Is PSD2 the start of a Fintech Regulation “Arms Race”?

Latest great guest post by Paul Rohan Author: PSD2 in Plain English

The EU is not alone in considering how public data policy and Fintech regulations might foster more dynamic innovation in its economy. The Australian Government this week asked its Productivity Commission to consider how financial data aggregation could be standardised and how Open APIs could facilitate access to critical transactions data for Fintech operators.  The aim is that the Australian Fintech sector will help create the “modern, agile economy of the future” and Fintech innovations will “lubricate the economy and drive a transition that previously wasn’t possible”.

The PSD2 model is also creeping around the borders of the EU28m.  Norway, as a member of the European Economic Area (EEA), is automatically in the scope of PSD2.  We can expect that Swiss Fintech operators are casting envious eyes at PSD2 and are asking Swiss Policy Makers for equivalent access.  Australia (24m), Norway (5m) and Switzerland (8m) could add a population of 37m (wealthy) people to the 500m people in the EU28 that will be served by a market with Open Banking APIs.

Paul Rohan explains PSD2 and the Future of Banking

What might motivate these Public Policy interventions?  Public policy makers in trading blocs around the world are seeking to both emulate and rival the global success of Silicon Valley. Clusters of high-tech industry, such as Silicon Valley, receive a great deal of attention from public policy makers.

US economic growth is fuelled by innovation in Silicon Valley. Entrepreneurs in Silicon Valley find access to capital easier because venture capitalists find it easier to consider and compare multiple investment opportunities. Universities in California with strong technical research capabilities are closely linked to commercial activities. Firms access deep markets for technical labour, managers and other inputs. Information about new technical and market opportunities flow through informal networks very quickly.

Loosely organised collaboration takes place between firms within these informal networks. These characteristics lower the costs of invention and enable growth at large scale.  Firms clustered in this environment drive strategies that aim to reshape markets and industries rather than merely seeking tactical advantages against established rivals. Silicon Valley is an example of a virtuous circle, with multiple new inventions commercialised throughout the United States and exported worldwide.

The latest evidence of collaboration within informal networks in Silicon Valley is the use of Fintech APIs.  Nimble and innovative Fintech firms are loosely clustering together through APIs.  A Fintech innovator can decide to pay to use an API or to develop a similar program.  The developer can also look for a cheaper provider of a similar API.  APIs can turn complex and repetitive processes into a few lines of computer code.  Programmers don’t have to “reinvent the wheel” in every new program. They can focus on the unique parts of their software and attack market opportunities at faster speeds through using specialist API providers. This environment generates a higher rate of technical progress and one more attuned to market needs.

The EU, in the shape of initiatives such as PSD2, is making a determined effort to change its market dynamics.  Economic growth in the EU has been lacklustre so the stakes are high.  The EU Commission believe that the EU’s Digital Single Market can create up to €415 billion in additional growth, hundreds of thousands of new jobs and a vibrant knowledge-based society.

However, the market structures within the EU are clearly not demonstrating the “virtuous circle” visible in Silicon Valley.  The EU Digital Market today is made up by national online services (42%) and US-based online services (54%) with EU cross-border online services representing only 4%.  Despite the formation of an EEC in 1973 and a single currency in 1999 (now used by 19 of the EU28), processes working across EU Member States are producing only 4% of the trade in the EU Single Digital Market.  The EU’s Policy efforts to emulate and rival Silicon Valley are now accelerating.  With PSD2, the EU has moved to force adoption of Open APIs by EU banks.

The XS2A articles of PSD2 seem to be only one part of a broad EU plan to make the local bank-to-bank account payment schemes more relevant in the emerging API Economy.  Immediate SEPA payments will make payments from bank accounts as fast as the Card Schemes.  Interchange caps will make the established Card Schemes as less attractive revenue source for the EU banks that issue cards to their payment account customers.  The EU Payments Accounts Directive will make a basic and inexpensive payment account service more easily available to any unbanked EU citizens.

This is a combination of public policy interventions that could give the EU a distinctly different Digital Market structure to the US.  US Digital firms may increasingly find that they cannot “copy and paste” their strategies and existing US product range into a broadly similar EU environment.  There has been some tension on Data Policy between the EU and the US.  Some US legislators have accused the EU of using antitrust cases to disguise its own technology interests, questioning the motives behind some of the EU market interventions. 

Public policy makers and researchers have spent decades studying how they could improve the competitive strength of their economies in global markets. As early as 1990, Michael Porter was writing his classic paper on the “Competitive Advantage of Nations”. This research posited that the character and trajectory of all successful companies is fundamentally the same. Companies achieve competitive advantage through acts of innovation.

However, there is a pattern (such as Silicon Valley) where certain companies based in certain countries are capable of consistent innovation.  Porter’s research focused on how some clusters of companies ruthlessly pursue improvements and seek ever more sophisticated sources of competitive advantage.  These clusters are able to overcome the substantial barriers to change and innovation that so often accompany previous success.

According to Porter, the suggested answer was four broad attributes of a country or trading bloc. These attributes are.

1. “Factor Conditions”. The trading bloc’s position in factors of production, such as skilled labour or infrastructure, necessary to compete in a given industry.
2. “Demand Conditions”. The nature of home-market demand for the industry’s product or service.
3. “Related and Supporting Industries”. The presence or absence in the trading bloc of supplier industries and other related industries that are internationally competitive.
4. “Firm Strategy, Structure and Rivalry”. The conditions in the trading bloc governing how companies are created, organised and managed, as well as the nature of domestic rivalry.

In crude terms, how could we assess EU Financial Services and EU Fintech against these four attributes?

“Factor Conditions” don’t appear to greatly hold back the global competitiveness of EU Financial Services and EU Fintech.  The EU has capital, skilled people and a scientific base.

“Demand Conditions” in the EU does look to be a problem. The composition and character of the home market usually has a disproportionate effect on how companies perceive, interpret and respond to buyer needs.  The EU Digital market is highly regionalised.  Trading blocs gain competitive advantage in industries where the home demand gives their companies a clearer or earlier picture of emerging buyer needs.  Demanding buyers pressure companies to innovate faster and achieve more sophisticated competitive advantages than their foreign rivals.  Loyalty to local brands in Member States may not serve the EU in the longer term. Demanding buyers provide a window into advanced customer needs; they pressure companies to meet high standards; they force them to improve, to innovate and to upgrade into more advanced segments.

Financial Services is a pivotal “Supporting Industry” in the EU Digital Market. The third broad determinant of advantage is the presence of related and supporting industries that are internationally competitive.  Suppliers and end-users located near each other can take advantage of short lines of communication, quick and constant flow of information and an ongoing exchange of ideas and innovations. Companies have the opportunity to influence their suppliers’ technical efforts and can serve as test sites for R&D work, accelerating the pace of innovation.

PSD2 seems to be an effort to foster the development of digital supply chains in the EU financial services industry with those characteristics.   However, we need to ask just how closely located are EU suppliers and end users.  In global terms, many EU cities are small.  The European Union has 24 official languages.  It is the same distance by road between Lisbon and Helsinki as between Los Angeles and New York.  There are eight land borders and a ferry crossing between Lisbon and Helsinki.

In terms of “Firm Strategy, Structure and Rivalry”, circumstances and context in the EU create strong tendencies in how companies are created, organised and managed.   In practical terms, the presence of strong local rivals is a powerful stimulus to the creation and persistence of competitive advantage. Domestic rivalry is seen as important because it uniquely stimulates dynamic improvement. Local rivalries often go beyond pure economic or business competition and become intensely personal. Domestic rivals compete for market share, people, technical excellence and “bragging rights.”

What role might EU law makers see themselves playing in fostering the development of the EU’s Digital Market?  They probably see their role as a catalyst and challenger; it is to push EU companies to raise their aspirations and move to higher levels of competitive performance, even though this process may be inherently unpleasant and difficult. Law makers cannot create competitive industries; only companies can do that.

Porter suggests some simple, basic principles that Public Policy Makers should embrace to play the proper supportive role.  In designing PSD2, EU Policy Makers seem to be following some of these basic principles:

1. “Public Policy Makers should focus on specialised factor creation.” The factors that translate into competitive advantage are advanced, specialised and tied to specific industries or industry groups. Due to PSD2, EU managers will learn the rules and disciplines of managing regulated AS PSPs, PISPs and AISPs and operating API Management and API Monetisation processes. The EU are leading the way globally in creating this overlay layer over bank account payments.
2. “Public Policy Makers should enforce strict product standards”. There is no doubt that PSD2 is a strict regulation. It could promote competitive advantage by stimulating and upgrading Financial Services demand in the EU.  EU Banks and Fintechs will have to develop management processes, upgrade technology and provide features that respond to these demands.
3. “Public Policy Makers should sharply limit direct cooperation among industry rivals”. In tandem with PSD2, EU Regulators are freeing up access to Automated Clearing Houses and seeking separate ownership of payment schemes and payment processing platforms.
4. “Public Policy Makers should deregulate competition”. PSD2 has deregulated access to payment account data, requiring AS PSPs to share this data with PISPs, AISPs and other AS PSPs.

In crude conclusion, when a trading bloc prompts and supports the most rapid accumulation of specialised assets and skills, its companies gain a competitive advantage.  The EU seems anxious that its banks will engage faster with an Open API Banking environment than any other competing economic area.  When the environment in a trading bloc affords better ongoing information and insight into product and process needs, its companies gain a competitive advantage. EU banks seem likely to rapidly learn how to share data and processes with API Developers through the PSD2 legislation.  Finally, when the local environment pressures companies to innovate and invest, its companies both gain a competitive advantage and upgrade those advantages over time.

As long as the vibrancy of Silicon Valley sets the pace, EU Banks and EU Fintechs could come to expect that an active and interventionist EU public policy agenda will try to stimulate them to rival that pace and vibrancy.  In short, if PSD2 doesn’t help EU banks and Fintechs to pick up the pace of innovation and collaboration closer to the Silicon Valley pace, we can expect the EU policy makers to swiftly review the impact of PSD2.  The review of PSD1 concluded that insufficient innovation and competition had followed PSD1, so PSD2 was formulated.  Following that logic, if a review ultimately shows that PSD2 doesn’t provide sufficient stimulus to EU digital innovation and competition, we might expect PSD3 to be formulated.

What relevance are these macro-level trends and dynamics to market participants?  These Public Policy interventions can change market structures as much as new technologies can change market structures.  Innovative firms need early-warning systems that monitor Public Policy makers as well as new technologies.  Early-warning signals can translate into early-mover advantages.

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