Plastic Cards

“It was necessary to reconceive, in the most fundamental sense, the nature of bank, money, and credit card; even beyond that to the essential elements of each and how they might change in a microelectronics environment. Several conclusions emerged: First: Money had become nothing but guaranteed, alphanumeric data recorded in valueless paper and metal. It would eventually become guaranteed data in the form of arranged electronics and photons which would move around the world at the speed of light.”

– Dee Hock, Visa’s first CEO and one of the pioneers of the bank card association model

Look in your wallet. If you are like most Americans, you have at least one thin plastic card that you use to pay for things at many merchants. Take out one of those cards. The card you picked is about 3 3/8″ long by 2 1/8″ wide, weighs about a fifth of an ounce, has a magnetic stripe on the back, and has your name and a 15 or 16 digit account number embossed on the front. It is called a payment card. Yours is one of more than 1.1 billion payment cards in the hands of U.S. consumers in 2008. You can pay with these cards at up to 8 million merchant in the US and tens of millions more around the globe. Once cardboard, now plastic, the card itself is becoming an anachronism. As anyone who has paid online knows, the digits—with their unique link to you—are what matters. How these digits are stored and transmitted is a detail.

Chances are that you have a few credit cards. These have the logos for the American Express, Discover, MasterCard, or Visa card networks on the front. All of the MasterCard and Visa cards, and a portion of the American Express and Discover Cards, are issued by a bank that has a relationship with cardholders like you. The name of that bank appears on the front of the card. When you pay with a credit card, your purchase will appear on your next monthly statement. You can pay in full or finance your purchase over time. Some of these credit cards require you to pay in full when you get your statement and don’t give you the opportunity to finance; they are often called “charge cards” but we will lump into credit cards.

If you had only one card in your wallet, odds are that it is the one your bank has given you to take cash out of your checking account at ATM machines. This card doubles as a debit card: when you pay with it the funds are taken from your checking account. On the front, your ATM/debit card has a logo for your bank and probably has a logo for either Visa or MasterCard. American Express does not issue debit cards and Discover has issued relatively few. On the back, your debit may have a logo for STAR or one of several other EFT networks that enable you to pay using by entering in your PIN.

You might also pull out a prepaid card that has a Discover, MasterCard or Visa logo on it. These are cards that already have money loaded onto them. You might have bought one of these prepaid cards-and loaded money onto it-at a retailer so that you could have the convenience of paying with plastic. Your employer might have put your wages on a prepaid card enabling you to withdraw cash from ATMs as well as pay for goods at retailers. These cards are especially attractive options for the 7.7 percent of American households that do not have checking accounts.

All told, in 2008, Americans used their 1.1 billion plastic cards 21.3 billion times to pay for $3.7 trillion worth of goods and services. (We adjust all dollar values in this book so they reflect purchasing power in 2008.) The average charge was about $100. A typical consumer paid with a card 29 times over the course of a month at a retail location, paid 10 bills a month on a card, and paid 4 times online.

Many U.S. wallets are bulging with other cards. You may have cards that allow you to pay at particular retailer such as Neiman Marcus. While such store cards are numerous—there were 493 million in 2008—U.S. households only used them for $143 billion in purchases, or less than 4 percent, of what they put on the debit, credit, and charge cards that could be used at many merchants. You may also have a prepaid card—preloaded with money—that allows you to buy at a particular store such as Starbucks or to make long-distance phone calls (these types of cards are sometimes referred to as stored-value cards). In this book, we focus on “general-purpose” payment cards, which you can use at many different merchants.

You carry payment cards because you expect that merchants you want to shop at will take one of your cards for payment. But they don’t have to. In fact, unlike cash and checks, merchants cannot take your card for payment unless they have entered into an agreement with an agent of for the card brand whose logo appears on your card. MasterCard and Visa are accepted at about 8 million merchant locations. That’s about 2 million more than take Discover and 3.4 million more than take American Express. Although MasterCard and Visa have a clear edge when it comes to smaller merchants, the card brands are almost on par when it comes to where people spend money.

Merchants must pay a portion of each purchase made with a payment card to the firm that processes their card transactions. Yet most retailers have chosen to accept payment cards. And those that take one brand of card usually take several brands of cards. They don’t have the bulky-wallet problem consumers have: although they may post many decals displaying the logos of the cards they accept, they can use the same equipment to handle many different kinds of cards and can often find a business that will process all of their card transactions for them. Merchants take cards because they know that customers have these cards and want to use them. They get sales if they take cards and lose sales if they don’t. Cards that few customers carry may not be worth the bother; the JCB card that is mainly carried by Japanese visitors to the United States, for instance, is commonly accepted in high-end stores in tourist destinations frequented by Japanese visitors, but has much less acceptance elsewhere.

That brings us to a fundamental feature of payment cards. Just as you cannot dance the tango without a partner, a payment card needs both consumers and merchants. This is what economists call a “two-sided market.” Businesses in such markets need to get two distinct types of consumers to use their platform. Take the singles scene. If you want to open to nightclub where the two sexes can mingle you need to make sure that you get enough women to show up to interest the men and enough men to show up to interest the women. Or consider online job boards. Employers will not use the board if you do not have enough good people looking for jobs and job seekers will not use the board if there are not enough employers posting jobs. Shopping malls are another example. Retails stores will not rent space unless enough shoppers come to the mall and shoppers will not come to a mall unless there is a selection of stores they want to shop at.

Card brands cannot readily persuade people to carry their cards if cardholders cannot use it to pay at many places. Nor can they easily talk merchants into accepting their cards if few customers want to use that brand. Many have tried to start payment card brands only to find that this chicken-and-egg problem was just too hard to crack. Even clever technologies have flamed out. Pay-by-Touch developed a way to pay with your finger. You could set up an account at a kiosk at a store and register your fingerprint. To pay you just swiped your finger over a terminal that could recognize your fingerprint. No more cards and beyond some grisly scenarios a sure way to reduce fraud. Nevertheless, aside from a few Piggly Wiggly stores, few merchants installed the kiosks. Consumers had little motivation to setting up an account that they could hardly ever use. Pay-by-Touch, like most companies that have tried to start payment systems, is no more.

The strategies used to establish payment card systems, the economics of pricing payment cards, the business and operational problems faced by participants in the card business, and the business ecosystems that characterize this vast industry all turn on the two-sided nature of payment cards.

So has the evolution of payment cards since their birth in 1950. Early that year, Frank McNamara gave some cards to a few hundred people in Manhattan and talked some local restaurants into paying his company 7 percent of the meal tab billed to the Diners Club card. He fanned out to other cities and ignited the first general purpose payment card system. But the card industry did not experience a big bang. Rather, from these small beginnings, the industry has expanded gradually over time. Part of the story involves new card platforms coming into the business; Diners Club was followed by Carte Blanche, American Express, and BankAmericard within the decade. But more of the story is how these card platforms have nurtured the two sides of the market over time-with customers gradually attracting merchants gradually attracting customers gradually attracting more merchants and so on. What might have looked like tidal waves at the time-Bank of America flooding its customers in California with cards or Sears offering most of its store cardholders a Discover Card-now appear as ripples in the ocean.

Much has happened in the last sixty years to make plastic seemingly ubiquitous. In 1970, a bit less than a generation after the industry’s Manhattan birth, only 16 percent of households had payment cards and many retailers like as supermarkets and liquor stores didn’t take them for payment. With few households having cards and few places to use them, the average spending on plastic per household (across all households) was only a little more than $55 per month (about 1.5 percent of the average monthly household income). Today, most large retailers, supermarkets, and mail-order firms take plastic, along with a rapidly increasing number of taxis, health-care providers, and small retailers. And payment cards are the main currency for Internet transactions. Almost everything bought online is paid for with digits taken from a payment card, either directly or through an intermediary such as PayPal that allows individuals to take credit cards. Most consumers make at least some purchases with a plastic card. [And in 2002, the most recent year for which we have data, on average households charged $1,280 per month on payment cards (about 25 percent of their average monthly household income).] Indeed, payment cards have become a global common currency. We do not know of any exceptions to the statement that it is possible to pay with at least one of the major card brands in every country in the world.

Still, in 2008, almost sixty years after the payment card industry was born, 33.7 percent of payments made by U.S. households are made with cash and another 13.8 percent by personal checks. And those figures exclude housing costs such as monthly mortgage payments that are often paid by paper check. Dee Hock’s “guaranteed data” have a long way to go even in the country that has had cards the longest.

Although cash and checks may not be toppled for generations, if ever, payment cards have nonetheless wrought a revolution. Humankind has seen only four major innovations in the most routine aspect of economic life-how we pay and get paid for things: the switch from barter to coin around 700 BCE; the introduction of checks by the Venetians in the twelfth century; the shift to paper money in the seventeenth century; and now the payment card. Let’s be clear again, though-it is not the card, it is the digits, and as we will see, when it comes to the electronic transfer of funds, plastic cards are not the only game in town.

The industry behind this revolution, the subject of this book, is quite extraordinary. To see why, think about what has to happen for you to be able to buy a pair of shoes at the nearby mall using a payment card. You must have a card. Someone had to issue you that card, and in the course of doing so, may have worked with other companies that helped it determine whether you were a good prospect. It hired another company to manufacture your card, which in turn probably bought the magnetic stripe from someone else, and it has probably lined up another firm to send you statements and collect your money.

To let you buy your shoes with plastic, the local store has to accept the card you have. That store had to sign a contract that enabled it to accept the card you present and ensures that it will be reimbursed for (most of) the price of your shoes. One business may sign the local store up and take care of everything, from

installing the terminal equipment, to processing transactions, to settling up accounts. Alternatively, one business may sign the merchant up, and another may take care of the details after that. The business that installs equipment and processes the transactions works with other firms: manufacturers of card-processing equipment for sure and perhaps other companies to assist in the processing and accounting work. Still other companies make the software that runs the terminals at the checkout counter.

The card networks whose brands appear on the front of the cards are the hubs in a vast interconnected network of businesses and consumers. After you present your card to a merchant at a physical location, the clerk swipes the card through an electronic terminal near the cash register. Within seconds, the terminal connects to a computer miles away and verifies the willingness of the entity that issued your card to pay for your purchase. Over the course of a year, these computers process billions of transactions in the United States between the millions of merchants who take payment cards and the hundreds of millions of consumers who use payment cards. It is a tour de force.

This feat is all the more extraordinary because the computers have so many masters to please. Suppose you used your MasterCard credit card. MasterCard does not actually issue cards to anyone nor does it sign up merchants itself. Its customers are banks-some issue cards, some service merchants, and some do both. The system has to transfer money to the merchant from the bank that signed up the merchant. It must transfer money from the bank that issued the card to the bank that signed up the merchant. The bank that issued the card must obtain all the information necessary to bill the cardholder. And all along the way, the system works to collect and distribute various fees among the parties that have participated in each transaction. MasterCard is paid a transaction fee for sitting in the middle of all this.

How this complicated coordination takes place, and how the institutions developed to accomplish all this, is a story of how solutions to complex organizational and technological problems emerge and evolve in markets.

Now commonplace and intimately part of our lives, payment cards have a fascinating past, present, and future-all determined, more so than in many industries, by the intersection of economics, business, law, technology, and public policy.

Ever wonder why your credit card bill comes from Delaware? You need look no further than the U.S. Supreme Court’s 1978 Marquette decision, which allowed credit card issuers to get around state interest rate caps by issuing the cards in states without interest rate caps to consumers in states with interest rate caps. Delaware rolled out the welcome mat for credit card issuers, and jobs that New Yorkers might have filled went to Delawareans instead.

If you have ever gone to a restaurant in France, you may be curious why the locals enter numbers into the handheld terminal the waiter brings to the table while the waiter fiddles around with your card and then realizes he must get you to sign. It isn’t a secret society. Most French have-and have had for many years-“smart” cards that have a personal identification number (PIN) securely stored on a chip. The card device honors the card if the PIN that cardholders type in matches the PIN on the chip-no need to call the central computer to see if the card has been stolen. But it isn’t that the French made a technological advance U.S. card companies couldn’t make. Telephone connections were historically less expensive and more reliable in the United States than in France, so there was no business case for using smart card technology, which is more expensive than magnetic stripes, in the States. Magnetic stripe cards could be replaced by something smarter in the U.S. As we will see, efforts by MasterCard and Visa to persuade merchants and consumers to move to cards that the consumer can wave at checkout (these are contactless cards that have a “near-field communication” chip in addition to a magnetic stripe) have fared poorly in the last half decade. They have the faced the same chicken-and-egg problem that bedeviled Pay-by-Touch.

You might also consider how the card businesses make money. You pay little or nothing, at least not directly, for having a payment card that you can use to buy things. Your debit card comes with your checking account, and there are few additional charges for it. You may pay an annual fee for your charge card, but you get the benefit of the float on your purchases between the time you purchase and the time you pay; perhaps you also get other rewards, like airline miles. It is unlikely that, at least until recently, you had

pay an annual fee for your credit card, and like charge cards, you get the benefit of the float and perhaps freebies from hotel discounts to free insurance. (Of course, if you have a credit card and decide to finance your purchases, you will pay finance charges.) This is a typical two-sided market-no different than Adobe giving away its reader software and charging companies for the production software, Microsoft charging developers little for its tools and making its money from computer purchasers, or your local television station showing you Lost reruns for free while making its money from advertisers.

And returning to Europe, the following is curious. Card networks-many affiliated with MasterCard and Visa-started in continental Europe shortly after they began in the United States. Yet different kinds of cards succeeded on each side of the Atlantic. Credit cards surged in the States; debit cards were available from the beginning, but they didn’t take off until the mid 1990s. Debit cards grew rapidly in France, Germany, Portugal, Norway, and Sweden. Some convergence has taken place in the last decade; credit cards have become more common in Europe while but debit cards surged in the U.S. Culture? Institutions? Technology? Historical accident? We touch on this puzzle, but we do not claim to solve it.

The Key

The plastic card you pulled out a few minutes ago is the key that usually starts the electrons flowing through the vast piping of the payments business. It empowers you to move money over through computers and over communication lines to a merchant to pay for goods or services you want in return. From the front, the card has some interesting features. Your account number is embossed at the bottom and identifies the cards. In the U.S., Visa cards start with a “4”, MasterCards with “54 or 55”, Discover Cards with a “65“ and American Express Cards with a “37”. The remaining digits on the card identify additional details, such as the bank that issued your card and your account.

But it is the magnetic stripe (or magstripe) on the card’s back that really makes it useful. That stripe holds most of the critical information on your card account: your name, account number, expiration date, card type, and perhaps other details as well. That information gets sent from your merchant’s terminal over communication lines to various computers.

The magstripe is a quite efficient, but not terribly smart technology. Smart cards can be brighter. The French version mentioned earlier is not at the head of the class: it just holds the same information as the magnetic stripe in a more secure way-it is much more difficult for a card thief to read the information off a smart card. But it is possible to download data and software onto the chip and create a card that does much more creative things. There are operating systems and applications for these cards just as for other chip-based devices. For now in the United States, smart cards are a technology-albeit a potentially powerful one-in search of an application that consumers want. Many are betting that mobile phones will have contactless chips (which are smart) so that consumers could pay by waving their phones at a device at the point of sale. Japanese consumers who have benefited from more advanced mobile phones have been able to do this since 2004.

Turning on Payments

How does a payment card work in practice? The answer varies a bit according to the specific card. Let’s focus on the most popular brand of card-Visa-and one issued by one of Visa’s largest members-Bank of America. Figure 1.1 shows some of the important elements. Suppose you go to Best Buy to purchase a new Blue-Ray DVD player and you swipe your Visa card issued by Bank of America (the “issuer”) through a card reader. The card reader takes data off the magnetic stripe on the back of the card. It combines this data with information about the merchant and the dollar value of the purchase to create an electronic message. It then dials the telephone number of a computer maintained by Best Buy’s merchant processor, Chase PaymentTech, which handles BestBuy’s card transactions. Once connected, a message is sent Chase’s computer. This computer reads the message and figures out that you have used a Visa card. It dials up Visa’s computer system (there are actually two that work in parallel just in case one of them goes down). After reading the message, Visa’s computer knows to check with Bank of America’s computer to see whether you have enough money on your credit line to cover the purchase. If you do, Bank of

Figure 1.1 How do payments work? Source: Bank of America

America’s computer will send a message back to Visa’s computer authorizing the transaction. Visa relays the message back to Chase PaymentTech, which then sends a message back to the terminal at the store. The terminal prints out the receipt that you sign. Because the entire transaction was captured electronically, the main purpose of the receipt is to help resolve disputes when cards are stolen and signatures are forged. This authorization process usually takes just a few seconds. Standing at the register it may almost appear instantaneous to you.

Best Buy then automatically submits a request for payment to Chase PaymentTech, which in turn, sends it on to Visa’s computer. The Visa computer passes on the request to Bank of America’s computer, which posts the transaction to your account. Visa’s computer consolidates this transaction with all the other Visa transactions and settles accounts among banks. For this purchase, Bank of America pays the merchant processor, which then pays Best Buy. This process is typically completed within two to three days from the time you made your purchase. The Best Buy store receives about 98 percent of the amount charged for your MP3 player. The remaining 2 percent difference is called the “merchant discount,” which is the fee paid to the acquirer for providing its services. The processor, in turn, pays about 1.8 percent of the purchase amount to the issuer, in this case Bank of America. That 1.8 percent “interchange fee” is set by Visa. MasterCard has a similar fee (American Express charges a higher merchant discount typically while Discover charges a lower one; the interchange fee is included in this discount when they handle both the consumer and the merchant directly).

This process is the same whether you used a Visa credit or debit card until almost the end. With a credit card, the issuer compiles information on your charges over the course of the billing cycle (usually thirty days) and sends you a statement. The issuer expects full or partial payment typically within twenty-five days of the end of the billing cycle. With a debit card, the issuer simply deducts the charges from your checking account-generally within a day or two of the purchase. Your monthly checking account statement will then contain your debit card purchases as well as other account activity.

When you’ve used your debit card, you might have noticed that debit transactions can be authorized with either PIN or a signature. When you sign, you’re making a signature debit transaction, which goes through either Visa or MasterCard, as just described. When you enter a PIN, you’re making a PIN debit transaction, which goes through one of the EFT networks, such as STAR, Interlink, or Pulse. (EFT networks started out as ATM networks, later adding debit capabilities for retail purchases.) Of course, you can enter a PIN only at a business that has installed a PIN pad, although some EFT systems have started to allow some insurance companies and other businesses to accept PIN debit transactions without requiring PIN authorization. Somewhat confusingly, at many businesses with PIN pads, you have to choose the credit rather than the debit button to make a signature debit transaction. (PIN debit and signature debit are also referred to in the industry as online and off-line debit, respectively. We don’t use those terms since PIN and signature debit transactions are all processed electronically-or online, in common parlance.)

Banks that issue debit cards can enable their customers to use these cards with a signature (through agreements with MasterCard and Visa) and a PIN (through agreements with one or more EFT networks). Almost all debit cards can be used with a PIN, but only about [70] percent can be used with a signature. A Visa or MasterCard logo on the front tells you the card can be used for signature debit, while the EFT logos on the back tell you which EFT networks your card works on.

Some of the intricacies of the card transaction described above arose because issuers such as Bank of America are each a single node in a network of thousands of issuers and acquirers. These issuers and acquirers do not operate the network they just hang off of it. If you had presented an American Express card or Discover Card, a few things would have happened differently because these networks are usually also acting as the issuer for the cardholder and the acquirer for the merchant. Especially if it is large, the merchant might have a direct line to American Express. In that case, the message created by swiping the card through the reader goes directly to American Express’s computer for authorization, and the computer sends the response right back to the merchant. American Express takes on the role of both merchant processor and issuer here, thereby cutting two steps out of the message relay process described earlier. If the merchant does not have a direct line to American Express, the message goes to the merchant’s processor, which then transmits the message to American Express, thereby cutting one step out of the

process. Surprisingly, with the use of fast computers and reliable telecommunications networks, there is no perceptible difference between the speeds at which American Express, Discover, Visa, and MasterCard process transactions.

At the Center

American Express, Discover, MasterCard, and Visa are the major “brands” of payment cards in the U.S. You can recognize them from their distinct logos. Together they account for the preponderance of the dollars spent with general-purpose payment cards. Each operates a “network” that connects merchants that are seeking payment for goods and services with consumers that are making payment for goods and services. Each network has a distinct set of computers and rules for processing transactions, seeking verification, getting approval, transferring funds, and capturing billing information. Table 1.1 shows their shares of spending at merchants for 2008.

American Express is the oldest brand. It started in 1850 as an express company-sort of a cross between bicycle couriers and United Parcel Service. It introduced its first hit payments product, the travelers cheque, in 1891. Its first charge card, the American Express Green Card, was launched in 1958. In the late 1980s, it started a credit card, Optima. Initially a case study in poor product planning, Optima developed into a solid product by the mid-1990s. For most of its history Amex wanted to “go-it-alone” so that it did everything from signing up the merchant, to authorizing and settling transactions, to caring for the consumer. In the early 1990s this payment card pioneer decided to approach banks to issue Amex cards that would the routed over Amex’s network. It started signing up banks around the world. MasterCard and Visa tried to prevent its U.S. bank customers from issuing their cards as well as Amex cards. A U.S. Department of Justice lawsuit went against them and beginning in 2004 Amex started signing up major banks in this country.

Discover is the youngest brand. Sears, Roebuck and Co. introduced the Discover Card in 1985. This orange-on-black card became one of the greatest business success stories of the 1980s-helped by Sears’s seventy-plus years of experience with a store card and its decision to offer the card to twenty-five million creditworthy Sears cardholders. By 1991, the Discover Card was accepted by more merchants than the American Express card. Though its growth slowed substantially after its initial success, Discover was still the eight-largest issuer of payment cards in the United States in 2008. Meanwhile, Sears spun off Discover in 1993 (after various mergers Discover became a stand-alone company in 2007) and sold off its store card business to Citigroup in 2003. Discover, like Amex, has also recruited banks to issue its cards.

Visa is the biggest card brand. More than half of the general-purpose payment cards in the United States have the blue, white, and gold Visa logo on the lower right-hand corner, and almost all the merchants that take payment cards take Visa cards. Visa is also the largest player in signature and PIN-based debit. It accounted for 63 percent of consumer expenditure made on general purpose debit cards in 2006. In addition to debit cards that are routed over its regular network, it owns Interlink, which is the largest PIN-based network measured by transaction volume. Visa started in 1966 as the BankAmericard franchise system, although its roots date back to Bank of America’s go-it-alone card program started in California in 1958.

MasterCard was started at the same time as Visa. Cards with the orange-and-red MasterCard balls are second only to Visa cards in abundance. In 1978, Visa overtook MasterCard with respect to the number of cards issued. MasterCard reversed its relative decline in 1992, after embracing novel card programs run by nonfinancial giants like AT&T. Then, in the late 1990s, MasterCard persuaded several banks-most notably Citigroup, which is the second-largest credit and charge card issuer in the United States-to shift their issuance toward MasterCard. As a result, MasterCard has made a big comeback in credit cards, nosing out Visa for the lead in terms of the number of cards and volume of outstanding balances in 2002, although

it still trailed slightly in terms of the volume of credit card purchases. Visa’s growing lead in debit cards has overwhelmed MasterCard’s increase in credit cards leaving MasterCard a distant two overall.

The banks that issued cards or acquired merchants owned MasterCard from 1966 to 2006 and owned Visa from 1971 to 2008. During those years the banks elected some of their members to the boards of the two organizations and those boards appointed management. The banks paid fees to cover the cost of the networks, which therefore operated on a more or less break-even basis rather than seeking to maximize their profits like ordinary companies. MasterCard decided to turn itself into a for-profit publicly traded corporation in 2006. It did an IPO and its bank members collected some of the proceeds. Visa followed in 2008. The banks do not have a majority share of these networks, which are run like all publicly traded companies by an independent board of directors. The networks now treat the banks as customers rather than members. The transformation of the MasterCard and Visa organizations from membership associations to publicly traded companies is one of the most significant changes in the payments industry in the last half century and will likely reshape payments going forward.

In the Field

American Express, Discover, MasterCard, and Visa are at the center of the payment card ecosystem. But the real action takes place in the constant competitive struggle for the consumer and the merchant who form the two sides of the payment platform. American Express and Discover are in the fray. MasterCard and Visa are too, but primarily through their bank customers, who compete with each other as well as with American Express and Discover.

Let’s look at a snapshot of the issuing industry in 2008. American Express and Discover were the third and eighth largest issues of general purpose payment cards based on the dollars paid by consumers to merchants on those cards (what’s known as transaction volume). All of the other issuers were banks that were customers of the MasterCard of Visa networks. Two-thirds of the transaction volume was accounted for by eight issuers, as shown in Table 1.2, which include six MasterCard and Visa members as well as American Express and Discover. Six large banks, J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, Capitol One, and U.S. Bank accounted for 48.3 percent of transaction volume. Over time fewer banks have accounted for more of the transaction volume as a result of the smaller banks exiting from credit-card business and the merger of banks into larger entities. A decade earlier it took the [X] largest issuers to account for 50 percent of transaction volume.

Among these large issuers there is a great deal of diversity as a quick look at the five players that account for 56 percent of transaction volume.

JP Morgan Chase has the top spot because it is a significant player in credit and debit even though it isn’t the largest issuer of either-it is second in credit and third in debit (prepaid is still too small to affect the rankings). It has attained this position in part because of mergers and acquisitions over the last decade. J.P. Morgan and Chase Manhattan combined in 2001. The new company bought Bank One in 2004 and Washington Mutual in 2008, both of which were significant card issuers.

Bank of America is now the largest issuer of debit cards. That goes hand-in-hand with its position as the largest consumer bank in the United States. Most people get their debit card from the bank where they have their checking account. But it also a result of the bank’s decision to bet heavily on debit cards in 1994 when these cards were just taking off in the U.S. It issued debit cards to 90 percent of its checking account customers, rather than the 70 percent that was more typical in the industry. Fifty years after introducing the first widely successful credit Bank of America was the third largest issuer of credit cards in 2008. This card pioneer has also come a long way through mergers and acquisitions. Charlotte-based NationsBank bought San Francisco based Bank of America in 1997 and Charlotte became the headquarters of the new entity, which kept the Bank of America name. In 2006 Bank of America bought MBNA which was the fifth largest general purpose card issuer and the third largest credit card issuer at the time. MBNA only

issued credit cards (it did not take deposits like most banks) and specialized in co-branded cards such as WHAT. Bank of America then bought LaSalle Bank in 2007 which issued both credit and debit cards.

Citigroup was the fourth-largest issuer but mainly based on its fourth-pace position in credit cards. It has been a significant player in that part of the business from its national beginnings in the 1960s. It was the largest credit card issuer from [WHEN] to [WHEN] and was the second largest issue of credit cards in 2002. It shook up Visa in 1998 when after not getting some things it wanted it shifted a significant portion of its credit card portfolio over to MasterCard. For many years it was unique among MasterCard and Visa issuers in operating two stand-alone card brands-Diners Club and Carte Blanche-both of which it has since sold. Unlike Bank of America Citi didn’t embrace either ATM machines when they came out or debit cards. It has put less emphasis than its San Francisco and Charlotte-based rivals in securing consumer checking accounts. As of 2008, Citi was the 12th largest issuer of signature debit cards despite being one of the third largest commercial bank in the United States after Chase and Bank of America. Although Citi is known for having built itself into one of the world’s largest financial institutions through acquisitions, unlike Chase and Bank of America, it did not acquire banks with significant credit or debit-card portfolios during the 2000s.

American Express was the largest credit card issuer with 23.5 percent of credit card transaction volume in 2008. That was enough to make it the third largest issuer overall despite issuing no debit cards (it doesn’t accept checking account deposits). Amex has been a significant innovator in credit cards since its founding in 1958. It has the largest corporate card program, which enables executives to charge expenses to Amex cards, and operates one of the most successful membership reward programs, which encourages cardholder loyalty. Unlike Bank of America and Chase Amex has grown organically rather than through the merger with other card programs.

Wells Fargo rounds out the list of the top five. Its number 3 position as a debit card issuer, with 12.5 percent of purchase volume, offsets its number 8 position as a credit card issuer, with a 2.3 percent share of volume. Credit cards account for only a fifth of Wells Fargo’s payment card transactions. Wells Fargo had a 66 percent increase in its payment card purchase volume between 2007 and 2008 as a result of its purchase of Wachovia shortly after the financial crisis hit in September 2008. Wells has some history in common with Amex-it was also started as delivery company in the mid 19th century by the original founders of American Express.

These issuers can offer useful cards only if merchants accept these cards for payment. Someone has to go out and sign up merchants to accept cards and then manage the transactions that take place of these cards. This part of the industry is less visible to the public but is every bit as important as the consumer side. It is also far more complex. The consumer gets a card in the mail and is all set to pay anywhere with it. The merchant needs to enter into a contract with an acquirer, install equipment to accept cards, integrate card acceptance with its methods for accepting and keeping track of payments, and have agreements in place to process those transactions. A number of companies work with the merchants. In the frontline are the acquirers who sign up the merchants and often handle some or all of the processing for them.

In 2008 the 10 largest acquirers, shown in Table 1.2, accounted for 78.5 percent of purchase volume. Six of these are owned by banks that also issue general purpose cards: Chase, Bank of America, Wells Fargo, First National, and RBS WorldPay although the last of these was on the auction block as of the beginning of 2010. The other four specialize in merchant acquiring and do not engage in traditional banking or card issuing. These include FDC, Elavon, Global Payments, and Heartland Payment Systems. They all have relationships with banks though. MasterCard and Visa only allow financial institutions that belong to its network to enter into contracts with merchants. Some companies like Heartland enter into agreements with banks under which they do most of the work and effectively rent the bank’s license to acquire. Others like FDC enter into partnerships with banks under which the banks have the merchant relationship but FDC does much of the work processing transactions. All of these acquirers help merchants to enter into

contracts to accept MasterCard and Visa cards. They also help American Express and Discover although both of those networks mainly acquire merchants on their own.

FDC deserves special mention among the acquirers both because of its important role in the merchant-side of the card business and because of the tentacles that it has into many other parts of the business.

It was originally started by American Express which spun if off in 1992. It bought the STAR EFT network in 2004 and sold Western Union, which operates the largest money-transfer business in the world, in 2006. It had two significant alliances in 2008: one with Chase PaymentTech, which it dissolved at the end of 2008, and the other with Wells Fargo Merchant Services, which remains in force. Taking all of its relationships into account, FDC provided payment services to 3.1 million merchant locations in 2008 (almost 40 percent of the 8 locations that accept general purpose cards) and processed $1.4 trillion of payment transaction volume (about 43 percent of all general purpose payment transactions) that year. FDC also helps financial institutions process card and other payments as we discuss below.

STAR, which if the second-largest EFT networks, is a young character for the payments business. In 1984 it started as a network that managed ATM machines for banks so that consumers could use their ATM card to take money out of the ATMs by any bank on the network. Two years later STAR made it possible for ATM cardholders to pay with the card at participating merchants but charge volume was low well until well into the 1990s. Through a wave of mergers and acquisitions in the late 1990s and early 2000s, a number of EFT systems including STAR, MAC, HONOR, and Cash Station became a single system operating under the STAR brand and owned by Concord EFS.

The Facilitators

The businesses discussed above are essential for connecting merchants and consumers making it possible for them to transact with each other using the digits that are embossed on those plastic cards in your wallet. Every one of those businesses depends on many others who are also critical for making it possible for the consumer to pay at many merchants with her card and for card-paying merchants to zip through the checkout lines at millions of retail locations.

Consider the steps involved in buying the shoes discussed above. Someone has to manufacture the terminal at the checkout counter through which you swipe your card. Verifone sells about half of the terminals in the U.S. There are more than fifty other major manufacturers that sell terminals around the world. The company that has entered into the contract with the merchant to accept one or more card brands, and advises them on other choices they need to make, does not necessarily process the transactions that take place at the merchant. Merchant processors such as FDC take on that role. The acquirers may also delegate some of the work of signing up merchants, especially small ones, to independent sales organizations (ISOs). The banks also rely on other businesses to help them take care of their card customers and otherwise manage their businesses. Chances are you credit card statement wasn’t generated by your bank but by a “card processor.” TSYS is the largest third-party card processor in the U.S. It handles [X] percent of credit card transactions. FDC is also a significant card processor, while TSYS is also a major merchant processor. Card networks and banks also rely on companies to manufacturer the cards. Gemalto is the largest maker of cards worldwide, but [WHO] is the largest seller of magnetic stripe cards in the U.S. as of 2009.

Around the World

Payments is a global business. No matter where you go in the world you will find many merchants that take cards. Each of the networks we have described operates globally although their presence varies across countries and their organization varies somewhat. MasterCard has operated as a centralized global entity for many years. Visa used to operate as a federation of regional cooperatives. When it went public in 2008 it combined all but one of these entities into an integrated firm. The exception was Visa Europe which

remains a cooperative of banks that has a license to do business as Visa in Europe. American Express has mainly expanded its global footprint by entering into bank relationships in a number of countries around the world. Discover was a largely American company until 2008 when it purchased Diners Club which has a merchant acceptance network and issuing business in a many countries.

While these four born-in-the-USA brands are accepted at merchants in most countries around the world many countries have their own domestic card “schemes”. The specifics vary enormously across countries. In some countries such as France there is a domestic association of banks that operates a card network. That association-Cartes Bancaires in France-has a relationship with a global network-Visa for France-which enables cardholders to use their cards at merchants that accept the global card brand when they travel. Other countries such as Portugal have a domestic association in addition to having banks that issue cards of the global brands. Some countries such as China prohibit banks from issuing the global brands. The Chinese have designated China Union Pay at least for now as the domestic network for banks. The merchant side of the business also varies across countries. In some countries it turns out only one or two entities can sign up merchants. That may be because of regulations or because market forces limit the possibility of entry.

China Union Pay (CUP) has become a major player on the world stage for payments. It is at the center of one of the fastest growing domestic card markets in the world and is the brand held by China residents, who with their new-found wealth, are increasing their travel throughout Asia and the rest of the world. CUP has entered into merchant acceptance deals with other networks around the world such as with Discover in the U.S. The JCB card is another Asian brand that has played on the world stage. That is despite the fact that the Japanese still mainly use cash and checks for payments.

Much of the world still relies on cash for most transactions. That is even true in Brazil, Russia, India, and China. As these economies surge the electronic payments industries are progressing rapidly. Payments businesses see enormous opportunities to switch merchants and consumers from cash and checks. Consider India. About [90] percent of retail payments are made in cash. There are only [XXX] point-of-sale terminal that accept credit cards in a country of [XXX] billion people. The emphasis in India as well as many lesser-developed countries is to leap-frog the countries that have physically wired terminals and to rely instead on mobile phones which many Indians already have. The idea is that mobile phones can be used by consumers to make payments and by merchants to accept payments. Other countries such as Brazil and China are rapidly increasing the acceptance by merchants of cards at the point of sale and the use of cards by consumers.

It takes a visit to the poorest parts of Africa to really appreciate the importance of payments for economic life and the excitement that infuses this industry at the start of the second decade of the 21st century. Few people have banking relationships and transactions all require cash. In several countries new payment systems have started based on mobile phones with prepaid cards. People can load money onto the phones at various locations. They can then use the mobile phones to transfer money wirelessly. While still in their early stages these new systems appear poised to revolutionize economic life.

This volume cannot do justice to the complexities and nuances of payments around the world. We therefore focus on the US, which is the country from which payment cards originated as wells as the largest payments market in the world. Fortunately, a number of authors around the world have agreed to write chapters about their countries and these will appear on our website as well as in a supplementary volume.

The Road Ahead

The following thirteen chapters explain the origins of the payments card industry, how it works, the many dimensions of competition that shape how the players described above interact, how regulation and the courts have and continue to shape this industry, and the many facets of innovation, and disruption that are likely to transform this industry in the coming decade.

“From Seashells to Electrons” (chapter 2) discusses payment cards as the fourth in a sequence of major innovations in how people pay for things, following the development of metallic coins in ancient times, the creation of checks in the Middle Ages, and the spread of paper money during modern times. Payment cards have resulted in the increasing use of digitally represented and electronically transferred money. Although technological change in computers and reductions in communications costs made this revolution inevitable, it started in the United States at a time when the country had a highly fragmented banking system and a populace heavily dependent on paper checks. These factors have shaped the evolution of the payment card industry in the United States and influenced its evolution elsewhere.

“More Than Money” (chapter 3) traces how a few hundred cards for charging restaurant meals in New York spawned millions of cards for paying for and financing the purchase of goods and services around the world. The combination of payment and financing services on credit cards, along with other key innovations, resulted in the rapid growth in the number of merchants who took the cards and the number of consumers who used them.

Indeed, as we show in “From Gourmets to the Masses” (chapter 4), payment cards have spread through society and have benefited consumers from almost all walks of life. Only the wealthy had payment cards in the early 1950s; only the poor lack payment cards today. With the spread of payment cards, people can better coordinate their income and expense, smooth income and consumption over their lifetime, and even more easily start and finance a small business. (Of course, just as some people eat and drink too much at restaurants or drive too fast, some people take on more debt than they should.)

Merchants have benefited as well. Payment cards make buying easier for their consumers. Store owners and customers like payment cards because they are fast and because customers want to be able to use them. “From Sardi’s to Saks.com” (chapter 5) looks at the growth of payment cards from the merchant side. It explains why merchants take cards, and it documents the growth and spread of merchant acceptance of payment cards over time.

“It Takes Two to Tango” (chapter 6) is our economist’s version of an intermission. Instead of champagne, we serve up some of the interesting economic characteristics of payment cards. Chief among these is the chicken-and-egg problem. No consumer wants a payment card if merchants won’t accept it. No merchant wants to take payment cards if consumers do not carry them. This problem and the fact that the payment card industry has to cater constantly to merchants and consumers have wide-ranging economic implications. Chapter 6 explains that the payment card industry is one of many industries that face this two-sided problem and describes the economics of multisided platform industries.

“Plumbing the Depths” (chapter 7) explains how the pieces of the many parts of the payments business fit together. Part of our excursion is spent describing the “plumbing” of the payments business-the various pieces of software and hardware technology that have to work together to make everything happen. It turns out that like most old plumbing this isn’t a pretty picture. Much of it looks jerry rigged yet it all works very well. Another part of this excursion will examine the diverse businesses and their interdependencies that make up this complex ecosystem.

The blood, guts, and gore come next, with three chapters that focus on competitive strife in various facets of the payment card industry. “System Wars” (chapter 8) explains how the card systems have competed with each other in two grand wars. American Express’s war with MasterCard and Visa looked as though it was going to end in defeat for American Express in the late 1980s. But American Express fought its way back in the 1990s. The other war, between MasterCard and Visa, is less public because these systems have the same members, but it is no less serious than that with American Express. Visa had American Express and MasterCard on the ropes in the late 1980s but both resuscitated themselves were vibrant competitors in the second half of the 2000s. The other system war was over debit. Visa and the EFT networks battled over the allegiance of the banks who issued debit cards, consumers who had to choose between signing and entering a PIN at checkout, and merchants who had to weigh lower cost of PIN-based debit against the desires of consumers who wanted to sign just as they always had with credit cards.

“Issuer Brawls” (chapter 9) goes into the trenches in which the individual issuers of cards fight for consumers. It documents the intense competition among issuers, and shows how it has benefited consumers through lower prices and higher quality. “Backroom Battles” (chapter 10) describes the little publicized, but extremely important struggles, in the industry’s back room where merchant and cardholder transactions are processed and where the payment card plumbing is largely operated.

The government had on outsized influence on the shape on the payments card industry throughout its history as described in “The Watchdogs” (Chapter 11). MasterCard and Visa began their lives helping banks push credit cards on American households. That tapped into fears that consumers would take on too much debt or enter into lending terms that they didn’t understand and would come to regret when they did. Over time various practices for all types of payment cards have come under fire and resulted in legislation and new regulatory powers. The antitrust laws have also shaped the payments industry. Antitrust concerns deterred American Express from selling its beleaguered card business to Diners Club in the early 1960s thereby changing the course of history for both companies. MasterCard and Visa decided to abandon operating as associations because the antitrust courts in the U.S., and especially antitrust regulators abroad, were suspicious of bank collaborations.

“On the Web” (Chapter 12) looks at the “alternative payment systems” that help people make payments over the internet. In one sense the traditional payment brands have conquered the web. Most transactions on web sites are made using a general purpose payment card carrying one of the major brands. But it is usually much more time consuming to pay with a card online than at the checkout counter. Instead of just swiping and being done you have to enter your name, address, accounting number, expiration date, security code, and hope that you’ve filled in all the blanks and haven’t made any typos. That inconvenience has helped spawn alternative brands with PayPal the best known and most successful to date. With PayPal you enter your account information once and then pay quickly at any merchant that takes PayPal. Even though you can select one of the major brands to pay with PayPal is a threat to the traditional systems because it encourages people to pay with their bank accounts.

“Inflection Point” (Chapter 13) explains why the payments card industry is in the midst of an inflection point—a sharp break from the past—and how that will affect the members of the payments ecosystem, including merchants and consumers, going forward. Innovation has taken place slowly in the payments business. Almost three millennia after its invention cash is still widely used around the world. Four decades later the magstripe is still the dominant technology for verifying that your card. Yet the last several years has seen an incredible acceleration in the pace of innovation and the results of this will start revolutionizing how consumers and businesses pay each other over the next decade. Based on current investments and developments around the world it appears likely that the mobile phone will play a significant role in how consumers pay and interact with merchants, issuers, and other parties involved in transactions. The mobile phone comes with a powerful computer, wireless communication, internet connection, a software platform, and increasingly a friendly and useful screen. The combination of these features together with the fact that almost everyone carries one makes it likely that the mobile phone will become a new powerful key for payment transactions. At the same time after decades of stability new business models have emerged. MasterCard and Visa have been let loose by their bank founders and like all publicly traded companies are seeking growth and profits. Meanwhile the traditional go-it-alones American Express and Discover started networks in the last few years and are imitating the bank-centric approach of their larger rivals. New payment systems based on making electronic transfer between checking accounts—including PayPal—are also emerging to challenge the longstanding incumbents.

“And They Don’t Take Cash” (chapter 14) offers some concluding observations and conjectures about what is to come in the ongoing revolution in paying and borrowing. Increasingly, financial transactions are taking place over electronic networks in which consumers and merchants are represented by series of numbers. Money is just an electronic picture, kept on some computer media, of what you owe and what you have. How long plastic will remain the physical form for recording and transmitting that series of numbers is both unknown and completely beside the point. The true revolution, the one that is sure to be even more important in the future than it is today, was the development of computer networks for exchanging electronic money.