Digital Transactions Authoritative, insightful and timely information for payments professionals
Some dragons are harder to slay than others, and a few are fire-breathing. Here’s our annual look at the industry’s fiercest beasts, this time ranging from the endless war over interchange to eager-beaver regulators to the woes of digital currency.
By John Stewart and Jim Daly
If payments were easy, everybody would be doing it. And while it may seem that everybody is getting into payments these days, those who’ve been at it a while know it’s not easy—a fact the newcomers may learn to their regret.
Herewith, our annual catalog of the principal reasons for that occupational difficulty. We present this latest batch of headaches not to discourage anyone but rather as a dose of reality, a timely reminder of the forces arrayed against even the most intrepid executives and entrepreneurs.
For it is only with hard-eyed realism about these problems that they can be solved, or at least managed. Time and again, the energy and resourcefulness of the e-payments business has been brought to bear on an issue because of a willingness to confront the issue forthrightly. And more often than not, those efforts have borne fruit.
For example, who today laments the rising volume of substitute checks, the paper-based offspring of Check 21? A familiar complaint five or six years ago, that problem melted away as determined work by bankers and vendors recruited more and more paying financial institutions as endpoints for image-exchange networks.
It’s true enough that such successes are seldom secured so quickly or absolutely. The business of problem-solving in payments is a messy affair, with progress in fits and starts and seemingly as many setbacks as solutions. Certainly, some of the issues on this year’s list are not likely to go away any time soon. It’s hard to imagine a fast or easy armistice in the war over interchange, or a hasty withdrawal from the field by federal regulators who have only recently discovered electronic payments, to take as examples just the first two items in our ranking.
But as with most endeavors, persistence pays off. The keys will be patience, flexibility, and farsightedness. That will be true for established companies as much as for the legion of startups.
As for the industry as a whole, Digital Transactions estimates electronic transactions last year totaled 119 billion, up a healthy 7.5% over 2011. That growth rate happens to nearly match the 7.3% average annual rate of growth in total transactions since 2005, and represents a continued recovery from the recession-induced plunge the industry endured in 2009.
Not a bad record so far, and something to lean on when the going gets rough dealing with the difficulties that follow.
1. The Ongoing Assault on Interchange
Defenders of the traditional model of bank card interchange these days might feel like Dorothy and her friends cautiously walking through the dark forest. You just never know when a hungry lion, tiger, or bear might step out.
These seeming predators take the tangible form of merchants—and their lawyers— who say interchange rates set by Visa Inc. and MasterCard Inc. are too high and that the attendant network rules are too restrictive. These restive card acceptors are causing all kinds of trouble for those who receive the interchange merchants pay: credit and debit issuers and their frequent allies, the networks.
The networks and banks had hoped the $6 billion settlement pending in U.S. District Court in Brooklyn, N.Y., would end the longstanding conflicts, but that’s far from the case. Nearly 8,000 mostly large merchants representing at least 25% of credit card charge volume have opted out of the damages part of plan, saying it would limit their future ability to sue the networks and does little to change the interchange status quo.
Judge John Gleeson, who is overseeing the Brooklyn case, a year ago approved the settlement on a preliminary basis but said final approval called for a higher standard. At a big hearing in September ahead of his decision on whether to grant final approval, he acknowledged the opponents have raised some important issues. Many observers expect he’ll ultimately give his okay, but the deal seems to be one of the most unpopular business agreements in recent history.
Various opt-out merchants, including Target Corp., continue to fight on with new interchange lawsuits. Visa has even sued Wal-Mart Stores Inc., a vocal opponent of traditional interchange, in hopes of undercutting the arguments Wal-Mart might make if it sued the networks over interchange—something the huge retailer hasn’t yet done.
Meanwhile, large debit card issuers, whose interchange revenues took a 50% haircut two years ago from the Federal Reserve’s price cap implementing the Dodd-Frank Act’s Durbin Amendment, got a new set of worries in July. A federal judge in Washington, D.C., declared that the Fed didn’t follow Congress’s intent and set the cap too high. The cap, about 23 cents per transaction, might go down to 7 to 12 cents or even lower if the Fed loses its appeal in a case brought by retail trade groups and some individual merchants.
2. The New Sheriffs in Town
It has become practically a cliché to say there is a new regulatory spirit at loose in the land. Now the payments business, long ignored by regulators, is finding out what that really means.
Federal agencies have discovered independent sales organizations and prepaid program managers, and are extending their reach to rein them in. In recent months, the Federal Trade Commission has included ISOs among other plaintiffs in suits it has filed against telemarketers it says were selling phony “rate-reduction” plans to credit card holders at prices ranging from hundreds to thousands of dollars each. The ISOs, the agency alleges, were processing the telemarketers’ transactions and advising them on how to manage chargebacks—all while ignoring sky-high chargeback rates and protecting themselves by boosting reserves.
Independent Resources Network Corp. (IRN), Westbury, N,Y., and Milwaukee-based Newtek Merchant Solutions were two ISOs caught up in FTC complaints filed against telemarketers this spring. In both cases, the FTC based its complaints against the ISOs on the 18-year-old Telemarketing Sales Rule, which makes it a violation of the FTC Act to give “substantial” support or assistance to fraudulent telemarketers.
The FTC’s action against ISOs, and the legal basis for it, are new developments, says attorney Holli Targan, of Jaffe, Raitt, Heuer and Weiss, a Southfield, Mich.-based firm that represents companies in the acquiring business. “I have not heard of this particular approach before, utilizing that regulation and going on a sort of aiding-and-abetting idea,” she told Digital Transactions News in June.
Nor are prepaid card distributors immune to the new regulatory spirit. In May, the Federal Deposit Insurance Corp. fined Austin, Texas-based Achieve Financial Services LLP $110,000 and forced it to pay $1.1 million in restitution to cardholders. The FDIC alleged a MasterCard-branded prepaid card program Achieve managed with First California Bank, Westlake Village, Calif., deceptively promoted services, pricing, and features. The bank was forced to cough up a $600,000 penalty.
The banking overseer based its regulation of a nonbank entity on a theory that intimately links banks and the prepaid program managers they hire. Under the theory, the FDIC refers to Achieve as an “institution-affiliated party” of FCB. Experts say this theory could lead to more such actions against third parties.
And, not content with policing ISOs, the FTC has said it wants to ban telemarketers from using four payment methods in any transaction: remotely created checks, remotely created payment orders, remittances, and authorization codes for prepaid cards. The comment period on the proposal closed July 29.
3. The EMV Routing Mess
When the chip card powers devised the Europay-MasterCard-Visa (EMV) standard nearly 20 years ago, they didn’t foresee a time when control over debit card transaction routing would be handed over from issuers to merchants. But that’s just what the Durbin Amendment to the 2010 Dodd-Frank Act does, and it plays merry hell with industry plans to deploy EMV in the United States.
EMV incorporates a so-called application identifier (AID) that specifies card type (credit or debit) and is proprietary to each major network. This does not allow for the kind of merchant-driven network choice mandated by Durbin—unless one of the networks opens up its proprietary AID to the industry or the industry agrees on a common AID. Both MasterCard and Visa have proposed to do the former, while a group of regional debit networks have proposed the latter.
There has been some agreement between the two camps. This summer, for example, the regional networks agreed to let applications from Visa and MasterCard work on U.S. chip cards with the common AID. Apps run under the AID and control such functions as offline and online authorization and security.
But the regional systems maintain their insistence that ownership of the common AID must be held equally by all networks, with each network having an equal voice in governance. That leaves the ultimate resolution of the issue unclear while a major deadline—a mandated shift in fraud liability from issuers to merchants that aren’t equipped to accept EMV cards—looms less than two years away.
4. Virtual Currencies’ Legal Morass
Virtual currency might go “poof” just as fast as it appeared on the payments scene if its run of bad luck with the law continues. Government, it seems, just can’t see the virtues in virtual currency—its speed, low cost, and ability to bypass established currencies and national borders hassle-free.
Instead, bank regulators, prosecutors and legislators seem fixated on the anonymity and ease that virtual currencies, Bitcoin the most prominent among them, afford criminals in carrying out their proscribed transactions.
Unfortunately, virtual-currency users on the dark side are providing law enforcement with grounds for its suspicions. In October, federal authorities arrested the alleged operator of Silk Road, a big underground online drug market that used only Bitcoin for payments. The FBI shut down the Silk Road Web site and seized $3.6 million worth of Bitcoin.
Silk Road was not the only place where Bitcoin and its digital cousins have bumped into those in power. In August, New York State’s chief financial regulator announced an inquiry into virtual currencies, saying that their operators might need money-transmitter licenses.
Earlier, two U.S. senators wrote to Attorney General Eric Holder complaining that Bitcoin was an untraceable peer-to-per currency and a tool of money launderers.
But others say virtual currencies’ legitimate potential can’t be ignored. The U.S. virtual-currency market grew 52% in 2012 and this year it could more than double to $10.9 billion in purchases, according to Javelin Strategy & Research. Most purchases have been for content in social-network games, but analysts say virtual currencies’ big growth will come from purchases of non-game online and physical items.
In late July, backers of the legitimate uses of virtual currency announced plans to create the so-called Digital Asset Transfer Authority, an industry group that will promote self-policing.
5. States of Frustration
In an era of global electronic commerce, many in the payments industry say demands by states that non-banking financial companies get money-transmitter licenses are a relic of the past that make it hard for startups to break into the market, retarding innovation.
Public officials, however, argue forcefully that technology hasn’t put fraudsters out of business and that their job is to make sure that people who hand money over to a wire-transfer company or other money transmitter have assurance that their funds will reach the intended recipient.
Even some in the payments business do not disagree that state licenses protect the public. But the best way to achieve the sometimes conflicting goals of competitive services along with consumer protection, they say, is a federal licensing system that would create just one set of rules.
There’s no doubt that a money transmitter that wants to operate in all 47 states that require licensing faces an expensive and time-consuming task, according to Digital Transactions’ October cover story (“States’ Rights”).
Xoom Inc., a digital money-transmitter that had an IPO this year, says each state’s requirements and costs vary, but they can go up to $500,000 for one license. Payment processor Meracord LLC paid $10 million to get its first 41 licenses, and it’s taken five years.
Aaron Greenspan, the frustrated chief executive of Think Computer Corp., which wants to operate a mobile-payments service called FaceCash, has sued the state of California in federal court to challenge the constitutionality of the state’s money-transmitter law. Greenspan says the law has stonewalled FaceCash and gives regulators too much discretion to approve or deny license applications.
6. EMV’s Charms Are Waning
Debit routing isn’t the only problem related to EMV. Merchants, including a number of big-box retailers that once enthusiastically backed the chip technology because it replaces the dreaded magnetic stripe, have turned cool toward the chip card standard.
A grab-bag of reasons accounts for this turnabout. Some of the biggest:
– An October 2015 deadline for shifting fraud liability from issuers to merchants that haven’t deployed chip-enabled terminals by then. Merchants say that deadline is unrealistic, and want it extended. Visa and the other networks so far have stuck by it.
– Cost. Some merchants say for the money it will take to deploy and program new terminals, train staff, and rewire stores, they’d just as soon take their chances with the fraud losses.
– No impact on online fraud. Most major retailers also run e-commerce sites, where fraud is expected to explode once EMV is fully implemented, as it has done in every other region that has adopted the technology.
– Age. The nearly 20-year-old EMV standard is getting to be long in the tooth by technology standards. Time for a radical update, say some merchants. Some are investigating the idea of an open-source alternative.
This list doesn’t even account for how merchants feel the debit-routing issue surrounding EMV could rob them of the routing freedom granted to them by the Durbin Amendment. All in all, a much darker picture for EMV than just two or three years ago.
7. Not for Commerce?
Another promising technology losing steam is near-field communication (NFC), a short-range radio-frequency identification protocol that can set up interactive links between consumers’ mobile devices and a range of other devices and media, such as POS terminals and banners embedded with NFC chips.
The technology can do some pretty cool and useful things, like automatically apply rewards points to reduce or wipe out the tab at the point of sale, or upload new offers and rewards from the terminal. But for the basic function of doing a payment, most folks say swiping a card works just fine and is plenty fast enough. And the marketing function, as with payments, requires close cooperation among a wide array of parties not accustomed to talking to each other—and trusting each other with data.
Factors like these have slowed even the biggest and most well-funded NFC initiatives, such as Google Inc.’s Google Wallet, which went back into the shop earlier this year for an overhaul and emerged with a concentration on online commerce.
Alternatives are emerging to fill the void left by NFC’s failure to arrive, including quick-response (QR) code scanning and, most recently, a technology called Bluetooth Low Energy, which both PayPal Inc. and Apple Inc. have harnessed to let stores identify customers as they walk in and link them to their payment credentials.
With BLE running, and with customers’ phones embedded with the right apps, merchants can set up transactions so the customer doesn’t have to swipe, tap, or do anything else to check out with his goods. That means there could finally be a payment method even easier than swiping.
8. Mobile Deposit’s Fear Factor
Want to spook a banker? Just mention the term, “remote deposit capture,” particularly the mobile variety.
Bankers, it seems, have an inordinate fear of customers depositing checks into their accounts by snapping pictures of them on a smart phone and uploading the images through their online-banking app. There are security risks, of course, especially of so-called duplicates such as a check being deposited first at one bank and later at another.
Bankers’ fears seem to have increased after the Federal Financial Institutions Examination Council, a consortium of federal bank regulators, published its “Guidance on Remote Deposit Capture Risk Management” in 2009. At the time, remote deposit through home scanners and personal computers had made a beachhead, but mobile capture was just getting started commercially.
Many bankers interpreted the FFIEC’s guidance, which the regulators issued as instruction for preventing losses rather than as a set of rules promulgated in the wake of verified losses, as their cue to impose tight controls on mobile capture, according to Celent LLC banking analyst Robert Meara. These “misplaced risk concerns” may be holding back the mobile RDC market, according to Meara, who wrote an Endpoint column about the issue in Digital Transactions’ September issue.
“Celent finds little evidence of ongoing operational losses from RDC,” he wrote. “In three consecutive annual surveys of RDC-deploying financial institutions, nearly 90% reported having suffered no RDC losses at all. And, losses among the other 12% were not recurring events.”
Fear hasn’t derailed mobile RDC by any means. Celent estimates 20 million consumers and small businesses will use it this year, a number that could double by 2015. And Javelin Strategy & Research estimates that 64% of financial institutions offer mobile deposits.
But many banks and credit unions that ostensibly offer mobile capture have policies that tightly restrict the number and dollar amount of deposits a customer can make in a given time period, which prevents the service from reaching its full potential, some observers say.
The solution, they say, is for bankers to use the latest technology for preventing duplicate deposits as a supplement to normal risk-control measures, determine their true exposure, and adjust policies accordingly.
9. Prepaid’s P&L Riddle
During their not-so-long-ago formative years, prepaid cards typically came laden with activation, reload, ATM-withdrawal, monthly, and inactivity fees. But public-relations disasters such as the Kardashian card and other high-fee prepaid cards bearing the name of a celebrity, along with more scrutiny by consumer groups, cast prepaid card fees in a negative light.
Added to this were more regulation and a growing savviness by cardholders that forced many prepaid card program managers to either drop or lower their most onerous fees.
Prepaid card revenues and expenses, however, still generate controversy. Witness the uproar earlier this year over the payroll card that a McDonald’s Corp. franchisee in Pennsylvania gave to employees. While the card’s fees were not particularly noteworthy, what was noteworthy was that the card was the franchisee’s only method by which he paid his hourly employees.
Payroll cards might cost an employer less than cutting checks and perhaps they were less of a hassle than overseeing a direct-deposit program, but their exclusive use made the franchise owner the target of a highly publicized lawsuit by a former employee.
The owner quickly added other ways employees could get paid, but by the time the dust settled, payroll card providers found themselves on the defensive and the federal Consumer Financial Protection Bureau had weighed in on the matter.
Meanwhile, with its Bluebird card for customers of Wal-Mart Stores Inc. and its newly revamped Serve card, American Express Co. of late has tried to portray itself as the consumer-friendly prepaid card provider. Serve, for example, has no reload fees if the customer does the reload at 14,000 7-Eleven or Walgreens locations, and its $1 monthly fee is waived if the cardholder enrolls in direct deposit.
AmEx’s pricing plans illustrate the complex choices program managers face in a shifting environment. For example, should they charge upfront for reloads and get revenue right away, or forgo the fee in hopes of generating more usage and thus more revenues through merchant fees? Various providers are using different formulas, and no one yet can claim they’ve found the answer to the prepaid profit-and-loss riddle.
10. A Money Shortage
Make no mistake. There’s no shortage of money flowing through e-payments systems, but for startups in mobile wallets and other hot new fields, there could be a looming shortage of capital.
Estimates vary of just how many wallets have been launched over the past two years, with some putting the number as high as 140. That’s too many for many venture capitalists, the players that have traditionally provided the funding for payments startups.
A crowded field, combined with questionable merchant and consumer adoption, has already led to a hefty drawdown in the flow of capital. Funding for mobile-payments startups sagged to $92 million in the first six months of this year compared to $370 million in the first half of 2012, according to Rutberg & Co., a San Francisco investment bank.
When even giants like Google Inc. and the three mobile carriers backing Isis have struggled with mobile payments, it’s hard to blame investors for feeling skittish. Granted, startups like LevelUp Inc. and Paydiant Inc. have achieved some success. And PayPal Inc. in September paid a cool $800 million for Braintree Inc., a startup merchant processor with a big stake in mobile payments. But it will likely take a breakthrough in user adoption, combined with a shakeout among the multitude of startups, to really get the venture funding flowing again.
