PAYMENTS: REFURNISH OR REBUILD?/media/corporate... · This reduces fees from cross-border transactions and transaction interest rate earnings. It impacts both the front-end and back

PAYMENTS: REFURNISH OR REBUILD?

MASTERCARD CHAIR TRANSFORMING FOR THE FUTURE

Prof Regine Slagmulder

Prof Bjorn Cumps

Post-doctoral Researcher Yannick Dillen

Our solution to your specific needs

The financial services sector is facing its most radical change in decades. At the origin we find at least 4 societal change drivers: increased regulation, changing customer behaviour, technological innovation and new entrants in the sector. The sector is confronted with increased competition from both large established tech companies − such as Apple, Google, Amazon, Facebook − and small fintech start-ups that are moving into the financial services space.

From a sector perspective, we identified 2 distinct types of trends: the ones enhancing the existing system and the ones trying to rebuild a new financial services system. It is clear that a lot of the innovations focus on disintermediating the incumbent organisations. There is a clear move towards more decentralisation and peer-to-peer (P2P) collaboration. Blockchain technology enables value transfers through a decentralised, P2P consensus process. International money transfers are improved dramatically using P2P operating models. Technological innovation is making it easier for people to connect, exchange value and pay without the need of a traditional financial institution. We are witnessing a new wave of democratisation of financial services, giving a group of consumers easy access to services that were previously out of reach. New start-ups are attempting to enter these markets by offering better and simplified access to more convenient and secure financial services at lower costs, and with increased transparency. Those are all the ingredients of a good disruption as defined by Christensen1. Yet, contrary to what many believe, disruption does not necessarily mean the end of existing financial services organisations. Yet, many of the current trends are forcing them to go beyond the status quo: from Single Euro Payments Area (SEPA), with a focus on increased efficiency at lower prices for customers to Payment Service Directive (PSD) II with Open Application Programming Interfaces (APIs) for increased competition, innovation & transparency.

The change drivers at societal level drive the various trends we see at payments sector level. But how can organisations deal with these changes? Based on our research, there are 4 capabilities organisations should focus on to remain relevant:

• Design superior customer experiences • Set-up data-driven experiments • Build multi-party collaborations • Provide platform-based solutions

Based on our experience in working with organisations, these are 4 crucial capabilities for them to master in an increasingly turbulent environment like the payments sector. It is impossible for organisations to predict what will happen. But by investing in these 4 capabilities they will be better prepared for the road ahead.

1 Christensen, C.M. et al., “What is Disruptive Innovation”, Harvard Business Review, December 2015.

EXECUTIVE SUMMARY

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The Drivers of Change

The global payments industry is still healthy and growing.2 A recent consulting report indicates global payments growth towards nearly $2 Trillion in 2025 with expected increases in transaction-related and account-related revenues.3 That growth represents a worldwide average CAGR (Compound Annual Growth Rate) of 6% for the period 2015-2025. Western Europe is expected to grow by 2% and Eastern Europe by 7%.

However, some big changes lie ahead. Together with global industry experts, Vlerick Business School identified 4 key drivers of change – technological advances, increased regulation, changing customer behaviour, and new, often unconventional competitors. These change drivers are not specific to the payments sector, but are more general at societal level. They are the main forces that drive the various trends that will be discussed in later sections of this report.

Figure 1: Main change drivers at societal level

One of the most fundamental change drivers identified is the change in customer behaviour. As people are increasingly moving their lives online, organisations, including financial services organisations, will have to follow. Many of the technology companies have set new standards on both access and convenience. Many customers expect the same ease-of-use from their financial institutions that they are used to from companies like Apple, Facebook, Amazon. Preferably at low prices and wrapped in a customer experience layer. This is new for financial services organisations.

Closely tied to the changing customer behaviour is the increased rate of technological innovation. Financial services has always been an IT-driven sector. Yet, many of the new technology paradigms go beyond the traditional, transaction-focused, monolithic IT systems they know so well. SMACIT (Social, Mobile, Analytics, Cloud, Internet of Things) technology set things in motion a few years ago, yet this was only the start. Distributed ledger technology (blockchains), digital currencies, augmented reality, AI & deep learning, biometrics, and many other technologies convolve into a mix of technologies organisations need to master. As always, understanding the technology is the easy part. Assessing the

2 McKinsey & Company (2015), ‘Global Payments 2015: a healthy industry confronts disruption’, October, 33 p. 3 BCG (2016), ‘Global Payments 2016’, 28 p.

Technological Innovation New Entrants

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impact on existing business models and trying to both create and capture value using these new technologies will be the real challenge.

As technological innovation takes up a more prominent role in the financial services sector, new organisations have entered the sector. Large technology companies − such as Apple, Google, Facebook, Amazon, Alibaba and others − clearly show an interest in the easy-to-access, lucrative parts of the financial services system. Payments is certainly part of that equation. In addition, many new tech-savvy start-ups have started offering very focused, convenient and user-friendly solutions. Whereas these fintech start-ups and tech giants often compete with the incumbent organisations, they seem equally interested in collaborating with them. In any case, the new entrants are firing up industry dynamics, competition and ecosystem collaboration. A complex interplay of different forms of interaction between organisations is emerging as a result.

Finally, it is clear that regulation remains one of the important drivers of change for the financial services sector. Especially in Europe, where organisations face both national and European regulation, the challenge is daunting. Not because of the implementation of new rules and regulations as such, but also because the regulatory changes have a fundamental impact on the business models of financial services organisations. For example, SEPA and interchange fee regulation have an impact on how payments processes are organised. PSDII with Access to Accounts (X2AS) will have an even more fundamental impact on how the different organisations interact.

Changing customer behaviour, technological innovation, new entrants and regulation all have a substantial impact on the financial services sector as a whole, and on the payment sector specifically. In the next section we zoom in on some of the major trends identified during our interviews with payment sector executives.

Trends in Payments – Refurnish or Rebuild?

In this section, we describe a number of important trends in the payments sector. It is clear that most of the experts we interviewed expect customer needs and behaviour to shift towards very low cost, extreme convenience, and increased security of payments. Important recent developments in technology, infrastructure and regulation include trends such as data-driven infrastructure, invisible payments, biometric identification tools, instant payments, peer-to-peer (P2P) payments, Automated Clearing House (ACH)-based transactions, Single Euro Payments Area (SEPA), PSDII, blockchain technology and tokenization standards. We briefly discuss how each of these trends might impact the current payments system.

Data-driven infrastructure In many Western countries, the traditional payments infrastructure is being upgraded to pave the way for more advanced payment solutions based on advanced data analytics. There will be a growing need to integrate data sources, data infrastructure and data management. A key challenge for payment providers is to appropriately capture the large amounts of data from customer transactions, while making sense out of that. Data insights then need to be translated into relevant customer solutions (e.g., more control over expense patterns) or better customer relationships (e.g., refined loyalty programs).


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Moreover, incumbents are facing the challenge to go from a traditional approach of relying on ‘silo’-like data towards an approach that is more open and customer-centred, while staying in line with more stringent data privacy regulations.

Invisibility of payments Mobile payments are increasingly making use of integrated payment apps that are adding an additional layer over an existing payment method. In most cases, the card rails and infrastructure are still used, while the integrated payment apps are displacing the point-of-sale and the digital interface is relegating the payment to a utility in such a way that the payment ‘disappears’.

“Emerging payment solutions take away the pain to pay, which gives consumers more appetite to buy the products of the merchant that is offering this payment method. The smartphone apps of OpenTable, Starbucks and Uber are examples of solutions where consumers almost literally forget about the payment.” (Senior Vice-President at a leading POS solution provider)

Biometric identification New point-of-sale (POS) technology is emerging in which biometric identification is used to identify the user and to authorize a payment transaction. Payment methods using fingerprints or facial recognition create a seamless transaction in which no physical cards are needed. This can push many firms active in the payments industry out of the front-end of payments transactions. Although the customer POS relationship may improve, transactions are again becoming more invisible. The increasing number of (especially online) interactions is driving higher demand for such identification and authentication.

Instant payments Innovative solutions are emerging that enable merchants to receive payments in real-time from their customers’ bank accounts. They are denominated as real-time payments or instant payments. In Europe, national instant payment schemes that allow real-time direct-to-account payments are becoming increasingly popular. If instant payments can achieve the same level of perceived security as the current credit and debit card payments, their popularity is likely to boom.

“Every payment transaction will be real-time. Time lags will no longer be accepted by the current digital generation.” (Head of Securities Markets at a global financial services provider)

Peer-to-Peer Payments Peer-to-peer (P2P) payments can be seen as a derivative of real-time payments. Card schemes have traditionally added value to the payments system, as they enable real-time trade between actors that do not know each other, in a world where funds travel at less than real-time speed. A P2P payments system, such as Venmo or Dwolla, can challenge this by bringing parties directly in contact without a formal third party.

ACH transactions In Europe, several national Automated Clearing Houses (ACH) are joining forces to create a centralized processing infrastructure for Single Euro Payments Area (SEPA) transactions. ACH transactions are frequently used for automated payments of recurring bills, while the system can also be used for payments through mobile apps. The combination of several ACHs could lead to real-time clearing and settlement, making ACH payments easy and quick alternatives for credit card based payments.


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Single Euro Payments Area The relatively high costs of payments have been considered as a tax on trade by the regulatory authorities. The European Commission’s Payment Services Directive I, has created a legal platform for the Single Euro Payments Area (SEPA). SEPA imposes that all cross-border payments have to be charged at the same rate as domestic payments and that settlement periods have to be reduced from 3 days to 1 day. This reduces fees from cross-border transactions and transaction interest rate earnings. It impacts both the front-end and back-end of the payments ecosystem. The aim is to create a level playing field to increase innovation and competition and to support the digital and electronics payments agendas.

Payment Service Directive II The European Commission’s Payments Service Directive II (PSDII) wants to make it easier for newcomers in the market to acquire an operating license, contains new guidelines with respect to payment card fees, and targets increased security risks in e-payments. Third-party Payment Providers (TPPs) are allowed to get access to the consumer’s payment account for informational services and payment initiation. This may push merchants towards new payment services providers if they can offer more convenient payment methods. Moreover, PSDII aims to counter the increased security risks in the e-payments space through proposing a so-called 2-factor authentication requirement for e-payments. For every transaction, 2 authentication methods will be needed, which is not necessarily promoting a seamless payment transaction, but is expected to lead to a significant increase in security.

Blockchain technology Distributed ledger technology (blockchain) has the potential to create an infrastructure where payments transactions are managed by a distributed network of processors. The value transfer would be recorded in a distributed ledger, while settlement is near real-time, counterparty risk is eliminated and the switching network in the middle is made superfluous. Blockchain technology possesses the ability to create a ‘block’ that contains the authenticated history of all previous transactions in a network. Every participant of the network has a unique key with a private and public part to create new transactions and to verify existing transactions. In order to complete a transaction, the private part has to be shared with other parties in a network where everyone has the entire copy of the ledger.

The technology can set the stage for peer-to-peer payments on a large scale as it entirely eliminates the need for third-party validation and their switching fees. Of course, the regulatory authorities will have to issue a support statement for the technology first and it will have to prove its value in a niche (e.g., gold trade), before it could make its entry in the payments industry. Also, industry incumbents can still play an important role as they possess the scale, network and infrastructure that can facilitate the adoption of distributed ledger technology.

“The ‘Spotify of payments’ has not yet arrived. Before this would happen, a major technological improvement must be linked to a change in the business model of the payments industry, which is to date still largely based on the proposition that every transaction is linked to a fee. However, this proposition is likely to change in the near future.” (Senior industry expert)


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Tokenization standards Sensitive data elements in a credit card transaction are being increasingly substituted by a non-sensitive equivalent that encrypts the client’s data in a token. Such a token replaces the 16-digit account number with a unique series of numbers. Apart from online transactions, the process of tokenization is also used for connected devices, such as smartphones, to be securely used for making everyday credit card-based payments. In order to make payments more safe, tokenization standards are applied. The higher volumes of e-payments, the increased number of payment services, and the growing technical complexity of e-payments have led to more security risks, resulting in some severe security breaches in recent years. The recurring ID that is made for every credit card payment facilitates the customer journey for credit card payments. Besides, the transaction becomes more secure as data are encrypted in a token, reducing the number of fraudulent payments.

Table 1 provides a non-exhaustive overview of the key trends that are emerging in the payments sector and whether they are expected to link strongly to one or more of the 3 customer requirements (low cost, convenience and security). The majority of the trends are aiming to make payments more convenient. Convenience is a broad term which comprises ‘fast’, ‘smooth’ and ‘elegant’ payment methods, while providing easy access. Many trends appear to impact more than one of the 3 requirements. Blockchain technology, for example, has the ability to make payments cheaper, safer and more convenient.

“The technological enhancements are setting new standards for what customers expect from a payments transaction. Payments like they happen in an Uber taxi will not become the standard, but they contribute to the perception of what will be seen as a ‘normal’ payments transaction.” (Senior industry expert)

● Trend Customer expectation Convenience Security Low-cost Data-driven infrastructure ●

Invisibility of payments ● Mobile Wallets ● Biometric identification ● ● Instant payments ● ● ACH transactions ● ● Peer-to-Peer payments ● ● Machine-to-Machine payments ● ● Single Euro Payments Area ● Payment Service Directive II ● ● ● Blockchain technology ● ● ● Digital currencies ● Mobile money ● Tokenization standards ●

Table 1: Main change drivers at societal level and their potential impact


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When further analysing the different types of trends, different classifications can be used. Figure 2 illustrates the distinction between “enhance” and “rebuild” trends. Most trends we see today are focused on enhancing the existing payments infrastructure. Either make it faster and more performant (instant payments, ACH, SEPA, …), more automated (IOT with Machine-to-Machine payments – devices paying themselves), or more convenient (Mobile wallets). These trends focus on taking away friction or customer pain points in the existing system.

Figure 2: Main trends at sector level

Some other trends such as decentralized infrastructure (Blockchain), P2P payments, new currencies (bitcoin, Ether, …) or Mobile money (e.g., M-Pesa) more fundamentally change the way the current payment system is built. Whereas the “enhance” trends simply refurnish the payments house, the “rebuild” trends tear it down completely and lay the foundations for a totally new house. As illustrated in Figure 3, (Distributed Ledger Technologies (DLTs), Mobile money and P2P schemes can all be seen as non-traditional ways to transfer value between senders and receivers. This is fundamentally different from the “enhance” trends discussed above.

Figure 3: New non-traditional payment infrastructure (WEF 2015)


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The distinction between “enhance” and “rebuild” trends is important as different industry dynamics will be needed in dealing with these trends. What is typical about the “rebuild” trends is that it does not make sense for organisations to try to do this on their own. Typically, they need scale and depend on network effects in order to become truly successful. The payments sector does not need hundreds of distributed ledgers, each built by a different financial service organisation. If the existing payments system really needs to be rebuilt, it will only be possible if a sufficient number of organisations collaborate and scale it. Rebuilding typically needs a scalable ecosystem approach if ever to be successful.

In this section, we discussed and categorised the main trends in the payments sector as identified by our interviewees. In the following section, we will zoom in on how organisations can prepare for the sector change ahead.

The Need for New Business Capabilities

In the past, industry incumbents could afford to adopt a wait-and-see attitude with respect to new trends in the payments landscape as the changes were rather confined and evolutionary. Today, however, the environment is changing more quickly than ever. To survive and sustain growth in the long run, companies cannot rely on recipes from the past. The new business environment requires incumbents to invest in building new business capabilities to help them deal with the speed and scope of the change. Based on our extensive experience and case-study work, we identified a set of 4 capabilities that can help organisations deal with the change ahead (see Figure 4).

Figure 4: Required business capabilities4

Design superior customer experiences Products and services are not enough to win over or keep customers. The digital space is notorious for how fast it commoditizes products and services. Ultimately, value is attributed to the total experience of engaging with customers in ways that fit with their modern

4 Viaene, S. & Danneels, L. (2015). Driving Digital: Welcome to the Exconomy. Cutter Consortium.


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connected and mobile lives. Furthermore, today’s companies must make their customer’s transition from the digital into the physical world of experiences, and vice versa, seamless. Organisations should understand that it is crucial to take an outside-in perspective — putting themselves in the customer’s shoes — when designing value propositions. They need to embrace digital technology as a way to enhance relationships with customers, offering truly relevant and appealing customer benefits. They also recognize that, to be successful, every part of the organisation must contribute to this vision. This stands in stark contrast to the traditional functional approaches for creating the customer experience and the business routines that push products onto the market instead of pulling customers in.

Set up data-driven experiments Customer attention is hyper ephemeral in the digital space. New experiences are introduced constantly and switching between competing value propositions is best regarded as the rule rather than the exception. In the digital world, customers want to have control over their own customer journeys. Organisations should treat customers as moving targets and avoid working with untested assumptions. They understand that being relevant once is not enough; they must remain relevant. The way to do this is to keep up with the customer’s digital self. Digital leaders deploy information technologies broadly to continuously monitor markets, sense customer needs and track behaviour, systematically experiment with value propositions, and respond by swiftly scaling propositions that work. This implies a strong and wide-ranging cultural focus on using data and business analytics as competitive weapons. For such digitally attuned companies, adoption of big data technologies comes naturally, as they allow businesses to move from being product-oriented to offering a continuation of valuable experiences, and from mere transacting to building long-term relationships.

Build multi-party collaborations When moving into unfamiliar territory, established organisations can rarely reinvent themselves from within. In addition, no single organisation owns all the data, skills, and capabilities needed to compete for the customer in a digital world. The ability to partner strategically — going beyond transactional deals or outsourcing — is rapidly becoming a core capability to compete digitally. Organisations today should be fundamentally open to collaboration. They bet their future not just on what their own companies are capable of, but on what others — including partner companies, customers, and start-ups — can do. They reconceive their business strategies and business models through the function of business ecosystems of digitally connected partners that are able to successfully co-create and share value. Moreover, they do not just select partners to get access to scarce, complementary skills or capabilities; rather, they do so to accelerate their learning cycle through co-creation initiatives enabled by digital connectivity, collaboration, and knowledge management opportunities. Such companies realize, however, that if internal collaboration is problematic, then co-creating with external partners is going to be extremely difficult.


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Provide platform-based solutions Digital innovation capability depends on the effectiveness of combining the company’s unique digital assets with those of others. Today’s most valuable digital partnerships are built around “digital ecosystem platforms” (i.e., carefully managed architectures of reusable and integrable digital assets). Organisations should open up their existing digital asset base as services to a wide array of ecosystem partners. Accessibility and convenience are key to leveraging the often sizable investments in creating digital platforms. Organisations should also “virtualize” — or information-enable — physical assets to make the physical world digitally accessible. This allows them to use these assets at maximum capacity on demand and to develop sharing economy business models. They must understand that digital ecosystem platforms are the key to long-term economies of scale as well as scope.

The MasterCard Innovation Labs example below is a good example of testing, experimenting and innovating in an ecosystem setting in an agile way to stimulate intrapreneurship in the organisation.

MasterCard’s successful Innovation Labs constitute a worldwide network of co-creation and fast-working labs in which the payment technology giant works closely together with customers and partners on developing key innovations. In the Dublin Lab, the Launchpad programme was born, which was widely lauded across companies around the world and various industries. Starting from identifying a well-defined problem together with particular customers and partners, MasterCard then brings together a multi-disciplinary team of designers, developers and product experts from their Labs or other parts of MasterCard to come up with a radical idea to solve the challenge in just one week. At the end of the week, they have a working prototype, a video advertorial of the solution and a go-to-market plan. MasterCard runs Launchpads around the world on a weekly basis. Participants are often banks, but can be ‘unusual suspects’ too, such as Maytag, a U.S. supplier of washing machines used in laundromats. The problem they faced is that all these machines typically operate on quarters, which is becoming outdated very fast. In one week, MasterCard and Maytag built a prototype of an app called Clothespin. The app allows customers to use the laundromat ‘coin-free’ and instead pay directly with a mobile phone, while being notified when the laundry is ready. Impressive is the speed at which MasterCard can perform. The innovation teams are empowered, while management is fully on board. The company’s culture plays a big role in making this work.

Conclusions

In this paper we zoomed in on the major change drivers and trends in the payments sector. But more importantly, which capabilities organisations can build to prepare for the changes ahead. Figure 5 brings together the different elements of our discussion.


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Figure 5: Challenges, trends and organisational capabilities

The impact of the emerging trends on the payments industry is unclear. Typically, industry observers indicate 3 different scenarios ahead:

• The first one is a stand-alone scenario where particular technologies disrupt the traditional players. This would imply that the traditional players do not, or are too slow to, respond to the changing nature of customer expectations, while new players take over power and the market.

• The second scenario is one of collaboration or isolated co-existence between the new and the incumbent players. Traditional players can partner with new players through complementary use of emerging technologies. Also, they can each cater to a different part of the market in isolated co-existence with respect to each other. This means both types of players play from their own strengths, trying to bring the best solution to the customer.

• The third scenario is that the existing players observe, learn from or absorb these new technologies and new players, while starting to provide these services themselves. This entails a fast and strong transformation of traditional players, while creating their own alternative capabilities.

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Several studies56 indicate that in developed and mature financial markets scenario 2 is the most likely one. The sector and the existing operating model is disrupted yet this does not mean the destruction of the traditional players. Traditional players can bring their strengths to the table (a large existing customer base, business and regulatory expertise, deep pockets,…) and combine them with the strengths of new players (strong user experience, no legacy, customer understanding,…). Which scenario will ultimately unfold? We are convinced it strongly depends on which organisations are most successful in building the necessary capabilities we put forward. Organisations claiming their place in the changing payment sector will need to invest in the capabilities discussed above to be able to absorb all of the changes ahead.

5 World Economic Forum Study, “The Future of Financial Services – How disruptive innovations are reshaping the way financial services are structured, provisioned and consumed”, June 2015. 6 Citigroup, “Digital Disruption – How fintech is forcing banking to a tipping point”, March 2016.


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