Welcome to another issue of CTPI Weekly, your premium newsletter on tech design and policy.

Today, we'll cover:

The process of commoditization,
The law of conservation of attractive profits,
Pix and the price race to the bottom, and much more.

This week we decided to discuss one of our favorite topics from a different angle. We are taking a step back and looking at the greater picture to understand how non-market forces, like regulatory interventions, can impact the business of technology companies, and how we should interpret and act upon them.

Now, let's get to it.

M. and J.

Pix and the commoditization of payments

Many companies struggle to identify opportunities in regulatory trends. And, to be fair, that isn't something most MBA courses would prepare their executives to do. But the truth is that non-market forces, like regulation, play a decisive role in changing the dynamics of any given market. And while most ignore or fight back, the most successful firms manage to understand, embrace, and leverage opportunities wherever they come from.

The discussion about the commoditization of payments usually comes up as a threat motivated by regulatory interventions. Although we could discuss whether we should pin that process exclusively on regulation, seeing the process as a threat that needs to be avoided only sets the market back. Now, how to see opportunities in commoditization, you ask? That's where things get interesting.

Commoditization is a loaded word in business. It's the valley where all expectations for profits go to die. It's a concept at the core of The Innovator's Dilemma, Clayton Christensen's paradigmatic book that continues to guide generations of startups and tech companies until this day.

Today, we'll go through the concept of commoditization, and how to use it to pursue opportunities following regulatory interventions. We'll be looking closer to the case of commoditization of P2M payments following the introduction of Pix in the Brazilian market.

About commoditization

Commoditization is the process a market goes through when the performance of a given product is widely considered good enough so that customers are not willing to pay a premium for increased quality over this threshold. This process leads to the point where it no longer matters which service provider is chosen, as they are all interchangeable.

There are many potential causes for commoditization. One of them is when firms "overshoot” customers. That is, in the race to improve the key performance-defining attributes of a product, they end up reaching the point where their product is "good enough” and can't increase profits by increasing its quality. According to Prof. Christensen's research, customers buy products to perform jobs they need to get done and choose products based on a predictable hierarchy of needs. First comes functionality and reliability. Then, convenience, customization, and, last of all, price. So when a market hits customers' needs on all four of the first criteria, the next frontier for competition becomes price, which is when commoditization kicks in.

Another potential cause is when an industry standard levels the playing field in a way that it's either impossible or unproductive to differentiate. This one is more straightforward. If all players sell the same product, no one will be able to charge a premium for it. Simple as that, the product becomes a commodity.

So what can firms do?

That characterization was enough to make the whole industry go knocking on Prof. Christensen's door. And he answered the prayers with one simple but elegant concept: the law of conservation of attractive profits. The law states that whenever a product becomes a commodity, firms can afford to outsource its production and focus their energies on what is not good enough in that same value chain. The idea is simple: draw the entire value chain where the product belongs, then outsource (modularize) what is good enough and internalize (integrate) what is not yet good enough (the hardest job in the chain).

Prof. Christensen explains that integration is like energy - it doesn’t disappear, it just shifts from one place to another. So the shift of one portion of a value chain from integration to modularity affects the rest of the value chain. This is what he calls the law of conservation of integration. This theory is also known as the law of conservation of attractive profits since firms can make attractive profits as they solve the hardest problems (therefore, the attractive profits are where integration is). So, the solution for a modularized, commoditized market is to move to an adjacent place of the market where what matters most to customers is not good enough.

From Seeing What's Next:

”We have also called the law of conservation of integration the ‘law of conservation of attractive profits,’ because companies make attractive money when they solve the hardest problems. The hardest technical problems mandate solutions that are tightly coupled integrated systems. When modularity and commoditization cause attractive profits to disappear at one stage in the value chain, conservation of integration means the opportunity to earn attractive profits with proprietary products will emerge at an adjacent stage. Conservation of integration explains why it is not accurate to characterize an industry as integrated or disintegrated. There are numerous types of integration in any given industry. Specialists are integrated, just in different ways. Whereas integrated firms might span an entire industry's value chain, specialist firms might be integrated to produce a single component that itself is not good enough. Or they could be integrated across whatever interfaces drive customization and convenience, which could be the point of customer interaction or the interface with suppliers”.

The law of conservation of integration, therefore, states that companies can make attractive profits by solving the hardest technical problems that demand tightly coupled integrated systems. When modularization and commoditization cause attractive profits to disappear in one stage of the value chain, the conservation of integration means that opportunities to earn attractive profits with proprietary products will emerge at an adjacent stage. Integrated firms may span an entire industry's value chain, while specialist firms may only be integrated to produce a single component that is not good enough or across whatever interfaces drive customization and convenience, such as the point of customer interaction or the interface with suppliers.

Pix and P2M payments

When the Brazilian Central Bank created Pix and mandated all major banks to join, it created an industry standard for payments. The current regulation allows banks to charge merchants Pix transaction fees, and each bank can set its own criteria. P2M payments, however, are on their way to commodity-land anyway.

Here are a few reasons why this market will be commoditized:

Since it works really well (reliability), the space for differentiation between banks is highly reduced.
The infrastructure cost per transaction is very low, irrespective of the amount being transferred, and does not depend on as many intermediaries as the card rails. Every Pix participant pays BRL 0.001 (USD 0,0002) per transaction received. That's 1 USD cent for every 50 transactions.
Competition in the Brazilian banking industry is increasing, with regulators prioritizing initiatives such as open finance, interchange fee caps, and risk-based regulation. Success stories like Nubank's are also drawing attention to the industry.
Players like Nubank have already announced they will not charge for Pix transfers at all, and even incumbents like Banco do Brasil decided to waive the fee for single-proprietor businesses. This is significant because Nubank is the largest player today in Brazil in number of business clients and in the number of Pix alias keys registered to business accounts.
Pix effectively connects any two accounts in Brazil. So, network effects are no more. It doesn't matter if my bank has 100 or 100 million clients because I can still make and receive payments from any account in Brazil. It also means there is no actual value in moving money from one account to the other. Pix has solved that.
Pix is extremely flexible and can support a number of innovative functionalities because it can add arbitrary metadata to the payment transfer itself. And the regulators are planning many additional functionalities in the near future.

We don't mean there are no opportunities in payments anymore, far from it. It's just that the hardest job to be done is not moving money from account A to account B anymore. It’s now on whatever can be built on top of or around Pix to deliver value to the customer.

A good place to start is integrating backward into whatever jobs merchants need to get done on the backend to make and process sales. Customer onboarding, payment conciliation, inventory management: all jobs companies need to fulfill in the back-office wherever there's a payment flow.

Another path forward is comparing features of the current payment methods and identifying what are their key capabilities — the jobs they perform — apart from transferring funds. To do that, we use a three-step framework.

Map all the stakeholders, how they interact, and what jobs they need to perform
Identify which jobs and interconnections in that system Pix can perform or render obsolete and set them aside
Audit all remaining jobs to investigate which continue to drive value to the stakeholders and, ultimately, to customers.

Take cards as an example. Because of their unique architecture, card rails allow for a number of features, like paying with pre-approved credit limits, loyalty programs, chargeback dispute resolution, and many others. These are integrated features in card rails. Now, new entrants could explore opportunities to bring these features to Pix's modularized architecture. The way to do it is to take advantage of the fact Pix allows money and data transfers between any two institutions in Brazil to build whatever requires additional specification or governance, integrating the capabilities that are lacking on Pix.

In any case, the bottom line is: although regulatory interventions may lead to the commoditization of parts of a value chain, there are always opportunities for attractive profits in analyzing the market in a systemic fashion, identifying the jobs that are still not good enough, and integrating it to drive performance where it matters the most to customers.

Want to learn more about how to pursue opportunities in payments? Let us know what are your burning questions in this space!