Key Points
Credit and debit card payments made in physical stores add up to a huge amount of economic value — $4 trillion in transaction volume in the U.S. alone in 2013, and that volume is growing as more and more people move away from cash.
But traditional card payments technology has evolved slowly, and merchants must choose from a confusing and expensive array of services and equipment in order to accept credit cards. That's creating an opportunity for more agile players that can offer innovative technology, easy-to-understand pricing, and less clunky software and hardware.
The credit card companies themselves aren't going anywhere for now. Visa and MasterCard in particular will remain an indispensable part of the chain because they don't actually process payments. They simply provide the rails that the credit card system works on: They issue credit card numbers to consumers, and operate the networks that ferry payments information between consumers, merchants, and their respective banks. Credit card processors like First Data that actually do the work of processing merchants' credit card transactions on the back-end are also in a strong position.
Two pieces in the chain are particularly vulnerable to disruption: the makers of the actual hardware — basically card readers and registers — that are used to physically accept card payments at stores, and the hundreds of vendors known as merchant service providers or MSPs, which set businesses up to accept credit cards. The MSPs act as middle-men, connecting merchants to the big banks, credit card-processing companies, and credit card networks like Visa. They are being pushed to become more tech-savvy and merchant-friendly.
Point-of-sale hardware faces an immediate threat from mobile devices. Many small- and medium-sized businesses are replacing their cumbersome point-of-sale hardware with tablets and smartphones outfitted with easy-to-use software and attachable credit card readers. These devices are cheap and easy to implement, they do not require consumers to adopt new behaviors, and free up retailer space previously devoted to bulky hardware.
The new payments companies — including PayPal, Leaf, Revel Systems, Square, and others — could shove traditional MSPs aside as they bridge the offline and online worlds. They pair their mobile registers with consumer-side smartphone apps, and often also provide additional merchant services, like software for loyalty programs or for parsing online consumer data. These new companies want to replace the old players that focused mainly on logistics, i.e., helping merchants take credit card payments.
To keep things in perspective legacy MSPs still have some huge competitive advantages: Namely, they have existing relationships with the majority of merchants who accept credit cards and with banks. They also have established marketing channels and large sales forces. Large MSPs, particularly those that also actually do the back-end credit card processing themselves, will move to acquire new payments technologies to squelch the disruption threat.
Introduction
Credit cards have become such a familiar tool in advanced consumer economies worldwide, we hardly think about how they work. But each credit card transaction involves a complicated chain of interactions that make it possible for funds to be properly relayed between banks, merchants, and consumers.
There are six essential links in the chain: acquiring banks, issuing banks, card networks, hardware providers, merchant service providers or MSPs, and credit card processors.
In this report, we'll explain what each of these players do, and how much value they add.
We'll also explain why there are two parts to this chain — the hardware providers and MSPs — that we think are particularly vulnerable to disruption.
We've often written in the past about how the payments industry is being transformed by fast-growing tech startups.
These new companies are using mobile devices and elegant software to help merchants streamline their payments systems.
But we've never looked in depth into the specific parts of the payments industry that are most under threat from this wave of disruption, and why. This report aims to do just that, and in the process clear up confusion about how the credit card-driven economy works.
The credit card payments ecosystem is far from simple. It is as sprawling as might be suggested by the fact that it channels trillions in economic value every year.
Tech-driven changes will impact the different players in dramatically different ways. It's important for all the participants involved — financial services, retail, and potential disruptors — to understand what's at stake for them in this current wave of payments innovation.
This report focuses mainly on the U.S. market and offline transactions at physical stores, however, with slight variations the story holds for e-commerce and for credit card transactions in other markets, too.
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Context: The U.S. Credit Card And Debit Card Markets
The transaction volume of the largest payment card companies remains an important indicator of the overall health of the payments industry in the U.S., as well as globally.
In our last payments report, we estimated U.S. credit and debit transaction volume at just under $3 trillion for 2013.
We have now raised that estimate, and believe total card transaction volume reached more than $4 trillion in 2013.
(The chart to the right shows volume through the third quarter, the last period for which data was available.)
Our estimate is based on the sum of U.S. credit and debit card transaction volumes reported in company filings from Visa, MasterCard, American Express, and Discover and adjusted to reflect these companies' share of the total market (which is around 95%).
As you can see in the chart, transaction volume is still growing reasonably fast — 9.5% in the third quarter of 2013, compared to the third quarter of 2012.
One explanation for the growth is that consumers continue transitioning away from cash and are paying for an ever-increasing share of purchases on credit and debit cards. The growth of e-commerce is also helping to fuel card transaction volume growth.
People are buying online more often, and can't use cash for these transactions.
If we break down the transaction volume number further, to include only offline retail card transactions, we see that growth is much lower. Offline transaction volume in the U.S. only grew by about 6% year-over-year from Q3 2012.
In other words, e-commerce accounts for a big slice of the growth in credit card volume.
What stands out is that the offline market dwarfs the online market by about three-to-one, but it isn't growing nearly as fast.
Competition is going to heat up as new payments companies steeped in online data and Internet services take aim at the huge offline payments market and bring new services to bricks-and-mortar retailers.
How The Payment Card Ecosystem Works, And Why It's So Ripe For Disruption
Here is the basic structure of the credit and debit card payments industry.
Acquiring banks are large retail banks that seek out or acquire merchants who want to accept payment card transactions, and provide them with an account into which funds can be deposited. It used to be that these banks worked directly with many merchants, but that's no longer the case. Instead, many acquiring banks work hand-in-glove with the entities listed below.
Other merchant acquirers, including credit card processing companies and merchant services providers, or MSPs: These firms emerged as a key link in the payment card industry, once it grew too large and technologically complex for banks to be able to manage one-on-one relationships and processing services for all their merchants. There are two main types of acquirer:
Large credit card processors like First Data, Chase Paymentech, Heartland, and Bank of America Merchant Services. These firms play a dominant role that is largely invisible to the consumer — and many merchants, for that matter. When a credit card is swiped, they do the actual processing work on the back-end. But because the credit card economy is so large they can't be tasked with striking up relationships with every single merchant that wants to take credit cards.
That's why there are hundreds of independent firms that act as agents for acquiring banks or the large payment processors, known as MSPs or ISOs. These are merchant-facing vendors that basically act as consultants, setting up businesses to accept and troubleshoot credit card payments, without doing the actual back-end processing themselves. They vary in the range of their services, but work in collaboration with one another, the banks, and the large processors, as well as the point-of-sale hardware providers. They might provide underwriting help, assistance with the point-of-sale technology that actually sends the payment information away for processing, and offer ongoing monthly statements and troubleshooting. They charge per-transaction fees for their services.
Issuing banks provide credit or debit cards and accounts to consumers.
The credit card networks are the credit card companies such as Visa, MasterCard, and American Express. They provide the technology and the computer networks that carry transaction information. The wrinkle is that American Express and Discover are different from the others in that they work directly with consumers and merchants, disintermediating the role of the banks and ISOs and MSPs. Visa and MasterCard work only through banks that act as issuing banks and acquiring banks (that's why Visa- and MasterCard-powered payments are also known as "bankcard transactions").
Hardware providers sell point-of-sale devices to merchants. Sometimes, the providers of the hardware also provide some of the merchant services detailed above.
Once the basic structure of the payments card industry is understood, it becomes easy to see why MSPs face a threat, and why anyone involved with retail point-of-sale hardware should be especially nervous.
To begin with, the ecosystem of third-party merchant services is very confusing, and riddled with complicated fee structures. The promise of companies like Revel Systems and Square, which themselves can be seen as MSPs, is that they offer merchants a simple and intuitive software-driven interface to view their credit card and other transaction history, and an upfront flat fee. The fee is a bit high — 2.75% of every card transaction with Square — but the benefit is that merchants don't have to worry about haggling with a confusing array of vendors.
There are conflicts of interest at the heart of the legacy MSP and acquirer ecosystem. As we said, many MSPs and ISOs work very closely with the banks, large processors, and hardware providers. While there's no reason to think that they are working conspiratorially together to fleece merchants, the high degree of opacity and the tangled Web of relationships definitely gives many retailers pause. Complaints about byzantine fee structures bound in retail trade publications. Now that there are alternatives to old-line MSPs, merchants may see them as a way to get out from under the thumb of the old system, and regain some clarity and leverage.
The traditional hardware providers — which are often MSPs themselves — have benefited from merchants' dependence on clunky and expensive payments terminals and register systems. Also, once a traditional register system is implemented, there is a huge switching cost involved in leaving the hardware behind if you become disenchanted with the technology. Today, many small- and medium-sized retailers are opting for tablets and smartphones outfitted with attachable card readers (they plug into an audio jack). The added advantages are that they allow sales people to roam the sales floor, and that switching systems doesn't involve much cost. The attachable card readers are very inexpensive, or provided free.
Credit card readers have proven irresistible for many small- and medium-sized businesses in the U.S., 40% of which now use the devices, according to a BIA/Kelsey survey.
How A Card Transaction Works
A simplified version of the path of a credit card transaction is displayed at the right.
The diagram serves to illustrate how many moving parts it takes for a credit card transaction to be authorized, processed and settled.
Consumers usually apply for credit cards at issuing banks like Wells Fargo or directly to credit card networks like American Express. The card network sets rules for when a card can be issued, and if the applicant fulfills these criteria he or she is issued a card and a credit account.
Acquiring banks seek to provide merchants with accounts into which funds from merchandise sales can be deposited. This relationship and the services connected with it is often mediated by a merchant-service provider, or MSP.
The actual processing of these transactions is often handled by yet another company, the payment processor, like Bank of America Merchant Services.
When the cardholder makes a payment in a bricks-and-mortar store — we'll say for a purchase of $100 — the card is swiped through a point-of-sale device, which is provided to merchants by a legacy hardware provider like Verifone, or a new entrant like PayPal Here.
The information from the transaction is electronically transmitted to a processing company — which requests payment authorization from the cardholder's issuing bank.
If the cardholder has credit available, the issuing bank authorizes the transaction.
The next step in the process is clearance and settlement. When the merchant is ready to settle, she sends a request with her authorized transaction history to the processor. The processor submits the request to the card network and the card network requests the funds from the issuing bank.
The issuing bank disburses $100 to the card network less an interchange fee which is set by the card network and usually amounts to about $1.50. The card network takes an additional cut of about $0.15 before sending the remaining $98.35 back to the processor.
In the interim, the MSP may also take a fee, known as the "markup," which isn't pictured in the chart.
The processor sends the money to the acquiring bank, which provides the merchant with an account. The mark-up fee split between the MSP, the processor, and the acquiring bank amounts to about $0.35. The acquiring bank then deposits the remaining $98 into the merchant's account.
There are a few caveats:
As we mentioned before, companies like American Express, Discover, and Diners Club operate as closed networks which means that these companies fill many of the roles between the merchant and the consumer.
As we said before, companies often play two or more roles in the value chain. For example, First Data provides points-of-sale hardware in addition to providing processing services.
Why New Entrants Are Putting Pressure On The Legacy Players
New entrants in the payments space with a background in software, mobile and Internet services, and big data have the potential to put pressure on legacy players across every step of the payment card transaction chain.
The reason new entrants are gaining any traction in the short term is that they offer something to merchants or consumers that older companies do not provide, or are only just beginning to provide at any scale.
They bridge the online and offline worlds of payments and commerce.
Consumers are beginning to complete transactions through smartphone-based digital wallets, both online — and importantly — in physical stores. Merchants are beginning to take those payments — as well as traditional credit card transactions — through tablet and smartphone devices.
All the pieces are there so that all this transaction data can be tracked and be transformed into a trove of cloud-stored data on customer purchase history and preferences.
This data might provide bricks-and-mortar retailers with the insights that historically have only been available to the largest e-commerce outfits, like Amazon.
In other words, the largest benefit provided by many of the new mobile card reader-based systems isn't the simple fact that merchants can use iPads as registers.
The real benefit is that they provide the merchant with easy-to-use software, with the kinds of intuitive user interfaces that Silicon Valley specializes in, to track purchases and provide deeper insights on purchase history and trends. This data can then be shared across store locations, or used to generate personalized recommendations and offers.
"Amazon generates 35% of its revenue from product recommendations," says Marc Freed-Finnegan, co-founder of retail loyalty start-up Index, which we recently profiled.
Issuing product recommendations is a direct result of Amazon's ability to track purchases, he says. "If every retailer has a ... revenue opportunity that they haven't realized yet, that's huge."
Freed-Finnegan's statement gets at the core value provided by many of these new payments companies: There is enormous revenue potential for retailers that are willing to transition from legacy systems to the online world, by aggregating data generated by offline and online sales, not to mention loyalty programs, and email and content marketing.
Of course, traditional merchant service providers are aware of these features and are beginning to provide them.
But the advantage of the new players is that they are native to mobile and the cloud, while legacy companies need to build the technology, or get it through partnerships or outright acquisitions.
Examples Of New Payments Systems And How Legacy Players Are Responding
Some merchants are already taking advantage of the new technologies and capabilities, while others are just getting started.
LevelUp is one example of a company that's luring retailers with the promise that it can help them enter this new world of data-mediated and cloud-powered commerce.
LevelUp can be seen as a kind of complementary MSP, that's used only for smartphone-based payments. The company provides point-of-sale solutions that come in the form of either software that can be used on a merchant's mobile device like a tablet, or stand-alone hardware. (See image, right.)
When a customer at a LevelUp retailer has the LevelUp app, he or she can make a payment simply by having it generate a QR code, which is then scanned by the terminal, or by the merchant's mobile register.
The company charges a low 2% flat fee for those app-based transactions, which is lower than the total fee paid by many retailers for traditional credit card transactions.
However, if a LevelUp merchant wants to take a credit card payment, it must rely on a traditional setup.
In other words, LevelUp doesn't replace the current system, it merely offers an add-on.
The company's belief isn't that it's going to generate massive revenue based on skimming 2% of LevelUp-powered transactions. It believes that merchants will generate a great return on investment thanks to a built-in analytics and loyalty platform, which will allows them to upsell customers and bring in leads with targeted offers, based on data collected by LevelUp's consumer- and merchant-side apps.
The merchants will share a performance-based fee with LevelUp.
"We see very little value added in the transaction of money itself," says Matt Kiernan, LevelUp's Marketing Manager.
While legacy processors aren't necessarily falling over themselves to imitate LevelUp-style services, processors and MSPs have shown an interest in partnering.
In fact, in early 2013 LevelUp struck a deal with Heartland Payments Systems, a vertically integrated U.S. payments processor, which also acts as an MSP and has relationships with many resellers or ISOs.
As part of the deal, Heartland will do the back-end processing for LevelUp's own transactions, which are completed through apps but ultimately tied to consumer credit cards that they link to LevelUp accounts.
Importantly, LevelUp also gained the support of Heartland's sales team, which now offers LevelUp's mobile payments system to Heartland's network of merchants.
Another company, Revel Systems, provides iPad point-of-sale software that doesn't just allow merchants to track credit card payments, it's also customizable. It can help them track gift card loyalty programs and pulls in a customer relationship management or CRM system to help them collect and analyze valuable customer data.
It offers industry-specific features, like an order display system for restaurants that need kitchen workers to be able to quickly pull up orders.
Like LevelUp, Revel also relies on traditional payments companies to process its transactions.
The Disruption Threat
It's commonplace to say that the entire credit card-based payments industry is under threat from mobile payments or app-centric companies like LevelUp and Revel. But the truth is that it's specifically hardware vendors and traditional merchant service providers who are more directly being challenged, particularly those that serve small- and medium-sized businesses.
But the threat is more diffuse, than direct.
It's about disrupting the traditional merchant services model with innovation, but not necessarily about replacing legacy players with new ones, since they actually tend to be complementary. New MSP-type outfits like Revel and Square have the technology, while legacy players have the marketing acumen, the relationships, and the established sales channels.
Traditional MSPs and hardware vendors might develop or acquire new technology and software, or team up with the new entrants and forge mutually beneficial ties, much as Heartland did with LevelUp, and several processors and MSPs have done with Revel Systems.
Meanwhile, the credit card companies Visa, MasterCard, American Express, and Discover aren't immediately threatened by new payments startups either.
They are still seeing a slice of those transactions made by the new merchant service providers or MSPs, in the form of a network fee. So are credit card processors.
Likewise, banks must still be involved in bankcard transactions as the ultimate stewards of the funds involved in any payment, and guaranteeing each party's creditworthiness.
THE BOTTOM LINE
Credit and debit card payments made in physical stores add up to a huge amount of economic value — $4 trillion in transaction volume in the U.S. alone in 2013, and that volume is growing as more and more people move away from cash.
Two pieces in the chain are particularly vulnerable to disruption: the makers of the actual hardware — basically card readers and registers — that are used to physically accept card payments at stores, and vendors of payment services to merchants.
The credit card companies themselves aren't going anywhere. Companies like Visa and MasterCard will remain an indispensable part of the chain because they don't actually process payments.
Many small- and medium-sized businesses are replacing their cumbersome point-of-sale hardware with tablets and smartphones outfitted with easy-to-use software and attachable credit card readers.
The new payments companies — including PayPal, Revel Systems, Square, and others — are trying to bridge the offline and online worlds.
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