The Disappearing Moats in Payments (#36)
Equal access to capital, talent, and users is making it tough to build long-term competitive advantage
Welcome to the 36th issue of the Unit Economics. Today, I wrote about the increasing number of large-scale payments businesses, why they struggle to build long-term competitive advantages, and where they can possibly build one. Dive in!
For a long time, payments was an industry dominated by a few. Visa, Mastercard, American Express, FIS, Diners Club, and Capital One were likely the more common non-banking payments companies we would hear of. Few tried to compete, but hardly any could.
Why? The incumbents had huge moats.
Moat is a simple term for any competitive advantage that allows businesses to protect their profits, growth, and market share in the long term. For Visa, Mastercard, and the others above, the business boasted of a number of these.
Banking Connections
The bank partnerships were essential for payments companies to become part of the user journey. They still are, but the companies today can deflect the burden on many of the intermediaries. Earlier, the banks had high control of the payments journey with little to no non-banking consumer applications, and this meant that the payments companies were often dependent on banks for distribution.
As one would guess, some of the oldest payments companies were spin-offs or managed by banking institutions in their earlier days. For example,
Visa was launched by the Bank of America as the BankAmericard program. Later, the program was extended to multiple issuer banks, who then undertook the management of Visa.
Similarly, and as a response to the BankAmericard program, Mastercard (then Interbank Card Association) was founded by a small alliance of regional banks in California.
Even Capital One was initially an independent credit-card division of the Signet Banking Corp. before it was spun off.
The banking connections were a clear differentiator for the early movers, as only a limited number of institutions could boast of such bank connections and fewer had the patience to go through the hassle.
Long-Term Contracts and Economics of Scale
The ones that built the networks and the issuing capabilities for the payment methods further established the advantages through restrictive contracts that limited the market for competitors. An excerpt from the USA vs Visa Inc. and Plaid Inc. documentation referenced this argument:
“…. coupled with Visa’s long-term, restrictive contracts with banks, are nearly insurmountable, meaning Visa rarely faces any significant threats to its online debit monopoly”
By entering into restrictive contracts with large and fast-growing banks, such payments companies were able to (1) raise switching costs for banks and (2) grow their distribution exponentially as the banks grew. And over time, this translated into higher volumes and ever-improving unit economics. There are perhaps a few examples of network effects as prominent as the one that the income statements of Visa and Mastercard show.
High Costs of Entry
Additionally, these payments companies invested heavily in building the infrastructure to connect with banks. For instance, those who built up the card networks or the white-label ATMs had to incur high costs in (1) developing the physical machines and (2) brokering agreements in the multi-party model with banks and regulators.
The effort and the financial costs, especially with the lack of private capital, cut off large parts of the entrepreneurial population to consider entry into payment systems.
Now, compare the above to today’s environment, where we see tens of payments companies operating at large scale across countries.
How did that happen? The moats grew thin.
APIs, Internet, and Shift to Software: the internet offered new ground for experimentation and of building payments services that banks already did not offer. Further, the easy access to infrastructure on the cloud and the improvements in software lowered the costs of development. And with APIs – the integration effort with banks was less burdensome for the consumer facing ones. Eventually, the lower costs of building a payments business meant that companies were able to unbundle and specialise in parts of the payments journey, with lower reliance on banks.
Larger Addressable Market: the ubiquity of the internet and mobile has had positive rippling effects on the payment habits of users, i.e., many that were driven by cash or cards have switched to the digital methods for payments: account-to-account, digital wallets with NFC and QR codes, and others. Similarly, the migration of businesses to e-commerce has translated into lower costs of distributing payments solutions to merchants. On both sides, the size of the pie got bigger for software-based payments companies. We can expect the pie to continue growing, with Juniper Research estimating ~10% CAGR for domestic digital payments over the 2020-25 period. With a big enough market, there can be multiple winners in the long run - saves companies from fighting out in a winner-takes-all market.
Access to Private Capital: the unit economics of payments businesses depend on volumes. With access to venture and private equity capital, hundreds of payments businesses today have the fuel to attain scale and become viable. And it is this promise of raising capital and the opportunity in digital payments that continues to push more entrepreneurs to build, improving the speed of innovation in payments and the number of competitors in each area of the industry.
Open Banking: lastly, the industry has been helped by the open banking push from regulators, where multiple payments companies can today leverage the licenses and deposits of banks or third parties through simple integrations. This has democratised payments, and other Fintech services in large, by allowing companies to build applications with a front-end focus and has allowed the likes of Stripe, Adyen to enable complicated money flows with simple-to-use APIs.
The access to capital, engineering capability, knowledge, and hundreds of millions of users have all combined to lower the barriers to build and scale payments businesses. But this has posed another problem to the larger businesses: when access to resources is not an advantage, how does one build a long-lasting brand?
Where is the moat?
Building a payments business is most definitely easier today but building a brand out of that business is tougher. This is especially true when competition for each part of the payments slice has pushed the focus away from differentiation or unit economics and towards distribution.
Today, the product features become commoditised quickly. And with the distribution focus, the goal shifts simply to gaining scale faster than your competitors. Scale begets higher valuations and more private capital. As a result, the metrics tend heavily towards acquisition and engagement, and little is discussed of the long-term retention.
This is the environment in which payments businesses operate today. Few take the chance to go against this status quo. And for all in the industry, the question stays the same: where is the moat?
The question is tough to answer, especially since payments is supposed to be a seamless background function, and often – the best experience you can give to your users is to make the act of payment almost invisible. Now, if people do not engage for long with your brand, especially with the absence of a physical card or device with your name imprinted, the chances of developing user affinity are low. This is one of the reasons why payments, especially consumer apps, continue to struggle with retention.
How can payments businesses then build a long-term competitive advantage?
All the moats that we discussed for Visa, Mastercard, and the likes forced retention of the banks, merchants, or users on the network. There is little that can be forced in today’s environment, but the retention-focus will be a good start to think about competitive advantages. How can businesses drive long-term retention? I suggest three ways.
Offer First-Class Customer Support
Polished user interaction and designs are the bare minimum for most payments’ applications today. But the quality of customer support has not kept pace with the convenience of using the applications. We know that poor customer support experience is a leading reason for high churn in many consumer applications, and it is partly a result of the execution and scale-driven mindset that drives organisations.
But this is equally a rare opportunity to differentiate. While building and shipping comparable features is common for competitors, the same would be tougher to match with customer support unless the companies are culturally designed to give the same respect to the function. I have little doubt then that payments organisations that focus on delivering a first-class customer support experience, assuming feature parity on other aspects, are likely to develop a potential moat.
Build New Forms of Loyalty programs
Every conference room that has had discussions on retention has likely also heard of loyalty programs. The success of Frequent Flier and the Starbucks Rewards is a testament to their effectiveness, and we are seeing the consumer-based payments businesses (Klarna - Vibe, Afterpay - Pulse) introduce such programs lately. These rewards do not have to follow the collect-and-redeem structure, however. (I had earlier written on how the reward programs are changing today).
There are few better examples of this than the co-brand card by Amazon and ICICI Bank in India. The card offers up to 5% off on all transactions on the platform, and this value proposition comfortably stands above those of all other payment methods for purchases on Amazon. The simplicity of the offer has earned the card over two million users in ~two years and the religious following of many. Paytm is attempting to do the same with its co-brand cards. Notice that in all these cases, the rewards appear aspirational and promise privilege - offers that are levels above the usual.
If you wish to build something similar, think of the problem in another way: what aspirational rewards can you offer?
Utilise Traditional Marketing Techniques
The internet and mobile have changed how people interact with brands, and with the exposure to hundreds of applications and logos – it is increasingly challenging for businesses to capture the mind share of users. You can do performance and influencer marketing, but you will not be unique.
These marketing concepts stay critical for acquisition, but what else can payments businesses do to differentiate? Go traditional.
The core marketing concepts that studied the human psyche still apply to the digital-first businesses. Yet not as many brands today use the traditional methods of large-scale video ad campaigns, jingles, and in-store presence to build mind share.
Think of the iconic Apple advertisements. Blog posts, pictures on Instagram, and ads on Facebook are unlikely to have the same long-term impact on users. Klarna is another strong example of a company that has focused on elaborate ad campaigns, and the size of their user base (90Mn+) probably tells us something of the campaign successes. Mastercard, more popularly, used ad campaigns, sports partnerships, jingles, and the Priceless tagline to build tremendous mind share with the users. The same was true of the hype that the recent Cred ad created.
For companies that operate on a large scale, it appears that event partnerships and video campaigns are important long-term levers for building brands.
Maybe it is time then for the consumer payments apps to get back to the board and come up with catchy taglines and jingles, for who knows that it may be the only chance for them to create something of a moat.
What else can payments businesses do to create moats? Write back to me or add a comment below if you have any thoughts on the topic. In case you feel your friends or family would be interested in reading about payments, feel free to share the blog with them as well. See you in a couple of weeks!