This article is the first in what will be a series of articles from industry leaders on the business of building and managing innovations, particularly within payments platforms and networked businesses. In our inaugural article, we will take a look at the evolving role of capital, corporate development, open technology, and the creation of external innovation ecosystems in the business of growing a payments network into new channels and onto new platforms.
The Network Effect
Payments networks are, by their very nature, distributed ecosystems – that is ecosystems in which many different players help sustain it. Certainly some payments networks are more distributed than others, but almost universally, the management of a payments network requires the participation of other companies – acquirers, issuers, processors, technology providers, software developers, systems integrators… the list goes on. These participants help manage the technology development and dissemination of the payments network’s core processing capability, but they also play a fundamental role in the business functions of a payments network. In short, they help to drive the “network effect” that is at the heart of growing the company into the core business. That network effect, with its positive externalities, may be described as follows:
• Participants in the network derive the value of their participation from the other participants present in the system.
• The greater the number of participants, the greater the value, and the greater the number of new participants who are attracted to the network.
• As the participant base in the network grows, more new participants are attracted to the platform because they may find the greatest number of potential interactions there.
• As more new participants are attracted to the network, the existing participants derive increasing value from the business, concentrating more of their investment in that network.
This is the “virtuous cycle” to which observers of network businesses often refer. Each step of value creation in the series above feeds the next step, with the last step cycling back again to the top of the list. The power of well-functioning network ecosystems is that they become almost self-perpetuating cycles of value creation and growth, almost seeming to feed themselves in endless repeating cycles. However, this impression of power underlies a potential peril in these systems, particularly if the business professionals tasked with managing network ecosystems begin to believe that the growth cycles are self-perpetuating. Like a top once wound and released, the growth cycles continue to spin.
Yet a top can slowly, or suddenly, spin to halt as it meets resistance. Payments networks are no different – they require constant oversight and a steady hand providing regular re-spins to keep the network cycle turning. These re-spins most often take the form of adding value to the network core proposition, and in turn, adding participants and interactions to ensure that as the network of users grows, so too does the value proposition they encounter in the network itself. The core proposition of the network must constantly evolve as the users grow and change, and their expectations of the value proposition change as well. Constant recharge of the network effect is therefore critical to the health of the system. This is particularly true if the payments network begins to encounter resistance, whether in the form of regulation, competition, or potential defection by existing participants. All of these forces are beginning to work against the major payments networks today.
As they move into new geographies, new ecosystems, and especially into new roles with their existing participants, payments networks are finding that the top is getting harder and harder to keep spinning.
However, as we will discuss a little later in this article, there are creative ways for managers to engage an expanding base of ecosystem participants in a direct and focused effort to help keep the network relevant and the spin at the heart of the network vibrant.
Driving the Network Effect
Successful management of a payments network requires an understanding of both the strength and seduction of the underlying network effect. While growth may seem self-perpetuating, it rarely is for long. However, there are a few fundamental strategies to driving growth in payments from a network-centric view that can help a payments executive effectively counter the seductive siren song of self-perpetuating spin from within the center of the network ecosystem. Put simply, three basic strategies – when well understood and effectively executed – can help business managers keep the gyre of growth at the core of the company strong and healthy. In descending order of priority, these strategies are:
• Attract Participants: Bring More Participants to the Network. This strategy may seem obvious, given the fundamentals of driving the network effect as discussed above. However, effective managers of payments networks must understand that this is not only the most important strategic imperative for their business, it is also the most nuanced. As payments networks grow into new marketplaces and new ecosystems, management of this imperative becomes more challenging. For example, a consumer payments system trying to attract new pools of consumers and merchants in emerging markets may need to expand the definition of “direct participant” in the network beyond “financial institutions” to include mobile operators, money transfer operators, governments, and retailers. A manager whose view of the business has been formed by 20 years of cycling growth with financial institutions alone may be strongly resistant to this redefinition. However, there is a powerful catalytic potential available to a payments business as it engages more directly with other network businesses, such as those just mentioned, that payments mangers should consider. If two network-effect businesses connect in a way that allows each to provide complementary services from their core business to common customers, the increase in power to the network effect of each can be significant.
• Drive Interactions: Provide Participants with a Range of Ways to Interact. As more participants join the network, a payments manager must give them a broad range of valuable ways to interact. This often takes the form of what most of us think of as traditional product development and management – making enhancements in core products to maximize their performance for key customers, opening access to new channels through tools that optimize those core products in these new environments, and creating new, unique product capabilities that meet the need of key growth segments. Increasing the ways in which participants can interact enhances the value of the network as well, ensuring that participants bring as many of their interactions as possible to the network. Extending this strategy to the participant groups listed above, this activity can include the practical examples of building services that complement core payments capabilities in new acceptance segments (such as small ticket payments), building software platforms that improve the performance of core payments in eCommerce or mobile, and developing new payments capabilities (e.g.: prepaid) that serve the needs of common customers also served by mobile operators, money transfer operators, or governments.
• Add Value: Enhance the Value of Each Interaction. As participants connect with the network and grow their interactions, the spin at the heart of the network strengthens with each subsequent interaction that traverses the core. Successful management of the core payments business derives from a model where the physical network adds value to each transaction as it traverses the core. This is particularly powerful when the value the network adds is both something the end customer can see and is tied uniquely to the network core. This takes the form of what most of us think of as traditional service or systems development. Practical examples here include fraud and risk scoring in real-time, loyalty treatment application, and delivery of information and analysis associated with the transaction back to relevant participants. Unique value delivered from the core back to participants at the edge of the network increases the likelihood that those participants will send subsequent transactions back to the core. This is particularly powerful if the value added to the transaction is derived from and delivered in context to all the other transactions.
The most common example of this may be that of scoring transactions for risk, on the basis of both characteristics unique to that transaction and in the context of all the other transactions crossing the network, and then delivering that score back to the participant responsible for managing the risk of that product and customer.
Managing the Growth Cycle
While management of the collective effect of these three strategies may be the ultimate responsibility of the most senior executive(s) of that business, responsibility for the execution of these strategies is often distributed throughout the organization. This distribution – the historical roles of each major group within the company, and the process of funding and investing in each area – may create challenges. Complications may arise in the business when this distributed execution fails to operate in concert or is at odds with the P&L imperatives of the executive suite. In many payments businesses, this distribution and the associated challenges may take the following forms:
• Attract Participants: Executives in sales and marketing typically take on the role of managing the interaction of the network with existing participants. These same executives, when coupled with business development managers, may have some responsibility for finding and attracting new participant groups. However, the new groups are most often new segments of existing participant types, as opposed to truly new types of participants. While financial structures for rewarding participation are fairly well-established (read: interchange, incentives, network fee discount schedules), those structures are often challenged to effectively reward the direct participation of non-traditional sources of network activity (read: new acceptance segments, money-transfer operators, mobile operators) or to stimulate their growth on the network.
• Drive Interactions: Executives in product development, business development, and services management are often the leaders responsible for building and managing the product innovation roadmap for the core business. This most often includes managing investments that enhance the core product offering, often with expense budget allocated for this use. However, this traditional approach and funding model may not work effectively for driving new platforms or services into new participant types or ecosystems. For example, expense dollars decked against opening an incremental acceptance segment in a new marketplace may trump those earmarked for new platform development to serve an adjacent ecosystem, particularly in an environment where maximizing return on investment is a near-term priority and maximizing longer-term revenue growth is viewed as a problem for, well, the long term.
• Add Value: Executives in product development, systems development, and network management are often the ones most directly tasked with managing investments in this area. If the payments network business includes a strong processing system at its core, the responsibilities for this area tend to skew toward the systems managers. Typically, this kind of investment is well-funded within the core business model, particularly when it takes the form of internal development using capitalized expense dollars. Executives in this area may argue in return that senior management often fails to recognize the core business benefits of adding capacity, streamlining systems, and updating platforms – creating the dread of building a business case for “break/ fix.” Challenges may also arise here if the core enhancements roadmap is not tightly aligned with the business interest of adding value in ways that participants can see.
Executives in this area may argue in return that senior management often fails to recognize the core business benefits of adding capacity, streamlining systems, and updating platforms – creating the dread of building a business case for “break/ fix.” Challenges may also arise here if the core enhancements roadmap is not tightly aligned with the business interest of adding value in ways that participants can see.
Structural Challenges for the Growth Cycle
As discussed at the outset, executive management of a payments network may operate under the impression that the network effect that spins the growth of the business is highly self-perpetuating. Much of management’s experience in the core of the business may reinforce that impression. As management makes incremental investment in driving core business adoption among current participants, the growth of the business in the near term may seem relatively healthy. Indeed, it often is. However, when the long-term growth of the business is dependent upon the extension of the core into new areas and new ecosystems, the current health of the core may work against it. Indeed, in those instances where the margins to the core are very healthy, this challenge can be magnified.
As we discussed above, major players in the payments network business are typically strong in their area of core payments capabilities, as well as generating respectable top line revenue growth and healthy operating margins. However, most of these companies have growth and earnings expectations that require expansion into adjacent markets and complementary ecosystems that lie beyond their core payments businesses. Additionally, these companies have near-term financial performance requirements that may impede their ability to grow new business opportunities with internal investment and development. Investment in new business growth through expense can be challenging, especially if revenues from that new business will take time before making a material impact on total company revenues.
A hypothetical multibillion dollar payments company with healthy margins might have an income statement as follows:
As the table shows, the combination of high operating margins and a healthy core business investment may reduce the pool available for internal investment in growth to a small percentage of total investment. This is particularly true if, as is demonstrated here, the growth prospects for the core business demand a significant share of investment in growth. When $1 invested in core business expansion pays off with $1.5 in a year, the investment in new businesses where payoff may be greater is often de-emphasized in the face of risk adjustment against longer-term payback.
The challenge of income statement investment also presents a potential solution. In the above example, the company may generate as much as approximately $2 billion in cash. In this environment, a company may be more favorably disposed to applying this cash – after returning a portion to shareholders through dividends or stock repurchase – to acquiring capabilities for new market segments with capital rather than building them off a modest investment fund through expense. However, most companies are challenged to deploy capital most effectively against new business growth for a number of reasons. Chief among them are:
• Company Capacity: Corporate development staff and professional advisors are staffed to execute a few, large, and clearly accretive deals where the majority of new business areas in payments are populated by smaller service providers.
• Corporate Development Approach to:
o Acquisitions: Emerging payments companies provide a speed, agility, flexibility, and relative neutrality in helping a traditional payments company bridge into a new ecosystem, many of which may be lost in the necessary corporate consolidation following an acquisition.
o Partnerships: Minority investments often may protect target company speed and agility, but management of strategic alignment with numerous minority investments may task overburdened core company business resources.
There is a potential answer to this structural challenge, and it lies in the combination of an innovative business approach to developing new platforms coupled with an innovative technology approach to managing the edge of a payments network. The business solution requires a tight alignment between product development and corporate development, creating a continuum of strategy from the identification of core needs and potential partners within product development to the execution of investments and partnership agreements within corporate development. The interplay between these two functions must be “hand-in-glove” rather than “hand-off” to guard against the creation of partnerships that don’t fit strategic objectives or the development of partnerships that cannot be executed.
The technology solution is a combination of providing value in the core of the payments network through internal capitalized development while delivering flexible access to the network, to network human capital, and to external development partners. This approach, and the key to its success, is described briefly below.
Changing the Paradigm for Growth
The coming change in payments network innovation creates a paradigm that drives value to the network by cultivating a stable of key partnerships with external development organizations that can bring the capabilities required by customers in new participant groups to the payments network business by bridging the space between the payments ecosystem and the new participant ecosystem with technology and services that combine the value of both for common customers. The best among network executives have a rigorous process for identifying external partners, capitalizing those partners with the cash generated from the high-margin core, and driving strategic direction to their development activities through a combination of tight business partnership, and often, direct investment of core personnel into the partner company to help execute the combined strategy.
This business innovation, which may be simplified as “throwing” capital and people over the wall to an external partner to stimulate growth, has been in vogue for a while in other technology sectors. Cisco is a prime example of a technology company with a strong, high-margin core business that has mastered the art of finding, capitalizing, and staffing external partners to grow into new business lines. As those partners mature and the new business line becomes well established, Cisco then often exercises the option of acquiring the remainder of the partner and integrating it into the core. Successful payments networks are beginning to do the same, particularly in the growth areas of eCommerce platforms and mobile commerce.
This approach is most effective, however, and becomes most powerful when married with the provision of a development integration layer, often facilitated through addressable programming interfaces (APIs) at the edge of the network. Payments companies have begun to provide open access to their payments platforms for third-party developers via APIs and developer toolkits, looking to replicate the success for their payment platforms that software platform companies have had. By working to deliver an easier way for developers to embed their payment capabilities into new business opportunities and new services, payment platforms are working to extend the reach and flexibility of their services far beyond what they themselves could accomplish through direct development on their proprietary network. Payments networks have always grown by opening access to their processing engines to card issuers and acquirers, as well as their third-party processors. Yet in this evolution, payments players are simplifying and democratizing that access while making it available to a new population of developers and business models.
Opening the edge of a payments network or payment platform to third-party developers helps to ease the integration of that platform into new commerce systems and new participant ecosystems, favoring user and acceptor adoption of the platform and increasing the resulting payments transaction flow and revenue streams back to the core payments network business. When combined with a corporate development approach that capitalizes and directs the activities of a set of strategic development partners, the effect on the core business growth can be significant.
External partners are becoming the new innovation catalysts in the payments network business. They are capitalized by the payments network, given open access to the edge of the payments network to apply its core capabilities to new constituents, and often populated by key people well-versed in the payments company business model and strategic objectives. External development partners and APIs are bridging the gaps between payments and other growth industries, creating common services from each ecosystem for their common customers and attracting more of them to each. This helps to solve the most challenging task in scaling a payments solution – attracting participants – which is also the first, and most fundamental, step in growing a payments network.