PayTech: the fundamentals of digital wallets
Assessing three segments: 1) Pure digital wallets and the case of PayPal, 2) Digital payment ecosystems and the case of AliPay, and 3) Social payment platforms and the cases of Venmo and WeChat
Fintech, in its broad definition, is the technological innovation that improves how money and capital are transferred, raised, and invested.
While the word ‘Fintech’ might be new, the relationship between technology and finance is not. The financial services sector has always been at the forefront of technological innovation and has been constantly disrupted by new and commercial technologies. For example, when people had to barter with physical goods with one another, the development and money in the form of gold nuggets and coins as a common medium of exchange, was a technical innovation. Or when checks commercialized the trend for cashless transactions three centuries ago in the age of paper money. And over the last century, we’ve delivered ATMs, online and mobile banking, algorithmic trading, wire transfers, etc. accelerating the speed of technological innovation in Finance.
The only difference with the recent Fintech boom is that in the past decade, tech companies have taken charge of innovation that was traditionally introduced by financial institutions, banks, hedge funds, and investment managers. This is the first time that we’re seeing players such as Google, Amazon, Samsung, and Facebook offer finance functions such as payments, lending, and investment. This is because of:
- The big data boom and the tech companies unparalleled access to customer data
- Tech companies are not subject to strict regulations similar to financial institutions and in combination with their agile product management expertise, are significantly more aggressive in taking on risks in developing new products, new technology, and opening new markets
This Fintech trend has left traditional financial institutions in danger of getting technologically leapfrogged on many fronts by tech companies that have never done finance before.
The unbundling of the traditional bank
A traditional bank would hold deposit accounts such as checking or savings accounts, provide payments and transfer services to move money between accounts, offer lending services such as personal and business loans and credit cards, have an investment banking division that helps businesses raise money from debt and equity markets, deliver investment advisory services, operate a trading department to provide brokerage and settlement services for traders, and run a private banking and wealth management services department for high net worth individuals.
Today, a traditional financial institution such as the full-service bank is threatened on all of its core services, as its value proposition has been unbundled by varying tech companies. For example, by branchless, data-driven neo-banks that provide deposit accounts at cheaper rates, by new payments service providers ranging from digital wallets such as PayPal and Venmo to decentralize technologies such as Bitcoin and other cryptocurrencies, by the personal lending marketplaces and peer-to-peer online lending platforms such as LendingClub and Prosper, and the business lending marketplaces through players such as Kabbage, Amazon, and Clearco, by crowdfunding and the crypto-based initial coin offerings and exchange offerings that target traditional equity fundraising such as IPO, by robo-advisors on the investment front that use artificial intelligence and machine learning to deliver customized investment advice at a low-cost, forcing pressure on traditional human advisors, low-cost online trading platforms such as Robinhood that are threatening retail brokerages, and by new consumer analytics companies such as Credit Karma and Mint that leverage big data to compete with financial institutions on cost, personalized budgeting, and credit planning to deliver personalized advice removing the exclusively of this services to the rich.
Fundamentals of PayTech
While paying with cash is still an option, some of the traditional payment methods in full-service banks at our disposal include:
- Writing or receiving a check
- Making online bill payments
- Receiving an electronic paycheck or money transfer
- Using a credit or debit card
Fintech in the payments space, or PayTech, doesn’t reinvent these wheels but rather builds upon existing payment infrastructure. PayTech’s goal is not to replace these methods altogether, but to evolve “Legacy systems” by building new layers on top of them to make these systems:
- Easier to use (i.e. enhance the customer experience)
- Faster and more efficient (i.e. technical improvements across the operations and value chain)
- Cheaper for both payers and receivers
Furthermore, innovations in the PayTech space comes in two categories:
- The centralized model. Which includes digital wallets such as PayPal, PayTM, AliPay, or Apple Pay, which use established technologies and usually involve taking on some forms of a financial intermediary role, such as customer authentication or providing an easier user interface than incumbents. In addition, there are other centralized innovations where newly integrated systems developed from scratch are born such as the case of m-Pesa in Africa.
- The decentralized model. This is a radical innovation, at times termed the ‘Radical Market’, and involves cryptocurrencies and new marketplaces that rely on blockchain technology. In this innovation, the network, consisting of all the participants, takes on the role of the intermediating party.
An overview of legacy payment systems
The ‘Checking’ system
The process through which money gets transferred using a check showcases the limitations of legacy payment systems and serves as the backbone upon which many new payment innovations are built.
The checking system has five important stakeholders:
- The sender
- The receiver
- The sender’s respective bank
- The receivers’ respective bank
- The central routing system (eg. the Central bank or Federal Reserve)
When using a check:
- The sender writes a check to someone, the receiver, and to do so, they need to have a checking account with a bank
- After the check is sent and the receiver gets it, they’re going to either deposit it at their bank or cash it. Either way, the check ends up in possession of a bank on the receiving end
- The receiving bank scans the check and identifies the sender using identification numbers on the check which will include the routing number that identifies the sender’s bank, and the account number that the sender has with the issuing bank
- Based on these numbers or identification methods, the check gets routed back to the sender’s bank through a centralized check routing system operated usually by the central bank. In the case of the United States, the systems are operated by the Federal Reserve with its 12 branches located across the country
- When the sender’s credentials are verified, the settlement process begins where money changes hands. For this, the sender’s bank receives the information, performs verification tasks to make sure that the sender does have an account with enough funds to cover the amount of the check, and once verified, will send the money to the receiver’s bank, routed through the Central Banking system. Settlement finalizes once the money is in the receiver’s bank account and that’s when the check is labeled as cleared
As shown above, in traditional legacy settings, this could take up to two weeks because the paper checks have to be physically moved through the system with many intermediaries having a say in the process.
Relative to cash exchange, the checking system has a key advantage which is the crucial innovation to the mass adoption of checks:
The flow of information is asynchronous with the flow of money
In other words, by getting a check, the receiver gets information that they’ll get paid before they’re paid at a settlement point sometime later. This time separation is a critical development in a financial system because it builds upon public trust in the system. It allows a seller to deliver goods of value once they get the information and trust that money will come later. This enables transactions to happen faster in higher volumes. Building trust in a system is not easy and that’s where the financial intermediaries such as central banks and issuing banks come into the picture, as they enable the flow of information and capital. This is why central banks and regulatory bodies spend resources combating fraud by placing layers of safeguards such as monitoring fund transfers, customer identification, advanced encryption, reversibility of payments, pre-authorization of funds, electronic routing, etc.
Financial intermediaries are a critical part of a well-functioning financial system because most transactions in the economy rely on dealing with untrusted parties that we’ve never met before, offline, or online. In other words, these institutions and intermediaries provide safeguards that alleviate the problems introduced by information asymmetry in trade and the flow of money.
And in return, these financial institutions, expected to be compensated for creating this trust and breaking down information asymmetry. And the more trust is needed, the higher these costs are going to be.
And this is where PayTech enters. Tech companies are trying to disintermediate this legacy system by taking on some of the intermediation roles that financial incumbents provide, such as authentication, secure transfer, identity management, which they believe they can do better with more advanced technology, aiming to capture a piece of the pie of the transaction fees that the legacy system has traditionally demanded.
The ‘Automatic Clearing House’ (ACH)
The Automated Clearing House — ACH –is currently the dominant form of high-value non-time-critical payments in the US and most countries across the world. It’s a secure electronic messaging system and allows transactions to be initiated by either the sender or the receiver and is used commonly in making direct deposits, paying utility bills online, and when using a payment app such as PayPal or Venmo. Therefore, despite ACH being a “legacy system”, it is the bedrock upon which a lot of PayTech innovations are built.
The ACH network is usually operated by central banks and in the US by both the Federal Reserve and a private company called the Clearing House. The ACH network is very similar to a messaging app that ensures secure payment-related messages are communicated between banks. To perform an ACH transaction:
- The sender will fill a form on their bank’s website or mobile app with basic information, such as the payment amount, the receiver’s bank information, routing, and account numbers. This information is gathered into a payment request and transmitted to the bank’s server. This request can go both ways — for example, if you are paying a bill online, you’re sending your bank information to the receiver and authorizing them to generate the payment request on your behalf, and they transmit the request to your bank. In either way, the request ends up in the ODFI server (i.e. the sender’s bank)
- After the OFDI receives the request, the sender will conduct standard intermediation tasks, such as authenticating the account, making sure the request is authorized, and that there’s enough money to make the transfer
- Then, the bank will use the payment request information to generate a standard text message file — a standardized ACH file consisting of all the relevant identifiers — that is transmitted to the ACH network and the RDFI
- The RDFI will identify the receiving account and notify the receiver that they have money incoming. This completes the information flow of this transaction
This process is fairly quick but not instantaneous, and because everything is done electronically, there are no paper checks to be routed and therefore the settlement and the money flow occur much quicker, either on the same day or within a couple of days.
The primary advantages of the ACH system compared to the checking system are:
- Reduces the time lag between the information flow and the money flow because, in the paper checking system, the information flow is limited by the physical speed that the checks can move while in the ACH network, the information flows digitally.
- The average cost per transaction is ~$0.0001 in the US and this low cost is because communication isn’t done in real-time but in batches freeing up demand on the communications infrastructure allowing it to scale.
Despite these advantages, the ACH system has several drawbacks:
- Despite the good backend infrastructure, the main drawback of the ACH is that it’s not very easy to use. For example, when was the last time you remembered somebody’s bank routing and account numbers?
- Furthermore, this information takes a long time to retrieve and each bank and receiving merchant tends to have varied, non-intuitive, and user-unfriendly interfaces. All of this add-on to the learning curve of the end-user thereby discouraging them from using it frequently and adapting the system.
And this is where most PayTech innovators come into the picture. They take the available infrastructure and build their user-friendly interfaces on top of it so users would tap into the ACH more often without realizing they’re using it. Hence, the main value proposition of PayTech innovators is that rather than building an alternative communications infrastructure and converting people to it to create scale, they design apps and good user interfaces.
In essence, the connection between PayTech and existing tech is that a lot of the PayTech innovation involves building good wrappers around existing solutions that make them easier to use, such as using mobile numbers or email addresses rather than traditional identifiers, or replacing bank-level authentication methods, such as micro-deposits, with biometric authentication through placing fingertips on smartphones, or auto-filling forms using the mentioned identifiers and authentication methods. These wrappers are called digital wallets.
The pure digital wallet: Paypal
PayPal is one of the earliest modern fintech companies in the payment space that popularized the idea of a digital wallet, which has consequently been further refined by other fintech companies ever since its arrival.
Digital wallets such as PayPal connect to our bank accounts as the main source of money and just as we put cash into our physical wallets, we can transfer actual capital into a virtual balance in the digital wallet. Then we can send this balance instantly to other people who also use the wallet with more user-friendly identifiers such as mobile numbers or email addresses. Actual money will follow later on through conventional banking payment systems provided by the local banking system such as the ACH.
In the case of PayPal, both the sender and receiver accounts will be linked to their respective phone numbers. PayPal will have one or a number of its own bank accounts and PayPal’s bank (i.e. the third intermediary bank) will serve as the central conduit of money flow in the system.
In this ecosystem, most pure digital wallets such as PayPal are not banks and don’t want the increased regulation with the banking charter and therefore, to legally deposit and hold money they need to partner with the bank and set up a main bank account within the regulated system.
To deposit money into the wallet, the app first authenticates the sender’s request for example, biometrically, and then initiates an ACH transaction that pulls cash from the sender’s bank account into the wallet’s bank account. Although this is the app’s account, it can not touch this money and use it for other purposes and simply hosts that money as a custodian on behalf of the sender. This amount will be linked to the sender’s PayPal account, showing up as a virtual balance in the wallet. Here, information and capital flow are decoupled from the traditional payment rail, ACH in this case.
Now, if the sender wants to send money to another PayPal user, they put in the receiver’s identifiers, and the virtual balance can be transferred instantly while on the back-end, PayPal does not have to move the money. And transactions scale. If anyone decides to withdraw, converting virtual money into real ones, the process occurs via standard transaction infrastructure such as ACH, from PayPal’s bank account to the receivers. The settlement process and speed will depend on the ACH.
In summary, the key distinguishing features of digital wallets include:
- Money flows on the original payment rails as usual (e.g. ACH)\
- Banks do what they’re good at, moving money from one account to another efficiently and securely
- Information flow is decoupled from the traditional system and it’s predominately initiated within the digital wallet applications.
- As long as it’s within the wallet's ecosystem, virtual balances can be moved around instantly and freely and used just as money.
These features enable digital wallets and tech innovators to facilitate economic transactions without becoming a bank and focus on tasks such as information processing and user authentication through incremental technologies rather than building new payment infrastructures and ecosystems.
The business model
In the case of Paypal, on the revenue side:
- It has a tiered pricing model which is free to use unless users decide to withdraw to settle fairly quickly by not using ACH, or users want to fund their balance using credit cards, or the user is a merchant who’s getting paid.
PayPal net revenue 2020 | Statista
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This model has the advantage of attracting and retaining price-sensitive customers and maintaining margins by charging merchants a slightly higher rate especially as the number of users or demand-side network effects scales. And as long as PayPal maintains a fair share of merchants in its ecosystem, it can sustain this revenue model.
PayPal Revenue and Usage Statistics (2021)
In the late 90s, paying for things online still had a stigma attached to it. There wasn't any assurance that goods…
On the cost side:
- Not being a bank and not having to develop a new payment infrastructure reduces costs as the development costs are on the software rather than the hardware side, which reduces fixed and ongoing costs as the maintenance of the bank accounts and bank-related compliances become the responsibility of the bank partner. In the cases of PayPal, its main costs are incurred in software maintenance and R&D. In PayPal’s business model, the marginal cost of processing one more transaction or having one more user, is minimal and the system is easily scalable.
Therefore considering the relatively stable revenues and the low fixed and marginal costs, digital wallets can have much higher profit margins compared to traditional financial institutions in offering payment services.
PayPal Holdings, Inc. - PayPal's 2021 Investor Day
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Digital payment ecosystems: the case of AliPay
Limitations of pure digital wallets
Barriers to entry for pure digital wallets are low. Partnerships between competent software development teams and a good bank partner can lead to a digital wallet that can handle payments easily. And consequently, competition can be fierce in the space, depending on the regulatory environment, particularly in the emerging markets. Therefore, (product) differentiation will be key to success.
Furthermore, the revenue models of pure digital wallets such as PayPal, do not create many incentives for people to keep their money in the ecosystem, as it’s not earning any interest. So users will only keep the minimum balance.
And lastly, most of the digital wallets are targeted toward online e-commerce users, such as eBay purchases and their offline penetration is minimal. For example, it will be difficult to go to a grocery store try to pay with PayPal rather than with a credit card or cash, especially in developing and emerging markets. Therefore, to grow business and compete with incumbent alternatives such as credit or debit cards, pure digital wallets need ways to tap into offline transactions.
AliPay: interest on deposits
AliPay initially launched as the PayPal equivalent in China, as a subsidiary of Alibaba, and just like PayPal, was a pure digital wallet targeting e-commerce and online purchases/transactions. But very soon it realized that people didn’t have the incentive to keep money in the wallet as they found better use in external markets that at the minimum paid them the free interest rate.
To overcome this problem, AliPay partnered with a money market fund rather than a custodian bank that provided higher interest rates than savings accounts. And in response, unless outside investment options had significantly higher returns, users became more incentivized to keep the money within the AliPay ecosystem.
As AliPay succeeded in growing its deposits, Ant Financial was born, a subsidiary that connects the AliPay ecosystem with more investment options, such as peer-to-peer lending, stock brokerage, and insurance products. And in a matter of years, AliPay’s simple digital wallet had become a full-service ecosystem centered around the wallet.
While this strategy provides higher returns, it also bears more risks. For example, compared to PayPal where the bank account is insured and quite risk-free, all the investment options provided by Ant are risky and the practice of taking deposits and channeling them into risky investments makes AliPay a FinTech shadow bank which will require regulatory approval.
AliPay: QR codes to penetrate offline transactions
The problem in China was that the majority of the population had never participated in online transactions before, let alone use online banking. Alipay used the QR code as a solution –simple in design and powerful in effect. With a large majority of the population owning smartphones, AliPay targeted street vendors who couldn’t afford card terminals, expanding their presence into offline and face-to-face segments that carried a large portion of China’s daily transactions.
The interesting point here is that Alipay wasn’t the first company to deploy QR codes in payments, and other firms, such as Starbucks, had already implemented it in their ecosystems. But the uniqueness of AliPay’s approach was the primary focus of deployment on the merchant sides of the marketplace and having codes physically available that cuts down the need for hardware, and everything else including payment notifications, accounting, viewing, etc. is performed on the app’s UI.
Because of its low cost and convenience, QR-code-based payments are ubiquitous all over China to the point where cash is often not accepted anymore. This operational innovation has been used in other developing and emerging markets including AliPay and WeChatPay in China, PayTM in India, Foloosi in the UAE, Phonepay, and AsanPardakht in Iran.
Social payment platforms: Venmo & WeChat
Due to strong demand-side network effects and viral aspects of word of mouth, social networks represent a unique opportunity to growing a PayTech ecosystem. In essence, if most of your friends are using a particular payment platform to make payments and transfers, then you will also be more inclined to use it as well.
Venmo: putting social into finance
Venmo, which is now part of PayPal, adds a layer of social meaning to ordinary transactions. While its revenue model is almost identical to PayPal’s, its key innovation is that it has combined the social and financial elements of a single financial transaction into its platform. Venmo started with the millennials and their problem of splitting a bar tab and turned it into a social network status update where users could broadcast their financial transactions to all their friends and maybe adding some emojis or selfies. This feature took the awkwardness out of the problematic and awkward social transaction and added a financial overlay to a user’s typical social media posts.
Venmo does not directly monetize its social features, but mines its users' social and financial data and grasps a much more granular perspective on a user’s financial profile, which opens the door for a series of customized financial products based, particularly in short-term lending and insurance.
WeChat: putting finance into social
WeChat is a Chinese social networking platform that combines Facebook and WhatsApp. To monetize its network’s interactions, WeChat built an internal payment ecosystem with users’ network handles serving as identifiers and money flowing via traditional banking infrastructures (e.g. ACH).
WeChat’s key innovation was to focus on the social aspects of its network and started with its so-called “Lucky Money” campaign wherein many Asian countries during important holidays such as the Lunar New Year, people hand out gifts of small amounts of money wrapped in red envelopes to one another. It’s customary for one to both receive and gives out these red envelopes. In action, when one receives an envelope, they take the money out, put it in their envelope, and give it to somebody else. In essence, a lot of small money changes hands without entering or leaving the “Red Envelope” system, very similar to a PayPal ecosystem, making it ideal for the virtual balance-based digital wallet.
Therefore, WeChat seized this opportunity and launched its Red Envelope feature during the Lunar New Year of 2014, and its users sent and received virtual balances to one another without transferring much to or from the bank. This feature went viral overnight and gained a large number of users at least temporarily. To retain users within the ecosystem WeChat opened up a marketplace similar to the Facebook marketplace that allowed users to conduct Venmo-like transactions with friends and make online purchases with members of their social network, all powered through its WeChat wallet. This led to a large number of WeChat-based merchants who otherwise wouldn’t be able to build an online capability.
Digital wallets have been around for some time, and we might see new ones in the coming years, but their essence will not change much. They use current banking infrastructure, build amazing UI and CX on top of the current payment infrastructure, and innovate with new features to entice users to make transactions within their local payment ecosystems.