Payment remains one of the high frequency activities (certainly few times every week, if not every day) conducted by consumers and businesses. In the last 3 decades there has been an enhanced focus on this seemingly inconspicuous but all-pervasive activity. Is there more value to be extracted from “Payments”?
Importance of payments & payments data
For a start, payment data is perhaps the most intimate data a business can get from its customer. Spending patterns help create a precise customer persona which enables atleast two aspects: First, it facilitates sharper cross sell opportunities – It’s like sniper shooting rather than carpet bombing in serving advertisements to customers, thus improving marketing dollars’ efficiency. Secondly, lenders use payment data to create predictive risk models which lower credit costs. Additionally, banks scramble for their customer’s payments as is it provides access to low-cost deposits i.e. day end customer’s account balances.
But it is not always so obvious on where businesses make money in payments. A brief note on the payment economics is given in Box 1.
Box 1: Who makes money, how and why?
Today, cards, digital wallets, mobile payments and online payment modes with 24/7/365 are common. However, behind the scenes, there are synchronized set of real time activities that ensure functioning of the system.
As a simple example, in a physical world, when I pay €100 at a shop, the shop (or merchant) receives only €98. This €2 (called Merchant Discount Rate – MDR) is the cost paid by the merchant for enabling multiple payment options for me – if the merchant didn’t accept cards, I would, perhaps, go to the next shop which accepts cards!
This MDR is shared by broadly three service providers enabling this system:
- Card issuing bank- the bank which issues the credit card
- Acquiring bank – the merchant’s banker who provides the bank account and POS machine to the merchant
- Networks – Entities which facilitate real time messaging across banks i.e. if merchant has an account with Bank A and my account was with Bank B, the network facilitates real time movement of messages between the two banks to facilitate my transaction. VISA/Mastercard and country specific networks (e.g. Unionpay in China) are some examples.
In splitting MDR, the acquiring bank which collected €2 in our example above pays the largest share to the issuing bank (sometimes upto 80 percent of the total MDR) as the issuing bank takes credit risk– simply put, the issuing bank needs to get compensated for the risk that I may not card bills on the due date or may default whereas they would have paid out to the acquiring bank and onward to the merchant typically on the next business day- technically, this part is called “Interchange fee”
The acquiring bank also pays a part of the MDR to the Network (called “Network fee”) and retains a small portion for itself (called Merchant Service Fee).
In addition to facilitating the entire payment infrastructure in their respective roles, a material cost element is implementation of fraud prevention measures, incurred by issuers and the Networks.
Extrapolating this payment mechanism in the digital world created an ecosystem of payment service providers such as online payment gateways and payment aggregators. Simply put, payment gateways are technology service providers that facilitate easy integration of the various payment options online whereas payment aggregators are entities which collect money on behalf of the online e-commerce business and settle it with the Merchants’ banker within agreed number of days. Payment aggregators will always need a bank where they can collect money on behalf of their merchants. Some of the largest payment service providers are Stripe, Square, 2checkout, Adyen etc.
In the online world, the MDR still remains a direct revenue source which gets split between the entities in the chain. It may be mentioned that the online MDR, also referred to as “Card Not Present” – CNP MDR, is higher than in the physical world where the Cards are Present (CP). This is to compensate for addition security measures needed to mitigate online frauds.
In addition, payment aggregators earn money on daily balances held in segregated bank accounts before such monies are settled to the merchant. Lastly, digital payments permit real time data collection which can be monetized for multiple use cases within the data privacy laws of each country.
Factors supporting rise of non-bank payment companies
In the last two decades, over 40+ payment unicorns have been created in the payment space which are non-banks including likes of Stripe from US, Klarna from Sweden and Razorpay from India. A combination of factors has facilitated the rise of these non-bank payment companies:
Firstly, payment companies started with a common premise that payment needs to be an “Embedded service” i.e. at the point where the customer needs it in their buying journey. Advancements in Application Programing interface (which enables disparate systems across different organizations to talk to each other in real time) and cloud native applications (which permits scaling capacity on demand rather than time consuming on-premises servers) supported this vision.
Secondly, the explosion of e-commerce over the last 2 decades which was further accelerated during Covid has given a big tailwind.
Thirdly, multiple modern digital payment rails are getting created. One of the most prominent examples created in the last decade is India’s Unified Payment Interface system (UPI). While this topic requires a separate discussion, the creation of such instant payment rails has “shaken and stirred” the business landscape.
Lastly, regulatory barrier for non-banks to enter payment space came down as these payment companies supported the objectives of customer convenience, inclusive banking and reduction in cash transactions.
Yet, these factors still do not fully explain the value created by payment companies.
Differentiation by successful payment companies
With the explosion of e-commerce, Payment companies started layering value -added service to online merchants thereby gaining ground over traditional banks.
Firstly, the payment companies’ merchant onboarding process is significantly simplified – in effect, a new online store could sign up and start collecting money from their customers in less than 24 hours through multiple payment modes.
Secondly, these payment service providers took all the “tertiary” work of collecting, recording and reconciling money thereby allowing e-commerce companies to focus on their core business. In return these payment company charged a fee to these merchants for providing such services.
Furthermore, some of the companies like Klarna evolved into credit underwriting for their customers in the form of buy now pay later (BNPL) for customers. Few others have created short term lending models for Merchants based on projected cash flows.
Collectively, the external and internal factors have resulted in top 10 payment companies globally have a market cap higher than top 10 banks in 2021 by about USD 400 million.
However, I believe that asymmetry in value between some of the payment companies and neo banks /digitally agile banks will narrow in the coming years:
Firstly, this valuation asymmetry to a large extent is due to the fact that fintechs are valued on growth whereas banks are valued for profits. We are already starting to see valuation convergence as investors expect tangible and recurring profits.
Secondly, some of the fintech’s which venture into the lending business may end up trading capital for short term profits due to growth compulsions. Many banks tend to be more calibrated backed by lending experience across economic cycles.
Thirdly, in a rising interest rate scenario, banks could cross subsidize payment business against customer balances thereby putting more pressure on payment companies’ profitability (more so in Europe and US where the economies are coming out of zero or negative interest rate regime).
Lastly, neo banks and digitally agile banks are more likely to extract value from customer data since they can offer broad product range to monetize customer data more effectively. Banks which are market leaders on acquiring and issuing cards will be bigger beneficiaries in this space since they can keep both the Interchange Fee and Merchant service fee for themselves.
However, the landscape promises to remains complex:
First and foremost, while banks have a big potential, digital transformation of legacy banks is much easier said than done. This requires not only budgets but also a big shift in deep rooted culture.
Big tech is entering this space. A prominent example is Apply Pay which has tied up with many banks in the US to enable PoS payments. Banks felt compelled to tie up with Apple due to FOMO: what if customers link payment card from competitor bank with ApplePay which will cede all payments & related data of customer to competitor! Apple Pay gets a share of the card issuance commission from the Bank as revenue model. Such partnerships alter the landscape.
Regulatory bodies are reviewing and capping card MDRs to accelerate digital payments. Interchange fee on Credit cards in Europe were reduced to 0,30 percent after implementation the PSD 2 whereas MDRs in US are upto 2 percent. In addition, these bodies are also facilitating newer payment rails (such as the Indian UPI or the Brazilian PIX) which can fundamentally alter the incumbent business models.
Hence, in making investment decisions in payment companies, a multitude of factors need to be considered, first of which is establishing the value add by the payment service provider with the sizing of the direct and indirect revenue possibilities and profit pools thereof. In the end, Payment services without intelligent data, value added services and ability to cross sell profitably is a race to zero!