China surging in payments technology: lessons for the West
What has driven the explosive growth of Asian payments technology from giants such as Ant Financial and Tencent? What are the implications for the West? Where will there likely be investment and acquisitions? Mark Rodrigues, senior advisor, and John Meehan, partner, Arma Partners, explore.
A primer on payments and why it matters
Lesson 1: Payments are the key to serving the customer
There is an old saying that nothing happens in business until someone sells something. Times have changed. Today the consumer is empowered to engage in discovery on their own, often without a salesperson. One can browse the internet and get all the product information on their terms. Some apps even allow the consumer to take their own smartphone-scanned measurements to be fitted for shoes and clothes. Indeed, the online customer is engaged at any time and their payment, rather than the vendor actively making a sale, has become the key commercial “happening” from which everything else follows.
Lesson 2: Don’t look at payments in isolation
In the late 1980s Steve Jobs asked a room full of Harvard Business School students: “What’s the worst manufacturing problem?” Answers were shouted back such as “low inventory turns”, “spoilage”, and “too much working capital”. No, he said. The worst manufacturing problem you can have is making something that no one buys.
This lesson on manufacturing applies to payments. It can’t be looked at it in isolation, but as part of a continuum. Payments, discovery, fulfilment, authentication, and credit are all part of the consumer experience and feedback. Imagine a frictionless payments function that fits in the customer journey.
Lesson 3: Compare Alibaba with Amazon to understand how China is different
Amazon seems to work best with a customer that already knows what it wants. They are an efficient retailer with an end-to-end customer experience that is best in class. Everything from inventory management to “last mile” delivery is under constant improvement. If something is the wrong size or the customer changes their mind, the return policy and procedure is very easy.
In contrast, Alibaba runs a virtual mall, “Taobao”, and has very little inventory – even at Hema, their bricks-and-mortar store. It is almost as if the company reallocated all the attention and capital that Amazon puts into inventory and applied it to a more comprehensive customer experience. It not only provides access and reach for thousands of small and mid-sized companies, but also a fully linked experience for the consumer/customer. By bringing together multiple ecosystems including retail, commerce, finance, video, mobile, gaming and a physical store, Alibaba offers an addictive experience that is tailored carefully to each individual user. The effect is one of exploring a virtual mall that knows you (and your family and friends) already.
Alibaba’s use of a network of partnerships that deliver analytics and artificial intelligence (AI) capabilities allows the company to track and anticipate the preferences of more than 500 million active customers. This research into and obsession with feedback was reflected in the formation in 2011 of Ant Financial, the Alibaba affiliate that operates the market-leading Alipay service.
The state of play in China
Chinese consumers have embraced the shift towards a cashless society far more enthusiastically than their peers in the rest of Asia, Europe, and North America. Official government figures reported $12.8tn of mobile payments transactions in China from January to October 2017 alone. Ant Financial’s Alipay and Tencent’s WeChat Pay services claimed over 90% of this activity, according to Analysys International.
The Chinese payments success is about extraordinary timing. Growth of disposable income, the advent of internet and mobile, and China becoming a production powerhouse has sparked the economy. Add to this a huge population with a crude banking infrastructure and the time was ripe for companies to serve both payments and commerce needs.
We know the Chinese government has developed programmes to provide funding and resources to developing technologies with payments applications. Cyber, AI, and supercomputing are all examples that play to the impact of payments technology.
Tech giants such as Ant Financial and Tencent, the former of which is reported to be set to raise $9bn at a valuation of approximately $150bn, also benefit from home government policy. Historically China has been highly restrictive in its approach to inbound foreign direct investment and, in the judgement of a 2017 report from the IP Commission, a habitual patent policy infringer. The World Trade Organization ruled back in 2012 that US card payments providers were being discriminated against in China, with their entrance deliberately restricted until Union Pay could catch up and become an option to Chinese travellers.
At the time of writing, global trade is being tested on many fronts and we do not fully know how much of this is political posturing rather than substantive policy change. Trade imbalance and finetuning policy approaches to the information age has been with us for a long time. But both the US and EU have their own policy tools as well and, led primarily by the Trump administration, are now employing them more readily to deny incumbents like Ant Financial and Tencent the same level of access that they had previously enjoyed. Ant learned this in January when it was refused approval from the Committee on Foreign Investment in the US for its $1.2 billion acquisition of money transfer company MoneyGram International Inc. In Europe, PSD2 will likely provide not only open banking options to the consumer but increased vigilance on privacy as well.
What to watch in the next two to three years
Protectionism to consolidate incumbents’ control in domestic market but create obstacles to EU and US expansion
Even with Ant Financial and Tencent’s dominant market position currently, we see the large Chinese incumbents becoming even stronger and more controlling in their home market. Today a foreign company that wants access to Chinese consumers has to go through their existing ecosystem. Visa and Mastercard are still waiting for licence approvals and face the likelihood of having to set up local joint ventures rather than establish wholly-owned operations. If the price of entry is to concede a share of your firm to the incumbents, the Chinese market is only likely to become more restrictive to outsiders.
Of course, in recent months we have seen western policymakers take retaliatory action against Chinese protectionism. With the White House having taken the unprecedented action of blocking Broadcom’s bid for Qualcomm on national security grounds even before any deal had been agreed, we can expect regulatory approval to remain a significant obstacle to Chinese payments expansion for the foreseeable future.
Accordingly, we believe that Chinese payments companies looking to establish footholds in the EU and US will instead do so via minority stakes and partnerships. The $160 million Series C round led by Tencent and Allianz that the German digital bank N26 raised in March provides a template for this. Still another example is Ant with Paytm. We expect more of these kinds of strategic placeholders which provide access without flagging national security alerts and restrictions.
Chinese firms unconstrained by privacy concerns du jour
It goes without saying that any payment system is based on trust. There is near zero tolerance in the market for any payment technology that can’t meet this basic need. So, at a time of heightened sensitivity about how Facebook handles its users’ data and with the new EU General Data Protection Regulation (GDPR) being lauded as a best-practice template for regulating Googles and Amazons in other jurisdictions, it looks highly challenging for the US Internet giants to tack payments and the associated financial data protection requirements onto their existing activities.
By contrast, Chinese regulators and consumers are far less concerned by the idea of a non-bank financial. Take Ant Financial as an example, an Alibaba affiliate spun out to allay concerns over foreign investors’ control of the Alipay system that now separately oversees a $230 billion asset management business comprising the world’s largest money market fund.
We can therefore expect Tencent and Ant Financial to fuel growth through acquisition as well as organically, particularly as they roll out their products in other markets. But in the US and European markets, while there is still a natural advantage as a payment provider to being scaled – hence recent consolidation among the likes of Vantiv and WorldPay, Ingenico and Bambora – we need to ask the question of whether renewed scrutiny of providers’ trustworthiness favours small innovative fintechs over the large incumbents with infrastructure.
In North America and Europe, we have seen a number of new players enter the payments ecosystem across the entire value chain, from issuing to networks to P2P/remittance, with disruptive business models and high levels of funding (e.g. Adyen, iZettle, Stripe, Revolut). We have also seen the internet giants and retailers becoming increasingly active in payments (e.g. mobile wallets of Apple, Samsung, One Click payments from Amazon, Walmart Pay etc).
This is forcing the traditional payments providers and banks to scale up and participate in payments innovation or risk being left behind (e.g. PayPal’s acquisitions of Paydiant and TIO, ING’s acquisition of a majority interest in Payvision, the aforementioned Vantiv’s merger with WorldPay, Global Payments’ acquisition of Heartland and Realex, BNP Paribas’ acquisition of Compte-Nickel, Ingenico’s acquisition of Bambora, Wirecard’s acquisition of Citi Prepaid etc). We expect this consolidation to continue as players seek further scale, look to broaden their capabilities, expand into new markets and acquire innovation.
In addition, private equity firms continue to be active acquirers in the market given the positive sector dynamics, attractive business models and opportunity to further expand/grow through M&A (e.g. Nordic Capital’s acquisition of Trustly, Francisco Partners’ proposed acquisition of Verifone, Advent/Bain’s acquisition of Concardis, and Hellman & Friedman’s acquisition of Nets).
Given the size and growth of the Chinese payments market, it offers a significant opportunity for Western payments companies. To date the strategy has been to act as a gateway between China and the rest of the world, for example to enable acceptance of UnionPay and Alipay in North America and Europe, as they wait for licenses to operate in the domestic market.
Payments will be a key promontory on the AI battleground
Nobody really knows quite how high the stakes are here but some believe that, unchecked, artificial intelligence could variously become more important to the global economy than electricity or present a threat to individual choice and the development of well-functioning societies. The geopolitical dimensions of the AI race were laid bare last summer when the Chinese State Council outlined plans to draw level with American companies and research facilities by 2020 and establish China as the global leader in AI by 2030.
Payments is a critical part of the AI debate because the process captures data on the buyer, seller, and their behaviour. Machine learning (ML) technologies rely on access to reams of data to learn and refine their processes, which can in turn be applied to these masses of unstructured data. The less restricted access to a greater volume of data that Chinese payments companies enjoy relative to their western counterparts will allow them to fast-track the development of AI products and utilise them for applications such as security and process optimization.
Accordingly, we also expect to see a growing volume of small AI firms being consolidated for technology and talent by larger fintech firms and aspirants, in deals that at first glance may seem like “mission creep”. For the likes of Ant Financial and Tencent, who have already established AI research facilities in both China and the US, these early-stage acquisitions could supplement their development of IP in-house – though may also face regulatory obstacles, where the target firms are from the current leading AI hotspots of the US and Western Europe. Alternatively, American and European fintech firms may rely on “acquihires” of specialist AI engineers to counteract the stricter restrictions they face in using customer data to inform the development of new AI technologies.