This is part 1 in my Payments 101 series. Other parts in this series are as follows:
Payments 101: Part 1 – An overview (this article)
A payment is the transfer of value from a sender to receiver. Every payment consists of 3 components: (1) initiation of the payment, (2) funding of the payment and (3) delivery of the payment. Consider a transaction in which a customer purchased a battery from a retail store using a credit card. The payment is initiated when the merchant swipes the customer’s credit card (to be fully accurate, the actual payment transfer is initiated later and only an authorization request is initiated at the time of purchase). The transaction is funded using “credit” i.e. the customer does not have to pay for the product immediately and the value of the product is added to his/her credit card bill, which the customer will ultimately pay. The delivery of the payment is completed when the customer’s credit card bank (known as the issuer) has delivered the money to the merchant’s bank account.
According to McKinsey, Payments is a $2T/yr revenue industry and has been growing at a 6% growth rate over the last decade. Note that this includes only the fees that are generated as part of the payments transaction and the not the value of the money that is moved via the payments ecosystem.
Open loop vs. closed loop models:
There are 2 main models within the payments industry:
Open loop: This model is used by almost all large scale payments systems. As new intermediaries join the payment systems, their customers automatically get access to the entire network and vice versa. Therefore, open loop payment systems are easy to scale. Banks are the most common intermediaries in the open loop system show below. An end party can be a consumer or a merchant (and they gain access to this network by opening bank accounts). Therefore, merchants and consumers can get access to each other by joining such a system. For e.g. amazon.com (merchant) can accept credit card payments from any banked customer in the US because all US banks and amazon.com are plugged into this open loop system.
Source: Payments System in the US, 3rd edition
Closed loop: These systems operate without intermediaries. Therefore, the end parties have a direct relationship with the payments system and need to individually integrate with the payments system. The original American Express and Discover systems, and the proprietary card systems (for example, a Macy’s credit card accepted only at Macy’s) are examples of closed loop systems. Closed loop systems have the advantage of simplicity. As one entity sets all of the rules and has a direct relationship with the end parties, it can act more quickly and more flexibly than the distributed open loop systems, which must propagate change throughout the system’s intermediary layers. The owner of a closed loop system is also able to capture a large chunk of the value that is being created (vs. an open loop system in which the created value gets distributed among various intermediaries).
The disadvantage of closed loop systems is that they are more difficult to grow than open loop systems; the payments system must sign up each end party individually. Payments service providers like PayPal and Western Union are closed loop systems…but they are users of open loop systems. Another example of closed loop system is gift cards. A gift card is issued by a merchant/retailer and can be used only at that retailer.
Open loop systems are able to effectively operate because of the chain of liability. For example, a simplistic credit card payment transaction consists of the following: consumer > consumer’s bank (Bank A) > merchant’s bank (Bank B) > merchant. If a transaction has been successfully authorized then Bank A owes the money to Bank B. Even if the consumer does not pay the credit card due amount to Bank A, the Bank A will still need to pay the amount to Bank B. Therefore, Bank B does not take on the risk of non-payment (which is borne by Bank A in this case) by the end customer. The liability flows like this along the chain. Therefore, each player in the chain bear liability for (and also protect) customers that they link to the network.
Push vs. Pull transactions:
Payment Transactions can also be classified as either push transactions or pull transactions. Push or pull refers to the action of the party that is entering the transactions into the system. For example: Imagine B owes $100 to A. Both these customers use Venmo and plan to use that platform for completing the transaction. This settlement/transfer can happen in one of two ways on Venmo:
A can request $100 from B. This is known as a “pull” transaction
B can on his/her own send $100 to A. This is known as a “push” transaction
Therefore, the same transfer of value can be a “pull” or “push” transaction depending on how the transfer is initiated. “Push” payments are fundamentally much less risky than “pull” payments. In a “push” payment, the party who has funds is sending the money, so there is essentially no risk of NSF, or non-sufficient funds—“push” payments can’t “bounce.” In the above example, A can request $100 from B but B may refuse to pay that money. On the other hand, if B sends $100 to A then there is almost no risk of the funds not being transferred as Venmo knows that B has the required amount in his/her Venmo account and has also authorized the transaction.
Credit card networks are “pull” payment networks. For example: A consumes a meal at a restaurant B. A “pays” the bill at the end of his/her meal but the fund transfer or movement is not initiated at that time. At a later time/date, the merchant (or the merchant’s bank) initiates the actual fund transfer request. Therefore, this transaction is a pull transaction.
However, they are guaranteed pull transactions. This is because at the time of delivery of service (for e.g. when you complete a meal at a restaurant and are paying your bill via a card), the merchant sends an authorization request over the network. The goal of this authorization request is to confirm that the customer has enough credit in his/her account. If the merchant gets a “yes” response to this authorization check then the rules of the card networks guarantee that the consumer’s bank will need to honor the pull request that the merchant (or merchant’s bank) generates at a later date. We will review this flow of information in more details in the 4th part of this series.
Net Settlement vs. Gross Settlement:
Payment systems can also be classified on the basis of settlement protocol. There are 2 types: (1) Net settlement and (2) Gross settlement. In a net settlement system, the net obligations of participating intermediaries are calculated by the payment system on a periodic basis—most typically daily. Checking, card payments systems, and the ACH are all net settlement systems in the United States. In a gross settlement system, each transaction settles as it is processed. From a consumer perspective, this will determine the speed of the payment transfer. For e.g. a gross settlement payment is typically “instantaneous” while a net settlement payment (like ACH transfer of payroll) can take 1-2 days to complete. Wire transfers are typically gross settlement. Because of the large size of a wire transfer, net settlements can increase the risk in the financial system.
2 key metrics are used for measuring Payments volumes: (1) Transaction count and (2) Transaction amount. The following chart shows the growth in these metrics in the US in the last 2 decades:
Some key insights from the above charts are as follows:
Count and value of check transactions have decreased in the last 2 decades
Debit cards and credit cards are the 2 most popular payment systems on the basis of count. This is expected as these are popular consumer payment options and are used multiple times by millions of people each day
ACH is the dominant payment system when it comes to the payment amount or value. This is because most of the biggest value transfers (e.g. a company paying its annual tax bill or paying employees’ salaries…which can run into millions of dollars) typically happen in the form of an ACH transfer (or a check). Note that credit card and debit card contribute a very small portion of payment volume by amount
Credit cards, Debit cards, ACH and checks are payment systems. There are 2 other common payment systems that are missing in the above charts: (1) cash and (2) wire payments.
The anonymous nature of cash makes it difficult to track the count of cash transactions. However, it is estimated that cash is about as prominent as debit cards in usage.
Wires represent a very small portion of payment transactions by count but is the largest portion by value. In 2018, FedWire (one of the largest wire service) had ~167M wire transactions in 2018. For context, there were ~50B credit card transactions in 2018 i.e. 300X the wire transactions. However, these wire transactions represent a total transaction amount/value of $695 Trillion (compared to $5 Trillion in credit card transaction value). Wire transfers represent such a large portion of the payments amount because of the high-value financial market transactions that use wire transfers (the average transaction value of a wire transfer is $4.1M). Wire transfers are rarely used by consumers and, therefore, are not included in the above charts.
The totals shown are large—much larger than the U.S. Gross National Product. This is because a single commercial transaction (such as a consumer purchase) can result in multiple payments, as the various parties in the value chain move funds to effect payment, settlement, etc. For e.g. company A initiates an ACH credit transaction for $5000 into the account of its employee B (for monthly payroll). This will count as one transaction. The employee can then use this amount to purchase various products (via debit card, credit card) or via ACH debit (to pay the apartment rent). Therefore, the initial $5000 transfer will be counted as various payment transactions/ values.
To read the 2nd part in the series, click here: Payments 101: Part 2 – Is Cash still the king?