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Payments vs Transfers

Many people don't understand the difference between payments and transfers:

A transfer is the simplest operation: you move money from account A to account B. They can be irreversible and in many cases, the same entity often controls both accounts. For example, you send money from your bank to your broker.

A payment is made in exchange for goods and services and it has an implicit contract associated. The rules of this implicit contract are codified in the payment network rules.

The value of a payment network

We could absolutely build a crypto payment network (and that would be great) but it is important to recognize what are the many functions of existing payment networks before calling them obsolete. For payments to work well, you need:

Buyer guarantees

Credit for the buyers and seller's guarantees

Dispute adjudication

Foreign exchange services

A recognized brand and an “acceptance network”

Compliance

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1. Buyer guarantees

If sellers don't deliver the goods, buyers want to know they’ll get their money back. This requires somebody to onboard and control the sellers and take the risk if one of the sellers runs away with the money before delivering the goods.

In the Visa network, this has been done historically by "acquirer banks" that have relationships with merchants. Wells Fargo, Chase, and Bank of America all have an acquiring business. In the last 15 years, acquirer banks have passed on the burden of onboarding and underwriting risk to payment processors like Stripe and Square. Commerce is growing too quickly for banks to underwrite everybody that wants to set an online store.

When underwriting merchants, the key variables are:

Certain industries like cruise ships and events have a long return window: they charge you today but deliver their services in 6 months or more. The payment processor accrues risk proportional to that return window. If a grocer goes out of business, there is a week or two of payments to refund. But if a cruise company goes out of business, there are +6 months worth of payments to refund.

Those industries also have highly correlated refunds: one canceled cruise ship is a lot of refunds. Cruise companies are likely to go bankrupt if their cruises have to be canceled because they simply can’t pay all those refunds at the same time.

Overall fraud rate of the industry: the gift card industry is prone to scams, so acquirers have learned that merchants routinely run away with buyer’s money at a higher-than-usual rate.

Cash doesn't have buyer guarantees and as such, people are wary of using it for large purchases to be delivered later (but are fine with using it to buy chocolate in a kiosk).

Cost: Buyer guarantees have a cost directly proportional to the total payment.

2. Credit for the buyers

Consumers spend a lot more if you give them credit. Merchants (with high margins) are usually happy covering many of the associated fees because they make it up in increased volume. In the Visa network, card issuers like Chase and Capital One provide that consumer credit when they issue you a credit card and a credit line.

Debit cards are also issued by these issuer banks and part of the payment network but they have no credit associated. And as you'd expect, the average order value of debit cards is often much lower than credit cards, even for the same merchant

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. If the consumer defaults on their credit, it is the issuer's problem. Merchants don't need to be underwriting each customer individually.

Buyer’s credit was not invented by card networks. Stores used to extend credit to its buyers and keep a tally of how much each one owed (before computers!). One of the main innovations of the card networks was managing this credit for smaller merchants

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and one of the reasons that merchants were happy to accept them. From Chapter 1 of

Electronic Value Exchange⁠

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[A merchant] had three girls working on Burroughs bookkeeping machines, each handling 1,000 to 1,500 accounts. I looked at the size of the accounts: $4.58. $12.82. And he was sending out monthly bills on these accounts. Then the customers paid him maybe three or four months later. […] His accounts receivables were dragging him under.

Most consumer credit in the US is revolving credit: you draw from it as you buy things, and you pay your outstanding balance wherever you can. But credit can take many forms:

In LATAM installments are more popular: you buy an item today and pay over 12 installments, one a month (“coutas” in Argentina, “parcelas” in Brazil, “meses sin intereses” in Mexico).

Buy Now Pay Later (BNPLs) are the latest form of consumer credit: you pay in 4 installments, every two weeks to match salary payments. This is increasingly popular where revolving credit is popular but not really interesting wherever installments are already common.

Cost: Providing credit has a cost proportional to the amount of the purchase.

3. Dispute adjudication

When buyers and sellers disagree, the network needs to adjudicate the dispute. This is expensive because it requires human attention and nobody wants to do it. Neither the seller nor the buyer (or any agents that represent them) can credibly do this work, so you need a third neutral party. In the case of Visa, it is supposed to be the network but in practice the issuers do some of this work, which is why merchants largely lose disputes.

This is not always necessary. Buyers trust aggregators like Amazon to return their money if there is a problem. But without buyer guarantees and a dispute system, smaller merchants have a harder time getting off the ground.

Cost: Adjudicating disputes has a fixed cost per dispute, but a high one.

4. Foreign exchange services

Let’s say the buyer wants to pay with 100 USD and the merchant wants to receive 100 EUR (on the purchase day the FX rate was 1:1). Somebody needs to:

Provide the seller’s currency (EUR) and take the buyers currency (USD)

Nobody naturally wants to be holding all sorts of currencies. FX rates fluctuate everyday and you need to be very careful if you are exposed to those fluctuations.

Hold the FX risk during the return window

Two months after the purchase, the buyer asks for a refund. The FX rate is now 1:1.2. The merchant wants to return 100 EUR but at current rates, that is no longer enough to cover the 100 USD the buyer wants to receive. Somebody needs to produce the missing USD. Who is holding that risk?

Cost: Both of these services have a risk proportional to the total amount of the payment.

5. A recognized brand and an “acceptance network”

Consumers only know to pay with a “payment method” if it is advertised to them often (i.e. a brand) and there are a lot of merchants that accept it (an “acceptance network”). The network effects in payments are very strong. You know how all shops have Visa and Mastercard signs

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stuck to their windows? It takes a lot of work to make that happen in most of the world. A global payment network doesn’t just manifest!

Cost: The cost of maintaining this network and brand is not linearly related to the network's processing volume but definitely proportional.

6. Compliance

You may not think as compliance as "a job to be done" but as soon as regulators start chasing you, you will! The regulators want to prevent certain goods and services to be exchanged for money (drugs, sex, etc.) and they pressure anything that functions as a payment network to do their bidding.

This is far from perfect but it allows large companies and the government (large sectors of the economy) to use the card networks.

While keeping compliant is a value-proposition to most actors, it less important for decentralized systems like crypto

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Transfers have fixed costs, payments have variable costs

Transfer systems are much easier to set up because they don't provide all these services. Importantly, they can have “fixed” costs where the cost of a transaction is not proportional to the amount of the transfer. The transfer system is not exposed to any variable costs.

But as you saw, 4/5 of the payment services have variable costs and as such, need to have a variable rate to operate.

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