US Payments: Winners and Losers in Mobile

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

November 4, 2013

US Payments: Winners and Losers in Mobile

  • On Thursday, Google announced Android support for “host card emulation” which places payments credentials in the cloud and allows them to be securely accessed by mobile applications including digital wallets; in particular, NFC-enabled wallets no longer need to access the secure element of a ‘phone for payment credentials and so a roadblock presented by the carriers to mobile payments adoption has been lifted.
  • We now expect mobile payments to exceed industry forecasts for $50bn by 2017 and industry efforts to enable e-couponing to accelerate. Given First Data estimates US marketing/advertising spend potentially available for new digital solutions at over $500 billion (versus merchant card fees of $70 billion), this will shift competitive dynamics in payments from branded processing to the data access/analytics needed to target/personalize real-time “pay with points” and “e-couponing” programs at point-of-sale.
  • Industry advantage will accrue to firms that are able to effectively implement e-couponing through accessing/analyzing in-store transaction data from merchants and out-of-store transaction data from issuers, and those that can provide cloud-based authentication solutions; the importance of in-store data gives merchants more leverage in payments negotiations. Other winners will include:
  • AXP and Chase Merchant Services (because of closed-loop access to both cardholder and merchant data, and the ability to advantage acquiring businesses by discounting network fees and, to the extent e-coupons drive card utilization, splitting interchange with merchants);
  • VNTV (because of its analytics services to both issuers and merchants, leading share as an acquirer hence access to merchant data, and attractiveness to an issuer looking to build or strengthen a closed-loop);
  • MCX (because of access to in-store data), and suppliers to MCX as a consortium and merchants individually including: COF and ADS (because analytics capabilities and private-label platforms make them natural credit partner for MCX members), FIS (because of its expertise in, and partnership with MCX around, cloud-based authentication), and DFS (as a likely credit partner of, and agent to extend acceptance of MCX products beyond, consortium members).
  • Losers will include the carriers (because the secure element of a ‘phone can now be by-passed), card-on-file plays such as Pay-with-Amazon and PayPal (because static card numbers on file will be replaced by dynamic tokens in the cloud), and smaller issuers who will find it challenging to invest in the infrastructure for differentiated e-coupon programs:
  • Small issuers can work with Visa programs, such as V.me and Visa Offers, but both involve sharing the personally identifying information (PII) of their customers with Visa.
  • Large issuers are not prepared to share PII with Visa and, indeed, are concerned that Visa’s services to smaller issuers (around fraud management and cardholder offers, for example) are undermining their ability to build competitive advantage beyond discounted network fees. Along with network rules that are perceived to be restrictive and the Durbin debit interchange caps that apply only to “open loops”, this is causing tension between large issuers and the networks. The usual issuer recourse of shifting volumes to the other duopoly network is expensive and disruptive, and large issuers are looking for alternative solutions such as Chase’s private processing arrangement and WFC’s partnership with Amex around credit cards and Bluebird.
  • BAC is an important wild-card. If it follows Chase’s example by first taking back control of its share of an acquiring joint-venture with First Data and second negotiating with Visa for private-processing this will reduce network scale and revenue growth (given Chase and BAC account for ~40% of Visa’s US volumes). Furthermore, it will likely catalyze other large issuers to work together on their own mini-network; collaboration between issuers on a network has a precedent in clearXchange, the joint venture between Chase, WFC, and BAC for settling and clearing P2P payments. We have three observations about the economics of the Chase closed-loop:
  • While the arrangement has been presented as Chase licensing VisaNet, Visa will not receive the network fee that merchants would ordinarily pay and is almost surely not getting the network fee that Chase would otherwise pay. The license fee may have been set so that the deal was not dilutive to Visa in 2014, particularly given Chase’s volume shift from MasterCard, but it is almost surely dilutive as Chase’s private-processing volumes build beyond 2014.
  • Chase’s private processing volumes will likely build because the closed loop gives its acquiring business, Paymentech, important advantages including the ability to offer more favorable rules and pricing policies to merchant customers including by an undercut of Visa’s network fees. Given the acquiring fee for a large merchant is typically less than 5 cents (and sometimes fractions of a penny), while the network fee to the merchant is 5-6 cents on debit and double that on credit, a small reduction in network fees has a disproportionate impact on acquirer price-competitiveness.
  • In addition, the closed-loop facilitates partnership between Chase and merchants on the design and implementation of e-coupon programs with the potential to favorably influence cardholder behavior around choice of merchant and choice of card provider. If the former proves out, Chase will gain share in its acquiring business; if the latter, Chase will gain share in its issuing business and likely catalyze action by BAC and other large issuers to protect their core credit and debit (checking account) franchises by vertically integrating their issuing and acquiring businesses and so dis-intermediating the networks.
  • We expect growth in US purchase volumes at Visa/MasterCard over the next 6 years to lag by 1-2% our forecast for overall growth in card volumes of 9% (up from 7% from 2006/12 as the economy improves) because of share gains by AXP, MCX (and it likely partner DFS), and EFT networks (see Exhibit). Unlike over the last 6 years, V/MA are unlikely to be able to increase pricing in the US (because Durbin increases the ability of merchants to implement low-cost routing and because of discounting of network fees by Chase and other bank closed-loop networks) so that US revenue growth will not exceed growth in purchase volumes. The growth estimate does not include the effect of share loss to bank closed-loop networks to which V is more vulnerable than MA because 40% of its US volumes are concentrated with JPM/BAC versus 20% at MA.

Exhibit: Purchase Volume Forecast by Payment Rails (excludes impact of bank closed-loops)

Source: Nilson, SSR Estimates

Overview

We believe mobile payments will happen sooner, and be more transformative to the payments industry, than investors expect:

  • Sooner: With Android “KitKat” support for host card emulation (HCE – see Appendix for review of the technology) announced Thursday, Google has resolved an important road-block to adoption of mobile wallets by enabling payment credentials to be securely managed in the cloud rather than on the secure element of a device. In supporting HCE, Google has shifted its position from providing a wallet (and competing with the carrier-sponsored Isis wallet) to providing a platform (which does not involve access to the secure element of a smart phone and the associated carrier tolls) for all mobile wallet providers. Assuming carriers do not attempt to lockout HCE, we expect mobile payments to exceed industry forecasts of $50 billion by 2017. We note that, once they reach a tipping point, technology transitions can happen quickly (see Exhibit 1); furthermore, substantially all point-of-sale terminals shipped today are NFC-capable and, particularly given an acceleration in the usual 4-year POS terminal replacement cycle because of the October 2015 date for a shift of fraud liability from issuers to merchants on EMV cards, will likely be installed at most merchants by 2017 compared with 5% today.

Exhibit 1: Structural Change in Newspaper and Music Business

Source: McKinsey, NAA, RIAA

  • More Transformative: Our core thesis is that the shift to mobile payments (even if initially small relative to overall card volumes of $4 trillion) will channel funding from merchant advertising/marketing and issuer-level rewards programs to “pay-with-points at point-of-sale” and “e-coupon” programs. Mobile payments are the catalyst for this for two reasons: firstly, because the screen on a ‘phone allows a user to select “pay with points” options at point-of-sale (just as consumers presently do online – see Exhibit 2), in a way that is not possible on a card; and, secondly, because the payments chip on a ‘phone has more powerful information-processing capabilities than the mag-stripe on a traditional card. In particular, unlike a mag-stripe[1], a chip can manage balances and coordinate payments across multiple payment accounts (including loyalty points accounts as well as a primary payments account) and allow point-of-sale terminals read and write access (so that they can read payment credentials to accept payment and write rewards in real-time to loyalty accounts managed through the payment device). The ability to design and implement e-coupon programs and, in particular, to control and protect the payments data that will be used to personalize and target offers is already affecting industry structure including, for example, motivating the formation of the merchant consortium MCX and the decision by Chase, announced last February, to establish a private processing infrastructure.

Exhibit 2: Integration of Loyalty Program and Payments on Chase-Amazon Card

This “e-couponing” is potentially transformative because the ability to personalize/target offers to a consumer’s payment patterns and context (e.g. location and time of day) will likely render them more cost-effective in influencing consumer behavior than current merchant marketing/advertising programs (including than less targeted coupon offers such as Groupon) and issuer-based card rewards such as miles and cash-back. Industry structure is already being influenced as merchants and issuers address the risks and opportunities:

  • Merchants: Merchants see an opportunity to break the cycle where, through the interchange mechanism, they are funding issuer-based rewards. In a mag-stipe environment, Target has shifted 14% of US tender to its proprietary “RED” cards by offering a 5% discount on all RED card purchases; the promise of mobile is that MCX can achieve similar steering success (across merchants accounting for $1 trillion of consumer spending) at a lower cost by using e-couponing rather than a blunt, umbrella 5% discount.
  • Issuers: Auriemma Consulting reports from an August survey that over 80% of consumers said they would use a card more frequently if it included merchant-funded offers. In a mag-stripe environment, these so-called “card-linked” offers are typically presented online and redeemed for statement credit; the promise of mobile and chip-enabled payment devices is that these offers can be made more relevant (by being presented in real-time dependent on payment patterns and context) and convenient (by being redeemable at point-of-sale in the normal flow of a payments transaction). Issuers care because if e-couponing influences consumer choice of payment card and payment provider, it will affect their core credit and checking account franchises.

Winners and Losers

Issuers and merchants have experience of working together in payments through co-brand programs and through private-label cards. However, real-time, context-sensitive e-couponing will demand a deeper and more dynamic relationship as successful personalization/targeting of e-coupons will require the integration of in-store payments and behavior information available to the merchant and out-of-store payments and behavior information available to the issuer. Put another way, the shift to chip-enabled payments shifts the competitive dynamic from branded processing to data access and analytics.

Winners in the US Shift to Mobile Payments

  1. Merchants: The unequivocal winners are merchants because they now have an important bargaining chip at the payments table: access to SKU-level in-store transaction data. This new power is reflected in more “merchant-friendly” approaches adopted by the networks (including an increase in the merchant share of incentives and higher staffing of merchant-facing functions). Merchants are aware of the importance of their data and have come together in the MCX consortium in part to protect and control these data as payments shift to mobile.
  1. Suppliers of Data Analytics: The personalized targeting of e-coupons is obviously data-intensive, and we see suppliers of analytic solutions that can help interpret and leverage the “big data” generated for consumer payments activity as winners. Among large, publicly traded companies, COF, AXP, and VNTV are leaders in data analytics with VNTV, in particular, enjoying an important opportunity to support its large merchant-clients with e-coupon program design. To provide a sense of scale, we note that FDC has estimated US marketing and advertising spend potentially available for new digital solutions at $550 billion[2] compared to the $30 billion US revenue pool for acquirers and, more broadly, $66 billion in fees paid by merchants for card acceptance (see Exhibit 3). It follows that, if e-couponing works, a small shift in the overall merchant marketing budget to “pay with points” at POS programs designed and executed with in partnership with analytically-oriented acquiring processors can make a meaningful difference to the acquirer revenue-pool.

Indeed, a flow of merchant marketing dollars to e-couponing could have a transformative effect beyond the acquiring business because the numbers are large relative to overall issuer economics including interest income as well as the interchange fees in the above exhibit; AXP made the point publicly in an August 2011 presentation (see Exhibit 4). As a result, if e-couponing proves to motivate consumer behavior not only around choice of merchant but also around choice of bank provider, then issuers will need to become involved to protect their core credit and debit (checking account) franchises. Obviously, this has long-been part of Amex’s “closed-loop” strategy and we believe it was a motivating factor behind Chase’s announcement last February of the creation of its own private processing infrastructure. We discuss these closed-loop arrangements in detail below.

Exhibit 3: 2012 Merchant Card Fees

Source: Nilson, 1022

Exhibit 4: The Digital Commerce Opportunity as Reported by American Express

Source: American Express, Financial Community Meeting, August 2011

  1. Closed-Loop Networks: We prefer AXP over V and MA because, as a closed-loop network, AXP has access to both cardholder and merchant information, and so greater ability to innovate around e-couponing; in addition, it does not need to coordinate innovation as much with third-parties (although, of course, there is some volume over third-party issuers of Amex-branded cards such as WFC). Visa and MasterCard are more structurally disadvantaged since their business model has traditionally been to provide brand and processing services to issuer banks (which own the relationship with cardholders) and acquiring banks (which own the relationship with the merchant). Visa is attempting to address this through the V.me wallet and Visa Offers which are appeals to the issuer and cardholder respectively to provide Visa with personally identifying information (PII) in return for value-added services, but large issuers are not willing to provide this information and are concerned at Visa’s attempt to establish a direct relationship with their customers.

Indeed, we believe a desire to keep its cardholder PII confidential prompted Chase to move forward with private processing and we see the closed-loop that Chase is building as a likely winner in mobile payments. While Chase is licensing VisaNet, it will surely not be paying the same per-transaction fees as on transactions through the standard Visa open-loop. Furthermore, on its private-network transactions, Chase can collect the merchant network fees that would otherwise be paid to Visa. In practice, we expect Chase to discount these network fees (of 5-6 cents/transaction on debit and 10-11 cents on credit) so as to give a pricing advantage to Chase Merchant Services (CMS) in seeking new merchant clients; given acquiring fees for large merchant clients are typically less than 5 cent/transaction and sometimes fractions of a penny, a small discount in the network fee can make a big difference to acquirer pricing advantage. We note that acquiring contracts are typically structured to allow a carve-out for three-party networks (as Chase’s closed-loop would be) so that Chase can offer a network discount and win “partial” acquiring business from new merchant-clients for transactions originated on a Chase-branded card without renegotiation of the in-place acquiring contract (which would then be restricted to transactions originated on the cards of other banks); of course, Chase is then in poll position to win the entire acquiring business when the contract does come up for renewal.

Given the ability to discount network fees and, as a three-party network, to win partial acquiring mandates, we see share gains by CMS in the acquiring business as highly likely. A more conjectural thesis is that Chase, by partnering with merchants to implement e-couponing, can generate a more valuable proposition for consumers than traditional card rewards and so win share in the issuing business. If this occurs, it will likely trigger more vertical integration by BAC, WFC and USB who both have meaningful issuing and acquiring businesses (with USB owning Elavon – see Exhibits 5 and 6) as they look to protect debit and credit franchises; in BAC’s case, it would likely first seek to gain sole control of Bank of America Merchant Services (BAMS) which is presently a joint venture with First Data. Such vertical integration will cause the acquiring industry will evolve from the current structure where large merchants typically have a single acquiring processor to a structure where large merchants have BAC as the acquirer for transactions originated on BAC-branded cards and Chase as the acquirer for transactions originated on Chase-branded cards e.t.c, and a default acquirer (possibly one of the vertically-integrated players) for all other transactions.

Exhibit 5: 2012 Purchase Volumes by Issuer and Network

Source: Nilson

Exhibit 6: 2012 Purchase Volume across Debit and Credit for Top Acquirers

  1. Private Label Card Companies: If e-couponing redefines competition by motivating consumer switching behavior between issuers leading BAC and possibly other banks to follow Chase’s example in vertically-integrating their issuing and acquiring businesses, C and COF will need a strategic response given their acquiring businesses are sub-scale from a closed-loop standpoint. One solution would be partnering or acquiring one of the bank-independent acquiring processors: VNTV, for example, has the acquiring scale of Chase.

A second solution is to expand the private-label card business in which C and COF are share-leaders behind GE (see Exhibit 7). More generally, we believe that private-label card businesses are winners as merchants look to use e-couponing to steer consumers towards store-card products both to control and protect transaction data (so that it cannot be used by Google, for example, to drive their customers to competing providers) and to manage card acceptance costs. The control and protection of data has motivated Starbucks store card product which now accounts for over 20% of US tender, and the management of card acceptance costs has motivated Target’s “RED” store products which, across credit and debit, now account for 14% of US tender (see Exhibit 8).

Exhibit 7: 2012 Private Label Outstandings and Charge Volume in $bn

Source: Nilson, 1019

Exhibit 8: Percentage of Store Sales at Target Paid for Using Store “Red” Cards

Source: Company Reports

The challenge faced by private-label card providers is the limited utility of their products which, unlike Visa and MasterCard branded products, are not “general-purpose” in the sense of being widely accepted. Aside from the customer inconvenience of having to carry multiple store cards, the limited-utility of the credit products has an economic consequence: card activity (in terms of both outstandings and charge volume) tends to be disproportionately lower than on general-purpose cards than costs (in terms of issuing plastic and servicing cardholders). As a result, the economics of store credit cards depend on higher card APRs which can lead to adverse selection (better-credit customers will tend to prefer the lower-APRs on general-purpose cards).

As a result, we see the organization of merchants into the MCX consortium (whose members account for $1 trillion of US purchase volume) as an important development for private-label companies. Those that can leverage their existing merchant-platforms and service organization to become partners with MCX will achieve broader utility for their products (assuming acceptance by all, or at least a critical mass of, consortium members) which will therefore create less wallet-clutter for consumers and more favorable economics through more general-purpose utilization; some wallet clutter is inevitable but digital wallets will increase consumer tolerance by automating payment from a primary account and context-sensitive management of the “top-of-wallet” card. MCX will be looking for credit partners that can support them in using payments data in the design and implementation of e-couponing programs, and we see COF and ADS as natural candidate-partners given their analytics capabilities.

  1. Other Present/Likely Partners of MCX: In addition to private-label credit programs, MCX has confirmed an interest in offering ACH-enabled “decoupled” debit products probably leveraging the experience of Target which is a member of the consortium and whose ACH-enabled debit product now accounts for 6% of US sales having grown rapidly from 2010 when it was launched. Target offers a hefty reward for use of its proprietary cards: a 5% discount at point-of-sale or Target.com and, since November 2011, free shipping for Target.com purchases. To support this discounting, Target comments, “our internal analysis has indicated that a meaningful portion of the incremental purchases on our REDcards are also incremental sales for Target, with the remainder representing a shift in tender type”; the company has added that as long as it continues to see 50% sales lift on activated cards it will continue to market the proprietary debit card “aggressively”.

The promise of e-couponing to MCX is that it can achieve a similarly meaningful influence on consumer behavior but in a more cost-effective manner (and without members discounting against themselves) through the personalization and more precise targeting of offers based on consumer patterns revealed through “hard” payment data (as opposed to the “softer” intentional data generated by, for example, online search and social activity). The challenges for MCX are to design and implement e-coupon programs that achieve this objective and to manage the settlement risk involved in using the ACH network as payment “rails” for debit product since it is not possible to verify funds-availability in the payment account before completing a transaction; this is not possible with signature-debit either but issuers, not merchants, take the risk for card-present transactions and it is not an issue with PIN debit transactions since funds-verification can be effected in real-time.

The tasks of designing the rewards programs and managing the settlement risk of ACH transactions are data-intensive and we believe MCX members will need intensive support from vendors to optimize their programs collectively and individually. As discussed above, we see COF and ADS as natural partners for MCX based on its expertise in the data-driven design of card reward programs and loyalty/marketing solutions respectively. Given its existing partnership with MCX and expertise in check authorization (which presents the same settlement issues as ACH-enabled debit), FIS is a winner; in addition, FIS owns the NYCE PIN-debit network and it would be natural for MCX to manage debit settlement risks by offering consumers the option of PIN-enabled debit over the NYCE network. That said, MCX has confirmed to us that PIN-debit is not being given the same priority for now as ACH-enabled debit.

MCX products will have more utility to customers if they can be used by merchants who are not members of the consortium, and MCX is likely to be able to generate a compelling rewards-proposition for purchases at non-member merchants given that MCX can source rewards more cheaply than bank issuers and given the opportunity to leverage data from in-MCX purchases. These rewards will probably not be redeemable by “pay with points” or e-coupons at point-of-sale at merchants who are not members of MCX and non-member merchants will likely pay interchange to the MCX consortium. Indeed, we believe these will be important disadvantages to non-member merchants of MCX and will lead MCX to increase penetration of the merchant community over time.

However, if MCX card are to be used at all at non-member merchants, they will need to be enabled for a network and, at least in the case of credit cards, carry an acceptance brand. In the case of debit, this broader acceptance at merchants who are not members of MCX can be achieved by enabling the cards for FIS’ NYCE network; in the case of credit, it can be achieved by enabling the cards for Discover which has close to parity acceptance with Visa and MasterCard in the US albeit at the cost of opening its loop to third-party acquirer processors such as First Data and TSYS; the notion is the card would be used in MCX-brand mode for payments at merchants who are members of MCX and in Discover-brand mode for payments at merchants who are not members of MCX. A partnership between MCX and Discover would also offer the opportunity for Discover to provide credit on a private-label basis within the MCX network and Discover-branded basis outside the MCX network, and for MCX to enable debit cards for the PULSE as well as NYCE PIN-debit networks to broaden the out-of-MCX acceptance footprint.

  1. Suppliers of Authentication Solutions: Until now, payments credentials have been stored on a payments device (on a mag-stripe or chip for a traditional card or on the secure element of a smart ‘phone for the Isis wallet). However, the storage of these payment credentials in the cloud offers the potential for greater security, assuming a trusted transaction engine and particularly given the opportunity for dynamic tokens (versus embossed card numbers on current plastic which are tokens, albeit static, in that they stand-in for the hidden primary account number), greater customer convenience (no need to provision payments credentials into multiple devices), and savings (no need to pay for secure storage on each payment device). As payments go mobile, they provide a compelling use-case for technologies that can authenticate consumers and securely associate them with cloud-based information (in this case, payments credentials but also healthcare account information, for example). SimplyTap, which worked with Google on HCE, is an example; FIS and Paydiant are others.

In theory, the carriers can play a role by using the knowledge that a particular mobile device is registered to a particular user to authenticate that user. Verizon, for example, announced last month an upgrade to its cloud-based “Universal Identity Service” and articulated a goal of being the world’s “largest identity provider[3]”; in practice, the carriers have not taken a lead in the US and preferred to attempt to monetize access to the secure element of a smart ‘phone.

Losers in the Shift to US Mobile Payments

  1. Open-Loop Networks: Given the importance to e-couponing of in-store transaction data, merchants are looking to protect and control it giving rise to changes in industry practice that impinge on the Visa/MasterCard business models including, for example, the Starbucks proprietary card which provides a precedent for more general proprietary cards from the MCX consortium, and Chase’s private processing network which provides a precedent for more general fragmenting of the network business into bank closed-loops.
  • Starbucks/MCX: In the case of Starbucks, consumers can fund the Starbucks prepaid account with Visa/MasterCard products (both directly and through PayPal) but Visa/MasterCard see only aggregated information when the consumer replenishes the card or PayPal account as opposed to the more granular (albeit not SKU-level) information when the consumer visits a Starbucks store. Obviously, Starbucks is a special case because frequent store-visits mean a consumer is more willing to devote scarce wallet- or screen-space to a Starbucks proprietary card or app respectively. However, we expect digital wallets to increasingly be able to manage card/app clutter and MCX to offer a card/app product which can be used at all MCX merchants as well as an API which can enable “pay with MCX” functionality on members’ proprietary mobile apps. We note that MCX, unlike Starbucks, will not allow customers to fund with Visa/MasterCard.

Quantifying the impact of MCX is speculative particularly given there have not even been any pilots yet (although we expect them by early 2014). We believe MCX is organized and committed to ensuring that merchants take advantage of the shift to mobile payments to escape from a position which they resent deeply: that of funding, through the interchange mechanism, rewards that are associated with issuer brands and not merchant brands. If we assume that over the next 6 years the MCX consortium shifts 15% of volume to its payment products as Target has done over a shorter time period, split 2:1 debit-to-credit, and membership expands so that it accounts for $1.5 trillion of total purchases (versus $1 trillion today), we generate the forecasts shown in Exhibit 9. This indicates annual growth in purchase volumes at Visa/MasterCard in the US will run 1-2% below assumed growth in overall card payment volumes, excluding the possible impact of bank closed-loop networks, because of share gains by MCX and DFS (assuming it partners with MCX to provide out-of-consortium acceptance and can leverage at physical point-of-sale partnership with online payment companies such as PayPal), AXP (because of its closed-loop advantage), EFT networks (because of the post-Durbin migration of debit from signature to PIN authentication), and store cards (as some large merchants implement proprietary mobile payment solutions independently of MCX).e impact on Visa/MasterCard volumes of the possible formation of closed-loop networks by the banks.

Exhibit 9: Electronic Purchase Volumes by Payment Method (estimates do not take account possible bank closed-loops)

Source: Nilson 1011, 1019; SSR Estimates

  • Chase/Bank Closed-Loops: We believe a key structural impact of the shift to mobile payments will be vertical integration of issuing and acquiring businesses as industry participants look to improve targeting of e-coupons and “pay with points” at point-of-sale programs through integrating in-store payments data (available to an acquiring processor which has forged a partnership relationship with a merchant) and out-of-store payments data (available to an issuing bank). We view the Chase private processing arrangement as an early example of this vertical integration and, as discussed above, expect Chase to gain share of the acquiring business – at least for transactions originated on Chase-branded cards if not more generally – by discounting network fees.

If Chase can use its position as acquirer to design and implement compelling e-coupon programs, it will support its merchant-clients in gaining share from competitors and hence gain share of the acquiring business. Furthermore, if these e-coupon programs influence consumer choice of credit or debit card provider, Chase will see a closed-loop advantage in its issuing business and hence engage a virtuous circle of winning share in both the acquiring and issuing businesses. Under these circumstances competitors will need to respond by closing their own loops where they can so that BAC, for example, closes the loop with BAMS (after gaining control of the joint venture with First Data). Other banks with smaller acquiring businesses, such as WFC and USB, may close their loops and/or form a mini-network (as BAC, WFC, and Chase have done with clearXchange to clear P2P payments) although this will not have the three-party advantage of truly closed loops.

Regardless, the effect of this clustering of payment networks will be to fragment and disintermediate the Visa and MasterCard systems. We see Visa as more vulnerable than MasterCard because its business is more concentrated with the two issuers, JPM and BAC, most able to form closed-loops; as shown in Exhibit 10, JPM and BAC account for 40% of Visa’s purchase volumes (and this concentration will increase as Chase shifts volume to Visa from MasterCard as part of the terms for forming its private processing network) versus just over 20% at MasterCard.

Exhibit 10: 2012 Purchase Volumes by Network and Large Issuer

Source: Nilson 1017, 1016, 1012, 1011; V/MA Debit/Prepaid includes PIN

  1. Small Issuers: Visa and MasterCard are addressing their disadvantaged access to issuer and merchant-level payments data through programs such as V.me and Visa Offers which, in essence, offer smaller issuers and merchants the promise of design-support for e-coupon reward and other value-add programs in return for access to their data. In particular, issuer participants in V.me share the personally identifying information (PII) of their consumers to enable, for example, e-mail alerts from the wallet.

Large issuers are not prepared to share PII in this way and, indeed, are concerned that network services to smaller issuers (around fraud management and cardholder offers, for example) are undermining their ability to build competitive advantage beyond discounted network fees. Along with network rules that are perceived by large issuers to be restrictive and the Durbin debit interchange caps that apply only to “open loops”, this is causing tension between large issuers and the networks. The usual issuer recourse of shifting volumes to the other duopoly network is expensive and disruptive so that large issuers are looking for alternative solutions including Chase’s private processing arrangement and WFC’s partnership with Amex around credit cards and Bluebird. To the extent these structural arrangements generate advantage for large issuers than cannot be matched at the network level, small issuers will lose share.

  1. Small, Stand-Alone Acquirers: To the extent mobile payments and hence e-couponing drive vertical integration of issuing and acquiring businesses, independent acquirers will be disadvantaged; they will not have access to the discounted network fees of closed-loop competitors and will not be able to access issuer-level payments data in the design and implementation of e-coupon programs.

As a stand-alone acquirer, VNTV has alluded to these risks and particularly the possibility that Chase, as a closed-loop network, may split interchange – that is use a portion of interchange revenues to fund e-coupon and other point-of-sale rewards programs. As a response, VNTV is the first acquirer to work with the Visa Offers program in which merchant rewards programs are informed by the network-level payments data available to Visa as opposed to the issuer-level payments data available to issuers; as noted above, the key difference is that issuer-level data can be mapped to personally identifying information (PII) because the issuer knows the identity of the cardholder whereas

network-level data cannot (except in the case of issuer participants in V.me). In practice, we believe VNTV will emerge a winner because it has the scale and analytics capabilities to be attractive as a partner for an issuer looking to build or strengthen a closed-loop. Acquiring processors that are not able to forge partnerships with issuers and do not have the scale to invest in leading data-analytics capabilities will lose share.

  1. Carriers: With the availability on Android of support for host card emulation, the US shift to mobile payments will likely evolve so that payment credentials are stored in the cloud rather than locally on a device and tokenized to improve security. Losers include the carriers because the actual secure element of a ‘phone can now be by-passed
  1. Card-on-file plays such as Pay-with-Amazon (because static card numbers on file will be replaced by dynamic tokens in the cloud). PayPal is evolving its model from a card-on-file play by extending its brand promise from simply protecting sensitive account information (since network- and issuer-level tokenization will increasingly accomplish this for both C2B and P2P payments) to providing value-added as a payment brand with, for example, order-ahead, skip-the-line, and Beacon-enabled hands-free payments; these convenience-services will likely need to be complemented with e-couponing.
  1. Starbucks experimented with managing multiple payment accounts in a mag-stripe environment with its Duetto card which carried two mag-stripes: one for payment with a Visa account and one for payment with a prepaid Starbucks account. Duetto was discontinued in February 2010 but the experience is likely to have shaped its current mobile strategy.
  2. Estimate provided by Ed Labry at this year’s Money 2020 conference
  3. http://www.americanbanker.com/issues/178_199/verizon-aiming-to-become-keeper-of-consumers-digital-identities-1062823-1.html
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