The euro had a lengthy gestation period and then hit the markets in 1999 with a whoop, circulated as a currency in 2002 with a bang and is now creating a fairly large explosion in the European financial markets. Throughout this process, banks have been responsive but not proactive to the changes implied by European Monetary Union, particularly when it comes to integrating infrastructures across the eurozone. The result is that the European Commission has forced change through the European financial markets.

Why force the change?

When the euro was first discussed in the early 1980’s, everyone anticipated dramatic change in European business. The rationale for this change is at the core of the commitment of the European Union countries to achieve economic reform and achieve their aims to transform the region into "the most competitive economy in the world".

Now the euro is here, the surprising factor was the lack of change within the European banking community to harmonise their payments processes in preparation for its introduction. Most banks implemented the currency facilities, but did not integrate their payments facilities across borders.

This lack of integration has been a major barrier to creating a seamlessly integrated euro payments structure and so, bearing in mind that this is a critical part of building Europe’s future competitiveness on the global economic stage, it is not surprising that the governments of the eurozone nations have been totally behind legislating to make it happen.

The result is that the Commission has created a raft of rules and regulations to restructure the financial markets through the Financial Services Action Plan (FSAP). The "objective is a Single Payment Area, in which citizens and businesses can make cross-border payments as easily, safely and efficiently as they can within their own countries and subject to identical charges".

How is it going?

Since FSAP’s endorsement in March 2000 through to the end of July 2004, 39 of the 42 measures had been adopted in the EU nations. That is pretty impressive when you consider that this is a complex and massive change programme, operating across 25 countries – the 15 original European Union nations plus the 10 accession countries that joined in 2004. However, adopted by the nations versus implemented by the banks are rather different statements.

For Europe’s banks, FSAP is a major headache. For example, banks face new payments rules (the new legal framework, also known as the Payment Services Directive), new accounting rules (IAS), new securities trading rules (MIFID) and new capital adequacy rules (Basel II). Add into the mix other regulatory requirements – such as European banks listed in the USA need to comply with Sarbanes-Oxley – and you can see why some bankers feel blown away by a melting pot of change.

By way of example, I want some euros using my debit card

Just to illustrate the point, one of the most obvious impacts of the euro regulation has been the changes to bank charging structures on low-value cross-border payments. These charging structures were dramatically altered by EU Regulation 2560/2001, which was announced in 2001. This legislation effectively wiped out historically healthy margins on low-value cross-border transactions.

The legislation was implemented in July 2002 for cash withdrawals and card payments, and extended to credit transfers in July 2003. The nature of the regulation is that all electronic transactions within the euro zone of €12,500 or less have to be charged at the same level as an equivalent domestic transaction. This limit rises to €50,000 in January 2006.

The importance of this ruling has been dramatic. For example, in 2001 a bank customer withdrawing €100 from a euro cash machine outside their domestic European country would have been charged €4 on average, while domestic withdrawals and payments are free or cost just a few cents. The same can be said for a cross-border credit transfer of €100 which averaged €24 in charges compared to virtually free domestically.

So how have Europe’s banks responded?

The disappearance of a rich vein of cross-border payments charges, margins and profits, for the banks is a big loss. At the same time, the cost of converting systems to comply with new legislation and new initiatives is a major cost. After all, replacing all the interfaces to traditional clearing systems with new pan-European systems is a major investment and change program. Nevertheless, that change is currently underway.

The change began in earnest with a meeting of Europe’s key financial market players in Brussels in March 2002. The meeting included key personnel from 42 European banks, 3 Credit Sector Associations – EACB (European Association of Co-operative Banks), ESBG (European Savings Banks Group), FBE (European Banking Federation) – and the EBA (Euro Banking Association).

The reason this meeting was critical was that it resulted in the financial markets agreeing the plan for the creation of a Single European Payments Area (SEPA) with the vision to ensure that "by 2010, Euroland payments will be treated like domestic payments". The meeting also created the European Payments Council (EPC), to provide the governance structure to guide and implement SEPA.

The implementation of that vision covers a wide variety of changes to low value cross-border payments, from standardization of bank account numbers (IBAN) and branch codes (BIC) to the introduction of a Pan-European Direct Debit (PE-DD) and the replacement of national clearing houses with a Pan-European Automated Clearing House (PE-ACH). Nearly all of these changes are consolidated in the Step2 (Straight Through Euro Processing) infrastructure, owned by the EBA, with a critical focus on creating and ensuring the success of PE-ACH.

Step2 and the Pan-European Automated Clearing House (PE-ACH)

PE-ACH was launched in April 2003, in cooperation with SIA of Italy as a technology partner and Swift as a messaging partner, using the latest technologies and XML standards. The intent is to supersede the national ACH’s with PE-ACH and, sure enough, the system is slowly growing in stature processing 145,000 transactions on average per day in December 2004.

As of November 2004, PE-ACH counts more than 87 direct participants and 1,350 indirect participants (indirect participants are banks that are known to the system but send and receive their payment messages through a direct participant).

All very worthy but there is an awful long way to go. The biggest issue is that the EBA can launch many initiatives using new technologies but most of the banks are still grappling with their own proprietary ACH’s. Thirty-six national and domestic ACH’s are operating across Europe processing euros, and any pan-European player already has to interface with these.

There are also many larger ACH processing infrastructures in existence that could have more weight than Step2. For example, Voca – formerly known as Bacs Ltd prior to 12 October 2004 – processes an average 17 million transactions a day compared to Step2’s 145,000. Bacs has linked up with Interpay in the Netherlands and the standards body Twist (Transaction Workflow Innovation Standards Team) to extend its focus on B2B payments and corporates across Europe. And there is no logical reason that a few others such as RPS in Germany and SIT in France could not team to create their own Pan-European approach.

The melting pot boils

Then you have a number of other critical euro initiatives.

Target2 is consolidating high value payments infrastructures and is being driven by the European Central Bank in conjunction with the National Central Banks. Swift is driving change through SwiftNet and its mandate under the Giovannini Committee to create a common clearing and settlement protocol.

Add on to this the rapid pace of change of retail payments with EBPP, EIPP, micropayments, epurses, contactless payments. Then throw in the raft of other standards bodies influencing the markets and you really have a complex spaghetti of systems and standards that needs addressing fast if the European Commission’s objective is to be achieved. Remember, that objective is a "Single Payment Area, in which citizens and businesses can make cross-border payments as easily, safely and efficiently as they can within their own countries and subject to identical charges".

To achieve that objective, European bankers need to have clarity. Clarity can only be driven if someone unstrings the spaghetti of systems and standards.

The spaghetti comprises:

• legacy infrastructures that cost billions to maintain (banks spend about $14 billion per year on payment technologies);
• governments and central banks that invest in domestic payments infrastructures at the possible expense of the pan-European objectives;
• new technologies that are displacing existing operations and infrastructures as rapidly as they appear;
• a range of standards bodies who want to be the owners of the standard to secure their own futures; and
• global players who can muscle their own structure at the expense of the small players who cannot keep up.

Unless the spaghetti is unraveled, most banks will be between a rock and a hard place, with many of the smaller banks only able to cope with cross-border payments by outsourcing this capability. Equally, losing profitability and margins on cross-border euro activities whilst having to invest heavily in new infrastructures and systems, leads to the same conclusion. And the most likely folks to outsource to will be the big global players – Citibank, HSBC, JP Morgan, Deutsche Bank – who have the breadth of scope and depth of pockets to sustain this forced change program across the euro-zone.

Thank goodness Charlie McCreevy, the European Commissioner for Internal Market and Services, promised us in December 2004 that we could "rest assured, there won’t be another (Financial Services) Action Plan".

Chris Skinner is a director of TowerGroup and founder of ShapingTomorrow.com.
Breffni McGuire is a senior analyst in global payments for TowerGroup.
Web links: www.towergroup.com and www.shapingtomorrow.com
Author's email: Chris Skinner