This story appears in the March 2009 issue of Cards&Payments.
A fresh crop of alternative-payment systems seeking to bypass interchange and the prospect of renewed interchange-rate regulation could intensify the rising threat to U.S. card issuers' credit and debit card revenue.
Most of the alternative-payment systems are startups led by entrepreneurs, but processing giant First Data Corp. is behind one new project getting attention. And although alternative-payment schemes have struggled for years to gain a foothold, some experts say these ongoing efforts, combined with continued growth of existing alternative online-payment schemes, may begin to take a measurable bite out of issuers' interchange revenue within a few years.
Most of the latest examples are powered by less-costly automated clearinghouse networks instead of traditional card networks. They include Shell Oil Products US's Shell Saver Card, issued in conjunction with First Data; an on-us debit network concept crafted by startup Bling Network Ltd.; and the recently renamed National Payment Card Association, which initially is targeting gasoline retailers with a low-cost debit payment card (see chart).
Though the economic downturn is pushing more consumers to use debit payments to manage expenses, this trend also may favor some of the new debit-based payment models. "These alternative-payment schemes will not replace (interchange) anytime soon, but they will certainly start gaining market share at the expense of the current system," says Adil Moussa, an analyst with Aite Group.
Even more ominous for issuers is the possibility that lawmakers this year again may consider legislation to rein in interchange (see story).
The latest alternative-payment schemes capitalize on merchants' complaints about interchange expenses they say are too high and cut more deeply into their profits each year. They harness automated clearinghouse networks and the Internet to bypass traditional card networks and the interchange rates they set. Some use new contactless-payment technology or convert existing plastic in consumers' wallets, such as merchant-loyalty cards and driver's licenses, into debit cards that operate apart from traditional interchange-based card networks.
Card networks Visa Inc. and MasterCard Worldwide set the interchange rates that determine how much of the sale card issuers should receive. Merchant acquirers pay issuers interchange and incorporate that cost into the discount rates they charge retailers. Credit card interchange rates average about 2% of the purchase, while debit interchange rates can range from about 50 cents for PIN-debit transactions to about 2% of the sale for signature-debit transactions, but some rates in some merchant categories are even higher.
American Express Co. and Discover Financial Services set their own merchant-transaction prices, although Discover allows merchant processors to negotiate prices with smaller retailers.
The Merchants Payments Coalition, which represents 2.7 million U.S. stores and is affiliated with the National Retail Federation, estimates that interchange fees cost retailers $48 billion last year, up from $42 billion in 2007. The coalition bases its estimates on historic averages.
The merchants group is lobbying lawmakers to force card networks to reduce their interchange rates. Interchange expenses, they say, cut deeper into retailers' profits every year, hurting consumers in turn because they ultimately pay through higher prices for products and services.
"The average U.S. household ends up paying about $427 extra each year, which goes to issuers in the form of interchange, and it's unacceptable," contends J. Craig Shearman, federation vice president of government affairs.
Tolan Steele, Visa head of global interchange strategy, counters the notion that interchange rates have increased. Visa's average interchange rate for all transactions, including credit, debit and commercial cards in all merchant segments has stood at 1.61% since 2007. That price reflects the cost of providing security and fraud protection for card issuers and consumers, he tells Cards&Payments.
"More merchants than ever are using the Visa system because of the conveniences it provides to merchants, Steele says. "Payment volume is growing, but interchange rates are not accelerating."
The existence of a growing number of alternative-payment schemes that bypass interchange is proof of a competitive system, he adds.
Alternative online-payment schemes have gained significant ground in recent years ("Online Payment Brands Grow: Should Issuers Feel Threatened?" June 2008). EBay Inc.'s PayPal shows the greatest near-term growth potential, says Red Gillen, an analyst with Celent LLC.
If present trends continue, by 2012 banks will collectively see a decline of $1.2 billion in interchange revenue as more merchants accept alternative online payments, he says.
But the online retail industry accounts for less than 10% of total retail sales, according to the National Retail Federation, and e-commerce growth rates are slowing as the Internet matures.
Far more merchants could achieve interchange-rate relief if a critical mass of alternative-payment schemes emerged for brick-and-mortar retailers that use the less-costly ACH network rails. But such schemes suffer from a lack of brand recognition, a broad acceptance base and consumer inertia, says Bruce Cundiff, research director at U.S.-based Javelin Strategy & Research (see chart).
"Consumers don't care about interchange," he says. "There has to a really powerful incentive for the consumer to change behavior and a unique merchant-loyalty angle to make it worthwhile for merchants to make changes at the point of sale."
Results of independent ACH-based debit-payment schemes are mixed so far.
Tempo Payments Inc. developed an alternative debit network several years ago, offering merchants transaction rates equal to about half the cost of bankcard interchange. It reached acceptance through some 200,000 retail locations before the company abandoned the concept last year.
"We realized it would take too much time and money to build an alternative payment network from scratch," says Mike Grossman, Tempo CEO. Tempo continues to support Mastercard-branded decoupled debit card products, including one with HSBC-North America Inc.
Revolution Money Inc.'s RevolutionCard debuted in 2007, promising merchants a transaction rate of 0.5% of the sale through an Internet-based credit card. The company struck a deal about a year ago with Fifth Third Bank Processing Solutions to help push merchant acceptance, but the card appears to have hit a plateau at some 300,000 undisclosed merchant-acceptance locations. The company will not disclose the number of consumers that have signed up for RevolutionCard.
But a few new entrants are hoping to succeed with mass-marketed alternative-payment schemes for brick-and-mortar retailers. An advantage this time around could be a recent shift by some consumers from credit to debit payments to control their day-to-day spending during the economic downturn.
Indeed, this behavior shift could open doors for alternative-payment players, Cundiff says. "A lot of consumers are having trouble getting credit, and some have decided they don't even want to use credit," he says. "This shift is a big deal. It presents some opportunities for innovators."
And not just for new players in the market. Shell in January launched the Shell Saver Card at 14,500 Shell-branded gasoline stations, promising to halve the retailers' transaction costs. First Data processes Shell Saver Card transactions through the ACH system. Its TeleCheck subsidiary authorizes and guarantees Shell Saver Card transactions, and merchants receive payment within a day.
Customers can obtain the Shell Saver Card at Shell retail outlets and must sign up online, where they provide checking-account information and select a four-digit PIN. Shell is offering a discount of five cents per gallon on gas with each Shell Saver Card purchase through June; afterward the discount goes to two cents per gallon.
Shell stations on average pay about 2% of the sale for all non-Shell general credit card transactions, says Elizabeth Hudson, Shell manager of U.S. consumer cards. Transaction fees for the Shell Saver Card transactions are about half that, she says.
"Our retailers tell us that interchange-based transaction fees are their second-highest expense, right after labor, and that gives them heartburn," Hudson says.
Shell retailers also accept the Shell MasterCard and its proprietary Shell card, which charge zero transaction fees. Citigroup Inc. issues both cards, and Shell declined to disclose volume or receivables on those card portfolios.
As many as 60% of consumers do not qualify for those cards because of worsening consumer finances and the credit card industry's tighter credit standards, Hudson says. Moreover, many consumers seem to prefer debit more so than in previous years, she says.
"We're capitalizing on debit's momentum by touting the fact that the Shell Saver Card links directly to your checking account," Hudson says. Although Shell will not release numbers, Hudson says the Shell Saver Card so far has exceeded company expectations.
The Shell Saver Card uses a magnetic stripe, but First Data says ConnectPay can also support bar-coded cards or the contactless Go-Tag that First Data introduced in August. Go-Tag uses radio frequency identification technology and offers supports merchant loyalty programs.
"Getting more-powerful loyalty mechanisms is almost as vital to merchants as lowering transaction costs," says Mark Wallin, First Data general manager for TeleCheck and ACH services. First Data has conducted ConnectPay tests with undisclosed merchants, and "strong interest" exists from other petroleum and supermarket retailers, he says, declining to name them.
The Shell Saver Card is a solid example of a merchant committing to an alternative payment scheme, although its long-term success remains to be seen, Cundiff says. "First Data is hoping Shell's effort will breed trials with other merchants," he says.
Paying With Driver's Licenses
National Payment Card Association, another scheme launched a few years ago, offers an ACH-based debit payment card program primarily to gasoline retailers, harnessing customers' driver's licenses or existing merchant loyalty cards as payment cards. The company sees its advantage in that merchants offering the service need not issue any new cards to customers.
Struggling to get off the ground since 2004, the company this year received a $2 million investment from venture-capital firm KPG Ventures LLC. It plans to use the funds to expand into the supermarket and chain drug-store channel.
Customers enroll with National Payment Card by linking the mag-stripe data on their driver's licenses to their checking accounts through an Internet site, by telephone or by mailing in information from a cancelled check. Participants then swipe their driver's license, or a merchant-supplied card, through a standard point-of-sale terminal and enter a PIN to pay for merchandise.
Nineteen states, including Texas, California and Florida, provide driver's licenses with mag-stripes.
Merchants pay an average of 19 cents per debit transaction, enabling them to feed instant rebates on purchases back to consumers, says Joe Randazza, National Payment Card president and CEO. "Merchants save an average of 40 cents per debit transaction under our program, and most of them are giving it right back to consumers with a discount of three to 10 cents off per gallon of gas."
National Payment Card settles its transactions in batches within a day, and various check-guarantee companies guarantee them, Randazza says.
Although Randazza will not say how many consumers are enrolled in the program, participating retailers report strong growth and increased loyalty, he says, noting National Payment Card will process $400 million in debit transactions this year.
Cundiff is doubtful that National Payment Card will catch on nationally, however.
"Consumers have shown hesitation to use branded merchant loyalty cards, and now we're asking them to pay for stuff with their driver's licenses? I find it hard to make that leap," he says.
Another organization helping merchants bypass bankcard interchange, Bling Nation Ltd., hopes to bring community banks together with merchants to create local on-us debit networks.
"The Visa and MasterCard debit model is scaled to drive profits for very large banks, acquirers and processors, while community banks make very little money on debit or it's a money-loser for them," says Wences Casares, Bling co-CEO. "We want to bring debit transactions down to the local level so that community banks are not paying for global payment systems and big banks."
Bling eventually plans to process debit transactions for merchants within a community bank's region using contactless chips equipped with Near Field Communication technology embedded in mobile phones. But until such phones become available, consumers would use a contactless sticker, or Bling Tag, attached to their mobile phones to initiate payments, Casares says.
Initially merchants would need a special reader to accept Bling transactions, but the company says it is working on technology to adapt existing terminals to accept Bling.
Participating Bling merchants would pay 1.5% of the sale. Bling would keep 0.3%, and the rest would go to the issuer. Approximately 0.25% would cover transaction costs, leaving 0.95% as profit for the issuer.
Casares says that, under a signature-debit transaction with the highest fee of 3%, including terminal costs, approximately 1.51% goes to the acquirer, 0.09% goes to the network, 0.92% to the processor and about 0.25% covers the transaction cost, leaving 0.23% as profit for the issuer. Bling can connect to banks through an ATM-network switch, on online-banking provider or a core processor.
Bling's concept has gained attention partly from the cachet of its advisers, which include former Citibank Chairman John Reed and former American Express Co. President Jeffrey Stiefler. Cundiff, though, is skeptical about its chances.
"It's asking a lot of merchants to put the burden on them to change consumers' behavior at the point of sale," he says.
But economic and technology trends favor alternative-payment schemes in the long run, says Bruce Parker, vice president of strategy and innovation for banking software company ACI Worldwide. "We are seeing a surge in debit payments, with mobile payments expected to take hold within a few years," he says. "That combination of conditions is ripe to create major opportunities for alternative payment schemes in the future."
The hurdles facing startup alternative payment systems today are high. It is unlikely that any will achieve enough penetration on a mass scale in the near future to threaten mainstream card networks or their interchange models. But the collective effect of online and brick-and-mortar alternative payment schemes may one day prove significant and should not be ignored. CP