Unknown to most western investors, a huge innovation has been taking place in large developing countries India and Brazil, which I think can have profound changes in the payment industry. These countries have realized that democratization of finance is the lifeblood of a dynamic economy and are leap-frogging towards a "cashless" digital society. Curiously, this innovation has been birthed by the country's federal governments (more specifically their central banks) and not any private enterprise.
These countries are laying the foundation for a frictionless cashless society. They have created what is known aspublic sector payment rails, which are experiencing exponential growth. These public payment rails are digital infrastructure that enables real-time (within seconds or minutes) digital money transactions between entities without any middle men.
Payment rails in a nutshell
A payment rail is essentially the backbone of all digital money transfer between one individual or entity to another. All payment rails fundamentally do the same thing - provide the infrastructure to move money from one location to another (just like a railway for goods and passengers).
Payment rails are nothing new. Credit card companies like Visa (V, Financial), Mastercard (MA, Financial), American Express (AXP, Financial), Paypal (PYPL, Financial) and so on have been providing this for years. So have debit card rails. Others are regional players like M-pesa in Kenya or Alipay (which runs through Alibaba (BABA, Financial)) and WeChat Pay (owned by Tencent (TCEHY, Financial)) in China. Meta Platforms (META, Financial) is rolling out Facebook pay and Whatsapp Pay, while Apple (AAPL, Financial) and Alphabet's (GOOG, Financial)(GOOGL, Financial) Google have their own wallets. Another big attraction is for Cryptocurrencies are their potential for use as a payment rail (apart from its use as a store of value, which so far has been a bust).
The problem (or feature if you are a "rail" or invested in one) with most of these private payment rails is that they are a middle man (or one of several middle men), and the middle men invariably take their piece of the transaction. For example, if you transact with Visa or Mastercard, the various middle men collectively take 1% to 3% of the value of the transaction, while Paypal charges 2% to 4%. This fee is usually paid by the merchant selling you goods or services, so the fee is hidden from the consumer. However, this raises the prices of goods and services and makes the middle men extremely rich. China's WeChat and Alipay only charge 0.6%, which goes to show how much of a death grip the middle men have on western countries.
Here is an example of the middle men in a typical payment ecosystem in the western world. The complexity is bewildering, and it's good to remember each of these middle men players in this ecosystem has a hand in your pocket to extract their toll.
Now that we see the problem here, let's look at the new development of public payment rails and how they could disrupt the industry.
India
India introduced the unified payments interface (UPI) payment rail in 2016. The UPI is a payment rail via which a person or entity can transfer money between bank accounts in real time (within seconds or minutes). This means you can send or receive money or scan a quick response (QR) code to pay an individual, a merchant or a service provider to shop, pay bills or authorize payments.
To enable payment using your phone, all you need is a mobile payment application and the virtual address of the payee (that reads something like Kiranashop2298@abcbank or a mobile phone number or an email), or just scan a QR code of the recipient. This implies you can make payments directly to the accounts of a vendor or a person, in one step, and both parties receive immediate confirmation. There is no repetitive step involved. For example, entering bank details or other sensitive information each time you need to make a payment is unnecessary. It is simple, free of charge and instantaneous. UPI allows people to make transactions 24/7 all year round. Currently, one can transfer up to 1 lakh (about $1,500) in a single UPI transaction.
UPI was launched in 2016 by the National Payments Corporation of India (NPCI), the government sponsored organization that oversees retail payment systems in India. The NPCI is governed by the central banking authority, the Reserve Bank of India (RBI), which is equivalent to the Federal Reserve in the U.S., and its primary goal is to drive India towards becoming an all digital / cash-free economy. UPI can be used with any supported wallet app in India like Google Pay, Uber (UBER, Financial), PhonePe, Paytm (NSE:PAYTM, Financial), etc.
India also allows UPI payments for people who do not have a phone as long as their Social Insurance Number (called the Aadhar number) is linked to their bank account. Since in India, the Aadhar number is linked to the person's biometric information (fingerprint), the payer just has to enter the number and put their thumb on the reader.
UPI is growing quickly and is expected to reach 500 million Indian citizens by the end of the decade. Given that UPI transactions are free, the middle men like credit card companies and their associated payment accessories will likely be getting squeezed in India.
Brazil
Enabling the entry of Nubank (NU, Financial) and other challenger banks in Brazil is the profound regulatory and infotech reforms undertaken by the Brazilian government. Key to these reforms was the establishment of the automated clearing house system for interbank transactions by the central bank (Banco Cenral do Brasil).
Pix, the Brazilian instant payment scheme, was launched by the central bank on Nov. 16, 2020, after a process of intense dialogue with the financial industry's representatives and society. Since then, the use of Pix has grown considerably over the period, and it will certainly evolve further. Pix was built to democratize access to electronic means of payment, boost the digitalization of payments and foster the competitiveness and efficiency of the market. Pix is a versatile instrument that can be used in diversified situations involving fund transfers between people, companies, or the government.
Pix, allows fast money transfers over smartphones and became so ubiquitous in the 17 months after it was launched that even panhandlers are accepting Pix payments. All that’s needed to send cash to someone is a simple key they’ve set up, such as an email address or phone number. Pix works through multiple apps from banks and other digital wallet services. Brazil now registers more instant transfers than the U.S.
Pix was built to be open, interoperable and competitive. The central bank does not provide any direct payment services – it only provides the infrastructure. Pix was built to solve coordination problems, replacing proprietary bank wires and transfers as a cheap, convenient alternative. P2P users were expected, but now there is the onboarding of B2B users as once the QR code standards were finalized, small and medium enterprises (SMEs) were able to onboard QR code enabled transactions. Pix aliases are portable and the users’ information is stored in the database ("Transaction Accounts Identifier Directory" (DICT) - the sole alias database operated by BCB) which is encrypted and protected by law.
In the future, Pix will add new functionalities, such as getting cash-back and preprogrammed payments, which are currently offered mainly through credit cards. Other features such as short range wireless contactless payments as well as access for people without smartphones (similar to India's UPI) are in the works.
United States
The U.S. has no lack of payment rails from credit cards and apps like PayPal and Venmo. The common thread is that unlike the public sector rails, they charge some sort of fee or another, much of this hidden or obscured in legalese. The government has had no urgency to get involved in setting up a public payment rail given the choices and the pro-private sector ethos.
The closest the U.S. has to a public rail is system called Zelle, which is privately owned by a consortium of banks. Launched in 2017, Zelle has over 924 banks participating in its payment network. In 2020, Zelle facilitated over $307 billion in payments. Zelle is a P2P payment service handling transactions between users. It is owned by Early Warning Services, a private financial services company owned by the Bank of America (BAC, Financial), BB&T, Capital One (COF, Financial), JPMorgan Chase (JPM, Financial), PNC Bank (PNC, Financial), U.S. Bank (USB, Financial) and Wells Fargo (WFC, Financial). Zelle allows users to send people money directly from their bank account to another account without the need for a bank wire. After a fast and simple registration process using their email or phone number, users download the app and use it to send money to anyone registered on their payment network. The service is only available to U.S. bank account holders. The Zelle payment network is also available within its partner bank apps, such as those from Chase or Wells Fargo. For users to transfer money, they must enter the recipient's cell phone number and email address. Transactions are fast, with funds reflecting in the recipient's account in minutes.
Zelle earns money by facilitating payments with banks. Whenever a user utilizes Zelle to make payments, participating banks on the platform earn revenue. As a result, consumers benefit from low-cost P2P money transfers without paying commissions and fees to a third party running the app or the rails. In 2018, Zelle launched another function in the app, allowing users to pay merchants for purchases such as groceries. The merchant pays a 1% fee for processing the payment, with the fee going to the bank running the payment network. So overall, Zelle has a much lower cost than other U.S. payment solutions, but does not come close to matching the public pay rails from Brazil and India. Zelle is also limited to a small amount of money depending on the bank (from $500 to $5,000 a day).
Canada
Canada has payment rail system called Interac which has been around since 1984. While not free, it is low cost and convenient and widely used. Interac is owned by a consortium of Canada's major banks and serves as the country's debit card system and for low volume e-transfer system (up to 3,000 Canadian dollars ($2,298) a day per account). Users can transfer money using email or mobile phone number as long as these addresses are registered in your bank.
Interac charges for each transaction, though the charges are far less than what is charged by credit card companies. Transferring large amounts is still done by wire and is quite costly. Plus, it's not real-time, and transactions can take several hours to be posted.
Canada is currently about to introduce (at some point in 2022) the Real-Time Rail (RTR), a national payments system sponsored by the Federal Government and administered by a public sector entity called Payments Canada. This will enable fast, data-rich payments, giving the government and businesses of all sizes the ability to move large sums of money instantly and with certainty. Not too much is known about the details of RTR except that it can be used to handle large amounts of payments in real time and with reconciliation functionality built in.
Implications of the rise of public payment rails
The massive success of UPI in India and Pix in Brazil among the common man is a wake-up call for the payment middle men in the rest of the world. This tells me that the world is hungry for fast, low cost payment solutions which can cut out the toll-collecting middle men that are becoming increasingly unnecessary.
While public pay rails are less developed in other parts of the world, there will be an inevitable push to lower the price of transactions charged by the private payment rails in developed countries, and other developing countries will likely adopt these solutions for their own citizens. While currently organizations like the credit card processors (Visa, Mastercard, etc.) enjoy a wide moat, their lucrative oligopoly is under threat. For example, in countries like India and Brazil, I don't see how a high cost solution could make much headway against a practically free and real time solution that is already established.
Of course, the private players will certainly fight back with political lobbying, and by adding more frills and marketing to their products. For example, credit cards offer all kinds of points and rewards to users as well as insurance benefits, fraud protection and of course credit. However, this service comes at a high cost, some covert and hidden and some overt like interest charges. Merchants (and especially small and medium businesses) hate them almost universally because of high costs, but untill now they did not have many alternatives. With the arrival of free public financial rails as well as low cost private rail like Zelle, this oligopoly's days are numbered. I foresee vendors offering incentives and preferences to customers paying via low cost solutions rather than by higher costs credit cards.
As a matter of fact, the stock prices of the Brazilian credit card acquirers (like StoneCo (STNE, Financial)) are under pressure. While I don't know how much of this is due to the rise of Pix or how much is it due to the tech crash in general, it's tough to compete with the public payment rails.
Conclusion
I think the current dominant private financial rails like Visa and Mastercard will have to get more competitive or prepare to be disrupted by public real-time rails or very low cost private real-time rails. It's going to be interesting battle with the advantage going to the low cost provider. In fact, I think soon banks will fight to offer you access to free rails just to get your deposits given the rising interest rate environemnt and enormous amounts of corporate debt in the U.S. I think Amex and PayPal are particularly exposed as they are high cost providers and disliked by vendors. They will have to scramble to stay relevant.
One big caveat of real-time rails in that like cash, the money moves so quickly that if one was to make a mistake in say, choosing a wrong recipient, it is gone in an instant. It is a non-reversible transaction. If you made a mistake, good luck getting your money back. This feature of course makes it a target for fraudsters and criminals.
But, when you think about it, it's not too different from cash. However, unlike cash, the transactions are traceable. I am sure business models will spring up which will add bells and whistles to the underlying real-time rails, like insurance, fraud protection, credit and rewards (similar to credit cards). The good thing is that it's up to the consumer in regards to which payment system will win in the end, once it's been introduced as an option.
