Payments innovation has failed to live up to the hype
Payments is widely applauded as one of principal theatres of game-changing innovation in financial services. The essential nature of the business, and the high volume of transactions, have certainly attracted a lot of entrepreneurs and venture capital and made some high-profile figures extremely rich. But in reality 20 years of innovation have changed nothing fundamental, and done next to nothing in terms of creating value for consumers. Dominic Hobson asks why.
How we pay each other is more important than what we pay each other with. Or so it can be argued. Money, after all, is just a social convention. Anything a payee will accept in payment counts as money.
But if the infrastructure by which payments are made – the extended systems of systems and networks of networks that span the globe – are out of action for more than a few hours, entire economies and societies are at risk of collapse.
Payments remain expensive, especially for consumers
In fact, the systemic importance of the global payments infrastructure can be measured by the transaction costs its users pay. The payments industry enjoys annual revenues of US$1.5-2 trillion – a figure equivalent to 1¾ to 2¼ per cent of global GDP in a normal, non-Pandemic year.
Somewhere between half and two thirds of that sum is paid by retail consumers in the form of the payments charges that retailers pass on to them, extortionate fees and rates of interest on overdrafts and credit cards, and wide spreads on cash deposits and foreign exchange (FX) bargains.
Consumers pay the most because it costs the global payments infrastructure just as much to process a grocery bill of $40 as an inter-company payment of $40 million. In all, it is a system that costs every consumer on the planet about US$1,000 a year.
That is a surprisingly high figure – and the transaction costs are higher still for the unbanked, which continue to rely on cash and payday loans – given the high levels of digitisation in the payments industry, and the heavy involvement of non-banks for many years.
Non-bank competition to provide payment services has done little for consumers
It was proved more than half a century ago that non-banks can process payments more efficiently than banks. The first credit card (Diner Club) was invented in 1950. Visa dates its foundation to 1958, and the history of Mastercard begins in 1966. Even PayPal is more than 20 years old.
All three are worth more than the banks today precisely because they can process large volumes of transaction information at low cost. Indeed, their chief effect is to transfer revenue from banks to themselves, rather than from banks to consumers.
Not one of relative newcomers Adyen (2006), Stripe (2010), ApplePay (2013) or GooglePay (2015) is less than six years old. Yet all they have really proved is that mobile phones provide a low-cost infrastructure for existing methods of payment.
Risks in payments favour the status quo
The main obstacle to meaningful innovation in payments is that payments entail more than processing. They create counterparty credit and settlement risks, which become steadily more significant as payments increase in size.
Large payments also require liquidity – and at the moment only banks can provide that. Non-bank payment service providers (PSPs) do not even want to. In the end, the demands of risk and liquidity management impart too great a bias to the status quo for radical change to occur.
Cross-border payments are unreconstructed by FinTechs
This systematic conservatism is most extreme in cross-border payments, which continue to rely on chains of correspondent banks to intermediate currency buys and sells. An average of US$1.5 trillion crosses national borders every day, intermediated by an average of 2.6 banks.
Regulatory pressure to combat financial crime has inadvertently added an oligopoly to the costs. Almost every cross-border payment passes through one of just 15 banks out of the 25,000 that exist.
What FinTechs have entered the cross-border payments markets have not changed this, though they have eaten some of the profits made by the banks in the foreign exchange (FX) markets.
Payments FinTechs have changed little in most markets
The same is true of even the successful payments FinTechs: they have changed nothing fundamental in domestic markets either – in North America and Europe at least.
This is less true of China or Kenya, for that matter. AliPay (founded 2004) and Tenpay (2005) are genuine innovations, but they were made possible by the lack of incumbent institutions and conventions only.
Likewise, Mpesa was able to rise from nothing to a dominant position in Kenyan payments within a decade, using mobile telephony, because the banks had created nothing for them to displace. Outside Kenya, where the environment is less open, Mpesa has had less success.
Apple Pay and Google Pay continue to use existing debit and credit card systems. Innovation by the FAANGs in payments, as in almost everything they do in the real world rather than the universe of hype, is incremental rather than fundamental.
Even if Amazon or Google or Facebook entered the payments business at scale, making use of their large installed client bases, they would still have to buy or rent or build an underlying infrastructure to have any hope of detaching business from the incumbents. And to displace the banks they would have to become banks capable of managing risk and supplying liquidity.
Crypto-currencies are (mostly) useless as payment instruments
Cryptocurrencies, on the other hand, have had no serious impact on payments at all. At the moment, hardly any retailers will accept payment in Bitcoin, though a number of fast- food companies, airlines and on-line vendors do.
Not many consumers, including even those who own crypto-currencies, regard their investments as money. Regulators treat them as securities. Institutional investors view them as commodities or hedging instruments.
In short, hopes that crypto-currencies can replace fiat currency in day-to-day payments are already disappointed, and are likely to be extinguished altogether with the advent of central bank digital currencies (CBDCs).
Payments FinTech hype continues unabashed
Yet Payments FinTechs continue to fuel expectations that they can revolutionise payments, and investors are buying their stories.
Crunchbase lists more than 20,000 companies that claim to be invested in “payments,” a thousand of them having secured fresh funding in the last year, a quarter in the last three months.
But what is taking place in payments FinTech is at best no more than another winner-takes-all race to decide which payments service provider can scale fast enough to intermediate the most payments, and then use economies of scale and network effects to drive other contenders from the field.
It will take an inordinately long time to achieve such an exalted status, because there is no global markets in payments. Every country has formal barriers to global intenders, to say nothing of the informal barriers erected by national payments idiosyncrasies, such as the American fondness for cheques.
Cherry-picking and cream-skimming PSPs could drive banks out of payments
The idea that leading PSPs can defy the logic that keeps the existing banks in control of payments is based on a superficial analysis of the limited ambitions of the PSPs themselves and especially on a limited understanding of how payments must actually work: one that ignores liquidity and risk.
True, sizeable PSPs could effect meaningful change by accident. By squeezing the banks of the revenues they enjoy from payments – chiefly the spreads on the associated cash, currencies and loans – the PSPs could drive the banks, as well as their rivals, out of the business.
After all, banks will scarcely be willing to bear the costs (including capital costs) of managing counterparty, credit, settlement and liquidity risk if they cannot also enjoy the revenues which stem from assuming them.
Payments FinTechs are, in essence, cherry-pickers and cream-skimmers, which profit from intermediating between merchants and consumers. It is the banks which provide the balance sheets which make those activities possible.
Genuine innovation in payments depends on doing what banks do, but better
It follows that a genuine innovation revolution in payments – to be judged by its ability to cut that US$1,000 per annum charged to every consumer at least in half – must find a better way to do the work currently assumed by banks.
That the work must still be done is not in doubt. Without banks, the services provided by the PSPs would soon collapse. Indeed, entire economies and societies would be put at risk.
One option is a user-owned utility akin to CLS or SWIFT, which could run a low-cost infrastructure that provides the underpinning for the more frivolous innovations of the kind provided by PSPs today. But questions soon pose themselves.
Payments remain a stubbornly national activity, so virtually every country would need a utility of its own. To facilitate cross-border payments, the utilities would have to agree to inter-operate.
That would raise (probably insuperable) issues of liability if any one utility was paid but failed to pay. Inter-operability would also require standards, which national payments practices would make it extremely hard for banks to agree and then adopt.
Counter-intuitively, genuine innovation may depend on central banks
Would banks want to own such utilities anyway? They would further empower the PSPs, without enriching the banks. The PSPs would be reluctant too, because the regulators would scarcely allow a utility to operate without capital buffers and other risk-reducing restrictions.
A more realistic set of owners might be the central banks. CBDCs already represent a temptation to displace commercial bank money altogether, and the PSPs could replace the banks as checkers of retail identities and providers of retail accounts without being given banking licences.
It is an improbable vision of the future: central banks providing a platform for non-banks to compete for the business of consumers. But it is more likely to generate value for consumers than the present dispensation of Potemkin innovation in payments.
Written by Dominic Hobson, Co-Founder Future of Finance, March 2021