Opinion & Analysis: Five Challenges for Banks And Merchants

Steve Mott

Financial institutions and retailers are natural allies—not enemies—and nowhere can this alliance yield more profitable results than in mobile payments. Here are five problems the two sides must solve to make the most of this great mobile alliance—along with five proposed solutions.

(Editor’s note: This article is the second part of a two-part piece examining the natural complementarity of banks and merchants in payments and the impact their collaboration could have on trends in mobile payments and marketing. Part one ran in the July issue.)

In part one, we argued that banks and merchants aren’t natural enemies, despite appearances to the contrary lately. Indeed, the two camps have been set at odds only by the distortions created by the current payments system. In fact, most banks and retailers have much to gain, and little to lose, by working together on a new system built on mobile payments and marketing.

But to make this collaboration work to best advantage for both camps, five challenges must be met:

Challenge #1: Make mobile payments cost LESS than plastic card transactions. The first big problem to solve together is figuring out how to make mobile more efficient. Mobile should take costs out of payments, rather than costing more than card-based transactions.

To illustrate, take the initial, proposed generation of near-field communication (NFC) payments. Big banks will likely fill most mobile-wallet offerings with their highest-rewards-bearing credit cards, which they make the most money on, and consumers are likely to agree to load them for initial use. This means, on average, mobile transactions will come at a higher average tender cost than today’s card-based purchases.

Worse, consider the cost of loading to those wallets a high-fee rewards credit card. As an example, let’s start with widely reported carrier market pricing of $5-to-$7 per account per year. This estimate includes a Trusted Service Manager key-management system and the cost of enabling a secure element in a carrier-controlled handset. It assumes passing those fees along to issuing banks and/or accepting merchants.

At an assumed rate of consumer usage at maturity, the incremental cost could easily be 10 cents to 20 cents more per transaction. (For occasional-use consumers, those incremental costs could be a dollar or more!) And that’s before counting lots of additional fees banks and merchants are likely to incur as mobile services are expanded.

Why would any merchant sign up for the current mobile business model if its payment costs are going to be significantly higher than today’s plastic? This question is especially pertinent if merchants have to make large infrastructure investments but only get baby steps in terms of better transaction security—and little in the way of PCI relief.

Ditto for issuers, which are likely to see continued fraud and customer-service problems with the use of payment accounts where key credentials (e.g., the payment account number and expiration date) remain in the clear.

Solution: Force the card networks to beef up the conventional version of NFC (a one-way technology based on ISO protocol 14443) to support real security (i.e., full encryption of all account credentials). How do banks and merchants force that?

– Work together, on standards bodies and in the marketplace to push tokenized, encrypted payments over the updated NFC terminal protocol (ISO 18092, with more robust two-way communications between handsets and terminal);

– Share risk-management data and collaborate on fraud-mitigation measures on mobile transactions to take fraud and related costs out of purchases to the extent possible;

– And work together to develop mobile-hardware cloud-based security solutions that serve all members of the emerging mobile-payments ecosystem—something even Visa agrees will be the future of payments (according to statements made at industry conferences over the past year).

Challenge #2: Use Visa/MasterCard credit card rails for plastic, but not for mobile. Because Visa, MasterCard, and their big members have no motivation to change the status quo of payments, and are working hard to transport most of the rules, rates, and policies from the card-based paradigm to the chip-based, mobile domain, banks and credit unions should remember that the card networks don’t own their members or their products, and work primarily to benefit the biggest American banks.

So, what if banks and credit unions decided that they own their lines of credit, and while they might use Visa and MasterCard Bank Identification Numbers (BINs) for card-based transactions, they don’t have to use them for remote transactions (online or mobile)?

Other, non-BIN numbering conventions can be and are used, and they can be owned and managed by the financial institutions themselves—or even by merchants—rather than by a network. Visa and MasterCard could (and are likely to) come up with an “honor-all-devices” dictum to expand upon their “honor-all-cards” rule, but today’s poisoned banking-regulation environment is likely to take a dim view of that.

Solution: Providing a line of credit does have measurable value, and banks deserve fair compensation for providing that value and managing the associated risk. But in recent years, up to 60% of bank credit card revenue goes out the back door in excessive credit risks and resulting chargeoffs—greatly distorting the cost and impairing the profitability of offering credit lines

Some network executives call that a “merchant subsidy” because the amount of the writeoffs exceeds the interchange collected, but the reality is that what’s written off is mostly bank interest charges and punitive fees, not most of the goods that would be purchased anyway.

So the stage could be set for issuers to reclaim their line-of-credit products, and restore a more prudent—and cost-effective—basis for providing credit:

– Continuing abuse of the nation’s credit system by some banks is drawing increasing attention—especially from the Consumer Financial Protection Bureau;

– Enterprising banks with more respect for the integrity of the payment system will find that better customer information and relationship management—helped out in no small way by working with merchants—will prove instrumental in lowering their credit risks;

– And it’s not beyond the realm of consideration that banks and merchants can work together on managing down all forms of payment risk, and can develop new models for sharing liabilities and negotiating fees at fairly compensated levels.

Why? Issuers can lower costs by removing the excesses of card-based credit, and gain revenue from improved usage (including higher wallet share), by collaborating with like-minded merchants that accept the better products and help promote their use in mobile environments.

Challenge #3: Make debit transactions happen at cost-plus rates. A different opportunity exists for payments made from demand deposit accounts (DDAs)—bank products which also are not owned by the card networks.

Debit cards are merely one means for a bank customer to access his or her own funds on deposit at a regulated bank or credit union. Why not explore the use of the ubiquitous automated clearing house (ACH) network to support a new genre of debit payments? If PayPal can succeed by famously arbitraging various bank networks, why can’t the banks do it for themselves?

For example, grocers often tie ACH payment accounts to store cards, and do direct debits from a consumer’s DDA. Billers do the same thing—billions of times a year. And mobile-banking platforms can and do support ACH payments and transfers in various forms; some new mobile services integrate mobile payments via ACH settlement rails as well, such as mShift, which offers greatly reduced interchange fees from participating banks due to the lower cost of using the ACH rails. Those transactions don’t ride the Visa/MasterCard rails, and don’t have to.

Moreover, under the new Durbin Amendment economics, most issuers can’t afford to provide debit card rewards programs. The cost of those programs can be shifted to the mobile-marketing function, however, and banks and merchants can negotiate specific consumer-ingratiating programs that can be far more effective than, say, generic Visa Extras.

With banks and merchants working together on their own rails, bank revenue for processing debit transactions will go lower. But by removing a lot of the legacy costs of signature-based plastic cards, it is almost certain that all but the very largest issuers could achieve more profitable transactions.

Solution: Moving to a new orientation for debit transactions (i.e., just charge fees for the costs of depositors accessing their own funds, plus a fair mark-up) now seems inevitable:

– That’s the way the rest of the world, and most of the regulating central banks and government agencies, view the economics of debit payments;

– Untethering debit transacting from the disparaged, higher-cost signature-debit card model fostered by the card networks is now, post-Durbin, simply an economic reality for banks as well as merchants;

– Additional costs can be wrung out of PIN-debit payments as well, with the ACH network increasingly viewed as one great asset to restructure how consumers can access their deposited funds at regulated financial institutions.

The key is to philosophically get beyond the Visa-inspired legacy that banks should profit as much from charging merchants to enable consumers to access their own funds as they do when they shoulder credit risks to lend out bank funds to those same consumers. That fantasy existed mainly in just the U.S., and the sooner everyone moves on, the faster bank and merchant relations will improve.

Challenge #4: Develop other ways to pay for mobile. Many observers believe prepaid-account payments will dominate mobile commerce in the near term. They’re relatively easy to obtain, use, manage risk with, and price to competitive market value. Moreover, prepaid accounts are available to just about anyone.

Conventional prepaid camps currently divide up into open-loop/use anywhere variations now being pushed by banks like Chase to avoid Durbin rate caps, and merchant-based closed-loop/private-rail alternatives that are much cheaper to process but have limited acceptance. But why should ‘prepaid’ be constrained to just those two legacy ”ideas”?

In April, Google Wallet, which currently features a prepaid payment account from Citibank/First Data, bought prepaid processor TxVia Inc. so it could own its own prepaid issuance and processing platform, and create its own “virtual” MasterCard debit card to make it easier for consumers to load accounts for making mobile payments.

American Express now offers a low-fee, consumer-friendly prepaid account option for use in digital venues. Cardis, a Dutch company, enables fluid loading and transfers of balances for low-value payments, and aggregates charges to minimize fees and costs.

The trick with prepaid will be to figure out merchant acceptance. To be sure, merchants could develop their own, hybrid-accepted variations, but that might not achieve ubiquity. But what about banks and merchants developing their own, open-loop prepaid account using, say, a Discover brand? Discover has nearly equal acceptance to Visa and MasterCard, and is well-positioned to support mobile applications these days. Or a bank-merchant virtual MasterCard, like Google’s?

Solution: While some regulatory issues with prepaid have adversely affected its economics recently, banks and merchants (working together with processors) appear to have a comprehensive, cost-effective solution path at hand that can be tailored to mirror the ubiquity and usability that mobile transacting affords and demands:

– Banks (and non-bank issuers) can vet consumers pretty well these days, and mechanisms proved out by prepaid debit card issuers can enable immediate, albeit limited, use of prepaid accounts while the vetting is being completed;

– Merchants can foster distribution through their facilities at the point of sale and online, as well as through loyalty and marketing applications in conjunction with banks;

– Processors can—if they decide to—interoperate in new ways to achieve far broader acceptance, and—if issuers and merchants pressure them to—facilitate universal loading of value through any sets of rails that cooperate;

– Mobile data and record-keeping can help all parties manage the transactional risk;

– And the characteristics of use can help both banks and merchants qualify customers for regular credit and debit products, including private-label versions.

Challenge #5: Figure out how to divvy up the mobile-marketing largesse. As previously noted, the “big bang” in mobile transacting will be on the marketing aspects—discount offers, coupons, promotions, advertising incentives, product-reference bounties, and on and on.

In terms of economic impact, the marketing-revenue upside could be five, 10, even 20 times the financial benefit of rationalizing payment fees, fraud costs, and other inefficiencies of the legacy payments paradigm. So why keep fighting over the payment fees when there’s so much money to be made on more cost-effective marketing in the mobile paradigm?

One approach that’s making the rounds with a number of the top 25 (but not the top five) banks is moving to a cost-plus based model of payment fees in conjunction with partnering merchants—whether Visa and MasterCard like it or not. Under this approach, merchants and banks would jointly work through the actual costs of delivering payment products through bank products (no mean feat given decades of regulation and market-power impacts). They would set the fees accordingly, then put payments in the closet and move on to marketing.

Nobody expects a Groupon-like, broadcast-mode couponing model at 75% reduction from retail prices to prevail, but mobile technology—with its ability to gratify buyers and sellers with intimate, relevant and targeted marketing—offers huge potential for commissions for those who foster and broker purchases that can be demonstrated to produce incremental business. But that’s only IF transaction and user data can be protected from misuse—something that only banks and merchants can truly assure, on behalf of their mutual customers.

Solution: While it is unlikely that merchants will cooperate with anyone on accessing the long-sought SKU/product data from mobile transactions until long-festering issues with the current payments system can be addressed, there is growing hope that banks and merchants can move from the current merchant-funded rewards models to real partnerships that enable truly gratifying transacting. Here are the key steps to make this happen:

– Banks actually do have it within their power to help merchants craft a symbiotic solution to what ails payments; most know that interchange fees built up over decades of market power will dissipate over time, so the trick is figuring out how to replace that revenue with commissions from mobile-marketing innovations;

– Moreover, banks have it within their power to craft ways to work with merchants to secure both transactional data and marketing data (i.e., SKU/product identification by account or individual) in a trusted way that protects their mutual customer;

– And banks perform for a living account issuance and management—something even the most sophisticated merchants tend to struggle with;

– But banks can’t benefit materially from the mobile transformation without partnering with merchants—which control the transaction data (at least for now) and still determine the rate of acceptance adoption (at least until consumer demand kicks in naturally);

– And merchants likely won’t be able change the payments paradigm without coming to the table on the mobile-marketing opportunity;

– And that means both sides putting up any and all transaction data on the negotiating table to figure out how to safeguard—but still monetize—the information necessary for buyers and sellers to transact more efficiently.

So the choice is clearly writ for banks and merchants alike: Either let Google, PayPal, Isis, Visa/MasterCard, and the rest dictate how mobile transacting will take place in the next decade, or put down the cudgels from decades of battling over payment fees, and begin negotiating the future of mobile commerce.

That future will driven by data, not payments. The accompanying charts depict the array of ways SKU/product data might be monetized. The first chart depicts the diverse and complex set of marketing interactions that can occur with mobile transactions. These interactions can be monetized to a much greater extent by creating usage and behavior profiles that make solicitations (and inquiries) more targeted and relevant to both buyers and sellers.

The second chart depicts a hierarchy of SKU/product data in order of complexity and comprehensiveness of the data collected. The more consumers proceed down the hierarchy, revealing more data about themselves and their purchase behaviors along the way, the more they—and providers (e.g., banks and merchants)—can expect to gain in terms of financial benefits.

Such a migration could take the industry years to achieve in terms of critical mass, but the progression appears inevitable when so many young consumers are so willing to share so much about their personal information and preferences and plans in venues like Facebook.

The key for both banks and merchants is to get started now—early in the going—learning the domain, understanding customer behavior and needs, and setting the standards for security and privacy.

Once sufficient opt-in mechanisms and cooperative behaviors are learned (e.g., consumers providing extensive information in a blind manner until a purchase event has been decided), the bank and the merchant can set prices on THAT value to third parties (including ad networks).

The incremental financial benefits from making purchases more effective for everyone can also remunerate the consumer. Mobile buyers can get better discounts by providing more information to sellers that aid in placing future purchases (e.g., subscription and advance buying).

Third-party venues such as Facebook will provide bounties for reference sales to friends, while charging product and service providers fees for enhanced product placement. Advertisers and ad networks will generate higher commissions—-and pay higher placement rates—for rifle-shot mobile pitches and purchase results.

But the downside of unfettered mobile marketing is equally dramatic: What if, as in a recent example affecting a national retailer, a young woman buys a pregnancy test product at a pharmacy, then receives coupons, discounts, and other marketing promotions on baby products (e.g. from another drugstore)—perhaps just at the moment she is sharing her handset interactions with another person? Besides a whopping privacy violation, the merchant that executed the original purchase could lose a customer, and/or lose future sales to a competitor.

Concluding Thoughts

The industry got a glimpse of the possibilities of a hyper-local mobile world with the Bling Nation experiment, where local banks cooperated with local merchants in small communities to support a symbiotic new debit payment ecosystem built on use of mobile handsets. That experiment folded last year when Bling tried to exercise its own jurisdiction over loyalty and rewards, but as Google has demonstrated, commerce, like politics, is fundamentally local in nature—where both banks and merchants live.

Now, consider the imposition of Google, PayPal, Visa, Isis, and MasterCard on banks and merchants trying to make a better living out of mobile transacting. The imposition of these middlemen between buyers and sellers not only presents the specter of lost control over data security and consumer privacy, but also the likelihood that each of these intermediaries plans to capture the bulk of the upside marketing revenue for themselves.

That economic reality, as much as anything else, is why banks and merchants will find their way to collaborating on mobile.

So banks and merchants are not enemies by nature, yet they have been made such by the excesses of collective action and market power in the card-based paradigm. If mobile technology is permitted to manifest itself by cooperation between these true generators of transaction value—ahead of disintermediation by middlemen mobile providers or pre-emptive regulatory intervention—the payments system of the future will, in leaps and bounds, become more vibrant, value-adding, productive, and gratifying.

Steve Mott is proprietor of BetterBuyDesign, a payments consultancy based in Stamford, Conn. Reach him at stevemottusa@yahoo.com.