The stranglehold of payments networks

March 29, 2012

I’m mostly offline today, since I’m attending a payments conference at the Kansas City Fed. (And tomorrow I’m attending an econobloggers’ conference at the Kauffman Foundation: how jealous are you?) There’s a lot to digest here, but one thing already seems clear: if you look at the main players in the payments industry, whether they’re incumbents or new innovators who aspire to disrupting the status quo, everybody seems almost unthinkingly resigned to working on and within the present architecture, where consumers pay with their credit or debit cards, and merchants require some kind of way of accepting those payments.

Exhibit A, in this regard, is “The Credit Card Is The New App Platform“, a piece by Reid Hoffman and his colleagues at Greylock Partners, talking in a very smart way about all the value that can be added to credit cards as we move to a world of mobile apps and payments. The idea, basically, is that right now you have a dumb piece of plastic where all the real value is in that Visa or Mastercard logo; in the future, there’s a lot of opportunity in terms of making that piece of plastic much smarter.

Most of the most exciting innovation in payments, including companies like LevelUp, not to mention the iTunes store, is built on credit or debit card accounts: the first thing you do, when you download one of those apps, is type in your card number, and when you pay, the payment is ultimately made on your card — which means that it necessarily involves making substantial payments to those payments networks. iTunes, the conference was told this morning, has some 150 million card numbers on file, which is one reason why it’s so attractive to people looking to sell content or apps or music. Similarly, one of the great attractions of the Amazon Marketplace, for both buyers and sellers, is that Amazon already has the buyer’s card information on file. Other innovators, like Square and Stripe, are also innovating around credit and debit cards, specifically by making it much easier for the payee to accept those payments.

Visa and Mastercard, of course (and American Express, too) are very happy with this. They can work on innovations themselves, or they can outsource innovation to the likes of Reid Hoffman; either way, they get paid, because they’re the default payments architecture. But what we’re missing here is any kind of threat to their dominance. And that’s a great shame, because these dominant companies have an enormous amount of pricing power. The interchange fees that they charge merchants only ever go up; it took an unbelievably hard-fought act of Congress to bring those fees down just for bank debit cards. (Which is one reason why the number of prepaid debit cards is rising fast: they’re exempt from Durbin rules, and can charge very high interchange fees.)

The keynote speech at the payments conference today came from Joseph Farrell, the director of the bureau of economics at the Federal Trade Commission. He talked at great length about the importance of lowering the transaction cost of payments, and the way that would benefit both consumers and society; he also suggested that this was a key aspect of what the conference was about.

He’s right about the first: transaction costs are too high, and should come down, and there would be large positive externalities were that to happen. He’s wrong about the second, however: there’s actually precious little discussion at the conference about how transaction costs might come down. There’s much more talk about the way in which they go up far too easily: Visa and Mastercard have enormous pricing power, and can raise their prices as much as 30% without noticeably losing any customers at all. Merchants feel forced to accept such cards, no matter what the cost, while the costs to consumers, in the form of higher prices, are extremely well hidden. Visa and Mastercard essentially levy a non-negligible tax on a huge percentage of retail payments, and do so in a largely invisible manner; they then rebate some of that tax revenue back to consumers, bribing those consumers to force the merchants to pay the tax.

At one point last year, I got very excited about a new payments service called clearXchange, which promised the ability for people to pay each other without going through the Visa or Mastercard networks. And because it is backed by giant banks — Wells Fargo, Chase, and Bank of America — it has the potential to be really huge.

The problem is, it doesn’t actually work: it hasn’t taken off, for technical reasons I don’t pretend to understand. All I know is that when I meet executives from those three banks and bring up clearXchange, they tend to change the subject very quickly. It’s certainly not something which they seem to think is going to revolutionize anything, any time soon.

There is some innovation around payments which doesn’t involve Visa and Mastercard in some way. One peer-to-peer payments app I was shown today, which isn’t publicly available yet, is built on the EFT network, the one you use when you withdraw money from an ATM. And another delegate told me that fully 26% of revenue at Starbucks comes from its mobile app, which can be (and often is) funded directly from your bank account, without having to go through Visa or Mastercard.

But that kind of thing is laborious and expensive for startups: one of PayPal’s big competitive advantages, for instance, was the fact that it found a way to link PayPal accounts to individual members’ accounts at thousands of banks around the country. That’s non-trivial, and it’s much easier to deal with just two or three payments networks.

So color me pessimistic, here, at least in the US. There really is a huge public interest in bringing down transaction costs, and moving the locus of payments-related innovation away from the Visa and Mastercard networks, and towards cheaper and more direct bank-account connections. But I see no indication that’s going to happen. In that sense, I have the same view now that I had in 2010, when I said that there wasn’t much prospect of real competition in payments. It would be great were that to happen. But I’m not holding my breath.

As a consequence, the government really has to get involved here, lest the payments networks simply continue to raise their interchange fees and extract ever-higher rents from everybody else. But the obvious entity to do that is the Federal Reserve, and, at least judging by this morning’s remarks from Kansas City Fed president Esther George, that’s not going to happen any time soon. No one really wants new regulation. Which is surely music to the ears of Visa and Mastercard.

Update: One other intriguing idea I was given at the end of the conference: what about using the check-clearing architecture as a payments mechanism? With Check 21, in theory everything could be electronic, you don’t actually need paper checks. (Although some lawyers apparently say you do.) The problem, I think, would be ensuring funds were available. But if you can do that, it could work very well — and much more cheaply than the Visa and Mastercard systems.


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