Changing Economics of Payments

2 Dec 2015

Happy ‘After’ Thanksgiving everyone, I’m coming out of my tryptophan coma and thought I would go for a mental stretch. This is a pretty big topic, and I won’t do it justice. Thanks in advance for your comments and perspective. [Note I’m not naming the titles of my reference blogs and used only URLs.]

Payments may be the worst covered press area in all of business. Perhaps this wacky blog is like having to go to Star or National Enquirer to find out the real story on UFOs. There seems to be much more money to be made in stimulating uncertainty. This holds true in selling to both public (ie Square $6B market cap) and private (ie Stripe > $5B) investors. Obfuscation would all be fun and games if there weren’t real consequences as investment continues to pursue stunted ideas (Clinkle, Monetise, Card Linked Offers, Mobile Wallets, Firethorne, …etc).

The award for the BEST speech in payments in 2015 goes to Judd Linville, CEO of Citicards. I highly recommend watching his Money 2020 fireside chat prior to reading this blog.


Payments are going through explosive global growth, with significant changes in economics, consumer behavior, technology integration, and competitive dynamics. Regulation combined with new competitive forces that “bundle and integrate” payments are reducing interchange and allowing smaller companies to operate at scale. Expanding use of electronic payments is a tide rising which will lift all boats in next 2-4 yrs, but longer term value is flowing away from large issuers into the network (see orchestration).

Today, Issuers give most of interchange back as rewards, and large issuers enjoy significant economies of scale particularly in areas such as risk mgmt, rule making and acquisition. Large players have historically enjoyed VERY significant advantages as they not only defined the rules, but owned the underlying infrastructure and built corresponding utilities (fraud/risk) that could not be matched by smaller players.

Mobile, Authentication and Tokenization are enabling specialization within payments, undermining the traditional economies of scale and causing fragmentation. Specialization will result in much greater credit competition and thus NIM compression.  As an example, Paypal started life solving a trust problem. Never before could 2 small parties transact reliably online. Apple’s iPhone platform can solve a good portion of this trust problem with solid authentication enabling new payment and credit providers to take advantage of data in new ways to enable trusted interaction and commerce.

Payments work enormously well, and are quickly moving to something we NO LONGER THINK ABOUT….. they are embedded in how we interact with merchants. Large issuers are struggling to adapt and participate in this new world. Their struggle has been masked somewhat by the success of new rewards schemes that have given them par with the previously untouchable Amex. Research described below shows that payments is the only networked business in the history of man to grow less efficient over time. Market forces are coming in like a tsunami, and payment network participants must tilt to be more merchant friendly.

No investor can stay out of payments, and my top personal bets are in networks and merchant friendly specialists. From a network perspective, there are many ways to perform a payment, but only a few where intermediaries can make money and invest.  Visa and Mastercard are very efficient networks and earn their small slice.  The banks want to own the network and rules, but the face an insurmountable roadblock in merchant adoption and existing network efficacy.

Frequent readers should probably skip the section below as it is a rehash of several previous musings.

Network Theory and Commerce

As I’ve stated many times, closed networks always precede open networks until scale is reached (Building Networks and “Openness”, 2011). Weak Links (nodal affinity) influences network creation, and there are VERY few open networks which exist in Nature. This is logical as Networks form around a function rendering generic open networks less “efficient” than specialized networks around any given specialized need.

Scale-free distribution (completely open networks) is not always the optimal solution to the requirement of cost efficiency. .. in small world networks, building and maintaining links between network elements requires energy…. [in a world with limited resources] a transition will occur toward a star network [pg 75] where one of a very few mega hubs will dominate the whole system. The star network resembles dictatorships in social networks.

-Weak Links

Networks NATURALLY form around a function and other entities are attracted to this network (affinity) because of the function of both the central orchestrator and the other participants. Open networks (internet/TCPIP, Visa, NASDAQ, … ) succeed where a common infrastructure benefits MANY NETWORKS.

Visa and MasterCard have transitioned to become common network infrastructure, a position FAR MORE valuable than that of a closed credit delivery system. They are a network of networks. However their rule making and governance processes do not match the other open networks listed above (NASDAQ, Internet, …).

Commerce is Broken. There are very few “payment problems” in the US, after all none of us ever leave the store without our merchandise. The payment data point is the key measure of success for manufacturers, retailers, advertisers, distributors, payment providers. When was the last time you clicked on a banner ad? Or used your mobile phone in store beyond price comparison? As I outlined in Remaking of Commerce and Retail, and What do Retailers Want? Retail is an insanely hard business where most compete to sell commodity products at the highest possible price. Unlocking the “commerce” capabilities of mobile will reshape the $2 Trillion advertising market and $14 Trillion retail landscape, as new customer shopping experiences are created which leverage consumer data.

Payments – Big Picture

Payments is a network business that works Very Well (in OECD 20 countries) with very solid infrastructure built on the basis of a 4 party model. Technically there are many ways to complete a payment, but there are very few models (ie Visa and MA) where companies will invest.  V/MA are networks are a clear winner for merchants, consumers and banks as shared economics allowed for billions in investment in infrastructure and ubiquitous access to credit.Payment Value

Europe’s SEPA provides a crystal clear case study of “openness” and regulation. While technically excellent, the regulation of interchange and the opening of networks has significantly impacted investment and innovation.  The same will be true of the US efforts in Real Time Payments. Less than 0.5% of payments will need this new facility, it is NOT an effort driven by market need. New payment instruments face the problems of: issuance (consumer side), acceptance (merchant side), use (value delivery), participant investment, competition from existing networks, risk/fraud, and regulation.

In its simplest form, payments are a brokering business which manages trust and value exchange between two entities engaged in commerce. Logically, a broker must be removed from the transaction to maintain the trust of both parties, and deliver value through managing the financial risk associated with the transaction. Reward schemes, impugned the neutrality of this “brokering” role by creating incentives separate from the underlying commercial transaction. However, as Europe has learned in SEPA, there must be brokering incentives.

Unfortunately normal market forces have not operated here. Bank Issuers sought to increase reward schemes, and since they owned the rules, they increased the friction within the network, outside of normal market forces. NYU’s Thomas Philippon published jaw dropping research detailing how Payments and Banking are one of the few network businesses in the HISTORY OF MAN to grow less efficient (rail, telecom, energy, …).

interchange fees NY Fed

Banks normally give most interchange back to consumers in form of rewards. For issuers, the real issue of interchange reduction, combined with mobile authentication is hyper competition in consumer credit issuing. This dynamic will enable a resurgence in private label and small bank issuance as well as new companies (ex Affirm) to deliver consumer credit using non traditional scoring techniques. Impact on large issuers is two fold: lower interchange means reduction in rewards (lower stickiness, increased turnover) and increased competition means reduction in ANR (Avg Net Receivables) and the rate on these receivables NIM (Net interest Margin).

As you can see within the First Annapolis 2Q15 chart below, ANR is decreasing for the top 3 issuers (competition), while purchase volume accelerates (11-15% CAGR shift to electronic payment).  While Private Label ANR growth is exploding (SFS/ADS 13%-34%) and purchase volume grows at double the major cards. The good news for top players is that electronic payments growth will mask much of the shifting competitive dynamic for next 2-5 yrs (see world payment report).

First Annapolis

First annabolis

Network Dynamics

Networks are being rewired as competitive forces, regulation, weak links and data democratization enable new specialized networks (see Commerce and Banking – What is the Difference). Interchange is going toward 0 with regulation and competition from non-traditional networks driving the change. For Example, Google Buy Now performs payment as a loss leader, ships your goods for free from your physical store all to get the data. This enables physical small retailers to compete online. [See Platform Economy for more detailer here].

Retail, Banking, Commerce, Mobile, Consumer Behavior, Payments, Communities are all undergoing radical changes. As I wrote in Internet 3.0 (i3), new networks are attacking traditional competitive barriers:

  • asset intensity -> information intensity
  • economies of scale -> modularity and specialization
  • vertical integration -> best of breed
  • product -> value network orchestration (ex Uber)
  • brand -> consumer value
  • Risk management -> authentication
  • vertical integration -> Community collaboration
  • opaque rules -> transparency and reputation

New specialized networks (think Uber) are hyper meritocracies which react to serve areas that are: #1 inefficient, #2 opaque, #3 poorly serve the consumer or #4 at risk (ie Darwinian). Today we see this dynamic take place in many areas: App Stores, Uber Drivers, MOOCs (College Learning), Wikipedia, Blogs (vs Newspapers), …etc. [See Blog on Internet 3.0: Collaboration in Commerce].

Mobile Operator Example

A non-payment example of this network chaos is in mobile. Apple’s financing of iPhones, virtualized SIMs and share of industry profits combined with Google’s Fi have thrown the MNOs for a loop. How do they differentiate? Where do they create value? At the top of my list of recommendations is collaboration.

Apple has 4 primary strategic weaknesses: 1) it does not partner well (closed network and proprietary standards) and 2) it relies primarily on hardware for revenue, 3) its entire organizational culture and focus is on hardware 4) it locks consumers into its walled garden. Apple’s business model is perhaps the best example of how closed networks win through the domination of a benevolent “channel master” (see iPhone 6 – Apple’s Strategic Opportunity).Data-options

Compared to Apple, Google’s world is much more democratic, it wins by delivering value through customer choice every day (search, maps, mail, play, HCE, …).  Google is commerce enabling (not hardware), which tilts toward the consumer and toward the merchant (in advertising). Where Apple has a walled garden; Google is a semi open platform that supports many gardens and clusters.  Where Apple’s business is driven by hardware margin; Google’s is driven by daily consumer and merchant choice.

Merchants and Banks consider working with Google and Apple a Faustian Bargain (at best). There are no trust facilities for interaction, thus a common “enemy” maintains its dominance by fragmentation of foes. This problem is what my team and I at Commerce Signals is working to resolve.

Payment Network Economics

Globally, electronic payments are still in their infancy, which makes investing in it so much more exciting. For example, over 90% of the global electronic transactions occur in the top 10 markets (representing less than 10% of the world’s population).  This would seem to point to a future where electronic payments are poised to grow geometrically as the number of nodes grow. (see Structural Change in Payments).

Complexity in payments is driven by the quest for control and margin of the various participants, not by necessity. This is what makes understanding payments so hard…. most of the changes are not logical, but political. The friction (inefficiencies and illogical design) in payments is what makes them work. As I’ve stated before, no engineer would design a payment system to operate the way we do today (see Push Payments). Thus there is beauty in this chaos! The V/MA model created incentives for 1000s of banks to invest in payments, and I doubt if we will ever see any other companies that could repeat this feat

  1. Risk and Identity
  2. Data/Commerce Value
  3. Consumer Behavior/Trust/Acceptance
  4. Issuance/Customer Acquisition/HCE
  5. Regulatory/Rates/Rules (Fees)
  6. Mobile/Payment in the OS

Networks are in the Drivers Seat

As I wrote previously, nothing will dent the 25%+ CAGR of Visa/MA, as 92% of electronic transactions are completed by less than 10% of the world’s population. Perhaps the best analysis done on global payments is from Cap Gemini (2013 World Payments Report). Markets like Asia and CEMEA are growing electronic payment volumes by over 22% CAGR. The network effects are enormous, it is like mobile in the late 90s, or the internet since the mid 90s. No investor can stay out of payments, and my top personal bets are in networks and specialists.

95% of payment investors would have done better putting $1 into V/MA in 2011, then pursuing start ups…. As it would be worth over $4 today.



Visa and Mastercard are very efficient networks taking just 5-10 bps of a transaction. Visa and Mastercard have “won” the payment wars. They are in control of mobile payments, EMV, tokenization of cards, new rules (ex VDEP). They are now starting to “tilt” their networks to be more merchant friendly to enable commerce collaboration (see my blog from last week). Even in Europe where interchange will be capped at 30bps for credit and 20bps for debit the networks win, there is minimal impact to network fees. Perhaps the only exception is in Debit.

As if the growth story were not good enough, the levers of control within payment networks are rapidly expanding, as are their services. For example, VDEP is to Tokens what VisaNet is to Cards (MA has equiv in MDES).  VDEP/MDES are the KEY ENABLERS of Payments in the OS. Visa has established rules that will greatly accelerate mobile payments. Removing all economic incentives and data from wallet providers and enabling frictionless enrollment/adoption/use that is consistent with how physical cards work today.

Both Visa and Mastercard realize that their future rests in leveraging their neutrality, thus “tilting” away from their prior “bank centric” model into something that is MUCH MORE merchant friendly. Bank issuers certainly WANT to be in this role, for example the largest US Visa issuer JPM has created a unique off VisaNet transaction routing (see blog) and is building a new data business (ChaseNet) to compete here.

Visa and Mastercard win when consumers and merchants transact.  Encouraging use by consumers, and acceptance by merchants, istop priority… The future of the networks is COMMERCE. This may seem like a logical statement, but historically Visa and Mastercard acted as extensions of the large issuers. Look for both networks to create new teams to rebuild relationships with merchants.. they know they have work to do. [See related blog]


Historically there has been deep vertical integration in payments. This created barriers to entry and thus only well capitalized participants to compete at scale. The primary impact over the next 5 yrs will be the advantages of scale that top incumbents enjoy. Historically top issuers not only created rules, they also negotiated special pricing, and were able to invest in specialized risk management infrastructure. Perfect authentication drives out payment margin particularly when that authentication is done within a platform that banks cannot control.

The advantages of vertical integration is changing as 3rd Party authentication (ex Apple) enables the deconstruction of payments into various focus areas. This creates many opportunities for new specialists (ex Braintree, Stripe, Prosper, Hyperwallet, .. etc)  …. which further accelerate delivery of new value “bundles”. Consumer migration into these bundles creates significant incentives for further fragmentation/rewiring of traditional payment networks.  For example, developments like tokenization have an enormous “leveling” ability that will enable small issuers to compete at the risk levels of large issuers.

The modern form of retail banking envisioned a “financial supermarket” (see Forbes Sandy Weill) where the transactional account was a loss leader for cross selling 50 odd other products, the new “banking like” product is centered around electronic payments with an access network (think Greendot, WU, ATMs, …) to get money into and out of the system. Loss of this network has implications for all of Retail.

The Retail Bank dilemma now becomes apparent. A classic “innovators dilemma” where the loss leading core deposit account, tied to a profit making credit card, has been undercut by pre-paid for a majority of consumers, and the profitable product faces new competition all while making branch distribution a significant millstone in cost to serve. As if that weren’t enough, 90% of the other money supermarket products must be sold face to face (need a branch).  While the retail bank could adapt to compete, the rest of the organization is forcing it to keep the branches and move upstream to the affluent high margin clients.

Issuer/Supermarket Strategies

Strategy #1 – Own the Rules, create closed network, and grow data services (JPM)

Strategy #2 – Go up market (Citi)

Strategy #3 – Be the best retail bank (BAC/ WFC). Protect consumer information

Strategy #4 – Collaborate, Innovate and use data (Cap One)

Strategy #5 – Merchant Centered (ADS/SFS)

Example – Chase Pay

See the Money2020 announcement by Gordon

Chase is positioning this as a way for CPT to gain volume. Value Prop: we will clear ChasePay transactions at 0bps. Given that ChasePay and MCX don’t exist yet it may be a little pre-mature to take a bet against another Acquirer (ie FD). What is actually happening is that MCX retailers will be switching ONLY ChasePay transactions to Chase. The reason JPM/Gordon are so obtuse on the strategy here is that they bought the volume of 2 MCX participants (names with held) at VERY LOW margins in hopes they can make it up with the other merchants.

I just learned that ChasePay requires custom integration WITH EACH MCX Participant. So ChasePay will NOT be accepted everywhere MCX’s CurrentC  is.. Wow.. talk about confusing! So.. CPT may gain incremental volume at no margin in hopes of attracting other merchants.

ALL ISSUERS are just shaking their head on this. Why would JPM want to shake up the apple cart and force a new network where they make no margin? Chase has created a Visa war plan I don’t understand. Another leg of this plan is tokens, as Chase pushes The Clearing House (TCH) to develop a token facility. Remember that FD has Citi, BAC and WFC as customers.. and they can do anything that CPT can do [See ChasePay Thoughts for more info].

JPM looks caught in a “I want to be AMEX” moment… at a time where Amex itself is looking to re-invent. The value of OPEN is huge.. and it is unfathomable that the largest issuer in Visa doesn’t see it. (See Building Networks and Openness)


Acquiring margins are very challenged. But you would never know this from the stock performance. Earnings multiples have gone from 9x to 20x in last 3 years.

Industry Multiples

processor performance

Acquirers are very adept at passing fees to their merchants. I like acquirers because they are the closest payment entity to the merchant within the payments industry (thus naturally positioned to deliver value). On the downside, most acquirers have been pushed into a pricing play by top 60 merchants and have not been able to leverage data assets effectively.  Most are also extremely challenged in relationships as their invoices are indecipherable. If your customers don’t trust you it is hard to deliver incremental services/value.

Financially, larger merchants have always negotiated much lower rates directly with issuers. Thus SMBs (ie long tail) make up over 60% of the profit potential in payments. New merchant aggregators (ex Poynt, Square, Stripe, Braintree, …) are helping SMBs gain leverage. This will impact merchant acquiring first, with $2-4B margin impact in next 3 yrs. The valuations in this space make no sense at all. Why would I want to buy Square with 2-3% of payment volume at $6B when I could buy FD which has 53% of volume for $15.6B.

The TOP area to invest in here is around the payment terminal and point of sale. There is a once in a lifetime opportunity to reconnect merchants as the EMV mandate. Two top processors told me that small merchants are in big trouble, particularly as the issuers will be pushing back all fraud to non-EMV merchants VERY aggressively. Think of it this way. EMV does NOTHING to help the small merchant.. currently no business bares cost of fraud in card acceptance.  Verifone and others have put the equivalent of “rotary dial” telephones into merchants for 20 yrs. Once Merchants realize they can gain choice and capability they will switch. For this reason I love Poynt, Square, Braintree and other merchant friendly POS/Payment providers.

Beyond POS, there is MUCH room for acquirers to play directly with merchants. One of my favorite examples is Alliance Data, creating a mobile app to fill out a credit application using your carrier mobile data and instantly approve you for loan in store (see PR). How do you use this credit? A virtual Visa card.

My message: look for collaboration

I tell my kids that the last 20 years was spent having Fortune 100 org building an airport hub that served a local community. There were no airlines.. no standards.. Collaboration was defined by the channel master (Apple is best example). There was no Fortune 50 looking to drive $1B plus in a partnership.. partnerships came and went as no one had the energy or focus to make them work. This time is passing…  Payments is about collaboration and network. You can’t run a network that alienates merchants… everyone must be accountable for value delivery…

5 thoughts on “Changing Economics of Payments”

  1. Very thought provoking as always Tom, and much appreciated. If I differ from you in one area it is that I think that direct-to-account instant payments are more of threat to the networks than you do, because I expect the merchants to heavily incentivise direct-to-account from inside their own apps. As people were saying today, Walmart Pay looks dumb (card on file at CNP rates via QR) but if the default option on Walmart Pay becomes ACH it looks much smarter (especially when they ditch QR and shift to Bluetooth).

    I completely agree with you about tokenisation. This is _bigger_ than chip and PIN, and given the expense of the infrastructure, the pressure to use tokenisation for things other than mobile payments is strong.

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