America has inched closer to a cashless society in recent years, as more transactions have moved from hard currency to debit cards or online payments. An entire ecosystem of businesses has grown to help people move money from one account to another—but that system is about to change.
The Federal Reserve recently launched a new system for account-to-account transfers that could disrupt the market for debit transactions and, in turn, the prospects for Fintech companies. The impact of this new system will vary depending on how companies are positioned. Companies that rely on payment processing fees for the instant transfer of money could face headwinds as the new system eats into their business, and companies that develop innovative offerings that go beyond simple money transfers could be relative winners.
The FedNow system
On July 20, the Fed launched a new system to facilitate the transfer of money instantly from one account to another called FedNow. Prior to that launch, Americans relied on a slow system to move money directly from account to account—the ACH transfer system. ACH transactions can take 2-3 days to settle and came with other inconveniences, like holiday and weekend closures.
For example, if Uber sent a driver their earnings at the end of a shift using ACH, the money would not be available for 2-3 days. Or, homeowners who wanted to pay their mortgages via ACH would need to schedule the transaction in advance.
Seeing the dissatisfaction caused by these delays, many companies stepped up to provide solutions. Debit transactions facilitated by companies including Visa (V) and Square (SQ) allowed for instant payments, but those transactions often came at a cost, with companies charging between 20 cents and 2% per debit transaction. Check cashing services also offer instant access to cash, but those also came with fees. Cash transfer apps let people send money directly and instantly, but if you want to move the money to a bank account instantly you have to accept fees.
The new FedNow system offers 24/7, account-to-account transfers that are free and instantaneous—creating an attractive alternative to services that are slower or more costly.
A decrease in debit usage would be a headwind for interchange fees
One immediate impact of the FedNow system could be a decline in demand for debit transactions. When similar systems were introduced in China, Brazil, India, and Western Europe there were major decreases in debit usage.
We expect the introduction of FedNow will slowly eat into the use of debit over the coming years. If so, the new FedNow system represents a risk for some fintech companies, particularly those that rely on debit transactions for revenue.
For example, half of Visa’s transaction volume is debit. A few years ago, the company attempted to buy Plaid, a financial data company that offered technology to connect financial institutions and facilitate money movement. The purchase was blocked by regulators, but internal documents showed that Visa executives estimated the emergence of a low-cost transfer system might cost the company $300-$500 million in debit revenue each year.
Visa is not the only company that could be challenged by a new transfer system. Any financial company that taxes payments could see challenges. Payment processors Square and PayPal’s (PYPL) Venmo app both charge users to move cash from the app to bank accounts right away. FedNow could put pressure on usage and those revenue streams.
Winners will add value beyond transfers
As disruption comes to the payment processing industry, we believe fintech companies that offer more innovation and greater breadth of services may emerge as relative winners.
For example, Affirm (AFRM) offers point-of-sale credit—letting consumers choose to pay now, later, or over a series of installments. Making credit determinations requires risk management and sophisticated analytics, and Affirm recently built on its platform by introducing debit+, a highly innovative card that offers the same debit or installment payment options. The data we track shows that adoption is high and the new product is helping the company move to the brick-and-mortar space from ecommerce. We believe debit+ could help the company achieve a 30% CAGR.
Robinhood (HOOD) is another fintech company successfully diversifying its products and achieving growth. Robinhood started as one of many stock trading apps in 2015, but we believe the company is now one-of-a-kind. The company has added a range of services, from interest-generating sweep accounts to pensions, and has become synonymous with trading among young investors.
We expect the Fintech playing field to continue evolving as the move to a cashless society matures. The launch of FedNow and its ability to provide consumers and companies with faster, less expensive ways to move cash between bank accounts is another development that Fintech companies—and investors—must adapt to. While companies that rely on transaction fees could be under pressure, the ones that respond by stepping up innovation in their products and services could position themselves for long-term growth even as the landscape changes.