In the wake of the global pandemic, alternative payment methods have been required to transact business at nearly all levels of the economy. The market for alternative payments was already going through a natural transition before social distancing and lockdown dramatically accelerated growth in the digital sphere.

Over the last decade, digital wallets have grown from a niche payment option to a global phenomenon – with 22 percent of point-of-sale spend globally in 2019. Asian consumers and American millennials are used to seamless payments for daily transactions – with increasing expectations for simple, secure ways to make payments. Today, Asia leads the world in digital wallet adoption, and Chinese leader Ant Financial is on the precipice of what will perhaps be the largest IPO in the history of the world. But eye-popping financial results at PayPal and Square, fueled by Venmo and Cash App, are proof that digital payments are gaining traction with mainstream American consumers.  Investors have taken note.

Big deals in venture capital, IPOs and M&A transactions are following the money, as digital payments are becoming ubiquitous in both new and emerging markets. Smart investors will be well advised to beware of the lurking regulatory and legal issues faced by digital payments businesses before transacting.

What are digital wallets?

Digital wallets, also known as mobile wallets, are consumer-focused apps that facilitate payments, typically via smartphone. Mobile banking apps tend to accrue fees or recycle money into loans, but digital wallets don’t. In the late 1990s, commercial versions of digital wallets became popular, with PayPal as one of the first well-known examples. Soon after, the technology reached mainstream once smartphones came into our lives. In the U.S., companies like Zelle and Venmo have gained momentum by creating simple peer-to-peer mobile payments. Big tech companies are betting big on digital payments, evidenced by Apple Pay, Google Pay, SamsungPay, WhatsApp Pay, and more.

Digital wallets in Asia – a duopoly

Today, Asia is the hub for digital wallet innovation. While the trend is speeding up in many parts of the world, digital wallet adoption in Asia is unparalleled. In fact, in China, digital wallets account for 48 percent of payment volume and seven percent of e-commerce spend. Mobile wallets have been successful in Asia because they provide a solution that is better than cash.

The innovation in Asia has coincided with the rise of smartphones and super apps use, which helped the area get ahead. Additionally, digital wallets in APAC countries make up 58 percent of regional e-commerce payments and have surpassed cash at point-of-sale. But, their ubiquity in Asia presents a barrier to startup opportunity, as tech giants dominate certain countries in the region. For instance, Ant Group’s Alipay and rival Tencent’s WeChat Pay maintain a mobile payments “duopoly.” According to The Economist, in Asia, Alipay and WeChat Pay account for 54 percent and 39 percent of the country’s mobile payments market by value, respectively. These companies are processing trillions of dollars in transactions each year, while in economies like Japan and South Korea, credit cards are still the most popular form of payment. In other regions like South Asia and Southeast Asia appear to offer more room for startup growth. Meanwhile, India is home to 34 percent of digital wallet deals, followed by Singapore at 19 percent.

Digital wallets in the United States – opportunities and challenges

Digital wallet adoption is now accounting for 24 percent of e-commerce spend in the U.S., according to data from Worldpay. Digital wallets are going up against an engrained credit-card dominated system that uses rewards and travel programs to stick to customers over the long term. While QR codes have been a powerful lever for mobile wallets in Asia, the trend is just beginning to arrive in the U.S.  Key retailers like Starbucks and Walmart have added QR codes to the register option, and their use in the U.S. during the pandemic has enjoyed the substantial benefit. For example, QR codes are being implemented by restaurants to allow customers to order and pay for meals on a contactless basis, enabling safety and cost reductions from disposable menus and less waitstaff.

Attacking the U.S. market for digital wallets involves special challenges:

-Looking beyond the initial transaction to compete with sticky loyalty programs, and indeed, find ways to incentivize customers.

-Higher transaction volumes between the different value chain players require interoperability and centralized infrastructure.

-Security and compliance costs to secure the highest quality, lowest risk and great number of customers.

Venture capital investment

So far in 2020, digital payments companies Checkout.com, Stripe, and Adyen raised giant piles of cash from venture capital and other investors. Leading digital payments investors include Coatue, Insight Partners, DST Global, Blossom Capital, and numerous sovereign wealth funds. While the amount of capital that venture capital firms deployed into emerging growth companies declined 11% on a year-over-year aggregate basis in Q3 2020, fintech deals were up, with digital payments leading the surge. Payments solutions embedded in the end-user experience for non-financial businesses are gaining traction, together with data collectors and infrastructure players.

Accelerating M&A in digital payments

While the eye-popping venture capital financings of unicorns like Stripe’s $600M Series G preferred stock capital raise (at an estimated enterprise value of $36B) made headlines, digital payments solutions also drove significant M&A volumes in 2020.  This was evidenced by three acquisitions by the U.S.’s largest credit card networks American Express, Mastercard, and Visa. In January of 2020, Visa transacted to acquire Plaid for a total potential value in excess of $5B. In June of 2020, Mastercard transacted to acquire Finicity, a financial data aggregator, for a deal value in excess of $1B.  In August of 2020, American Express announced its acquisition of fintech lender Kabbage, aiming squarely at the small business market with a broader set of payments products.

In the digital wallet world, the ability to collaborate with other value chain players – and even new industry entrants – could be one of the most unique and innovative features of a successful company. This phenomenon was evident in Visa’s announced acquisition of VC-backed Plaid. Depending on how they leverage the network effects, industry leaders can find a way to capitalize on the massive amount of data that exists along the value chain. This data will help create and own standards and to design platforms for improved overall customer experience.

Regulatory issues with digital wallets

Due to regulations, digital wallet players are very regionalized. For example, Apple Pay is a big player in the U.S. but has zero presence in India. Additionally, Facebook’s WhatsApp Pay roll out in India has been held up by countless regulatory issues. Specifically, Asia’s fragmented regional regulatory landscape comes with an array of legal challenges. For example, licensing procedures may vary across geographic markets – without more consistency, and the different local regulatory requirements may result in increased costs and the amount of time required for companies to expand their digital wallet footprint.

In the United States, compliance with federal and state money transmitter laws is a byzantine enterprise, and often just the tip of the iceberg in terms of regulatory compliance.  In addition, digital payments businesses must comply with:

-The Consumer Financial Protection Bureau and its prepaid rule, which requires a regulated entity to provide a consumer with two disclosures prior to acquiring a prepaid account. Legal challenges to the prepaid rule are gaining steam, but in the meantime, compliance should be architected into the business model.

-Anti-money laundering rules issued by the Financial Crimes Enforcement Network (or FinCEN) if the business provides “money services.”

-Banks and bank affiliates must also comply with the Bank Holding Company Act.

-The Office of the Comptroller of the Currency, or OCC, can provide a further layer of regulation on top of embedded functionalities. A federal regulatory movement is afoot to combine the byzantine layers of regulation between the federal government and the various state and local agencies into a single federal system.  State regulators are pushing for a passport system like Europe where regulation by one state would suffice for all states “opting in”.

During the pandemic, some non-U.S. and U.S. federal and state regulators have implemented regulatory sandboxes, where requirements are temporarily relaxed to provide spaces for new platforms to test new technologies.  Policies should support access, rather than raise barriers to adoption.  The smartest startups are engaging with regulators, while architecting compliance into the product roadmap, to ensure regulatory compliance.

Meanwhile, investors should do their due diligence prior to committing capital, as in addition to all of the regulatory compliance issues, digital payments companies are vulnerable to a data breach, cyber-attack and theft, and are often built with software containing lines of code with open source.

The future of digital payments looks green.

Good advisors can help navigate key business, regulatory, and legal issues at the formation stage, in the scaling phase, and then to achieve optimal exits from digital payments’ businesses.

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Louis Lehot is the founder of L2 Counsel. Louis is a corporate, securities and M & A lawyer, and he helps his clients, whether they be public or private companies, financial sponsors, venture capitalists, investors or investment banks, in forming, financing, governing, buying, and selling companies. He is formerly the co-managing partner of DLA Piper’s Silicon Valley office and co-chair of its leading venture capital and emerging growth company team. 

L2 Counsel, P.C. is an elite boutique law firm based in Silicon Valley designed to serve entrepreneurs, innovative companies, and investors with sound legal strategies and solutions.