Why Most Payments Innovation Fails: Unpacking the Reasons

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David True

President and Board Member, NYPAY

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We are in an age of payments innovation: myriad ideas with mountains of money betting on them. A large reason for this rush is the nature of our payments system: it is complicated and unwieldy, yet generates tremendous profits. All of which is catnip to those looking for a business to disrupt.

Yet few of these ideas will become successful products.

Why? Because the same complexity that provides the profits make big changes difficult (as I’ve argued in an earlier post).

“Complexity” is an easy excuse—so I’ll unpack it with a bit of history to make the challenges of payment innovation clear. And then I’ll offer a framework to use when you hear about the next big thing in payments.

Way back when it was simple…

Many years ago, a payment was one person giving money to another in exchange for something. A simple arrangement, where both parties know each other. Sometimes the seller would accept an IOU—extending credit—but it all stayed among parties with direct connections. Two parties, really simple.

The advent of checks brought a new party into the mix: a bank, and with that an early network, to clear checks between banks. So now three parties: the customer, the bank, and the merchant—with banks having customer and merchant relationships.

Payment cards: unpacking the complexity of convenience

The first credit card made things easier, since the customer had one item—a card—that took the place of many checks. And initially cards replicated the check system, with the bank in the middle, having relationships with both merchants and cardholders.

And as this grew, bank realized they needed a clearinghouse for card payments, so the precursors of Visa and MasterCard arose. Only this time, the clearinghouse had names consumers saw: Visa and MasterCard. These bank-owned networks, a fourth party, joined the mix.

As banks reviewed their businesses, the majority decided it was more effective to concentrate on issuing cards rather than signing up merchants, which gave rise to merchant-acquiring banks, who focused on signing up new merchants. Merchant acquirers work with processors whose systems run the merchant side of transaction. Acquirers generally have sales teams, but they also work through independent sales organization (ISOs) to contract with merchants.

“[Other companies, notably American Express and Diner’s Club, chose a different model: they issued cards themselves, rather than though banks—a different model. This post pertains to the dominant model, that of Visa and MasterCard.]”

And now there are seven parties: consumers, card-issuing banks, networks, acquiring banks, processors, sales teams (e.g. ISOs), and merchants.

Benefits and competition: how the unpacked bits worth together

Electronic payments provide benefits for all parties, but the biggest beneficiaries were card-issuing banks, who gained significant new revenue as card use expanded. And since Visa and MasterCard were owned by bank issuers, they shared in that revenue.

Merchants were less happy: in many cases customers spent more on cards then they had done with cash or checks, but each card transaction cost the merchant a % of the sale (“swipe fees”). But merchants want to sell, and if their customers wanted to pay with plastic, they generally said yes.

To increase consumer acceptance, the networks introduced zero liability, to reassure consumers that they would not bear fraud risk. This drove greater consumer use, and greater merchant acceptance.

The system worked well to grow card usage–and there are now more than 1,000 banks competing to get consumers using their cards. On the other side there are thousands of ISOs competing to sign up merchants.

What connects them? The cards networks, in the US chiefly Visa and MasterCard. As connectors, the networks make the rules direct participants much follow; direct participants are bank issuers and acquirers.

During the last decade, Visa and MasterCard moved from being owned by banks to being independent, public companies. So networks now compete, fiercely: Visa tries to get banks to issue cards only on their network, and MasterCard does the same. So if Visa does something issuing banks do not like, MasterCard may take the opportunity to convince that issuing bank to issue cards only with MasterCard.

Issuing banks compete to get customers to use their cards; ISOs compete to own the merchant relationships; networks compete for issuing bank volume. And consumers bear no risk and see a system that works just fine.

The unpacking, summarized:

So what’s the framework in which a new product must find it’s place?
• A system with multiple unrelated participants where each has limited influence on the others
• What makes merchants happy is generally different from what make other parties happy
• All parties compete with like parties for customers (merchant v. merchant, issuers v. issuers, network vs. network, etc.)
• There are thousands of competing issuers and ISOs

The unpacking in use: examples

Now let’s think about a new product—say, some kind of biometric to reduce fraud losses. This is a benefit to the overall system, since no party in it benefits from fraud.

The networks could mandate it, but they don’t bear fraud losses; they could endorse it, but without incentives an endorsement doesn’t have much of an affect.

The logical party would be a card issuer. But that bank competes with other bank issuers to get consumer to use its products. And most consumers carry cards from multiple issuers. How do you convince your customer to change behavior at time of payment without driving that customer to use another issuer’s card, that does’t required a change in behavior?

How about a product that reduces swipe fees? The merchants would be happy. But no one else would be, since those fees pay many other parties in the process. And even with merchants, if the product requires consumers to change how they pay, there is a risk the consumer abandons the purchase. And loss of a sale would far outweigh any reduction in swipe fees.

All of this may help explain why Square’s IPO was at a lower price that expected. Innovation, yes. Rapid and large scale disruption? In payments, not so easy.

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