How to achieve safety in payments

The technological opportunity in payments

In the old days, the field of payments was inextricably interlinked with banking. Money was only held in bank accounts; the only way to move money around was through banks.

Advances in computer technology coupled with financial innovation have changed all this. Banks are no longer the only game in town for the business of holding money. An array of innovators are now in the payments game. A few interesting examples are:

  • Paypal is a pure-play Internet company, which rides on top of bank accounts, and gives users a payments solution.
  • Western Union moves money from person to person across the globe without referencing a bank.
  • M-pesa, in Kenya, does payments over mobile phones. Money is fed into a phone as with topping up a pre-paid card. Money is then transferred to another person using an SMS.

These developments have far reaching ramifications. We can now think of payments as a distinct industry, one that is not joined at the hip with banking. Banking is primarily a risk management business, of coping with callable deposits which have an assured rate of return, even though the assets are opaque and risky. In contrast, payments is primarily a computer technology business, closer to the working of a depository or an exchange.

As Merton Miller said, banking is a disaster-prone 19th century industry. If a critical function like payments can be increasingly decoupled from banking, it would make the world safer.

There are two distinct problems in payments. The first is the systemically important payment system which is the core utility of the currency. In India, it is the RTGS. This is an entirely separate issue. The present discussion  is about the second component of the field of payments: the non-systemically important payments systems which are used by households and firms. This is an ordinary financial technology business.

The problem

When person X wishes to transfer Rs.100 to person Y, if the banking channel is used, the steps are as follows:

  1. Person X lends this money to the bank by putting it into a deposit account.
  2. He instructs the bank to send this to person Y.
  3. At the other end, it shows up as a demandable loan from person Y to the bank.

The balance sheet of the bank is inextricably tied into the payments transaction. Through this, all the problems of banking flow into the field of payments. Banks have opaque assets with 20x leverage or worse. It seems odd to place a mission-critical function such as payments in the hands of such entities.


In the old world, it was not possible to enjoy the benefits of payments without suffering the credit risk of a bank. One solution that was mooted was for payments to get done in central bank funds. You can do this for a few special situations like the securities clearing corporation, but probably not for most other situations.

The same problem arises with a mobile phone company:

  1. When you feed money, by topping up a pre-paid account, this goes into the balance sheet of the mobile phone company.
  2. Now you have to hope that when the time comes for you to spend this money, the mobile phone company is still solvent.

Faced with this situation, conservative financial regulators have proposed a few solutions:

  1. Mobile phone companies cannot do payments; payments is the exclusive preserve of banks. (This is the state of affairs in India).
  2. Mobile phone companies must become limited purpose banks.
  3. Mobile phone companies must come under full banking regulation.

All these three solutions are unsatisfactory, because they are rooted in the old paradigm, where payments was inextricably intertwined with banking, and it was felt that this is the only way it could be. We need to look beyond this.

An alternative solution: Segregation of client funds

A remarkably clean solution has been invented in the field of asset management: Segregation of client funds.

Consider a money manager such as an asset management company (AMC). At a legal level, the AMC is a mere advisor. Client money never goes onto the AMC balance sheet. Customer money sits completely separate. If the AMC goes bust, this has zero implications for clients. In the entire history of such arrangements, there has been only one episode (MF Global) where segregation of client funds did not work, in protecting customer moneys. This is in contrast with the history of banking, where failures have been taking place across the centuries, across all countries, with a high frequency.

Under such an arrangement, client funds would always sit separately, segregated from the balance sheet of the payments provider.

Segregation of client funds requires a corresponding supervisory capacity – and MF Global shows us that this supervision can possibly fail. But it would involve a much lower failure rate when compared with the problems of banking.

Implication 1: Mobile phone company as payments provider

Suppose Vodafone is my mobile phone company. When I supply Rs.1000 into my mobile wallet, this would go sit separately in a customer trust. This would not go into the balance sheet of Vodafone. If Vodafone were to go bust, this money would be returned to me. This solves the problem of the credit risk of the payments provider.

If we could do this, it would open up an array of payments innovations. The only regulatory burden placed upon the provider would be: Never ever keep customer money on your own balance sheet. We would then need some small resolution capability to kick in when the payments firm goes bust, to take money out of the customer trust and give it back to the customer.

Implication 2: This can be done with banks also

Bank accounts can be broken up into two kinds: illiquid and liquid. (From a customer perspective, this is analogous to the Tier 1 and Tier 2 of the New Pension System; the former is illiquid and the latter is demandable). Illiquid accounts would be loans from customers to the bank (as all bank deposits today are) and have greater restrictions against convertibility. Liquid accounts would not belong to the bank. They would be segregated client funds, used for payments activities.

This would derisk customers from the problems associated with bank failure. It would greatly reduce the complexities of banking regulation and supervision. It would put banks on a level playing field when compared with other technological strategies in the field of payments.

When banks do not capture the interest income on the liquid accounts, this will force a healthy unbundling of payments and banking. Banks who engage in the payments business would have to explicitly charge for payments services. This would help ensure a level playing field between bank and non-bank players in payments.

Implication 3: How to store segregated client funds

Payment vendors could place client funds into current accounts with the central bank for riskless safekeeping. Or, they could place them into NAV-based money market mutual funds, so as to earn some return.

In this framework, there would be N money market mutual fund accounts belonging to M entities. The payments system would be a technologically diverse array of alternative competing mechanisms through which money flows from account i to account j, which generates a fee income for the payments provider.

Conclusion

The idea of segregated client funds, which is very well established in some areas of finance such as money management, brokerage, etc., can be usefully applied in the field of payments, to cut through the gordian knot of banks and payments.

The technological opportunity in payments

In the old days, the field of payments was inextricably
interlinked with banking. Money was only held in bank accounts; the
only way to move money around was through banks.

Advances in computer technology coupled with financial innovation
have changed all this. Banks are no longer the only game in town for
the business of holding money. An array of innovators are now in the
payments game. A few interesting examples are:

*  Paypal is a pure-play Internet company, which rides on top of
bank accounts, and gives users a payments solution.

*  Western Union moves money from person to person across the
globe without referencing a bank.

*  M-pesa, in Kenya, does payments over mobile phones. Money is
fed into a phone as with topping up a pre-paid card. Money is then
transferred to another person using an SMS.

These developments have far reaching ramifications. We can now
think of payments as a distinct industry, one that is not joined at
the hip with banking. Banking is primarily a risk management business, of coping with callable deposits which have an assured rate of return, even though the assets are opaque and risky. In contrast, payments is primarily a computer technology business, closer to the working of a depository or an exchange.

As Merton Miller said, banking is a disaster-prone 19th century
industry. If a critical function like
payments can be increasingly decoupled from banking, it would make the
world safer.

There are two distinct problems in payments. The first is the systemically important payment system which is the core utility of the currency. In India, it is the RTGS. This is an entirely separate issue. The present discussion  is about the second component of the field of payments: the non-systemically important payments systems which are used by households and firms. This is an ordinary financial technology business.

The problem

When person X wishes to transfer Rs.100 to person Y, if the banking
channel is used, the steps are as follows:

1.  Person X lends this money to the bank by putting it into a
deposit account.

2.  He instructs the bank to send this to person Y.

3.  At the other end, it shows up as a demandable loan from person
Y to the bank.

The balance sheet of the bank is inextricably tied into the
payments transaction. Through this, all the problems of banking flow
into the field of payments. Banks have opaque assets with 20x leverage or worse. It
seems odd to place a mission-critical function such as payments in the
hands of such entities.

In the old world, it was not
possible to enjoy the benefits of payments without suffering the
credit risk of a bank. One solution that was mooted was for payments
to get done in central bank funds. You can do this for a few special situations like the securities
clearing corporation, but probably not for most other situations.

The same problem arises with a mobile phone company:

1.  When you feed money, by topping up a pre-paid account,
this goes into the balance sheet of the mobile phone company.

2.  Now you have to hope that when the time comes for you to spend
this money, the mobile phone company is still solvent.

Faced with this situation, conservative financial regulators have
proposed a few solutions:

1.  Mobile phone companies cannot do payments; payments is the
exclusive preserve of banks. (This is the state of affairs in
India).

2.  Mobile phone companies must become limited purpose banks.

3.  Mobile phone companies must come under full banking regulation.

All these three solutions are unsatisfactory, because they are rooted in the old paradigm, where payments was inextricably intertwined with banking, and it was felt that this is the only way it could be. We need to look beyond this.

An alternative solution: Segregation of client funds

A remarkably clean solution has been invented in the field of asset
management: Segregation of client funds.

Consider a money manager such as an asset management company
(AMC). At a legal level, the AMC is a mere advisor. Client money never
goes onto the AMC balance sheet. Customer money sits completely
separate. If the AMC goes bust, this has zero implications for
clients. In the entire history of such arrangements, there has been
only one
episode (MF Global) where segregation of client funds did not
work, in protecting customer moneys. This is in contrast with the history of banking, where failures have been taking place across the centuries, across all countries, with a high frequency.

Under such an arrangement, client funds would always sit separately, segregated from the balance sheet of the payments provider.

Segregation of client funds requires a corresponding supervisory
capacity – and MF Global shows us that this supervision can possibly
fail. But it would involve a much lower failure rate when compared with the problems of banking.

Implication 1: Mobile phone company as payments provider

Suppose Vodafone is my mobile phone company. When I supply Rs.1000
into my mobile wallet, this would go sit separately in a customer
trust. This would not go into the balance sheet of Vodafone. If
Vodafone were to go bust, this money would be returned to
me. This solves the problem of the credit risk of the payments provider.

If we could do this, it would open up an array of payments innovations. The only
regulatory burden placed upon the provider would be: Never ever keep
customer money on your own balance sheet. We would then need some small resolution capability to kick in when the payments firm goes bust, to take money out of the customer trust and give it back to the customer.

Implication 2: This can be done with banks also

Bank accounts can be broken up into two kinds: illiquid and
liquid. (From a customer perspective, this is analogous to the Tier 1 and Tier 2 of the New Pension System; the former is illiquid and the latter is demandable). Illiquid accounts would be loans from customers to the bank
(as all bank deposits today are) and have greater restrictions against
convertibility. Liquid accounts would not belong to the bank. They
would be segregated client funds, used for payments activities.

This would derisk customers from the problems associated with bank
failure. It would greatly reduce the complexities of banking
regulation and supervision. It would put banks on a level playing
field when compared with other technological strategies in the field
of payments.

When banks do not capture the interest income on the liquid accounts, this will force a healthy unbundling of payments and banking. Banks who engage in the payments business would have to explicitly charge for payments services. This would help ensure a level playing field between bank and non-bank players in payments.

Implication 3: How to store segregated client funds

Payment vendors could place client funds into current accounts with
the central bank for riskless safekeeping. Or, they could place them
into NAV-based money market mutual funds, so as to earn some
return.

In this framework, there would be N money market mutual fund
accounts belonging to M entities. The payments system would be a
technologically diverse array of alternative competing mechanisms
through which money flows from account i to account j, which generates a fee income for the payments provider.

Conclusion

The idea of segregated client funds, which is very well established
in some areas of finance such as money management, brokerage, etc.,
can be usefully applied in the field of payments, to cut through the
gordian knot of banks and payments.

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