DEMYSTIFYING DIGITAL PAYMENTS Amitabh Saxena Managing Director Digital

DEMYSTIFYING DIGITAL PAYMENTS Amitabh Saxena Managing Director, Digital Disruptions November 12, 2014

We’ll spend the next 60 minutes going over two main topics. 1 Fundamentals of Card Payments • • Roles of Payment Networks Ecosystem Participants Transaction Processing Card Economics Based on Electronic Payment Systems 101 (available online) 2 Mobile Money as a Payment System • Similarities and Differences to Card Network Schemes • Interoperability: Benefits and Challenges Based on Electronic Payment Systems 201 (available online) 2

Electronic payments boost financial inclusion in two main areas. 1. Enhances Traditional Payments 2. Enables Standard Banking Products Offers a safer, faster, cheaper, and more convenient way to make and accept regular payments. Examples: a person-to-person transfer to a remote part of the country by text message; a merchant paying a supplier through a debit card. Allows additional utility or ease of access to standard bank products. Examples: receiving government-funded social benefit transfers directly in a recipient’s bank account; storing money on a prepaid card; using electronic transaction history to help loan or insurance underwriting. Electronic options are, on the whole, superior to cash and traditional paper-based products such as checks and savings passbooks. 3

Among all forms of payments, card networks offer the most promising model for financial inclusion. 1970 s Card Networks (near real-time, e-funds retail payments) 1970 s Automated Clearing House (electronic batch process to automatically debit or credit accounts) 1800 s Wire Transfer (real-time, usually large volume, e-funds transfer between banks) 1500 s Check (paper-based IOU) 700 BC Cash (notes, coins) Global card networks offer security, speed, scale, and true ubiquity: accepted in (almost) every country, at millions of merchants, with (almost) any bank, and on (almost) any device. So a key question is: can this model be extended or adjusted for the underserved? 4

A payment network is at the heart of so-called “Four-Party” Model, connecting consumers, merchants, and their respective banks. Four-Party Model In reality, within this model there are other stakeholders who provide additional services, such as loyalty and rewards, fraud reduction, POS terminal installation, as well as those who take on outsourced activities, such as prepaid processing. 5

Open-loop card networks like Visa and Master. Card perform three main roles. Visa and Master. Card are two payment networks that connect thousands of banks globally, which in turn connect millions of consumers and merchants with each other. Domestic network play much the same role at a local market level. They are not financial institutions, do not directly interact with consumers and merchants, and do not hold any funds. 1 2 3 Define membership rules Payment networks are open to member financial institutions, and define the “rules of the game” for card payments. Build brand trust Both consumers and merchants must have confidence that the payment system will work – securely, quickly, and hassle-free – thus building trust, via brand promotion, is an on-going activity. “Process” Transactions As tech companies in the payments industry, networks provide key infrastructure to facilitate processing of card payments. Note that card networks such as American Express and Discover are, for the most part, “closed-loop” networks (i. e. , not open to other bank members) and thus focus on #2 and #3. 6

Authorization is when the issuing bank determines whether or not the payment transaction goes through. Step 1: Authorization Note: Authentication occurs before transaction processing and is the act of verifying the consumer’s identity. This usually happens by prompting the consumer to enter a Personal Identification Number (PIN) or having the merchant compare the consumer’s signature on the transaction receipt with the back of their card. 7

The transaction is then cleared, i. e. , sending the relevant financial information of the transaction to the issuing and acquiring bank. Step 2: Clearing 8

Settlement is when the actual funds, net of any fees, between the two banks are transferred and the merchant ‘s account is credited. Step 3: Settlement Note: This flow is for a credit card transaction. In the case of a debit or prepaid card transaction, the cardholder’s account is debited immediately. 9

Card network transaction economics are largely driven by two separate but related features: merchant discount rate (MDR) and interchange. Merchant Discount Rate related but distinct Interchange A fee, usually expressed a percentage of the sale (rate), that the acquiring bank charges the merchant for the benefit to accept cards. This is the largest fee paid by the merchant, and is set by the acquiring bank usually on a “cost-plus” pricing based on interchange. A fee, usually expressed as a percentage of the sale (rate), that the issuing bank charges the acquiring bank as a “reimbursement” to take on certain activities and financial risk (i. e. , default, fraud) of the payment. Interchange varies by card, merchant, and payment type, and depending on the market, is set by the payment network, a consortium of banks, or the government. Note that closed-loop networks do not have interchange (as the issuing bank and acquiring bank is one and the same), and thus keep all fees collected from the merchant. 10

In the example below, the merchant fee is split between issuing (83%) and acquiring banks (17%); both then pay “assessments” to the network. Four-Party Model Transaction Economics 11

Agenda 1 Fundamentals of Card Payments • • Roles of Payment Networks Ecosystem Participants Transaction Processing Card Economics Based on Electronic Payment Systems 101 (available online) 2 Mobile Money as a Payment System • Similarities and Differences to Card Network Schemes • Interoperability: Benefits and Challenges Based on Electronic Payment Systems 201 (available online) 12

Though not every deployment has yet been a success, mobile money growth, on the whole, has been impressive and shows no sign of stopping. Ubiquitous Card Network Model * Mobile Money Growth = Universal Financial Access? Source: GSMA, MMU 2013 Mobile Financial Services State of the Industry Report. At time of publication, 13 deployment had more than 1 M active users; 123 deployments offered mobile savings, insurance, and credit. 13

Mobile operator-led mobile money schemes appear to resemble a traditional “Three-Party” payment model… Four-Party Model Three-Party Model Mobile Money Model Direct relationship with end-users Combined platform/account-management 14 Closed-loop

…with three main differences. 1 Mobile money does not require providing additional “hardware” to the consumer and merchant. Transactions occur with the mobile handsets already owned by the end-users, decreasing the overall costs of the payment system. 3 2 Mobile operators manage agents, not merchants, in mobile money. This resembles more the way a bank manages its fleet of ATMs. The underlying consumer account is prepaid, rather than credit. With consumer credit cards, issuing banks make the majority of their revenue first through interest, then consumer fees, and lastly through interchange. In contrast, most* mobile money MNOs make relatively little revenue directly through payment transaction fees, but benefit through greater use of its core business of voice and data. 15

While interoperability among payment programs is desirable for all participants, technological and organizational issues have held it back. Interoperability means a way for payment programs to interact with each other (for example, mobile money program A with mobile money program B), or between payment schemes (for example, a mobile money program with a traditional card payment scheme). Generally, this is mutually beneficial for all stakeholders: • provides additional relevance and utility for consumers and merchants • increases the overall revenue pool • reduces structural inefficiencies Two obstacles have prevented broader interoperability thus far: Technological Organizational No standards exist to-date for mobile money interoperability, or between mobile money and other schemes, most notable card networks and money transfer. While there are one-off projects, there is no wide-spread interactions among programs. It is challenging to get competing stakeholders to collaborate (e. g. , banks) as well as those that are cross-sector (e. g. , banks, MNOs, vendors, governments), especially if there some stand to gain or lose more than others. 16

Questions or comments? amitabh@digital-disruptions. com