The US Payment System
The US payment system was previously either the physical transfer of actual currency from a consumer or business to a merchant who then deposited the funds into a financial institution or the issuance of a check on the consumer’s account and negotiation of the check by the merchant to a financial institution and the transfer of funds between financial institutions.
The US payment has now evolved into an informational network in which a consumer initiates a purchase of a physical or digital product through an electronic network for the exchange of funds between consumers, merchants and financial institutions. The government regulates the electronic network through its rules and regulations and determines the amount of costs allocated and profits allowed to each member of network.
The electronic network currently is separated into three distinct payment paths: ACH; debit and credit.
The ACH is characterized by the digitalization of physical or digital checks with the processing being handled by financial institutions and their related companies. The cost of the system is low because the information is digital. The risks in the system are that the sender does not have funds in their account to cover the purchase. As a result, ACH is not generally available for the immediate purchase of goods unless the consumer is known to the merchant, or the delivery of the goods will not occur until after the merchant knows that the funds are available.
The debit network is a closed loop system operated by financial institutions in which a financial institution issues a debit card to allow immediate access to available funds in the consumer account. The merchant is assured that the funds are available because the bank has confirmed the balance in real time. Accordingly, the risk of loss to the merchant is low and because of the regulations, the consumer is responsible for the safe keeping of the debit card and the access codes necessary to activate the debit card.
The government regulates the amount the banks can charge for a debit transaction. The benefits of the law changes allow consumers to retain more of their funds. The limitation of the system is that the consumer has to have funds available at the time of purchase. The debit network is triggered by the consumer selecting debit at a point-of-sale device.
The credit payment path has multiple sub-paths depending on the availability of credit to the consumer. The costs of credit to the consumer are determined by the consumer’s credit history and the associated risk of repayment and/or the risk of fraud in the transaction stream.
The typical credit transaction involves multiple parties in the network. A financial institution issues a credit card with a certain credit limit with the bank taking the financial risk of the person not paying the debt. For taking this risk, the bank charges high rates to the consumer.
The consumer activates a purchase through a point-of-sale device operated by merchant and connected to a private credit processing company (typically VISA, Mastercard, etc.). The electronic request for credit is processed over an ultra-high-speed network coupling the card to the device to the issuing financial institution and the returning electronic informational approval sent back through the system to the device. The costs of operating the system are costly but the costs are borne by the merchants who receive less than the purchase price of the transaction. This cost is commonly referred to as the merchant discount rate and is typically 2% to 5% of the total amount depending, of course, on the industry and the related risk of loss. The system mitigates the risks by charging the merchant for losses rather than the bank or the VISA network. As a result, the system is highly profitable with relatively low fraud losses.
This credit system has been dominated by several large firms and the related bank systems. Competition with the existing system would require either government action in regulation or duplicating the existing POS system with all the merchants. Neither alternative is practical at this time.
A relatively new system of credit is developing, namely buy now pay later (BNPL). The BNPL is a system activated at the merchant POS which allows the consumer to buy now but pay later in instalments, at no interest. The cost of the credit is borne by the merchants who pay the BNPL finance companies (BNPLFC) interest on the funds or a set percentage of the purchase. The risk of loss on the purchase can be allocated between the merchant the BNPLFC as determined by their agreements or by the BNPLFC. The benefits to the consumer are evident in that they can buy now and pay overtime without the high credit card interest rates and can match the payments to their cash flow. The benefits to the merchant are immediate sales by over covering the sales objection of no funds available or high payment costs or high interest costs. The merchant can also control their financing costs by limiting the BNPL option or sharing the risk with the BNPLFC.
The current problem with the development of the BNPL is the time necessary to obtain approval of the transaction and the lack of integration into the POS system. Consumers do not like to wait and have expectations of immediate answers.
In order for the BNPL to rapidly expand and for the restrictive control by the VISA Net over credit transactions to be loosened, a new dynamic system has to be developed. The combination of the existing debit network and block chain technology can create such a new dynamic evaluating structure at low cost.
The system would operate as follows:
The consumer would go to the merchant in the same manner as always but would use a special bank issued debit card. Since the card is issued by a bank under their KYC rules, the identity and credit history of the consumer would be known and available for evaluating BNPL risks. The consumer would go to a mobile application on their phone to ascertain the availability of BNPL options or other credit alternatives. The merchant would be known because of the GPS location of the consumer or a consumer selection. The consumer could then see their alternatives prior to making the purchase decision. This method would allow the consumer to know options and accordingly help the merchant to overcome the risk of rejection by the BNPLFC.
Once the consumer links their card, the POS device would trigger the debit network.
Instead of the consumer going directly to the debit network to check on the availability of funds available in their account, the consumer will be presented with options. These options, which would need to be presented quickly to the customer, are;
BNPL from the primary BNPLFC
BNPL from a BNPLFC willing to accept a lower rated credit consumer
Loan against financial assets of the consumer (line of credit or crypto)
New credit line issued by a credit card company
In order to obtain such speed, the request would need to go through a direct high speed block chain to various related companies (Merchant BNPL, Third Party BNPLFC or financial institutions). The Hedera network can run transactions outside the private gateway on a public gateway/ledger system as fast as VISA Net but at a lower cost.
The consumer can then choose their option immediately with the net funds being readily available to the merchant.
The system operates by using the government regulated low-cost debit network with the high-speed new block chain technology and can be coupled with direct machine learning (Ai) in the BNPLFC to facilitate faster responses.
Written by Ken Mages
CTO, Hamilton's Reserve Inc.