FinTech: Life Cycle of a?Payment

The basic payment lifecycle begins with the payer or payee sending instructions for payment. This could happen via credit card, check, or wire/ACH, and ends with settlement and reconciliation.

In the simplest form, the payments landscape includes

• the payer,
• the payer’s financial institution,
• the payee’s financial institution, and
• the payee

A basic payment transaction is from the payer (or customer) to the payee (or vendor). While between the two parties, the payer pays the payee directly, there is actually more to the payment than that.

In its most basic form, the payment flows from the payer’s financial institution to the payee’s financial institution via some sort of network.

This ‘network’, which connects the two financial systems, is essentially the plumbing of the payments network, and there are several different types of networks, including central banks such as the Federal Reserve and ECB and clearinghouses such as CHIPS. In addition to those, SWIFT also plays a role. While the network does not act as a payment system directly, it acts as an information transfer system between financial institutions to share financial data.

While the networks are the ‘plumbings’ for the payments system, there are four major types of payments (excluding cash). There are (1) paper-based systems, which include checks, (2) high-value payments or wires, (3) batch transfers, and (4) cards. While the paper-based method and most batch transfers utilize the four-corner approach, card (both debit and credit) payments have more than a few pass-throughs and many different stakeholders.

Paper-Based Payments

Paper-based payment channels include payments such as checks. The process is fairly simple, with the approach mostly following the simple four-corner approach, whereas the payer writes a check, and the payee then gives the check to their bank, which collects the funds through a network, such as CHIPS or Fedwire. Overall, paper-based payments have declined over the past several years as consumers and companies alike move away from writing checks and towards paying online via credit card or direct transfer with a wire or ACH.

Wire Transfers

Wires transfers are also known as Real Time Gross Settlement (RTGS) or HighValue Payments. Wire transfers are typically used between businesses when there is a need for fast, secure, and final transfer of value. Given the speed, these are considerably more costly than paper-based or batch systems. Individual wire payments are processed in real-time through two main systems: Fedwire and CHIPS.

How it works. the sender (payer) instructs its bank to wire money to the beneficiary (payee). To instruct the beneficiary’s bank, the sender’s bank uses direct access to the “high-value system” to debit the sender’s account (at the sender’s bank) with the central bank and credit the beneficiary. Given that instructions are final and irrevocable, the central bank provides the funds to the beneficiary in an immediate timeframe. Through this transaction, the central bank stands as the guarantor of the system for both banks.

Wire payments processed through CHIPS are netted against one another throughout the day, with the end-of-day-settlement. Wires represent a small number of payments but a high value.

Batch Systems

Batch systems, such as the Automated Clearing House (ACH) in the U.S. and BACS in the U.K., were established in order to handle large volumes of relatively low-value transfers. As these transfers did NOT have the same immediacy requirements as wire transfers, participants would exchange batches of transfers on a daily basis, with settlement occurring the following day.

Essentially, an ACH operates on a batch, store-and-forward model: individual payment requests are stored and grouped into batches throughout the day, rather than processing each payment separately. The value of ACH payments is usually less than large value wires.

While ACH has historically been used for domestic transactions, these are increasingly becoming a way of transferring money internationally. Also, while one of the drawbacks of an ACH transfer was the longer transaction time, this is changing as countries such as the U.K. offer a Same-Day BACS process known as Faster Payments Service (FPS). Meanwhile, the implementation of Same-Day ACH debit in the U.S., kicked off on September 15, 2017.

Card Payments Involve Several Stakeholders

The industry lines among these players have started to blur in recent years, not only as long-term players begin to occupy different areas of the value chain but also with the emergence new “ish” kinds of competitors entering the industry such as PayPal and Square, for example.

Merchant Acquirers

Banks have the largest share of this market, but non-bank entities are growing faster. Merchant acquirers essentially functioning as the distribution and sales arm of the payments industry, merchant acquirers sign merchants to card acceptance agreements and are generally the merchant’s first and primary point of contact.

These merchant acquirers earn a gross “discount rate” of around 200 basis points, the majority of which is passed on to the value chain and ultimately to the card issuer in the form of interchange income. The net spread after subtracting out interchange and payment network fees (also known as net acquiring revenues) for merchant acquirers is inversely correlated with the size of the merchant, with fixed transaction fees being common for larger merchants and based on a percentage of the sale amount more commonly associated with smaller merchants.

In the U.S., the top 10 merchant acquirers have 80% of market share based on purchase volume, with WorldPay (acquired by FIS in July 2019) leading non-bank acquirers. Though while around 50% of the market is controlled by banks, that non-bank merchant acquirers are growing faster (organically and through acquisitions).

Merchant Processors

Merchant Processors serve as the gateway to the payment networks. Merchant processors provide authorization, data transmission, data security, and settlement functions as an outsourced service to merchant acquirers.

Merchant processing is a scale-based business, with only a relatively limited number of larger players. Traditional processors usually earn a flat fee per transaction, with businesses being sourced from their own sales force, partner banks, and independent sales organizations (ISOs).

Although merchant acquirers and merchant processors are not the same, as they serve two distinct functions, they can be owned by the same entity. First Data has the largest share, and interestingly enough, another three out of the top 10 merchant acquirers outsourced their merchant processor services to First Data. Adyen and Ebanx, are other payment vendors that combine merchant acquiring and processing.

Payments Networks

Payments Networks are the backbone of the electronic payments system. The payment networks connect transactions between acquiring banks and issuing banks. They enable electronic payment authorization, clearing, and settlement.

Also, network providers set interchange rates and rules for their respective issuers and earn transactional fees based on the number of transactions processed, and in some cases, a licensing or assessment fee. Aside from price, payment network entities compete with each other on issues such as reliability, merchant acceptance, and additional value-added services. The largest network providers include Visa, MasterCard, UnionPay, and American Express.

Card Issuer Processors

Card Issuer Processors provide a variety of outsourced functions. Services provided by issuer processors include outsourced authorization, settlement, customer service/call centers, loyalty program administration, and statement printing and mailing services. Card issuer processors typically earn a monthly fee per account from the card issuer, and in several cases, a transaction fee.

Card Issuers market card-based products to consumers. The card issuers generate fees, including transaction fees (interchange) and nuisance fees (such as late fees), in addition to net interest margin in the case of revolving cards.

In the U.S., card issuers earn an interchange fee of about 180 bps of the purchase amount for credit cards and about 23 bps for debit card transactions. With that being said, card issuers generally pay the network a transaction fee and royalty fee, which combined run in the range of 5 to 10 bps.

Financial Technology Partnerships

FinTechs are bringing innovative ideas for how banks do business. With modern technology architecture and no corporate bureaucracy, FinTechs are addressing bank inefficiencies, reducing execution time and costs, and improving customer satisfaction.

While 'FinTechs,' at first, were more or less viewed as potentially displacing banks, today, FinTechs appear more willing to form partnerships with banks or think of them as a potential exit strategy. For example, to enhance their online payments offering, both J.P. Morgan and Bank of America announced a partnership with PayPal, and First Republic partnered with Blend to offer faster and seamless mortgage applications. Keycorp recently acquired HelloWallet, a personal financial management product.

Several banks (and payment networks) have launched FinTech incubators to stay up to date with new technology. Through these partnerships, FinTechs aim to accelerate payments and improve convenience, transparency, and other aspects of the customer experience. In turn, FinTechs gain access to banks’ customers and sponsored accelerator programs.

Open banking platforms

Open application programming interfaces (APIs) provide access for software developers to communicate with a company’s proprietary software. Open APIs are great as new developers are constantly coming up with new features that add value to users.

While banks have been less willing to share their proprietary code, some banks are beginning to warm up to the idea of an open banking platform. As banks open their backbone to approved partners, FinTechs can get access to the bank’s data and information to create new applications and deliver new services to customers. Open APIs have spurred innovation in the tech space, and the same result is expected in the banking industry.

API solutions are helping banks and FinTechs find ways to collaborate more often than compete. For banks, API solutions can help find innovative partners and, as a result, offer newer financial services. For FinTechs, APIs can get them working more effectively with banks’ systems instead of building new systems on their own. For example, by integrating machine learning capabilities, companies are relying on API solutions to fight cybersecurity threats by quickly authenticating borrower information with very little human input.

Faster Payments Task Force

With industry stakeholders well aware of disruption in the payment space, the Federal Reserve is also looking to build a framework to guide financial institutions to a faster payments system.

As a result, in 2015, the Fed created the Faster Payments Task Force, which focuses on three key areas: (1) Governance and Regulation, (2) Infrastructure, and (3) Sustainability and Evolution. With the participation of over 300 industry stakeholders, including non-bank payment providers, financial institutions, merchant and corporate businesses, regulators, consultants, and consumer groups, the Task Force presented 10 recommendations to improve the U.S. payments system, in its “Call to Action” report, published on July 21, 2017

Some Highlights of the Task Force 10 Recommendations to Achieve a Faster Payments System:

• Establish a faster payments governance network
• Establish an inclusive directory workgroup to identify and recommend a directory design for solutions to interoperate in the faster payments system
• Enhance Federal Reserve settlement mechanisms to support the faster payments system (24x7x365)
• Conduct research and analysis to address gaps in cross-border functionality and interoperability

The goal is that by implementing these recommendations, the payment system would be faster, ubiquitous, broadly inclusive, safe, highly secure, and efficient.