By Steve Mott

Just when you thought it might have been safe to take a breath of relief from the relentless change in the payments business, an epic transformation of the merchant acquiring business is taking shape. Its early course suggests that relations between acquiring banks and issuing banks will never be the same. And that prospect has most acquirers rubbing their hands in anticipation.

The events triggering this transforma­tion might seem to be unrelated, but below the surface, the ingredients of epic change are stirring:

• Walmart leads millions of merchants in winning settlement on a lawsuit against Visa and MasterCard in 2003
• First MasterCard (2006) and then Visa (2008) become public companies
• Some of the major acquiring processors undergo financial restructuring (2007 and 2008)
• Some of the biggest banks and even one association stray from the conventional payment card playbook to test the waters of innovation

The seeds of this change have been building up for three decades. With the birth of electronic draft capture in the 1970s and terminalization by 1981, banks outsourced card processing to IT specializing companies to avoid having to invest in that challenging business. Like many other IT businesses, scale came to matter, and merchant processors began a steady wave of consolidation that continues today. Now, the Top 10 acquirers (so named because they acquire the merchant relationship and the merchant’s transactions) control more than 70 percent of the business, and while about 8,500 regulated financial institutions are listed as acquirers, only a handful do their own merchant processing.

Along the way — consistent with its IT roots — the merchant acquiring business came to be relentlessly price competitive. In fact, First Annapolis reported in a recent quarterly publication that price compression in recent years for major acquiring processors had been to the tune of 8-to-10 percent, per year. Some investment analysts peg the long-term rate compression at more like 2-to-4 percent. Whatever the rate, acquirers wake up each Jan. 1 knowing they need a few percentage points of revenue growth just to get back to where they were the year before.

Meanwhile, on the card issuing side of the business, life continued to be prosperous and deserving of a financial institution’s predominant focus. The average interchange rate on signature-based cards has oscillated a bit during this same 30-year period, but it’s mostly gone up — even with the impacts of declines in signature-debit card rates stemming from the Walmart settlement.

The result has been a business that generated $120 billion in revenue and $24 billion in operating income in 2007 (according to Cards & Payments magazine). This, in spite of issuers losing more than $35 billion in charge­offs gambling on marginal credit risk decisions, and pumping out 6 billion pieces of direct mailings for which the return rate continues to be less than one percent.

By contrast, the acquiring business rang up $70 billion in revenue but just $2.4 billion in operating income. On this side of the card payments business, interest on outstanding balances and a wide array of consumer penalty fees don’t exist on the top-line, so there’s no room for marketing excesses along the lines of charge-offs and direct mail. In fact, the situation continues to grow more imbalanced, as a recent survey from Aite Group shows.



More importantly, this chart shows that issuers earn the lion’s share of what merchants pay to accept bankcards (called the Merchant Discount Rate). In fact, issuers get about 80-to-85 percent of the basic rate, with the networks taking 5-to-6 percent and the rest going to the acquirers. (For smaller merchants who use Independent Sales Organizations, or ISOs, there’s an additional mark-up, but more on that later.)

In the early years, that distribution made sense because the issuers were taking credit risk on consumers. But given the industry’s penchant for actively seeking out credit risks (the majority of which are the 41 percent of U.S. households living paycheck to paycheck), more and more industry participants and legislators are asking if this one-sided allocation has grown unproductively out of balance.
The rapid growth in online purchases (where the merchant bears all the risks, costs and liabilities) and in signature-debit card processing, where the bank can see the balance before approving a purchase, begs additional questions. Thus, risk for card issuers is clearly getting lower. Meanwhile, the acquiring side of the business does the majority of the heavy lifting, and gets less and less each year for the effort.

To compensate for price compression on core processing fees, many acquirers preserve their margins by charging for ancillary services, such as risk-management checks, administrative fees and terminals or interconnections.

As well, the proliferation of interchange rates by Visa and MasterCard into hundreds of categories (up from a couple dozen only five years ago) has made calculations of these charges so complex and volatile that many acquirers, and even some ISOs, are going to an “interchange-plus” pricing philosophy, and applying their mark-up for processing services to merchants on a per transaction basis on top of those fluctuating rates.



Then came the news from MasterCard’s new CFO, Martina Hund-Mejean, who in May alerted investment analysts that the No. 2 bankcard association could continue to raise international rates — charged mainly to acquirers and their merchants — at “2 percent per year for the foreseeable future.” Such rate increases had been largely responsible for MasterCard’s strong growth from international operations over the past five to six quarters, as well as its whopping stock price — recently exceeding $300 a share. Similar impacts from international growth in volume and rates has propelled Visa’s new stock price to a high of nearly $90 a share.

Most U.S. acquirers believe that the card associations would like to increase their rates to them, too. But the economics don’t work out so well here. Internationally, bankcard interchange is about 60 percent of the level it is in the United States, while acquiring fees are much higher — which makes the typical total cost to merchants more or less the same. In other words, except in the United States, which continues to drive about half the bankcard volume, revenues are more equitably balanced between issuers and acquirers.

So, if Visa and MasterCard, as newly public companies, decide to push their rate increase aspirations upon U.S. acquirers (instead of working to achieve a more equitable balance with issuer revenues) there are signs that resistance will surface.

First of all, interchange isn’t really interchange the way it’s presented in the association rate schedules. Following the Walmart settlement in 2003, the nation’s biggest retailers have cut their own deals with Visa and MasterCard and now enjoy actual interchange rates less than half of what most other retailers pay. And these are the same merchants who push relentlessly for reductions in processing costs. As a result, many of these national merchants are no longer profitable for acquirers to service.

That’s why some of the biggest processors are moving “down-market” and eschewing unprofitable bids on big-retailer business in favor of serving smaller merchants — e.g., through the ISO channel. (One recent study showed that the ISO channel drives only 20 percent of transaction volume but 65 percent of overall acquiring profits.)

Other processors are experimenting with innovations on the core business model of card acceptance. In one instance, issuers and acquirers in certain low-risk merchant categories (e.g., books) “self-insure” amongst themselves with respect to charge-backs and fraud, which typically amount to less than 1 percent of the dollar volume processed in these categories. This model is an alternative to working charge-backs and fraud through the association system, where the handling costs often exceed the dollar value of the transactions in question.

Besides the substantial costs savings, such models constitute a veritable “shot across the bow” of the associations, which cling to the one-size-fits-all risk management model that, in effect, subsidizes the higher-risk activities of questionable merchants with the valiant efforts of lower-risk retailers to remove the “noise” in their card acceptance. To-date, despite association rules to the contrary, hundreds if not thousands of adult and gaming merchants continue to accept bankcards.

What acquirers are realizing is that once you move beyond the constraints of the conventional association business models, there’s a lot of money that can be made by creating their own balance point, vis-à-vis issuers.

For instance, PayPal charges an overall bundled rate of 3.65 percent for card acceptance, and processes those transactions through a mix of credit and debit “rails” — augmented by very low-cost ACH and account-to-account transfers — for an average cost of a little more than 1 percent, which, along with 27 bits per second of charge-backs and fraud, results in a 2.27 percent margin, and a hefty 62 percent of the purchase dollar volume.

The prospect of arbitraging bank and private networks has some acquirers salivating as they contemplate bolder strategies outside the realm — and control — of the card associations. To some extent, they have been encouraged by some recent actions by some of the nation’s leading banks. For example, Wells Fargo, HSBC, Capital One and MasterCard have extended that brand’s use and acceptance (and therefore access to its network wherever merchants accept the mark) to payment product innovations, such as virtual debit cards and one-time use credit card numbers, decoupled debit cards and prepaid debit cards. All are waiting to see if Visa has an appetite for similar variations on the card brand theme.

Finally, the financial restructuring of some of the major acquiring processors will likely result in cleaner, less ambiguous and more direct bases of competition among some of the industry’s leaders — both in the United States and worldwide.

All of these industry events have built a backlog of pressure for changes in the acquiring business. The long-term impacts of these changes seem most likely to be fought out over e-Commerce, where the perceived inequities of the current system are the greatest. This segment is already moving to more cost- and service-effective payment alternatives in a big way, including PayPal, Google, BillMeLater, and most recently, AmazonPayments.

While more sharply defined processors and alternative payment providers battle over mainstream online merchants, the biggest changes are likely to take place with the now millions of smaller Internet retailers who heretofore have been stuck with paying merchant discount rates of 4, 5 and even 6 percent!

Many smaller merchants — now also the targets of bigger processors moving down-market — are pushing back on ISO mark-ups and winning (or simply departing for direct relationships with the bigger processors). At the same time, payment alternatives are now getting serious consideration by online merchants of all sizes. PayPal insulates merchants from some of the impacts of being “cash-registers” for both issuers and ISOs; Google Checkout offers payments for free if merchants buy ads; and AmazonPayments lets Web site builders replace ISOs as payment intermediaries. The growth and increasing marketshare of these new acquiring players demonstrates that things in the acquiring business might be changing before our very eyes.

So the stage is set and the battle engaged, with e-Commerce as the first act in this epic battle for a fundamental re-balancing of who pays and who benefits from bankcard acceptance in the decades ahead. It looks to be a challenging and exciting experience for all involved.

About the Author

Steve Mott is chief executive officer of BetterBuyDesign.com, a virtual investment and consulting company specializing in brokering high technology ideas for the New Economy.