Too big to fail, or too big to see small? Credit companies and micro-payments

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It is a well-known truism that companies lose their market share (and their shirts, and sometimes their life), when they are so tied into their big, currently lucrative business model to support the small opportunities that can grow into big ones. In this instance, I am referring to the credit-card companies who missed the boat on micro-payments, got lucky in that no one stepped in fully (or at least successfully), and seem dead set on doing so again.

Most people think of credit cards in terms of the consumer side. You make a purchase, the agreed price is $x, you swipe your card (or put the number on the Web page or through the phone), and within some period of time get a bill that you pay off. From the seller (a.k.a. merchant) side, it is a little more complex, with all sorts of pricing and fees that you pay. Put in other terms, if I sell you an iPod for $299 and charge your Visa or MasterCard, my store will pay some amount in fees to the credit card company for the privilege of processing the transaction. Why would I do that?

  1. It is very hard to do business nowadays without accepting credit cards. This is just a cost of doing business.
  2. It is a lot easier and safer to manage my funds via the credit cards, rather than have to worry about cash, which can physically take up space, get ruined, become misplaced, or be stolen, anywhere in my store or on the way to the bank.

The fees paid by merchants vary widely and are very confusing. Many claim this is done intentionally by the processors and credit card companies in order to get more from merchants. If you want a good introduction to how to read the bills, check out the article in the April 2007 issue of Inc magazine. I would also recommend a good credit card consultant if you process any serious volume. In a very simplified version, the merchant essentially pays several fees:

  1. Monthly fee: This is a flat monthly fee for the right to accept and process credit cards, and may include a terminal (that card-swipe machine you see at your local store), support or other services.
  2. Per-transaction fee: This is a flat fee that is charged per transaction. Average rates tend to be $0.10 to $0.15, according to the aforementioned Inc article and several experts I have spoken with, but tend to move higher for Internet merchant accounts, i.e. those accounts specifically set up for processing payments online.
  3. Discount rate: This is anything but a discount. It is the percentage of the transaction the processor takes. It covers both the interchange fees from Visa and MasterCard, as well as profit to the processor. 

 Using as an example PayPal, the most popular processing engine on the Internet, the fees in its two basic plans are as follows. It is important to note that PayPal has dramatically simplified the structures. Most processors do not provide the advanced online services PayPal does, and charge different rates based on card type, etc.

  • Website Payments Standard
    1. Monthly fee: $0
    2. Per-transaction fee: $0.30
    3. Discount rate: 1.9% to 2.9%
  • Website Payments Pro
    1. Monthly fee: $30.00
    2. Per-transaction fee: $0.30
    3. Discount rate: 1.9% to 2.9%

If you look at the numbers, you quickly see that if your average sale size is $50, $100 or more, the per-transaction fee of $0.10-0.30 is only a tiny amount of the total sale, bumping your discount rate up by at most 1%, and usually far less. No one wants to give up 1% in additional costs, but it is not disastrous. If it is, you have more fundamental business problems and need professional help.

On the other hand, when you make sales of under $10, and especially really small ones like under $1, you can see that the per-transaction fees can double, triple, or worse your discount rate. If you sell 2 readings of an ebook for $5, even if you somehow got a discount rate of 2%, the $0.30 per transaction fee adds 6%, quadrupling your discount rate. This is a serious issue.

These very costs - which used to be worse - are the main reason many stores have those wonderful signs that say, "minimum charge for credit card $10/$20" or similar.  And it is for this very reason that many businesses built around selling items for small amounts online took a very long time to take off.

How did it get this way? Visa, MC and the like are really just passing their costs on. They have a fixed cost to process each transaction, and they have a percentage cost for each transaction, hence it makes sense to pass it on that way. However, those fixed costs are, largely, minimal. In the early days of the credit card industry, for those of us who remember it, there were no Internet or dial-up terminals. The merchant took your card, made an impression, and then forwarded it on to the processor. Handling all these paper slips was quite a labour-intensive and capital-intensive proposition for both merchant and processor. Add to that the probability of lost slips, meaning lost ability to get the funds as well as possible theft, and the costs could get quite high.

No longer. Today, nearly every credit card transaction is handled electronically. The per-transaction costs are tiny. Visa does not even break it out separately in its 10K. Thus, although these charges may have dropped, they certainly do not reflect the lower costs. Given the efficiencies of electronic transaction processing, the card companies certainly viewed it as in their best interests to reap the rewards of the information technology revolution and earn higher profits.

The issue here is that if they did, indeed, reduce these amounts, the minimum size of a credit card transaction would go down, opening a whole new class of transactions, i.e. micro-payments.

As a result of the credit card firms clinging to their old models, many new attempts to support micro-payments has opened up:

  1. Carriers: The wireless carriers have opened up their billing infrastructure. Although their costs are still high, they are certainly more flexible and lower than the credit card companies. Thus, many companies have begun to offer small transactions that would not be economically feasible via credit cards, charging instead via the carriers. Although many of these do eventually get passed through to the credit cards when the carriers charge their bills: (a) any extra middleman means someone is taking a profit they could have had; (b) when AT&T or Verizon wireless, with their massive size, process payments, it is undoubtedly at a far less profitable rate to the processors than the many smaller providers. 
  2. ISPs: A number of ISPs began to offer services similar to mobile carriers. This has not taken off in the United States.
  3. PayPal: PayPal has been very wise, effectively becoming a bank. Sure, the traditional PayPal is where I have an account with a credit card number, as do you, and I can send money to your PayPal account from mine, thus charging my card. But many people now maintain PayPal balances and send funds from one person to another, or one consumer to a merchant, without ever going near credit cards. The cost to PayPal of these transactions is near-zero, while the lost profit of these transactions to the credit card firms is quite large. Let's look at it via the numbers. In the last quarter for which information was reported, Visa received $749MM in service fees on payments transaction volume of $652BN. Put in other terms, it makes revenue of 0.11% of processed volume. PayPal, which is both a competitor and a customer of Visa, had $602MM in revenue on $14.93BN in payments volume. In similar terms, PayPal makes revenue of 4.0% on processed volume, or 36 times the revenue per dollar of transaction. Some of this is simply due to PayPal being in a higher-fee business, further down the food chain from Visa. But a large amount of it is due to PayPal being able to simplify transactions between accounts without needing the credit card companies.

Other similar firms are slowly (or not so slowly) popping up.

The credit card companies missed the boat. They viewed themselves as indispensible, that no one can do non-cash or slow-check transactions without them, thus:

  1. We can charge what we want.
  2. We can structure it how we want.

Along came the carriers, and especially the PayPals, and said, "we will change the model":

  1. We will provide low-cost person-to-person or business-to-business transactions without the credit cards
  2. We will make it a "push" model: the money is transferred when I push out to my merchant, rather than giving the merchant enough sort-of-secret information, like my credit card number, known in industry parlance as PAN, and lately lots more information, like the address, secret number/CVV/CSC/CVV2/etc., wherein they now can "pull" information out of my account. I recently was involved in a PCI compliance project with a company that processes large amounts of credit card transactions each month.

What will happen next?

  1. Smaller competitors (assuming PayPal and similar to be "small") will continue to provide more secure, easier-to-use, easier-to-protect and lower-cost models, eating into the smaller, and even larger, transactions that used to be the sole domain of the credit card industry.
  2. These competitors will begin to see how they can provide better solutions even for larger transactions and will begin to offer methods to make payments not only online, but directly compete with the cards' bread-and-butter, "card present transactions."
  3. Eventually, some of these may dwarf or even acquire a credit card company. Certainly the turmoil in the financial services industry, between the credit crunch and corporate troubles, will leave at least one weak enough to be acquired.

It is hard for those of us who remember the radical notion of a credit card, "will that be cash... or Chargex," to think of the credit card industry as a dinosaur. But the reality is that it is an old-time business. Unless it changes its model, it will be in trouble soon.