Trade Journal | June 15, 2005

Why Invest in Payment Innovations?

By: Sujit Chakravorti and Emery Kobor
Source: Journal of Payment Systems Law

A critical part of electronic commerce is the payment component. Such commerce may require adoption of different technologies to better enable the secure transfer of payments. In this paper, we provide a framework to study the creation and adoption of payment innovations in the context of strategic decisions by payment providers. Recent payment innovations  have stressed the conversion of information flows from paper-based systems to automated and electronic alternatives and the improvement of delivery channels that leverage greater connectivity afforded by advances in computing power and telecommunication technology along with greater usage of the Internet.

Based on interviews with market participants and a review of the relevant economic literature and trade publications, we answer the question: Why invest in payment innovations? We present a matrix that organizes contemporary payment innovations by innovator (large bank, small bank, nonbank innovator, data processor and joint-venture) and by strategy of the payment provider (cost reduction, increase revenue, customer acquisition and customer retention). We categorize specific market participants and specific innovations in a profit matrix. This exercise demonstrates the fluidity of the market. Over time the types of institutions providing these services may change as the applications can move from niche specialty to market commodity.

Let us begin by clearly defining some terms and drawing some distinctions that play a pivotal role in our argument. First, a payment  is a transfer of money  from the payor  to the payee. The form of money that is relevant to this discussion is a balance in an account at a bank. Thus, payment is made by debiting the payor’s account and crediting the payee’s account. Both payor and payee are known as transactors. Although the payor and payee may have the same bank, in general they do not, so either (a) banks have to cancel offsetting claims between them (i.e. netting occurs) or (b) an interbank payment  or settlement must be made on the books of a correspondent bank or central bank at which both the payor’s and payee’s banks have accounts.

A payment system  is traditionally defined in terms of a system for making such interbank payments. Such a system may encompass a means for a transactor to initiate a payment: communications and computation infrastructure to carry each transactor’s initiation message to its bank and also messages among banks to direct interbank payments to be made; contracts, laws, regulations and industry standards to establish rights and responsibilities of transactors and their banks and to facilitate coordination among them, and so forth. We interpret this definition broadly to include various value-added services that are complementary to the payment per se. Often broader technological innovations, such as account aggregation and electronic presentment of bills, are bundled with payment services. Business reasons to provide such services include profitable sale (either explicitly or else bundled with payment services) to existing customers, creating and satisfying demand among transactors who are otherwise unable or unwilling to be payment-service customers, and mitigating or managing risks borne by transactors and banks.

Although banks continue to control the settlement process, profit opportunities are shifting away from the transfer of funds to value-added services and providing payment system access to underserved markets. New innovations allow nonbanks to identify underserved market segments and deliver targeted products, including clearing services and the delivery of payment-related information. Recent developments include account aggregation, electronic bill presentment and payment (EBPP), online peer-to-peer (P2P) payments, and stored-value payment instruments.

Payment innovations can be divided into two distinct categories: They can be classified as technology or service innovations. Technology innovations use technology to modify an existing process or product, or create a new one. For example, new technology confers the ability to view and pay bills online. Service innovations are changes in the product or process that do not necessarily involve changes in the underlying technology such as frequent flyer miles on credit card products. Often innovations may be both technological and service-related.

With new technology being a focal point of payment system development, banks and nonbanks face a range of strategic options (e.g., proprietary research and development, joint ventures, venture capital investment and alliances). Each approach carries unique costs and benefits. These strategies are not mutually exclusive, however. Banks have pursued different investment strategies for different products and have even used different investment strategies for the same product at different stages of development.

Based on interviews with market participants along with other sources, we provide a framework to study payment innovations. We are able to identify what types of firms invest in creating innovations and how these innovations are brought to market and adopted by payment system participants. We also identify the strategic reasons why payment providers adopt payment innovations. Lastly, we discuss the evolutionary process of an innovation.

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