Open Banking won’t kill card payments
We are true believers in Open Banking (look at our portfolio), but we still invest heavily in companies that rely on existing payment networks. Why is that? We want to explain.
Ever since the concept of Open Banking first emerged in the early 2010s, it has been seen as a way to improve competition and transparency in financial services. Giving consumers control over their data and making it easier for them to share helps to level the playing field between the big incumbents and nimble new entrants.
Nobody expected the banking industry to transform overnight, but progress has been slow. More than a year after Open Banking launched in the UK, only 22% of consumers were aware of it, despite 84% of financial services businesses claiming to have it in their offerings. And this is in the UK, which many see as one of the most advanced countries for Open Banking.
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We are firm believers (and investors) in the technology’s potential, but it has yet to break into the mainstream. Once it does, many believe its combination of open data, open APIs and instant payments will lead to the death of the card. We disagree.
Doom mongering about cards misses the point. Open Banking is undoubtedly the future of payments, but it’s not the whole future. The digital payments pie is growing, and there will be plenty of space for different approaches to flourish.
Cashless payments have been growing for some time, but the pandemic forced rapid and widespread adoption of digital and cashless transactions worldwide.
Perhaps because of this, payments technology has become one of the biggest investment trends in the technology world. There were more payments deals in Q2 2020 than for 2019 as a whole. Funding only grew in 2021.
This trend is just the start. Cash isn’t going to disappear entirely, but we don’t see it ever reaching the same level of usage it had previously. With billions more people using digital payments technology worldwide, the next few years will be vital in deciding how the future looks.
Open banking makes payments faster and smarter
At its most basic, Open Banking allows users to:
- Open up their banking data to third parties.
- Empower those parties to act on their behalf.
- Transfer money directly from one account to another, bypassing the current card payments infrastructure.
This alone may be enough to give you a feel for the technology’s potential, but to truly understand, it helps to look at what it replaces.
Every time you buy something with your card, a convoluted process begins:
1) The merchant’s terminal (or ‘gateway’, if you’re paying online) scans your card to determine the payment network. It then contacts the network to confirm you are authorised to transact.
2) The network then contacts your bank, which checks you have sufficient money and, if so, approves the transaction.
3) Your bank communicates this to the network, which passes it on to the merchant’s bank (the ‘acquirer’) to authorise the transaction. The transaction is then ‘approved’ on the terminal.
This is only the start. At the end of the day, the merchant’s bank begins the settlement process, communicating its daily transactions to the network, which requests the money from your bank.
The system, sometimes referred to as the ‘four-party model’, works well for the most part. It’s fast (transactions usually take less than 3 seconds to be authorised), and fraud levels are low.
It can be expensive for merchants, who pay a small fee for each transaction to the customer’s banks (known as interchange), the network and their bank (process outlined here).
These fees can be considered a security fee, protecting the merchant from fraudulent payments and allowing the customer to receive refunds. However, the card system (‘rails’) harks back to the 1950s and brings layers of complexity and cost.
Open Banking payments allow the customer to authorise the transaction directly from their banking app, pushing the money directly to the merchant’s account. The technology is newer, with fewer vulnerabilities, meaning there is no need for card networks to offer security or to charge the fees that come with it.
This leads to drastically lower fees. Our portfolio company Banked, an Open-Banking-based payments provider, charges 0.1% for facilitating payments, vs the 1–4% that merchants pay card networks. What’s more, Banked delivers the money instantly rather than after a settlement process.
These improvements primarily benefit the merchant rather than the consumer. Still, there is scope for providers to reinvest some of the cost savings in consumer rewards such as loyalty points or cashback.
All payments were not created equal. Buying a coffee on the way to work doesn’t need the same level of protection as buying a big-ticket item online that ships from overseas. Open Banking offers the opportunity to create faster, cheaper and ultimately simpler options for many of the small transactions we make every day.
Of course, there are still some road bumps Open Banking will need to overcome before it reaches full adoption. For instance, the current absence of chargebacks means payees are giving up a little security in exchange for a faster, cheaper transaction, so it won’t be appropriate for all purchase types unless a payment protection insurance option is added.
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Where it is used, merchants will enjoy much faster payments at a fraction of the cost. But the Open Banking story goes well beyond the simple movement of money.
Open Banking is much more than just payments
So what is the appeal for individuals? Here, Open Banking offers the opportunity to make their financial lives far more transparent and manageable. Allowing you to open up your banking data enables individuals to see and control their spending across all their accounts from one central hub.
Starting from a comprehensive picture of an individual’s spending makes it much easier to:
- Introduce budgeting (as with services like Emma)
- Automate cashback and rewards
- Analyse spending for people with limited credit histories, like Koyo Loans and Credit Kudos are doing.
Open Banking empowers individuals to understand their finances far better, earn rewards or switch providers effortlessly, or even use its APIs to automate time-consuming tasks away entirely.
There are still road bumps. Until March this year, users needed to reauthorise access to their data every 90 days. This created a retention challenge for Open Banking-based products. Customers were all but opted out of their services a few times a year. The FCA has now abolished that rule, so it will be interesting to see the impact on Open Banking usage.
So if Open Banking offers time and cost savings and far greater flexibility and transparency to consumers, why do we think cards have a future?
Cards offer security and control to payments infrastructure
Open Banking has grown steadily in recent years but hasn’t yet led to the death of the card. The opposite, in fact.
In recent years, the number of cards in circulation has grown steadily, with 97m in the UK alone in 2019/20. However, this growth is partly driven by a fundamental reshaping of what a ‘card’ is and who offers them.
Ironically, one of the factors leading the growth of cards has been the sidelining of the physical cards themselves. 86% of the cards mentioned above were contactless-enabled, meaning they could be used for fast, PIN-free transactions either using the physical card or on smartphone-based platforms such as Apple Pay and Google Pay. Even pre-pandemic, Visa was reporting staggering growth in contactless payments worldwide.
Amid the excitement about Open Banking, it’s easy to forget how incredible cards are as a technology. They are essentially tiny computers that you can use anywhere to move large sums of money in seconds. They are very secure and don’t require batteries (a key advantage over smartphone-based payments, just ask the Financial Times journalist who found herself facing criminal charges after her phone ran out of battery on a bus!)
For all their backend complexity, cards are painless for consumers, even for more advanced functions like chargebacks.
The fees charged to merchants mean cards are a more expensive form of payment than cash or Open-Banking-enabled bank transfer. This cost is easy to justify as a simple security fee when purchasing online or in other scenarios where card-not-present fraud is possible. And as cards have moved toward contactless payment and then smartphone-based contactless payment, ease of use has only improved.
The next stage of the card’s evolution is a further step away from the physical and reshaping how we think about financial services.
Card infrastructure enables embedded financial services
If Open Banking is valuable because it can open up your finances, card technology is useful for its constraints. Issuers can impose limits on how card users can spend balances, and card networks provide security and enable chargebacks for refunds.
In short, they form the perfect infrastructure for companies to build on.
Andreesen Horowitz publicised the idea that one day soon, ‘every company will be a fintech company’.
In short, they believe ‘embedded finance’ companies such as our portfolio companies Weavr and Banxware are making it drastically more accessible for any company to offer financial services. They will make it easier to provide financial services in the same way Shopify or AWS made it easier to start an e-commerce or software business over the last decade.
Financial services businesses will cease to be consumer-facing by default. Instead, they will become the backend financial infrastructure that allows non-financial brands to offer financial services.
Think of it this way: Uber and Lyft already offer banking services directly to their drivers, e-commerce merchants can set up bank accounts with Shopify directly. Uber, Lyft, and Shopify aren’t finance companies, but people rely on them for financial services. Over time, it will become cheaper and easier for more companies to offer banking, lending, payments and other services.
By offering these services, customers can access financial services through brands they know and trust. At the same time, companies can earn additional revenues, deepen their relationship with customers and improve retention. Cards are a crucial part of how they do this.
Take the example of Outfund, a portfolio company of ours that provides growth capital to e-commerce companies. Money is provided through virtual cards. Companies can only spend it in ways pertinent to growing the company, such as Google ads or inventory. This drastically de-risks lending and allows borrowers to access better rates.
And this is just one application. The success of companies such as Marqeta and, more recently, Weavr and Highnote speaks to the demand for card-issuing services from businesses of all kinds.
Card technology has a promising future anywhere you need spending to be monitored and controlled — from corporate cards to family pocket money.
Card technology is extremely well established and available around the world in a way Open Banking isn’t yet. This opens up avenues for innovation, as our portfolio company Pomelo Pay shows. It allows merchants to accept payments anywhere, through any payment method, independent of the consumer’s payment behaviour.
Open Banking isn’t there yet, but it’s growing quickly
Even as the UK and Norway lead the pack in terms of Open Banking adoption, there is still a long way to go. The UK’s Open Banking Implementation Entity reported in November 2021 that an estimated 8% of digitally enabled consumers regularly use at least one Open Banking-enabled service, up from 5.5% in December 2020. That’s an impressive growth rate, but it’s far from a majority, and well below the levels we expect the technology to reach.
But this doesn’t mean that Open Banking is the be-all and end-all. As it gains popularity, it could pressure incumbents to cut prices — as we’ve seen in the recent spat between Amazon and Visa in the UK. However, as embedded finance reshapes how people consume financial services, card technology offers a robust and well-established infrastructure to underpin the transition.
We are excited about the future of payments, and if you are building something that will shape it, we want to hear from you! Get in touch via pitch@fomcap.com or by signing up to Floww.
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