The Green Sheet Online Edition
October 09, 2017 • Issue 17:10:01
The death of interchange
Beneath the beauty and mysticism of terroir, grape growing and varietal blending in Sonoma County's Wine Country, where CrossCheck is located, lies a stark business reality: the ground is shifting beneath our feet. This is due to several factors.
First is the direct-to-consumer movement, which has entirely eliminated the broker, distributor and retailer for boutique wineries too small to get distributors to sell for them (large distributors carry 10,000 wine labels in their portfolios). Second is the rise in buying wine online, which has shifted the wine buying experience away from frequenting local wine specialists to consult skilled wine experts about which wines to buy.
Third is the so-called retail apocalypse, which means brick-and-mortar stores in general have some cost burdens, such as unsustainably high "percentage of sale" rents and employee salaries and benefits. Fourth is the specter of Amazon buying Whole Foods. It's too soon to know what the implications for wine retailers will be, but the selection of wines available in retail stores will likely shrink to just a few popular brands. The retail mix in a supermarket is part of a larger portfolio focused on high-volume throughput, not satisfying wine enthusiasts.
In short, the three-tier distribution network put in place after Prohibition is rapidly being deconstructed. A new distribution model is being created that will disrupt the traditional commission and payment structure in a big way.
As with grapes, so with cards
The same is happening in the payments industry. For many years, retailers have complained the cost of payment processing is too high. But back when the credit card industry was being formed, card acceptance was seen as a revolution. It was a "chicken or egg" problem for issuing banks. Merchants didn't want to take cards because nobody had them, and consumers didn't need cards because merchants didn't take them.
Initially, merchants paid as much as 6 percent interchange and waited a week to get paid. Many things had to happen in those early days, including the creation of an army of feet-on-the-street salespeople to sell the idea of taking credit cards to merchants. This was an enormous task.
The first credit cards as we know them (not store cards) were issued in 1958 by the Visa predecessor organization, BankAmericard. It wasn't until 1973 that Visa had fully electronic authorization, clearing and settlement. It's probably accurate to say that not much changed during the ensuing 40 years.
Many people reading the The Green Sheet will recognize the name Dee Hock, the visionary behind Visa and one of the true heroes of the payments industry. A 1996 article published by Fast Company recalled Hock holding up a Visa card to the audience and asking how many knew what it was (of course, everyone did) and asking, "How many of you can tell me who owns it, where it's headquartered, how it's governed or where to buy shares?" There was only "confused silence" in the room. Then Hock added, "In Visa, we tried to create an invisible organization and keep it that way."
When Hock drafted the original Visa bylaws, he encouraged member banks to innovate and even compete with Visa. He said he wanted members to freely "create, price, market, and service their own products under the Visa name." His vision was that Visa would be "largely self-organizing."
But it was not to be, probably due to the very structure of the organization. Originally, Visa was owned by the member banks. Thus, Visa was controlled by less than two dozen, very large, commercial banks, which were the largest card issuers.
Acquiring, the stepchild
Acquiring took a backseat to issuing. Acquiring was messy, complex and complicated. But it necessarily accompanied issuing tens of millions of cards, which is what it took to get a critical mass. Back then, the largest issuing banks were not prepared to enter the acquiring business or sell merchant services themselves.
The original idea of interchange was that the issuing bank and the acquiring bank were two different entities, and that it would take a few days to settle transactions (the merchant used a knuckle-buster to fill out a multipart paper business form, which had to be split and sent to all parties in the transaction). The merchant would receive payment in a few days. Meanwhile, the issuing bank billed the cardholder and was paid after the statement date. On average, the issuing bank might have to wait 15 to 20 days for reimbursement from the consumer. Interchange was a way to compensate them for this.
For a typical transaction ($50), the interchange might be 87 cents, dues and assessments payable to Visa would be 7 cents, and card markup to the processor might be 20 cents. So the effective rate paid by the merchant would be, in this case, 2.28 percent, a typical card present/card-swiped rate. Total fees would be $1.14.
You might ask why issuing banks would receive 76 percent of merchant fees simply for issuing cards to consumers. This question is even more relevant today. Chances are good the issuing and acquiring bank in a transaction are one and the same, since the majority of credit cards are issued by Chase, BofA, Citi, Capital One, US Bancorp, and Wells, which are also the major acquirers.
Then there is the question of why these fees keep going up, when every other form of electronic processing and settlement has seen prices decline. We are seeing a movement to faster payments, which means same-day payment, since all checks and ACH entries now settle in one business day. The number one thing most merchants want is to be paid the same day, which is why merchant cash advance has been successful. When it comes to issuing, the average American with a card is revolving a balance of $16,425. About 60 percent of cardholders revolve their balances, up from an historical figure closer to 50 percent. The cost of funds for a major bank is in the 1 or 2 percent area (the Fed funds rate as I write this is 1.25 percent). The bank will charge consumers a rate of 14 to 22 percent to revolve balances.
New payment rails coming
A 2015 study by the Federal Reserve calculated that the return on assets for a typical commercial bank is 1.36 percent; for large issuing banks it is three times that: 4.36 percent. While, legally, banks must give consumers 20 days to pay any given set of transactions without penalty, the typical credit card accrues interest at 2 percent a month. This is twice what the bank can get in the investment market for short-term funds.
The handful of banks dominating this business would be better off reducing the current interchange rate by 50 basis points. Here's why: in the not too distant future, a challenger (Apple Pay?) will build another set of railroad tracks from merchants to the issuing banks.
Processors will need to settle directly with perhaps only a dozen major issuing banks and one omnibus settlement bank for everyone else. The transactions will go directly to issuing banks in real time for authorization. No other processors or intermediaries will be involved. Issuing banks will use next-generation artificial intelligence to do credit scoring on consumers in real time, which will reduce bad-loan charge-offs by 50 percent, or more. There will be no justification for issuing banks getting a fee of 87 cents for a $50 transaction.
Let's not pretend the card brands are going to provide exciting, new payment innovations that will justify their fees for basically being toll booths. New initiatives such as Verified by Visa and the Visa program to convert checks to ACH evince minimal accomplishment. The recent EMV rollout has been a boondoggle that should (but probably won't) cause heads to roll. When there is a monopoly (or duopoly) slack abounds for failed projects. Now EMV is being touted as a five-year rollout, which is certainly not how it was portrayed originally.
I give interchange as we know it no more than five years. After that, transactions will settle directly to demand deposit accounts, where all payments settle ultimately anyway. Payment processing will become a commodity, and it will be, to use the current nom de jour, "frictionless." There will be no more room for an extra 50 basis points, and frankly, there shouldn't be 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 email@example.com.
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