How digital payments became politicized

Visa, Discover, Apple Pay and PayPal have all cut off or limited their payments services to so-called hate groups in the wake of violence that erupted when white supremacist and neo-Nazi groups protested the removal of a Confederate statue in Charlottesville, Virginia.

After learning that PayPal played a key role in raising money for the white supremacist rally, PayPal said it would bar users from accepting donations to promote hate, violence and intolerance. Apple disabled payments via Apple Pay on websites that sell white supremacist and Nazi-themed merchandise. Discover said it would end merchant agreements with “hate groups, given the violence incited by their extremist views” while Visa and Mastercard said they were cutting ties with a number of sites they “believe incite violence,” don’t comply with their acceptable-use policies or engage in illegal activities.

It’s fair to say that in the fraught political atmosphere of 2017, even payments have become politicized.

Some say it’s a private company right to take that kind of stand, others say it infringes on First Amendment rights. While it’s arguably not the place of payments companies to be making moral determinations, it’s also not illegal for them to do so. And whether or not they “should,” companies in payments and beyond have made the decision to respond. The question is what the repercussions are for the payments system if they keep acting as de facto watchdogs who will inevitably experience pressure from customers who threaten to take their business to another payments firm.

“Payments are necessarily neutral,” said Jason Oxman, director of the Electronic Transactions Association. “They don’t take a political position, they don’t prefer any company or any consumer over any other. They’re a tool and they’re a very helpful tool in driving commerce but also ensuring consumers have the necessary ability to save for the future, make investments, retire comfortably and protect their resources.”

Commerce in the U.S. takes place over electronic payments systems, which processed $6 trillion worth of payments last year, according to Oxman.

“Electronic payments drive commerce and make commerce possible,” he said. “Sometimes those tools are used by people whose behavior is illegal or unliked. It’s important not to blame the tool of the activity of the people who have used the tool.”

Is it PayPal’s job to play watchdog?
The whole idea of payments and electronic transactions is built around two concepts: identity and risk. Payments companies need to know who has access to their services, who their customers are, and if the account holder’s digital identity matches his or her physical activity. And when it comes to money movement, merchant acquirers and processors are there to mitigate some of the risk involved.

But just by nature of payments being digital transactions, payments companies have found themselves in a position to track payments and to be able to understand things like how people are using their money and what kinds of things merchants are selling.

“A lot of these companies are responsible for connecting with these previously unseen people are being put in a position of being the de facto watchdog. They can’t be in the position to allow certain things to happen,” because of Know Your Customer and anti-money laundering regulatory requirements, said James Wester, research director for IDC Financial Insights’ global payments practice. “There are a lot of these companies now being asked to do. Because they’re at heart about mitigating and limiting risk, their default position might be that they’re not going to allow certain types of consumers, merchants, transactions to take place because it’s not in their best interest.”

Many of these decisions can be traced back to Operation Choke Point, a 2013 Department of Justice initiative that requires U.S. merchant acquirers to submit the types of merchants they provide electronic payments for. Many acquirers won’t work with certain types of businesses that are perfectly legal but risky from a regulatory perspective — pronography, firearm sales, even “racist materials” for example.

Many acquirers choose not to do business with these types of companies for a big reason — and it’s not because of their moral compass. It’s because the chargeback rate — the rate at which a merchant returns funds to a customer — on those transactions tends to be really high; if someone receives a bill for a pornography order, people often say they didn’t buy that and ask for their money back. That high chargeback rate makes it particularly difficult from a risk perspective to underwrite these transactions, Wester said.

“They just say ‘we’re not going to do that, it’s too much of a risk, it’s hard for us to model it, it’’s hard for us to make money on it.’ It’s not out of any moral or ethical decisions, it’s a business decision,” he said.

For those companies who do choose to underwrite risky businesses, Operation Choke Point set intentionally higher regulatory requirements for them to be able to accept those payments — effectively intimidating those merchant acquirers from doing business with them. The point was to make it troublesome to the point that it was hard for companies to find partners that would want to process the payments.

Earlier this month the Department of Justice shut down Operation Choke Point, but it’s not clear all other agencies have too. If companies keep taking political stands they run the risk of the regulators stepping in to “choke” them again — not by forcing them who and who not to do business with, but by “pressuring them to curate it in a certain way,” said Brian Knight, a senior research fellow at the Mercatus Center at George Mason University.

Oxman said he’s hopeful that kind of “intimidation” happens less from now on.

“Payments companies shouldn’t be held responsible for criminal behaviors,” Oxman said. “It’s bad for business.”

Payments companies could cut off the underserved
Perhaps the biggest impact digital payments has had on the world is their ability to bring financial access to previously unbanked individuals and new businesses and consumers into the economy.

Governments want financial inclusion for all too: they want to be able to recognize tax revenue and protect people, which is easier for them to do when everyone’s financial transactions have a digital footprint.

But as companies like PayPal and Visa take political stands and declare where they stand on different issues, they risk shutting people out of the financial system when they exist to bring them in.

“As we build out financial inclusion, we start adding more people, more merchants into the financial system, so there’s more oversight,” Wester said. “What does that mean when it comes to how much oversight organizations can do and in terms of shutting that off?”

Wester said it’s a trend that’s only going to grow the more we bring individuals and merchants into the financial system and that while it’s not necessarily good or bad, it’s an inevitable truth that needs to be understood. “For a company like a bank or a PayPal or Square, is their job to be in a position where they have to be making moral decisions?”

A perilous path
Even without Choke Point, companies acting as the de facto watchdog will always run the risk of regulatory intervention, Knight says.

“If you see firms being pressured to take a political side… those firms may be getting regulatory pressure because they’re seen as being too powerful,” he said.

And while firms have a lot of choice in who they’d decide to do business with, or not, and many criteria they can use to make that determination, political world view is not one of those classes.

“Big players have a disproportionate share of the market,” Knight added. “If they all get together or independently decide they aren’t going to do business with group X, Y or Z, that runs the risk of effectively cutting those groups out of the payments system.”

The most visible and most global brands will continue to be pressured by their constituencies and special interest groups to show their value by, in some cases, choosing not to service entire markets, says Dorothy Crenshaw, founder and CEO of crisis communications firm Crenshaw Communications.

“The public is looking to business leaders [for moral leadership] because they respond,” she said. “They have a board of directors and all kinds of red tape but they can act and they have acted. Its up to brands to decide which side they’ll choose.”

ETFs, overindexing and the power of financial brands

Just doing some thinking about the growth and future of the ETF industry:

In my eyes, ETFs began as a second-generation of mutual funds with the following characteristics:

  • Passively managed: ETFs were passively managed (though that’s changing), building upon Jack Bogle’s success at Vanguard.  Most research at the time clung to the Efficient Market Hypothesis and academics declared that trying to beat the markets was a fool’s game.  ETFs were this vehicle.
  • Cheap: They were cheap.  If theory shows that you can’t pick stocks and win the game that way, better to index and reduce fees for better long term success.  ETFs’ passive structure enabled fund sponsors to get big and compete on price, driving prices further downward.
  • New access: Beyond their philosophical underpinnings and reduction in asset management fees, ETFs also opened doors to new asset classes (commodities), markets (Peru), and strategies (leveraged short funds) that weren’t easily accessible or understandable for retail investors previously.

Things are a’changin

Things are changing.  With Blackrock’s purchase of Barclays Global Investors iShares (BGI), ETFs are no longer seen as a pure threat to the much larger mutual fund industry.  Diversified asset managers like Blackrock and PIMCO, mutual fund firms like Vanguard and Fidelity, and online brokers like Schwab are building and buying ETFs as part of a larger smorgasboard of choices for their clients.  ETFs fit in like precious metal and international funds into a firm’s offerings.

In a sense, ETFs have now become purely productized, competing against similar strategies in different structures.  Contributing to this trend is the fact that numerous ETF offerings targeting the same strategy/geography have all hit the market. With multiple offerings for almost every market and strategy in ETF land, overindexing has blurred any and all distinctions in investors’ minds about which securities to select.  Instead of doing the work to pick the most appropriate security, brand will ultimately trump other things.

While there may be 3 general, broad ETFs for investors to get Chinese market exposure, most retail investors have no idea that they’ve been structured differently, that the compositions of the indices these ETFs track are wildly different and have led and may very well lead to different performance outcomes.

Brands, brands, brands

What this means, then, is (like most things in life), competition in the ETF space gets muddled.  ETFs compete against mutual funds every bit as much as they do against each other and with this backdrop, the emergence of the firm’s brand will trump performance and index structure.  Index composition or the race to build a better mousetrap becomes less important.  Branding will sway investor decisions and assets away from the smaller, more innovative players, towards the larger, stronger brands.

Like everything commercial, brands wield power.  So true in the financial sector as well.