PSD3: Paving the Way for the Embedded Finance Revolution

The European Commission’s proposal for the third Payment Services Directive (PSD3) has ignited anticipation within the financial sector, particularly among payments enthusiasts, according to Finextra. Building upon the foundations laid by PSD2, this new directive introduces a series of pivotal changes and advancements that could potentially reshape the landscape of financial services innovation. While full implementation isn’t expected until 2026, the released report offers a tantalizing glimpse into the potential future of payments.

A central facet of this proposal, and arguably the one with immediate and substantial implications, is the move to level the playing field between traditional banks and non-bank entities when it comes to providing embedded financial services. The rise of non-banks in retail payments has been evident, and the PSD3 proposal suggests that this trend is on the brink of an explosive surge in opportunities over the upcoming months and years.

What exactly does this entail for the world of embedded finance, and how should organizations brace themselves for the changes ahead?

The recent years have witnessed a significant surge in embedded finance innovation. Financial services, spanning lending, payment processing, insurance, and more, have found their way into non-financial businesses, also known as ‘non-banks,’ such as retailers, airlines, and car dealerships. At first glance, this integration may not seem revolutionary, but when one considers the integration of financial products into digital interfaces, the potential offerings to consumers become virtually boundless. Essentially, obtaining financial services becomes a seamless extension of consumers’ everyday digital experiences, akin to signing up for a loyalty app or retailer’s card scheme.

For this transition to occur smoothly, it’s imperative that ‘Payment institutions’ (PI) or ‘Payment Service Providers’ (PSP), third-party entities facilitating embedded payments for consumers and assisting merchants in accepting payments like PayPal, are effectively in place. This enables consumers to interact with embedded finance, while organizations can seamlessly incorporate the required embedded finance options.

In this context, non-bank entities can take the crucial next steps towards integrating financial services like lending, payment processing, or insurance into their offerings, without necessitating redirection to conventional financial institutions. This expansion of their product portfolio translates to fresh revenue streams and enhanced customer experiences. The beneficiaries extend beyond the organizations themselves, encompassing customers who can access a broader array of services through a single, trusted platform.

Notable examples already exist, such as Square’s introduction of the ‘Square Card.’ Prior to this innovation, sellers had to wait for days to receive funds in their external bank accounts, or they had to pay a fee to enable instant deposits. With the Square Card, however, transactions processed on the Square platform are seamlessly routed using the Square account, enabling businesses to receive instantaneous income.

Presently, entry into the realm of embedded payments and embedded finance presents certain challenges, as non-bank PSPs are required to hold an account with a commercial bank to offer specific payment services. Unfortunately, commercial banks often decline to establish accounts for non-bank PSPs, driven by concerns like anti-money laundering controls.

This imbalance between traditional banks and non-bank PSPs can impede innovation in the financial space. Recognizing the growing importance of non-bank PSPs since the introduction of PSD2, PSD3 revisits this issue, aiming to ensure that non-banks can capitalize on the emerging opportunities. The directive mandates more stringent requirements on banks concerning services to non-bank PSPs, including a mandate to explain access refusal, even extending to withdrawal of service. Justifications must be grounded in the specific circumstances of the payment institution, including valid suspicions of illicit activities.

The measures outlined in the PSD3 are poised to improve the payment sphere, fostering a more equitable environment for traditional banks and non-banks alike in their pursuit of delivering financial services directly to consumers and merchants. This regulatory framework is expected to catalyze further innovation in embedded finance, giving rise to an upsurge in partnerships between banks, technology providers, and distributors of financial products through non-financial platforms. For non-bank entities, this presents a competitive advantage, offering greater space for innovation and an additional revenue stream minus the burdens associated with running a bank. Consumers stand to benefit as well, with financial products conveniently accessible at the point of need, streamlining their journey.

As the draft legislation advances, the European Council and the European Parliament will review the proposal, culminating in the agreement upon the final text. For businesses, the recommended course of action is to meticulously review the regulatory document and deliberate on the adaptations or innovations necessary to secure a leading role in the realm of digital payments innovation and the impending embedded finance revolution.