TL;DR - for the busy ones

Longer settlement times substantially raise capital requirements for fintechs, in line with a hyperbolic function pattern. On the flip side, shorter settlement periods can significantly boost a fintech's capacity for handling transactions, similar to an increase in capital. Tech that provide rapid settlement times, such as blockchains, can empower fintechs to manage higher transaction volumes more efficiently.

What are settlement times and why should we care?

Settlement times refer to the duration it takes for money to transfer from one account to another. This could be from one bank account to another or from a crypto address to another digital wallet. Once the transfer is complete, the new owner has full access to spend or manage the funds as they wish.

Most users of fintech apps don't usually experience settlement times firsthand, which is part of the challenge for these companies. Typically, a user might download an app like Wise and fund their account using a debit card. Behind the scenes, Wise likely works with a payment service provider (PSP) such as Stripe or checkout.com to process the card payment. After the funds are deducted from the user’s card, they appear in the Wise app almost instantly, ready for immediate use. To the user, it appears as though the funds have settled in their account, as they are now available for further spending. When a user transfers funds to a friend’s bank account in Mumbai, the amount is deducted from their Wise account and shows up in the friend’s account within seconds, already converted into INR. To both users it looks like the transaction is complete and the funds have settled. However, this is not entirely the case. There's more happening behind the scenes, which is fortunate for me since I’m writing this blog post but an unfortunate complexity many fintechs have to manage.

In reality, apps like Wise perform a sort of tech/finance magic. They transform a process fraught with multiple partners and varying transaction times—none seamless or instantaneous—into something that seems just that. This feat is accomplished by bridging delays between partners through the provision of short-term credit lines. Each transaction in the sequence must be settled before the funds become fully available. Funding the Wise Account via a card payment involves these steps in terms of data-flow:

1. The issuer, usually the user’s bank, approves the card payment if the user has sufficient funds.
2. The card scheme (such as Visa, MasterCard, or Amex) relays the approval message to the merchant’s Payment Service Provider (PSP), in this case, Wise’s PSP, which could be a company like Stripe or checkout.com.
3. The PSP informs the merchant about the transaction's approval status, typically via a webhook notification.

By the third step, the merchant — in our case, the wallet provider — receives notification of a successful card payment. However, this doesn’t mean the wallet company has the funds in their bank account yet, nor that the funds are ready for further use. In practice, the issuer first transfers the funds to the card scheme, typically once a day. From there, the funds move to the PSP, and only then are they available to the merchant. Despite those multiple steps this flow is still only a simplification; the process often involves additional players. For example, in the notification flow, there's usually a processing company managing the card payment on behalf of the issuer.

Overall, it takes multiple days for the funds to reach the merchant's account, often at least two, but it can extend up to fourteen days, which is less uncommon as one might think, with 7 days being a more likely average.

How do settlement times relate to capital requirements?

Let's consider a hypothetical fintech called TxPay. It starts with $1 million in the bank and experiences a consistent flow of user funds. TxPay operates as a remittance app, enabling users to fund their wallets via cards and then transfer money abroad to banks in Europe, India, or the US. Its users send $200k in remittances daily. We are tasked with determining the financial resources required for TxPay to maintain its customer-facing operations. For simplicity, let's assume that TxPay operates with no employees and incurs no other expenses during this period.

TxPay has partnered with a card payment gateway, Streak Inc., which settles funds within seven days. For simplicity, we're considering all these days as working days in our calculations. Additionally, TxPay has struck an advantageous deal with their remittance partner, RemittancePayout Inc., requiring funds transfer only at the moment a user initiates a remittance transaction, thus eliminating the need for pre-funding. Consequently, the company's cash position would unfold as follows.

Initially, TxPay starts with the full $1 million in the bank. As the day progresses, this balance decreases to $800k, with funds being transferred to the remittance receiving institution for the recipient.

From Day 1 to Day 7, the amount owed to us by Streak Inc. (our payables) increases by $200k daily as we continue to process transactions. This scenario essentially requires us to provide a temporary credit line to our users, who expect their funds to become immediately available. By Day 6, we enter into an overdraft, essentially utilizing a credit line from the bank, which we can't repay until our relationship with Streak Inc. concludes.

On Day 8, an equilibrium is reached: Streak Inc. begins to repay us the accumulated funds, starting with the $200k from transactions made 7 days earlier. Concurrently, a new batch of $200k is processed and consumed, balancing the pay-ins and pay-outs. From this point forward, Streak Inc. continuously owes us $1.4 million as long as these transaction volumes persist. If we cease operations with Streak Inc., users can no longer load funds via Streak Inc., and our balance will diminish by $200k daily for 7 days until the final $1.4 million is settled.

In this example, TxPay benefits from a cooperative bank that provided a $400k credit line on demand, no questions asked. If the bank had been less accommodating, our business would have halted on Day 5. We would have missed out on $400k of transactions over two days, resuming only on Day 8. This assumes customers wouldn’t wait and instead spend $600k on Day 8, a scenario that might eventually lead us to stop accepting payments temporarily. Frustrated customers might then turn to a more reliable service, meaning we lose business.

This case illustrates that TxPay's maximum transaction volume is largely dependent on the payable terms with Streak Inc., our card acquirer / PSP. With 7 days of payables and $1 million in capital, we can now calculate the maximum amount of volume we can do until we reach the equilibrium, namely by dividing our capital by the number of available days, resulting in $1m / 7 = $142.86k per day. From this calculation we can already see that the quicker Streak Inc pays us, the faster we reach our equilibrium and the more money we can spend each day.