A New Model for Value Exchange

It’s time to replace interchange with a model that fairly represents the value each party receives.

Fintechs have shown us the way to create exciting new forms of financial services. But we are merely scratching the surface of what the age of intelligent systems can do for the payments industry. One such solution can be to enable a dynamic and fluid new form of interchange.

I believe that, in the not-too-distant future, the system of interchange will not be controlled, as it is today, by one market vertical, namely the card networks. Rather, interchange will become as dynamic and fluid as any new payment form the market can dream up. How could this happen? Let’s start by looking at the difference between payment type and payment form.

There exist only three payment types, all based on a source of funds: pay now, pay later, and pay before. Pay now types rely on a depository account that holds variable amounts of money. Pay later types represent a generally finite line of credit underwritten by a lender or entity willing to take on credit risk. Pay before types rely on an aggregated depository account holding finite funds earmarked for some future use.

Accepting any of these payment types means that the payee has to determine if there are sufficient funds in the account to cover the payment, that the account is in good standing, and that the accountholder actually owns the account—all basic tenets of determining interchange.

Yet the form used to access a source of funds (meaning payment type) and, by definition, which entity controls or influences this access, will define the future transfer of value for a payment. In other words, disruption in payment forms leads to disruption in the commercial model.

Unique And Inviolable

So, let’s look closer at this idea, starting with pay now types, which are the most vulnerable to interchange disruption but also hold many of the characteristics for change present in the other two types.

Financial institutions have done a good job throwing up roadblocks to intruders looking to gain entry to the retail depository market. But these walls are crumbling because of a number of factors. These include a combination of regulations, the development of new real-time payment networks, new processing technologies built for purpose through cloud-based services, and the expansion of digital access to funds.

This environment is enabling rapid distribution of issuance and acceptance services across all consumer and merchant categories, a trend that also serves to encourage more direct or bi-lateral payment forms. Also, payments-orchestration software allows merchants to better understand transaction behaviors, costs, and frictions.

For example, least-cost debit routing will become the norm, as will expedited/instant clearing and settlement, which benefits the merchant and consumer. But these factors will disadvantage higher-cost, higher-friction pay now forms as merchants nudge consumers toward a better experience at the point of purchase, where they can receive enhanced benefits in the form of money management, discounts, and convenience.

Similar factors are in play for pay later types, but here the stakes for the industry are much higher. Interchange was originally created in the credit card market, and its legacy framework remains true to those beginnings. Credit cards and personal loans are critical components of banks’ revenue streams.

As I’ve written in this space before, merchants are increasing their strength in the consumer and small-business credit markets.  Consumers see the value of accessing highly personalized, short-term, budget-friendly credit. And now that interchange rates are set to rise for business cards and card-not-present transactions, there will be even more aggressive moves by merchants to shift transactions from high-cost credit cards to lower-cost loans.

And then there is Pay Before. This payment type is poised for significant growth coming from two main forms. First, closed-loop stored-value wallets, which are especially appealing to merchants that want to either decrease their reliance on high-cost card transactions or penetrate new markets.

But a digital wallet that consumers can dip into for ad hoc or monthly payments is just the start. These wallets are also capable of housing rebates, credits, gift cards, and promotions like cashback, all representative of key merchant strategies.

Second, there is cryptocurrency and the exploding market for Non-Fungible Tokens. Briefly, these are tokens that represent an asset such as a piece of artwork or a collectible. To trade in these NFTs, consumers enable a cryptocurrency wallet and fund it with a specific currency called Ethereum. This is where the value of the blockchain comes into play, because Ethereum is used to not only pay for these assets, but also to ensure they are unique and inviolable.

Rent Gathering

We now have a retail-payment strategy that is inextricably tied to an entirely new transfer of value between two parties, one that seeks to eliminate risk entirely.

How does one quantify (i.e., establish a fee structure for) these new kinds of value transfer? The NFT market represents the real future of interchange, one where digital information and payment-credential data merge and enable the creation of dynamic business models that define the level of value transfer in any given transaction.

The current construct the payments industry uses to define value transfer is locked into a model that is increasingly irrelevant to the market. Traditional interchange structures have become  rent-gathering mechanisms tied to controlling access to the funding source.

Relying on regulators and lawyers to carve out exceptions just digs the hole deeper. It’s a complicated issue without easy solutions, but solving it holds the key for real market expansion and a stronger industry.

—Patricia Hewitt is principal at PG Research and Advisory Services, Savannah, Ga.