In China, Cashless Is King

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In China, Cashless Is King

From Alipay and WeChat Pay to the digital RMB, the past, present, and future of China’s digital payment services.

In China, Cashless Is King

A card displaying QR codes to pay electronically with WeChat Pay and Alipay sits on a vendor’s table at a farmer’s market in Beijing, Tuesday, Oct. 27, 2020.

Credit: AP Photo/Mark Schiefelbein

Since the founding of the People’s Republic of China in 1949 (and even prior to that), cash has always been king in China. As recently as the turn of the century, Chinese citizens largely depended on these bills adorned with the face of “Grandpa Mao” for all offline purchases. The growth of the internet planted seeds of change that would upend that default.

In 2003, Alibaba’s online customer-to-customer platform Taobao (similar to an auction-less eBay) faced a crisis in confidence: buyers had no method to ensure sellers would deliver a quality product once a payment had been made. In order to overcome this deficiency, CEO Jack Ma designed a system wherein the buyer’s payment would be held on the platform in escrow and only released to the seller’s account after a satisfactory product had been received. This was the birth of the Alipay function. Though initially limited to Taobao, Alipay quickly moved to providing its escrow services for other online platforms as well by 2004, and continued on a growth trajectory that saw it encompass 81 percent of domestic consumers by 2020.

The payment feature on the social media platform WeChat, meanwhile, had its origins in the 2014 Lunar New Year festivities. As the preeminent Chinese holiday, the Spring Festival has long been characterized by a tradition of exchanging money in “red packets” (hongbao) between friends and family. With Alipay already commanding a huge space in the mobile payments market at that time, Tencent (WeChat’s owner) needed a clever way to induce WeChat users to link their bank cards with the app, thus becoming WeChat Pay customers. It devised a scheme whereby friends could create virtual red packets that their friends or family would then be able to open, with a larger share of the total pot awarded to those who opened the packet the quickest.

A major driver behind the rapid adoption of mobile payment systems was the lack of credit card infrastructure in China at the time of the smartphone revolution. Such a phenomenon is analogous to China’s de facto bypass of the email system, with instant messaging apps such as WeChat being the preferred manner of communication even in business contexts.

China had largely been a cash economy prior to the large-scale introduction of the QR-code system, and many vendors had not yet installed the point-to-point terminal infrastructure that would be required to process credit card payments. Another factor in the success of online payments was the relative lack of regulation in that space in China at the time these platforms were being built. When the mobile payment applications were first getting off the ground, authorities were very hands-off in dealing with these operations, both due to a lack of familiarity with the new technology and the initial small size when compared to the banking sector. Government policy at that time heavily encouraged the growth of the e-commerce sector, thus adopting laissez faire tactics conducive to rapid growth.

As a result of their widespread adoption, Tencent and Ant Financial (Alipay’s financial holding entity) gained access to vast troves of user data, giving them an advantage in offering loans to retail consumers that commercial banks did not possess. Due to the informational asymmetry, Alipay was only ponying up around 2 percent of the capital required to service microloans while capturing 30-40 percent of a loan’s interest income. Along with their risk-gauging ability, these Ant-facilitated loans enjoyed a delinquency rate of only 1-2 percent, much lower than had been the case for commercial banks acting on their own. On the one hand, Ant’s facilitation of loans had made it much easier for individual borrowers and small businesses to receive funds; in the past, Chinese banks had been much more likely to loan to institutions that could put up collateral and were less likely to default. On the other hand, the corresponding sharp increase in total debt outstanding owed to banks, mainly smaller regional banks, carried a risk that an economic shock could sink their operations.

It was these new microlending practices in particular that eventually drew the attention of both national government regulators, including the state-run central bank, and local commercial banks. Many of these rural banks with which Ant was transacting were joint-stock corporations, managed by a combination of municipal government (usually controlling) and private investors. Ant had in effect been leveraging its market power to induce banks to bear most of the risk for these transactions in exchange for only a small bite of the profits. This was a necessary precondition for the commercial banks to gain access to Ant’s massive user base and its swaths of consumer data. In effect, Ant was firmly in the driver’s seat in its dealings with commercial banks due to the unequal bargaining power stemming from its scale of operations.

The China Banking and Insurance Regulatory Commission had already issued notices in the months prior to Ant’s planned IPO that it was going to take a much harsher look at microlending. In short, the central government was wary of microlending due to its potential risk of distributing loans to risky consumers, and the local banks were dissatisfied with the level of risk they were forced to assume to gain access to Ant users due to Ant’s superior bargaining power. In light of those developments, it did seem unwise for Ma to make provocative comments at the Bund Conference on the eve of his company’s IPO, but the government response was by no means completely out of left field, as some Western media outlets have seemed to portray.

In fact, certain foreign commentators have actually lauded the government attempts to rein in these quasi-monopolistic mobile payment systems’ microlending practices, viewing it as a government effort to hedge against financial risk. Prior to this crackdown, fintech companies were in effect escaping the regulations that constrained the activities of traditional financial institutions by branding themselves as tech companies. A subsequent antitrust probe was opened that put both Alipay and WeChat Pay on notice of looming further regulation. The proposed policies would subject any non-banking institution to investigation by the People’s Bank of China (PBOC) for potential monopolistic behavior.

What will likely end up being the greatest domestic challenge to Alipay and WeChat Pay’s dominant positions in the long term is the looming introduction of a digital RMB currency (eCNY). Already being piloted through lotteries in select cities throughout the country, the eCNY has to potential to become a PBOC-backed direct competitor to the mobile payment apps. Among the reasons cited for its introduction are the cost of storing cash, historical counterfeiting problems in China, and the fact that cash is often used to engage criminal behavior.

The system works by distributing funds to digital wallets, which can be housed on a new app created specifically for the eCNY or on the apps of commercial banks. The user is then able to scan a QR code (or pay online) to complete a purchase – a process strikingly similar to that of the existing mobile payment apps. The central bank plans to utilize existing commercial bank infrastructure to popularize the currency rather than hijacking the entire payment system, creating what is known as a tier-two system (though it is unclear if Alipay and WeChat Pay’s systems will be incorporated into the general rollout). Even if Alipay and WeChat Pay are not involved directly by having the eCNY incorporated into their wallets, it is possible they could at least play an indirect role though the numerous commercial banks with whom they maintain partner relationships.

The eCNY would provide the PBOC with more tools to control monetary policy. For instance, the central bank could gift funds that expire at a certain date or steadily depreciate over time in order to incentivize spending. It would also allow transaction data to be monopolized by the government rather than private companies. The PBOC deputy governor has stated that the eCNY would only convey transaction data to a single third party, that being the central bank itself. Government access would lower the potential for exportability of the eCNY into a potential global currency, but this should not affect the domestic market much since users of existing mobile payment apps are used to having their data collected. There have been some reports that the PBOC would like to have the rollout completed in time for the 2022 Beijing Winter Olympics; however, it is unclear if COVID-19 has pushed back that timeline.

It will take time for merchants to begin to adopt the eCNY and for user-to-user transfer of funds to become systematized, but that process has already begun to take shape – even with some improvements on the current duopoly technology. The lotteries have incorporated a new feature whereby two users with eCNY functionality can transfer funds by tapping their phones together even if neither are connected to the internet. Huawei has since began incorporating that feature into its new phone models, which come with eCNY functionality.

These developments bode well for the eCNY gaining traction moving forward, but not all analysts are convinced Alipay and WeChat Pay will be upended. The convenience of WeChat in particular as the world’s most dominant social media platform as well as Alipay’s multifunctional app that allows for purchases of goods, food, travel tickets, and more could lead to users sticking with those systems even after the eCNY rollout is complete. WeChat’s unique ability to transfer funds to a friend or family member on the same screen where a chat is taking place seems particularly difficult to overcome for those close-knit transactions.

The duopoly is therefore likely to hold in the short-term, though a steady erosion of the market power of the two firms may follow as network effects diminish once more consumers sign on to the digital RMB, leading to a more competitive market. Look for the merchant and online spaces to more quickly shift to allowing alternatives in addition to the duopoly platforms. Granting all of that, WeChat Pay and Alipay will still remain key players in the mobile payment space into the foreseeable future. Furthermore, their operations abroad are unlikely to be replaced by the eCNY.

The meteoric rise of Alipay and WeChat Pay in China has brought convenience to the lives of more than a billion consumers. Within their home country, Ant Group and Tencent have consolidated their market shares into seemingly intractable positions. Notwithstanding all of these successes, recent events demonstrate that greater challenges could be on the horizon. The era of domestic regulators turning a blind eye to fintech expansion has reversed course dramatically. The central bank itself appears ready to enter the fray, presenting a unique opportunity to erode the market duopoly.

Though this combination of factors quite possibly will dim the prospects of each company to some extent, opportunities for partnership and expansion abroad, if leveraged successfully, could still allow for overall revenue growth and brand expansion. Digitization of payment infrastructure is a trend that is already off and running in the developing world. Systems in place in Africa, Latin America, and Southeast Asia do not perfectly mirror the Chinese model. However, the wealth of experience Chinese fintech entrepreneurs have gained will still be invaluable in charting the path forward in these nations. Look for Ant — especially if and when its IPO is revived — and Tencent to remain prominent in global news outlets into the foreseeable future.