Friday, January 8, 2010

Analyzing the market for credit and debit card payment

I had blogged earlier about how the pricing model of credit and debit cards have been responsible for preventing the development of the market for electronic payment of utility bills. An excellent article in the Times explored the prizing strategies of electronic payment networks like Visa and Mastercard and comes to a few interesting conclusions about a market that is set to overtake cash purchases in the US by 2012.

Electronic payment through credit or debit cards involve four participants - the card issuing bank, the payment network, the merchant or retailer who accepts payment through these cards, and the consumer who uses the card. The payment network agencies provides an electronic network that acts like a tollbooth, processing the transaction between merchants and banks and collecting a fee that averages 5 or 6 cents every time in the US. Further, banks that issue Visa cards also pay a separate licensing fee, based on payment volume.

The major source of discontent against the networks come from another fee, the interchange, amounting to 1-3% of each purchase, that merchants are forced to pay everytime a debit card is swiped. This is then forwarded to the cardholders bank as an incentive and to promote the issuance of more cards. The banks in turn use the interchange fees as a growing profit center and to pay for cardholder perks like rewards programs.

Here are four observations about the aforementioned business model and market structure

1. Electronic payments sector is a classic example of network effects. Customers prefer using cards with the widest acceptance and merchant retailers benefit from minimizing transaction costs by dealing with limited numbers of networks. This sets the ground for payment networks to exploit the resultant increasing economies of scale conferred by the large network of consumers and merchants.

Once the market structure gets established with a few dominant payment networks, consumers and merchants are left with limited options. Merchants cannot refuse the existing networks as it would lower their sales, while consumers opting for alternative networks will be left with limited choice in their shopping and often have to be prepared for making cash payments.

2. Given the aforementioned market structure and business model, competition is more about winning over banks that actually issue those cards than consumers who use them. So the incentive is to reward banks handsomely and win them over, most often at the cost of the merchant retailers and consumers. Such rewards come in the form of higher fees payable to the cardholder's bank by the merchants, who in turn promptly shifts the burden to consumers.

The only way out of this gridlock is to incentivize banks to issue cards with newer payment networks. However, the network effects presents considerable entry barriers for any new agency.

3. The payment networks' explanation for the exorbitantly high prices charged by them is that their services are charged based on its value addition to its customers. They claim their fees as "not a cost-based calculation, but a value-based calculation", and argue that the costs of using such networks has not gone down because the cards now provided greater value than they did five or 10 years ago.

In other words, the payment networks argue that the value added to its users, both comsumers and merchants, by way of a standardized and convenient payment platform far outweighs the payments (or price paid) made by them. This logic goes against similar breakthrough technologies, across sectors, that have while dramatically increasing productivity and convenience have also led to sharp declines in prices.

4. In the case of interchange fees, Visa used its market power to nudge (or force?) consumers into signining on debit card payment reciepts instead of entering the PIN number. The payment network does not charge any transaction fees for payment using PIN, whereas it charges an amount similar to those paid for credit card transactions for those consumers making payments by signing on debit card payment reciepts.

This is another example of the inevitability of such monopoly/duopoly markets being vulnerable to various price discrimination/market differentiation strategies, most often detrimental to consumers.

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