In business, I look for economic castles protected by unbreachable moats — Warren Buffet
Money when seen as a medium of exchange has many physical forms, from metal to paper to binary. But of all, plastic money or payment cards have had a range of social and economic consequences. Unlike other forms, cards also turn out to be a lucrative business with Visa, Mastercard and American Express holding a central position in this landscape.
Globally, there are over 6Bn cards running on Visa/Mastercard network, transacting over $18Tn every year. While, American Express with its 130Mn proprietary cards, accounts for another $1.5Tn. The payment card networks are seemingly as complex as Meta’s entire family of apps (3Bn Daily Active People), but only a lot more secure and less well know.
The story of how payment networks came to be is an unlikely emergence of cooperative competition among the principal promoters of modern capitalism, the banks. Payment networks are two sided platforms intermediating between a consumer’s bank and a merchant’s bank, just like modern social networks intermediate between users and advertisers. However, Visa, Mastercard and Amex possess unit economics which rivals many silicon valley giants.
“Rank every firm (excluding real-estate-investment trusts) in the S&P 500 index by their average net-profit margins last year, five years ago and a decade ago, and only four appear in the top 20 every time. Two are financial-information firms, the others are Mastercard and Visa.” — Economist
This article briefly reviews the transformation of consumer credit from ledger books to plastic cards and the strength of the card payment network business model.
History
Credit has been around for a long time. Initially, it was characteristic of an agrarian society. There are records of credit arrangements between traders in ancient civilizations (trade credit for the first time bundled a loan and a sale in a single exchange). Post industrial revolution, credit became an important tool for financing large scale production. At the same time general stores had been extending credit to customers with seasonal incomes. But, it was only in the 20th century that consumer credit became widespread with the emergence of large retailers. Credit was now characteristic of a consumer society.
Act 1: The Merchants
Managing paper ledgers and storing cash for high volume low value transactions overwhelmed many merchants. During the first half of 20th century merchant lending programs were introduced using credit accounts and charge plates. Now, customers could record a transaction and clear their accounts at the end of month. The charge plate was a metal embossed customer identity. It was inserted into a receipt machine and then impressed using a carbon paper. No bank backed the charge-plate, but rather it was an internal 30-days billing convenience provided by the store. (Signatures would not work because they were not transferable and with population growth, trust became an issue. Also, checks were considered risky by the merchants). Department stores liked this service because it tied a customer to the store. However, such a program could only be afforded by large retailers. This was followed by ‘Charge-It’ plates issued in 1946 by a Brooklyn banker named John Biggins, these were issued by a bank rather than a merchant and were honored in a local area. Charge plates were effective in highlighting the benefits of customer loyalty to the merchants.
Act 2: The Network
Second half of 20th century began with the introduction of ‘Diner’s Club’ in 1950. It was an independent card company, its product was a charge card made out of cardboard targeted at New York City businessmen. Covering restaurants and hotels, Diners Club provided a broader medium of exchange, one that extended to all the merchants in the club rather than only a specific merchant in case of charge plates and the short lived ‘Charg-It’ bank card system, which was accepted only in a local area (two-sqaure-block radius because merchants had to leave sales slips with the bank). Initially, the biggest advantage to club members was that this gave them a ready made accounting for filing expense and tax reports. With time, it became a symbol of exclusivity and prestige.
Diners Club had established a pricing program which had to be acceptable to both merchants and cardholders. Members paid an average $3/year (membership fee) and hotels, restaurants and nightclubs paid an average of 7% of its members’ checks (merchant discount rate). This strategy validated the attractiveness of the model and once the idea was out there, the competition began. To avoid paying the merchant discount rate, many retail merchants (low margin) introduced a card program of their own. Afraid of loosing their customers to competition, retail merchants would not agree to have a common card program. Whereas, Diners Club merchant restaurants would easily agree to a common program, since premium restaurants served a differentiated product and many had a common client base.
Act 3: Revolve
All card programs, including the ‘Charge-It’ system of 1940s, required customers to pay their bill in full at the end of the month. This was to change with the introduction of the BankAmericard, by Bank of America (erstwhile Bank of Italy).
The Glass-Steagall legislation of 1933 restricted national banks from operating across state lines. Intended to prevent formation of large banks, it also discouraged consumer credit programs. As a result banks usually restricted themselves to investment banking business.
However, Bank of America had been engaging in consumer lending programs because of its presence in California which had relaxed many banking restrictions. These initiatives, although unprofitable had allowed Bank of America to build a strong network and now it planned to consolidate its consumer lending operations under a card program, called the ‘BankAmericard’.
Revolving credit was the innovation that distinguished BankAmericard from existing charge cards. This program was later franchised to other banks across states. Bank of America undertook a massive negotiation exercise under the leadership of Dee Hock (considered father of FinTech). It acted as a cooperative platform for other banks to agree upon an interchange network while they were free to compete in the market of consumer credit.
By 1970s, owing to operational challenges, the interchange program was spun off and became Visa. This was soon followed by the formation of Mastercard which came along in 1966 as the Interbank Charge Association (a cooperative of banks that did not want to align with the existing system). Interestingly, BankAmericard today runs on the Mastercard network.
By the 1950s, American Express had a successful but mature traveler’s checks business (Many customers kept travelers checks outstanding for long periods ~90 days, this provided Amex with free float) and as a result of its strong brand Amex had acquired a pseudo bank status. When Diners Club became a big deal, payment cards industry seemed a natural fit for American Express. After an unsuccessful attempt to acquire Diners, it entered the charge card industry independently in 1958, with the first ‘plastic’ charge card (Diners Club made the switch in 1961). The major selling point for Amex was trust, since it assumed responsibility for all fraudulent transactions (a core value proposition of its traveler’s checks product as well). By 1980s, Diners Club would spread itself too thin in response to American Express and the Bank Cards, that the pioneer soon declined to negligence.
Unit Economics
Now lets understand how cards work, and how payment networks make money. A transaction involves a multi-step process that results in the transfer of funds from a consumer’s bank into a merchant’s bank using the consumer’s credentials.
Remember, the pricing strategy employed by Diners Club with the first charge cards, still guides the economics of a card payments value chain.
For Visa and Mastercard, a transaction involves 5 parties:
- Issuer: The financial institution that issues the card, issuers derive most of their income as interest income on the extended credit and interchange fee per transaction.
- Cardholder
- Merchant: Is charged a percentage of transaction value (Merchant discount rate)
- Acquirer: The financial institution responsible for the merchants’ transactions with the network. They derive most of their income for commodity processing functions i.e. installing terminals, processing transactions, and sending out statements.
- Network: Visa and Mastercard act as the network between the issuer and the acquirer, they collect a transaction fee for the use of their network. The networks themselves do not move money; rather, the networks’ settlement reports are used by the banks to transfer funds among themselves, typically using a wire service available only to banks.
Merchant fee charged per transaction (Merchant discount rate) is shared and mirrors the risk owned by different parties. Since the issuer owns credit risk, it gets to keep the largest fraction, while the acquirer owns less risky charge back risk and the network keeps a nominal amount but for an essentially riskless processing function. However, if we consider the costs, the network incurs negligible marginal costs, whereas the issuer and the acquirer incur significant costs in the form of provisions for defaults and chargebacks. This cost structure highlights a critical factor: riskless zero marginal cost nature of cards payment network business.
Considering the cost structure of payments networks with a comparable network business like Meta, we can see evident differences. Both businesses are characterized by zero marginal costs, however Meta incurs huge R&D and Marketing expense. In contrast, despite maintaining a technology infrastructure, Visa incurs ~6% on ‘Network and Processing’ with no mention of R&D in its annual report.
GAAP operating expenses increased 11% over the prior year, primarily driven by higher expenses related to personnel — Visa Annual Report 2022
Cost of revenue in 2022 increased 11%, compared to 2021. The increase was mainly due to an increase in operational expenses related to our data centers and technical infrastructure — Meta Annual Report 2022
It almost looks like payment networks earn monopoly rents, but that view is mistaken because merchants are free to markup their goods and consumers are free to pay in cash (government merchants do actually add a surcharge for card transactions but its a nightmare customer experience). So far the established view is that the merchants find value in accepting credit cards and the discount fee is thus arrived at by market forces. Perhaps, card payment networks possess a strong moat in the form of a network too complex for anyone to replicate along with entry barriers in the form of long term restrictive contracts with partner banks.
Visa’s Chief Financial Officer has acknowledged that building an extensive network like Visa’s is “very, very hard to do” and “takes many years of investment,” but “if you can do that, then you can have a business like Visa’s that has a relatively high margin.” — USA vs Visa Inc. Antitrust Complaint
Is the future for payments networks secure ? It is important to note the emergence of payment solutions offered by fintechs like Stripe and Klarna, these make use of direct bank transfer networks (UPI in India, Fed Now in USA) bypassing the payment networks. Payment networks have reacted to some of these developments, but were blocked by antitrust agencies. Further online stores like Amazon can easily encourage customers to use these services. But until then, being a payments network operator seems to be like owning the internet.
PS: Some experts believe that technology companies understate capital expenditure by expensing R&D, given the way the accounting rules are framed. If instead R&D is capitalized, net margins for many technology companies might come close to that of payment network companies.
Reference
Nocera, Joseph (1994). A Piece of The Action How The Middle Class Joined The Money Class
