As of Saturday, January 13, all EU member states were to fully implement the revised Payment Services Directive, known as PSD2.1) Among other things, PSD2 allows third-party payment service providers to gain access to customers’ bank accounts (with the customers’ consent, of course), and customers’ banks are required to provide API connection for identity verification. Its potential impact should not be underestimated. For example, under PSD2, customers and merchants can, in principle, cut credit cards and debit cards out of their transactions, saving significant costs along the way. In addition, banks can no longer “own” their customers’ account data or prevent competitors from accessing them.
The EU’s PSD2 is a major development in payments and financial market infrastructure, a once-sleepy “back-office” function that is now alive and kicking. The essence of PSD2 is to encourage competition and reduce the information advantages of incumbent banks. Likewise, the Bank of England announced in July 2017 that non-bank payment service providers can become direct settlement participants in the UK’s payment system, as long as certain requirements are met.
Access to financial market infrastructure such as payment systems has important implications for market competition. The study of industrial organization shows that competition is reduced by vertical integration. A vertically integrated incumbent that produces both “upstream” and “downstream” goods can effectively reduce competition in the downstream market if its stand-alone competitors rely on the incumbent for providing the upstream good.2) Financial market infrastructure is the ultimate upstream good for almost all economic activities. Privileged access to market infrastructure makes banks “special” and, in some situations, may encourage anticompetitive behavior. Good examples to keep in mind include two antitrust class lawsuits in over-the-counter derivatives markets in which investors accused dealer banks of, among other things, using their unique positions as clearing members in OTC derivatives to shut off new entrants that aim to compete with dealer banks in the transaction of these derivatives.3) One of these lawsuits has been settled, with dealer banks paying $1.86 billion.
While privileged access to market infrastructure is valuable and probably incurred banks substantial costs to “acquire” in the first place, banks also realize that a certain degree of disintermediation is inevitable, especially if they face a comparable or even higher cost of capital on certain activities than their customers do. One example of this is clearinghouses, another central piece of financial market infrastructure that safeguards much of the $540 trillion OTC derivatives market.4) Basel III banking regulation has made it costlier for banks to provide clearing services to customers in derivatives because clients’ cash margin—funds that are posted as collateral to cover expected losses if default happens—is counted toward the leverage ratio of banks that clear the trades for customers, increasing capital costs.
While in the past banks acted as intermediaries standing between customers and clearinghouses, in today’s regulatory environment it often makes more economic sense for certain types of customers to directly access clearinghouses, reducing reliance on banks’ balance sheets that have become more expensive. Indeed, various types of direct clearing arrangements are already set up (Eurex and LCH) or proposed (CME).5)
Read the full post at ProMarket.
Haoxiang Zhu is the Sarofim Family Career Development Professor and an Associate Professor of Finance at the MIT Sloan School of Management.