SOX Compliance refers to the adherence of an organization to the rules and requirements established by the Sarbanes-Oxley Act of 2002. Financial reporting, information security, and audit regulations are necessary to promote proper governance within corporations by introducing transparency, integrity, and accountability to reduce corporate fraud. This compliance system requires internal controls, thorough documentation, and internal checks to ensure the correctness and security of information and encourage the needs of investors and regulators.   

In cases like Enron, WorldCom, and W. Craighead, executives manipulated financial data to hide debts, inflate earnings, and mislead investors. This caused a misconception of their profitability, ultimately leading to massive losses when the truth came out. Also, this scandal exposed the vulnerabilities in corporate governance and accountability in financial reporting.    

What are the Objectives of SOX?

Under the Sarbanes-Oxley Act, the senior executives of an organization, particularly the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), are required to personally validate the accuracy of financial statements and ensure they are free from any financial misstatements. Section 302 of this Act mandates that these executives are accountable for verifying the organization’s financial figures and the effectiveness of its internal controls. By appending their signatures, they take personal responsibility for the integrity of the reports.  

If any inaccuracies or fraudulent practices are later discovered, severe penalties, including fines and imprisonment, are imposed. Therefore, this provision ensures transparency, accountability, and trust in financial reporting.   

To adhere to the SOX regulations, organizations must implement internal control systems to prevent financial misconduct. In addition, the controls should be constantly examined and monitored to ensure the organization’s integrity.  

A Concise Overview of SOX 11 Titles

The Sarbanes-Oxley Act is a wide document that includes 11 sections (also referred to as titles), each dealing with a different element of corporate governance and financial accountability.

1. Public Company Accounting Oversight Board (PCAOB) 

Public firms undergo mandatory audits, which fall under the oversight of the Public Company Accounting Oversight Board (PCAOB). The PCAOB is responsible for developing guidelines and standards that govern the preparation of audit reports. It enforces these standards strictly and initiates an investigation whenever necessary.  

The board also monitors the activities of independent accounting firms that are engaged in performing these audits.  

2. Auditor Independence 

This title has nine sections that emphasize the independence of an auditor by specifying the requirements to avoid conflicts of results. It forbids the auditors from providing any non-audit services to their clients. Additionally, it enforces a one-year cooling-off period before auditors can work as executives for former customers. 

3. Corporate Responsibility 

Title III underscores personal accountability by demanding certification from CEOs and CFOs about the accuracy of their financial statements. This implies that executives are directly liable for the accuracy and integrity of the company’s financial statements. Therefore, it ensures enhanced transparency and mitigates corporate fraud. 

4. Enhanced Financial Disclosures 

Under this title, companies must disclose more information about their disclosures, such as insider trading, off-balance-sheet transactions, and pro forma earnings. Fast and reliable disclosures help investors assess the health of a company so that they can make an informed decision as to whether they should invest in a particular company. 

5. Analyst Conflicts of Interest

The title aims to enhance investor’s trust in the analysts’ reports. This includes disclosure of any kind of interest along with the rules of conduct and deals with conflicts in financial analysis. Everything should be disclosed to the public, from analyst’s portfolios to corporate payments. 

6. Commission Resources and Authority 

It gives the Securities and Exchange Commission (SEC), the US regulatory agency, more power to punish any violation of securities laws by a broker, advisor, or even a dealer, which improves law practice and market control.  

7. Studies and Reports 

Mandates various studies related to the market practices by the SEC and the Controller General. These are done to evaluate the status of the issuer’s corporate governance and to evaluate unethical practices in investment banks, accounting firms, and credit rating agencies. These reports minimize the incidence of fraud in the financial ecosystem. 

8. Corporate and Criminal Fraud Accountability 

This title enforces strict penalties for fraud, including the hiding, modifying, or destroying of financial records, which can result in imprisonment for up to 20 years. Additionally, it mentions monetary fines and penalties for anyone who helps deceive shareholders.

9. White Collar Crime Penalty Enhancements 

The six provisions under this title further enforce increased penalties for crimes committed by white-collar professionals, including failure to certify financial reports. Implementing stricter sentencing aims to mitigate malpractices and reinforce the accountability of executives. 

10. Corporate Tax Returns 

This title states that the CEOs must personally append their signatures to the organization’s tax returns. This is done to ensure the executives’ accountability in filing accurate tax returns and prevent tax-related fraud. 

11. Corporate Fraud Accountability 

This title consists of seven sections. It states that corporate fraud is a punishable crime, and various penalties are imposed for fraudulent activities. The SEC is provided with resources to tackle the issue of corporate fraud while imposing sanctions on individuals who execute suspicious transactions. 

SOX Controls and Compliance Requirements

SOX controls act as an essential security net that protects organizations by mitigating the risk of errors and fraudulent activities in financial statements. They operate as an internal mechanism designed to maintain balance, accuracy, and truthfulness in the financial reporting system in accordance with the laws and standard practices in the industry.  

Many organizations use the COSO (Committee of Sponsoring Organizations) Framework to implement SOX controls. It includes the use of detailed internal controls and risk management. 

The COSO framework emphasizes on:  

• Risk management, i.e., the processes of assessing and minimizing any threats to the accuracy and completeness of financial information.

• Data integrity to maintain the trustworthiness, completeness, and validity of financial information.

• Compliance monitoring is done by regularly monitoring external and internal requirements.

Therefore, by utilizing the COSO framework, organizations will be able to implement strong SOX compliance controls, which will strengthen the foundation for transparent and trustworthy financial reporting. 

The Core of SOX  

Section 404 remains the most important aspect of SOX. This section requires organizations to document and test their internal financial controls annually to demonstrate their effectiveness. Therefore, it tends to keep companies in check and, more importantly, illustrates that there exists a strong control environment around the company’s financial statements.  

Why is SOX important? 

The Enron Scandal

Enron employed eggshell techniques to conceal large amounts of owed, enabling the company to exaggerate profits before its eventual disintegration, which caused considerable financial losses to its investors. Their audit company, which was Arthur Andersen, did not manage to detect or prevent this crime. In order to avoid similar occurrences in the future, SOX ensures that these two functions are kept completely separate among the same firm so that they have no bias when it comes to delivering the required report.  

What is a SOX Compliance Audit?

A SOX compliance audit evaluates a company’s internal controls to ensure they align with the requirements and regulations set forth by the Sarbanes-Oxley Act, particularly concerning financial statements and IT security. Auditors typically begin by reviewing the design and structure of an organization’s controls to identify any potential weaknesses or gaps. Successfully passing a SOX audit offers external stakeholders’ greater confidence that the company is committed to transparency, accountability, and the accuracy of its financial reporting. This not only ensures compliance but also enhances the company’s reputation for trustworthiness and reliability in the eyes of investors and regulators.  

For example, if a company’s IT system is hacked due to fewer controls, it could lead to financial inaccuracies. SOX audits are intended to identify these vulnerabilities and keep financial information secure.  

The SOX Audit Process 

Auditing SOX is a procedure for evaluating the integrity of a company’s financial reporting processes. While this process is highly detailed, it can be broken down into four key stages as follows: 

1. Designing Proposal for SOX Audit Work

The initial phase of any Sarbanes-Oxley (SOX) audit is to identify the scope of the audit precisely. This scope defines the boundaries and focus areas of the audit, including financial processes, systems, compliance controls, and risks to be evaluated. This facilitates a more focused and efficient approach to the evaluation and is in accordance with the Public Company Accounting Oversight Board (PCAOB) Accounting Standards No. 5, which supports the top-down auditing approach.  

The top-down audit approach begins with a high-level evaluation and gradually narrows it down to the finer details, i.e., beginning from considering the broad picture and scaling down to specific details.  

The first step usually involves identifying key stakeholders and conducting initial information-gathering sessions with the relevant stakeholders. After this, the key areas of interest are focussed upon.     

• Accounts that have a higher chance of financial reporting failure.

• Critical assets can greatly impact the financial figures.

• Critical assets can greatly impact the financial figures.

• Important systems and processes that are crucial in providing financial information.

The purpose of this step is to proactively identify and assess potential risks to the accuracy and quality of financial reporting. By adopting this approach, the audit scope is designed to estimate the factors that could pose a risk to reliable financial reporting, pinpoint the sources of these risks, and evaluate their potential impact on the business. This phase, known as the control measures expectation, ensures that any significant risks or distortions are detected and addressed before they can go unresolved or unnoticed by the organization’s internal control systems. Ultimately, it strengthens the integrity of financial reporting by ensuring that potential issues are managed effectively.  

2. Determining Materiality in SOX

This stage of audit is useful since it enables you to spend time only on the relevant aspects of financial reporting. Below are the simplified four key procedures: 

Step 1: Identify What is Material

The first step is determining the items in the profit and loss statement and the balance sheet that can be regarded as ‘material.’ These are the items whose omission or misrepresentation could influence the economic decisions of the users.  

Usually, auditors measure materiality by taking a percentage of the significant accounts, such as 5% of the total assets or 3-5% of the operating income given.  

Step 2: Find Material Account Balances by Location

Perform the same steps regarding the financials of all business departments. Should any account balances surpass the material thresholds in Step 1, those departments will be included in the scope of SOX compliance activities in the next year.  

Step 3: Identify Key Transactions

Conduct a meeting with your controller and the process owners to map out the transactions that will impact these material account balances.   

Step 4: Assess Financial Reporting Risks

Inherent risks are risks that exist due to the nature of the business or its environment and could potentially lead to misstatements in the financial statements. These risks arise from factors beyond the control of internal controls or audit procedures and could significantly impact the accuracy of financial reporting. 

3. Identifying SOX Controls

In conducting the materiality analysis, auditors should focus on identifying and evaluating the effectiveness of SOX controls that mitigate the risk of inaccurate financial transactions. By doing so, they ensure that these controls contribute to a more reliable and transparent financial reporting process.   

i) Separation of roles and duties

Among the important categories of SOX controls is the separation of roles and duties. This control ensures that no single individual has complete control over critical processes. For example, different people should be involved in approving an invoice and posting elements of that invoice. By separating these responsibilities, the company reduces the risk of one individual manipulating financial data or engaging in fraudulent activities. 

ii) Transactions Auditing

Another category is transaction auditing, which includes timely reviews of transactions performed by individuals entitled to auditing. This is done to detect any deviations in financial transactions. 

iii) Balance confirmations

Balance confirmations provide external auditors with the necessary assurance that the account balances align with the reported balance. This ensures documentation accuracy and credibility. 

Material accounts often require the establishment of more than one control for effective security against inaccurate financial statements that are capable enough of influencing the decision-making of stakeholders, called material misstatements. It is the organization’s responsibility to assess and determine the effectiveness of the controls that enable the people, processes, and technology involved in the whole system. Risks are not created equally, so there are key and non-key controls within the framework of the SOX audit process, where key controls are the most important ones in mitigating significant risks that could potentially lead to material misstatements in the financial statements.   

4. Carrying out a Fraud Risk Evaluation  

Dedicating efforts to develop a secure framework of an internal control policy calls for an assessment of the different fraud risks, such as inaccurate financial statements, that are likely to occur within the organization. To curb fraud, organizations must focus on preventive measures and warning signs. Organizations can proactively mitigate the likelihood of the occurrence of fraud and improve the measures of dealing with any such incidents by establishing and enforcing strong internal controls.    

Let’s explore some simple policy measures you can put in place to prevent the above-mentioned fraud.

i) Segregation of Duties

Fraud is easier to perpetrate when one individual has both the means to engage in the wrongdoing and also conceal it. This means that the execution and concealment of fraud must involve different individuals. It is similar to having internal controls in place.

ii) Expense Reimbursements

It is difficult to avoid fraud in the organization without effective management of expenses incurred by employees. To address this issue, the reimbursement policy must be established and disseminated to all concerned. Before getting any reimbursement, use more than one approver, i.e., the boss and some other member(s) of the team.   

iii) Periodic Bank Reconciliation

Make sure that the account balances reported in your company books are periodically verified with those of the actual bank to avoid any differences. This not only assists in detecting fraud but also eliminates possible problems in the future, such as delays in payment or disruption of accounting processes.

5. Managing Process and SOX Controls Documentation

The controls present in the compliance processes should also be documented appropriately. All aspects related to key controls must be comprehensively addressed, including their definitions, implementation, performance, testing, risks, populations, and evidence. However, managing these aspects can be challenging because the same risk might span across multiple processes and units, making it difficult to monitor everything effectively. Even a small oversight, such as forgetting an update, can lead to significant future cleanup efforts and potential control failures.  

To mitigate this issue, employing a relational database management system (RDBMS) as a central repository is highly recommended. Unlike traditional spreadsheet-based systems, SOX-compliant software built on a large, integrated database can streamline the entire process. This centralized approach enables seamless integration of all program functions, reducing the need for frequent updates and minimizing the risk of overlooked changes. Additionally, RDBMS-based systems allow for handling larger volumes of data in less time, improving efficiency and ensuring more accurate monitoring and reporting of controls, thereby enhancing compliance and reducing future complications.  

6. Testing Key Controls

SOX control testing is done to guarantee the effectiveness and reliability of the controls. It involves demonstrating that the tests are designed to actually assess the controls when performed. It also involves affirming that the people defined as process owners consistently applied the controls during the audit process. Finally, testing must show that the controls are able to prevent or detect material misstatement in areas where they are intended to provide protection.  

Control testing may also incorporate several approaches, including, but not limited to, ongoing assessments, observations, interviews with process owners, transaction walkthroughs, document review, or even performing the process again.  

7. Assessing Deficiencies in SOX

An auditor addressing a particular gap creates an “issue.” The audit team has to decide whether it is a design issue or an implementation issue that can be solved by retraining. They will also state whether this is a control deficiency that needs to be managed more carefully because it is associated with greater risk.  

8. Delivering Management’s Report on Controls

At the end of your SOX control testing, a detailed report is prepared for the audit committee. While there will be much information accumulated during the whole process, the report shall incorporate the view of management regarding the compliance status, together with evidence supporting it.   

The report shall incorporate the following information: 

• Management’s opinion and evidence towards that conclusion.

• A recap of the evaluation of the approach adopted and the outputs.

• Results of all the assessments, including enterprise-wide, IT, and key control.

• The control breakdowns, control gaps, and their associated factors.

• The input from the company’s statutory auditor.

By continuously participating in this approach and employing the necessary paperwork and practices, you can enhance your compliance initiatives and promote a sense of ownership at all levels in your organization.  

SOX Compliance Audit Checklist

Here’s a general checklist that can be used for SOX compliance audits: 

1. Ensuring protection against tampering with sensitive data 

There should be systems installed to monitor and alert unauthorized or intentional changes made to financial information. This ensures the integrity of the records and lowers the possibility of fraud.  

2. Implement control access 

Implementing the least privilege access principle on sensitive data. It should not be accessed by unauthorized personnel. With limited access to financial information, organizations can control uncontrolled changes and keep the integrity of sensitive data.   

3. Limited access to Auditors 

Auditors play a major and critical role in SOX compliance, and to maintain objectivity, they should be granted access as and when needed to perform their roles effectively. This is a very transparent way to protect the company’s financial information. 

4. Detect Information Security Incidents 

Detection of incidents related to information security is primary. There should be systems installed meant to detect and report security breaches in real time. This will help to prevent possible damage and ensure that financial systems are always secure. 

5. Track Action within Financial System 

Tracking actions within the financial system is vital for a clean audit trail. Each significant transaction must be date-and-time-stamped with a record of the detail used by auditors and compliance officers to trace back the accuracy and completeness of the financial data. 

Consequences of SOX Non-Compliance

The Sarbanes-Oxley Act (SOX) outlines severe penalties for those who fail to adhere to its provisions, including huge fines and imprisonment for CEOs and CFOs who approve false financial reports. This guarantees the organization’s management’s focus on financial reporting integrity.  

One such high-profile case occurred at HealthSouth Corporation, where executives exaggerated profits by over $2 billion and brought Richard Scrushy, CEO, to court as one of the first under SOX.  

One scandal that highlighted the need for SOX was WorldCom, which manipulated the financial records to exaggerate profits by nearly $11 billion. This scandal not only ruined the company but also caused major losses to investors and employees. 

Benefits of SOX Compliance

The SOX instills confidence in the integrity of published financial statements, which induces them to invest. It strengthens the credibility of companies and investors and thus helps to create a more secure investment environment by ensuring that data is accurately presented.  

In addition, SOX mandates organizations implement effective internal controls, which results in more efficient performance in terms of the accuracy and reliability of financial records. Making financial reporting as accurate and complete as possible reduces risks of errors or fraud. This enhances the organization’s overall financial management and accountability.   

Key Provisions of the Sarbanes-Oxley (SOX) Act of 2002

The SOX was approved to boost corporate accountability and transparency in financial reporting. Let’s explore the key sections: 

Section 302 

One of the important provisions is Section 302, which mandates a senior corporate officer to certify personally the accuracy of financial statements and compliance with the US Securities and Exchange Commission (SEC) disclosure standard. Officers who knowingly sign false financial statements will incur severe penalties, including imprisonment.  

Section 404  

This establishes the requirement of establishing and maintaining internal controls for accurate financial reporting. Such an improvement brings benefits in accountability but is often criticized for incurring heavy costs in compliance.  
To know more, click here.

Section 802  

Section 802 addresses recordkeeping. It prohibits the destruction or falsification of records, defines retention periods, and identifies business records to be maintained (including electronic communications).  

Who must comply with SOX?

All publicly traded companies and their wholly owned subsidiaries that do business in the United States must comply with SOX, including companies listed on U.S. stock exchanges and their auditors. Additionally, securities analysts and accounting firms that perform audits in public companies must comply with SOX regulations.  

Although private companies and non-profit organizations are not generally required to adhere to SOX, there are some notable exceptions. For example, private companies that are filing a registration statement with the SEC and preparing for an initial public offering must comply with SOX.   

In addition, the SOX protects the whistleblowers at private companies, i.e., employees who provide services to public companies are protected if they report misconduct or malpractices involving their public clients.  

SOX is a US regulation. However, it extends its reach beyond the US borders. Any foreign company conducting business in the US or listed on US exchanges must also comply with SOX. 

SOX Compliance Challenges

The most common type of challenge organizations face with SOX compliance is Dependence on Spreadsheets and End-Users. 

What used to be a simple accounting device known as a spreadsheet is now an integral part of most, if not all, processes under SOX. It connects data and eliminates manual work. The downside is that as the audit process becomes more sophisticated, so is the level of scrutiny over processes and each document produced. Unfortunately, spreadsheets are usually slow, do not guarantee efficiency and lack uniformity. 

Using Spreadsheets in SOX Compliance has the following risks: 

• Version Control: Working with older versions is prone to mistakes.

• Incomplete Downloads: Potential errors could occur because some data may be missing following an improper download.

• User Errors: Typing incorrect information or deleting data without intention can be costly.

• Inconsistent Data Sets: Drawing any analysis from erroneous or incomplete information will lead to wrong outcomes.

• Lack of Communication: Most of the time, the process owners do not have access to crucial control information because Internal Audit files are usually stored away in the auditors’ PCs and never circulated. This means that they view their controls only three times a year and hence are not integrating them into the processes.

• Increased Costs and Resources: When it comes to corporate governance, SOX has brought some fundamental positive changes in companies’ financial reporting, but compliance costs have been on the rise. According to Protiviti’s yearly studies, these costs have also been driven upward by implementing new systems like COSO and the evolving requirements of the auditors.

How can Encryption Consulting help?

Encryption Consulting helps organizations achieve enhanced security posture and manage the intricacies of compliances, such as SOX, NIST 2.0, FIPS 140-3, etc. Our encryption advisory services include thorough audits and assessments to identify the gaps in various processes that can expose your organization to compliance risks.  

We specialize in designing customized recommendation and remediation roadmaps that address the vulnerabilities identified during the audit process. These roadmaps provide recommendations or remediation roadmaps to mitigate the risks caused by the vulnerabilities and to achieve and sustain all the necessary regulations and compliance standards. 

Therefore, by aligning your processes with SOX requirements, we help organizations achieve compliance, mitigate risks, and enhance their security posture.

Conclusion

SOX has been successfully implemented for more than two decades, and its impact on corporate governance is significant to this day. Instead of just checking out ‘check the box’ compliance, organizations adopting the requirements of SOX enjoy better internal controls, proper accountability, and enhanced public confidence. The emphasis on SOX compliance also develops over time; as the practice of doing business increases, so does the need for transparency and corporate responsibility in the global economy.    

Financial statements must be accurate and truthful within a healthy economy, which is not a matter of good practice but of a functioning whole structure. 

The PSD2 is a customer-oriented regulation that enhances customer control in terms of who can access and use their financial information from third-party providers, which also simplifies payment processes using strict security measures. It facilitates a customer-centric model of financial services through secure and seamless payment processing and transforms how we interact with digital financial services. 

What PSD2 Brings in the Next 5 Years?  

With the introduction of PSD1, a new secured and organized model for payment services was made available in the market. It dealt with issues of transparency, ways to protect customers, and policies about payment service providers. However, it failed to keep up with the fast growth of digital payments, such as the digitalization of payment methods, the emergence of third-party service providers, and security concerns. This is where PSD2 steps in, bridging such gaps and preparing the payment sector for future changes. Here’s how PSD-2 is heading in the next 5 years: 

Stronger Global Influence of SCA

PSD2 emphasizes the need for Strong Customer Authentication (SCA) across the world. This regulation requires secure means of making payments and dynamic linking of transaction amounts to authentication data, ensuring end-to-end security for digital payment processes.

Expansion of Open Banking  

As PSD2 encourages open banking by promoting the use of Application Programming Interfaces (APIs), it enables financial entities and Third-Party Payment Service Providers (TPPs) to connect their different systems seamlessly.

By using APIs, banks securely exchange their specific data or services, including account details, payment initiations, etc., to authorized TPPs. This results in TPPs offering financial services to customers, therefore promoting open banking.

Increased Collaboration between Banks and TPPs 

PSD2 removes the previous restrictions for non-banks, enabling Third Party Providers (TPPs) to offer payment initiation and account access services beyond the EU. There are mechanisms prescribed in the directive that bridge the old systems of operation and new systems. 

Improved Cross-Border Payment Framework 

With the introduction of PSD2, the cross-border payments system becomes more effective as it demands the disclosure of fees, exchange rates in real-time, and exact time frames for the processing of the transaction. A standardization of payment processing standards and protocols, alongside effective privacy and security controls, promotes the efficacy of performing cross-border transactions and reduces the costs involved at the same time, thereby enhancing the EU’s internal market and competitiveness on a global scale.  

Such advancements facilitate effective and efficient interactions between financial institutions and TPPs within the EU. These measures will no doubt position the EU as a leader in digital financial innovation. Also, these advancements guarantee a dynamic structure of payments, enhancing PSD2’s impact and ensuring a safer, interoperable, and user-oriented payment field for financial institutions and TPPs. 

Two Core Focus Areas of PSD2 Compliance  

The PSD2 regulation places a strong focus on two essential areas: 

• Eliminate monopoly by increasing competition in the market and encouraging innovation.

• Securing customer-sensitive data and enabling secure transactions.

Elimination of monopoly

PSD2 has reformed the financial ecosystem by providing fair opportunities and encouraging other forms of creativity, thus reducing the monopoly of conventional banks. This is possible due to the inclusion of two new regulated services, as follows:

Payment Initiation Service (PIS)

This service makes it possible to pay for goods or services without having to use a specific application from the bank, thereby decreasing the need for conventional payment methods and providing more paths for consumers. This is an open banking aspect whereby a Payment Initiation Service Provider (PISP) plays a critical role. PIS allows the consumer to pay through specified PISPs, i.e., previously validated third-party applications handle payments on behalf of the user. This aspect adds flexibility and user-friendly enhancements. 

Account Information Service (AIS)

This service enables third parties, known as Account Information Service Providers (AISPs), to combine bank account information from various banks. It helps users to manage their funds from a single location and even track their spending habits effectively. Also, the user is not charged for any card transaction as they can pay straight from their banking account.   

For these services to be availed, PSD2 compels banks to provide access to a licensed third-party payment services provider through APIs, thereby ensuring there is an ecosystem that is not only customer-oriented but also eliminates monopolistic trends.  

Securing customer-sensitive data and enabling secure transactions

The widespread adoption of digital payment methods has transformed the financial ecosystem and has undergone a major evolution. However, the issue of protecting sensitive customer information and preserving the integrity of transactions has become a critical concern. The PSD2 addresses such threats of data breach and fraud as it implements Strong Customer Authentication (SCA), which improves the processes of verifying users, and the Secure Open Standards of Communication (CSC) to protect transferred information from being accessed by unauthorized persons.  

1. Strong Customer Authentication (SCA)

The implementation of Strong Customer Authentication (SCA) is a key provision of PSD2, aiming to enhance security levels in payment transactions and protect client data from unauthorized access. SCA requires all online service providers processing payments to apply multi-factor authentication (MFA), meaning that a user must verify their identity using two or more out of three different authentication factors. 

• The first factor, Knowledge, refers to something that the user knows, such as a password or personal identification number. This acts as the first barrier to entering the servers or any other critical assets.

• Second, Possession refers to something that the user owns, like a cell phone or hardware token. For example, a user can receive a one-time password (OTP) via mobile text messaging or use a device application to create an authentication code.

• The third factor, Inherence, is something that the user is, such as biometric patterns like fingerprints, facial structure, or voice recognition. SCA enforces biometric verification, which is unique to everyone, adding an additional layer of security.

For example, in electronic banking transactions, the user first enters the banking password or PIN, which acts as a ‘Knowledge’ factor, which triggers an OTP sent to the user’s registered mobile phone to fulfill the ‘Possession.’ Apart from that, to add extra security, they may also require the user to authenticate using ‘Inherence’ by verifying with a fingerprint or facial recognition. Thus, protecting the user under the multi-authentication process. 

2. Dynamic linking

Dynamic linking is a feature of SCA enforced by the PSD2 for protection against transactional fraud. This involves the creation of an authentication token that is unique and is generated in advance for a particular transaction, such as the amount and payee. 

• Net Transaction Tokens: Each token is issued for a specific transaction and cannot be reused for any other amount or recipient. This prevents playback attacks, where authentication tokens are reused for illegitimate transactions.

• Tamper Evident: Any alteration of transaction data, including past tokens or trying to conduct a transaction, will lead to the cancellation of that transaction. Thus, only intended transactions will proceed, increasing overall security.

3. Secure Open Communication Standards (CSC)

To protect interactions between banks and third-party providers (TPPs) after third-party access is introduced with PSD2, Secure Open Communication Standards (CSC) are also established, which consist of: 

• Secured Access: APIs are developed by the banks for TPPs while ensuring the privacy of customer data. This is aimed at enhancing the past practices of accessing data, such as screen scraping, which involved copying data present on a screen. With the help of APIs, data is exchanged in a more orderly and secure manner, reducing security risks.

• Confidentiality and Integrity: Trusting communication established by the respective bank and TPPs should ensure that transferred data remains secure from breaches and is only accessed by relevant individuals to maintain its integrity.

• Digital Certificates: This type of certificate ensures that only trusted individuals who are authorized can access consumer information, therefore enhancing security. For instance, recognizing eIDAS-based digital certificates secures the identity of the parties involved in transactions.

A Comprehensive Overview of PSD1 

In 2007, the European Union Payment Services Directive 1 (or PSD1) was introduced to harmonize payment processing in the EU and create a common market for payments. The directive was set up in 2009 and defined rules for payment services, legalizing the infrastructure of bank payments in Europe with the application of the Single Euro Payments Area (SEPA). This infrastructure, powered by International Bank Account Numbers supported by Direct Debits, made payments across European borders effective. The directive opened the market to new payment service providers while facilitating cross-border operations for enterprises in the EU. 

The Objective

The directive aims to cover all forms of payment, whether electronic or not, across the European Economic Area (EEA), consisting of the EU, Iceland, Norway, and Liechtenstein. It benefits the European economy globally by integrating the Member States into a singular economy featuring swifter payments within the region, higher transparency for the consumers, and stronger rights regarding refunds. By legally framing payment services, PSD1 achieves an even higher level of compliance with the acceptance of certain standards by all payment service providers and enhances the reliability and security of transactions across Europe. 

Why PSD1 evolved into PSD2?

Digital evolutions in payment mechanisms prompted the European Commission to update the Payment Services Directive towards the end of the year 2013. Thus, in 2014, a directive was proposed to supplement the existing legal texts with provisions of continued consumer protection, security enhancement, and the creation of a more open and competitive payments market. This was known as PSD2, which was approved in 2015 and adopted by 13 January 2018. 

What are the key changes between PSD2 and PSD1?

Change	Description
Improved Safeguards for Online Transactions	PSD2 enhances security through multi-factor authentication (MFA), reducing the number of online payment frauds.
Access to Accounts (XS2A)	Before permitting any TPP access to data relating to a customer’s account, the banks are expected to protect the customers and prepare for the system.
Payment Surcharging Prohibition	No extra charge shall be imposed on card payments, which promotes equity and increases customer satisfaction.
Support for E-Payments Provisions	Explanatory details are provided regarding the timeframes of execution and fees charged for payments for international operations by non-EU service providers.
Enhanced Consumer Rights	Better protection of users’ rights to manage their information held by third parties.
Tighter Regulations on TPPs	Stricter provisions to prevent unauthorized players from entering the digital payments market, increasing consumer confidence.
Open Banking Requirements for Banks	Banks are required to give TPPs access to their system APIs.
Transparency in Fees and Charges	Encourages users to participate in decision-making activities that involve the services of the payment providers.
Regulatory Technical Standards (RTS)	Security measures, such as Strong Customer Authentication (SCA), including biometrics and OTPs, were introduced to enhance protection.
Liability Provisions	Clarifies responsibilities associated with unauthorized transactions and minimizes risks in case of timely reporting.
Improved Cross-Border Transactions	Regarding cross-border payments within the EU, a single regulatory approach is applied.

Where is PSD2 applicable, and who should comply?  

PSD2 applies across all the EU member states, governing financial institutions, payment service providers, and all other parties involved in such payment systems.  

While the regulation primarily focuses on consumers in the EU region, any payment service provider, bank, or financial institution outside the European Union that has customers in the European Union or provides services to individuals in the European Union is also subject to the provisions of the PSD2 regulation.  

Who needs to comply?

Compliance with PSD2 is required for several entities within the financial services sector. 

• Banks, including both legacy banks providing payment services or accounts in the European marketplace and Fintech and Neobanks, which are technology or digital banks as well as other non-entry institutions providing payment or account access services in the region, must adhere to the regulations.

• Third-party providers, as well as foreign providers of payment services, are entities developed outside the EU that offer payment services to EU citizens or, in some cases, residents and must also be compliant.

Requirements 

1. Implement Strong Customer Authentication (SCA)

One of the essential requirements of the revised Payment Services Directive (PSD2) is that banks should implement Strong Customer Authentication (SCA) for remote access to customer accounts and for online payments as a security measure through two-factor authentication methods. Therefore, two of the three factors will apply: something they know (password), something they have (smartphone or token), or something they are (biometrics like fingerprints or facial recognition).  

2. Security

Security is accomplished primarily through APIs with identity authenticated via PSD2 compliance certificates. These SSL/TLS certificates encrypt sensitive data and authenticate banking entities and third-party payment service providers (PSPs) for trusted commerce transactions on websites. This approach to enhanced transaction security relies on a process called Strong Customer Authentication (SCA), a new requirement that introduces specific technical standards such as PSD2-compliant certificates and requires Multi-Factor Authentication (MFA). 

3. Digital certificates

The Regulatory Technical Standards (RTS) define the two main requirements that involve the use of digital certificates. These are as follows: 

 i) For the identification of payment service providers: Article 34 of RTS states that Payment Service Providers (PSPs) must identify themselves to the financial institution’s API. Therefore, RTS requires the use of a Qualified Website Authentication Certificate (QWAC) or Qualified Electronic Seal Certificate (QSealC) when accessing a customer’s account information.  

ii) For applying secure encryption between all the communicating parties: Article 35 of RTS states that all the communicating parties, such as PSPs, financial institutions, etc. Must be encrypted by using “strong and widely recognized encryption techniques.” 

The Regulatory Technical Standards (RTS) for Strong Customer Authentication (SCA) and Common and Secure Open Standards of Communication (CSC) specify two types of digital certificates for financial institutions and TPPs for secure communications to comply with PSD2. These are as follows: 

• Qualified Website Authentication Certificate (QWAC)

These are used to protect data in peer-to-peer communications and to identify the endpoints, like banks and third-party providers (TPPs). This implies that all the data passing through the channel is protected in terms of authentication, integrity, and confidentiality. 

These types of certificates use SSL/TLS protocols defined in the IETF RFC 5246 or IETF RFC 8446 to encrypt the sessions and protect the data in transit. 

• Qualified Certificate for Electronic Seals (QSealC)

These are used to create e-seals for the protection of data or documents using standards such as ETSI’s PAdES, CAdES, or XAdES and claim their origin from a legal entity. It provides protection to specific blocks of data at rest and data in transit, i.e., end-to-end, even if passed through an intermediary.

These certificates provide authentication and confidentiality. 

PSP Certification Process

Step 1: The PSP is required to register itself with its respective National Competent Authority.    

Step 2: The PSP will now request a Qualified Trust Service Provider (QTSP) to avail themselves of a qualified certificate.  

Step 3: The QTSP uses the public register created by the National Competent Authority to validate the PSP, and then it issues the QWAC and/or QSealC to the PSP.  

Step 4: Once the PSP has obtained the qualified certificate, it can use the financial institution’s API(s). These API (s) grant them access to customer information and payment networks. Here, the role of QWACs and QSealCs comes in as they are used to identify the PSPs and encrypt the communication between the parties.  

Step 5: Now, whenever a customer wants to view his data, the data is securely transferred from the financial institution to the end customer via the PSP. 

4. Ban on surcharges

Under PSD2, companies such as airlines and event organizers are forbidden from charging additional fees added to the transaction, also known as a surcharge. This implies that PSD2 has defined a surcharge ban for ticketing, food, and travel purposes. 

5. The reidentification process for credential reset

Reidentifying will take place when the credential reset process occurs, and banks should then ask customers who forget or misplace a key element to undergo reidentification before allowing electronic payments and transactions. Reidentifying themselves means the customer has to undergo reidentification to their bank through the Strong Customer Identity Verification (SCeID) process for verification of their identity. 

Understanding PSD2 Exemptions 

PSD2 contains several exemptions, and most of these are concerned with payment amount:  

• Recurring payments or transactions under 30 Euros can be exempted.

• High-value transactions may also be exempted if the bank is successful in proving that the transaction is below a certain risk level through risk analysis, such as:

– 100 euros for fraud rates below 0.13%.

– 250 euros for fraud rates below 0.06%.

-500 euros for fraud rates below 0.01%.

The Benefits of PSD2   

For End Users	For Payment Service Operators
Enhanced payment mechanism.	Increased client retention.
Improved transaction security.	New income sources through third-party application fees.
Provides enhanced security of clients’ banking details.	Improved cross-functionality and user experience.
Versatility of payment options.	Improved market competition.

Concrete Impacts of PSD2 on Consumers and Businesses 

1. Enhanced security

The PSD2 presents numerous benefits to consumers, most notably increased security. This includes consumers having to prove their identity through two or more factors whenever they make online payments due to the new policy on Strong Customer Authentication (SCA).  

For instance, when consumers make a purchase through the Internet, they are expected to input their password, which is the Knowledge factor. Then, an OTP (Read One Time Passcode) is received. Afterward, the consumers confirm their identity through fingerprint recognition. All of these are layered to secure the transaction and to reduce fraud.  

2. Expansion of payment methods

Another benefit provided by PSD 2 is the increase in payment methods. This information allows third-party payment services to send the payment request to the customer’s bank through Payment Initiation Services (PISPs). For example, an online payment can be made from a bank account, a form of payment that is different from the usual card payment.  

PSD2 allows consumers to access information about their finances using account information services collected from various providers. For example, it allows people to directly view their financial data across different banks on an app to give a clear picture of their finances and help them make informed financial decisions. This level of transparency and control empowers consumers to stay on top of their financial health with ease.   

3. Increased trust in businesses

Increased trust among customers is one of the major advantages that the PSD2 provides to businesses. Thus, by adhering to security and safety measures, companies demonstrate to protect their customer’s sensitive data and transactions, building more customer trust. For instance, an online retailer using SCA assures that its customers’ payment information is secure and increases the levels of assurance.  

Not only is it subject to increasing competition and innovation, but it also includes the involvement of third-party providers, with customer consent, to allow access to customer data. With that, new services and products created by businesses are possible. For example, a fintech company developed a budgeting tool linked to the bank account of a customer that would give personalized advice from transactions within the customer’s history, which was something not possible before PSD2.   

4. Efficient operations in businesses

Operational efficiency is executed through API-enabled secure communications between banks and third parties. Therefore, a business that integrates a bank’s API for direct payments can reduce payment processing times and provide a more seamless experience for its customers. 

Key Challenges  

1. For businesses

There are many challenges businesses face when implementing PSD2 while keeping its competitive stride.  

• High regulatory compliance costs

  Achieving compliance with PSD2 can be costly as companies adhering to it find upgrading and securing data systems to be resource-straining, particularly for smaller organizations. Traditional banks must compete with agile fintech companies. Otherwise, they are bound to lose customers.

• Integration of systems

  As organizations install third-party services without disrupting current operations, it leads to the ever-present risk of severe security breaches, making it necessary for businesses to focus on the security of customer data and make sure that third-party providers are compliant with the strongest security measures.

• Consumer education

  The reasons for the extra authentication steps and the new financial applications they may be using should be clearly provided to customers. Also, they should be adequately supported rather than introduced into this environment to make it more trusting with respect to PSD2.

2. Security challenges

The PSD2 aims to enhance innovation and improve payment services across Europe, but while it simplifies the banking and payment ecosystem, it also introduces several security challenges.  

• Risks of cyber attacks

  PSD2 has allowed third-party providers to access banking APIs and customers’ account data with user consent. It is a significant boost for innovation; however, it also attracts more attention from cyber criminals to these accounts. This is because it creates multiple points through which an attacker can exploit just one of them to gain access to highly sensitive financial data and cause a breach.

  This happens because the directive particularly emphasizes collaboration between banks and third-party players, which results in a lot of data being shared. The more sensitive payment and personal information divided among several entities, the greater the risk of misappropriation by any one entity. This leads to data breaches and errors due to mishandling because of inconsistent security measures.

• Complex transaction monitoring

  Transaction monitoring is required to establish an anti-money laundering (AML) framework. However, this becomes more complex with PSD2 because it scatters financial data across many stakeholders. This fragmented data makes it more challenging to ensure compliance everywhere, generating loopholes for fraud in the system as it gets harder to track suspicious transactions with regulatory compliance across all parties involved.

Therefore, a clear need for strong measures such as strong user authentication, data encryption, and continuous monitoring is required in solving PSD2 and open-banking security challenges. 

Conclusion   

The Payment Services Directive (PSD2) introduces a revolution in the European landscape of financial services. It brings in the aspects of security, competition, and customer rights, making consumers the ultimate stakeholders in their data. Most of the changes will be incorporated within existing entities, such as banks and fintech companies, as well as overall processes, such as consumer behavior, which will contribute to the emergence of a more secure and better financial services provision to consumers.