross-border payments for pounds sterling and euros. For firms who feel uncomfortable about using bitcoin, creating private distributed ledgers that transfer other units of value is an option. Some, such as Ribbit.me, are seeking to use a distributed ledger for non-cash items like loyalty points, allow - ing them to become interchangeable and potentially driving up their value for mul- tiple scheme users. Others are transferring property contracts or financial derivatives with the potential to trigger automatical- ly contract conditions, such as a pay-out when interest rates move. The ease with which blockchains can be established makes them of interest to firms operating in parts of the world that lack the infrastructure to transfer large-value con - tracts or amounts of money. "A big area of interest has been the supply chain," says Hywel Ball, assurance manag- ing partner at consultancy EY. "Gas com- panies especially can look at supply chains in remote locations and be assured that money is going where it should. A lot of focus has gone into financial services be - cause that's where the big savings can be made, but private blockchains might get adopted in other areas first." Perhaps the most fundamental unit being migrated on to a blockchain is real money, specifically that paid and received by the central bank. Setl, the firm that is propos - ing this shift, believes it is time to replace the real-time gross settlement (RTGS) sys- tems, which were developed in the 1990s to make big transfers between banks, with something more efficient. In the UK, the RTGS system uses cen - tral bank money to settle payments made through the CHAPS high-value payment system and the funds transfer mechanism which supports the CREST securities set - tlement system. By settling through the central bank, big banks can have confidence that the trans- fer of value has taken place. However, this currently requires the big banks to hold large capital buffers at the central banks. By using a distributed ledger to conduct transfers, central bank money could be used to settle transactions 24/7, says Setl's chief operating officer Peter Randall, and removes the need for bank money to be tied up in a buffer account as the system would provide validation that the transac - tion can take place. There are several hurdles to overcome before blockchain is more widely adopted. Processing blockchain payments is not fast enough to support large-scale operations. As chains grow they become unwieldy. This is one driver towards the development of private ledgers tailored to overcome this lag. Different ledgers would not interact, but groups such as the R3 collective, which has 41 banks as members, are seeking to overcome the challenge by developing technology standards. The use of automated value transfer and a permanent transaction record do not eliminate all the problems that can occur in a transaction. If an account is hacked, a theft could be made to look like a legiti - mate transfer. Market abuse could still be conducted using legitimate transactions at any point and would need to be tracked around the clock, not just in office hours. Consequently, regulators will require some changes to the way finance is run and regulated. "If you are running transactions on a blockchain, which operates 24 hours a day, 7 days a week, you have then got to have real-time regulation," says Mr Randall. This raises further questions about the accessibility of a distributed ledger to au - thorities, notes EY's Mr Ball, and also the role of auditors in overseeing transactions on a distributed ledger network. "A lot of the blockchains will be private networks, so would that blockchain be audited as a chain or would each of the individuals somehow have to form their own view?" asks Mr Ball. "There are sev - eral issues impacting the speed of adop- tion, not least of which is the computing firepower that will be needed to run sig- nificant blockchains, but the questions [around regulation] are also likely to slow down adoption." Share this article online via raconteur.net The ease with which blockchains can be established makes them of interest to firms operating in parts of the world that lack the infrastructure to transfer large-value contracts or amounts of money Authorities are keen to allow innovation to develop, but not on any terms. The Financial Conduct Authority (FCA) has developed a "sandbox" to allow new ideas to be tested in a regulatory environment before going live. In March 2015, the UK government issued a policy paper entitled Banking for the 21st Century: driving competition and choice in which it pledged £10 million towards research into digital currencies while requiring digital currency exchanges to be subject to anti-money laundering regulations. This levels the playing field with existing financial services providers. "The UK government, in particular HM Treasury, has been very focused on attracting innovative companies in this space," says Jeremy Allaire, chairman and chief executive of Circle, a payment app. "That had an influence on us being part of the FCA's Innovation Hub, a sponsored programme to bring companies through licensing. I think the fact that we are using this cutting-edge technology as part of what we do made it attractive for them to regulate us." If regulators are able to use the blockchain to support supervision of financial services, they could become more effective, argues Setl's chief operating officer Peter Randall. "It is possible on a blockchain to report every single time a bank fails to make a payment that it should have paid or fails to transfer assets that it had said it would transfer," he says. "With those things recorded indelibly on a blockchain, a regulator has the capacity to ask banks to reduce rates of failed trades. A regulator can see a bank starting to get into trouble then make the necessary policy adjustments in order to stop that bank from trading, or could inject some emergency liquidity." REGULATING BLOCKCHAIN UNDERSTANDING THE BLOCKCHAIN Source: Goldman Sachs USAGE OF CRYPTOCURRENCIES IN THE PAST 12 MONTHS Source: PwC 2015 Percentage of consumers who have used cryptocurrencies Blockchain is a distributed public ledger of all cryptocurrency transactions and is the core underlying technology for bitcoin Online shopping Online gaming or gambling sites Anonymity when buying products Payment of credit card bills Checkout counter/kiosk Mortgage payment Restaurant/bar Utility bills International transactions Micro-payments (under $10) Peer-to-peer payments 81% 17% 17% 14% 10% 10% 9% 8% 5% 3% 3% Counterparty A sends funds to counterparty B 01 Transaction is configured into a block 02 Transaction is broadcast across the entire network which validates it 03 Block is then added to the chain which records the entire non-reversible history of transactions in a public ledger 04 Counterparty B receives funds from counterparty A 05 banks currently focusing on streamlin- ing their technology – the Prudential Regulatory Authority has referred to their IT as 'antiquated' – new entrants see this as an oppor tunity. Under P SD 2, incumbent bank s will face yet another challenge as they risk becoming disintermediated from the payment s business by an entirely new foe. "The new PSD 2 legislation really cre- ates two different service propositions," says Ms Oakes. "One is banking, with the three functions of lending, deposit tak- ing and payments. The other is the new entrants who don't necessarily want to offer lending or deposit taking. They just want to provide payment services. Consequently we will see different busi- ness models and different propositions." Banks are naturally risk averse and have been conser vative in their use of customers' personal data. It has been used to try and sell customers products at par ticular points in their lives. A new set of tools being offered by star tup f irms shows far more imagination, but they must really excite customers if they are to take hold. "Consumer banking customers want a ser vice to work every time and for the money to move to and from as or- dered," says Thomas Collins, director at KPMG. "Consumers are not con- cerned about the mechanism that gets it there." What they do care about is the here and now. Balancing cheque books is a lost ar t. Moving money from A to B without hassle is the expectation. Banks and ser vice providers that can use data to offer f inancial management tools to help the digital customer ef- fectively move their cash optimally are increasingly useful and viable. For example, personal financial man- agement tools that categorise spending, so the customer can evaluate the cost of latte consumption, really offer opportu- nities to save some money. When cus- tomers start to see patterns of spending it gives them the capacity to budget, po- tentially saving as a result. That support can only be welcomed in the current cli- mate. The Chartered Institute for Secu- rities and Investments suggests that 18 to 30 year olds should be saving £800 a month to get a pension of £30,000, yet the Office for National Statistics tells us this is 35 per cent of an average annual £27,200 salary. "They will allow you to create a sav- ings pot within your actual bank ac- count, so that if you wanted to save up to buy a car, you could see that chunk separately from the rest of your cur- rent account," says Ms Oakes. "There are fantastic concepts around contin- gent payments. As society moves to an era where more individuals are self-em- COMMERCIAL FEATURE F rom January 2018, you will be able choose who handles the payments from your account. It does not have to be your bank. A host of other f irms can be used; they will not have to be a bank and you will not need an account with them. This innovation is the result of a revision to the European Commission's Payment Ser vices Direc- tive (PSD 2), a set of rules designed to make payments within Europe cheaper, easy and better for customers. "I think banks are struggling," says Liz Oakes, director at KPMG . "They have data on customers, but they have never really used it in the way that consumers might f ind helpful to them. The wave of challengers [to banks] is a fantastic thing because the com- petitive pressure they are generating makes the legacy incumbent banks sit up and star t to produce the kind of ser vices and the innovation that we all like to see as consumers." PSD 2 will require banks to allow oth- er f irms to connect easily with their systems in order to facilitate payments. As a result customers can pick the best account for them – perhaps with a good interest rate – and also pick the best payment ser vice for their needs. It sets competition in banking at a new level. A whole new type of business will come into effect. Payment Initiation Services, which the Financial Conduct Authority says "initiate a payment trans- action at the request of the user from an account held by the user at another payment service provider", and Account Information Services, online services that provide a consolidated view of the user's payment accounts from across payment service providers, will become regulated, viable businesses. Introducing challengers to the status quo of banking is not new. The UK has seen star tup banks giving the bigger f irms a shove since the f inancial crisis f irst made them a bit wobbly, ranging from Ipagoo, six-year-old branch-fo- cused Metro Bank, and soon-to-launch Atom Bank and Starling Bank, both technology-led star tups. With the big THE CHALLENGER IN THE RED CORNER In less than two years you will be able choose who manages payments from your bank account, but will more choice make paying easier or harder? ployed or working freelance, the date on which transactions leave your ac- count is more critical. It makes manag- ing cash quite challenging." Ser vices such as direct debit that of- fer a f ixed-date payment are looking in- creasingly inflexible in an environment where the mechanisms need to match customer circumstances. For example, contingent payments can be set up so that a bank or payments provider makes a payment on the day that money is due in, but not before those funds arrive. These are great ideas, says Mr Col- lins, but the capacity for them to gain traction will rely on critical mass and that can be diff icult to build up. "We have seen some people who have moved accounts since the process be- came easier, but the numbers are very low," he says. "The only drivers that re- ally catalyse people have been f inancial incentives, but as new ser vices are of- fered, we may see a profound change in behaviour and the use of the current account switching ser vices." A chicken-and-egg situation could develop in the near future as excellent ser vice propositions are limited by cus- tomers who are conser vative in their adoption and banks that are conser v- ative in their offering. "Banks, in par- ticular, are too ner vous about crossing the threshold of providing advice," says Mr Collins. Many ser vices that have been under the covers of the retail banking envi- ronment, such as dispute management ser vices from credit card companies or bank account provision, will have been taken for granted by customers. Star tups will likewise have to manage their own operational challenges while maintaining simplicity of use, warns Ms Oakes. "The more third par ties there are in- volved in a transaction, the more diff i- cult it is to f igure out where your mon- ey is as a customer and who you need to contact in the event of a problem," she says. "For challengers to succeed, they will have to grasp how complicated this is for themselves and for customers." www.kpmg.com/uk/futurefs What they do care about is the here and now. Balancing cheque books is a lost art. Moving money from A to B without hassle is the expectation Startups will likewise have to manage their own operational challenges while maintaining simplicity of use

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