What is a payment, anyway?

Stripped to its fundamentals: a payment is a message, with new information, about a debt, with a certain confidence level associated with it.

This is not how most of the world thinks about payments. You probably think that when you pay for a coffee with a credit card you’re “moving money” to the cafe. But that isn’t what physically happens; generally speaking, nothing moves as a result of the transaction and, most especially, nothing moves while the coffee is still warm. So why is the cafe happy to give you coffee after you’ve flashed your plastic?

You could have made a payment by saying “I’m good for $4; please give me coffee”, and in some cases (such as stores you have a tab with) that suffices. But the reason it works at scale is that the trust problem has been solved by so-called payment rails, which are a constellation of firms that have implemented a protocol to quickly make a series of offsetting promises about debts such that the cafe quickly becomes almost positive it is owed money for the coffee and that that debt will be collected with a very high certainty.

In credit cards, a brief and intentionally simplified version of the actions of the payment rail is: you agree with your bank that you owe them $4, your bank agrees with a credit card network that it owes a particular processor almost $4 (taking a fee), and the credit card processor agrees with the cafe that it owes them a bit less than $4 (taking another fee).

In the settlement phase of the transaction, the credit card processor makes an agreement with its bank that it owes the processor a bit less than $4, which it discharges by having their bank agree that it owes the cafe’s bank a bit less than $4, which the cafe’s bank discharges by agreeing they owe the cafe a bit less than $4. And so your debt for coffee is now two offsetting debts; between you and your credit card issuer, and between the cafe’s bank and the cafe. You will, at some point in the future, probably up with your credit card issuer, and the cafe will probably withdrawal money from the bank (perhaps to e.g. buy beans or pay the barista), but from your mutual perspective the transaction for the coffee will be long over by then.

Critically, settlement happens later (painfully later, measured in Internet speeds; a few days by more traditional calendars).

Many people think that this is painfully complicated and would be much simpler if you could just pay money from your bank account to the cafe’s bank account directly. Why don’t we do that, and what would it take such that we could do that?

Core features of payment methods

When we covered payments in Japan, many readers were surprised that a convenience store needed to interoperate with 40 payment methods. Worldwide, there are more than a hundred major ones, and a long tail with literally thousands of entries. These all compete with each other for customers, for businesses willing to accept them, and for individual transactions.

There are something like fifty axes you could categorize payment methods by, but to make it simpler for this essay, lets compress them to five: total cost, customer user experience (UX), certainty, settlement time, and reversibility. These five features are why bank account to bank account payments are not yet routine for most transactions, and improvements to them are why that is going to change over the next few years. (And, indeed, why they’re already seeing explosive growth in some markets).

Cost: As we’ve covered previously, the payments industry makes most of its revenue by taking a small fee from every transaction. The exact size of that fee and how it is priced varies wildly between payment rails. Businesses would broadly prefer to spend less money on payments costs, but that isn’t their only preference.

Customer UX: Different ways to transact look very different from the customer’s perspective, both in terms of the benefits they are offered by a payments scheme (rewards, warranties, protections against fraud, etc) and the actual mechanics of communicating with the business they are paying about their payment method.

The credit card networks made this so easy in real life that we underappreciate how much intellectual effort underpins it: you pass a plastic token to the cafe, the cafe passes it back, and neither of you even had to consider the supply chain which resulted in a custom-made computer processor arriving in your mailbox or the public key cryptography that that chip used to prove to its issuers that it was absolutely positively in someone’s physical possession at the cafe at exactly the time it ran the transaction there.

It turns out that users’ propensity to transact is acutely sensitive to the friction associated with transacting, particularly online. Since no one has figured out how to pass a plastic token through the Internet yet, there must be some data entry step at some point, and payment methods vary in how (and where, and when) this takes place.

Certainty: If payments are a promise about a debt, and some promises are worth more than others, how should a business reason about promises made using a particular payment method? Businesses get a decision about when to provide goods and services; should they provide them immediately after (... or even before?) a payment is made? Should they wait until the payment is more likely to successfully settle?

Settlement time: There is, for many payment methods, a gap between when the payment is made and when the recipient receives funds. For credit cards, in much of the world, this is a few days, but it can be much longer. (In some markets, such as Brazil, the market standard expectation is for credit card transactions to settle in approximately a month.)

Reversibility: Some payment methods allow payments to be reversed after settlement. This is, in the main, a consumer protection measure which payment schemes use to make transacting on them more palatable with consumers. Businesses as a class benefit from that, since they’re in favor of more transactions and larger transactions, but particular businesses suffer a bit when the embedded option is exercised and a transaction is reversed after the product/service has been delivered.

Since businesses have more knowledge of their cost structures and risk than payment networks do, some businesses prefer less reversible payment methods and some prefer transaction-maximizing payment methods.

An example of how subtle this is: precious metals dealers are extremely vulnerable to fraud (because they’re in the business of literally giving people gold, which can be trivially turned back into money at another precious metal dealer). They earn relatively small margins on their transactions. Accordingly, they strongly prefer less-reversible payment methods.

Video game sellers are also extremely vulnerable to fraud, both so-called “friendly” fraud (where the customer wanted the service but didn’t want to pay for it), family fraud (child and parent disagree with respect to desirability of purchasing the video game; bank backs parent; video game seller loses out), and fraud where the buyer is using stolen credentials to obtain something which can be resold (similar to the main risk to precious metal dealers). Unlike precious metals, video games have extremely high margins, and therefore most in the games industry optimize for payment methods with high conversion rates and treat fraud as a cost-of-doing-business.

How bank transfers stack up

The payments industry, and the tech industry more broadly, is sometimes excessively informed by many of its members being physically within the United States, and the “natural” thing for me to do at this point would be to explain ACH payments and why they’re not acceptable for most transactions.

Nah, let’s do it the other way.

The most interesting bank transfers payment method in the world right now is India’s Unified Payments Interface (UPI). It is less than 5 years old, is currently experiencing meteoric month-over-month transaction growth, works almost flawlessly for online transactions, and broadly benefits from being developed in the context of the modern Internet rather than being an overlay network on paper moving around.

UPI offers extremely low cost, instant confirmation, instant settlement, virtually certain, low reversibility risk transactions. That is a truly magical combination, and explains much of the growth. The fact that, in India, it is mostly competing (even for online transactions) with physical cash settlement is another. The dominant way to pay for e-commerce transactions in India has historically been cash-on-delivery, which necessitates a complicated and leaky value chain between delivery staff, delivery networks, payment networks, and the sending business.

The customer UX of UPI is novel, and is to other bank transfers what URLs are to IP addresses. If you don’t live in India, it is highly likely that your bank-to-bank transactions involve giving your counterparty a code representing your bank, a number for your bank account, and some metadata about yourself. UPI instead has the user register a “virtual payment address” (VPA) with their bank.

It might look something like an email address, but doesn’t have to; the important part is that it can be short and memorable rather than a string of digits. The business attempting to charge a VPA communicates details of the transaction to the clearinghouse, which performs a real-time lookup of that VPA to find which bank custodies it. That bank then does a real-time authorization with the user directly, typically via a push notification or SMS message, confirming the details of the transaction.

In an IRL transaction, one could do the same (via keying in your VPA on a terminal) or, more commonly, one could use QR code payments, similar to the booming category in Japan, which execute the handshake for you. And indeed, India’s market leader Paytm is a partner in Japan’s market leader PayPay.

That's what UPI does. Here is what UPI does not do:

Payment authorization is not linked with banking information. Without the user in the loop to authorize the transaction in real time, possession of a VPA is essentially worthless. This is very not true of banking credentials in, most notably, the U.S. Knowing a bank account number in the U.S. is sufficient to try debiting it, and bank account numbers are also passed around promiscuously, such as on checks (in carefully designed block print to make these security tokens even more readable). Credit card numbers have the same problem.

This is a very important design choice. It optimizes for customer security but pessimizes for payment convenience. Most transactions (by count and by transaction amount) are repeated transactions; much of the payments industry exists to make repeated transactions less frictionful for all parties. SaaS is one salient example, but rent and mortgages are typically fixed amounts on a fixed schedule between repeated parties, most e-commerce merchants will hope the user comes back (and want to charge their credentials on file rather than forcing a re-authentication), etc etc. UPI adds substantial friction to repeat transactions compared to how bank transfers are implemented in many countries.

Access to a bank account statement is not needed to confirm payment. A key function of payments rails is allowing someone, for example a store clerk or a cronjob running at an e-commerce retailer, to verify that a transaction was (probably) paid for without needing to be able to access the company’s bank account. For understandable reasons, access to bank accounts is tightly controlled within businesses.

This is historically difficult for bank-to-bank transfers! They assume you have access to the bank account to verify receipt of them! And they mostly don’t have metadata about the transaction on them! So you need a human, with full read access of all recent transfers, to manually reconcile to see that the payment happened! This deserves even more exclamation points than it already received!

Because UPI is designed to be intermediated by computers rather than by humans, transactional information gets captured by the payments company while the transaction is in progress, and that can tell the clerk (or cron job) that the payment succeeded without them needing access to the bank account.

This is a fun engineering challenge in many countries, which are often overlaying bank transfers as a payment method on top of bank transfers as a settlement method.

One method of solving it is issuing “virtual bank accounts”, which are either single-use or limited-use numeric bank accounts (thus the acronym VBAN, for “virtual bank account number”) which are allocated to a predicted transaction shortly before it happens. If that VBAN receives a transfer in the correct amount, you can (hopefully) conclude it was from the right counterparty for the right transaction without needing to investigate it manually. You can then have a system which has access to the VBA (say, one operated by a payments provider) communicate that the transaction was authorized to the clerk (or cron job) without needing the payment provider to have access to the business’ underlying non-virtual bank account.

Bank payments in countries with less modern systems than India

There isn’t a strict hierarchy of good/better/best for bank payments. Different ecosystems have made different tradeoffs and arrived at their current position via very different historically contingent paths.

Japan

In Japan, domestic bank transfers go over the Zengin network. (Zengin is short for Zenoku Ginkou Shikin Kessai Network, and rather delightfully would literally translate to something like “All The Banks”, which is indeed their domestic footprint.) They’re commonly referred to as furikomi, in the same way that many savvy U.S. consumers would call a bank transfer an ACH transfer (even if it didn’t actually hit the ACH network).

Zengin is a clearinghouse; it operates as an interbank intermediary which both routes information about individual payments and also acts as a counterparty for settlements. A user’s bank credits them with funds instantly if received during business hours; the funds are actually received after business hours, when Zengin totals up funds flows for the day and sends instructions to the Bank of Japan for net settlement between participating financial institutions.

Furikomi are almost instant during business hours, and the plan is to gradually increase that to almost all of the time. (The “More Time System” is, because Japan, helpfully explained by a penguin fairy in an anime short if you’d like more detail.)

Furikomi are not free or near-free, and while there is government pressure to reduce costs to pass to consumers some of the benefit of computerization, they are still a major revenue driver for banking in Japan. The cost of each payment is borne by the sender, difficult to predict in advance unless one extremely enjoys banking procedure trivia, and generally in the range of $1 to $8 irrespective of payment amount.

Funny story: I bought my condo with a furikomi after being disbursed my mortgage’s amount into my bank account, and the bank solemnly informed me that they would, of course, charge an $8 fee on the transaction. It was politely suggested that I should wait in the room with the bank officer for the few minutes where the money was in my account, because while it would seem extremely unlikely that someone would rob a bank by getting a mortgage and then simply leaving with the money, it has happened a non-zero number of times.

Furikomi require the sender to know three numbers about the recipient (bank number, branch number, and account number) and result in the recipient learning two things about the sender (name and phone number, both of which are configurable at transaction time). This extremely limited information makes furikomi positively maddening to reconcile. The best way to do it is to tell the consumer to overwrite their name to include a transaction ID, but many consumers will ignore that instruction or typo their transaction ID, and as a result furikomi are generally received at Internet speeds but interpreted at salaryman speeds, as a team of overworked clerks gets a daily Excel file of bank transactions and laboriously associates them with anticipated invoices, mostly via manual labor.

Because furikomi have a user-borne cost and because they’re too slow to release services in real-time, they are mostly used for B2B payments. (Consumer use of furikomi is generally for large-ticket purchases like e.g. rental payments, cars, professional services, and similar. One would never buy a coffee with them.)

United States

In the U.S., there are multiple clearinghouses for bank transfers. The most common one in payments is the Automated Clearing House (ACH), which hints to its historical origins: ACH was an improvement on manual clearinghouses, which were originally used to process millions upon millions of paper checks in a mostly centralized fashion to avoid the necessity of each bank breaking out each other bank’s checks to courier to them directly.

ACH transfers support both push and pull transactions, but they have an interesting relationship with payment certainty. When you start an ACH transaction, you get functionally no guarantee that the account numbers were accurate and the account has funds sufficient to cover the transaction. You will have more of a guarantee generally later that day that the transaction avoided the most glaring problems, but still no guarantee of funds sufficiency, because ACH is “negative confirmed”; you don’t get a final message representing probable success, you merely observe the lack of a message representing certain failure.

As a result, most businesses relying on ACH payments will not release goods or services prior to the end of the “return window”, which is the time by which an ACH participant is bound by regulation to send a message indicating insufficient funds. This is typically 5 business days. NACHA, the organization which administers ACH, huffily insists that ACH doesn’t actually take 5 days to clear, and that it happens multiple times every banking day, but in practice most recipients (or their banks) will hold transactions for several business days prior to accepting them.

ACH payments are generally free to end users in the U.S., though a few banks will attempt to monetize them. (Looking at you, Bank of America.)

Bank transfers are an extremely small percentage of customer-to-business payments in the U.S. In addition to the speed issue, which might get improved by FedNow when it launches (wags have referred to it as FedLater), bank payments have no consistent way to receive metadata, and despite being no-cost they compete with well-developed credit card ecosystems which credibly offer better-than-free pricing through rewards schemes (to the customer, who generally gets to choose which payment method they use to transact).

Europe

The Single Europe Payment Area (SEPA) offers free, instant transactions between European banks. They’re pull based; a user communicates their banking information to a business, which debits the user’s account, rather than the business communicating their banking information to the user in order to send them money.

Again, this is a choice and it has some consequences. One is that payment credentials in Europe are reusable and, as a consequence, both convenient to keep around to facilitate repeat transactions and persistently dangerous if leaked.

Fraud rates in Europe for SEPA transactions are notably high, at many, many multiples to UPI or furikomi. (And probably higher than ACH pull payments, though that is a closer call.)

It is often underappreciated outside the industry that fraud regimes are a choice which have to balance many social goods. Europe made a political decision to allow instantaneous payments between nations, including to financial institutions in less-developed countries with weak controls. That decision has a cost associated with it, but the European project has many costs associated with it, and Europe has decided as a collective body to allocate them in some fashion based on political processes.

Why isn't the future here yet?

I expect we’ll see bank transfers as a more prominent part of the payment mix in much of the world.

Amazon is often credited with asserting three invariants about customer wishes: they want more selection, at lower prices, delivered faster. In payments, we should expect the arc of history to bend towards instant payments, which are free or better-than-free to customers, which are pervasively available within nations, which interoperate (by government mandate and/or competitive pressure) between individual banks and wallet systems, and which have very, very good online and IRL experiences.

Bank transfers are far from that idealized future state, but getting closer.

In India, and perhaps in similar countries, I expect bank transfers (via UPI) to eat much of the payments market, and future payment methods will often be UX affordances on top of underlying nearly-free bank transfers rather than parallel systems.

In the U.S., I expect bank transfers will struggle to see general adoption as a payment method, even after the release of FedNow, but who knows what will be built on top of them. Cards are very popular and entrenched, and the economic model allows them to outcompete free on price alone. New payment methods will need to find something very interesting to offer to capture the user’s interest, and some participant in the transaction to pay for it; Buy Now Pay Later had the interesting insight that some businesses would happily underwrite their customers’ use of credit if someone else took the payment risk. Perhaps we’ll see similar experiments in applications using bank transfers as the underlying payment rail but with more complicated economics split creatively between the parties.

In Japan, I expect that financial institutions will push to make furikomi better but not better enough to compete with their card issuing businesses unless government decisively forces the issue. Although banks are a policy arm, someone has to pay for them eventually, and with net interest mostly off the table due to Japan’s economic situation for several decades, payments are the most viable option on the table in consumer banking.

One interesting gap in bank transfers almost everywhere: outside of a nation (or for the EU, an economic block), they tend to be almost impossible to use. (International wire transfers exist, but they’re almost physically painful, and none of the improvements discussed above are yet contemplated for them.) International commerce is exploding; Chinese consumers, for example, are increasing their spend ex-China at something like 30% annually. Payment methods which punt on international transactions can’t solve for payments in even the medium term.

My employer Stripe believes that the world will be knit together by what we call the Global Payments and Treasury Network (GPTN), allowing customers and businesses to interoperate between various bank-based networks in countries/regions without themselves needing bank accounts in every region they do business in. We’ll see! There exists lots of work yet to do in building it. (As always, opinions here are my own thoughts.)

Take money, for example. I have a literal degree in East Asian Studies, and while money was implicated (economy, business, work culture, etc) and I was taught how to count it, the culture that is money came up precisely once: “Japan is a cash-based society.”

If you read the same textbook, or if you’ve read no textbook at all, here are some updates to the state of the world:

Payments in Japan have changed enormously in the last 20 years. The rate of change is accelerating. You will see some echoes of some of these trends where you live, sooner rather than later.

I have to reiterate my usual disclaimer: I work at Stripe, but the following are my own opinions. Also, you can reasonably assume that I'm personally or professionally exposed to almost every company in the Japanese payments space; in addition to it being my literal job to keep on top of it, I also find it convenient to e.g. be able to buy coffee.

Credit cards

The overall business of credit cards and debit cards is similar in Japan to the United States. Feel free to read those essays if you need a refresher on the overall model.

There are some differences in underlying infrastructure (e.g. Japan has a national switch sitting in the middle of several global payment rails) that would only interest payment geeks. More interesting are some changes in the fundamental UX of cards.

In Japan, credit cards are payment instruments first and loan originators a long second. You have to opt-in to the provision of credit and announce your intention to do so to the store clerk.

For Japanese readers: in the United States, when you get your statement, you can pay in full, in which case you will not be charged interest, or you can pay any amount less than full but more than a specified minimum payment, in which case you will be charged interest on a revolving basis, starting on the day you made the transaction but being assessed in the statement cycle following the one you didn’t pay in full. You are correct, this system is virtually incomprehensible to people not professionally involved in it, and it is a cause of much angst for users and regulators of the financial industry. It is probably because of America's inscrutable culture.

(Since arch humor does not always travel well, I'll make that explicit: Japan is widely considered, both domestically and abroad, to have a culture which is somehow extremely distinctive and explains almost any imaginable difference between Japan and the rest of the world. The story is much more complicated than is popularly believed. If you only read one book about it, Sugimoto's Introduction to Japanese Society may be among the best available.)

Anyhow, back to payments, because understanding payments' material reality is much more useful to predict the world than reasoning from first principles about capital-C Culture.

The intense friction associated with accessing credit makes spending on credit far, far less common than in other nations. Of course, and contrary to the belief of many, Japanese consumers do actually use credit and are sometimes unhappy when they cannot use it, such as when checkout systems don’t offer the option to “split the payment” (pay in a fixed number of installment with a equivalent-to-interest fee charged later by the card issuer) or “pay it with revolving [credit].” This is often forgotten in discussions of localizing globally-produced services for the market. Money is a culture all to itself!

Quite a bit of the UX of Japanese credit card apps is around managing the (extremely ponderous and legacy-heavy) mechanics of recategorizing previous payments from single-payment to split-payment to revolving credit and back again.

Interchange rates in Japan are not materially regulated, relatively high, and treated as commercial secrets. They’re on a need to know basis and the industry feels you don’t need to know, even if you (...hypothetically) process credit card payments. The Japanese Fair Trade Commission has taken a dim view of this publicly and is investigating the matter.

The same applies to debit as well as credit, which means that Japanese debit cards often earn rewards at the same rate as credit cards (never a basis point more than 1%, a curious bit of pricing discipline which I will not further comment about explicitly).

No discussion about credit cards in Japan would be complete without mentioning JCB, which has about 20% of the market.

Credit cards are the original network effects business. Big networks eat smaller networks alive. Most countries did not have the complex mix of factors decades ago, when credit card networks were incubating, to support domestic networks which achieved escape velocity from the global payments networks.

Japan did, and JCB is the result. It is likely China  will also have enduring domestic / domestic++ credit card networks (UnionPay, etc); it feels far less likely that many other nations will develop them in the future. One interesting question for the payments industry is whether new payment methods will see global consolidation (as credit card networks did), have regional winners, or have national++ networks.

My personal prediction is “You’ll actually see all three”, driven by a mix of regulatory desires worldwide to move more of their payments business “closer to home” (and, sometimes, to avoid explicitly American control of non-American financial rails), flourishing customer choice in using different payment methods for different use cases and those use cases naturally being more or less geographically-bounded (international travel versus subway rides, for example), savvy bizdev teams, technology substrates like e.g. mobile platform penetration, and other factors.

One other fun note about credit cards in Japan: in the U.S., tech companies are often seen as muscling in on the financial industry’s turf. In Japan, tech companies are a growth engine for the financial industry. Rakuten Card is either the largest or second largest issuer in Japan, and it exists because Rakuten’s core business, an eBay-meets-Shopify marketplace, suffered majorly from many customers having no trusted way to pay online in the late 1990s.

So they did the natural thing for a tech firm. They bought a bank and onboarded tens of millions of Japanese users to credit cards for the first time ever. It seemed neater.

Jokes aside, Rakuten embraced early something that many ecosystems will in the coming years: payments makes existing franchises stronger. Their core loop is getting someone onto their payment rails as a convenience to use the core business, capturing their payments business outside of their own ecosystem (which is margin accretive), rewarding their users with points for that business, and making those points most useful within their own ecosystem than they are outside of it. This brings the users back and encourages them to move more of their business to Rakuten’s (many, many) product lines versus their competitors.

This isn’t dissimilar to the reason why every bank wants payment rails: it keeps you with the bank, earns the bank revenue even when you’re not transacting directly with the bank, and will bring you back to the bank’s product lines in the future.

Increasingly, the same logic will apply to non-bank firms which have broad user bases. It may even eventually apply to large user bases centralized around something which is not traditionally described as a firm. (A potentially interesting fintech interview question: “What is the smallest number of things that would have to change about the world for Beyoncé to offer a credit card?”)

This will drive what I believe is a defining feature of the future of payments:

Payment method heterogeneity

If you go to a grocery store in the United States, you have functionally four payment choices: cards, checks, cash, and (often forgotten by technologists, for predictable reasons) publicly-provided benefits.

When I bought my morning coffee at the friendly neighborhood 7-Eleven convenience store today, I asked the shop staff for permission to take a few photos. They illustrate a trend that I would bet on hitting most of the world: payment method heterogeneity. In Japan, we are witnessing a Cambrian explosion in payment providers, payment systems, and payment modalities.

A picture worth a thousand words:

That is 40 payment brands (though not 40 distinct rails) all vying for customers, retailers, mindshare, share of wallet, and customer habits. And that isn’t nearly all of them.

You almost certainly recognize some of these logos, particularly in the top right (credit card networks) and the bottom right (mobile payments wallets by Apple and Google).

Here is the same question asked at point-of-sale. (Apologies for the poor-quality photo; I was attempting to not impose upon my friendly neighborhood clerks and optimized for speed over quality.)

Let’s take them somewhat out of order, for reasons which will become apparent later:

Cash

What is there to say about cash? Volumes worth, nothing at all, or something in between. Since a newsletter isn’t a place for a historical treatise, I’ll make one casual observation and one serious one.

The casual observation: An older gentleman in front of me in line yesterday asked how to pay cash for a purchase at this store. I was surprised, and then I was surprised that I was surprised, that anyone at a convenience store in central Tokyo would still use cash. That might have been the first cash transaction I observed in this store during the pandemic.

The pandemic has accelerated many existing trends worldwide, and it certainly provided a boost to the financial industry and government’s long, mutual plan to transition Japan to less dependence on cash for routine transactions.

The financial industry wants this because money. In a low-interest environment, which has described Japan for 30 years and counting, payments are (by far) the most lucrative product to sell to most customers.

The government wants this for more complicated reasons. Some are predictable from Seeing Like a State; governments prefer legible things to illegible things like humans prefer oxygen to carbon monoxide. Digital payments are more legible than cash. No conspiracy is required; governments will, given the ability, organize their environments to have more digital payments and less cash and cash-like payments, often without even needing to intend this.

In Japan though, this is definitely an explicit, declared plan. Japan wants to increase digital payments’ share to 40%, up from about 20% currently. Some of the proffered reasons are decreasing the tax gap (which, perhaps surprisingly to external observers, Japan is institutionally convinced is rather high) and supporting the financial industry. As I've mentioned previously, the financial industry everywhere is considered systemically important is a privately-owned publicly-relevant policy arm.

One experiment Japan rolled out in the last year or so was My Number Points. My Number is a recent (and sometimes controversial) national identification scheme, giving a large number of nationally- and locally-administered government services a single identification number for every resident of Japan.

One claimed benefit of the system is that it will be easier to administer stimulus directly with it. My Number Points were a trial run at this. The government offered 25% cash back, administered via your preferred payments provider, if you opted into it with that payment provider, demonstrated you were uniquely getting the benefit for yourself that one time by providing your My Number card, and went through a (paaaaaainful) UX. The benefit was capped at 5,000 yen a person (about $50) and probably did not cause a sea change in customer attitudes about payment methods.

A more effective intervention was on the other side of the market: Japan had a variety of subsidies to encourage uptake of “cashless” payments systems on the business side of the market, reasoning that making electronic payments systemically more convenient would encourage more user adoption of them, which would drag along holdouts, which would encourage more user adoption, etc.

One such campaign, recently sunset but still mentioned by many vendors as of this writing (e.g. see Rakuten Pay's solicitation, if you can read Japanese), was that the government would subsidize half of the cost of terminals (up to about $300) if a) payments providers were willing to cover the other half and b) payments providers temporarily zeroed out the cost of interchange (and other fees) through October 2021. The government offered to subsidize the cost of the interchange as well.

As you can imagine, businesses often respond positively to the government offering them free money, and the payments industry used its very large boots-on-the-ground sales force to move many, many, many POS systems into eateries, cafes, small apparel shops, and other businesses in Japan where penetration of credit card readers had historically lagged.

This was accidentally accelerated by the coronavirus epidemic. Shops were looking for ways to improve their physical environment and market those improvements as being health-protecting, to bring foot traffic back, and “No need to touch the staff’s hands even indirectly” suddenly became a very popular selling point.

The first widespread entry in contactless payments is almost 20 years old:

Electronic money systems

The original entry into contactless payments in Japan, available since the early 2000s (after a rich history [PDF] of transportation-specific payment systems out of scope here), was so-called electronic money systems. The payments geek shorthand is “closed-loop stored value transportation cards which turned into open-loop stored value IC cards.” Got it? Good.

If you would prefer that explanation in more words:

Transportation systems worldwide have interesting payment problems. Japan has many interlinked transportation systems, owned by a variety of public and private entities, and strongly encourages intermodal transportation. This makes the payments problem even harder, and it is already hard enough in transport: the designed throughput of a turnstile at a Tokyo subway station is faster than credit cards can be sequentially authorized.

So the transportation companies developed systems with several goals, and speed, speed, speed was one of the dominant ones. This lead to prepaid cards with a chip in them. Unlike credit cards, which are conceptually speaking a pointer to a record in a bank’s database about you, the prepaid cards contain the money “on the chip.” While there is eventually a recordkeeping process in a database (and the actual money is, of course, in the formal financial system and not on a card), the turnstile can verify funds availability (or charge you, on the way out) without needing to hit the network.

This makes it robust against outages (always a design consideration for infrastructure in Japan, to the credit of its engineering community) and optimizes for speed.

Transportation systems often have ancillary goods and services co-located with them, like e.g. cafes, convenience stores, flower shops, etc. As the Suica and other payments methods became so obviously superior to pre-buying tickets in advance, these shops started to say “Wouldn’t it be great if you could just tap the same card for a coffee? We are also acutely throughput constrained. We could also use a low-cost payments method is economically viable on extremely low ticket sizes.”

And, to simplify two decades of business development, the various operators figured out interoperability, you can use your Suica/Passmo/etc interchangeably for almost all ground-based transit, most ancillary services, and most convenience stores, and you can even put them in your phone these days.

Fun fact: your phone (very probably) sports a little extra silicon specifically to support this use case. Yes, your phone. It’s cheaper at global scales to put it in every phone versus having to support multiple supply chains and try to walk users through this product matrix.

Weirdly, penetration of the electronic money systems grew and then… stagnated. They’re functionally unusable online, despite some efforts to change that. The transit operators are not fundamentally payment businesses and have not executed well on improving merchant adoption after some (brilliant) work to get them accepted by large convenience store and cafe chains. Rakuten (Edy), 7/11 (Nanaco), and a few other large players all tried their own entries, and while many are sustainable businesses none caught fire.

The hot market in Japanese payments is:

App-based payments

QR codes have been big in Japan for almost 20 years, despite flopping so catastrophically in the U.S. that the CueCat is still a joke among technologists of a certain age. (Interestingly, that may have caused technologists to overlook how useful QR codes are.)

The core use case for QR codes in Japan used to be communicating URLs to users in physical space. Technologists who grew up reading English often don’t appreciate that https://URLなんて読みやすいとは限りませんよ.com is how they read to many people in the world. Understandably, McDonalds felt it was difficult to direct in-restauraunt customers to URLs that felt like that to e.g. get menu information or download coupons, and so QR codes took off here. The UX of scanning them is ingrained in most phone users’ muscle memories.

Enter app-based payments, which largely (but not exclusively) use QR codes to bridge the gap between the user and store, in one of two ways:

The extremely easy to deploy way:

You see this extremely commonly in China and less in Japan, but it definitely exists (at e.g. my local sandwich shop): the store has one static QR code, printed near the register, with the logo of the supporting app near it. To pay, you scan the code in the app, key in the amount, and click Send. The store instantly receives notification of the payment on either a tablet that the payment scheme gave them or alternatively on a clerk’s cell phone.

The more common integrated method:

This requires that the store have a supported point-of-sale system, but is generally a better user experience.

Either a) the user initiates the transaction by showing a dynamically generated QR code from their phone to the clerk, who scans it or b) the store initiates the transaction by showing a dynamically generated QR code to the user, who scans it. The point-of-sales system does an online handshake with the payments scheme, syncing information about the transaction in progress (which the payments scheme is, notably, totally unaware of in the above deployment method). The user is immediately charged the amount they agreed to pay.

These are often referred to as QR-code payments but the payment apps are so-called "super apps", and while payments is their dominant use case it is a tip of the iceberg. I prefer thinking of them as application ecosystems with a payments bit attached rather than as QR-codes with ancillary features.

The one that appears to be running away with the Japanese market, of many entries, is PayPay. To my discredit as a payments geek, I originally did not notice their entry into the market because mild dyslexia convinced me I already had an account, and so missed their primary user acquisition strategy in late 2018, which was paying people gobsmacking amounts of money just to sign up.

It is something of de rigeur in the U.S. tech community to laugh at Softbank for splashing large amounts of money to win large markets. PayPay, a joint venture between Softbank, Yahoo Japan, and Indian payments company Paytm (and isn’t that a sentence worth mentioning in discussions of globalization), spent hundreds of millions of dollars directly subsidizing user growth, which it achieved meteorically.

There are presumably videos you can watch of the UX on the Internet. The short version: it is really, really good. It may be the best Japan-specific software available on your phone. Not just in payments; it is the best software period. It is a fintech’s geek’s idealized dream of how good a core user experience can be. I could also list some quibbles, for example a KYC process which thinks I am not a person who could actually exist, but the core use is amazing.

In addition to payments, it supports free instant transfers to friends (which are generally locked within the ecosystem), a points- and rank-based reward system, some bizdev tieups with the likes of Uber Eats and Yahoo Auctions (the eBay of Japan), ancillary financial services, a truly I-can’t-believe-thats-allowed system which will “simulate” “investment” of your points, etc.

If one were a PM at a payments app, whether PayPay, Line Pay, or e.g. Cash App in the U.S., one dominant concern might be “How do I minimize my users’ perceived need to install multiple of my competitors’ apps?” That’s a fun intuition pump and predicts some things that have actually already happened. One example might be two payment apps deciding to make mutually compatible QR codes (your users can read my codes, my users can read your codes, and this Just Works™) and settle between their respective financial ecosystems on the back-end, in return for soft agreements that they will not expand into each other’s turf directly.

Convenience store payments

Convenience stores not only take payments, they have their own payment rails, because every ecosystem and every infrastructure player has a natural synergy with payment rails.

These still account for about 15% or so of Japanese e-commerce, and solve for a few different issues for an e-commerce user and business.

Problem: it’s tough to push cash through your computer screen and cash-on-delivery, offered pervasively by Japanese logistics firms, requires you to be home to accept the delivery.

Solution: the e-commerce site gives you a payment reference number and instructions, on an optionally printable voucher, to take to a designated convenience store chain. You go to any of their locations and pay in cash. The convenience store chain instantly tells the store that your payment was good and later settles with them electronically, mixing the actual physical cash with their giant flowing river of an operational problem. (Do you know what 7-Eleven did to solve this problem? Of course you do. They bought a bank so they can recycle the cash into on-premises ATMs without leaking tiny convenience store margins.)

Konbini payments (spelled after the most popular romanization for the shortened form of convenience store) are conceptually beautiful. The actual UX of them is pretty terrible, mostly because the integration layer (the actual surface a user sees) was coded in the late 1990s and hasn’t seen an update since, anywhere. If you go to Amazon and try to pay with konbini payments today, you get to appreciate that late 90s orange chrome aesthetic one more time.

Why do users like konbini payments? They’re accessible: literally anyone can use them. Salaryman, child, and immigrant alike are equal in the eyes of the konbini system; it turns cash into HTTP requests for them all. They’re secure: many Japanese consumers were burned on credit cards with unauthorized or dubiously authorized recurring transactions from merchants, and while there are legal and structural protections against that, nothing has the peace of mind of “I will know, absolutely positively, that the only money I pay you will be cash I lay out on the counter.” They’re privacy preserving: sometimes people want to buy things without e.g. family members knowing about the transaction, and konbini payments are (while not anonymous) the easiest way to do that.

Convenience stores also have one complementary offering: they can take delivery of parcels for you, from e.g. Amazon, and hold them until you come by. This a nice example of infrastructure improving the world in a delightful way, and free to the user (konbinis love recurring foot traffic). A common use case is “I’m a salaryman and will not be home at any conveniently predictable hour to take delivery; the local konbini is open 24/7/365.” A less common one, but one of the beautiful emergent things that happens once you get a new capability, is “I’m visiting my parents-in-law and would like to get them a gift but would like to hand it to them rather than having a delivery person do so, so I will ship it to the convenience store next door and unbox it myself rather than shipping it to them directly.”

Bank transfers

The dominant platform for B2B transfers in Japan is bank transfers (furikomi). To make this brief I’ll concentrate on the differences with ACH transfers in the U.S.: they’re functionally instant within banking hours, have finality guarantees closer to a wire transfer than an ACH payment, have a direct cost ($1 to $8 or so, depending on the sending bank’s pricing matrix, size of the transfer, and whether the sender is a consumer or business), and are reconciled manually a truly depressing portion of the time.

Reconciliation is matching your invoices (anticipated payments) with your bank statement (received payments). Furikomi have very limited metadata on them (customer name and phone number), and if you want to automate the matching, you need to instruct the customer to overwrite their name at their bank and include a reference number. Users will frequently botch this and so you will need to evaluate the instantaneous transfer later at human-powered speeds with a staff of overworked clerks looking at transaction amounts, timing, historical records, and similar to guess whether Taro Tanaka is paying on invoice #35234 issued to a company (“Maybe his employer?”) or invoice #234235 issued to Junichiro Tanaka (“Maybe a family member and not one of the several million people sharing that last name with no relation?”)

There was a similar system, PayEasy, developed which allowed business users to push transaction data to a financial intermediary prior to giving the user a reference number, so that transfers would deterministically resolve in real time. It enjoys quite a bit of adoption by governments for tax payments but comparatively little by the private sector.

Furikomi have benefited enormously from advances in online and mobile banking, which are (unfortunately) several years behind peer nations in their UXes. It no longer requires queuing for a teller or visiting an ATM to make one. That said, due to the reconciliation issue and UX issues, they lag in adoption for smaller ticket and B2C purchases.

This is often not appreciated: “Why are businesses happy to pay for payments?” One reason: if you enact high-friction walls around giving you money, people are less likely to give you money, and you would prefer the money even at a marginal cost to no money at all. That seems almost unmentionably straightforward and yet is underappreciated by many who model payments as “a tax” on sellers of goods and services. Another reason: you should prefer to have computers count money versus having people count money, because they are faster, cheaper, and less error prone, and that directly affects the UX you can offer users.

Ambitions thwarted

I had thought I could jot down most relevant things I knew about the Japanese payments market in time to make press, but ended up only making a tiny dent in the surface. Let me know if this sort of thing is interesting; if so, I’ll be happy to elaborate on Japan and perhaps cover other major markets in the future.

If you enjoy this topic, please come visit once it is safe to do so and give the payments ecosystem here a spin while enjoying Japan’s many, many reasons to visit. I would predict with high confidence you’ll see something that you will eventually see at home.

Debit cards made retail banking a better business

Much of financial services concerns stocks and flows; money sitting mostly idle or money moving between places. Financial service firms can charge for either of these or both, but typically one predominates.

Prior to the introduction of debit cards, core deposit accounts for retail users were a boring business to be in. (Banks historically consider consumers and small businesses to have strikingly similar banking needs and, largely for organizational reasons, group them together. We’ll call them “retail” users for simplicity; different banks call them “core banking”, “community banking”, and similar internally or in their financial statements.)

In the United States and much of the world, payments are free or near-free for retail bank customers. The defining feature of U.S. deposit accounts, check processing, both lends them their name (“checking accounts”), contributes billions of dollars of operational cost and credit risk, and is assumed to be free for both sides of the check transaction. This was historically subsidized by net interest earned on one’s balances and by using the core deposit relationship, and the frequent stops by the bank branch it used to entail, to sell loan products which had a healthier margin profile.

An interesting wrinkle about net interest is that most customers don’t contribute much. In much of the U.S., median checking account balances at account creation are only around $3,000. On a portfolio level, they increase slowly over time as customers' incomes rise slowly over the course of their career and as they save money.

At a 4% net interest margin, this account would only contribute about $120 in margin during its first year. In the U.S., the industry generally estimates approximately $350 a year in costs to maintain a checking account, of which approximately $120 is direct marginal cost (as opposed to e.g. a pro-rated portion of the cost for the branch footprint).

So most checking accounts (and particularly, most checking accounts where the customer had no other products from the bank) were negative contribution margin. That sounds better in an annual report than "We lose money on most customers even when everyone does everything right."

They were subsidized by banks and, indirectly, by customers of banks with larger balances, who were mostly unwittingly paying a higher spread between their own deposits and their loan pricing. This was a considered policy choice, because (as previously covered) the government prefers almost all members of society to be banked, but it was not an easy policy to implement around the edges. In particular, neighborhoods which had low concentrations of retirees and small business owners were difficult to service profitably on the branch model. Regulators and legislators attempted to put a thumb on this scale for decades, with mixed success.

Enter debit cards, which like many technologies were available (1960s) before being common (1980s) and then becoming ubiquitous (1990s). Debit cards  fundamentally transformed the economics of retail banking.

Consider again the median bank user, who might have a pre-tax income of around $60,000, post-tax post-transfers cashflow of $3.5k a month, and rent of approximately $1,000. (These numbers likely sound low to many readers; remember that the median American is not a professional employee in a coastal city.)

This user might very well have somewhere on the order of $2,000 of debit card transactions a month. This implies about $300 a year in interchange revenue, substantially more than their contribution from net interest.

Debit cards were a major structural factor in the retail banking boom of the 1990s, because neighborhoods which were once marginal prospects for new branches were suddenly both a) directly margin contributive immediately while b) having several embedded options on neighborhood economic growth, aging of the customer base, and cross-sells within the customer base. Neighborhoods that had handily merited a bank branch for the same reason now saw increased competition, from multiple banks first and eventually from multiple branches per bank, as each bank worried that a competitor could steal their debit cards by being one block more convenient.

This isn’t just an American story. Here in Japan, the persistently low interest rate environment for the last 30 years has made retail banking a very bad business to be in. However, over the last 15 or so years, the Japanese financial industry and government have made a concerted push to move the nation from being cash-based to using electronic payments, which for most typical consumer purchases means credit cards. The government’s current target is 40% of the payments mix, about double the current amount, which would put it on parity with the present state of play in the U.S. (and behind Asian peer nations, at around 50%).

Debit cards as an infrastructure upgrade

In addition to revolutionizing the economics of retail banking, in the U.S., debit cards quietly (and mostly accidentally) introduced instant business-to-consumer payments.

Many European readers are amazed that I keep harping on this, but “money moves much slower than data” has been a core feature of the U.S. experience for my entire life. The reasons behind that could fill volumes, but for now please just accept that we run the largest economy in the world on top of financial infrastructure that truly does lack a core primitive you’d expect it to have.

Anyhow, a bundled feature of credit cards and debit cards alike is that businesses can refund transactions. This is broadly considered a boring implementation deal. And they can even over-refund transactions in some circumstances. This was largely planned, to the extent it was planned, as an operational convenience. A customer might buy $150 of dresses in two transactions, return them to the store, and receive a single $150 refund rather than having the clerk hunt down both original transaction IDs to refund.

Eventually, someone realized that over-refunds plus debit cards accidentally create a novel payments network. You could just capture a debit card and then refund money never actually spent on it to transfer the customer money. That money would arrive in their bank account substantially instantly, rather than in the 3-5 business days that was more typical in the U.S. until recently. This required no negotiation with their bank, travelled over nearly universally accepted existing infrastructure, and involved no mutli-party stakeholder negotiation over whether a migration would disadvantage any economically significant part of the financial ecosystem.

This feature quietly lurked in the financial industry for many years but only became widely adopted in the last decade, first by the gig economy and then by wallet apps.

Typically, the apps offer their users a choice: payouts at the speed of banking, for free, or payouts at the speed of the Internet, for a small convenience fee. Cash App charges 1.5% with a minimum of a quarter. Lyft charges a flat fee of 50 cents.

This is an extremely high margin service and it is very, very, very popular with users. Many report that it transforms the nature of their interaction with the underlying application; delivery driving for casual drivers becomes something that you can burst up to fill an immediate cash need or mentally allocate against a particular desired expenditure (e.g. “Drive for 3 hours to afford a night out starting immediately after you log off.”)

The actual physical implementation of this once used niche financial players but these days is offered directly from Visa and Mastercard. Stripe offers it as a product called Instant Payouts.

Interestingly, pricing instant payouts serves an important packaging goal for fintech applications: the actual thing that the user wants isn’t money in their bank account faster. It is to be able to meet an obligation at a known time in the immediate future. Charging a convenience fee for instant payouts allows fintechs, and businesses with embedded financial infrastructure like gig economy platforms, to position their own debit cards as a free alternative with the same instantaneous funds availability.

This allows the fintech to shift the cost of instant payments from their own users to the businesses their users transact with. In particular, in the U.S. at present, they’ll almost certainly do this by having a debit card issued by a Durbin exempt financial institution.

Durbin-exempt interchange

We covered this briefly in the issue on community banking, but debit card interchange in the U.S. is presently capped to 21 cents plus 0.05% of the transaction. This is much, much lower than credit card interchange.

This was passed as part of the sweeping Dodd-Frank legislation in the wake of the financial crisis. If you imagine society as being in a perpetual dialogue with the financial sector, you can conceptualize this as a demand: in return for partially paying for your bailouts, commercial users require you to not charge us nearly as much for payment services. Find another way to subsidize your retail bank users; it’s not our problem.

Community banks had this to say about that: we didn’t cause the global financial crisis. We weren’t there on Wall Street creating exotic derivatives on asset backed securities. (Community banks might, ahem, hope that anyone who understands the mortgage supply chain stayed had too many things to worry about to protest this point.) We remade our retail franchises around the expectation of debit card interchange. If you cap the price on it, you’ll kill our institutions, cause millions of Americans to lose access to branch banking, and further roil the commercial real estate market, which we fund in most of the nation.

Senator Dick Durbin heard arguments like this, substantially agreed with them, and proposed an amendment to Dodd-Frank exempting banks with less than $10 billion in deposits from the interchange cap. It passed, and the fintech industry (which barely existed at the time) accidentally inherited a business model.

The fintech industry calls institutions under that cap Durbin-exempt issuers. Most of them continue issuing debit cards to their local communities, as they’ve done for decades. A handful of them partner with other firms to provide debit cards (and other banking services) to those firms’ customers.

This was an unintended structural alliance, but is extremely favorable for businesses engaging in it. Fintech companies offer relatively deep integrations with regulated financial services without themselves having to become banks, by piggy-backing on underlying banks’ capabilities to offer those services. The banks handle the compliance, custody, risk management, and a portion of the customer service, as they always have, but the fintechs provide a scaled national go-to-market strategy that no community bank could independently develop.

The most visible beneficiary of this has been the neobanks, which in the U.S. at least are almost invariably software companies that have a mobile app which integrates tightly with a debit card provided by a partner bank. That is (by far!) the easiest pathway to launch a banking product in the United States; it takes literally years, tens of millions of dollars, and substantial execution risk off of go-to-market. Most neobanks will attempt to figure out a scalable approach to attracting and retaining customers then try to increase contribution margin through other products. (It is an interesting open question whether neobanks in the U.S. will ever outgrow their banking partners, either for operational reasons or because society demands it of them.)

Many infrastructure providers, Stripe included, further abstract financial services (like debit card issuing) into suites which they offer to platforms building up on them. This “embedded fintech” lets companies whose core competence is software development for a particular vertical industry deeply integrate financial services into their core platform without actually providing it themselves.

Innovation is happening apace in this space, but as of today, the main monetization engine for this sort of relationship is the Durbin-exempt interchange on debit cards. The software platform, fintech platform, and bank split on the order of a hundred and change basis points (1.X%) of each transaction of their customers.

The value proposition for customers is an interesting one. Its a faster way to get access to one’s money. But the money is also… better? Because it is enhanced by the software provided by the platform, which can mirror a ledger of it (like any financial institution could) but use intimate knowledge of the customer’s business to make their software offering categorically better given that it is aware of transaction-level data about how money flows.

This lets platforms do things like e.g. automated tax reporting, bookkeeping, business analytics, etc, on top of their core services, without needing to directly charge their own users for this. The payments revenue is (from the perspective of the platform) extremely high margin.

SaaS companies offering "money, but better" thus act as an acquisition channel for relatively small banks which would otherwise have their own software offerings comfortably crushed by the largest banks in the world, which in the past few years have actually started to introduce very good mobile applications. Those banks have not, however, started innovating with respect to particular business or customer verticals; their retail offerings are (sometimes painfully) one-size-fits-all.

These services tend to make sticky products even stickier. Businesses can churn off a SaaS product, but once the SaaS product is intimately integrated into the flow of operations of their business, churn rates decrease markedly. It is difficult to get more intimately integrated with a business than to be directly in their cash flow. Since SaaS companies' enterprise values essentially move inversely with churn rates this is extremely powerful for them, even on top of the direct revenue contribution.

And thus a measure intended to rap Wall Street’s knuckles for the financial crisis has inadvertently caused rapid innovation in the main financial surfaces that many consumers and, particularly, small businesses interact with.

Infrastructure: it’s a fascinating world.

Further reading

Many readers have asked where I’d suggest starting to get a better handle on these topics. Payment Systems in the U.S. is my go-to recommendation for a quick survey, although I don’t love the book. The American Banker magazine has many interesting factoids about e.g. the economics of checking accounts in its back archives.

The Federal Reserve system (and its counterpart in other nations) publish very detailed reports on these subjects, and while their discoverability can frequently be poor the comprehensiveness is wonderful.

Finally, if you have dozens of hours to invest in the topic, getting familiar with the quarterly and annual reports of a small number of banks will, over time, really help to develop intuitions about both banking and the payments industry.

If you’ve not previously worked professionally on this, try First Republic’s reports; they’re large enough to have good production value on their reports but they have a very simple business to understand relative to e.g. the largest banks in the world. Wintrust and Silvergate are also good for similar reasons. After you feel like you largely understand what a typical bank’s reports look like, try Green Dot Bank or Evolve Bank and Trust to see how interaction with fintechs changes the equation.

If you find this sort of thing interesting, Stripe is hiring aggressively. As always, my views on these subjects are my own, but I like to think that I've learned a bit on this industry in my five years here.

Consider the humble credit card. Swipe it. Tap It. Dip it. HTTP GET it. You have probably used one, mostly oblivious to how it is a complicated bundle of services with a pricing structure strictly more complicated than a venture capital fund’s.

Here is how your bank thinks about it. (A useful jargon word to know: if you have plastic with your bank’s name on it, that makes the bank the issuer of that card. This helps to distinguish it from the other banks involved in a credit card transaction.)

Bundling and unbundling

It’s a truism that there are two ways to make money in financial services: bundling and unbundling. Credit cards aren’t just a bundle, they’re a Mandelbrot set of bundles. The bundles contain bundles. It is bundles all the way down… and all the way up.

One way to think of bundling is as cross-subsidization: you can charge users (or other parties, but we’re getting ahead of ourselves) more for X to give them Y for less than they expect, or even free (or negative!) Credit cards are cross-subsidization engines, both within a particular card as used, within a portfolio of customers using a particular card, and across a financial institution’s customers.

This last bit is very important: sometimes credit cards make money by losing money on the card itself. This is fairly rare, and mostly limited to a small number of issuers at the higher end of their product lines and customer archetypes. You can lose money on e.g. a particular entrepreneur’s personal rewards card to capture their deposit banking business, mortgage, and business banking, and while most financial institutions don’t set out to do this, individual accounts being single-product losers within large portfolios of users is unexceptional and very, very planned.

But let’s talk about the vastly more common case cards are designed around, where a good-fit, non-fraudulent user is expected to pull their own weight revenue-wise.

Revenue levers for credit cards

Net interest. Interchange. Fees. Marketing contributions. There, that’s (just about) every way your card can make money. Taking them in turn:

Net interest

Credit cards facilitate high-frequency minimal-human-involvement extensions of relatively tiny consumer loans bundled (ba dum bum) into an ongoing relationship with parameters negotiated very infrequently relative to individual transactions.

It’s often forgotten, but prior to credit cards, many Main Street retailers like e.g. pharmacies maintained hundreds or thousands of credit accounts for customers individually, necessitating their own back offices, accounting, and collections headache. This was in the ultimate service of getting customers to choose them over competitors, transact in larger sizes, and come back more frequently, the “only three aims of marketing.”

Credit cards represented banks saying: “You know, if you had a specialist doing that for you, it would be much more efficient. They’d have computers doing the math, not bookkeepers. They’d have departments doing collections, not clothing salespeople worried about offending customers who they’d need again at Christmas. They’d have access to cheap deposits to fund loans, rather than expensive working capital. They’d be adequately capitalized against losses, rather than having tiny margins backed by almost no equity, like most retailers. They’d diversify against regional and sectoral risk, rather than being all-in on the plant down the road still being open.”

So credit cards generate loans. A lot of loans. The traditional business of banking makes money on loans by funding them with a mix of cheap deposits and more expensive equity, charging adequately, collecting a spread, and using a portion of that spread to pay for operational costs and defaults.

Credit cards made the business of making loans work much better, by encouraging loans to be automated (rather than bespoke), by encouraging them to be more frequent, and by making them be iterative games rather than one-shots. This, and credit cards’ other revenue streams, let banks relax the “credit box” for loans originated by cards versus comparable unsecured signature loans.

The credit box, a metaphor from consumer underwriting, is conceptually a matrix which maps customer quality, loan amount, and similar to the prices you’d need to justify the underwriting decision or an outright denial, representing “This loan is negative expected value at all conceivable prices and we shouldn’t make it, at all.” Relaxing the box means approving more customers, approving smaller (less lucrative) and larger (riskier) loans, and giving borrowers better pricing.

Interestingly, credit cards make originating loans a distinct business from holding loans. Depending on a bank’s appetite for consumer credit risk and how much in deposits and equity they can back their loan portfolio with, they might not be able to satisfy all customer demand with their own resources. Some banks will package “pools” of those originated loans and sell them on to investors, earning a fee for the ongoing servicing of the loan (they are still the ones receiving payments and on the other end of the telephone, after all) and generally a premium to the pool’s face value (because investors are willing to pay more than $100 for the promise to repay $100 and 12% annual interest over time).

But as mammoth of a business as lending is, lending is not the reason credit cards took over payments in much of the world. Interchange is.

Interchange

When you swipe your card at the local cafe, multiple sales have necessarily happened. One is selling you a coffee. One was selling you a credit card. And one was selling the cafe on the desirability of accepting your credit card brand.

The sale to the cafe went something like this: You’d sell a lot more coffee if you accepted our credit cards. The best coffee drinkers carry our plastic, and they will drink coffee where they can use our plastic. You should pay us a bit for bringing you these desirable coffee drinkers, just like you’d pay for an ad in the paper that brought you desirable coffee drinkers.

That fee is called interchange. (Technically speaking, the industry dices up the fee into a few different parts and has different names for them, but let’s agree to call it interchange for the moment.)

The lion’s share of interchange goes to the card issuer… at least for the moment (oh don’t worry, we’ll get to that). Issuers have this argument for why they should get most of the fee: they do most of the work in the ecosystem. They signed you up for a card. They take the credit risk if you drink your coffee but don’t pay your bills. They will answer a phone call at 3 AM in the morning on the second ring if you have a problem with the card.

A much smaller portion of interchange goes to the credit card processor, to the acquiring bank, and to the credit card network. (Stripe makes a very large portion of our revenue by taking a small portion of the cost of interchange which we charge our business users.)

Interchange makes cards so valuable you’re paid to use them

Interchange ended up with different regional equilibria as credit cards ate parts of the payments pie worldwide.

In the United States, issuers quickly discovered some customer archetypes which absolutely printed money via interchange. A major one was business travelers, who were largely not customers of the credit but only needed the cards for money movement. And they moved a lot of money, mostly between their employers and airlines/hotels.

Competition for the business of business travelers caused one of the most important innovations in both consumer banking and the travel industries ever: cross-subsidization of credit card customer acquisition with travel company loyalty points. This economic engine became so massive that it is now worth strictly more than the airlines themselves, and it sparked a change of practice across U.S. cards: competing aggressively for customers by rebating interchange in the form of either rewards (such as airline loyalty points) or cash back (a post-transaction discount).

This had fascinating implications for the microeconomics of credit cards. For one, competition for desirable credit card users is so intense that profit margins for banks decline midway up the credit score ladder (and for some segments are actually persistently negative), before recovering for the most desirable users (who spend so much that their interchange finally outruns the rewards expense). (See Table 3 in this PDF.)

For another, this ended up being an almost peculiarly American experience. In Europe, regulators were worried about the cost of interchange to businesses (rather than consumers) and capped it. Since issuers didn’t have the margin to compete on rewards paid for by interchange, they instead leaned into branding and convenience, and credit cards became a smaller portion of the payment mix (about 47% of electronic payments, compared to almost 70% in the U.S.).

Curiously, in Japan, interchange is uncapped (and, according to the government, maddeningly opaque) but financial institutions held the line on rewards at 1%. This makes card issuance an extremely profitable business to be in in Japan, so much so that it subsidizes the rest of consumer banking in Japan’s persistent low interest rate environment (which depresses the net interest margin that consumer deposit accounts generally generate most revenue from, historically and in much of the world).

Fees

Fees have gone out of favor in much of consumer-facing finance, but credit cards have historically been rich sources of them. You can broadly categorize them into account fees and usage-based fees, with the former applying to most holders of a particular card (though issuers frequently waive them for marketing/etc purposes) and the latter based on user behavior that the issuer wants to discourage and/or price.

The two dominant types of credit card fees are over-the-limit fees and late payment fees. Both have declined as a percentage of the revenue mix over the last several years, due to consumers having better visibility into their usage (largely via mobile apps and IVR systems) and due to regulatory pressure to compress fee levels. The CARD Act alone probably returned over $10 billion a year to consumers.

Marketing contributions

One insight the industry had is that there is a limit to business’ desire to pay for payment acceptance but a much higher willingness to pay for customer acquisition. As technology has allowed credit card companies tight loops to their customers, they are increasingly attempting to nudge their purchase behavior in provable ways then invoice businesses for a portion of the marginal revenue driven.

A very customer-visible example of this is on Square’s Cash App, which periodically offers “Boosts” which rebate much more than interchange rates for particular purchases. These are sometimes paid for by the issuer as a marketing expense, but more frequently they’re the marketing spend of the boosted business. For example, Cash App (as of this writing) offers 10% off on one use at any grocery store and 5% off up to ten online purchases at Adidas. Without any internal knowledge, the first of these is very likely to be Square subsidizing the customer to motivate future behavior; the second is likely Adidas paying Square to send them more sneakers-hungry consumers (and send less to Nike). This sort of thing makes credit cards into a “channel” where advertisers compete with money, just like they compete for placement on retailer’s shelves or in the weekly insert in a newspaper.

If you are familiar with Bank of America or Chase mobile apps, you may have noticed partner rewards programs that periodically offer you, e.g., 5% cash back for a transaction at Starbucks. These are administered by a publicly traded company called Cardlytics, which charges the likes of Starbucks to drive them business, pays the consumer incentive out of the marketing spend, and also pays the bank for lending them the customer relationship. It is real money; they paid banks more than $100 million in 2020.

It is believed by many that banks make lots of money selling "your data." This is not a significant contributor to the economics of credit cards, for reasons which are slightly too complicated to get into in this piece. The short version: much like Google and Facebook, issuers can demonstrate to the most sophisticated organizations on the planet that they can deterministically influence actual purchasing behavior. That's easier to sell than a CSV file and worth more to more businesses.

That is substantially every way to make money with credit cards. Balancing these against each other is a fascinating exercise in marketing and product design, which will revisit later in this series.

Debit cards: a horse of a different color

Debit cards are a very similar product with enough under-the-hood differences that they deserve their own moment in the sun. In particular, due to a quirk of U.S. interchange regulation, they basically fund most of the fintech industry.

See you next time for it. Later in the series, we’ll discuss how the microeconomics of these products have helped turn payments infrastructure into a platform and ecosystem.

Free-as-in-beer banking

Advocates for the un- and underbanked have long had one request of the financial system: can you just get us a free basic checking account, please. This was the white whale for decades. It was technically possible but would have been extremely burdensome for community banks, because it is (fundamentally) a call to subsidize some depositors at the expense of others. That subsidy would have been bearable for the largest, most broadly distributed financial institutions in the world, but would have covered almost the entire deposit base of many community institutions. The tough part about subsidies is that someone has to pay for them. As we discussed previously, community banks exercise quite a bit of influence in the U.S., and so proposals for "free banking" got quietly killed.

So it would probably surprise advocates, burned from this discussion in the 1970s, 1980s, 1990s, and 2000s, that in 2021 the U.S. has nationally distributed free banking offerings that users love, that are profitable for the industry, and that do not stem from a regulatory mandate.

The key driver of the change has been competition for the deposit business of regular households. It's a fascinating story.

Perhaps some readers may not remember this, but prior to the mid-1990s checking accounts had price tags. In the 1990s, “free checking” became a marketing phenomenon, partly aimed at growing the number of banked households but mainly a pricing war between a consolidating industry hunting for share in local markets.

Free checking wasn’t free. Instead of most depositors paying a predictable (and relatively small) fee for their checking account, a tiny portion of the depositor base was assessed many, many $25-$35 fees stochastically based on how frequently their incomings and outgoings were temporarily mismatched. This resulted in a perverse tax-the-poorest-harder situation, where more than $10 billion annually was collected, with the large majority of it coming from less than 10% of banked households [PDF]. Overdraft fees made the math for free checking work for most of the country, at ruinous cost for a portion of it.

But. Things. Are. Getting. Better.

Online and, especially, mobile banking have given consumers more up-to-date visibility into their funds flows and allowed them more control over fees. That alone wouldn’t have helped (and didn’t help) folks whose primary problem was that they didn’t have enough money for obligations at least some of the time.

What has helped there is competition by apps, which a) knew that users who experienced them virtually universally hated overdraft fees and b) successfully decreased servicing costs for marginal users to the point where they could be profitable on tiny amounts of per-account contribution margin.

This combination let them ostentatiously kill overdrafts and use that for marketing. Chime’s recently highlighted “Fee-free overdraft up to $200.” Cash App similarly leaned into this for years.

The financial industry thought, for many years, that the customers added or retained by these improvements would be disproportionately expensive to service and low-revenue. Cash App has experimentally disproven that. Their cohort graph is a thing of beauty (see page 9 here [PDF]); enterprise SaaS level net expansion revenue on cohorts of consumers recruited at a $5 cost of acquisition.

This did not go unnoticed in the financial industry, particularly in 2020 when “widely distributed branch network” became a tougher thing to sell on. Online-focused banks are aggressively competing on this axis. Ally Bank dropped overdraft fees entirely. Some in the industry expect at least one top-10 bank to shortly experiment with it for marketing purposes, which (given competitive dynamics, particularly vis regulators) will likely cause a lot of following.

We’re not done with improvements here, given approximately $10 billion in overdraft fees assessed a year, but it was considered impossible for decades to do the thing you can now get from multiple competing providers available on every smartphone.

Sidenote: Smartphones themselves are a beautiful example of technical and financial innovation making new capabilities almost universally available. When the iPhone debuted it was high-end consumer hardware. These days entry-level Androids are given away to attract mobile service contracts.

Fast transfers

If you’re an internationally-minded American in the financial industry, you get ribbed about two things constantly: checks (“what do you mean the country that invented high-frequency trading mails around pieces of paper to move money and that those pieces of paper have account security tokens literally printed on them in block letters to make them easier to read”) and transfer times.

“Moving money between bank accounts takes 3-5 business days” has been the rule in the United States for most of my life. This quietly changed and many people have not really noticed. It happened via a combination of sustaining innovation, greenfield transfer networks, and heuristic credit decisions made at superhuman rates by computers.

The Automated Clearing House (ACH) moves about $60 trillion (!) a year. It was started as a backoffice improvement to solve the problem that banks processing checks would have to mail or courier checks between each other, and gradually expanded into electronic payments over time.

ACH payments historically operated on a daily or twice daily batch processing, and they’re (importantly) “negative confirmed.” This means that you do not get immediate reliable feedback that an ACH transfer or withdrawal has succeeded. The association’s rules require financial institutions to report errors (via even more batch processing) within 5 business days, and given that errors are expected in the ordinary course (most commonly, insufficient funds, since funds availability is not and cannot be guaranteed at transaction time), businesses and banks have to make decisions on what degree of risk they’re willing to tolerate.

ACH moved to same-day settlement (rather than next-day settlement) in 2018 for most transactions. This has accelerated funds availability, but it did not achieve real-time or near-real-time guarantee about funds sufficiency, so giving the user money before the 5 day window expires still runs some credit risks.

Banks have gotten much better at evaluating this credit risk and accelerating payments for low-risk transactions, such as federal government transfers, established direct deposit relationships, and others. The “others” is the most interesting category, because it’s a problem which would have been intractable prior to computers but is now fairly pedestrian data science, and using it is uniformly pro-consumer (giving people access to their own money faster).

Depending on the institution, some of the factors that go into heuristic acceleration might include age of account (more established accounts experience less errors, of virtually all types, than newer accounts), frequency of the transferer/transferee relationship, experience across accounts regarding the transferer (“Shouldn’t we treat Google transfers as money-good? They literally never bounce.”), desirability of the customer relationship (“Shouldn’t we be willing to take a tiiiiny bit of credit risk to keep e.g. a dentist’s custom? They’re very lucrative.”), etc.

In a pattern we often see in finance, this innovation has occurred in parallel with new user behavior and new networks, most obviously the Zelle consortium in the U.S. and app-driven closed payment networks like Venmo and Cash App.

Zelle was, in large degree, a response by banks to avoid being disintermediated by the payment apps, and now processes more than $300 billion of transactions annually. These are both free to consumers (banks subsidize them to keep their depositors from going elsewhere) and almost instant, including outside of banking hours. Venmo and Cash App both have transaction run rates around $250 billion per year.

Perhaps counterintuitively after quoting twelve digit sums, the impact on consumers of these innovations is larger than it looks. Single-day or single-weekend liquidity mismatches are responsible for large financial and social consequences, particularly for less well-off users, ranging from multiple $35 overdraft fees to getting one’s power or water service turned off. Being able to tap friends and family for funds instantly, or move money between one’s own accounts instantly, helps to avoid this.

We see this in B2B services, too. Many small businesses operate very close to the margin essentially all of the time, and the number one request from businesses of almost all sizes at Stripe is accelerating payout timing. It turns out there are many ways to do this at an acceptable cost for acceptable levels of marginal risk if one is creative, and we continue to be very, very creative. That helps to turn Stripe into an overlay network on the global financial system. We can do internal settlement at Internet speed even between businesses that have a very complicated least-cost route between them through existing financial institutions.

Remittance costs are cratering

A phrase that no one has ever said: “I really enjoy making international wires.”

Nonetheless, this has gotten better over the last few years, especially over heavily-used corridors. (In remittances, “corridor” is a term of art meaning an origination location, a destination location, and a currency or currency pair. For example, “US to Mexico while converting dollars to pesos” is one of the busiest remittance corridors in the world; the opposite direction is a different ballgame for structural and demand/supply reasons. As a result, professionals think of it differently.)

Anecdotally, as someone who has for almost 20 years had to move money between the U.S. and Japan, all-in costs have declined by 90% for small transfers and double digit percent for large ones. Japan to the U.S. is a relatively high-cost corridor (mostly due to user willingness to pay), but Wise (nee Transferwise) has gotten the pricing on a $1,000 transfer down to about $10. The best provider in the market used to charge $40 plus a (conveniently underdisclosed) ~2% spread on the currency conversion.

Interestingly, there are now multiple Japanese banks that actively court foreign depositors (which was almost unthinkable 20 years ago), and they finally do for retail users what sophisticated counterparties have long had available: constantly publish reliably available prices for currencies with tight spreads. One of these banks currently quotes a spread of .3 JPY per dollar, which works out to about 0.25%.

More active corridors like the aforementioned U.S. to Mexico have similarly benefitted from vibrant competition by the financial and non-financial sectors. Walmart is a major player here (through partnerships, a frequent feature of non-financial firms offering financial services), and has fairly competitive pricing, at about 3% at the typical remittance (about $300).

One of the major themes in driving remittance pricing down has been focusing on operational costs, which for remittances are dominated by retail presences at both endpoints of the transaction. Transitioning remittance senders to apps (and encouraging them to do their cash management in either the traditional banking sector or in adjacent ecosystems like pre-paid cards) reduces the labor and retail footprint required on one leg of the transaction. In cases where both legs use apps (or websites, or phone centers), the transaction can asymptotically approach free.

Since remittances are a high-salience user need for some user groups, financial institutions (and other businesses) on both sides of the border can choose to sacrifice revenue on remittances to win more business from those customers. We see this pattern again and again: because financial transactions are high-salience and often high-frequency, non-financial firms would prefer to commoditize their complement and drive the cost of transacting to nearly zero. This was historically difficult for a host of reasons, but technological and business innovations are making it so achievable that many don’t realize how quickly it is happening.

Common themes

Innovation in finances often starts at the “edges” of the traditional financial ecosystem but moves in, sometimes gradually and sometimes rapidly. It is not the sole province of either tech startups or banking incumbents; partnerships between the two are responsible for most interesting product development in the space. The competitive interplay between startups (with attractive new user experiences) and incumbents (with operational scale and distribution advantages) is a core driver of improvements becoming ubiquitous. Another is regulatory or quasi-regulatory action; finance is networks at every scale, and sometimes fiating the existence of a new equilibrium is more efficient than hoping that everyone simultaneously decides to move there together.

Stripe believes that financial services for businesses are also getting better, through measured and responsible innovation happening at financial institutions, software companies, and elsewhere. We partner with leading financial institutions to make capabilities that either didn’t exist or were limited to only the most sophisticated businesses more widely available. This helps put startups on a level playing field with incumbents, increase the pace of innovation for all industries, and improve the lives of everyone who transacts on the Internet.

That's why I work there. If building better financial infrastructure for the Internet to enable the next few decades of financial innovation sounds like an interesting challenge, we're hiring aggressively.

Obligatory disclaimer: these are my own views, not those of anyone I am associated with.

Community Banking: The Dark Matter of the U.S. Financial System

The United States has many more banks than peer nations. There are more than 5,000 banks in the U.S. but only about 400 in each of the U.K. and Japan, for example. One reason for this is that the U.S. is dependent on community banks throughout much of the nation.

A community bank is a locally-oriented financial institution, generally much smaller than regional or national banks, focused largely on the “traditional business of banking” (taking deposits and lending) versus the capital markets functions that the “money center” banks also engage in.

Community banks are often assumed to run on small town values, glad handing, and sleepy scenes reminiscent of It’s A Wonderful Life. This causes them to be overlooked by technologists and the wider financial industry, to our mutual discredit. Community banks are actually financial dark matter; their market impact and the policy regime supporting them influence all Americans’ access to banking services and many fintech product offerings.

Sketch of a community bank

Let me sketch out a small software-enabled company with approximately 40 employees and a cap table that can fit around a dinner table:

The 50th percentile [community bank] … held nearly $169 million in total assets. … At a 4 percent margin (the difference between the yield on loans and the interest paid for deposits), a $169 million bank generates roughly $6.5 million in annual revenue. … [C]ommunity banking is essentially a highly regulated small business enterprise. [0]

Banks in the U.S. can be chartered by the federal government or the state; community banks (and their close cousins, credit unions) are dominantly chartered by states. They form the largest portion of the banking industry in exurbs and rural America; 20% of counties have no bank branch except through community banking [PDF]. While they’re smaller as a percentage of banking activity than they have been historically, they still represent about 10% of all loans and deposits kept in the country.

The business of a community bank is taking deposits cheaply and lending at a higher rate. Both of these functions are historically local in nature, but that is changing. Community banks sell themselves on convenience and having a human-centric relationship with customers, as opposed to the driven-by-algorithms approach of the money center banks.

The local nature of community banks is not just a source of warm fuzzies. It is also an important risk factor. If you are the bank in a factory town, and the factory closes, your deposits will be spent down (and so your cost of funding goes up) at the same time your loan customers suffer financial stress (and your credit quality deteriorates). This dynamic kills banks without diversified customer bases, particularly during financial crises. The global financial crisis is often remembered as a cautionary tale about big banks and the global financial system, but the friendly bank on Main Street suffered the worst; over 400 banks failed between 2008 and 2011. More than 85% were prototypical community banks; small, local institutions with less than $1 billion in deposits.

The financial system is a policy arm

The U.S.’s financial system is best conceived of as a public/private partnership. Each financial institution is in constant competition with all others for customer relationships, deposits, loans, and ancillary product revenue. However, the government does put a thumb on the scale, particularly for politically powerful groups.

Community banks are surprisingly powerful in the U.S., largely because they are very popular with their customers relative to Big Finance, they are indispensable for politically powerful local groups like landlords, real estate developers, and farmers through their commercial loan books, and they have earned an appealing narrative about financial access. It is difficult to overstate how dependent commercial real estate is on community banks in much of the country, and it is a symbiotic relationship; the investors who organize them are usually local business owners with heavy real estate interests.

Branches are not cheap to create or operate, and the large banks concentrate them in densely populated areas with relatively wealthy customers and businesses nearby. Community banks are willing to take worse economics to have branches in places where the large banks don’t; this keeps those places tied to the national financial system.

This is a policy aim of the government, both due to the economic impacts and because most residents being banked is core to orderly provision of benefits, taxation, and other government functions. A bank branch is a retail point-of-presence for the SSA getting funds to a pensioner, for the IRS collecting payroll taxes, and for the DEA interdicting fentanyl, staffed and funded by the private sector.

Impact of community banking outside the system

Because the continued existence and thriving of community banking is a policy goal, regulations or competitive measures which would disfavor them versus the large banks and other financial players are actively undermined. Fintech frequently feels the ripples of this.

Many technologists ask why ACH payments were so slow for so long, and come to the conclusion that banks are technically incompetent. Close but no cigar. The large money center banks which have buildings upon buildings of programmers shaving microseconds off their trade execution times are not that intimidated by running batch processes twice a day. They could even negotiate bilateral real-time APIs to do so, among the fraternity of banks that have programmers on staff, and indeed in some cases they have.

Community banks mostly don’t have programmers on staff, and are reliant on the so-called “core processors” like Fiserv, Jack Henry & Associates and Fidelity National Information Services. These companies specialize in extremely expensive SaaS that their customers literally can't operate without. They are responsible for thousands of customers using related but heavily customized systems. Those customers often operate with minimal technical sophistication, no margin for error, disconcertingly few testing environments, and several dozen separate, toothy, mutually incompatible regulatory regimes they’re responsible to.

This is the largest reason why in-place upgrades to the U.S. financial system are slow. Coordinating the Faster ACH rollout took years, and the community bank lobby was loudly in favor of delaying it, to avoid disadvantaging themselves competitively versus banks with more capability to write software (and otherwise adapt operationally to the challenges same-day ACH posed).

Durbin Exempt Interchange

In the wake of the global financial crisis, a broad swathe of reforms was passed to clip the wings of the financial industry. One amendment to the 2010 Dodd-Frank bill, named for its sponsor Senator Durbin, imposed a limitation on the amount of interchange that could be charged on debit card transactions. The amendment had a carve-out for smaller financial institutions with less than $10 billion in assets.

A full recounting of the effects of the Durbin amendment would have to cover free checking accounts, insufficient funds fees, and the competitive dynamics of interchange within a multi-sided credit card ecosystem. The part most relevant to technologists, however, is that the Durbin exemption for small financial institutions makes debit cards very lucrative if and only if they are issued by a small financial institution.

Think of a fintech company with a debit card. Square’s Cash App. Chime. Robinhood. Stripe Issuing, and users like Ramp and Bench. All of them, virtually without exemption, are brought to you courtesy of a small financial institution that you are unlikely to have heard of (unless you work in fintech or read Terms and Conditions for fun). Durbin exempt interchange is the revenue model which got a thousand pitch decks funded, because it is free to the ultimate consumer and protected by a moat guaranteed (for the moment) by Uncle Sam, contingent on the consumer choosing to use your app’s card.

This let a generation of those apps compete on user experience without being crushed by large banks' pricing power. Customer acquisition for fintechs would be difficult if you could walk into any of the top ten banks and walk out with a 1% rewards debit card (which previously existed but don't anymore at large institutions, due to the Durbin amendment capping their revenue substantially lower than that).

Fintech as the banks’ Finfriendemy

Fintech has a complicated relationship with community banking. Community banks had already suffered some of their business leaking to larger banks as banking moved increasingly online, but were not worried about large banks competing with them from branches in their core markets. The math never penciled out.

Online customer acquisition, however, has allowed well-funded fintechs to provide better services cheaper than the local small business financial institution. Some customers are voting with their wallets. This has become even more acute during the pandemic, when footfalls (the delightful bricks-and-mortar phrase for what technologists might call eyeballs) at branches declined precipitously. One of the key themes for the industry in the past year has been maintaining the sense of human connection with someone who never sees your staff anymore.

At the same time, partnering with fintechs has allowed some community banks to greatly strengthen their franchises. Cross River Bank is an interesting example; a major line of their business is originating loans for fintechs which are then largely sold to funding sources that the fintech has lined up (such as investors looking for yield in a low interest environment). This gives CRB an interesting cross section of credit risk across the U.S. footprint of their customers’ customers rather than just the credit risk local to the bank in New Jersey, and allows them to share in the risk with the fintech and associated lenders rather than taking it entirely themselves.

One commentator [1] waggishly described Affirm as an API between Peloton and CRB, due to Peloton being a very large account at the time of their IPO. This is probably unfair to all three parties; ~30% revenue concentration is certainly notable, but each company is in a very different business. None could engineer their to the desired user experience without both other partners.

It is an open question as to whether many community banks are positioned to create niches like this for themselves in the Internet economy. One model that reduces the sophistication required and level of strategic risk is platforms providing them capabilities which bolt onto the traditional business of banking.

Brokered deposits are one example of a function which is increasingly becoming a platform. Banks use deposits as a cheap source of funding for loans, but the growth of deposits in a local community is constrained by, among other things, the underlying economic growth of the community, and banks might max out their deposit base without being able to serve the demand for loans in their community. The traditional remedy is tapping deposit “brokers” outside the community, who largely represent large, sophisticated pools of money which will go anywhere with nationally competitive interest rates.

In recent years this is getting intermediated by software rather than by people serially negotiating over phones on a daily basis, to the mutual benefit of community banks, firms which have lots of end users with deposits, and those end users.

This model forms a major portion of the revenue mix for virtually every discount brokerage (with the notable exception of Robinhood). A brokerage might have billions of dollars of customer cash on hand but, if it doesn’t have an affiliated bank, very limited ability to turn that cash into net interest revenue.

A platform like StoneCastle intermediates between the brokerage and banks, solving both incredibly fun operational challenges of storing and moving money, and effectively bidding the deposits out daily to the banks most willing to pay to support their loan books. The brokerage's customers get FDIC insurance on their deposits and liquidity which might feel quite close to cash. Meanwhile, the net interest spread the broker collects for this subsidizes the other services of the brokerage. This allows them to offer e.g. commission-free trading and asset management "for free." (It is popularly believed that payment for order flow is the primary subsidy brokerages receive. This belief is straightforwardly wrong for every brokerage except Robinhood.)

Brokerages have gigantic staffs of engineers, customer support agents, and other professionals. All of them are paid for by, effectively, the imbalance between checking account balances and demand for commercial real estate loans at a particular small bank in Kansas.

The financial infrastructure the world rests atop of causes many underappreciated ripples in our lives. It is full of these delightful rabbit holes. I hope to explore many of them with you in future issues of Bits about Money.

Further reading

[0] This quote is from The Most Fun I Never Want to Have Again, a swashbuckling startup tale about a Georgia community bank. It is part personal career narrative, part fundraising journey, part paean to the public image of community banking, and part behind-the-curtain look at how sophisticated executives at them evaluate their own success. Highly recommended.

[1] Marc Rubinstein, the above cited waggish commentator, writes a monthly newsletter on banking which is compulsory reading for anyone interested in the space.

The community banking community itself publishes surprisingly many podcasts, particularly during the coronavirus era. They’re an interesting mix of marketing content, shooting the breeze with peer professionals, and (to mangle the Picasso observation) artists getting together and passionately talking about where to find cheap turpentine. I particularly enjoyed an episode about the business benefits of colocating a cafe (even when, as it turns out, regulations forbid a bank from actually selling coffee).