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NY financial regulator: Our payments infrastructure is “disco-era” tech and we should mandate improvements

By Michael Carney , written on December 22, 2014

From The News Desk

What’s the quickest way to enter the good graces of a payments entrepreneur? Tell them that the legacy financial infrastructure, things like ACH (automated clearing house) transfers and international remittance, is awful technology that needs to be trashed like yesterday’s garbage.

That’s basically the exact message the industry got last week from New York’s top payments regulator, New York Department of Financial Services (NYDFS) Superintendent Benjamin Lawsky. In a keynote on the changes to his department’s proposed BitLicense digital currency regulations, Lawsky told an audience at the Bipartisan Policy Center think tank in Washington, DC on Wednesday:

I think it would shock most consumers to learn that – at its core, despite modest improvements – the ACH system has changed little since it was created four decades ago in the 1970s. And that is why – as recent press reports have noted – it generally takes you longer to transfer money electronically than it would to physically transport that cash to another state or country. Indeed, many consumers are perplexed that, in a world where information travels around the globe in a matter of milliseconds, it can often take several days to transfer money to a friend’s bank account. So, in other words, in an age of smart phones and on-demand technology, we have a disco-era payments system.
The good news for entrepreneurs and consumers alike is that, unlike most frustrated industry observers, Lawsky is very much in a position to change things. He suggested in his speech that regulators – presumably the NYDFS included – ”should consider actively pushing for, or even perhaps mandating, improvements.” This was after he predicted that without the necessary innovation, banks could end up meeting a similar fate as Blockbuster Video. (Yes, he actually said that.) Lawsky argues, rightly:
Our children, and our children’s children, will not hesitate to bank digitally. They will demand speed and efficiency in the payments world.
Lawsky was quick to dismiss money laundering prevention as an excuse for our outdated financial infrastructure, saying:
I think that explanation is largely a red herring. Preventing money laundering at banks is, of course, critical. Indeed, it has been one of the top priorities of our Department. But I do not believe that finding a solution to that issue represents an insurmountable problem. That is particularly true in an age where we are able to shoot a robot spacecraft into the atmosphere and land it safely on a comet several worlds away. It is also belied by the experience of other countries, where payments between banks can settle within a matter of hours or even minutes.
While Lawsky had few positive things to say about the legacy banking and payments infrastructure, he did predict that established financial institutions will adjust and adapt in time, after recognizing that it’s in their “long-term interest to do so.” The most likely avenue for this capitulation: through the acquisition or adoption of disruptive startups in the space.

We’ve already seen some of this activity, both on the M&A and investing fronts. Among recent deals, PayPal acquired Braintree (which itself acquired Venmo), First Data acquired Gyft, Citibank acquired PayQuik.com, and Greendot acquired Loopt. Also, Square, for example, counts JP Morgan Chase, Citi, Barclays, Goldman Sachs, and Visa as investors. Impressive as this list is, it’s indicative of the cap table of many other up and coming fin-tech startups. Given the what’s at stake, expect to see much more consolidation in this sector.

Lawsky may be most notable in Silicon Valley for his role in regulating the digital currencies. But, as the top financial regulator in the world’s most influential financial market, his purview extends much further than that. And even within the more narrow digital currency space, he’s been seen as a friend to innovation and progress.

With his brief departure from the topic of BitLicense at last week’s event, Lawsky appeared to give a major gift to those innovating in the broader payments sector. His message: the work you’re doing is important and the industry won’t be able to ignore you forever, I’ll see to that.

Read the relevant portion of Lawsky’s speech in full, below:

When considering the evolution of the payments system, it may be useful to think of it in the following way. 1) You can build entirely new tracks to connect different stations to one another, or 2) You can update the existing tracks in order to make travel faster and more reliable.  Virtual currencies would fall into the former category of new tracks connecting consumers and businesses, but there is also an existing sets of tracks in the payment world in desperate need of repair and improvement.

One example is the Automated Clearing House (ACH) system that banks often use to transfer customer money to one another.  I think it would shock most consumers to learn that – at its core, despite modest improvements – the ACH system has changed little since it was created four decades ago in the 1970s.  And that is why – as recent press reports have noted – it generally takes you longer to transfer money electronically than it would to physically transport that cash to another state or country.  Indeed, many consumers are perplexed that, in a world where information travels around the globe in a matter of milliseconds, it can often take several days to transfer money to a friend’s bank account.

So, in other words, in an age of smart phones and on-demand technology, we have a disco-era payments system.

Even many new entrants into the mobile and app-based payments world – who are doing some truly interesting work – largely have to build their technology on top of that ossified, existing system.  So, what is the cause of that startling market failure to innovate within the legacy bank payments system?

Some people blame regulators' focus on rooting out money laundering. They say that faster payments technology will make it impossible or extremely difficult to spot fraud and illegal activity.

However, I think that explanation is largely a red herring.

Preventing money laundering at banks is, of course, critical. Indeed, it has been one of the top priorities of our Department.  But I do not believe that finding a solution to that issue represents an insurmountable problem.  That is particularly true in an age where we are able to shoot a robot spacecraft into the atmosphere and land it safely on a comet several worlds away.  It is also belied by the experience of other countries, where payments between banks can settle within a matter of hours or even minutes.

I think a more likely explanation is that what we are seeing in the payments world is the classic type of market failure that exists in a monopoly-like system – where existing entrants have little incentive to innovate and are instead content to continue extracting unjustified rents from consumers.  The technology exists to change the system for the better, just not the will.

That is not to say that regulators are blameless. When you have a monopoly-like system – with very high barriers to entry – it is the regulator’s job to prod their institutions to overcome that collective action problem.  In other words, it is sometimes the regulator’s job to serve the public interest by pushing market actors to do what those market actors are unwilling to do themselves.

Indeed, I think that the current market failure in the payments system is, in part, why there has been so much excitement about virtual currency technology.  Virtual currency could have the potential to force the existing, legacy payments system to up its game in a significant way.

It is, of course, important not to be Pollyannaish about these types of things – as is sometimes the tendency among tech evangelists.  Virtual currencies such as Bitcoin are a very, very long way from being a credible challenger to banks or the existing payments system. (Though the imprimatur of financial regulation will probably help.)  But I think virtual currency could eventually cause some amount of self-reflection in the legacy financial system.  And it may even cause some banks to confront the Blockbuster Video problem.

The problem that in an age of heightened consumer expectations for real-time, digital payments, if banks fail to innovate, they could eventually face a real challenge.  Blockbuster Video stores used to be on virtually every corner in of our country. But with the emergence of Netflix, they practically disappeared overnight.  Money is, of course, a different animal from something like video or music technology.

The financial crisis notwithstanding, I think most people still feel more comfortable entrusting an old, well-established, FDIC-insured bank with their money, rather than a tech start up.  That said, if banks continue to torpedo even modest updates to the payment system, they ultimately do run at least some risk of facing the Blockbuster Video problem.  Our children, and our children’s children, will not hesitate to bank digitally. They will demand speed and efficiency in the payments world.

My guess is that banks will eventually adjust. It is in those institutions' long-term interest to do so – both from a financial and an existential perspective.  And they will probably co-opt or acquire some of the most promising technology after a period of trial and error.  Regulators, for their part, will have to keep up and find ways to permit innovation and improvements, while protecting against money laundering.  But if banks do not make significant progress soon, regulators should consider actively pushing for, or even perhaps mandating, improvements.

That is not typically the way regulators like to operate.  It is generally better to let the market make these types of determinations.  But at a certain point, enough is enough. And four decades of slow-to-non-existent progress in the bank payments system seems like fair warning.