Fintech in payments: Changing perspective

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This is the third in a series of articles about fintech's role in payments. This one is about the process of settlements and the changes that are coming in. Settlement is the process by which the payer's account with his or her bank is debited and the payee's account with his or her bank is credited.
The last article laid the framework for the analysis around four pillars - authentication and authorisation, clearing and settlement, merchant discount rates and interchange (the revenue source) and interoperability. Click through to http://www.khaleejtimes.com/business/the-swift-silent-change-in-consumer-payments for reference.
The revenue pool for facilitation of the settlement of cross-border transactions is quite rich. According to Global Payments 2015: A Healthy Industry Confronts Disruption published by McKinsey, the total cross-border payments volume is in the region of $30.5 trillion. The estimates for the margin on such transactions ranges from about 0.11 per cent for business-to-business transactions to about 3.40 per cent for consumer payments to businesses or other consumers.
Currently, 95 per cent of the revenue for these transactions are earned by banks.
The existing model for settlement usually involves a third-party "settlement" bank whose role is to hold accounts for both the payer's bank as well as the payee's bank. On receiving instructions from organisations such as MasterCard, Visa, SWIFT or other networks, these settlement banks effect the transfer from the payer's account to the payee's account. While the basic process itself is simple, there are a number of levels and variations of this. For example, not all payer-and-payee bank pairs will have the same settlement account. This creates the need for another layer of banks which act as connectors between the original participants in the transaction. All this leads to multiple cost-points and delays due to trust and reconciliation challenges. Which is why good funds could take days, weeks or even months to be transferred. And the cost can go up quite significantly. Also, when dealing with cross-border payments, the more time that it takes for settlement, the higher the exposure to loss due to changes in foreign exchange rates. Hence banks tend to "cover" this exposure by adding on significant margin to the transactions.
Two major trends are disrupting this process. At one level, the players in the payments space are moving beyond the banks. For example, there is talk that WhatsApp may enter into payments in collaboration with payment switches such as the UPI in India, or Facebook could also look at payments. Already M-Pesa, WeChat, EasyPaisa and a number of other hitherto "closed-loop" systems are opening up to interoperability in a phased and logical manner. The volumes that these systems generate are far in excess of what the existing banking technology is built to support. Hence, such systems will look for more efficient settlement processes.
The other major trend is the basis of trust itself. An excellent article on trust-based settlement by Antony Lewis, Head of Business Development at itBit, a bitcoin exchange based in Singapore (http://www.coindesk.com/ripple-medieval-banking-digital-twist) explains how the medieval system of hawala finds echoes in new blockchain-based crytocurrencies. At the heart of this is the establishment of trust between participants in the system through the instantaneous recording and archiving of transactions across multiple independent servers. Every time a payer's service provider records an IOU to the payee's service provider, this IOU is stored in hundreds if not thousands of places. This ensures that no participating entity can deny the IOU. A default will mean expulsion from the system. In addition, the value of a crypto-currency kicks in. Basically, "convertible currencies" like the US dollar or the British pound or the euro are no longer required as the common standard. Each service provider will convert the amount that it needs to pay or receive into a given number of units of the crypto-currency instead of the convertible currency.
The expected sudden increase in both domestic as well as cross-border transactions due to the massive shift to digital payments has opened up the game for startups in the fintech world to build the technology to support this multiplication of transaction volume.
Another area is where players like CurrencyFair are working in. Essentially matching the demand-and-supply of currency exchanges in real-time and settling only the net amounts. The underlying assumption is that there is an equilibrium in the flows of value between two trading countries.
Ripple on the other hand is a blockchain and cryptocurrency-based settlement mechanism that seeks to replace the current "settlement bank"-based mechanism. Ripple is in fact working with the banks to achieve this. From the traditional world, the Society for Worldwide Interbank Financial Telecommunication (SWIFT), founded in 1973 and connected to most of the banks in the world is also revamping its offering. Called the Global Payments Initiative (GPI), this new mechanism will decrease settlement days to about just one. Also, it will most likely use blockchain instead of the current complex of agreements and validation mechanisms.
A couple of days ago, MasterCard and the Government of Andhra Pradesh (one of the largest states in the Indian Union) joined the Ethereum Enterprise Alliance. Ethereum itself is one of the largest players in cryptocurrencies.
Clearly, this is an exciting world for startups and entrepreneurs to explore.
The writer is a Partner at BridgeDFS, a bespoke financial advisory firm (www.bridgeto.us). He's a digital banking and digital banking financial services evangelist, practitioner, advisor and consultant. Views expressed are his own and do not reflect the newspaper's policy. He can be contacted at ves@vyashara.com