A Mental model for understanding the Payments Value chain.
80% of what you need to understand Payments.
A mental model is a tool to understand how a thing or a process works. A simplified framework if you like.
Since Kenneth Craik laid the foundation for mental models, a number of notable minds like Charlie Munger and James Clear have found them useful.
So instead of tasking your brain to memorize everything about a concept, you can create a way to make sense of it most of the time.
This leads me to my next point: As with all things in our lovely world, mental models are not absolutes or facts. There are variations and exceptions.
Payments is an area I’ve found useful to adopt a mental model for. We contend with various versions of Payments within our domestic markets and also across borders. Things move so fast that even experienced professionals get confused.
But this can be simpler. So here goes my 7-piece framework on dissecting any Payments system I want to understand. It is also very useful for designing Payment products.
- Tokens
A Payment Token is a representation of value. In Digital Payments, we move money around electronically, so these representations are digital. E.g. Payment Cards ( Debit, Credit, or Prepaid), accounts, and Digital Wallets. Previously we had physical Payment tokens like Cash or Cheques.
Payment Tokens are important because they kick-start the transaction. If you do not have any digital representations of money, you will be excluded from the Digital Payments. This is the predicament of the group of people we call Financially-excluded.
When you are studying any payment system, find out how transactions are initiated or what Tokens are used seamlessly on the platform.
2. Systems
The Payment Systems are a large group of middleware (fancy name for systems that act as a logical glue in an ecosystem) that do a lot of the heavy lifting and processing of transactions. Depending on the Token involved you can have a couple of them. I’ll discuss 2 below.
a. Payment Switching Software: This is an intelligent, secure router. It receives information from different sources in encrypted formats, decrypts them to determine where to route them to, and handles other things like message enrichment, currency conversion, etc. Some
b. Card Management System. Watch out for a deep dive on this one.
There are other systems like Terminal Management software, Gateways and interfaces, and Treasury management systems. etc. If you are building a Payments product, find out what functionality your system needs to fill in the missing gaps.
Last note on this section: These systems store and transmit sensitive data so they need to adhere to standards defined by global bodies like PCI-DSS and PA-DSS rules as well as other relevant standards defined by local regulations.
3. Channels
Channels are the customer touchpoints. They are also called terminals. They help answer this — How will customers use or interact with the payment functions?
They are in 2 major categories: 1. Physical — what can be touched. examples include POS and ATMs and 2. Virtual — what can’t be touched. examples include Mobile apps and Web.
There are 3 things to note about channels to avoid confusion.
i. A mix of physical and virtual tokens can be used on different terminal types. Virtual cards can be used on ATMs even though it is a non-virtual Terminal.
ii. Aggregating channels under a specific use case can unlock innovation in some markets — e.g. aggregating POS and Mobile under Agency banking for low-value transactions.
iii. Channels are further categorized as Electronic and Digital. So the old-school channels are referred to as Electronic whilst the more modern, mostly virtual channels are referred to as Digital. I am not sure why as all transactions are still Electronic :).
4. Settlement
A Payment transaction is made up of 2 parts. The actual transaction and the settlement. It is not complete until these 2 parts are complete.
All the money transported on Payment systems is en-route somewhere. What Payments does is to make it easier, faster, and more secure. But if it is easier, faster, and more secure and the money doesn’t get to its final destination on time ( surprise! this happens a lot), then Payments is no longer a game changer but a bottleneck.
Remember this: Cashflow is the lifeblood of any business. If Merchants do not get their money on time( this can mean a lot of things), then they will look for other means including reverting to cash payments.
Effective Settlements give timely value to all the parties in the payment chain and also calculate fees effectively. 2 things to note here
a. The Settlement period, is defined by the regulator or the card scheme. You’ll see a value like T+x where x can be 0, 1, etc.
T is the date when the transaction happened. T+x is the date by which all the parties should have received value.
b. Take note of narration: Narration explains the specific transaction. It becomes important as payment routes become complex. Design a narration and a parameter for your Payment product. Discuss it with external integration parties so it is returned in the feedback to your system.
5. Disputes
In transporting value from one place to another, things could go wrong. Actually, things go wrong a lot. I need to emphasize again.. a lot.
Trust is the main currency in the Payments value chain. Trust is built and trust is transferred from platform to platform. If anything erodes that trust, it is really difficult to get it back. The biggest factor that can tamper with trust is when your transaction is in error and your money is missing.
The thing is to proactively identify scenarios that could lead to disputes and create very clear processes on how to deal with them. 2 things are important here.
a. Define timelines for the process to be completed. This sets an expectation for the customer or stakeholder.
b. Also define information to be supplied and who is responsible for that.
Bonus points for you if you can automate all or a part of the dispute process.
6. Security
Security is how we assure every stakeholder that this ‘remote’ method of controlling their hard-earned cash is safe. There are various categories of security in payments.
Customer-focused: How do we ensure the right customer is the one initiating the payment? Here we have the PIN, OTP/2FA, Biometrics, etc.
Channel-focused: How do we ensure the Channel used for the transaction is safe and not susceptible to compromise? For Physical terminals, we have a PIN entry device (PED) and encrypting PIN pad (EPP) and for virtual: protocols like SSL, and 3DS2 for card transactions as well as others defined by the PCI DSS group.
System-focused: All transactions are routed in and out of systems as highlighted above. If we don’t secure them, they provide an easy entry point for fraud. Encryption( Transaction & Data) as well as access control must be taken seriously.
7. Regulations.
Regulations are perhaps the most important piece.
Why? You could do all the 6 things above well, and it all falls to waste on account of regulations. Regulations are defined per market and also per card scheme. It’s a set of guidelines that specifies what is acceptable, how it should work, and who/what body is allowed to do them concerning how to move money around.
- Regulations are why crypto is not allowed in Nigerian Fintech Ecosystem even though the tech and talent are abundant.
- Regulations are why only specific organizations are allowed to issue cards and anyone else interested must work with them.
I could go on and on.. bottom line, pay attention to regulations so your efforts do not waste.
So there you go, a straightforward, 7-piece model to teardown any Payment system you want to unravel.
If you are interested in Fintech and Payments, I have more articles in store for you. Let’s connect.
