Benefits of closed-loop payment networks

I was surprised to note the continual downward trend of fraud figures reported by PayPal (see graph [includes some interpolation]), including their recent figures of 0.18%, which is about 1/3rd less than comparable figures with Visa/MC.  This is one of the obvious value-adds of closed-loop payment schemes.  PayPal is an example of a [dominantly] closed-loop scheme, in which the merchant and the consumer use PayPal for payment, thereby making it easier for the scheme provider to detect fraud.

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., Authroize.net).  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?

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.

Intuit joins the ACH-based flat-fee band wagon

Intuit has created an ACH-based payment network where merchants pay a flat fee of $0.50 per transaction (link). This is fast work on Intuit's part, coming less than 3 months since they acquired PayCycle for $170 million (link) Intuit, based on its Quickbooks franchise, has relationships with 3.7 million small businesses. The 170 million dollar question is, will this offering gain critical mass where we will see the Intuit bug in enough payment pages?

To contrast this offering, let us look at other similar offerings. NACHA's SVP charges a flat $0.745 per transaction for their transactions (link). There seems to be some transaction for this product at universities, with government agencies opting in as well. PayPal charges merchants a discount rate of approximately 3.9%, which is comparable to what Amazon and Google Checkout charge.

I was talking with a long-time industry insider, who sees the trend towards flat-fee based discount rates. Where do you think the industry is heading?

JP Morgan's analysis of PayPal - A must read

I came across a very good analysis of PayPal by JP Morgan (link). The PayPal blog also talks about it. If you are interested in payments systems, this is a must read.

Paypal Mobile: Is it a non-starter?

I was reading Carol Coye Benson's blog about cash going away. Such posts catch my attention and got me thinking. Why are we not using P2P (peer-to-peer) mobile payments when friends/colleagues have to pay each other (splitting a meal tab...)? A related question is why has Paypal not been able to make mobile payments more successful/ubiquitous? This question is topical, in light of Ebay's recent focus on Paypal and its mobile offering (2009 Analyst Day presentation).

First, a background of the offering. Paypal mobile has been around for over 2 years now. Paypal has over 70 million active users. The cost for individuals to make payments to each other is free (other than the cost of the SMS charged by the telco, if you are using SMS/text). Paypal does not charge individuals any fee to load their wallet from a DDA/bank account. They do not charge individuals any fee to withdraw the money back to their DDA/bank account. In summary, Paypal's mobile payment service is free to individuals to pay each other. It is reasonable to assume that most of Paypal's active users in the US have a mobile phone (see Tomi T Ahonen's post). However, I would assume that only single digit percentage of active users have registered for mobile payments.

I suspect we, as consumers, do not use Paypal mobile as we have not made the necessary shift in our lifestyle. There has been no incentive or education for us to incorporate Paypal Mobile into our lives. No major ecosystem player has encouraged the use of Paypal Mobile.

Why is Paypal not pushing their mobile offering? Paypal mobile is an opportunity for Paypal to move from the online payments space to the physical world. Peer-to-peer payments seems to be a low hanging fruit in Paypal's retail payments strategy. Or is it?

Let's look at why physical merchants (the kind Carol visited in Oregon) have not embraced Paypal mobile. The cost of acceptance seems to be the first place to look. For most small vendors, Paypal fees work out to about 3.5%. This is a pretty high cost.

Acquirer/ISO recruit merchants and help them in accepting [new forms of] electronic payments. Is the absence of such a partner in the Paypal Mobile ecosystem affecting adoption?

Are mobile payments still an oxymoron? Is Paypal not interested in physical retail payments (aka Paypal Mobile), as it sees lots more growth in the online world? Would love to hear your thoughts?

Interchange fees, innovation & disintermediation

There has been a lot of debate on the level of interchange fees (aka merchant discount rates - the fees paid by the merchant for accepting an open loop network card), and the role it plays in fostering commerce.

Supporters, typically issuers, says it fosters innovation, increases sales at stores... Opponents, typically merchants, says that the fees paid by merchants are subsidizing issuers marketing programs. Interchange fees were not particularly controversial until the proliferation of reward cards. The interchange rates for reward cards are at least 20 basis points higher than for the basic card, and are therefore balked at by the merchants especially those that have slim margins.

In a world where intense competition is getting organizations to review every single expense, merchant's focus on interchange rates is not misplaced. In the 'old' days, merchants did not have much of a choice and came to terms with the world dictated by Visa/MasterCard.

However, new entrants are changing the landscape. Paypal, Amazon and Apple have tremendous market reach. They have the ability to be an alternative to the payment networks. This is already true for Paypal in the US ecommerce world. Amazon is well on its way as well.

It is not obvious to me that focus (or limits) on interchange rates implies reduced innovation. There is plenty of innovation taking place in the payments industry, outside of the realm of the traditional payment networks. This innovation is not being funded by interchange fees. Innovation will continue

Having said that, I agree that Congress must not try to mandate interchange rates and stifle the competitive nature of the payments industry.

Do you support limits on interchange rates? How does the disintermediation of payment networks in the online world extrapolate to the offline/retail world? Is iPhone providing a glimpse of what may be looming on the horizon?

Merchants may get real-time access to funds at lower rates

Typically, if a merchants wants to pay low fees, they get access to their funds later (e.g., ACH payments received after 3 days). If the merchant wants to get access to their fund immediately, they would have to pay a higher rate (e.g., credit/debit cards payments are received overnight).

This seemed to be an immutable reality that merchants had come to expect. Lower rates/fees and 'immediate' access to funds seemed to be a contradiction.

There is light at the end of the tunnel. Digital Transactions reports that PayPal is piloting a payment method where the merchants can have access to fund immediately (overnight). The rails are different from ACH and payment card rails. The disruptions keep on coming.

It will be interesting to see how this innovation plays out. All the best to PayPal for continuing to move the ball forward. Innovations that reduce online merchant's cost of accepting payments cannot come fast enough, especially in the current economic conditions.