Sunday, January 31, 2010

Growing up in the land of the rich

Retailers and payment schemes (Visa, Mastercard...) jousting on the interchange rates and impact it has on the economy has been interesting.  Rates paid by retailers vary tremendously (based on many different factors which I shall not get into here).  To drive a stake in the ground, the rates are around 1.8% in the US for credit cards.  In a world where margins are thin, 1.8% seem like a king's ransom.

With this perspective, let us look at rates paid by online retailers to process online payments.  Using PayPal as a benchmark, PayPal charged merchants an aggregate fee of 3.54% in Q4'09, nearly twice as much what merchants pay in the physical world.  Additionally, PayPal's transaction processing expense rate and losses added up to only 1.36% [in Q4'09], resulting in a margin of a whopping 62%.

Fortunately for PayPal, their competition charge as much, but do not have the great business model of being able to keep most of the money.  In a traditional (Brick-n-Mortar) model, the fees paid by merchants are split between at least four parties, the acquirer, the processor, the issuer and the network/scheme, with most of the fees heading to the issuer (around 80%).  In the online world, there is yet another mouth to feed, the payment gateway (e.g.,  Thanks to the disruptive innovation of PayPal, they successfully created a model where there is only party at the table, PayPal.  In an increasing number of transactions, PayPal is the Payment Gateway, Acquirer, Network and the Issuer (and in these cases it costs them a few pennies to process a payment transaction).  Through this innovation, they get to charge what the competition charges (high rates), while being able to keep most of it.

Isn't it wonderful to participate in a sub-optimal world of online payments.  PayPal's large margins are funding their red-hot growth that is many times larger than the industry average.  With each passing year, PayPal will continue to grow (both top line and bottom line) at the cost of the other players, with competition only being able to watch PayPal demolish them.  The existing business model of Visa/MasterCard has tied the hands of the traditional players and forcing them to play in a playing field that is lopsided and favoring PayPal.

And, if you think that above situation is an unfair advantage for PayPal, wait for them to play their next card, Mobile Payments.  The above structural disadvantages are holding back the traditional players in mobile payments, as nobody wants to add yet another player who demands a cut (the telecom operator).  Guess what, the efficiencies and the margins that PayPal has can easily accommodate the player whom the competition is pushing out.

How do you think Visa and MasterCard, the public companies will respond to protect their turf and deliver shareholder value?


  1. Well, In India, the Payment Gateway can be avoided and the NEFT Mechanism, can be adopted by Online Merchants.
    Receiving of funds through the NEFT Mechanism is the best way, as no cost is involved, and this can be used from any Bank Site.
    However, for this to be a success, the levels of integrity of the Online Merchants should be very high.

  2. Prashant,

    I went thru' your [related] post. Very interesting. Similar to your NEFT Pay proposal, in the US alternative payment options based on ACH are becoming more commonplace.

    I would be curious to know whether online merchants in India are integrating NEFT mechanism in their payment pages? Are consumers comfortable sharing their bank account details with online merchants that they do not know.

    Look forward to continuing this dialog.

    Best Regards,