Mercator encourages acquirers to develop value added services

PaymentsNews reported yesterday on a Mercator report titled, "Merchant Acquiring in the United States 2008: Birth of the perfect storm".

Pressure on merchant acquirers has always been strong, but things are expected to get worse. Mercator encourages acquirers to protect their businesses by focusing on value-added services leveraging payment data, among other things.

"Diversification of merchant services business models and emphasis on ancillary revenue streams generated by value-added services, fee revenue on non-bankcard payment processing, and new ways in which acquirers can leverage their data will all be necessary for continued market performance. Payments savvy merchants, who understand that the electronification of payments and the systems that support them are tools that can be used to optimize business, are after providers that can help them achieve that optimization."

Sounds a great deal like PIVAS (Payment Information Value Added Services) promoted by Gartner.

What do you think? This calls for a very different mindset from that of cutting costs. Are acquirers in your country able to think differently and develop new services to boost revenues?

Are Asian banks having second thoughts about outsourcing acquiring to third party processors?

Last week, an executive with a regional bank in Asia explained to me that they were beginning to regret the decision to outsource their acquiring activities to a major third party processor. They are finding that without direct control of their acquiring business, it is now much harder to develop marketing promotions and partnerships with merchants.

These promotions have become very important for credit card issuers in Asia. They're all over the place. As just one example, I took a picture on Saturday of a Citibank promotion at a restaurant in Singapore. See other examples here of joint bank/merchant promotions that are possible when banks retain their acquiring activities.

In a separate discussion, this same complaint was echoed by another regional banker who had looked at outsourcing their acquiring activities as well, but had decided against it for the same reason. They had come to the conclusion that they would quickly lose the ability to develop promotions with merchants. Acquiring was considered too strategic to outsource.

In yet another discussion, an executive with a third party processor mentioned that there is a growing desire among Australian banks to look at issuing and acquiring holistically, in order to get more out of their payment activities. This after seeing the issuing side of the business hamstrung by interchange regulations.

Third party processors are not usually the right people to understand and offer marketing services to banks and merchants. They focus heavily on technical operations, getting lots of terminals out and churning through lots of transactions, the more the better. Now, to satisfy banks better, third party processors may need to look at things more from a marketing angle and move up the value chain a bit.

Examples of card promotions possible when banks retain their acquiring activities

You can see these promotions across Asia, where many banks are still active in merchant acquiring and see it as a useful support function for their card issuing business. Some banks are finding that without direct control of acquiring, it is much harder to develop marketing promotions and partnerships with merchants (more here on banks having second thoughts about outsourcing their acquiring activities).

I took this picture on Saturday at a restaurant in Singapore. This promotion is exclusively for Citibank cardholders. When I paid, I saw that there were several terminals behind the counter, one of them a Citibank terminal. So Citibank has an acquiring relationship with the restaurant, but so do UOB and DBS, suppliers of the other terminals behind the counter.



Then, at a Caltex petrol station, I got this offer when I used my HSBC card. The offer is stapled to the credit card slip (it could have been printed at the bottom of the credit card slip instead, and targeted based on my prior fill-ups at Caltex, but it wasn't). Again, just like the prior example, Caltex has an acquiring relationship with HSBC.



Here are a few other examples of bank/merchant joint promotions:
Old, boring cards have trouble competing side by side with new generation cards
A crowd of cards caught copycatting, doing their best to look exactly alike
Another ‘Exciting-new-card-versus-boring-old-card’ picture
Tod’s leather goods
Making credit and debit cards more valuable in the Philippines


Since I was in reporter mode, I couldn’t help stealing a picture at an iconic retailer in Singapore that every Singaporean knows, Mustafa Centre.


You can clearly see 5 terminals here representing 5 different acquirer relationships. If you look closely, you can see the main feature that requires all these terminals – credit installments, with each bank offering their cardholders a slightly different plan.

Why doesn’t a third party processor offer a universal installment plan application that can link up to any of these banks through a single terminal? That would bring costs down for the bank, reduce counter top space for the merchant, simplify procedures for the clerk, open the installment feature up to lots of other banks that don't do acquiring, and provide the third party processor with a cool feature to help win new business.

More on Free Payment Processing

A couple months ago, I wrote a piece called "Free payment processing" which looks at using marketing revenues to subsidize commoditized payment services. Eric Remer (I believe his company's blog is PaySimple blog) just provided an interesting comment to that post.

Aneace,

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

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? According to a promo industry trends report, in-store advertising alone is a $42 billion industry in the US, around the same amount as total interchange fees paid by merchants last year to accept Visa, MasterCard, American Express and Discover cards. Spending on loyalty programs is estimated at $2 billion, the same as sampling (another $2 billion) and just a little more than games ($1.8 billion). Direct marketing still tops the charts at $53 billion.

Catalina Marketing is an interesting company to look at in this space, although they are not involved in payment processing. 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 (their most recent annual report is here).

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.

5 ways to prepare today for the risk of lower interchange revenue tomorrow

When Australian banks got hit with mandated interchange fee cuts, virtually all of them reacted the same way. They devalued their rewards currencies and increased the annual fees charged to cardholders. Some began issuing American Express cards in addition to Visa and MasterCard, for higher rewards rates.

Whether or not interchange gets regulated in the US or Europe remains to be seen. But there are things that banks can do today that can help adjust to the current pressure on interchange and prepare for potential risks.

“Just because there might be a tornado doesn’t mean we should live in the basement, and just because there is a risk that interchange fees will go away doesn’t mean that we should act like they are already gone,” says David Evans over on the Catalyst Code blog. “What we can say, however, is that there is a significant risk that interchange fees will fall and banks need to be prepared for that scenario.”

If you are a banker hearing increasingly loud calls for interchange regulation, how do you prepare? Here are a few things that can help improve your profitability today, and will help you adjust better than your competitors if interchange gets cut tomorrow.

1 – Cut the cost of rewards by getting merchants to pay for bonus points that they provide to your cardholders. Merchants can agree to co-finance your rewards program in exchange for the free advertising and marketing that they get when you promote the relationships to your cardholders (more here). Merchants also value the ability to include targeted marketing messages in the statements you provide, or on the bottom of card receipts (more here).

2 – Cut the cost of running your rewards program by simplifying the rewards redemption and fulfillment process. Give customers the ability to redeem points directly at certain merchant locations, whenever they want. This helps to cut costs related to sourcing of rewards, inventory management, delivery of rewards to customers, etc. Merchants like it because your cardholders will use their rewards to buy things that they might not have bought otherwise.

3 – Switch rewards hungry premium card customers to American Express for higher interchange revenue that might not be impacted by the same regulations as Visa and MasterCard premium products. This happened in Australia. However, the tactic might not work as well anymore, as merchants now appear to be focusing on surcharges and other steering mechanisms that could apply to any card product.

4 - Choose Visa, MasterCard and American Express premium products that have a decent and plausible interchange story attached to them. Stay away from premium card products which generate higher interchange fees but which don’t offer real, tangible benefits to merchants above and beyond those offered by standard credit cards or even debit cards. It’s those additional benefits to merchants that make a scheme product valuable to you, since merchants will have less of an incentive to attack interchange fees on those cards, or steer customers away from using them.

5 – Add new merchant acquiring fees (if you are also an acquirer) to charge for items which you may have been giving away free. Even better, develop new revenue streams on the acquiring side. If interchange gets cut, there is an opportunity for acquirers to offer new value added services that are paid with a portion of the money freed up by the lower interchange fees. See more posts on acquiring here.

Are some banks already preparing for lower interchange fees?

To get ready for a potentially far less profitable card issuing business, some banks could be preparing to focus more heavily on a business that they have traditionally neglected: acquiring. This is what I have heard recently from several consultants and analysts in Europe, and my upcoming conference presentations will focus on this angle.

With credit margins already under pressure due to fewer revolving customers, and with the threat of reduced interchange becoming more real, issuing profitability might be on the way down. Acquiring has been neglected, even abandoned by many banks, so there might be an opportunity for new strategies. Some banks could offset decreasing profitability and revenues on the issuing side by developing new revenue streams on the acquiring side.

This strategy is especially relevant if interchange gets cut. Merchants will be paying less, so there is an opportunity for the merchant’s acquirer to offer new value added services that are paid with a portion of the money freed up by lower merchant discount fees.

What other ways can a bank deal with interchange risks? An individual bank doesn’t have much of a role to play in protecting interchange, that’s the role of the payment schemes. But a bank can choose Visa, MasterCard and American Express products which have a decent and plausible interchange story attached to them, and stay away from card products which generate higher interchange fees but which don’t offer additional benefits to merchants. It’s those benefits to merchants that make the product valuable to banks.

I am working on a more detailed “how-to” list of things banks can do today to prepare for the risk of lower interchange tomorrow.

Boots till receipt promotions

Lots of merchants already print promotions and marketing messages at the bottom of till receipts, but they are based only on the amount the customer spends in one transaction. The next step is to print these offers and messages at the bottom of credit and debit card receipts, using a richer set of trigger criteria, like the date of the customer's last visit, or the number of visits or amount spent over a given period.


I picked up a couple things at Boots in London and received this promotional offer at the bottom of my till receipt. All shoppers get the offer. I didn’t use my Boots loyalty card (I don’t have one) and the checkout clerk didn’t ask if I wanted to apply for one.

But I did pay with a credit card.

Imagine if the same type of offer appeared at the bottom of the customer’s credit or debit card receipt, triggered based on whatever criteria Boots chooses, using payment data managed by Boots’ acquirer. The customer has been to Boots before, but not recently? Include a special offer at the bottom of the receipt, for occasional customers that could be shopping elsewhere. The customer is a heavy duty frequent shopper? Print a message encouraging the customer to apply for a Boots co-branded payment card.

Eight predictions on the impact of SEPA

First Data's John Chaplin, speaking at the Digital Money Forum in London, makes eight predictions on the impact of SEPA. Before I go through the predictions, I want to first say that the arguments were quite intelligent and persuasive. I found myself analyzing each prediction as John made his argument, then switched and began analyzing why John, as a First Data executive, would be making the prediction. You really can look at each of these predictions on both levels, as a general idea, and then why the prediction is important to First Data.

1 - Every part of the cards business will change. Some banks feel that they won't be impacted by SEPA, or that they are already "SEPA compliant". John's advice: "Think again."

2 - Interchange will survive but at a much reduced level in many markets. Most markets will likely evolve towards the French market, where merchants pay low interchange fees on debit, and consumers pay an annual fee of around 30 Euros.

3 - Many national payment schemes will disappear and MasterCard and Visa will become even more powerful brands.

4 - At least one European debit card brand will emerge and will take at least 15% of the market within 5 years.

5 - Many national processing companies will become uneconomic and cease to exist in their current form. "30 companies doing inter-bank processing in Europe cannot last. Lots of these national processing infrastructures are going to disappear."

6 - Card schemes providing processing will be forced to change and will have to chose what they want to be.

7 - Increased regulatory intervention will happen, as self regulation will not deliver results fast enough. Does anyone really believe that if you are a monopoly in Greece or wherever, that you will happily open up to other networks, processors and brands if you are not forced to?

8 - Large banks and some non-banks will aggressively exploit SEPA freedoms and opportunities.

John throws in two jokers that could disrupt all of these predictions:

1st joker - The European Commission abolishes interchange. The EC is already very angry with MasterCard and could just go ballistic with all interchange models and simply abolish the practice.

2nd joker - Rapid convergence of debit card and ACH processing. These are managed separately today, but they could conceivable converge, and bring about disruptive change.

Where is SEPA taking us? Will there be a third debit card scheme in Europe?

Charles Bryant, of the EBA got this question from the floor at today's Digital Money Forum: "Will there be a third debit card scheme in Europe?"

Answer: "My gut feel is that yes, there will be. It will be a simple debit card, with an acceptance brand, and will combine all of the national brands that exist today. But everything is frozen right now, due to things like interchange uncertainties, the current economic climate, and so forth. The jury's still out, but my gut feel is that yes, there will be a European debit scheme."

The idea of a European debit scheme competing with Visa and MasterCard is a very emotional subject, and the comments here kind of highlight that. At a gut level, yes, many Europeans would like to see such a scheme. But on a cold, pragmatic, business level, it is harder to see how to justify such a brand. What pain would a third brand address? Whose pain would that be? This is not clear to me at all.

Forum Monétique 2008

Voici la présentation de mon intervention hier à Paris, au Forum Monétique 2008.

Le titre: Comment valoriser le paiement auprès des commerçants? Peut-on renverser les tendances actuelles?

SEPA, co-branding, lobbys de commerçants, consolidation des processeurs,… autant d’initiatives et de pressions qui mènent à la baisse des revenus des banques acquéreurs. Quelles sont donc les initiatives visant à développer une stratégie de valeur ajoutée pour les commerçants? Les pilotes sans contact ou NFC répondent-ils à l’attente des commerçants et permettent-ils de renverser les tendances actuelles? Comment tirer plus de valeur de la transaction de paiement et réduire la pression sur les prix?

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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 Amazon.com 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)

Uncovering the hidden value in interchange fees

OK, I know that’s a provocative title, but bear with me.

My last post showed how printing targeted promotions at the bottom of POS receipts costs merchants a few cents per impression versus close to a dollar for traditional direct marketing campaigns. The customer checking out right now hasn’t been here in over a month? Print a special offer to encourage him to come back in the next few days. Try doing that with direct mail. And imagine how much it would cost.

Substantial savings are possible because of hidden value in the payment transaction, or in other words, hidden value within the interchange fees paid by merchants.

Let’s take a hypothetical fast food chain, convenience store chain and supermarket chain, with average transactions of $7, $20 and $30. These retailers are probably paying average interchange fees per transaction of 25¢, 60¢ and 80¢ respectively. Merchants think of the fees as a “hidden tax”, and they compare them with utilities like electricity, water and gas. Banks need to focus much more on the marketing value of their services, and get merchants to see payment as another marketing and advertising channel rather than simply a tax or utility.

But it might be too late for this to help protect interchange. Banks too often see interchange as purely a legal issue. The industry as a whole is not moving fast enough to build new value linked to those fees. It’s possible that interchange will continue getting clobbered all over the world, and cut to a fraction of current rates. In their place, new fees will arise for the marketing features that some of the more nimble banks will add to their merchant services offerings. In other words, the financial value hidden within the payment system would shift from issuers to acquirers. Now that would be revenge for the banks that went against conventional wisdom and kept their acquirer activities over the past decade, wouldn’t it?

Acquiring margins are squeezed, yet profits are up – what’s the story?

The average interchange rate in the US has increased by 22% in ten years, yet total actual fees charged to merchants, including interchange, have only increased by 11% (see Aite Group report, An Acquiring Paradox: Discounts Are Squeezed, But Spreads Are up). Acquirers appear to have swallowed a large portion of the increased interchange by lowering their own transaction fees, presumably in response to merchant pressure. It’s tough being on the front lines.

“Back in 1995, the average discount rate, or the charge to merchants for card processing as a percent of the sale, was 1.87%, with 1.4% for interchange and 0.47% for the acquirer. Interchange is a component of gross revenue that acquirers must pass on to card issuers, so the acquirers’ share of discount revenue was 25.1%. In 2004, the average discount rate was 2.08%, with interchange accounting for 1.71% and acquirers’ revenues 0.37%. That means the acquirers’ share was 17.8% of discount revenue.”

Why have acquirers agreed to this? Do they enjoy being squeezed? Obviously not. Some have managed to work their way around the problem. The Aite report points out that some acquirers have compensated by adding administrative fees, application fees, statement fees, and lots of miscellaneous fees. So merchants now pay for things that used to be free, or rather were implicitly included in the acquirer’s transaction fees.

As interchange gets challenged and cut around the world, acquirers may have more room to breathe and may be able to further develop services to merchants, for additional fee revenue of course. When interchange goes down dramatically, some merchants could be willing to spend more on other services provided by an acquirer. These merchants would be spending less overall than they were in the past with full interchange, yet they would be getting more value out of electronic payments. Basically, they could be enjoying lots of new services for free. In this scenario, the value would come from acquirers, not issuers, and would be reflected in the acquirer’s portion of revenues, not interchange.

Here’s a wild idea. Imagine that an acquirer provides a new service that helps merchants encourage customers to use their debit cards rather than mileage heavy credit cards. An automated steering feature. Merchants benefit by cutting the overall cost of payment processing, since there would be fewer high interchange transactions. The cut in costs could more than justify merchants paying an additional fee for the acquirer’s service.