Different Worlds: Why digital payments should not be regulated as an offshoot of banking
The essence of banking is taking calculated risks, and banks’ profitability comes from taking such risks. That is not to say that bankers are inherently risk-loving; they often display a strong conservative bias, which is a natural form of self-protection against excessive risk-taking. Calculating risks appropriately requires getting as much information as possible on the underlying sources of risk. Bankers therefore seek to establish ongoing relationships with their customers as a path to capture further information.
On the other hand, the essence of payments is offering transactional services with the minimum amount of risk. Profitability comes from customer service and convenience, not taking risks on behalf of customers. So payment systems are designed to offer customers maximum functionality, speed and convenience, at adequate levels of security and certainty for all parties. Modern payment systems seek to minimize risk by conducting transactions on a funded basis and by operating as close as possible to real time. Technology, rather than relationships, lies at the heart of transaction speed and certainty.
In a new paper, we analyze the ways in which digital payments are emerging as a specific field of expertise, and how and why it differs from banking. The principal differences between the two fields are that banks prosper greatly from managing risk and little from network effects, whereas payments providers typically seek to avoid risk and prosper greatly from network effects. This leads to fundamentally different outlooks between the practitioners in each field.
For payments providers, being able to handle transactions on a funded basis and in real time is enormously liberating because it enables transactions with less well-known parties. It makes it possible to opt for mass-marketing channels, without having to worry as much about screening customers. It also makes it possible to engage indirect service channels; for instance, offering cash in/cash out through a network of thousands of retail outlets. This is not to say digital payments do not carry risks, but the aspiration is always to limit them.
In payments, the quality or depth of individual customer relationships matters less than their number and breadth. This is because payments can only be understood in the context of a network, and the size and breadth of the user base are defining characteristics of the network itself. Payment systems are subject to strong network effects (the more users on it, the more valuable the service is to any given user) and operate in a multitude of two-sided markets (there needs to be buyers and merchants, bill payers and billing companies, wage earners and employers).
That´s not necessarily the case with banking: There may be scale effects because serving more customers is cheaper than serving few, but one customer doesn´t directly benefit from there being a large number of other bank customers. Banking is fundamentally about the functioning of institutions (how they manage risks and build enduring customer relationships), whereas payments is more about the functioning of ecosystems (who is in it and how big it is).
As payments become more deeply researched and its practitioners more specifically educated in it, these differences in economic drivers of banking versus payments ought to create a differential regulatory treatment. Traditional banking regulation seeks to limit the risks banks assume, because when banks fail the money they lose belongs to ordinary people, who vote, and the broader economic consequences of bank failure can be severe. For both these reasons, politicians feel the need to bail out failing banks. Payments are traditionally regulated as part of banking regulation, and often by the same regulatory institutions, but the imperatives that drive banking regulation should not drive payments regulation. A failure of a payments provider should not necessitate a bailout with public funds. While it may prove highly inconvenient to many people, it is difficult to imagine the failure of a payments provider causing financial market contagion, as did the collapse of Lehmann Brothers, for instance.
Payments are their own industry and they deserve their own regulatory regime, finely attuned to the relatively minor risks that payments generate. Changes in banking in the past 20 years have been substantial, but the greatest changes and opportunities in the next 20 years are likely to arise in payments.
Ross P. Buckley is a Scientia Professor; the CIFR King & Wood Mallesons Chair of International Finance Law; and a member of the Centre for Law, Markets and Regulation, at UNSW Australia, Sydney.
Ignacio Mas is a Senior Research Fellow at Saïd Business School, University of Oxford.