Unbundling Credit Cards: Real-Time Settlement and Marketplace Lending

What is a credit card? This post will explore how a credit card is actually a bundle of products. Credit cards bundle together a real-time payment method, an offer of credit, as well as a variety of cardholder benefits like travel insurance or fraud protection. Why was this bundle created in the first place? Does it still make sense to keep these products bundled together?

Credit Cards in the Americas

Take a look at this chart from a 2016 McKinsey report (that is meant to sell their consulting services):

Note the relative importance of credit cards in the Americas (the green and sunflower-colored blocks). In Asia and Europe, debit account transactions are much more prominent. Why is that?

Credit Cards as a (Real-Time) Payments Innovation

There is a plethora of reasons for the popularity of credit cards in the US, and it is a complicated issue on many fronts (regulatory, cultural, historical context) but the hypothesis I want to focus on is that America lacks a real-time payment system. Take a look at this chart from a November 2016 report from the BIS:

Credit cards (my education on the history of credit cards is due in large part to Joe Nocera’s book) cobble together “real-time payments” by combining payment with credit. Before credit cards, there were no real-time payment options available other than bearer instruments like cash. In any payment system that does not settle (money is moved between transactors) in real-time, there is counter-party risk created in the transaction. Credit cards solve the real-time payments problem by attaching to it a credit product that can handle the counter-party risk in an acceptable manner for merchants and consumers. Peet’s lets me walk out with a latte in hand and nothing other than an IOU, because the counter-party risk is transformed — Peet’s accepts the counter-party risk of their acquiring bank, not me. I don’t owe Peet’s, I owe my credit card issuing bank. The banks settle between themselves. In this coffee-shop example, credit has created money in this four-party credit card transaction.

Unbundled Payments: Debit Card and Real-Time Payments

The increasing availability of real-time payments (consumers and merchants are able to settle transactions in real-time across the banking system) may result in the unbundling of payments and the offer of credit. Debit cards are not strictly speaking real-time, because they do not settle instantly, or even same-day. However they do clear in real-time, and so the coffee-shop transaction is facilitated. They are growing in popularity, but mostly replacing checks, not credit cards, as this table from The 2013 Federal Reserve Payments Study shows below. Notably debit card, prepaid card, and ACH have grown quicker than credit card.

Real-time payments are also under development by payments industry leaders. The Clearing House is a company whose shareholders include the largest global banks. According to their website, “[it] is the only private-sector ACH Operator in the country, processing approximately 50% of all commercial ACH volume in the U.S.” They are actively pursuing a real-time payments system that will operate similar to ACH, and is supposed to be available in 2017–18.

And blockchain.

Unbundled Credit: Marketplace Lenders

Marketplace lenders such as Lending Club, Sofi, and Prosper have been addressing the debt-consolidation market in a meaningful way, and are displacing the most desirable credit card balances from credit card issuers. This is threatening the bundled business model. As marketplace lenders become more sophisticated and are able to integrate more tightly with payments providers and provide point-of-sale as well as line-of-credit solutions, they will be able to undercut credit card companies because they do not need to subsidize the programs that credit card companies offer.

Toward the Unbundled Future

The threads are starting to fray. As a result of a class-action suit settlement in 2013, the card networks had to nullify their rules against merchants surcharging. The Durbin Amendment only applies to debit cards, but tempers the bundling of products with payments by capping the interchange fee.

Durbin / debit cards notwithstanding, a consumer’s access to the non-cash payment system is reliant on her credit-worthiness, and those who are not credit-worthy or who choose to use credit-free payment products on the card networks (debit cards) must pay more for access to it. (Many Americans still lack access to financial services! Perhaps they can afford and be profitably addressed by unbundled products, like with prepaid cards? I digress.) This implies that the payment service aspect of credit cards is subsidized by the credit aspect of credit cards, in the form of higher interchange fees as well as interest income. Not only does it cost money to use a debit card, credit card issuers offer excellent benefits to their users in the form of rewards.

This obfuscates pricing to the consumer, and drives inefficiency from price misinformation. Merchants account for credit card fees by increasing their prices. Let’s take credit card rewards to an extreme level. Suppose credit cards were able to offer 50% rewards on travel. They are able to do this by charging travel-related merchants an interchange fee of 55%. How does that distort consumer behavior?

By unbundling credit from payments, there can be more transparency in pricing, and consumers will be able to make better consumption and financial decisions.

Has the US payments landscape been slow to transition to real-time because banks recognize that it may cannibalize and reduce the profitability of their credit card businesses?