Digital Transactions Authoritative, insightful and timely information for payments professionals
From continued interchange challenges to pokey transactions to uppity merchants, the payments business has a full agenda of pesky problems. Here’s our look at the latest crop, ranked in order of gnarliness.
By John Stewart and Jim Daly
If it is true that what doesn’t kill us makes us stronger, then the problems presented herewith in our sixth annual catalog of industry headaches should ultimately yield a more robust electronic-payments business—for the survivors.
Make no mistake. This year’s crop of challenges are doozies, ranging from powerful new entrants in the vast and sprawling point-of-sale market to a potentially expensive new network fee to big-box merchant opposition to anything that might undercut an eventual retailer court case against credit card interchange, including the sweeping antitrust settlement reached in July.
Add to that an equally determined campaign to create a merchant-controlled mobile-payments network, a network whose underlying purpose could be to blow up the decades-old interchange system.
Funny thing, though. All these issues aren’t scaring off new players. Startups by the dozens have barged into the business in the last couple of years, with most of them keying their products and services to the bubbling, but so-far unformed, market for mobile-payments apps.
This influx of tech players suggests a new issue, one we haven’t included here because it is still developing. Much of the buzz surrounding mobile payments concerns the painfully slow adoption of a powerful POS technology called near-field communication (page 16). But the nagging questions surrounding NFC may be masking a more fundamental problem for incumbent payments processors.
The problem is that, for all the talk about mobile payments, payments may not turn out to be the main revenue event. In fact, they may become merely a bolt-on, or even a loss-leader, used to entice merchants to adopt something else. That something else, many now say, is likely to be offers and rewards.
The first hint of this direction emerged a year-and-a-half ago when Google Inc. unveiled Google Wallet and said the new service would offer transactions at no charge. Instead, the King of Search would look to make money by matching merchants with customers via on-the-spot offers and redemptions through the wallet. Many others, including the carrier-backed Isis venture, have adopted variations on this theme.
If an increasing number of processors—including tech giants from outside the payments industry—start treating payments as a freebie in service to some other revenue-generating service, what does that do to the P&Ls of the incumbent payments specialists? The answer’s not yet clear, but the early signs do not bode well.
For now, though, there’s one sign that looks good, indeed. Overall electronic transactions originating with U.S. consumers enjoyed a second straight year of robust growth in 2011, shooting up nearly 10% to 110.6 billion, according to Digital Transactions estimates. The market is describing a trendline that should at least temporarily unfurrow the brow of the payments strategist who must work out ways to contend with the issues that follow.
1. The Emergence of a Potent New Network
Who could have predicted as recently as two or three years ago that the major card networks would face competition for point-of-sale payments from PayPal Inc.? And who could have foreseen that aiding and abetting this development would be one of those established networks, namely Discover Financial Services?
Yet that prospect is just what emerged in August when the two companies announced a deal under which Discover essentially white-labels its network to allow PayPal to run transactions at merchant locations on PIN-based, PayPal-issued cards.
That’s right, there’ll be old-fashioned, mag-striped PayPal-branded cards in circulation by the time this partnership swings into action by the second quarter of next year.
PayPal, in fact, has been laying the groundwork for this assault on the established networks’ POS preserve for some time. Recognizing that its dominance in e-commerce transactions, nice as it is, could only account for a sliver of the overall payments pie, the eBay Inc. processing unit began courting major chains last year to sell them on PayPal acceptance at their cash registers. In January, Home Depot Inc. became the first to process transactions, and soon enough several more big names in retail followed suit.
Consumers could tap their PayPal account by using a PIN-protected, unembossed PayPal card or by entering a mobile phone number and PIN at the POS terminal. The new cards coming under the Discover deal will replace those unembossed cards and will bear account numbers within a range unique to PayPal.
A big plus for PayPal is that Discover began outsourcing merchant acquiring several years ago. As a result, the network is now nearly as extensive as those of Visa Inc. and MasterCard Inc., reaching 7 million locations. At the stroke of a pen, in other words, PayPal becomes what some observers are calling “the fifth network,” after American Express Co. as well as Visa, MasterCard, and Discover.
Of course, it’s not quite so easy as scribbling on the dotted line. Discover may link to terminals at all of those locations, but PayPal still has to sign the merchants. For that chore, the company is turning to independent sales organizations, the same force that largely built the acceptance network for Visa and MasterCard. PayPal has already begun wooing ISOs with special “buy rates,” the processing percentages ISOs pay processors and then mark up to merchants.
And ISOs are not strangers to PayPal. They have sold the service to online merchants for years along with PayPal’s Payflow gateway.
The established Big Four networks might argue the POS pie is expanding fast enough to accommodate PayPal. They may sing a different tune this time next year, though, if it turns out PayPal is diverting transactions that once ran through their switches.
2. The Unsettling Settlement
As of mid-October, 10 plaintiffs in the massive credit card interchange cases filed against Visa Inc., MasterCard Inc., and some large banks had gone on record against the settlement their lawyers announced July 13.
It’s now up to presiding Judge John Gleeson of U.S. District Court in Brooklyn, N.Y., to ascertain whether the gripes have any substance. Lawyers filed a motion for preliminary approval Oct. 19, but observers say final approval may not come until well into 2013.
At first glance, the merchants, which challenged the way the networks set interchange as anticompetitive, seemed to have obtained a good deal. The settlement calls for the defendants to pay merchants $6.6 billion in damages ($6.05 billion to class merchants and $550 million to a handful individual plaintiffs) and for Visa and MasterCard to provide another $1.2 billion in temporary credit card interchange rate reductions.
Merchants also would get some relief from various network rules, especially the restrictions on surcharging, and they could form groups to bargain with the networks over future interchange rates.
But the plan also would preclude merchants from ever again taking the networks to court over interchange and rules. As merchants absorbed the implications of that provision, the chorus steadily grew louder against the settlement. Trade groups even sent a letter of complaint to Congress.
The protests call into question how effectively merchants and their attorneys communicated with each other during the lengthy negotiations that concluded only two months before an expected marathon trial in the 7-year-old case was set to begin in Gleeson’s court.
One attorney for the class merchants attributed much of the dissent to the disparate agendas of trade associations and individual merchants. Public statements from some merchants in favor the agreement showed that the startover sentiment was not universal.
Apart from their initial expressions of support for the plan, the card networks said little as the controversy grew. But their attack-dog proxy, the Electronic Payments Coalition, took merchants to task for seemingly wanting to get with credit cards what they got with debit card cards through the Durbin Amendment, which was lower interchange costs that they didn’t pass on to consumers.
The EPC also noted that court procedures set high hurdles for rejecting a negotiated agreement. A hint of urgency seemed to be in its statements, however, as if to tell Judge Gleeson, “pull up this drawbridge fast before the barbarians sack the castle.”
3. The FANF Frenzy
Never was the Law of Unintended Consequences borne out in the payments business quite so exquisitely as has been the case with the fixed acquirer network fee (FANF) from Visa Inc.
This new network fee, which took effect in April and replaces and reduces a few older charges, will result in net lower costs for merchants, Visa argues. Not all merchants are buying that argument, and at least some acquirers are skeptical, too. To be sure, the FANF starts small, but it soon runs into some pretty serious money. For example, a single location considered “high volume” pays just $2.90 per month. But a bustling chain with more than 4,000 stores pays $85 per store, or more than $340,000 monthly.
Card-not-present merchants, aggregators, and fast-food establishments pay the FANF according to volume. So an e-commerce site doing less than $200,000 a month, for example, pays 45 bucks. But a major site or quick-service chain grossing $400 million or more monthly coughs up $40,000.
How is this an unintended consequence? It was unforeseen by those who passed the Durbin Amendment in 2010 as part of the Dodd-Frank Act. Durbin was supposed to cap debit card interchange and hand new transaction-routing control to merchants. But Visa could see that the new routing provisions were going to eat into its volume even before they took effect in April. Hence, the FANF, which is levied on acquirers and passed on to merchants as a way of encouraging merchants to concentrate volume with Visa.
The new fee, which applies to both credit and debit transactions, is under investigation by the Department of Justice. In the meantime, acquirers and their clients will have to pay up.
4. What To Do About Square?
Want to rile up somebody at an independent sales organization? Just mention 3-year-old Square Inc., the merchant processor that uses smart phones and iPads for terminals.
Founded by Jack Dorsey, co-creator of Twitter, Square seemed to be in the news constantly over the past year, what with announcements about who has invested (Starbucks and Visa among them), how many merchants (several million, perhaps), how much volume it has (an estimated $6 billion annualized) and the company’s valuation (an estimated $3.25 billion in July).
A portion of Square’s volume comes from part-time sellers looking to accept cards, and some of it comes from small businesses that ISOs either miss, ignore, or reject.
Some payments veterans question whether privately held Square is making any money. And it’s had its missteps: Square pulled the plug on a small test in New York taxicabs early (see our 10th-ranked issue).
Signaling its intention to move upmarket, the San Francisco-based processor stunned the payments industry in August with the news that Starbucks would integrate the consumer-facing Pay With Square app into its mobile-payments offering—and that Square would process all of Starbucks’s bank card transactions. In other words, Square, which feeds its transactions to Chase Paymentech, was effectively becoming the coffee king’s ISO.
Square soon came out with even more significant though less-flashy news. In addition to its standard 2.75% discount rate for swiped transactions, Square rolled out a pricing plan based on a straight $275 per month for merchants generating up to $250,000 in annual volume.
The standard pricing would cost merchants less at annual volumes below $120,000, but at $250,000, the merchant’s marginal cost would be a mere 1.32%. The new pricing plan thus puts strong price pressure on ISOs competing for established small businesses, many a cut above Square’s original franchise.
5. Can Retailers Create a Viable Mobile-Payments Network?
Interchange seems to be Retailer Enemy No. 1 these days. How to escape the evil clutches of Visa and MasterCard? Form your own payments network, that’s how.
A group of about two dozen retailers announced in March that they indeed were planning a network to handle mobile payments. A few months later, they christened their network Merchant Customer Exchange, or MCX. Founding merchants included such heavyweights as Wal-Mart Stores Inc. and Target Corp.
The idea, according to the founders, was to create a network with lower costs and greater efficiencies than the existing card networks. But it wasn’t long before rumors of discord were heard. Not surprisingly, the biggie was whether Wal-Mart, the world’s largest retailer, would be calling all the shots at MCX, to the detriment of the other members.
The gossip grew loud enough that an executive at Best Buy Co., which has a seat on MCX’s board, felt compelled to address it at a Chicago mobile-payments conference in early October.
“There are many, many merchants that are involved in MCX,” said Best Buy senior director of financial services Stephanie Swain, referring to the recent news that six more had joined. “I’ve had potential merchants come up to me and say we also don’t want to be involved if it’s just a Wal-Mart initiative … this is not about one merchant, this is about a collection of merchants. We are very, very well aligned.”
Swain also said that MCX was much more than just a way for retailers to avoid bank card interchange. It’s about using payment data, developing standards, and new technology, she insisted.
MCX’s main task this fall is finding a chief executive. That person’s success, and the network’s success, may depend on how well he or she can keep members’ suspicions about favoritism at bay. If the new boss succeeds, Visa and MasterCard may well have something to worry about.
6. The Race to Real Time
In the world of mobile, even next-day funds availability isn’t good enough. That’s causing a good bit of disruption as networks figure out how to settle transactions faster to keep up with consumers who are becoming accustomed to instant availability of all other data, from search results to digital coupons.
In August, the automated clearing house tried to change its rules to allow for same-day settlement of credits and debits (they typically settle next day). The proposal failed, and now NACHA, the network’s regulatory body, has to go back to the drawing board.
But already processors are preparing for something even faster—real-time transactions. Fidelity National Information Services Inc., for example, this fall introduced PayNet, a new network designed to process non-card payments through the company’s NYCE debit switch. Transactions settle with near-instantaneous effect. Some 200 banks were using PayNet at its introduction.
Meanwhile, Dwolla, a payments startup in Iowa that lets consumers pay merchants and each other, this spring unveiled FiSync, a technology that lets users instantly transfer funds from bank accounts to their Dwolla accounts. Dwolla worked on FiSync out of frustration with the perceived pokiness of the ACH. And next year, FIS rival Fiserv plans to introduce faster payments on its new SpotPay mobile-acceptance service, using its own Accel/Exchange debit network.
It’s all exciting news for consumers, but challenging times for processors and networks that can’t keep up.
7. The Small-Ticket Mess
The FANF levy is far from the only unintended, and mostly unfortunate, consequence of the Durbin Amendment’s debit card restrictions. One of the most vexing is how the law has made so-called small tickets—transactions generally under $15—more expensive for merchants to accept.
Consider this: Before Durbin, the small-ticket debit interchange rate, as set by Visa Inc. and MasterCard Inc., was 1.55% plus 4 cents. Now, under Durbin, it still is, for issuers under $10 billion in assets. Note the large percentage and small fixed fee. But transactions on debit cards from big issuers are now priced at 21 cents plus a tiny percentage, 0.05%. So a $5 sale on one of these cards costs 21.25 cents when before it was only 11.75 cents—nearly doubling the levy.
Convenience-store proprietors, fast-food establishments, vending-machine operators, and a host of other small-ticket sellers are furious. But for now, there’s surprisingly little action to fix the problem. USA Technologies, which makes card readers for vending machines, last month extended for another year a deal with Visa that gives transactions on its machines the old pricing. But that’s a temporary fix that applies to a limited pool of payments. In the meantime, some vendors may conclude it’s cheaper to give away their product than to sell it.
8. Continuing Doubts About the PIN
The debate over the PIN’s future is raging on as the payments industry prepares for EMV chip cards and as debit card issuers adjust to the new economics created by the Durbin Amendment.
A card’s PIN is a static authentication tool—it doesn’t change, which means that if a fraudster learns it, the cardholder’s sensitive data are at risk of compromise. Visa’s U.S. EMV plan emphasizes dynamic authentication that relies on one-time codes. And the few EMV cards from U.S. issuers so far mostly rely on signature authentication. Hence the doubts about the PIN’s future.
But PINs remain highly popular with both consumers and merchants. PIN debit’s recent growth rates are outpacing signature debit’s growth.
Debit card issuers, hungry for the higher interchange revenue from signature debit, for years urged their customers to sign rather than use a PIN for purchases. But the profit dynamics changed in October 2011 when the Durbin Amendment’s interchange price controls developed by the Federal Reserve Board took effect.
The Fed’s price cap for regulated issuers, a group that accounts for about two-thirds of the debit market, made no distinction between signature and PIN debit. With revenue equalized, PIN debit’s far lower fraud rates suddenly gave issuers a reason to promote the PIN.
The PIN clearly has a future in the short term, and it probably will survive the transition to EMV, though its ranking in the authentication hierarchy is far from determined.
9. The Rise of Tablet Computers as POS Terminals
Soon after Apple Inc. introduced the first iPad in 2010, software developers eyeing the payments and loyalty markets as well as some ISOs quickly determined the gadget could easily function as a card-accepting point-of-sale terminal.
Square, for example, made the iPad the centerpiece of its Square Register service. Groupon Inc. recently announced the national rollout of the iPad-based POS system for restaurants that it acquired when it bought the Breadcrumb startup in May. Another startup, Revel Systems Inc., this summer unveiled an iPad payment system for grocery stores.
An iPad comes with no guarantee of payments success, however. Square in October quietly pulled the plug several months early on a small test of iPad payment modules in New York City taxicabs.
Still, some analysts see the iPad and new tablets running on Google Inc.’s and Microsoft Corp.’s mobile operating systems as threatening traditional POS terminal players such as VeriFone Systems Inc. and Ingenico S.A. VeriFone in particular has a strong position with small merchants potentially receptive to the allure of inexpensive, tablet-based payment services.
VeriFone offers specialty portable terminals and a full suite of e-commerce services, but it undoubtedly will have to play some defense as the new tablets make their mark.
10. Are Community Banks Getting Squeezed out of Payments?
Angst is no stranger these days among community-bank executives, and one issue in particular nags at some of them: How long can they hold on to their share of the payments franchise? This is critical because, in their view, payments are intimately linked to checking accounts, and these accounts are a vital link to their customers.
And they see the payments franchise slipping away to bigger players, including major non-bank firms offering slicker technology or account-like features in a prepaid card.
“I think about it all the time,” says Bob Steen, chairman of Bridge Community Bank in Mechanicsville, Iowa. “It all comes back to that checking account, the transaction account.” If small banks lose competitiveness in payments, he argues, customers will abandon them. “I don’t believe our franchise has much value without payments,” he says.
One thing that might help is real-time payments (our sixth-ranked issue). The ability to offer faster payments, says Steen, is “absolutely” vital to shoring up the position community banks hold in the business of moving money.
