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Credit, private or public, is of greatest consequence to every country. Of this, it might be called the invigorating principle. -Alexander Hamilton

So which is it? Is lending a good business, where moats and profit pools are durable and one can build billions in equity value … or is it an inevitable cash bonfire when the cycle turns? Is credit a critical lubricant for the economy, the more the better, or a creeping contagion to be limited, particularly in the “shadow” banking system? As someone who co-led the seed round in one of the first alternative lending companies (OnDeck), and went on to serve as Chairman, but who has not invested in a single lender since, I stand somewhat astraddle this issue. After watching closely for ten years, I remain convinced that the leaders of Alt Lending 1.0 (specifically Lending Club, SoFi and OnDeck), if they can avoid getting acquired due to depressed stock prices, will build enduring platforms. I am most worried about the wave of “me, too” players that came next, Alt Lending 2.0. Most of them built their business plans on the now shifting sands of temporarily high valuations and cheap capital, and have insufficient differentiation to carve out a durable niche. I am most excited about the Alt Lending 3.0 players, who have had the ability to learn the appropriate lessons of the past decade and can both pick their spots and choose a more capital efficient path.

If you look at the question with an eye towards history, what is perhaps most surprising is that venture capitalists are thinking about lending at all. In the past, non-bank lending was either about disreputable segments or scale finance companies, and in either case raised equity with the promise of distributing yield based on high ROE, not primarily creating high multiples through exits. What changed? In a phrase, “marketplace lending”.

To explain what that is, I’ll quote myself … I was asked by a banker in 2014, before any of the lending IPOs, to explain Lending Club. Here’s what I wrote back to him (edited for brevity and clarity):

I’m quite familiar with them.  They are the pioneer in an innovative new funding model for specialty finance companies, whereby they originate loans and then sell them off entirely, without keeping any of the risk or needing to tie up any equity capital in their assets.  They receive a ~4% origination fee and an ongoing 1% annual servicing fee on the assets.  They benefit from a number of unsustainable trends, including:

  • historically low yield environment
  • a massive amount of high interest rate credit card debt burdening consumers, as a result of the credit crisis
  • a robust credit environment, with defaults at historical lows
  • banks and credit unions still “in their bunkers” relative to making new unsecured personal loans to consumers

I believe many or all of these trends will reverse in the next 2-3 years, but Lending Club has built a substantial business and diversified away from their historical base of unsecured consumer loans, so I believe they will end up being a survivor.  To the extent to which their innovation (marketplace funding of loans) is durable, it will have created a new species of competitor for banks, pure play loan originators who can compete based on marketing prowess, underwriting skill, proprietary product creation and other areas where FIs have historically been weak.

Marketplace lending is the “technology” that creates the biggest risk for FIs on the asset side, in the same way that prepaid is the “technology” that creates the biggest risk on the liability side (per this essay):

One of the good things about being an obstinate cuss with no capacity for new ideas is that it creates efficiencies like this one … I don’t have to change a word of this, even two years later.

Marketplace Lending

It is still possible, though I believe increasingly unlikely, that marketplace lending will be a durable innovation. As a society, we decided that mortgage originators should hold some risk in the product they create after they nearly destroyed the world in 2007; should other types of credit be treated differently? The specific mechanism used, whereby a bank technically originates the asset on behalf of the marketplace lender for compliance reasons, has been challenged by the courts. A more straight-forward risk to the model is demand for these assets through cycles. In normal yield and risk environments, asset owners have required that originators be aligned with them regarding asset quality. If rates rise and credit quality deteriorates, this demand will likely re-emerge.

That said, I don’t think it matters whether marketplace lending ends up being a viable long-term funding strategy or not. What Lending Club, OnDeck and others proved was that they could effectively compete with banks and build share in their respective categories. The unique way that Lending Club funded its assets was a feature, not the entire product. As an example, when I backed OnDeck originally, it was before marketplace lending (or “peer to peer” lending, as it was originally called) was in vogue, and the assumption was that we would have to follow the traditional asset funding path. That path involves funding initial loans using 100% equity, until the assets are proven out, then layering in leverage over time. This generally starts with a 50% loan-to-value advance rate, eventually climbing to 80-90% over time as/if the assets perform. Ultimately, you can build a highly redundant funding machine, as OnDeck has done, with essentially equal parts balance sheet funding (using high advance rate leverage and an SPV), rated securitizations and whole loan sales (the prosaic, old school term for what now goes by the dazzling nom de guerre marketplace lending).

As an amusing aside, I’ve now been involved in two public panel discussions and multiple private conversations with Lending Club investors around funding models. It always goes the same way … they say that there is no more resilient model in capitalism than a marketplace model, hence the ineffable beauty of Lending Club. I then ask how a marketplace could be more resilient than a marketplace PLUS a securitization conduit PLUS committed multi-year balance sheet funding (the SoFi, Avant and OnDeck model, among others). Following that I am branded an apostate and asked to relinquish my Fintech Fan Club ™ membership card. In point of fact, I consider no fewer than 6 current or past Lending Club board participants close personal friends, and the visionary investments they made in that company cemented their reputation as great investors. I just think the reason they chose well is the classic venture capital formulation of “great founder, big market”, rather than any notion that Lending Club discovered the credit equivalent of cold fusion. The fact that Lending Club was able to scale without using equity in its loans because of the marketplace model was a brilliant strategy, but far from the most important aspect of the success of the company.

The things that matters about how you fund your assets are a)cost, b)liquidity and c)risk … as an originator, you need to manage all three. The marketplace-only model focuses exclusively on risk, and emphasizes to the point of fetish the idea that the originator bears no ongoing exposure to the assets once sold. Of course that’s not true: If all of your assets go pear-shaped, you’re almost as screwed as if you owned them. Risk is not the only thing to focus on.

Venture Capital in Alternative Lending

The debate around marketplace lending is a bit of a sideshow. The fundamental questions are:

  • Can non-bank lenders take share from banks?
  • If so, in what categories?
  • Can it be done in such a way that equity investors can earn venture-type returns?

I do believe that non-bank lenders will take share from banks, though I think they have to pick their spots carefully. I think an economic model can be built that works through cycles, though there will be some white knuckle moments along the way. Marketplace lending, or whole loan sales, can be a useful part of a diversified funding scheme, but is not mission-critical to creating venture returns.

To understand why and where banks are vulnerable, we need to decompose lending into its critical parts: Customer Acquisition, Credit, Funding, Servicing/Customer Relationship Management.

Lenders have to attract customers, figure out if they want to lend to them, fund the assets that they create and then service and collect from the borrowers over time. Despite much rhetoric to the contrary, banks are not particularly terrible at any of these skills, and they benefit from enormous economies of scale across the entire value chain. In order to compete, non-bank lenders need to pick one or multiples of those aspects of the chain, and differentiate in a way that is hard for banks to follow.

Funding Advantage

The hardest way to compete with banks is relative to funding, which makes it all the more peculiar that the alternative lending sector has come to be branded by its asset funding methodology, marketplace lending. The average cost of funds for a bank, according to the FDIC, is 0.06%, assuming they fund their loans using deposits. OnDeck’s funding costs for its assets averages 5.3%. Lending Club has paid a median return to its asset purchasers of 7.4%. Any start-up lender, particularly in unsecured or novel credit categories, will start out with rates in the mid-teens, if they can get leverage at all. No one can fund cheaper than a bank.

While we’re on costs for a moment, another common anti-bank argument is around inefficiency in terms of marketing and servicing. Lending Club estimates that the big banks suffer from operating expenses as a percent of loan balances on the order of 5-7%, while it has marketing and servicing costs of around half that amount. While true, I’ll point out that most of the bank expenses they highlight are fixed expenses like branches and compliance, which makes that expense burden irrelevant to the profitability of the marginal loan. In addition, what banks overspend in these areas they make up for in IT and G&A … for example, banks on average spend 7% of revenue on tech, compared to 12% at Lending Club and a whopping 24% at OnDeck. When combined with the enormous and irreducible funding cost disadvantage, we can safely say that neither funding nor cost structure represent areas of long term competitive advantage for the insurgents. That leaves us with Customer Acquisition, Credit and Servicing/CRM, plus combinations of the above. The good news here is that there is opportunity in each.

Credit Advantage

Most start-up originators focus on the opportunity to innovate in credit decisioning. The headline appeal of new data sources and new data science seem too good to be true as a way to compete with stodgy old banks. And, in fact, they are indeed too good to be true. Building new credit models is hard, inherently time-consuming and expensive. Fundamentally, you can’t figure out how to distinguish between the “goods” and the “bads” without sufficient “bads”, and “bads” cost you money. Credit losses can also take some time to develop, depending on the category, and assets can behave quite differently in different economic cycles. Until you have a model that is proven in a highly durable way, your cost of capital will be very high.

But wait, it gets harder. Sexy new data sources can be tricky, particularly in consumer lending. Not only can you not intentionally use criteria that the regulators view as prejudicial, you also can’t leverage variables that seem innocuous but end up being correlated with things like race and marital status. Further, the new data itself isn’t interesting; what’s interesting is how it affects credit quality. You can have all of the hypotheses you want about how data should rank risk, but no one cares until you demonstrate it.

The recipe for success here starts with picking a truly underserved segment. Then figure out some new methods for sifting the gold from what everyone else sees as sand; this will end up being a combination of data sources, data science and hard won credit observations. At least some of your credit observations have to be non-obvious. One good test is to see if FICO scores help to sort risk; if they do, pick another category … banks understand FICO scores. It is important to choose a segment with relatively small dollar amounts and relatively short duration. Credit models are judged on unit performance more than dollar performance, and small dollar/short duration lending allows for many more “bads” on far fewer dollars. It is also a bulwark against bank competition. With larger loans, banks can and will invest human resources to underwrite loans; with smaller loans, they don’t have that option. Finally, while starting in an out of favor category is probably essential, it can’t remain true forever. You have to have a game plan for moving mainstream once you’ve built your competitive advantage in underwriting.

There are relatively few examples of companies that have gotten all of these elements right, but there are some. Oportun provides credit to otherwise highly disadvantaged Hispanic borrowers. What a bank sees as a 620 FICO, Oportun sees as an employed but challenged immigrant with a spotless record of sending remittances home. Sub-prime and near-prime lenders like Avant and LendUp have proven out extremely advanced consumer credit models in unattractive segments, and are working quickly to leverage those models into more mainstream businesses. In small business, OnDeck chose a large segment that had historically been attractive but hard to serve. Where a bank sees a generic SMB with a business owner FICO score of 650, OnDeck sees a plumber with far higher efficiency than comparable businesses in its zip code, and a glowing set of reviews on Angie’s List. This hard work comes at a cost; OnDeck’s R&D expenditures, noted above, are characteristic of the successful companies in this category. You have to have real IP to win here.

These companies are building defensible moats against bank competitors for a variety of fundamental reasons. The one area where the funding cost advantage that banks have doesn’t work for them is in areas where new credit models are required. Regulators insist that banks keep disproportionate amounts of equity capital in reserve when they try new things, and while their debt capital (ie, deposits) is cheap, bank equity capital is quite dear. In addition, these segments generally start out with high APR models. They can support high interest rates, as by definition these customers don’t have good alternatives, and as discussed, they require high interest rates to compensate for the risk and elevated cost of capital. Over time, APRs can come down dramatically, but these segments are generally dismissed in the early days as predatory or niche.

Customer Acquisition Advantage

Developing an advantage in Customer Acquisition is harder than it might appear. At first blush, it might seem that all it takes is to pick an unloved segment and get to know its idiosyncrasies and tendencies well enough to create a focused channel and tailored dialogue. In practice, progressive and thoughtful traditional lenders like Capital One have mined most of the segments large enough to build a business around. The only way to build a durable competitive moat based on Customer Acquisition is to become integrated into a channel that is proprietary, contextual anddata-rich.

Integration is an old lending concept that has been reinvented in the modern age of networked computing and hosted software. Decades-old companies like Synchrony and Alliance Data were “integrated” at the point of sale in the form of paper applications for store-branded credit cards; now we have modern versions like Greensky, Bread and Affirm. These companies don’t leverage their channel to find a new or underserved segment; instead, they gain access to well understood, prime consumer credit via partnerships with companies hoping to sell things more efficiently.

It has historically been critical that these integrations be proprietary. Most, or all, of these companies insist that they be the only credit option in that channel (or at least have exclusivity by credit tier), and in fact, in most categories the credit providers get paid by the channel to lend, as well as by the borrower. It continues to surprise me that merchants have allowed this to continue in the age of marketplace lending. If I ran a retailer, I would not only refuse to subsidize point of sale lending with a merchant discount, I would run a real-time auction between lenders for each consumer seeking credit to make a purchase. This is likely not feasible today, but certainly technically possible over time.

On the B2B side, good examples of this are starting to emerge in the reinvention of commercial sales finance. Companies like Noesis and Wunder are providing tools to vendors of HVAC, solar and other high ROI systems to both prove the value of this equipment to business customers and finance the sale at the same time. For years, Bluetarp has been replacing the historical role of vendors in providing trade finance to the buyers of construction materials; now they as well as new entrants like Behalf are pushing this methodology into other verticals.

The home run is when the credit offer is not only presented in context, but also can be structured with the benefit of relevant data. Fundbox lends to small businesses by advancing them payment on receivables, in what is akin to a traditional factoring transaction (though without claim to the asset). They integrate with online accounting systems like Quickbooks, which not only provide them access to customers, but do so in a way that allows them to learn a great deal about the creditworthiness and demand for capital of their prospective customers. Bluestem Brands has a business called Paycheck Direct, in which they integrate with payroll systems to provide access to an e-commerce catalog on credit to low FICO employees; by having access to the payroll system for both underwriting and collections, they have a massive advantage over payday lenders.

One company that is synthesizing all of these elements is AvidXchange. Avid’s core business is Accounts Payable automation and commercial payments; they integrate and control the payment process of B2B customers. Based on that data, they know when and if suppliers are going to get paid, and in fact are responsible for making those payments. As such, they are in a unique position to make highly attractive credit offers to otherwise cash-starved vendors, leveraging their native integrations, proprietary access, ability to make contextual offers and data-rich software footprint. They can provide capital to the least creditworthy vendors simply based on the strength of the buyer and Avid’s insight into the likelihood of payment. This kind of position allows more than just sifting for gold (differentiating the creditworthy from the non-creditworthy), it actually creates the opportunity for the more alchemical process of turning fundamentally credit-challenged customers into good risk.

Servicing/CRM Advantage

A promising but infrequently used vector in the lending space is to capitalize on a servicing, or more accurately, customer relationship-oriented strategy. The hero company here is SoFi, who focuses on the HENRY segment (High Earning, Not Rich Yet). They started with student loans, as a low risk asset class that had historically been underwritten in an unsophisticated fashion. With its narrow spreads and government subsidies, student lending in and of itself was unlikely to be a sustainable niche, particularly in a rising rate environment. To the credit of the SoFi team, they knew this from the outset, and treated student lending as their gateway product; they have now launched a nearly full suite of consumer financial products into their loyal base of student lending customers. The company generated that loyalty through laser focus, and by going above and beyond for their customers. It is hard to imagine a traditional bank lender providing job placement services for their borrowers, much less networking dinners and dating services.

Where Do We Go From Here?

While I’ve come to be known as a skeptic on marketplace lending per se, I see a great deal of opportunity in alternative lending more broadly. That said, things are going to get harder before they get easier. Valuations are down significantly, and the market volatility combined with a slowing economy will produce challenges with both default rates and access to liquidity. Of the alternative lending 1.0 players, Lending Club will be a survivor, and a long term leader. While it doesn’t have many of the distinctions I note above as important, it has scale, a brand in the capital markets for producing high quality assets, and an unbelievable management team. In fact, Lending Club may be the best example of managerial execution in a commodity market since Amazon, and like Amazon, if they continue on their current path they will figure out a way to create enormous value. OnDeck, in a sense, has an easier road ahead. They are very far along an experience curve with regard to the new world of small business lending, and it’s hard to imagine someone catching them. I worry about the 2.0 originators, which tend to be only slightly differentiated fast followers of either Lending Club or OnDeck; it will be very hard to be anything other than the leader in this shaky market environment.

I’m quite excited about Alt Lending 3.0, made up of earlier stage originators whose strategies line up with the precepts above, and who have gotten the memo about appropriate valuations and capital efficiency. For lending high flyers, as for the rest of the “unicorns”, the notion that high growth and “disruption” justify valuations detached from estimates of future cash production has gone away. Companies seeking funding in the lending space today generally have less of the Gold Rush mentality of the Alt Lending 2.0 players, who sought to take advantage of an enthusiastic investing community; instead, they are motivated by legitimately unmet needs and the prospect of meaningful moats. For the first time in a decade, I’m feeling like it’s a great time to be starting a lending company

Submerging Payments, Part II

codebloo —  September 14, 2015 — 4 Comments

Not much more than 100 years ago, the ice industry was a major component of the US industrial economy, contributing $660MM (in today’s dollars) to the GDP and employing 90,000 people, more than the total population of good-sized cities like Albany, Atlanta and Nashville. In the early part of the 20th century, ice went through what appeared to be its “disruption” (probably Ye Olde Techcrunch called it “FrostTech” or something at the time), where the industry shifted from natural ice (literally, I sh*t you not, chopping blocks out of lakes and shipping it coated in sawdust) to manufactured ice, made in industrial scale factories.

Sadly for the ice industry, that was not the disruption they should have been watching. What ended up eviscerating the ice industry was the advent of in-home refrigeration. Refrigerators weren’t invented to make ice, but they made ice on the side, as it were. More importantly, they obviated the need for purchased ice by doing the job of ice, which is to say, cooling food, much more efficiently. I can only imagine the self-satisfied ice-trepreneurs who moved gracefully from lake chopping to managing ice factories, smugly speaking at business schools about how they recognized that “they weren’t in the ice harvesting business, but rather in the ice provisioning business”, until they realized that they were actually entirely out of business. The key idea here is that the ice industry didn’t get disrupted by technological innovation that changed how they did business; the industry essentially went away as a result of their value proposition becoming subsumed in an entirely different value chain.

Which brings me to the payments industry. All kinds of market participants “buy” payments today … consumers make a payments purchasing decision when they choose a card (or cash, check or bitcoin); retailers buy payments when they select a merchant processing solution; governments and non-profits buy payments when they make decisions about what tender types they will accept and via what providers; and in the B2B context, both buyers and suppliers face off against the payments industry when they decide how to settle their bills and accept payments against invoices. Industry participants (issuers, acquirers, processors, lockbox vendors, etc) have been chipping ice out of lakes for years, and are newly wary about these new ice factories (mobile phones, EMV, NFC, blockchain rails, etc) that are springing up in various pockets of the industry.

Those new enabling technologies miss the main point, the real disruption that should be terrifying the incumbents, which is that fewer and fewer market participants are making any kind of payment decision at all. Over time, consumers won’t say “I’ll choose the card that has the best mobile interface”; they will choose Uber (or Apple Pay, Paypal, etc) and whatever funding mechanism they selected at inception will just fire away. God help the ISO that tries to get the attention of a retailer who has selected Booker (or Shopkeep, Revel, etc) as their ERP system; that merchant has already lit up payments within the software that runs their business. Governments and nonprofits will similarly turn a deaf ear to payments companies, having leveraged fundraising software from Evertrue (or Abila, Blackbaud, etc) or built General Ledger integrations into peerTransfer for cross-border payments. Businesses, having selected Billtrust (or Paymetric, Delego, etc) for their invoicing and AvidXchange (or Taulia, Chrome River, etc) for their Expense and Payables Management, will have no need or interest in speaking with traditional cash management and lockbox vendors.

Elegant, integrated and cloud-based software is submerging the payments business, and stripping it of its value. We at BCV have invested in a number of companies along this theme, including Billtrust, Booker, Chrome River, Evertrue and peerTransfer.  Today we’re announcing a large investment in AvidXchange, alongside Foundry, NYCA, TPG, KeyBank and other industry notables.  AvidXchange is the leader in AP automation solutions for the middle market, and has quickly built a substantial commercial payments business that provides additional value to their software customers.  Mike Praeger and his team have been ahead of their time in recognizing that controlling data and workflows creates a unique opportunity to monetize payments volume, and we’re excited to help them take it to the next level.

Many existing payments companies are already partnering with our software companies, and others, but many are ducking their heads in the sand. To those ice harvesters, I quote my 7 year old daughter: Beware the frozen heart.

On Prepaid

codebloo —  August 14, 2014 — 7 Comments

My friend Dan Schatt recently published a great book called Virtual Banking (incidentally you can buy it here). Dan was kind enough to ask me my thoughts on the prepaid space, which I have always felt poses great opportunities for entrepreneurs, and great risks for incumbents. I contributed the below essay, which found its way into book, alongside great content from Dan, Renaud Laplanche from Lending Club and many other thoughtful folks.

Until recently, there were three types of payment cards, and each of them stayed pretty much in its place. Credit cards and debit cards were issued by banks, the former to provide transactional lending (pay later), and the latter to provide access to a current account (pay now). Prepaid cards, the new kid on the block, were still largely a gifting vehicle, but increasingly also included a general‐use, open‐loop reloadable version. These cards were a stored value account purchased either fully loaded or where value could be added through various load mechanisms (pay before).

But now that old triumvirate is crumbling. In particular, the prepaid card has rebelliously left its historical place as either a gift card or a card of last refuge for the underbanked, and has now entered the mainstream. This development poses many risks for community financial institutions, as the prepaid architecture gives rise to all sorts of entrepreneurial competition. That said, prepaid is also a significant opportunity to broaden product lines and modernize customer‐facing applications without massive changes to core processing systems. How financial institutions grapple with, take advantage of, or succumb to prepaid may determine their relevance in the coming decades.

What do we mean by prepaid, and why is it so disruptive? The trade association for prepaid cards, the Network Branded Prepaid Card Association (NBPCA), defines prepaid cards as a “non‐credit payment option,” 3 a classic example of the fallacy of defining something by what it is not. The organization does go on to usefully enumerate the largest categories of prepaid card: General Purpose Reloadable (GPR), Payroll, Incentive, Healthcare, Government Disbursement, and Gift. This inability to define prepaid is a general problem, and the NBPCA provides a version of the most common type of answer: It isn’t a bank account, it isn’t a credit card, and here’s a list of examples of what it can be.

The problem with this definition and all of its variants is that they are quickly becoming dated. How is a prepaid account different from a bank account, when it comes with paper checks, automated teller machine (ATM) access, and Federal Deposit Insurance Corporation (FDIC) insurance? How is it different than a credit card now that companies like Insight Card Services and AccountNow offer hybrid products with a short‐term lending component?

These product distinctions (checking, savings, line of credit, credit card, etc.) have always been driven by regulators and bank technology vendors, not by consumer preferences in any event. The prepaid architecture is allowing them to collapse into a single account structure, with many diverse features, making the definition of prepaid as what it is not now impossible. As the categories of prepaid multiply out from the six listed earlier, into Travel, Expense Management, Insurance, and Digital Content, among many others, defining prepaid by example becomes long‐winded at best.

For the purposes of this chapter, there are two important characteristics of a prepaid card or account (in general, I will use prepaid card, but it’s important to note that increasingly prepaid accounts won’t need an accompanying card):

  • Prepaid cards reduce the financial institution to the role of commodity utility, allowing an independent program manager to design and market the product, as well as manage customer interactions.
  • Prepaid cards have limited transactional interaction with core banking systems, in that they create an account structure that sits atop a single pooled traditional debit account. Individual transactions hit against this intermediary account structure, which in most all cases is more modern, flexible, and feature‐rich than a core banking system.

The combination of these two factors has allowed the prepaid card to be the primary vector by which entrepreneurial firms have entered the consumer financial services arena, threatening territory traditionally monopolized by banks and credit unions. These firms are redefining what can be offered to consumers and small businesses and, in doing so, shifting the basis of competition.

The latest wave of innovation in prepaid is focused on capturing the primary account for consumers, which had historically been a combination of a demand deposit account (DDA) and a savings account, almost always held by a “local” bank or credit union. Obviously, the term local when discussing financial services is fraught, given that the four largest banks control approximately 40 percent of household banking assets from central headquarters locations, but it has historically been the case that the majority of consumers chose their primary bank based on branch location, so if a Chase branch is the closest to your home or work, it is your “local” bank. Because of this dynamic, the consumer banking industry became largely a real estate play. The national banks went on a branch‐building spree, aiming to become the bank of choice in the cities and larger towns, and truly local financial institutions took comfort in the knowledge that so long as they were a convenient option in their trading area, they would get their share of deposits.

Prior to the smartphone, it was difficult for any nonbank to challenge this physical reality except on the basis of offering high interest rates for savings accounts or CDs. It is telling that the latent threat to financial institutions was always Wal‐Mart, and, in fact, prepaid partnerships with GreenDot and American Express enabled that latent threat to become very real. Wal‐Mart always had the real estate, and the prepaid architecture has allowed them to offer financial products, with a geographic density far greater than any branch network. That said, Wal‐Mart’s customer base and brand positioning are such that the customers they are siphoning off from traditional financial institutions are generally the unbanked and underbanked. The graver threat, from a customer profitability perspective, are what are often called the “neo‐banks”— nimble, entrepreneurial firms that are leveraging the prevalence of the smartphone to convince customers that physical proximity no longer matters.

Who are these neo‐banks? The most public examples are Simple and Moven, but the prepaid architecture is so straightforward and flexible that many more are just launching or in formation. Perhaps the example that proves the point most dramatically is has created prepaid debit cards that are as fully featured as most bank accounts, and are cobranded with dozens (heading towards hundreds) of micro‐affiliates.

Effectively, you can get a “bank account” that shows the world your affection for Gay Pride, Garfield the Cat, Frida Kahlo, or The Walking Dead television show, among many others. While it’s easy to dismiss these as trivial, many banks had the same reaction when MBNA launched its affiliate model in the credit card industry, only to find itself thoroughly outflanked.

This proliferation of neo‐banks has been enabled by technology. As mentioned, the core innovation that enables mainstream adoption of branchless banking is the smartphone, but there are companion technologies that are just as instrumental. The primary category of innovation is around account opening. Traditionally, account opening was almost entirely done in a branch, as much of it had to be done in person. Companies like Jumio and Andera have now enabled Web‐based account opening, and even phone only account opening, leveraging electronic signatures. Once the account is open, technology from Mitek and others enable mobile remote deposit capture, so that checks can be loaded into an account without a branch or even an ATM visit. One by one, the reasons to visit a branch are being demolished.

In the first instance, this seems largely like a threat to community financial institutions (FIs). Not only do you have the “big four” marketing into your base, but you have national branchless players trying to poach your customers.

But let’s imagine the possibilities whereby community FIs can leverage these trends and capabilities to their benefit. The fact is that most community FIs have been offering relatively plain vanilla product because they are dependent on their core system vendor to provide them functionality, and none of the large vendors are exactly dynamic. Community FIs need to consider ways they can leverage the flexibility of prepaid technology to innovate and move more quickly.

One opportunity is generational. The demographics of credit unions and local banks are not promising for the future; to be blunt, they skew old. Unless these financial institutions can survive as the bank of choice as the wealth and locus of banking activity moves from one generation to the next, they will become increasingly irrelevant. Prepaid is one weapon in that fight.

It makes a perfect teen product, given its natural limits on overspending and the ability to add parental controls. Its useful for parents with children away at college, allowing them to load money for expenses as needed. In either of these instances, it becomes an opportunity to convert the child/ recipient into a primary account owner over time. In particular, the community FI can leverage the relationship with the parent to offer credit to the next generation, with the parent as guarantor. At that stage of life, anyone who will offer credit becomes a student’s best friend.

Another significant opportunity is within the small business segment within a community FI’s trading area. Although there are some neo‐banks now getting started to serve the small business population, no one has critical mass. These small companies are hard to reach, and frequently value their relationship with a local bank (or, less frequently, credit union) as a source of credit when needed. Small businesses have a variety of needs that prepaid can solve quite elegantly. More and more employers are offering health savings accounts (HSAs), based on prepaid technology, to their employees as an alternative to traditional health benefits. Prepaid cards can provide a less expensive alternative to paper checks for small businesses that employ the underbanked. Many industries that employ salespeople use prepaid cards as a sales incentive program; local banks are in a great position to provide this technology to small businesses. One area where prepaid has already started to make an inroad, largely driven by a PEX Card, is in the expense management area. This, too, is a product that could be logically distributed by community FIs.

If the community FI has both a solid consumer base and good relationship among the local small business community, there is an opportunity to capitalize on the opportunity presented by linking those two groups via prepaid. The economics of traditional debit, post Durbin, do not allow for bank‐funded rewards programs to generate new accounts or create loyalty.

That said, a community financial institution could leverage its relationships with local retailers to create a merchant‐funded rewards program, which helps them to drive traffic to their stores and creates a distinctive product for the bank or credit union. Further along this theme, the FI could create a specialized gift card, leveraging Restricted Authorized Network (RAN) technology to limit the spend on the card to local retailers. Again, a distinctive product for consumers that provides unique value to a financial institution’s small business customers.

As has been articulated throughout this book, new innovations in financial services are both opportunities and threats for community financial institutions. Prepaid is a dramatic example of this important point. Small banks and credit unions have traditionally survived and thrived based on their local relationships and physical footprint; the prepaid architecture has unleashed the entrepreneurial energies of dozens of new and compelling branchless competitors, who challenge long‐standing relationships and make geographic density irrelevant. Prepaid also provides a vector for innovation for community FIs themselves, enabling them to partner with entrepreneurs to create and offer cutting‐edge products to local customers who otherwise would lack awareness or access to these innovations. It is critical to recognize that there is little time to ponder this issue; the competition is on the move, and the only question is: will local banks and credit unions be as well?

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Trends in payments innovation.

Yeah, I’ve done it … this blog basically consists of a slideshow.  Obviously we know what comes next:

24 signs that you may be a Fintech nerd

Click bait
The founder of twitter started a payments company … and you won’t believe what happened next

Answer these question and find out what kind of chargeback you are.

And so on.

In fact, I pulled this deck together to brief the board of a large, global payments company on what’s been happening in the start-up payments community over the past 12-18 months.  It’s a little sparse and works better with a voiceover, but I thought it was interesting enough as kind of a survey course syllabus to post for comment.

Trends in Payments Innovation

Race to the Bottom

codebloo —  May 5, 2014 — 4 Comments
I don't always invest in commodity products, but when I do, I prefer not to lose all my money.

I’d like to think that the vast majority of the investments we make are in companies whose products and services are not commodities, and not subject to the brutal forces of commoditization.

In those cases, we are looking at markets where companies can win based on product differentiation, or where what they are doing is very hard and/or protected by intellectual property.  That said, the broadest definition of what we as venture capital investors do is invest in disruption, and certainly one of the vectors of disruption is through commoditization.  So while backing a company about to be commoditized is, well, stupid … backing a company that is doing the disruptive commoditizing can be exciting (despite some recent commentary to the contrary.)

Exciting, and terrifying.

Particularly terrifying if you don’t have a gameplan; without one, you may succeed at chowdering an industry’s margin structure without creating any value.  Through trial and error in this field of endeavor, I have found four general models that can work.

1. Be the lowest cost provider

One of the sneaky elements of our investment in Simple (fka BankSimple) was that, while the common perception was of a company leveraging awesome mobile-first design and zero fees to acquire and delight customers, the actual key was the ability to serve customers far more cheaply and hence more profitably than banks.  The customer acquisition stuff worked also, which was nice, but in fact the way to make money in the DDA segment (a commodity) is through disruptively low costs.

Another segment purportedly running this playbook is the “peer to peer” lending community (Merely writing that phrase makes me want to tear my hair out.  While it’s kind of delightful to imagine a multi-billion dollar hedge fund and a near-prime borrower as “peers”, it’s not exactly accurate.) I’ve seen a ton of charts detailing the “cost to serve” advantages of these companies.  My issue with this analysis is that, of the meaningful elements of the cost bar of a lending  business, at least three (cost to acquire, cost of credit losses and cost of capital) far outweigh cost to serve.

The one thing we know conclusively is that these lenders have a stratospherically higher cost of capital than their bank competitors, who leverage their nearly free deposits for liquidity.  Alternative lenders who can create durable advantages in customer acquisition and/or underwriting will create value; merely being low cost in terms of operations will not be sufficient.

2. Lock up differentiated distribution

In the relatively near future, most retail investors will have their money managed using algorithms that solve for market returns, properly allocated across asset classes, rebalanced tax efficiently and optimized for minimal fees.  This will be hideously disruptive for stockbrokers and other corrupt money managers, but will it create value for the disrupters?

There are a whole crop of new companies who are steadily building Assets Under Management using this new model.  The challenge is that the classic “cost to acquire vs. lifetime value” math is almost always upside down when you are providing a service that is, by definition, undifferentiated and focused on lower costs.  The winner(s) here will be those companies who get introduced to their customers for free, either through harnessing viral growth (has not yet happened in this category, though Robin Hood is showing signs) or figuring out a high volume channel.

3. Serve the previously unserved (and ideally previously unserveable)

Square has had a tough time in the press recently.  They have gone from a $10B IPO candidate to a lost cause/acqui-hire in a 3-4 months, on no news.  This says more about the state of financial punditry than it does about Square.

PayPal figured out something fundamental 15 years ago, which is that while most underwriting models start by saying “no”, it’s smarter to say “yes” to nearly everyone and then throttle usage on the backend.  In this way, you enable faster growth and accumulate the necessary “bads” to train your models, all the while managing losses through tightly gated credit limits.  High delinquencies, but low severity.  Square adapted this methodology to merchant underwriting, and in doing so enabled millions of merchants previously shut out of electronic payments to get in the game.  At various times in their lifecycle, they have been over-valued, but those who now dismiss them do so at their own peril.  Their recent moves, to tack back from their experiments with Starbucks and p2p remittance towards a more robust value proposition for small merchants, represent a doubling down on what made them special to begin with.

Merchant payments has never been a particularly interesting business.  Retailers fundamentally don’t care who provides their payments, and will ultimately largely view it as an embedded feature of a commerce system.  But Square’s landgrab in a previously unserved segment may provide them with sufficient escape velocity to make their optimistic investors look smart, particularly when combined with a legendary founder and a world class team.  And I’m enough of a contrarian to have their back now that the world has turned against them.

4. Change the game

This is the one in a million shot, and ultimately why most of us do what we do. Once in a career, maybe, you get a chance to back a team that is turning a commodity business into one that creates huge value for customers and for the company.

Merchant payments is a commodity?

 Well, what if you also have the cardholder information, and can disintermediate the visa/mastercard model by creating an “on us” transaction.

Remittances are a commodity?

How about turning cross-border cash transfers into cross-border commerce, and enabling immigrants to pay bills, top up mobile phones and create gift cards for free, instead of getting gouged on fees.

Factoring is a commodity that can’t scale?

What if you had comprehensive information on when the buyers would pay their bills, and could turn a risky transaction into a riskless transaction.

All of these are big bets, and none of them may pay off.  But the juice is surely worth the squeeze.

Redefining FinTech

Matt Harris —  December 17, 2013 — 14 Comments

I’ve spent the better part of my career investing in technology companies involved in financial services.  Given that, it’s a bit surprising how much I hate the term FinTech.

Historically, FinTech has defined the technology vendor community selling into banks and broker/dealers.  Until 2008, this was a reasonably good business.  Since then, there has been increasing consolidation, both on the financial institution side and on the vendor side.  As a result, while ostensibly there are still thousands of banks in the US, the vast majority of the budget is tied up by 20 FIs, and the vast majority of the revenue goes to the large, incumbent vendors.  It is a classic logjam, and woe betide any small firm looking to selling into that mess.

The much more interesting opportunity in financial services isn’t selling to financial institutions, it is competing with them.  As I have written elsewhere, banks in general are retreating from customer-facing activities, not vigorously defending their turf.  This happened in merchant payments, for example, even in advance of the financial crisis.  In 1988, banks had 62% market share in the acquiring industry; now they have 38% and shrinking.  Currently, banks are losing share in the DDA market, the lending market and the personal finance market, among others.  I anticipate that the corporate treasury services market will be next, hence my current obsession with b2b payments.

As you might expect, entrepreneurs figured out this new reality far more rapidly than venture capitalists.  One example from my experience is OnDeck, a small business lending company, and a ridiculously fun and exciting company to be involved with.  I invested in their first round of capital and have been on the board since 2006.  From the time of that initial investment until I finally came to my senses, I was one of several investor directors urging the company to offer their underwriting and processing platform to banks as a vendor, in addition to (or instead of) being a direct lender to small businesses.  Thankfully, the entrepreneur (Mitch Jacobs) and the CEO (Noah Breslow) kept their eyes on the prize, and while the company has several very productive referral relationships with financial institutions, OnDeck has continued to originate loans directly.  As a result, it has grown like topsy and will soon pass the $1B mark in terms of capital lent to small businesses.

To paraphrase the pushback of the management team, their basic argument went like this, “Do we really want to put our destiny in the hands of bankers?”  That argument, in brief, explains why every time someone asks me if I invest in “FinTech companies”, I respond that actually I invest in financial services companies.  Given that this distinction, while meaningful to me, is always met with blank stares, I’ve now tried to put some analysis around it, which you can see here:

Market Cap - Bank vs non bank analysis vjb5(2)

My colleagues and I (thanks to Jordan Bettman and Matt Brennan for their help with this) defined three universes of companies:  Banks, Bank Vendors and (for lack of a better term) Finsurgents, ie, companies providing functionality that had historically been the province of banks.  The results are clear.  The bank vendors’ market capitalization relative to banks’ market cap remains relative constant, with a slight premium reflecting the fact that technology spending at banks is growing faster than bank revenue.  But the Finsurgents’ market cap relative to banks grows at twice the rate, which is quite logical in that these players are taking an increasing share of profit pools that would otherwise belong to banks, not depending on banks for their revenue.

In defining these groups, we had the requirement that the companies be public for the whole period 2003-2013.  As such, while the bank and bank vendor universes contain all the logical players (vendors include Fiserv, Deluxe, D+H, TSYS, Diebold, ACI, etc), the Finsurgent group misses key players who have either gone public post 2003 (Visa, Mastercard, Fleetcor, Wright Express, Cardtronics, Vantiv, Higher One, Greendot, Netspend), plus companies who are still private or are subsidiaries (Square, Paypal/Braintree, Stripe, Lending Club, OnDeck), not to mention the entire Bitcoin universe, etc.  In 10 years, I suspect that these lines will have entirely diverged, as the banks become relatively stable financial utilities, their vendors settle into a symbiotic but unexciting and slow upgrade and refresh cycle and the Finsurgents complete their takeover of customer facing applications and innovation in the sector.


Submerging Payments

Matt Harris —  December 5, 2013 — Leave a comment

The mimagesost important development in merchant payments right now isn’t happening in Silicon Valley (though I do think PayPal is only a few chess moves away from becoming the fifth network.)  It isn’t happening in New York City (though I’m increasingly convinced that NYC can be the center of the alternative lending universe.)  It isn’t happening in Atlanta (though I do like the mojo Frank Bisignano has brought back to First Data.)  And it isn’t in cyberspace (though surely math-based currencies will have their day.)

It’s in Durango, Colorado.  And it will likely destroy much more value than it creates.

The trend I’m referring to is commonly referred to as integrated payments, or embedded payments, but I think of it as submerged payments.  The leading (and, indeed, defining) company in the space is Mercury Payments, in remote Durango.  Before Mercury, the traditional retail payments industry practice was for merchants to make two decisions regarding their point of sale (POS); first, they pick a software provider, and then separately, a payments provider.  Sometimes these two were loosely coupled through various integrations, but rarely were they tightly linked (basically never for small and medium sized merchants) and almost never sold together.  In the world of on premise software, it was difficult to merge a necessarily dynamic platform like a payment processing system, which changes frequently due to association rules, with a static POS system that could only be upgraded through CDs sent in the mail.

What Mercury realized was that the increasing adoption of SaaS-based solutions at retail meant that payments could be far more easily (and far more tightly) integrated into POS software.  They began a landgrab in the retail software developer community, offering payments wholesale to these developers, who could then offer attractive rates to their customers on an embedded basis.  Better yet, they could use the payment card data (with sensitive details tokenized) as the basis for a CRM system, so that in essence the payments platform became the identity utility for the software system.  Good luck to the ISO salesperson who walks into a salon looking to sell payments at a 5 basis point discount, when for the merchant a decision to change payment processing providers means switching software vendors, or at least losing access to your customers’ tokenized card numbers.

Merchant acquirers currently differentiate primarily on distribution (generally feet on the street), and only at the margin on technology, approval rates, customer service and uptime.  In a submerged payments world, that is entirely flipped around.  Distribution changes from sales to business development, and payment companies will be pitching POS developers on their technological sophistication, advanced features and nimbleness.  Those are not adjectives commonly thrown around about the incumbent merchant acquirers today.

This trend is not entirely lost on the industry.  Both Vantiv and Global Payments have made acquisitions in the space (see here and here), and everyone else has at least added the word “integrated” somewhere on their website.  But they are also doing some of the wrong things, in particular acquiring or investing in POS software companies themselves.  If I’m a developer, am I going to choose an embedded payments partner who has a software package in the market competing with me?

Ultimately, regardless of what they do, this is a bad trend for the sector.  Payments are becoming dial tone … expected to be there, always on but never acknowledged, and certainly not worthy of a premium price.  At its IPO, Mercury will likely be worth $2-3B, representing approximately 5% of the enterprise value of the merchant acquiring segment, by my estimates.  In five years, they will likely be worth $5B, given the likely share gains they will see as SaaS POS systems crowd out on premise software.  Sadly, by that point, I expect they will be fully 20% of the segment’s market value, as price erosion and market share losses degrade the margin structures of their over-levered, largely fixed cost competitors.

It turns out that no one wants to buy payments, they just want commerce.

What’s The Big Idea?

Matt Harris —  October 4, 2013 — 4 Comments

Perhaps I’m just simpleminded, but one of the most important things I look for in a company is the ability to summarize the problem they are solving in one sentence.  Often, at the outset, I’m less interested in solutions than problems; I want to be asked a question that stops me in my tracks.  At the heart of most transformative companies is a simple question, and once you’ve heard that question you are instantly convinced that there has to be a better way.

Starting with a question, rather than with a solution, gives you a telling diagnostic for the magnitude of the problem.  Way too many companies start with a solution and go looking for a problem, and as a result end up without anyone who really needs what they are selling.  Perhaps the most acute example of this in financial services is the current obsession with mobile wallets at point of sale.  “Why can’t I pay for something with my cell phone?” is about as much of a burning question as “Why can’t my dog speak French?”; both things would be cool but aren’t exactly mission critical.

Here are some examples from the industries I follow:

  • Square/Braintree/Stripe:  Why can’t most merchants take credit and debit cards?
  • Xoom/iSend:  Why are international remittance fees 10% of the value being transferred?
  • Taulia/Tradeshift/Billtrust:  Why are most business to business payments made by paper check?
  • Wealthfront/SigFig:  How can the asset management industry extract so much value while significantly underperforming index funds?
  • CAN/Kabbage/OnDeck:  Why do banks underwrite small business loans using the business owner’s credit score?
  • The Climate Corporation:  Why can’t we predict the weather?
  • Bluebird/Moven/Simple:  Is it necessary for banks to charge fees?
  • Paypal/Dwolla:  Why is it so hard to move money around?
  • SoFi/Common Bond:  Why do all student loans have the same interest rate?
  • ZipCar/RentTheRunway:  Why do we have to own expensive goods that we use infrequently?
  • Yapstone/Plastiq/Zipmark:  Why do I still pay my rent with a paper check?
  • DriveFactor/CellControl:  Why do good drivers subsidize bad drivers?

Once you have your question, then you can do the required research to find out the answer.  Sometimes the answer is a brick wall, but other times the answer points towards a solution.  Frequently, as you can see from my answers below, there have been legitimate blockers to a solution historically, but advances in technology newly allow hard problems to be solved.  When you find a circumstance like this, a painfully acute problem that was historically intractable, but due to new innovations is now solvable, please email me.

My Answers:

  • Payments acceptance:  Primitive and stodgy underwriting needlessly excludes many low risk merchants; legacy hardware creates a prohibitive fixed cost for low volume merchants.
  • Remittance expense:  Cash handling, both on the send and receive side, is wildly expensive.
  • Paper in B2B payments:  There is tremendous inertia, driven by workflow on both the AP and AR side.  [This will not be solved quickly]
  • Value destruction in asset management:  In the absence of clear data, investing choices have been driven by brand preference vs. rational analysis.
  • FICO scores in small business lending:  Historically it has been the only scalable and low cost way to underwrite a sub-$100,000 loan.
  • Weather prediction:  The data capture and analysis problem has been too large and expensive to solve.
  • Banking fees:  Banks have to support a very expensive branch infrastructure, as branch location has historically been the primary decision factor for consumers in selecting a bank.
  • Money movement:  The four party payment model and the resulting interchange economics were built to compensate issuers for credit transactions and have been inappropriately applied to other types of money movement.
  • Student lending:  Government driven programs are slow to change, and as a society we have issues with financial discrimination relative to education (and health care.)  [This may still end up being a problem]
  • Sharing economy:  The transaction costs in rental models have outweighed the benefits in the absence of inexpensive real time communication networks and scale infrastructure investments.
  • Checks in rent payment:  Landlords have mini-monopolies once renters move in, and therefore lack motivation to sacrifice any economics to make payments easier.
  • Auto insurance:  Collecting information on safe vs. risky driving has historically been impossible.

[This post originally appeared on here:]

It’s been a fascinating couple of weeks in the token world.  We have Monopoly’s decision to replace the iron with a cat, based on a poll launched on their Facebook page.  Feels like selection bias to me; is anyone surprised that the population of people who are fans of board games on Facebook also like cats?

More germane to my obsession with payments was the announcement that Braintree re-launched Venmo as a cardholder side multi-merchant tokenization system.  I realize that’s a mouthful, but here’s what it means:

  • Braintree provides payment acceptance to many (most?) of the most popular online and mobile merchants, like Uber, Fab, HotelTonight, LevelUp, etc.
  • Because all of these merchants have huge mobile traffic, they encourage users to “vault” (ie, store) their credit card information with them, so when they return they can check out with one click (or in the case of Uber, no clicks.)  In actuality, all of these payment card details are vaulted at Braintree.
  • Braintree has convinced at least some of these merchants to contribute their users, on an opt-in basis, to a consortium, such that if I am an Uber customer, and I show up to HotelTonight for the first time, Braintree recognizes me and asks me if I want to use the credentials I’ve already stored with Uber to check out with HotelTonight.
  • Braintree has 35MM credit cards vaulted … maybe 20% of the adult US population, and probably 100% of the early and mid adopters in this country.
  • The reason this works, from a security perspective, is the data on the device you are using.  Because they fingerprint your phone (or PC), and require a password, they have the classic “something you have” and “something you know” security formulation nailed.  In the mobile use case, they also have fraud sensitive data like location; if anything I think this will be a more secure transaction than a typical e-commerce situation (more on that later.)

In the real world, the concept of a token generally refers to the act of substituting something simple and convenient for something more cumbersome or complicated.  Think of the utility of a subway token in preference to cash, or (as in Monopoly), how much easier it is to move a game piece around a board than your physical self.  In the payments world, tokens have traditionally been used to enhance information security.  Tokenization* is a system where you substitute a proxy set of identifying information for the real payment card data, so that merchants don’t have to handle this sensitive and regulated data and it isn’t exposed more than necessary.  This original logic for tokenization (keeping merchants free from hosting payments data) has been taken to the next level by Braintree … the same idea is now being used to make the payment experience quicker and easier, through their consortium model (“if you’ve paid anywhere else, you can pay here, too.)

The important irony here, which is also true of Square’s tokenization strategy (Square Wallet, where you the Wallet serves as a “token” to mask the underlying payment card credentials), is that the tokens being used are actually more authentic than the underlying “real” identity.  Historically and generally, tokens are nonsense strings of characters, designed to abstract away from and hide the true goodies, your credit card number.  But consider the token that Braintree is using:  the fingerprint of your device plus your location plus a password.  And Square?  They use a picture of your face.  What’s more real, a 16 digit number or a picture of your face?  Remember, the purpose of the payments query that a merchant initiates when you try to pay for something, whether on-line or in-store, is authentication, ie, are you actually you?  This gets done through the inherently flawed mechanism of merely checking that the card that has been presented (or typed in) is actually valid.  What Braintree and Square have done is create self-authenticating tokens in a natively multi-merchant construct, and that is a frigging big deal.

The current retail payments industry rests on what is called the four party payment model.  The four parties in question are:  1)cardholder, 2)cardholder’s bank, 3)merchant and 4)merchant’s processor/bank (known as the merchant acquirer).  When the cardholder swipes their card at a merchant, the card and transaction data flow through the merchant acquirer to the cardholder’s bank, which confirms that the cardholder is authorized to make the transaction.  This structure was invented and is perpetuated by Visa and Mastercard, who serve as the information switches between the four parties.

They’ve never been linked, that I’ve read, but I think it’s more than a coincidence that Visa was founded shortly after the interstate highway system.  Before Visa, non-cash transactions were done using store credit … because most merchants knew most of their customers before the 1950s, you didn’t need elaborate authentication schemes.  After the 1950s, Americans grew far more mobile, and store credit became less practical; hence Visa and Mastercard emerged, to enable transactions between strangers.  If you’ve ever used Square Wallet, you’ll know what I’m talking about here:  it feels like the 1940s.  When your face pops up on the retailer’s point of sales system, and the clerk calls you by name, you are no longer a stranger.  I’ve yet to have the pleasure, but I’m certain that when I show up on OpenTable and am greeted by name and asked if I want to check out with my Uber credentials, I will also feel warmly recognized.

This is horribly threatening for all of the incumbent players in the four party model:  traditional acquirers, issuer and the networks.  Plain vanilla merchant acquirers will struggle to compete with Braintree online and Square offline as their tokenized user bases grow (NB:  Square is actually well behind Braintree on this front and we’ll see how they do; IRL is harder than online.)  The issuers lose their ability to differentiate.  Once tokenized and hidden, any given card product is far more vulnerable to being displaced, as the issuers have already learned from PayPal.  How do you stay “top of wallet” when there is no real wallet?  As for the networks, their demise is harder to articulate.  Visa and Mastercard are fortresses, growing 20% per year like clockwork, despite the law of large numbers.  I will leave it at this:  in a world where everyone is known, there is no need for an omniscient middleman.  That feels like a scary fact for the networks.

*Per usual in these blog posts, I’m sure there is a specific definition of tokenization that I’m getting wrong.

Square Puck

Matt Harris —  November 24, 2012 — 21 Comments

Replica of first hockey puck ever used (it actually was square-ish)

Square Puck:  sounds dangerous, right?  I think it is.

There’s a famous/trite expression, commonly cited in the venture business, about how you want to skate to where the puck is going, not to where it is right now.  As I watch the payments industry grapple to deal with the phenomenon of Square’s micro-merchant processing business, I’m reminded of this truism, and increasingly convinced that all the incumbents are skating in the wrong direction.  This doesn’t mean that Square will achieve the kind of world domination that their valuation implies, but it does mean that lots of other folks are wasting vast resources and time pursuing the wrong goals.

In just the last week, Bank of America announced a micro-merchant offering, and TSYS bought ProPay, a vertically focused Square clone.  In the past year, we’ve seen a steady drumbeat of product announcements from Verifone, Intuit, PayPal, NCR, WorldPay* and PayAnywhere*, all directly focused on competing with Square’s dongle-based merchant payments service.  Meanwhile, in the investment community, there is a lot of self-satisfied sniggering about Square’s business model, in which it is assumed that given pricing and risk, Square loses money on every swipe.  Their recent move to undercut Starbuck’s already razor thin processing costs, even though they aren’t the low cost provider, reinforces this view … there’s no way that is profitable business for Square.  If Square is entirely dependent on merchant processing revenues, they are not only overvalued, they are in fact worthless … that business will never produce meaningful cash or be strategic to anyone.

But that’s irrelevant, as it is increasingly obvious that the merchant side of Square’s business is somewhere they had to start, but nowhere near where they plan to land.  At the end of the day, Square is a consumer-facing company; that is their DNA, their culture and their IP.  The entire merchant processing effort is a loss leader, a necessary evil on the way to building up sufficient retail coverage to make their mobile app useful to consumers.  It’s not too different from what LevelUp is doing, but Square’s approach, both in terms of pricing and design, is far more elegant and nuanced, probably because they control their own payments infrastructure and LevelUp outsources to Braintree.   All of the incumbent merchant processing and terminal infrastructure players who are freaking out about this and building direct rivals are totally missing the point, and are lunging to compete in a segment that will ultimately have a negative profit pool.

Typically in this blog, and more generally in life, I avoid making explicit recommendations and predictions.  I’ve just been humbled too many times by the world’s unpredictability.  But I’m going to make an exception in this case.

The recommendation is that Verifone should swallow their pride and do a comprehensive business development deal with Square, where they enable their entire existing merchant base to accept Pay With Square in exchange for essentially taking over Square’s merchant processing hardware business.  Given Verifone’s bluster and defensiveness regarding Square, I think this is unlikely, but it would be a master stroke.  Square doesn’t think hardware is strategic and is increasingly just trying to build their merchant base (see:  Starbucks deal) and they are only messing with Verifone as an accidental byproduct of their initial go to market strategy.  Square would do this deal if Verifone could convince them that they would take good care of their customers.

The prediction is that in six to twelve months, the conventional wisdom on Square will have changed to reflect the growing reality that Square isn’t primarily a merchant acquirer, but instead a mobile wallet provider.  Pay With Square, just like Google Wallet, PayPal and the other wallet providers, creates a unified merchant-facing cardholder application, which aggregates the user’s existing payment accounts behind the scenes, and layers on offers and enhanced information.

At that point, someone (probably not Verifone, unfortunately for them; my bet is Heartland or Global Payments, with Chase Paymentech as a long shot) will do the business development deal I describe above and PayPal, Verifone, BAMS,TSYS et al will be left holding their dongles.  The whole merchant processing community will then lurch toward some kind of cardholder side functionality, directly or through partnerships, and an unbelievable amount of time will be wasted essentially recreating the current Visa/MC merchant-issuer network in a Balkanized and therefore useless way.  Discover will get bought by Google for $35B and Amex stock will go up 30%.

Unfortunately, by that point, the puck will have moved again, and Square will have abandoned the mobile wallet play in favor of their actual ultimate goal, which is to become a new tender type, disintermediating payment cards altogether.  He shoots…he scores!

*For the record, I think WorldPay and PayAnywhere, with their focus on the SMB segment vs. the true micro-merchant segment, have it right.  NB:  my firm is an investor in WorldPay.