How to Deregulate Payments (like Telecom)

23 July 2012

This will be a new blog type.. perhaps a little offbeat .. a living blog that “iterates” based upon community feedback. Idea started yesterday in a few of my informal chats. I’m no telecom expert, but fortunate to know some very good people who are. Yesterday I was having a chat on the EU’s Proposed Interchange Cap with a telecom friend and He drew several analogies to what happened in Telecom back in the 70s when AT&T was forced to open up its network.

Example: Telecom

MCI took AT&T to court to get interconnection, and that put them in a position to offer universal switched service, which they proceeded to do. When the FCC tried to stop them, the circuit court of appeals refused to sustain its order, essentially on procedural grounds. The upshot of this series of discrete decisions, which none of the responsible parties-except maybe Bill McGowan-either foresaw or intended, was the transformation of the long distance business from one of franchised monopoly to open competition. In MC/ Telecommunications Corp. v. FCC, 561 F2d 365 (D.C. Cir. 1977), the U.S. Court of Appeals authorized competing uses of microwave systems serving business and data communications markets; the court also concluded that the FCC had no general authority to insist on approval of new services without a finding of “public convenience and necessity.” In a later proceeding in the MCI case, 580 F2d 590 (D.C.Cir. 1978), the same court held that the previous decision’s mandate required AT&T and the FCC to provide interconnections to MCI. – Telecommunications Deregulation: Market Power and Cost Allocation Issues, 1990 edited by John Robert Allison, Dennis L. Thomas

Several interesting points in this story:

  1. Telecommunications regulator (FCC) was captured by AT&T and wanted to protect them from competition. The deregulation was unintended.
  2. Investment in this sector was throttled by a monopoly which controlled end-end distribution.
  3. Unlocking the monopoly allowed others to compete, take risk and invest. Consumers benefited, telecom costs  decreased, capacity and quality increased, and are now a commodity (ie dumb pipe) business. For example Jim Patterson wrote in this Sunday’s brief “Verizon has a wireline unit that, despite continued investments in fiber, cannot manage to offset its losses from legacy technologies to earn a profit.  With the exception of FiOS Internet and Video, the rest of the business is largely a victim of increased wireless substitution, VoIP (as opposed to traditional TDM voice) penetration, cable competition, and the cloud”

The EU can be credited with attempting to deregulate payments through SEPA (see SEPA – Chicken and the Egg  , Payments Innovation in Europe). As I stated in Building Networks and Openness

The network forms around a function and other entities are attracted to this network (affinity) because of the function of both the central orchestrator and the other participants. Of course we all know this as the definition of Network Effects. Obviously every network must deliver value to at least 2 participants. Existing networks resist change because of this value exchange within the current network structure, in proportion to their size and activity. Within the EU, SEPA undertook a rewrite of network rules and hoped that existing networks would go away or that a new (stronger) SEPA network would form around its core focus areas (SCT, SDD, SCF, ..). It was a “hope” because the ECB has no enforcement arm. In other words there was a political challenge associated with ECB’s (and EPC specifically) ability to force an EU level change on domestically regulated banking industry.. given that SEPA rules destroyed much value in existing bank networks, the political task was no small effort. We have seen similar attempts (and results) when governments attempt to institute major change in networks (Internet NetNeutrality v. Priority Routing, US Debit Card Interchange, …)

Managed Deregulation

Managed deregulation seems to have problems… particularly when there is an attempt to force a “product/Service” like SEPA CF or SEPA DD. While there are no technical issues w/ SEPA there are issues around incentives, local/regional policy and lawmaking, regulatory enforcement, …etc. Like ATT/MCI case above, Local Country banking regulators are “captured” by the entities which they regulate. This is not unique to Europe at all.. As I’ve stated many times with respect to India, RBI has attempted to “manage” innovation in mobile payments to ensure that banks are in control (vs. MPESA Success in Kenya success was “accidental”).

“Unmanaged” deregulation seems to have a much better track record in telecom, payments, and other areas such as “internet” services (ex UBER and the NYTLC). With respect to Payments, what is the switch that needs to be opened up? Perhaps the best example is Sofort (SOFORT Overview) and “opening” ACH/iBAN transfers.  US banks are proceeding in the opposite direction (see ACH System in US), and have generally resisted changes to improve ACH “speed” for this very reason, as any RTGS system possess a risk to them (see Real Time Funds Transfer in US). Payment Value

Although some readers will be highly offended at my suggestion that success was not guided by government directives and oversight (ie Internet – Al Gore’s invention, Glosplan, The French), it is important to note that a company with a business plan was ALWAYS behind success…  pushing for the change, against regulators who largely work to protect the industries they regulate.

Dodd-Frank V2

Dodd Frank has had tremendous repercussions for the industry (Bloomberg estimates $22B). In my view future regulation should avoid any price setting, as effective markets are the proper mechanism to align price to value. However payments is not a competitive market, and Dodd-Frank has not changed this. Lawmakers should endeavor to kick start a new wave of investment from 100s of companies in payments and commerce. Working to make payments a competitive market, just as Telecom is today.

Here is my simple framework for unlocking a new wave of competition.

#1 Settlement.

The current card schemes are insanely complex. No one in their right mind would start off with a design of a debit request to an account holders financial institution if everyone is connected (my design is in blog Push Payments). In order to maintain flexibility in risk management, the clearing mechanism must let any participating party assume risk on the transaction. Therefore my recommendation is to enable the participation of non-banks in local country RTGS systems (FedWire in the US)…. creating a certification process by which new participants (like MSBs Amazon, PayPal, Google, WMT) could establish a settlement account with the Fed just as the banks do. There is real time funds transfer here (only RT option in the US), once funds are moved there is no reversal. This puts the onus on the participating entity to manage risk and Fraud. It also keeps from having the banks do any technical work at all…

#2 Issuance and Value Storage.

We need to look no further than BitCoin to see the need for new regulations surrounding issuance. Transfer of funds between entities is covered above, and my view is that non-bank participants should be licensed and agree to abide by current money transfer  regs (ie. Fincen/AML, ..). Issuance of “credentials” and storage of funds is another matter. Long term storage of funds is a banking function, and should be regulated, settlement funds face state escheatment issues (but largely unregulated unless interest is paid), while storage of “Value” is completely unregulated (ie Coupons – a form of legal tender, Pre paid offers, bitcoins)?

From above, if we allow non-banks to participate in real time funds transfer (like Sofort), then third parties are acting as agents (on behalf of consumer, merchant or bank) to direct the funds. If a good/service is purchased immediately (commerce) then there is no regulation, however if the value is “held” for future use it is generally regulated (hence MSB, eGold, bitcoin issues). Thus the rules under which third party senders operate (as agents), are different from the entities at the end of the transactions (banks, merchants, consumers).

Most know the story of MPESA and how telecom minutes became a form of value exchange which evolved to over 10% of Kenya’s GDP. There is an obvious need for issuance to more closely resemble cash in its ease of exchange, verification, anonymity and storage.

Our current need is for simplified laws surrounding account under a given value amount (say $2000). Providers of service should be lightly regulated through self reporting, “transparency”, and the need to keep settlement funds with the Fed. In this proposed model, a bitcoin exchange must ensure that no single individual has processed more than the threshold in a given time period. Hence the need for KYC of exchange participants (when converting to cash).

#3 Authentication

Most are aware of my favorite payment quote

…If you solve authentication.. everything else is just accounting”  (Ross Anderson @ KC Fed).

Sharing and validating of identity is critical to a functioning payments system. 3rd parties which have consumer permission must be able to participate in common infrastructure (credit bureaus) and share data on bad actors with other participants without fear of repercussions. eSignatures, eVerification, remote KYC should all be defined within law.

Would love more input here.

#4 Acceptance.

No Change Necessary. Just as MCI forced its way into the switch, other providers must be able to participate in the payments “network”. For a merchant to accept a new payment type, the following must happen

  • Merchant agreement (with merchant Acquirer)
  • Network Agreement (between Payment Issuer/Network)
  • Processor Agreement
  • Acceptance device
  • Consumer Instrument
  • PCI Certification (in some cases)
  • POS Integration

The Pipes between a merchant and its processor are owned by the merchant, they can decide what flows through those pipes with one major exception: accept all cards. Dodd-Frank allowed market forces to take effect here through steering and incentives… although few merchants have acted, as they hope to keep pressure on a credit settlement. To accelerate acceptance market forces, there must be “open-ness” in the connection. I believe this is largely in place, as merchants face few challenges IF THEY WANTED to add a new payment type like PayPal. They have chosen not to because it offers no benefit (vs a debit card).

Summary

Innovating on the existing networks is hard. The core to any payments success is access to the transactional account. There are several successful approaches today:

  1. Sofort (my favorite example). Operating as agent on banks web site to initiate payments on consumer’s behalf. This can’t work in the US as there are no “wires” or direct RTGS system which correlate to IBAN in Germany.
  2. Amex/Bluebird “bank in the box” account. With direct deposit, bill pay, electronic payments, ATM, … but getting consumers to adopt a new account is not really “open”
  3. Bitcoin/eGold. Consumers buy item of value which can be exchanged
  4. Solutions which work off of PIN debit (a very cool area that is overlooked). Best examples are Acculynk, Star’s Expedited Transfer, NYCE’s A2A Money Transfer Visa’s VMT, Dwolla,

The US needs open access to a RTGS system, where any party can assume risk. Giving non-banks the opportunity to participate in Fedwire may be the quickest way to move the ball. For EU, perhaps giving open access to a common settlement service would be faster than mandating protocols/services. In other words.. build a new system for settlement  which banks must participate.. and let non banks in as well.  Build the Future vs. fixing the past.

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4 thoughts on “How to Deregulate Payments (like Telecom)

  1. How do you propose to set minimum capital requirements to accept that risk? Should Google have to keep a cash collateral account with the Fed equivalent to 25% its daily settlements? What about charge-backs? Cross-border? Etc. What startup has the funding to tackle all those problems while gaining scale fast enough to be a viable alternative in the consumer’s mind? Consumers WANT a MasterCard, Visa, American Express or Discover account because they trust the process…which is why merchants also want to accept those cards whether they bitch about it or not.

    Craig J. Maurer
    US Equity Research | Payment Processing & Specialty Finance
    CLSA Americas, LLC
    1301 Ave of the Americas, 15th Floor
    212 408 5923 | craig.maurer@clsa.com
    AIM: cjmac97

    • I would start simply, with a second tier of participation that has individual and daily transaction limits based upon settlement funds. Perhaps an even “lighter” form would be to require a licensed correspondent relationship. Banks are lothe to give Wire access to their customers… particularly at $0.05 (Fed cost).

      All transactions are final and operate under Reg J. So chargebacks would look more like a real time credit in a separate transaction. This puts all risk on the entity initiating the wire. If we take the Sofort model.. Optimal.. only credits should be initiated. But this would require banks to provide access to wires. This is the right thing to do.. but would take more time to implement.

      Your point on consumer “loyalty” and trust is valid. Any new payment scheme must start with customer value at the core. Why is bitcoin popular? anonymity would be my answer. What problems are there today? From my perspective the #1 problem is that Visa/MA are not neutral.. they are very biased toward banks. #2 Innovation is completely broken, switching costs are high, and products look the same as 20 yrs ago.
      #3++ How can you transfer money to your daughter in college.. NOW. ? How can you keep your payment data to yourself? How can you make money from your payment data?

      Quite frankly Craig there is a very large portion of the population that would like to stick a knife in banks and twist it.. I’m not one of those.. but there is a market for alternative payments.. just not a profitable one.

  2. Pingback: How to Deregulate Payments (like Telecom) | BitcoinMagazine.org

  3. Pingback: Headline News from PaymentsNews.com - July 25, 2013 | Ideal Payment Solutions.comIdeal Payment Solutions.com

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