NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

We stand at the precipice of a transformation in our interaction with financial services. This transformation is driven by the fact that, despite notable technological advancements — especially with the rise of digital banking — financial services are still plagued by significant inefficiencies.

These inefficiencies take two primary forms. Firstly, there are a number of frictions within the back-end systems that enable financial service delivery, marked by cumbersome manual processes and a lack of seamless communication between these systems and the various financial services offered by an institution. These different financial services often exist in siloes, and it’s difficult for users to piece them together effectively to meet their diverse needs without the support of a financial advisor — a service that’s inaccessible to many users. To take one example, if you have a bank account and credit card — even with the same bank — the internal systems that enable these services usually don’t communicate with each other.

Secondly, users grapple with a knowledge gap, relying on imperfect mental models instead of having comprehensive information about which financial products will meet their true needs. Consumers rarely get enough information from the market to determine which products are really best for them, and there is often a bewildering array of products available — for example, there are 5,146 mortgage products in the U.K. alone. As a result, they turn to mental models to inform these decisions — and these models are often based on faulty beliefs. This leads people to make common financial mistakes, like holding a balance on a credit card, or taking out a loan against a fixed deposit account and paying the bank interest, rather than just withdrawing the funds in that account, because it gives them the illusion of having more money.

These inefficiencies, and the user behaviours they help perpetuate, cause challenges for all customers. But they’re particularly damaging for lower-income customers, in both developed and emerging economies, as they can lead to late charges and other punitive fees, while also causing people to select financial products that aren’t the best suited for their actual needs. Even when the product is the right one, the lengthy documentation required becomes a barrier or a high cost — for example, providing an insurance company with doctors’ reports, etc. to make a health insurance claim.

Artificial intelligence (AI) services are emerging to address the latter inefficiency, with robo-advisors gaining traction in many markets. In the near future, AI is likely to advance to the point where it can understand all the products that are available in the market and advise customers even more effectively than a human financial advisor (though that’s no guarantee that these AI advisors will be serving customers’ best interests).

However, there’s a need for more discussion of solutions that address the former inefficiency — the diverse frictions within the back-end systems that enable financial transactions. Efforts to streamline these processes, reduce transaction costs and enhance operational efficiency will be pivotal in shaping the future landscape of financial services. Let’s delve into how these efforts are emerging, and what the near future holds.

The Next Frontier of Automation in Payments and Financial Services

In the quest to address the frictions and inefficiencies in the back-end systems behind financial transactions, the holy grail is automation. In payments, this automation is currently based on straight-through processing, measured by the percentage of transactions processed without human intervention by the provider.

The next frontier of automation involves machines or your personal AI advisor autonomously initiating payments and managing financial services on behalf of individuals and legal entities (e.g., businesses). This will enable AI services, the Internet of Things (IoT) and fleets of smart devices owned by individuals or businesses, governed by smart contracts that define the conditions and operational parameters for when these transactions will be made, how much will be paid, etc. This is similar to direct debits or automatic payment plans, where a user gives a provider permission to transfer money from their financial account on a specific, pre-approved schedule to pay for a product/service. But this new degree of automation is much more convenient than just setting up an autopay plan: Imagine buying an IoT-enabled refrigerator which automatically links to your financial accounts through your smartphone to “pay for itself.” Most importantly, in contrast to a direct debit or autopay plan, in this next level of automation, the user retains complete control and all payments made are push payments. This autonomy will be a paradigm shift: Think of autopay plans as cruise control, vs. automated financial services as a self-driving car.

From a global development perspective, this shift will enable efficiencies that not only lower the cost of vital financial services but also enable new and more suitable consumer products, allowing more low-income communities to access them. And though it will take time for this degree of automation to reach these communities, it has the potential to create a high-trust, low-cost infrastructure for payments and other financial services, as opposed to what we have today: a low-trust, high-cost system that excludes many customers.

The key question is: How do we reach this future? A glimpse is seen in the unregulated world of decentralised finance solutions that leverage blockchain and cryptocurrencies. Some governments, businesses and development sector organisations are moving in that direction too, leveraging technology to develop regulated concepts: for instance, the UNCDF’s Open Regulated Global Payments Inter-Network, (Aug. 2022), the IMF’s Multi-Currency Exchange and Contracting Platforms (Nov. 2022), and BIS’ Unified Ledger concept (Feb. 2023). Recently, the Unified Asset Interface (UAI) concept caught my attention, promising transformative possibilities, not just for payments but across all asset classes. As these concepts converge, it’s important to recognize that the existing payments infrastructure has scale but is inefficient, while these new technologies bring hyper-efficiency but lack scale. However, if they’re designed with users at the centre (i.e., by allowing them to own and control their own data), these next-generation digital public infrastructures (DPIs) could rapidly gain scale due to significant efficiencies and the resultant cost savings.

Payment infrastructure is commonly likened to rails, drawing parallels with the evolution of train tracks from narrow gauge to broad gauge and ultimately to high-speed rails. However, the impending transformation in payment infrastructure is so profound and varied that a more fitting analogy is roads. Consider today’s payment infrastructure as akin to roads before the existence of highways. Crucially, roads exhibit interoperability, enabling seamless transitions from existing roads to new highways. Similarly, the emerging payment highways are tokenized, decentralised and “regulated by code” — which means regulations are embedded in code so that transactions comply by design, as exemplified by BIS’ Project Mandala. Since they’re designed to be integrated with the existing infrastructure, financial services based on these technologies have the potential to be both interoperable and hyper-efficient.

Different countries are likely to leverage a blend of strategies in pursuing this evolution. Some will independently construct their own digital public infrastructures and formulate regulations, while others will engage in collaborative efforts through economic unions. This diversity of approaches can exist within a unified network, as long as these efforts emphasise unification over uniformity. Analogous to driving across borders, where a driver’s license, vehicle registration and insurance are recognized by foreign transport authorities and motorists abide by local speed limits and traffic laws, regulation of these autonomous financial systems will be localised, while the technology itself operates on a global scale. This dynamic is much like the internet, a global technology that’s governed locally, with each jurisdiction’s telecom authority overseeing their internet service providers.

Challenges and Innovations in Verifying Users’ Identity

However, there’s a key challenge to this evolution: the need to verify users’ identity with certainty. Just as a driver’s license is essential for operating a car, verified identity is essential for using financial services — and this has proven to be a stumbling block for much of the world. Some countries, ranging from smaller ones like Singapore and Estonia to larger ones like India and Brazil, have tackled this challenge by building DPI, while many others have explored national identity schemes. Whatever solution countries pursue, innovative approaches are necessary to expedite progress.

Drawing parallels with the concept of simplified due diligence or tiered Know Your Customer (KYC), one such solution would involve offering services to individuals with basic financial needs without extensive KYC processes. In this approach, providers of next-generation and autonomous financial services could use a simplified or partial process to swiftly issue and verify users’ digital identity, making it easier to deliver services to more of the world’s 8 billion people.

This would require regulators to make a distinction between functional identity and foundational identity. The former requires just simplified due diligence, while the latter requires full due diligence. To better understand the difference between these two approaches, consider India’s Aadhaar identification system, which is based on 10 fingerprints and two iris scans, as an example of foundational biometric identity. In contrast, functional biometric identity could be as straightforward as one fingerprint or a face scan — technologies already employed by billions of smartphone users. Positioned at opposite ends of the spectrum, these different approaches enable individuals to initiate their journey with a functional identity, progressing towards foundational identity as they engage with more and more financial services.

Taking these efforts a step further, multi-attributable identity involves associating an identity with multiple attributes or characteristics. This entails forming an individual’s identity using various elements, including personal information, biometric data, behavioural patterns or other unique identifiers. Essentially, it’s the utilisation of a combination of different attributes to establish and verify someone’s identity. This approach holds the potential to enhance security and accuracy by relying on a broad range of characteristics rather than a single identifier.

Functional identity, when coupled with multi-attributable identifiers, opens the door to a multi-pronged approach that could help increase access to autonomous financial systems and other financial innovations. It raises the need to explore identity solutions for phone owners and non-owners simultaneously. Emphasising unification over uniformity, the overarching goal is to creatively include everyone through various means.

There are several ways to achieve this goal, increasing the number of people with verifiable identity, and thereby maximising the user base for emerging innovations in financial services. These may include:

1. Smartphones: There is an opportunity to leverage already-captured biometrics, which are stored locally on each smartphone, to create functional identity for billions who currently lack digital identity. It’s crucial to note that this doesn’t imply that Apple and Google would become the entities that verify and issue a person’s identity; rather, they can facilitate identity issuance and authentication by allowing other trusted systems to access the data that’s secured and stored on the phone, under the oversight of a multilateral body.
2. Non-biometric identifiers: This involves linking multi-attributable identifiers to create a unique identifier, which is done by combining two or more identifiers using an agreed-upon formula. Examples of these identifiers could include a user’s existing tax ID number and their mobile number. After providing these identifiers, the user would be sent a one-time passcode via text or email that they could use to gain access to a financial service. 
3. Agent-assisted services: Agents play a vital role in enrolling users in various financial services. As tamper-proof registration devices become more affordable, the potential for agents to use these devices to verify the identity of users who don’t have their own phones increases significantly.

Whatever process is utilised, gaining access to digital financial services hinges on acquiring digitally verifiable identity — a crucial enabler. However, another vital aspect of these services involves enabling users to effectively reach each other — i.e., addressability.

This raises another area where providers and other stakeholders are innovating: proxy identifiers. Also known as aliases, proxy identifiers link a payer or payee’s financial service provider (FSP) with a short identifier that is easy to remember, allowing the public and the business sector to transact in a seamless manner without needing to know and input the user’s bank account details when initiating a payment or reading a QR code. Think of proxy addressing as a human-friendly identity — like the use of mobile numbers/email addresses to access services, rather than identity numbers nobody knows or remembers. Notably, UPI in India, Pix in Brazil and mobile money in Africa have all experienced rapid adoption by utilising proxies as addresses for users’ bank/mobile money accounts. In these systems, the pivotal step of registering a proxy to a FSP becomes critical and can seamlessly occur during the creation of a user’s digital identity.

The combination of a digital identity and a proxy can empower billions of users to engage in financial services across both new and existing payment infrastructures. By bringing these new customers into the digital financial services sector, these new approaches to verifying identity and address accounts via proxies can help bring the marginal cost of most transactions to near zero, offering the potential for these transactions to be conducted free of charge (like in India and Brazil).

Combating Financial Crime: A Key Priority and Advantage of Hyper-Efficient Financial infrastructure

A significant portion of friction in financial systems, particularly in cross-border transactions, revolves around combating financial crime — through anti-money laundering measures, countering the financing of terrorism, anti-bribery checks, fraud prevention and more. Despite the automation of these checks, numerous instances of false positives arise, such as similar names or variations in spelling, necessitating manual intervention. This not only creates bottlenecks but also escalates costs for all customers.

However, with advancing technology, authorities can now generate profiles for both natural persons and legal entities. Additionally, they can link previously disparate information to unveil otherwise invisible networks of relationships, effectively creating a financial graph — i.e., a representation of the relationships and transactions between individuals or entities. A financial graph offers a way to visualise the financial transactions of one person who uses different financial instruments, which can help to identify any illicit activity.

Drawing parallels with our roads analogy, some motorways are now monitored by average speed cameras, calculating speed between two points instead of at a single location, as in the old system. This approach has influenced driving habits, resulting in a higher level of compliance than initially anticipated. Similarly, technological advancements in financial services offer opportunities for applications that can combat fraud and financial crime more effectively, ushering in an era of hyper-efficiency.

A Mindset Shift is Required To Embrace the Future of Financial Services

India surpassed its financial inclusion target an impressive 41 years ahead of the original projection, achieving an 80% inclusion rate within just six years. To draw a parallel, India’s accomplishment is reminiscent of the United States’ initiative in the 1980s to install a landline in every home. However, replicating India’s digital public infrastructure approach in other countries today, using current technology, would be akin to attempting to install landline phones in every household. Instead of trying to repeat past successes, it’s crucial to move ahead and leverage emerging technologies more efficiently.

Certainly, there is a need for DPI, but the focus should not be solely on current methods. Instead, similar to how mobile technology enabled faster and more cost-effective connectivity in Africa, a forward-thinking approach is needed. One such approach is DPI packaged as a solution (DaaS) — typically offered by private companies working on behalf of governments. Another is next-gen DPI, which is being actively promoted by BIS and others, as discussed above.

It is equally important to acknowledge that technology alone is not a cure-all. It does not eliminate the necessity for capacity building and technical assistance at an ecosystem level, nor does it negate the need for a hands-on approach to ensure financial inclusion for those currently excluded.

In the future, the evolution of financial services will certainly exceed our current imagination. Virtually every emerging use case will propel us towards hyper-efficiency. However, a crucial consideration lies in how much of this value is retained by the private sector versus passed on to the end user. The extent of this distribution depends largely on regulatory frameworks. As regulators navigate the evolving landscape, their decisions will shape not only the trajectory of financial innovation but also its broader impact on society and consumers. As these developments unfold, balancing innovation with consumer protection will be paramount in shaping the future of financial services.

NOTE: The author would like to thank Siddharth Shetty, Dr. Promod Varma and Nandan Nilekani for discussions on UAI, Sopnendu Mohanty for a discussion on Global Layer One, Kieran Murphy for a discussion on Multi-Currency Exchange and Contracting Platforms and Michael Richards for his contribution.

Arunjay Katakam is the author of “Generation Hope: How Inclusive Economics Can Help Us All Thrive.” He is a writer, speaker, thinker, serial entrepreneur and recovering wealth-chaser, building non-profit startups such as the Inclusive Action Lab to solve meaningful problems.

Photo credit: George Prentzas