No Interchange

If you’re even remotely associated with the world of payments chances are you were watching or atleast curious about the Federal Reserve Board meeting yesterday to announce the final version of VISA/MC Debit card fees rule commonly known as Durbin amendment.  Durbin amendment is referred to as the piece of legislation appended to The Dodd-Frank Wall Street Reform act which basically slashes the fees on Debit cards by about 50% and mandates a host of other criteria for processing VISA/MC Debit card transactions. Life will never be the same again for Banks that issue these cards and the Merchants that accept them.

But first some Background (if you’re in Payments space, skip this): Merchants pay a fee to VISA/MC everytime somebody uses a Credit/Debit Card to purchase goods/services. This fee is called “interchange” in payments parlance. When VISA/MC came into being in late sixties/early seventies these fees were as high as 5-6% on average. Today the interchange fee is about an average of 1.7-1.8% and combined with various other fees that Merchants need to pay for accepting VISA/MC the total fees for a Merchant accepting plastic could be anywhere between a low of 2% to high of 7%, generally larger the Merchant, smaller the total fees. The fees on VISA/MC branded Credit Cards is generally higher than VISA/MC Debit Cards but regardless of Credit or Debit Merchants need to pay a fee to process card payments. Clearly these fees are an impediment to open commerce, however they are source of big revenue for big banks (the issuers of Credit and Debit cards, more than 99% of all VISA/MC branded cards are issued by less than 1% of the banks ).

And now a little bit of History: VISA (and Mastercard ) started in the late sixties as an offshoot of BankAmericaCard. A man with a formidable personality Dee Hock – an employee of bank in Seattle took leadership and created a “franchise” type model with the VISA logo where other banks could join in the ecosystem thereby effectively “opensourcing” the closed BankAmericaCard. Since then it was phenomenal growth through seventies, eighties and early nineties, unrestrained it grew about 10,000% by 1994.  However outside of VISA/MC domain in the mid-eighties interbank ATM networks started appearing and by about mid-nineties these ATM networks (i.e. Debit Card Networks ) had become all pervasive. VISA/Mastercard fearing loss of business, each bought an ATM card network and re-branded them with their logo (Mastercard bought Cirrus network and a while later VISA bought PLUS network) thus diversifying into Debit card processing. Since Debit cards are essentially Debit there is virtually no risk of Credit default. Moreover the costs of acquisition of a new Debit card customer is lower than that of the Credit Card customer so the fees for processing Debit cards should be lower (since high acquisition costs by banks is often cited as the reason for interchange fees). However VISA/Mastercard applied virtually similar fees on Debit cards as they did on Credit Cards citing their “brand value”. The Debit card system has seen phenomenal growth in the past 15 years. In 2008 total amount of Debit card transactions at VISA surpassed the amount of Credit Card transactions. Given the aftermath of financial crises there was an additional shift of Consumers to Debit over Credit (avoiding the fear of being trapped in a Credit trap ) during 2008/9 and Debit surpassed Credit in all metrics. Infact only ACH system remains a larger payment system than Debit now that Credit is beaten.

The heat really started in 1996 when attorney generals of various States sued VISA/MC on anti-trust grounds. Additionally Merchants led by Walmart filed a parallel class action lawsuit. Since 1996 there is an ongoing war, between the Merchants and Federal and State governments on one side and Banks and Card Associations (VISA/MC) on the other, to lower these fees, with multiple battles being fought and most ending up in victories for Merchants. The lead counsel from the States side was Llyod Constantine who chronicles the anti-trust litigation against VISA/MC in his book “PRICELESS: The Case That Bought Down The VISA/MasterCard Bank Cartel, Kaplan publishing”

But on June 29^th,2011 this war ended. Yes the fees on Credit Cards as well Debit Cards are still around but you see – the future of payments (both offline, known as CP i.e.  Card Present and online, known as CNP or Card Not Present ) has moved to a different paradigm. A paradigm where interchange fees are becoming irrelevant and need to be supplanted with new sources of revenue.In light of Fed’s decision on Jun 29th on lowering and essentially capping Debit card processing fees, I believe the larger issue of Durbin amendment will be the overall shift from processing fees to “value add” fees.  But first lets look at what the final rule from the Fed says: On December 16,2011 the Fed issued its draft proposal which calculated the average Debit transaction to be about $38 and average interchange fees per VISA/MC branded transaction to be about $0.44 (I am simplifying things here, the actual fee varies depending on whether the Consumer signs the payment slip or pays using a PIN and host of other factors ). It basically proposed capping the fees between $0.07 to $0.12, slashing them by almost 75% citing the legislation’s mandate of “fair and reasonable” in proportional to cost. It left the proposal open to comments form public and all interested parties till about Feb of this year.  And comments it did receive -  more than eleven thousand of them. Basically the “Durbin Drama” has been playing out like a soap opera since the beginning of the year. There have been debates galore, litigation filed in courts – which recently was thrown out by the courts, extensive lobbying in both house and senate to introduce bills to delay it culminating in the Tester amendment which didn’t pass the Senate as it failed to muster the 60 votes needed.  And why shouldn’t it – at stake were about $15-$20Billion in annual revenue.  The short of it was an intense cry and lobbying from the banking industry including small mid-sized banks (which were exempt in the Durbin amendment i.e. the fee reduction would not apply to them but they nevertheless felt threatened) and counter crys from Merchant lobbies which left the Fed in an unenviable position trying to please both.  Additionally the initial draft proposal did not take into account fraud protection and reduction fees and a host of other “auxiliary” costs e.g. actual card issuance, chargeback fees etc. Almost as result when the Fed announced the final rule yesterday it took a “half-way” approach by capping the rate at $0.24 ($0.23 plus a penny for fraud protection) and ad valorem 0.05% of transaction.  There is an additional clause in Durbin amendment that dealt with providing Merchants a choice of networks to route Debit transactions. The choice of networks is important as otherwise Merchants complained they were held “hostage” to the “add-on” charges of a single network.  The Fed’s decision here is the Merchants must be offered atleast one network that can process Signature Debit and another one that can process PIN debit. The changes are supposed to take effect Oct 01,2011.

Now, unless you are directly employed in the Debit card division of a major bank the question that immediately pops-up in everyone’s mind is – “what’s in it for me ?”

The answer unfortunately is “not much”. You see, Merchants lobbied for reducing the fees on Debit cards saying they’ll pass the savings to Consumers. That was a smokescreen. Don’t expect to see that additional $0.45 you pay when pumping gas using your Debit card, to change. Firstly the actual reductions that get passed to the Merchant will be lower than the reduction mandated by Fed since there are other charges that intermediate processors charge Merchants over and above the interchange fee (the total fees are known as Discount fees ). Secondly and more to the point , the Durbin amendment did not legislate that Merchants should pass savings to Consumers. Nothing much will change for Consumers/End-users.

The fun question is how does this affect Paypal, Google Checkout, Amazon Payments and the like ? Ah – it gets interesting here.  All these payment systems have intermediated themselves between the VISA/MC and/or ACH payment systems and the Consumer.  Now, we here in Silicon Valley have a habit of comparing anything and everything in payments with Paypal but first some numbers for calendar year 2009:

Type                             Volume (Trillions)            Transactions (Billions)

Credit Card                 $1.9                                       21.6

Debit Card                  $1.5                                       37.9

ACH                             $37.2                                    19.1

Paypal                         $0.07

(source: Federal Reserve, 2010 payments study)

Of the total approximately $4T in dollar volume of Credit/Debit cards the total volume of online/ecommerce in USA is anywhere between $300-$500B depending on whose report one goes by. Which in percentage terms is about 7-10% of total payment processing volume. Paypal’s volume (Paypal branded volume, excluding its non-branded gateway) for last coresponding year is appx $71B, say half of which is from the US.  So as percentage of total payment volume Paypal is less than 1% , even as percentage of total ecommerce volume is about 8-12%. In other words while Paypal (and others in this space combined) are considered behemoths in the valley the Fed basically ignored them. It did solicit comments but in final version of the Rule Paypal will reap a windfall somewhat like large Merchants. So is all hunky dory ? Not really. The bonanza for Paypal will be limited, mostly because Paypal has already done everything it could to steer Consumers to pay using their bank account (which saves Paypal the interchange fees for VISA/MC ) and already factored it into its business model i.e. appx 50% of the Users use bank accounts to pay. Of the remainder the benefits will accrue only for those using Debit Cards and not Credit Cards.

However there is one more thing – lost in the din over Durbin. The preferential placements of payment options and more importantly incentives/discounts for preferred payment options. For the longest time retailers were prohibited to offer either incentives or discounts or cash surcharge the Consumers for using one payment system over another. E.g. If I chose to pay by VISA the Merchant was prohibited from charging me extra i.e. a surcharge as opposed to paying by cash (which is cheaper for the Merchant to process – the notable exception this are gas stations charging less for cash – but that’s an exception – not the rule ). Additionally the rule was for online/ecommerce all payment options e.g. VISA/MC, Amex, Alternate payments should be presented to the Consumer in same manner i.e. no preferential treatment or placement online.  Last year Oct 2010 VISA/MC settled with DoJ and rescinded the “equal preference rule” .  I believe this rule has the potential to change payments more than Durbin will. For the first time startups developing new payment alternatives can compete on equal footing if the Merchant is given a choice to pro-offer those discounts/incentive in the way Merchants feel its best for their business.  This is opportunity calling. Reducing fees for Merchants and building a better Consumer experience online is where Silicon Valley startups can excel. In short within the past one year the changes in payments domain make it exciting again. The innovation is just starting to happen, it will rock the the payments world.

Advisers/Investors/Friends:

This Wednesday Nov 18,2009  American Express  announced it was acquiring Revolution Money for approximately $300M. It did not say whether the purchase will be all cash, all equity or part cash part equity.

The announcement was sudden but not entirely surprising. Happy that the founders/employees of Revolution Money got an exit. The fruits of the merger will take time but there is an immense hunger in the payments industry for anything new. If anything this transaction proves that demand for an alternate way to pay remains high on the Merchant as well as Consumer side. Here’s a pre-lim and informal analysis.

To understand where Revolution Money was about lets ask a few basic questions:

1) How many transactions had Revolution Money actually processed  ?
2) How many  Merchants/Social Networks were using it online ?
3) How many Revolution Money consumers were issued cards with lines of credit underwritten by a bank ?
4) Which Merchants/POS were using it offline ?

The answers to first three questions is “not many” , actual numbers not disclosed but piecing together from various  analysis looks less than hundred thousand. The total number of transactions processed using a Revolution Money card online or offline was minuscule. In various interviews Revolution Money reps claimed claimed that they are “putting 6000-8000 new accounts on the books each day” This statement was cleverly worded to say the total number of potential users and transactions as opposed to the number of actual users who had done atleast one transaction. The only significant online site (there were multiple offline sites but this is the only online one I know)  to accept Revolution Money was buy.com However the number of users actually transacting at buy.com using Revolution Money was less than 1% (I cannot cite a source for certainty since its based on second hand information – but came from the right direction )

The answer to the forth question is significant number of Merchants had the capability to accept Revolution Money (Revolution Money claimed almost 1 million merchants given their relationships with third party processors e.g. Paymenttech etc.) however there were hardly any Consumers with Revolution Money cards. The number of Consumers were likely less than tens of thousands (classic chicken and egg problem )

In addition Revolution Money tried launching a  facebook application which really went nowhere inspite of a  $25 bonus to sign up. The online P2P money transfer service was launched on AOL online messenger (given that Steve Case was one of the initial investors) and given AOL’s own shrinking share the uptake was low (again Revolution did not publish any actual transaction numbers ). The numbers published by Revolution Money claimed over 400,000 users signed up using the $25 bonus but they never mentioned what percentage of those users who actually made a transaction.

A little bit of history:

Revolution Money started as GratisCard and after extensive market studies/research in 2006 formally announced itself on Mar 23, 2007 in WSJ and Business week with a promise to launch in April 2007. It finally launched in September 2007 as Revolution Money. It announced a  Series B $50Million in funding about the same time. About one and half years later it announced  Series C of $42M which was a flat/down round. Subsequently in July 2009 it raised  another down round for $20M which was not announced publicly. In total the company had raised more than $110M (Series A wasn’t publicly disclosed ) and was valued for less than $200M post series D. On Nov 18,2009 the deal for approximately $300M was announced with AMEX.

The Good:

AMEX gets a platform for launching PIN based debit and an alternate brand name which it can use as ingress point for debit and other forms of Alternate Payments including P2P. Scott Loftesness of Payments News and Jim Breune of NetBanker have summarized it well in their opinions. AMEX hasn’t acquired any substantial number of users through this transaction but simply a platform, however given its captive user base it can use this platform to try out new offerings without cannibalizing its own namebrand. Revolution Money did the best they could given their options.

The Bad:

It is sad that they weren’t more successful and couldn’t fetch a premium. The hunger for innovation in payments remains. That is why AMEX was willing to shell out $300M for a company that likely had less than hundred thousand users/transactions with over $110M raised.

The Ugly:

Revolution money focused on business relationships/channels after raising tons of money and splurging it. (They had brandname board members like Larry Summers etc. which cost heavily ). Users were not there and it wasn’t able to think of innovative ways to get users to transact.  They had the potential to grow much bigger. Ultimately with multiple layoffs and money depleting fast they had limited choices.

Summary:  Revolution Money raised over $110M through 4 rounds over three years and seems to have gotten less than 100K users/transactions (That would make user acquisition cost of $1000+/user). They were able to build a new platform to process transactions and cut deals with various acquirers. Whether this deal will yield benefits for AMEX remains to be seen. I predict limited benefits given the “Enterprise speed” type nature of AMEX. However AMEX willing to pay $300 for a platform means they saw some leverage in scaling what Revolution Money had build and given the hunger for something new in payments were willing to pay premium for simply a platform. Imagine the premium for a company with users and a platform ?

Hello All,

If you are interested in my take on the Billmelater acquisition here’s a quick writeup ( If not – ignore the rest of the message) Hope all is going well.

Monday morning Oct 06th Ebay/Paypal announced it was acquiring Bill me Later for $840M in cash and another $125M in options for a total of $965M. In an year that has not seen any tech IPOs and barely any billion dollar tech M&As this is making  Silicon Valley news. It does seem like a good deal for Paypal and great exit for BillmeLater. Here’s my take on what prompted the acquisition, what it means for the future of online payment systems.

Billmelater (based in Maryland ) – was started in year 2000 by Gary Marino (former VP at Chase Manhattan Bank ) post Chase-JP Morgan merger. Mark Kwatinetz of Azure Capital Partners provided funding after a “re-cap” i.e. repricing the company during the early 2000s tech bust. BillmeLater’s first major client was overstock.com and growth didn’t really start until about 2003-2004. In 2003 revenues were $613K, growing to $54M in 2006 and by 2007 revenues had reached $86M and the company had raised north of. $200M in capital and $500M line of credit (debt).

Paypal’s recent growth has come primarily from providing itself as an alternate payment system of choice at online Merchants. The value proposition is that Paypal increases the options available to consumers and hence (real or perceived) increases sales.

Reasons for acquisition:

Paypal had a debit option (i.e. ACH ) outside of the traditional VISA/MC processing but no credit option. BillmeLater will provide the credit option outside of VISA/MC. It  seems this should help in reducing credit costs for paypal (since it pays VISA/MC for every VISA/MC transaction) but it doesn’t help that much since the bank issuing credit under BillmeLater brand uses VISA/MC type infrastructure and charges only marginally lower than VISA/MC affiliated banks. Its not like Paypal didn’t try this itself – it has a “pay later using Paypal” option  but the uptake there has been less than stellar. Additionally the “footprint” of Paypal’s reach with online merchants was actually smaller than BillmeLater’s given that BillmeLater was able to sign up Amazon (the largest online consumer base) as a merchant. Lately as BillmeLater was gaining merchants Paypal’s and BillmeLater’s salesforces were constantly coming up against each other, so this will increase salesforce efficiency. The biggest gain maybe a reduction of the “sweetener” deals that Paypal was having to cut e.g. with Southwest, Dell etc. where Paypal was selling below cost price, hoping that the number of consumers it would gain would in the long run offset cut throat discounts it was offering to sign up major online merchants (to increase its consumer base).

For BillmeLater this is basically coming of age. Their growth rate while still good was slowing down as they faced the inevitable age slowdown (the revenue growth this year was predicted to be $120-130M). Additionally while having created a large footprint in US they did not have any overseas presence and again this was leading to restricted prospects for long term growth (The credit model that BIllmeLater uses is difficult to implement and scale in other countries). The final straw may have been the looming credit crisis since BillmeLater depended on a single bank issuing credit in realtime by checking various credit related scores; again the “fear” of credit crisis was probably larger than the “logic” of such crises.

What it doesn’t do:

Consumer side problems remain. Since neither of the companies do much to address the classic issues facing consumers in the VISA/MC system i.e. identity theft and fraud resulting from credit/debit card compromise, fragmented incentive system and an obsolete billing system those problems remain largely unsolved. While BillmeLater partially solved the problem of identity theft by not issuing plastic cards it is still susceptible to scams similar to credit card ones since the issuing system is the same with a 16 digit number. Neither of the companies address the issue of a fragmented incentive system (e.g. why can’t I transfer my United award miles to AA and vice versa).

Merchant side Interchange/Processing Fees problem remains as large as ever. In the online world a payment is nothing but a transfer of few kilobytes of data from one end to another and having to pay 2-3% per transaction in today’s Internet age is gross in-efficiency. If anything this acquisition will consolidate the interchange market and frustrate online merchants further with lack of an efficient payment system. In other works the opportunity for an online payment system than can effectively address the interchange issue just got larger!