How and Why Is The U.S. Payments Infrastructure Behind?
After writing about the social implications of payments, I received several questions as to how the U.S. payments system works, what are its key problems, and why is the ecosystem not more effective. This piece will address these issues as well as answer the question as to how a country that leads the world in technological innovation can still be struggling with such a fundamental component of its economic growth.
How The Current U.S. Payments Ecosystem Work
A typical payment, as illustrated in Figure 1, is processed through several layers of what is known as the “payments stack.”
Step 1: Payment Facilitator
Let’s use an example to walk through this payment process. Say a customer enters a small retail store, known as the “merchant,” and purchases goods on Square’s point-of-sale hardware device using her Visa credit card. In this case, Square acts as the payment facilitator, or PayFac. Other common PayFacs are Lightspeed and Stripe, but many more exist, including niche providers, such as Toast for restaurants. A PayFac is a relatively new type of Payment Service Provider (PSP) that bridges the gap between the merchant and the acquiring bank/payment processor. A PayFac can underwrite merchants, process transactions, and manage disputes.¹ By insulating merchants from the compliance, underwriting, and integration associated with payment processors, these PayFacs make it easier for merchants to accept credit and debit payments.
To assess the significance of the PayFac, let’s look at what the process was like a decade ago. Independent Sales Organizations (ISOs) sold payment processing capabilities to merchants, on behalf of banks, acting as the middlemen pictured below in Figure 2. The merchant would then wade through a cumbersome integration and underwriting process with the payment processor, which could take weeks to conclude.²
PayFacs removed the role of ISOs from the payments stack and created a much faster and easier, though still flawed and expensive, process for merchants.
Step 2 and 3: The “Acquiring” Side
Now back to our example. Once the payment is made on Square’s hardware, data is sent to the merchant’s bank, known as the “acquiring bank,” via a payment processor. For this example, let’s say Wells Fargo is the acquiring bank and FirstData is the processor. First Data’s role is to relay the data to Wells Fargo and, if the payment is approved, pay the merchant at the end of the process.
Step 4: The Clearing System
The card network, in our example Visa, acts as the intermediary between banks. Visa routes data between banks and makes sure everything runs safely and smoothly. Visa, along with Mastercard, has become ubiquitous across the payments ecosystem, allowing card holders to have confidence in their ability to pay with their card at nearly every merchant. This confidence makes Visa and Mastercard popular with merchants and consumers, even if the fees associated with these networks are burdensome.
Step 5 and 6: The “Issuing” Side
The “issuing bank,” for example JP Morgan, issued the card to the customer and is ultimately liable for the purchase made by the customer. JP Morgan will work with an “issuing processor,” such as Fiserv. Once Fiserv approves the transaction, the data is sent back through to the retail store who can complete the transaction with the customer. As the issuer, JP Morgan is liable for the payment. While that comes with some heightened credit risk, it also means that JP Morgan receives the lion’s share of the interchange fees in the payments process, as seen in Figure 3.
Step 7: Interbank Settlement Service
Even though the merchant has been debited the transaction and the customer has been credited, the transaction is not over. JP Morgan still has to send the payment through an interbank settling service, either the Fed or an alternative private provider. This clearing and settlement of the payment is known as the “wholesale” portion. Most of these payments are made over ACH, which can take days to complete.
Key Pain Points With the U.S. Infrastructure
The U.S. payments infrastructure has three significant pain points: speed, fees, and interoperability (the ability of different systems to communicate effectively and accurately with each other).
Speed
In the example above, the merchant does not receive the cash on the same day, but instead waits days for the settlement via ACH. This can greatly influence working capital requirements and the merchant’s ability to pay bills.
Real-time payments (RTP), in which the payment is processed nearly instantly (or at least on the same day), has been a focus of other countries for over a decade. In Europe, for example, the U.K. led the way putting together a faster payments task force as far back as 2004 and adopting a system in 2008.⁴ For comparison, the Fed created a faster payments task force only in 2015 and is not expected to roll out the infrastructure until 2023.⁵
Even many emerging markets have implemented RTP more effectively than the U.S. India, for example, created a Unified Payments Interface (UPI) in 2016 which grew to 955M monthly transactions in late 2019.⁶ Designed for mobile phones with the ability for third party technology players to build on top of the UPI network, this RTP system was designed for a new age of payments.
Fees
The legacy transaction-based business model is a blaring pain point. In Figure 1, the card issuing bank and processor keeps processing fees from the card network, the card network keeps fees from the acquiring bank and processor, and the acquiring bank and processor keeps fees from the merchant. On top of that, the payment facilitator takes another significant fee per transaction. While large merchants can negotiate lower fees, smaller merchants have limited bargaining power, and as such are especially burdened by these interchange fees. Figure 4 below shows that Square’s average merchant discount rate is 2.92%, a significant cost on any transaction.
The government has previously recognized the inequity of fees. The Durbin Amendment, part of Dodd-Frank, set limits on the interchange fees a merchant pays banks for debit card transactions. However, the amendment did not address interchange fees on credit cards, which remain much higher than debit cards and much higher in the U.S. than abroad (Figure 5).
Interoperability
The interoperability between components in the payments ecosystem is critical, as breaks can lead to costly mistakes. In the U.S., the number of layers in the system and existence of rival transaction networks greatly complicates the ability to work in conjunction with one another. The EU is also ahead of the U.S. on this metric. Regulation PSD2, a 2015 European initiative that required implementation by 2018, increases pan-European payments cooperation, opened up the European banking system, and established a standard for payments data transmission, ISO20022. This standardization makes it much easier for all payments players to interact with each other.
Why Has Change Been Difficult in the U.S.?
While there’s no clear explanation of why the U.S. has struggled to adopt an enhanced payments infrastructure, a few theories are:
● U.S. banks and card networks remain profitable creating no motivation for new payments infrastructure. These companies fell victim to Clayton Christianson’s innovator’s dilemma, where prioritizing costly expenditures for new innovations is pushed aside to continue focusing on high margin businesses.⁹
● The actors in the U.S. payments infrastructure have heightened lobbying power to keep the status quo. The U.S. government won’t intervene until it is clear that intervention is necessary.
● There is a lack of clarity in the U.S. over who is responsible for innovation of the payments infrastructure and the Fed is hesitant to compete with private solutions.
● The U.S. is unique in its fragmented banking system. While the number is shrinking, America still has thousands of different banks. This fragmentation increases the complexity of working together, which is necessary to truly transform the payments system. The Fed’s faster payments task force consists of over 300 payments stakeholders, illustrating the complexity behind what is needed for cooperation.
● U.S. culture and habits have made it difficult to accept change. Consumers have a much higher threshold for taking on credit debt than consumers of other countries. This has entrenched the credit card in society.
● New payments technologies in the U.S., particularly mobile, have seen slow customer adoption because consumers are used to the legacy infrastructure. In contrast, emerging markets benefit from the lack of legacy infrastructure leading to high customer adoption of new innovations.
Over the next few years, the Fed and payments innovators will work on creating a faster, cheaper, more equitable payments infrastructure. It has finally become clear that this change is necessary. Financial companies that thrive will be the ones that adapt to this new world.
[1] Arthur, Chandra. “Understanding the Payments Layer Cake.” Blog, blog.finixpayments.com/understanding-the-payments-stack.
[2] Ammon, Angie. “The Evolution of Integrated Payments: Payment Facilitation.” Finix, www.finixpayments.com/blog/what-is-payment-facilitation/.
[3] Huang, Tien-tsin, et al. Payment Processing: Payments Market Share Handbook Tenth Edition. Payment Processing: Payments Market Share Handbook Tenth Edition.
[4] “Payment Systems Task Force Members and Terms of Reference Announced.” Office of Fair Trading, 31 Jan. 2007, web.archive.org/web/20081019110152/www.oft.gov.uk/news/press/2004/43-04.
[5] “U.S. Path to Faster Payments.” Faster Payments Task Force, fasterpaymentstaskforce.org/.
[6] “Real-Time Payments Systems and Third-Party Access.” A Perspective from Google Payments, Google, Nov. 2019, static.googleusercontent.com/media/pay.google.com/en//about/business/static/data/GPay_RTP_2019.pdf.
[7] Huang, Tien-tsin, et al. Payment Processing: Payments Market Share Handbook Tenth Edition. Payment Processing: Payments Market Share Handbook Tenth Edition.
[8] Resendiz, Joe. “The Cost of Accepting Credit Card Payments: NA vs EU.” ValuePenguin, 3 Sept. 2019, www.valuepenguin.com/interchange-fees-na-vs-eu.
[9] “The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail.” Clayton Christensen, claytonchristensen.com/books/the-innovators-dilemma/.
