Will PSD3 inspire the inevitable embedded finance revolution?

Calling all payments nerds! The European Commission has published its proposal for a third Payment Services Directive (PSD3), building upon the achievements of PSD2 which sets out several key changes and developments that may impact financial services innovation. Implementation is not likely to take place before 2026, but the report has provided a sneak peek into what the future of payments might look like… and it’s very exciting. 

The most interesting measure, and the one that, in my opinion, will have the biggest impact right now, is the attempt to further level the playing field between banks and non-banks when it comes to offering embedded financial services. We have already seen a huge increase in the role of non-banks in retail payments, and this latest proposal signifies that this market is likely to explode with opportunities in the coming months and years. 

So, what does this all mean for embedded finance and how can organisations prepare?

An Earth Shattering Idea?

In recent years we have seen a substantial growth in embedded finance innovation, with financial services (lending, payment processing, insurance and so on) all being integrated into non financial businesses, or ‘non banks’, such as retailers, airlines and car dealerships. 

This might not seem like such an earth shattering idea, but, when you consider how financial products are now being integrated into digital interfaces, the possibilities of what can be offered to consumers are potentially endless. Essentially, acquiring financial services becomes a natural extension of consumers' non-financial everyday, online experiences like, for example, signing up to a loyalty app or retailers card scheme. 

For this transition to take place, ‘Payment institutions’ (PI) or ‘Payment Service Providers’ (PSP) - third parties offering embedded payments to consumers and helping merchants to accept payments like PayPal - need to be in place so that consumers can engage with embedded finance, and organisation can deploy the necessary embedded finance options. 

Non-banks can then take the necessary next steps to integrate financial services like lending (PayPal loans etc), payment processing or insurance into their offerings without the need to redirect to traditional financial institutions, thus extending their product portfolio and providing new revenue streams. This also benefits their customers who can access more services through one, trusted platform.

We are already seeing examples of this with the likes of Square and its introduction of the ‘Square Card’. Prior to the introduction of Square Card, sellers either had to wait for a number of days for funds to reach an external bank account, or would need to pay a fee to activate an instant deposit. Now, using a Square Card, when a seller on the Square platform processes a transaction, the payment is routed directly using Square account which results in instantaneous income for the business. 

Levelling the Playing Field

Currently, however, entry into the embedded payments and/or embedded finance space can be difficult, as non-bank PSPs are required to have an account with a commercial bank in order to provide certain payment services. However, commercial banks often refuse to open an account for non-bank PSPs due to concerns over matters such as anti-money laundering controls. 

Requiring non-bank PSPs to rely on commercial banks can sometimes result in an uneven playing field between banks and non-bank PSPs and hinder innovation in the financial space.  Due to the growth in the importance of non-bank PSPs since the introduction of PSD2, PSD3 revisits the issue to ensure that non-banks can access the new opportunities on offer: 

“Requirements on banks regarding bank account services to non-bank PSPs will be considerably toughened, with a stronger requirement on banks to explain access refusal, covering also withdrawal of service. Justification for refusal must be based on the specific situation of that payment institution, including serious grounds to suspect illegal activities being pursued.”

By ensuring that both financial and non-financial businesses are given access to the EU’s different payments systems, measures imposed by PSD3 will mean that embedded payment and financial services can now increasingly be offered by non-banks, and non-financial institutions. 

Embedded Finance Revolution 

The measures referred to here should significantly reform the payment space, with traditional banks and non-banks working on a much more level playing field when it comes to offering financial services directly to consumers and merchants. 

This regulation will likely enable even greater embedded finance innovation, where we expect to see a higher number of partnerships between banks, technology providers, and distributors of financial products via nonfinancial platforms. For non-banks, this creates an advantage in the market, with more room for innovation, while creating a new source of revenue without incurring the overhead associated with operating a bank. For consumers, financial products will be provided right at the point of need, removing friction from their journey.  

The next step for the draft legislation is for both the European Council and the European Parliament to review the proposal and agree on the final text. A next step I would recommend for businesses? Look through the regulations document carefully and consider what changes or innovations you need to invest in to ensure your business is in the driving seat of digital payments innovation and the inevitable embedded finance revolution.