The payments business continues to transform itself, sometimes faster overseas than in the United States.
There were indications of this last month at the International Payments 2004 conference in London. A major theme was that cost pressures on the international payments business are driving continuous change.
Citibank admitted that it has not increased payments revenues for several years but took comfort from having strongly increased profits through outsourcing. Citi, J.P. Morgan Chase & Co., and HSBC Holdings PLC all plan to white-label internal global payments services for use by correspondent banks. New alliances can increase market share and transaction volume at low cost.
Other key responses that will be more important this year and next are outsourcing and the adoption of Extensible Markup Language (XML). However, Chase believes that savings of 25% to 40% are required to make outsourcing cost-effective. HSBC itself targets an ongoing cost reduction of 5% to 10% per year.
Cost pressures on individual banks are affecting industry infrastructures. Tom Buschman, the development manager of Shell's treasury group and the head of the London-based XML standards group Twist, noted that a recent study by the London School of Economics shows a general trend for payments infrastructures to move from nonprofit to for-profit.
According to Lazaro Campos, the head of Swift's banking industry division, Swift is responding to cost pressures by moving toward fixed pricing as much as possible and will move away from per-transaction fees.
Since Swift has moved to a TCP/IP backbone, the cost of an extra message is effectively zero across Swiftnet. This will continue to put severe cost pressures on all industry participants. How much will banks ultimately be able to charge for a service that costs them nothing?
"Outsourcing of services is also emerging as one of the new business models, helping financial service providers to drive down their cost base," says Tracey Womersley of the newsletter Card World.
Central processing hubs and outsourced operations are cheaper than distributed solutions. For example, conference chairman Eric Sepkes, a vice president and the director of global financial institution strategy for Citigroup, noted that the U.K. interbank payment system, Chaps, was 15 times as expensive to run before it was centralized to one system and processing hub.
However, the adoption of central processing hubs and outsourcing requires strong interoperability. Since most legacy systems are incompatible and too expensive to rip out, a software overlay is required to bridge the gap between them.
For interoperability, XML is the best game in town. Its adoption is therefore a major focus of the strategy of most payments participants.
"There is the need for standards that can be adopted by all trading partners, and relatively quickly," says Mike Taipale of the Federal Reserve Bank of Cleveland, who is also the chairman of Nacha's Council for Electronic Billing and Payment. (I am a member of the council.)
XML can be extremely useful in eliminating costs. Mr. Campos said Swift reduces its own costs in updating rules by 70% through the use of XML.
The big players are starting to wade into the waters.
Stephen Axelrod, Microsoft Corp.'s European Union industry manager for wholesale banking, announced at the conference that its InfoPath software, which allows the seamless translation of Excel worksheet data into XML data, and vice versa, is now a standard part of Office 2003. Most companies today use Excel more than any other tool to provide interoperability throughout their supply chain.
The European Union's lead in payments is particularly strong in XML. Swift has a 40-person team that focuses just on standards and interoperability; I am the sole U.S. delegate to UN CEFACT TBG5, the United Nations standards-setting body working on XML financial messages. Other European groups such as Twist and Swift are working with the U.S. groups IFX and OAGi to standardize the core of all payment messages using XML. But most of the experts at the working group meeting are European.
Though XML is great in concept, the data must be of high quality for it to be useful in seamless interoperability. With bad data, the returns for banks diminish fast. Profits can be severely affected.
"Risk management works best when data quality is highest," said Visa's Joe Bugajski. "Every financial organization knows the truth that revenue less experienced risk equals the bulk of profitability. Conversely, poor data quality induces higher-than-expected risks, because of systemic errors.
"For instance, credit fraud prediction depends on accurately modeling 'bad' behavior for selected market segments," Mr. Bugajski pointed out. "If the data used for the models is erroneous, say to the tune of 3% per feature (or field), then calculations using these features - for example, neural networks in HNC/Fair Isaac products - might have an inherent error rate of 3% X the number of features, because errors are additive. If 'number of features' is 10, then an error rate of about 30% may be expected in predictions derived of the erroneous data.
"These errors show as false positives and as false negatives," Mr. Bugajski noted. "For example, when one has a large volume of payment card transactions to score for likelihood of fraud, this error rate can mean unnecessary losses in the hundreds of millions of dollars. Conversely, a 30% reduction in error rate yields an additive benefit; for instance, if 3% drops to 2%, the total error for 10 features drops to 20%, and 10% of hundreds of millions of dollars is a whole lot of money.
"The same argument about the losses and unmanaged risks due to poor data quality applies to calculations used in marketing promotions, sales campaigns, billing, exception handling in back-office operations, and everywhere else raw data is transformed or aggregated into new information," Mr. Bugajski said.
This wouldn't be so serious if the quality of data were not generally bad.
Thirty percent of all purchase orders are incorrect, and 70% of all documents have data discrepancies, according to John Hammond, the head of Exonomy, Standard Chartered Bank's trade finance portal. According to Mr. Axelrod of Microsoft, all but 10% of cross-border transactions need repair or reworking. (This explains why international funds transfers are so expensive even though Swift's per-transaction fees are quite low.)
However, Mr. Hammond sees efficiency gains of 25% to 50% over all if you can get the data quality issue right.
The conference participants also heard that some of the past proposed solutions are not ready for the market.
Bolero, as originally conceived, is not moving forward, because it did not achieve global mass; today the shipping companies work directly with each other. Swift has retooled Bolero and is about to re-release it in an improved business model.
Several speakers noted the backwardness of certain systems. General Motors still makes 40% of its payments via paper, noted George Thomas, the president of Electronic Payments Network. He also said Intuit has no electronic module for payments, just paper-based systems. Nacha itself was hit by ACH fraud when a criminal bought Dell computers that were being paid out of its corporate account.
The backwardness of some systems gives opportunities to those still willing to innovate. Innovative payment systems are rushing in to fill the unmet needs in the marketplace.
RosettaNet has established a logistics council. However, RosettaNet costs $10,000 per company to adopt - not much for a large corporation, but surely higher per bank. With more than 9,000 banks in the United States, will this standard fly without an easier means of access?
European bankers have created a pan-European ACH system, and the high-value Target2 payment system is designed to be the backbone of the payments and securities settlement in euros.
Visa noted that modifying just one data field for an ISO standard payment message can cost more than $2 million and six months of hard work throughout its payment network. As new systems multiply, expenses rise.
One possible solution also involves interoperability. "Single window" is Swift's term for access to all payment systems. Electronic Payments Network will offer a single-window Swiftnet connection to its customers.
The increasingly interconnected world creates risks, however, and trying to reduce risk is a major preoccupation in the post-9/11 world. A cross-border collateral pool task force for global payment liquidity enhancement was recently created at the Bank for International Settlements. Office of Foreign Assets Control screening is now required for messages entering the United States.
The "travel rule," 31 CRF 103.33(g) of the Bank Secrecy Act, requires that personal information "travel" with remittance data. Unless an XML-enabled system is used to transmit such data, the bank will probably be liable for transmitting bad data.
Nacha is working on such a system in its Electronic Billing Information Delivery Service project. Ebids, which the Council for Electronic Billing and Payment runs, is designed to XML-enable the U.S. ACH system in a limited way.
Content-rich XML messages are large and burdensome to a network. Ebids would let a reference to a unique Internet address be transmitted with the payment instruction, so banks and customers could examine and manipulate the detailed data offline, without burdening the ACH network.
Michelle Jones, a pioneer in the movement to outsource business processes offshore, spoke to me after the conference about issues related to the USA Patriot Act. Ms. Jones is the vice president of marketing at Covansys Corp., a Michigan-based consulting and technology services firm, and the coordinator of the site CSIInstitute.com.
"The Patriot Act seeks to do for the transfer of money what Homeland Security's Container Security Initiative does for cargo," she said. "Accuracy and synchronization of all the documents related to a business transaction are critical to keeping a business' supply chain moving."
Covansys has discussed supply-chain risk in the new, regulated environment with hundreds of retail and manufacturing executives, Ms. Jones said. "We commonly hear that 'We don't have a problem' or 'Someone else in our supply chain is managing this for us.' Organizations assume that once they've issued a purchase order, their responsibility and liability is eliminated until the goods reach the warehouse."
That is an incorrect assumption. Consider Wal-Mart, which outsourced store cleaning to a company hiring illegal immigrants. In the end Wal-Mart may be held responsible.
Costs cannot be cut forever without cutting corners or radical reengineering of the business processes involved, and the risks for executives who outsource cannot be any greater.
Penalties under Sarbanes-Oxley also include time in jail for senior corporate executives. Nevertheless, some experts predict only a major terrorist event that bankrupts a major bank or corporation will really get everyone to focus on the risks that aren't being addressed.
