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The digital payment revolution is gathering pace across the globe, posing a major threat to companies that have dominated the payments and banking landscape for many years.
The digital payments revolution is gaining strength as people increasingly pay for goods and services using contactless technology, rather than coins, notes or cheques. The impact is most keenly felt in emerging economies, providing a financial lifeline to the unbanked and helping the fight against corruption and tax avoidance.
China is arguably the most advanced country for digital payments technology. According to McKinsey, more than 30 per cent of the Chinese population use Internet payments (including via mobile devices), which covers almost every scenario of daily life and helps generate the world’s largest e-Commerce market – with 16 trillion renminbi-worth of annual transactions.1
The shift towards digital payments is also having a sizeable effect in the developed world, too; where regulators have the twin tasks of ensuring the security of consumers while at the same time promoting competition. The direction of regulation will have a major impact on the winners and losers; potentially breaking the monopoly of banks and credit card companies who have long dominated the payments market and making way for a new breed of disruptors.
The term digital payment, often also referred to as electronic payment, applies to a range of different instruments including debt and credit cards, and online payments systems such as PayPal, or simple electronic transfers from one bank account to another.
Digital payments provide convenience to the consumer and lower costs to businesses. By easing the buying process, the process can boost sales and improve customer retention. A customer is more likely to return to the same e-commerce site where their information is stored. But the digital payments revolution is also helping to transform economies, particularly in the emerging world, which is leading the charge away from cash.
The ability to transfer money electronically is now available in 85 per cent of the countries in which the majority of the population lacks access to formal financial institutions, according to a report published by the GSMA and Boston Consulting Group2. “Such technologies enable customers to more easily and efficiently pay bills, deposit cheques, transfer funds and manage accounts”, the report points out.
Kenya, where around two-thirds of the adult population make or receive payments using local mobile payments systems such as M-Pesa3, is a leading example. India has taken the most dramatic leap into the digital era, banning 86 per cent of the currency in circulation in November 2016 to demonetise the economy and eradicate tax evasion. The move could transform the government’s finances and its ability to fund schools, hospitals and other infrastructure4. Brazil has used digital welfare payments to overcome corruption and lifted millions out of poverty via its Bolsa Familia programme5.
The transition in emerging markets has been easier than in the developed world. “Most people in developing countries have always used cash rather than cheques or debit and credit cards. Today, the easiest way for the rapidly-increasing middle classes to make a payment is via a smart phone,” says Jason Bohnet, Senior Securities Analyst at Aviva Investors in Chicago.
Large parts of the population are simply skipping over non-digital technology, and helping those countries move ahead of the US and Europe in this area, Bohnet adds.
That view is supported by PwC, the professional services firm, which says digital payments technology in emerging markets has “leapfrogged from branch banking to e-banking and now mobile money5”.
The lack of a supportive banking structure, young ‘tech-savvy’ populations and the desire of governments to boost financial inclusion are among the factors that “will aid the creation of a state-of-the-art payments ecosystem, which will set the pace for markets worldwide”, says PwC.
However, the “the key enabler for electronic payments”, according to PwC, is regulation and a framework that balances enabling growth with security so that consumers feel comfortable using this technology. Many emerging market governments have opened their markets to non-bank players and introduced a differentiated banking licence for both bank and non-bank players aimed at furthering financial inclusion, adds PwC.
New EU regulation
The critical role of regulation explains why Charlotte Meyrick, UK Equities Fund manager, Aviva Investors, believes forthcoming legislation from the European Commission that seeks to create a single market for payments could be a “game changer” for the European banking sector and the payments industry. An effective regime would facilitate a new generation of payments products and services, while boosting the security of internet payments and account access. If all goes to plan, the legislation – known as the Second Payment Services Direction (PSD2) could come into effect in 2018.
PSD2 aims to boost competition by breaking banks’ monopoly on user data, whilst also enhancing the security of internet payments and account access. It would force banks to allow licensed third parties, such as financial technology companies, to access bank account data. It would also allow these third parties to make payments without having to redirect clients to another service such as PayPal or Visa.
PSD2 will also prohibit non-transparent pricing methods for international payments. Currently, banks and brokers disclose up-front fees, either a fixed fee or a percentage of the transfer amount, but can make extra profits by offering clients a poor exchange rate.
House of Cards
The original PSD was passed in 2007, implemented in 2009 and opened up the payments market in EU to non-bank payment companies. It was also the first attempt to create the legal foundation and infrastructure for an EU-wide single market for payments after the emergence of varying regional technology, which hampered the harmonisation of cross-border payments.
Currently, the major bank card associations and companies operate payment networks that link the four parties involved in each card transaction: the cardholder; the cardholder’s bank; the merchant who accepts the card in exchange for goods and services; and the acquiring bank that process transactions for merchants.
The new legislation stems from the regulator’s belief that the four-party system is detrimental to both merchants and consumers. “It is inefficient, expensive, opaque and an impediment to digital commerce growth,” says Meyrick. “PSD2 attempts to break down the wall that has protected legacy technology and stimulate transformative innovation.”
PSD2 will introduce two new types of license payment activities:
Account Information Service Providers (AISPs)
Entrants to this area could offer online services that provide a consolidated view of a user’s payment accounts across different providers. This allows consumers to have a single login for each of their payment accounts. AISPs would have access to information currently monopolised by banks, such as a customer’s account balance or bills and subscriptions. Meyrick believes transparency in account information could lead to more frequent churn and/or the rationalisation of bank accounts. Examples of companies that operate in this area in the US include Envestnet and Intuit owned Mint.com.
Business, corporate and SME customers would be heavy users of the services offered by AISPs, given their tendency to use multiple banks and need for real-time account information on their financial position, according to the professional services firm Accenture7.
Payment Initiation Service Providers (PISPs)
PISPs could initiate a payment transaction at the request of the user to another provider, so bypassing the likes of PayPal or Visa. This should enable faster payments, given the reduction in the number of intermediaries involved, and increase security.
In theory, banks, card schemes, acquirers such as Worldpay, alternative payment providers such as PayPal and Klarna, or a completely new entrant could become a PISP. Accenture estimates that one in three online debit card transactions and one in every 10 online credit card transactions will move to a PISP by 20203.
“They have the greatest potential to disrupt the current ecosystem, specifically payment processors, merchant acquirers and card schemes, all of whom facilitate transactions,” says Meyrick.
While PSD2 is clear in its ambitions, there are questions over how they will be achieved and how quickly. PSD2 was published in the Official Journal of the EU on January 12, 2016 and should become effective at national level two years after that, implying a date of January 12, 2018. However, the European Banking Authority (EBA) has yet to provide regulatory and technical guidelines. Furthermore, it is unclear whether the standards will be homogenous across the EU or whether individual countries can specify bespoke structures/standards.
Given the uncertainty, it seems likely the original PSD2 launch date of January 2018 will be delayed until at least October 2018, if not later. There are other impediments preventing adoption, according to Meyrick.
“There isn’t a single product in the payments ecosystem that has been completely displaced as consumers are often unwilling to trust non-bank/card scheme providers,” explains Meyrick. “PSD2 in isolation will not drive grandiose change; it will depend on the incentives and services developed by third parties to deliver better value.”
“However, the market is starting to think about the risks and pricing this into company valuations much earlier,” adds Meyrick.
Meyrick believes that despite Brexit, PSD2 will be implemented in the UK since, “London has been at the forefront of drafting the legislation and there have not been any murmurings since Brexit suggesting any change to that approach.” She adds that the UK would want to remain as compliant as possible with Europe in this area to remain competitive.
Figure 1: Winners and losers from PSD2
Source: Aviva Investors, March 2017
The global context
Even before PSD2, European countries with a high proportion of online retail transactions and digital payments have been most successful in developing alternative payments systems that bypass the card acquirers and card networks. Examples include MobilePay in Denmark, Ideal in the Netherlands (which accounts for 60 per cent of ecommerce transactions) and Swish in Sweden.
“In all three instances these business models have been backed by banks and provide good examples of incumbents being proactive to ensure they are well placed to benefit from regulatory change,” says Meyrick.
While Europe is ahead of the US in terms of regulation, Bohnet argues initiatives by private companies can achieve the same goals as PSD2; namely greater customer choice and the ability to access information across multiple accounts. “PayPal, for example, has partnered with Visa and MasterCard and some other financial institutions to boost customer choice”, says Bohnet. The lack of regulation also hasn’t stopped the launch of apps for tablets and mobile phones, which are facilitating digital payments.
“The move away from credit cards to payment via a mobile phone or even a watch is creating huge opportunities for companies that facilitate and procure those transactions as well as the wireless providers that monetise the transaction,” says Tony Gilliland, Senior Securities Analyst at Aviva Investors in Chicago. “There are around 100 companies involved at the moment, suggesting there is huge scope for consolidation.”
The revolution in digital payments could even disrupt Mastercard and Visa, who have “the most robust duopoly in the world”, according to Gilliland. “Every dollar they receive translates into 66 cents of profit, but they’re waking up to the new reality.”
1 McKinsey & Co: Disruption and Connection: Cracking the Myths of China Internet Finance Innovation Greater China Practice, July 2016
2 Embracing the Digital Revolution: Policies for Building the Digital Economy, GMSA &Boston Consulting Group February 2017
3 Standard Chartered: Financial Inclusion: Reaching the unbanked, 2014
4 BBC News Online, 14 November 2016: Why India wiped out 86 per cent of its cash overnight
5 How does Bolsa Familia work? Inter-American Development Programme, September 2015
6 Emerging Markets: Driving the payments transformation, PwC, 2016
7 Consumers’ initial reactions to the new services enabled by PSD2, Accenture Payments, 2016
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 29 March 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
The following investment professionals contributed to this article