Understanding the Payments Industry: What Is Money?

As described by the model we introduced in our recent article, Understanding the Payments Industry, at their heart payments are a simple movement of money from one party to another. Here we explore an often overlooked but important question for understanding payments: What is money? 

Economists commonly describe something as ‘money’ if it performs three functions:

1. Provides a stable store of value, enabling consumers to smooth purchases and consumption over time
2. Acts as a convenient medium of exchange so that goods and services can be traded
3. Is a widely recognised and generally accepted unit of account, enabling goods and services to be priced (and compared) relative to the value of money

There is an extensive debate around what qualifies as money in the realms of digital assets and cryptocurrencies (which we’ll comment on in future articles), but our description of the payments landscape applies primarily to the transfer of what we refer to as ‘real money’, namely:

• Physical cash (i.e. banknotes and coins)
• Central bank liabilities (i.e. money deposited into accounts at a central bank such as the Bank of England)
• Regulated commercial liabilities held with banks (i.e. money deposited into commercial bank accounts) or as e-money deposits (e.g. prepaid accounts)

A central bank liability involves money deposited in wholesale accounts, which are available to just a small number of licensed institutions, primarily commercial banks. In England and Wales, banknotes are also a central bank liability, but since the processes around handling physical cash are sufficiently distinct from electronic payments, we consider it separately. In Scotland and Northern Ireland, the issuing of banknotes is undertaken by several of the main commercial banks in each country, which have been granted the legal right to issue currency denominated in pounds sterling, backed by the banks’ cash deposits at the Bank of England. There are technical legal differences between notes issued by central banks and those issued by commercial banks, but the general payments journey (including processes for cash withdrawal and cash deposits at a customer’s bank) is identical in the eyes of the customer.

Regulated commercial liabilities are created when customers (individuals, businesses or other financial institutions) deposit money with a regulated bank. Depending on the breadth of services offered by their bank, customers will be granted access to several payments services, potentially including card payments; account-to-account payments via the Faster Payments Service (FPS), Bankers Automated Clearing Services (BACS) or Clearing House Automated Payment System (CHAPS); foreign exchange and international payments; cheques; and cash-in/cash-out services.

Electronic money institutions (e-money providers) provide payments services to customers in a similar way to regulated banks. However, whereas the banks lend out those deposits in mortgages or other forms of consumer and business loans, e-money providers must hold equivalent liquid deposits with a custodian bank (typically one of the major global banks).

The efficient exchange of value is a key component of a successful modern economy. In the UK, cash is used for just 15% of transactions, with most payments handled by card networks or other electronic payment methods. Whilst these payments are valued in pounds sterling, what is being exchanged is ownership of commercial bank or e-money institution liabilities to customers. For example, when Doug reimburses Richard for lunch with a faster payment transaction, Doug’s £10 deposit (a liability for Doug’s bank) is transformed into a £10 deposit in Richard’s account (a liability for Richard’s bank).

The payments networks have evolved to facilitate multiple ways to transfer value to achieve an economic outcome, and it often is a multi-step process. For example, consider a commuter’s journey into central London one morning:

What about unregulated money?

Efficient value exchange requires a high level of trust. Liabilities at regulated banks such as, say, ‘Santander money’ or ‘Lloyds money’ have equal value in the eyes of customers. Furthermore, both institutions have high levels of confidence in each other to settle with central bank money, so are generally happy to facilitate payments between their respective customers. Trust in payments networks is achieved because connecting participants must adhere to scheme rules and technical standards designed to protect the viability of the network (minimum capital requirements for banks and safeguarding rules for e-money issuers). It also helps that bank deposits in the UK are mostly insured for retail and small or medium-sized enterprise customers under the Financial Services Compensation Scheme.

There are many alternative currency concepts that are analogous to ‘real money’; e.g. airline loyalty points, supermarket rewards points, or credits used within specific digital environments (e.g. Robux). But are they money? Each these have some but not all of the attributes that describe money, i.e. providing:

1. A store of value
2. A convenient medium of exchange
3. A widely and generally accepted unit of account

All the above examples display the first attribute in that they can be kept easily in digital or physical form and exchanged later for goods or services. 

Loyalty points and other alternative currencies often perform well on the second attribute, as they are designed precisely for the specific ecosystem in which they operate and so seamlessly integrate with the service provider’s storefront. Loyalty points are usually a liability for the ultimate service provider; the process by which customers spend those points happens within accounting systems controlled by the provider of the service, which means accepting loyalty points for payments can be a simple and low-cost financial operation.

Many alternative currencies and loyalty points do not deliver the third attribute of money by design, as their use is restricted to certain merchants and service providers (it is difficult to use airline points to buy a meal at your local restaurant). So, whilst these alternative currencies have economic value, we would not consider them to be money.

Extending the payments model beyond ‘real money’

Whilst our industry model is designed to describe payments using real money, we find it is also an effective way to consider value exchange for many alternative currencies.

Given the potential of loyalty points programs to enhance the customer experience at a low marginal cost while creating a highly powerful mechanism to collect data and learn about customer preferences, it is unsurprising that there are many innovations in this space. From a consumer’s perspective, these solutions may offer similar functionality to money and the competitive set of alternative currencies is blurring the distinction between ‘loyalty money’ and ‘real money’. There are several loyalty schemes offering points and spend opportunities across multiple merchants. In the UK, Nectar has been the preeminent example. Boasting 18 million customers, it potentially has a reach to rival the largest high street banks. 

It is important that potential investors understand the opportunities and risks that are unique to businesses which have a large exposure to unregulated money. In addition to the customer experience and insights benefits outlined above, operators of unregulated money may have access to zero-cost funding, as customers often prepay for their purchases. Breakage also is a source of value, and this is not immaterial for the large programs. For example, Starbucks recognises over $200 million per year in breakage from its highly successful stored value card. Care must be taken to appropriately manage breakage: setting it too high risks undermining the viability of the currency, but setting it too low results in a missed opportunity for value capture.

Outside the regulated space, until now the ecosystems served by these alternative currencies have typically been small relative to the real economy, and so the macro risks associated with them being unregulated are low. It is unsurprising that regulators were genuinely concerned when the global tech giants were considering launching their own digital currencies with the expectation that these could be used and accepted across their broad ecosystems. Businesses at this scale and reach creating their own (unregulated) money could yet have a significant impact on the real economy. 

Co-authored: Douglas King Richard Mould

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