A Land of Innovation, but How Competitive is the Payments Industry? Part 1: Looking Beyond the Card

In recent weeks, the topic of competition within payments has been hotly debated by several industry commentators.

It has been claimed that there is more competition than ever, with the presence of new payment methods often cited as the primary reason.¹ While it is true that there is innovation in the payments industry, and there are lots of efficiencies and economies of scale, does this mean the industry is sufficiently competitive?

In this two-part blog series, I will seek to answer this question, starting with a look at competition between different payment methods before drilling down into the market for payment cards.

The U.S. Payments Market Today

The payments industry can be thought of as comprising many different markets, including markets for consumer (C2B), interpersonal (P2P) and business (B2B) payments, all of which may have several sub-markets, featuring participants such as gateways, fraud providers, processors, networks, issuers and independent sales organizations (ISOs). I will focus on the market for consumer payments in the U.S., which for several years has been primarily composed of sub-markets for four-party debit and credit card payments (Figure 1).

What Comes First: The Card or the Alternative Payment Method?

We might expect innovation to oust incumbents, much as Netflix displaced Blockbuster or smartphones took over the cell phone market. In many parts of the world traditionally dominated by cash payments, we have seen this: super app digital wallets WeChat and Alipay have rapidly taken over as the preferred consumer payment methods in China, driven by attractive features for consumers and attractive fee structures for merchants.² UPI in India and Pix in Brazil have seen consumers using real-time payments at merchant points of sale, cannibalizing both cash and card payments. Why is this innovation not hitting other parts of the world traditionally dominated by card payments, such as the U.S.?

I believe the answer here lies in incentives. In the four-party card model prevalent in the U.S., consumers pay using cards issued by banks, who receive interchange fee income for every card-based transaction as determined by card network fee schedules.^3,4 Credit card merchant fees – of which interchange fees are by far the largest component – are currently unregulated in the U.S. and averaged around 2.24% of the transaction value as of 2022.⁵

Figure 2 shows that, in countries where we have seen new “disruptive” payment methods successfully penetrate the consumer payments market in recent years, card payments were either nascent (India), or there were large unbanked populations (India, China and Brazil), or credit card interchange fees were regulated (China).⁶ In the U.S., none of these conditions exist, and I believe this dynamic helps explain why credit card payments persist.

Understanding the Incentives: Two-Sided Markets with Network Effects

In economics, the four-party card market has widely been studied as a ‘two-sided market’, wherein networks are platforms that need both issuers (to partner with on customer-held bankcards – “the customer side of the market”) and merchants (to accept their bankcards – “the merchant side of the market”) in order to function.

As Sidak and Willig (2016) put it, ‘Typically, platforms in two-sided markets charge a low, sometimes negative, price to attract customers on one side of the market and a higher price to the other side of the market.’⁷ Sidak and Willig offer the example of shopping malls, which may offer free parking to attract shoppers while charging retailers rent based on the potential value of customer footfall. In these types of markets, network effects can amplify the impact of a price change; for example, if more people choose to visit the mall, business will be charged more to sell there.

The same is true for card payments. Merchants usually have a simple choice when it comes to credit cards from these major networks – either accept them with their fee structures, or refuse to accept them and risk losing a large portion of sales. They often cannot even opt to accept only lower-cost cards due to network Honor All Cards rules⁸ which limit selective acceptance. For credit card payments, merchants generally cannot leverage competition between the card networks, as a credit card is usually enabled and branded with only a single network – unlike with the co-badging of networks that exists on most debit cards, as required by U.S. law.

What about Alternative Payment Methods?

It is my belief that card payments face limited competition in the U.S. today. Leading P2P apps have large customer bases and sufficient processing infrastructure, but they often lack solutions that operate independently of traditional bank accounts and cards. For example, digital wallet providers, such as Apple, Google, and Samsung have partnered with the global card brands to create mobile wallets funded primarily with credit and debit cards that customers load into their wallet. Other, nascent providers of alternative technologies have been purchased up by incumbents.⁹ Even central bank digital currencies and cryptocurrencies have a limited track record of performance in consumer payments in any country.

What does the future hold?

Even with the current competitive landscape, there is hope on the horizon for payment alternatives to cards. The Federal Reserve, for example, has developed its FedNow real time payments (RTP) rail which will compete with The Clearing House’s (owned by the major U.S. banks) existing real-time payments rails. Both can be developed for retail use cases with new and iterative pay-by-bank products potentially utilizing these real-time networks. Aside from faster settlement, potential benefits of real-time payments include lower costs and faster refunds.  However, pay-by-bank payments may still face adoption challenges for consumer-to-business payments given the aforementioned limited incentives for banks to migrate customers away from card payments. These hurdles mean the solution to competition issues within the U.S. consumer payments industry isn’t just about introducing new payment methods. Competition can also be increased within the card industry, which will be explored in Part 2.