Open banking and the rise of bank-to-bank payments

We’re reaching a tipping point for bank-to-bank payments and PSD2 and open banking might just push us over the edge.

Direct Debit, the most common means of collecting bank-to-bank payments, was devised in the 1964 by a Unilever executive, as an automated way to collect recurring, variable payments from ice cream vendors, without having to ask permission each time.

• In 2016, Direct Debit made up 20% of all 122 billion cashless payments taking place in the EU (source: European Central Bank, Payment Statistics for 2016).

• Direct Debit volumes in the UK reached 4.2 billion in 2017 (more than double what they were at the turn of the millennium), representing a 3.8% growth on 2016 (source: Bacs Payment Schemes Ltd, 2017).

There are several factors that have contributed to the growth of Direct Debit in the UK and Europe:

Better access Third-party providers like GoCardless have opened up access to Direct Debit to thousands of SMEs in the UK who could not previously meet the revenue and bond criteria set out by banks. These providers act as a merchant account for businesses, developing and managing banking relationships on their behalf.

Ease of use More commercial providers offering Direct Debit has led to significant improvements in user experience. While the former paper-based Direct Debit system was clunky and disconnected from the rest of a business’ workflow, GoCardless now gives merchants a simple, automated way to collect payments, through an app within their billing or CRM software, through an online dashboard or by building their own integration with our REST API.

Macro-economic trends The growth of the ‘subscription economy’ in the last decade has led businesses to seek payment solutions more suited to a recurring revenue business model. Bank-to-bank mechanisms like Direct Debit allow these businesses to collect recurring payments against a subscription plan with a single mandate, while reducing involuntary churn and transaction costs (payment failure rates and transaction costs are lower for Direct Debit than for cards).

So, why doesn’t everyone use Direct Debit?

One of the attractions of Direct Debit is that it’s a ‘pull-based’ system, enabling a merchant to trigger and stay in control of recurring payment collection. However, this typically has two side effects:

• Payments take a few days to clear (typically five days under Bacs and three under SEPA). This makes it unsuitable for payment where immediate clearing of funds is needed - for example eCommerce.

• Customers enjoy strong protection in the form of unlimited refund rights under Direct Debit scheme guarantees such as this one in the UK, making it unsuitable for high-value physical goods like cars, or within industries where there is a high incidence of fraud.

For global subscription businesses, Direct Debit presents a different challenge. Since bank schemes are globally fragmented, a business wanting to collect by Direct Debit in multiple geographies, would, until recently, have to forge local banking relationships (or third-party provider relationships) in each one.

Where bank-to-bank falls short, cards have become the fall-back option. Their global reach, along with the facility to set up recurring card paymentswith a single upfront customer authorisation (in a similar same way to Direct Debit), has led to them becoming the default payment method for many global subscription businesses.

But cards weren’t designed for recurring payments and the costs can be high: card payments typically cost more (2-4% per transaction compared to <1%) and fail more often, since they can expire or get lost or stolen, hitting subscription businesses where it really hurts - involuntary customer churn (consider the stat commonly-quoted in SaaS business circles that it’s seven times more expensive to gain a new customer than to keep one.)

A global bank-to-bank payments network

So why is the use of Direct Debit on the rise? Let's take one of the challenges discussed above - global fragmentation.

GoCardless has started to address this by joining the dots between domestic and national Direct Debit schemes, with the aim of creating a global bank to bank payments network, with a single point of access and a standardised user experience.

GoCardless currently supports Bacs in the UK, SEPA across the Eurozone and Autogiro in Sweden with Betalingsservice in Denmark and BECS Direct Debit in Australia opening this year.

Because of this, Direct Debit is becoming an increasingly attractive proposition for global companies taking recurring payments and more and more of them are now offering this as a payment option to customers, from SurveyMonkey to Receipt Bank, TripAdvisor, Box and more.

That leaves Direct Debit with two other drawbacks: timing and the risk of fraudulent refunds of ‘chargebacks’. On these, open banking might just have the answers.

Smarter, faster bank-to-bank payments

There are three important elements of the pan-European PSD2 legislation, which work in the favour of bank-to-bank payments:

• Creation of Account Information Service Providers (AISP)

• Creation of Payment Initiation Service Providers (PISP)

• Credit and debit card surcharge ban

Let's take these in turn.

AISP

Until now, banks have been the sole owners of financial data like account details, balance and payment history. Under PSD2, payment providers and other organisations can apply to become an Account Information Service Provider (AISP).

Businesses and consumers will be able to tell their banks to share relevant banking data with an AISP. For GoCardless, being an AISP will mean we’re able to make payments that are:

• Smarter and less likely to fail - for example, they could be triggered when money is in your customer’s account

• More secure - for example by authenticating new mandates through your customer’s online banking account.

PISP

Under PSD2, providers like GoCardless may also become Payment Initiation Service Providers (PISPs), meaning they can trigger instant ‘push’ payments from a customer to a merchant. These payments are immediate and, like Direct Debit, will carry much lower fees than credit and debit cards.

Since the customer is ‘pushing’ the payment to a merchant (although it’s triggered by the merchant), PIS payments don’t carry the same refund rights as Direct Debit ‘pull’-based schemes, meaning they are more appropriate to use for high-value transactions or within industries with a high risk of fraud.

As it stands, PIS payments require a customer to authorise each payment - so it’s not as easy to see how they could help a business taking recurring payments. The value, we predict, lies in the ability of PISPs to intelligently combine different types of bank-to-bank payments to suit a merchant’s needs.

Consider this: A global SaaS (software as a service) business has stitched together a patchwork of customer payment methods across different territories to try and find the optimum balance between customer experience and conversion, security, risk of payment failure and overall transaction costs.

Soon, a provider like GoCardless could do the juggling for them. For example, it may be important to our SaaS business that the first payment of a new subscriber goes through instantly. In this case, GoCardless will be able to initiate their first payment using PIS. If Direct Debit mandate and PIS authorisation are given at the same time, GoCardless can revert to Direct Debit for the seamless collection of subsequent payments.

Similarly if our SaaS business had one customer that needed to pay for a perpetual license, GoCardless could facilitate that high-value transaction using PIS, rather than Direct Debit, to reduce the risk of chargeback.

We are already seeing these kind of merchant-initiated ‘push’ bank to bank payments in the Netherlands with iDEAL and in Germany with SOFORT. We will start to see much greater usage of these types of payments in the next few years.

Card surcharge ban

PSD2 includes regulation designed to increase transparency in payments and ensure that customers avoid unfair or hidden charges at the point of purchase.

The credit and debit card surcharge ban, which came into effect on 13 January this year, makes it illegal for businesses to add surcharges to credit and debit card payments anywhere in the EEA.

While this regulation does not directly impact bank to bank payment methods, it does make them more attractive to businesses who have traditionally used cards and who are sensitive to transactions costs.

With typical transaction costs of 1% or less, compared to 2-4% for cards, it’s easy to see why businesses operating with low margins might turn to bank to bank alternatives. We have already seen this happening in the travel industry, where operators are asking customers to pay for their holiday instalments by Direct Debit, through GoCardless.

Could bank to bank rival credit and debit cards?

The opportunities for bank to bank payments are significant, leading some analysts to predict that they will become an everyday reality for consumers, capturing 20% of customer spend away from existing card schemes.

For businesses that take recurring payments, the new-world proposition for bank-to-bank payments is a compelling one: a global network, offering low transactions fees, high security, low payment failure rates and the ability to accommodate high-value and instant payments - all with a single customer mandate.