Last year, over $8 trillion of commerce passed over digital payment networks. At the same time, about 60% of payment volume was still processed with cash.
To say that this ecosystem is large is a laughable understatement. The payments industry is gigantic. It's massive. It's ridiculous. It's the back bone of the entire global economy. And it still has lots of room to grow.
But it's not just large. It's also changing very quickly. Forty years ago payments were processed with cash and checks. Then came the plastic card, imprinted onto carbon paper and processed manually. And then came the Internet and digital processing.
Today, millions of people use those same plastic cards online, "swiping" their cards without any face-to-face interaction. That change is subtle, but it's revolutionary. It's a wholly new phenomena in the history of business. Sure, people were mailing in rent checks back in the 1970s and 1980s, but those checks were eventually opened by a human being, run manually through processing, and then physically stored.
It's possible today to hit a button on your smartphone to pay a cup of coffee. One gentle, tiny tap of one single finger. That's the only human interaction in the entire payment process. That's insane!
For most consumers and many investors, the processes that allow this amazing feat are in the shadows. We take it for granted. It just works.
Today, we are going to lift the veil on the payments industry and discuss how the industry is shaped today. Then, we'll discuss the future of payments and how non-traditional companies like Google (NASDAQ: GOOG), Amazon.com (NASDAQ: AMZN), Facebook (NASDAQ: FB), and Apple (NASDAQ: AAPL) are reshaping the industry in a very, very major way.
How does the payment system work?
There are four participants in the typical digital transaction, starting with the consumer.
The consumer, that's you and me, is pretty self-explanatory. We want to buy a good or service, and we're going to use our card to pay for it.
The second participant is, obviously, the merchant. This is the seller of the good or service we want to buy. It's the store.
The consumer's card is linked to a bank account, which brings us to the third participant into the process, the bank. There are two banks involved, each filling a different but similar role—they're the source of the money.
The consumer's bank is the entity that manages the transfer of the consumer's money to be used for payment. In industry parlance, this bank is known as the issuer. If the consumer is using a debit card, the issuer will use the available money in that account to pay the purchase price. If the card is a credit card, the issuer will use the customer's line of credit linked to that card to fund the transaction.
The issuer doesn't actually pay directly to the retailer. Instead, it reimburses the retailer's bank, known as the merchant bank or acquirer. This can be a bit confusing, so let's use an example.
If you swipe your card to buy a pair of shoes, the merchant bank authorizes the transaction and pays the shoe store for the purchase. The merchant bank then communicates with the consumer's bank (the issuer – the bank where you have your checking account or credit card) and asks to be paid. The consumer's bank then reimburses the merchant bank, closing the transaction.
These banks receive a small percentage fee of each transaction they process. These fees, called "interchange fees", were quite lucrative in the past, but legislation like the Durbin Act have limited that income source for the banks. But don't worry, the banks are also making money on the interest charged for the credit account or the fees on the checking account.
The fourth participant in the process is the glue that holds the whole system together, the payment network. Visa (NYSE: V) and MasterCard (NYSE: MA) are the largest and most dominant of the payment networks.
These companies build and operate the digital pipes that connect the merchant to the acquirer to the issuer. Think of their business model just like a toll road; Visa built a payment network like an interstate highway system, and every transaction (like a car) that passes over the network is charged a fee. These companies make the action behind your transaction possible, and they charge for access to the system.
There are other players that don't quite fit into these definitions, but are hugelyimportant.
Some companies straddle these simplified definitions. American Express (NYSE: AXP) for example operates its own payment network and its own bank. When you use your AMEX, the issuer and payment network are the same company.
Other non-traditional companies are also entering the mix and having a huge impact on the industry.
I'll refer to these companies as payment enablers, and they represent the cutting edge of payment technology.
Among others, Google, Apple, Facebook, and even Amazon fit into this category.
They are not banks, and they have no desire to be banks. Banks must deal with regulations, fraud, credit risk, and other really annoying and expensive problems.
Nor are they merchants in the traditional sense (Amazon being the obvious exception here). Google and Facebook don't charge you money to search the Internet or send a friend request. Yes, you can go to the Apple store and buy products directly, but Apple's real business is selling iPhone and iPads wholesale to merchants.
These companies are not networks either. They don't have the desire to develop technology to manage charge backs, authorizations, clearing, and settlements.
What these companies are doing is reshaping the way that consumers engage in commerce. Jim McCarthy, Visa's Executive Vice President of Strategic Partnerships and Innovation told me that, "a lot of the experiences being shaped are primarily being driven by these third parties. They are the ones writing the programmable interface, the new mobile edge for the way consumers engage in commerce."
In other words, these companies are replacing the swiping of a plastic card with new, easier methods for the consumer to initiate a transaction. They are redefining the front-end, the façade that takes the hugely complex and intimidating back end of payment processing and hides it behind a simple, fast, intuitive design that consumers love.
What about PayPal?
PayPal, the payments division of eBay (NASDAQ: EBAY), is similar to American Express in that it straddles a few of these definitions.
PayPal has some bank like qualities – it offers credit to consumers to pay later and offers deposit like products where you can keep your money in a PayPal account. It also has some enabler like qualities – there is hardly an e-commerce website online that doesn't accept PayPal as a method of payment.
But PayPal is not a payments network. It taps into the payment network of the card you have stored in their system – it could be Visa, or MasterCard, or American Express.
In this way, PayPal exists as a sort of platform, a bridge with qualities similar to many of the various players but without fully embracing any one role in the process.
How have these "enablers" evolved over time?
Google, Amazon, and the others first made waves when they each introduced a new product called a "digital wallet" several years ago. Consumers could store all of their credit and debit card data in these "wallets" and access them when shopping online. The theory was that if would be easier for Google, Amazon, or another company to hold your information for you, so that you wouldn't have to repeatedly type your 16 digit card number, expiration date, etc.
This concept does work in theory. PayPal has very successfully applied this framework across the Internet. Amazon's "One-Click" feature is a brilliant application of making commerce easier by storing credit card and shipping information. But beyond that, the feature largely flopped.
In an interview with Fortune, American Express CEO Ken Chenault addressed the failure of the "digital wallet".
I don't think [digital wallets] are dead, but if you go back to what I said publicly in 2011, I didn't think these wallets met a value proposition. I'm going to tap to pay? What's the friction that it's really solving? What are the benefits that I'm getting? How is that helping me in my shopping journey? At the end of the day, the failure of wallets was not being focused enough on customer needs.
Chenault's reasoning on digital wallets defines not only that technology's shortcoming, but it also defines the future of the industry.
What does the future of payments look like?
The future of payments is currently being defined by two driving trends: a frictionless transaction experience, and the movement to mobile.
To illustrate how this transformation is taking shape today, let's look at two brief case studies that really exemplify both the frictionless and mobile concepts.
Uber is a start-up car ride service. If you need a ride, you download the Uber app onto your smartphone and click a button that says "Request Pick Up". Using your phone's GPS, the app sends out a request to Uber drivers in the area. These drivers are not traditional taxi's, but are everyday folks looking to make some extra cash.
The driver receives your request, accepts it, and the Uber notifies you of the driver's name, their car, and a rating derived from peer reviews. You can track the car's location as they approach on the phone using GPS, or the app will notify you when the driver is there.
From there you simply tell the driver where you want to go, you are dropped off, and that's it.
There is no exchange of cash. No swiping of a card. No human requirement whatsoever to facilitate the payment.
The Uber app simply charges your pre-stored card for the correct amount at the completion of the ride. The driver is paid every two weeks by Uber.
The entire transaction is hidden. There is no friction. You simply get in the car, go to your destination, and then get out. The entire process is facilitated on your smart phone. It can't get much easier than that.
Mobile Banking in Africa
In the emerging markets and third world, the future of payments is taking shape today. In many of these countries in Africa, Asia, and South America, there is no existing infrastructure to facilitate the digital networks deployed in the U.S. and Europe.
To access these markets and provide modern financial services to these populations, companies like Visa have used mobile to change the DNA of the entire payment system.
Without the hard lines on the ground, the only choice for bringing bank accounts, digital transactions, and other tools is through mobile. Visa is doing this in a remarkable way.
Imagine a local man or woman walking into a convenience store to buy groceries in rural sub-Saharan Africa. In the past, this person may not have access to even a simple checking account, meaning that they must use cash to purchase these goods.
These open them up to serious risk of theft and inflation stealing the value of their money. To solve this, Visa has successfully layered its prepaid card business on top of Africa's exiting mobile phone network.
Visa is able to link an individual's 10 digit phone number to a 16 digit Visa card number. That same individual can now take their cash and effectively deposit it into an account at that same convenience store. The individual can then access their money wherever Visa is accepted.
The new system is safer, is very simple for the consumer, and it's only possible thanks to mobile.
The next 10 years
To map out the payment landscape for the next 10 years, we can revisit the individual players in the entire payment transaction to see how it will likely play out.
Consumers and Merchants
First, the consumer should expect to see an increasingly simplified and increasingly mobile payment experience. The plastic card is far from going extinct, but expect to see more and more opportunities to pay with frictionless services designed by enabler companies.
The same applies to merchants. Mom and Pop shops will increasingly turn to services developed by larger corporations to make the checkout experience as frictionless as possible. Larger merchants may seek to develop their own solutions, but conceptually the objectives are the same. Easier checkout is a universally good thing for merchants.
Banks and Payment Networks
For banks, the process is not likely to change much if at all. Bank's benefit from increased usage of the cards in terms of per swipe fees and the use of their deposit and loan products. A world with more digital payments is a better world for banks. Expect to see open cooperation among the banks themselves and the other participants in the payment process.
The primary objective for payment networks is to increase digitized commerce. Visa's mission statement is in fact "to accelerate the electronification of commerce." To revisit the previous analogy, they want more cars to use their highways. More cars means more tolls. This means cooperating and encouraging enablers to expand the reach of existing networks—Google, Facebook, Apple, and Amazon.com are not threats to Visa or MasterCard. They are critical strategic partners.
To add value on the margins, expect the payment networks to increasingly leverage the data they collect from their massive database of transactions to assist merchants and banks increase their profits. This shift is meant to mitigate the risk of being a commoditized player in the process. Between restrictions imposed by government regulations and increasing clout of large retailers like Wal-Mart or Amazon.com, the payment networks could find themselves squeezed out of some of their margin.
American Express CEO Ken Chenault described American Express' strategy, saying "We bring together users, card members, and merchants, and the data is incredibly valuable. We know where they spend online and offline. We want to deliver benefits and services when our card members want it, where, and how they want it."
Again, whether its AMEX, MasterCard, or Visa, the objective is to increase the traffic on their networks. If they can assist merchants in growing sales, that's a win-win proposition.
No payment participant will impact the consumer's experience more than the enablers.
Many expect that one day Apple will add near field communication (NFC) technology to the iPhone, opening up the possibility for widespread mobile payment adoption. This is the technology where you simply wave your smart phone over a reader at the grocery store, gas station, or elsewhere, instead of swiping your plastic card.
Other's think that NFC is a bridge technology, and that another location aware technology will leap frog it, allowing you to keep your phone in your pocket and pay automatically. Imagine an Uber like experience at the grocery store, where you simply bag your groceries and walk out the front door. By the time you finish unloading your groceries into the car, there is a receipt in your email inbox for the automatic check out.
Or imagine walking into a coffee shop, and having your coffee already prepared and paid for. You simply walk to the counter and pick it up. The ordering and payment processes happening completely hidden, driven by a location aware app in your smart phone.
These possibilities are not far off in our future, and they will be driven by the consumer facing companies I've coined as enablers here.
Amazon's "One-Click" has stood as the gold standard in frictionless transactions since it was first patented in 1999.
If these enablers have their way, in the not so distant future the friction of even that single click will be eliminated.
It's a bold new world for payments, and one that's shaping up to be a big win for everyone involved.