The payments innovation illusion: why so few are getting so rich by changing so little
The curious thing about innovation in payments is that the only market participants to be damaged by it are the banks, and even they are still very much in business. All that appears to have happened is that the card networks and a select group of rapidly scaling FinTechs and their investors have become enormously wealthy by cherry-picking low cost, high margin payments business from the banks. Is payments innovation not actually the transformative phenomenon we are always being told it is?
It is worth asking whether one observer calls “the boiling ocean of payments FinTech” amounts to anything. 20 years on from the PayPal initial public offering (IPO), innovation has proved that banks are not needed to make payments (which was known already), that payments can be made much faster (ditto) and that non-bank accounts can be pre-funded from bank accounts (which was not worth doing if banks had bothered to provide competitive services of their own).
Uncompetitive banks created an opportunity for payments FinTechs
The fact that incumbent banks were so hopelessly uncompetitive merely created room for a class of limited purpose FinTechs to cut the payments revenues of the banks and transfer wealth from bank shareholders to themselves. It is certainly a valuable trade. The US$95 billion market valuation of Stripe at its latest fund-raising, for example, exceeds the total value of e-commerce in 2010, the year Stripe opened for business.
Meanwhile, the basic infrastructure of banks, central banks, automated clearing houses (ACHs), real-time gross settlement systems (RTGSs) and debit and credit card networks remains intact. Indeed, the card companies have grown more valuable than the banks, not less. And PayPal was simply the first company to realise that a profitable payments business could be built on top of the existing banks, ACHs and card networks. It has helped furnish Elon Musk with enough money to send rockets into orbit.
Transformative change can occur at the level of the networks only
As a result, once-powerful banks are losing payments transmission business, and both they and their challengers find themselves engaged in a race to the bottom on transaction fees. Technology makes this more bearable. But radical, meaningful, transformative change requires innovation not on top of the networks but at the level of the networks – or what payments insiders generally refer to as “the rails.”
Even the most successful crypto-currencies have not so far disturbed these underlying networks. None is widely accepted as payment. The exchanges on which they are traded have struggled to escape a reputation for being hacked or pilfered by insiders. And the transactions costs of buying and selling crypto-currencies make the high commissions and gaping spreads of retail FX transactions look cheap. Though they have developed networks, they have yet to compete with existing payments systems.
It is only in less developed economies, where money transmission has until recently taken the form of physical cash, that effective and scalable new payments networks have arisen. In China, for example, the banks have comprehensively lost retail payments to social media networks (namely, Alipay, WeChat Pay and TenPay). In east Africa, likewise, banks have lost retail payments to Mpesa, which is owned by two telecommunications companies, Safaricom and Vodacom.
Yet even these networks have not disrupted the role of the banks in taking deposits and lending them, or moving them, or investing them. As foreigners living and working in China have found, it is incredibly difficult to use AliPay or We Chat Pay without opening a bank account, and impossible without attaching at least a foreign bank card. In the same way, even an Mpesa account must be topped up by cash or a transfer from a bank account.
Cross-border payments are almost completely unreformed
Cross-border payments are yet another instance in which FinTechs have devoured some of the margin of the banks. Otherwise, the old banking model is completely unreconstructed. Banks maintain hundreds or thousands of accounts with correspondent banks all over the world. The average correspondent bank payment passes through 2.6 banks, and several more if it is couched in one or more obscure currencies. As a result, cross-border payments are expensive, slow and opaque.
The cost has become so painful that the Financial Stability Board (FSB) has identified solving it as a priority. In a joint project with the Committee on Payments and Market Infrastructures (CPMI), it published between April and October 2020 a three-stage “roadmap”1 with specific goals and timetables to improve existing payments infrastructures in the short term and explore whether new infrastructures could in the long term make a meaningful difference.
Hundreds of billions of dollars are tied up as liquidity buffers
One reason that cross-border payments are expensive is that correspondent bank accounts have to be funded, with cash or credit. This is costly. The average Global Systemically Important Financial Institution (G-SIFI) has US$230 billion in precautionary liquidity buffers in multiple currencies, of which 10-30 per cent is used to cover intra-day payments. It is estimated that more efficient management of intra-day liquidity alone would save each large bank US$50-75 million a year.2
It is an opportunity yet to be seized by a credible FinTech, though some are certainly attempting to capture it. This is a remarkable feat of entrepreneurial conservatism in the face of an explosion of international travel, remittance payments and cross-border purchases even of items of limited value.
True, FinTechs have made significant progress in cutting the costs of remittances and currency exchanges. This represents savings to consumers but – in common with every innovation in payments – they are achieved by redistributing margin from banks to FinTechs.
The cost of payments is a hefty tax on economic growth and the standard of living
The overall cost to the world economy of making payments remains extraordinarily high. Total payment transaction costs are currently running at US$1.5-2 trillion a year. This figure equates to a tax on economic growth equivalent to 1-2¼ per cent of global GDP, or US$1,000 per head of population.
Of course, trust exacts a toll. One reason banks and FinTechs can extract such lavish rents is that consumers want assurance their payments will reach the intended destination. The regulators have composed detailed regulations, designed to achieve the contradictory goals of cheapness and safety. And the banks and central banks have built and maintain and operate an expensive infrastructure of ACHs and RTGSs, precisely to deliver those twin assurances. Payments FinTechs rely on that infrastructure just as much as the banks.
And the gatekeepers to the infrastructures are the correspondent banks. They add substantially to cross-border transaction costs, by restricting access to domestic RTGS systems, providing limited transparency into the whereabouts of a payment and any charges levied upon it, and by creating the need to maintain massively expensive liquidity buffers.
As long as extended chains of banks are needed to complete cross-border payments and the accounts foreign banks maintain with domestic banks (what the foreign bank calls its “Nostro” account and the domestic bank calls its “Vostro” account) have to be reconciled, plenty of inefficient, costly and technologically unnecessary work will be generated.
Blockchain models, Stablecoins, data standards and APIs are helpful but not transformative
The contrast between the correspondent banking system and a self-reconciling blockchain network, in which the value of the payment is intrinsic to the network and is actually sent from one address to another rather than achieved by the reconciliation of two separate domestic transactions, is stark. In its purest form, blockchain also dispenses with netting by ACHs and gross settlement in an RTGS system.
The starkness of this contrast explains why Facebook, for example, saw an opportunity to leverage its network with a Stablecoin (initially called Libra, but now branded as Diem) its members could use to make payments.
In principle, a universal network – or any network enjoying significant network effects, such as Facebook – can make payments more cheaply than any set of networks, no matter how efficiently they inter-operate.
And current payments networks do not inter-operate efficiently. Consumers have to identify themselves separately to make use of any payments channel, instead of having a single identity that allows them to switch seamlessly between channels.
Similarly, despite the efforts of SWIFT to standardise how members of correspondent banking networks exchange information, through the ISO 15022 and ISO 20022 standards and their predecessors, data about payments is not always exchanged in a convenient, machine-readable form.
The recent rediscovery of Application Programme Interfaces (APIs) to facilitate data exchanges is promising for progress in inter-operability, in the sense that APIs do not insist every node on a network must speak the same language.
However, even APIs do not escape the standardisation problem completely. API data standards have become a necessity. They are nevertheless useful. They can, for example, enable an ISO 20022 network to exchange information with an Ethereum network.
Public Ethereum networks, like any Blockchain network, are in principle universally open and accessible, so they in theory never encounter the inter-operability barrier. Reality, however, differs from principle. Blockchain network come in more than one flavour, and they are also obliged to interact with permissioned Blockchain networks and traditional payments networks too. The cost of settling crypto-currency transactions remains high.
The obstacles to change at the network level are formidable
All of which makes the idea of creating a universal network a pipedream. Yet building even a set of efficiently inter-operating sub-networks faces many obstacles.
One is national governments and national regulators. In Africa, for example, there are 55 governments and tens of thousands of languages. And every country – not just in Africa – has its own payments culture. The Swedes are worried about the disappearance of cash, while the Americans still write cheques, and the Germans insist on direct debits.
KYC, AML, CFT and sanctions screening checks are a major source of additional cost
On top of these national differences, international regulators have laid on regulators recommendations on Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks that also come in distinctly national flavours.
So global banks – and it is banks, rather than FinTechs, that are doing the work – are obliged to conduct subtly different checks on anyone wanting to make a domestic or cross-border payment, depending on the jurisdiction.
Being largely manual, paper-based and not standardised across jurisdictions, the cost of these checks is already high, and still rising. In fact, in international payments, where the cost is coupled with the risk of being fined by regulators for any mistakes, the KYC, AML, CFT and sanctions screening risk is now so acute that it is actually shrinking the number of correspondent banks prepared to intermediate payments at all.
McKinsey has estimated that compliance accounts for an eighth of cross-border payment transaction costs, behind only liquidity (a third), treasury (a quarter) and FX spreads (a seventh).3
Digital identities (digital IDs) could add efficiency but create data security and privacy concerns
Clearly, machine-readable, cryptographically secure digital identities have the potential to drastically reduce the cost of compliance for individual customers, as do the Legal Entity Identifiers (LEIs) promoted by the Global Legal Entity Foundation (GLEIF) for corporates.
As it happens, the adoption of either or both would also give an incidental boost to the adoption and use of crypto-currencies. Where counterparties are anonymous, and there is no scope to retrieve mistaken payments, anything that increases the level of assurance about the identity of a counterparty is bound to be welcome.
However, exchanging information about the identity of payers and payees alongside information about payments is not as obvious a gain as it appears. The two data sets do not have to be commingled; they do not even need to be exchanged on the same network. If they are, it creates an unnecessary vulnerability to hacking and puts the confidentiality and privacy of counterparties at risk.
However, the digitisation of the information about payments and the parties to them, especially on blockchain networks, will tempt regulators to abandon relying on banks and FinTechs to report suspicious transactions.
Instead, regulators will become nodes on the networks, and therefore parties to all data exchanges on the networks. This possibility is already evident in demands from regulators in South Africa as well as (more predictably) in China.
Where to strike the balance between the competing demands of combating financial crime and protecting personal privacy and confidential information is far from clear, at least in countries which believe that not everything which individual citizens do is a matter of interest to the State. This issue is likely to become acute as the use of digital identities in digital payments gathers momentum.
Merchants are baffled and exasperated by the consumer-driven nature of payments reform
For merchants, however, a requirement to maintain customer confidentiality (or disclose customer identities) would be just another payment problem to manage. Merchants want to be paid by customers for the goods and services they supply. For them, the proliferation of payment methods and channels has created more confusion than benefits.
Understanding the difference between the offerings of Stripe and Square and Adyen and Rapyd and Checkout.com and Authorize.net – to name just six of the alternatives they face – gains them everything (namely customers) but also nothing.
In fact, the multiplying army not just of payment service providers but of methods of payment, such as Shop Now, Pay Later (the Klarna model) and electronic payment at point of sale (eftpos) Online (now happening in Australia), is creating further exasperation.
While innovations of this kind benefit consumers, they create opportunity costs, connectivity and integration issues, reconciliation problems, compliance risks and customer experience challenges for merchants.
What merchants need is a low cost, flexible service that enables them to adopt and discard payments channels as they wax and wane and adapt nimbly to changes in the wider payments environment – such as the January 2021 decision by Mastercard to increase interchange fees five-fold for online purchases in the European Union from consumers in the post-Brexit United Kingdom.
Radical change depends on infrastructure, regulation, CBDCs and open access to RTGS systems
So where will radical, genuinely innovative reform of payments come from?
One possibility is already becoming visible. All payments market infrastructures are moving from batch processing of payments to real-time processing. Though the effect is to make instant payments possible, this is not the primary motivation. The real reason for the change is the need to support the explosion of payments providers and payments methods that so disorients merchants.
With their installed client base, and the consequent network effects, a fully digitised market infrastructure has the potential to facilitate more meaningful innovation than the payments industry has managed so far, especially if the infrastructures in different domestic markets open their membership to foreign banks and inter-operate with each other.
The obstacles to that happening are not technological but political, social and cultural – and effective international regulation can help to clear them.
A second looming possibility is a retail central bank digital currency (CBDC). If a CBDC can provide an effective substitute for old-fashioned physical cash in the form of value on a network, it would (by definition) provide a genuinely new network for making payments.
It would also not be a network which was owned and controlled by a crypto-currency issuer or a large social media or other technology company. An open, neutral CBDC network of this kind would spark a wave of innovations designed to exploit its official backing.
A third, more speculative, possibility is an easing of the restrictions that deny foreign banks easy access to domestic payments systems. If they had direct access, rather than being forced to access them via domestic correspondent banks, even cross-border payments could be made, if not peer-to-peer, at least between the accounts of the underlying beneficiaries. This would also reduce the costs of the liquidity buffers that most banks are forced to keep in their Nostro/Vostro accounts.
The most revolutionary possibility is the end of banks as we know them
A final, more speculative possibility is that the unique tasks currently performed by banks – namely, deposit-taking and credit advances – are gradually assumed by specialist providers of the same kind that have taken an increasing share of the payments activity the banks once monopolised. However, this is dependent on other developments achieving universal status.
The technology which underpins crypto-currencies is well-placed to disrupt deposit-taking, because value is stored on the blockchain itself rather than a separate account, but it will take CBDCs to universalise that reality – provided the central bank that issues the CBDC does not elect to preserve a privileged position for retail banks. That loss of status might even be welcome to banks, since a CBDC could also relieve them of the burden of maintaining expensive liquidity buffers.
Experiments currently taking place in the Decentralised Finance (DeFi) market suggest that not only deposit-taking but credit advances could also be handled by a new class of specialist firm. Indeed, this will be essential if the banks lose their ability to lend because a CBDC has robbed them of funding from deposits.
The prize is certainly great. At the moment, the cash leg – the payment part – is the greatest single constraint on the tokenisation of securities, which is rich in potential to revolutionise how securities are issued, traded, settled, safekept and serviced. More efficient payment could also transform the costs of foreign exchange transactions, boosting direct as well as portfolio investment.
Payments innovation is so far disappointing
Yet, although the elements of a payments revolution are visible – inter-operable networks and CBDCs in particular – and a great deal of superficial innovation has taken place in how payments are made, the payments industry has yet to be disrupted in the way that bookselling (which Amazon transformed), hotels (AirBnB) and taxiing (Uber) were.
So far, innovation in payments is not even incremental; it is iterative. The ISO 20022 standard, to take an obvious example, may represent an advance on ISO 15022, but it represents no advance at all on the payments thinking of the 1970s.
Indeed, the lack of enthusiasm for adopting ISO 20022 reflects at least in part the intuition that standards are not a transformative technology but a 20th century solution to a 20th century problem of limited computer processing power and storage capacity.
That forced 20th century banks to solve the problem of efficiency in payments by searching for a worldwide consensus among tens of thousands of banks, brokers, asset managers and corporates on the formats in which they would exchange information with each other.
This was the paradigm which led to the creation of SWIFT in the 1970s, as an alternative to allowing one bank (namely Citi) to reduce the inefficiency of cross-border payments. As long as that paradigm persists, nothing fundamental will change.
Written by Dominic Hobson March 2021
1. Financial Stability Board, Enhancing Cross-Border Payments, Stage 3 roadmap, 13 October 2020.
2. Oliver Wyman, Intraday Liquidity: Reaping the Benefits of Active Management, 2018, Exhibit 1, page 2.
3. McKinsey Global Payments Map.