by Hugh Mullan, Technical Specialist and Economist, PSR
Regulators are often seen as the referees in markets. There to support fair competition. This blog discusses the benefits of this and its limitations; and when more direct intervention may be required to provide innovation in payment systems.
Regulator as referee
Economic regulators often seek to stimulate competition by using antitrust powers to enforce against anticompetitive agreements and abuse of a dominant position. Merger regulation is used to prevent loss of competition due to market concentration. Ex ante regulatory powers may be used to lower barriers to entry and seek to remove incumbency advantages from undermining competition.
In short, the regulator seeks to set a level playing field between competitors in the hope that the competitive process will benefit end users. For example, through lower prices, higher quality, and new products.
Twenty years ago, the Cruickshank Report was damning about the state of competition and user outcomes in UK payment systems:
“The lack of competition identified in the money transmission market are caused by the underlying economic characteristics of payment systems. Network effects mean that there is a natural limit to the extent to which competition is possible between payment systems. As a result, inefficiencies can persist for years, and payment systems can be run in the interests of those who control them rather than the public interest. The Review’s findings are echoed in the experience of many other countries. To deal with these fundamental problems requires sustained intervention.”
Much has been done to create a fairer playing field in payment systems, particularly by focusing on the structure of schemes; their rules of membership and decision-making. There is also now a dedicated referee for the payments sector.
However, given the deep-seated issues identified by Cruickshank, it is not surprising that these conditions may not always be enough to stimulate major innovations in payments. It is, though, such innovations which benefit users and the economy by far the most. So, what should happen when the conditions of the market do not support innovation?
Sometimes, regulatory action may be required to stimulate innovation more directly.
I provide below some examples of when a regulator or legislature has gone beyond relying on competition to generate innovations. More specifically, they provide examples of when (i) a particular innovation has been identified and mandated for delivery by the industry; (ii) an innovation has been created by the regulator; and (iii) legislation has been introduced to target innovation in a particular payment method.
Innovation through regulation
The UK has benefitted from a more interventionist approach. A pre-cursor to the PSR, the Payments Systems Task Force, was established due to concerns about a lack of competition and innovation in payment systems. The Task Force comprised government, consumer groups, and banking industry associations, but was chaired by the Office of Fair Trading which also provided the secretariat.
The main contribution of this Task Force was the introduction of Faster Payments. In 2005, it took three days for an internet or telephone payment to clear into the payee’s account following initiation. This was considerably longer than what was available in comparable European countries.
The banks said initially said that there was no demand for a faster payment service.
This illustrates a chicken-and-egg issue with innovations. How does one know if they are valuable when they have not yet been developed and marketed?
The banks also said that developing the technology would be costly and there was not a business case for it.
This illustrates the difficulty that the private costs and benefits of an innovation to the banking industry may not justify investment, but comparing the costs to the benefits which would be realised by society may indicate strongly that the investment is worthwhile.
This problem arises in a number of ways in payment systems. First, the most powerful innovations in payments tend to require joint development by the banks and, so, none gain a competitive advantage. The difficulty is likely made more acute in the UK due to the traditional free-if-in-credit personal current account proposition which means that the vast majority of payments do not attract a direct fee despite generating a cost.
Second, the network effects referred to by Cruickshank mean that a person will tend to use the payment method which others are using. This creates strong incumbency advantages for what exists already. It also makes it harder for new offerings to gain traction unless supported widely by banks encouraging adoption by their customers.
Third, if the industry needs to move together in order to realise the full benefits of major innovation, then such innovation can be held up by laggards. Innovation in payments risks moving at the pace of the slowest.
All of these factors mean that competitive pressure may not be sufficient in the payments sector to generate meaningful innovation.
Arguably, some of these same forces slow important potential innovation in payment systems today or will do in the future (perhaps, for example, in relation to Open Banking; the New Payments Architecture; or using Faster Payments for point-of-sale or online payments to retailers).
The Task Force estimated the likely use of Faster Payments; evaluated the value of this to society; and compared it against the costs to the industry. It was estimated that there would be up to 193 million faster payments made by consumers if the service were free. IT development costs of introducing faster payments were forecast to be up to £65 million. The Task Force found “while there was no convincing narrow cost-recovery case, the wider business case showed a significant notional value accruing to the United Kingdom economy”.
So, in retrospect, was this innovation, initiated by regulatory intervention, worthwhile?
Well, in 2019, there were nearly 2.5 billion payments using Faster Payments in 2019 (13 times higher than predicted) and its use continues to grow rapidly. Small businesses have found it particularly useful in paying wages and supplier invoices without needing to sign up to originate BACS Direct Credits and rather than paying by cheque or cash.
Banks developed a faster payment method than originally specified.
I think that it is clear that the regulatory intervention to push the industry to introduce Faster Payments was worthwhile. Indeed, the benefits of Faster Payments, and the further innovations it triggers, are likely to increase further as it works with other innovations around mobile banking, open banking and, potentially, as an alternative to card payments.
More broadly, the example of Faster Payments provides an example of how a more direct form of regulatory intervention is needed in order to trigger real change – identifying the demand for a way of paying which is possible, but absent, and tasking the industry with providing it.
In some circumstances regulators might themselves be the innovators. There is currently a lot of interest in Central Bank digital currencies as an alternative to recently developed or proposed private digital currencies, like Bitcoin and Libra. Sweden’s Riksbank is already testing an e-krona.
In other circumstances, where competition policy processes may be viewed as slow or ineffective, government may itself seek to stimulate innovation by targeting the gatekeeper roles which can be created for certain players in the payments space. For example, in Germany, legislation has been introduced giving the right for payment service providers and e-money issuers to access technical infrastructure that contributes to mobile and internet-based payment services. This is seen, by some, as seeking to give payment service providers direct access to the NFC (near field communication) interfaces of Apple’s mobile devices – potentially allowing in-store payments to be made using iPhones but without using Apple Pay. Currently, when point-of-sale payments are made through an iPhone, these payments are always made through Apple Pay.
Most of the time the role of an economic regulator is to create the conditions whereby competition is as effective as it can be, given the structure and conditions of the industry. Effective competition may, then, be expected to create the incentives for firms to innovate. Occasionally, the regulator can take some steps to tweak those incentives, perhaps by influencing industry structure or conditions.
But a regulator should also be thinking more broadly about what it wants to see the market delivering for its users, and whether the market is delivering this. If not, the regulator should consider taking more direct interventions to ensure the desired innovation comes about.
So, what innovations do you think that there should be in the payments sector? Are the benefits of these to society likely to outweigh the private cost of provision? Is the competitive process likely to deliver these?
Hugh Mullan is a Technical Specialist and Economist at the Payment Systems Regulator and has previously worked as Assistant Director at the Competition and Markets Authority.
The views, thoughts and opinions expressed in this blog are his own and do not necessarily represent those of the Payment Systems Regulator.