Disintermediating traditional banking, in real-time.
A thematic-driven analysis of real-time payments and the potential impact on the digital payments ecosystem.
Society has become more impatient than ever due to enhancements in technology. If Amazon can ship and deliver goods on the same day, but processing a credit card bill electronically takes 1–3 business days, how much riper for innovation does the digital payment space need to be before we see advancements that target the inefficiencies? A prevailing theme that drives the demand for on-demand goods and services is the rise of contextual commerce, where customers can transact anywhere at any time. But goods and services aren’t the only things we’ve become impatient for; it’s also payments.
The demand for faster payments and settlements has surged, giving rise to alternative forms of payment to service this gap. Many fintech companies have been breaking the barriers to entry that large incumbents once dominated to offer frictionless experiences that customers want. These API-first businesses highlight how digital payments can become revenue centers instead of cost centers by leveraging powerful orchestration layers and embracing open banking. The macro-environment has underscored companies' need to identify strategies to cut costs and focus on profitability, leading to further demand for efficient and affordable alternatives to serve their customers better. As payments become safer, faster, and more transparent worldwide, a paradigm shift is bound to occur in the United States as consumers and businesses find better alternatives to transact.
High fees and inefficiencies paving the way for alternative methods to rise
Over the years, waves of innovation have occurred in the digital payments space. From the many variations of digital wallets to ‘buy now, pay later’ programs, consumers and businesses have many options for payment types and payment methods, both online and in-person. Credit cards have been at the forefront of innovation in the past decade, with fintech companies offering corporate cards to businesses for expense management or pass-through digital wallets to individuals for frictionless checkout experiences. The card rail has become increasingly expensive to process, hurting merchants’ bottom line and forcing them to raise consumer prices.
According to TechCrunch, merchants in the United States paid upwards of $25 billion in credit card fees in 2022.
And it doesn’t stop at the high fees — credit card fraud is the second most common reason for identity theft, as claimed by the FTC. And these credit card fraud rates have been climbing yearly, with card-not-present (online) transactions being more susceptible to fraud. With all these fraudulent activities, issuing banks have needed dedicated fraud protection services to protect their customers.
Account-to-account (A2A) payments are an alternative payment method that sends funds from one bank account to another. A type of A2A payment is ACH (Automated Clearing House), which involves a bank-to-bank transfer. However, ACH takes time as it leverages batch processing for either same-day or multi-day processing. The processing occurs at a particular time of day, making it fast but not instant — an important distinction here. Further, ACH is only processed on business days, making it inconvenient for those who need funds or send funds when banks are closed.
Using the Fedwire network, wires are one of the most expensive ways to transfer money, with transaction fees costing anywhere from $15-$50. Similar to ACH, wires are fast but aren’t instant, either. This is primarily due to both methods traveling on payment networks that aren’t in real-time.
Understanding Real-time Payments
Let’s take a look at how real-time payments work fundamentally:
Let’s start with an example of an individual using their mobile device to purchase a new desk for $300. In their online experience at checkout, they can either ‘Pay by Card’ or ‘Pay by Bank’. Once they select ‘Pay by Bank’, they can choose which bank and account they want to pay from. They can view and confirm the transaction details using Strong Customer Authentication (SCA) or equivalent-level authentication (i.e., Face ID and smartphone) to log into their bank account.
Once they verify and confirm the transaction details, they can click ‘Pay Now’ to initiate the payment. The account credentials become tokenized before going through the RTP network as a security standard. Their bank account credits the $300 transaction and moves into the RTP payment rail. The RTP network will validate if your account has sufficient funds before sending the funds to the merchant’s account. The merchant receives the $300 instantly, and the payer and payee will receive a settlement notification. The transaction data is recorded for easy reconciliation.
Let’s dive deeper onto the characteristics of real-time payments by segmenting the payment infrastructure into the following four categories:
Reach
Real-time payments already have a sizeable attainable market reach as more people in the United States and worldwide have bank accounts than credit cards. RTP also expands its reach into the underbanked population largely because these households are less likely to have credit cards. According to a 2021 study, the FDIC claims that 95.6% of Americans are banked, of which 81% are fully-banked, compared to 71% having credit cards.
Conversion
A simplified user experience for the RTP checkout process yields an increase in customers completing a payment. A straightforward integration with your banking app paired with SCA can give customers the confidence that a transaction will go through quickly and securely. On the other hand, many checkout forms require the user to manually enter their card information, which leads to an incomplete checkout. A study by Bankrate explains how people feel uncomfortable saving their credit card information on websites or apps. Less than 40% keep their card information on websites, and less than 25% on mobile apps. Further, there are many reasons for credit card denials, including an expired card or an issuer’s risk system suspecting fraud, which decreases authentication rates.
Security
Regulations require RTP to follow the Payment Service Directive 2 (PSD2), which mandates multi-factor authentication. Two of the following three are needed to comply:
- Something the user knows (a password)
- Something the user owns (a smartphone)
- Something the user is (using Face ID to verify identity)
These protocols are in place to mitigate fraud while not compromising on streamlining the user experience. A 2021 J.P. Morgan report shows that only 5% of organizations faced real-time payment fraud, whereas 26% faced corporate credit card fraud. Security measures also adapt to the transaction, depending on the transaction size, whether it is a non-variable recurring transaction and the related parties who are transacting (for instance, B2B payments). Since real-time payments are credit push transfers, users must give the green light before a transaction is processed manually. This authentication can help reduce the risk of fraud. Pull transfers are also available in real-time; however, this would apply to subscription payments as the buyer has authorized the merchant and the payment terms.
Cost
Merchants can see cost savings of 70–80% per transaction when customers are not using cards. These savings can be passed down to consumers through reduced prices, cash-back rewards, or benefits from loyalty programs. The cost reduction results from the disintermediation of players across the value chain, particularly card networks.
Drivers for RTP adoption
Scalable open banking APIs
The reliability of Open Banking APIs has enabled synergies between fintech providers and financial institutions to create sticky products that boast frictionless experiences for the end user. After all, innovative solutions and lower-cost operating models of fintech companies paired with a large customer base of institutions can yield significant adoption. With these rapid changes come changes in business models that unlock new revenue opportunities that were previously nonexistent.
Banks exposing their Open APIs has created revenue opportunities for all players in the ecosystem. Fintech companies can sell their API products as a service to customers to meet their needs. Banks can both garner new customers and, more importantly, serve existing customers when opening their data to service providers (fintech companies) who provide the interface.
The connected world we all live in today is a testament to the need for exposing APIs to, in this case, transact more quickly and securely. Leading fintech companies building in the RTP space are creating their APIs to connect to customers’ banks to facilitate instant payments.
Need for faster, cheaper, and safer payment methods
As evident earlier, the credit card industry includes multiple intermediaries, mainly taking advantage of a duopoly structure and charging high fees for merchants. These fees trickle down to consumers in the form of higher prices. More affordable alternative payment rails, particularly instant payments, are faster and have built-in provisions to reduce the risk of fraud. Budding fintech companies are building API-first products to build on top of the RTP network. There are many use cases (discussed later) where the need for faster and safer payments is required, both with businesses and consumers.
International competition
Thanks to widespread smartphone penetration and high-speed internet, emerging markets have boasted radical innovation, enabling mainstream access to financial services at their fingertips. These include India’s UPI, Brazil’s PIX, the United Kingdom’s Faster Payments, and Singapore’s FAST/PayNow, among many others. If we were to rank all the countries worldwide regarding their fintech innovation, the United States would not be at the top of the list.
PayTM’s interoperability and the breadth of payment options for most of the population have seen significant adoption over the last few years. During a recent trip to India, I noticed firsthand how merchants of all sizes, from large retailers in major cities to small farm-to-table stands in rural villages, have QR codes posted at the point of sale so consumers can pay using PayTM, India’s staged digital wallet. The powerhouse behind PayTM is UPI, or Unified Payments Interface, the rail that has allowed anyone to make instant payments 24/7/365 since 2016. The widespread adoption in this once cash-dominated nation is mainly driven by the 2016 government’s demonetization policies and public-private partnerships, which encouraged ubiquity in digital payments. According to Statista, the monthly transaction volume for payments made over the UPI payment rail in April 2022 alone was around 9.8 trillion rupees, including online and in-person transactions. This is a 17-fold increase from August 2018, when payments made over the UPI were around 550 billion rupees.
Other countries share a similar payment infrastructure that offers real-time payments to businesses and consumers. The downside, however, is that each nation has its own rails, making cross-border payments challenging in real-time. According to Techcrunch, this headwind has led to opportunities for countries to work together, especially India and Singapore, since funds transfer amount to over $1 billion each year. Enabling instant payments between the UPI and PayNow facilitates the speed and efficacy of these transactions and further fuels the transaction volume. The continued innovation further explains the significance of developing the infrastructure needed to enable the interoperability of cross-border payments. Unlike these markets where instant payments are moving hundreds of millions of dollars per month, the United States has yet to fully build out its government-backed real-time payment system, or FedNow.
Rise of FedNow
Fintech companies need standardized APIs to integrate their products and services into RTP nationwide. As seen with India, having cooperation from government agencies can help drive the necessary infrastructure for widespread adoption. Federal Reserve’s FedNow network will launch in mid-2023 and will be able to support RTP and RFP (request-for-payment). FedNow includes over 10,000 financial institutions, and its direct competitor consists of The Clearing House (TCH), which established RTP in 2017 and is governed by many large banks. According to TCH, the fourth quarter of 2022 has seen the highest value of RTP transactions of $22.7 billion, a 15% increase in dollar value from the previous quarter.
“The volumes crossing TCH’s network, overall, bear testament to the demand — where last year there were 172 million transactions processed, tied to about $72 billion in value. Growth rates have been in the double digits across the last several years and are being given a tailwind by B2B use cases.” — PYMNTS
How digital wallets can accelerate RTP
Real-time payments provide the infrastructure that businesses and consumers need to transact in real-time. But the user experience of these digital products is critical as end-users interact with these payment rails. A robust RTP rail with a lackluster interface will do little good.
Digital wallets, primarily staged ones (think Paypal or PayTM), have a wide variety of use cases that support the needs of businesses and consumers. According to ARK Investment Management, digital wallets have saved merchants approximately $50B in costs. Let’s look at how digital wallets can further catalyze the growth of RTP:
“In 2021, digital wallets facilitated 49% of e-commerce transactions, up from 18% in 2016.” — ARK Investment Management
Despite credit cards being the most popular source for online and POS (point-of-sale) payments in the United States, the digital wallet market has increasingly captured more market share. Digital wallet usage is forecasted to grow at a CAGR of approximately 22% in the United States from 2022–2031, reaching a market size of $16.2T by 2031, according to PR Newswire. Pass-through wallets, like Apple Pay or Google Pay, store and tokenize credit card information. In contrast, staged wallets, like PayPal or Google Wallet, offer services beyond storing credit cards, like peer-to-peer transfer, storing bank account information for instant payments, and financial services for businesses.
As we see more technologically advanced countries utilizing digital wallets over credit cards, it’s safe to assume that the United States will follow a similar path as more reliable infrastructure becomes available. Integrating real-time payments in digital wallets allows consumers who already use digital wallets to take advantage of instant payments and can attract more market share as more consumers see the value. This integration applies to both in-person and mobile commerce transactions. Mobile wallet penetration can further accelerate as countries expand their national payment rails to enable cross-border payments through wallets, like India and Singapore, for instance.
With digital wallets becoming a central interface for all payments, it allows adjacent use cases to be integrated within the ecosystem, such as identity verification for onboarding, as it has the same high level of authentication and convenience for end-users.
With real-time payments embedded in digital wallets, the payer and the payee receive confirmation of a successful transaction at the time of settlement as transaction data passes downstream. This transparency helps with expense management and reconciliation for businesses — not to mention instant cash in the bank — and consumers who want more detailed payment information.
Other significant use cases for RTP
Marketplace and early payouts
As a merchant actively selling products in a marketplace, having funds instantly in your account will help alleviate cash flow problems and quickly reinvest the funds back into the business for growth or pay suppliers and salaries. This need led Amazon to build a seller’s wallet, a wallet for sellers to easily hold and transfer funds to multiple parties in and out of their accounts.
With the gig economy growing at a CAGR of 16.8% until 2028, early and instant payouts are a critical feature as it helps lower attrition rates by the companies that offer early access to wages and also help those living paycheck to paycheck. Further, since RTP operates around the clock, 24/7/365, anyone expecting funds in their account doesn’t have to wait until the next business day and hour.
Request for Payment (RFP)
Request for Payment, like an invoice, is when a business requests a payment from the recipient using a pull payment. This concept is familiar to RTP given its use for many ACH payments, but with RTP, customers can receive the RFP, validate the transaction details, and confirm payment to send the funds instantly.
Subscription / variable recurring payments
Today, credit cards are a popular payment method for subscription billing. If a credit card were to expire and there were no updates to the payment method, the transaction would fail — also known as involuntary churn. Bank accounts, on the other hand, don’t have an expiration date. Once your account is linked as the primary payment method, the risk of the transaction failing is significantly lower. The use case also extends to variable recurring payments (VRP), where the payment size can fluctuate and only requires one Strong Customer Authentication step at the beginning. Direct debit isn’t as transparent, instant, and flexible as VRPs. These VRPs provide two use cases:
Both types of VRPs are similar in that they allow those functions without needing additional authentication, which would otherwise add friction to the processes. Since VRPs use the RTP rails, one can expect high transparency of transaction data and scheduled transactions through a secure platform and the flexibility to change any parameters if needed.
Given the complex use cases of VRPs, ‘bank-on-file’ payments may become a popular alternative.
Current innovators embracing A2A payments
Many impressive fintech companies, both domestically and internationally, are building products that make the space even more compelling.
Link Money (United States)
Link sells its Pay by Bank product to businesses via API integration to offer customers a frictionless experience at checkout. The company also offers Verify, another product that complements Pay by Bank and provides identity verification to reduce fraud and enhance customer experience. The company has a few thousand connections to banks nationwide, making it attractive to businesses that need a reliable A2A provider.
The revenue opportunity is scalable for Link as it charges a $0.50 +1% fee — cheaper than credit card fees — for every transaction processed. Link can support its growth by continuing to build more products that are core to the value proposition, which enables opportunities for cross-selling, maximizing coverage with more financial institutions, and easy integrations with a wide variety of marketplaces and platforms. Once FedNow becomes available, Link can leverage the instant payment rail to better serve customers than they do now, which will further grow the company’s revenue. Since Link is one of the earliest fintech companies to build as such, they have a first-mover advantage in the United States.
Link’s valuation would be based on processing volume and reach, given it is a payments company. An appropriate valuation multiple is the total processing value divided by its enterprise value (TPV/EV). This metric focuses on how much the company processes as a multiple of its enterprise value. The EV/NTM EBITDA multiple, a supplement to the first one, is essential to highlight the path to profitability and the overall health of the company. Link is backed by reputable investors like Tiger Global ($10M seed) and Valar Ventures ($20M Series A).
Other companies innovating in the space include Token and Kevin, both based in Europe and have raised $40M and $65M, respectively, to serve the growing demand for instant payments.
Incumbents trying to grab onto market share
Major incumbents, particularly card networks, are not blind to the incoming threats the credit card industry faces. These companies have been making acquisitions to hold onto as much market share as card alternatives have been slowly chewing away. Here are some examples:
Mastercard’s acquisition of Vocalink (2016, $920M USD), Finicity (2020, $825M USD), and Nets (2021, $3.19B USD)
Vocalink, Finicity, and Nets offer real-time payment products that allow Mastercard to extend its position beyond card rails to better serve its customers.
Visa’s acquisition of Currencycloud (2021, $925M USD) and Tink (2022, $2B USD)
The purchase of Currencycloud can boost Visa’s presence for cross-border payment products in real-time. Tink, similar to the acquisitions of Mastercard above, will help broaden Visa’s product offering and retain market share in the real-time payment segment.
Visa’s partnership with Thunes (2022)
Thunes, a payment infrastructure company, specializes in cross-border payments through digital wallets. This partnership can extend the market reach and capabilities for Visa Direct, which can “connect to an additional 1.5 billion wallet endpoints, across 78 wallet providers, in over 44 countries through a single connection.”
My thesis
For real-time payments to accelerate growth throughout the United States, increased collaboration and alignment between the public and private sectors are needed to garner reliable infrastructure to support the many domestic and international use cases. It’s just a matter of time before two parties — businesses or individuals — instantly transferring funds to each other are considered table stakes. Banks like J.P. Morgan have already started building a roadmap to serve their clients better using the new rails. With the proposed launch of FedNow in 2023 and with FedNow’s availability to any bank in the United States, it is no surprise that all financial institutions will be jumping on this new rail to avoid falling behind.
I firmly believe the United States will see a decline in the use of wires and ACH payments in the future as instant payments will be significantly more efficient and an affordable alternative. Same-day ACH has increased by about 86% in dollar volume and 16% in payment volume from 2021 to 2022, according to NACHA. This rapid growth of same-day ACH is a testament to the demand for faster payments. However, headwinds will likely occur in the card industry over the coming years. Regarding how the instant payment rails would stand against card rails, I anticipate fragmentation of payment methods at checkout, particularly in e-commerce and B2C/retail segments, since consumer behavior takes time to evolve. However, ‘pay by bank’ will penetrate the B2B, some B2C (non-retail), and large-ticket transaction segments faster, given the dynamics at which these use cases play. Increased fragmentation will likely be followed by consolidation of payment methods as the instant payment rails become more sophisticated and the interoperability of these rails becomes addressed.
The concept of credit has long existed for centuries and became popular in the United States during the Roaring Twenties. Given the nature of alternative payment methods and the usage of bank accounts, I am particularly optimistic that the ‘credit line’ will be embedded into the bank account for consumers to spend and pay back when required instantly. Combining one’s personal funds plus loans from the same bank or third-party providers may pose new and additional revenue opportunities for the players in the ecosystem.
Lastly, use cases in advanced fraud prevention are likely to occur to combat other potential headwinds, like ensuring consumer protection over the instant payment network. Companies offering fraud protection as a service or payment companies offering advanced fraud protection as an ancillary product for additional revenue opportunities are likely.
The future of the digital payment ecosystem will be a coexistence of multiple payment rails, with some only serving specific use cases, some declining in usage, and some increasingly penetrating new and existing use cases as it grows over time. Real-time payment rails are slowly but surely making their way into how businesses and individuals transact worldwide. Based on the above analysis, it will likely become ubiquitous in the foreseeable future.
Disclaimer: All information presented within this site is for informational purposes only. Because this information presented is based on my personal opinion, it should not be considered investment advice.
Thank you, @Ryan Van-low, for our rich conversations in the office on RTP and the future of credit — your input has been included here.
