Book Review: The Pay Off

The world’s first credit card transaction is said to have have been conducted by Frank McNamara at Major’s Cabin Grill in New York City on 9 Feb. 1950. The Diners Club Card was used for meals at restaurants in the city’s Midtown neighborhood. As cards became popular among office goers, banks also entered the industry.

But the cards issued by these institutions were loss-making propositions and prone to fraud. It took more than a decade and several innovations – the invention of a smart card with a pin to prevent counterfeiting, the Magstripe (the stripe at the back of a card) by IBM are examples – and an increase in the number of card-accepting institutions to make credit cards even more popular.

Nowadays, it is difficult to imagine life without a credit or debit card. But they are only one of the many ways in which we make purchases. Cash is another. Online merchant processors make e-commerce possible. Then there are smartphones, which can be tapped to make a payment.

All these payment methods have converted payments into a burgeoning industry: payments revenue was just under $5 trillion in 2019. That revenue was spread across various modes, formats, technologies and jurisdictions.

But the average person knows very little about how payments work. The Pay Off: How Changing The Way We Pay Changes Everything is an excellent introduction to this mostly opaque ecosystem. Written by alumni of SWIFT, the world’s biggest cross-border payment network, the book’s professed aim is to narrow “the gap between our dependency on payments and our awareness about them.”

It does a great job in achieving this aim and provides a layman’s introduction to this gargantuan and, often, confusing world. There are times when it gets carried away in its enthusiasm for technology-oriented payment solutions but that’s a minor quibble for a book that makes a complex topic accessible to lay audiences.  

The payments industry has a broad scope encompassing regulation, politics, networks, and technology. To that end, the book’s chapters and sections gallivant between different concerns and topics.

Thus, one chapter discusses the effect of ECB regulation on bank revenues from payment services while another introduces how credit cards work. Yet another chapter discusses the industry’s changing models and its use as a geopolitical tool. In the book’s final chapters, its authors discuss the effect of technology on payments and the industry’s future.

From Cash to Cards to Phones

“How we pay and get paid is a function of not only how we want to pay or be paid but also of how those around us want to pay and get paid,” the authors write.

There are three risks associated with a payment transaction: credit risk or the creditworthiness of involved parties in a transaction, liquidity risk or the presence of a counterparty and markets for a transaction, and convention risk or the risk of having an acceptable and commonly chosen method of payment.

Out of these, the third one has undergone a dramatic transformation in the last two centuries. Money is a social construct but its conventions varied across the world until about two centuries ago. Paper money was invented in China but it wasn’t until the British Empire moved to in the 18th century that it became popular across much of the world. The advantage of cash, as paper money is commonly referred to, is that it is convenient and anonymous. Accounting for cash is also relatively simple. But it is not cost-effective to manufacture, especially for low denominations notes and coins, and requires external storage. Anonymity is also a double-edged sword because it makes cash difficult to track.

Credit cards are an alternative to cash. The majority of cards today use a four-corner model pioneered by Bank of America’s credit card in the 1960s. In this model, there are four actors: buyers, sellers or merchants, acquiring banks, and issuing banks. Except the buyer, each actor in the model gets a percentage cut of the overall price for verifying and validating credit information.

The acquiring and issuing banks rely on transaction volume for profits while the payoff for merchants is the prospect of more sales from card-using customers. The high margin interchange fee charged by banks serves dual purposes. First, they generate profits and cover operational costs. Second, they enable card issuers to provide “free” services, such as airport lounge access and discounts at prominent retailers.

In recent times, tech apps like the Buy Now Pay Later (BNPL) app Klarna have modified the four-corner model to a three corner one. Thus, merchants are paid immediately by the company while its algorithms split customer payments into installments based on their credit score. Credit risk is quantified and verification, previously done by acquiring banks, is now handled by the company itself. 

Other tech startups, such as Stripe and Square, have also innovated the four-corner model by making it easy for small businesses to accept merchant payments. This has brought new customers and merchants to the payments industry. Services like Apple Pay and TenPay use Near Field Communication (NFC) technology and further expand payment infrastructure to phones, removing expensive card machines from the process. The innovations have made paying for purchases an almost reflexive act, similar to checking your phone for a text.

A SWIFT Dominance

While there are many channels in the retail payments landscape, the options to transfer money across borders are fewer. Western Union remains the biggest and most popular venue for cross-border transfers. TransferWise, a startup with a valuation of over billion dollars, has emerged as a competitor but it is still to become a serious challenger.

Part of the reason for this is that cross border transfers are an exercise fraught with regulations and complexity. You need ready liquid markets between two currencies and sufficient funds to cover your bases (and minimize risk) and expedite the transfer process.    

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) forms the backbone for most cross-border bank transfers in the world today. The non-profit’s messaging system is the technical equivalent of passing money along a human network across geographies. SWIFT’s messaging route is often circuitous and almost always involves some exchange in US dollars. Each correspondent bank (as intermediary banks in the process are known) charges a service fee that adds up to an expensive transaction overall.

Suffice to say, the many instruments and means available for payments across the globe has resulted in convoluted pathways for money domestically and internationally. As disparate as the world’s payment systems might seem, however, they are policed by a single country: the United States. The considerable economic heft of the American economy and the dollar’s dominance in global trade transactions has made JP Morgan and Citibank the world’s biggest correspondent banks. The digitalization of payment processes has further made it easier to track payments and opened up a new front in geopolitical maneuvering.

This front heavily favors America and displeasing its government carries the burden of significant economic cost. The country’s agencies often use their power to punish nations. In recent times, SWIFT, a supposedly neutral non-profit, has also kowtowed to American diktat and shut access to its network when America imposes on. a particular country.  

Iran and Russia are the most recent examples. The former country was cut off from international financial markets in 2018 because it has nuclear ambitions. Russia invited American wrath for its invasion of Ukraine in 2022.

The effect of such sanctions can be acute as liquidity for currency pairs, other than those involving the US dollar, is thin. The greenback’s primacy in global transactions is such that even a parallel system of correspondent banks, that functions outside of the American pale and clears payments only between each other, will eventually run into a regulated entity that trades in dollars and will be forced to close its operations, the authors write. As paradoxical as it may seem., tech systems that timestamp transactions with origin and destination IP addresses have helped increase surveillance of payment systems.   

Are there alternatives?

Cryptocurrencies, which supposedly are borderless and function outside regulatory bounds, are advertised as one. But crypto infrastructure, wracked regularly by hacks and replete with meaningless buzzwords, is far from rivaling the plumbing of mainstream finance. The liquidity of cryptocurrency markets is also far too small to enable such transactions. Centralized cryptocurrency exchanges, like Coinbase, are also amenable to toeing the official US line. Coinbase, North America’s biggest crypto trading exchange by volume, blocked Russian wallet addresses to comply with US sanctions.

In this context, it is important to remember that tech startups haven’t really disrupted financial services. Fintech is mostly a sheen for customer-facing tech apps that have devised ways to reach new audiences. Tech products and services are mostly acquirers i.e., they bring customers into the network for payment processing giants. For example, Square and Stripe take out the hassle of opening merchant accounts for small businesses, enabling them to immediately begin accepting payments after account opening. In the backend, the company’s systems still have to pay interchange fees to Mastercard and Visa.

Their products are not necessarily cheap either. Square and PayPal charge a flat rate per transaction and do away with monthly fees. But the rate – between 2.6% to 2.7% – is higher as compared to other merchant processors and, according to some assessments, is best suited for businesses with low sales volumes. Thus, the levers and infrastructure for payments have expanded even as they are still controlled by legacy banks and payment processors.

What’s The Future?

It is tempting to write obituaries for cash, given the prevalence of digital payments and its declining use in many countries. But cash use will persist, write The Pay Off’s authors. Available evidence also backs up their claim.

Meanwhile, digital money is set to undergo another paradigm shift. Countries around the world are investigating or have already released digital currencies. Known as Central Bank Digital Currencies (CBDCs), such currencies establish a direct connection between central banks and citizens. That connection opens a wealth of possibilities, including universal basic income and interest deposits.

And what about banks? They are universally hated as symbols of greed and excess. But Leibbrandt and De Teran say banks are irreplaceable.

“Moving money involves risk and requires liquidity: for all the alchemy technology brings to the table, these two elements cannot be magicked away…it is difficult to envisage countries or central banks tolerating anyone handling the business without the benefit of a bank balance sheet and a good dollop of regulation behind them,” they write. To remain relevant, banks will have to move with the times. Some, like JP Morgan, have developed their blockchain and their own coins to expedite transfers and create new markets for commercial clients.   

A central bank’s sphere of influence might become circumscribed in the future. Research by the Bank of International Settlements has found that the number of correspondent relationships between banks fell by 20 percent between 2011 and 2018. Whatever the official reason for this development, it points to an increasingly fragmented payments web.

Domestic payment networks are replacing the earlier global interconnections managed by Mastercard and Visa. The European Union is developing a Pan European Payments Initiative to replace national payment systems across its member countries; China has Union Pay; India has already launched a Union Payments Initiative (UPI) that serves as payment rails for its incipient e-commerce industry.

Even the impact of punitive sanctions against Russia and Mastercard and Visa’s withdrawal from the country has failed to make much of a dent to its local payment systems. This is because the National Payment Card System, known as NSPK locally, is the backend for Mastercard and Visa systems. In their absence, the local card network has taken on their functions and the effect of sanctions has been ‘blunted’.

On the international payment transfer front, however, things are beginning to change. SWIFT’s political leanings are eroding trust in the nonprofit. This, coupled with the dollar’s dominance in global transactions, has made many nations uneasy with the current setup. “As the act of paying becomes less explicit and more abstracted, the philosophical divides and geopolitical battles will become increasingly evident and more heated,” write the authors.

Cryptocurrencies might step in to fill in a possible gap. Bitcoin’s global credentials and accessibility might find favor with countries chafing at US restrictions on international market sales of their dollar-denominated reserves. Ethereum, the world’s second-most valuable cryptocurrency blockchain, has been described as a “world computer” by its proponents. Each node in its blockchain already stores data – similar to debits and credits – about transactions running on various financial apps connected to the main chain. The apps or services are charged “gas fees”, not unlike the fees charged by correspondent banks in the SWIFT system, for computational effort and storage on the main chain. Except these gas fees are dynamic and based on a slew of parameters, such as transaction size and frequency, defined in its protocol. Ethereum’s blockchain could serve as global infrastructure for a worldwide eco-system of financial apps and services.  

All of this means that payment systems, as we know them today, are about to undergo another transformation. How the profits of that transformation are divided among stakeholders is another story. Or, perhaps, the topic of another book.