Jul 5, 2006

How interchange value could slip from banks to third party payment processors

In some countries, like the US, banks abdicated ownership of the payment experience when they sold their merchant acquiring businesses to third parties like First Data. If these third parties were to offer merchants an enhanced payment product that supports merchant-centric features built into the credit and debit card payment transaction, and which merchants find very attractive, convenient and easy to use, we could see a major shift in how merchant fees are split.

Today, approximately 80% of the merchant fee goes to the issuer in the form of interchange and 20% to the processor/acquirer. If interchange gets cut in half, like what happened in Australia, we could see merchants agreeing to pay the same amount for a substantially improved payment product, but with 40% going to the issuer in interchange and 60% to the processor/acquirer. That flip would triple the size of the revenue stream to processors and acquirers. Making the moment of payment more valuable to merchants could be the cornerstone of a major organic growth strategy for companies like First Data.

Why isn't this happening in the US today? One reason is that enhancing the moment of payment is not easy. Nobody really owns the moment of payment anymore. Banks certainly don't. The best they can do is issue contactless cards that emulate magstripe cards. Processors don't either, as their primary focus and interest is on responding to requests for authorization. POS terminal vendors kind of own the moment of payment, but only for limited features that don't need additional data at the moment of payment. Pretty useless. The industry has structured itself in such a way that no single company can do deep payment innvoation anymore. You have to get lots of unrelated companies, and their competitors, into the same room and try to get them to work together. A fantastic way to kill innovation.

So why is this happening in lots of other parts of the world? Unlike banks in the US, banks in virtually every other country are moving or planning to move to EMV chip cards, a key technology that makes it much easier to create new payment product enhancements. Another reason is that Welcome has found a way to engage in deep, end-to-end payments innovation without involving lots of unrelated companies. We established a single payment software development organization over ten years ago that develops software for the full end-to-end solution, the back-end system software, POS terminal software and card software. So deep innovation can be done quickly and efficiently without involving everybody and his uncle.

Today, more and more banks around the world are attracted to this very unique vision. We saw the opportunity many years ago but did not expect it to take so long to get here. Had I known, I would have probably chosen another line of business. Everyone's effort and tenacity (or pathological stubbornness, in my case) is now paying off. Welcome's revenues are growing at 50% per year and our ebitda at 100%. And we are just beginning what we call our "phase 2" development, with a much larger total addressable market than phase 1. But more on that in a future post.

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