Disrupting Payments: The Incumbents' Response

Bob Chakravorti, Chakra Advisors
June 6, 2019
Image of payments made on multiple devices.

Advancements in computing and mobile technologies have provided the impetus to create new payment mechanisms. Furthermore, non-bank providers, e.g. Venmo and WeChat Pay, social media WeChat’s payments arm, play an increasing role in the provision of payments that has traditionally been the domain of banks. For example, Visa, MasterCard, American Express, and Discover had greater than $6 trillion in U.S. purchases in 2018 up over 10 percent from 2017. In the same period, Alipay, initially created for online shopping similar to PayPal, and WeChat Pay in China generated over $37 trillion. Comparisons across countries is difficult for many reasons but these figures illustrate the potential for fast paced adoption and usage of new payment mechanisms.

In this blog, I discuss how payment disruptors are forcing incumbents to transform themselves. This transformation will result in greater speed, connectivity, and reliance on “push” payments. Will banks and established payment networks be able to improve the speed and convenience of making payments or will technology-driven firms be able to engender trust along with providing convenient and expedient resolution systems in the event of fraud or nondelivery of goods and services provided by certain bank-intermediated payment mechanisms? Ultimately, consumers and businesses may prefer to have different types of payment mechanisms for different use cases. Regardless of the number of payment mechanisms, there will likely be a convergence of the underlying payment infrastructure used to settle payments.

Payment Infrastructure

At the core of any payment system, there is a communication network that allows for information to be exchanged among transactors, processors, networks, and banks. In the past, these networks were predominately operated by banks, bank consortiums, or central banks. These communication networks used dedicated telecommunication lines that were generally limited to banks. More recently, social networks are considering or have started to offer mobile payments using their instant messaging platforms. WeChat Pay and Alipay have been successful because bank-intermediated payment services had low adoption and usage in China. In the future, Facebook Messenger may provide a similar payment platform in the United States leveraging its social media network.

WeChat and Facebook are able to leverage their networks that are significantly greater in size than a financial institution’s customer base. Therefore, these networks are able to take advantage of on-us transactions where both the payor and payee have accounts with the network resulting in book entry transfers.

Before discussing the need to improve the underlying payments infrastructure, let us describe how funds are generally transferred. For most non-cash-based payments, the transfer of funds occurs between accounts at banks. The transactors, a buyer and a seller, use bank-intermediated instruments to make payments. Either the buyer instructs her bank to send the payment, known as a “push” payment, to the seller’s bank or the buyer authorizes the seller’s bank to collect funds from her bank, known as a “pull” payment.

The payment mechanism may differ depending on whether the payment is between known parties, at remote locations, and if transactors are consumers, businesses, or governments. Several solutions for each of these payment segments are being considered but adoption and usage remain challenging in the United States. Can we improve our current payment mechanisms to be used across payment segments or do we need new ones? Furthermore, is the goal of one universal payment mechanism realistic?

Although the last time a payment rail was introduced in the United States was over 40 years ago, many improvements have been made to existing rails. Are these improvements sufficient going forward? Let us briefly review where we are. One common characteristic of most U.S. payments is that they are “pull” payments. In other words, the payor authorizes the payee to collect funds on her behalf. For example, when paying by check, the receiver of the check must present it to the payor’s financial institution directly or indirectly for payment. There is no guarantee that the funds will be available in the payor’s account when the check is presented at her bank. Checks remain a popular form of payment for business-to-business and person-to-person payments in the United States. In addition, voided checks are often used to set up ACH payments to make sure routing and account numbers are accurate.

Pull payments can be made more secure by using real-time authorization systems and providing guarantees. When using a debit card, the network authorizes and transfers the funds to the payee’s account essentially eliminating settlement risk, the risk that the funds will not be transferred at settlement. For credit cards, the issuer guarantees funds if certain procedures are followed. Card networks are sophisticated global networks that offer real-time authorization of transactions and payment guarantees resulting in high global acceptance of their branded cards. These types of payments are very popular for consumer-to-business payments along with travel and entertainment expenses for businesses. Card payments are also expanding their use cases although today’s underlying fee structures may prevent entry into certain payment segments. However, card networks may reduce fees to entice new payment categories as they have done in the past or create fund transfer systems that use push payments.

ACH payments were initially created for certain types of relatively low risk payments and come in two forms—ACH debit and ACH credit. ACH debit payments are used for recurring bill payments and suffer from settlement risk similar to checks. ACH credit payments are often used for payroll disbursement and are only initiated if sufficient funds are available eliminating settlement risk. ACH payments have been successful for recurring payments such as remote bill payments and payroll disbursements. The main advantage of ACH payments is low cost although these payments may lack enhancements of other payment mechanisms.

Faster Payments

In 2015, the Federal Reserve created a taskforce, called the Faster Payments Taskforce, consisting of financial institutions, third-party payment providers, businesses, payment networks and others in the payment ecosystem to consider a faster, safer and an ubiquitous new payment rail. Some market participants continue to question the need for faster payments. Although called faster payments, these new payment rails should improve upon information flow, security, user experience along with faster clearing of payments especially given the improvements in data analytics, mobile technology and seamless exchange of information across borders.

The merging of non-payment and payment data allows for greater efficiency in commerce broadly. Today, payment and invoice flows occur on different systems that are not often integrated. A payment mechanism with broader messaging capability to request remittance, reconcile invoices, and make payments would be a game changer for business-to-business and person-to-person payments along with consumer bill payment. The marriage of social media with payments allows for the payment information to be embedded in a “conversation” often with pictures, e.g. a Venmo payment. Such payment mechanisms were initially targeted at person-to-person payments where transactors trust each other. We are likely to see similar improvements to other payment segments in the future.

Security is a major concern for new and existing payment mechanisms and could be improved. First, instead of using account credentials for transactors some other identifiers could be used such as an email, phone number or one-time use tokens. Imagine the savings to payment providers if the number of reissued cards and replacement accounts was significantly reduced because account payment credentials were not freely exchanged among transactors. Zelle, a payment network set up by a few banks, stole a page from PayPal by using email instead of account information. Second, authentication of account holders in an online world especially during on-boarding and resolving fraudulent activity could be enhanced with a robust global ID system. While setting up new bank accounts has improved, it may still take days before funds are available primarily due to verification and authentication of account holders. To resolve fraudulent activity for a transaction account, often documents are sent in the mail or one may have to present identification at a bank branch in person. Both options seem extremely archaic in today’s world.

A new payment rail based on the Federal Reserve Taskforce recommendations for faster payments is real time payments (RTP) created and operated by The Clearing House, a consortium of 25 of the largest commercial banks operating in the United States. This network offers a communication system that is integrated with the transfer of funds. Requests for remittance and necessary adjustments can be made before payments are sent. Payment receipts can also be sent. These features are significant upgrades from how ACH networks operate today. In addition, all payments are “push” payments. To encourage integration with other networks, RTP offers application protocol interface allowing for better integration into other types of payment platforms.

RTP is bank consortium’s response to new nonbank payment mechanisms. The RTP payment rail will allow banks to compete in two ways. First, banks will be able to provide new payment mechanisms that use this infrastructure to better compete with nonbanks. Second, banks participating on RTP are looking to increase cooperation with nonbank networks by creating seamless funds transfers across different parts of the payment system.

Why Are Banks Worried About Losing the Payments Business?

One of the key banking functions is deposit taking. Banks are attractive places for deposits because of deposit insurance provided by the government in the event of bank failure. In addition, banks have access to liquidity from the Federal Reserve which allows banks to provide access to their customers’ accounts during times of financial stress. Because nonbank accounts are not supported by these safety nets, customers may limit the amount of funds held in these accounts to just meet their payments activity. Banks will likely continue to provide a safe place to store liquid funds. One estimate suggests that lost deposits to nonbank payment networks would only be less than 1.5 percent of total deposits.

Banks also earn significant revenues from existing payment mechanisms. When paying by payment cards, banks are able to earn per-transaction fees from merchants. Merchants pay around $90 billion to accept card and mobile payments of which the lion’s share goes to issuing banks. For checking and ACH transactions there is a potential to earn non-sufficient funds (NSF) and overdraft fees when transaction accounts are overdrawn. The Consumer Financial Protection Bureau estimated that these fees totaled $17 billion for the year ending September 30, 2016. The ability to earn these fees would be reduced significantly if push payments are adopted. Of course, push payments could be associated with credit lines that may have fees attached to them but NSF fees would disappear.

As a result of nonbank payment entrants, bank revenue will likely decrease. How much it will decrease will depend on how much volume is being replaced along with what types of payment transactions are being replaced by these new payment mechanisms. In the case of China, mobile payments replaced cash. In more advanced markets, new payment mechanisms may replace bank-intermediated payment mechanisms for certain types of transactions. While new payment mechanisms may not eliminate existing ones, growth rates and revenue of existing payment mechanisms will be impacted resulting in lower fees, better services, or both.

Finally, payment services are generally bundled with other financial services such as loans. Nonbank payment networks such as Square and PayPal have started to extend credit based on analyzing creditworthiness from their payments data. In some cases, nonbanks have considered acquiring banking licenses. If nonbanks are able to leverage their payments services with other financial services, banks will face competitive pressures for other financial products. I look forward to exploring this type of disruption in future blogs.

Where Are We Headed?

Banks will continue to be an important part of the payment landscape because they will likely remain as the custodians of funds because of the government guarantees on deposits. However, their current fee structures are being challenged by new types of products offered by nonbanks. It is important to note that payment mechanisms are not equal in terms of protections and convenience offered. In addition, nonbank payment providers must expend resources to be compliant with the ever-increasing complexity of the regulatory framework. In the end, consumers and businesses will benefit from the transformation in payment products resulting from advancements in computing and mobile technologies although the process promises to be disruptive eventually leading to a better and more seamless payment experience.

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