Balancing the Economics of Interoperability in Digital Finance
There is a common misconception that digital financial services (DFS) providers in developing markets simply lack the right low-cost technology to create a level playing field for interoperable payments. However, the business case for — or against — interoperability is much more complicated. A number of economic incentives must be in equilibrium for interoperability to work for everyone. When these incentives are misaligned, participants often lack the commitment necessary to effectively interoperate, no matter how cost-effective the technology.
Photo: Chara Lata Sharma, 2017 CGAP Photo Contest
The first step toward creating balanced incentives is to understand the various types of charges and costs involved in interoperable payments schemes. What, if any, additional fees customers pay for interoperable transactions often depends on how these economic incentives are structured. Below are several types of costs that often apply in an interoperable environment.
Scheme fees are the charges made to providers for their membership or participation in an arrangement that defines mutually agreed terms for how to interoperate (i.e., a scheme). Effective interoperability requires a concerted effort to structure rules and processes (as discussed in the previous blog in this series), and further effort to institutionalize these processes through some sort of scheme or payments management body. All of these activities require time and money.
Participants in many schemes pay fees to cover the costs associated with scheme management. Scheme fees are typically determined by the size, structure and level of overhead. Because payments are a volume game, the more participants in a scheme, the lower the unit costs for each participant.
Cost savings can be achieved where there is no centralized, dedicated scheme management body, but these financial savings often come at the price of a lack of focus and noncompliance with scheme rules on the part of participants.
Switch fees are the charges made to providers for routing transactions through a central technology solution (i.e., a switch). Many interoperability initiatives start from the premise that a switch is necessary, but this is not always true. If switches facilitate a high number of transactions, they provide operational efficiency in clearing, settlement and oversight. But there are alternatives to switches when there is insufficient volume, as will be discussed in the next blog in this series. The business case for a switch depends on whether it is cheaper to run than the alternatives.
Scheme and switch fees are often bundled together in practice when a single organization manages a scheme and operates a switch. However, these costs must be understood separately if correct strategic decisions for scheme development are to be made. A scheme may decide to procure their own switch, outsource to an existing switch provider or licence a few different providers to provide the service to that scheme.
For retail payments transactions, the revenues and costs associated with sending and receiving payments are often unbalanced. In an interoperable environment, this may mean that one organization is making less money on a transaction, while another is making more, than they would for a transaction sent and received on their own network.
For example, mobile money providers often generate revenue through a combination of transaction fees and cash-out fees, while costs come from commissions to agents on cash-in and cash-out. This means that a mobile money operator may bear the cost of customers cashing in while relying, in part, on cash-out fees to turn a profit. If a customer was to cash-in with Provider A and then send off-net and cash-out with Provider B, Provider A would lose the cash-out revenue it would have earned had the transaction stayed on its network. Conversely, the provider who receives that transaction is likely to earn cash-out revenue without having incurred the cost of the transaction’s origination through a cash-in.
Interchange is simply a balancing payment between providers to help close the economic imbalance in this type of scenario. Interchange can be employed in a few different ways:
- A no-interchange model, where no payments are exchanged between participants.
- A sender-pays model, where the provider sending the transaction pays a fee to the receiving provider.
- A receiver-pays model, where the provider receiving the transaction pays a fee to the sending provider.
A no-interchange model is the simplest to understand and implement, but often means that whatever economic imbalance might exist ends up being recovered from end-users, normally in the form of surcharges for off-network transactions. These surcharges can have the effect of driving down use of the service.
A sender-pays model is often positioned as a charge to recover the cost of using another party’s infrastructure. This is the model ATM transactions use, and the charges to the sending institution are usually passed along to the customer. (This is also the reason many customers make efforts to use only ATMs that are part of their network — so they avoid the additional fees.)
A receiver-pays model compensates the sender for the costs he or she has incurred for bringing funds into the network, along with operational costs for running the sending side of the business. This is the model most card schemes use when you swipe your Visa or Mastercard at a store. It is also the model that has been used in Tanzania for mobile money interoperability to allow for same-price on-network and off-network person-to-person transactions when sending from M-Pesa to M-Pesa, M-Pesa to Tigo, Tigo to Airtel, or some other combination.
The interchange fee model is much more difficult to implement than the other fees, and it is a minefield of provider strategy and competition law. However, it allows customers to transact off-net as easily as they do on-net, and ultimately leads to increased transaction volumes in the ecosystem.
All economic decisions taken at the scheme, switch and provider level ultimately impact the end user. If costs are effectively managed and incentives are appropriately aligned between stakeholders, there is no reason an end user should have to pay more to transact across providers.
Where interparty fees are appropriately balanced, where customers have an economic incentive to use interoperable payments, and where providers see the value in promoting this service, off-network volumes will increase and further lower scheme and switch costs on a per-transaction basis. This further improves the business case for interoperability at both an end-user and provider level. Conversely, misaligned incentives, additional customer charges and provider disinterest can create a feedback loop that drives down the value proposition and ultimately spells disaster for a scheme.
The economics of interoperability are complex and difficult to navigate, but the difference between effective and ineffective business models can make all the difference in ensuring a long-term, sustainable value proposition for all.
CGAP has developed a financial model for helping digital financial services providers to understand the potential impact of interoperability on their financials. Contact Will Cook for more information.