The Amazonization of retail payments

The phenomenon of “Amazonization” refers to the wholesale disruption occurring across retail and eCommerce thanks to the leviathan-like presence of Amazon.com. Considering the platform shift happening in the retail payment space, I believe the same phenomenon of ‘Amazonization’ that happened to eCommerce will eventually happen to the retail Payments space. 

In this post you will find an analysis of the trend and its main consequences.

The dominant payment interface

Paying for things is a universal need and human beings adopted different technologies throughout history to satisfy this need (I won’t elaborate more on this here but if you want to dig deeper you can refer to these two amazing titles on the history of money: The Ascent of money by Prof. Niall Ferguson, Money changes everything by Prof. William N Goetzmann).

During the 20th century, cash payments remained the dominant interface to pay for things. 

The general financial habit of the average western citizen was the following: open up a bank account, eventually get a card linked to that but use the bank account as your payment hub. Bank accounts were essentially the acquisition channel for the payment service and cash transactions were still the most common form of retail transactions.

With the new millennium, mainly due to the Internet taking off, things started to change and the % of cash transactions started to fall.

A new interface has clearly taken over the retail payment space from cash: card. Similarly, the bank account lost its acquisition channel nature for the payment services. It’s not a coincidence that the most important consumer fintech unicorns around today (Monzo, Revolut, N26) started as a debit card services (there are also regulatory and operational implications to them starting up as cards and not full bank accounts, but I believe the main rationale was commercial – today it is much easier to attract users with a card than with a bank account).

More recently, another payment platform has been launched: Operative System Wallets.

Wallets are not that new, but they struggled to take off due to complexities in distribution and then adoption problems. Making the wallet a native feature of your smartphone, a key component of your OS experience, is solving these distribution and adoption problems. 

Considering the symbiotic relation that each individual has with their smartphone, I believe there are the conditions for a new paradigm shift in the payment behaviour of users: in 10 years the main entry points for payment services will be your OS wallet – Apple pay, Google pay or a proxy – not your bank’s card.

The first signals of this theory are emerging: the adoption of OS payments wallets is growing more than 50% y/y and the trend will relentlessly be reinforced as more people upgrade their smartphones to newer versions that support wallets.

Amazonization of retail payments

As the entry point for retail payment services will be the OS wallet and there are currently only two OSs in the market, the logical consequence is that aggregation theory will be applied to the retail payment space as well.

Source: Aggregation theory by Ben Thompson

Apple pay and Google pay will do to payment what Amazon did to ecommerce and Facebook did to news/content: they will be the only acquisition channels for payment services and all the ‘technical’ service providers will be battling on these platforms to get the users’ attention.

Aggregation theory in the Payment space

When such a strong gatekeeper emerges, it is very unlikely that it will not try to capture some of the market itself, exactly as Amazon did for e-commerce. My expectation is that many basic payment needs will be sorted out through one of these providers (Google or Apple) and it will be essentially impossible to compete with them, especially for basic needs very close to the platform level, as these (Apple and Google) will have operational efficiencies exponentially bigger than any other payment provider.

These basic payment needs will comprise a set of basic payment products and probably including also the identity of the user – I won’t be surprised if Apple will start KYC-ing users and then allow seamless switching between payment providers (similar to Apple SIM model).

PAAS (Payment-as-a-status) and the new payment scenes

There will be a second level competition, similar to the Amazon Marketplace model, where a group of brands, old and new, will be offering premium payment products and compete on top of the main wallet platforms for user attention. This is where neobanks will battle with incumbent banks, but also non-financial brands, to get their market share.

I expect that payment methods will converge towards being a status symbol of your social position, becoming a differentiator of your personality. The main value that they will provide to users will be social positioning, not very differently from brands like Rolex or Ferrari.

Users will be acquired through Apple pay or Google pay by Brand X, and then Brand X will upsell a better service, convenience or status (eventually through a physical card). 

In this context, Payment products will essentially be very similar to fashion products, they will appeal to different socio-economic demographics, focusing on specific niches and use cases, and their ultimate differentiator will be their brand.

In the past, this is something that only Amex was essentially doing, using its brand as a socio-economic status symbol, making it very appealing to corporate westerns. The differentiation, that was before an Amex monopoly, has been replicated for different target audiences, mainly millennials, by a plethora of new neobanks that are building differentiated consumer payment services for specific niches. 

Examples include: metal card by N26, Wooden card by Treecard, Wooden card by Tomorrow, Crypto-backed card by Bitwala, Gold-backed card by Glint. Even though their main product today is still a physical card, they are selling something else: a status-symbol (Metal card by N26), a financial service (Gold-backed card by Glint), a political statement (Wooden card by Treecard or Tomorrow).

Their proposition, that today is embodied by the card, goes obviously beyond a pure payment one.

In this model, leveraging the wealth of financial infrastructure businesses emerging, many non-financial payment providers will join the bandwagon and will successfully compete against old payment providers: if people are willing to pay thousands of $ for a Louis Vuitton bag, why won’t they activate a LV card on Apple pay and then upsell to a luxury Louis Vuitton diamond card to exhibit every time they pay? 

Traditional banks will suffer: as hybrid organizations, that are not tech companies and are not marketing-driven companies, they won’t necessarily have the flexibility and the user understanding to become fashion brands, and they won’t have the technological capabilities and the strategic positioning to build competing wallet platforms. Traditional banks will share the fate of  newspapers in the Facebook era – they will compete against so many providers that only a handful of them will manage to profitably stay in business.

Conclusions

I believe that OS wallets have the potential to fundamentally change the Payments landscape over the next decade. I’m convinced that general purpose payment services belong to the past and they will entirely be captured by a handful of global tech platforms. 

Leveraging the huge wave of financial infrastructure services, payments will probably become a business of branding and it will be crucial for anyone willing to stay in the retail payment space to fully understand the type of user they are catering to and focus on serving them much better than anybody else. 


Resources

  • McKinsey Payment report 2020 – LINK
  • The Ascent of Money by Prof. Niall Ferguson – LINK
  • The History of Money by Jack Weatherford – LINK
  • Money changes everything by Prof. William Goetzmann – LINK
  • Statista Digital Wallet penetration – LINK
  • Ben Thompson’s aggregation theory – LINK

The backbone of cross border transactions: correspondent banking

A few weeks ago, while preparing my 10k analysis for Adyen, I came across a very interesting McKinsey report on Payments and stumbled into the following table on cross-border transfer flows and revenues:   

What really surprised me, even more than the huge revenue chuck of the B2B segment, was the disproportion between consumer and business segments and, at the same time, the opposite trend in startups. Here is why, I thought, I see so many startups trying to build in the C2C payments space, even though in B2B there is a 5x bigger opportunity. Trying to get to the bottom of this, I started investigating, together with some fellow guilders of the Fintech Product guild, on the fundamental piece of infrastructure that powers these transactions: correspondent banking.

The goal of this post is to go through the process of sending money through correspondent banking corridors and to look at how new technologies might change it all.

What is correspondent banking?

Correspondent banking is defined as “an arrangement under which one bank (correspondent) holds deposits owned by other banks (respondents) and provides payment and other services to them. 

In order to fully get the concept and the implications of this banking model, it is very useful to contextualize it in the wider bank transfer ecosystem.

Sending money through your bank to somebody else is a fairly standardized process nowadays: based on the recipient destination you might have to fill in in your app few or less fields – but ultimately the complexity is totally abstracted away from the bank user. In reality, sending money to somebody with an account in your bank or in your country (economic area) or in the rest of the world, it’s a very different process.

If your recipient is in your bank – the money will be transferred in a matter of seconds, it’s just a change in the liability side for your bank.

If your recipient is in your same country or economic area – the transfer will take some more time but it will essentially be guaranteed by a ‘national’ payment scheme (SEPA).

If your recipient is in another part of the world, things get trickier: unless there is a specific agreement between your bank and the recipient bank, there is no common scheme that is connecting them, because a common global scheme that connects all the banks in the world doesn’t really exist. To send your money to your destination, your bank will have to be part of a global network that regulates correspondent banking (the SWIFT network) and a correspondent bank will have to act as an intermediary.

As shown in my example, It is possible that more than one correspondent bank will be necessary to get to the destination, but due to the hierarchical structure of the SWIFT network, the delivery of the payment to the counterpart is essentially guaranteed.

PS: Just to be clear, the financial mechanics of this transaction are more complex than a simple money transfer, because the correspondent bank will also provide currency exchange service, thus it will have to hedge the currency transaction in some form, but this complexity is external to the pure corresponding banking process and thus I will not explore it in this post.

SWIFT, the most critical telecommunication company in the world

As briefly anticipated above, the core of the correspondent banking model is represented by SWIFT, the Society for Worldwide Interbank Financial Telecommunication.

SWIFT was created in the 1970s by a consortium of banks, that still owns the company, to facilitate cross-border banking interactions. Since the 70s, SWIFT has been the essential monopolist in cross-border payment infrastructure.

As suggested by the name, SWIFT is a telecommunication company that supports financial applications: it essentially delivers billions of messages every year to make the cross-border monetary flow happen. An important thing to note is that SWIFT is a pure telecommunication company: it can deliver your messages to anyone fast and securely, however, it doesn’t provide the legal framework for settlement that banks often establish on 121 basis. 

The volume of transactions processed is staggering:

SWIFT Annual Review 2019

The data around the monetary volumes of these transactions is not clearly presented but numerous sources reports around multiple hundreds of $ trillion per day.

Going back to the example presented above, how does SWIFT concretely work to move money?

SWIFT doesn’t physically move money, and the transactions are not settled at SWIFT level or on SWIFT balance sheet. SWIFT is a telecommunication company that propagates messages containing financial transactions’ details between origination and destination. This is done essentially through two methods: serial or cover.

The Serial method is simply a chain of single transactions between each bank in the chain with each bank having an account at the other bank. The payment information and the settlement instruction travel together in the MT 103 message (the most common SWIFT standard).

Correspondent banking – Serial method [Source: BIS]

The Cover method decouples the settlement from the payment information. On one side, the MT 103 with the payment information is sent directly through the SWIFT network from the originating bank to the receiving bank; whereas the settlement instruction (the cover payment) is sent via intermediary banks through the path of direct correspondent banking relationships – through an MT 202 message.

Correspondent banking – Cover method [Source: BIS]

The cover method is theoretically cheaper, because banks do not take any additional fees from processing an MT 202 message, while they do it for an MT 103. In reality there are other cost elements involved in the equation to be factored in.

The cover method is also faster because the destination bank is aware of the incoming message and can investigate if the payment is stuck somewhere upstream, something that isn’t possible for the serial method, where the destination bank becomes aware of incoming transactions only when they are at destination.  

The next step in correspondent banking 

Over the last decades multiple attempts of disintermediating have taken place: multiple players have attacked one by one multiple use cases that were once served by SWIFT, but the Brussels-based consortium remains the core infrastructure of the vast majority of the cross-border payment volumes.

The latest attack is mainly coming from Ripple, a company that built a blockchain based technology which claims to be cheaper and more efficient than SWIFT. 

Due to the nature of the problem, I believe that blockchain technology can be extremely promising in the B2B cross border space, but due to various reasons, network effect being the first one, so far nobody has not cracked the SWIFT domination.

Anyhow, the future of SWIFT and correspondent banking is a very fascinating but also very articulated topic and it definitely deserves a stand-alone post. Stay tuned.

Thanks to my friend (and former SWIFT employee) Alex Eliseev for his kind and extremely valuable review of this post.


Resources

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:

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.