How Should UK Banks Prepare for SEPA?

The aim of the single euro payments area (SEPA) is to ensure that every bank makes it as cheap and easy for customers to make a cross-border credit transfer/direct debit as domestic credit transfer/direct debits. The European legislation that underpins this initiative is the Payment Services Directive (PSD), which also covers other payment-related issues. The PSD has to be incorporated into the legal and regulatory frameworks of each member country. In the UK, the PSD will be incorporated into the Financial Services Authority (FSA) rules.

How Does SEPA Affect Banks in the UK as a Non-euro Country?

Just because the UK economy is non-euro based does not mean it escapes the preparation for SEPA (and neither do Sweden, Denmark or the new accession countries). Although, it must be noted that the exchange rate issue does create extra complexities for these countries, compared to the euro countries.

By January 2008, UK banks should be in the position to offer their customers:

1. The ability to make a direct euro credit at UK domestic credit prices to any country in the EU. (The FX rates, fees and associated margins are not specified.)
2. The ability to receive and process a direct debit claim in euros from any country in the EU; again the FX, fees, rate and margins are not specified.

Additionally, under the SEPA Cards Framework (SCF) there is a drive to standardise the interface between merchants and merchant acquirer. One significant issue for the European Payments Council (EPC) is that the interface between merchant and merchant acquirer (e.g. message and file formats) is standardised in each EU country but generally with a different standard. This means that the market for merchant acquiring services is limited to each country, contrary to the single market idea.

What will happen, and by when, is not yet clear but it is likely to require major change to the merchants’ and merchant acquirers’ systems.

What Are the Operational Challenges for Banks?

The diagram below illustrates the typical systems architecture of a UK bank today.

This diagram indicates that:

• The SWIFT based world of CHAPS and currency payments is message based, mainly real time and highly manual in nature (hence the dotted line around the CHAPS and currency boxes showing human operational activity).
• The domestic low value payments world is file-based, batch-based and usually tightly tied into domestic accounting systems because of clearing cycles with very little human intervention.
• The domestic low value payments are not connected into the currency accounting systems and so currency accounts (i.e. a bank account denominated in something other than sterling) usually do not have direct debits, standing orders or credit transfers (other than those credits based on SWIFT payments via correspondent banks).

Given this architecture, the practical implications of SEPA boil down to the following issues:

1. From the domestic accounts and the euro accounts a cheap mechanism has to be found for processing euro credits to other EU banks. One solution might be to just cut the price of SWIFT euro credit transfers. This, however, is unappealing given the manually intensive (and therefore expensive) nature of current SWIFT payments. Furthermore, the SWIFT payment service is generally ‘better’ than that required by SEPA, including advice and same-day capability. For domestic payments, the cost of processing is reduced by having much of the data related to the payment already stored (e.g. standing order mandates databases or credit transfer mandates) and maintained by users themselves via Internet or telephone banking.
2. Receiving and processing euro direct debit mandates and claims from other European banks against both sterling and euro accounts. This is fundamentally new technology in several senses. First, the bulk of UK banks do not have the capability to process and store direct debit mandates against currency accounts. The direct debit systems for sterling accounts cannot process payments in anything other than sterling. Furthermore, they are based on different cycle times to those suggested for SEPA.

The result of these changes could be quite major IT spends. Another important feature of SEPA is ‘reach’, i.e. that a payment can be made from – or to – any European country. It is not at all clear what will happen after SEPA’s introduction but we believe the solution will look like the diagram below.

The main elements of the new architecture are likely to be:

• A central European ACH, probably based on the EBA STEP operation. This will offer services as a central switch to both individual banks or country based ACHs.
• Country-based ACHs will probably develop an option that would allow banks to re-use some of the existing software and interfaces that they already have to connect to the country-based ACH, e.g. VOCA in the UK.
• Individual banks will have to choose whether to interface directly to a Central European switch or to a local ACH, which in turn connects to the Central European ACH, or a mixture. For example, a UK bank with European subsidiaries may choose to plug into a number of local ACHs.

What About the European Subsidiaries of a UK Bank?

It is unlikely that most UK banks will develop bilateral relationships with a payment provider in each country so they will look for someone to become their prime provider of SEPA payment services. It could be another bank or it could be a new figure emerging on the European payments stage, the Pan-European Automated Clearing House (PE-ACH).

In either case, a UK bank is going to have to develop a new strategic relationship to fulfil its payment obligations. If a UK bank has a subsidiary bank in a eurozone country (e.g. Ireland, Spain or France) and that bank runs on a common software platform with the UK parent, then additional work is required.

The European subsidiaries of a UK bank will have to behave like any bank within the eurozone and therefore UK banks must provide the ability to make credit transfers and receive direct debit claims.

They must also provide a direct debit origination service that allows a direct debit originator to create direct debit mandates according to the SEPA scheme rules. These will almost certainly be different to those they currently use (e.g. days in the cycle, file formats and liabilities in the event of a claim rejection).

Furthermore, in euro countries, banks have to migrate the bulk of their direct debits and credit transfers from their domestic schemes to the new SEPA schemes by the end of 2010. (The UK can continue with BACS indefinitely.) This migration is a big challenge for direct debit originators and high-volume corporate payers, such as payroll agencies. If the European subsidiary of a UK bank has these types of customer, it will be the bank’s responsibility to persuade them to change their (the corporate’s) systems to the new formats.