Call to Action – Submit Response to Fed

1 Dec 2013

As most of you know, the Federal Reserve published a paper entitled Payment System Improvement and opened it for comments http://fedpaymentsimprovement.org/. Responses are due 13 days from Today. My response can be viewed here.

After witnessing the mess that Regulators and Central Banks can create (FFIEC 2 Factor Auth, UK Faster Payments, SEPA, …), you should take time to submit something for your organizations.  We all need a flexible regulatory environment which provides a fertile field for Innovation and technology evolution (of payments and banking).  How should the US payment system evolve? What is Broken? What is working? Who should lead (Government or Industry)? This is the context behind the survey which covers: tokens, real time payments, fraud systems, mobile payments, and approach.

Summary View

  • The Payment System works today for 95% of needs. Let’s NOT force everything to be real time. Just as we have Rail and Ship transport today… some consumers still demand next day air delivery (a business need that consumers will pay extra for).
  • The problem with the payment system is NOT speed, it is control. The American Banker article How Big Banks Killed a Plan to Speed Up Money Transfers speaks to the uneven playing field faced by small banks, MSBs and other service providers.  Why are big banks blocking this real time effort? Because the top 4 are formulating plans to restrict use of bank owned settlement infrastructure and create new semi-open REAL TIME settlement networks (ie ClearxChange) which will only work for the largest institutions (see New ACH Payment System for background on this initiative). The second paragraph of the Fed’s paper

    Industry adoption of new payment services and technology in this country has been driven mostly by market forces rather than government direction

    is incorrect. Industry adoption of CORE payment services is driven COMPLETELY by the top 5 banks. Top 5 Banks created and hold veto power over: Visa, MA, TCH, NACHA, … and most industry infrastructure.

  • There are only 2 regulatory changes I would request: #1 mandate transparency in rule making for both government controlled (FedWire) and private Payment Entities. No more anonymous voting on common infrastructure, the NACHA and TCH voting procedures are a mess.  The WSJ article above demonstrates the obfuscation.. and the subsequent success of this blog. #2 Allow non banks to assume risk and decrease compliance requirements (for banks) surrounding this service. (more on that later)
  • Over 40% of US consumers are no longer well suited for traditional banks and are migrating to new products (pre-paid/GPR cards) that are offered by new intermediaries. Payments are not only critical to the top of the pyramid but to the bottom. Non banks and the unbanked must be able to participate in the payment system. Again the issue is NOT real time payments, but ACCESS (control).
  • The core technical challenges in Payments are #1 Consumer Authentication, and #2 Risk Management. Non banks are best positioned to Authenticate a Consumer, and may also be best suited to manage risk (as Paypal does in Card Not Present). Banks bear the weight of KYC/AML requirements today and therefore look to control the entire process. If we want consumer centered investment, Non Banks must be able to participate, and bear risk. If the central bank commits to technology of yesterday  we will not be able to leverage new capabilities and consumer experiences will be highly fragmented. (ex a new Apple device which would enable real time, irrefutable transaction signing).
  • The core business challenges in payments today are around value. Banks do not want to invest in networks that benefit merchants (ie Debit, DDA) and Merchants don’t want to invest in networks that benefit banks (ie Credit, Contactless). Payments are just the last (easiest) phase of a long Commerce process. No one should force banks to invest in merchant friendly mechanisms, but banks should not be in a position to BLOCK success here.
  • There will be NO INVESTMENT, if there is NO RISK. Payment profitability is driven by risk management (including fraud, authentication, credit risk, …).  We must allow entities that can bear risk to participate and invest.
  • Network efficiencies MUST IMPROVE (see Thomas Phillippon below). The GOAL of payments should be to provide LEAST COST ROUTING to support consumer preferences of where and how they want to pay and authenicate (ex Apple, Google, …). Expanding an existing utility (ie Fed Wire) may provide a faster path to new capability, and develop a higher quality of service, as competition develops among private networks (analogy is Darpanet ).

MCI Interconnect in Financial Services?

The metaphor for change in the payment system may be the 80s MCI interconnect battle (see Wikipedia), combined with a new regulatory regime which would allow non-bank participation in an OPEN settlement network (Connection + Settlement). See my blog How to Deregulate Payments like Telecom. To understand the current state of industry quantitatively,  NYU’s Thomas Philippon published jaw dropping research detailing how Payments and Banking are one of the few network businesses in the HISTORY OF MAN to grow less efficient (rail, telecom, energy, …). Obviously Regulatory Capture is an issue as regulators protect Bank margins and discourage rate competition. The fundemantal flaw to the Fed survey is an underlying assumption that change will be made to existing utilities and existing players. I’d rather take the MCI approach where the government provides for open interconnect and allows other parties to assume risk. This is why Telecom, Airlines, Stock Exchanges, and the Internet work today. There will be no change, or new investment, unless Regulatory Capture and Big bank control over common utilities is broken.

In another example, from my blog Tokens – Merchant Options obviously there is a need to tokenize a direct draft ACH/DDA to hide the consumer’s account number. This is what the TCH upick system (bespoke TCH token system) was developed around. However banks have NO incentive to deliver innovation around DDA tokens as it would decrease risk and increase consumer adoption in a model where they can not charge ANY interchange. Thus innovation is directed toward revenue (a logical imperative), and conversely merchant avoidance is based upon cost/value (hence no adoption of card POS tokens).

The EU’s ELMI model is perhaps the best developed regulatory standard. Perhaps the US pursues something similar which would serve as a federally chartered MSB. Or provide for existing MSBs to operate (and assume risk) on a settlement network (like Fed wire).  This is my core recommendation, rather than taking a 5 year approach, the Fed should create an open settlement service, in which private utilities (ACH, Visa, …) must compete with. Australia (EFTPOS) and Canada (Interac) have both successfully consolidated debit infrastructure as a result of regulatory mandates (and these remain bank owned networks). Today Fedwire competes with TCH in settling payments, but garners much less than 1% of settment (see FedWire Volumes).

The Fed should consider consumer requirements and preferences, after all it is the consumer’s money. Similar to the MCI telecom case, regulators should consider the minimum consumer servicing requirements. If a consumer wants to pay through an intermediary (like PayPal, Amazon, Google, MCX, … ), or have money stored with an intermediary, or want to remain anonymous to the merchant in a transaction, they should be able to do so. As the Visa model evolves, Consumers should be able to INITIATE the payment request with the Bank (as opposed to the Visa/MA model of merchant requesting payment based upon consumer credentials).

Today, ODFIs are responsible for all risk (in ACH and Card Present). The Regulatory burden they face is substantial (Fed, OCC, CPFB, …etc.).  There are very big plans by the banks to gain tighter control over the payment network (see Tokens and Consumer Authentication).  Fundamentally, if we want change, we must improve transparency and allow risk to be assumed by non banks (and consumers).  Consumers should have the choice to take the slow railroad (with guaranteed delivery) or an instant transfer that cannot be reversed.

The FED should be very mindful that their direction does not just impact Innovation at the top end of the consumer pyramid: over 40% of US consumers are unprofitable to US Banks (see Prepaid – Future of Banking?). The Amex/WMT Bluebird product is proving to be an attractive alternative “banking lite” product with ability to direct deposit. The story of MPESA in Kenya may be useful here, as a non-bank was granted an exception which enabled the service to grow from 0 to 10% of the GDP in 3 yrs. Regulators and the Central bank do NOT look favorably on this development, as 10% of the GDP flows out of M1 into a single non-interest bearing settlement account which cannot be leveraged by banks to offset loans (ie liquidity ratio). But consumers love the service…

Key Topics which I believe need to be addressed:

#1 Bank Ownership and Control of the Payment Rails

  • Cost Transparency/Reporting
  • Speed Transparency/Reporting
  • Transparency of Rule Making and Voting in Infrastructure
  • Non Bank Ability to Connect
  • Non Bank Ability to Take Risk
  • Non Bank Participation in Settlement (ex Federally chartered MSB, or non-bank access to FedWire)
  • Consumer Authentication Standards, and Ability for non-banks to assume role (see KYC)
  • Common Reporting/Alert Interface in Transaction Origination and Settlement

#2 Issuance and Value Storage (from How to Deregulate Payments like Telecom)

We need to look no further than BitCoin to see the need for new regulations surrounding issuance. Transfer of funds between entities is covered above, and my view is that non-bank participants should be licensed and agree to abide by current money transfer  regs (ie. Fincen/AML, ..). Issuance of “credentials” and storage of funds is another matter. Long term storage of funds is a banking function, and should be regulated, settlement funds face state escheatment issues (but largely unregulated unless interest is paid), while storage of “Value” is completely unregulated (ie Coupons – a form of legal tender, Pre paid offers, bitcoins)?

From above, if we allow non-banks to participate in real time funds transfer, third parties (ie Sofort) would act as agents (on behalf of consumer, merchant or bank) to direct the funds and assume risk on behalf of consumer. If a good/service is purchased immediately (commerce) then there is no regulation, however if the value is “held” for future use it is generally regulated (hence MSB, eGold, bitcoin issues). Thus the rules under which third party senders operate (as agents), are different from the entities at the end of the transactions (banks, merchants, consumers). See ACH Origination Risk.

As in the MPESA example above, there is an obvious CONSUMER need for issuance to more closely resemble cash in its ease of exchange, verification, anonymity and storage.

Our current need is for simplified laws surrounding account under a given value amount (say $2000). Providers of service should be lightly regulated through self reporting, “transparency”, and the need to keep settlement funds with the Fed. In this proposed model, a bitcoin exchange must ensure that no single individual has processed more than the threshold in a given time period. Hence the need for KYC of exchange participants (when converting to cash).

Summary – new HUB vs evolving existing networks

The current ACH system will never go away (related blog). There were $33.91 TRILLION moved over the network in 2011, compared to total debit and credit volume of around $4.5 Trillion. What path should regulators take?

#1 Improve ACH (primarily speed and fraud management). The highest priority will be around third party senders (TPS), the lowest priority will be regular customer directed debits and payments to billers.

Third party senders (TPS) are a subclass of Third Party Service Providers (TPSP) which originate ACH transactions based on a direct consumer relationship.  Alternatively TPSP are also known as “processors” whose customers are banks (primarily) and have no direct consumer relationship. Banks are not happy with the “free riders” on their network (see  blog). Most bankers view companies like PayPal and Xoom as riding on their rails for free. One of their biggest issues is that they do not have visibility into the actual beneficiary as the settlement account hides where the payment is going to. This impacts their ability to perform risk management and authorization. Take these issues together with the increased regulatory focus on AML and we have a fertile environment for change (HSBC’s See Deferred Prosecution Agreement, and business overview of HSBC’s issues from Reuters). Note that AML concerns are much more relevant to International ACH Transactions (IAT). This blog is not focused on IAT.Token

Banks must therefore architect a solution to evolve ACH while the ship is moving. This is a much better approach than that taken by the UK of mandating faster payments… (one bank was losing 30M GBP a WEEK from fraud when launched). The consensus approach seems to be one surrounding tokens and directory (my blog from last year Directory Battle Phase 1).

#2 Build a new competing network (around Fedwire) which would allow for non-banks to assume risk

 

Sorry for abrupt end.. I’m sounding repetitive.. .so I’m stopping

Commerce and Banking – What is the Difference?

21 Nov 2013

Warning… long blog.. random unstructured thoughts

This is the question I came up with in a lunch chat with my friends at Omidyar Network and not exactly something I can adequately address in a blog, a book, or a lifetime.. but hey some idiot like me may as well throw it out there.

Why am I asking this question?

My investment hypothesis is that Banking and Commerce will be undergoing a fundamental rewiring. Therefore I’m wondering who the winners will be? What needs to be built? What are the signs that progress is coming? These are my selfish drivers.

On the altruistic side, how can we massively expand the global economy? Enable millions of businesses and billions of consumers to participate in the world economy? Within emerging markets, which is more important to invest in? Banking or Commerce (see blog Expanding Global Economy).

Where am I coming from? Network View

Well I’m certainly no economist, but I do know a few things about networked businesses. How are Banking, Commerce, Society, Government influenced by network effects? How has it evolved?

One of the most influential books I’ve read on this topic is Weak Links by Peter Csermely (viewable on Google Books here). If I had one book for you to read during the Holidays 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, social networks, payments, and society after reading it. Example below on Peter’s insights into how the creation of money altered society, established “weak links” and Capital Markets (p 263)

weaklinks

Wow… just when I thought I knew everything about payments. The advent of money led to the development of concept of PERSONALITY!? (Certainly a new way of thinking about networks). The idea that increasing use of money drove new social and economic structures is obvious; less obvious are the connections formed, the “weak links”, beyond the flow of funds: non monetary data, relationships, reputation, …etc. I prefer to think of this “personality” dynamic, within weak links, as behavior (as influenced by Malcolm Gladwell).

These “weak links” represent the world’s most complex network, and this network is going through a FUNDEMENTAL change as communications networks have greatly improved the efficiency of network creation to a near frictionless flow information. There are 2 fundamental questions for me here:

  1. What is the cognitive limit to networking (ie. associations, data, ..etc)? and what are the tools to improve them (ie Platform which I will cover later), and
  2. How do we connect the unconnected?

Most surprising to me, within Peter’s work, was the idea that scale free distribution (completely open networks) is not always the optimal solution to the requirement of cost efficiency. For example, Peter states in his book

in small world networks, building and maintaining links between network elements requires energy…. [in a world with limited resources] a transition will occur toward a star network [pg 75] where one of a very few mega hubs will dominate the whole system. The star network resembles dictatorships in social networks.

Therefore, there is a case to be made for specialization and “semi open” networks when it comes to COST efficiency. Logically, the boundaries for star network size are associated with the value of connection exceeding the cost.

Given the complexities of weak links discussed above, we can see (from a networked view) why managed economies (like the old USSR) lost to social structures where dynamic networks could be formed on value.  We can also see how consumers at the bottom of the pyramid are more heavily influence by the the few links they have (ex social programs, corrupt dictators, populists, …etc).

This all leads to a question for us, as a society, where should we try to “centralize” services and functions? Would it be better to provide the tools to “connect” and educate the mass market on how to discover services (ie value, reputation, price, …)? Or force everyone into a network with no other options? (Sorry for the Healthcare tangent).

Star networks naturally occur, but they also occur artificially. Banking has both dynamics, as connectivity and strong links are required for efficiency. Banking System’s network dynamic is also strongly influence by regulation that manages the connection and the information flow. What would an unmanaged banking system look like? This is what we see today in BITCOIN.

US Bank regulation impacts participation, services, value, location, communication, … etc. In a world of free information flow, should consumers have a choice? What choices should they have? The need of government is to track financial information for the purpose of taxes and management of economic activity. The need of consumers is to connect to the economy efficiently.  Thus star networks exist both as natural (self organized communities) and unnatural (regulated services, dictatorships) phenomena.

How do consumers select a Bank? Well back in 2006 we commissioned an analysis and found that branch location (convenience to home/office) was the number one factor in consumer bank selection. In the last 2 years we have seen a SEA CHANGE as US banks now work to thin out their branch network. Many drivers here, but it certainly doesn’t help that the fee restrictions from Durbin led to a consumer banking environment where the bottom 40% of consumers are no longer profitable (see Future of Banking).

Where are these bottom 40% going? Pre-paid (see Bluebird). Although Banks don’t want the bottom 40%, they also don’t want Walmart to succeed. Retailers like Walmart love these consumers, as they are their core. Banks products are becoming “banking lite” services productized and sitting on a retail shelf to buy. Pre-paid “specialists” have thus materialized, and established players hate the idea that consumers will to think of bank services in this light (a product which can be bought.. and switched). Of course it makes sense to ask your regulator from protection against consumer choice, but this is certainly not to benefit the consumer.

How do consumers select a retailer? Not all commerce is retail, and I can’t possibly do justice to answering this question. The CEO of Safeway also outlined how 80% of any given Store’s customers were within a circular proximity of his stores, and that store location was driven by density/competition/demographics.  However, this is convenience selection process is NOT the dynamic with Amazon or Walmart. It would seem that the value of connecting to Walmart and Amazon is different for certain population groups. (see Future of Retail).

Quantitative Data

Big picture first. How can we measure “networks”? Perhaps the real question is what are we trying to find. We could look for efficiency of the network itself, or the financial health of the nodes, or the scale (number of nodes). The last one makes little sense as everyone participates in Commerce and Banking to some extent.

With respect to Banking and Networks, NYU’s Thomas Philippon published jaw dropping research detailing how Payments and Banking are one of the few network businesses in the HISTORY OF MAN to grow less efficient (rail, telecom, energy, …). Consumer banking examples are plentiful: is how can the banks justify paying 0.2% interest on your savings, but charge you 15% on your card? (See Future of Banking: Prepaid..?). Obviously regulators are protecting bank margins, with some Bankers ACTIVELY discouraged from rate competition. This is the DEFINITION of regulatory capture (regulators DISCOURAGING philippon_newfig1consumer competition).

Commerce is far too broad to generalize. It encompasses manufacturing, services, retail, infrastructure, rules, codes, …etc. Logically improved information flow should improve transparency, improved transparency should lead to improved consumer choice and growth of specialists focused on serving ever smaller niches of demand. We certainly see this dynamic today in HighTech manufacturing (Cisco, Samsung, Apple, …), US capital markets, telecommunications, professional sports, ..etc. How can we measure this? One of the best scholarly articles I’ve read on networks and global commerce is from Humels, Ishii and Yi (See paper as published by US Federal Reserve). From the abstract

Using input-output tables from the OECD and emerging market countries we estimate that vertical specialization accounts for up to 30% of world exports, and has grown as much as 40% in the last twenty-five years. The key insight about why vertical specialization has grown so much lies with the fact that trade barriers (tariffs and transportation costs) are incurred repeatedly as goods-in-process cross multiple borders. Hence, even small reductions in tariffs and transport costs can lead to extensive vertical specialization, large trade growth, and large gains from trade

From a Commerce (Manufacturing) network view, over 30% of export growth was fueled by network effects associated with specialization. These effects (growth) were highly correlated to trade barriers (ie, network friction) and  infrastructure (payments, commercial banking, transport, logistics, communications, …etc).

How has information flow impacted Retailers? Net Margin in retail has taken a nose dive (from 4.2% in 2006 to 2.8%, see data by industry from CSI market). Retailers have no one to protect them from the forces of competition (ie Bank regulators) and therefore have a much tougher job as they work to sell commodity goods at the highest possible price, in a world where they don’t know the consumer’s name (see Retailer CRM).  It seems obvious that data transparency (ex show rooming) and new networks provide price and reputation information and that consumers are changing behavior.retail margins 2

Commerce and Banking

Summary: the only difference between Commerce and Banking is REGULATION. Banking is a highly regulated activity…. Commerce is not. Providing access to financial services is a much harder problem to crack because of local regulatory hurdles (see my notes on MPesa and Reaching the Unbanked).

If commerce, networks, banking, government and society are evolving how SHOULD we change our artificial structures (ie regulation, government, …etc.) to support? Have we reached an apex where the pendulum will swing quickly from centralization to hyper democracy? And hyper capitalism? Where SOCIETY creates and evaluates rules which are established based upon their aggregate network effects, not on lobbyists, politics and junk science?

The most immediate areas impacted are those networks that do not deliver value, as barriers to entry and switching costs are overcome value and scale of alternative networks and new business models. 200 years ago we could walk into our local country store and ask the shop keeper to put our purchase on our account. We could barter for goods and services.  Today, the regulatory hurdles for a store to provide this simple service are substantial.

Banks, manufacturers, retailers, service providers are all capable of issuing credit based upon identity, reputation, history, use, …etc. A home builder could take on the ability to sell, lend, lease and repair a home. Yet the enormous regulatory requirements on selling, lending, leasing inhibit the viability of this vertical service integration.

With respect to payments, as my friend Osama outlined to Tim Geithner, what if the future of payment profitability was driven not by interchange, but by the flow of data? What if Apple were to give away new iPhones, with free connectivity, with the provision that they share data on preferences and behavior? This is NOT some future state, these discussions are happening today. We tend to view these discussions in context of the companies, products and structures that exist today (ex. how could Visa enable this?). Yet existing networks have proven an inability to adapt, as they were formed around an existing value proposition in which each node became “attached”. If you change the core service, you change the entire network.

The inability of other networks to adapt is FAR less concerning to me than regulation that will destroy innovation and create artificial PROTECTIONS around existing structures. In the example above, what if the government mandates controls around PII making the prospect of free phones and free data non-viable. Who wins? Consumers gain increased protections on their PII, but loose a service. Should they not be able to make this trade themselves?

Another example is Prosper in social lending. A great example of innovation which was “guided” by the SEC to become a securities dealer (see Wikipedia, Crowd Sourced Credit, and my blog on Reputation). Now every loan must be registered as a security (see example) . This may be the right thing for us to do as a society, transparency and auditing are valuable functions which increase the flow of capital and efficiency of a market. But must we be required to submit to these regulations when we want to take on another type of risk? Having the government certify “accredited investors” or “accredited borrowers” may be best as an optional service that must prove its value.

In the emerging markets we see the MASSIVE success of MPESA. With few exceptions (Philippines, PK, Colombia, Peru, Ghana), we see every other country working to ensure this DOES NOT happen in their market. India is at the top of my list of offenders, where entrenched bureaucrats and regulators work to protect domestic banks at every level, regardless of the potential macro economic benefit (review IMPS for example).  Beyond banking the same dynamic plays out in Commerce as well capitalized companies like WalMart are hammered for making unapproved INVESTMENTS in infrastructure (see WSJ).

Clearly the pain point is around banking, but it is not something that banks alone can address as they themselves are regulated, it is a regulatory issue (see US Payment Innovation and Regulation).  Europe has done a fantastic job addressing the regulatory issue (within the ELMI construct, SEPA, …etc.), their problems are around nanny state consumer protections and EU rules do not make their way into domestic law or regulations. A government that protects against everything, inhibits free association, consumer choice and the assumption of risk. (now I sound like Milton Freedman).

“Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government.”
― Milton Friedman

“Government has three primary functions. It should provide for military defense of the nation. It should enforce contracts between individuals. It should protect citizens from crimes against themselves or their property. When government– in pursuit of good intentions tries to rearrange the economy, legislate morality, or help special interests, the cost come in inefficiency, lack of motivation, and loss of freedom. Government should be a referee, not an active player.”
― Milton Friedman

“The society that puts equality before freedom will end up with neither. The society that puts freedom before equality will end up with a great measure of both”
― Milton Friedman

Platforms

Just as use money enabled a specialization and concept of “personality”, telecommunications is opening up a new world of free form association, both business and societal.

Open Source is a model most of us are well familiar with. (further reading… I ran across a very nicely done paper from 2 MIT students: Implication of Open Innovation and Open source to Mobile Device Manufacturers).  Given that mobile, advertising and payments are all networked businesses… business models supporting distributed innovation should advance at a faster pace than those controlled by a single entity. For example, Amazon, Samsung, Motorola, LG, HTC, Verizon, ATT, Vodafone, .. all make much larger investments in the Android platform (than in IOS). (I would love to see an analysis of combined capital investment in android platform)

From my blog Stage 4 Value Shift

…this distributed innovation hypothesis is NOT playing itself out (ie Apple). Apple’s 1Q12 showed iPhone revenue alone was $24.4B, which is bigger than all of MSFT revenue combined.  Analysts have shown that Apple now garners 75% of mobile handset profits, with only 9% of handset market share.  So while Samsung alone has outsold Apple in Units this quarter (41M vs. 32.6M), and Android just topped 50% market share (vs Apple’s 30.2%).. Apple’s handset business PROFITABILITY dwarfs that of all of the competition (COMBINED).

So… What are the factors of competition today? Can someone else change the game?

The big downside in distributed innovation is complexity, there is a need for a “channel master” or chaos reigns. Many Android users witness this chaos when an app won’t work on a new hardware/OS combination.. Distributed innovation is not something that established businesses are good at. It has proven most successful in product PLATFORMS where the pace of change in each component is changing at a rate where no one company can make the capital investment to remain competitive (ex. Moore’s Law, PC architecture through present day). Intel played a very important role in this process, as it worked outside the scope of the CPU in areas such as: Intel Architecture Lab (IAL, developed common standards like PCI),  stimulated external innovation (developer training, testing, Intel Capital), industry marketing, patent/licensing. Intel defined what the PLATFORM was.. something that is common sense to us today.. but rest assured it was not given to them, rather it was something that they stepped into and took leadership of.

From Delivery to Discovery

Commerce and banking have many effective platforms to coordinate supply chains and payments. Today the nature of commerce competition is on quality, price and distribution (delivery). What if the nature of competition shifts from delivery to discovery? Shifting the model by which “weak links” are established today.  Today an individual must sift through mountains of search results and travel sites to find the best deal. We see complete garbage in banner ads and TV.

Who can proactively help you form networks of value, and expand how consumers manage their network, identity, personality? Most would agree that Google is best positioned here. I’m also very excited about the prospects of a company I’m incubating in this space. Ok.. this is getting off track quickly

Summary (I just finished reading a few of the federalist papers last night.. so pardon in advance).

The key for global economic growth is allowing individuals, and companies, to assume risk. The lines between Commerce and Banking SERVICES should blur, and start from the Commerce side as regulated intuitions have an unfair advantage in their protection. New networks provide for free form associations, and will improve in their ability to organize as platforms mature. These networks are capable of higher forms of risk mitigation, but are throttled by bespoke institutions and regulations.  Bitcoin is perhaps the best example of a disruptive force to hit banking. Europe is proving to be a role model in banking regulation, but their innovation in financial regulation has been offset with a local enforcement and complex environment where consumers cannot assume risk.

My message here is for Governments and regulators as much as it is for innovators. We must allow consumers to make decisions for themselves, and avoid regulating every behavior or government centralization and control will tend toward tyranny that is unaccountable and unchangeable.

Payment Start ups – MSB or Bank?

7Sept Update

Late last year the state of Georgia created a new bank type. See link below

http://www.paulhastings.com/assets/publications/2197.pdf

 

16 Aug

I had 6 calls in last week on the same topic, covering different companies…(Strange how things go in waves… )…. General theme is what regulatory structure should I take on if I’m a payments business. My answer is: go talk to your attorney, as this is not legal advice… just a few random thoughts for INVESTORS.

This blog is a follow on to my note 2 months back Payments: What is a Start-Up to Do?  Perhaps the best way to start this off is from the quote I gave in US Regulations, which demonstrates the regulatory evolution that has taken place over last 10 yrs.

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.

Data points from this week:

  • New payments focused bank led by Bob Willumstad (former AIG CEO) – Independence Bancshares (public company IEBS: OTCQB).
  • Carol Realini bought Obopay US (the MSB licenses)
  • Wirecard’s international MNO wallet success (see 2013 earnings presentation, and Bank Licenses.
  • Greendot 2x run up.. now a bank and “model” GPR card and BANK IN A BOX.
  • Analyst question… would Visa ever seek to be an MSB or a Bank?
  • US regulatory clamp down … KYC enforcement is the theme here. Banks must know their customers.. and also KYC every single one of their corporate customers beneficiaries.

Thoughts for the day

If there is one thing you do today.. get familiar with Wirecard. I love this model….  I’ve gotten myopic in my old age (48), at Citibank I was 100% focused outside of US.. in last 2 yrs I’ve switched to 90% US focus.. now paying the price. I can’t believe Wirecard slipped my radar. 2,400MM EU transaction volume.. almost 500MM EU in Rev.. 2,700MM EUR Market Cap. Think of them as a white label banking platform with bank licenses. For those that read my blog.. Wirecard is a new cluster at scale in Europe and Asia.

Don’t have time to make this a 5 page blog.. so I will resort to bullet points

  • MSBs are limited, and costly, licenses. If the core of your business is leveraging another primary account (bank), and leveraging existing “rails” then this is probably the right structure. In the US, you must work to obtain 47 separate licenses with each state individually.
  • Bank licenses are certainly more flexible, and provide for managing the customer relationship but there are 3 big downsides. #1) your financial reports and balance sheet must include a separate bank division #2) Acquiring customers is really hard #3) Regulatory burdens can be insane and consume your time and capital (Ex, CRA and Bloomberg article)
  • Most Start ups “rent” a license through an existing  player. Square/Chase, Google/Bancorp, …
  • Leveraging existing banks is proving very, very problematic as they own the customer, “rails” and the “rules”
  • Today, Top issuers, Networks, Retailers and Platforms are at War here… See CEO View – Battle of the Cloud 5. There are billion dollar bets being made..
  • In Europe, an ELMI Structure is the global reference model for a start up.. unfortunately there are no other regulatory equivalents (see E-Money regulation in the EU)
  • Mobile payments (physical/POS) success today centers around transit.. and is either transit led or MNO led.
  • NFC is failing completely.. technology is fine, but the supply chain and distributed control are unworkable
  • Every major entity today is competing for the “TSM” role. My belief is that Apple, Google, Amazon are in the Driver’s seat.
  • I am 80% confident that Visa, MA will follow Amex’s/Discover and obtain bank licenses in a limited number of markets. Neither wants to be first.

Take Away

If MNOs look to retain a leadership role in payments, then Wirecard is the reference model. I’m not the only one to see this… Today we see banks working to squeeze in their existing product (Credit Cards) in to the mobile phone. As MPESA’s success showed, mobile payments are much more likely to succeed when you have one leader capable of driving a focused value proposition.  Why squeeze and existing product into the phone if you can create an entirely new one? What if the future of banking “profitability” is driven less by Net Interest Margin, Treasury, and Transfer Pricing and on more on Consumer Data…?

Buy Wirecard (I just did). I also think they will be acquired within 18 months… Buyers: Visa, MA, Platforms, … Biggest Hurdle: Who can handle having a bank balance sheet.

wirecard

Related Blogs

Paypal – Lending

Investors Guide to Mobile Money

Emerging markets – MNO Led

India – the craziest market on the planet

How to Deregulate Payments (like Telecom)

The US needs open access to a RTGS system, where any party can assume risk. Giving non-banks the opportunity to participate in Fedwire may be the quickest way to move the ball. For EU, perhaps giving open access to a common settlement service would be faster than mandating protocols/services. In other words.. build a new system for settlement which banks must participate.. and let non banks in as well. Build the Future vs. fixing the past.

23 July 2012

This will be a new blog type.. perhaps a little offbeat .. a living blog that “iterates” based upon community feedback. Idea started yesterday in a few of my informal chats. I’m no telecom expert, but fortunate to know some very good people who are. Yesterday I was having a chat on the EU’s Proposed Interchange Cap with a telecom friend and He drew several analogies to what happened in Telecom back in the 70s when AT&T was forced to open up its network.

Example: Telecom

MCI took AT&T to court to get interconnection, and that put them in a position to offer universal switched service, which they proceeded to do. When the FCC tried to stop them, the circuit court of appeals refused to sustain its order, essentially on procedural grounds. The upshot of this series of discrete decisions, which none of the responsible parties-except maybe Bill McGowan-either foresaw or intended, was the transformation of the long distance business from one of franchised monopoly to open competition. In MC/ Telecommunications Corp. v. FCC, 561 F2d 365 (D.C. Cir. 1977), the U.S. Court of Appeals authorized competing uses of microwave systems serving business and data communications markets; the court also concluded that the FCC had no general authority to insist on approval of new services without a finding of “public convenience and necessity.” In a later proceeding in the MCI case, 580 F2d 590 (D.C.Cir. 1978), the same court held that the previous decision’s mandate required AT&T and the FCC to provide interconnections to MCI. – Telecommunications Deregulation: Market Power and Cost Allocation Issues, 1990 edited by John Robert Allison, Dennis L. Thomas

Several interesting points in this story:

  1. Telecommunications regulator (FCC) was captured by AT&T and wanted to protect them from competition. The deregulation was unintended.
  2. Investment in this sector was throttled by a monopoly which controlled end-end distribution.
  3. Unlocking the monopoly allowed others to compete, take risk and invest. Consumers benefited, telecom costs  decreased, capacity and quality increased, and are now a commodity (ie dumb pipe) business. For example Jim Patterson wrote in this Sunday’s brief “Verizon has a wireline unit that, despite continued investments in fiber, cannot manage to offset its losses from legacy technologies to earn a profit.  With the exception of FiOS Internet and Video, the rest of the business is largely a victim of increased wireless substitution, VoIP (as opposed to traditional TDM voice) penetration, cable competition, and the cloud”

The EU can be credited with attempting to deregulate payments through SEPA (see SEPA – Chicken and the Egg  , Payments Innovation in Europe). As I stated in Building Networks and Openness

The network forms around a function and other entities are attracted to this network (affinity) because of the function of both the central orchestrator and the other participants. Of course we all know this as the definition of Network Effects. Obviously every network must deliver value to at least 2 participants. Existing networks resist change because of this value exchange within the current network structure, in proportion to their size and activity. Within the EU, SEPA undertook a rewrite of network rules and hoped that existing networks would go away or that a new (stronger) SEPA network would form around its core focus areas (SCT, SDD, SCF, ..). It was a “hope” because the ECB has no enforcement arm. In other words there was a political challenge associated with ECB’s (and EPC specifically) ability to force an EU level change on domestically regulated banking industry.. given that SEPA rules destroyed much value in existing bank networks, the political task was no small effort. We have seen similar attempts (and results) when governments attempt to institute major change in networks (Internet NetNeutrality v. Priority Routing, US Debit Card Interchange, …)

Managed Deregulation

Managed deregulation seems to have problems… particularly when there is an attempt to force a “product/Service” like SEPA CF or SEPA DD. While there are no technical issues w/ SEPA there are issues around incentives, local/regional policy and lawmaking, regulatory enforcement, …etc. Like ATT/MCI case above, Local Country banking regulators are “captured” by the entities which they regulate. This is not unique to Europe at all.. As I’ve stated many times with respect to India, RBI has attempted to “manage” innovation in mobile payments to ensure that banks are in control (vs. MPESA Success in Kenya success was “accidental”).

“Unmanaged” deregulation seems to have a much better track record in telecom, payments, and other areas such as “internet” services (ex UBER and the NYTLC). With respect to Payments, what is the switch that needs to be opened up? Perhaps the best example is Sofort (SOFORT Overview) and “opening” ACH/iBAN transfers.  US banks are proceeding in the opposite direction (see ACH System in US), and have generally resisted changes to improve ACH “speed” for this very reason, as any RTGS system possess a risk to them (see Real Time Funds Transfer in US). Payment Value

Although some readers will be highly offended at my suggestion that success was not guided by government directives and oversight (ie Internet – Al Gore’s invention, Glosplan, The French), it is important to note that a company with a business plan was ALWAYS behind success…  pushing for the change, against regulators who largely work to protect the industries they regulate.

Dodd-Frank V2

Dodd Frank has had tremendous repercussions for the industry (Bloomberg estimates $22B). In my view future regulation should avoid any price setting, as effective markets are the proper mechanism to align price to value. However payments is not a competitive market, and Dodd-Frank has not changed this. Lawmakers should endeavor to kick start a new wave of investment from 100s of companies in payments and commerce. Working to make payments a competitive market, just as Telecom is today.

Here is my simple framework for unlocking a new wave of competition.

#1 Settlement.

The current card schemes are insanely complex. No one in their right mind would start off with a design of a debit request to an account holders financial institution if everyone is connected (my design is in blog Push Payments). In order to maintain flexibility in risk management, the clearing mechanism must let any participating party assume risk on the transaction. Therefore my recommendation is to enable the participation of non-banks in local country RTGS systems (FedWire in the US)…. creating a certification process by which new participants (like MSBs Amazon, PayPal, Google, WMT) could establish a settlement account with the Fed just as the banks do. There is real time funds transfer here (only RT option in the US), once funds are moved there is no reversal. This puts the onus on the participating entity to manage risk and Fraud. It also keeps from having the banks do any technical work at all…

#2 Issuance and Value Storage.

We need to look no further than BitCoin to see the need for new regulations surrounding issuance. Transfer of funds between entities is covered above, and my view is that non-bank participants should be licensed and agree to abide by current money transfer  regs (ie. Fincen/AML, ..). Issuance of “credentials” and storage of funds is another matter. Long term storage of funds is a banking function, and should be regulated, settlement funds face state escheatment issues (but largely unregulated unless interest is paid), while storage of “Value” is completely unregulated (ie Coupons – a form of legal tender, Pre paid offers, bitcoins)?

From above, if we allow non-banks to participate in real time funds transfer (like Sofort), then third parties are acting as agents (on behalf of consumer, merchant or bank) to direct the funds. If a good/service is purchased immediately (commerce) then there is no regulation, however if the value is “held” for future use it is generally regulated (hence MSB, eGold, bitcoin issues). Thus the rules under which third party senders operate (as agents), are different from the entities at the end of the transactions (banks, merchants, consumers).

Most know the story of MPESA and how telecom minutes became a form of value exchange which evolved to over 10% of Kenya’s GDP. There is an obvious need for issuance to more closely resemble cash in its ease of exchange, verification, anonymity and storage.

Our current need is for simplified laws surrounding account under a given value amount (say $2000). Providers of service should be lightly regulated through self reporting, “transparency”, and the need to keep settlement funds with the Fed. In this proposed model, a bitcoin exchange must ensure that no single individual has processed more than the threshold in a given time period. Hence the need for KYC of exchange participants (when converting to cash).

#3 Authentication

Most are aware of my favorite payment quote

…If you solve authentication.. everything else is just accounting”  (Ross Anderson @ KC Fed).

Sharing and validating of identity is critical to a functioning payments system. 3rd parties which have consumer permission must be able to participate in common infrastructure (credit bureaus) and share data on bad actors with other participants without fear of repercussions. eSignatures, eVerification, remote KYC should all be defined within law.

Would love more input here.

#4 Acceptance.

No Change Necessary. Just as MCI forced its way into the switch, other providers must be able to participate in the payments “network”. For a merchant to accept a new payment type, the following must happen

  • Merchant agreement (with merchant Acquirer)
  • Network Agreement (between Payment Issuer/Network)
  • Processor Agreement
  • Acceptance device
  • Consumer Instrument
  • PCI Certification (in some cases)
  • POS Integration

The Pipes between a merchant and its processor are owned by the merchant, they can decide what flows through those pipes with one major exception: accept all cards. Dodd-Frank allowed market forces to take effect here through steering and incentives… although few merchants have acted, as they hope to keep pressure on a credit settlement. To accelerate acceptance market forces, there must be “open-ness” in the connection. I believe this is largely in place, as merchants face few challenges IF THEY WANTED to add a new payment type like PayPal. They have chosen not to because it offers no benefit (vs a debit card).

Summary

Innovating on the existing networks is hard. The core to any payments success is access to the transactional account. There are several successful approaches today:

  1. Sofort (my favorite example). Operating as agent on banks web site to initiate payments on consumer’s behalf. This can’t work in the US as there are no “wires” or direct RTGS system which correlate to IBAN in Germany.
  2. Amex/Bluebird “bank in the box” account. With direct deposit, bill pay, electronic payments, ATM, … but getting consumers to adopt a new account is not really “open”
  3. Bitcoin/eGold. Consumers buy item of value which can be exchanged
  4. Solutions which work off of PIN debit (a very cool area that is overlooked). Best examples are Acculynk, Star’s Expedited Transfer, NYCE’s A2A Money Transfer Visa’s VMT, Dwolla,

The US needs open access to a RTGS system, where any party can assume risk. Giving non-banks the opportunity to participate in Fedwire may be the quickest way to move the ball. For EU, perhaps giving open access to a common settlement service would be faster than mandating protocols/services. In other words.. build a new system for settlement  which banks must participate.. and let non banks in as well.  Build the Future vs. fixing the past.

Social Payments: Paying the Blogosphere

This could be the death knell for established news organizations. Having just renewed my subscription to the online Wall Street Journal last week, I was struck at how much of my news comes from informal social networks. I received a call today from an interesting team operating in this space… quite frankly a fabulous payment idea: Paying the blogosphere.

19 February 2010

This could be the death knell for established news organizations. Having just renewed my subscription to the online Wall Street Journal last week, I was struck at how much of my news comes from informal social networks. I received a call today from a team investigating this space… quite frankly a fabulous payment idea: Paying the blogosphere.

Take a look at Flattr’s YouTube video to get the picture. [youtube=http://www.youtube.com/watch?v=kwvExIWf_Uc]

One of the many competing w/ Flattr is Kachingle (see patent application). My uninformed opinion is that services in this category can structure themselves as commercial services and avoid MTO regulatory burdens. Kachangle’s approach (described in patent app above) seems to be “billing as a service” … in essence users are buying a service for a fixed monthly subscription at $10/mo. Others “social payment providers” contemplating entry here should be very cautious to avoid used of “tokens” which can be “redeemed” (Big US issues here… See eGold and  US DOJ Final, US DOJ Indictment). The rule of thumb for operating in the US: regular payments for a commercial value added/reseller service.. Good.. flexible payments to anonymous end parties .. Bad.

Key payment considerations

  • Where is NewCo legal entity and target customer base?
  • Where is NewCo operating from?
  • Where is NewCo’s bank account?
  • Is it a commercial service or “money transfer”? You have a regulatory requirements with either, but money transfer services are much more burdensome. If commercial service, then commercial requirements typically dictate disbursement KYC as well as tax/revenue reporting.
  • If service is money transfer, business will not only face regulatory hurdles, but also payment clearing hurdles associated with “payment aggregation”. Networks do not want intermediaries operating a payment network within their existing network as they loose their ability to manage regulatory control (ex. AML, sanctioned payments, …)
  • How does NewCo move money in? Cross border? Who will bear regulatory risk? Clearing bank? Network? NewCo?
  • Are there tokens or other stored units of value that can be exchanged?  

A great blog from a publishers perspective http://steveouting.com/2009/08/28/paycheckr-the-sharethis-for-donation-pay-options/

PayPal Shut Down in India

The RBI published Annex I circular on November 27, 2009 (RBI/2009-01/ 236). India’s regulators are some of the toughest on the planet. They expect that organizations read their guidelines.. The country manager should have some scars on his back after this one.

11 February 2010

NYTimes article from last night

India’s Central Bank Stops Some PayPal Services‎ – 

Simply put.. paypal has no license (See RBI list ) for Operating a Payment System in India under India’s Payment and Settlement Systems Act, 2007. The RBI published Annex I circular on November 27, 2009 (RBI/2009-01/ 236).

It Appears that RBI’s central issue is with PayPal’s role as an “unlicensed” Money Transfer Service. This issue is certainly not new to PayPal (see US Regulations – Online Payment/Transfer). As highlighted in the circular above:

All cross-border inward remittances under MTSS must be accompanied by accurate and meaningful remitter information (name, address and unique identification number of each remittance like, MTCN) on funds transfer and related messages that are sent and the information should remain with the transfer or related message through the payment chain. A unique reference number, as prevalent in the country concerned, must be included.”

Further, Paypal’s “agents must”:

Indian Agents should have effective risk-based procedures in place to identify cross-border inward remittances lacking complete remitter information. The lack of complete remitter information may be considered as a factor in assessing whether a cross-border inward remittance or related transactions are suspicious and whether they should be reported to the FIU-IND. The Indian Agent should also take up the matter with the Overseas Principal if a remittance is not accompanied by detailed information of the fund remitter.

Issue for PayPal is that its “agent” in this case is its commercial bank that initiaties the domestic ACH. My guess is that they are also in a bit of hot water for allowing this connectivity in light of the Nov 2009 circular (and subsequent inaction).

In order to resolve RBI’s issues, PayPal must:

  1. Obtain an MTS License (or a Payment System License)
  2. Renegotiate terms and services with its clearing bank(s) so that they will comply with “Indian agent” responsibilities above, namely PayPal must provide detailed information on remittance (above) to clearing bank and hold information in country so that bank can perform both AML sanction screening and other SAR reporting
  3. Put the detailed technology plan in place capture and send information to bank
  4. Review Plan with regulator
  5. Obtain regulatory approval on end state plan and request exception process for operating until final (end state) is in place

India’s regulators are some of the toughest on the planet. They expect that organizations read their guidelines.. “Better to ask forgiveness than permission” is a regulatory approach that probably works best before you are public company.

Note that PayPal’s “merchant” transactions (where an eBay buyer is paid) are not covered within the MTS regs above, unfortunately for PayPal it is difficult to screen these commercial transactions from other payments,  hence the broader impact in clearing both commercial “merchant” ebay payments and P2P/Remittances. 

My related Post

Cash Replacement

NACHA on Aggregation

SEC AML/Patriot Overview Regs

US Regulations – Online Payment/Transfer

This blog takes a look at the regulatory risk today’s start ups face and gives background on how PayPal got to where it is today. For today’s “emerging” payment companies, there are 4 primary choices for operating in the US: 1) Obtain the licenses, 2) Operate as an agent of an entity with the proper licenses, 3) Sell your software to a licensed entity, 4)Exchange non-monetary forms of value (minutes, eGold, credits, …).

Lessons from PayPal

January 25, 2010

I was on the phone today with Jeff McConnell, a tremendous exec with a long history of leading innovation in money transfer (WU, Moneygram, iKobo, …). In some respects it’s hard for me to believe that 2002 is 8 years ago, and I was reminded of how challenged PayPal was in obtaining the proper licenses “after the fact” in its early business.

In his 2006 book The PayPal Wars, Eric Jackson did an excellent job laying out the challenges paypal faced in its early years.  In the early days after its inception in 1999, PayPal was moving toward becoming a bank, but the Internet startup decided that banking regulations were too cumbersome. “We just wanted to be able to facilitate a quick payment,” he said. “The question of how to classify PayPal lingered for some time….It’s a sort of modern-era Western Union.. really, all PayPal is doing is shifting money around on your behalf.” 

To see the “change” in PayPal’s regulatory approach, take a look at 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.

This 2002 regulatory view, by the Paypal exec team, was based on a position that PayPal was acting as a Third party payments aggregator (TPPA), not in need of a money transfer license. TPPA is a description used for merchants that are charging a credit card for a product or service that they do not own. TPPAs simply facilitate the exchange of money between two parties sometimes using a credit card as a funding source. Several fraud and AML incidents arose which got the attention of both federal and state organizations. It became clear that PayPal was being used for much more then payment for goods within the eBay marketplace.

In Feb of 2002, the Federal Deposit Insurance Corporation (FDIC) ruled that PayPal is not a bank, which accelerated efforts by states to pursue PayPal for violating money transfer laws (New York and Louisiana are most notable).  This could have been the death knell for PayPal, as they were operating without the proper licenses. PayPal’s “post facto” licensing efforts were greatly aided by the local political support from thousands of eBay’s buyers and sellers. Today, according to spokesperson Michael Oldenburg,  PayPal is licensed as a money transmitter in 43 states (not all states require a license), demonstrating that regulatory risk was far greater than what they articulated in the 2002 prospectus. For those interested in the legal/regulatory conundrum faced by regulators, I highly recommend:  Regulating Internet Payment Intermediaries, by Ronald J. Mann, University of Texas School of Law

For today’s “emerging” payment companies, there are 4 primary choices for operating in the US:

  1. Obtain the licenses
  2. Operate as an agent of an entity with the proper licenses
  3. Sell your software to a licensed entity
  4. Exchange non-monetary forms of value (minutes, eGold, credits, …).

Obtain the licenses

For those of you that read my Blog, you’re probably aware that I’m fairly negative on Obopay, however they do excel in obtaining US MTO licensing (https://www.obopay.com/corporate/stateLicenses.shtml) . Unfortunately, all of these US licensing effort seems for naught as they are pulling out of the US and focusing in emerging markets as the “sender pays” model does not work in developed countries (morphing from a failed US P2P effort to Remittance). Today, PayPal, Western Union, Travelex, Moneygram, MoneyBookers (soon to be NY licensed) also operate as licensed Money Transfer Organizations (MTOs).

Becoming an MTO is not for the faint of heart, as regulatory capital requirements in excess of settlement obligations (fiduciary assets) are a complex (state by state) maze. This creates a challenging dynamic where capital reserve requirements grow as payment volumes grow. As a start up this means you not only need to raise capital to start the business, but also the regulatory capital BEFORE you get the state licenses.

MoneyGram’s 2007  “investment issues” offer many insights into MTO challenges. MGI suffered an $860M+ plus loss as it shifted out of high yield asset backed securities (which lost their investment grade rating). To preserve liquidity it sold $630MM in preferred and received debt financing of approximately $500M, a situation which today leaves MGI common shareholders in a $870MM equity deficit.

Operating as an MNO is not your only choice. I’m amazed at how few companies there are attempting to develop a bank based model. Trolling the dust bin of failed financial institutions may provide a unique opportunity for a start up to acquire the “shell” of a licensed bank to develop a “payment” focused value proposition. The strategy behind Revolution Money’s acquisition by Amex gives Revolution the “best of both worlds”: an acquirer and a bank. If it were not for Amex’s bank charter (and associated regulatory capital), Revolution’s PIN based debit would be highly susceptible to NACHA aggregation restrictions if they are operating as a non-bank, operating as a type of decouple debit.

I know from my own personal experience that operating as a “payment bank” is not without challenges, not just Citi C2it.. (which stopped 2.5 yrs prior to my role), but Citi GTS which today provides many of the banking licenses for payment providers like WU, Vodafone, ZAIN, …  In addition to Citi GTS, one of Citi’s most profitable “global” retail bank businesses is NRI (Non Resident Indian) which serves affluent Indians (within the US, UK, …) with comprehensive services that cater to the needs of affluent clients. Citi also effectively up sells NRI clients services within its investment and commercial bank.

Operate as an agent

Pre-paid cards offer a “fast track” to operating a new payment service (Revolution money, Squareup, payoneer, iKobo, …). In this model the service relies on the licenses of the underlying bank (example Metabank). The legal precedent here is rather new as witnessed by May 30, 2007 finding by the First Circuit , which affirmed that the National Bank Act preempted New Hampshire regulation of the pre-paid product. In the “agent” model, it is therefore paramount that start ups seek a federally chartered partner. 

There is still substantial “risk” in this pre-paid agent model, as traditional banks and networks control the “rails” for this payment type. For example, Consumer accounts must be “funded” from either a card or DDA account. NACHA has developed new rules which significantly curtail the ability of a “payment aggregator” operating off of a current account (see NACHA Tightens Risk Management and aggregation rules) . Additionally, card networks and acquirers are much more attuned to the risks that these new payment intermediaries present.

My top vendor in the bank model is CashEdge (having been the banker who signed the agreement at Wachovia). CE is the “3rd party sender” for Citi, BAC, Wachovia, PNC and other top banks representing approximately 50% of US DDA accounts. You don’t hear about them much because they are a white label “bank friendly” service. They excel in risk management, with a team second only to paypal. Most of you in the US reading this already use their software.. but just don’t know it.  In the mobile space, I love the innovation at BlingNation.

Sell your software

This is rather straightforward. Within the mobile money space, companies such as Monitise, HyperWALLET, Fundamo, Paybox (now Sybase 365) all provide good platforms from which to build an offering. Issue for small companies is that the entities which have the necessary license have largely made significant bets here already. Of course some of the bets by big banks (some alliteration here) have been terrible, most notably Firethorne which has lost the accounts at Chase, Citi and Wachovia all in the last 8 months.

Exchange non-monetary forms of value

Beyond the scope for my discussion here. My advice is that this is a slippery slope and you will have trouble (as a payment company) attracting “A Class” capital. Look no further than the history of e-Gold for education on the issues.

U.S. GOVERNMENT SEIZES E-GOLD ACCOUNTS, OWNERS INDICTED

Summary

In writing this I cannot help but be struck by many similarities in the “unregulated growth” of PayPal and Vodafone’s MPesa. The growth of both companies was driven by an existing customer base and a value proposition which addressed clear gaps within the payment systems of their respective markets. In both cases, there was no clear regulatory authority to restrict them and once they were firmly established (through contagious adoption) it was too late to stop.

Within the EU, the ECB has developed ELMI regulations that are supported by other initiatives such as SEPA (See http://www.paysys.de/download/Krueger%20e-money%20regul.pdf).

Related posts

http://tomnoyes.wordpress.com/2009/12/16/cash-replacement-part-2/

http://www.banking.state.ny.us/legal/lo020603.htm

http://www.ecommercetimes.com/story/18211.html?wlc=1264432425

The Power of Mobile Money..

Economist Article

Telecoms: The power of mobile money | The Economist

 Extending the “network” of financial services into the unbanked is a tremendous challenge. Modern G20 countries have developed significant legal, regulatory, and technology infrastructure over 100 years. Such basic elements as customer identification for KYC, or consumer protections are not in place within many 3rd world countries. Mobile money attempts to leverage the “mobile network” as a financial services network. The telecos (appropriately) are driven to enable mobile money services to provide a way for the “unbanked” to pay their bill. As long as the value stays in the teleco network there are few issues. However, when “cash out” points are established then the same regulatory issues will need to be addressed and decisions made as to whether to “connect” the mobile network to bank networks. 

Anyone familiar with the subject knows that African regulators are particularly sensitive since the success of MPESA. Any success in mobile money that results in value exchange external to the mobile network will be facing the same regulatory requirements that banks do. In short, the “mobile networks” will not be morphing into banking networks without compliance to the same bank regulations which all financial networks face.

In speaking with both the FSI and the Network involved in MPESA, I asked them both separately what assistance they were looking for in Kenya, or if they rolled it out in another African market. Both separately said “someone to own the risk” [e.g. payment risk management]. Providers are thus recognizing that Payment authorization will require a new risk models then what are currently in place within other payment networks such as cards (e.g. HNC’s Falcon). Note that banks have significant dedicated risk teams (20-50 people) focused here.