Moving Money: The Future of Consumer Payments

3 Innovation and Evolution of the Payments Industry

Technological developments involving the Internet, web-based software, wireless communication, computers, and data analytics are coming together in ways that promise to transform how consumers and merchants transact with each other.1 Payments, behavioral targeting of advertising and marketing messages, location-based targeting of advertising and marketing messages, and e-commerce including mobile commerce are being integrated in ways that will transform how consumers and merchants interact with each other. Unless public policy interferes, these mashups2 will likely reshape—and enhance—the payment experience for consumers and merchants. Many commentators focus on how we will pay at the point of sale and the role that Near Field Communication (NFC) on contactless cards or mobile phones will play in that.3 We posit that the physical method of payment—often called the form factor—will in fact vary across geography and over time as a result of past investment decisions in hardware , software, and processes in the payments ecosystem. The mashups we believe will reshape the industry as we know it today will not, however , depend on the form factor. The physical method of payment at the 3 Innovation and Evolution of the Payments Industry david s. evans and richard schmalensee 36 We would like to thank the Brookings Institution for financial support, Karen Webster for helpful comments and suggestions, and Cheryl Morris for exceptional research support. 03-0277-1 CH 03:03-0277-1 CH 03 5/23/12 5:06 PM Page 36 point of sale is a detail in a much larger transformation of the purchasing experience for consumers and merchants. To dwell only on the payment factor as enabling innovation in payments, in fact, minimizes the impact that technology will have on this industry. Our goal in this chapter is to describe how these mashups could affect the evolution of payments over the next decade. History has shown that nothing is inevitable in the payment card industry. The cost of changing already good methods for buyers to pay sellers can well exceed the benefits of innovations. Government policy can also affect the direction of change by overruling the market and by adopting policies that, despite the best of intentions, have unanticipated adverse consequences for consumers and businesses in the complex payments industry. During this period of creative destruction now sweeping the payments industry globally, policymakers should especially heed the Hippocratic warning “Do no harm.” Electronic Payment Card Industry Today The U.S. electronic payments industry is based on a network that moves money between consumer and merchant bank accounts using computers , software, and communication links.4 Origin of Payment Card Networks The technology that underlies today’s payment card networks was first widely deployed in 1979, when Visa introduced the first electronic data capturing terminal.5 Mainframe computers did most of the processing and storage in central locations. Consumers had magnetic stripe cards and merchants had electronic terminals. At that time the merchant swiped the card through the reader to start the process of authenticating the consumer and authorizing the transaction. The swipe initiated a signal that traveled through a series of intermediate computers that switched the transaction to a central processing unit. By exchanging signals with the cardholder’s bank to assess the cardholder’s account, this unit then determined whether to authorize the transaction. If the Innovation and Evolution of the Payments Industry 37 03-0277-1 CH 03:03-0277-1 CH 03 5/23/12 5:06 PM Page 37 transaction was authorized, the unit then exchanged signals with other computers on the network to move the designated amount from the cardholder’s bank to the merchant’s bank. The various computers were connected over private networks that interconnected as necessary. One can think of this computer system as being based on the interaction of two thin clients6 at the point of sale: the magnetic stripe card that contained a small amount of data on the consumer, and the pointof -sale device that contained little intelligence. Most of the work for the network was done at various hubs, especially the central one belonging to the owner of the card scheme, which consisted of multiple large computers . MasterCard and Visa have upgraded their systems over time but the basic architecture has remained the same. These networks are more complicated than they might seem at first glance. At the periphery of the networks are individual merchants, the larger of which operate in many...