Do We Need a Global ACH?

In Conversation With Do We Need a Global ACH? Gareth Lodge, Celent Neil Burton, Earthport CELENT

In Conversation With Global ACH, or iach as it is sometimes called, seems to be the buzzword of the moment. To turn end-user demand and industry interest into reality, we need to ask if there is a good business case for a global ACH?

The role of an ACH in the payments ecosystem To answer that question, we first need to understand the role of an ACH (automated clearing house) in the payments ecosystem. A recent paper 1 by an ex Federal Reserve Bank executive provides a useful framework for analysing payment and settlement issues. The four major components of the framework include the payment system, payment schemes, payment infrastructure, and payment services: The payment system is the network of endpoints represented by deposit accounts in banks Payment schemes specify payment instruments by which the public gains access to the payment system Payment infrastructure supports clearing and settlement of payment instruments across the payment system Payment services are the specific means by which banks provide their customers with access to their deposit accounts for payment purposes, using instruments specified by various schemes. According to the FED, clearing, the main task of an ACH, is the exchange of instructions for transferring claims on banks. ACHs exist to serve the schemes the rules around a particular type of payment such as a Faster Payment in the UK, or the SEPA Credit Transfer in Europe. ACHs are usually regarded as infrastructure. Though a critical component of the payments process, ACHs do not handle client funds, which are the domain of banks, payments service providers and increasingly, new entrants who either do not know, or choose to pay little heed to the traditional model. 1. Facilitating Consumer Payment Innovation in the U.S. through Changes in Clearing and Settlement: A Public Policy Perspective, Bruce J. Summers 2

Characteristics of an ACH Automated Clearing Houses, or ACHs, are great at what they do, namely, domestic clearing, usually at exceptionally low cost, and with very high transparency and service levels. They are generally national in scope. They deliver outstanding reliability and economies of scale, and enjoy a virtual circle of support and investment. Furthermore, in some ways they are future-proof. Significant changes are rare, and maintaining their extremely high operational characteristics is the highest priority for their owners (the banks) and regulators. They are the constant that can be relied upon. And relied upon they are. Domestic payments such as payroll are crucial to any economy; failure is front-page news, and has the potential to bring the banks and economy to their knees. It is very much in the interests of the local banks which usually own them to ensure they have the investment and support to deliver payroll, pensions, and all the other forms of collection and disbursement upon which a local economy depends. Because clearing is critically important to the efficient operation and integrity of the financial system, ACHs are typically classified as SIPs or systemically important payments systems, and their activities are monitored by a governing body, usually the national central bank. When ACHs were first created, international transactions were a rarity and so ACHs are domestic in focus. Even today, over 90% of payment volumes never cross a border. But the level of cross-border transactions is increasing, as is the quest for the next level of cost savings. ACHs are about scale they tend to have relatively fixed costs, and so driving additional volumes creates even greater savings. If that s the case, does the concept of a global ACH - that is, an ACH operating across multiple countries, make sense? Can we consolidate the ACHs and create multi-national ACHs that provide both greater scale and also address the growing cross-border traffic? 3

Is big necessarily better? Direct comparison between ACHs is challenging because levels of functionality vary. Some ACHs are thick (i.e. common complementary functions centralised in the ACH) and some are thin (where each bank retains functionality internally). Some countries, typically those with few banks, manage without an ACH at all, usually operating a multilateral clearing model. But even so, ACHs provide clearing at a very low cost frequently less than a cent per transaction. According to a report some years ago, prior to SEPA, European ACHs were typically charging between 1 and 10 cents per transaction. Following the standardisation of schemes and consolidation of Eurozone ACHs, that average figure has reduced. Though payments is often described as a commoditised business (international payments remain the exception to that rule-of-thumb 2 ), the small variations in national payments schemes and in the business processes run by the national ACHs, are deeply ingrained into national culture. Some years ago, a project called WATCH attempted to establish a worldwide ACH; the project was eventually abandoned due to the massive costs and challenges in bringing stakeholders to a common view. Indeed, the holy grail of economy of scale may be a mirage; according to Boston Consulting Group 3, the cost of complexity can offset scale advantages ; and segregating operating models may even reduce cost. As SEPA has shown, consolidating domestic payments schemes takes massive investment and time. The SEPA project has taken an investment of over 9bn 4, over more than 10 years. 2. http://www.earthport.com/assets/uploads/2012/03/cross-border-payments-perspectives-a-glenbrook-earthport-research-brief.pdf 3. Winning after the Storm Payments 2011 Boston Consulting Group 4. TowerGroup 4

Might interlinking ACHs, or other standards based approaches work? Another initiative, the International Payments Framework being developed by the IPFA, seeks to improve nonurgent cross-border credit transfers by providing rules, standards and operational procedures and guidelines to enable ACHs to interconnect. IPFA services have been enabling transaction flow between ACHs in USA and Europe since late 2010. With connectivity between several other regions in the plan, this model shows promise on paper at least. In practice, it has been beset with challenges arising from issues with differences in routing tables, silo architectures within participant banks, and concerns about cannibalisation of income streams. SWIFT Remit is a similar initiative focused on remittances, which also goes a good way towards meeting the requirement. These standards based approaches improve connectivity but usually do not address the commercial challenges. Banks adopting these standards must still establish bilateral commercial relationships with other banks who also participate. 5

Or would a broadening of scope deliver more value? Interlinking ACHs only solves part of the requirement. Clearing is only a small part of the cost of making a payment. According to an analysis from Boston Consulting Group 5, clearing accounts for only 8% of total cost of an international payment. Most of the costs - and risks - of processing are in initiation, capture, processing and customer service. Settlement is 4%, initiation and capture is 30%, preprocessing and processing is 35%, and customer service and interaction is 23%. Though banks make between one third and one half of their income from payments 6, the availability of resource to invest in it is limited. The already heavy regulatory burden has grown since the financial crisis in most banks, resulting in almost no discretionary investment or project resource. Consequently, the line between the collaborative and competitive space has moved and there is no bright line 7. Banks need market infrastructures and other players such as payments service providers to step up further into the value chain. This will not only enable costs to be reduced through consolidation, but will also allow the target market to be broadened, thus enabling the fast growing international retail payments segment to be served cost-effectively, and pre-empt further expensive regulatory involvement. 5. Winning after the Storm Payments 2011 Boston Consulting Group 6. Ibid. 7. Independent Review of Governance and Performance of the Payments Council 2009 11 6

Make something better, or create a better thing? There must be a better way but to see it, you have to look at the big picture. Optimising the individual components of the existing 50 year old model will only result in small improvements. To quote Einstein insanity is doing the same thing over and over again and expecting different results. In our day-to-day life, we can see real-life examples of starting afresh. Apple, Dyson, Facebook et al would not be trying to make ACHs international. They would be trying to enable e-commerce. Each took existing ideas, but focussed on their own purpose and experience. Sounds far-fetched? PayPal and Google Wallet are both examples closer to home where this has already happened. Mobile payments schemes are another. The service providers exploit, rather than replace, the high fixed cost, low margin payments clearing and settlement systems, simply providing an overlay which delivers convenience and value; and hence attracts an optimal price without incurring massive investment or risk. 7

Redefining Global ACH Global market trends are moving towards greater volumes of lower average value transactions. E-payments and m-payments are growing at 19% and 49% respectively, according to the World Payments Report. And banks facing a growing onslaught of regulations have little appetite or capacity to build or buy new payments services. The pressing need is for a global payments service which re-intermediates banks into the whole of, not just a small part of, the value chain. A few banks are starting to describe this as a Global ACH a cost-effective, fast to adopt service which reaches all the main trading channels and is accessible through a single commercial agreement. That is a wider requirement than traditional ACH; it requires the movement of client funds, rather than simply the sorting of payment instructions. It is closer to the business model exploited by money transfer operators (MTOs) than traditional correspondent banking. Where correspondent banking is an open loop based on multiple messages passed through a chain, MTOs operate a closed loop in which they have direct control of the delivery of value to the beneficiary. The idealised service is then, the predictability and transparency of closed loop, with the global reach of open loop. Crucially, there is also the transfer and settlement of money, rather than just the messaging and sorting of payment instructions. This model exists today in many forms. It is similar to the way a corporate treasurer runs his accounts. Some banks operate it, though typically only for a few selected bilateral channels. Given the fast growth in e-commerce and other forms of low value international payments, it presents a significant opportunity for anyone who gets the formula right. 8

Gareth Lodge Senior Analyst glodge@celent.com +44 7753 614647 Neil Burton Director, Product Strategy neil.burton@earthport.com +44 7802 790663 Read the complete series of In Conversion With' vision papers 9