Lazard Insights

Digital Disruption in PaymentsBret A. Miller, CFA, Director, Research Analyst

Summary• One of the biggest consumer businesses in the

world is one consumers never see: the payments system that undergirds just about every non-cash financial transaction we make.

• In the United States, the entrenched multiparty ecosystem of the card networks makes it hard for newcomers to incentivize banks, consumers, and merchants to change behaviors, but in China almost overnight, digital wallet super apps have simplified and revolutionized digital payments.

• India is a massive cash economy at an inflection point, where smartphone adoption and government initiatives set the stage for digital payments, and competition will be fierce between well-financed startups, domestic banks, traditional card networks, and Chinese internet platforms.

One of the biggest consumer businesses in the world is one consumers never see and are not even aware of: the payments system that undergirds just about every non-cash financial transaction we make. With $41 trillion of consumer purchase expenditures globally, and still $17 trillion, or 41%,1 of that amount consisting of cash and checks, there remains a long runway for secular growth in non-cash digital payments, which are increasing at a rate around 10% a year (Exhibit 1).

Lazard Insights is an ongoing series designed to share value-added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights.

Exhibit 1Secular Growth in Card and Digital Transactions

0

100

200

300

400

500($B)

North America Emerging Asia EuropeAsia Pac CEMEA Latin America

2012 2013 2014 2015 2016

331361

393438

483

As of December 2016

Source: Bank for International Settlements Red Book, Capgemini Financial Services Analysis 2018, ECB Statistical Data Warehouse, WorldPay Global Payments Report 2018

2

The migration from cash to card is not new, but the pace of innovation and disruption within the payments landscape has accelerated. The biggest enabler of change and innovation in payments has been the smartphone, which has inspired and powered new digital payment use cases as well as more ways to pay and be paid. Digital wallets have become a new form factor with which we pay. The smartphone itself, through an attached dongle or through the camera and QR codes, can now be a point of acceptance for payments, and that has substantially lowered the upfront cost of acceptance for merchants. Uber has improved customer experience to the point that many consumers now expect payments to occur seamlessly in the background—a phenomenon that has actually habituated many people to hop out of traditional taxis without remembering they need to pay. And companies like Square in the United States and Alipay in China have shown that the software and data surrounding payments can be very valuable in enabling tangential services, such as lending.

So how has the innovation and disruption impacted the payments markets, and where do we think it is going? We believe the answers and conclusions vary dramatically across regions. China offers a case study in which the leading internet platforms launched Alipay and Tenpay, solving a real market need around making online payments for ecommerce purchases, which has disrupted the incumbent card network. In the United States and most developed markets, the entrenched Visa and Mastercard payment systems—which include the banks, merchants, consumers, and merchant acquirers—are very strong and have been partnering with the new technology-led entrants to build on top of the existing ecosystem. Finally, India is a country at an inflection point, ripe for conversion to digital payments with an economy still dominated by cash and a variety of different companies looking to capture a share of the enormous digital payments opportunity.

China’s Leapfrog from CashFive-to-ten years ago, China was primarily a cash-based society, with China Union Pay cards distributed through banks in a structure similar to the Visa and Mastercard ecosystem. Fast-forward to the present, and the mobile payment wallets backed by the leading Chinese internet platforms dominate the payments market, processing over $10 trillion digitally per year.2 By almost any measure—the scale or penetration of the mobile internet, ecommerce, or financial technology—China has leapfrogged the United States, bypassing plastic mass-market cards in favor of smartphone-based digital wallets. The adoption of digital payments has been a key enabler of this innovation.

As low-cost, open-sourced Android smartphone adoption began to ramp up in China in 2012, ecommerce gained traction on Alibaba mobile apps. In what was largely a cash economy, Alibaba recognized the need for a trusted solution that could scale at a

low cost for mass consumer adoption to easily pay for ecommerce payments online.

Prior to Alibaba’s innovation, cash-on-delivery—COD—was the standard for ecommerce purchases. China Union Pay cards were mostly used by only high-end consumers at stores in larger cities. That left a big opening for Alibaba to solve a real problem, where the incumbent card network had failed to invest. Alibaba’s solution, Alipay, functions as a digital wallet, funded through a bank account or with cash deposited with an agent, enabling a trusted way to pay for ecommerce purchases on Alibaba sites, even for consumers without a credit or debit card.

Ecommerce on mobile devices was the killer app for Alibaba that drove adoption of Alipay, while messaging and gaming were the killer apps for Tencent’s internet platform, which quickly followed with its own digital wallet. Merchants in China were eager to gain access to these users, so Alipay and Tencent developed integration tools to let users pay for third-party services through their digital wallets (such as ordering food or movie tickets or paying utility bills online). Furthermore, these digital wallets are able to be used in the physical retail world as consumers can pay for purchases at local merchants by scanning a QR code with the mobile app’s camera. Alibaba and Tencent together have more than one billion highly engaged users, whose lives are deeply integrated into their respective super apps that span ecommerce, communications, media, gaming, financial services, and other offline services, as illustrated in Tencent's WeChat Pay user interface (Exhibit 2).

Exhibit 2WeChat Pay User Interface

$

MOVIE

Movie Tickets Group Buy

Rail and Flight Hotels Specials

Go Dutch Tencent Charity Order Taxi

Public Services Card Repay Gifts

Wealth QQ Coins Utilities

Quick Pay Transfer Mobile Top Up

$

Q

WalletWeChat Payment

...< Me

$

For illustrative purposes only

3

As of 2017, 36% of point-of-sale payments and 65% of payments online were made through digital wallets in China, which puts adoption of mobile payments well ahead of the United States.3 We believe the mobile payments disruption in China was enabled by a unique set of circumstances: an incumbent in China, Union Pay, that had not invested sufficiently to address the mass market and online transactions; smartphone adoption that led to significant ecommerce demand; the need for a trusted way to pay; and, finally, massive Alibaba and Tencent user bases who wanted an alternative to cash payments at physical retailers.

The Power of the US IncumbentsIn China, the new mobile wallets merely had to provide a solution that was better than cash. Here in the United States, would-be disrupters need to change the behavior of all of the participants within the entrenched ecosystem. In most developed Western economies, the Visa and Mastercard ecosystem already works quite well. For consumers, any new system would have to offer a payment method that is easier than swiping a card and more lucrative than receiving rewards points. The banks profit from the interchange revenue they receive from debit and credit cards, and the cards also promote stickier customer relationships. And for most merchants, the cards make the sale process as frictionless and fast as possible, which is generally a much greater priority than any concern around fees for all but the largest merchants.

The very scale and complexity of the payment networks poses a high barrier to entry. The Visa network, the largest, has issued more than three billion cards through thousands of banks, enabled by merchant acquirer partners, and accepted as payment for goods and services at millions of merchant locations (Exhibit 3).

When a customer puts a card in a terminal, the payment information gets routed from the merchant acquirer to the card network, which obtains authorization from the bank that issued the consumer’s card, and in turn debits the buyer’s card account and credits the seller’s bank account. The whole transaction takes place almost instantaneously with a high degree of reliability and security.

Not only is the system seamlessly efficient, but its participants have a powerful incentive to maintain it. Every step along the way they take a cut. The typical credit card transaction in the United States generates roughly 2.5% in fees. We estimate the comparable cost in an Alipay transaction, which reduces the number of intermediaries, runs about 0.5% (Exhibit 4).

So with that higher US hurdle—as long as Visa and Mastercard continue to innovate to keep pace with technological change in features like smartphones, ecommerce, and security—we believe the incumbents will sustain their dominance. Their strategy has been to partner with potential disrupters, and convince them to deploy their solutions on top of the existing Visa and Mastercard networks. For example, the vast majority of Apple Pay and Paypal wallets are funded by Visa and Mastercard cards. Indeed, innovators like Square have actually helped cement Visa's and Mastercard's leadership by enabling micro-merchants like plumbers and dog walkers to accept cards instead of cash and checks. Visa’s CFO described the way the company thinks about its mission to partner with the innovators at a recent conference:

"… the way we look at it is that we have a network that can add a lot of value to almost any kind of situation where people want to pay or be paid…it's probably the network that offers the most functionality and the least cost. So if you have a way to pay or be paid, even if it's a very new way, our job is to persuade you that you

Exhibit 3 The Scale of Visa's Ecosystem Creates Barriers

3B+CARDS 13K+

ISSUERS

44M 3K+ACQUIRERS

$$

$$

$ $ $ $

MERCHANT LOCATIONS

ACCEPTANCE

ISSUANCE

For illustrative purposes only

Exhibit 4US vs. China: Payment Flow Chart

For illustrative purposes only

US: Visa / Mastercard

CHINA:

50 BPS

MERCHANT MERCHANT ACQUIRERCONSUMER

Alipay

CONSUMER MERCHANT DIGITAL WALLET BANK ACCOUNT

30 BPS 20 BPS 200 BPSNETWORK CARD ISSUING BANK

$ $

4

RD00199

Notes1 Source: Mastercard, Investor Day 2017 Presentation2 Source: “Ant Financial’s Alipay to Impose Fees on Some Users as Costs Mount”. Wall Street Journal, 21 February 20193 Source: World Pay Global Payments Report, November 20184 Source: Visa, Morgan Stanley Technology, Media & Telecom Conference, 27 February 20195 Source: Mastercard6 Source: Citi Research Estimates7 Source: World Pay Global Payments Report, November 2018

Important InformationOriginally published on 27 March 2019. Revised and republished on 11 April, 2019.

This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. 

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should just do it on our network and to co-opt you.... right now, there isn't any particular situation that is a disruptive threat that is making headway, because I think a lot of these people are our partners. They are not competitors."4

The Great Race for IndiaNotwithstanding the near universal acceptance of plastic in the developed markets and the phenomenal success of digital wallets in China, payment systems still have a lot of room for global growth. A substantial minority of the world’s population, some 2.5 billion people, do not even have access to banks. India is the market that we find most ripe for rapid change. Cash still dominates, accounting for 86% of all consumer purchase spending, and ecommerce penetration remains very low.5 At the same time, inexpensive Android smartphone availability is increasing internet access, with smartphone penetration reaching about 25% of the population.6

The government has encouraged the introduction of payment acceptance systems in an effort to formalize more of the economy and increase tax compliance. It recently instituted policies to reduce the supply of cash and set standards to make it easy for third-party mobile wallets to connect with bank accounts and transfer money between parties, referred to as Unified Payments Interface, or UPI, wallets. By pairing smartphone adoption with the government’s initiatives, we believe the stage is set for significant secular growth in digital payments in what is the fifth-largest economy in the world.

India is not as closed a market as China, so there is opportunity for foreign investment. Competitors, domestic and international, have flocked to the opportunity, joining Visa and Mastercard, whose presence in the market extends back three decades, in a race to sign up consumers as well as merchants to accept payments through QR codes. Visa and Mastercard have a substantial footprint—their

debit and credit cards made up about 80% of the card-based payments in India in 2017, but off a low base.7 However, numerous UPI mobile wallets are gaining rapid adoption in low-value but frequent person-to-person and micro merchant payments. Adding to the mix, there is also the local debit network called RuPay, Paytm wallets backed by Alibaba, and Google and Facebook are also experimenting with UPI wallets, though it is unclear if their goal around payments is to gain a foothold in Indian ecommerce, build a payments business, or simply to reduce friction and aid advertising conversion rates.

Over the next several years, we believe the US-based processors will compete vigorously, lest they miss out on this next large market opportunity as they missed out on China. The Chinese companies will be an important factor as they look to expand their presence across Asia. Nevertheless, we could see a scenario where the government ends up favoring local initiatives. Indeed, it has already put in place laws around data localization that US companies view as restrictive.

Investment ImplicationsThe number of competitors with the resources to compete for a share of this vast market testifies to the differing paths that payments markets have taken around the world, and the magnitude of the opportunities. We believe the winners will enjoy additional compounding and sticky recurring revenues in a business that generates high profitability and strong returns once it has achieved scale. As the industry evolves, we believe we will find attractive investment opportunities among both the incumbents and newer technology-enabled entrants. We will continue to deploy our global sector experts across regions and across sectors to ensure we understand and capitalize on the opportunities arising from the payments revolution.