Payments: MCX and the Advantage of the Amex and Chase “Closed-Loop” Networks
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
September 29, 2013
Payments: MCX and the Advantage of the Amex and Chase “Closed-Loop” Networks
- As “closed-loop” networks, Amex and (with the Paymentech merchant processing business and its white-label licensing of VisaNet) Chase enjoy business and regulatory advantages over other payment and bank providers. Specifically:
- Business: Given direct relationships with both merchants and cardholders, Amex and Chase are able to combine in-store transaction data with out-of-store purchase data to design and manage merchant loyalty programs. This “closed-loop” advantage will be increasingly important as merchants leverage the shift to mobile to improve ad-spend efficiency through electronic couponing; we note both Amex and Chase remain committed to the Isis mobile wallet which uses NFC-technology to facilitate electronic couponing.
- Regulatory: Closed-loop networks are exempt from Durbin and so can offer prepaid accounts, with demand-deposit features such as bill-pay, check-writing, and ATM-access, without facing restrictions on the card acceptance fees charged to merchants. Amex has leveraged this with its Bluebird “checking and debit alternative” account (see Exhibit) marketed through Wal-Mart and will have superior, unregulated economics as the merchant distribution channel for payment services becomes more important including, in particular, with the launch of MCX.
- The closed-loop advantage of Amex and Chase will only increase if, as seems likely, the Durbin interchange cap is lowered from the current 24 cents/transaction to 7-12 cents/transaction, and banks must restore profitability by increasing consumer fees.
- In this context, Chase’s initiative to develop its own proprietary closed-loop network (through licensing VisaNet) is not merely an offensive measure to add value to merchants by gaining direct access to transaction data but also a defensive measure to protect the core retail transaction account franchise.
- While technically “closed loop”, Discover outsources merchant processing and so must partner with third-party processors, such as First Data, to accomplish what Amex and Chase can handle in-house; this is already creating an obstacle in the Paypal/Discover joint venture.
Exhibit: Bluebird by Amex Marketed through Wal-Mart as a “Checking and Debit Alternative”
In July, MCX appointed Dekkers Davidson as CEO from Barclaycard US where he launched a cloud-based mobile wallet using QR codes at point-of-sale. While MCX has shared only the barest details of its plans (barcode initially rather than NFC, for example) and not given a timetable for launch, it is an important initiative that will likely transform the payments and advertising value chains, and broader relationship between retailers, banks, and customers. Existing MCX members process $1 trillion in annual payments (compared with $4 trillion for the current major networks combined and approximately equal to the US purchase volume of MasterCard – see Exhibit 1), so the MCX card/wallet will launch with scale.
Exhibit 1: Purchase Volume on General-Purpose Credit Cards
The transformational potential exists because a core goal of MCX is to integrate advertising/couponing with user profile/preference information including that revealed by payments/transaction records. This will make advertising meaningfully more efficient through targeting individuals rather than demographic groups; the numbers are large with $170 billion of US media ad spend (see Exhibit 2) representing approximately 7% of US retail sales of $2.4 trillion. Furthermore, if successful in improving advertising efficiency, MCX will generate a competitive edge for consortium members, and hence incent broader merchant participation until MCX becomes a “table stake”, particularly in categories such as apparel, restaurants, department stores where advertising spend is a significant portion of gross margin (see Exhibit 3).
Exhibit 2: US Total Media Ad Spending by Media Exhibit 3: Advertising Spend/Gross Profit
Advertising efficiency will get an additional boost if, as is likely, MCX partners with an online provider, such as Foursquare and Facebook, capable of filling out user profiles with the purchase/coupon activity of friends shared through social media. MCX will not, however, work with an online partner that does not protect merchant ownership of their own transaction data; as John Manna from Lowe’s puts it: “What would those other wallets be doing with that data if they were the ones collecting it? Would they use it to steer consumers to competing stores? The control and ownership of the data is really important to all us retailers”.
The Role of Store-Specific or “Proprietary” Cards
A core principle of MCX is that merchants individually (not collectively through the consortium) will own their own data; in practice, this means MCX will, at least initially, need to use store-specific or “proprietary” cards – just as Target and Starbucks presently do – to wall off in-basket transaction data from consortium members, the provider of the ultimate payment account, and other intermediaries. These proprietary cards (whether physical or virtual in a mobile wallet) will need prepaid functionality to store electronic coupons even if funds from an ultimate payment account are passed through (as in the case of the Target debit card) and not loaded (as in the case of the Starbucks card).
Proprietary cards also offer merchants the potential to lower acceptance costs by steering customers to fund via electronic check (over the ACH network) rather than a Visa/MasterCard-accessed account. The Target debit card is funded exclusively through ACH payments and is referred to as a “decoupled” debit card since the card is not issued by, or tied to, a particular bank but accesses through ACH checking accounts at a variety of banks; interestingly, ACH is not available for funding the Starbucks card. In practice, as debit interchange falls (from an average of 50 cents before October 2011 when the Fed implemented Durbin to approximately 24 cents, incidentally reducing bank revenue by ~$6 billion, and possibly falling again to 7-12 cents depending on the outcome of on-going litigation), the incentive to steer to ACH from traditional debit is declining; this is particularly true given ACH settlement risk which arises because merchants cannot check funds availability in real-time, as they can with PIN debit, and do not enjoy Visa/MasterCard protection if funds prove unavailable, as they do with signature debit.
From Interchange to Electronic Coupons
However, there remains a strong incentive to steer to ACH from credit, to the extent a customer is motivated by card rewards rather than financing (as is the case for approximately 70%, of spending on credit cards); this is because credit interchange remains 1.5-2% of transaction value and can reach 2.5% on “premium” cards with high customer rewards (see Exhibit 4). While these rewards are ultimately funded by the merchant (through the interchange mechanism) they are associated in the customer’s mind with the issuer bank, and it is this that merchants will seek to change through MCX. If a merchant is going to fund rewards, it would rather these at least support the merchant brand, rather a bank brand, and better yet drive measurable
Exhibit 4: Credit Interchange on $40 Transaction
In short, taking advantage of the transition to mobile, MCX hopes to redirect interchange to electronic coupons thereby creating an incentive for cardholders to switch to MCX, over bankcard, payments. The transition to mobile is an important catalyst because it has the potential to relieve customers of the wallet-clutter arising from a multiplicity of store-specific coupons; indeed, applications such as Apple Passbook, are designed to achieve precisely this. To be successful, MCX will need to convince customers that its rewards offer a better value proposition than traditional issuer bank rewards (as Target has done with the 5% discount offered on purchases made with Target cards). To the extent MCX uses electronic coupons, important components of the case to customers will be at will relevance, clutter-management, and redemption convenience; the latter suggest that MCX will likely offer an umbrella coupon program, so that rewards can be redeemed at any MCX merchant, along with store-specific programs.
Bank Response to MCX
Banks are responding to the threat that merchants will use merchant-based rewards, including electronic couponing, to migrate customers from bankcard- to ACH-based payments. A collective solution is to tokenize ACH so that a customer account is represented by a temporary “token” number rather than the permanent checking and routing account numbers. This has security benefits, but may also increase bank control over routing if ACH migrates to a token-only protocol; a customer will then not be able to enable ACH payments simply through providing a voided check to a merchant since tokens, and hence up-front bank, involvement will be necessary.
Individual bank solutions include vieing for MCX business perhaps through offering white-label credit or decoupled debit, and vieing for the business of individual merchants whether or not participating in MCX. We note that while MCX is a collaborative merchant approach to reshaping an industry structure in payments seen as excessively favorable to issuers, merchants are also looking for an edge over their merchant competition. Issuers can play an important role since they have access to data about a customer’s “out-of-store” purchase activity – that is, their payments at competitor merchants. Arguably, this out-of-store payments data is more valuable than putatively intentional data from online search activity.
Regardless, combining out-of-store (even if not in-basket) purchase information with in-store transaction information directly available to a merchant holds the promise of improved ad-spend efficiency. This is a key success factor for a merchant particularly given the dynamics of trade-spend; merchant promotions are often funded by manufacturers (so CPG companies in the case of grocery stores) and a merchant who uses these funds more efficiently can expect a greater share of trade-spend and hence possible virtuous circle of increasing advantage over competitors. Of course, issuers have partnered with merchants in the past, most visibly through co-brand cards, but these partnerships have tended not to involve relatively static rewards programs rather than the more dynamic electronic couponing that will be enabled by mobile wallets.
Isis and the Opportunity for Amex and Chase
Electronic couponing demands more intense, “big-data” driven engagement between issuers and merchants than the co-brand partnerships of the past, and this is reflected in a shift of focus at MasterCard and Visa; at MasterCard, for example, 40% of account personnel are merchant-facing which we estimate as having more than doubled over the last five years. However, Visa and MasterCard (and hence their issuers) are structurally disadvantaged in that their data relationship with merchants is at one-remove; the defining characteristic of “open-loop” payment systems is that an acquiring bank represents the merchant in the network.
In contrast, Amex operates a “closed-loop” payment system where it has a direct relationship with both merchant and cardholder, and so has full access to all transaction and consumer data. Combined with in-basket transaction data (available to the merchant) this can improve the efficiency of ad-spend and electronic couponing. Amex has invested in exactly this including through acquisitions such as that of Loyalty Partners, specializing in multi-partner and customized loyalty programs, for US$585 million in March 2011. At the time, Amex’ Vice-Chairman Ed Gilligan articulated the company’s strategy around working with merchants to drive incremental sales: “the loyalty coalition model is growing rapidly in many parts of the world. Increasingly, consumer decisions about where to shop and how to pay are based on loyalty offerings and Loyalty Partner is a premier player in this space”.
Technically, Discover is also a “closed-loop” system but, in practice, Discover outsources merchant processing so that the involvement of processors, such as First Data, is necessary to implement partnerships. As PayPal has found out, this can make working with Discover unwieldy; Amex does not face the problem because it does not outsource processing. The other issuer that now controls both a network and merchant processing business is Chase which assembled the resources as a result of two important transactions:
- In May 2008, Chase announced it was ending its joint venture with First Data around the Paymentech merchant processing business, and moving its share of the joint venture in-house as “Chase Paymentech”. Gordon Smith, then-CEO of Chase Card Services, commented on the firm’s focus on merchant value-add: “Merchants are moving beyond traditional payment vehicles and we expect to be at the forefront of the industry, developing and investing in new forms of payments and related transactions that bring value to merchants”.
- In February, Chase announced it was entering into a 10-year license arrangement to white-label Visa’s processing system, VisaNet, and use this to develop a proprietary processing service that will manage both payments and loyalty rewards as well as lowering card acceptance costs; the service will not be under Visa’s acceptance brand so Chase will need to introduce its own acceptance brand and sign acceptance agreements with individual merchants. Jamie Dimon commented of the deal: “It allows us to go to merchants and strike our own [deals]”.
We note that both Chase and Amex, the only two companies with truly closed-loop architectures, are also the only two remaining participants in the NFC-enabled Isis wallet (now that Capital One and Barclays have dropped out). The closed-loop architectures of these two firms give them an important advantage as mobile wallets catalyze merchant use of electronic couponing, and it makes sense that they back the enabling NFC-technology. Barcode technology, of course, can be used for couponing (as it is now for paper-based coupons) but is less convenient in that the mobile wallet user will need to scan each coupon; in the case of NFC technology, the wallet can be smartened to select and redeem any relevant coupons in one “tap”.
Bluebird, Chase Liquid, and Durbin
Another characteristic shared by Amex and Chase remaining in Isis, but not Capital One and Barclays which dropped out, is that Amex and Chase both have significant prepaid franchises including Amex Serve and Chase Liquid. With an important caveat discussed below, prepaid cards are exempt from Durbin interchange regulation and so offer the issuer a chance of higher fees than debit cards.
Unfortunately for Visa/MasterCard issuers, the Durbin exemption fails if the prepaid account can be accessed other than by a card, such as for bill-pay for example. As a result, initial bank attempts to circumvent Durbin by transferring the functionality of a demand-deposit account to a “prepaid” account failed. However, Durbin does not apply to “closed-loop” networks such as Amex and the private network Chase is developing as a result of its licensing deal with Visa. This creates an important regulatory advantage in the prepaid business for closed-loop networks, in addition to the advantage they enjoy through having full access to merchant transaction data and cardholder data. Amex has deployed that advantage with its Bluebird prepaid account in joint venture with Wal-Mart (see Exhibit 5); in February, Bluebird had $275 million loaded funds and 575,000 customers of which 85% were new to Amex and 45% under 35.
Exhibit 5: Bluebird Prepaid Account Marketed by Amex through Wal-Mart as a “Checking and Debit Alternative”
Bluebird is marketed through Wal-Mart’s near 4000 stores in the US explicitly as a “checking and debit alternative”; subject to an account maximum of $100,000 it is FDIC-insured and offers, in addition to card-access at point-of-sale, non-card access including bill pay, checking (albeit subject to pre-authorization), and ATM access. The consumer fees are meaningfully lower than other prepaid accounts (and checking accounts) because when the Bluebird account is used at point-of-sale it generates unregulated fees. As attorney Tom Brown put it in a 2012 pre-paid conference: “there is no restriction on what Amex can pay itself”. There is rich irony in the Amex/Wal-Mart partnership:
- First, having for years been blocked out of the bank distribution channel for its payment services by the network exclusivity rules of Visa and MasterCard (finally struck down by the Supreme Court in 2004), Amex now finds itself in an advantaged position with respect to the increasingly important merchant distribution channel; this is because, unlike Visa/MasterCard bank issuers, it can add demand-deposit features to prepaid accounts without triggering Durbin fee restrictions. As a result, it is in a position to offer “checking and debit alternatives” to consumers through retailers, including MCX, at more attractive rates than traditional banks!
- Second, having for years railed against the high acceptance costs of general-purpose cards and demanded regulation, Wal-Mart has partnered with a high and unregulated fee provider. Indeed, it is precisely the high (and non-Durbin regulated) acceptance fees charged by Amex when Bluebird is
- accepted at competitor merchants that allows Wal-Mart to offer “checking and debit alternative” features at below-market rates.
Given Durbin, as implemented by the Fed in October 2011 (let alone how it may be implemented following current litigation under Judge Richard Leon), rendered approximately one-third of bank checking accounts unprofitable (because of the loss of debit interchange), banks are likely to have to increase consumer fees. There is therefore a meaningful opportunity for Amex to distribute unregulated prepaid accounts with demand-deposit features through retailers not merely to the “under-served” by banks but also to the “served but dissatisfied with checking account fees”. Daniel Eckert, vice president of financial services for Wal-Mart, put this explicitly: “Bluebird is really designed as a checking and debit alternative to appeal to the millions, and I would even suggest tens of millions of customers who just aren’t getting the value they’re expecting from their traditional checking accounts.”
In short, the unintended impact of Durbin has been to provide a regulatory advantage to closed-loop networks in providing a transaction account. In this context, Chase’s initiative to develop its own proprietary closed-loop network is not merely an offensive measure to add value to merchants through combining transaction data with cardholder data in the design and management of loyalty programs, but also a defensive measure to protect the core retail transaction account franchise.