The banking system, a giant settlement infrastructure

A few weeks ago I noticed a tweet from one of the most interesting accounts I follow on Twitter, that of Holger Zschaepitz

As I didn’t fully understand the impact of the fact highlighted in the tweet, I decided to research more into Target2 balances and generally on how the banking system works, ultimately as a giant settlement system.

This post is the product of my investigation and aims to give a clear explanation of the journey an interbank payment goes through in its lifecycle.

Central banks as a settlement infrastructure

Even though today we see banks as huge organisations, diversified into a number of business lines and products, one of the original and key functions of a bank is to enable fluid payments between agents (companies and people).

This somewhat low-profile function actually shapes a lot of the bank’s activities and behaviours.

Let’s use a simple example of domestic payments: a customer A  who wants to pay a firm B in the same country.

During the day the National Central Bank will simply log the payments flow and facilitate the exchange of money (Intraday credit). At the end of the day, Bank A and Bank B will have a net position with the NCB. Assuming, for simplicity, that there was only one payment that day, A will have a liability with the NCB (A owes money to the NCB) and B will have a claim (NCB owes money to the Bank B). At that point A will have to settle its liability, either paying directly with its reserves or borrowing money in the money market (Settlement of credit).

The following day the game starts again, in the same way.

The type of settlement previously described is net and not in real time:

  • Net: transactions are aggregated over a certain time window and only the net value is settled
  • Not in real time: the settlement is done once a day, not as soon as the transaction happens

Real Time Gross Settlement (RTGS)

Over the last decades a new type of settlement infrastructure has become the standard in banking: Real Time Gross Settlement.

This new system essentially settles transactions immediately and at a gross level: every transaction is settled on a one-by-one basis as it reaches the platform, so there is no end-of-day net to settle.

Some famous examples of RTGS are Fedwire in the US, CHAPS in the UK and, the object of my investigation, Target2 in the Eurozone.

Trans-European Automated Real-time Gross Settlement Express Transfer System (or Target2) is a payment system that enables the speedy and final settlement of national and cross-border payments in central bank money. 

An average of around 350,000 payments with a value of about € 1.7 trillion is processed using Target2 each working day. In one year, TARGET2 settles about 90 million payments with a value of about € 430 trillion.

What is a Target 2 balance?

Going back to the tweet, I couldn’t really understand why a real time settlement scheme has balances: if any agent always settles real time its claims, why is the concept of balance even present?

The devil is always in the details and, even though Target2 is a European centralized RTGS, legally speaking, it is made up of multiple component systems operated by the national central banks (NCBs) and the European Central Bank (ECB). And the real time settlement is widely applied to the agents of the system but not to anybody, in particular NCBs don’t really settle their liabilities and claims with the ECB.

Let’s use another concrete example: let’s say an Italian customer wants to pay a firm in Germany.

In this system every agent settles real time except for the National Central Bank claims and liabilities that stay unsettled: those unsettled claims and liabilities are called Target2 Balances.

Therefore, Target2 balances are cumulated cross-border transactions, executed through the Target2 system and facilitated by the ECB, that provided liquidity to the National Central Banks to make those transactions happen, but not settled yet.

This is the latest update of the Target balances:

The reason behind this huge imbalance between core and periphery of the Eurozone is a very long and complex discussion that would easily end up in politics so outside the remit to my investigation. 

Wrapping up

Finally, this analysis really revealed how central is the payment function to the banking system and how the omni-present principles of elasticity and disciplines are ingrained at every level of the payment infrastructure. Interestingly, in my opinion this is something that applies to any type of monetary system, including that of cryptocurrency, as I discussed in my previous post on Bitcoin and the hierarchy of prices.


Resources

Settlement systems:

Target 2 imbalances:

Fintech 2.0, how to survive when your product becomes a feature

The most important narrative in the fintech ecosystem nowadays is arguably that of fintech-everywhere, more formally known as embedded finance.

The essence of the embedded finance concept is that, over the next few years, a significant part of the consumer financial services available today will not be distributed anymore by financial institutions; they will instead be natively embedded in other non-financial products and simply become an extra feature to the product. In other words, financial services will become features of other macro-products. To give an example, Uber may offer a checking account or a credit card to its drivers who, consequently, may not need a Barclays account anymore.

A lot has been written on the topic and you can find some useful links in the Resources at the end of the post. In this post, I want to reflect on where fintech consumer startups will sit in this new world, and what is a viable strategy for them when their products are being transformed in a feature.

The new unbundling: embedded finance

Gentlemen, there’s only two ways I know of to make money: bundling and unbundling.

Jim Barksdale

The current fintech ecosystem was born in the last decade through the unbundling of the financial industry: every startup focused on one specific problem and solved it orders of magnitude better than existing institutions, mainly banks, would.

ING-DiBa, N26, revolut: fairly good incumbents and FinTech re ...

At the end of this first round, some clear winners emerged in each vertical: N26, Monzo, Revolut, Transferwise, Lending Club, Funding Circle, SoFi, Robinhood.

Over the last few years a different process, of rebundling, took place: many startups started to rebundle other financial products on top of the original core proposition, mainly attracted by easier upselling and revenues expansion. Neobanks like N26 or Monzo added lending products, a lender like SoFi added a savings account, Revolut expanded to trading, and so on.

The recent embedded finance trend looks to me like a new iteration of the eternal bundling and unbundling cycle. This time financial services are not unbundled by a new or younger financial institution, but rather decomposed into atomised features that are added to existing products by large consumer brands and technology giants.

How to survive when fintech is everywhere

Most of the fintech startups who succeeded so far did it essentially by using the same recipe: building a better and more modern user experience on a new distribution channel (smartphones) for an extremely focused product. This has been the real value brought by most fintech unicorns.

In a world of embedded finance, a better native mobile UX won’t be enough for them to survive, simply because that UX won’t be the best in class anymore.

In a world where Uber offers a bank account natively integrated in the app to its drivers, a shiny banking app with a fantastic user experience will inevitably be less competitive because it adds friction to the overall user journey.

First, the user will have to switch apps and remember how to navigate that app, with an obvious additional cognitive load. Second, and even more important, Uber will definitely have more margin to offer competitive pricing than any fintech startup, because the acquisition cost of that bank account will be much lower than that of a startup and also because the financial feature can be used as a loss/leader to subsidise the core product.

In this new world, I believe there are 2 possible moves for most of the existing fintech consumer companies:

  • Move down the stack – become an infrastructure provider
  • Move up the stack – become an aggregator

Move down the stack: Infrastructure provider

The financial infrastructure wave is exploding at the moment. “We are building a new piece of financial infrastructure” or “We are the Stripe of X” is the new “We are the Uber of Y”, and definitely one of the most powerful pitches to raise funds today.

In this scenario, startups will have to move down the stack, building a B2B product that will allow consumer facing brands to offer financial products with a trivial integration and with minimal resources. They would essentially expand the Stripe or Adyen model to other categories (more here on Adyen).

The assumption here is that essentially anybody who has a direct relation with the user will monetise also through a financial product, but won’t change its core business to refocus on finance. They will use a payment-as-a-service or banking-as-a-service provider to power these financial features (more here).

In this hypothesis, a plethora of B2B fintech companies will battle to enable the creation of financial services for more customer facing brands.

I believe this is the way forward for extremely specialised, mono-feature companies with low-frequency interactions product: firstly challenger lenders like Lending Club or Funding circle, or even an hyper focused product like Transferwise.

In low frequency interaction products, it will be very hard to compete with companies that interact with users on a daily basis, so they will probably have more chance of growth switching to become full stack service providers for more customer facing products.

They will have the experience in vertical (lending, cross-border money transfer, etc..), they are modern enough to be API first and they are young enough to adapt to mutated market conditions.

Move up the stack: Aggregator

For more customer-facing startups it will be extremely hard to battle only with the current approach, but I believe they can reposition themselves upper in the stack.

If people will directly take loans or create accounts through other large consumer products, then an emerging need will arise for the re-aggregation of these constellations of accounts and products under one single umbrella. Somebody will necessarily become the single financial touchpoint of the user: the aggregator of a fragmented experience.

To win this aggregator role, it would be essential to actually provide an extra value to the user, beyond the simple aggregation of multiple accounts: probably autonomous money and ecosystem creation will be crucial. A first flavour of this model is what Credit Karma started to build on Autonomous finance (more on CK vision on autonomous money here).

I imagine essentially all the neobanks will fall in these categories, as ultimately consumer businesses and for which a pivot to an infrastructure product would be technically, but even more, culturally, too complex.

Moving forward

The new shift in consumer behaviour is not very visible yet, but a number of new initiatives (Shopify ReUnite being only the most recent one) will only accelerate this trend. It is crucial for any company competing in the space to start moving down or up the stack now, as in a few years the first winners will start to emerge and it will probably be too late.


Resources

Bundling/Unbundling:

Embedded finance/Fintech everywhere:

Autonomous Finance

Adyen, payments made easy

As my fellow Product Peon taught me a long time ago, the best way to learn quickly how a specific company works, is to analyse its 10k. For this reason, in the Fintech Product Guild, we decided to start a ’10k-a-month’ club. This month we analyzed Adyen, a payment company.

What does Adyen do?

Adyen was founded around 15 years ago to facilitate the adoption for merchants of electronic payments. At that time, the payment chain was extremely fragmented with multiple players coordinating different pieces of the chain: gateway, processing, risk management, acquiring (more on the evolution of the payment industry here). Adyen approached the problem from a different perspective: they built a merchant centric product, a payment-as-a-service infrastructure which essentially made the process of accepting a payment much easier for their merchants.

The venture went very well, they secured a lot of fundings and went public in 2018. Today Adyen is a public company which offers a payment platform to support the growth of its merchant through various ways:

  • a wide range of payment methods accepted
  • quick plug and play scalability in new countries
  • user-centric checkout solutions to improve merchant conversion rates
  • fraud prevention

Financials analysis

Income statement

Over the last 3 years Adyen saw a sustained growth, with its total payment volume growing 1.5x from from 2017 to 2019 that directly transacted into a 2.5x growth of the net revenues.

Adyen total payment volume and net revenues

Their revenue model is based on four elements:

  • Settlement fee: % of the value for acquiring services (to be netted of interchange fees)
  • Processing fee: fixed fees (10 € cents) paid when a transaction is initiated via the Adyen payment platform
  • Sales of POS (Point of Sales)
  • Other services: exchange service fees, 3rd party commision

From a gross revenue perspective, the settlement pillar appears as the dominant component of their business, with a contribution of more than 85% to the total revenues.

Adyen revenues split

Anyhoo, the situation looks different when we consider the net revenues component.

Adyen revenues split with common size analysis over net revenues

In reality, considering their holistic approach to payments, it is obvious how each component of their product self reinforce the others: they offer a single package which aims at solving every problem of the payment cycle and each business line should be analysed with these lenses – losing a few millions on the POS business is a no brainer, when this will lock in the merchant and guarantee extra Billions of € of transactions on the platform.

Adyen income statement with common size analysis (over net revenues)

Overall, they show a pretty solid growth of revenues and a very strong operating margin (over net revenues), which sits around 51%. This is a very healthy margin, especially when compared to other competitors in the space.

Main payment providers operating margin

Adyen’s growth over the last years has been impressive, but this must be contextualized in a favorable trend for the entire payment industry. The revenues of the global industry more than doubled in the last decade and the expectation, based on McKinsey Global Payment Report, is that they will grow even further in the next 3 years.

In this already positive wider environment, Adyen benefitted even more from the shift away from cash towards electronic payments – with a total number of non-cash transactions almost doubling in the last 5 years.

Balance sheet

The biggest insight deducible from the BS is that, not surprisingly, payments is such a liquid business! 67% of Adyen assets are in cash or cash equivalents, and 19% are Receivables for a total 86% of current assets.

Adyen balance sheet with common size analysis

Looking at the common size analysis, the sheet shows a strong continuity with the previous year. Most of the items didn’t significantly change from 2018, with a clear organic expansion of the BS.

Statement of Cash Flows

The SCF is in line with the growth story told by the Income Statement and Balance Sheet. Adyen presents a positive operating cash flow which grew steadily in parallel with the net profit, with minimal net financing and investing flows.

If we abstract that trend and represent it in the typical cash flow curve, we identify a company in its late growth/maturity phase: a company which is producing strong operating cash flow, it’s not highly negative on investing anymore but it is also not distributing back to investors yet.

Looking ahead

Adyen’s financials describe a company in great shape and ready to scale its business further very quickly. Even though it is playing in a crowded industry, the Dutch company is in perfect position to become the go-to payment platform in particular for enterprise customers who want a modern, digital-first payment infrastructure – less so for SMEs who would probably look at more self-serve platforms like Stripe.

The recent pandemic will probably only accelerate their growth, due to the obvious shift to digital products of many users, a segment where Adyen is much better positioned than many incumbents in the space.

Overall, Adyen is definitely a solid company with a very scalable business model and a promising future.


Resources

Adyen:

Payment industry maps:

Pricing:

Bitcoin and the hierarchy of money

Over this quarantine, I’ve decided to invest some time in a renowned Coursera course on Banking. The course is great and one of the core concepts of the class is the Hierarchy of Money. Being myself very interested in cryptocurrency, I’d like to explore in this post where Bitcoin sits in this hierarchy.

First of all, what is the hierarchy of money?

Even though every dollar looks the same, not every dollar has the same value. To fully understand this we have to first clarify a core concept: every dollar is essentially a promise to pay from somebody, an IOU. The more this debtor is trustworthy, the more your dollar has value.

Thus the hierarchy of money can be thought of as a multi-tiered pyramid where the tiers represent IOUs (promises) with differing degrees of acceptability.

Considering the Balance sheet of the institutions involved, the underlying pattern is fairly straightforward: any entry in the system is ultimately a promise to pay from somebody else, except for the central bank reserves, that represent the single trustless element in the system.

This interconnected system creates a pyramid of money and institutions which differ both qualitatively and quantitatively.

It is usually possible to move from one layer to the other paying a discount (exchange rate, par rate, interest rate). Actually, in periods of boom, credit is perceived as valuable as dollars and this discount goes to zero. But during a crisis, the situation changes brutally, and it might be even impossible to move up in the hierarchy (if nobody wants to buy my credit, I can’t convert it in any more liquid form of money).

The international hierarchy of money | Download Scientific Diagram

A fundamental property of the hierarchical system is that, as currency demand goes up and down, supply can be adjusted elastically through these layers without losing a component of discipline (at the end of the day, you have to settle your obligations).

This is probably the most important feature of our monetary system: it allows us to manage the systemic fluctuation of the money market without constant crisis. This is not a trivial property because, as Allyn Young clearly explains in this paper, before the creation of the FED, the system was totally inelastic and systemic liquidity crises were ordinary.

Where does the Bitcoin sit?

Bitcoin is a crypto currency who runs on a decentralised ledger technology and which presents one core property: it is artificially scarce, a total number of bitcoin has been planned and no other Bitcoin will be issued in the future. This scarcity is widely considered by the BTC dogmatist as the ‘killer application’ of the product, the real competitive advantage over the concurrent monetary systems.

With these concepts in mind, a few hypotheses can be made on the position of BTC in the hierarchy.

Hypothesis 1 – bitcoin is not part of the monetary system, it is an asset

Bitcoin is not really an ultimate reserve of value, it is an asset. It is traded in the lower rank of the pyramid as any other security, but it doesn’t constitute the foundation of a new system.

In this scenario, BTC is not very different from other commodities: it can be seen as a safe haven, but it doesn’t ultimately represent a risk-free asset, its value depends on the market made around it.

Hypothesis 2 – bitcoin as the top of a new pyramid

This is what is mainly believed by Bitcoin dogmatists and activist investors. In this world BTC is essentially the ultimate safe haven, if there is a crisis anybody wants it because it is the most valuable asset, being at the top of a brand new monetary standard. This is a more fascinating scenario, but I believe it is very far from reality today.

Ignoring the obvious scalability issues (today around 7 transactions per seconds are guaranteed by the Bitcoin chain, orders of magnitude less than what would be needed in this eventual new world) if BTC has to become the cornerstone of a new monetary standard, this standard lacks probably the most important feature of any monetary systems: elasticity.

We find elasticity in every layer of the current monetary system: we find it in the intraday liquidity operations for settlement, we find it in the overnight repo market, we find it in the ultimate ability of a central bank to act as lender of last resort.

All the features mentioned above are very nice properties that allow the global monetary system to act as a giant settlement infrastructure, smoothly enabling transactions between agents. The same transactions wouldn’t eventually be all possible in a BTC monetary system, because that system has a cap in amount of currency available and if the demand would eventually exceed the supply, some transactions would necessarily be stopped, with consequent liquidity crises.

Conclusion

I believe that Bitcoin today is obviously an asset and it’s very hard to see it as the new foundation of a future monetary system, simply because there isn’t any system built around it: there isn’t a central bank which can introduce an elasticity component through credit and there aren’t transmission channels of this elasticity to the wider economy.

On the other side, there is a strong discipline embedded in the BTC design which I believe, if complemented with credit – the other crucial pillar of a sound monetary system – could represent a promising start for a new global monetary system that goes beyond the existing global dollar standard.