In Apple Pay, Signs of a Digital (Payments) Divide

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Screen Shot 2014-09-11 at 6.36.12 PMA few hours after Apple’s press conference Tuesday, a spokesperson from a mobile payments startup sent along a note detailing the company’s coming integrations with Apple’s newly announced payment system. She remarked that in 30 minutes, Apple did what no one else could in 10 years: “move mobile payments from a nice-to-have to a must-have.”

It’s a common refrain among technology types. But the belief that Apple Pay will turn the payments industry on its head draws on a long-held assumption in the tech industry that the Internet (the virtual network where no one know you’re a dog) and the physical marketplace (where the bartender already knows your name) live by the same rules. In fact, these two marketplaces operate under much different dynamics, which will eventually push Apple’s efforts into a much different direction than most people think.

Apple Pay, two ways
First, let’s quickly review the way the system works. Apple Pay will allow iPhone users to pay participating partners using their existing iTunes account. Partners can integrate the software into an application, point-of-sale system or online checkout just as they do with PayPal or Amazon buttons. Then Apple plays intermediary, passing the data through notoriously complex components of the payment industry.

But the core technology of Apple Pay — the system that allows it to encrypt payment information on a device and hook into the existing payment structures — needs to be separated from the way in which the technology can be used. On Tuesday, Apple CEO Tim Cook laid out two potential scenarios for the system: one, a virtual payment — the type of ecommerce transaction we’ve made for years — and two, a proximity payment made between two nearby devices via near field communication (NFC).

To understand Apple Pay, it’s important to look at the viability of each scenario within their respective markets.

The ecommerce market, where the virtual payments would be made, is still relatively young. Online, critical institutions such as payments remain not only inefficient — but structurally incomplete. Despite the efforts by retailers and technology companies, the rate at which consumers abandon goods in their digital shopping carts has remained at or above 70% for years. These are legitimate problems that govern the growth of the marketplace as a whole.

In that sense, Apple Pay fits Apple’s strategy of entering a market which has seen substantial investment but still has yet to capture the consumer’s imagination. The idea of building a payments mechanism into the operating system is the type of innovation that’s needed. That’s why Apple Pay will likely have a meaningful impact on the way we buy goods online almost immediately.

Offline payments are a different animal. The industry is dominated by a set of entrenched competitors, each of which plays a small role in the process of moving money from customer to provider. It’s at once extraordinarily uncompetitive and remarkably efficient. Plus, the economics of the offline payment industry put the pricing pressure on the merchant, making changes in business models — a frequent vehicle for disruption — relatively inert for the consumer.

From a consumer perspective, paying offline is not a problem. That’s why nearly every major project focused on driving users to pay with their phone has failed. PayPal’s project is still fledgling, Google’s wallet struggles, and Square ditched its mobile payment app — a project that was once considered the future of the company and offered a comparable, if not better experience than Apple Pay in-store.

However, the projects that have focused on the merchant side of the equation — namely, mobile credit card readers from Square, PayPal and others — have taken off. What’s more, they are actually driving consumer adoption. A study from Javelin Research found that the introduction of mobile credit card readers, which effectively expanded the total addressable market for credit cards, has coincided with a 10% decline in the amount of cash consumers spent in 2013 from a year earlier.

A virtual industry building for a physical world
The variations here expose an often overlooked structural difference between physical and virtual markets. Online, the near perfect parity among sellers — our ability to buy from Burma as easy as Boston — means that success of a seller is often determined by their ability to rapidly respond to consumer preference. Subsequently, the consumer drives the market in an almost totalitarian manner.

That’s a relatively new phenomenon. In physical markets, the constraints of proximity create a collage of independent microcosms in which sellers sell to certain consumers and consumers buy from certain sellers. That scarcity reduces competition and decreases the likelihood for a seller to invest in say, a new point-of-sale system or payment processing capabilities such as Apple Pay.

Given the explosion of the Internet over the past two decades, the technology industry tends to approach problems from a virtual mindset. They tend to overemphasize the role of the consumer in driving change in a market, and underappreciated the critical role that the sell-side plays in its evolution. For local technology, that has led to a lot of money poured into projects with little return.

This is not to say Apple Pay will fail. When the most powerful technology company in the world puts its weight behind something its hard to bet against it. For one, iPay, or more-so NFC, will decimate Square, PayPal Here, and the dongle card reader market. The company has eliminated the need to use a dongle, positioning the iPhone or Google Wallet in a perfect position to take over the very small business market where it got its start.

But Apple’s success in local will not come from the proximity use case that Tim Cook showed off Tuesday. In local, its success will largely come from integration with Uber, Grubhub, and other booking and scheduling services where the transaction occurs virtually and redemption occurs locally.

Eventually, we will reach singularity, and the division between man and machine, physical and digital will be trivial. Until then, companies need to build for both worlds.

Steven Jacobs is Street Fight’s deputy editor.