MarketView is Edgar, Dunn & Company's e-letter providing you with timely views on the critical issues at play in today's global payments economy. MarketView taps the opinions and knowledge of EDC's payments experts across global markets, translating developments with immediacy and relevance to the challenges you face today and in the future.

IN THIS ISSUE:

European Merchant Acquiring at a Crossroads

For many years it has been predicted that the European merchant acquiring market will follow the same evolutionary path as the US. A period of fairly rapid consolidation through acquisitions will create a US style market with three or four major players dominating it. Small players will gradually disappear, unable to compete with the lower unit costs of these scale players. This belief led to extraordinary acquisitions of merchant acquiring businesses across Europe at price/earnings ratios that at the time seemed to depend on optimistic growth predictions. Since they were made, the economic climate has worsened considerably.

But it is not only the economic climate that has changed in Europe. Many of the factors that were thought to drive market consolidation have been altered to the point where it is reasonable to believe that Europe’s path is diverging from that of the US.

One of the key drivers for consolidation was the belief that the Single Euro Payment Area (SEPA) initiative would lead to a homogenised market by 2012 free from technological/legal differences and regulatory barriers. Whilst SEPA has driven change, it is a very long way from creating such a market. It remains fragmented with strong national and regional differences in technology preference, business culture, service expectations, pricing, currency, language and regulatory environments. And the demise of national debit schemes seems to have been prematurely announced, leaving in place a major hurdle to the ambitions of any pan-European acquirer.

Although SEPA may be delivering its value more slowly than hoped for, its regulatory adjunct, the Payment Services Directive (PSD), is potentially going to shift the market in favour of smaller scale, more customer-differentiated acquirers. The ability under the PSD of organisations to become Payment Institutions may threaten the large scale pan-European merchant acquiring model. If merchant groups emerge and form intra-industry organisations to handle their own acquiring needs, this will remove one of the key sources of large transaction volumes that currently support the “scale is all” business model. In the past such groups would have struggled to overcome the regulatory hurdles but the PSD facilitates this move.

SEPA and the PSD are also creating an opportunity for the merger of Automated Clearing Houses and card processing businesses. In the past the nature of the two businesses was sufficiently diverse to make merger inappropriate. However, partly driven by process and technology convergence, but largely by co-ownership by banks seeking to make efficiency improvements, it is conceivable that this convergence will occur across Europe. We may see the emergence of a pan-European Automated Clearing House with card processing capabilities. Of course it becomes a relatively short step for a business of this nature to go a little further along the value chain and become a white-label provider of acquiring services to the banks who own it or an acquirer in its own right. If such a competitor does emerge, any individual bank wishing to become a large scale, market dominant player, as is the case in the US, will be facing a considerable competitor. The US market offered no such resistance during the period of rapid consolidation that led to its current acquiring market structure.

It would be easy to dismiss the slow pace of market change and argue that it will eventually get there and that consolidation is inevitable because merchant acquiring is a business entirely dependent on economies of scale. The larger an acquirer becomes the more competitive they are irrespective of the challenges and costs of doing so. However, Edgar, Dunn & Company’s work in the acquiring community has consistently demonstrated that there is a limit to the economies of scale argument. Although Moore’s Law still operates on the IT cost base, this is no longer the defining function of acquiring costs that it once was. If economies of scale are achieved at the expense of customer service or the ability to support the needs of the market, there is a risk that the acquirer becomes a large scale “plain vanilla” utility business with little to bind them to their customers. Such bonds will be vital in the highly competitive banking world that is about to emerge in Europe as a result of the current economic crisis.

The European market may be the birth place of a new form of acquirer. In the past acquiring was a business conducted by banks in order to support their issuing business. As a means to an end, acquiring supported high credit card margins and it barely mattered that it was a marginal activity. The rise of debit cards made the challenge of processing increased transaction volumes a key driver in the development and culture of acquirers. The “size matters” argument was born and remains alive and well today. However, there are signs that in a market where credit expenditure is likely to fall and debit card usage rise, acquiring may be stumbling towards a new business rationale.

In this new world an acquirer’s ability to handle and analyse very large amounts of data, implement complex technology and support customer activity at point of sale will be focused on addressing merchants’ marketing needs. Payment may become integrated into the delivery and management of customer loyalty programmes able to go far beyond the abilities of today’s solutions. Acquirers are in a unique position to address this need. There are other examples of business functions within the merchant sector that an acquirer could address including e-invoicing services. In doing so they would be moving towards a position where merchant acquiring becomes a means to a different end and increased profitability. This will create strong relationships that low price competitors will find hard to disrupt however great their economies of scale.

We may be at a cross roads in the European market. In one direction lies a US style, utility market where the chase for transaction volume is driven by a belief that scale is the only important source of competitive advantage. In the other a world in which scale plays a part but so do customer service, cultural sensitivity and an ability to go beyond the basics and serve a greater part of the merchant value chain.

The Time for Chip in the United States

The debate whether the U.S. should adopt chip to reduce fraud is not new – arguments for and against have taken place over the last decade or more. Conditions in today’s environment may make this the time for the U.S. to take another serious look at chip technology.

First, interoperability issues are already arising as cardholders travel from mag stripe countries, like the U.S., to countries that have already migrated to chip, such as many of the European countries. With increasing frequency, cardholders run into acceptance issues with their mag stripe card, even though merchants are supposed to continue support for the mag stripe. These issues are likely to increase as more countries globally continue their migration to chip.

Second, contactless may provide the path to chip in the U.S. Many participants in the industry are investing in contactless and mobile. In addition to conventional benefits associated with speed and convenience, both are chip based technologies that generate a unique transaction code rendering fraudulently obtained data useless for a second transaction. It is EDC’s point of view that any new payments technology must have a migration path to mobile payments in order to be relevant and attractive in the market. However, since most other major payment markets have adopted contact chip, the issue of global interoperability will need to be resolved. The appropriate mix of dual chips, both contact and contactless, can address this issue.

Finally, fraud trends may support revisiting the question of chip investment:

• The frequency and size of mass data compromises is increasing. Large compromises, such as Heartland Payment Systems earlier this year, captured headlines with millions of customer accounts potentially compromised. Many cards had to be re-issued, increasing customer service costs for issuers and fueling cardholder concerns over security and integrity of the overall payment system. Additionally, merchants bear high costs associated with PCI compliance.
• The fraud problem in the US is becoming un-masked. Card spend has historically kept pace with, or exceeded, fraud growth rates. This has the impact of making fraud, at least in basis points, appear reasonably stable – until now. The current economic downturn has resulted in declining spend, while fraud in dollar terms has more or less maintained at previous levels. Doing the math, fraud in terms of basis points is now rising. In today’s environment, fraud may no longer be viewed as a manageable expense.
• Cross border fraud migration has long been a recognized issue, but is now becoming a reality – targeted at the U.S. As data from the U.K. shows, fraud migration has shifted toward non-chip countries, specifically the U.S. With the largest payment markets moving towards full chip adoption, including markets right on our borders (Canada and Mexico), there is growing concern that:

1. The U.S. will be targeted if left unprotected
2. Countries that have converted may exert pressure to modify rules so that their investments are not sub-optimized by fraud committed on their cards in non-chip countries

Any effort to address fraud must include an attack on both Point of Sale (POS) and Card Not Present (CNP) fraud. CNP fraud is a significant problem in the U.S. In fact, e-commerce fraud, the largest component of CNP, reached $4 billion in 2008, up 8% from 2007. Additionally, fraud data has shown significant migration between POS and CNP channels. Industry cooperation is needed to find a solution – whether it leverages the chip in the consumer’s card, relies on challenge-response technologies which either engage the consumer or utilize behind the scenes computer generated data, uses expanded data sets to enhance neural networks, or is a mix of these and other technologies.

Given these fraud trends, the steady march of contact chip across the globe and the emergence of contactless, the time may be right for the U.S. to seriously address the following key questions:

• Can contactless/mobile address the needs of the U.S. market while maintaining global interoperability? Does the conversion of other markets to chip cause interoperability issues that may drive the US toward a chip based solution?
• What level of fraud would create a positive authentication business case for the U.S.? How will fraud migration from other geographic markets impact the business case?
• Given the lead times required to convert, and the likelihood of fraud migration as other markets convert to chip, how much longer can the US afford to wait?
• What solutions should be implemented to address Card-Not-Present fraud?

Only by making a coordinated effort to close off all channels to fraudsters will the industry be successful in significantly reducing payments fraud in the U.S. and beyond. Given existing investments coupled with the increase in fraud, the time for chip in the U.S. may in fact be now.

ATM Direct Charging Changes the Competitive Landscape in Australia

In March 2009, the Australian financial services industry implemented changes to the ATM system as part of the payments system reforms initiated by the Reserve Bank of Australia (RBA). The changes focused on two overall areas – direct charging and access:

• ATM operators are now able to charge a cardholder directly for an ATM cash withdrawal or balance enquiry (‘direct charging’)
  • The fee must be displayed on the ATM screen and the cardholder must be given the option not to proceed with the transaction;
  • Bilateral ATM interchange fees previously paid by ATM card issuers to ATM acquirers were set to zero;
  • Sub-networks, i.e. shared ATM networks that set a multilateral ATM interchange fee for intra-network ATM transactions between members, were able to retain the multilateral fees rather than directly charge member cardholders;
  • Smaller card issuers were permitted to enter into an arrangement where they paid fees to an ATM operator so that their cardholders were not direct charged.
• An access code was implemented through APCA (Australian Payments Clearing Association), setting out the terms and conditions for new entrants and the requirements on current participants in dealing with new entrants.

Prior to the reforms, interchange fees of around AUD $1 per transaction were payable by the ATM card issuer to the ATM acquirer. The ATM card issuer generally charged its cardholders a ‘foreign ATM fee’ for these transactions, which was approximately AUD $2 per cash withdrawal. These foreign ATM fees were not displayed at the time of the transaction but typically debited from the cardholder’s account and appeared on the bank statement. The RBA observed that ATM interchange fees rarely changed and did not appear to be subject to competitive pressure.

The introduction of direct charging has changed the competitive landscape in the Australian ATM industry and is likely to have further ramifications as the industry evolves over time:

• A new revenue model – Independent ATM operators (representing 48% of ATMs deployed) have been the primary beneficiaries and now receive a greater proportion of revenues. ATM operators are typically now charging about $2.00 per cash withdrawal and $0.50 to $2.00 per balance enquiry on foreign ATM transactions (versus the $1.00 per transaction previously received as interchange from the ATM card issuer). At first, some card issuers continued to charge a reduced foreign ATM fee, but competitive forces led to the virtual elimination of foreign ATM fees after just a few weeks. As a result, many cardholders are generally paying the same level of fees as before, but the party receiving and controlling the level of these fees has shifted from the card issuer to the ATM operator.
• Network expansion – The higher direct charge revenues earned on foreign ATM transactions (versus interchange) has improved the economics of operating off-premise ATMs. This is expected to encourage further network expansion, particularly by independent ATM operators and there is early evidence that this has begun. In the EDC Australian ATM Market Study 2008, participants estimated that the market would expand at a moderate rate to 35,400 ATMs by June 2013 (from 27,306 ATMs in March 2009). Most of this growth is expected to occur in the off-premise segment. While total industry ATM transaction volumes are expected to rise somewhat, we expect transactions per ATM to decline slightly over time due to the growth in ATMs deployed.
• Increasing site costs – As competition for sites increases and site owners become more attuned to the new pricing arrangements, site costs are expected to rise.
• Variable charging – Many expected to see the introduction of variable fees across individual ATM networks (e.g. higher charges for rural areas due to higher servicing costs; fees that changed depending upon the type of site or time of day). Currently most ATM operators charge the same fee at all ATMs within their network.
• New shared access arrangements – Following similar developments in the US, new shared access arrangements have arisen to provide free ATM access for cardholders of smaller financial institutions. These arrangements vary in structure. For example, rediATM was created as a sub-network of over 1,400 mainly credit union ATMs. In addition, National Australia Bank recently announced that it would join rediATM, taking the combined network to 3,100 ATMs. Both Westpac and Cashcard (the largest independent ATM deployer) have also established a number of direct charge-free ATM access arrangements with smaller card issuers.

• Cardholder behaviour – As expected, there was a sharp decline in the proportion of foreign ATM cash withdrawals in March, down to 38% from the usual 46% of total ATM cash withdrawals. Most cardholders are paying similar fees to the previous model for utilising foreign ATMs, but are now more aware of the fees because of notification at the time of transaction. However, over time we expect convenience to override aversion to fees and the usage of foreign ATMs to move back to near historical levels.

For financial institutions and independent ATM operators, the introduction of direct charging has fundamentally changed how they view their ATM channel/business. Smaller card issuers are concentrating on securing greater free access for cardholders through shared access arrangements. Larger financial institutions and independent ATM operators are focusing on expansion of off-premise ATMs and network optimisation. Outsourcing and benchmarking are likely to have an increasing role.

About Edgar, Dunn & Company

Edgar, Dunn & Company (EDC) is an independent global financial services and payments consultancy. Founded in 1978, the firm is widely regarded as a trusted advisor to its clients, providing a full range of strategy consulting services, expertise and market insight. Global capabilities include in-depth industry and consumer benchmarking, strategy, risk management, marketing, profitability improvement, operations, and new products and technologies. With locations in Atlanta, Frankfurt, London, Paris, San Francisco, Singapore and Sydney, EDC serves clients in over 30 countries on six continents. More information can be found at www.edgardunn.com

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