On-line Payments: Cut Up Your Credit Cards!

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Paul Sagawa / Artur Pylak

203.901.1633 / 203.901.1634

sagawa@ / apylak@ssrllc.com

July 13, 2011

On-line Payments: Cut Up Your Credit Cards!

  • As the Internet economy has become an ever larger part of consumer transactions, the payments industry has slowly adapted to fill its needs. Today, with the Internet accounting for roughly 5% of US retail transactions, and with new technology poised to add secure point-of-sale payments to basic capabilities of a smartphone, tension is rising between the traditional payments industry and the leading Internet players. Given that payments represent a quarter of all banking revenue, the web-based interlopers will face stiff opposition from financial institutions already mobilized by a new regulatory regime. Despite this, we believe Internet “meta-aggregators” like Google and Apple will be able to create attractive new businesses in facilitating payments
  • The traditional value chain for retail payments begins with a consumer who is issued a payment instrument – e.g. credit cards, debit cards, checks, etc. – by a bank. Credit/Debit cards, the typical basis for non-cash retail payments, are associated with a payment network, such as Visa or MasterCard, which operates an infrastructure for merchant acceptance and consumer authorization. Actual payments from the consumer bank to the merchant bank are facilitated by 3rd party payment processors, such as Global Payments, Fidelity National Information Services, or Fiserv. These roles are strictly regulated, with particularly strong scrutiny of banks, which must underwrite the credit and manage the customer account, including collections
  • Advances in technology are beginning to disrupt the traditional value chain. On-line leaders have begun to establish non-bank payment accounts to facilitate e-commerce via services such as Ebay’s PayPal, Google Checkout, and Amazon Payments. These intermediaries aggregate payments and manage authentication, allowing users to fund purchase via low or no fee automatic bank transfers, disintermediating high fees charged by issuers, payment processors and card networks. While some accounts do tie back to credit and debit cards, the largest on-line players have established scale and consumer brand equity, putting them in position to squeeze payment networks and card issuers. Clearly consumers trust the web – in addition to the 17.7% annual growth of e-tail, 30% of American consumers used non-bank payment accounts in 2009
  • The dramatic rise of smartphone adoption raises an even more threatening prospect to the traditional payments industry. The next generation of these devices will be equipped with Near Field Communications (NFC), a technology that provides fast, secure, two-way connections at very close range. Using NFC, smartphones and tablets can act as electronic wallets, authorizing payments at retail via specialized terminals at the point of sale. NFC transactions promise to be faster, more convenient, and less vulnerable to fraud/theft than card-based sales. Gartner projects 349M global users and $429B in NFC transactions by 2015
  • The battle for NFC domination is underway and several platforms have already emerged. Isis, a joint venture backed by Verizon, AT&T, T-Mobile, Discover, and Barclays is pitting the carriers in one corner against payments incumbent Visa and it’s banking partners: US Bank, Bank of America, Wells Fargo, and JP Morgan Chase along with privately held startup DeviceFidelity which is providing the underlying NFC technology. Google has teamed with Citigroup, FirstData, MasterCard, and Sprint with it’s already announced open platform, Google Wallet. Apple is unlikely to sit idle considering its stake in mobile devices, and an announcement on NFC by year end would not be a surprise
  • Competition in NFC will be a race to critical mass on two separate tracks: consumer adoption and merchant penetration. For consumers, adoption will be dependent on acquiring a device with NFC capability, activating an app, and opening a credit account, while merchant penetration will depend upon negotiations with merchants and the deployment of NFC readers to stores. Carriers will look to push subscribers to their own networks, while smartphone platform architects will look to integrate NFC payments into an integrated user experience. Banks and payment networks will look to leverage their existing credit relationships with consumers, and importantly, with merchants, to get a head start. The disparate strengths of these categories of players, and the potential regulatory burden on non-banks, has driven the coalition approach by all serious players
  • We currently see the Google/MasterCard venture as best positioned given its head start and lead in smartphone market share. Google Wallet NFC features come standard in several of the latest released Android devices. Visa’s solution is next best given backing from 4 of the top 6 credit card issuers and play with a technology that is compatible with most mobile devices including iPhone. Isis seems to be an attempt by the carriers, a distant fourth payments player, and the number 13 card issuer to get a foot into the marketplace. Neither Amazon or Apple have publicly yet announced an NFC strategy, but believe that the balance of power in the nascent NFC space could tip should they choose a side
  • Longer term, we believe Internet-based payments, both mobile and fixed, could grow to a large majority of non-cash payments. While all of the first consortia for NFC platforms include both card issuers and networks, the balance of power will likely shift toward on-line players, allowing them to squeeze providers of credit underwriting and network services. While it is conceivable that these companies could opt to cut out financial intermediaries entirely, the accompanying regulatory burden might be more than Google, Apple or Amazon would be willing to bear. Nonetheless, returns for purely financial players in the NFC and on-line credit game will likely see significant pressure, while “meta-aggregators” earn fees for aggregating transactions, as well as providing added services to consumers and merchants

How You Gonna Pay For All of This?

Dot com era prophesies about e-commerce emptying the malls and laying waste to Main Street USA have proved to have been more than a little bit hyperbolic. Rather than a flood, e-commerce has been a slow and steady stream. A decade or so later, the Internet now accounts for 4.5% and growing of US retail transactions, fatal to some in the hardest hit categories – records, books and toys – but manageable for most others (Exhibit 1).

Nevertheless, the stream continues to flow. On-line retail sales are growing at a nearly 18% CAGR since 2002, with 14% growth in the recession plagued 2010. Amazon’s $18.5B in 2010 US retail sales puts it just into the top 20 of America’s largest retailers at #19, but its 46% YoY growth is more than 6 times the pace of the second fastest grower on the list (Exhibit 2). Indeed, if all the companies on the list maintained their 2010 pace, another year would see Amazon in the top 13, passing McDonalds, Macy’s and Rite Aid along the way. Interestingly, a Temkin survey also reveals Amazon as the highest ranked American retailer for customer experience against all comers.

While e-tail presses forward, another battle front is opening. The proliferation of smartphones and tablets is bringing Internet access to the street, and with that, the brick-and-mortar store. New technologies are vying to turn mobile devices into wallets and cash registers, with the potential to take much more of the $87 trillion in annual US transaction volume into the Internet domain. This is obviously a huge opportunity. On a global basis, payments generated more than a quarter of all banking revenue in 2010.

This is How We Do It, Baby!

The default payment mechanism in the US is cash, which is almost universally used and accepted at retail. Despite this, the use of cash is falling, with the major non-cash mechanisms – debit cards, checks, credit cards, automated clearing house (ACH) transactions, and checks – collectively growing more than 27% between 2006 and 2009 (Exhibit 3). More than half of these transactions are executed via credit and debit cards, with more than 75% of all Americans reporting that they hold a credit or debit card. In contrast, checks are used by 85% of Americans, but their use for transactions declined at a 7% CAGR 2006-2009.

For on-line merchants and mobile payment facilitators, the target market is the nearly $3 Trillion in annual credit and debit card transactions from the four major card networks – Visa, MasterCard, American Express, and Discover. In a typical transaction, there are four intermediaries in transferring payment from consumer to merchant (Exhibit 4). The card is issued by a bank, which underwrites its credit, approves transactions and manages the relationship with the consumer. This relationship is highly regulated, particularly so in the wake of recent legislation. The card is affiliated with a card network, which negotiates with merchants for acceptance and transaction fees, manages authentication, and transmits payment information. When a merchant is presented with a card transaction, it forwards the request to a payment processor, such as Fidelity National, First Data or Fiserv, which contacts the issuer bank for authorization. Upon approval and the completion of the sale, the authorized transaction is stored in a batch to be submitted for payment through the credit card network, from the issuing banks to the merchant bank, which credits the merchant, minus fees paid to the participants in the value chain.

We Know Who You Are

The credit card industry’s relationship with the Internet is complicated. On one hand, the wide penetration of credit and debit cards has helped to fuel the explosive growth of e-commerce, just as e-commerce has contributed to the growing percentage of retail transactions conducted via these instruments. On the other hand, e-tailers have grown frustrated with traditional credit card networks charging premium fees for on-line transactions despite strong evidence that the incidence of fraud is considerably lower for the leading Internet merchants than it is for brick-and-mortar stores. The justification for this – that the physical inspection of a card at point-of-sale offers superior protection – is questionable, given the data web-based businesses have gathered on their users and the ability for computers to pinpoint location and deviations from historical behavior.

The cost of credit and debit cards, particularly for small on-line merchants, has led on-line leaders to explore alternatives. The initial success came from PayPal, which was acquired by eBay in 2002. PayPal allows users to “fund” individual accounts either by depositing money or linking directly to a bank account or other authorized funding instrument. On-line transactions executed with PayPal allow for a simple, secure transfer between PayPal accounts without generating bank, credit processing or credit card network fees. While some users choose to fund their PayPal accounts via credit cards, many on-line merchants refuse to pay the additional fees for that option. As such, most users fund their accounts via direct payments from their banking accounts, typically with little or no fee.

PayPal has been successful, handling $92B in transactions in 2009 (Exhibit 5). In the same year, a survey by the Federal Reserve revealed that 30% of American consumers reported using PayPal or a like service, with 49% having used automatic electronic bill payment from their bank accounts, an arrangement referred to as Automatic Clearing House (ACH) transactions (Exhibit 6).

Google has entered the non-bank payment account business with its Google Checkout product, as has Amazon with Amazon Payments. Apple has not yet moved to sidestep credit card fees, but is widely expected to do so. We note that by requiring that these payment accounts be funded either by deposit, by pre-authorized transfers from bank accounts, or through the traditional credit industry, the on-line players avoid underwriting debt, and thus, avoid regulation as a bank. While these programs are small relative to the $3 trillion credit card industry, the growth of on-line commerce and the looming threat posed by mobile payments have raised the alarm for traditional payments players.

It’s a Smartphone AND a Wallet!

According to a recent Pew Research Center study about 35% of American adults own a smartphone running a major platform: Android, iOS, Blackberry, Windows, or WebOS. Google’s SVP of Mobile, Andy Rubin reported in late June that half a million Android devices were being activated around the world daily. ComScore projects that 1 in 2 mobile devices in the US will be smartphones by the end of 2012. Gartner forecasts that sales of smartphones in the US will double from 78M Units in 2010 to 159M in 2015 (Exhibit 7). Given an average replacement cycle faster than every two years, an explosion of downloadable apps, and regular over the air software upgrades, new capabilities can migrate into user hands at an unprecedented pace.

With near ubiquitous connectivity, pocket portability and a huge user base that views their devices as must-carry daily companions, smartphones are poised to attack that other must-carry: the wallet. Smartphones already offer the functionality of a small PC, camera, navigation device, and portable video game player. 27% of smartphone users already view their mobile device as their primary Internet access vehicle (Exhibit 7). Smartphones are already being used by some small businesses as point of sale terminals. Startups ROAMPay and Square offer smartphone merchant processing hardware, software, and processing services. Users simply download an app, link their merchant account, attach a small piece of hardware, and they’re ready to swipe. Why not use a smartphone as a payment mechanism?

There are a four basic ways to enable payment transactions via a mobile device (Exhibit 9). The first to arrive was SMS text messaging. Users text payment information to a merchant and are billed via their carrier. Outside the US, SMS text messaging has been a popular form of payment growing from ~$10B in 2008 to $31B in 2010 – small compared to conventional payment instruments such as credit and debit cards, but demonstrating a CAGR of 76%. The second method, USSD, is similar to SMS with the difference being that the standard allows for a two way data connection to be opened and allows for 182 characters versus the standard SMS 140 character limit. While these methods do not require significant new infrastructure, they are losing favor due to poor reliability, slow speed, inadequate security and high processing costs.

WAP (Wireless Application Protocol) payment is like traditional e-commerce, except the user performs the steps on their smartphone/tablet rather than a PC. A user simply logs onto a site or an app via a mobile device at a retail store and can execute a payment with a credit/debit card or non bank payment account such as PayPal, Google Checkout, or Amazon Payments. WAP is PayPal’s current mobile payments strategy and it is currently available as an app for iPhone, Android, and Blackberry. It has the benefits of familiarity for consumers, security on-par with traditional e-commerce, and collection of customer data for merchants, but it can be cumbersome and very slow for users that have not already installed an app specific to a particular merchant.

Finally, there is near field communication (NFC). The underlying technology, Radio Frequency Identification (RFID) has been around since the 80’s and is employed in key/security access systems, inventory control systems, and in the late 1990s for payments in passive fobs used for applications such as toll collection and gas station payments. Extensions of the technology have added the capability for fast, secure, two way data exchange over distances of no more than a foot. Both iOS and Android are presumed to be adding support for NFC in their next releases, and mobile devices supporting these standards are expected to include the low cost chips for the technology as well. Ostensibly, a user can swipe their mobile device within a foot of a specialized NFC terminal at a retail store, punch in a PIN code, and be on their way, no merchant specific app required, payments process by traditional or non-bank means.

But, are we there yet?

It sounds easy, but deploying NFC-based mobile payments requires adoption by users, connections to sources of funds, acceptance by merchants, deployment of NFC readers, implementation in mobile devices, and distribution of the software to enable transactions. Ultimately, consumers, retail merchants, wireless carriers, card issuers, card networks, and mobile device platform players all have a major stake in the outcome. The jockeying amongst these players for influence and control have the potential to put progress off track.

With this complexity in mind, the NFC Forum was formed in 2004 to develop contactless mobile payment standards. It now boasts 145 members that include the likes of MasterCard, Visa, Microsoft, Google, AT&T, NTT Docomo, Broadcom, Qualcomm, Samsung, PayPal etc. Apple and Amazon are notably absent. The NFC Forum has already published 15 technical specifications that include peer to peer device connectivity and card emulation capabilities. However, rollout and adoption of the technology in the US is proving to be more complex as several competing standards have emerged.

Three Ways to Leave Your Credit Card


Three notable NFC mobile payments initiatives have been launched in the US: mobile carrier led Isis, Visa’s tie up with 4 of the 6 top card issuers, and Google’s wallet team up with MasterCard, Citigroup, First Data and Sprint. Each group touts a different form factor, device, and business model, making it unlikely that the other groups can sustain momentum if one should gain critical mass. Meanwhile, Apple and Amazon both remain on the sidelines, while eBay’s PayPal continues on a non-NFC WAP mobile app path. Movement by these players, either to support one of the existing initiatives or to launch a new approach could dramatically shift the competitive balance.

Isis. In an odd combination, AT&T, Verizon, and T-Mobile, which represent a 72% share of the US wireless market teamed with payments network Discover, about 3% of credit card transactions, and Barclays, the #13 card issuer (Exhibit 1012). This is clearly a carrier dominated effort. Specs haven’t been announced, but the group is likely to back a subscriber identity module (SIM) based NFC solution that would allow carriers to have a chip they can control and could be used across a range of wireless devices. Isis is expected to collect some small transaction fee for its service. The future of this venture is uncertain as its plans have been tweaked since being formally announced in November 2010. AT&T’s proposed merger with T-Mobile also jeopardizes the success of this venture and may raise concerns in regulatory approvals. Isis also lacks the involvement of a credible technology player to enable the solution in handsets or at a point of sale. In earlier days, carriers would have simply demanded that handset makers support only the ISIS solution, but the rise of downloaded apps has greatly weakened carriers’ ability to control handset functionality.  To complicate matters with its Discover partner, the carriers indicated a willingness to bring other payments networks onboard Isis in April 2011. There are also questions as to whether archrivals Verizon and AT&T can really work cooperatively in the best interests of the initiative as a whole. With all of these questions, we believe this venture is unlikely to keep pace.

Visa. Visa’s NFC trials are notable in that the number one payments provider has teamed with 4 of the top 6 card issuers: Bank of America, JP Morgan Chase, Wells Fargo, and US Bank representing $1.3T in 2010 processed transaction volume. Furthermore, Visa has partnered with an NFC device startup, DeviceFidelity, which uses a microSD NFC plug in solution and in the case of the iPhone, an add-on case with NFC capabilities. NXP Semiconductor produces the NFC chips. Carriers are absent from this tie up and Visa expects to collect an interchange fee. Given Visa’s size and scale, we believe this standard is likely to have some staying power, though requiring an off-board peripheral is a likely deal killer for many, if not most, consumers. Should this venture survive, we see Visa shifting to an embedded NFC solution. We believe Visa will need closer cooperation with device makers and carriers to gain widespread adoption.

Google Wallet. Google’s initiative represents an optimal ecosystem with a player from each major constituency: MasterCard, Citigroup, FirstData, and Sprint. Google has also enlisted merchant partners that include: Bloomingdale’s, Duane Reade, Foot Locker, Macy’s, Peet’s Coffee, Subway, Toys ‘R Us, and Walgreens among others. Google Wallet uses an embedded chip to enable payments via Citibank issued MasterCards or its own Google Prepaid card at merchant point of sale locations. Google Wallet enabled devices are compatible with MasterCard PayPass contactless terminals that are processed by FirstData. The solution will be initially available on the Samsung Nexus S 4G running on Sprint’s network. Like its Android OS, Google is planning to make Google Wallet free to merchants and consumers expecting to gain from advertising revenue. While this is the best positioned NFC offering and closest semblance to a true ecosystem, it is still limited to users that are both on Sprint, the #3 Wireless carrier, and have a Citi MasterCard, the #5 card issuer. We would expect Google’s initiative to gain momentum and attract more hardware makers, another carrier, and perhaps several more issuers.

What About Japan?

Japan presents an interesting case example of a market adopting mobile payments early. NTT  DoCoMo has been using NFC technology in its handsets since 2004 via a branded mobile wallet service called Osaifu-Keitai. DoCoMo has come to dominate mobile payments in Japan building an ecosystem through investment and partnerships. In 2005, it invested in Sumitomo Mitsui, the number #2 credit card issuer in Japan. To enable the technology, it teamed with Sony to develop the proprietary the FeliCa chip. With no competing NFC standards in Japan at the time, DoCoMo’s rivals KDDI and Softbank Mobile also adopted the chip to reduce customer churn. Further, to grow a presence at points of sale, DoCoMo invested in a number of convenience store chains to deploy contactless terminals for users to tap their phones. As a result, consumers can use their phones to pay for transactions at over 450,000 contactless terminals around Japan. 60M of about 125M mobile subscribers in Japan have NFC enabled phones and about 16% of all subscribers actively use the NFC service. While this figure seems low, the payment preference of choice in Japan is still cash. Also, DoCoMo’s most popular payment plan, which bills directly to phone bills rather than linking cards, has a cap of ~$114 per month in charges, limiting the amount users can spend on their phones.

As the Japanese mobile payments market is dominated by a single player, competitors KDDI and Softbank are openly welcoming bringing in more open NFC standards into the marketplace. DoCoMo as a charter member of the NFC Forum and dominant player is forging ahead with its plans to create a global mobile NFC standard. It announced an agreement with South Korean wireless provider, KT Corporation, to introduce cross-border NFC payments in 2012.

Winners and Losers

In the long run, Internet based payment mechanisms offer significant advantages over traditional debit and credit cards. They are more secure, less vulnerable to fraud, more convenient to users, lower in cost, and offer valuable information to merchants. As with nearly any innovation that upsets a long established business system, there will be obstacles along the way – inter and intra group rivalry, the deployment of an infrastructure of NFC readers, confusion by consumers faced with multiple alternatives, etc.. Nonetheless, the logic of the solution is irrefutable, and with time, we believe it is inevitable that these solutions will become a large, and possibly, predominant payment mechanism in the US. In this scenario, who wins and who loses? (Exhibit 13)

Winners: Like most things in the Web2.0 world, we see value accruing to the “meta aggregators” Google, Apple, Amazon and Facebook, which we believe will provide platforms to integrate user experiences across platforms, including managing payments made via mobile devices. Web savvy merchants will also be beneficiaries, as the technology promises to reduce costs and provide meaningful data. NFC hardware for mobile devices is very low in cost and subject to commoditization, but point-of-sale terminal makers, such as Verifone, will likely be real beneficiaries of the coming roll out.

Losers: The traditional card networks, issuers and payments processors have the most to lose. NFC mobile payments could break users from their dependence on cards, bypassing the authentication and settlements process in favor of more straightforward transfers. At best, these players will face significant pricing pressures as fees become more transparent to users and switching costs decline. At the same time, banks will still have the opportunity to underwrite consumer debt, although likely on very different terms.

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