Blockchain Payments: Beyond the Hype

Every great disruption has its roots in fundamental pain points. For those operators and investors in fintech and blockchain, we have been talking about these broken experiences in financial services since 2008/9 after the financial crisis coupled with regulatory changes, the rise of digital payments, the smartphone and of course Bitcoin. The boom in fintechs is well documented and a largely successful succession of innovation leading to the finance industry getting cheaper, more convenient, and safer by leveraging technology (The Motley Fool: more info) but more fundamental revision of plumbing for moving money (especially cross border) has still not changed.

Naturally, those early days witnessed a hype cycle in blockchain payments that quickly ended in a trough of disillusionment due to the uncertainty of the status of the digital transaction being transferred (is it an asset, a commodity, a security, or a currency and is it taxable when transferred?), the lack of interoperability between different countries or jurisdictions (due to regulations around AML), and the volatility of the cryptocurrency (making any merchant nervous to accept blockchain-based digital transactions as a form of payment as well as a challenge for them to reconcile). Finally, the technology was simply not up to scratch with poor end to end UX with multiple steps (too technical for the average user) to take as well as the risk of high transaction volumes (as would be expected at scale in payments) congesting blockchains, resulting in slower processing times, and transaction higher fees.

Most importantly however, apathy seems to rule in relooking at payments infrastructure: One can lose sight of pain points in the payments industry because for the average Western consumer, payments seem to work well enough. Often it’s the lack of understanding of how margins are shared in legacy systems that have led to this apathy and acceptance of the status quo at the individual level. Let’s address this apathy:

First we will take a step back and look at several painful consequences of how our payments industry works today, to re-emphasise why we need change. Although 2008 makes it a long time to just be talking about the promise of blockchain payments, it is our belief that today in several sub sectors we have started to cross a chasm. In future blog pieces we will be double clicking on several sub sectors of payments where innovation seems to be happening with evidence of scale and equally where there is yet to be. We will also be looking at where investment activity is happening. We believe the combination of improved blockchain infrastructure (addressing the issues of fees, scale, and reliability), solutions for finality and chain fragmentation and the emergence of regulation around stablecoins (bringing trust, liquidity and addressing volatility) make for tailwinds to continue to blow us across the chasm towards mass adoption and daily use cases. We will also be deep diving on some of these specific technologies and on stablecoins in a future piece: We now for the first time have a digital equivalent of sending cash that is increasingly becoming relevant and accepted with 150bn$ of organic volume activity (Forbes: more info) and acceptance by Visa (Visa: more info).

Where that leads us as longer term venture investors riding these waves, is to “skate to where the puck is going to be”. The next conversation on web3 payments is not just about addressing speed and costs flaws of legacy infrastructure but that its inherent composability, openness and programmability enable complete new payment experiences, more inclusion, less monopolistic control, and flips the opportunity to focus on the underlying data represented by the payment vs the movement of funds itself. And if we need a reminder that payments remain a valuable pot to re-address: In aggregate the legacy payments processing revenues reached a staggering $1.9 trillion in 2020 (McKinsey: more info)!

So What Exactly is Broken with Payments Today?

Broadly speaking the pain points can be segmented into categories of transaction costs, speeds, access and governance. The following examples illustrate each of these segments in turn:

Costs:

Lets first cast our eye to Sub-Saharan Africa where 65% of people are unbanked or suffer from extracting fees in remitting key funds vital for survival (Cambridge Management Consulting: more info). The average cost of sending US$200 in 2021 from Tanzania was 27 percent (Statista: more info). On the business side, the average importer struggles with USD currency controls which simply restrict their ability to grow.

Moving to the West — Card acceptance is a crucial component of the global payment market: It is estimated that 52% of all global point of sale payments are made using either a credit or debit card (Carta Worldwide: more info). However, card legacy systems are decades old and rely on numerous intermediaries, such as issuing banks, acquiring banks, issuing processor, acquiring processor, and the card networks themselves, to validate and settle transactions. Unfortunately, each intermediary adds complexity, risk, and fees to the payment process. No surprise, along with the myriad of middlemen comes a myriad of fees including the sometimes regulated Interchange fee (paid to the customer’s bank, the card issuing bank), Scheme fee (paid to the card schemes like Visa or Mastercard) and the Acquirer markup (paid to the merchant’s payment provider — the acquirer or PSP). The fees are so complex and opaque that optimising them is an art and designed to maintain a status quo. Many merchants simply do not understand how they are charged nor how to optimise them.

The combined service charge hitting merchants for accepting credit cards can be as high as 3.5% per transaction (business expert: more info) Although debit cards can reduce costs, there are additional costs associated with card-not-present transactions (aka online), higher risk transactions (e.g. fx, gaming, crypto etc) and a honey pot of margin hidden in cross border transactions.

These seemingly small percentage fees add up quickly and can become a drag on growth, especially for smaller merchants with tighter margins. It’s also not a realistic scalable option to simply not accept cards for most merchants. They fight so hard and pay significant customer acquisition costs, so that to choose not to offer payment methods which are preferred by customers (such as cards) would come at significant customer drop off risk, this holds true especially for smaller merchants. Effectively these same small merchants can pay over four times more on average than larger ones due to lack of volume discounts. For larger merchants, they also benefit from orchestration and least cost routing to further reduce fees spent. they fail to address the underlying issues inherited from the infrastructure.

Speeds:

Have we become so used to mediocrity that we have stopped asking why we cannot send funds over a weekend or bank holiday because our banking system has decided to take a “well deserved” break? Ask those suffering from devastating emergencies in war or wildfires if waiting for T+3 bank settlement is acceptable (as well as paying the intermediary fees). Do consumers also appreciate that these same merchants also might have to wait up to 3 days to receive their funds from card payment intermediaries? For small merchants, the cornerstone of many economies, this cash flow is their life blood and although merchant credit exists, it exists at a cost.

Access:

The average Western consumer does not think much about interoperability when we have integrated Faster Payments in the UK and Instant SEPA in Europe but lifting the lid beyond domestic payments in Europe and we discover that we are far from integrated: Why did it take 11 years after the acquisition of Venmo to enable seamless movement of money from a PayPal account to Venmo without an intermediary bank with its additional fee/settlement time (Pymnts: more info)? For cross border transactions, why do we, the end user, accept that the myriad of payment systems don’t speak to each other and thus need to rely on correspondent banking delays and intermediary fees or take extra manual steps, ourselves, to send money? Seamless instant payments across Europe is a key driver of the European marketplace and similar initiatives are desired for developing continents: The African Union (AU) and its member states have set the goal of implementing a digital single market and to lower trade barriers by 2030. Instant, and integrated payments systems can facilitate cross-border payments to power this. Despite the proliferation of instant payments in Africa, less than half are interoperable and even within countries with multiple ones only Ghana has interoperable instant payment systems (ecdpm: more info). Interoperability goes beyond technical integrations — it includes identifying recipients and ensuring that they are able to receive a payment and making payments using a different mobile money provider without requiring further KYC processes. This type of interoperability is rare in mobile money markets, though it commenced in Kenya in 2022 according to GSMA. Globally, mobile money interoperability is poor: More than 100 countries now have at least one mobile money service in place, and interoperability exists in around half of these countries despite evidence of interoperability driving increased adoption and usage including off-net and cross-platform transactions (GSMA: more info).

Governance:

The issues are not limited to costs, efficiencies and access: There remains a lack of governance in several cases due to a lack of programmability and control: Why are the US taxpayers not challenging their government more about the $2.2bn of fraudulent Covid-19 payment errors made because of a lack of control of where the Covid Funding money was going and how it was being spent (US Government Accountability Office: more info)?

Sometimes overt controls are not what is desired however: The very same current payments systems that governments, regulators and corporations espouse as open, inclusive, and global can ironically be weaponised for political or monopolistic control as seen respectively in recent Swift (Leibniz Institute: more info) and Apple App Store battles (BBC: more info). Competition is a positive outcome of both these events but there are impacts from the continual fragmentation of payment systems with associated interoperability frictions (as described above) and longer term leads to risks associated with a de-globalisation of the world’s economy (The Economist: more info).

Similarly in emerging economies, many countries are enforcing rigid digital ID schemes as a precursor to access the financial system. This not only risks excluding populations, it significantly opens the door for cyber attacks and identity theft especially given the state of cybersecurity and data protections in Africa.

That’s Why We Funded Fintechs, surely?

Investors praise and invest in the glossy new fintechs to attempt to address many of the UX, access, cost or efficiency flaws illustrated above, yet they are all built on top of existing payment and banking infrastructure. Sure, they can abstract away complicated back-office processes, provide some integration and orchestration as well as improve front end UX and sometimes even subsidise fees (unfortunately via short lived investor funds) but their fundamental problems remain. Payment flows still go through the same legacy payment networks, where they spend a lot of money settling payments — costs that are then passed on to consumers. Even companies such as Wise (a prior portfolio company of our sister fund Firestartr), who pride themselves in speed and cost only support “instant” (<20 seconds) payments 55% of the time with an average fee of 0.65% (Wise: more info). This benchmark should perhaps be the starting point for further improvement. In Africa, according to our portfolio company Yellow Card, quasi-colonial cross border infrastructure means that roughly 80% of cross-border payments originating from African banks are processed offshore, mostly in the U.S. or Europe. That translates to higher costs and processing times that are sometimes measured in weeks and won’t magically disappear. Those that can afford it the least, end up paying the most.

Indeed, many pundits point to the more recent fintech explosion in Africa, and even going back to the likes of Mpesa, as the panacea for financial inclusion. Mobile money has been a game changer for Africans in terms of access but users of it still don’t get the perks of banking as we know it in the West i.e. earning interest on banked savings and building up a credit score based on a history of spending. Financial inclusion is much more than access — it’s about financial health. Most notably financial health in Kenya has fallen, not improved, since 2016 (Carnegie Endowment: more info).

Addressing the Root Cause

Fundamentally sticking a “fintech plaster” on the problem has limitations. Blockchains on the other hand give consumers, fintechs and their merchants a solution to these issues of access to funds, settlement time, high foreign exchange fees, and payments out of business hours. Blockchains are upgrading the underlying plumbing and making payment systems break down existing walled gardens. To illustrate this with a few examples:

• Blockchain payments settle in seconds regardless of location and are getting faster.
• Costs for payments have gone down tremendously delivering <1$cent transaction fees as a fixed price irrespective of transaction size (GrowThePie: more info)
• Decentralised finance protocols have been battle tested in multiple market crashes over the past years, and increasingly show a competent alternative to the inefficient, redundancy bound correspondent banking model for FX markets. Uniswap research suggests that DeFi exchanges may lead to as much as 80% lower fees in remittance payments (Uniswap: more info).

Low transaction costs/speed, transparency, improved UX and compliance are the absolute minimum requirements that blockchains need to check to even compete in the global payments space. Fabric has several portfolio companies addressing these pain points including Nilos (Fabric Ventures: more info), Fiat Republic (Fabric Ventures: more info) and Ramp Network.

Are we there yet however, at scale? No. Many valid interjections raise questions around settlement finality on public chains, privacy requirements in payments, fragmentation across chains, poor end to end UX, reliability of the underlying L1s and lack of pull payments and refunds. We will be deep diving later on the required technologies to enable true scaled blockchain payments. In addition, we face continued regional uncertainty around stablecoin regulation but also have seen significant recent momentum with EU/Mica, UK, Dubai and recently the USA (S&P Global: more info) to give us optimism and we will deep dive on stablecoins later as well.

What Should the Next Conversation on Blockchain Payments Focus on?

It feels to us that the required technical and regulatory tailwinds are now with us. This gives rise to the question of, if we assume these issues are being solved, what is the next conversation we should be having on the investment opportunities within web3 payments. In our view, this conversation will be about assets that are tokenised and the movement of those assets as composable, programmable and data rich. It will enable a wider inclusion of people -specifically the underbanked (as driven by our investment in Yellow Card and within self-sovereign identity (coming)) as well as a wider inclusion of payment flows — specifically those flows that we simply have not been able to execute on using the existing layer cake of legacy payment rails. It will flip the conversation to focus on the rich data that the payment was associated with or was a means to an end in delivering. This is the data powering tailored products, personalised user experience and automated transactions.

The next conversation will be about payments that are freed from the artificial restrictions imposed from legacy payment systems, such as microtransactions at fractions of a USD cent costs, going where fiat USDs just can’t go and in the process reinvigorating the business models of content creators or streamers.

The next conversation will be about changing our definition of what a payment is from a discrete set scheduled event to a streaming flow of real time payments mirroring the delivery or consumption of services, whether that be for salaries, rent payments or accounts receivables. The faster recycling of these funds for reinvestment by those whose “owed money” it actually is, will drive the economy forward more efficiently. Our investment in Superfluid (Superfluid: more info) is an example of this theme.

The next conversation will be about payments with embedded rules to deliver built-in controls on how funds can be sent or where they can be sent or how they can be frozen, adhering to regulatory requirements. Our investment in Due.Network’s on-chain payment method (Fabric Ventures: more info) is an example of these themes and we can also imagine how self-sovereign, reusable KYC ID from idOS (Fractal: more info) becomes a seamless modular component of such an end-to-end automated payment flow.

The next conversation will be about payments with smart contracts to carry out specific “if-then” logic transactions based on predefined terms and conditions connected immutably to specific characteristics such as purchase behaviour, delivery and loyalty and the AI-powered algorithms interpreting them.

For the first time, we’ve developed an “unopinionated” (not implementing restrictions, bans, censorship at the protocol level), freely interoperable and programmable settlement layer controlled by no single entity allowing us to stand on top of giants in composable user experience and distribution.

Crypto has for too long been positioned by the mass media as the ‘wild wild west’ when it comes to its participants and projects built on top, but contrary to this belief it really renders itself to a settlement layer with all the above improved features, while being fully compliant traceable, auditable and regulated (such as stablecoins for example under Mica) for all those rational AML and protection of “singularity of money” reasons. This vision of web3 payments not only re-engineers web2 payment plumbing but can offer so much more. These are examples moving from ‘Tradfi’ through ‘DeFi’ to the world of “NOFI’’ that we at Fabric strive to invest in. A world where NOFI has moved beyond just focusing on “no friction finance” to mean payments that are”not just about finance”.

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