By Brandes Elitch
CrossCheck Inc.
In the early 1980s, I worked in the cash management group for a major insurance company that was owned by one of the largest financial services companies in the world. The day I started work, they hired the management consulting firm McKinsey & Co. to evaluate the whole operation, top to bottom, and implement something they called "activity value analysis."
The idea was that all employees would keep journals documenting what they did during the day, and it would be a relatively simple matter to calculate inefficiencies and redundancies and take appropriate action to reduce expenses.
Of course, while this was happening, everyone was busy justifying their existence and lost focus on their real purpose, which was to generate revenue, pay claims, and keep the independent agents and regulators happy.
During this time, we employees would exchange meaningful glances and say, "Big changes are coming!" And they were. Within a couple of years, every senior manager of the firm was terminated, from the chief executive officer and president on down. The firm was sold to a German company, and the parent company CEO was also terminated. Big changes, indeed.
Today, as I look at the payments landscape, I see big changes in store for the ISO industry. The underlying causal factors have been in plain view for some time, but now they are apparent even to casual observers.
Let's start with a look at how it all started. In the credit card industry, the focus has always been on the issuing side: how many cards can we issue? This is an industry of tremendous scale: you need to issue tens of millions of cards to garner any kind of meaningful market share, and only a dozen or so banks can do this.
Also, most banks were more comfortable underwriting consumer credit, say, a $5,000 unsecured credit card line, than processing the merchant side of transactions.
Over time, only larger banks could become "principal banks" of what were then card associations, meaning the banks were association members. The largest merchants typically used the largest acquiring banks. Some industries, such as grocery stores and convenience stores, negotiated directly with the associations for special interchange rates.
Smaller merchants typically had banking relationships with community banks that were not principal members, and those banks used upstream correspondent banks or had relationships with third-party ISOs that brought their own processors.
It was like a railway: POS to gateway to processor to network to issuer and back down. It was continuously available and secure, but it was inflexible.
The 1979 advent of electronic ticket capture created the ISO industry as we know it. Suddenly, somebody needed to inventory terminals, program and install them, train merchants, and handle ongoing customer service.
Banks weren't capable of doing this then, and most banks aren't capable of doing it today (just look at the banking industry's anemic efforts to deploy remote deposit capture to date, something that should have been a slam dunk).
While the largest banks focused on the issuing side, the ISOs made it all work, selling merchants on card acceptance and thereby enabling consumers to use their cards at merchants essentially everywhere.
This is the extraordinary contribution ISOs made to the industry. You could say it was the electronification of payments that created the ISO industry, and it is the further electronification of payments that is changing it now.
Some people believe this year is the beginning of the end for the traditional POS platform. Up to now, merchants have paid more for in-store POS devices than it would cost to purchase PCs. But with an Android OS tablet, priced at $100, the numbers have changed. For a small merchant, an Android tablet with a Square Inc. reader can handle all POS functions at a quarter of the price.
Look at what happened in the cash register industry. At first, every merchant had a cash register and a separate POS terminal. The cash register manufacturers figured out they could do both functions, with a big net savings to merchants.
The Apple Inc. iPad was another game changer: for $500, merchants could get touch screen technology, which used to be really expensive. Initially, these were mobile applications, driven by consumers shopping at the POS, and are now online too.
Historically, POS providers seem to have devoted the brunt of their efforts to maintaining their price points rather than dropping prices to be competitive with new devices.
To become competitive, POS manufacturers must move to the cloud, taking the processing out of the store and into data centers. They will have to be compatible with all devices, not build an application for each platform. This changes the POS game in a big way.
Recently, I attended a presentation by Aite Group LLC on this subject. The presenter, Aite Senior Analyst Rick Oglesby, pointed out that for the last 30 years, merchant acquiring has been run like a railway, where the processor specializes in a single type of transaction.
We will need to support multiple transaction types and services, for example, loyalty programs, transaction modifications by third parties like Google, electronic receipts for consumers and reconciliation for merchants, as well as credit apps, rewards, commissions, discounts, offers and coupons.
In the new environment, card swipes will be replaced by taps at the POS. Data will flow back from new payment players that need to be on the back-end of transactions, and this will increase complexity so the back-end software will need a complete facelift. The only way to manage this is to remove the complexity from POS devices.
The result: a gateway will manage the connections to the marketing providers, alternative payment vehicles, devices and the development community. As Oglesby said, "The gateway will be the cable company, and the device will be the cable box."
But the real implication for ISOs is that payment acquiring now becomes the low man on the totem pole. Some merchants will be able to connect directly to the card brands and skip the processors altogether. For ISOs, the goal should be to focus on services, not devices.
Now there are three components to the buying experience: the POS hosting providers, the payment providers and the marketing providers. Large merchants could be processors themselves and do POS hosting, but small merchants will need turnkey solutions, which ISOs can and should provide.
This is complicated by the fact that Visa Inc. will incentivize migration to Europay/MasterCard/Visa and near field communication (NFC) technology to attack counterfeit card fraud.
All three major equipment manufacturers have embraced NFC. For ISOs, this means 11 million terminals in use will need to be replaced. Even at a rate of 2.5 million annual replacements, it would take over four years to complete the conversion to new card readers.
I also want to touch on looming antitrust litigation against Visa, MasterCard and 13 of their largest banks. This is a sequel to the 1996 class-action lawsuit, popularly known as the Wal-Mart case, which cost said card brands and banks $3 billion in monetary damages and over $25 billion in income lost due to changes in business practices (according to Bryan Keane, an analyst for Deutsche Bank).
That case was narrowly defined, and the government did not bring a price-fixing case against the card brands at that time. The plaintiffs in the current case (the National Restaurant Association and the National Association of Convenience Stores, among others), which are not yet certified as a class, claim the card brands overcharged merchants, and that the 2 percent interchange rate typically charged should be in the range of 0.50 percent.
Imagine the impact on the defendants if credit card interchange rates were reduced by 75 percent, to say nothing of the effects on the ISO community.
And if the court finds for the plaintiffs, the damages would come primarily from the 13 large banks that are the Visa Class B shareholders. In 2009, industrywide interchange fees were in the range of $40 billion, and this case could cover eight years.
A finding for the plaintiffs would have a material effect on the capital base of these banks, and it would have a material effect on the income statements for any ISOs focused on interchange. It should be an exciting year.
Brandes Elitch, Director of Partner Acquisition for CrossCheck Inc., has been a cash management practitioner for several Fortune 500 companies, sold cash management services for major banks and served as a consultant to bankcard acquirers. A Certified Cash Manager and Accredited ACH Professional, Brandes has a Master's in Business Administration from New York University and a Juris Doctor from Santa Clara University. He can be reached at brandese@cross-check.com.
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