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Payment Innovation Evolving Within Well Defined Boundaries

R ecently, I put together a presentation for a training class at our company on the evolution of the credit card industry. Do you know who invented the credit card, and for that matter, most of the innovations that are associated with it? It was Diners Club, or more specifically, a man named Frank McNamara, in 1950.

The American Management Association once listed the 75 greatest business decisions ever made, and this was one of them - and yet McNamara left a couple of years later to become an executive in a lumber business. This is a very interesting story, particularly for people in the credit card business. For more details, visit the Web site at www.dinersclubnewsroom.com.

The credit card industry has come a long way since 1950, or to be more accurate, it came a long way from 1950 to about 1979, when electronic draft capture replaced paper tickets. Not much has been done since then, however, unless you count the de facto status of the credit card as the payment medium for the Internet.

I believe that big changes are in store for the credit card industry over the next couple of years, particularly with regard to the "card not present" environment, and they will foster changes in the ISO industry as well.

A credit card works very well when the person and the card are present, and there is a signature. It is, however, designed to work well within certain boundaries:

- Transaction Size: Since there is a discount rate involved, merchants with big-ticket items would not want to accept a credit card. For example, a merchant with a discount rate of 2% would not want a consumer paying for a new Chrysler 300M with just a card; the discount would be $600. - Type of Transaction: The associations have identified a dozen or so categories that they call "high risk." They actively discourage these merchants from settling with a credit card. The associations are getting even more active, to the point of blocking authorizations and imposing massive fines.

- Risk: Being an acquiring bank is a risky business because there is a nine-month tail on consumer chargebacks. The processor or bank (or both, if they are sharing liability) has to underwrite the merchant, just as they would an unsecured loan. This is an expensive and time-consuming task.

- Physical Proximity: The associations have rules that prohibit "forum shopping." That is, if you are in a high-risk business in California and you are having trouble finding a bank to underwrite your risk, you cannot go to Lebanon, for example, to find an acquiring bank.

You would think that this would be obvious, particularly when you consider the risks involved (sovereign risk, currency risk, no generally accepted accounting principles, no equivalent of our Office of the Comptroller of the currency for banking oversight and regulation, potential blocks on convertibility, freezing of accounts, etc.).

However, you have to wonder why this is such a hot topic when the ETA puts on two seminars in a 30-day period on Cross Border Acquiring. (They couldn't get everything into one hour?)

- Aggregators: When merchants cannot get their own merchant account, they go to an "aggregator" to get one. This originally came to pass when advertising agencies/fulfillment houses took on clients in the Mail Order/Telephone Order business.

The agency did the entire campaign for the merchant, including shipping and billing, and found that if it did the billing it could add a spread above the "buy rate" to increase its margin by another 50 basis points. The problem is that the acquiring bank never really knows who the merchants are in the underlying transaction, so the fundamental rule of banking, "Know Thy Customer," is out the window. The associations are now drawing a bead on the aggregators and requiring that merchants have their own account, which will have the additional benefit of highlighting those merchants with high chargebacks.

- Pay Pal: Pay Pal is a fascinating model for a number of reasons, but let's concentrate on how it moves money. Sellers who accept credit card payments must pay 2.9% and a 30-cent transaction charge to Pay Pal. (You might think that this is high, but many small merchants pay as much as five percent!)

The buyer has a choice: pay with a credit card or agree to have a checking account debited. If the buyer chooses the card, Pay Pal has to pay the buyer's credit card company a two percent interchange fee, and after collecting the same two percent from the seller, Pay Pal breaks even.

But if the buyer allows the checking account to be debited, Pay Pal doesn't have to pay the interchange fee (yes, it has to pay a small fee - say, 50 cents - to clear the ACH transaction), and it gets to pocket the two percent from the seller.

Of course, Pay Pal can see the obvious result, and it is moving to "motivate" consumers toward the demand deposit account (DDA) option by offering interest on deposits within the Pay Pal system. Now the company is offering its own debit card and an online bill payment service.

- Technology: The associations are not what you would call technically savvy. The mere fact that they are high-cost providers is some evidence of that, although that is not so important in the ultimate scheme of things when you understand that they are driven by the issuers and that the acquirers take second place, so it really doesn't matter to them, does it?

Proof? Visa's response to high fraud levels for Internet transactions was to propose Secure Encryption Technology (SET), which at the time was about 10 times more complicated than its concurrent rival - remember Y2K? Likewise, other P2B, B2B, smart card and purchasing card pilots have all led nowhere.

- Demographics: Studying demographics is always surprising (and depressing) for a well-fed corporate bureaucrat like me. It is really astonishing that a large number of individuals in our society have no savings to speak of and are really only a few paychecks away from insolvency.

While I have heard association salespeople claim that "72% of all Americans have a credit card," this statistic would make an underwriter in an issuing bank faint dead away. It is perhaps more likely that only about half of the population has a credit card, and it is unlikely that this statistic will change in my career.

Still doubtful? I have two case studies for you: Providian and Nextcard. I hope you didn't have stock in either of those two businesses, each of which trumpeted their "unique ability" to sell credit cards to that segment of the population that has never had one.

Now indulge me while I make a prediction: Insofar as "card not present" payments are concerned, you will see the associations lose significant market share (I predict around 20% to 30%) to DDA-based payment mechanisms, and this will happen in the next two years.

Part of the issue for "card not present" merchants is the ability to access a consumer's DDA account quickly and easily, and to achieve "finality of settlement." This has been difficult to do because of the sheer size and complexity of the number of bank processors and processing systems out there.

And while there have been ways for merchants to cover their exposure to bad checks, there is new technology that will make it easier for check guarantee companies like CrossCheck to manage their exposure, which in turn will make their services more cost effective for merchants with small tickets.

Here are some examples of the new technology:

Indivos www.indivos.com

This company has been characterized as the first truly new payment system since the invention of the credit card. Here's how it works:

The consumer goes to a merchant where he or she shops regularly and is given incentive to enroll in a loyalty program. The consumer then registers with a fingerprint and chooses how to pay for future transactions - swipe a credit card or a debit card, or write a check. On future visits, the consumer goes to a touch screen to order, the fingerprint is automatically captured and the payment is effected behind the scenes. The consumer pays with a fingerprint!

Now if you think this through, it is a logical extension for the merchant to "incent" the consumer to pay with a DDA account as opposed to a credit card. Further, such loyalty programs can be linked to other merchants where the consumer might shop, and the check can be guaranteed.

Please look at this company's Web site, because in this limited space I am not doing the product justice. Identico solves the convenience issue associated with non-credit card payments. Identico www.identicosystems.com

This company solves another traditional problem at point-of-sale: fraud. The consumer registers at the merchant by putting his or her driver's license and check in a reader. The reader captures the image of the person's face and the check information. The next time that person wishes to pay with a check, the merchant (who can be anywhere in the U.S.) swipes the check, which automatically pulls up the image of the person, and it then can be compared to the person standing in front of them.

This solves the fraud problem associated with non-credit card payments at point-of-sale, and it is cost-effective and easy to implement.

Payment Resources International www.paymentresource.com

You really need to look at this Web site, because here is an ISO who has figured out before anyone else that the future lies not in reselling printers and terminals and managing its buy rate, but in providing and managing information for its merchants. Its Transaction Central product is the only example I have seen of this thus far, and it is a couple of years ahead of bank reporting systems for the small merchant.

PRI also has linked this to a wireless payment device, a Palm VII, so that a merchant can get set up quickly and easily, link multiple wireless input devices, and get real-time reporting of all ACH and card transactions. This solves the "ease of use" factor for merchants regarding DDA transactions (PRI can clear these both as a check with guarantee or as an ACH with guarantee).

Global Payment Solutions www.echexnet.com

Madeleine Gestas (415-577-4294) has developed a two-pronged product that will drive consumers to DDA-based solutions.

The first is for consumers without a bank account (and if you think that this is a small market, you are mistaken). The consumers are given a card for free, which they can load in a variety of ways. A second card can be given by the consumer to someone else, who can be in the U.S. or in another country. That person can get the money that has been transferred out of any local ATM. For this ability, the consumer pays a small charge, dramatically less than the current alternatives.

The second product is a way to clear high-volume transactions currently considered "high risk" by the associations as DDA-based transactions on the ATM tracks. Thus, a merchant who is currently paying 4% to clear an $80 transaction ($3.20) will see the settlement charges drop to the $1 range. In the non-face-to-face business, this is a very large part of the overall volume.

You may have read in The Green Sheet that two recent judgments have gone against the associations.

The first cause of action claimed that association rules prevented their member banks from offering any other non-Visa or MasterCard cards, and that consumers suffered as a result. This may open the door for American Express or Discover to begin offering cards through networks of banks, which they have been unable to do until now, and it may cause them to get more involved in the acquiring business.

The second judgment found that merchants were harmed by the associations' practice of requiring that merchants who take MasterCard and Visa credit cards also had to take MasterCard and Visa debit cards. If you are familiar with the latter, you will know that they are not swipe and PIN-based cards but rather signature-based, which has engendered a higher cost structure for the merchants without any concomitant benefits.

I cannot really say what impact this will have on merchants, except to make the obvious comment that more competition usually lowers the price for both merchants and consumers, which will make it harder for the associations to compete with cheaper DDA-based solutions.

You undoubtedly have noticed a common thread in all of these products: They are low-cost providers compared to the associations, which are high-cost providers.

But there is more - they are making the buying and settlement experience as easy as using a credit card, both for the consumer and for the merchant. That will mean that more of those transactions will clear on the DDA and ATM tracks, and that will require ISOs to focus more of their resources on these areas.

I am interested in hearing how you feel about this, and if there is some interest I can expand on these matters. Please email me at brandese@cross-check.com.