Square ‘could become sixth pillar’ of the banking sector

It’s a low margin business and bankers say it has struggled to win the necessary R&D from internal budget allocations, opening the gates to the disrupters. But it’s not lost fees on payment terminals that are at stake, but the more valuable data generated by payments that can be used to make good lending decisions and assess business risk.

Institutional investors in Square say their bet is that the NYSE (and soon to be ASX-) listed company run by Jack Dorsey will be better than banks at using that data, and even more so it if can successfully integrate Afterpay, bringing the retailing and consumer networks together.

“Square is a small player at the moment but over the long term they have the potential to really give the banks a run for their money,” says Mark Arnold, chief investment officer at Hyperion Asset Management, which has large holdings in Afterpay and Square.

“There are a lot small businesses excluded from the banking system and trends over the last few decades towards bigger banks has resulted in less competition and less innovation. That is one of the key reasons we were attracted to Square. We think the whole sector is ripe for disruption, both on the consumer side and the business side.”

Arnold, who is likely to hold Square CDIs on the ASX when Afterpay stock is converted, acknowledges the market share of the disrupters is tiny at present, given the size of the overall banking industry. “But these guys have the chance to do what Elon Musk wanted to do 20 years ago with PayPal: disrupt the banking industry in a major way,” he says.

“The seeds are being sown now and we will see serious disruption of the banking industry by giving customers a better experience and improving the allocation of capital [towards small business].”

Dorsey made his aspirations for Square clear this week, briefing shareholders – who have seen their stock nearly triple in two years – on the rationale for the Afterpay deal. Square has traditionally focused on micro-business but with Afterpay, it can move higher up the retailer food chain.

“For us to be able to scale from the smallest of shops in your neighbourhood, up to the largest retailers in the world, with one solution that brings people to the rest of our ecosystem is exactly our strategy,” Dorsey said. Square’s shares are up about 13 per cent over the course of the week since Australia’s largest ever M&A deal was announced on Monday morning.

Of the big banks, Commonwealth Bank is responding the most aggressively. CEO Matt Comyn said in May the bank considered itself a “platform”. After expensive lessons from the rollout of its Albert terminals, CBA is doubling down, buying Doshi from Westpac’s Reinventure fund to help improve the experience for merchants at the point of sale. It’s also working with Little Birdie and BigCommerce.

ANZ cut a deal in the merchant acquiring space, a joint venture with Worldline, a large French operator, to help modernise the bank’s technology, although the impact of this tie-up is uncertain. Westpac’s payments strategy is also unclear, even more so since it has decided to switch horses and back Afterpay over Zip.

National Australia Bank, meanwhile, has the biggest SME loan book and hence the most to lose if the disrupters get a foothold. Challenges in merchant acquiring are well known to CEO Ross McEwan: Royal Bank of Scotland, which he previously ran, sold its merchant acquiring business Worldpay during the financial crisis only to buy another acquiring business when it realised how strategic the data was.

“NAB are going to need to figure out what does [the arrival of Square] mean for their merchant acquiring business,” says an adviser to one of the banks.

As the banks hit the drawing board on merchant engagement, they will also try to keep fending off big tech coming for their retail customers. As Apple works with the big banks in partnership to digitise debit and credit cards onto iPhones, it is also developing its own credit products with Goldman Sachs in the US. The latest version of Google Pay in the US, meanwhile, looks very much like a banking app.

But following the Afterpay deal this week, all eyes will be on Square’s Cash App, which is used by 70 million Americans. Ben Pfisterer, who ran Square in Australia until 2019, says it’s inevitable Cash App will come to Australia.

“Square to date has in Australia been solely in that small, mobile, micro-merchant space. But if they get an integration with Cash App right and launch that in Australia and integrate that well with the Afterpay card, it would provide an interesting consumer banking proposition,” Pfisterer says. “Absolutely the banks should be concerned.”

Like the banks, regulators are scrambling to keep on top of it all. While Afterpay’s acquisition by Square is a triumph for the former’s founders and the local fintech scene, the entry into financial services from the likes of Square, Stripe, Apple, Google, Amazon and Facebook raises new questions for regulators and policymakers about data governance and how the concentration of market power should be assessed.

On Friday morning, Reserve Bank governor Philip Lowe, appearing before the House of Representatives economics committee, said payments policy involved “a lot of complicated issues” and “the payments landscape is changing very, very rapidly”. “Our regulatory arrangements need to keep pace with that ... we have further work to do here.”

Liberal senator Andrew Bragg, whose select committee on financial technology provided a tailwind for Afterpay and fintech policy, is aware that more detailed policy work needs to be done. Treasury has commissioned a review of the regulatory architecture of the payment system, which has been delivered but not released.

“If you want to have competition for the big four banks in terms of payments and systems, it is going to come from these quarters and you have to make sure you don’t rub that out,” Bragg says. “We welcome competition, we need more competition in payments and in systems. But we don’t want a handful of big tech companies eating our economy or democracy. We have to keep our eyes wide open about this while welcoming competition.”

For Square investors such as Mark Arnold, Dorsey’s company is exciting “because it is a data-driven business, and they can make loans that are profitable because they have data from the merchants and use that data in a sophisticated way that creates productive money in the economy and actually grows the economy”.

“Competition is good. It will force the banks to lift their game.”