Saturday, March 12, 2011

The End of Interchange?

Last week, the Federal Reserve Board requested comment on proposed regulation that would “establish debit card interchange fee standards and prohibit network exclusivity arrangements and routing restrictions.” The proposal is an outcome of the Dodd-Frank Act, which stipulated that interchange fees be “reasonable and proportional” to the cost incurred by debit card issuers.

The Fed proposed two schemes for setting interchange rates, but effectively capped interchange at 12 cents per transaction. Today net debit interchange is around 40-45 cents. In effect, the Fed is planning to reduce interchange by at least 70%.

The cap was lower than many people expected and came as a surprise for the industry. In response to the announcement, shares of Visa and Mastercard plunged more than 12%. While this may hurt our own bottom line, we support the direction of the Fed’s proposal.

Because most people who regularly use debit cards are unaware of the associated interchange fees, it’s difficult to decipher what this proposal means for consumers. Doing so requires an understanding of the history of interchange.

History of Interchange
In the 1950’s, when credit cards were introduced, most people bought with either cash or checks. Regular customers with good credit would frequently have accounts at stores, and would get a bill at the end of the month for all their purchases. Credit cards allowed people to buy stuff from more stores without having to carry cash around. They were also safer to user and more convenient than carrying checkbooks around, so consumers loved them. Merchants liked them too, since they brought in new customers who merchants otherwise wouldn’t have been able to extend credit too.

Of course, building this system and marketing it to customers was extremely expensive in an era when calculators were just beginning to catch on. So the credit card companies charged merchants a fee for accepting payment via a credit card: instead of getting 100% of the value of a credit card transaction, the merchant would get 95%-97%. The credit card companies also charged customers interest if they didn’t pay on time, and the combination of interest and merchant discounts was enough to make the business profitable.

Over time, the industry grew and evolved. Banks got into the game and begin to issue credit cards through associations that eventually became Visa and Mastercard. Credit card acceptance usage and acceptance exploded in the 1960s and 1970s to the point where they were ubiquitous. The card associations were owned by the banks, and paid them most of the discount fees that they earned from the merchants, which became known as an interchange fee.

Success of Debit
The success of credit cards demonstrated the need for a safe and convenient alternative to cash. But it wasn’t until the emergence of debit cards when card based payment became commonplace.

Debit cards began as a byproduct of ATM cards in the 1980’s. Because ATM usage was immediately popular, banks began engineering a method for customers to use ATM cards as an alternative to credit cards. Because few merchants had terminals that could accept PIN based ATM cards, debit cards were designed to work with merchant’s existing credit card terminals, and to route transactions over the existing credit card network.

Today, debit cards transactions are still routed through two separate payment networks---signature debit, where customers provide their signature and the transaction is routed over the credit network, and PIN debit where the customer enters their ATM PIN code and the transaction is routed over an ATM network. Regardless of how the transaction is routed to the card issuing bank, the money always comes out of a user’s checking account.

Debit cards also had interchange fees associated with them, just like credit cards. Initially, the interchange fee that merchants paid on debit card transactions was much lower than what they paid on credit card transactions. While cash and checks didn’t have any fees associated with them, they had hidden costs. They had to be stored under lock and key to prevent them from being stolen, somebody had to deposit them at the bank, and there was always the risk of getting a bad check or counterfeit cash.

Compared to the alternatives, debit cards were relatively cheap for merchants to accept. Debit cards were also available to everybody with a bank account, regardless of their credit history. Furthermore, banks loved having an additional source of revenue from card fees, especially from customers who either wouldn’t or couldn’t get a credit card. So everybody loved debit cards. Not surprisingly, debit card usage grew rapidly throughout the 1990’s and 2000’s. A whole segment of the industry, prepaid cards, came into existence to provide debit cards to people who didn’t even have bank accounts. It wasn’t long before most Americans had a debit card in their pocket. In 2009, debit cards overtook both credit cards and checks to become the most widely used payment mechanism in the US.

However, as debit card usage grew, the industry structure changed. Mastercard and Visa realized that debit was a huge growth opportunity and began to compete aggressively for customers. Most people already had checking accounts by this time, so Visa and Mastercard were competing for the right to be the logo on a bank’s debit card. The quickest way to win a bank over was to offer it more interchange revenue from merchants. So Visa and Mastercard consistently raised interchange fees charged to merchants on debit card transactions.

Merchants didn’t like these ever increasing fees, of course. Because most merchants had a terminal that can accept a debit or credit card with the Visa or Mastercard logo, the networks had enormous market power. The merchants had no ability to negotiate with Visa and Mastercard, who up until recently were owned by the banks. Visa and Mastercard logically deployed their market power in the interests of their shareholders and customers, the banks.

These changes were hidden from cardholders. Marketing and rewards programs persuaded customers to use cards rather than cash. The cost was paid by merchants in the form of increasing interchange fees. Even when the cost of processing declined---as payment processing switched from paper to electronic---interchange fees continued to rise.

Congress to the rescue
The system as it stands today is clearly broken. Banks benefit as the cost of processing decreases and interchange fees increase. With their tremendous market power and lobbying capabilities, banks ensured that nothing much could be done about it for a long time. In this, as in many other things, the financial crisis changed everything.

Last summer, Senator Dick Durbin from Illinois attached an amendment to the Dodd-Frank Act that required the Federal Reserve Board to regulate interchange fees. As soon as the banks realized what had happened, they lobbied furiously to have it removed, but the financial crisis had weakened their position. With minor exceptions for small banks, government benefits cards, and prepaid cards, the amendment became part of the final act.

The Durbin amendment is clearly a flawed piece of legislation. For one thing, it completely ignores credit interchange. Furthermore, the precedent of the Fed setting prices in a private market is troubling, and it’s not something the Fed likes doing. The Fed also doesn’t have complete freedom to regulate interchange, but must look only at the incremental costs of processing transactions. There is a serious risk that over-regulation will kill the flexibility and innovation that the banking world badly needs.

How this impacts consumers
The Board’s proposed regulation will change the debit card industry. Interchange fees will no longer be a significant money-spinner for large banks. Because most rewards programs are funded by interchange revenue, they might disappear entirely on debit cards.

To compensate, the large banks will be forced to charge higher fees to some customers, especially those who only open up a low balance checking account.

Merchants should see big cost savings, running into the billions of dollars. But if the experience of Europe or Australia is any guide, little if any of this will be passed on to customers.

Friday, March 11, 2011

The rise of Credits

Facebook recently announced that the only payments mechanism on the Facebook platform will be Facebook Credits starting from July 1. As with anything related with Facebook, hard numbers are difficult to come by, but by all accounts Facebook Credits is growing rapidly, and forcing through this change will only help that.

Credits could be revolutionary

Credits are essentially a private currency. The US has a long history of private currencies. Private currencies usually function as replacements for the US dollar in a particular geography, where they can help to keep money in the community and drive business to local stores. In that way. The fact that Credits is "virtual" doesn't change its fundamental nature; it's a private currency usable within a specific community.

What makes Credits exciting is the size and reach of that community. At 500 million users and growing, the Facebook userbase is already larger than the population of the US. In fact, Facebook's population is exceeded only by that of India and China. Comparing population growth in China with Facebook's growth, Credits could easily become the most widely accessible currency in the world by the end of this decade.

Of course, the fundamental purpose of any currency is to act as a means of exchange*, and Credits won't really be useful until more people, especially merchants, accept it as a form of payment. That's where the Facebook API comes in. For the thousands of app developers on Facebook, Credits is now the only way to get paid for their efforts. This guarantees a rapidly growing base of merchant acceptance for Credits. Given how addictive many of the games built on Facebook's API have proven to be, this move by Facebook guarantees a steadily growing demand for Credits.

Of course, comparison's with earlier virtual currencies such as World of Warcraft's Gold, and Second Life's Linden dollars is inevitable. And in the early stages, Facebook Credits certainly resembled these earlier virtual currencies. But the twin factors of Facebook's massive userbase and rapidly growing acceptance through the Facebook API guarantee that Credits will be much more revolutionary than anything that has come before.

Facebook Credits is not PayPal

Another comparison that I've heard made is between Facebook Credits and Paypal. Paypal was a revolutionary p-2-p transfer mechanism when it launched 12 years ago. Since then it has evolved into a money transfer behemoth, processing over $60 billion in payments volume in 2008. Its primary revenue stream is from helping merchants process payments online. Paypal is definitely the premier online money transfer mechanism today, but it's a very different from Credits in many ways -

  1. Despite being seven years older, Paypal doesn't have nearly as many users as Facebook. The size and engagement of Facebook's userbase gives Credits a gigantic advantage.
  2. The Facebook API is another huge advantage; Paypal's X API is no comparison.
  3. Paypal doesn't have a virtual currency. Any money in your Paypal account is denominated in dollars. Credits is a virtual currency, and because of its convertibility into multiple currencies, it's like a private version of the IMF's SDR.

Credits needs work

Credits still has a long way to go to reach its full potential. Facebook needs to do a few things -

  1. Mandate Credits for everything on Facebook. Not just third party apps, but accept Credits for stuff like buying ads.
  2. Make Credits freely transferrable between users. This will immediately increase the utility of Credits for users; Credits will immediately become a money transfer mechanism reaching 500 million people at one stroke.
  3. Reduce the effective interchange rate, currently an eye-watering 30%. There is no way that Credits will be usable as a real world payment mechanism until this comes down to <5%.
  4. Get ahead of the regulatory curve. In the US, apply for money transmitter licenses in the required 48 states, and in other countries get a banking license or partner with an existing in-country bank. Paypal did it; so can Facebook.

Facebook would be smart to do all the above in a carefully phased manner. Start by pushing the use of Credits on the platform and allowing users to transfer Credits between themselves at par. This will create an incentive to hold Credits and use them as a payment mechanism rather than convert them immediately into dollars**. Then start reducing the interchange rate to convert Credits into real currencies. Do this at a steady rate, say 1% a month. Again, people will be incentivized to hold on to Credits for as long as possible, rather than convert into other currencies. All of this should be sequenced with the appropriate state, federal, and international licensing. Done carefully, this should ensure that any revenue lost from reduced interchange is more than made up through massively increased volume and seigniorage.

A Facebook Bank anybody?

Building a currency** has always been a Catch-22. People don't want to use it until lots of merchant's accept it, and merchants' don't want to accept it till lots of people use it. Unable to force usage by writing a law, private currencies have always solved this problem by persuading a small group of merchants and users to use it in a particular geography.

The flip-side of the Catch-22 is strong network effects***. Once enough merchants and users start using it, there is tremendous value for additional users and merchants to join in, and the system can grow very rapidly. The only limiting factor becomes the total population size and the scaling speed of the underlying technology. If Facebook plays its cards right, Credits will grow exponentially; much faster than Paypal ever did. I even have a bet going on LongBets about it.

Essentially, Facebook could become a private central bank, issuing a widely distributed and accepted currency. They could build a leveraged balance sheet, just like any other central bank, and with a degree of control and flexibility over their 'economy' that central banks can only dream of. Of course, they would have to develop expertise in managing a multi-currency balance sheet and hedging risks, but those skills can be imported into the organization fairly easily.

Another intriguing possibility that the combination of a virtual currency opens up is a virtual bank. A bank within Facebook, that takes deposits in Credits, and lends to anybody who needs it****. So will we see a Facebank sometime this decade?

* and a store of value, and a unit of account, and a standard of deferred payment.

** or Ringgit, or Euros, or whatever

*** same goes for building a payments network

**** initially, probably startup gold-farms and poker players looking for an ante