By Brandes Elitch
CrossCheck Inc.
The sea change occurring in the payments industry is largely due to emerging technologies. But some of the disruption is being caused by inexorable pressure on interchange-based pricing. It's important for ISOs to understand how these factors will affect both their merchants and their own revenue streams.
When we talk about the credit card business, we're talking primarily about the card brands - Visa Inc., MasterCard Worldwide and Discover Financial Services - which collectively comprise about 90 percent of the market. This is a "network" business, meaning the bigger the network, the more benefits for consumers and merchants, up to a point.
The network can dominate the business, at least until a new technology comes along, and that is what's happening now. It is also a "two-sided" market because the card companies compete for both merchants and consumers.
Steven Pearlstein noted in a Feb. 5, 2011, Washington Post column that, in the industry's early years, the emphasis was on signing more merchants, so merchant fees had to be kept low. Card companies charged more of their costs to cardholders, with annual fees and high interest rates.
But as time went by, and the card brands were almost universally accepted by large merchants, the acquirers gained the ability to raise merchant fees with little attrition. Now things have reversed: price sensitivity is higher with the cardholders and lower with the merchants.
The result is that the brands have increased merchant fees to pay for the rewards cards that now make up half the card base, and pay cash rebates to get new cardholders.
The U.S. Government Accountability Office found that card processing fees have increased 25 percent since 2005. On top of that, issuers charge an extra 50 basis points for interchange on rewards cards.
In an April 2008 report, The Kansas City Federal Reserve Bank showed that, from 1996 to 2005, average interchange went from 1.3 percent to 1.6 percent, and is nearly 2 percent today. From 2001 to 2008, total interchange tripled - from $16 billion to $48 billion. This model doesn't seem sustainable, at least not to me.
Meanwhile, no significant new technology has emerged at the retail POS since the adoption of electronic ticket capture. That is about to change. With more efficient technology and lower cost, lower prices result, in theory.
These new payment products will not necessarily generate interchange for the card brands, and by implication, will not generate interchange-based commissions for ISOs, which is why sales agents should be following these developments. Merchants certainly are.
In September 2011, the National Retail Federation began a lobbying campaign to reform credit card interchange fees, which it said generates $30 billion a year for banks and card brands. This is the next stage of the Durbin Amendment. The NRF represents 1.6 million retail businesses that employ one in five U.S. workers.
Similarly, the Merchants Payments Coalition and the Retail Industry Leaders Association have lined up on the side of interchange reform.
In testimony given a year ago to the U.S. House of Representatives Financial Services Committee, the general counsel of the NRF, Mallory Duncan, presented 2008 data from Cards and Payments that showed the numbers behind issuer interchange profitability.
Given that issuers make half their money from revolving credit card debt, it is surprising that cost of funds is 6.3 percent, operations and marketing are 28.6 percent combined, fraud is 4.5 percent, and pretax profit is 60.7 percent. Total fee numbers break down as follows: annual fees, $3 billion; cash advance fees, $8 billion; penalty fees, $18 billion; and merchant fees, $42 billion.
Another perspective is to compare profit margins of the retailers with those of the card brands. Visa's profit margin is around 40 percent, and MasterCard's is not far behind. Large oil companies are between 15 and 20 percent. A study of profit margins for large retail corporations between 2003 and 2007 showed retail profits as a share of sales to vary from 2 to 4 percent.
All this talk about interchange (both for credit and signature debit) came to a head with the Durbin Amendment, where the Federal Reserve found a "market failure" in debit card pricing by the card brands.
This is not unprecedented. Most people are unaware that among the motivations behind the establishment of the Fed in 1913 was to end the widespread practice at that time of banks charging something like an interchange fee for cashing paper checks, which was viewed as an impediment to interstate commerce.
With fewer than a dozen major bank card issuers and large acquirers (bank and nonbank), it might come as a surprise the concentration of ISOs in the industry. On its website, Visa lists 1,253 ISOs that provide sales, customer service, training and transaction solicitation.
An October 2011 study by First Annapolis Consulting revealed that the majority of ISOs are small, with over half of them generating less than $500,000 in annual revenue, while a number of large ISOs generate over $20 million in annual revenue, and they represent about 94 percent of the total annual revenue for the market.
While the large issuing banks and large acquirers increase their market share and total revenue, technology could change the current network model, and it could change the whole revenue model for ISOs. Some key players behind the new technology are eBay Inc. and its subsidiary PayPal Inc., Google Inc., and Apple Inc. And they've all been in the news lately.
Frank Hayes recently blogged on StorefrontBacktalk, "Not unlike IBM in the '80s and '90s, Apple is in the highly enviable position that it can wait until it's time [for a new infrastructure] and then still dominate the market. ... Indeed, it might even be easier and more effective to do it that way.
"That strategy will determine who will define the retail NFC standards that matter - the ones on the checkout counter and the retailer's data center. And that won't be Apple."
In other words, Apple should let Visa, Google, PayPal, Square Inc., and ISIS fight it out as they pay for the new payment infrastructure. And then, when the bugs have been worked out, Apple can jump in.
American Express Co., Citigroup Inc., Discover, MasterCard and Visa have signed on as credit card partners for Google Wallet. Consumers can walk into large retailers like Macy's and Toys "R" Us and tap their phones to pay.
The expectation is consumers will load Google Wallet loyalty cards onto mobile phone apps and expand the number of participating merchants. However, Google Wallet currently works only with the Sprint Nexus S 4G smart phone.
With the mobile wallet, stores can pull consumers in via time-, location- and preference-based marketing. This can expand purchases, much like the credit card did.
In fact, expanding payment choices was probably the biggest contribution of the credit card; it allowed consumers to buy on unsecured credit, so merchants were able to make sales that wouldn't have happened before credit cards came along.
Mobile wallets and cloud solutions will create sales in a different way.
In October 2011, PayPal Director of Communications Anuj Nayar gave the company view on Google Wallet and near field communication (NFC). John Donahoe, eBay Chief Executive Officer, has already called NFC "not for commerce." But PayPal is supporting Google's Android operating system, although right now not many consumers are using NFC-enabled phones, and merchant adoption is limited.
Nayar said mass adoption of NFC is at least three years away. But, even then, it will not replace mobile payments. PayPal is instead investing in a solution for in-store merchants to integrate PayPal into the checkout experience.
In a few months, PayPal will unveil a one-stop shop for merchants to manage payments, which will include payments accessible from any device and at brick-and-mortar stores. PayPal has 100 million users, and they can customize offers based on existing user profiles.
At the recent opening of the Web 2.0 Summit, Sean Parker, best known for founding Napster, said, "Facebook would have to screw up royally, and Google would have to do something really smart" for Google's social network to prevail. (Facebook has 800 million users to Google's 40 million).
At the same conference, Marc Benioff, founder of Salesforce.com, stated, "Facebook is becoming a vision of what the next-generation consumer operating system is." Google has a great online search and advertising platform; Facebook has a widely embraced social platform; eBay has an entrenched e-commerce platform.
In October 2011, eBay launched the PayPal Access online identity program and an open X.commerce platform for payments to let merchants tap into cashless transactions.
X.commerce will match merchants with independent developers building new ways to handle checkouts and other aspects of running shops with online outlets. PayPal Access will let people shop at websites using names and passwords from accounts at eBay's financial transactions service.
One of the sharpest observers in this space is Russ Jones. Writing in the Oct. 17, 2011, Glenbrook Payments Views blog, he said, "PayPal is ... rethinking how shopping could be made easier for both buyers and sellers. ... A shopping list could be built online and then shared with the merchant upon in-store check-in" to match with product availability and purchase incentives.
PayPal imagines users would have a wallet capability that would hold the consumer's payment methods, current offers, loyalty and gift cards, available points, purchase history, and digital payments. But who controls the wallet and where does the payment data reside?
In PayPal's case, the wallet would be one of the functions inside the PayPal Mobile app, and the wallet would act as the user interface to the consumer's payment data in the cloud. This is in sharp contrast to Google and ISIS, where the wallet is the app and the payment data resides in the phone.
Here is where it gets interesting for ISOs. According to Jones, PayPal envisions offering buyers the ability to adjust their funding methods after they leave the store.
Buyers have the ability to sit down at the end of the day and adjust how they want to fund purchases, perhaps using their bank account for budgeted purchases, their credit card for discretionary purchases, and installment purchases for large ticket items, Jones wrote.
Now, as an ISO, which of these revenue streams are you participating in, and how can you add value to the merchant now?
Brandes Elitch, Director of Partner Acquisition for CrossCheck Inc., has been a cash management practitioner for several Fortune 500 companies, sold cash management services for major banks and served as a consultant to bankcard acquirers. A Certified Cash Manager and Accredited ACH Professional, Brandes has a Master's in Business Administration from New York University and a Juris Doctor from Santa Clara University. He can be reached at brandese@cross-check.com.
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