irst of two parts

In December 1997, The Green Sheet published the first article in this series, titled, "What Are The Costs of Merchant Processing?" This is an update of that article. It is also a warning bell to the players in our industry who might not be focusing enough on the potential impact of the Visa lawsuit against First Data Corp. (FDC) over First Data Net (FDN) and FDC's countersuit against Visa.

Much has happened since December 1997. Telecom costs have continued to come down. Technology has improved, driving down costs of processing equipment and storage hardware as well as software development. New CRM software packages have helped reduce costs of providing call center service to merchants.

The Internet has been used by all of the major acquirers to deliver information to merchants in efficient and useful ways. Real-time processing now allows merchants to view transactions as they occur and to implement changes in downloads from any PC in the world at any time.

But the fundamentals of our industry's cost structure remain the same. There are still three categories of costs for merchant processing: those based upon the dollar volume of processing (interchange), those based upon processing transactions (transaction fees) and those based upon delivering information to the customer (monthly fees).

Part I of this article discusses the current and future status of dollar-volume-based fees. Part II will discuss transaction and customer-service fees.

Fortunately for all of us, the major costs - those driven by dollar volume - continue to be the same and apply equally to all acquirers (except for giant merchants such as Wal-Mart). Interchange, dues and assessments continue to be charged to all acquirers in an even-handed manner across the board by Visa and MasterCard. It is Visa's and MasterCard's level playing field of dollar-volume cost structure that allows for free market pricing that, in turn, gives the small players the opportunity to compete with the big players. (I will give more specifics on this point in Part II.)

Basic Visa interchange for a vanilla credit card transaction is 1.37% and for a Visa Check card is 1.25%. Visa dues add another 8.4 basis points to the dollar-volume-based costs. MasterCard's basic interchange rate is 1.38% for both credit and Master Money transactions with assessments at 9.5 basis points. Of course, Visa and MasterCard each has added an additional 10 cents per transaction to the costs of interchange.

Two significant lawsuits may change the stability and level playing field of dollar-volume-based costs.

The Wal-Mart case regarding offline debit cards (note that Wal-Mart previously negotiated a favorable fee structure for giant merchants with Visa in the late '90s for credit transactions) is on track to be heard in court next spring.

This is the case in which Wal-Mart and other large retailers sued Visa to stop requiring acceptance of the Visa Check card. Since its filing, the courts have allowed this case to become class-action litigation, and every single merchant in America is likely to be affected by the eventual outcome in some way.

Many expect an out-of-court settlement. Others anticipate a lengthy courtroom face-off. Billions of dollars are at stake. We should get a better feel for the outcome of this case sometime in mid-2003. The outcome may result in a fundamental change in the way interchange is assessed to merchants for non-credit transactions.

In my view, however, it is not likely that this outcome will change the nature of our level playing field. I believe that the result of this litigation will be reduced interchange costs for offline debit transactions. That will keep pricing neutral with respect to acquirers.

The other lawsuit, however, may have a draconian impact on all of the non-FDC owned acquirers. Visa has sued First Data over First Data Net. FDN is the new name attached to the system developed by FDC designed to work around (and eliminate the fees charged for use of?) the VisaNet processing system. Among other things, the associations' systems collect funds minus interchange from issuing banks and pay them to acquiring banks that then pay their merchants.

FDC processes for banks that issue cards as well as for banks that acquire transactions from merchants. A portion of cards (currently 15%) accepted by FDC merchants is issued by FDC banks. So why does First Data need Visa to "get in the middle" of the settlement of these transactions? First Data has the ability to work with its issuers and acquirers to clear and settle all of these "on-FDC" transactions.

This "on-us" idea isn't exactly a new opportunity for someone in FDC's position. It has little, if anything, to do with improved technology. Every processor who ever processed BankAmericard or Interbank transactions for both issuers and acquirers had the same opportunity to clear and settle "on-them" traffic, even back in the days of paper tickets.

For goodness' sake, local bankers still meet over coffee in the morning in small towns to exchange paper checks that are "on local community banks." The idea of "on-us" systems is not a new or original construct within the financial community.

But is Visa really the enemy of FDC? All certified association third-party processors sign contracts that prevent them from taking advantage of all of the association systems with one hand while they cut the association out of the action with the other.

Of course, FDC signed on to the same rules of engagement that every single processing entity has agreed to from day one of our industry. But it seems FDC may have created First Data Net in a bold attempt to change the level playing field heretofore preserved by the associations' rules.

Is First Data's position nothing more than a brazen but straightforward power play? The associations are currently challenged to use their talent and resources to defend themselves against the U.S. Department of Justice, the class consisting of all the merchants in the U.S., and foreign governments around the world who are challenging their fee structures. Attacking when the enemy is looking the other way has been an effective battlefield strategy for millennia.

If First Data wins this lawsuit and is allowed to move forward unfettered, it could have the ability to drive all of us out of the acquiring business. First Data processes almost 1 billion transactions each month and, according to The Nilson Report, Issue No. 758, owns all or a portion of 42% of the merchant contracts in the U.S. through its direct business, alliances, ownership in Paymentech and recent acquisition of British Petroleum's (formerly ARCO's) PayPoint unit.

Fifteen percent of Visa's volume could be processed as "on-FDC" traffic today. Winning this lawsuit likely would increase FDC's percentage of "on-FDC" traffic dramatically because FDC would use its pricing advantage to maintain and grow its merchant and issuing businesses. This would allow First Data to actually attempt to accomplish its well-publicized goal of dominance.

Remember First Data's slogan of not long ago? "To process every electronic payment transaction worldwide from the point of occurrence to the point of settlement." Was this slogan a precursor to a sweeping goal to alter the competitive landscape by significantly changing the rules?

Visa and MasterCard charge fees to acquirers and sponsor banks for using their authorization and settlement systems. These extra fees are above and beyond interchange, dues and assessments and are not generally known to small acquirers and ISOs because they are normally buried in the sponsor bank fees or the back-end processing fees. Nevertheless, these extra fees in fact exceed all other variable transaction costs combined! (I will address transaction costs in Part II of this article.)

If First Data is able to avoid these transaction-based costs of settling and authorizing through VisaNet, its variable costs of transaction processing will be cut by more than 50%. How do other acquirers compete against that? Do you think large merchants will leave other acquirers to save a half-cent or more on each transaction? Who do you think will own the entire petroleum, QSR and other low-ticket markets in a very short time?

Of course, as more transactions move to First Data, its 15% "on-FDC" share will grow, and more and more issuer/acquirers will be motivated to use First Data to benefit from its advantageous cost structure. Because the concept of "on-FDC" will be expanded to include all merchants and issuers on the FDN platform, the advantage may become overwhelming. Will our federal regulators allow a victory by First Data in this lawsuit to stand once they truly understand its impact on the entire acquiring industry?

As if this isn't enough to get our attention, what happens if First Data decides to either (1) fight payment of dues and assessments for "on-FDC" transactions or (2) create its own brand altogether and set its own interchange rates and ISO compensation parameters, just as American Express and Discover do in their closed-loop systems?

In the late '80s, Citibank fought a battle to stop paying dues and assessments to the associations for "on-us" traffic. In the environment of the '80s, when the associations were at the height of their strength, Citibank lost this struggle and eventually sold its large acquiring business to First Data. If First Data is able to implement FDN, what are its chances of winning the battle to kill dues and assessments for "on-FDC" transactions as well?

If victorious, not only would First Data have the benefit of eliminating the transaction fees imposed by Visa and MasterCard on the rest of us. It also would be able to eliminate the 9.5 basis points of MasterCard assessments and 8.4 basis points of Visa dues as well.

This potential one-two punch could be the end of the competitive game. First, FDC could reduce its variable transaction costs by more than 50%. Second, it could possibly save another 4 to 6 cents per average transaction by avoiding dues and assessments. If FDC decides to pass a portion of this cost savings on to its merchants, it then will be able to re-evaluate the need to pay significant portions of its revenues to ISOs. When discussing dollar-volume-based costs in 1997, I stated, "Except for Visa's new discount to a few gigantic merchants, Visa and MasterCard have one interchange structure that applies to all acquirers. As long as this fundamental pricing structure remains constant, our industry has many great years ahead of it."

Now our future is in the hands of the courts, and our businesses may be at risk. Will First Data prevail? Will the playing field remain level with respect to dollar-volume-based costs?

And if FDC does prevail, will it be a result of its superior products, technology or service to the nation's merchants? Or will it be because an industry player is expert at leveraging its size to outbid everyone else when it comes to acquisitions? Or will it be because that same player is able to extract necessary concessions from its "business partners" if they are to stay in business?

According to some Wall Street analysts, Total Systems (TSYS) has been taking market share away from First Data in processing for issuing banks. Some industry observers think that were it not for acquisitions, FDC's market share would be eroding in the acquiring business as well. Western Union Funds Transfer income looks to be the jewel in the FDC profit crown, not card processing.

Will First Data Net provide the platform for victory that FDC has not been able to achieve in a competitive marketplace? Stay tuned. It might get interesting.

Bob Carr is the Founder, CEO and Chairman of Heartland Payment Systems, the nation's largest privately owned merchant acquirer and ninth largest overall, with annual revenues exceeding $300,000,000. Heartland was recognized by INC Magazine as the 57th fastest-growing private company in America and is one of the 10 largest INC 500 companies. Bob was a Founder and Vice President from 1988 to '90 of the Bankcard Services Association, which has since become the ETA.

Before entering the bankcard industry in 1986, he developed computer software systems for unattended fuel pumps and created the first integrated accounting applications for PCs. He also started the computer department at the Bank of Illinois and served as the Director of the Computer Center and as a mathematics instructor for Parkland College. He earned degrees in mathematics and computer science from the University of Illinois in 1996 and 1967.

To learn more about Heartland, visit www.hpsteammates.com or www.heartlandpaymentsystems.com. You can e-mail Bob at Bob.Carr@e-hps.com.