Mastering Risk Management in the Digital Payments Space: what’s new and how to thrive
By Julio Prado
Paradigm shift providing merchant acquirers with the opportunity to either follow in the footsteps of Stripe or fall behind.
The payments industry is currently undergoing a significant amount of change. We will focus on three main pain points; the ramifications that the COVID-19 pandemic has had for merchant acquirers from an economic perspective; from a behavioural viewpoint; and overarching market developments that are intensifying competition and increasing market opportunity.
In 2010, two Irish brothers named John and Patrick Collinson, founded a company called Stripe, in Silicon Valley. Stripe was created with the intention of helping online businesses accept digital payments without having to go through the traditional payment process, which involves a complex network of players and transaction fees. Now, digital payments are quick and efficient, but in 2010, the payment industry was cumbersome and opaque. Stripe launched its services in 2011 and quickly became a Silicon Valley darling. Charging 2.9% per successful transaction, Stripe began to quickly grow, and on the 14th of March 2021 it became the then most valuable private company in Silicon Valley, valued at $95 bn. It surpassed Facebook, Uber and others before going public. This begs the question - how?
One of the critical factors that has enabled Stripe to become such a highly valued company is the COVID-19 pandemic. Over the past year, merchants have had to shift operations from the physical world to the digital one. This is where companies like Stripe come in. Stripe helps retailers easily set up the needed digital architecture to accept online payments. During the pandemic, many retailers have been required to transition from accepting payments in cash to accepting digital payments. This transition was already underway but the pandemic has accelerated the transition. As a result of this, card payments have drastically increased, greatly benefiting most players in the payments industry, and not just Stripe. Notwithstanding, within this ecosystem, a specific type of payment institution called merchant acquirers has also felt the damaging side of COVID-19. Merchant acquirers are exposed to a specific type of credit risk which has made them somewhat vulnerable in this scenario. As this article hopes to explore, the pandemic is just one element of a wider discourse in the payment industry, which is experiencing a paradigm shift. This shift will provide merchant acquirers with the opportunity to either follow in the footsteps of Stripe or fall behind.
The intricacies of the payment industry
The payments industry is complex and intricate. It is worthwhile to briefly review how the industry operates in order to adequately understand how it is changing. Traditionally, the payment value chain is comprised of three agents standing between customers and merchants: merchant acquirers; card networks; and issuing banks. Merchant acquirers are financial institutions which process payment transactions for companies or merchants. Card networks provide the infrastructures that enable payments to move between entities, i.e. Visa and Mastercard. Finally, issuing banks are the banks that issue credit and debit cards to individual customers on behalf of the card networks. These three entities work together behind the scenes whenever card purchases occur.
For example, when we pay for a coffee in the morning from our end we simply tap the payment terminal or insert our pin code and we are done. This brief interaction triggers a much more complex chain reaction. When we make such a payment, the transaction gets sent to the merchant’s issuing bank, which passes on the transaction to the card networks, which further submit the transaction to the customer’s issuing bank. The issuing bank checks that the customer has enough money in their account to make the purchase. If so, it sends a confirmation that the customer does have sufficient funds to fulfil the payment back through this chain (through the card network, to the acquiring bank, to the merchant). All of this occurs during a couple of seconds that you have to wait between tapping your card or inputting your pin and the payment terminal displaying “PAYMENT ACCEPTED” on its screen. This is a high-level explanation of the standard value chain within the payments industry. However, additional components have been added to this process.
Over the years, payment intermediaries have appeared, adding or removing extra steps within this value chain. Examples include independent sales organizations (ISOs), which act as intermediaries between merchants and merchant acquirers. Stripe is such an example. These ISOs gather all the payments between merchants and merchant acquirers and send these through to the acquirers. Other examples are payment facilitators (PayFacs) and payment-service-providers (PSPs), which provide an open banking solution that streamlines this entire process. These have blurred the previously defined lines within the industry, and toughened competition. All of this, however, has been exacerbated by the PSD2, a directive we will explore further on.
The rise of Credit Risk
The first important thing to note is that merchant acquirers are the first and last point of contact when merchants and customers engage in a transaction. In this way, they open and close the payment cycle. The second, is that during the entire chain explained above, no money is actually being passed. All that is being passed on is the request and confirmation that the customer either has or does not have the funds to complete the transaction. The actual payment occurs a couple of days later, when the merchant bundles all of its transactions (over the past days) and sends these to the merchant acquirer, which sorts these and claims the funds from the corresponding banks, and finally passes these payments to the merchant. This is why when you make a payment by card, you do not see the money leave your account immediately. As a result of this, merchant acquirers are exposed to three types of risk:
- Card refunds, where the merchant voluntarily returns the money to the consumer;
- Card reversals where the merchant cancels the payment after it has been accepted but before the settlement has occurred;
- Card chargebacks, which are triggered by the consumer after the settlement has occurred, due to a dispute between the customer and the merchant over various possible reasons, including: a dispute over the validity of the transaction, the service or product not being provided, or bankruptcy.
We will now concentrate on the latter of these risks, given that merchant acquirers are predominantly affected by this type of risk, which turns into a credit risk, as discussed below.
Since no money has been initially exchanged, this means that in effect, the merchant acquirer has extended a “line of credit” to the merchant on behalf of the customer. The merchant, on the other hand, guarantees to provide the purchased good or service. However, in the event of the merchant going bankrupt, they would fail to deliver the purchased good or service. In this event, the customer usually files for a chargeback against the merchant, but given that the merchant is bankrupt, the chargeback automatically goes against the merchant acquirer, since they were the ones that extended the “line of credit”. This is one specific scenario of chargebacks impacting merchant acquirers negatively. However, chargebacks are something merchant acquirers have to deal with on a daily basis, given that card networks will fine or avoid working with merchant acquirers with a monthly bounce rate above 1%. Regardless, this specific type of credit risk can be overlooked by merchant acquirers, since these usually carry out deep due diligence and “Know Your Customer” procedures before signing-up a new customer. These upfront procedures provide them with the confidence that their customers have a solid financial foundation, or, for those that don’t, that a contingency plan is implemented. These procedures have provided positive results for many merchant acquirers given that they can be relatively confident of the future financial position of their clients. Unfortunately, this has now changed as a result of the COVID-19 pandemic and its subsequent economic consequences, placing merchant acquirers in a vulnerable position.
COVID-19 from an economic perspective
For over a year, COVID-19 has forced virtually all businesses and individuals to adapt to a new normality that has caused almost all businesses to see a drastic fall in revenue. Social distancing, curfews and limited services, albeit a necessary health precaution, have taken a significant toll on economic activity. Juniper Research(2020), for instances, suggests that overall retail spending has dropped 14% globally, directly impacting the payment industry. McKinsey (2021)found that the payment industry, which was growing by around 7% annually, dropped by 5%-7% compared with revenues of the previous year. In order to prevent a drastic recession, European governments eased monetary and fiscal policy, through government backed debt flowing into the economy. This has been done at an unprecedented level. Just to put things into context, the fiscal response to the COVID-19 crisis was three times larger than that of 2008-2009, fiscal packages are estimated to have gone over $10 trillion (McKinsey, 2021). Western European countries have allocated around $4 trillion between them (McKinsey, 2021). This amount is 30 times greater than the value of the Marshall Plan adjusted to present day value (McKinsey, 2021). In the UK these policies took the shape of CIBLS, BBLS and CLBILS, which have emitted a total of around £70 bn in debt (House of Commons Library, 2021). Almost all businesses were granted access to these, which resulted in over a million and a half businesses taking these loans to avoid bankruptcy (AccountancyDaily, 2021). In fact, so many businesses have taken on this debt that bankruptcy levels towards the end of 2020 were better than those during 2019. Insolvencies in the UK dropped by 34% and liquidations by 41% (The Insolvency Service, 2020).
Even though these schemes did prevent a wave of bankruptcies at the beginning of the pandemic, it may merely have delayed them. Since many companies overleveraged on these loans and saw a drastic fall in revenue, their credit status has been badly damaged. Furthermore, overleveraged accounts and damaged credit scores, suggest that many of these now fall outside the risk appetite of banks, further affecting their capacity to repay these loans and borrow additional funds. This is already beginning to become apparent when looking at the new British financial aid scheme, the Recovery Loan Scheme (RLS) . The RLS is the replacement scheme aimed to fill in the void left by the CBILS and BBLS. However, this scheme has tougher credit checks and higher interest rates than its predecessors (interest rates are as high as 15%) making it a lot harder for companies to be eligible for this scheme. According to one of the largest UK banks, on the second day of these schemes going live, they received less than 500 viable applications. This same bank approved around 2,000 applications in the first two days of the BBLS going live (SmallBusiness, 2021). Furthermore, not only do businesses still have to operate in tough conditions, but now they also have to repay their previous loans. This increases the risk of bankruptcy, and as a result, the risk of merchant acquirers seeing an increase in charge backs. However, as previously explored, there is a silver lining. The payments industry has been one of the few industries that in some way has also benefited from the pandemic as a result of customer purchasing habits changing.
COVID-19 from a behavioural perspective
Aside from an economic impact, COVID-19 has also forced customers to change their purchasing habits. This is not exclusive to what customers spend their money on, but how they spend it as well. Health concerns during the pandemic has exacerbated the use of digital payments over cash. Although most transactions around the world are still conducted in cash, the percentage was rapidly falling before the pandemic, from 89% in 2013 to 77% in 2019 (Economist, 2019). The COVID-19 crisis has exacerbated this trend. During 2020, digital wallets accounted for 25.7% of transactions at point-of-sale payments while cash accounted for only 20.5%. The increasing adoption of digital payments has also fuelled the rapid growth of e-commerce by providing faster and easier payment experience. During 2020, omnichannel shopping sales have grown by 50% (Nielsen, 2020). Omnichannel provides shoppers with a multitude of ways to shop online and receive their products, most of which do not involve the use cash as part of the transaction. As a result, a diminishing use of cash becomes apparent as digital payments become the popular alternative.
These trends are expected to continue in the post-COVID era. A study carried out by Mastercard in 2020 found that 79% of people globally used contactless tap-and-go payments at point of sale. The same study found that 74% of these would keep using contactless payments beyond the pandemic (Mastercard, 2020). All of these trends provide merchant acquirers with a growing number of users and as a result, a growing market. Therefore, even though the COVID-19 pandemic has increased the risk of potential chargebacks, it has also stimulated a digitalisation trend which has intensified market growth. However, there is one more component that is contributing towards this paradigm shift, and this is the PSD2 regulation.
Introduction of the PSD2
Another challenge faced by merchant acquirers is the appearance of the “Payment Services Directive 2” or PSD2 which went into effect at the end of 2020. The directive aims to increase security and consumer choice by enabling third-party payment providers (or TPPs) to enter the industry. TPPs enable businesses to accept online payments through open banking instead of having to go through the traditional payment network (Sage, 2020). However, the services of TPPs are not exclusive to businesses such as PayPal, any merchant or even merchant acquirer can become a TPP, all that is needed is a Payment Initiation Service Provider (or PISP) license and an Account Information Service Provider (or AISP) license. These two licenses enable both merchants and merchant acquirers to request open banking information from clients and if accepted, request payments from these (CardAlpha Consullting, 2018). This can enable merchants to integrate their digital payments within their own value chain. However, it is important to remember that for open banking to carry out transactions, it must first ask for permission from users.
Hence, the inclusion of TPPs in the industry is not exclusively going to toughen competition, but also blur the lines within the sector. Since this directive was introduced in 2018, the use of TPPs has drastically increased: from 2018 to 2020, the amount of API calls generated leaped from 55.8 million to almost 5.1 billion (Payments Industry Intelligence, 2021). A survey carried out by the Open Banking Implementation Entity together with Ipsos MORI found that since the start of the pandemic, the UK’s small business community is increasingly utilising the services offered by open-banking providers as businesses look to future-proof their business operations (Open Banking, 2020).
The inclusion of TPPs is expected to toughen competition between the different types of players in the market, which encourages merchant acquirers to take on added risks to remain competitive. The appearance of TPPs comes at a time where merchant acquirers are faced with much higher levels of credit risk than before, as discussed previously. Now that competition is also toughening, merchant acquirers are faced with a challenging environment and might have to face further risks. As a result, it is of utmost importance to make sure the credit risk process in place is effective and quick.
Opportunity, threat & speed
As can be seen, the payments industry is undergoing a true paradigm shift, both as a result of regulation changes and the intensification of already present digitalisation trends. These changes present merchant acquirers with opportunities, threats and a need for speed. On the one hand, the COVID-19 pandemic has exacerbated digitalisation trends in the retail industry which has accelerated the use of digital payments, providing merchant acquirers with a rapidly growing market. This has provided these with the opportunity to capitalise upon it by onboarding new clients. On the other hand, the COVID-19 pandemic has also increased the risk of bankruptcy for businesses, predominantly SMEs. Therefore, while merchant acquirers will want to capitalise on the expanding market, it is important to do so in a risk-controlled manner to avoid chargebacks.
Again, the regulation changes enacted towards the end of 2020 have introduced new players in the market, TPPs. The main competitive advantage that TPPs have is that they leverage open banking to make payments, in this way, circumventing the entire payment chain. Even though commissions are higher when compared to those of merchant acquirers, they require a much simpler and cheaper set up, making them more appealing to small retailers. By using open banking, payments are done instantly, funds are transferred directly from the customers bank to the merchant’s bank. Even though any merchant acquirer or even merchant can become a TPP, the introduction of these companies and innovative services, provides merchants with more choices. More choices for merchants means tougher competition standards for merchant acquires. Hence, the speed element becomes apparent. Thus, merchant acquirers need to capitalise on the growing number of opportunities appearing as a result of market growth, while differentiating between viable and non-viable customers as a result of the overleveraging issue, and all of this with a need for speed, given the intensification of competition.
Wiserfunding works for today and not just yesterday
Pre-COVID-19, the payment industry was dominated by manual and lengthy processes which generated significant bottlenecks in the industry. For instances, according to Stripe, the underwriting process could take anywhere between 5-12 months. Furthermore, the monitoring and credit risk analyses of companies was carried out by teams of analysts with the objective of gathering as much information as possible from the company on a regular basis to complete analyses on an ongoing basis. According to Stripe, this costed about a quarter of a million pounds. Of course, with COVID-19 all of these face to face, lengthy and manual processes have all had to be digitised, but doing so quickly, effectively and achieving a positive outcome, is a hard task. At Wiserfunding, we believe we can help with all of the pain points explored above in a digital manner. The below table details how:
|Opportunity||Prospecting tool: Our prospecting tool provides our customers with the opportunity to generate extensive lists of potential clients, while applying filters to these to ensure that these fit within the companies target market and target risk levels. Leveraging this tool enables merchant acquirers to quickly identify new opportunities that fit within their risk profile, allowing them to quickly capitalise upon them.|
|Threat||Credit Rating Tool: Our credit rating tool enables merchant acquirers to generate credit reports on any company with a turnover up to £200 million in under ten seconds. These reports leverage the best of academia with years of credit risk experience to provide our clients with over 200 data points as well as an SME-Z score, an S&P bond rating equivalent, a one-year point-in-time PD and an LGD. These reports are 30% more accurate than the market standard.|
|Speed||Both of these solutions are fully digitalised and enable customers to see results instantly. We take a holistic approach to these reports, providing our clients with not only information about the company, but also the industry and country. Many of our clients use these as an initial screening tool, given that large numbers of companies can be processed at once. These help our clients quickly identify and differentiate viable and non-viable companies, providing them with a competitive advantage over other players in the market.|
There is no doubt that the payments industry is undergoing a tremendous paradigm shift in the middle of a ground-shaking pandemic. This places merchant acquirers under added pressure, given the vulnerable position these are in as a result of their exposure to a very specific type of credit risk. Not only are they under more pressure from a credit risk point of view, but also from an intensification of competition and a growing number of opportunities. Over the next year, merchant acquirers will have to juggle all of these moving pieces and possibly more if they want to become the next Stripe. It is important to see these changes as an opportunity to strengthen merchant acquirers instead of a threat to their presence in the industry.
At Wiserfunding, we want to help merchant acquirers through these turbulent times and ensure that you belong to the winning team when and if the winds of change lessen. We believe that our prospecting and credit rating tools can aid merchant acquirers quickly identify and distinguish opportunities from land-mines and thus help these capitalise upon existing and future opportunities.
Our services are not just for upfront merchant selections. We constantly update our data bases to reflect merchant changes that can be better or worst than in the past.