Volume 8, Number 21 May 2015 McKinsey on Payments

Foreword 1

Gauging the disruptive potential of digital wallets 3 While they have established a solid foundation for growth, digital wallets are by no means a guaranteed success. They must continue to evolve if they are to have a truly disruptive impact on the payments landscape. Providers can improve their chances by focusing on six “markers” for success in payments innovation.

New partnership models in transaction banking 11 A number of trends are leading to a fundamental rethinking of the traditional model by which banks offer transaction banking services to clients outside their established markets. Four distinct partnership models offer the best opportunities for banks seeking to succeed in an evolving landscape.

Toward an of : An interview with Chris Larsen, 19 CEO of Ripple Labs McKinsey on Payments sits down with the co-founder of Ripple Labs to discuss the nuts and bolts of the Ripple protocol, the implications for the correspondent banking model, and the emergence of an “Internet of Value.”

Faster payments: Building a business, not just an infrastructure 23 A faster payments infrastructure is not an end in itself, it is an opportunity for banks to deliver innovative products and services in both consumer and corporate payments. To monetize this opportunity, financial institutions should focus relentlessly on design, customer experience, accessibility and convenience. Gauging the disruptive potential of digital wallets 3

Gauging the disruptive potential of digital wallets

Digital wallets are having a moment. The recent launch of and the accompanying media attention are bringing them into the mainstream. Technological and market developments have expanded their potential. Payments networks have shown a willingness to unbundle their offerings and permit non- bank players to use their tokenization protocols. EMV technology adoption in the U.S. has accelerated. And consumers are more open to adopting digital-wallet- like offerings like mobile boarding passes and Starbucks’ loyalty app.

Sameer Gulati Yet for many in the payments industry the Design a compelling value question of whether digital wallets (see proposition Marie-Claude Nadeau “Defining the digital wallet,” page 4) will 1. Deliver significantly more customer value Kausik Rajgopal ultimately succeed is still an open one. In than rivals. Entering payment credentials the U.S., PayPal and other early digital wal - when shopping online is often considered lets attained scale through online com - cumbersome, making convenience a long - merce, but attempts to bring mobile standing consumer payments priority. In the payments into the physical world have had U.S., McKinsey’s annual Mobile Consumer limited success. Panel consistently identifies convenience as the leading factor in consumer adoption of To provide a structured perspective on how mobile payments. Most digital wallets, in - digital wallets will evolve, this article cluding Apple Pay, Visa Checkout and examines the market through the lens of Google Wallet, accordingly emphasize con - McKinsey’s six markers of payments venience in their value proposition. Until disruption success (first described in “The now, however, paying with future of payments: Markers for success,” offline in markets where card penetration McKinsey on Payments , June 2011). The six is strong has been only slightly more con - markers are grouped in three critical areas: venient than existing methods . designing a compelling value proposition; executing a measured go-to-market strategy; While most payments industry advances and planning thoughtfully for expansion. must overcome inertia and network effects, 4 McKinsey on Payments May 2015

Defining the digital wallet

The term digital wallet has been applied to diverse forms of electronic payments, even some as simple as prepaid cards. In addition to money, however, traditional wallets also typically hold various forms of pay - ment and identification that might be stored and accessed digitally. This article therefore defines the digi - tal wallet as a software application that enables users to digitally store money, payments credentials and more, and to use these to implement various types of cashless transactions.

motivating consumers to alter their funda - To significantly increase customer conven - mental payments behavior is particularly ience, providers should expand wallet func - challenging. In online commerce, PayPal ini - tionality beyond basic payments capabilities. tially added convenience by introducing Options include digital storage of ID cards, emails and passwords. Today, Apple Pay uses driver licenses and other items carried in its fingerprint recognition feature, Touch ID, traditional wallets ( Exhibit 1). The Osaifu- for online shopping, which replaces pass - Keitai wallet developed by NTT DOCOMO words with biometric security. However, be - in Japan, for example, includes electronic cause consumers still perceive credit and money, credit cards, ID cards, loyalty cards debit cards as a major convenience for on- and electronic fare collection on public tran - site transactions, digital wallets will need sit. Digital wallets could include applications even stronger value propositions to displace that deliver targeted offers, which could be entrenched card-based payments. designed to redeem automatically at the point of sale—a major convenience for value-oriented consumers. India and several While most payments industry other nations are even considering the is - advances must overcome inertia and suance of personal IDs that could be stored in digital wallets. network effects, motivating consumers In addition to convenience, Apple is empha - to alter their fundamental payments sizing security and privacy in Apple Pay behavior is particularly challenging. . Other wallets, including PayPal’s and Turkey’s BKM Express, address these concerns by withholding payments details Digital wallets that demand more effort and from merchants. Historically, consumers time than currently favored payments meth - have considered security and privacy to be ods are also unlikely to gain widespread important primarily for online and mobile adoption. For instance, requiring buyers to transactions, but recent breaches of card add devices to their phones, narrowly limit - data at retailers suggest that value proposi - ing the forms of accepted tender, or requir - tions containing strong security and privacy ing manual entry of bank information could components could be effective in driving all hinder acceptance. wallet adoption. Gauging the disruptive potential of digital wallets 5

Exhibit 1 Digital wallet The digital wallet Potential applications presents diverse commerce-related In-person applications card/cash extending well alternative Mobile NFC, QR-codes beyond payments incentives and loyalty Mobile payments Coupons, location - Payments processing, based offers, card swipe “sleeve” “pay with loyalty points” Identity Driver’s license, health cards, boarding passes Banking and Peer-to-peer/ bill pay digital goods View accounts and Pay friends and transfer money purchase Mobile/E-commerce music, apps “check-out” Mobile site or in-app purchases

Source: McKinsey Payments Practice

2. Create broader merchant value proposi - failed to attain scale. So to succeed, digital tions. Minimizing cost is a top merchant pri - wallets like MCX will need to find other ority in payments. The Merchant Consumer ways to drive revenue growth. Possibilities Exchange (MCX), for example, which com - include improving the customer experience, prises more than 60 U.S. member retailers, more effectively delivering offers and loyalty is establishing a digital-wallet platform de - propositions, and collecting and sharing signed to reduce members’ costs. The plat - more consumer data with merchants. form addresses member concerns about rival digital wallets, like Apple Pay, that index For online and , payments heavily on credit cards and can therefore and digital wallet innovators like PayPal’s skew a merchant’s payments mix toward Braintree have recently gained a foothold higher-cost methods. But excessive focus on by delivering seamless customer experi - costs might also reduce consumer appeal— ences that dramatically increase purchase for example, by requiring shoppers to dis - conversions. Conversion is valued highly by close information they are unaccustomed to smaller online and mobile merchants intent providing for retail payments, such as bank on winning new customers and gaining re - account numbers in the U.S. Historically, peat business. Some digital wallets build on payments disruptors that focused on cost at the shopping experience developed by retail the expense of customer experience have giants like and Walmart, who ex - 6 McKinsey on Payments May 2015

pedite the checkout process by storing and In the early niche-market stage, issuers can auto-populating previously used payments also pursue users (Android credentials. These innovators offer this ca - users in the case of Google Wallet; iOS in pability and conversion performance to the case of Apple Pay). For merchants, smaller merchants who cannot develop the these might be frequent users of their pro - tools themselves. The payments processor prietary mobile apps. The issuer might, for Stripe, for example, minimizes cost while instance, create a simple link with existing- providing easy merchant integration and an app functionality to avoid confusion be - uncomplicated customer experience. Ex - tween the wallet and other apps. Defining tending such merchant propositions to the and delivering a value proposition for these physical world is another way for digital customers will be critical to gaining early wallets to offer merchants more than just adoption . cost savings. 4. Leverage existing ecosystem and infra - structure. The tokenization protocol devel - oped by EMVCo (used for the first time by When expanding into new markets Apple Pay and likely to be adopted by oth - digital-wallet providers should proceed ers) illustrates this important success marker well. By using 16-digit tokens—the cautiously. Markets often differ same format as existing credit and debit significantly in such critical aspects as card numbers—along with other existing data fields, the protocol enables more se - card interchange economics, cure routing of payments via established regulatory environment, technology networks and POS infrastructure while penetration and consumer behavior. minimizing requirements and network in - tegration costs.

Wallet-like merchant apps, including those Execute a measured go-to-market of Starbucks, Otto’s Yapital in Germany and strategy Target’s Cartwheel in the U.S., also use ex - 3. Penetrate niche market segments first. isting POS infrastructure to drive consumer Consumers’ expectations for digital wallets adoption. Because these products use QR vary widely, so it is difficult to address them codes, however, related apps do not require all at the outset. One approach is to initially near-field-communication (NFC) termi - target smaller market segments. This enables nals. By contrast, Apple Pay, Google Wallet narrow tailoring of product design, partner - and others use NFC to deliver a seamless ships and marketing, which not only im - customer experience that, in the U.S., has proves the odds of early success and keeps thus far come at the expense of broad mer - customer acquisition costs manageable, but chant acceptance. But, as merchants re - also lets the wallet provider offer merchants place older payments terminals with NFC- quick access to customer segments, which and EMV-enabled models, this obstacle can be an important incentive. should diminish in importance. Gauging the disruptive potential of digital wallets 7

Plan thoughtfully for expansion In addition to putting pressure on inter - 5. Adapt offerings to other markets. When change economics, regulations can also pres - expanding into new markets, digital-wallet ent challenges to data-gathering efforts and providers should proceed cautiously. Mar - analytics-based value propositions related to kets often differ significantly in such critical wallets. Apple Pay has said it will not collect aspects as card interchange economics, reg - payments information, but Google Wallet ulatory environment, technology penetra - and others might decide to gather and use tion and consumer behavior. Markets with payments data, in which case they will face substantial economic differences, for in - different security and privacy constraints in stance, can present considerable challenges, the markets they enter. such as lower levels of interchange. This can make charging incremental fees to issuers Established consumer payments preferences (such as Apple Pay’s 15 bps fee) more diffi - can also have an impact on digital-wallet cult, and can also negatively affect network success. For example, bank account-funded tokenization economics. In markets with low wallets might gain ground faster in markets interchange fees, such as the EU, where like Germany and India, where non-card interchange will fall below 0.3 payments methods (including direct bank percent, wallet providers might need to find account access) are more common. Intro - monetization alternatives ( Exhibit 2). duced in the Netherlands in 2005, the

Exhibit 2 Card penetration and interchange levels by country, 2013

Digital wallet Average interchange level for credit cards business models must Bps adapt to diverse 1.5 market conditions, such as varying U.S. interchange levels Canada 1.0 Brazil

India China

0.5 Spain

Sweden Germany France UK

0 0 5 10 15 20 25 30 35

Debit and credit card penetration Source: Strategy Analytics; IDC Percent 8 McKinsey on Payments May 2015

iDEAL wallet platform, which does not use Telecommunications and Clearing Institute, debit or credit cards, gained acceptance at making displacement a tall challenge. 100,000 online stores. Conversely, in Euro - From the technology standpoint, mobile pean markets where rewards play a smaller wallet providers will also need to adapt to role, pay-with-points wallet features would differences in smartphone penetration lev - likely have less appeal. els and merchant-acceptance technologies In some countries, new entrant wallet prod - in different markets. Apple Pay, for in - ucts, even those with advanced features, will stance, is likely to have a smaller presence have to compete with incumbent offerings in markets such as China, India and Korea already embedded in the infrastructure. In where iOS penetration is low ( Exhibit 3). Japan, a market that is highly conducive to Similarly, NFC wallets should gain quicker launching new technologies, the Osaifu- acceptance in places where that technology Keitai wallet has 10 years of history and is already has a strong presence, such as Aus - tralia and the UK . now used even for government-issued IDs. In South Korea, Bank Wallet Kakao was re - 6. Tap adjacent profit pools to differentiate cently launched in partnership with 16 Ko - offerings and add value. Convincing prospec - rean banks, as well as the Korea Financial tive partners to pay for wallet services solely

Exhibit 3 iOS share of handset shipments Apple Pay adoption Percent of units shipped, 2013 could be slower in ≤5 5-6 6-10 >10 N/A countries with lower iOS market share

Source: Strategy Analytics; IDC Gauging the disruptive potential of digital wallets 9

on the basis of transaction volume may gen - Wallet providers therefore might need to erate only modest revenues because it taps seek alternative revenue streams that offer a profit pool that, in many markets, is al - more meaningful growth potential—possi - ready under margin pressure. In the pay - bly commerce-related revenue streams ( Ex - ments value chain, the war over endpoints hibit 4). Coupons and data analytics, for (such as the consumer and merchant inter - instance, have strong links to payments and faces in the case of wallets) is already com - transaction data. In fact, the line between pressing margins in mature markets as the value chains of payments and com - providers continually offer more compelling merce is already blurring as payments rewards and discounts. processes blend into the purchase experi - ence—a change exemplified by Braintree In mature market pockets where inter - and rideshare provider Uber. This could change revenues are under pressure, such open adjacent commerce revenue streams as PIN and debit cards in the U.S., tok - to payments incumbents. enization fees may provide a viable alterna - tive. While these fees tap the same revenue Given mapping capabilities at the device and stream, they also promise to reduce risk customer levels, tracking the performance of costs throughout the payments value chain. digital-wallet marketing campaigns is also

Exhibit 4 2012 revenue streams, global $ billion Large revenue streams adjacent to Card lending 134 payments blur the 134 lines with commerce E-commerce hosting 22 Merchant acquiring 14 Paid search 11 ATM 10 Checks 10 Coupons 9 Big data analytics 7 Cross-border 6 Issuer processing 6 General purpose prepaid 5 Credit processing 4 Wire 3 ACH 3 Private label prepaid 3 Money transfer 3 Debit processing 2 Cash 1 B2B card 1 Mobile ads 0.6 Commerce Card-based loyalty programs 0.4 Network Source: McKinsey Global Payments Map; McKinsey Payments Practice General purpose prepaid 0.2 Payments value chain 10 McKinsey on Payments May 2015

easier in the offline world, facilitating the initial market selection and building on ex - adoption of pay-for-performance models. isting infrastructure. However, they also This can become a winning situation for need to develop more comprehensive con - both merchants and wallet providers, sumer value propositions that can deliver wherein merchants pay providers based on the magnitude of user-experience improve - incremental rather than absolute , a ment that widespread consumer adoption model which more closely aligns the incen - demands. Finally, players will also need to tives for both. thoroughly consider what is necessary to ex - pand successfully into other markets and * * * revenue pools—areas that present strong The recent convergence of payments and promise for rapid growth, but in contexts commerce means digital wallets are here to that may be especially challenging to digital- stay. Yet, while they have established a solid wallet economics. foundation for growth, to truly become a payments disruption they must continue to Marie-Claude Nadeau is an associate principal in evolve. Many providers are, in fact, becom - McKinsey’s San Francisco office. Kausik Rajgopal is ing more thoughtful about their go-to-mar - a director in the Silicon Valley office, and Sameer ket strategies, particularly as these relate to Gulati is a principal in the London office.