Canada's payment system is in the midst of a transformation. The way in which people pay has rapidly become more electronic and mobile, fintechs and paytechs are developing new payment methods, and Payments Canada and the federal government are making changes to Canada's payment system and the legislative framework within which it operates. Ongoing developments in this area include:
- changes to Canada's core payments systems, including the development of rails for real-time retail payments;
- consultation regarding enhanced payments system access;
- forthcoming legislation that will establish a regulatory regime for payment services providers (PSPs);
- consultation regarding open banking; and
- initiatives exploring the merits of distributed ledger technology with respect to clearing and settlement.
This bulletin summarizes the various developments in this area with a view to showing how they relate to each other, and what is coming next.
The Role of Payments Canada and the Bank of Canada
By way of background, Canada's payment system is overseen by Payments Canada, which is governed by the Canadian Payments Act. Currently, Payments Canada operates two core payment clearing and settlement systems: (1) the Large Value Transfer System (LVTS), which is the electronic funds transfer system that settles large-value and time-critical Canadian dollar payments; and (2) the Automated Clearing Settlement System (ACSS), which is primarily used for clearing retail payments such as direct deposits, point-of-service purchases, pre-authorized debits and ABM transactions.
Canadian banks and the Bank of Canada are required to be members of Payments Canada. Certain other institutions, such as credit union centrals, trust and loan companies and securities dealers, are eligible for membership. Members of Payments Canada may participate directly or indirectly in Payments Canada's systems. PSPs are not eligible for membership in Payments Canada, and so are not currently able to participate in Payment Canada's systems.
Pursuant to the Payment Clearing and Settlement Act, the Bank of Canada has regulatory oversight of, and acts as the resolution authority for, designated financial market infrastructures. This includes systemically important payment systems and clearing and settlement systems such as the LVTS.
Beyond this, the Bank of Canada has two other roles in Canada's payment systems: (1) settling positions among the participants in the LVTS and the ACSS; and (2) providing liquidity by lending funds overnight to LVTS participants that owe funds at settlement time.
Work on payments modernization has been underway for a number of years. In 2011, the Report of The Task Force on the Payments System Review entitled Moving Canada into the Digital Age (PDF) called for an overhaul of Canada's payments system. In 2015, amendments to the Canadian Payments Act made significant changes to Payments Canada's governance and accountability structure. In 2016, Payments Canada set out its plans in Developing a Vision for the Canadian Payments Ecosystem (PDF) and the Industry Roadmap and High-Level Plan (PDF).
More recently, in 2017 Payments Canada released the Modernization Target State (PDF), which provides a detailed view of the payments modernization program. At the heart of this is the development of three new core payments systems: Lynx; the Settlement Optimization Engine (SOE); and the Real-Time Rail.
Lynx is a high-value payments system intended to replace the LVTS. It will process large-value time critical payments in real-time with settlement finality. Lynx will be designated as a Systemically Important Payment System, and will be required to comply with applicable Bank of Canada risk management standards (which are consistent with the Bank for International Settlements' Principles for financial market infrastructures). As in the case with the LVTS, only regulated financial institutions will have access to Lynx.
SOE is a batch payment system for the clearing of lower value and less time-sensitive payments, (paper-based and electronic), and will replace the ACSS and the U.S. Bulk Exchange. SOE will be designated as a Prominent Payment System and be subject to the applicable Bank of Canada risk management standards. Regulated financial institutions will have access to SOE. According to Payments Canada, consideration will be given to unbundling exchange from clearing and settlement and permitting broader participation for exchange functions.
The Real-Time Rail will be a new real-time retail payments system that facilitates the delivery of low-value payments with immediate funds availability for the recipient. This system is intended to provide clearing capability for retail and commercial purposes. The Real-Time Rail is expected to be designated as a Prominent Payment System. Regulated financial institutions as well as PSPs who meet regulatory standards (discussed below) will have access to the Real-Time Rail. This system will also potentially permit the unbundling of exchange from clearing and settlement. The Real-Time Rail will aim to simplify the payment experience, permitting users to make payments by using aliases (e.g., email or other identifier) and not requiring the beneficiary's account number.
There are to be two layers to the Real-Time Rail. The "system" layer will consist of core payment functionalities and key enablers (e.g., rules and procedures and a legal and business framework). The "service" layer will consist of customer-facing products/services developed by PSPs for the real-time exchange of payments. These are referred to as "Overlay Services" and will connect to the system through application programming interfaces (APIs).
2018 Review of the Canadian Payments Act
As part of the 2015 legislative changes, referred to above, a review clause was added to the Canadian Payments Act to require its review after three years. Accordingly, the Government initiated a review of the Canadian Payments Act in 2018, seeking input on two main issues: (1) whether the 2015 governance amendments achieved the intended policy objectives; and (2) potentially creating an "associate member" category for non-traditional PSPs.
The 2015 governance amendments were introduced in response to the Task Force Report to strengthen governance and increase accountability. More specifically, board membership was reduced to 13 directors from 16, of whom a majority were required to be independent and the voting structure was adapted from a volume-based voting structure to one where each member was entitled to a single vote. Amendments were also introduced to improve the accountability of Payments Canada by requiring formal annual reports to the Government as well as submitting (annually) a five-year plan, where previously no formal reporting was required.
Under the associate member proposal, PSPs regulated under the retail payments oversight framework (discussed below) would be eligible to apply for associate membership. Associate members would be able to participate in the exchange and settlement of payment items on the Real-Time Rail system, albeit as a separate and distinct class of members of Payments Canada. Associate members would be required to meet system-specific requirements before obtaining access to the Real-Time Rail, and if they wish to settle obligations directly through the Real-Time Rail they would need to meet Bank of Canada requirements to obtain a Real-Time Rail settlement account.
Consideration is being given to whether associate members should be eligible to exchange electronic payment items on SOE exchange networks (assuming they meet applicable access criteria). Associate members would not be eligible to settle items exchanged in the SOE and would need an arrangement with a settlement member to do this. Associate members would not be eligible to participate in systemically important payments systems, including the LVTS and Lynx.
In 2019, the Department of Finance released its Report on the Review of the Canadian Payments Act, providing a summary of feedback received on the 2018 review. According to the Report, respondents generally view the 2015 governance changes to be beneficial to the achievement of Payments Canada's mandate. Respondents noted that it was premature to provide an assessment as to whether the 2015 amendments enabled Payments Canada to fulfill its public policy objectives.
The Report also states that feedback on the proposal to create an associate member category was generally positive: there is widespread support for giving PSPs access to the Real-Time Rail, and general support for exchange-only access to the ACSS for associate members (meaning that associate members would be able to directly exchange payment messaging over the ACSS, while clearing and settlement of the actual payments would continue to be undertaken by direct clearers). There was also consensus that the regulation of associate members under the proposed Retail Payments Oversight Framework would ensure sufficient oversight.
Retail Payments Oversight Framework
In Budget 2019, the Federal Government proposed to introduce legislation to implement a new retail payments oversight framework. The framework would require PSPs to establish sound operational risk management practices and to protect users' funds against losses. The Bank of Canada would oversee the payment service providers' compliance with operational and financial requirements and maintain a public registry of regulated payment service providers. The retail payments oversight framework is expected to consist of the elements set out in the 2017 consultation paper on A New Retail Payments Oversight Framework (Retail Payments Consultation Paper). Please refer to our summary of this consultation paper, "Department of Finance Releases Consultation Paper on New Retail Payments Regulatory Framework".
The proposed oversight framework would take a functional approach which focuses on the payment function, not the type of institution that is providing the service. The following five functions performed by PSPs would be subject to the framework: (1) provision and maintenance of a payment account; (2) payment initiation; (3) authorization and transmission; (4) holding funds; and (5) clearing and settlement. Certain types of transactions posing limited risk to end users would not be subject to the oversight framework (e.g., cash transactions and closed loop cards). As well, the oversight framework would be limited to transactions carried out in fiat currencies (i.e., not virtual currencies).
The Retail Payments Consultation Paper identifies five types of key risks relating to retail payments:
- Operational risk, including data security and privacy.
- Financial risk, relating to liquidity and failure to properly safeguard end-user funds.
- Market conduct risk, including providing misleading or inadequate information to users of services.
- Efficiency risk, consisting of sub-optimal services.
- Money laundering and terrorist financing risk.
To mitigate these risks, the following requirements are proposed:
- Measures to safeguard end-user funds, including holdings funds in a segregated trust account with a financial institution that is a member of CDIC or a provincial deposit insurance regime.
- Operational risk-management standards, including a robust operational risk management framework with appropriate systems, policies, processors and controls, physical and information security policies, and a business continuity plan.
- Disclosure requirements, including that: (1) information contain adequate and relevant content; (2) information be provided in a timely manner; (3) information is presented in clear, simple and not-misleading language; and (4) information is easily accessible.
- Dispute resolution mechanisms.
- Liability rules whereby payors are not liable for losses due to unauthorized transactions or errors unless they acted fraudulently or failed to fulfil certain obligations (e.g., to take reasonable care to protect passwords).
- Registration with the designated retail payments regulator (the Bank of Canada).
- Promotion of privacy laws.
Another initiative with implications for payments is the ongoing consultation regarding open banking. Open banking refers to a framework where consumers and businesses can authorize third-party financial service providers to access their financial transaction data through secure online channels. Open banking can also involve consumers and businesses being able to authorize third-party financial service providers to initiate payments on their behalf.
The Government appointed an Advisory Committee on Open Banking in 2018 and released the consultation paper A Review into the Merits of Open Banking in January 2019. Please refer to our summary of the open banking consultation paper, "Government Launches Review into Open Banking".
In June 2019, the Standing Senate Committee on Banking, Trade and Commerce released its report Open Banking: What it Means for You. This report discusses open banking and makes recommendations for reforms in the interests of Canadian consumers and financial service providers. One of these recommendation is the development of a principles-based, industry-led open banking framework that would, among other things, address how the payments sector would be included within the framework. Please refer to our summary of the Senate Committee report, "Open Banking: A Call to Action from the Senate Committee on Banking Trade and Commerce".
The Advisory Committee on Open Banking is to deliver a report to the Minister of Finance assessing the merits of open banking after the consultations are complete.
Distributed Ledger Technology
Project Jasper, which is a collaborative research initiative by Payments Canada, the Bank of Canada, financial innovation consortium R3, and a number of Canadian financial institutions, was launched in March 2016 with the aim of understanding how distributed ledger technology (i.e., blockchain) could transform the future of payments in Canada.
In 2017, a whitepaper entitled Project Jasper: A Canadian Experiment with Distributed Ledger Technology for Domestic Interbank Payments Settlement (PDF) was issued.
Some of the developments discussed above will result in changes in the near future. In particular, once legislation is in place to provide for the Retail Payments Oversight Framework, PSPs will need to register with the Bank of Canada and ensure they comply with applicable requirements. Others developments, such as the consultation into open banking and the potential use of distributed ledger technology, will take longer to take shape. Meanwhile, the modernization of Canada's payments systems will continue to develop, financial institutions, fintechs and paytechs will continue to find new ways to pay, and consumers will increasingly expect flexibility and convenience.