Thursday, January 8, 2015

Why Innovation In Payments Is So Rare

I think a lot about payments, even though I haven't worked in the sector for over five years. I just think it's mind-blowingly cool that this abstract concept we call money manages to work, everywhere around the world, in mutually recognizable forms, not with perfect interoperability but damn near close to it on a local level, with universal understanding that it is simultaneously a medium to measure value (a price); a medium to transact (making a purchase); and at a minimally higher level of financial literacy, a value store (an account).

Yet as cool as a concept as money is, retail payments in the US haven't changed all that much since the advent of credit cards. Your options are basically check, card, or cash. I was reading an interview this morning that StrictlyVC did with Todd Chaffee of Institutional Venture Partners, that goes a long way towards explaining why.
Todd goes beyond the usual chicken-and-egg problem of payment devices and payment receivers (ie cards and readers), and gets to what I consider to be the heart of the payments ecosystem: trust.
[T]he thing about payments systems that people forget is that it isn’t a technology problem; it’s a system of guarantees. That’s what makes a payment system work – not whether the wireless NFC [reader] or the magnetic strip on the credit card will work.
Let’s go through the guarantees that have to be made – independent of the technology requirements – when you buy a shirt at the store with your MasterCard (or your Apple Pay, which is just a digitized means of authenticating your card, in a different form factor). The bank that gave you the card (the “issuing bank”) has to check that you have enough credit or funds to complete the purchase; if so, they have to make a guarantee to the bank that the store use to access the MasterCard network (the “acquiring bank” or “merchant bank”) that it will pay them the amount charged. The merchant bank makes a guarantee to the store that it will pay them; and you make a guarantee to the issuing bank that you will pay them. That’s three guarantees right there, and I haven’t even touched on questions of settlement, clearing, and fraud prevention that have to be run on each transaction. [1]

At the system level, the issuing bank has to guarantee that it will perform the above for all of its cardholders in order to participate in the MasterCard network. The merchant bank has to make a fourth type of guarantee, that in the event of a refund, error, or chargeback, they will send the payment through the network in the other direction. To do that they require the merchant to guarantee that to them, possibly even holding on to a percentage of the merchant's sales, if the merchant is not sufficiently creditworthy; it goes without saying that the issuing bank guarantees to pass it along to the consumer. What’s a chargeback? In the event that a merchant makes an erroneous or duplicate transaction, or is unable to deliver the goods or services offered, and the consumer and the merchant are unable to work things out, the consumer can appeal to MasterCard directly. If MasterCard decides on behalf of the consumer, the merchant has to pay the amount back to the consumer. This by the way is one of the reasons MasterCard doesn’t work directly with individual merchants but rather with regulated financial institutions that “sponsor” the merchant into the network: banks are less likely to fail than a merchant, leaving MasterCard on the hook for the chargebacks.

What we have is a huge system of guarantees that tell the merchant, “if I accept this guy’s card, I will get paid, even if it takes a few days for the money to arrive,” and tells the shopper, “you will be able to use this card to make purchases, because we, the issuing bank and the payment network, are giving you the full backing of our reputation (as long as the network is working and we have communication with it, and sometimes even when we don’t).” This has nothing to do with the form factor or authentication factor(s) of the payment and everything to do with the reputation and word of the actors and the system.

For each of those guarantees of payment, there is an equal and opposite relationship of trust. Ie, the merchant bank’s guarantee to the store owner is only as good as the store owner’s trust in the merchant bank. Luckily the system works pretty well, so our trust in it is taken (mostly) for granted, but we’re like the fish that don’t realize that they’re swimming in water. If you’ve ever tried to do a relatively large transaction in an environment without trust, you understand how important this seamless, all-permeating layer is to commerce. All of the above guarantees ultimately rest on the guarantee of the federal government that a) it regulates the financial entities providing the banking services; and b) if all hell breaks loose, it will be the guarantor of last resort and do whatever it takes to ensure all exchanges are honored.

This is one of the reasons banks find it so hard to innovate; they are locked into their role as reputation-supporters for the financial system, a role that is in inherent contradiction with experimentation and innovation. The difficulty they have innovating in this realm is directly proportional to their size, aka the amount of the financial system’s reputation that rests on their shoulders. On the flip side, there are certain activities that are reserved for institutions with a certain level of stability, ie regulated banks. Most financial products branded with a non-financial institution brand, such as Moven’s or Simple’s cards, are actually issued by an FDIC-insured, government regulated bank whose name lurks somewhere in the fine print.

[1] This is a dramatically oversimplified version of the transaction process, but it touches on the main players from a guarantee/trust perspective. It also glosses over how everyone gets paid.

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