Money and Payments: A Short Primer on Innovation and Branded Currency

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Howard Mason


November 21, 2015

Money and Payments: A Short Primer on Innovation and Branded Currency

  • In a fractional-reserve system, where money can take the form of customer balances at commercial banks, money-transfer likely involves the interbank exchange-of-value or “settlement”. Presently, this occurs through updating balances held by commercial banks at the Federal Reserve and cannot be accomplished in real-time (except by wire-transfer which is prohibitively expensive for the mass-market).
  • Among other authorities, the Bank of England has noted that use of a “distributed ledger” (as pioneered by Bitcoin) shared between participants and subject to a process[1] for agreement on changes to the ledger (a.k.a. valid transactions) would remove the latency of a central authority. Ajay Banga, CEO of MasterCard, properly cautions: “the real issue here will be [whether] legal dispute settlement systems accept a distributed ledger as resolving a conflict if and when it arises between a bearer and a receiver”.
  • Given demand among smartphone users for immediate person-to-person (“P2P”) payments, the latency of traditional interbank settlement has created a market opportunity for non-banks to accept bank-money in exchange for an alternative unit-of-account (such as a PayPal credit) which can be spent on a particular platform. Providers of these “branded currencies” can effect real-time settlement by updating proprietary accounting systems so that consumers gain the benefit of immediacy albeit at the expense of utility (since, by definition, branded currency is platform-restricted and can no more be converted into bank-money in real time than bank-money can itself be transferred). PYPL, of course, is looking to reduce this utility disadvantage by expanding its platform hence the acquisition of Xoom and strategy of extending its online franchise to physical point-of-sale.
  • The threat to banks of branded currency is that consumers will prefer them as a store-of-value over bank deposits because of their support for real-time payments. Large banks have responded through building a bank-owned payments utility, ClearXChange (CX) which supports real-time payments because banks honor clearance commitments (i.e. the non-monetary exchange of transaction information) by making “good-funds” available to end-customer recipients before final settlement (i.e. the interbank exchange-of-value at the Federal Reserve). Through its member-banks[2], CX has access to ~70% of demand-deposit-accounts (DDAs) in the US and we expect this to expand to nearly all DDAs through interoperability with FIS and FISV which, through their processing businesses, have direct connections to DDAs at regional banks and credit unions.
  • In building consumer usage, the natural distribution channels for CX are banks looking to add payments capability to the balance-check and remote-deposit-capture features of their own-brand mobile apps and digital brands, such as AAPL and FB, looking to increase platform-utility through adding payments but, unlike PYPL, unwilling to bear the regulatory scrutiny of becoming currency-providers or money-transmitters. We note that, like ChaseNet, CX represents an alternative routing infrastructure to Visa and MasterCard for POS transactions and that Durbin allows it to be used for Visa- and MasterCard-branded debit transactions. Furthermore, at least in the case of CurrentC, we expect CX to be used also to route private-label credit transactions (under terms agreed bilaterally between issuing bank and accepting merchant) with FIS, as contractual partner to the retailer payments consortium MCX, acting in the role of acquiring processor.

Investment Conclusion

While an Apple/CX partnership represents incremental competition for PayPal, we believe the dominant effect will be to stimulate primary demand for real-time P2P payments, and hence for PayPal credit as a branded-currency, and reiterate our positive view on PYPL with a $45 price target as set out in the note of June 11th titled “PayPal: Gateway Service to Integrate Offline and Online Commerce”.

Furthermore, we expect CX to partner with FIS so as to broaden its DDA-access from current large-bank members to the regional-bank and credit-union clients of FIS processing business and create a BIN-routing option (BIN for bank-identification-number) between retail-members of MCX, which has FIS as its contractual partner, and bank-members of CX. Durbin allows this infrastructure to be used for debit transactions, including those acquired on by on the Visa and MasterCard brands, and we expect bilateral arrangements between banks and retailers to allow it to be used for “private-label” credit transaction as well. We believe the disintermediation risk to Visa and MasterCard is under-discounted although note that, for the time being and as discussed in the note of July 3rd titled “V/MA: The Impact on Pricing Power of the Shift from PAN- to Token-Based Strategy”, the networks can preserve their economics by providing tokens even for transactions that are not PAN-routed (PAN for the network-provided primary-account-number).

MA is further along in token distribution than V having signed deals to support the private-label cards of C, SYF, ADS, and (almost surely given the broader institutional relationship) COF.

SSR Banks/Payments Preferences


To function as a medium-of-exchange, money requires a payment system to enable its secure transfer. Furthermore, in a fractional reserve system where money exists as customer-balances at commercial banks, this payment system must involve the interbank exchange of value or “settlement” (except where payer and payee hold accounts at the same bank which can then effect “ON-US” settlement through book-transfer on its proprietary accounting system). In the US, interbank settlement is accomplished by updating the balances that commercial banks themselves hold on a central ledger maintained by the Federal Reserve. The only way to do this in real-time is by Fed wire-transfer; next-day settlement options include the automated clearing house or ACH system[3] (used for check transactions), the bank-owned utility ClearXChange (CX), and the debit/ATM card networks (e.g. Visa/MasterCard[4] and the electronic funds transfer or EFT networks[5] such as STAR and NYCE).

The latency imposed on the transfer of bank-money by the need for traditional interbank settlement has created an opportunity for non-banks to brand their own currencies. These non-banks, such as PYPL, accept bank-money in exchange for an alternative unit-of-account (such as now-discontinued Facebook Credits) which can be spent on a particular platform (such as within an online game). The advantage of a non-bank currency is that real-time settlement is possible between platform-participants because, as with an ON-US bank transaction, it simply involves book-transfer update of customer balances on a proprietary accounting system. There is no interbank settlement since, from the standpoint of the banking system, there has been no change: the creditor remains, say, PayPal regardless of whether, and to whom, PayPal has written an IOU.

This advantage of non-bank currency in real-time funds-settlement is becoming more important with increasing adoption of smartphones because consumers expect[6] to be able to move money, particularly between themselves in person-to-person or P2P payments, easily, immediately, and at no-cost: put another way, P2P is the killer app for non-bank currency and a key reason for PYPL’s purchase of Xoom and, via Braintree, Venmo. The disadvantage of non-bank currency is that it has less utility than bank-money since its use is restricted to a particular platform. PYPL is looking to reduce this utility-disadvantage by extending its online franchise to physical point-of-sale with gateway services, which support the collection of transaction information and its use to improve fraud risk and customer relationship management, as the merchant hook.

With ClearXChange (CX), banks are responding to the threat that, drawn by quick and free P2P, consumers become more willing to swap bank balances for non-bank currency (e.g. a PayPal balance). With most large banks among its members[7], CX can access ~70% of US demand-deposit-accounts or DDAs and will likely broaden this by collaborating with issuer processors, such as FIS and FISV, which have DDA-access at regional banks and credit unions through direct connection to core processing platforms. While details have not been released, we expect CX participants to support real-time money transfer between themselves through a “good-funds” model where they honor the commitments expressed in clearance (which involves the non-monetary exchange of transaction information) and so make funds available to end-customers before final settlement (which involves the exchange of value through updating the Fed balances of counterparty banks). Indeed, CX can be thought of as an extension of ON-US settlement to ON-WE settlement in that participating banks agree to honor clearance balances on a shared CX ledger before settlement at the Federal Reserve.

The challenge for CX is building a consumer franchise. The natural distribution channels are banks looking to add payments capability to the balance-check and remote-deposit-capture features of their own-brand mobile apps and digital brands, such as AAPL and FB, looking to increase platform-utility through adding payments but, unlike PYPL, unwilling to become currency-providers; indeed, the WSJ has reported[8] AAPL is in discussions with CX. CX will improve its appeal to distribution-partners and end-users by expanding use-cases beyond P2P to include time-sensitive payments more generally including C2B (e.g. rent payments and bill-pay) and B2C (e.g. insurance claims). Furthermore, given the risk-management and authentication capabilities of Early Warning Systems (with which CX combined last month), we see no reason CX cannot extend to point-of-sale (POS) through partnership with retailers: SBUX, for example, can route debit transactions, even if authorized for My Starbucks Rewards with a Visa card[9], over CX.

Indeed if, as we expect, the FIS PayNet network becomes interoperable with CX, there will be a settlement route from the retailer payments consortium MCX, whose members account for ~one-quarter of retail spending in the US and which has FIS as its acquiring partner for its CurrentC-branded pay-and-save app and, and well over 70% of US DDA accounts. In effect, CX allows member-banks to achieve the low-cost routing of ChaseNet for network-branded debit albeit not for credit (since, to date, only JPM has obtained a waiver of Visa’s requirement that Visa-branded credit transactions route over Visa’s proprietary infrastructure). However, if a credit transaction is not network-branded, as can be the case for CurrentC transactions where the accepting retailer has a bilateral, “private-label” relationship with the credit-providing bank, CX routing is viable.

The broader context is that, unlike in 1966 when BankAmericard (rebranded as Visa in 1976) licensed its acceptance mark to other banks, the POS payments-market is mature and national rather than nascent and subject to restrictions (finally removed in 1994) on interstate-banking. As a result, large banks are looking more to gain share than develop a primary market and so focused on building their own national brands rather than a common brand[10]; this focus is only enhanced by the threat of non-bank brands such as PYPL. The extension of own-brand mobile apps to payments generally is an important aspect of this bank-branding with CX-enablement of P2P payments providing a critical beachhead and JPM’s development of ChasePay as an acceptance brand (leveraging control of a leading share of the acquiring market through Chase Merchant Services that has been broadened through partnership with CurrentC) the first-mover in POS payments.

However, ChasePay is not the only mover in POS payments with COF, in October, being the first US bank to enable NFC payment capability within its own app leveraging Android KitKat’s host card emulation (HCE) solution for cloud-based provisioning of card credentials and the Visa/MasterCard token solutions. The POS capability is not available on iOS devices because Apple does not allow third-party access to the NFC-controller so that NFC-enabled payments must route through Apple Pay although we expect this to change (just as Apple now allows, but did not initially allow, third-party access to TouchID). The significance of POS payments through a mobile app is that, having branded the consumer payments experience, the provider (whether a bank or digital player) can broaden fulfilment options beyond Visa and MasterCard. This is PayPal’s strategy with ACH, Apple Pay’s strategy with retail store cards[11], ChasePay’s strategy with ChaseNet, and we expect it to be the strategy of POS-enabled bank-apps with CX.

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, C, BAC, WFC, and GS.

  1. The emerging cryptographic field of “distributed consensus systems” looks to establish voting algorithms that strike the right balance between consensus-formation among participants (i.e. reaching accord on a single, internally-consistent record of transactions), correctness (i.e. rejecting fraudulent transactions), and confirmation-latency (i.e. reducing the time between a transaction and its confirmed “settlement” through final inclusion on the transaction ledger).
  2. CX members include BAC, WFC, JPM, COF, BBT, USB and PNC.
  3. NACHA, as the rule-making body for the ACH system, is working on same-day settlement protocols; in practice, this may be less useful than it seems given ACH returns (where a bank refuses a request for funds) will still be possible within a 3-day window and, in the case of fraudulent activity, a 60-day window.
  4. For example, Visa banks settle net end-of-day balances through a Fed1031 drawdown from the receiver of funds and a Fed1032 response transferring value to honor the 1031 request.
  5. While none of these options provides real-time exchange-of-value or “settlement”, the EFT networks provide real-time clearance (which is the non-monetary exchange of transaction information) since they are “single-message” systems which communicate clearance data in a single message along with the transaction authorization. In contrast, the primary debit networks of V and MA are “dual-message” with clearance data sent in an end-of-day batch message independently of the real-time transaction authorization.
  6. Federal Reserve reports ~70% of consumers want real-time payments.
  7. CX members include BAC, WFC, JPM, COF, BBT, USB and PNC.
  9. Durbin allows retailers to use any available infrastructure for routing debit transactions regardless of acquiring network brand.
  10. It is not lost on JPM the large banks that COF was able to build a market-leading credit-card business in the 1990s through leveraging the MasterCard brand.
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