How payments networks compete

Why does the US have so many networks when economics should drive to one?

Payment systems always have a network operator at their center. The very term “network effects” is shorthand for the value created by having a central switch that connects any two counterparties. Network effects theory establishes that the value of a network rises as it connects more endpoints, as a result, networks should naturally converge towards a single provider. Yet most US payments systems do not, which makes us a global outlier.

The US credit card system has two open networks (Visa & MasterCard) and two-closed loop networks (American Express & Discover). ACH has a Fed-run switch and a bank-run switch (TCH), but its rules are governed by a common standards body – NACHA. The Fed and TCH also compete in Wires (Fedwire versus CHIPS) and real-time payments (FedNow versus RTP). In Debit, we have two major Signature networks (MasterCard and Visa) and five major PIN networks (Interlink, STAR, NYCE, and Pulse). Zelle is a single switch, but Zelle still competes with Fintech P2P systems, e.g., Venmo, Cash App, Apple Pay Cash. The private sector networks all started as bank consortia but most later became public companies.

The US has so many networks because historically, we legally fragmented our banking markets at the state level and sometimes the local level (i.e., some “unit banking” states limited branching in a variety of ways). To have interoperability, the smallish banks of the time had to come together to share infrastructure. Most card networks started regionally (e.g., NYCE stands for New York Cash Exchange, Pulse grew up to serve local banks when Texas was still a unit-banking state, STAR grew from MAC which served the mid-Atlantic states).  Even MasterCard and Visa have regional origins with Visa west coast-focused (originally BankAmericard) and MasterCard east coast-focused (originally “Interbank”).

The most convoluted is NACHA (National Association of Clearinghouse Associations). When payments meant “checks”, each major city had a physical clearinghouse to exchange paper checks – Clearinghouse Associations.  Over time, these utilities added electronic capabilities – Automated Clearing House transactions (ACH). To exchange checks between local clearinghouses they formed a National Association, NACHA, that set the rules. Regional clearinghouses still have voting power in NACHA but interstate banking, industry concentration, and digitization have limited their visible role. TCH grew out of the New York clearing house which, like Ohio State University, became The Clearinghouse.

The US is also unique in having private sector networks competing with public sector networks. Most countries only have public sector payments switches for DDA-based payments. The US ecosystem is another legacy of our fragmented banking system. The biggest banks generally solved industry level issues through consortia, but small banks felt those consortia were not responsive enough to their needs; instead, small banks preferred to rely on Fed services. As a result, the three TCH networks “major” on the wholesale services required by big Treasury Services banks while the Fed networks meet the more basic needs of the smaller banks. Another way to put it is that TCH majors on Originators while the Fed majors on Receivers.

What are the functions of a network?

Payments networks move information and money between counterparties – usually from one bank to another bank. Networks can have narrow roles in the payments value change or provide a more E2E offering. Network infrastructure includes:

1. A messaging standard so that all counterparties send and receive the same data. SWIFT is a global network that just delivers messages in its standard, but does not move money

2. A physical switch to move those messages between counterparties. Some messages are real time, such as card authorizations, and others are batch, such as card settlements

3. A rule set to govern deadlines, exception processing, membership obligations etc. NACHA is just a rules body and moves neither money nor information

4. A settlement capability to move funds between counterparties, sometimes in batch, like ACH or Cards, and sometimes intraday e.g., for real-time payments

5. An adjudication capability to resolve disputes among members or among end users and to detect and prevent fraud

Networks themselves do not typically deal with end senders or end receivers. In the card systems, the senders are cardholders served by card-issuing banks while the receivers are merchants served by acquirers and acquiring banks; In ACH, the two roles are called “originators” and “receivers” rather than issuers and acquirers.

Closed loop networks like American Express & Discover do all these roles, but typically their messaging standard, rule set and adjudication processes align with their open loop rivals. That simplifies end user processes. But differences remain; for example, American Express has a 15-digit card number while all other card networks use 16 digits — surprisingly, this small difference causes issues along the value chain. In general, all networks are subject to the same regulations for consumer protection, money laundering, Know Your Customer (KYC), etc. Those regulations increase the pressure to standardize processes.

Network membership is usually limited to chartered financial institutions because members need deep pockets to stand in for any end customer failures. Consequently, senders and receivers may face financial limits on their activity relative to the size of their balance sheet, and they in turn impose limits on their end customers for the same reason.

Why don’t networks always become monopolies?

Being a leading network tends to bring high profits. The biggest network connects the most endpoints and is therefore delivering the highest value. The biggest network also has the lowest marginal and average costs and can therefore compete on price if it chooses to.

Another term for network is “two-sided market”. In Tech, we see giants like Google in search, Facebook in social networks, Amazon in marketplace, and Apple’s App Store are all two-sided markets that have higher volumes and profits relative to their smaller competitors. Facebook and Google connect advertisers to consumers and Amazon connects consumers and small merchants; Apple connects IOS users to app developers. While each of these companies has competition, they all have distinctive share within their ecosystem.

While US payments networks do often end up with a share leader, they only rarely converge to a full monopoly.

• In DDA payments, the Fed competes with TCH in all three payment methods, but without profit pressures. Fed pricing is governed by “cost recovery” regulations intended to level the playing field with private sector competitors; historically, banks have questioned whether those rules are rigoriously enforced. Further, smaller banks trust the Fed more than private sector switches governed by the largest banks and might choose the Fed regardless of price differences

• In credit card, the large issuers don’t want one network to have too much power. When the networks were associations governed by their members, interests between issuers and networks were aligned. But now that the networks are public companies, that is not always the case

• In Debit cards, the government mandates an “Unaffiliated” network on every card. In practice that means an independent PIN network like STAR, Pulse, or NYCE in addition to one or more Visa networks or MasterCard networks

• In P2P, Zelle is indeed the sole bank-centric network, but it faces competition from Fintech P2P operators like Venmo & Cash App

Networks face constraints on their ability to leverage leading share, notably anti-trust law. Zelle went to great lengths to keep a level playing field between large banks and small banks, both to entice more banks to join and to be perceived as fair; in particular, Zelle offered no volume discounts. Further, as volumes grew, they chose to lower prices for everyone rather than book profits for the big-bank owners. As a result, Zelle today charges a fraction of what they did at inception. The DOJ lawsuit outlines some Visa tactics in Debit that the DOJ believes cross the antitrust line.

How do networks compete?

Networks compete within a payment method for volume (e.g., TCH vs. Fed, MC vs. Visa) and they compete with other payment methods to capture Use Cases, e.g., P2P, C2B (Commerce, Bill Pay), B2C (disbursements), & B2B.

1.     Competition within a payment method

Almost every US payment method has more than one network, so how do the networks compete for volume? There is no real difference between a Visa credit card transaction and a MasterCard credit card transaction. Virtually all merchants accept both in exactly the same way – except that Costco accepts Visa but not MasterCard. The message standards are all ISO 8583 and the rules are mostly identical.

Since all the transactions and processes are standardized, it should come down to price but, the biggest issuers don’t pay much, if anything, to the networks – and big issuers account for 75%+ of credit card volume. To get down to that low level, the issuers have to pledge volume to the network, so most big issuers have the bulk of their portfolio on one network.

Among the biggest bank issuers, Most run their bank-brand cards on one network. In cobrand, big partners pick the network, so some issuers operate on the second network by necessity rather than by choice. For example, Citi historically was a MasterCard issuer, but it won the Costco cobrand contract that required Visa branding. Today, Citi’s overall volume is split between the two networks – but Citi brand is mostly MasterCard and cobrands are mostly Visa.

Historically, Visa & MasterCard had an acceptance advantage over Amex & Discover, which gave their cards an advantage with consumers. But both the closed loops eventually spun out acquiring to third-party acquirers to close this gap. Today, all four networks have domestic acceptance parity.

On the merchant side, the networks compete for cobrand branding, which influences on-us volume. But merchants otherwise have limited sway over what network brand a consumer presents at checkout. Nevertheless, the card networks are big direct marketers. Visa’s “Everywhere you want to be” and MasterCard’s “Priceless” are both instantly recognizable, but do they really move the needle? Originally, such marketing tried to lure consumers away from cash and checks, but today its role seems less clear. Some card professionals claim the network brand does influence conversion when applicants are given a choice. I for one don’t remember ever being given a choice.

It is mostly an historical accident that Visa is larger than MasterCard in credit card. The banks that ran Visa happened to come out on top of the merger wave unleashed by interstate banking deregulation. Visa also moved to volume discounts earlier than MasterCard, locking up the biggest issuers. MasterCard clawed back share by being Cobrand-friendly, but Visa eventually responded. MasterCard still dominates the corporate card space because it focused there earlier.

In ACH, TCH aND the Fed also share a rule set, a messaging standard and a common regulatory framework. The Fed caters to the smaller banks while TCH caters to the big Treasury Banks that own it. That means TCH is originator-centric while the Fed is receiver-centric. The same dynamic is playing out in the Real Time Payments.

CHIPS and Fedwire are both high-value, low-volume payment networks. CHIPS again caters to large originators while FedWire is more of a general utility. CHIPS nets transactions between large banks throughout the day and then net settles at end of day using Fedwire. Continuous net settlement means the banks don’t have to send so many FedWires, which would each incur a fee. That allows treasury banks to keep costs low for their commercial customers.   

The situation is most complicated in Debit due to government intervention – known as the Durbin Amendment. Prior to Durbin, major banks had Visa or MasterCard Signature Debit on the front of the card and that same network’s PIN brand on the back of the card (Interlink or Maestro). The Durbin amendment required a minimum of one “unaffiliated” network on each card and for practical purposes that mean a PIN network like STAR, Pulse, or NYCE. Interlink and Maestro remained on most cards, so a typical debit card has 3 networks or more.

In Real Time Payments (RTP), the Fed and TCH compete for bank affiliations. Most of the larger banks have affiliated with TCH but will add FedNow broaden acceptance. Smaller banks may not affiliate with TCH.  One key advantage of FedNow is that the US Treasury could convert all government disbursements to FedNow, providing a captive volume pool.

2.     Competition to capture use cases

Payment methods compete for primacy in particular use cases – which pits network types against each other. For example, when the banks were investing heavily to build TCH’s Real Time Payments (RTP) system, the card networks introduced Visa Direct & MasterCard Send to capture Disbursements volume (B2C) that might otherwise use RTP. Worse from the banks’ perspective, the networks passed rules obligating the banks to integrate with these card-based solutions.

In turn, when the banks created Zelle for P2P, Zelle also launched a disbursements capability that relied on easy-to-use Email addresses or Mobile numbers rather than 16-digit debit card numbers. It was less expensive than the card solutions and more ubiquitous than RTP.

Zelle P2P competed with fintech P2P systems that used Visa Direct and MC Send to fund stored value accounts and remit funds back to banks. Paradoxically, Zelle also used Visa Direct & MC Send to support non-member-bank customers. Zelle eventually opened up a C2B commerce use case that competed with Cards but restricted its use to small business. And Zelle has explored C2B bill pay – currently dominated by ACH (direct debits) and cards.

One of the reasons that RTP has not scaled as fast as expected is that other payment networks grabbed the high-volume use cases. Zelle majors in P2P but supports disbursements (B2C) as well; the card networks targeted disbursements via Visa Direct & MasterCard Send and target B2B accounts payable via procurement cards and virtual cards. C2B Bill Pay is already digitized via ACH & Cards. And NACHA launched same-day ACH in the same time frame for transactions that needed speed but not real-time. That leaves TCH & FedNow with the low volume/high value B2B transactions, which are not enough of to generate economic scale – particularly as they are spread across two network infrastructures.

Fintech Competition

No Fintech provides a scale alternative to the core payments networks. They mostly provide a digital experience layer that ultimately initiates a conventional payment. They monetize either by charging a premium for lower consumer friction, better consumer authentication or arbitraging one conventional payment method with lower cost conventional method.

• PayPal usually initiate a credit or debit card funding transaction in the background, although sometimes it uses ACH. In some cases, the consumer funds from a PayPal balance. When the back-end is a credit card, PayPal’s margins are thin, when it is a debit card, ACH or PayPal balance they are much wider

• Pay-in-four products convert a single eCommerce purchase into four back-end debit or ACH transactions. In-person versions generally push a virtual card into Apple Pay to tap-and-go at a merchant POS. Most of the Accounts Payable fintechs monetize via virtual cards as well

• A2A solutions present themselves as Card alternatives, but they typically displace Debit transactions with ACH transactions. In order to close the authentication gap they use Open Banking technology; but, Open Banking adds cost to the basic ACH, narrowing the economic gap with Debit

• Data Aggregators like Plaid, MX & Finicity provide data networks rather than payments networks; When they speak about extending into payments, they usually mean helping users initiate ACH

The outlier here is Blockchain solutions. Blockchain is a networking technology that doesn’t require a central switch.  Settlement happens instantaneously and irrevocably by transferring ownership of the crypto token from the seller to the buyer. Blockchains encode the rules directly into the transactions as “smart contracts”. Exception processes, like returns and chargebacks are governed by the Smart Contracts as well. A messaging standard for ancillary data can be encoded in the chain or into the transaction itself. Other than setting the original rules, the network does not need a standing organization – So it is more like NACHA, but without the Fed or TCH.

Unfortunately, Crypto itself is not a particularly good medium of exchange and even stable coins don’t have advantages over debit, ACH, or RTP. Conventional payment methods are used to buy the tokens, so it doesn’t entire displace the incumbent payment methods.

Blockchain’s challenge is that while it theoretically improves on the incumbent models for DDA-payments, it does not improve on them enough to displace them. Blockchains also don’t yet link to the back-end systems that companies and banks need to track and post transactions; they also lacks compliance infrastructure to satisfy regulators. Blockchain has potential as technology, but it is too early to rely on. Many incumbent networks are experimenting with blockchain primarily to improve their own cost structure rather than to displace other networks.

Relative to credit cards, Blockchains are not competitive. U.S. Credit Cards provide credit (duh!) in the form of grace periods and loans and they pay rewards to the consumers that use them. Blockchains offer an inferior economic value proposition to credit card holders and would only be used where there is no alternative.

Conclusions

Networks are essential infrastructure in payments. In most countries, the government or a bank utility provide that infrastructure and there is usually one switch per payment method. The government may even steer transactions to favored payment methods, as happens in India with UPI. The US is unique in having private sector switches competing with a public sector switches to serve the same payment method.

That competition leads to lower prices and more innovation although it also makes our system more complex. And competition and innovation do happen. Networks within a common payment method tend to specialize in a given bank segment or specific products.

But networks also compete to capture use cases across payment methods; for example,

• All payment methods have disbursements services that compete on speed, price, data load & consumer identifier (account number, card number, email, etc.)

• Most payment networks have a “faster” version that competes with Fedwire:

  • NACHA with Same-day ACH – slower but cheaper; same day is often fast enough

  • TCH with CHIPS – cheaper via continuous net settlement, but requires an intraday balance with TCH

  • Card networks with Visa Direct & MasterCard Send – cheaper but lower limits; uses debit card numbers to identify accounts, so impractical for B2B

  • Zelle – cheaper but limits calibrated to P2P and small businesses; uses email or mobile no. instead of account numbers

  • RTP – cheaper and carries more data, but lower limits; not yet ubiquitous

  • Blockchains – illiquid and lower acceptance; less supervised

Not having a monopoly network embedded by law or custom gives the US payments system its dynamism.

Key insights

• The US is unusual in having more than one network per payment method, with private sector networks competing with public sector networks. This is a legacy of historical limits on interstate banking

• Public sector networks try to create a level playing field for all financial institutions while private sector networks often tailor solutions for Treasury Services use cases (wholesale), which are concentrated among the largest banks

• Competing networks within a payment method typically share messaging standards, rule sets, exception processes, etc. The networks largely differ on economics

• In high-volume use cases, networks compete in a free-for-all – often fragmenting a large market into narrower niches. New volumes generate revenue at low marginal costs and therefore help overall network economics

• Fintechs have not created successful alternatives to incumbent networks

  • They have eased the friction to use those incumbent networks

  • They sometimes arbitrage between incumbent payment methods

  • PayPal is an exception when it makes payments from stored value

• Blockchains have attractive characteristics as a payment network technology, but, so far, they have not challenged incumbents

  • Crypto is not an attractive medium of exchange for domestic transactions as its price fluctuates and it is illiquid for other uses

  • Incumbent networks (other than Credit Cards) have low costs on an E2E basis – particularly to the high volume merchants and banks

  • Credit Cards provide credit & rewards to cardholders, making blockchains unattractive

  • Blockchains currently lack the compliance protocols needs for the biggest use cases – and adding those protocols will raise costs and introduce friction

• The US cornucopia of networks leads to payment dynamism that is sometimes absent in markets dominated by monopoly national utilities