Understanding the Changing Economics of SEPA
The introduction of the single euro payments area (SEPA) is a complex and lengthy process, with many stakeholders and involved parties. It is a market-driven project – with a clear push from authorities due to a perceived market failure in customer service developments. Due to the length of the process and parallel rapid information and communications technology (ICT) developments, SEPA also needs to accommodate technology changes. We need to harmonise the future European payment environment; not the historical systems. SEPA will lead to fundamental changes in interbank processing, customer payment services and market practices. It is important to understand the many dimensions of SEPA economics and incentives in order to establish an efficient European-wide governance and development process for payment systems.
The fundamental features of a common payment area are common standardised services and complete reachability. Any customer should be able to send payments using the available standardised payment instruments to any customer in the common area without any extra requirements. The common user standards mean economy-of-scale benefits for users and also for banks. SEPA will create a huge common European market for software with standardised bank interfaces. Every payroll, general ledger application and payables and receivables system can use the same interface with all banks for sending and receiving payment messages. Message standards are needed for all functions related to sending and receiving payments: sending and receiving credit transfers, direct debits, card payments and account statements as well as sending and receiving direct debit mandates (see figure 1). Direct debit may require special attention in order to establish efficient and secure handling of electronic mandates.
Common user standards constitute the most essential feature of SEPA. SEPA will be a common payment area for bank customers only when they can clearly see and use the new high level of common standardisation. Corporate customers in particular want to be able to send and receive payment data in the same format to or from all banks. Simple things, such as paper-based and screen-based giro forms, direct debit mandates and card slips/terminal interfaces, need to be harmonised in order to facilitate cross-border usage. Customers and bank clerks need to be able to recognise and understand SEPA payment-related documents irrespective of their geographical origin. The major source of SEPA scale benefits can be found in the common efficient customer interface standards, which provide costs savings for customers in sending and receiving payments from the banks.
The common e-banking standards will speed up electronification of bank services. The majority of both corporate and private customers prefer electronic payments due to service and cost benefits. The growth of electronic payments will help to considerably reduce banks’ costs. The processes can be automated and are easier to outsource than before, bringing economy-of-scale benefits. Standardised services mean that it will be easier to find ready-made payment applications for banks. There will be less testing needs and operational problems, because the ready-made software packages have large user groups among both banks and customers.
The Nordic and Baltic experiences show that very high automation levels (over 90%) are attainable (see figure 2). However, this requires sharply focused projects by individual banks as well as joint efforts by the whole banking sector.
The general growth of electronification across Europe is robust, and this includes payment services. This means that by 2010/2011 almost all payments will be electronic payments in all countries and paper-based initiations will be rare exceptions. In order to secure the economic benefits of electronification, SEPA must have a clear focus on efficient e-solutions. SEPA and a good e-SEPA design will give paper-based countries a good chance of catching up with these developments.
Most current payment systems were designed during an era when there were important limitations on data storage and communication. Data content was often limited to the storage capacity of a punch card or, later, to somewhat longer – but still very limited – records. The advances in technology have removed all these old restrictions so that today there are no practical limits on the data content attached to a payment. Modern technology has also brought a new data description method and language, extensible markup language (XML), which provides an efficient way to describe data content. Banks within the European Payments Council (EPC) have decided that the new payment message standards should be based on XML.
However, this is often seen as a conversion project in which the current messages and their contents are simply described using XML. The fundamental new feature of XML is a general dictionary of data elements that can be used for all messages and virtually limitless possibilities for optional data elements for customer-to-customer communication. Payments will in future contain mandatory fields for banks’ processing needs, but also an increasing amount of customer-only processed data, which banks merely pass through their systems in the original form. The bulk of essential data elements to be includde for customers’ needs are invoice-related data, which will be discussed in more detail in the following sections. The payment process needs to be designed to contain all the data necessary to end-users.
The benefits of electronification can only be achieved via good straight-through processing (STP) design from end-customer to end-customer. All corporate customers want to receive payments in a form that can be directly processed in their automated payments and invoicing work-flow processes. This requires that standardised payment messages contain the necessary addresses, identifiers and reference data. SEPA will require that changes be made to the applications of all stakeholders. A good overall STP design will benefit everyone and the most essential addresses and identifiers needed for STP are:
IBAN has been selected as the common account identifier, but there are still discussions on whether customers need to provide BICs also, or could all banks automatically look up BICs based on IBAN information. An automated BIC process has clear advantages in reducing costs and improving accuracy, as has been recognised by sophisticated banks, which have implemented automated BIC processes.
E-banking requires strong customer e-identification. A common customer identification system would benefit all customers and banks. The current non-standardised situation is a barrier for e-banking and a lot of resources are wasted due to the multitude of proprietary identification solutions. Security issues such as identification and encryption will be an important area of co-operation within SEPA.
Individual payments will be routed through many applications and via several service providers. For example, in the modern parcel mail networks and air freight systems, each item receives an individual unique number by which it and all related documents (such as waybills and invoices) can be traced. Most of these transportation networks provide an easy-to-use web service allowing the customer to follow the delivery progress. Each payment in SEPA would need the same kind of unique and individual payment transaction identifier, by which each payment could be easily found in error situations and other requests.
In end-to-end STP, receiving and sending customers should also be able to find, match and reconcile payment messages with information in their databases. The payee/seller should be able to find the receivables record for an incoming payment, and the payer/buyer should be able to find the order or payables information for incoming direct debits, e-invoices, etc. Customers need clear remittance information and especially reference codes that are easy to reconcile and which travel through the payments systems protected by check digits in order to reduce the risk of modifications. Customers need to know exactly which invoices have been paid and by whom.
STP has been a buzzword for many years. The time has come for the foundations of STP, in the form of common data formats, identifiers and references, to be established within SEPA. These must be harmonised within SEPA and considerable benefits can be realised via a good STP design (see figure 3 for basic STP elements). Without decisions on creating a good technical foundation for STP, this will not become a reality, and endless and generally fruitless discussions will continue.
E-invoicing is still considered by many banks as a value-added service, some even view it as a non-banking service. However, there is a clear and strong demand for bank-provided e-invoice services, and national standards have emerged in several countries. The use of bank-provided e-invoicing services is growing very rapidly in the Nordic countries, and interest is growing in many other countries.
The basic e-invoicing benefits for customers come from the completely automated invoice handling process. There is no need for the printing of invoices to be put into envelopes and sent by mail, opened by the receiver, with the further need of keying the data content into an accounting system. Instead the electronic information can be directly re-used by all parties in their accounting and work-flow systems. In addition, the e-invoices will, over time, build up into an e-archive that can easily be browsed for invoicing and payment information. Corporate customers will benefit the most from e-invoicing, and the potential aggregated yearly benefits have been estimated to be over EUR100bn (based on cost savings in the range of EUR10-20 per invoice and about 50-60 billion invoices per year). There is no other automation process in the payments area that can provide such huge benefits.
Bank-provided e-invoicing has clear benefits over other solutions such as direct emailing between customers or specialised e-invoice hotels, due to considerable synergies in the processing of payments. Currently, payment information is a subset of invoice information, because of capacity restrictions in older payment systems. Now all payment services can be re-designed to include e-invoicing data. The e-invoicing developments started as credit transfer proposals that included all invoicing data submitted to payers for approval via e-banking systems. Once accepted by the payer, these are automatically converted into credit transfers. The next obvious area of application is direct debit notifications, which can be converted into extended direct debit requests that include invoice data and are transferred by banks to payers as part of the direct debit process. The e-invoice data could also be attached to all debit and credit card payments so that customers get complete transaction information on card payments in electronic format. The synergies of bank-provided e-invoicing services stem from combining invoicing data with payment data, which means that separate reconciling and matching will no longer be needed. Banks can transport e-invoicing information based on account numbers directly between customers as part of payment service/transportation. Banks have in place secure customer identification systems and can thereby guarantee the sender’s identity, which will eliminate the increasing risk of fake invoices. E-invoicing is a typical example of network economies based on re-designing old paper processes using modern technology (see figure 4). Customers will be able to view all invoice and payment data using e-banking facilities and browse for any past invoice and payment using simple search mechanisms of the e-archive.
In order for e-invoicing to work internationally, common e-invoice standards are required. There are currently several ongoing attempts to establish such standards. One widely used standard is the Finvoice standard, which is aligned with the TWIST e-invoice proposal. Based on the new standards, all software providers for accounting and invoicing can start to build standardised interfaces. It is therefore important that banks at an early phase agree upon a common e-invoice standard for SEPA, as this would speed up developments. If different national standards are first developed in each country, the harmonisation process will be lengthy and much of the potential benefit will be lost. Also national legislations need to be harmonised in order to support international exchange of e-invoices.
Customers need to be motivated to make SEPA changes and providing e-invoicing benefits together with SEPA changes would increase customers’ interest in SEPA developments. E-invoicing is a good example of how banks should be looking at the new possibilities and trying to enhance payment services at the same time as SEPA harmonisation is being accomplished.
Although customers can see the overall benefits of SEPA developments in the long run, they also need clear and concrete direct benefits, which will motivate rapid migration. Customers tend otherwise to prolong the use of old standards. Running parallel standards in payment systems for a long period of time will be costly for banks. It is therefore crucial for SEPA that customers find the new services attractive so that the changeover occurs as rapidly as possible. The longer the period of parallel use of old and new services and standards, the higher the overall costs will be, especially for banks.
The worst scenario from the customers’ point of view would be deterioration in the current service level, in which important features, such as important STP remittance information, would not be available in SEPA products. This might turn customers against the move to SEPA services so that non-SEPA solutions would continue to prevail. SEPA products thus need to be based on best-practices from the start. It is therefore important to use the new possibilities of technology to provide advanced services. Customers are generally not interested in one-to-one changes of standards, but instead demand proven benefits from changeover efforts. From the banks’ perspective, the worst-case scenario may result in the need to re-design SEPA products rapidly, which would increase the overall investment costs.
Historically, a domestic payment clearing and settlement structure has been established in every SEPA country, usually as a monopoly automated clearing house (ACH). Within the EPC much time and resources have been devoted to the necessary interbank rule books and conventions. However, not much time has been devoted to developing the actual interbank clearing and settlement structure. So far, this has been left to be solved by the ‘market’. In order to reduce start-up frictions and costs of change, the infrastructure developments need to be more focused and based on common decisions and governance.
In SEPA, the economics of the interbank clearing and settlement structure demand cost minimisation and rapid processing, i.e. payments must be forwarded from sending to receiving banks as efficiently as possible. In order to reduce costs, the interbank payment messages and clearing/settlement methods need to be standardised. This will reduce implementation costs within banks and pave the way for consolidation of the payment infrastructure, thus bringing savings in fixed overhead costs and economies of scale.
Modern network technology also provides major cost savings via inexpensive direct communication in which the network sorts/delivers payments to the receiving bank. ACH transaction sorting processes can be effectively replaced by distributed network services, i.e. Internet-type TCP/IP networks such as SWIFTnet. Modern network environments are flat – without tiered and intermediary processing structures – which would only increase processing and communication phases and thus costs without any added value. In order to achieve efficiency, the interbank processing chain need to be as short as possible in SEPA. All processes will be end-to-end and on-time in future networks. Only administration and settlement will remain centralised. The Europe-wide settlement could be done via TARGET in a simple automated way, where the covers for sent transactions are booked in gross or net (see figure 5).
Currently, both the majority of banks and the national payment processors seem to see SEPA infrastructural developments as simply requiring common data standards and harmonised payment instruments. The current processors would continue processing but using new SEPA-compatible interfaces. However, there is no commercial need for so many processors in a common payment area. Investments to update the old legacy processors will be a waste of resources with no possibility of payback. Cost of change could be minimised by directly employing the network economy structures. Regarding interbank structures, banks are generally the owners of the current national ACHs. In order to establish a common European interbank processing network, banks need to start to cooperate effectively on the new common European payment area level instead of the old national level. A single efficient payment network is the most effective way to handle the European interbank payment volumes, and it could be established by a single efficiently governed institution.
SEPA will expand the payment application market considerably and the common standards will provide a stable platform for outsourcing operational services. Banks from different countries can use the same user-interface standards and services; IT centres can service banks from different countries; and banks from different countries can set up joint projects for system development etc. These opportunities are important especially for small banks that can, in this way, share the cost of change among a larger number of banks. SEPA creates new possibilities for cost savings and economies of scale by tearing down old national barriers that have hindered outsourcing.
Currently, national standards and the problems experienced with cross-border transactions have divided the European market into different national submarkets and thus limited competition possibilities. Europe-wide competition will increase with SEPA. Basically one payment account will be enough for a corporate customer to receive and send payments within the SEPA area. Corporate customers will therefore close many of the current payment accounts that have existed because of the slow nature of cross-border traffic. It will be much easier for a customer to have all its liquidity and transactions in one account. Customers will have more service provider alternatives, with increased competition generally improving services and lowering tariffs.
For banks, Europe-wide competition will have two opposing impacts. Banks will have better possibilities for buying the services they need in a larger market. On the other hand, they will also face more competition than before. In order to secure future business possibilities, all banks interested in providing payment services will need to develop their service levels and reduce their costs in order to be competitive. Standardisation of payment services according to best practices and automation will mean that the competitive focus will be on prices, customer support and additional services. The basic transaction services will be the same, but the customers will demand support, advanced e-archive services and analysis, leading to service competition being heightened.
All service providers will face big structural changes. Modern technology together with increased competition will drive down prices and margins in payments processing. It is essential for the service providers to be able to reduce their own costs also and not be tied up in expensive legacy systems. By 2010 e-payments will account for 95-99% of the total volume. The cost of IT processing is shrinking rapidly and will go down to a few cents or even lower. If the current trend of cost reductions continues, the cost of ICT resources (except human resources) needed for the current payment volumes will go down by about 75-80% by 2010 and by 90% by 2112. These changes will be especially drastic in countries that still have a large share of paper-based processing.
SEPA entails great opportunities if it is efficiently managed. However, the current focus seems to be too much on minimising short-term development cost and preserving current national structures. National institutions for standards and national infrastructures such as ACHs try to maintain their position as national service providers. However, this is not in line with the new SEPA economics. We need a Europe-wide focus and European institutions. There can be competing interbank service providers in the competitive SEPA environment, but all of these should have the objective of serving a Europe-wide customer base.
The standardisation and development of SEPA services should be forward looking in order to meet future needs. We would need a stepwise development process in which the next steps are planned while the earlier ones are being implemented. E-invoicing and m-payments are new developments, which require European attention. A governance structure for SEPA+ and e-SEPA labelled services are also needed. The development costs will be higher and SEPA possibilities will not be utilised if all modern developments are first effected on national level and only later harmonised. There is also a danger that SEPA will delay long-term developments if there is no governance structure in place for the standardisation of modern and added-value services.
SEPA will not be an isolated island but rather an open part of the global network economy. A good SEPA design can be a model for building the international payment infrastructure. On the other hand, an inefficient SEPA design will not be competitive with non-bank suppliers like PayPal and emerging mobile payment services, etc. There is a risk that the bulk of European payments could be transferred to these competitive global network-based real-time payment services.
In order to be generally and economically successful, the SEPA design needs to be significantly forward-looking. The focus should be on maximising future customer benefits and not on minimizing banks’ short-term costs of change. Customers are willing to pay for valuable and efficient payment services because these help them to improve their internal work-flows and reduce costs and time spent on payments. The SEPA payment services are built for the future use of customers and it is essential for SEPA’s success to listen to the needs of the different customer groups and involve them in the development, standardisation and implementation process.