We’ll start the discussion of payment ecosystems by looking at the limitations of pure digital wallets.
First, let’s think about product differentiation. You can build a digital wallet to handle payments with a competence software development team and a good bank partner. Consequently, competition is quite fierce in the space, particularly in the emerging markets, and you really need to distinguish yourself from the others with novel product offerings. Second, with the revenue model like we have discussed, you’re not making money by having frequent user withdrawals, you make money by keeping them within your wallet and transact with each other using the virtual wallet balances. But a pure digital wallet really doesn’t have much incentives for people to keep their money in, it’s not earning any interest.
So many people just keep the minimum balance in there and withdraw most of the balance as soon as they receive them.
Finally, most of the digital wallets are really targeted toward online e-commerce users, like eBay purchases. If you go to a grocery store instead and try to pay with PayPal there, you right away realize it’s quite a hassle and often impossible.
Most of these brick-and-mortar places would instead either rely on credit cards in the developed markets or cash in most developing markets. So, in order to further grow their business and compete with alternatives like credit cards, the wallet providers should really think about ways to tap into these more offline transactions.
Now, I’ll discuss one case, the digital wallet Alipay in China that really started to think about these issues ahead of time, which led to two key innovations that transformed the payment industry in that entire country. We’ll discuss each of them, and in doing so hopefully draw some lessons that could be applied to other markets.
Alipay started as the PayPal equivalent in China, as a subsidiary of Alibaba, which is similar to a combination of eBay and Amazon. Just like PayPal, Alipay was launched as a pure digital wallet. And soon it realize that people don’t really have much incentive to keep the money in the wallet because, as we said, it’s more rational to withdraw the money and put it into better use, like Investments that are in a positive return. Realizing this, they only make one minor change with major implications.
Notice the graph here, instead of partnering with the bank they partnered with a money market fund. Here, instead of a custodian bank account earning nothing, the money behind the wall it balances actually sits as money market Investments that earn an interest rate, which in China was often exceeding that of savings accounts. Transferring the $100 in is the same process on existing payment rails. But the key difference here is the periodic interest payments from the $100 in money-market Investments.
Now, let’s take a look at the incentives from the receivers’ perspective. They can withdraw the $100 as usual putting it back into their bank accounts. If they don’t and instead keeping it as the virtual balance, then it will earn a positive interest rate. So, unless their outside investment options have significantly higher returns, the receiver will be less incentivized to move the money out and more incentivized to keep the money within the Alipay ecosystem. And why stop there? Since they’re already partnered with an non-bank entity, why not further expand the set of things that the user can do with their balances?
This is when Ant Financial is born, which is a subsidiary entity that further connects the money market account with more investment options, like peer-to-peer lending, stock brokerage and even Insurance products. This is the second step of the innovation. After incentivizing users to state within the system with positive interest rates, now expand the offerings to steer the users further into products with higher margins.
The simple digital wallet thus becomes a full-service ecosystem centered around the wallet. You should note, however, that this business strategy is not without risks. In fact, compared to PayPal where their bank account is insured and quite risk-free, all those investment options here, including the money market account, are risky. This practice of taking user deposits and channeling them into potentially risky investments essentially makes Alipay a powerful fintech shadow bank. We’ll talk about the systemic implications of this in our credit tech course.
Before that, let’s talk about Alipay’s second Innovation, the expansion of the wallet to offline, face-to-face commerce settings. Soon after the wallet was introduced, the developers realized a big problem. The majority of the Chinese population have never participated in online transactions before, not to mention online banking. Sure they have a smartphone, but unless they are a millennial or younger, they haven’t really done much online shopping and they prefer the more traditional brick-and-mortar stores. In these transactions speed is the key, and they’re definitely not going to be bothered with finding and typing in all the stores’ email addresses and other identifiers when waiting in line at the checkout counter, this presents both a challenge and an opportunity.
And Alipay Solution is, again, very simple in design but powerful in effect. the QR code.
A scannable QR code with information embedded in is not really new. However, what’s interesting here is how Alipay chose to implement it.
Here we have a street vendor who obviously can’t afford an expensive credit card terminal. But if he signs up for a digital wallet like Alipay, he can physically print a QR code incorporating all his payment info, all this identifiers. So, for another wallet user waiting in line to ring up the purchase, instead of typing all this info in, they simply open the app and scan this printed QR code.
This scan pulls all the relevant merchant info from the code and automatically fills them in the app. All the user need to do is to type in the payment amount or just hand over the phone to the merchant and let the merchant do it for them.
Again, Alipay wasn’t the first company to deploy QR codes in payments, other firms, like Starbucks, did it earlier. But what’s unique here is really the way it’s deployed. The primary focus of deployment is, one, on the merchant side and, two, having code physically available, this cuts down the need for hardware. And, in fact, none is needed from the merchants except a phone to receive payment notifications, they don’t even need a scanner. Because of its low cost and convenience this type of arrangement is now ubiquitous all over the country to the point where cash is often not accepted anymore.
This simple process innovation is a case to consider for wallet developers, particularly in emerging markets with a lot of offline transactions and without a robust credit card network.