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Paradox in Payments: Fees, Fraud & Fragmentation

Strategically Speaking
Jun 26, 2013

Lee Wetherington Author: Lee Wetherington,

POP QUIZ: Lee boards a plane in Florida today. He must deliver a speech in Panama tomorrow. In which direction will his plane fly?

If you guessed “east” or “west”, youYin Yang Payments Paradox should probably avoid the “Places” category when playing Jeopardy™ at home. If you guessed “south”, you are very logical and well-versed in geography, but completely wrong. If you guessed “north”, you are either confused or cynical, but entirely correct. Today, I must first fly north (to Atlanta) before I can fly south (to Panama). It’s a plane-travel paradox, one with which many summer-time travelers are painfully familiar.

Payments are also suffering a season of head-scratching paradox. While we sometimes assume progress is linear, it is often anything but, especially in payments.

Payments fees are in decline, right? Yes…and also, no.

Durbin cut debit interchange fee income in half for big financial institutions. In aggregate, more than $100B in payments revenue will disappear thru 2016 due to regulatory fee-income compression. Even smaller exempt institutions are beginning to see their interchange rates wane due indirectly to market forces unleashed by Reg II.

So payment fees are in decline, right? Wrong. Think yin and yang.

EXHIBIT 1: To regain lost revenue, the card networks have unleashed a bevy of new fees, fees that unlike interchange—which passes from the acquirer to the issuer—are retained by the card networks. These include Visa’s Fixed Acquirer Network Fee (FANF), Acquirer Processing Fee (APF), and Transaction Integrity Fee (TIF), as well as MasterCard’s Network Access and Brand Usage (NABU) fee, Acquirer License Fee (ALF), and Staged Digital-Wallet Operator Annual Network Access Fee. Over the past three years, according to Digital Transactions, card networks’ revenues have grown faster than the transaction volumes they process. More fees, more revenue.

The bad news for issuers? Due to fierce competition for transactions, interchange rates are beginning to ebb for financial institutions exempt from Durbin. Visa’s cheaper PIN Authenticated Visa Debit (PAVD) alternative for acquirers has lured substantial volume away from regional EFT networks and compressed debit interchange rates. The good news for issuers? Debit transaction volumes continue to grow, and the card network fees listed above fund billions of dollars in rebates and incentives paid to card issuers.

EXHIBIT 2: While big-bank payment revenues have suffered, PayPal—who claims exemption from Durbin as a three-party network—has seen its payments revenue surpass each of the top 5 banks in the U.S., and it expects big increases in payments revenue this year and next. PayPal’s revenues demonstrate the continuing value and ability of payments to command fees.

The bottom line? Payments fees are not in decline; they’re shifting. Cap a fee in one place, and it will resurrect elsewhere. That’s the nature of the market. Issuers should not despair. Card networks must continue to compete both for acquirer volumes and issuer loyalty.

The winners of these fee wars will be not only incumbents with scale but smaller players with the creativity to remove friction and unlock value around payments. The future of payments will be more about influencing behavior that results in a payment and, paradoxically, less about the payment itself. Ultimately, payments will become virtually if not literally invisible, i.e., friction-less.

EMV will reduce payments fraud, right? Yes…and also, no.

Yes, when they arrive, EMV chip cards will substantially reduce card fraud at the point of sale, but they will also increase online payments fraud. In other parts of the world where EMV has been adopted, online fraud has increased sharply. In Britain, for example, card-not-present fraud grew to 62% of all card fraud in 2010 from 30% in 2004. In Canada, online fraud increased to 50% of all card fraud in 2010 from 31% in 2008.

This is called fraud “whack-a-mole”. Make fraud tougher in one place, and fraud will seek the more vulnerable alternative. Just because EMV will reduce card-present fraud does not mean net payment fraud will decline, especially since we are increasingly migrating to a card-not-present environment.

The real question remains: why not leap-frog to a superior form of payments security that leverages the considerable computing power of the average smartphone? If mobile payments are right around the corner, why not leverage the mobile device to secure both card-present and card-not-present transactions in ways not possible with the power of a chip card?

We are fast approaching ubiquitous mobile payments, right? Yes…but mostly, no.

It’s difficult not to feel a little Jeckyl-and-Hyde about mobile payments these days. On the one hand, there are 280 mobile payments startups in the U.S., and you can’t go a day without reading about a new mobile payments app, wallet, or pilot. On the other hand, the fragmentation introduced by 280 startups—not to mention the absence of interoperable standards and no clear, dominant leader in the space—means our approach to universal, ubiquitous mobile payments is slowing rather gaining speed.

Unofficial word from Isis’s NFC mobile-wallet pilots in Austin and Salt Lake is discouraging, and the head of Google’s NFC wallet recently left “to pursue other opportunities” after getting no traction. Meanwhile, cloud-based digital wallet providers like PayPal have had better results, but both WalMart and First Data have announced they will not accept or process PayPal at the POS.

So, is NFC dead? Not yet. According to ABI Research, the number of NFC handsets in the U.S. will grow from 40 million last year to over 100 million this year. And both Visa and MasterCard have recently signed agreements with Samsung—the world’s largest handset manufacturer—to allow those networks to provision payment-account data to Samsung’s NFC-enabled mobile phones.

Progress, right? Not without NFC-enabled POS terminals. If U.S. merchants are skeptical of EMV, they are outright dismissive of the incremental cost/benefit of NFC-enablement, especially considering the immanent launch of their own non-NFC payments network, the Merchant Customer Exchange (MCX).

So, are payments making progress? Yes, it’s just often unclear in which direction that progress is headed. I just hope my plane home tomorrow heads north.   

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