A helicopter view of Consumer Payment Innovation
By Peter Ehmke
We hear a lot about new FinTech startups, venture capital, disruption, the potential end of banks. We discuss the tipping point of innovation when the new world will finally have arrived. We go from conference to conference and read the plethora of daily newsletters. Sometimes it is good to step back from the day to day, take a look at the field from afar in order to better jump in again with clearer direction.
I propose that it is helpful to think about innovation in payments in two different, if connected, realms: the application layer and the infrastructure layer. They play by different rules and have different, sometimes overlapping, players, differing economics and success factors. The diagram below should help cut through some of the noise we hear to define where a player is situated in the payment ecosystem, their likely competitors, the kind of business model they will employ and so on. The further down you go along the strata the more likely you are to encounter strong financial regulation.
When you take a closer look at bank regulation, for example in the UK, you see that the regulators seem to be working towards this kind of market structure: open access and competition in the consumer facing application layer with open access to the infrastructure layer and services. This, it is expected, will drive competition by encouraging innovation from outside the banking system. Going forward the vertically integrated business models of the past will be difficult to maintain
The application layer is where most of what is talked about as “payments innovation” is playing out: ApplePay or Square, network/bank/merchant wallets, mobile payments, Venmo et al. These innovations are about leveraging the power of the new mobile digital world to transform the payments interaction, through a better user experience and/or additional value. The holy grail is a seamless commerce experience. They are aiming to do what the innovation of card payments achieved in the brick-and-mortar world and PayPal achieved for e-commerce: making it easy to exchange money between the accounts of the two parties to a purchase transaction. Adoption will be driven by meeting consumer and merchant expectation with a significantly better proposition than what is available today. Sexy technology and deep VC pockets cannot get you there alone.
Consumer payments is a huge and profitable business. Traditionally it has also been the way for banks to anchor their clients and their credit balances in their books. Payments has been a major relationship tool for banks. Innovators are looking to provide the better user experience and value than the banks in order to take a slice of the payment revenue or to further their own business models (e.g. Google’s payments for data play, Samsung’s platform play). They compete with the banks while at the same time building on the existing payment infrastructure: at the end of the day, money has to go from one bank account to another.
The challenge for the banks is to compete effectively in this layer against nimbler and more focused competition that can produce the required modern UIX faster. They can no longer count on the historic fact that having the account will guarantee them the payments business of the consumer. The old, interlinked vertical model no longer works fully.
Banks realize that to compete they either have to partner with other players who can provide the latest customer experience (e.g. TD/Moven), acquire the requisite skill through M&A (e.g. BBVA/Simple) or through proprietary innovation in that space (ChasePay). In short, banks can play in this space and they will. Their advantage is scale and the trusted and the numerous, heavily regulated account relationships.
There has been little innovation in the infrastructure layer till quite recently. Card networks and ACH have been around for a long time (heck, we still have checks (!). Traditionally the rails to make payment have been owned and operated by the banks and the card networks, a successful integrated business model in the last decades. New regulation opens up those rails to new players now and new technologies are appearing.
The new kid on the block is Faster Payments. Already a reality in many countries it is now finding its way to the US. It brings real time clearing of the payment, immediate availability of funds and near real time settlement of the transaction. All this based on new technology around ISO 20022 with the capability to carry more transaction related data than any of the existing payment rails. The additional data capacity is likely to drive increased value, especially in B2B payments. First transaction will happen in 2017. My eyes are on The Clearing House there. This technology is moving rapidly into the execution phase helped along by the Federal Reserve Bank through its work in the Faster Payments Task Force.
This will be a true game changer for the eco-system. It will allow straight through, account to account payment without the help of funded wallets or cards. The funds never leave the banking system.
Innovators will reach into this new rail through APIs. Banks will need to consider their business models on how they want to compete in this field as both enablers of - as well as competitors to - the innovators.
While VCs have funded most of the innovation in the application layer the investments in the infrastructure layer have traditionally been funded by the banks. In the case of Europe this has been driven primarily through regulatory edict (“You will build this functionality”). In the US it is a more mixed approach driven by pure ROI concerns and the realization that the Faster Payment juggernaut is unstoppable. Banks, of course, complain that this regulatory approach is unfair to them. But they will get a thorough modernization of their core systems out of the transition to Faster Payments. That will substantially lower their cost, improve their risk management and allow them to compete vigorously with the new competitors.
We are also seeing changes to the old picture of purely bank owned infrastructure. Advent and Bain acquired NETS which powers the Danish ACH. The U.K. regulator has pushed strongly for VocaLink to be taken out of bank ownership. A recent article suggested that MasterCard could be the acquirer. If true it would demonstrate how the players are adjusting their business models to account for the new world of payments. It is tempting to speculate that MA could be interested in this acquisition to give its processing business global scale: retail payments, the primary domain of the card networks, is only a small portion of global commercial payments. And the commercial and retail payments rails are converging.
The wild cards in the infrastructure layer are Ripple and the various Blockchain projects which attracted massive Venture Capital funding. However, when you look closely, neither are likely to get anywhere in the payments world without the banks. Ripple smartly realized this very early on and pivoted to becoming a B2B play for banks. And Blockchain is gaining traction as a technology only now that banks are investing and seriously looking at it. Investment in rails without banks is a herculean task. It is all about ubiquity – and banks today hold the accounts between which the funds flow. It remains to be seen how this technology will be applied in due course to the payment eco-system and how those VC investments will be monetized.
This structured way of looking at the payment market aims to provide a framework to think about strategic options in terms of which side of the market to play in. Players active in both layers will need to consider how they want to play in each layer. A lot will be determined by the economics available in each layer for the different players and business models (that is worth another helicopter ride in the future). We will see a lot of interesting movements.
From the helicopter we are able to see structure in all that color and movement, order in the chaos and noise of the payments world. Now let’s land this bird and join the fray! This is a most exciting time to be in payments.
Copyright 2016, Peter Ehmke, Edgar Dunn & Company