When Square Inc. debuted its mobile payment dongle in 2010, some industry pundits did not expect the startup to succeed. However, the Jack Dorsey co-founded company is still around and as prominent as ever in the public's eye. And it seems a certainty that the aggregation business model, popularized by Square, is here to stay.
Certainly, aggregation has technological and business challenges for anyone who wants to adopt it, but it promises increased efficiencies for merchant service providers (MSPs) and a significant class of small and midsize merchants. As the new year dawns, ISOs can do themselves a favor and investigate aggregation to see if it fits within their merchant portfolios and adds value to their product offerings.
Payments consultant Todd Ablowitz, President of Double Diamond Group, distinguishes merchant aggregation from transaction aggregation. An example of transaction aggregation is when several small-dollar transactions from an individual cardholder are added up and then processed as a single payment when a certain total dollar amount is reached. Apple Inc. employs this process when its users make 99-cent music downloads via iTunes accounts, Ablowitz said.
But merchant aggregation is different. It is where an MSP pools merchants into one account instead of giving each merchant a separate account. This, of course, is an over simplification of the process, but its advantages are evident. Merchant boarding is quicker on the front-end, and MSPs can more efficiently manage merchants on the back-end. "It simplifies things up and down the line," Ablowitz said. "There is no doubt about it."
When an ISO becomes an aggregator, the ISO, in effect, becomes the merchant of record in relation to the ISO's sponsor bank. The ISO's merchants then become sub merchants, with their transactions processed and settled through one account.
But not every merchant can be aggregated. The card brands have set up a $100,000 cutoff point for individual merchants. Businesses that exceed that yearly payment processing threshold cannot be aggregated and must have their own merchant accounts.
Ablowitz summarized the puzzle pieces an ISO needs to become an aggregator. "You need to have a gateway, or have a front-end processing platform or both," he said. "You need to manage the aggregated merchant account, the sub merchants. You need to have tools to get those merchants boarded and underwritten. So there's a lot of different things that you have to do."
Deana Rich, President of Rich Consulting Inc. and specialist in risk, fraud and regulatory compliance, said the risk taken on by new aggregators depends on the original makeup of MSPs. "If they are not taking risk and they are just a sales office, just as if they became a liability ISO, they would be taking more risk," she said. "If, however, they were already a liability ISO, by becoming an aggregator they are simply taking on a different type of risk, not necessarily more risk."
Becoming an aggregator can also involve a significant upfront investment, depending on the MSP's starting point. "If you are a small registered ISO who does not take risk and has 10 employees today, it's probably a relatively large investment for you," Ablowitz said. "On the other hand, if you are currently taking risk in your ISO, it may not be an enormous investment for you. It just depends on what your approach is, how much different it is from the things you do today and what the ROI [return on investment] is on the opportunity that opens up for you."
If the typical ISO is like a methodical accountant in the way it boards merchants and assesses risk, the aggregator is more like a skydiver who jumps out of the plane without first testing the parachute. It is why, in the aggregation model, the merchant boarding process is so simple and refreshing from the merchant's perspective; instead of having to fill out tedious paperwork and divulge detailed financials as a condition of being set up with a merchant account, a little general information is collected upfront, and the merchant is boarded in minutes.
Aggregators thus assess the risk of merchants over time and on the back-end. "Since there's no transparency, the ISO's going to have to make sure that they've got checks and balances to determine if the merchant changes from what it's saying that it is, say, from a window washer to selling drugs out of his house," said payments attorney Zahara Alarakhia. "There's really no way of knowing that until you look at the transactions and see how much would a window washer make selling washing services out of their house versus selling drugs out of their house."
Just because aggregators board merchants in a different way, they are not immune from complying with federal Know Your Customer requirements and other fraud mitigation regulations. "[In] the Square model, the true aggregation model, knowing your customer rules, all the credit underwriting with respect to the sub merchants, is still there," Alarakhia said. "You just do it over a longer period of time rather than prior to providing an account to a merchant. You still have to get it done."
Potential aggregators should also be aware of a movement underway at the state level to regulate aggregators as money transmitters. In January 2013, Square was slapped with a cease-and-desist order by the state of Illinois for not complying with its person-to-person money transfer rules. Aggregators may one day have to pay annual money transmitter fees to do business in each state, according to Alarakhia.
Alarakhia noted that, in order to be profitable, aggregators must have more transaction volume than traditional MSPs, since the amount of payments per merchant is, by definition, lower in the aggregation model. But payment software developer PayCube Inc., which builds proprietary technology infrastructure such as gateways and mobile wallets, believes ISOs can make more money in the long run by becoming aggregators.
PayCube Principal and co-founder Mustafa Shehabi said the typical ISO is a reseller of the payment processor's services. "They are completely devoted to just making the sale happen and collecting the residuals as part of the transactions happening between the merchant and the processor," he stated.
In Shehabi's view, the traditional ISO is just the facilitator of transactions, "not a player in the middle of the life of transactions." But an ISO that becomes an aggregator takes a central role in that lifecycle.
"The merchant's transactions come to you as an aggregator," Shehabi said. "And you actually send that transaction to the processor for authorization. And therefore, when the processor issues the settlement funds, it sends the funds to the aggregator, not the merchant. … And then the aggregator does its own settlement to divvy out what belongs to merchants."
It follows that by becoming an active participant in the transaction flow, aggregators make bigger profits. "Obviously the more you do, the more you get paid," Shehabi said. "It's a financial step up."
Beyond the financial benefits of aggregation, the model may provide the most valuable commodity of all self sufficiency. ISOs that resell the services of third-party vendors are beholden to those vendors; it is not the strongest position to be in, especially during uncertain and volatile financial times.
"They are not able to control their destiny," said Chandan Mukherjee, also a Principal and co-founder of PayCube. "But you need to control your own destiny in today's marketplace. Because gross margins are falling, gross margins per transaction are falling and attrition is going up. If you want to control your own destiny, controlling your own technology is imperative."
Shehabi noted how the aggregation does just that. "Merchants are the most slippery customers ever, and they will leave you in a heartbeat," he said. "When you are providing the technology behind it, when you have the solution going from you, you have much larger stickiness with that merchant, and therefore the merchant is not likely to abandon you."
Aggregation is also a big data play. Shehabi said, "If you are a player and the transactions are coming to you, it starts to open up in terms of the loyalty, the couponing, the incentive programs and all the statistical BI [business intelligence] information you can pick up. So there is a lot of additional juice that you can now extract out of those transactions."
Ablowitz put it bluntly. "I don't think you can succeed in the years to come without taking an aggregation model or a model that uses some of the hallmarks of aggregation, like frictionless boarding," he said.
Ablowitz pointed out that Square was not the originator of aggregation, as PayPal Inc. had been aggregating since the late 1990s. In those days, aggregation was generally frowned upon by the card brands. Merchants without electronic processing accounts would piggyback off of merchants that had such accounts; for example, a shoe store owner without an account would go to the bookstore next door to run transactions.
In 2002, the card companies developed Internet payment service provider rules to regulate the growth of aggregation. But Ablowitz said the rules were restrictive and burdensome. Then Square came along, incorporating in 2009 and rolling out its first products in 2010, and the landscape changed.
Ablowitz thus called Square the "godfather of the renaissance of the aggregator" and it confronted the industry with a fundamental question. "Why we are asking all these tiny little merchants so many questions?" Ablowitz said. "Why do we have 250 fields on an application versus Square asking 14? If they can do it, and they believe that the risk is manageable, why can't we?"
But Square ran into problems in 2013. Merchants complained that lengthy holds were being placed on their funds, resulting in Square eliminating those holds. Square has also gained a reputation for poor customer service, with merchants only able to get help from Square via email.
It should not be lost on the establishment that the very processes Square has trouble managing are the hallmarks of traditional ISOs. "There is no rule that says you cannot answer the phone," Ablowitz said. "And that's the differentiator that the people in our industry have. That's exactly what makes us the right place to serve small merchants and take a page out of these other guys' book."
Square has even taken a page out of the ISO's book and focused on getting a toehold in the old fashioned brick-and-mortar world. The San Francisco-based company launched its own POS service, Square Register, in 2011, and enhanced it with Square Stand in 2013. Square also partnered with Starbucks Corp. in 2012 to allow customers to pay for coffee and pastries with Square's mobile wallet.
Square is looking more and more like a typical payment provider, and its original dongle-based service looks less important to its future. "[The dongle] was a great way for them to market themselves as something different, whether it was profitable or not," Alarakhia said. "It was a way of getting them into the marketplace, and now they are actually offering products and services that are the typical products and services that are in the ISO market right now."
ISOs can use aggregation in a similar fashion, as a jumping off point for climbing the payment value chain. "Whole new [possibilities] open up in front of an organization when it converts itself from an ISO to an aggregator, from an aggregator to a gateway, from a gateway to a processor," Shehabi said. "And we keep going."
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