The Evolution of Real-Time Payments: Part 1 - Then and Now

Sonia (00:00): Welcome back to PCBB's Banking Out Loud Podcast. I'm Sonia Portwood. I'm your host for today's episode. And with me is Virginia Robbins. She's my cohost. How are you, Virginia? Virginia (00:19): Hey, Sonia. I'm great today. Good to see you and great to be back today. Sonia (00:23): Yeah. Very exciting. Our topic today's going to be on payments. And that's a pretty broad subject. As we began to explore this, we thought, "Wow, what a dynamic and exciting time it is for payments”. Everybody's talking about payments, real-time payments. It's everywhere. Everybody's offering it. And the changes that are coming, are coming very quickly. So, what we thought we would do is slow down just a little bit, back up, and let's talk about some of the basics, for those of us that are not the experts. What is a payment? What's the history of payments? What does today's environment look like? Where are we headed? And the structure, the infrastructure I think is critical to understand. What is the infrastructure of payments? How do they get moved from one person to the next? Sonia (01:19): And our guest today is our own Allen Sztukowski. Allen has over 20 years’ experience. He's a veteran in the financial industry. He's held leadership roles in operations management, securities trading, and compliance. We're happy to have you here. Welcome, Allen. Allen (01:40): Well, thank you Sonia and Virginia. It's very nice to be here, and I appreciate the opportunity to be able to speak with you guys today. Sonia (01:46): So Allen, you've been busy over the past six plus years. You've been on a number of taskforce, you've been on councils and committees. Why don't you take a few minutes and talk about those appointments and some of the goals of each of them? Allen (02.02): Yeah. Thank you, Sonia. The purpose of the efforts that are going on in the industry at this point are to try and find ways to make payments faster, to make them more accessible to consumers as well as businesses, and to really just kind of modernize the payments in general because they really haven't been modernized in a very long time. The Fed set up the Faster Payments Taskforce back in 2015. And the primary goal of that was to get stakeholders together to talk about payments and how they would envision them to be modernized. Some of the stakeholders were consumer groups. Some of them were merchants such as Amazon and other merchants like that, as well as financial institutions both big and small. Allen (02:41): And the idea was to scope out kind of what a successful faster payment would look like. The Faster Payments Council is an offshoot of the Fed's faster payments taskforce, in the sense that a group of stakeholders wanted to stay together to try and find ways to promote faster payments amongst the various stakeholders, being the same stakeholders that participated in the faster payments taskforce that the Fed have. That effort is continuing, and they're focused on standards and kind of working through some of the industry related items that need to be addressed to have it be more effective. And I think all the stakeholders really had the same objectives, which is to find a way to help modernize payments and make them faster, but at the same point and time, representing their key sector. And obviously, financial institutions have a very different set of objectives than fintechs. Sonia (03:37): Yes. And financial institutions want to be able to retain their deposits in all of these changes. And as we all know, you can bring in different sectors. They may collaborate, but at the end of the day, whatever's best for them is where their primary focus is going to end up. So okay, thank you. So I'm sorry to interrupt you. You had some other information about some of these taskforce and committees you've been on. Allen (04:04): Yeah. The Faster Payments Council was really an offshoot of the Fed's Faster Payments Taskforce, in that a group of these organizations wanted to stay together and work through some of the issues that they felt were meaningful to address, such as: Are there going to be rules to govern the future of faster payments? Kind of what are some of the standards that are out there? What roles should the various parties play in how those things should be structured? Those efforts are still ongoing, and they're going to be ongoing I think for the next several years. There's also a big huge educational piece that they're taking ownership of in the sense that they want to educate both the consumers and businesses about their options that are out there and make them understand the risks and features of faster payments as well. And I think they're doing the same thing with the financial institutions and just helping folks understand what the future's going to look like and trying to position folks to be successful in the future, regardless of what vertical you're in, be it the fintech, financial institutions, or the consumer groups. Sonia (05:06): Allen, are they publishing any data that is available to our listeners? Allen (05:13): Yes, the Faster Payments Council has a lot of information available on their website. A lot of it's educational. And really, it is focused for educating consumers and trade groups as well as helping financial institutions understand that really, they do have a vested interest in the success of faster payments, as well as the fintechs helping them understand how to level the field for everyone to participate fairly and evenly, and what role everyone has to play in that. Allen (05:39): In addition to those items, there's been other items that we've participated in, there's peer groups that are getting together of correspondents, such as us. There's groups of community financial as well that are getting together, as well as the consumer groups that are kind of working through how this is going to look from their perspective. And those efforts are ongoing, and I think that everyone's realizing that to have something be successful, there needs to be this collaborative effort amongst all the groups together, as opposed to just one set of industries working in a specific silo. Sonia (06:10): And Allen, just to bring this home just a little bit, these groups coming together, Is the end game of that to have real-time payments between all of these parties? Is that the reason everybody's coming together? Allen (06:27): I think that's the goal. I think some of the use cases can be solved by specific verticals, but there's always going to be a better solution if the various stakeholders are able to collaborate together. And I think the ongoing effort's going to continue. And I think over the next five to 10 years, there'll be tremendous change in the payments industry just in general as we move forward. Sonia (06:51): Okay. Thank you. Well, why don't we tell everybody exactly. What is a payment? When we say payment, what exactly does that mean? Allen (07:03): That's a good point Sonia and a good question. And I think people take it for granted. Right? We do. And I'll use a simple example of that. I walk into a store, I put something on the counter. The person at the cash register says, "That'll be $3.50." And I take out my wallet and I pay them in some way, be it cash, or a credit card, or however the payment's made. And that simple example like that really illustrates the key components of it. In a payment generally, there's three parts. There's what's called the request for payment. There's what's called the payment message. And then there's what's called the settlement of the payment. Allen (07:46): And the request for payment in that example is the cashier saying, "That'll be $3.50." And the payment message is me pulling out my wallet. I'm making a sign confirming I'm going to make payment to you. And then there's the settlement piece, which is I'm giving my $3.50 cents to that cashier. Every payment that's out there is based on those three components. Some of them might not have all of those components. But they will be based on one of those three or a collection of those three transaction types. Sonia(08:15): So is that, when you say a request for payment, is that a request going out as well as initiating a push of a payment without a request? Are those the same things in this scenario? Allen (08:29): Exactly. It might not be concrete. The cashier's not saying, "$3.50," because she wants to make a demand for payment. It's just she wants me to know how much I need to pay her. But just by conveying that message, that request for payment is being made. And something as simple as me pulling out my wallet sends a clear signal to that cashier that I actually intend to pay this. Virginia (08:48): And Allen, you mentioned pulling out your physical wallet. For a lot of folks nowadays, it's the digital wallet instead. Right? The indication of what that payment is varies so much now, now that we're all using our cell phones for a whole range of things. Allen (09:05): Absolutely. And all of those three stages of the payment can be manifested in multiple ways electronically, absolutely. Sonia (09:14): Okay. Very good. That's helpful, Allen. So, before we move forward, let's go back if we can and look at financial institutions. And give us a little history, a little background of where we started with payments and how that has evolved to where we are today. Allen (09:33): Yeah. I think it's really interesting when you take a step back and look at it from that perspective. Part of it is because as we go through them and I talk about them, you'll realize that there really hasn't been very much progress made in modern, in different types of payments in several decades at this point. As an example, outside of cash, the first type of payment back in the 1700s was what we call a check now, which used to be in the old days, it was an IOU. And that kind of evolved into checks. Allen (10:00): And so these items that were invented in the 1700s were modernized in the early 2000s when things started being processed electronically and settled electronically, as opposed to physically being shipped and presented to banks for payment. Along with that, you have another rail, the automated clearing house, or more commonly known as ACH. This was set up in the early '70s as a payment rail, and most people know ACH for how they make their monthly car insurance premium payments, or how they get paid by their employer. Your request for payment would be that you're actually working and you're expecting to be paid. You have this electronic file, which is the payment message. And then you have the settlement, which takes place at the various banks at some point in the future there. Sonia (10:43): That was a huge change for the industry. Was it not, Allen? I mean, because we were going from actually the only way payments were being made was between individuals by a check, and this was the first stab at automation of payments. Was it not? Allen (11:00): I think it was one of the first stabs of the mass automation of it because you've taken this process now, where as opposed to companies needing to write checks, they could process an ACH with 10,000 items in there at a time. And you really got some efficiencies based off of that. And you got rid of the paper processing as well. Mind you, checks still exist. And the other interesting part about this is no matter what payment rails have been created, or new payment methods have been created, a single one has never gone away. Most likely, they probably won't. And they'll continue to be there, it's just there's different refinements as things progress there. Allen (11:36): Credit cards were developed back in the late '50s, and they were structured a little bit different than they are now. But basically, it was the same kind of concept. you went into a store. You gave them your credit card to pay. And they accepted your card, realizing that at some point in the future, the item would be settled, they would receive the funds most likely the next day. And then from there, the next logical progression from there is the debit card rails, which are in the late '60s. Allen (12:00): And that's kind of similar. You go into the store. The person tells you, you owe them $3.50. You give them the debit card. They're not expecting to get paid right then and there, but they know they're going to get paid. In most instances, it reflects in real-time on your bank account, although that money hasn't settled and probably won't settle for at least a day or so, as the back behind the scenes processing takes place to do the settlement piece. Allen (12:22): And so if you look at those payment rails, methods of payment, you see that they're really, since the '60s and '70s, there hasn't been much that's changed. There's different nuances as far as how are people using the rails, but the actual rails themselves haven't changed at all. There's been incremental efficiencies gained, such as that checks are now cleared electronically, as opposed to the physical checks being extended. And this is why the larger bank branches were located next to the Federal Reserve branches in the old days. Right? Because they had to run the checks over to the Federal Reserve, who processed things. Or they had to run their checks to the other bank, so that bank could clear. That's not necessary now with the advent of the electronic check clearing, which came in the early 2000s. Allen (13:04): But beyond that, there hasn't been any new payment rails created recently since the debit card rails. And so the opportunity for refinement and finding different use cases to address is really ripe out there. Sonia (13:20): So Allen, you mentioned rails, payment rails. And I think we can all figure out that you're talking about that's actually the way the money is moved, and it's pretty clear when you're writing a check, how that's being moved. The check is either being send electronically, or back in the old days, actually being delivered for settlement. But then you move to ACH, and we talked about ACH as in bulk payments through a file that was sent. When debit cards and credit cards came along, were they moving along the ACH rail? Allen (14:01): Yes and no. The debit card rails are one that necessarily gives the merchant the perception of that real-time payment. there's this message that takes place right then and there when you present your debit card. That's the debit card rail. But debit card transactions are later settled generally through ACH or through some other mechanisms other than actually riding of the debit card rail. Sonia (14:29): So it's a messaging system that gives the appearance of a real-time payment. Allen (14:35): Correct. And I think that's a key point you have right there in that where things are now is that you're starting to see more products come out that give the perception of real-time payments without necessarily having the functionality of real-time settlement. And I think for the end users of it, such as if I were to send you some money through a platform such as Zelle or something along those lines right there, I would show that money's debited from my account in real-time, and you would see that it's credited to your account in real-time. And so it looks pretty slick from the consumer's perspective. But the reality of it is that money hasn't settled yet. And that money will settle at some point in the future, generally speaking, probably through ACH at the next cycle for processing those items. Sonia (15:18): So we think payments have changed a whole lot, but they really haven't. There's been, as you mentioned, some significant milestones that have come along that have made huge changes like ACH and wires. But what do we have today? Because from the consumers' eyes, and maybe some of our financial institution eyes, there's been huge changes with the different fintechs and the payment schemes that have come into existence today. Can you talk a little about those and how those payments are actually making their way through? Allen (15:53): Yeah, absolutely, When you look at how the existing payment rails, be it ACH, or debit, or credit card networks, are being repurposed, there's really two ways that's happening at this point. One is through a banking-based environment and one is through a non-banking-based environment. PayPal and Venmo is an example. Those are payment related products where to make a payment from one party to another party, the payment might flow through the banking rails, but the end funds might be credited to an account that's not necessarily a banking account on behalf of that end person receiving the payment. Sonia (16:37): How does the payment go through PayPal, for example? Allen (16:42): That's a great question because you can go to various stores and you can pay through PayPal. Right? PayPal uses the debit rails to process that payment message. And so when you process your item from PayPal, the item goes through the debit card processing, but the net settlement takes place inside of PayPal's own master account. So PayPal has this omnibus account that they have at a bank or financial institution, where they have all of this funds that they have that are in the PayPal system. And so it debits it from one person's kind of sub account on PayPal's general ledger, and it credits it to the person receiving the payment, to their sub account on PayPal's general ledger. Allen (17:20): from financial institutions' perspective, the concerns they might have for that is that those funds that are in that omnibus, PayPal or Venmo type of account aren't necessarily deposits that financial institution can attribute to a specific depositor. Allen (17:39): Banks would like something different in the sense that they prefer products that are more account to account based, a perfect example of this is Zelle. If you were to pay you $5 through Zelle, I would have my bank account be debited, and your bank account will be credited. The financial institutions see it going from account to account, as opposed to it just sitting in an omnibus account, like they would if it was through a PayPal type of environment. Allen (18:05): Really, you have these two different paths to go down. One is centric, or based upon the financial institution. And one is based upon an omnibus account that is held by a third party, such as a PayPal or a Venmo. Obviously, the financial institutions like it to be based on the account to account transactions. Allen (18:22): So you don't have that counterparty exposure that you would have if you were to process or work with a payment processor that doesn't do the account to account bank centric type of payments. Sonia (18:35): Thank you. That's helpful. Allen (18:37): One other key thing I want to talk about, you have payment products through other tech providers as well. And one thing to keep in mind with that is that those aren't new payment rails. Those are use cases to repurpose the existing payment rails. And in situations such as this, prime example if Facebook. you'll get paid today, the perception of the funds being there, but it settles like a debit card transaction would. Allen (19:05): So, by processing things like that, banks are participating in real-time payments. They're just not participating in the customer facing part of it, and that's what the fintechs have decided that they are able to control and able to master and they've done a very good job of getting that out there and having adoption of it, the Zelles, Venmos, PayPals. When you think of a payment based product, a lot of times you don't think of a bank centric product. Right? You kind of think of, I can pay my kid through Facebook, or I can do this through Venmo. Allen (19:39): And these other providers have done a tremendous job of making the customer facing front end, customer facing experience look so cool, that person doesn't even realize they're using a bank to make their payments or to receive their payments. whether financial institutions like it or not, they're processing these real-time payments for other people. They're not owning that customer's experience, but they're still doing their processing behind the scenes. Virginia (20:02): So Allen, does that mean that institutions have an opportunity for income when they process that? Or is there some opportunity for income here? Allen (20:11): There is. And some institutions have done a pretty good job capitalizing on that. And I think one of the first things that institutions need to kind of work through is: What is it that they want their role to be in the payments ecosystem? And there's different phases of this. There's the current environment and the future environment. For the current environment, really there's a couple different ways that banks can play. It comes down to: Does the bank want to actively compete against the fintechs the are out there, which is a difficult thing to do? Or does the bank want to embrace collaborating with the fintechs that are out there, which is a much easier thing to do? Because every fintech that has a payment based product, it's a bank payment product that they're using. Sonia (20:50): Allen, is it realistic to think that a community financial institution could partner with one of the large fintechs? Or are we in a situation where we really have to go through, say, our core system provider to provide us with that front end facing messaging system, if you will, for real-time payments? Allen (20:22): I think there's a couple points on that. For the front end customer facing piece, mostly likely you're going to have to work with your core provider because anything real-time, you have to have access and it has to be plugged into a payment rail in real-time as well. That front end, if it's riding the debit card rails, that needs to have a real-time integration with that rail to be able to process these things. The other thing that you need to have is you need to have a critical mass of this. Right? Because an example would be an institution can't create their own payment product and pay someone else who's at a different institution, unless that other institution's using that same payment product, or something similar, or something that could integrate with them. Allen (22:00): And this is where the fintechs have done a really good job in the sense that they've made their products cool, so people will voluntarily sign up for them. Some institutions have very successfully made that transition to partnering with fintechs in the sense that they've come to I guess a happy spot, realizing that it's going to be too hard to own that front-end experience, so let's just work with the fintech, because they need a back-end provider anyway. Right? They absolutely have to have access to the payment rails. Allen (22:26): And the fintechs also need a place to make deposits. At some point, those deposits with PayPal don't stay on PayPal's books. So, the fintechs are very dependent upon financial institutions working with them, both for access to the payment rails, as well as a place to put the money because PayPal probably isn't going to hold $5 trillion in deposits for other people. Sonia (22:49): Allen, can you give us an example of how a community financial institution may have partnered with possibly one of the fintechs to generate income? Allen (23:01): Absolutely. There are quite a few examples of institutions that have been able to partner with fintechs. And a perfect example of it would be a lot of the wealth management fintech entities that are out there at this point. They have a niche in that they provide access to the securities markets through mutual funds and things of that sort. But people need to put money into those accounts, and that's where the financial institution comes into play. They might partner with that fintech entity to provide the rails for the funding to come into their accounts. Allen (23:29): And so there are these symbiotic relationships where fintechs need financial institutions, and financial institutions needs these fintechs. But to get there, that institution needs to realize that they're probably going to give up that customer facing front end experience and be more of a utility behind the scenes to process payments and to store deposits on behalf of the fintech entity for their end depositors. Sonia (23:54): So Allen, in the news of late, we've seen where fintech companies have either applied for a bank charter, or have purchased an existing bank. And I'm sure that has a lot of people wondering how that's going to play out over time. And do you have any comments around that, or ideas about what you think is going to happen in the future as this continues to grow? Allen (24:28): That's a great question. And the reality of it is it's going to continue. Right? And the reason these fintechs are doing it, it's pretty clear in the sense that they have existing partners with financial institutions, but they're realizing or thinking that they might be able to provide that same service and product offering in a more cost effective way, where not only do they control the customer facing front end, but they also control the back end as well. And I think from their perspective, they're looking at in the sense that as a fintech, if I need to make these payments, it's probably more efficient and cost effective if I do that all on my own and not necessarily become dependent upon this other financial institution to process these things for me. Allen (25:08): With that said, I think there haven't been too many fintechs that have purchased financial institutions at this point because I think a lot of times as they dig into it, they realize that the reason that there is this inherent cost structure for financial institutions to process these certain things or payments on their behalf, and to hold the funds on their behalf, is because there's a big regulatory compliance burden that's associated with that. And so yes, you will see some that will continue to do this, to purchase financial institution. Obviously, when you become of a certain size, the efficiencies might make more sense. But I think for your typical fintech, most likely you're going to be better off just partnering with the financial institution. Sonia (25:50): Allen, is there any such thing in existence today that is a real-time payment, other than handing someone cash? Allen (26:03): There's a couple things. So, one is wires. Wires are real-time, irrevocable credit push payments, and outside of cash is primarily the one that's out there today that has critical mass. They've been around forever at this point and they're broadly accepted. The issue is there's a cost structure involved in processing wires because generally speaking, the customer facing front end doesn't have direct access to that wire pipe because of the amount of risk that would be associated with giving that direct access. Financial institutions are the only ones that have direct access to that. Allen (26:41): And so you have this process that makes things a little bit removed for that, which is why there's a bigger cost structure for wires and they tend to be high value things. There are real-time payment products that are coming out, one is the clearing houses RTP, or real-time payment product. It is a real-time messaging and real-time settlement-based product, and so it is kind of revolutionizing the way payments take place. But at this point, it's not at critical mass. I think over the next several years, it will get up to critical mass once it becomes more widely adopted by more financial institutions. And at the same time, the Federal Reserve is working on their real-time product, which is Fed Now, which has not even been created at this point. It's in the process of being created. Sonia (27:28): Do you feel that the Fed is going to be a leader in these faster payments? Allen (27:34): The Fed is going to be successful in their efforts for Fed Now. The clearing house is also going to be successful in their efforts. And I think collectively between the two of those, I think you'll have all the financial institutions covered. I think they both service financial institutions, but they both service them in a very different way. Virginia (27:53): So Allen, we've been primarily talking a lot about I think domestic payments. For our institutions that are either on borders, or have diverse populations international payment, how does that work into our discussion of payments? Allen (28:10): I think just as the evolution of payments, I think at some point in the future, we're going to stop thinking of payments as being a domestic payment and an international payment because I think where this is eventually going to be heading is it's going to be global real-time payments. And I think that over the next several years as some of these initiatives come into play, you're going to see a lot more in that area because obviously once the domestic piece gets taken care of, there's this natural tendency to solve for one of the largest pain points that financial institutions have, which is a cost effective way to send money internationally, as well as people making and receiving the payments as well.They're dying for a cost-effective way to do this. Allen (28:51): And it's ripe for automation as well, and I think just generally speaking, fintechs tend to look at where there's the highest amount of revenue to be made. And international payments are definitely there. Right? Virginia (29:01): So from a bank standpoint, I'm worried about payments because of the deposits, but I'm also worried about my fee income, from whether it be international payment, ACH income, debit income, consumer income, overdraft fees, et cetera. All of that sort of works into the equation of why I care about payments today. Allen (29:23): I think you hit the nail on the head right there. And that's the gorilla in the room, is that with payment modernization and things becoming more seamless and more real-time, as friction is removed, so is revenue opportunity because obviously, that's what financial institutions has managed to make revenue on. Sonia (29:43): Allen, thank you so much for joining us today. Our hope is our listeners walk away knowing something more than when they started. And, we also realize there is a lot more we could have talked about, Allen would you be willing to come back and continue our conversation about all the changes going on in the payments space? Allen (30:02): That would be wonderful I’d rally enjoy coming back, and thank you for having me today as well. Sonia (30:09): And thank you to our listeners. We hope you learned something new about payments today. And we look forward to continuing the conversation with Allen in the near future. Until then, make sure to check out our other episodes at pcbb.com/podcast, or your favorite podcast player.