How Silicon Valley is accelerating the disruption of Payments

Karthik Kalyanaraman
Jan 28 · 10 min read

It is mind boggling to see how fast the asian market has innovated and progressed in the payments space. The experience of paying a merchant in countries like China and India is far more superior than the west. Consumers pay by simply flashing their smart phones on printed QR Codes. Money instantly gets transferred from the consumer’s digital wallet to the merchant’s wallet(WeChat Pay, AliPay, PayTM). The system is simple, agile and devoid of any middle players besides the financial institutions and the payment technology company.


In the west though, payments are largely driven by credit cards. Merchants lose a considerable portion of their revenue in the form of inter-change fees, card network fees and payment gateway fees.

But, why is it that it has been hard to achieve adoption of digital wallets(or escrow) in the west?

History gives us some insights into this question. In the asian markets, digital wallets replaced cash, which was inherently difficult to manage for both consumers and merchants and the upside of using a digital wallet is far more superior. This naturally drove adoption and the network-effects followed on.

In the west, we are competing with credit cards. This is a completely different problem space. Credit cards already solve the inherent problems with cash and a new system trying to replace credit cards will need much more than what a digital wallet provides.

In order to understand how the western companies like Square, PayPal, Stripe etc. are approaching this problem, let’s try to understand what credit cards actually solve.

A credit card uncouples the ability to purchase from needing to have cash on hand and also it eliminates the requirement of even owning that cash at all — at least for the short term.

This is the fundamental achievement of credit cards. And what about the user experience? It is just about pulling it out of the dead-cow wallet and tapping it on a NFC enabled terminal at your favorite supermarket. For an average consumer, this is too good of an experience to replace.

Let’s look at this from the merchant’s perspective. In general, there are 4 components to a payment system — Payment gateway, Acquiring bank, Card network, Issuing bank.

Payment gateway — This is the entry point for a transaction. Traditionally, we had credit card machines that were huge and bulky. The way they make money is by taking a small %(~2.65%) of the transaction. The basic function of the gateway is to securely transmit the card information to the network. PayPal disrupted this space by introducing a gateway for the web. Later Square released the revolutionary Point of Sale(POS) reader that transformed your cell phone into a payment gateway. This led to a healthy competition in this space with PayPal introducing their own version of the reader and few other players like Clover, Shopify etc. coming up their respective versions of the same product.

Acquiring bank — This is the merchant’s bank and generally the place where the money gets deposited after a transaction. The acquiring bank also takes a small % (~19cents per $100) of the transaction as an acquiring fee.

Card network — VISA and MasterCard are the major card networks. Card networks are the rails of the card payment system. The function of card network is to receive the securely transmitted information from the gateway, talk to the credit card bank account and check if the customer has enough credit available, talk to the acquiring bank to validate the merchant’s account information and ultimately deny or approve the transaction. Again, the card networks make money take a small % (~13cents per $100) as network fee.

Issuing bank — This is the customer’s bank that issued the credit card. In a typical transaction, issuing bank takes the maximum cut in the form of interchange fee(~$2.20 per $100). So, in a typical $100 transaction, the merchant loses close to $3 in transaction fees and the $3 is spread across 3–4 middle players.

When we look at a typical transaction in China or India, the money moves from the user’s bank account directly into a digital wallet. In a typical retail transaction, the money moves from the customer’s digital wallet to the merchant’s digital wallet and stays in the merchant’s digital wallet without going back to the merchant’s bank account. This is because both the customer and the merchant is heavily incentivized for keeping the money in their digital wallets in the form of offers, deals and discounts at their favorite coffee shops, restaurants and malls. In effect, the digital wallets accumulates a lot of free cash which the company can use for investing in banks at a higher deposit interest.

In order to understand what this means, let’s understand why the deposit interest for a savings account in regular banks is too low and loans have high rate of interest. A typical brick and mortar bank generally make money through Interest rate spread. Interest rate spread is the difference of lending interest earned and deposit interest provided. When a customer deposits $100, she earns $0.10(for a rate of 0.1%) in interest and when she lends $100, she loses $10 in interest(for a rate of 10%). The bank effectively makes $9.90(10–0.10). This is the net interest rate spread earned by the bank.

But, when a big company decides to deposit huge sums of money in a bank, they generally have a negotiating power and end up getting better than 0.1% as deposit interest. This shrinks the interest rate spread for the brick and mortar bank. But, this creates a sustainable revenue stream for the wallet company from investing the free money stored on digital wallets of all of its customers.

What more? This also opens up revenue channels in the form of lending services for instance. Since the main user experience of a digital wallet is through an app, these companies are able to provide loans to their customers and merchants at much better rates than regular banks. This is because software is not a tangible asset and the cost of scaling the services is much lower than that of brick and mortar banks. In other words, the digital wallet company is aggregating the demand for deposit accounts by providing value added services by partnering with the retail merchants. This in effect diversifies the business model making them far more valuable than their counter parts in the west.

Coming back to the west, the rails of a payment network is the card network(VISA/MasterCard). Although it may not sound too difficult for a software company to lay new rails in the system, the network effects needed to achieve widespread adoption is extremely difficult. This is because it involves replacing the VISA/MasterCard powered credit and debit cards from the hands of customers and rewiring the software infrastructure of the payment gateways and the banks. This is only possible if a big cash cow like Apple or Amazon decides to build a new system and is okay to stay profitless for a long period of time. And this also explains why Apple decided to play on top of the existing card networks with its Apple Pay service rather than competing with them head on. This explains why it is hard to disrupt VISA and MasterCard.

But, how this will eventually change?

Only very recently the U.S. introduced tap-to-pay credit and debit cards. This means all the merchants are forced to replace their POS systems with NFC enabled ones. And naturally, Square, PayPal and others introduced NFC enabled versions of their POS systems. But, the biggest winners with this change in my opinion are Apple and Google. Because, Apple Pay and Google Pay work natively with NFC enabled terminals, this opens up faster adoption of these systems and whoever builds more value on top of their apps can accelerate usage. And effectively this has the potential to transform cell phones into the main gateway for payments. But, the merchant side experience is still owned by companies like Square and PayPal.

It will be interesting to see how these companies on each side of user experience will compete against each other in order to own the entire experience. And, I strongly believe the end users(customers and merchants) will be the clear winners in this battle.

Square recently introduced Square Cash Card by partnering with MasterCard. PayPal already has a similar card. The strategy behind this move is clearly aimed at owning the customer experience. More importantly, this aims at making the transacted money stay in the respective digital wallet(Square Cash account and PayPal account) effectively trying to emulate the strategy of asian payment companies.

By providing a card powered by MasterCard, Square has opened up a new way for its merchants and customers to use the balance in their Square accounts instantly without transferring the money back in to their bank accounts and losing roughly 1% in instant deposit fee, which was in fact Square’s original value proposition. In effect, Square is disrupting itself.

This is a great strategy because when customers use the cash card at Square powered merchant terminals, the payment gateway(Square POS), the acquiring bank and the issuing bank is Square. This in effect shaves the transaction/interchange fee away from regular banks and puts money back into Square’s pocket. There is no card network fee involved here because the transaction happens inside Square’s real estate and network. A merchant paying $3 for every $100 as a transaction network fee will be happy to pay $2 instead and Square takes all of it creating a win-win situation. This creates a sustainable loop for Square without changing end user’s behavior.

On top of this, Square has also added a lot more value to its merchants by providing services like Payroll, lending etc. in an effort to keep merchants and employees of the merchants in to Square’s eco-system thereby improving stickiness for its services.

But, who is going to own both the customer and merchant experience eventually?

I feel Apple and Google Pay have a lot to do in order to ride the wave of contactless payments. To start with, they have to build value added services for their customers to accelerate adoption. One of the things that can be a game changer is, building a money management service for the users based on their usage.

Again I feel, Square and PayPal are sitting at a much better position to build this than Apple or Google. This is because, when a customer buys a “matcha latte” at a coffee shop using Square POS and makes the payment using their Square cash card, everything happens inside Square’s real estate. This means, Square can easily surface the information in the form of analytics for both the customer and the merchant. The customer can see that she has “spent $12 on matcha latte this month” on her Square app and the merchant can see that “matcha latte has sold 45 times more than the previous month”. For Apple or Google, this involves more than software magic to surface such granular information to the customers.

Ultimately the banks are at a much bigger risk of losing their margins earned from interchange fees, overdrafts fees, acquiring fees and interest rate spread to the technology companies.

But are credit cards really getting disrupted and replaced?

Coming back to our definition of credit card which is uncoupling the ability to purchase from needing to have cash on hand and also eliminating the requirement of even owning that cash at all.

Sure, Square or PayPal’s MasterCard solves the need to have cash on hand. But, what about providing credit? I feel building lending services for merchants is a good first step in this direction as providing credit is nothing but lending money. But, the whole list of value added services like gas station cash backs, travel benefits, rental car insurance etc. provided by regular credit cards is a lot to cover and manage. But, the real question here is,

Will credit cards be relevant in the age of on-demand services?

We are slowly moving away from the age of ownership to an age of on-demand services. For instance, Uber, Lyft and self-driving taxi services like Waymo are making owning a car irrelevant. Subscribing to Netflix, Hulu etc. have made owning discs irrelevant. Spotify and Apple Music have made owning music content irrelevant. This is effectively transforming discrete irregular high value payments into continuous low value periodic payments. Only, time can tell whether credit cards will really be relevant when the payments becomes periodic and low value.

What about VISA and MasterCard?

Ultimately, when the customer and merchant experience is completely owned by technology companies, the rails is bound to get replaced. The card networks will be no more than dumb pipes and will become irrelevant unless they continue to innovate and build value on their moat.

I hope you enjoyed reading my thoughts. If you did, hit the applause button below, it would help others to see the story.

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Karthik Kalyanaraman

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Software Engineer | Curious about technology and the economics of the tech industry |

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