In the last years, after decades of lethargy, the retail payment industry has started to thrive. Means of payment which were unthinkable of in the recent past are now available, and innovative services are offered by old and new players. The revolution in information and telecommunication technologies has taken some time to shake what was a very dull and traditional business activity. But with fintech, it has finally arrived.
This revolution has hit all segments of the industry. Not only transferring value has become as easy and cheap as it has never been before, but also what is behind this value has changed substantially.
The arrival of new and disruptive technologies has caused some mayhem in the market. The possibility to offer innovative services has created new profit opportunities, and incumbents in the payment industry are now facing unprecedented threats by aggressive entrants with better technological know-how. As it is always the case in periods of turmoil, it is not necessarily true that innovation leads to welfare improvements. New technologies allow to offer better services, but they may also favor the emergence of monopoly positions, due for example to network economies of scale and the possibility to bundle the supply of goods and services. New types of risks may emerge, that are not fully appreciated by consumers, therefore biasing their choices with respect to what would be socially optimal.
Technology adoption displays very strong path-dependence. Players that will manage to build a strong position in the industry in the coming years will very likely shape its evolution in the future. For this reason, it is of paramount importance to act now to assess the benefits and risks of the new opportunities, and tackle the possible negative externalities with adequate policy interventions.
If we think about how retail payments are generally made, we come out with a handful of alternative options. The most traditional way, and the most common in the majority of countries, is with cash. But debit- and credit-card payments are becoming more and more common. In some countries, smart-phones are supplanting or have already supplanted plastic cards as a support containing the information required to make a payment, and they may also be offering different types of services, not necessarily fully transparent at the eyes of end-users. Finally, we can directly make an order to the financial intermediary where we store our assets to transfer some of them on our behalf to another account, through cheques or money transfers.
In synthesis, cash, debit- and credit-cards, and bank orders make the vast majority of retail payments, even if some of them go through our smartphone. But what are we transferring when we use these means of payment? Cash is fiat-money, a liability of the central bank that we may call central-bank-money. Although it is technically a claim on the central bank, it is outside money and its real value is a function of the credibility of the central bank.
When we do not pay with cash, we are very likely to be transferring bank-money. Obviously, this is the case when we use a cheque or we make a bank transfer. But it is also very often the case when we use a debit- or a credit-card. Bank-money is a liability of a commercial bank, which is one-to-one convertible in cash. It is inside money, whose value is formally guaranteed by the assets of the bank – and by the ample set of regulations that assure that these assets are worth at least as much as the amount of bank-money issued by the bank, i.e. its deposits.
But since recently, when we make a payment with a card or using our smartphone we might also be transferring electronic money. This is a liability of a financial intermediary different from a bank. It can be outside money, as bitcoins, or inside money, as the majority of electronic moneys issued by financial intermediaries around the world. Often, electronic money is also convertible one-to-one into cash, but this is not always the case. Remarkably, from the point of view of a customer, the using experience of paying with a card of a bank is identical to that of paying with a card of a financial intermediary issuing electronic money, although what is behind the value that is transferred can be very different.
The choice among the different alternatives
How do we choose among different means of payment? A rationale choice is based on the characteristics of each instrument in terms of its cost of usage, its effectiveness, and its riskiness. The cost of usage and the effectiveness are technological characteristics. Apart when we use cash, making a payment involves the transfer of a certain amount of information. This can be done on paper, as in the case of a cheque, or of the old payments with the credit-card, when a paper slip was produced and sent to the interested counterparties. But in all other cases it is done electronically. More efficient information procedures to match the two sides of a transaction, higher computing power, more user-friendly procedures or interfaces to link purchases and payments are all characteristics that make it more likely that a given instrument is less expensive and more effective.
The riskiness of a means of payment depends instead on a number of different features. A crucial feature is the value that is promised by the issuer. In the case of central-bank-money such as cash, the real value is guaranteed by the central bank and by how well it maintains price stability. Crucially, price stability is expressed in terms of the legal tender, that undertakes the function of unit of account. In the case of bank-money, perfect convertibility with cash is assured by contractual and normative provisions. The nominal value is therefore guaranteed and the real value is the same as that of cash. An identical case is that of electronic-money, which is one-to-one convertible into cash or into bank-money. On the contrary, holders of electronic-money whose value is linked to that of a pool of assets – as for example in the case of the Libra, the currency proposed by Facebook – incur the risk of imperfect convertibility with cash or bank-money. Of course, whether the real value of such an electronic-money is more or less stable than that of central-bank-money depends on the conduct of monetary policy, on money supply by the electronic-money issuer and on the relevant rate of inflation for each consumer. In fact, the real value of an electronic-currency may turn out to be more stable than that of the legal tender, if the central bank is not good at maintaining price stability. The same, at least in theory, could happen with outside electronic-money, such as bitcoins.
A related issue is how this value is guaranteed. In fact, promising one-to-one convertibility into cash is not the same thing as being able to perform it. In the case of bank-money, convertibility is guaranteed by deposit insurance and by bank supervision, which assures that the value of bank’s total assets does not fall below that of deposits. With electronic-money, the value is also guaranteed by the portfolio of assets of the financial intermediary. If electronic money issuers are required to hold assets for a value equivalent to that of the money that they have issued in the form of bank deposits, the guarantee is identical to that on bank-money. If this is not the case, holders of electronic-money may incur higher risks than holders of bank-money, even in case of formal one-to-one convertibility.
An additional source of riskiness is the liquidity of each means of payment. Clearly, even in the case of fully guaranteed one-to-one convertibility into cash, discovering that the money that we hold is not accepted to make a payment, for example because our counterpart fears it is counterfeit, will be a source of problems. Clearly, the risk of liquidity is going to be higher for moneys that do not offer, or guarantee, convertibility into bank-money or cash.
Finally, the riskiness of a means of payment is also related to that of the technological infrastructure that it adopts. The security of the plumbing, as the payment system is known in the jargon of central bankers, is a crucial issue, as the recent frauds at bitcoins exchanges have recently made clear. For this reason, in all countries payment systems are supervised by regulatory authorities.
In the environment described above, the market equilibrium is unlikely to be fully competitive and efficient. A number of factors work against such an outcome. For obvious technological reasons, transferring value within a network of users sharing the same technological platform – what is known in the jargon of the payment system as a closed loop system – is less expensive and more effective than transferring bank-money. These economies of scale emerge because, within a single network, any transfer of value from customer A to customer D amounts to two records in their positions within the system. A money transfer requires instead to record changes in the position of customer A with respect to his bank, call it B, in the position of bank B with respect to the bank of customer D, call it bank C, and in the position of customer D with respect to bank C. If banks B and C want to make the transfer in central-bank-money, a record in their reserve positions with the central bank is also necessary. This requires to standardize information protocols and to connect different computers and servers, all activities that require time and money. Clearly, network-economies-of-scale favor the concentration of the market in the hands of few corporations.
What these corporations will be, is related to a large extent to the effectiveness of the payment experience. Payments are increasingly generated by purchases taking place within platforms offering a large array of services, often owned by bigtech such as Amazon, Alibaba, Facebook, WeChat, Google. Suppliers of such services are in a better position to offer means of payment specifically tailored to the characteristics of their platforms. These corporations have thus strong incentives to create their own electronic moneys and exchange them within the network of their customers, as Alibaba has done with Alipay and WeChat with Tencent, and Facebook is willing to do with Libra. Having few players controlling the entire payment system, and with the ability to bundle purchases and payments, is likely to generate severe anti-trust concerns.
In addition, if such moneys are one-to-one convertible into bank-money or cash, monetary policy will remain in the hands of the central bank. But if this were not the case, a large diffusion of such means of payment might indeed hinder central bank’s ability to conduct monetary policy.
Finally, a subtler issue relates to the value of the information generated by payments. Electronic-money transactions are not anonymous, and can be linked to single purchases. They have therefore enormous value for marketing and lending purposes. How they would be stored, treated and used is indeed a major cause of concern.
The problems listed above are likely to be even more of a concern considering that customers choosing among different means of payment are likely to assign a prominent weight in their choices to cost and effectiveness, underestimating the risk that they incur.
All this, calls for regulatory intervention.
What type of regulation
The digital technology advancements we have experienced in the last fifteen years will produce epochal transformations and, if properly directed, will deliver enormous benefits. Payments systems are not immune to these transformations with a process that will have to be governed for the reasons discussed above. In addition, both the payments system and the digital markets that may be bundled with, such as information (Google), social interactions (Facebook), market places for commodities transactions (Amazon and Alibaba) and entertainment (Netflix and Spotify), they all share a common property, namely the presence of strong network externalities. This force has already displayed its effect selecting winners-take-all champions, and levels of concentration and market power that have rarely seen in market economies.
In this environment, we think there is no doubt a need of ex-ante and ex-post interventions to guarantee that innovations in payments systems produce their benefits, still guaranteeing stability.
In particular, operating ex-ante, regulation must grant at least three main objectives. First it must be able to induce transparency for users on the values of the different means of payments. Second, it should let monetary policy authorities to continue lead an effective monetary policy. Third, it must grant effective competition among the different means of payment.
As for the first objective of regulation, it should be noticed that lacking transparency on the value of means of payments, moral hazard issues may emerge with a bad and risky money winning over good and safer ones. This may in the end lead to a complete break-down of the new payment systems. One possibility to obtain value-transparency is that regulation requests any electronic money to be fully backed by perfectly convertible assets such as banks and/or central bank reserves.
As for competition, both ex-ante regulatory intervention and ex-post antitrust activities are important. Regulation should incentivize if not impose interoperability among the different payment systems so that customers can easily transfer their money across different systems. Standardization of protocols to transfer bank and electronic money across financial intermediaries is key for smooth interoperability. An alternative to full standardization that has been put forward in markets with network externalities is multi-homing, where users find it preferable to be active on several possibly competing networks. In the case of payment system this would require having wallets with different digital payments. Clearly, obtaining these outcomes is not easy and may require significant costs, such as duplicating costs of networks, which however will grant significant future benefits, which explains why regulation is needed.
Ex-post antitrust intervention should instead take care of the dominant positions that naturally emerge in markets characterized by strong network externalities. As mentioned above, companies already relying on large customer base will have incentives to expand new payment systems. They will be able to do so also both leveraging on the bundling of their core business with internal payment systems and also on the processing and use of the large amount of information they have on their customers. As shown by past antitrust interventions, bundling is a very powerful strategy that dominant firms tend to use in order to extend their power in adjacent markets. The risk that payments systems become quickly monopolized by the already dominant players is concrete and antitrust authorities must be on the monitor and promptly act if needed. As with regulation this is more easily said than done. Consider for example the recent acquisitions of Instagram and WhatsApp by Facebook. These mergers have been greenlighted on the ground that these companies where active in different markets. However, it is now clear that the business models evolve very quickly in digital and network markets and that possibly unrelated companies may be formidable competitors in a few months-time horizon. Independent Instagram and WhatsApp could have been now competitors to Facebook and Google on the advertising market.
Authorities and regulators should team up to identify the right trade-off between tackling the dangerous issues outlined above and at the same time guaranteeing that the technological developments on payment systems deploy all their windful to users allowing for a modernization of money markets.