Cover Story: Wall Street Pulls the Strings

Banks remain key clients, but ultimately Visa and MasterCard must serve the interests of major investors. Can they pull that off while warring with merchants over fees?

By Peter Lucas

Former Visa Inc. chairman and chief executive Joe Saunders couldn’t have been happier

on March 19, 2008, when the day’s trading on the New York Stock Exchange ended. Visa’s initial public offering had generated $17.9 billion in cash for the once bank-owned association, making it at the time the most successful IPO in the NYSE’s history.

Just two years earlier, Visa’s twin, what was then called MasterCard Worldwide, had blazed the trail for this moment with its own widely successful IPO.

The IPOs left Visa and MasterCard Inc. flush with cash. What may have been more significant, though, was that for the first time in their history the massive card networks were unchained from bank ownership.

To payments experts, this meant an opportunity to put the nettlesome problems of the past—chiefly a string of rapidly multiplying antitrust lawsuits brought by merchants charging the networks and member banks with fixing interchange pricing—in the rear-view mirror.

With the IPOs, Visa and MasterCard decoupled their fate from that of the money-center banks that had largely controlled them. In this way, going public was a defensive maneuver against suits in which an adverse outcome could yield trebled damages, and possible bankruptcy.

But it was also widely believed that pressure from investors, to which both companies were now directly accountable, would persuade management to abandon the controversial policies that gave rise to such lawsuits.

Hopes were also high among community banks that becoming market-driven companies would make Visa and MasterCard more attentive to their needs after years of catering to the agendas of big-bank owners—several of which were represented on both boards of directors.

Community banks, after all, have relationships with mom-and-pop merchants that Visa and MasterCard need to grow transaction volume and increase market share, two vital components for meeting earnings projections and keeping investors—and analysts—happy.

And so it seemed, in those heady days, that a new era for Visa and MasterCard was dawning. The world appeared to be their oyster.

Uneven Transition

Five and seven years into their respective lives as public companies, the question of just how much Visa and MasterCard have transformed themselves is a complex one to answer.

On the one hand, both networks have shown signs of fresh thinking and market agility when it comes to emerging products such as mobile wallets with the development of Visa’s V.me and MasterCard’s MasterPass.

They have also used their stockpiles of cash to either acquire or invest in cutting-edge payment technologies, as Visa did by taking an equity stake in mobile-payments startup Square, and MasterCard did with acquisitions of Travelex, a prepaid card program-management operation, and DataCash Group, a European e-commerce payment-service provider.

Further, both companies are reportedly demonstrating the client-relations skills needed to thrive in today’s fast-moving payments world by listening more intently to the needs of merchants and small banks.

On the other hand, both companies continue to be dogged by age-old problems. Merchant relations remain frayed, grumbling persists that the big-bank favoritism of the past still guides decision making, and an uncertain regulatory regime casts a cloud over the future.

Meanwhile, critics charge that both companies are too focused on piling on new fees to generate the revenues needed to meet earnings projections, as opposed to enhancing the value of their products and services to justify those rate increases.

And merchants continue to drag the two networks, along with major banks, to court to battle over interchange in a bitter feud that shows no signs of letting up until the merchants get what they want: either the elimination of the interchange structure or its reduction to mere pennies per transaction.

On balance, Visa’s and MasterCard’s transition from the clubby world of membership associations to the what-have-you-done-for-me-lately world of public companies appears uneven at best. But one thing is clear: As with any other public company, Wall Street ultimately calls the shots, a reality many both inside and outside the two networks have had to take time to adjust to.

“Visa and MasterCard are evolving into market-driven companies, but it’s a long process to change any corporate culture, especially when many of the employees that worked in the old culture are still at the company,” says Madeline Aufseeser, a senior analyst with Boston-based payments consultancy Aite Group LLC. “In regards to their relations with their merchant and bank clients, those are big constituencies and it is not uncommon for some in those groups to feel left out.”

Huge Merchant Victory

The central challenge facing Visa and MasterCard is navigating the increasingly complex post-Durbin world. For more than a year, the Durbin Amendment and its implementation by the Federal Reserve have further empowered merchants to legally fight the rising interchange fees they pay to accept debit cards.

While these fees go to issuing banks, not to the networks, those banks remain core customers of Visa and MasterCard, and the networks have have battled fiercely on their behalf, both in and out of court. Also, networks set interchange rates, so they are prone to resist regulation of the fees.

In late July, merchants won yet another huge victory when Judge Richard J. Leon of the U.S. District Court for the District of Columbia threw out the Federal Reserve Board’s cap on swipe fees and routing rules for debit card transactions (“Once More with Feeling”).

The Fed, Leon argued, had misread the plain language of the statute. The interchange cap was too high, and the routing rules too lenient.

Then, at a hearing in mid-August, Leon raised the possibility that merchants might win compensation for overpayment of interchange caused by the Fed’s ceiling, a figure Digital Transactions estimates at $3 billion.

The Fed in June 2011 released its final rule interpreting the Durbin Amendment, setting out an interchange cap and routing rules in the wake of intense lobbying by the banking industry and merchants, including Visa and MasterCard on one side and various retail trade groups on the other.

For better or worse, banks initially prevailed in their efforts to persuade the Fed to go with a higher cap and simpler routing requirement than ones the Fed had first proposed late in 2010.

But in handing down his opinion, Judge Leon ruled the Fed would have been better off with a rate cap similar to its December 2010 interpretation, which proposed a ceiling ranging from 7 to 12 cents. The Feds’s final rule, with its debit-interchange ceiling of 21 cents plus 0.05%, allowed for a congeries of costs clearly not permitted by Durbin, Leon said.

Similarly, where the final rule allowed issuers to go simply with at least two unaffiliated networks, Leon said an earlier Fed proposal of at least two competing networks for each authentication method—PIN and signature—was closer to the mark.

The Fed may appeal Leon’s decision, which came as the culmination of a lawsuit brought in November 2011 by various merchants and merchant trade groups on the grounds that the Fed’s final rule had violated the letter and spirit of Durbin. But if the decision stands, it will drain billions of dollars in interchange income away from debit card issuers and could significantly impact market share for Visa’s Interlink system, once the payments industry’s dominant debit network.

The final rule’s simpler routing requirement alone has already caused what Visa calls irrecoverable market-share losses for Interlink, though the debit network has recently staged a partial recovery.

(Visa also tried to staunch the outflow of debit traffic by announcing it could process PIN debit through its main VisaNet switch in a program called PAVD, for PIN-Authenticated Visa Debit. Although Visa claimed it had had this capability for years, even grizzled payments veterans said they never knew about it).

‘Underlying Issues’

Such losses, both for the networks and for their client banks, could lead Wall Street to pressure Visa and MasterCard not only to make peace with merchants, but also to find ways to work more cooperatively with them on payments initiatives, some observers say.

One such avenue could be to make a more concerted effort to demonstrate to merchants the value they are getting in return for acceptance fees, including a comparison of fees with the costs of running a proprietary card program.

“The recent rejection of the Fed’s implementation of Durbin will show if [Visa and MasterCard] are serious about turning over a new leaf,” says Steve Mott, principal of Stamford, Conn.-based consultancy BetterBuyDesign.

When contacted for this story, neither Visa nor MasterCard made executives available for comment. But signs of the “new leaf” may already be emerging.

Since Visa chief executive Charlie Scharf, who came to Visa from debit and credit card behemoth JPMorgan Chase & Co., took over earlier this year for the retiring Joe Saunders, he has openly attempted to extend an olive branch to merchants.

At the company’s tri-annual presentation to stock analysts in June, Scharf said: “All this talk of working together to [provide products and services that are] adaptable, flexible, and bring added value is targeted at getting at the underlying issue, not trying to address it after the fact. If we try to address the underlying issues after the fact, we will always lose.”

Scharf also cast the thorny issue of pricing in terms of the price-value equation many believe Visa must deliver to justify new network fees it has imposed since Congress approved Durbin as an amendment to 2010’s mammoth Dodd-Frank Act.

One of the most visible of these fees, which the network collects and have no relation to interchange, is the Fixed Acquirer Network Fee (FANF), levied on acquirers and passed on to merchants. The fee is intended to stem market-share losses by encouraging more volume (“What’s This FANF Thing All About?” September 2012).

“We want to compete on our capabilities and build the business in a way so that price is not the lever we have to pull for growth,” Scharf told the analysts.

In closing, Scharf added Visa is “not naïve,” that it will take plenty of time to improve merchant relations.

‘Serving the Spend Side’

While Scharf’s comments appear to be a step toward reconciliation with merchants, some payments experts point out that a similar outreach was attempted by Visa before it went public, only to go nowhere.

“When Scharf recently made his comments about improving relations with merchants, he could have been channeling former Visa USA CEO John Coghlan,” says industry veteran and consultant Eric Grover, principal of Minden, Nev.-based consultancy Intrepid Ventures.

In 2005, Coghlan, a former merchant, was named head of Visa USA, the then association’s biggest country unit. He attempted to smooth over merchant discontent after merchants filed their first legal challenge to interchange. That case ultimately grew into the landmark antitrust suit finally settled in 2012. Coghlan lasted at Visa for two years. 

Working more closely with merchants may appease major investors, but it would run counter to how the dynamics of the card industry have always directed the networks, some observers say.

Since consumer preferences determine how they pay, be it credit or debit cards, cash or check, the emphasis within Visa and MasterCard has always been to cultivate relations with card issuers, since they are ones that put cards in the hands of consumers and provide incentives to use them.

Consumer card usage generates interchange for banks and transaction volume for Visa and MasterCard. That’s an important component of their business model, which makes it unlikely Visa and MasterCard will ever give merchants the lowest possible acceptance costs.

“As long as consumer payment choice is more important than merchant payment choice, networks will and should be more focused on serving the spend side of the network,” says Grover, a former Visa International and bank executive.

Over at MasterCard, chief executive Ajay Banga is considered to be a good foil to Visa because he is less bank-centric than either Scharf or Saunders. But he has not been as vocal as Scharf about repairing merchant relations, which leads to questions about MasterCard’s position toward merchants.

‘Feeling the Squeeze’

Ultimately, if Visa and MasterCard are to succeed in repairing merchant relations, it will come down to their chief executives’ ability to guide the rank and file into playing the role of intermediary between banks and merchants.

That means moving past the age-old issues of transaction revenues and control over cardholder behavioral data that can be used by merchants and banks to create fee-based perks for consumers, such as rewards programs, and marketing campaigns that drive purchases.

“As Don Draper of [cable TV show]‘Mad Men’ likes to say, ‘If you don’t like the conversation, change it’ and that’s what Visa and MasterCard need to do with banks and merchants,” says John Schulte, senior vice president and chief information for Grand Rapids, Mich.-based Merchantile Bank. “Visa and MasterCard are in the best position to change the discussion from interchange to providing more value to justify merchant fees. They can also find themselves vulnerable to competitors, especially emerging payment options, if they don’t.”

Indeed, many merchants, especially online and mobile merchants, are embracing lower-cost payment networks, such as San Jose, Calif.-based PayPal Inc., which is making a concerted push into retail stores and working with Discover Financial Services via that card network’s merchant acquirers to reach small and mid-size merchants.

Last month, PayPal took another step toward achieving this goal by striking a deal with Plano, Texas-based Alliance Data Systems Corp. to offer PayPal acceptance to merchants enrolled in its private-label and cobranded card programs.

Also lurking in the shadows as a competitive threat is Merchant Customer Exchange (MCX), which was formed by a consortium of merchants generating more than a $1 trillion in annual sales. Dallas-based MCX, which counts such retail heavyweights as Wal-Mart Stores Inc., CVS, and Shell Oil Products US among its members, seeks to build a mobile-payments platform.

In July, MCX announced that Fidelity National Information Services Inc. (FIS) will provide transaction processing and named Dekkers Davidson, former managing director at Barclaycard U.S., as its chief executive.

While it is too early to tell what impact MCX will have on Visa and MasterCard, some community bankers say they have looked at MCX as an alternative, lower-cost network that merchants could use to siphon traffic away from Visa and MasterCard.

“It’s unthinkable that as a banker I’d be saying this, but our interests are starting to align philosophically with merchants when it comes to fees, because we don’t have the volume to offset increases and our customers won’t pay to cover them,” says Bob Steen, chief executive of Mount Vernon, Iowa-based Bridge Community Bank. “We are definitely feeling the squeeze.”

Treacherous New World

Despite the competitive challenges Visa and MasterCard face in the marketplace, their differences with merchants and discontent among small banks, payments executives remain optimistic that both companies have evolved, and will continue to evolve, for the better, albeit not always fast enough to satisfy all their constituents.

Just how well Visa and MasterCard adapt to the treacherous new world they operate in depends not only on whether they can change the conversation with their merchant and bank clients, but whether they can keep that conversation going.

Wall Street will be watching.

The Networks’ Unhappy Small Fry

It’s no secret that small banks play second fiddle to their big-bank brethren at Visa and MasterCard. Big banks, after all, generate the most volume, which makes them capable of individually moving market share for the two networks.

Nevertheless, small banks hoped that as Visa and MasterCard made the move to market-driven companies after their initial public offerings, they would no longer be treated as afterthoughts. So much for wishful thinking.

“Unquestionably there’s [still] an issue,” says Eric Grover, principal of Minden, Nev.-based payments consultancy Intrepid Ventures. “Within MasterCard and Visa, large banks, particularly large issuers, will command more resources at the expense of small banks and nontraditional licensees, which in the near term won’t move the [market-share] needle.”

For small banks, the rub with big-bank dominance of Visa and MasterCard is twofold. First, small banks lack the volume to offset increases in network fees charged to issuers. Second, they feel as though their concerns over fees and other policy issues often go unheeded by management.

“Visa and MasterCard have the lion’s share of merchant payments, but fees to process those transactions over their networks are going up and that is a concern, because it diminishes our interchange revenue and we don’t have a lot of lower-cost options,” says Bob Steen, chief executive of Mount Vernon, Iowa-based Bridge Community Bank.

Steen says his bank has looked into processing qualifying transactions through such alternative networks as the automated clearing house and Square Inc., but that alternative networks are not always much cheaper, often lack the ubiquity of the Visa/MasterCard networks, and can be less efficient.

With merchants steadily gaining ground in their long-running feud with Visa and MasterCard over pricing, however, smaller margins will be a problem for banks of all sizes.

“With the uncertainty the Durbin Amendment has created, banks have to accept that some transaction revenue is going away,” says John Schulte, senior vice president and chief information for Grand Rapids, Mich.-based Mercantile Bank. “The way to respond is to find ways to share cardholder data with merchants to deliver new value propositions that can justify fees.”

But concern over dwindling margins is just one symptom of small banks’ uneasiness with Visa and MasterCard. Getting their voices heard over those of large banks can be tough, regardless of the issue.

“It was hard enough as a small bank to have any input [with Visa and MasterCard] in the old days and now it is just a historical concept,” says Steen.

Some payments executives contend that both networks realize the value community banks bring to the table and are working to be more inclusive.

“There is an effort by Visa and MasterCard to boost relations with small banks and part of it is working through [EFT] networks like us,” says Dan Kramer, senior vice president for Des Moines, Iowa-based Shazam Network. “Visa and MasterCard, like the banking industry in general, realize there needs to be a better balance between large and small banks in the eyes of consumers.”

One way small banks can raise their voice within the Visa and MasterCard system is to work collectively to find processors and solution providers that can deliver new value-added products to strengthen their hand with consumers and generate more volume for merchants, according to Schulte.

As networks and technology facilitators, Visa and MasterCard are well-suited to fill that role. Whether they will lend a helping hand remains to be seen.

For Tokenization Tech, Banks Turn to an Entity They Own—TCH

Visa Inc. and MasterCard Inc. in competition with the banks that once owned them? It may not be as far-fetched as it seems.

In June, The Clearing House Payments Co. LLC (TCH), a New York-based processor owned by 22 big banks, announced it is developing a server-based switch that will use tokenization technology to mask consumers’ banking information when they perform transactions.

Both Visa and MasterCard have developed their own tokenization technologies. Given the networks’ long-standing relationships with banks, leveraging their offerings would seem a logical choice.

Meanwhile, TCH is best known as a processor of check images and as the nation’s only private-sector operator, or switch, for the automated clearing house network. It would seem a curious choice until, as some observers have pointed out, you realize banks still own TCH, while their control of the card networks ended with the IPOs years ago.

TCH declined comment for this story.

The big benefit of tokenization is that it provides iron-clad security for transaction data by creating a single-use card. Sensitive card data sent from a merchant to its processor are replaced with a unique set of encrypted symbols that are translated by the processor, which then sends back a tokenized authorization code. Even if hackers can break a token’s encryption code, the underlying data are useless.

Although TCH’s owners have elected to develop their own tokenization technology, some payments experts caution not to read too much into the move as it relates to their relationships with Visa and MasterCard. While the two networks have a history of developing new technology, especially around security, they are first and foremost networks.

“Neither MasterCard nor Visa is a technology company. They are networks that rely on technology they and their licensees use to process their products,” says Eric Grover, principal of Minden, Nev.-based consultancy Intrepid Ventures. 

Nor should it be forgotten that large banks have a history of developing entities that compete with Visa and MasterCard for transaction volume, such as the ACH. “These types of moves by banks are not unnatural. Even when they owned Visa and MasterCard, banks didn’t run every payment transaction through them,” says Todd Ablowitz, president of Centennial, Colo.-based Double Diamond Group.

If nothing else, the move by TCH is most likely an indication that banks are hedging their bets when it comes to future security initiatives, especially around digital wallets.

“The competition has changed from when Visa and MasterCard were membership organizations. It’s no longer American Express and Discover, there’s PayPal, Square, Google, and a host of other non-traditional players,” says Madeline Aufseeser, a senior analyst with Boston-based Aite Group. “Banks may be placing multiple bets as to which technology will win out, but they aren’t about to give up on Visa and MasterCard.”