When Short-Circuiting Is Fatal

Payments 3.0

A good working definition of short-circuiting something is “to force the termination of a process before its conclusion by bypassing one or more steps.” Short-circuiting also usually blows up the bypassed mechanism.

Established industries operate on mutually agreed-upon principles and rules. But when the rules become over-protective of a business, outsiders see opportunities to profit by short-circuiting the system with a new technology that effectively can change the rules.

Every startup loves to label itself a disruptor. But very few actually change all the rules and short-circuit core industry processes. Let’s look at some well-known examples to see short-circuiting at work, and then look at banking and payments.

Becoming a licensed taxi driver requires a major investment of time and money. In some cities, taxi “medallions” (licenses) sell for hundreds of thousands of dollars. But taxis are expensive for the customer and hard to find when you need one. Companies like Uber don’t try to improve the existing process. Instead, they short-circuit the whole apparatus between driver and rider.

Hotels are another protected industry, regulated at national, state, and local—and labor union—levels. But portals like Airbnb and HomeAway are short-circuiting the whole superstructure between the room seeker and the room provider.

What About Banking And Payments?

Banking is one of the most protected of all industries. There are safety and soundness principles, prudential rules, rules about money laundering and “know your customer,” consumer disclosures of several kinds, and thousands more rules. So far, banks have proved remarkably resilient to any short-circuiting strategies from new players. But wait.

Mobile-payments companies in developing markets started short-circuiting banks by the simple but brilliant expedient of substituting minutes for money and setting up local agents where customers can deposit or withdraw cash. These short-circuiters can serve customers who previously could not access banking services. Once established, they began digging into the well-banked as well as the un-banked. One example, M-Pesa, has garnered more customers than all the banks in Kenya put together in just a few years.

Markets where banking is mature and where nearly everyone has a bank account and a payment card once felt immune to short-circuiting—until established players woke up and saw it happening in their own backyards.

PayPal got its start serving the two parties to an auction who either didn’t have, or didn’t want to pay the fees for, a bank-based payment system. The service has short-circuited much of the payments paradigm, but it is still dependent on the banking system for final clearing and settlement.

Square enables small and informal sellers to accept credit cards and has found significant success thanks to smart phones and digital technologies. But it, too, depends on the banks.

The key to separating the clever disruptor from the fatal short-circuiter is to look at how much of the existing process, especially the profitable parts of it, is being short-circuited. The myriad systems from Dwolla to Apple Pay that, sooner or later in the process, default to the banking network are disruptive, but probably not fatal.

A common misconception is that, just by applying new technologies, banking-industry processes can be short-circuited. New technologies are almost always necessary. But technology alone wouldn’t have allowed M-Pesa to make banks irrelevant. It is how the technology is used that makes it not simply a disruptor, but a short-circuiter.

A new payment method that was a true short-circuiter would operate without needing a bank anywhere during the transaction. Right now, the blockchain/shared ledger systems seem to meet the short-circuiting test.

Some feel these systems may be in the role of the pioneers who don’t end up as the final success story. But whether it’s Bitcoin or Ripple, when someone moves from disrupting the bank-based payments system to short-circuiting it, banks may find themselves in the positon of the taxicab companies and chain hotels, rushing to preserve their fiefdoms by getting their allies in government to rule the challengers out of order.

History shows this often is just a stopgap measure on the road to eventually losing the franchise, be it the taxi franchise, the hotel franchise, or the payments franchise.

—George Warfel • george.warfel@edgardunn.com