Mar 26, 2008

Free payment processing

Google has been offering free payment processing to Internet merchants since they launched Google Checkout almost two years ago. Merchants get free credit and debit card processing when they also use Google Adwords, a direct marketing service that displays paying advertiser’s names alongside search results. Could a marketing subsidized payment processing model work for physical face-to-face transactions as well? Could an acquirer offer free payment processing? Not just cheap and very low margin services (where they’re headed to already, due to pressure on acquirer fees and interchange litigation around the world) but free, gratis, without charge.

Wired Magazine’s cover story this month is titled Free! Why $0.00 is the future of business. “A decade and a half into the great online experiment, the last debates over free versus pay online are ending,” writes editor-in-chief Chris Anderson. “In 2007 The New York Times went free; this year, so will much of The Wall Street Journal. Once a marketing gimmick, free has emerged as a full-fledged economy. Offering free music proved successful for Radiohead, Trent Reznor of Nine Inch Nails, and a swarm of other bands on MySpace that grasped the audience-building merits of zero. The fastest-growing parts of the gaming industry are ad-supported casual games online and free-to-try massively multiplayer online games. Virtually everything Google does is free to consumers, from Gmail to Picasa to GOOG-411.”

The article has a good bit of the hyperbola typical of Wired, but it is nevertheless an interesting piece on how the practice of shifting the cost of one thing on to another (i.e. cross-subsidies) has matured at the same time that unit costs of technology continue dropping rapidly. It pretty much comes down to giving things away in exchange for advertising and marketing revenue. That’s echoed by Kevin Kelly, another Internet guru who has also written about the economics of free: “Ads are widely regarded as the solution, almost the ONLY solution, to the paradox of the free. Most of the suggested solutions I've seen for overcoming the free involve some measure of advertising.”

Readers of my blog have heard me rant ad nauseum about making payment more valuable for merchants so that we can slow down commoditization and protect payment fees, including interchange. Is my angle all wrong? I’m wondering now if there is not a more powerful way to accomplish the same thing, but from a very different angle. Instead of resisting downward pressure on payment fees, why not learn from Google and speed the process along? Why not eliminate the fees and make money instead through marketing and advertising services built into the payment transaction? At first glance, this may be impossible for many acquirers to imagine, but when you look a bit deeper at how Google does it, the idea is not so far fetched and the financials work out to the acquirer’s advantage. Which is of course why Google is doing this.

How does Google’s free payment processing model work? For every dollar merchants spend advertising on Google each month, they can process ten dollars in sales the following month for free. Merchants normally pay around twenty-five cents to process ten dollars of sales, so merchants are in effect getting a twenty-five cent discount on ever dollar spent on Google Adwords. Google hopes that by being a trusted intermediary, they can reduce the number of purchase transactions that are abandoned when customers are uncomfortable giving up their credit card information to a merchant. In turn, this would result in more shoppers buying from Google’s AdWords clients and more merchants spending marketing dollars on AdWords.

A Deloitte study shows how Google views the entire shopping experience as a continuum from the first search through to the final purchase, which enables Google to envelop the payment transaction within the shopping context. “Because search-to-purchase firms make their money primarily from merchant advertising fees, rather than on transactions, the potential profits are much greater. The profit margin for solving the merchants’ commerce problems and delivering new customers and/or closed sales is two to three times that of the payments transaction fee. Data shows merchants will pay between 7-9% for delivery of a sale vs. 2% for merely processing the payment.”

How would this look in the physical world? Imagine an acquirer offering merchants the following, “For every dollar you spend delivering targeted promotions when a credit or debit card is used in your stores, you can enjoy free processing on ten dollars in sales.” Let’s look at the impact on the acquirer’s margins. Take the same one-dollar paid by the merchant for targeted marketing services, and the same twenty-five cents of processing fees waived on a ten-dollar transaction. In this scenario, the acquirer earns seventy-five cents on that ten-dollar transaction instead of twenty-five. Three times more revenue. Since normal acquiring fees are primarily made up of interchange that goes to the issuing bank, the impact on net margins is much higher. Some of the numbers I’ve been playing with show that an acquirer’s net margins can be five to eight times greater with free payment processing. So this model is even more lucrative for a traditional acquirer working with mainstream physical merchants than it is for Google with Internet merchants.

Things are not all rosy for Google Checkout. Small merchants might not worry a whole lot about letting Google manage the relationship with their customers, but large Internet merchants like and eBay want to have a direct relationship with customers and don’t want Google in the middle (to complicate matters, eBay is a key Google advertising account, yet refuses to offer Google Checkout, preferring instead its own competing payment service, PayPal). Acquirer banks don’t face these challenges in the physical space, where merchants almost never know the customer anyway, unless a loyalty card is used. The whole disintermediation issue is avoided.

One big challenge that acquirers do face is the ability to think differently and to position themselves in the marketing world. Most acquirers are tired of playing in a low margin, commoditized market and many have successfully added new services that generate more profitable revenues from merchants. So they are already going in this direction. It could be a matter of time before an acquirer decides that it would be better to provide payment processing services for free and make money elsewhere, rather than competing with cheaper and cheaper providers.

“There is a huge difference between cheap and free,” Says Wired’s Chris Anderson. “Give a product away and it can go viral. Charge a single cent for it and you're in an entirely different business, one of clawing and scratching for every customer.”

Hmm. Clawing and scratching for every customer. Sounds like today’s payment processing world.

Google seems to want to move into the physical world too, starting with Google Maps on petrol pumps that provide drivers information on hotels, restaurants and other local merchants, plus coupons to get you to go to those merchants. Will Google want to close the loop with a free payment service for those physical merchants? (play scary movie music here)


Anonymous said...

An interesting concept, but a key barrier to cross-subsidies is always persuading the receivers to accept the effect of the subsidy being offered. In this case, why would large high street merchants allow POS receipts etc to advertise offers from other high street retailers? The friction between Google and eBay is a good example and it would be a brave pos acquirer and to move to this model.

Additionally, the advertising medium could also become increasingly commiditised/price-driven in this model unless the investment in POS software technology - as well as scheme mandatory software - kept pace.

Although having said that, an interesting concept.

Aneace Haddad said...

A retailer doesn't have to provide offers from other retailers. They certainly do that from time to time already, but it is a small part of today's promotional marketing activities. Today most of the retailer's promotional budgets are spent on in-store promotions of the retailer's own products and services to the retailer's own customers. Data available at the moment of payment can help target those existing promotions much better.

Eric Remer said...

How are you? I actually live in Boulder, CO and run an electronic payment processing company in Denver.

Love your train of thought as I do believe we are getting closer to a free world. Payment processing is incredibly cumbersome and confusing for merchants (specifically small businesses). However even in a free world, there needs to be one part of the equation that merchants/consumers are willing to pay if they are receiving value. It has been proven time and time again accepting electronic forms of payments increases sales and reduces collection risk. Merchants have accepted that relationship, however, what they don't enjoy is the hidden fees, statement fees, up charges, inept service and provisioning process. I believe the exisitng distribution model is broken.

The problem with marketing supported anything is there is a finite number of marketers willing to spend $$. It is my belief that many of the free social networking sites will begin to feel this pinch relatively soon. FaceBook is the largest social networking site in the world and had $100M of rev. last year. Where will all the ad dollars come from to support the nings, my space, facebook, and the hundreds of others popping up.

So with that hurdle being a relative large one, how would acquirors really replace their Billion's of collective dollars in revenue through ads?

Very interesting concept, but how to execute on the vision is the real question.

Eric Remer

Aneace Haddad said...

Hi Eric. I like thinking in macro numbers like you're doing.

I agree that acquirers would not be able to collectively replace their billions of dollars in revenues through ads. But a single acquirer could use the strategy and create a very new and different offering.

All current billable services would likely not be offered for free. Lots of the things that acquirers sell today look like premium type services, or could be positioned as such, and could still be charged. The things that appear the most as commodities could be offered free.

How big are the advertising budgets that could be funneled through payment related marketing services? Catalina Marketing is one of the most relevant companies to look at. Catalina provides targeted marketing services based on coupons and marketing messages printed on cash register receipts in supermarkets. They charge on average 7.5 cents per message, depending on the type of targeting criteria used. 2005 revenues were $410 million.

What Catalina does in the supermarket space is what I keep talking about (roughly speaking) in the much larger retail space including convenience stores, quick service restaurants, fashion, and virtually all other physical retail outlets.

Catalina Marketing was purchased for $1.7 billion in April 2007 by private equity firm Hellman & Friedman. That's a multiple of sales that many payment companies would love to see.

(PS I bet Boulder is beautiful right now, this time of year. I haven't been back in a long time, but June and July were always a special time.)

Eric Remer said...

Boulder is certainly beautiful this time of year, with the blue skies and clear crisp, cool evenings. We have only been there a year or so and are definitely loving it.

I completely agree that there is a niche opportunity to exploit the relatively old guard and the "standard" ways of doing things in payments. We have a few things in the works that we believe could take advantage of some of the ineffeciencies in the marketplace and also tap into the "free" mindset.

You can keep tabs on that progress at Hopefully by mid/late summer we plan on launching a few of these programs.


Anonymous said...

Great Post!
Payment Processing

Jing said...

Great concept. This is a great example that we can turn a competitive pressure to a cometitive advantage.