Happy New Year, and welcome back to Net Interest, my newsletter on financial sector themes. If you’re new here, thanks for signing up. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes below. If you have any feedback, reply to the email or add to the comments. And if you like what you’re reading, please spread the word.
Dee Hock, the Father of Fintech
“Payments…is the battlefield of finance for the next decade.”
So said Jes Staley, CEO of Barclays Bank, at the end of 2019. Since then, the battle has only got more fierce. Last year was a record for venture funding in payments and new models like Buy Now Pay Later have picked up momentum. Anyone who did their Christmas shopping at JD Sports in the UK will have a first-hand account of how the battlefield looks:
Envisioning how the battle ends is hard because it’s being fought on multiple fronts: electronic versus cash, credit versus debit, open network versus closed, crypto versus fiat, regulated versus unregulated, inside the financial services system versus outside.
But an analysis of what happened before may be helpful and there’s no better place to start than with the Goliath on the battleground: Visa. Last year, the company facilitated $8.8 trillion of payment volume globally. It generates $22 billion of annual revenue and earns a margin of 68%. The Department of Justice has accused it of exploiting a monopoly in online debit transactions, where it has a share of 70% in the US. The company reckons its “#1 competitor continues to be cash” but in the meantime, Visa is “everywhere you want to be”.
Visa was founded by Dee Hock, a man who deserves credit as the Father of Fintech. Patrick Collison, founder and CEO of the newest big payments company on the block, Stripe, is an admirer:
@paulg For one thing, always surprising to me that Dee Hock isn’t more widely recognized as a business genius. Visa market cap per employee substantially greater than the (conventionally-defined) tech giants.
This piece looks at the history of Visa through the eyes of Dee Hock to see what lessons can be gleaned for contenders in the payments market today.
Dee Hock, the Father of Fintech
Credit cards were introduced onto the streets of Fresno, California, one mid-September day in 1958. They were the brainchild of Joseph Williams of Bank of America. Although cards were already in circulation, Williams’ cards were novel for bundling pre-approved credit with a payment facility. Many of the original features of Williams’ cards such as the one-month grace period and even the prevailing interest rate of ~18% per year are still in use today. It didn’t end well for Williams – card delinquencies spiralled and he was soon out the bank – but he deserves credit for getting the flywheel started. By inducing enough merchants on the one hand to accept the card and enough consumers on the other to carry it, he laid the groundwork for what would become a multi-billion dollar business.
The man who got the flywheel spinning was Dee Hock.
The day Williams was dropping credit cards in Fresno, Hock was working at an investment company in Los Angeles. Promised a profit share after he’d helped build up the company, he was conned by his boss and he moved up to Seattle to work in consumer lending and then banking. By 1966 he was “retired on the job” – his euphemism for working with no real commitment – at National Bank of Commerce in Seattle.
By then, Bank of America was licensing its card in other regions. The bank saw that both consumers and merchants were increasingly transacting between different states and in places where it had no presence. With no centralised credit bureau, it had no way to gauge the creditworthiness of potential cardholders outside its footprint; plus it was a pinch to persuade merchants outside California to open up an account at a Bank of America branch in California. So the bank franchised its credit card technology. For $25,000 plus a royalty linked to transaction revenues, other banks could take a license to operate the card.
This is where Hock comes in. One day he was called into his boss’s office:
“Since you once lived in California, you are no doubt aware of the credit card program of the Bank of America… A good many of our senior officers think credit cards are unsound, and I’m not certain I disagree with them. Nevertheless, Bank of America has decided to franchise BankAmericard and we have agreed to take a license. We would like to be in business within ninety days. We would like to borrow you to assist… What do you think?”
Hock didn’t especially like credit cards. “I have absolutely no use for credit cards. All I had were destroyed… I’ve not had one since and want none in the future.” But he took the job and ninety days later had rolled out a successful credit card programme for National Bank of Commerce.
Through the process, he began to see cracks in the licensing system Bank of America had established. Bank of America fulfilled its obligations as licensor by providing accounting software and marketing support, but it didn’t offer centralised clearing of transactions. Instead, the merchant’s bank was required to seek payment directly from the cardholder’s bank. As volumes grew, the system became unmanageable.
“Since each bank was both a merchant-signing bank and a card-issuing bank, they began to play tit-for-tat, while back rooms ﬁlled with unprocessed transactions, customers went unbilled, and suspense ledgers swelled like a hammered thumb. It became an accounting nightmare.”
The system faced tension balancing cooperation and competition between the licensing banks. At scale, cooperation broke down.
Dee Hock had a few thoughts about how the system could be refined. He’d been mulling over ideas of organisational structure for years. He thought that contemporary organisational structure had emerged as a response to the needs of the machine age, and was becoming outmoded. Inspired by his observations of natural systems he would later coin the term chaordic – a portmanteau of chaos and order – to describe an organisation that is decentralised, self-organizing, self-governing, and exhibits emergent properties.
“In the age of hand-crafting, the dominant forms of organization were the all-powerful churches, kingdoms, and hand-craftsmen guilds. Just as the age of machine-crafting led to the emergence of today’s organizations, ending the dominance of guilds, kingdoms, and churches, so too will the age of mind-crafting give rise to new, more chaordic concepts of organization that will end the dominance of today’s organizational structures.”
In creating Visa, Hock had two big ideas, one around organisational structure and the other about the very nature of payments. The two ideas would coalesce to form the foundation of Visa.
The Role of Organisation
Hock’s first big idea was that the solution to the problem faced by the licensing system was organisational, rather than necessarily operational. He envisioned a new type of organisation:
- What if ownership was in the form of irrevocable right of participation
- What if it were self-organizing
- What if power and function were distributive
- What if governance was distributive
- What if it could seamlessly blend cooperation and competition
- What if it were inﬁnitely malleable, yet extremely durable
Underlying these features was a drive to create a deeper level of trust within the system. Cracks in the licensing system emerged as trust floundered between participating banks and between them and Bank of America.
Indeed, trust is the first problem to solve in any payments system, as today’s contenders know:
- Max Levchin, CEO of Affirm uses the word trust six times in the first two minutes of his roadshow presentation to investors.
- Alipay was launched in China in 2004 to solve the problem of trust impeding growth in e-commerce. Weak consumer protection laws coupled with deteriorating consumer confidence around quality control made people reluctant to buy goods online. Alipay provided an escrow solution so that sellers wouldn’t get paid until buyers had confirmed satisfactory delivery had been made.
- This week Joe Weisenthal of Bloomberg characterised Bitcoin as “the first true religion of the 21st century”. What greater expression of trust is there than religion?
Hock took leave of National Bank of Commerce to work with Bank of America and the licensing banks to craft his new system. Back in school he had excelled at debating, and his skills came to the fore navigating the various constituents in the system. The first obstacle was Bank of America.
“We invented the *#~*’d system! We own it! We produce 40 percent of the system volume! *#*d if we will be pushed around!” said the Senior Vice President in charge. Hock was able to convince them that Bank of America would benefit far more from its share of a larger, more efficient market, than it could from royalties from the existing market.
He then had to get three thousand licensee banks on board. “Dee, it’s impossible. There is absolutely no way three thousand banks can be persuaded to surrender their licenses, become members of NBI [the forerunner of Visa], hold an annual meeting of members, elect a board, and have the whole thing in operation in ninety days. It can’t be done,” said the vice chairman of Bank of America.
But Dee Hock pushed through to deliver. By 1970, Visa was up and running, with Hock as its CEO.
Electronic Value Exchange
The second of Hock’s big ideas was the nature of the credit card itself. Perhaps because he had no use for credit cards himself, he saw their potential extending beyond consumer credit:
- The ﬁrst primary function of the card was to identify buyer to seller and seller to buyer.
- The second primary function was as guarantor of the value data.
- The third primary function was origination and transfer of value data.
“…It was a revelation then. We were not in the credit card business. Credit card was a misnomer based on banking jargon. The card was no more than a device bearing symbols for the exchange of monetary value. That it took the form of a piece of plastic was nothing but an accident of time and circumstance. We were really in the business of the exchange of monetary value.”
Hock used this insight to drive consumer adoption of Visa. As well as creating a system that engendered trust between participating banks, Hock used advertising to promote trust among consumers. In particular, he pitched Visa not as a “credit card” but as a medium of exchange. To solidify this, he borrowed from the first technology to scale trust—the coin.
In the seventh century BCE, the Lydians stamped a seal on their lumps of metal attesting to its authenticity. This stamp transferred the focus of trust from the buyer onto the authority assigning the seal. Of course, forgery led to some friction around that transfer, but it was a start. And as long as the authority was legitimate, its trust could be scaled widely.
Visa used its own stamp on all its cards. One of the reasons the original Bank of America system was able to steal a march on competing systems, notably Interbank (later renamed Master Charge and subsequently MasterCard) was its consistent name and stamp; by contrast Interbank employed a small ‘i’ barely noticeable in a corner of the card. Visa’s marketing tagline became “think of it as money”. Today, the company spends around $1 billion each year signalling its presence as a legitimate authority.
The insight that Visa facilitates not credit but electronic value exchange would bring Hock into conflict with member banks because, pushed to its logical conclusion, it renders them redundant.
In the early days of Visa, banks were very protective of their role as the interface between merchant and network. In order to accept card payments, merchants had to enter the system via a bank, to which they would pay a discount fee. Yet in 1979, Hock did a deal with JC Penney – then one of the three largest American retail stores – to participate in the system directly. The backlash was furious. Seeing it as a challenge to their role as merchant acquirers, banks resolved not to allow any more merchants to sign with Visa directly.
Hock’s thinking stemmed from his framing of the business as being one of electronic value exchange rather than “credit cards”. Such framing changed what it meant to be a “bank”. In response to the backlash, he said: “Many bankers refuse to realize that many large retailers can do everything a bank can do, and often better. Penney is more sophisticated in data capture and data communications than any bank I know of.”
JC Penney went through bankruptcy last year, so perhaps it’s not the best example, but the principle that banks don’t have a monopoly on data and value exchange can be conducted around them still holds. The emergence of embedded payments functionality is the latest iteration of that.
Hock also understood that, pushed even further, his insight paved the way for “a new form of global currency”.
Money would become nothing but alphanumeric data in the form of arranged energy impulses. It would move around the world at the speed of light at minuscule cost by inﬁnitely diverse paths throughout the entire electromagnetic spectrum. Any institution that could move, manipulate, and guarantee alphanumeric data in the form of arranged energy in a manner that individuals customarily used and relied upon as a measure of equivalent value and medium of exchange was a bank. It went even beyond that. Inherent in all this might be the genesis of a new form of global currency.If electronic technology continued to advance, and that seemed certain, two-hundred year old banking oligopolies controlling the custody, loan, and exchange of money would be irrecoverably shattered. Nation-state monopolies on the issuance and control of currency would erode.
With Bitcoin making new highs, his ideas certainly seem prescient! The only problem is that this “new form of global currency” remains undeveloped as a payments mechanism. Coinbase began with a strategy to facilitate payments but pivoted to a brokerage model as Bitcoin gained greater traction as an asset class rather than a payments mechanism. Early on, the company signed up dozens of merchants to accept Bitcoin, including ten with over $1 billion in revenue, according to the book Kings of Crypto, but demand on the consumer side fell flat.
Dee Hock Today
Dee Hock left Visa in 1984, but he’s still around, an active 92-year-old, living in Olympia, WA. He has expanded on many of his ideas in his excellent autobiography, One from Many and several months ago appeared as a guest on a series of podcasts at The Innovation Show.
One of his ideas is a framework for thinking about problems. “Understanding events and inﬂuencing the future requires mastering of four ways of looking at things; as they were, as they are, as they might become, and as they ought to be.”
Through this lens, he’s not enamoured of Visa. “By the standards of what Visa ought to be, it would be a lie to deny a sense of failure. In spite of my pride in all that Visa demonstrated about the power of the chaordic concept of organization and all the things it has accomplished, I do not believe that Visa is a model to emulate. It is no more than an archetype to study, learn from, and improve upon.”
He raises a few issues with the Visa model. As well as his regret that merchants, and even cardholders, never got direct access to the system, he raises concerns about Visa's duopolistic position. “Exchanging authorization information and monetary value in the form of electronic particles ought to be a highly decentralized, competitive business. Trying to design and impose a single, monolithic system on such an essential ﬂow of information seemed absurd.” While at Visa, he opposed the idea that banks could be members of both Visa and Mastercard, believing that would stymie the creation of new, competing payment networks. Being members of both would enhance competition between individual banks but not between the systems; Hock thought competition between systems a more desirable outcome. It’s an argument he lost. 
Additionally, although Visa makes its money from transaction activity and not from interest income, Hock regrets that so much of the broader industry economics still revolves around credit. “It was my hope that issuers would evolve from marketing the card primarily as an instrument for debt, to marketing it as an instrument for the exchange of value. It was my hope that revenues of issuers would evolve from reliance on interest on cardholder debt and discount from merchants, to reliance on transaction pricing for services provided. It was my hope that this would equitably distribute cost between the most afﬂuent and least afﬂuent customers.” Studies show the degree to which the least affluent customers subsidise the most affluent customers within the system.
Hock’s framework of thinking about things as they were, as they are, as they might become, and as they ought to be is useful, but it disregards path dependence. Although it is easy to envision an optimal payments system, there is no getting around that Visa in its present form does a good enough job – whatever its flaws – and will be difficult to overturn.
The practical side of Hock knows this. A lot of the technology deployed by Visa on his watch was predicated on what went before it, rather than what might have been. And political, regulatory and economic considerations – like blocking merchants from acquiring direct access to the system – meant that the system grew in the less-than-optimal way it did. The point here is that the story of payments is an incremental one.
As Lana Swartz comments, “the technologies of payment are a palimpsest.” Visa’s not going anywhere, but there’s plenty of scope for contenders to shape the future.
 For a big believer in complexity theory – Hock had been reading Complexity by Mitchell Waldrop when he crystallised his neologism chaordic – this is a counterintuitive perspective. One of the features of complexity is the power law dynamics it gives rise to, which means that without intervention the big get bigger. Visa’s market position is entirely consistent with that.
All quotes in this piece are from Dee Hock’s autobiography, One From Many: Visa and the Rise of Chaordic Organisation. A good summary of Hock’s ideas is available here, courtesy of Blas Moros. Another recommended reading is Electronic Value Exchange by David Stearns which is an excellent primer on the origins of electronic payments.
More Net Interest
Affirm: Back on the Road
One of the criticisms of the company is that it is too reliant on Peloton, which contributed 28% to its total revenue in its last full financial year. But fintechs have a history of working very closely with a narrow group of companies before diversifying out. When Square came to the market in 2015, 14% of its last full financial year revenues came from Starbucks, and those were loss-making. When Paypal came to the market the first time around, 67% of its volume was from eBay.
Similarly, Bloomberg and ICE were both highly reliant on a small number of clients when they started out. Perhaps the difference is that at eight years old, Affirm should have achieved higher diversification by now. The upside is that Shopify helps to address the issue.
I’ll be on a call next week to discuss the company. Join me and the team behind the S-1 Club write-up on Thursday, 14 January at 3PM EST by signing up here.
Banks vs Big Tech
Bankers are getting more visibly nervous about the relative power of big technology companies. This week, Ana Botin, executive chairman of Santander wrote an op-ed in the Financial Times.
Regulation now favours tech companies that intermediate financial services over banks. This is especially true for the rules on data, which powers payments. Large tech companies are becoming lending platforms without having to comply with most banking regulation. Their role, although still relatively small overall, is growing. Last year, fintech and Big Tech credit reached $795bn globally, according to the Bank for International Settlements. The pandemic will only entrench the digital players.We need to level the playing field — not to give banks an advantage, but to remove the advantage that tech companies have had for the last 10 years. Under EU regulations, financial firms must give tech companies access to customer-generated data if the customer agrees. This requirement should apply to data held by every sector, including tech companies. The playing field should not be tilted in favour of anyone.
She echoes concerns raised by the CEO of Unicredit in 2019: “We are asked to open up our data to everyone, which is fine, that's the rule, but if one of my clients wants me to have access to his data on Amazon or Google that is not possible… There is no reason why there should be an asymmetric treatment of banks.”
And, as brought up in More Net Interest a few issues ago, Jamie Dimon agrees: “And the regulator… eventually they're going to regulate the banking system out of business.”
Over the past ten years the regulatory pendulum swung squarely away from banks towards tech. The question now is whether swings back.
More on Tech Regulation
OK, it’s a bit further removed from financial services, but a former colleague wrote an excellent piece on how European regulation of Big Tech may differ from American regulation.
Justin is a telecoms analyst and was covering the sector in the early 2000s when regulation altered the dynamics of the telco market. While the US approach had been to tackle corporate structure, the European approach was to tackle market structure. So rather than requiring its telco companies to break up, it required them to unbundle. The result was devastating to corporate valuations.
18 years later, European consumers pay around eu30/m for fixed (including broadband) and eu20/m for mobile, which cost around 2-4x as much in the US. Verizon and AT&T’s combined market cap of usd450bn is 1.7x the size of the combined European incumbent telcos’ market cap, despite the latter also having extensive holdings outside their domestic market
(Incidentally, it’s the same in payments. Through regulation, interchange rates are so much higher in the US than they are in Europe.)
Justin argues the same process of “ex-ante” regulation in Europe could harm the Big Tech companies. He points out that last time around the stock market didn’t see it coming, and it might not this time either.