The article from “FinTech and Ukraine” cycle by Head of FinTech practice Sergii Papernyk tells about a complicated but dynamic and interesting evolution from carton credit cards to virtual money.Among the many innovations in the financial sector, the largest number of services can be found in the payment environment. And this is not surprising, since the transition to on-line trade and development of e-commerce wouldn’t be possible without simplified settlements for the merchandise purchased.
Fintech and Ukraine: Payment Systems. Part 1.
According to the MEDICI web portal, today’s Fintech sector includes more than 1,700 Finteh companies engaged in the payment industry. This figure is well above any other startups from the Fintech world.
However, the first payment systems emerged long before the Internet entered our lives. Part 1 of this article will deal with historical aspect of this Fintech area.
Evolution of Payment Cards
The first theoretical data about the use of cards as a means of payment appeared in England, where the idea of credit cards was put forward by Edward Bellamy in his book Looking Backward, published in 1888.
In 1891, American Express, being an ordinary courier service engaged in the currency shipment, issues the first American Express traveler’s check. Nevertheless, it is considered that the history of payment cards began in 1914 when trade enterprises began to issue credit cards to their regular customers in order to tie them even more to their chain of stores.
A paper credit card, issued by the Western Union Telegraph Company in 1919, was given only to members of the US government and allowed sending telegrams on credit at the government’s expense.
Short life of the cardboard cards drove the search for their replacement. Therefore, Farrington Manufacturing company released embossed steel cards. They helped to automatize the process of payment — the clerk had to make a data imprint. Then they were displaced by plastic cards since the latter turned out to be more practical.
In the 1940s and 1950s, during the “trade boom” in the United States, non-cash payment system began to replace cheque books. It is believed that the foundation for the bank credit cards was laid by John S. Biggins from the Flatbush National Bank in 1946. This scheme envisaged receipts which local stores received from clients for small purchases, after which the store handed these receipts over to the bank, and the bank paid them from the buyers’ accounts. Flatbush was the first place where a classic pattern of settlements, which the banking card business uses to this today, was tested.
However, officially, the first bank card was issued in 1951 by the Franklin National Bank in New York, and since that time this type of services began its rapid development.
In 1960, the first plastic card with a magnetic stripe was made. IBM also had a hand in this. The goal was to develop a safe data storage method, since neither barcodes nor perforations were notable for its reliability. Therefore, it was decided to use a magnetic medium which was already used in computers to store information.
Sometimes clients also needed money in cash, which ultimately led to the idea of creating an ATM.
The world’s first operating ATM appeared in 1967 in Barclays, in the northern part of London. But instead of plastic cards it accepted paper vouchers. It was possible to withdraw no more than 10 pounds at a time. Vending machines with chocolates were already common, and these vending machines, along with closing bank’s branch for the night, gave John Shepherd-Barron, a Scottish inventor, the idea of automating the receipt of money.
The first ATMs that accepted bank cards were installed in 1972 by the Lloyds Bank in the UK. Later, the development of telecommunications allowed the creation of entire ATM networks which could be used by several banks.
Innovations continued. In the early 1990s, Europe began to develop standards for smart cards, i.e. plastic cards with a built-in microcircuit, very similar to a SIM card. Today, a chip placed inside the card allows making contactless payments using PayPass and PayWave technologies.
Except for the Soviet period experience with payment cards in “Inturist”, payment systems came to Ukraine in 1996, when six leading Ukrainian banks were admitted to the international payment system Visa International Service Association.
Today, the largest first-generation payment systems using cards are Diners Club, American Express, Master Card, Visa International. They are still doing well, serving millions of customers around the world.
History of Money Transfers
Along with payment card service, there has been another successfully developing line of payment services, namely money transfers.
Perhaps the most striking story in the field of money transfers is the story of Western Union.
Hiram Sibley, a successful sheriff of Monroe County, New York, opportunely discerned potential of the telegraph communication and soon, having bought several telegraph companies, received an order for the construction of a transcontinental US telegraph line. However, his idea of using expensive telegraph communication for money transfers was even a better one.
Since that time, there was no need to send monetary funds by courier, and they could be transferred by simple telegraphic message in a matter of minutes. At that, no coupons or forms from the ledger were to be sent, but merely information about the recipient and the amount of payment.
The company kept moving forward, winning the market and extensively using new technologies, including the Internet. Western Union is the most popular money transfer system to this day.
In 2015, Western Union made 262 million money transfers between its clients for a total amount of 82 billion dollars. The company has more than 500,000 points for the receipt and sending of money in two hundred countries.
The second largest network of money transfers is MoneyGram, which is not significantly inferior to the leader in popularity.
Interbank Payment Systems
In addition to card service and direct money transfer services, there are closed-type payment systems that are not intended for use by consumers. For example, payment systems for interbank settlements.
Initially, banks communicated with each other via mail and telegraph. However, in the early 1950s, several years after the Second World War, countries began to actively engage in trade at the international level. As a result, this entailed a sharp expansion of the banking functions and operations, and, consequently, the need for new technological solutions.
In May 1973, with the participation of 239 banks located in 15 countries of the world, a payment system under the name SWIFT (Society for Worldwide Interbank Financial Telecommunications) was created and established. Due to the use of computers, the system allowed to ensure round-the-clock exchange of financial information with high level of security and control.
Today SWIFT includes more than 7 thousand financial organizations and banks located in 190 countries. Despite the sufficiently large distance from each other, they can freely exchange messages and interact round the clock.
Closed payment systems include country-level networks allowing the exchange of payment information between the central bank and commercial banks.
In particular, Ukraine has the System of Electronic Payments (SEP) of the National Bank of Ukraine and its use is mandatory for all commercial banks of the country.
Second-Generation Payment Systems
The world does not stand still. Many people constantly carry a few bank cards, with them, which, let’s face it, is not very convenient. Money transfer services, like Western Union, charge sufficiently high fees, and the speed of processing of the simplest SWIFT payments today is 3 to 5 days.
That is why, with the advent and spread of the Internet, payment services started to shift away from material items towards a more convenient infrastructure.
The most well-known non-banking payment systems of today emerged in the same year – 1998. Those were payment network PayPal and electronic payment system Webmoney Transfer.
PayPal was originally the result of the merger of a cryptography company Confinity and a brainchild of Elon Musk – X.com. The service was originally aimed at servicing e-auctions at eBay and it is no surprise that it was later purchased by eBay itself.
The transfer of funds was performed by means of the data exchange between user accounts linked to a payment card. PayPal service turned out to be ideal for cross-border transfers and quickly became very popular.
Today PayPal is a globally recognized brand. This is the largest and the most powerful representative of the independent electronic payment providers. The company is servicing over 169 million of active accounts in 203 markets around the world.
A slightly different logic of settlements was used for the Webmoney payment service. Legally, the system transfers property rights, which are accounted using special units of account – “title units”, denominated with reference to different currencies and gold (for example, WMU is an equivalent of UAH on U-purses). Funds can be transferred only between purses of the same type. The exchange of title units of various types is carried out in the exchange services which may not be directly related to Webmoney.
The company was established in 1998, the first thousand of registered users of the system was given a bonus of 30 “title units”. Since 1999, due to cooperation with Western Union, it became possible to make postal and wire transfers via Webmoney.
Webmoney continues to be a popular system of settlements. As of January 2018, the number of registrations in the WebMoney system exceeded the mark of 36 million accounts.
It should be noted that in addition to PayPal and Webmoney, other similar payment services have also gained popularity. However, the basic idea underlying all second-generation payment services is electronic money.
The development of payment systems of the new generation is closely linked to the concept of “electronic money”.
The term electronic money can be defined as a system for storage and transfer of both traditional and non-governmental private currencies. But, due to the development of a wide variety of electronic payment services, the term “electronic money” for a long time was interpreted in quite different ways.
In 1993, central banks of the European Union began to study the phenomenon of electronic money, which at that time was considered to be prepaid cards. In fact, it was recognition of the existence of electronic money at the official level. Starting from 1993, the development of both electronic money based on cards (card-based) and network electronic money (network-based) has begun. Approximately at the same time, large-scale loyalty programs, involving essentially the issue of the limited-use means of payment (“miles” for air carriers, “points” for discount cards), became popular.
Today, the legal nature of “electronic money” varies from country to country. Some countries are ready to recognize them as “private money” (USA, Scotland, Northern Ireland), in others (like, for example, in Ukraine), electronic money is not considered to be money, but a value unit and obligations of the issuer.
According to the generally accepted classification, electronic money can be roughly divided into the following categories:
- Fiat (emitted by the state) electronic money on the basis of networks – PayPal, the African payment system M-Pesa.
- Fiat electronic money on the basis of smart cards – Visa Cash, Mondex, Hong Kong Octopus card system
- Private electronic money on the basis of networks – WebMoney, QIWI, Yandex.Money, crypto-currencies.
The second-generation payment systems not only laid the foundation for a modern boom of payment fintech start-ups. This long evolution was necessary to prepare the society and governmental regulators to the fact that financial system is changing and will not remain the same in the future. Moreover, we already see that society needs more flexible approaches to the legal regulation of this area.
In Part 2, I will tell about the “third” and the expected “fourth” generations of payment systems. We will also try to analyze the readiness of the Ukrainian legislation for innovations in this area and to figure out what will be useful for a payment fintech start-up.