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How Apple Pay will affect ISOs and the card brands

10/13/2014   category: Near Field Communication (NFC)

In the payments industry, we are always interested in profitability and the margins, and the wine industry is no different. A recent article in Wine-X magazine by Brendan Eliason, Assistant Winemaker at David Coffaro Winery, identifies the cost of making a bottle of ultra-premium wine. He breaks it down by the cost of the grapes, oak barrels, packaging (label, cork foil), bottling, overhead including utilities and marketing, and employee compensation. His total cost amounts to $28 a bottle.

So, for example, to earn a profit of $20 per bottle, he sells the wine wholesale for $50 a bottle. The wholesaler takes the standard 33 percent markup, selling it to the retailer for $66 per bottle. The retail markup is the industry standard of 50 percent, so one bottle of wine sells for $100 in the store. But I've saved the best for last: in a restaurant, the price is triple the wholesale cost, or $225 a bottle. Obviously, this example is exaggerated, but there is truth to it. What's wrong with this picture?

What's wrong is the same thing that's wrong with the credit card industry, and why National Retail Federation members have dropped out of the recent Visa Inc. and MasterCard Worldwide "settlement."

In 2012, the credit card brands proposed a $7.5 billion class action settlement (Payment Card Interchange Fee and Merchant Discount Antitrust Litigation Opt-Out Cases, U.S. District Court, Eastern District of NY, #14-01720). Merchants had the option to opt out of this settlement. And hundreds of retailers opted out, stating the settlement offered meaningless reforms that would not help them control the costs of accepting credit cards.

Instead of settling, they filed antitrust lawsuits against the card companies alleging price fixing and preventing merchants from steering customers to cheaper forms of payment. The card companies moved to have these suits dismissed, but in July 2014, Judge John Gleeson ruled that these merchant lawsuits could proceed, a major blow to the card companies.

Perils of ignoring resentment over interchange

I am continually amazed the card brands do not recognize the degree of resentment and outright hostility the top 200 retailers have toward interchange pricing. Large retailers have pressing challenges right now: figuring out the role of digital channels and the future of the physical store, integration of the supply chain, and new demands for fulfillment speed. The last thing they want to deal with is increasing payment processing costs.

These merchants pay more for interchange than any other line item expense, except for cost of goods sold and personnel. They cannot understand why the pricing keeps going up. They do not take ever increasing costs of card settlement as a normal and customary business practice. The card brands brush this off as whining, but this is a big mistake. Apple Pay is going to provide an alternative, and it will change the numbers that drive the acquiring business. It will take another four or five years before that happens, but it will happen. Here's why.

With Apple Pay, Apple Inc. made a radical about-face in adopting near field communication (NFC), which it had heretofore studiously rejected. Apple designed an interface that goes a long way toward addressing card hacking and fraud (a big concern of merchants and consumers) but it just hands off the transaction to whatever acquirer the merchant is using, and nothing changes in the merchant-acquirer relationship as it exists now.

To be precise, nothing changes in the numbers that drive the business, except perhaps that it is rumored Apple will be paid 15 basis points for managing the fraud component. Working within the existing fabric of card brands, issuers and acquirers is the price Apple had to pay to deploy this product, and so the company did it. I heard someone say this was a "very Jobsian move" on Apple's part, whatever this means.

Up to now, mobile wallets have been a complete failure with American consumers. Some pretty big players have thrown a lot of money at this all for naught. Apple Pay could change that. However, this is not going to happen overnight, because:

  • About 11 million installed card terminals have to be replaced to accommodate chip and PIN cards.
  • Some estimates are that ISOs can physically replace only about 2 million a year.
  • Only about 220,000 terminals now are NFC-enabled, but, as Jim Bruene wrote in NetBanker, "If you've ever tried to use one, you know that 200,000 of them are either not working, or are buried behind beef jerky on the counter."
  • Using Apple Pay is not as easy as taking a card out of your wallet and swiping it in the reader.
  • Cash is still a big component of the payment system, and I doubt Apple Pay is going to make a dent in cash spending.
  • Merchants need to replace existing terminals to accommodate chip and PIN, and are reluctant to spend even more money for hardware and software to process payments.
  • Consumers are reducing credit card purchases; if this trend continues it is not favorable for acquirers.
Apple talked about not keeping the data on payments, and about not being a payment processor. Its role is just to make it easier for consumers to use mobile payments, providing an added layer of security, and routing transactions to acquirers running on the existing Visa and MasterCard rails. Apple said it won't be disruptive to the existing payments infrastructure. This might be true in the short term, but I doubt it will be true in the long term. Here's why.


There are about 10,000 commercial banks, savings and loans, and credit unions in the United States. However, there are only 11 large issuers. This is a business of huge scale because you have to have millions of account holders to have a critical mass. These 11 financial institutions have somewhere around 83 percent of the demand deposit accounts in the United States.

Benefits of card issuing without Visa, MasterCard

Now here is where it gets interesting. The large banks could just issue new cards to cardholders that do not have the Visa or MasterCard brand. They could provide an "OurBankcard" that would offer special reward points to any given cardholder based on all of the business he or she brings to a bank. For example, if a consumer has a small business, or is a large client of the Trust Department, there would be special benefits.

The marketing and cross-selling opportunities are endless. When a consumer uses the "OurBankcard" at a merchant, the transaction will be routed directly to the bank that issued the card. It won't ride the card brand rails. The issuing bank won't have to pay an acquiring bank, because the merchant will have an omnibus account with the new processor: Apple Pay, which will route the transactions directly to the 11 banks, plus a 12th bank acting as a switch for the smaller institutions.

Apple Pay will write railroad tracks directly to these 12 financial institutions, but the retailer will only need one account with, guess who, Apple. The compelling fact is that 83 percent of the time Apple will route transactions directly to the issuers to get paid, and Apple will pay the merchant the next business day because it's Apple's merchant. Now the cost will drop from 2 percent to around 50 basis points, and merchants will actively encourage use of the card.

So at this point, what role will the ISO play? Well, there might be an underwriting role here for smaller merchants, because there will always be some merchants who are too new or too nontraditional, and Apple might not want to deal with the expense of signing up and installing them. But maybe not. Square demonstrated that calling on merchants in person and installing hardware is no longer necessary: it can all be done by mail.

Big changes are coming to the payments industry. Last month, I wouldn't have foreseen that Apple would be a game changer or a major player in "our" industry. But I now recognize this could transform the ISO industry as we know it. If I am correct, this will be the biggest change since the adoption of electronic ticket capture and, of course, it follows that other events I haven't even thought of yet will follow. As an ISO, you might want to speculate on this; I would certainly like to hear your thoughts.

Source: greensheet.com

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