Banks/Non-Banks and Commerce Networks (Why I love V/MA)
27 July 2014
This blog has been in 50% mode for 2 weeks! Obviously summer is not my productive time (I must be German). There will be a noticeable change in my blogs these next few months as I work on a newco launch. Blog will therefore focus more on concept, much less G2. This will be a transition piece…
What is the benefit of becoming a bank? Would Paypal buy a bank? That is the rumor… I have no idea on this one.. 0% confidence.. my guess is no way. There are some great payment+bank companies (Amex, Wirecard and Alliance Data), and some great payment non-bank companies (Visa, MA, Stripe, Paypal, …etc). What are the business drivers of becoming a bank? What are the Pros/Cons?
For those without time to read below, a bank license brings on enormous compliance cost and restricts: what business you can do, how you manage consumers and their data, and what risks you can take. The upside for being a bank? You get to take risk with other people’s money. Simply put, any company contemplating a bank license must have a business plan MORE dependent on managing risk than on orchestrating commerce value. Today there are many bank licensed “specialists” which support non-banks (TBBK, Meta, Alliance Data)… so why would you want to become one? Paypal is on the fence here, as historically they won in eCommerce because of their ability to manage risk (CNP Fraud). Do they want to grow in risk management? or in everything else?
When looking for the right regulatory structure of any company, we must assess their current network plans in the context of commerce AND banking. Not just how your network delivers value today… but rather how you deliver value in the future? Banks tend to make most of their money within their own node, whereas others in commerce are highly dependent upon other partners (manufacturers, distributors, agencies, sales, …). Electronic payment growth and network services are set to grow geometrically, yet payments are very very sticky and hard to change. This is the start up investor conundrum: How do you make intelligent investments in payments/new networks? There are 3 basic options
1) Help others expand their networks
2) Build new networks
3) Build communities with minimal need to network outside of your environment (Facebook, Amazon, Alibaba, BANKS?…)
92% of all electronic transactions are done in the top 10 markets. (Cap Gemini’s World Payments Report is a must read). 90% of the worlds population is not connected to financial services. There is a n-squared dynamic when this takes place.
Many entrepreneurs, journalists and technologists miss THE CORE facet of Visa and Mastercard: a business platform where thousands companies invest billions of dollars. There is no way to compete technically with this business model, rather the ONLY way to “compete” is on value and services. Where Amex has the ability to deliver much broader and richer services (as they own both merchant and consumer accounts), they have a downside: no one else investing in their network (scale/adoption).
My firm belief is that both V and MA have the opportunity to grow Revenue 4-10x in the next 5-10 years. Their principal challenge is to “tilt” their models away from Banks and toward the 2 parties that matter most in commerce: Merchants and Consumers. Payments work well, but so did the Sony Walkman. The bets that Google, Apple, Amazon, Facebook and others are making is on value orchestration (in a new network). Does this involve payment? Not really.. at least not as a primary focus.. Payment is there.. but orchestration is about commerce; payment is just one of many important processes (See blog Payment in the OS). Don’t look at payments as something in isolation, payments are the “connections” made in commerce; they are made for a purpose. These payment connections are rapidly changing from many environmental forces:
- Internet flow of information,
- Google enabled discovery
- MNOs have enabled constant connectivity
- Social has enabled reputation across activities
- Online retail has enabled price transparency, comparison and product reputation
- Changing of Bank roles, products and services
- New Consumer behaviors
Payments = Network
Payments are the connections of the GDP. If we were to map payment flows, we would unlock a map of the global GDP at the micro level, from employment to shopping, behavior and preferences, to demand and supply. Perhaps this is why our government loves payment information. Oh.. the stories here.. (for another time). Free information flow on the internet is enabled through openness and a single primary protocol, whereas payments operates within 100s of proprietary networks with a complex series of clusters and “switches” (there is effort in connecting, authenticating and managing risk). Just as it would be nearly impossible to change the protocol for the internet, it would be difficult to bring about fundamental change in payments (see Rewiring commerce). Connecting business is much different than connecting information (the core of my NewCo.. but I digress).
From a network strategy perspective, the business opportunity of changing “payments” pales in comparison to the opportunity to influence connections in commerce, banking and manufacturing. Payments support business and consumer needs; they do not alter their path. This insight is the downfall of bank payment strategies around “control”, and their inability to “tilt” toward merchant friendly value propositions.
A top 5 retailer provided my favorite commerce quote “I think of Commerce as a highway, the payment networks are like a toll bridge. I don’t mind paying them $0.25 to cross the bridge, but they want to see what is in my truck and take 2-3% of what is inside. Hence I’m looking for another bridge… “ (See Rewiring Commerce). Google, Amazon, Facebook, Alibaba, Rakutan, V, MA, Amex, eBay all understand this. Rather than charging toll for crossing their bridge, these networks are beginning to execute against plans to grow the size of the goods in the merchant’s truck.
Intelligent use of data increases the effectiveness of the merchants, and in a way that also benefits consumers. Tilting more toward merchants and consumers.. means tilting away from banks. This is VERY hard for a bank to do. It is a change worth making however, as assisting merchants could meant 4x-10x of their current value creation (payments is roughly a $200B US business, marketing is $750B).
My favorite book on networks is Weak Links by Peter Csermely (viewable on Google Books here). If I had one book for you to read this is it. This book is tremendously arcane, detailed, technical, deep.. but I guarantee you that you will have a new view of commerce, banking, advertising, biology, social networks, payments, and society after reading it. In connecting to networks, each of us have limited resources. Therefore optimize our connections through finite set of “hubs” (unless there is some larger orchestrator).
Think about the battle in connecting networks, as each of us have limited resources we can connect only to a finite set of “hubs” (unless there is some larger orchestrator). Examples are Wikipedia and Google… these serve as the directories of information. It is almost IMPOSSIBLE to displace an efficient hub. This is why I love Visa, MA and Amex. If they can shake the issuer legacy.. and add a few merchant friendly services, they could drive 4x of their current value. Specifically, payments is roughly a $200B business, whereas marketing is $750B (in US).
Against this network strategy and services backdrop, there is an enormous transformation taking place in Commerce and Banking. In other words existing networks are evolving their services, as the “hubs” that they connect to (banks, retailers, manufacturers, aggregators, ..etc) undergo change within their “core”. See Remaking Retail, Future of Retail Banking: Prepaid?.
The regulatory/compliance “headache” for payment “innovators” revolve around connecting networks and engaging in non-commerce transactions. I’m not just talking about just small guys.. but BIG ones too (think Google, Apple, Amazon, Walmart, MCX, …etc). Existing networks have an existing value proposition, and many don’t like to have their services leveraged by competitors (see Banking and Commerce: What is the Difference?, Don’t Wrap Me).
This leads us to Banking Services… expanding beyond commerce. This is area is very nebulous because of the complexity of regulatory authorities covering “banking” and money services. Here are just a few of the US regulators
What are Banking Services? Anything the regulators say are banking services. I’m not joking.. this is why I put the Paypal 2002 prospectus at the top. Banks are highly regulated, and the compliance costs are extraordinary. Regulators are attacking all things payments and banking with renewed vigor. Along with compliance constraints, there are constraints on how you can use data. As an example, my online banking team in Germany had to purge the server logs of IP addresses every 30 minutes (regardless of use for fraud). (see Banking and Commerce: What is the Difference).
So what is the upside of being a bank? It’s certainly not the regulation or the mandatory compliance courses forced on every employee. The “benefit” of being a bank is the ability to take risk with other people’s money. Unfortunately, the BIG downside to being a bank, is that data can no longer flow outside of your organization. I cannot understate this limitation.
Banks have much clearer and hence stricter obligations as regards the sharing and protection of sensitive information, commonly known as ‘bank secrecy’. This matches the generally more extensive regulation of a bank, as opposed to the regulation of an ELMI or MSB.
Acquiring a new consumer financial account is hard, even if you get the consumer to create an account with you, you must get them to fund it, or take credit risk on them. These are the problems that banks have dealt with for 100s of years.
Banks have much clearer and hence stricter obligations as regards the sharing and protection of sensitive information, commonly known as ‘bank secrecy’. This matches the generally more extensive regulation of a bank, as opposed to the regulation of an ELMI or PI. Based on the same reasoning why non-banks require less strict regulation for their business and prudential risk involved, it follows that also their activities and also access and handling of certain information and data is restricted accordingly.
Would Paypal Buy a Bank?
Again, I have no idea here, but it doesn’t seem to make much sense. Considering a bank license is like watching flies in your kitchen window: the ones on the outside want in, and the ones on the inside want out.
For long time readers, I put together a blog about 4 years ago covering this topic Payment Startup: MSB or Bank? and US Payment Regulations. As I outlined, there are very few payment regulations covering purchase of tangible commercial goods (this is true globally). We can see the evolution from PayPal’s 2002 prospectus.
We believe the licensing requirements of the Office of the Comptroller of the Currency, the Federal Reserve Board or other federal or state agencies that regulate or monitor banks or other types of providers of electronic commerce services do not apply to us. One or more states may conclude that, under its or their statutes, we are engaged in an unauthorized banking business. In that event, we might be subject to monetary penalties and adverse publicity and might be required to cease doing business with residents of those states. A number of states have enacted legislation regulating check sellers, money transmitters or service providers to banks, and we have applied for, or are in the process of applying for, licenses under this legislation in particular jurisdictions. To date, we have obtained licenses in two states.
How does Paypal operate today?
- Licensed money services business in 47 states (all states which require one)
- Bill Me Later, and paypal working capital are structured so that loans are originated by WebBank (Utah ILC). See this 2013 note on structure/issues
- PayPal had been a market leader in “deposit” rates, through the Paypal Money Market fund (see Link). This fund was shut down in 2011 due to treasury rates/market conditions (see link).
- A Discover partnership has yielded little fruit at the POS. Paypal had been claiming that there was an “exclusive” nature to the network agreement, whereas DFS was clear they could work around it by providing other services. (My blog on topic)
- Paypal has been telling investors it plans to move to the POS, both with mobile, and an experimental paypal plastic card (running on Discover). Nothing is moving here, my guess is that JambaJuice is their #1 in volume and would be surprised if that had more than $50-$100M TPV ($1.5M-$5M in Revenue).
- MasterCard pre-paid card for PayPal “balance” spend. I love this product, it is how I get cash out of my paypal account at the ATM.
- Wells Fargo Clears Paypal ACH volume in US.
- Paypal as strong acquiring relationship with Chase.
- ADS partnership (see WSJ). In 2013 Paypal and ADS created a partnership with 3 primary components: ADS credit risk management (BML), Paypal merchant acceptance, Data/analytics/marketing at POS.
- PayPal has had a bank license in the EU since 2007, when it merged its prior legal entity (Paypal Europe LTD) into this Lux based Bank. (http://www.paymentsnews.com/2007/05/paypal_obtains_.html)
- Great outline of Paypal’s regulatory approach to EU is from their own whitepaper https://circabc.europa.eu/sd/d/3435be20-e7bb-45ea-8289-dfaaea253a23/reg_org-eu_paypal_en.pdf
- In Australia, PayPal serves its customers through PayPal Australia Pty. Ltd., which is licensed by the Australian Securities Investment Commission as a financial product
- Per eBay’s 10k “In markets other than the U.S., the EU, Australia, Canada, Brazil, and Russia, PayPal serves its customers through PayPal Pte. Ltd., a wholly-owned subsidiary of PayPal that is based in Singapore. PayPal Pte. Ltd. is supervised in Singapore as a holder of a stored value facility.”
I see little upside for Paypal expanding it’s EU bank model to the US, as its current network assets and future opportunity revolve more around supporting commerce than managing risk. Paypal’s current structure and partnerships (with ADS, Discover, MA, GE, …) provide the flexibility to deliver banking/lending services. For Paypal, Bank ownership would only hinder their broader efforts to deliver value to consumer (through data). Alternatively, a bank structure does work for other companies like Wirecard. The Wirecard bank model is a tremendous fit within a network where mobile operators serve distribution channels for financial services.
With respect to the Paypal/Bank rumors, my guess is that there is an “opportunistic” assessment going on .. and that this rumor is just one of the paths they have looked at. I also have a strong feeling that Discover is looking for a “partner/acquirer” that can make use of its network while it is still somewhat relevant. Particularly since its M&A discussions with a top 5 bank 2 years ago did not happen.