Competition in payments

By Felix Salmon
June 22, 2010
Adam Ozimek reckons that we need more competition in the payments space, and that interchange regulation is going to impede progress towards that goal:

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Adam Ozimek reckons that we need more competition in the payments space, and that interchange regulation is going to impede progress toward that goal:

I think we can all agree that more competition is, when feasible, the best way to deal with undesirable market power…

I think this issue deserves a much closer look, because some not so futuristic technologies like mobile payment seem to be potentially disruptive market entrants that could upset the Visa/Mastercard duopoly. Lawmakers need to be cautious with this, because if you’re going to start setting prices, then you’re messing with the profits for potential entrants, and thus possibly disrupting the future path of innovation. The welfare impacts of accidentally preventing a market entrant or technological innovation here would be huge, and would likely trump any welfare benefits of the proposed regulations.

I don’t see it this way at all, partly because we don’t all agree that more competition and innovation is necessarily the optimal way to go with respect to payments.

Being able to easily pay for things without worrying about the mechanism is a great public good. The U.S. had a disastrous experiment with privatized payments between 1836 and 1861, when thousands of local state-chartered, private banks issued their own paper money. There was a lot of confusion, and of course many of the notes traded at a discount, especially when they were carried out of state. (To this day, if you travel internationally and try to exchange pounds for dollars using Scottish banknotes, there’s a very good chance you’ll get a worse rate than if you’re exchanging the standard Bank of England notes.)

The introduction of Treasury notes in 1861 rationalized things wonderfully, and made commerce a lot easier: no longer was there a risk that the banknote in your wallet was issued by an insolvent bank.

When banks started issuing private checks to their customers, a lot of the problems associated with banknotes returned. Yes, there were the credit problems: the account the check was drawn on might not have any money in it, so there was a credit risk associated with accepting checks as payment. But there were also the boring old logistical clearing and settlement problems as well, and the Federal Reserve spent an enormous amount of effort and money putting together a complex nationwide system facilitating check clearing at par. This cost the Fed money, but again it helped smooth commerce more generally.

The system of checks and cash worked until the banks grouped together to create MasterCard and Visa in 1966. There were small-scale charge cards before then, most notably Diners Club, which was founded in 1949. But MasterCard and Visa (or the InterBank Card Association and BankAmericard, as they were originally known) signed up as many banks as they could to become truly formidable networks. Still, they weren’t direct-payment cards, at the beginning: the customer wasn’t paying for the goods with her own money, but rather borrowing the money to pay for the goods from her card issuer. It wasn’t until the 1980s that MasterCard and Visa started unifying their systems with ATM cards, to create PIN debit.

The logistics behind all of this were formidable, both in terms of clearing and settlement and in terms of getting the requisite approvals from banking regulators in the U.S. and around the world. But it was worth it, as a glance at the market capitalizations of MasterCard and Visa (they’re worth over $50 billion between them) indicates. And remember that it’s the card issuers, rather than MasterCard and Visa themselves, who make the real money, both from interest payments and from interchange fees.

Every so often, non-bank players like Diner’s Club or American Express would come up with a bright idea in the payments space, and some of them made good money for their owners. More recently, PayPal took advantage of the fact that, unlike Europe, the U.S. has a very antiquated and expensive system for moving money directly from one bank account to another. (In Europe, it’s as easy as a phone call, or hopping online; there’s no fee.) So PayPal set up shop in the U.S. to facilitate payments directly between individuals, taking a small cut for itself along the way. But PayPal wasn’t an improvement on the simple European system: it was merely an “innovation,” if you want to call it that, born of sclerosis and greed in the U.S. wire-transfer system.

Realistically, the best hope for real competition in the payments space comes from mobile payments: most of us, I’m sure, would love to be able to leave our wallets at home and just walk around with our phones. And in Kenya you can do just that, thanks to the M-Pesa system there. But note what’s necessary for M-Pesa’s success: you need a strong telephone monopoly, like Safaricom, which is at least as creditworthy as the local banks; and you need an unbanked population desperate for any kind of payment process at all.

In America, it’s pretty much unthinkable that someone like AT&T would get into the payments business. The technology of me going into a store and adding the cost of a candy bar to my monthly phone bill — that’s easy. But the security issues involved with giving all my spending history to AT&T are not, given its history of breaches. What’s more, AT&T doesn’t particularly want to get into the business of chasing me to pay for my candy bar, it’s hard enough trying to get me to pay my phone bill.

And finally, the Federal Reserve would never approve of a non-bank like AT&T performing so many banking functions: if Wal-Mart can’t get a banking license, you can be sure that AT&T can’t either. The Fed’s ultimately in charge of ensuring that big banks don’t fail and that deposits are safe: if a friend of mine transfers money into my AT&T account and then AT&T goes bust, I’m still going to want access to that money. And the Fed has neither the ability nor the inclination to police AT&T’s solvency.

The fact is that payments are a utility; they’re regulated like utilities; and utilities tend not to see much in the way of innovative new entrants. There are some problems that innovation can solve. For everything else, we’re going to have to make do with MasterCard.

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