Friday, December 4, 2009

Engines powering disruptive innovations in Payments industry

As I get to look at the payment card economics for online retailers in the US and elsewhere in the world, a couple of things jump out
  • Merchant Discount Rates (MDR) are higher in the US (about 1%)
  • Fraud rates are higher in the US (about 1%)
Even though online retailers are picking up the costs associated with online fraud, online retailers still pay a higher MDR.  A double whammy.

What stumps me is the basis for higher online fraud rates in the US.  In the online world, payment cards are all magstripe cards (you can't use chip-n-PIN cards onine).  Therefore, the US being a straggler in adoption of smartcard-based payment cards does not hold.  US prides itself on having a lot of intelligence in the payment network to detect fraud.  In spite of this, the US has $4 billion in online fraud.

Are the above indicators part of the landscape which can't be changed, or are the above indicators indicative of staid incumbents with little incentive to change status quo?  If it is the latter, we must be able to see evidence on innovations from challengers.

PayPal has been a disruptive innovator.  Though the MDR charged by PayPal is about the same as what the rest of the industry charges, PayPal's merchants have immunity from chargebacks (a 1% saving to merchants).  The fraud levels (transaction losses) experienced by PayPal is about 30bps (100bps = 1%).  A 1% premium MDR charged by PayPal while experiencing only 30bps of losses is a good business model.  So here we have a disruptive innovator offering a true win-win offering.  The online retailer saves 1% in chargeback costs, which is about 20% increase in net margins.  PayPal gets a 1% premium MDR while managing losses at 30bps (resulting in 70bps larger margins).

PayPal has been and expected to grow at about 18-20% CAGR while the incumbents are growing at half the rate (around 9%), which is proof of the relevance of the disruptive innovation of PayPal.

This posted started off evaluating the [possible] uniqueness of the US online payments industry, but is ending up looking at how a challenger is disruptively innovating at the cost of staid incumbents.  Please look forward to a follow-up post which examines why PayPal is an anomaly in the world of payments systems.

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