Open Banking Payments: Revolutionising Financial Transactions
What is Open Banking?
Open Banking was born through a series of reforms called for by the competition watchdog in the UK, the Competition and Markets Authority (CMA). In 2018, these reforms, along with the updated Payment Service Directive (PSD2), brought Open Banking to the public in the UK and Europe.
In the US, things haven’t progressed at the same pace. However, measures are being put into place to accelerate the introduction of Open Banking after President Biden signed the Executive Order on Promoting Competition in the American Economy in July 2021. The order will enable the Consumer Financial Protection Bureau (CFPB) to formulate the relevant rules needed for the speedier introduction of Open Banking across the US, promoting market competition and choice for consumers.
So, what is Open Banking? Open Banking enables previously unimaginable connectivity between banks, third parties, and financial technology companies, allowing them to share their customers’ data securely and with explicit permission through the use of open Application Programming Interfaces (APIs).
This has enormous benefits for the end user, whether a consumer or business. It allows customers to have digital access to their financial data and to carry out financial transactions not previously available. Customers can share information about their account balances, transactional activity, savings, and investments, enabling third parties to carry out transactions on their behalf, such as paying a merchant or managing a recurring payment.
What is an Open Banking Payment?
In a retail transaction scenario, an Open Banking payment involves a third-party provider accessing a consumer’s bank account to initiate the transfer of funds on their behalf with their consent and authentication to pay a business for goods or services without the need for a payment network. This alleviates the requirement of a payment card and therefore no network involvement. The third-party payment provider has a contractual relationship with the merchant to enable it to receive open banking payments. When the consumer chooses open banking as the payment method at checkout, the open banking provider initiates the payment directly from the consumer’s account to the merchant account.
Is the Use of Open Banking Payments on the Rise?
The use of Open Banking payments in ecommerce, while relatively small in volume compared to card payments, is increasing, with the expansion into point-of-sale (POS) transactions expected soon. It’s worth noting that the use of cash as a method of payment is declining. There was a 35% reduction in the use of cash between 2019 and 2020. Simultaneously, ecommerce sales have risen from 5% of all transactions in 2006 to around 30% in 2020. The increase in ecommerce has led to the associated rise in the growth of open banking payments in the UK and Europe.
In the UK, for instance, there were on average a million open banking transactions a month in 2020. While that is a comparatively tiny number of transactions compared to other payment methods, it illustrates the continuing increase in merchant acceptance and consumer willingness to pay through that alternative channel. Equally, the number of third-party suppliers, including payment providers entering the market, has increased in the UK and Europe from just over 100 in early 2019 to nearly 500 in Q1 2021.
Open Banking and the Merchant
We’ve touched upon the increase in the number of merchants willing to offer this alternative payment method, so what are the benefits to the merchant? Traditionally, the acceptance of cards as payment for goods or services has a high cost attached to it. The cost to merchants of accepting card payments through the networks is known as the Merchant Service Charge (MSC). The MSC has a number of components, the costliest being the Interchange Fee, which is a percentage of each debit or credit transaction.
The Interchange Fee rates can be complex and depend on several variables, such as whether it’s a debit or credit card, the card scheme, whether the transaction is secure or non-secure, the region in which the transaction took place, and particularly in the US, the type of market the merchant is doing business in. The fees can range from around 0.2% – 2.25%, with those accepting Card Not Present payments generally paying the most.
Attempts have been made to reduce or limit the cost of accepting payments with the introduction in the UK and EU of the Interchange Fee Regulation of 2015, which capped this element of the MSC, effectively lowering interchange costs for merchants. However, a subsequent study of the UK card payment market found that savings from the cap were only partially reaching the merchants, while other components of the MSC, such as scheme fees, increased. For example, UK SMEs with a turnover under £50 million have seen their total card acceptance costs stay the same (no real benefit) or actually increase even as the IFR caps caused the interchange fee component to reduce. In real terms, therefore, the merchant hasn’t benefitted from this attempt to reduce the cost of accepting payments.
How Could Offering Open Banking Payments Benefit the Merchant?
Reducing the cost of accepting payments is an attractive proposition for any merchant. Merchants are keen to reduce costs and increase margins, and a cheaper method of accepting payments would be one way to achieve this. Open banking payments offer lower and more predictable costs compared to the additional fees of authorisations, chargebacks, and data security compliance associated with traditional card payments.
Increased convenience for consumers is another benefit. They experience a faster and frictionless checkout process with the use of biometric authentication, helping to speed up the process. This requires less effort on the part of the consumer, leading to a reduction in purchase abandonment and therefore more sales for the merchant.
Are Open Banking Payments More Secure?
A key factor for both merchants and consumers is the increased security associated with open banking payments. Consumers using this payment type must authorise every transaction with their bank using strong customer authentication (SCA). The use of SCA means that a consumer must provide at least two separate types of identification from three categories to prove their identity:
- Knowledge: Something they know, such as a password or PIN
- Possession: Something they own, such as a phone or payment card
- Inherence: Something they are, referring to biometrics like fingerprint or facial recognition
The need for the transmission of customer credentials such as card number and CVV during an open banking transaction is removed and replaced by biometric authentication. This makes the transaction as secure as possible, reducing the risk of fraud.
So, From a Merchant’s Perspective, What’s Not to Like?
- Cheaper
- More convenient for customers
- More secure, reducing fraud and increasing approvals
While debit and credit cards currently account for around 65% of US and 60% of UK retail sales payments, the benefits to merchants of open banking payments offer a compelling case for this alternative to the traditional method of network-based payments for both merchants and consumers.
What About Consumer Protection?
The case for open banking payments is compelling, but there is a potential fly in the ointment: consumer protection. With the absence of the traditional payment schemes and the ultimate arbitration they provide for dispute resolution, an open banking transaction appears to reduce the level of consumer protection. While the benefits to merchants are evident, consumers may potentially face an uphill struggle if they are unable to resolve a dispute with a merchant.
Advocates of open banking payments cite the speed of refunds as a major plus point for consumers if they become involved in a dispute with a merchant. They argue that there will be a much speedier and streamlined communication channel between a consumer and a merchant, increasing the likelihood of a satisfactory outcome. However, this relies on the assumption that both parties come to an amicable agreement and the consumer walks away with their refund. Should that outcome not transpire, the question remains as to how the dispute will ultimately be resolved.
Perhaps the contractual agreement between the payment provider and the merchant might include the refund of the consumer by the payment provider, with the resolution and subsequent reimbursement being sought directly from the merchant.
There’s clearly a benefit to the merchant of not having to navigate through the current dispute resolution process, which has its drawbacks. The cost of administering the schemes, the time it takes for the process to run its course, the adverse consequences of high chargeback rates, and the abuse of consumer protection through first-party misuse all add up to a burden for merchants. There is therefore an incentive to move towards open banking payments, which may further incentivise the merchant to look favourably and fairly upon a consumer dispute. The uncertainty still remains, though, as there’s been no clear and definitive solution to the perceived lack of consumer protection with open banking payments.
Will It Reduce First-Party Misuse or “Friendly Fraud”?
Open banking payments have little impact on the issue of first-party misuse, which is a post-transactional threat. However, will the enhanced security needed to carry out the transaction in the first place mean greater issuing bank pushback when cardholders try to claim a charge as fraud when, in fact, they willingly took part in the transaction? At least when it comes to fraud-related disputes, an open banking payment should be easier to defend from a merchant’s point of view. Also, how will the contractual agreement between the merchant and payment provider influence the outcome of such a claim? Only time will tell.
In Summary
The introduction of open banking within the financial ecosystem is one of the hottest topics in the industry right now. The progress of implementation continues at pace, with more financial institutions and third-party providers entering the market. The option for consumers to manage their finances with greater choice and flexibility is a compelling proposition, with the choice to utilise open banking payments being an attractive part of the offer.
There are many positives for both consumers and merchants in transactions facilitated by open banking. However, unanswered questions around consumer protection need to be addressed for there to be a compelling case for consumers to feel protected when making purchases. We await some clarification.