Digital Intermediaries Threaten The Payments Status Quo

Summary

• In a digital-first world, the checkout experience unbundles checkout from a physical place, shopping from a particular store (on or offline), and payment using a traditional payment method or issuer.
• Alternatives to traditional credit cards are emerging and slowly gaining scale, chipping away at the volume that once went traditional credit card issuers' way.
• Digital-first is disrupting pretty much every industry and has the potential to upend traditional firms - even the traditional payments industry.

March 19 will mark the one-year anniversary of the U.S. lockdown in the face of the global pandemic. Since then, the payments and commerce headlines have been mostly about one thing: the consumer's massive shift to digital.

Mostly because it's indisputable.

And it's likely to be the biggest headline of the next year - and beyond.

In a digital-first world, checkout is no longer about a plastic card dipped at a terminal in a store - and potentially no longer the slam-dunk domain of the traditional issuers and card networks that own that experience in the physical world.

In a digital-first world, the checkout experience unbundles checkout from a physical place, shopping from a particular store (on or offline), and payment using a traditional payment method or issuer.

In such a world, it also potentially unbundles the consumer and the merchant from the players, networks and business models that have defined what it means to "check out" for the last 60 years.

No More Bright Lines

The collapse of the lines between the physical and digital worlds over the last 12 months has set into motion the rise of new (and the acceleration of existing) digital intermediaries, like PayPal (PYPL), that have increasing control over the checkout experience - because they have aggregated large pools of consumers and merchants around the value proposition of convenience, safety, choice and the ability to save the consumer time.

At the same time, these digital intermediaries have developed - and strengthened - direct relationships with the consumers and merchants transacting on their networks, giving them tremendous influence over their own network dynamics over time.

In response to the pandemic, these digital intermediaries have focused on speed and convenience, riding the existing rails and leveraging existing payments preferences to get merchants and consumers up and running quickly in a world where physical restrictions drove many interactions digital.

But that's today.

Real-time rails, the growing influence of buy now, pay later (BNPL) networks on consumer credit choice, new technology and the trust that consumers have built over time with these networks lays the foundations for new business models that could potentially disrupt the profit pools of the traditional payments ecosystem.

Over the next decade, it's quite possible that merchants and these new digital networks - at scale - create incentives to shift consumer payments choice and merchant payments economics within the new connected endpoints they now control.

Once Upon A Time … In The 2019s

It wasn't that long ago that the lines between physical and digital were pretty bright, in spite of how hard the payments industry had worked over the last decade to blur them into being indistinguishable.

Like, a year ago.

As we bid adieu to 2019, plastic cards dominated at the physical checkout, despite the ambitions of the "Pays" to replace them, and despite the growing use of digital wallets and card-on-file credentials to make online purchases a growing part of the commerce mix. As retailers and the Census Bureau were very fond of saying at the time, more than 90 percent of sales still happened in the physical store.

In brick-and-mortar stores, consumers use their plastic cards because they are accepted everywhere, and using them is fast, easy, familiar, secure and reliable.

Issuers compete for consumers' top-of-wallet preference on card features, functions and rewards. Merchants compete for sales on product and price, integrating loyalty programs into the point-of-sale experience to drive preference. Card brands court issuers to ride their rails, and open their networks for FinTechs to innovate on top of their rails for the benefit of cardholders and merchants alike. The integrity of their networks powers a safe, secure and trusted commerce experience for all of its stakeholders.

In a digital-first world, however, digital intermediaries have the opportunity - and may have the power - to change many of those dynamics, because checkout is no longer a linear path. And because there are more and more new networks emerging that are building new acceptance networks that connect the consumer and the merchant with the point of sale.

In a pandemic-gripped world, merchants, eager to make sales, jumped on the digital-first train. Even SMBs.

PYMNTS research shows that merchants invested in offering card on file, delivery, curbside pickup, digital wallets, QR code payments and alternative payment options. They added BNPL brands in an effort to attract a millennial and Gen Z audience. They used marketplaces and aggregators to move sales to where consumers were searching for things to buy and services to use.

Consumers jumped on these digital-first trains, too - and they don't seem to be getting off. In many of the studies in which PYMNTS has tracked the consumer's digital journey over the last year, consumers report using digital-first options more often because merchants have made them easier and better to use.

Better digital-first merchant experiences drive the virtuous circle of adoption and usage - and the new habits are sticking. Of the 144 million U.S. consumers who have shifted digital since the pandemic - doing less in the physical world and more in the digital world for the same activity - PYMNTS research reports that roughly 80 percent say that all or most of their digital habits will stick.

Not surprisingly, merchants have changed their workflows and product offers to accommodate a consumer with different needs and new expectations for service. Their shift from "come to me" to "bring it to me" was, in many ways, made easier by the digital intermediaries that connected merchants and consumers to these new experiences - regardless of whether the customer was ordering food, buying groceries or purchasing any number of retail items.

A year later, stores large and small are shrinking their physical footprints in favor of a digital-first model.

The Rise Of The Digital Network

At the same time, the scale of the digital networks powering these experiences, or that could potentially do so, is increasing rapidly.

PayPal reported 377 million active users at the end of Q4. Loup Ventures estimated in November of 2020 that Apple Pay (AAPL) was active on 507 million iPhones worldwide. Amazon Prime (AMZN) reports 148.6 million users accounting for 69 percent of all purchases on Amazon; that would make the number of Amazon Pay users worldwide roughly 200 million. Google Pay (GOOG)(GOOGL) counts 150 million users (as of November 2020) and Google Assistant counts 500 million monthly active users. Amazon Alexa is available on 100 million devices. Square (SQ) reported 36 million active Square Cash App users at the end of December 2020.

Alternatives to traditional credit cards are emerging and slowly gaining scale, chipping away at the volume that once went traditional credit card issuers' way. Affirm (AFRM) reports 4.5 million active users, AfterPay (OTCPK:AFTPF) 13 million and Klarna (KLAR) 15 million.

Sure, these numbers are still modest compared to cards. But more than the number of users, though, is the momentum they seem to be gaining.

Take what's happening in what is still a small and relatively new category: BNPL. The latest PYMNTS Buy Now, Pay Later study of a national sample of 2,201 U.S. consumers conducted in early February of 2021 shows a millennial consumer twice as likely to have made her last online purchase using a BNPL option (26 percent of all shoppers who made a purchase) than the broader consumer base (13.8 percent), even though 90 percent of millennials also have a credit card. Most of those BNPL purchases were concentrated in the clothing/accessories and electronics categories.

Millennial behaviors aside, what's remarkable is the sheer number of consumers who've opted in to this new way to pay using a credit alternative over just the last year.

In March of 2020, when PYMNTS first went into the market to better understand consumers' online credit behaviors - and, in particular, millennials' use of buy now, pay later options - the story was quite different. At that time, the number of consumers using BNPL alternatives stood at roughly 4 percent and the share of millennials using them at 10 percent.

Seizing this momentum, each of these alternative credit networks is doing more to build a sticky network of consumers and merchants. They are leveraging high-yield savings accounts, rewards programs, money management tools and a growing directory of merchants that drive consumers with BNPL to their storefronts to create more preference - and volume - for a consumer who wants credit, but also wants repayment using funds on hand over a predictable, certain specified monthly term.

Analysts say that the shift to BNPL hasn't had much of an impact on the card networks - and likely won't, since the BNPL players ride the debit card rails, and card networks continue to collect network fees and interchange revenues on those transactions. That is true.

Except that could change.

But it's possible that, over time, BNPL intermediaries could shift consumers to a direct-from-bank-account model using ACH or real-time payments rails - and offer consumers an incentive for selecting that option. As these intermediaries build trust with the consumer, it is not unreasonable to think that they could or would do that and that at least a portion of consumers might make the switch.

These schemes, collectively, could also get enough traction over time to ding credit card interchange, the cornerstone of the payments industry business model for both issuers and networks. It's a long climb, but possible as these new credit networks expand the categories they serve to include higher-ticket items like travel and healthcare, cast a wider consumer net to grow their user base and volume, and/or white-label their platforms to power other digital intermediaries with BNPL ambitions.

But It's Not Just The BNPL Guys

Payments is a scale business. And when compared to the scale of the traditional payments networks, even if the numbers appear to be apples-to-oranges given the difficulties of separating the global from the U.S. percentages, these new networks have the potential to influence the future direction of payments and its current business model dynamics.

According to the latest Nilson report statistics, in the U.S., consumers have 336 million Visa and 231 million Mastercard credit cards in their wallets. Chase (JPM) has issued 92 million credit cards, Citi (C) 70.8 million and Cap One 99.7 million. American Express and Bank of America have issued 53.7 million and 55.6 million credit cards, respectively.

Any one of these digital intermediaries - Apple, Google, PayPal, Amazon - has the scale and the control of the endpoints today to influence that shift. As they scale, BNPL players have the potential to chip away at the edges.

Of course, what I have just laid out comes with a lot of "ifs.'" Mostly because they don't do so right now, and maybe they never will. And because this hasn't gone unnoticed by the traditional players that are innovating to leverage their own capabilities and scale to preserve their competitive advantage.

But there's another factor at play - and a few other players with potentially their own digital network ambitions.

Through their respective mergers, FIS and Fiserv (FISV) brought issuing and acquiring/processing together on a single platform. Chase operates its own consumer/merchant network, for all intents and purposes, and has invested massively in a digital transformation aimed at streamlining the payments experience. Citi is a Google Plex partner and will connect a "smart" Citi bank account to Google Pay and a connected ecosystem of commerce and financial services experiences.

In each case, investments in real-time payment rails could also portend a future where account-to-account payments - between consumers and merchants - create new payment networks at scale. The direct connection between the massive pools of consumers and their bank accounts - with millions of merchant endpoints - could potentially disintermediate or marginalize the rails that power those payments experiences today.

What's Next

Once upon a time, it was only PayPal that the card networks and issuers worried about.

Today, these digital intermediaries are all about choice and giving consumers the option to attach any card credential to their account and move between them at will - removing any friction that could get in the way of a great consumer and merchant experience. Offering choice is at the core of PayPal's explosive growth in users and volume - the subject of a very public battle with the card networks a few years back. The Pays and all of the digital intermediaries, save the BNPL networks, follow suit. Part of that digital-first acceleration is because digital intermediaries had existing rails and card credentials to leverage and fast track the delivery of those experiences for consumers and merchants.

Going forward, it is the constellation of new networks, using real-time settlement rails and account-to-account transfers, AI, state-of-the-art fraud and risk management networks, standards that can integrate authenticated identity into payments that could pose a real threat to what currently exists.

Being digital-first is much easier for a platform that was born digital - and so is scaling it.

Yet, as I said, payments is a scale business.

And change in payments historically happens slowly, even as the pace of the shift to digital has accelerated so rapidly over the last 12 months.

But it may not be that change happens so slowly this time. The difference between today and a decade ago is the sheer breadth of these digital intermediaries - the number of them that have emerged and are getting scale, the payments credentials they currently have, and how quickly they are forming and growing.

Not to mention the connections they have forged with their network endpoints, and the technical savvy and trust they bring to the digital experience for the consumers and merchants that are a part of it.

Digital-first is disrupting pretty much every industry and has the potential to upend traditional firms - even the traditional payments industry.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.