The Economist on mobile payments and market liquidity

The Economist recently published an article on mobile payment, which is suspicious of its success to say the least:

The fragmentation [of mobile payment systems] confuses merchants and consumers, who have yet to see what is in it for them. From their perspective, the current system works well. Swiping a credit card is not much harder than tapping a phone. Nor is it too risky, especially in America, since credit cards are protected against fraud. Upgrading to a new system is a hassle. Merchants have to install new terminals. Consumers need to store their card details on their phones, but still carry their cards around, since most stores are not yet properly equipped.

I believe the newspaper is too pessimistic. Yes, swapping credit cards is easy. But then it involves signing a bill (not the fastest and most modern system ever) and the card can be replicated. Hence why most of the rest of the developed world has moved to a ‘chip and pin’ form of card payment, which is only slightly more burdensome (and not very fast either). The US is also taking the same direction.

Most people who have recently swapped their ‘chip and pin’ card for a contactless one can witness how convenient and quick the new system is. Yet, they also believed that the previous system “worked well”. Following the same argument, it would have been hard to convince people to switch to cards since carrying cash also “worked well” (ok, it’s not as strong an argument). Switching to smartphone-based contactless payment would make the system as fast, yet reduce the number of cards and devices one carries.

The Economist continues:

But even Apple’s magic may not be enough to make mobile payments fly. It is not clear how merchants will benefit from Apple’s new ecosystem: it does not offer them lower fees for processing payments or useful data about their customers, as CurrentC does. As a result, they may refuse to sign up for Apple Pay or discourage its use.

Yet, as described above, speed is mobile payment’s major asset. Any retailer regularly experiencing long queues is likely to lose customers. Contactless cards already speed up the checkout process considerably. Unfortunately, they are usually capped to pay small amounts (GBP20 in the UK). Contactless mobile payment/NFC systems would remove that cap.

In another article, The Economist once again highlights its ambivalent stance towards regulation:

But the illiquidity problem will still be there when the next crisis occurs. In a sense, it is a problem caused by regulators; they wanted banks to be less exposed to the vicissitudes of markets. But you cannot make risk disappear altogether; you can only shift it to another place. Get ready for more moments of sheer market terror.

The article refers to the recent market turbulence and points to regulatory requirements that have made lack of liquidity a rather new problem:

Due to new regulatory restrictions and capital rules that make bond-trading less profitable, banks have cut back their inventories to the level of 2002, even though the value of bonds outstanding has doubled since then (see chart).

That is a problem when trading surges, as it did between October 10th and 16th, when volumes rose by 67%. “Credit is not a continuously priced market,” says Richard Ryan of M&G Investments, a fund manager. “When a bond price falls from 100 to 90, it won’t do so smoothly, but in big drops.”

This is correct. Market-making (mostly fixed income) is becoming trickier because harsher capital requirements make it more expensive to carry a large inventory of bonds through three channels: 1. deleveraging, as banks are pushed towards higher regulatory capital ratios (and as the new leverage ratio is introduced), 2. credit risk, as credit risk-weights are on upward trend, 3. market risk, as holding larger inventories penalise banks through higher market RWAs than before. I may write a whole post on this topic soon.

But the newspaper forgets liquidity requirements: banks are required to hold enough very liquid assets on their balance sheet (‘liquidity coverage ratio’). Given the combination of leverage and liquidity constraints, banks have to sacrifice other asset classes: the riskier bonds. This leads to the following very good chart, from a Citigroup report and reported by Felix Salmon at Reuters:

This has been an issue with The Economist since the start of the crisis: the same newspaper declares that banks needs to be regulated and safer and complains about the negative effects of regulation at the same time. Perhaps time to be less contradictory?

PS: The ECB published its stress test results yesterday. I won’t comment on them. I just thought the AQR was an interesting exercise, but its consequences must be carefully weighted and it is crucial not to over-interpret them (I’ve already written about the danger of ‘harmonizing’ assessments across multiple jurisdictions and cultures).