Key Points
- The two trillion-dollar global payments industry is forecast to grow 9% p.a. through to 2022
- Chinese companies are leading payments innovation and expanding globally
- Disruption in the payments industry is being driven by technological and regulatory change
The global payments industry is one that sits quietly underneath the world’s economies. Generally, businesses facilitating payments have been very successful through various operations whether it’s banks collecting fees for processing cheques, card network operators charging merchants for credit cards, or even one of the newer payments platforms charging retailers when a customer uses their mobile app.
In this Investment Horizon, we discuss the evolution of the payments industry and consider the drivers of change. We will look at some of the key players that have built the industry up and consider the new entrants that are disrupting these institutions.
A two trillion-dollar industry
The payments industry facilitates commerce and takes a margin from merchants when they sell their products. The industry has grown steadily, despite the pressure on payment processing fees from both competitors and regulators. Transaction volume growth is supported steadily by increased global spending and further boosted by a shift from the use of cash and cheques to payments by card and other electronic methods.
Growth of the global payments industry accelerated in 2017, growing 11% on the year prior – a faster growth rate than any of the five preceding years – to reach a total of $1.9 trillion in revenues. [1] It is forecast to reach $2.9 trillion by 2022.
The United States has been slow to develop
EFTPOS[2] technology originated in the US in 1981 but adoption was slow. In the US, consumer payments in cash are still commonplace and the majority of business-to-business payments are still made by cheque.
The US continues to be burdened by legacy banking and payments systems and has been late to the electronic payments party. They were slow to move from magnetic-strip cards to chip-enabled card technology and have been a laggard in adopting contactless payments as a result.
New Zealanders were early adopters
EFTPOS was officially launched in New Zealand in 1989, 8 years after its US release, and was embraced by merchants and consumers to the point where it is now used for most retail transactions. Today, many Kiwis have embraced contactless payments and are some of the highest users of contactless technology in the world.[3]
However, contactless payments in New Zealand are still facilitated through credit or debit cards whereas parts of the world have moved on past cards and contactless payments leaving the US, New Zealand, and other countries behind.
China is leading global innovation
China is currently leading the world in payments technology. Today, most payments in China are completed via mobile phone enabled QR codes: the customer can either scan the seller’s QR code and input the amount to transfer to the seller on their smartphone, or show the seller their own QR code generated on their smartphone which the seller then scans with their smartphone. Two companies dominate this payments space and process the vast majority of payments in China: AliPay and WeChat Pay.
AliPay and WeChat Pay operate closed-loop payments systems, in contrast to the open-loop systems of Visa and Mastercard. In a closed-loop system, consumers load money onto, for example, their AliPay account and when they go to pay, they’ll scan the merchant’s AliPay QR code. AliPay then facilitates the transfer of funds from one AliPay account to the other, all within its system. The same process follows with a WeChat Pay account. An open-loop system is where a consumer pays with their card using the merchant’s card-reader. The funds are ultimately transferred from the consumer to the merchant but it requires messages to be sent through a system of banks and network processors like Visa or Mastercard which connects the parties in order to authorise and confirm the transaction.
Closed-loop systems are simpler, but they require mass adoption by customers and merchants in order to be effective. The ubiquitous nature of AliPay and WeChat Pay in China is what has driven their success.
Source: CGAP
Mobile payments facilitated by QR codes are incredibly cheap for the merchant – they don’t need a card-scanning terminal and at the low-cost end, they can simply print out their unique QR code and display it at the checkout. This low cost led to merchants rapidly adopting the technology, followed by mass customer adoption.
China’s AliPay and WeChat Pay are not content with only dominating Chinese and other Asian markets though. Both companies have entered the New Zealand market where some merchants are now offering AliPay and WeChat Pay in-store at the point of sale. Having spoken to some of these local merchants, they don’t process very many payments through these methods but the customers, who tend to be visiting tourists or expatriates, that have used them are very happy that they can use their preferred payment method.
Disruption is continuous
Not only has China left the rest of the world behind in contactless payments, they have already moved into the next era of payments technology: facial recognition. Facial recognition enables payments without the need for a card or smartphone. Customers have their facial characteristics registered by a payment provider like AliPay or WeChat Pay. While at the checkout, the customer has their face scanned by a camera – where they may be required to nod or move their head to prevent fraud – and once their identity is confirmed, the payment is automatically made from their account to the merchant.
In China, facial recognition payments are already being used in retail stores, restaurants, supermarkets and banks. The application of facial recognition has even allowed for unstaffed supermarkets. Customers can pick their groceries from the shelves and then walk through a “smart payment lane”. Camera technology throughout the store recognises which products the customer has chosen, confirms their identity and then processes payment from the registered account.
This shift to mobile payments is beginning to disrupt large institutional providers by excluding card issuers (Banks) and payment network operators (Visa, Mastercard) from the revenue pool.
Will Big Tech turn up to the payments party and throw their weight around?
Big Tech (large technology companies such as Google) have long been tipped to enter the finance and payments space and we have recently seen this come to life with Facebook’s announcement of its cryptocurrency project, Libra. Libra, Facebook says, will be “a more efficient, low-cost and secure alternative” for those who can’t afford to use traditional financial services. The proposed cryptocurrency will be based on a stable-coin model, where a basket of world currencies determines the value of Libra and Libra itself is backed by holdings in currency. But, before that stage can come, Facebook will need to satisfy financial regulators across the globe that it complies with relevant legislation – this will be no small feat given the immediate opposition Facebook has copped from regulators and politicians in the short time since it announced the Libra project even though the cryptocurrency’s launch won’t be until next year at the earliest.
The opportunity for Facebook and other big tech giants in the payments space lies in their enormous existing user bases. Facebook has over two billion users, so already holds a valuable customer base and network. While the adoption of new technology within the user base is not a given, the opportunity these networks present can’t be denied. A significant challenge for big tech will be trying to establish a high level of trust necessary for their users to be comfortable having their financial assets held outside of the traditional banking system.
Customer and merchant centricity as the key to success
Success in the Chinese mobile payments system has been the result of delivering good outcomes for both customers and merchants. Mobile payments are cheap for a merchant to accept and, on the customer side, anyone with a smartphone can set up an account and make payments via an app. The network of customers and merchants has therefore grown rapidly because there is a very low initial set up cost and no friction in using the product. It’s simple, and it works.
Early movers are hard to displace in the payments industry, as the reach of the network is paramount. We have seen this with Visa and Mastercard dominating the global share of payments network activity. Visa, for example, has a network of over 53 million merchants and has three billion cards issued worldwide. A big benefit of being a Visa cardholder is having the confidence to use your card anywhere because of the universal nature of Visa’s network.
Conversely, merchants are willing to pay interchange fees to Visa to access the network of Visa cardholders as their potential customers. However, Visa and Mastercard are one step back from the action – a Visa cardholder doesn’t have a relationship with Visa, they have a relationship with the bank that issued the card.
Creating a new way to pay… Afterpay and others
The key drivers of success in creating a new payments system are a focus on customers and merchants as the core to the system; a focus on data and the value that can be created from its use; and a focus on millennials given the broad-based shift of wealth and spending power to this generational group. We will touch on each of these in detail now.
The Customers
Afterpay is a good example of a company using payments technology in a way that resonates with both customers and merchants. Afterpay offers customers the ability to receive goods instantly and pay later – in four fortnightly instalments. This model differs from the old-fashioned layby, where customers pay off the goods in full before they receive them.
Other companies including ZipPay, Laybuy, Klarna, and Sezzle have entered the buy now pay later space and are offering the same or similar payment structures.
Part of the beauty of Afterpay lies in its simplicity – the customer uses Afterpay (online or in-store) at the checkout and instalments are later automatically pulled from the customer’s credit or debit card registered on their Afterpay account – there’s no friction. More importantly, there’s no cost to the customer using Afterpay, provided the instalments are made on time.
Afterpay has achieved rapid growth in customer numbers because it allows customers to get goods instantly without needing to pay the full price upfront. It appeals to millennials who prefer debit cards to credit cards because they have an aversion to revolving debt but who enjoy the budgeting benefit they get from spreading payments out over time. Coupled with the fact that it’s free for the customer to use and it’s a simple, frictionless process – when a customer goes to the checkout, why not Afterpay it?
Source: Afterpay
The Merchants
The Afterpay team includes former retailers whose goal is to drive great outcomes for merchants. Merchants are racing to on-board Afterpay because when they have it available to customers, they achieve greater conversion rates at the checkout and the average order size increases. So, although the merchant pays Afterpay for the service, they also benefit from their customers using it.
Afterpay is the second largest referrer, behind Google, for online sales in Australia. Increased conversion rates and order sizes are a benefit, but perhaps the biggest drawcard for a merchant in using Afterpay is it unlocks access to a network of over four million active customers.
The Data
Today, data is the new oil. Having a direct relationship with the customer plus the ability to collect and use customer data, is like owning the oilfield.
The good oil in the Afterpay business is the data it collects from its user base. Afterpay collects data on each individual purchase made, as well as data on the repayments profile of its users. The application of that data becomes particularly valuable when applied to targeted marketing - and automated credit decisioning.
In a world where retailers are throwing money at online advertisers in hopes it will attract customers to their website, Afterpay is leveraging its large customer base by sending promotions to its customers to drive them to shop with their retailers. However, the Afterpay network is more valuable than its list of four million customers and their demographic details. Afterpay knows almost everything about a customer’s purchase – it knows what you bought, when you bought it, who you bought it from and where you bought it. The precise detail of this data is what makes it so valuable. Afterpay has the potential to turn on incredibly smart targeted marketing campaigns (via email, text and push notification) for its retailers given the specificity of the data it has available and the number of active users it has in its network.
Afterpay also uses the data it collects in its automated credit decisioning process. The data allows Afterpay to assess customer repayment profiles based on where they shop, what they bought, who else they are like in the customer base and other measures. This allows Afterpay to continually improve its credit decisioning so that it accepts customers who are more likely to complete their instalment payments and, most importantly, avoids customers who are more likely to default. Because the repayment cycle for Afterpay is so short Afterpay can rapidly collect data on consumers’ repayment behaviour and use it to improve credit decisioning and reduce defaults.
The Open Banking transition that is occurring now further presents an opportunity for Afterpay to utilise its users’ banking transaction data to more accurately assess customer creditworthiness and improve its credit decisioning process.
Millennial Spending: The Underlying Demographic Shift
Afterpay is focussed on acquiring millennials as customers because they haven’t been strong adopters of credit cards. Because of this, Afterpay is exposed to underlying millennial spending power which is forecast to be the largest of the generational groups by 2020 and onwards. There is no doubt that millennials are the future economic powerhouse and exposure to their spending will be increasingly valuable.
Does the winner take it all?
It’s unlikely. Afterpay offers a service that is replicable by its competitors and we have recently seen an announcement from Visa about entering the instalment payments space. We believe value exists in Afterpay’s ability to engage with customers in a meaningful way and allow them to grow their network and scale their business rapidly.
WeChat Pay and AliPay share market power in China. Visa and Mastercard are now benefitting from the continuing global shift from cash to card transactions with their payments networks still providing value to merchants and customers. But questions are now being raised about the future value of these payments networks in the face of the shift to cardless payments in China. Banks are now frantically partnering with fintech companies as well as developing their own technology in order to provide modern technology to customers.
What are the implications for investors?
We expect the payments industry to continue to have a dynamic future, as new technologies emerge and present opportunities for the industry, as well as threaten to disrupt incumbents. Regulation in the financial industry is favourable for disruption – Open Banking regimes benefit emerging companies by unlocking large pools of data previously held tightly by major banks. We are attentively watching the payments space as it develops and new technologies enter.
[1] McKinsey & Company, October 2018.
[2] Electronic Funds Transfer at Point of Sale.
[3] Mastercard New Zealand Annual Survey 2017.
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