The Payment Card Industry’s weird business model is a work of genius

Regular readers will know that I am extremely optimistic about the long-term potential of Bitcoin and cryptocurrency technology to revolutionise the financial system. But that doesn’t mean I think they will overturn all aspects of the system.

In particular, I am skeptical of claims that Bitcoin will have a meaningful impact on retail payments and break the stranglehold of the payment card companies.

Of course, many people disagree with me. Articles such as this one from last year are typical of the genre: “credit card companies” are accused of charging obscenely high fees, hindering innovation and being ripe for disruption.

Payment Cards fees might seem expensive but does it mean they are vulnerable to disruption?

Now, it’s true that the fees do seem expensive at first glance but, as David Evans has argued, it’s not obvious that the Bitcoin payment processors are really that much cheaper, once you take into account their spreads and the costs of getting into and out of Bitcoin at each end.

But the main reason I think the incumbents are in such a strong position is because the industry has extremely strong network effects, which leads to formidable barriers to entry. Would-be Bitcoin entrepreneurs need to understand this structure if they are to succeed.

The Payment Card Industry is marvellous and weird at the same time

When you step back and think about it, the modern payment card industry is a marvel – an underappreciated, underrated miracle of contemporary commerce: you can travel to any corner of the earth, armed only with a piece of plastic bearing the Visa or Mastercard logo. It’s a minor miracle.

But when you look at the businesses of the major card brands, they turn out to be really, really strange companies. They simply don’t do what most of us think they do.

Take a card out of your pocket… chances are, it will be a Visa or Mastercard, or maybe UnionPay if you’re one of my Chinese readers. Let’s assume it’s a Visa card for now. And we’ll worry about American Express later, because they’re different to all the rest.

Here’s one of my Visa cards again:

A Visa debit card, issued by first direct bank.

Notice something strange. There are two brands on the card. There is the Visa logo and there is one for first direct, the division of HSBC with whom I hold my current account.   Most other consumer products don’t have two firms’ logos on them. Something strange is going on.

Now, it it was first direct that issued the card to me, not Visa.

It is first direct’s website I visit to see my balance, not Visa’s

And it’s first direct I would call if something went wrong, not Visa.

I don’t have any relationship with Visa at all.

There’s no Visa call centre I can call if I have a problem with my card and there’s no Visa app on my phone.  This is strange: a hugely powerful global brand and yet the billions of consumers who use it don’t have a relationship with them.

It gets stranger. Another little-known fact is that no retailer anywhere in the world has a relationship with Visa either!  So we have one of the world’s most recognizable brands and nobody who uses their “product” has any relationship with them.

It’s worth thinking through why this might be and why it is such a powerful model.

How would you build a credit card system if you were doing it from scratch?

Imagine you run a bank in a world before credit cards.   Wouldn’t it be great if your customers could go to local shops and “charge” their purchases to an account that you hold for them?   You could make money offering credit to the customers and make some more money charging the merchants for providing this service.

This is what Bank of America did in California in the 1950s. They issued credit cards to lots of their customers in various cities and signed up local retailers to accept them. Great – the payment card industry was born! You could think of the model looking something like this:

A simple card scheme: a bank issues cards to its customers and reimburses local merchants who accept those cards

But this model has two really unfortunate problems:

• Your competitors are going to copy this and you’ll soon have schemes like this popping up all over the country, all run by different banks, on different systems, racing to sign up consumers and merchants onto their product
• Your customers will travel. And they will be very upset when they discover they can’t use your card in a merchant who only takes a different bank’s cards

You would end up with the situation in the diagram below: a merchant who banked with Bank B wouldn’t accept cards issued by Bank A. Why would they? They had no relationship with Bank A and who’s to say cards from Bank A would even work with their machines?!

Why would cards issued by Bank A be accepted by a merchant who uses Bank B if Bank A and Bank B operate competing schemes?

If you were running one of the banks, how might you respond to this problem?

One answer might be to view this as an arms race: perhaps the best strategy is for banks to enter an all-out war… sign up as many merchants as they can… sign up as many customers as they can and bet that you’ll be the last firm standing when the industry shakes out. Obvious problem: it would be ruinously expensive and what happens if it ends in stalemate? You still have the same problem.

But there’s another option… what if you cut deals with other banks: agree for them to accept your cards at their merchants in exchange for you accepting their cards at your merchants. This sounds quite promising but… obvious problem: how on earth would the merchant handle this? They’d need a huge book by every till that listed precisely which banks they could accept card payments from and which ones weren’t allowed. It would be chaos… But perhaps it points the way

A flash of insight – who are you really competing with?

Let’s recap: you’re a bank executive trying to build a payment card business. But your competitors are all trying to do the same and it’s going to end in tears: you’ll confuse the merchants with hundreds of different card types or you’ll go bankrupt trying to be “last man standing”.

It feels like having other banks accept your cards at their merchants would be good… but how to make it work?

And this is where a flash of insight changed the world.

Somebody realized that the cards “business” was actually two businesses.

The first business is all about offering credit to your customers, managing their accounts and processing their payments. We could call this card issuing.

And the second business is all about enabling merchants to accept card payments and get reimbursed. We could call this merchant acquiring.

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Aside: we call it “acquiring” because it’s helpful to model the card payment as a receivable that the processor purchases (acquires) from the merchant at a small discount, which you can think of as the processing fee.

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This is the key point: issuing and acquiring are totally different businesses which don’t compete with each other.

Sure… all the issuers compete with each other.

And all the acquirers compete with each other.

But the issuers don’t compete with the acquirers.

Indeed, they have a really strong incentive to co-operate… the issuers want all the acquirers to accept their cards… and the acquirers want to offer their merchants the ability to accept as many cards as possible.

So let’s imagine a group of issuers teamed up with a group of acquirers. And imagine they agreed that the acquirers would all process the cards of all the issuers in the group: every issuer’s card would be accepted by every acquirer.   They could use this forum to hammer out some standards: they would agree a common way to process cards, timescales for reimbursement, rules for what happens if something goes wrong… they’d define a “scheme”.

Now… this scheme would need two things: consumer recognition and merchant recognition. Consumers would need to know their card would be accepted at a participating merchant. And participating merchants would need to know a given card was part of the scheme.

So we need a brand. This brand would be something you could put on the cards and place in the shop window. It is how a merchant would know an issuer’s card was part of this scheme and it is how card holders would know a merchant was able to accept cards from that scheme.

One of these schemes is, of course, Visa. Another is Mastercard. And so on. And this is why cards carry two brands…. One to identify the issuer and one to identify the scheme.

In this way, the card schemes have created a system that allows merchants, who only have a relationship with their own bank, to accept payment cards issued by hundreds of other banks, without having to have any relationship with those banks at all.   The only thing that matters to them is that the issuer’s card is issued on the relevant scheme.

And this model has really strong network effects… the more issuers and acquirers in the scheme, the more useful the scheme is to card holders and merchants. It’s self-reinforcing.

Talk is cheap… how does it work in practice?

OK. So we have a paper agreement that says an acquiring bank will accept any valid transaction made with a Visa-badged card.   But how? How do they get approval from the issuer for the transaction? How do they get reimbursed? How does it work in reality?

Do all members of a scheme have to have a relationship with every other member so they can route the transaction to them for payment? That would be expensive and error-prone.

So this is where the scheme re-enters the picture.   In addition to maintaining a powerful brand and setting the rules, they also run a switch: the merchant acquirers send all their Visa transactions to Visa itself… and Visa then forwards them on to the appropriate issuer.   Similarly for Mastercard and the other schemes.

So we end up with a hub-and-spoke model… with Visa at the centre. (And Mastercard and Union Pay and so forth).

Issuers and Acquirers are members of a “scheme”, which sets the rules and acts as a central “switch” to route transactions. It means merchants with one bank can accept payments from customers of another bank, without having to maintain bilateral relationships

So now we can see why card schemes are so successful: their globally-recognised brands create networks that anybody aspiring to issue or process cards need to be part of. It’s a self-reinforcing virtuous circle that is extremely hard to disrupt

And this is why Visa’s “customers” are the issuing and acquiring banks… not end-consumers… Visa exists so that issuers can receive broad acceptance of their cards… and so that merchants can, in turn, offer broad acceptance.

But the schemes depend on consumer recognition – hence why they spend so much money advertising to consumers, even though the consumers are not their customers.

What does this have to do with Bitcoin? Push versus Pull

Notice something really important: this is a pull system… the reason you need all this infrastructure is because your card information has to get all the way from the terminal in the merchant back to the issuer so the issuer can pull the money from your account and send it back to the merchant.

By contrast, Bitcoin is a push system: once you know the merchant’s “account” details, you can just push the payment to them. So why do you need all these intermediaries?

If you were a Bitcoin payment firm trying to break into the retail market, perhaps that’s where you’d start? After all, it’s true that most of the payment card infrastructure simply isn’t needed in the Bitcoin world.

But notice how I set up this story. The infrastructure was the last thing I talked about. For me, the two most important things are:

1)   Global acceptance.

2)   The rulebook

Think about what Visa and Mastercard have achieved: they offer global acceptance and predictable behavior.   Wherever you are in the world, you can be pretty sure somebody will accept your card and you know how it will work and that there is a well-understood process when things go wrong. This offer is powerful. Ask yourself: if you could only take one payment instrument with you on a round-the-world trip, what would it be? If you couldn’t stake a stack of dollar bills, I suspect you’d opt for a credit card.

And this predictability – a consequence of the rulebook – is important: consumers enjoy considerable protections when they use a major payment card. They can dispute transactions and, in some countries, their (credit) card issuer is jointly liable for failures of a merchant. Consumers like to be nannied… even if they have to pay for the privilege!

So for those who aspire to overturn the incumbents, you need a strategy for how you will become the consumer’s “default” or preferred payment mechanism.

American Express has achieved this through a joint strategy of having large corporates mandate its use for business expenses and offering generous loyalty benefits to consumers… they effectively pay their customers to use their cards.

PayPal has achieved it through making the payment experience easier – but note, even here, many PayPal payments are fulfilled by a credit card account!

And this is why I harbor doubts about whether Bitcoin will become a mainstream retail payments mechanism, at least in the major markets… why would a consumer prefer it over their card?  Perhaps the openness and possible resistance to card suspension/censorship will attract sufficient users.  But it’s not obvious.

For me, the opportunity lies elsewhere: high-value payments, smart property and so forth.  But I could, of course, be wrong.  It wouldn’t be the first time…

An aside on history and factual accuracy

I know this account would scandalize a historian but that’s OK: It’s not intended to be historically accurate… the idea is to share intuition on why things are the way they are.

Some of the more important topics I’ve ignored or deliberately simplified include:

• I’ve not explored the difference between Visa Inc (public company) and Visa Europe (owned by its members)
• I’ve ignored the “three-party” schemes like American Express.
• I’ve also ignored fee structures and the importance of interchange.
• I’ve also not discussed the role of processors… specialist firms who effectively outsource the work of issuers and acquirers
• Security
• … and lots more