Digital Payments and innovation: Should the banks be worried?

Until a few years ago, the business of facilitating payments seemed a particularly unpromising one for start-ups to enter. Most transfers of money still run down a few main routes that link banks to one another. To consumers, most payments appear to be free because they are given away by banks as part of a bundle of banking services that some customers subsidies through low interest rates on deposits. Yet payments are turning out to be a battleground between banks and a slew of innovators trying to disrupt the market. Two firms, Dwolla and Square, have attracted my attention as they attempt to change the payments landscape.

Dwolla is trying to eliminate or significantly reduce the fees that merchants have to pay credit card companies. How does it work?

1. Users sign up online for a Dwolla account, which involves entering personal information like date of birth and Social Security number. Dwolla uses the information to make sure you are old enough to open an account.
2. You fund the Dwolla account by linking it to a bank account and transferring money to Dwolla. Small test deposits, which you must verify, are made to your Dwolla account to make sure you are authorized to have access to the bank account. Formalizing the setup can take a couple of days.
3. Using your Dwolla account you can then pay merchants who accept Dwolla or transfer money to individuals and notify them via an e-mail, or by Twitter or Facebook.

Transactions are now free for amounts under $10; otherwise, there is a flat 25 cents fee, rather than a percentage of the transaction. This can be very attractive to the merchants. But, the initial sign up process and having to constantly transfer money from your bank account to your Dwolla account create a lot of friction for the users. And it is hard to lure users away from the attractive rewards the credit cards offer.

Square is indeed wildly more popular than Dwolla and the Pay with Square option tries to reduce the hassle at cash register for both the consumer and the merchant. How does it work?

1. You install the Square app in your phone and it to your credit card. You also choose a picture for your profile. The photo is what the merchant uses to verify your identity at the counter.
2. When you walk into any of the 75,000 stores that accept Pay with Square, the merchant’s iPad cash register automatically alerts them to your presence, thanks to the Square app installed in your phone.
3. You make your purchase, say your name to the person at the cash register and your transaction is complete. You do not have to pull out your wallet or your phone.

I can see this working very well for small merchants who would not mind using a tablet as a billing machine. It also makes it easier for them to offer loyalty programs to customers and to keep them engaged.

The success of mobile payments would not have been possible without the massive growth in the number of smartphones and the falling cost of computing power, both of which are lowering the barriers to new entrants in parts of finance. Smartphones are vital to this, because by providing consumers with powerful computing devices and internet connections that are always on, they open the way to all sorts of other innovations. Innovations of this sort are forcing big banks and the credit-card networks to respond in kind, either by teaming up with the innovators or building their own competing systems.