Trends & Tactics: Open-Loop Prepaid Gains Ground

Open-loop prepaid cards are slowly but steadily gaining market share and now account for nearly 40% of the market, but closed-loop prepaid cards, especially gift cards, remain highly popular with consumers.

The 9th annual study of the prepaid card market by Mercator Advisory Group Inc., released in August, shows volumes on closed-loop cards grew 14% in 2011 and loads on the newer open-loop cards increased 24%.

In all, Maynard, Mass.-based Mercator estimates that prepaid card loads totaled $483.2 billion in 2011, up 18% from $410.8 billion in 2010. The closed-loop sector had $299.1 billion in loads compared with 2010’s $262.4 billion. Loads on open-loop cards summed to $184.1 billion versus $148.4 billion in 2010.

Most of the action in recent years has occurred on the open-loop side. With these cards, issuers typically pair up with a program manager such as Green Dot Corp. or NetSpend Holdings Inc. to distribute Visa, MasterCard, American Express, and Discover prepaid products through retailers, employers, or other channels.

But the foundation of the industry remains the closed-loop gift card usable at the locations of a single merchant. The gift card, a mainstay present for birthdays and Christmas, remains the biggest of the 17 market segments Mercator identifies on prepaid’s closed-loop side. Gift cards are a big reason closed-loop cards still account for 62% of all prepaid loads, according to Ben Jackson, a Mercator senior analyst. Mercator wouldn’t release gift card volumes, but says they grew 10% last year.

“Closed-loop is going to stay ahead for a while,” says Jackson. “In part that is a recognition of people’s gifting habits, ‘If I’m going to give a gift it’s going to be for something specific.’ Open-loop gift card providers have kind of a tough row to hoe in overcoming that perception.”

Closed-loop’s second-biggest sector is food-stamp cards distributed by states. Mercator estimates load volume increased 10% last year to $74.3 billion, an increase Jackson attributes to the tepid economy.

The fastest-growing closed-loop segments were campus cards used in cafeterias, laundries, stores, and other locations at colleges and universities, and incentive cards distributed by retailers to induce further spending. Campus cards, whose volume increased 30%, grew rapidly because schools “want to get cash off of campuses … they want to speed people through meal lines,” says Jackson.

Open-loop cards aren’t growing as fast as Mercator had earlier thought, but in 2011 they still captured 38% of the total market, up from only 4% in 2003. By far the fastest-growing open-loop segment last year was the one for cards distributed by states to deliver welfare benefits, formally Temporary Assistance for Needy Families (TANF). Volume grew nearly 100-fold, hitting $1.6 billion from a mere $16 million per year in 2008-10.

The huge jump was mostly the result of states replacing paper checks for TANF benefits.

Load volume for the U.S. Treasury Department’s Social Security card grew 55% as the federal government continued its migration from paper checks. Mercator estimates the government will save $1 to $1.80 for every check it doesn’t have to process. The Social Security segment ranked No. 2 in growth rate among the 18 open-loop segments Mercator identifies.

A broad category that Mercator calls “cash access,” which includes open-loop gift cards, remittance cards, general-purpose prepaid cards, and related products, grew 33% to $74.1 billion and is the largest of the open-loop segments. But several open-loop segments grew more slowly, under 10%, including employee and other incentive cards, and insurance cards. With the exception of insurance cards, where industry adoption lags, the slow growth reflects the overall economy, according to Mercator.

Mercator’s findings reflect the massive shift in how Americans are using telephones. Loads on closed-loop prepaid cards for long-distance calling on land lines fell 11%, but volume on open-loop cards for mobile phones grew 14%, Jackson says.

Mercator compiled its results from data provided by about 20 retail prepaid card issuers, major prepaid card processors, filings of public companies in the industry, and other sources.

Prepaid Cards That Merchants Help Load

A 2-year-old startup that allows consumers to use prepaid cards augmented with funds from participating merchants was expected to launch its product commercially late last month following a nearly nine-month pilot in the Bay area.

Emeryville, Calif.-based Marqeta Inc., which has already signed up about 250 merchants, is banking on the idea that consumers will respond better to real-dollar rewards than to other types of value and that merchants will line up to lock in customers’ spending in advance. “We like the idea that you just get extra money,” says Jason Gardner, the company’s founder and chief executive. “We’re dealing with real money, not points. Consumers are confused about what their points are worth.”

While he will not disclose how many consumers have signed up so far, Gardner says Marqeta is recruiting new merchants “every week” to accept the mag-striped Marqeta card, which works in conventional point-of-sale devices linked to the Discover network.

Those that have come aboard fall into a wide range of categories, including restaurants, groceries, doctors’ offices, hair salons, and auto-repair shops. Perhaps the startup’s most prominent merchant so far is online florist 1-800flowers.com.

Gardner, who says he took inspiration from Starbucks Corp.’s highly successful closed-loop prepaid card, says he wanted to expand the concept to a wide network of merchants. He started working on the idea shortly after leaving MoneyGram International Inc., which in 2007 had acquired his previous startup, a company called PropertyBridge Inc. that specialized in processing rent payments for landlords.

With Marqeta, retailers offer to match a percentage of what consumers load onto the card for spending at that store. A grocer, for example, might add $7 onto a customer’s $100 load. Other merchants with bigger margins typically augment loads by as much as 25%. While merchants can extend limited-time offers, they are required to post at least one so-called always-on offer. 1800flowers.com, for example, features a 25% always-on offer.

The idea, says Gardner, is that the merchant can count on committed funds ahead of the sale and is presumably locking in incremental business. “It’s all pay for performance,” he says. “The merchant pays us a commission for bringing him a customer who has paid in advance.” Commissions, he says, range from 5% to 10% of the load value. In addition, merchants pay discount fees based on signature-debit interchange to their acquirer each time the card is used at their store.

Consumers sign up for the card, choose the merchants they want to use it with, and load value on the Marqeta Web site, though the company also offers a mobile app. For now, consumers must use a major-brand credit or debit card to load funds, though Gardner says the service plans to add a capability to support cash and transfers from bank accounts through the automated clearing house network. Though transactions are routed by Discover, Marqeta handles authorization and settlement.

Other plans call for Marqeta cards for employees to support both discount programs and payroll. Marqeta was expected fairly soon to announce several “larger partners” for programs like these, including a “large restaurant chain” that is looking to streamline employee discounts.

Mobile transactions, however, are not on the immediate horizon. Since Marqeta works on the Discover network, its card will work in the newly overhauled Google Wallet. But Gardner and chief revenue officer Omri Dahan argue too much POS investment remains to be made to make mobile transactions practical for merchants. “Mobile payments are not a value proposition,” says Dahan. “It’s an interesting technology.”

While merchants may find appeal in the notion of prepaid sales, observers say Marqeta’s value proposition to them will rise or fall depending on whether the startup can deliver incremental business—purchases that the cardholder would not otherwise have made at the store.

With commissions, augmented loads, and discount fees on transactions to reckon with, merchants may also need the card to induce consumers to spend beyond what’s loaded on it, argues Ben Jackson, senior analyst in the prepaid advisory service at Maynard, Mass.-based Mercator Advisory Group. “A guaranteed future sale is great as long as it produces a margin,” he notes.

So far, consumers seem willing to oblige. Marqeta, which charges the card designated by the user for any spending beyond the load value, notes that overspend across its network has averaged 20.3%.

Stumbling Over Mobile Payments

With smart-phone usage on the rise, small online merchants are at risk of losing market share because most of them haven’t created e-commerce sites that work smoothly on mobile devices.

At the same time, independent sales organizations could lose business if they don’t find ways to help small clients deal with customers using mobile phones. That’s according to a report released last month that measures small merchants’ readiness to accept mobile transactions.

More than half of e-commerce and multichannel merchants surveyed for the report (55%) indicated their Web sites are not optimized for mobile transactions. That means pages are slow to load and checkout forms are hard to see and fill out.

Consumers viewing such sites on a mobile screen must do a lot of pinching and zooming to read or see anything. Even worse, some 70% of these merchants are not tracking mobile transactions as distinct from sales from PCs. These merchants as a result have no notion of such factors as cart abandonment by mobile users.

“It’s a little shocking that a merchant relying on e-commerce as a lifeline is not looking at these trends,” says Dave Abouchar, senior director of product management at ControlScan Inc., an Alpharetta, Ga.-based security-technology vendor that conducted the research with TransFirst, a Hauppauge, N.Y.-based merchant processor.

In June and July, the two companies canvassed more than 17,000 Level 4 merchants, in other words, those doing up to 20,000 e-commerce Visa transactions or up to 1 million brick-and-mortar Visa transactions each year. The research garnered responses from 736 retailers. Some 27% of the respondents were either e-commerce-only or multichannel merchants.

While the survey included questions about mobile usage at the point of sale, the lack of attention to mobile trends online is “the alarming [result] that needs immediate attention,” notes Craig Tieken, director of product at TransFirst. “One day, these guys will look at their numbers and say, ‘I’ve been flat in my sales.’ It’ll sneak up on them.”

There’s also a search penalty for e-commerce sites that don’t optimize for mobile devices, Tieken adds. Some search engines, like Google, relegate results from non-optimized sites to the lower rungs of searches. Without a site designed for mobile access, “chances are, I’m not even going to get looked at,” he says.

Mobile access to the Internet is fast entering the mainstream. Some 45% of U.S. adults now own a smart phone, which links to the Web more easily than a feature phone, while 17% of mobile users now access the Web mostly on their phone, according to research from the Pew Internet and American Life Project.

Meanwhile, some 19% of U.S. adults own a tablet computer, Pew says. These days, consumers, especially those under 35, are “umbilically connected to their phone,” notes Tieken.

Yet, the top reasons merchants gave for not optimizing are “customers are not asking for the service” (35%) and “no compelling reason to make the investment” (26%). But by not tracking abandonment, these merchants have ignored a valuable source of customer feedback. “We have to educate merchants on that,” says Tieken.

Indeed, the task of education and preparation falls to ISOs and other acquirers, say Abouchar and Tieken. “We have to deliver this information to the ISOs because it helps ISOs educate merchants,” says Tieken. This will require a new approach by ISOs to their clients, he argues, one that substitutes online-selling advice for “things that aren’t all that productive,” such as conversations about rate compression and pennies-off rate discounts.

The consequences could be serious for ISOs that ignore the problem. “If you don’t take this message to the market, somebody else will, and those that do will win out,” says Tieken.

In other results from the survey, 10% of physical and multichannel merchants (83% of respondents) are using mobile acceptance with either a smart phone or a tablet. Of these, some 35% said the mobile system supplanted a traditional point-of-sale device.

The iPhone/Square combination is the most popular, with 57% using an iPhone and 45% opting for the Square Inc. reader. Next in popularity are the GoPayment device from Intuit Inc. (18%) and the VeriFone Systems Inc. Sail technology (14%).

As for mobile wallets, only 3% of the respondents currently accept payments from a product such as Google Wallet or PayPal, but 33% indicate they are in implementation or have plans to start over the next two years.

FANF’s Unanticipated Credit Risk for Acquirers

Merchant acquirers and independent sales organizations always face risk not just from routine chargebacks, but also when merchants in their portfolios either suddenly bolt to another processor or go out of business. Now, Visa Inc.’s new Fixed Acquirer Network Fee, or FANF, is adding a new element of credit risk to the acquiring industry, according to First Annapolis Consulting Inc.

The risk comes not from the monthly fee itself, but in the way acquirers bill their merchants for it. Visa charges acquirers the FANF during the same month that a merchant generates Visa charge volume. As is the case with most other expenses, acquirers are passing their FANF charges through to their merchant clients, but usually not until the month after they’re generated.

That means if a merchant goes out of business, switches acquirers, or is involuntarily terminated as a card acceptor, the acquirer is exposed to a cash loss because Visa collects the FANF from that acquirer regardless of whether the acquirer has collected the fee from the merchant, according to First Annapolis.

“This is significant because the loss that results is a hard-dollar loss for the acquirer, unlike the acquirer’s other fees,” says the report. “Traditional acquirer fees, such as monthly fees or statement fees, are typically reversed when a loss occurs, meaning the accrued but uncollected revenue is written off with no impact on the acquirer’s cash position.”

First Annapolis recently surveyed about 20 acquirers about their FANF practices, and at least 15 are billing the fee in arrears, says report co-author Raymond Carter, a principal at the Linthicum, Md.-based firm. One acquirer hadn’t even started collecting it. Few underwriting managers have yet given serious thought to the risk implications of their FANF billing practices, according to Carter.

“I don’t think it’s hit the radar of the credit people yet, and it probably won’t until the dollar amount starts creeping up a little bit,” he says.

For card-present merchants, Visa assesses the FANF through an 18-tier schedule based on location numbers and whether Visa considers the merchant a “high-volume” business (“What’s This FANF Thing All About?” September). Visa calculates the FANF for card-not-present merchants, aggregators, and fast-food restaurants using a 16-tier schedule based on monthly dollar volume.

The extra credit risk may not seem like much when viewed on a per-location basis, but the exposure, or increase in exposure, can be large if spread across a portfolio. For example, First Annapolis estimates a small restaurant chain with five locations that generates $200,000 in annual charge volume faces credit exposure of only $7.50 at any given time. Risk is low because restaurants usually have card-present transactions and get few chargebacks, Carter says.

But, assuming the chain’s acquirer bills the FANF a month in arrears, the new fee adds $14.50 in credit exposure based on a charge of $2.90 per location, according to Visa’s schedule. That means the acquirer’s credit exposure has just increased by more than 200%.

In another card-present example, a delayed-delivery furniture retailer with five locations that also generates $200,000 in annual volume faces an estimated credit exposure of $9,000 because of the high average ticket and higher chargeback rates than the restaurant chain, says Carter. Assuming billing occurs a month later, the FANF would add the same amount of monthly risk, $14.50.

FANF’s credit risk rises for acquirers serving small and mid-size businesses because of the relatively high failure and attrition rates of those merchants compared with those of large merchants.

“It’s progressive,” says Carter. “If you’re an ISO that has a 25% attrition rate and you’re running into this problem on 25% of your portfolio every year, it can add up.”

The only way to eliminate FANF credit risk is to bill in advance, according to First Annapolis. While acquirers could do advance billing fairly precisely for card-present merchants, such a method might present some problems for online retailers, aggregators, and fast-food restaurants, since no acquirer knows exactly how much charge volume a merchant will generate.

The FANF is one part of Visa’s effort to protect its revenue stream in the wake of Durbin Amendment regulations that have caused a big drop in its PIN-debit transaction volume (“The Great Debit Network Reshuffle,” page 34).