Payments has been a rapidly evolving space over the past 20 years, and many companies have sought to get into it, even as the incumbents seek to evolve and expand their offerings. I have noticed, however, a lack of resources to get new employees up to speed on how different payment methods work. The purpose of the “Payments 101” series is to remedy that problem. Each week, I will focus on a particular aspect of payments, assuming no prior knowledge (except for earlier installments). Periodically, I will do a “deep dive” into a particular hot issue, such as faster payments. However, the fundamentals of payments have not changed in hundreds of years, and I will show that there is a simple framework that applies to all payment methods; only the rules and naming change. This explains why payment methods are converging and overlapping; as digitization becomes universal, there is much less reason for providers to confine themselves to their existing portfolio. Ultimately, I predict that universal payment engines (or payment hubs) will take over, and there will be a single set of payment transactions that emulate all existing payment types. To a large extent, this prediction is already coming true.
The Five Actor Model
For now, though, let’s go back to basics, with what I call the “Five Actor Model” of payments:
Five main roles – network, buyer’s bank, seller’s bank, and the buyer and seller themselves, exist in all payment methods in some form.
A payment, of course, is an exchange of value between two parties, which we will call the buyer and seller. Typically, the seller provides a good or service, while the buyer provides money.
In the case of cash, this is all there is to it; part of cash’s continuing popularity is its anonymity and universal acceptance. For all non-cash payment methods, however, there is an element of risk involved, so the buyer and seller need someone to manage that risk. We will get into the types of risk later, but for now, let’s just focus on identity risk.
Identity Risk: the risk that a party to a transaction is not who they say they are, and do not have the legal or practical authority to make the transaction.
In order to address this risk, you need two more actors; the buyer’s bank and the seller’s bank. Each represents to the other than their party is who they say they are, and that they have the ability to make good on the transaction. You see this most clearly in credit and debit cards, where the banks take on the risk of fraudulent payments (often referred to as the “zero liability guarantee”).
However, the identity risk moves further up the chain. Who guarantees that the banks are authorized to support the buyer and seller? Who guarantees that the banks are following all the rules governing the payment method?
In order to address this risk, we move up one more level, to the network. The most well-known are the global card networks: Visa, Mastercard, Discover, and American Express. The function of the network is to establish the rules governing the payment system:
- Who pays fees, and how they are calculated;
- What sorts of transactions are allowed (how big, what sort of buyers and sellers are allowed to make them)
- How disputes are resolved; and
- What are the qualifications for participation in the network.
There are other functions which we will get to, but these are the most important ones.
Applying the Five Actor Model to Various Payment Types
To demonstrate that this simple model works for all payment types, take a look at Table 1, which shows how the generic names for the five actors map onto the specific terms used by the various common payment methods.
Table 1. Mapping the Five Actor Model onto Payment Types
How different payment types share similar functions, if not labels.
Across the top are the familiar five actors from Figure 1, starting with the network and moving clockwise. Down the left side are eight common payment methods, as well as a growing one, cryptocurrency.
- Credit, debit and prepaid cards (also known as gift cards) all share some common terminology, in that the seller’s bank is called the merchant acquirer. Prepaid cards are different, because while they may have a network icon (or “bug), they come in two main types: open-loop, which use an open network like American Express or Visa; and closed-loop, which use a bank’s proprietary network and cannot be used anywhere except the merchant who issued them. There is much more to say about this, but I will leave that for a future installment.
- ACH, or Automated Clearing House, was originally introduced to replace checks (see how well that worked out!). The networks are different, and there is a bi-directional flow, which is unique. ACH transactions can be “push” or “pull” payments; pushing money into an account, or pulling money out. For this reason, the banks can be either ODFIs (Originating Depository Financial Institutions) or RDFIs (Receiving Depository Financial Institutions). Likewise, the buyer and seller can be either senders or receivers. For example, if you enroll in automatic debit for a loan, the lender originates a request to pull money out of your account. However, if you pay the bill individually on the lender’s website, then you are originating a request to push money to the lender’s account. As with cards, there are many complications that we do not have time for here.
- Faster Payments, or real-time payments, are a newer form of payment that combine characteristics of ACH and wires. There are a couple of different models, but they have the low cost of ACH with the fast settlement and irrevocability of wires. Irrevocability means that once you send a faster payment, you can’t dispute it, the way you can with cards or ACH; you have to claim that the transactions was made fraudulently. Any problems with the receiver, such as not getting the product that was promised, have to be worked out with the merchant directly. Therefore, they work best for bill payments, disbursements (like payroll), and other situations involving trusted parties.
- Wires are like Faster Payments, but generally involve much higher amounts, and are much more expensive. They are typically used by businesses or brokers to exchange hundreds or millions of dollars at a time, including stocks and bonds. Security is more manual, and a lot more stringent. The low end of wires (sub-$100,000) is gradually being eaten away by ACH, and in the future, by Faster Payments.
- Checks are the oldest non-cash payment type (except barter), and have their own set of regulations. Over the past twenty years, checks have become more and more dependent on digital networks, to the point where a picture of the check, not the check itself, is all that needs to be exchanged. Cards, ACH, and Faster Payments are all competing with checks, but checks illustrate well the principle that payment networks gain value from acceptance. Despite all their problems and inefficiencies, checks are more widely accepted than any other payment method except cash. They are the lowest common denominator, and extremely hard to kill for this reason. Their use is steadily declining, however, and eventually it will be politically possible to discard them.
- Cash and cryptocurrency are grouped together because of similar characteristics; cryptocurrency is explicitly models on precious metals, the oldest form of cash. I include them here mainly to show how universal the five-actor model is. Even cryptocurrency, although it claims to be independent of any government financial system, nevertheless depends on exchanges, which themselves have to have banking relationships in order to allow their customers to put money in and take money out of the system.
I will stop for today with the observation that, stripping away the jargon and rules, all payment methods function in similar ways, and in principle, can be converted into each other. This is obviously more complicated than it sounds, but it is the direction in which we are heading. Faster Payments already shares characteristics of ACH and wires, and will be competitive with cards in the future, which is why the card networks are all furiously building ACH-like capabilities. Recognizing that payments are similar is fueling a lot of innovation, such as the “unbundling” and “rebundling” of payments functions I wrote about in an earlier post.
Let me know in the comments if you liked this article, and if you have any comments or questions.