by Hugh Mullan, Technical Specialist and Economist, PSR
Increased competition between card payments and instant interbank payments could bring many benefits to those who make and receive payments, as discussed here. This might occur with technological developments, such as the New Payments Architecture.
However, even with the greatest payments infrastructure in the world, innovative alternative payment methods will only be used if the incentives can be created for people to use them. And how one creates those incentives, and makes adoption attractive, is difficult.
Here I consider what are the incentives to use alternative payment methods to cards?
A country of card payments
In 2019, for the first time, card payments represented over half of all payments in the UK. Payment cards account for a majority of payments by consumers and consumers account for over 35 billion of the 40 billion payments which were made in the UK during 2019. The strength of cards, relative to other payment methods, is particularly pronounced if you consider consumer payments made to retailers, whether online or offline.
Cash-use is declining rapidly, consumer usage of cheques has all but disappeared. 80% of adults made a contactless transaction in 2019. There are no prizes for predicting that consumer card use will increase relative to cash in 2020. Card payments rule OK.
Cards are so convenient and fast. They can pay for things in the shops and online. They can pay for the tube. They are even accepted now at outdoor markets and school fetes, especially with the growth of payment facilitator firms. Cards provide security and some protections when things go wrong.
But the rest of the world does not appear to be quite as card-obsessed as the UK.
In Sweden there is Swish. The service works through a smartphone application, through which the user's phone number is connected to their bank account, and which makes it possible to transfer money in real time, and confirmation is received by both parties within a few seconds. Swish was originally intended for transactions between individuals, but soon it started to be used for flea markets and collections at church services, and by sports clubs and other organisations as payment at small events where a credit card reader was perceived to be too expensive or otherwise impractical. Small companies who wished to avoid credit card charges and simplify online payments soon followed suit.
In Canada, there is Interac e-Transfer. It allows online banking customers to send money to anyone with an e-mail address and a bank account in Canada. The Interac Online service allows customers to pay for goods and services over the Internet using funds directly from their bank accounts. Because no financial information is shared with the online merchant, the Interac Online service is more secure than online credit card payments.
Are we missing out on something?
And having such a high proportion of consumer payments through card schemes may not be such a good thing. What about resilience? What about competition? What about choice? Might other payment methods be more efficient by costing less across all participants in a payment?
The UK developed world-leading Faster Payments (after a push from regulators), allowing rapid person-to-person and business-to-business interbank payments. We all walk around with powerful computers in our pockets, with sophisticated and easy-to-use software. We live in a world of rapid technological change.
And yet, despite all of this, the payment method which we use most to pay business is remarkably similar to how it has been since Barclaycard launched its credit card, back when England won the football World Cup. Sure, there are chips and pins, there is contactless, but one might have thought we might already have developed some attractive alternatives to card payments based on the technology we have. Faster payments is not a mobile payment system like Swish or Interac e-Transfer. It does not link customers of different banks through a smartphone app, common between banks, and allowing transfers with mobile phone or email addresses, and account number.
Even when we pay with our smart phones, using the likes of GooglePay, ApplePay, and Samsung Pay digital wallets (which 40% of 25-34 year olds did in 2019), these technologies are just riding on the back of the payment card schemes. They are a different way of using the same underlying payment method. And they certainly don’t compete with card payments.
There have been some attempts to introduce P2P alternatives in the UK - Paym, launched in 2014, is a mobile payment system in which recipients are identified by their mobile phone number instead of bank details. Similarly, Pingit allows payments and requests for payments using only a mobile phone number. Over time, these payment methods might have developed into providing P2B payments in some circumstances, as mobile payments have developed in Sweden and Canada.
Zapp was a function developed by VocaLink that would reside within mobile banking apps to allow users to make real-time payments to retailers when shopping online or in-store. It is now the Pay by Bank app offered through Mastercard.
However, these services have not really taken off.
The curse of the two-sided market
Payment systems are two-sided markets, where the value to a merchant of adopting a particular payment method depends, in part, on whether it is widely used by consumers; and the value to a consumer of adopting that payment method depends, in part, on whether it is widely accepted by merchants. Therefore, there can be a strong chicken-and-egg problem for a new payment method.
In meeting this challenge, card networks have built their popularity for both consumers and merchants over many decades. Card networks have also developed so that there are no transaction fees to the more price sensitive part of the market (consumers) with fees being charged to the less price sensitive part of the market (merchants).
Merchants may be willing to pay these fees because they do not want to miss out on a sale if the consumer has a preference for paying by card. Some merchants may also find that the costs of card payments are lower than alternative payment methods (for example, they do not require securing cash and then paying to deposit it at a bank branch). Consumers were attracted initially to credit card payments due to the benefits offered (airmiles and free credit) as well as by the ease of use.
How would new payment methods emulate this way of growing across both sides of the market, while still providing revenues to support profitable investment into such alternatives?
Given that consumers do not face a transaction fee when paying with plastic, there is a real challenge for a new payment method to appeal to consumers while getting them to pay for investment costs.
Therefore, it might be necessary for a new payment method to recover its investment costs from merchants, while trying to appeal for uptake by both merchants and consumers. This is a common feature of two-sided markets, like many payment systems.
One way of doing this might be for the new payment method to be lower cost to the merchants than card payments (while still recovering its investment costs). It might then be hoped that merchants would provide the appropriate incentives and disincentives to consumers to get them to switch across to the alternative payment method.
However, getting lots of merchants on board, and them offering sufficient incentives to consumers to get them on board, can take a lot of time, effort, and money. As noted, there is a strong chicken-and-egg problem in two-sided payments market. This acts as a strong barrier to entry and expansion for new payment methods, as well as a strong incumbency advantage for well-established incumbents. Even if there may be a longer-term benefit to merchants of supporting a competing payment method build scale and network economies, they tend to want to get on with running their own businesses and not spending too long thinking about how to set incentives about the choice of payment method.
There may also be differences between the incentives of different merchants to support an alternative payment method. The PSR recently found that the largest merchants (those with over £50m card turnover) appear to have a degree of bargaining power which means that card transactions are less costly for them than for merchants with a smaller value of card turnover.
Moreover, even if they were keen, it might be difficult for merchants to set incentives to shift consumers over to a new payment method.
One way of pushing consumers away from card payments to another payment method (which I assume here to exist and be cheaper to merchants) is to discourage them from using card payments over other payments. However, surcharging consumers for payment methods is largely prohibited in the UK. In the US, the Supreme Court has supported the right of a card scheme to prohibit merchants from doing anything to influence consumers’ choice of payment method. Even when merchants have been allowed to surcharge, most outside of an online environment do not seem to have found it attractive to do so.
Rather than seeking to discourage card use through surcharging, consumer choice might be influenced by providing positive inducements to consumers to use the alternative payment method, and to fund these through fees to merchants. If this all runs through the interbank payment rails (Faster Payments), is there a need for the bank of the merchant to send a payment to the bank of the consumer making the payment?
Would this take us back to the world of four-party interchange fees and the antitrust and regulatory battles that has induced?
So, there are some challenges in using price to influence consumers to choose a new payment method.
Instead, it may be that there are new elements of quality of a particular payment method which appeal to consumers and/or merchants. A new payment method may be more attractive because it is more convenient and works better with our mobile devices. Perhaps it is wrapped up in messaging services, or with the interaction we have with a merchant, particularly when paying online. There are certainly plenty of new services which might take advantage of the brave new world of Open Banking. Let’s explore the prospects for these a little more.
Taking the PIS (payment initiation services)?
The CMA has recently looked into the developing world of payment initiation services, in its Visa/Plaid decision. First of all, what are they exactly?
In the words of the CMA: PIS enable a payment initiation service provider to reliably signal to a payee that a payment has been initiated, thereby giving the payee comfort to complete a transaction (eg to release the goods or to deliver the service) without undue delay. Such services therefore enable consumers (ie end users) to pay merchants (ie businesses, such as retailers and fintech developers) directly from a bank account, without using a debit or credit card. This is a low-cost solution for merchants and consumers, and provides consumers with the ability to shop online without a payment card. In the UK, PIS-enabled payments are processed on the low-cost Faster Payments Service (FPS) network.
Second, are they gaining any traction in the UK?
According to the CMA: PIS-enabled payments remain at a relatively nascent stage of development within the UK but are increasingly gaining traction, in large part as a result of open banking regulations. The evidence available to the CMA indicates that the PIS-enabled payments segment is dynamic and rapidly evolving; the number of PIS providers active in the UK continues to grow, with a significant number of fintech developers and traditional payment providers (such as Visa, Mastercard, PayPal and American Express) entering the space in an attempt to capture new revenue opportunities. The CMA also found that consumers and merchants increasingly perceive PIS-enabled payments to be a viable alternative to card-based payments for C2B payments, and that the penetration of PIS-enabled payments is likely to continue in the future.
So, will people really switch from card payments to PIS-enabled payments?
The CMA thinks so: The available evidence indicates that there is already some demand-side substitution between card-based payments and PIS-enabled payments, and that this is likely to increase in future.
And this is even before the advent of the New Payments Architecture , stablecoins, and central bank digital currencies.
So, does that mean that we can look forward to a bright future of effective competition and choice between different payment systems as well as competition within different payment systems?
Follow the money
Open banking and the New Payments Architecture are great enablers for innovation in payments, and retail banking more generally. Their success will depend, in part, on how consumers and businesses adopt the new payment services that will become available. This, in turn, will depend on the attention that these services can grab and the incentives they create for their use. The incentives for all participants in a payment are likely to be important.
We have already discussed some of the challenges of getting consumers and merchants on board in the context of a two-sided market.
It is also worth considering the incentives of major retail banks (and the card schemes themselves) to develop an effective low-cost alternative to card payments.
Banks issuing payment cards to consumers receive an interchange fee (now capped by regulation) from the merchant’s bank every time that consumer makes a payment at that merchant. A retail bank will want to choose the payment method and scheme which is most profitable for the bank, while making available the payment methods that consumers are familiar with and currently prefer. If at least some of this interchange fee revenue adds to profits, then why would banks want to encourage their customers to move away from card payments?
On the other hand, perhaps retail banks need to innovate in the area of payments or risk being disintermediated.
It has been reported that Barclays CEO Jess Staley believes the banking industry will face challenges against the influx of what he considers to be loosely-regulated opponents, such as Apple and Amazon, declaring in October 2017 that mobile payments is "the battleground of finance over the next 15 years." Barclays has already taken steps to counter the threat to its business, by partnering with PayPal in April 2019 to explore ways Pingit and Paypal could work together.
In conclusion, there is value in everyone thinking about the incentives, for both those making payments and those taking payments, to adopt alternative payment methods, and how this is likely to occur in the context of a two-sided market. Thinking about these incentives is at least as important as thinking about the technological and regulatory requirements to bring these alternative payment methods into existence.
Hugh Mullan is a Technical Specialist and Economist at the Payment Systems Regulator and has previously worked as Assistant Director at the Competition and Markets Authority.
The views, thoughts and opinions expressed in this blog are his own and do not necessarily represent those of the Payment Systems Regulator.