The Nuts and Bolts of Payments | Fintech Inside - Edition #58 - 21st March, 2022

Hi Insiders, Osborne here.

Welcome to the 58th edition of Fintech Inside. Fintech Inside is the front page of Fintech in emerging markets.

Digital payments have made our online lives convenient. It takes us less than a minute to complete a transaction but at the back end, a complex series of events is triggered. What happens in the background? That's this week's edition of Fintech Inside - the nuts and bolts of payments.

That's not all, there's also details on Macquarie's "hot take" on Indian fintech startups, stock performance of Indian fintech companies and GoTo Indonesia's fintech business.

Note: Today’s edition is long and might get clipped in most email clients. Would recommend reading this on the web version.

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If you're building in fintech or have an idea that you'd like to riff on, I'd love to speak with you. Write to me at [email protected].

Enjoy another week in fintech!

?? One Big Thought

The Nuts and Bolts of Payment Gateways

Note: This is an excerpt of a post from my personal blog, originally published in Feb, 2017. It is lightly edited for more current statistics. The post over-simplifies how a payment gateway works and is intended to get a high level understanding.

Transactions are at the very heart of an economy and Payments power those transactions. India’s Financial Sector has seen sweeping reforms post 1991, especially in the banking sector. However, the population is still largely under served when it comes to access to basic financial services. With emerging technologies and growth in telecom infrastructure, Financial services and products can be made available to the masses at low costs.

India’s economy is largely driven by cash. The retail digital payments industry is estimated to be $5.5tn but only 50% payments are made digitally in Tier 1 & 2 cities, whereas this number drops to 30% in Tier 3 cities and 10% in Tier 4 cities. Printing and distribution of cash costs ~15-17% of the value of currency in circulation. As of Mar, 2021, India had $385bn (INR 28.32tn at USD 1 = INR 73.5) cash in circulation - that's a $58bn cost! India’s digital payments processing infrastructure has been close to dismal in the past. However, adoption of digital payments has seen a huge growth in the past 5 years. Convergence of events such as advances in technology, deeper penetration of telecom networks, access to high speed mobile data have resulted in increased adoption of digital payments.

What are Payment Gateways: Payment Gateway is a merchant service that enables payment acceptance/authorisation for merchants by aggregating various payment mechanisms for the end user (merchant’s customer). Payment gateways typically earn a percentage of the total transaction amount as commission for enabling/processing the payment.

Payment Gateways will continue to remain relevant in the future for the following reasons:

1. Growing Number of Payment Mechanisms: With the growing number of payment mechanisms, merchants find it difficult to keep track of successful transactions from each mechanism at the end of each day/month. Payment gateways makes it easier for the merchant to accept payments from any mechanism while maintaining a consolidated dashboard of all successful transaction. With growing methods of payment acceptance, merchants will continue to require a payment processor (payment gateway) to accept, process, settle and report all transactions.
2. Prevention of Fraud and Security: In the financial services industry, fraud and security risks are the highest. Payment gateways need to be proactive about its fraud detection technology and security breaches to protect, not just the merchant but also the consumer
3. High costs to maintain large scale payments Infrastructure: Costs involved in building a highly available, fully functional, secure payments network for the scale of India’s population will be huge. Immediately post demonetization, card networks and ATM servers faced massive outages because it couldn’t handle the high demand. The more decentralized the infrastructure (more payment processors) the lower the costs and better the service.

How do Payments work??Payment Settlement is a two step process

Authorisation Process

1. Step 1: Customer decides to make an online purchase through Merchant service and inputs credit card information
2. Step 2: Merchant Service receives the Customer information and sends it to the Payment Gateway
3. Step 3: Payment Gateway routes the information to the Processor
4. Step 4: Processor routes the information to the Customer Bank
5. Step 5: Customer Bank send authorization (or declination) to the Processor?
6. Step 6: Processor routes transaction results to the Payment Gateway
7. Step 7: Payment Gateway sends results to the Merchant
8. Step 8: Merchant decides to Accept or Reject the Purchase

Settlement Process

1. Step 1: Merchant informs the Payment Gateway to settle the transaction
2. Step 2: Payment Gateway send the transaction information to the Processor
3. Step 3: Processor checks the information and forwards the settled transaction information to the Customer’s Bank
4. Step 4: Customer’s Bank transfers the funds to the Processor
5. Step 5: Processor routes the funds to the Merchant’s Bank
6. Step 6: Merchant’s Bank credits the funds to the Merchant’s Bank Account and notifies the Merchant
7. Step 7: Customer’s Bank debits the funds from the Customer’s Bank Account
8. Step 8: Customer is notified of the Transaction Status (Accepted or Rejected)

Commission Split: Broadly, a digital payment commission is split in the following manner. Please note, the below split is a close illustration and not exactly how payment commissions are split. Commissions vary depending upon the payment volume, type of payment and a lot of other parameters.

Illustration of a typical commission split. Actual figures vary for each payment mode.

1. Transaction costs vary between 1.00% to 4.00% across different Payment Gateways (e.g. BillDesk, CCAvenues etc.) and across payment types (e.g. Credit card, Debit card, internet banking etc.)
2. An average 2.00% transaction cost is mentioned above for illustration purposes
3. Transaction cost between Customer Bank and Payment Gateway is negotiable. Higher the Transaction Value, lower is the transaction cost to the bank
4. The Payment Gateway margin as shown as 0.20% above, can thus be increased by increasing Gross Merchandise Value (GMV)

Payment Mechanisms:?India has many a ton of payment modes. Below is a quick list:

1. Cash
2. Cheque
3. Internet Banking
4. Mobile Banking
5. Card Networks (VISA/Mastercard/Diners Club, Discover, AmEx etc.)
6. National Electronic Funds Transfer (NEFT)
7. Real Time Gross Settlement (RTGS)
8. Immediate Payment System (IMPS)
9. Electronic Clearing System (ECS)
10. National Automatic Clearing House (NACH)
11. Prepaid Payment Instrument (PPI)
12. Unified Payments Interface (UPI)
13. RuPay (Card Network)
14. Aadhaar Enabled Payment System (AEPS)
15. Bharat Bill Payment System (BBPS)
16. *99# (USSD)

Here’s a helpful visualisation of India’s payments infrastructure:

Use this link to play around with the mind map. Note: this mind map hasn't been updated since 2017.

Business Models – Business Models classified on end customer acquisition basis

1.Business to Consumer (B2C): e.g. Paytm, Mobikwik, PhonePe, GooglePay etc.

• Multiple revenue streams: Cross sell various products i.e. personal finance, ecommerce, tickets etc.
• High Exit Value: An investment in this space will get a high value, provided the customer base is large.
• High Cost of Customer Acquisition (CAC): High cost of marketing, discounts & cash backs to entice customer to the service. The high CAC will be sustained over long periods to gain customer loyalty.
• High Fraud and Security Risks: Creative customers find it easy to bypass security features. High cases of fraud have been reported in PG’s of this model.
• High cost of expanding to different geographies: Expansion beyond home geography means replicate an already high cost customer acquisition strategy.

2. Business to Business (B2B): e.g. PayU, Razorpay, PineLabs etc.

• Merchant acquisition is a long process: Merchants have to be acquired one at a time to maintain scalability of the technology. Merchants can be divided into three buckets: low yearly turnover (INR 10-50 Cr), Mid yearly turnover (INR 50 to 2,000 Cr), high yearly turnover (INR 2,000 Cr and above).
• Sticky Client base: Although merchant acquisition takes long, once the merchant has migrated all payment acceptance to the payment gateway, it is difficult for the merchant to migrate to another PG.
• Pooled Fraud Detection Capability: With a large merchant base with millions of consumers transaction daily, the PG can pool resources and build fraud detection capabilities within the technology stack. This is a huge advantage over B2C fraud detection capability.
• Low Cost of Geographic Expansion: Cost of expanding to different geographies is low but time consuming. The process will have to be replicated brick by brick. By building a brand of payments, this time lag can also be reduced inorganically.

3. Business to Bank (B2Bank): e.g. BillDesk, Zeta, Juspay etc.

• Bank acquisition is a long process: Acquiring banks as customers is a long process as they have existing relationships and vendors. Technology needs to be radically unique to be accepted by banks
• Lowest cost of Merchant Acquisition: Merchant acquisition is done by the banks at their cost with a large acquisition machinery. In effect, the PG gains significant traction with merchants at virtually no cost.
• Chances of High growth: With the Bank leading the charge for merchant acquisition, the PG is highly dependent on the bank’s sales force for growth. Revenue on a transaction commission will take a longer time to gain some traction. Most PG models for banks currently have a licensing revenue model.

Would love to hear your thoughts on the payments industry in India. Write a comment below or email me

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3?? Fintech Top Three

1?? Macquarie's hot take on Indian fintech startups.

Macquarie released an analyst report which commented on Indian fintech startups. The comments said that Indian fintech startups are "just Direct Selling Agents (DSA) and that limits ability to scale with profitability". Easy to sound smart, Macquarie.

Takeaways:

1. Macquarie is right... but only partially. Most insurance and lending business models resemble digital DSA's. Macquarie's "hot take" falters in mistaking all of Indian fintech for lending companies. We've had spectacular innovation in payments (Citrus, Paytm, Razorpay, PayU), stock brokerage (Zerodha, UpStox, Dhan), Wealth management (Smallcase, Strata, WintWealth) and more. None of these companies rely on lending as a core part of their operations. They have elements of lending that support the core business model.
2. Innovation always precedes regulation, in India regulation has other priorities: Regulators unfortunately do not follow Zuckerberg's maxim of "move fast and break things" and rightly so. Here's the dilemma - Indian fintech startups want to innovate but without a license they have to partner with a licensed entity. Licensed entities fear regulatory action because of lack of precedent and hence err on the side of caution, sometimes overly so. This limits innovation. On the other hand, Indian regulators have largely kept away from issuing licenses to fintech startups. But licenses require large pools of capital which further reduces the pool at the top of the funnel.
3. What's wrong with being a DSA?: Macquarie uses "direct selling agents" for Indian fintech startups as if it's a bad word. What's wrong with having it as part of the business model? If in providing a credit product the fintech startup provides value to it's customers, why is it a bad thing? Banks are not going to do it. Someone has to do it. We've discussed several times in this newsletter and everywhere else that India is a credit starved country. There's nothing wrong with innovating the DSA model, making it more efficient and giving financial access to more users. In fact, in majority cases, fintech startups participate in risk by giving a First Loss Default Guarantee (FLDG), which no DSA does.

2?? Indian fintech stocks are not going as planned in public markets

Paytm's stock price is down 62% from IPO price and 67% down from high of $23.7. Policybazaar (PB Fintech) as well is down, 36% from IPO price and 47% from high of $19.1. Not really a fintech startup, but Fino Payments Bank is down 47% from IPO price valuing at $314mm. Star Health Insurance's stock price is down 30% from IPO price valuing the insurer at $4.83bn.

Paytm now is valued at $5.1bn (IPO m.cap. of $19bn, private m.cap. of $16bn). PB Fintech is valued at $4.53bn (IPO m.cap. of $6bn, private m.cap. of $2.4bn). All this while Sachin Bansal is going ahead with Navi's planned IPO and the Indian government doing the same with LIC's. Oh and Mobikwik didn't go ahead with its IPO.

Note: Stock price details are as on 17th March, 2022. USD 1 = INR 76. This is not stock recommendations or advice.

Takeaways:

1. Disconnect between private and public markets: These public market investors don't seem to be vibin' with us, private market investors. Seriously though, it seems there's a lot more excitement in private markets which is driving valuations high. Public market investors are probably comparing these startups to more established financial firms e.g. HDFC Bank, SBI Bank, Bajaj and others and seeing more returns there. This could trickle down though - globally, public market investors are seeing corrections already and this could force private market investors to do the same. There will obviously be the handful of star startups that will command unscientific valuations but the majority will see corrections.
2. Disconnect between performance and market sentiment: Paytm grew quarterly revenues 64% and 34% in Q2 (Jul-Sep, 2021) and Q3 (Oct-Dec, 2021) respectively. Policybazaar grew revenues 16% and 34% quarter-on-quarter in Q2 and Q3 respectively. These companies were still loss making. Similarly with the other public financial companies that went public recently. What gives?
3. Sachin Bansal's has other goals with his IPO: Odd that Sachin Bansal's going ahead with his IPO despite all this gloom in not just Indian markets but global ones as well. Methinks Sachin has other goals with going public. His licenses (banking, insurance and others) have been declined or stuck for a minute now. The only possible reason to go ahead with an IPO is to gain regulators and public's trust. Going public comes with disclosures, public scrutiny and more and this will potentially help his fintech ambitions with regulators.

Zaheer Merchant from Economic Times wrote this very ominous post in November, 2021. Do read.

3?? Indonesia's largest startup, GoTo, to IPO at a valuation of $29bn

Formed from the merger of Gojek and Tokopedia, GoTo filed its IPO prospectus to raise $1.1bn at a valuation of $29bn (upper band).

Takeaways: Yes, yes, I know GoTo is not a fintech company but I wanted to understand it's fairly large fintech business vertical. GoTo's prospectus is in Bahasa only and there's virtually no detailed analysis in English. I relied on some friends to source some for me. Below are some notes.

1. Fintech is a large business vertical: For the period 9MCY2021, Fintech & others accounted for 38% of the total Gross Transaction Value (GTV) growing from 32% in CY2018. On-demand Services was 11% and Ecommerce was 52%. This fintech GTV for nine months of 2021, grew 73% YoY to $8.5bn, annualised to $11.5bn. However, Fintech and Others vertical accounts for only 3% of the overall revenue.
2. Fintech has high net margins: GoTo makes 80% net margins (net revenue/gross revenue) on its fintech business vertical, compared to OnDemand - 32%, Ecommerce - 48%. However, GoTo makes the lowest take rate on its fintech business of 0.5%.
3. Fintech businesses in all verticals: GoTo has payments businesses, banking, lending, investments, insurance and many others. It claims to be the largest e-money platform and the largest cloud POS platform in Indonesia. I'm assuming the plan is to target and cross sell financial products to its 55mm Annual Transacting Users, 2.5mm driver partners and 14mm merchants (as of 30th Sep, 2021).
4. "Aggressive" valuation: In GoTo's case as well, all everyone seems to be talking about is the valuation - $29bn seems "aggressive". The combined entity was valued at $18bn at merger and separately have raised a total of $8.2bn over the years.

Note: This is not stock recommendation or advice or analysis.

?? International

Looking for the news digest? Read all the week’s fintech news and updates in India and SEA over at This Week in Fintech - India and SEA Edition.

??? Other Notable Nuggets

1. The ongoing liquidity crisis in Nepal
2. Over 99% of Bitcoin Volume Comes From $100K+ Transactions
3. The great NFT sell-off: has the digital collectibles craze hit its peak?

?? Song on loop

Fintech updates can get boring, so here's an earworm: This week a stumbled upon a beautiful Portuguese song - Grecia by Elsa y Elmar (Youtube / Spotify). It’s slow and mellow and the vocals are stunning. Great weekend listening.

???? That's all Folks

If you’ve made it this far - thanks! As always, you can always reach me at [email protected]. I’d genuinely appreciate any and all feedback. If you liked what you read, please consider sharing or subscribing.

1-min Anonymous Feedback: Your feedback helps me improve this newsletter. Click UPVOTE ???? or DOWNVOTE ????

See you in the next edition.