Merchants, Acquirers, and ISOs: Diverging Paths to the Future

This is the second installment of a six-part series exploring the growing economic tensions and structural conflicts between acquirers and issuers in the bank card business. All merchants are not created equal in payments.

One of the industry's biggest but worst-kept secrets is that in 2003, following the settlement of the merchant class-action lawsuit against MasterCard and Visa's “honor-all-cards” rules governing merchant acceptance, the bank card associations quietly reached out to the nation's 200 top retailers to negotiate reduced rates for credit and debit card acceptance.

In the public's eye, that new attitude toward pricing was reflected in volume-discount tiers introduced for several interchange categories beginning that year. But a number of national merchants, while under non-disclosure agreements with the associations, have nonetheless confirmed privately that they are getting pricing reductions on interchange well beyond their volume tiers. Moreover, some issuers claim they don't even know the actual interchange rates negotiated with these mega-merchants, as they are opaque to the associations' remuneration processes, according to an executive at one top 10 bank.

These same merchants have been brutal in negotiating further reductions in processing costs with their acquirers. First Annapolis recently reported that price compression in core processing charges for major acquiring processors has reached 8% to 10% a year! And two of the biggest processors report that Visa and MasterCard?fresh off their recent successes in tweaking up the fees that mostly accrue to acquirers and merchants overseas?are moving to do the same thing in the big U.S. market.

In response, desperate to preserve margins, some acquirers have moved to so-called interchange-plus pricing, where they simply pass along the myriad interchange rates promulgated by the associations?along with the interchange premiums assessed merchants when their customers use higher-priced rewards and business cards. Their merchants now pay the interchange fees, whatever they might be, plus the processor's markup on each transaction.

Disappearing quickly in the process are bundled rates, where the merchant was insulated from significant changes during the contract-service period, while the processor had the opportunity to pad a little margin into the pricing if the flat rates bid on the contract were reasonable.

Acquirers are also beginning to charge separately for services that used to be bundled into the pricing, such as authorization and chargeback fees, as well as fees for account applications and setups. Nonetheless, acquirer margins remain perilously tight, and price compression and high interchange remain the dominant challenges in that end of the business, according to a recent survey by Aite Group LLC.

But the bigger change in the acquiring side of the business is the move down-market to smaller merchants. One processor estimates that merchants other than the Top 200 generate only one in four transactions, but nearly two-thirds of the industry's margins!

This is also the market segment served by independent sales organizations, which for years have been able to mark up point-of-sale interchange and processor fees an additional 25% to 30% on qualified transactions, and 50% to 100% on non-qualified transactions (those with throughput problems and those rewards and business cards bearing higher interchange). But those conditions are disappearing rapidly, too.

By moving down-market, the bigger processors like First Data and Paymentech can simply squeeze the ISO out of the food chain, or force it to serve at lower margins (a subject we'll discuss further in the concluding article in this series). Smaller merchants are also getting savvier about payment-processing costs, and are increasingly confronting ISOs over excessive margins and poor service for the fees charged.

Ironically, small merchants' greatest source of leverage is alternative payments. While most providers naturally target the big merchants for adoption, it is clear there isn't much financial incentive to make them do so?given their current negotiating clout. But smaller merchants, especially those online, constitute the real business case for payment options.

For example, some researchers project that in five years, one in four payments made online will come from options other than signature-based credit and debit cards. Most of these options offer discounts from bank card interchange of 20% to 25%, and smaller merchants can get from 100 to 300 basis points in price breaks upfront from some ISO markups as well.

In addition, payment guarantees offered by most alternative payment providers reduce the costs of risk management, chargebacks, and fraud in the back-end?which can equal or exceed the costs of interchange. So why not go with PayPal? Or elsewhere? It's no surprise that the leading processor online, Paymentech, has embraced several payment options on its platform, as have several of the payment gateways.

But will the new focus on small merchants be enough to sustain the acquiring side of the business? PayPal offers American Express acceptance at the same rate its merchants pay for bank cards, giving them another leg up on ISOs. For online marketing firms, Google makes payments transparent by subsidizing their costs based on the ad and search spend of its merchants. And AmazonPayments' Flexible Payments Service enables Web-site developers to replace ISOs by enabling their clients to access Amazon's expanding payments and risk-management platform!

So the real threat to processors and ISOs clinging to the conventional bank card business is that the legions of new online businesses forming up every day never make their way into the conventional payments infrastructure in the first place?commoditizing and obviating the card-processing business perhaps forever.?Steve Mott