The traditional card networks are great at what they do and they’ve only gotten better over time. Transactions occur lickety-split over their networks. They provide valuable services to merchants and cardholders directly or through their bank partners. They have healthy market capitalizations—almost $180 billion for American Express, Discover, MasterCard and Visa combined (as of the end of April 2010). The old associations have made money faster than investors expected when they first IPO’d. Equity in MasterCard—the first of them to go public—sells for almost 5 times the June 2006 IPO price.
The card networks all recognize that their future lies in innovation. Hardly a day goes by without one of them (or several of them) announcing a new initiative somewhere in the world—from mobile to contactless to e-commerce. Indeed, it is the market’s faith that these companies will seize the incredible opportunities for shifting transactions from paper to electronic methods that feeds the multiples they command (more than 30 for Visa at the end of April 2010).
It is unclear at this point, however, whether the card networks understand how open software payments platforms will radically change the payments business in the next decade. They may have lots of plans in the works, may be behaving stealthily, just waiting to pounce on the first movers in their own sweet time. Or they may be unsure of what’s happening, what to do, and how to do it—they may be deer in the headlights of nimble rivals who aren’t saddled with old code and pre-web says of doing things.
In fact, the card networks have three stark choices: spur innovation with an open platform, innovate with a closed platform, or just stick to running the rails.
Each of these strategies poses risks. To evaluate them it is important to agree on three premises concerning how the payments world will evolve over the next decade regardless of what the networks do.
First, over time the distinction between the online and offline world in payments will vanish. Fast internet connections will become ubiquitous. Almost every device we interact with will have a connection. Those devices will access web-based software which will provide an increasing array of services.
We have already seen this happening. When the commercial internet started only a few computers were connected. Over time virtually all computers had internet connectivity. Then mobile phones started being connected. It is widely expected that most phones in industrialized countries will be internet-enabled in not too long. The third screen—the television—is next. Other devices are in the queue. Automobile manufacturers, for example, are incorporating internet capabilities in their cars and providing software platforms for applications. Importantly, for our purposes, point-of-sale devices will become internet-enabled and rely on services provided by web-based software. That will include everything from card terminals to cash registers.
This means that the neat distinction of today between online transactions that you do with your computer (or increasingly, the mobile phone) over the internet, and offline transactions where you walk into a brick-and-mortar store without touching the internet, will disappear. The internet will become like the electric power grid—something that almost every device is plugged into. The corollary is that it will be meaningless to talk about internet-payment providers, such as PayPal, as if they were an interesting group of foreigners. The alternative payment providers will be at the physical point of sale because the physical point of sale will be connected to the web.
Second, most devices even at the point of sale will rely on software, probably residing in the cloud, that provide valuable services. At the moment, most point-of-sale devices rely on software that either resides on the device or on servers that are accessed over a corporate intranet. Devices usually rely on a dedicated software solution. Once devices can obtain easy access to the internet it will prove more efficient to move software to the internet as well. Device makers may do this on their own to obtain greater control over software—including their choice of vendor and the ability to provide easy updates over the lifecycle of their equipment. Merchants may demand this as well because cloud-based software will provide them greater flexibility.
Innovation for the point-of-sale will move out to the cloud or will at least become un-tethered with the particular point-of-sale device. Internet-connected computers made it extremely easy for software developers to distribute products to businesses and people via a download. That, of course, led to an increasingly vibrant application community. Internet-connected point of sale devices will do the same. The mere availability of the direct link to the point-of-sale devices will ignite a developer community.
Third, there’s going to be limited room for software payments platforms. Several software payments platforms will succeed in becoming the “go-to” places where developers who want to incorporated payments and related functionality into their products and services. But it is doubtful that there’s going to be room for more than two or three.
Software platforms are driven by indirect network effects. The more applications that are written for them, the more customers (businesses and consumers in this case) will want to use them; and the more customers there are for the applications for a platform the more other developers will want to write more applications. The main reason this virtuous circle doesn’t lead to a monopoly platform is that different platforms can specialize in providing different services—product differentiation can offset indirect network effects. The other limiting factor is that software developers will port their applications to a few platforms but not many. They will go for the two or three platforms that have the largest reach assuming they are technically on par.
For payments, it is doubtful that the four card networks plus several alternative payments providers plus others will all succeed in operating software payments platforms. This point has, as we will see, has huge implications for the risks faced by the networks in choosing a strategy.
With these premises in place, it is easy to see the risks and opportunities that the card networks face during the new age of invisible engines.
Let’s start with the stick-to-your knitting strategy of focusing on just running the rails. That would involve future value-added services moving to third-parties. The software payments platforms would support ecosystems of application developers that would incorporate payments functionality into their applications. (Just to be clear, these applications could be software programs that support substantial businesses. That’s the vision for Square for example.) The applications businesses would earn revenue from their customers and the software platforms would earn license fees (and perhaps revenue cuts) from the applications business.
The card networks could charge for access to their rails. They would benefit from more applications generating more transactions over their networks. The risk is two-fold. On the one hand the software platforms and applications suck up a lot of the value that’s available from using the rails. The card rails could try to get a piece of the action but that brings us to the other hand: the software platforms, and perhaps other players, could try to disintermediate the rails altogether. In fact, one would expect that PayPal will squeeze card fees down. They are already moving transactions over to cheaper-for-them ACH. Their ability to do so will eventually put downward pressure on transaction fees for the card networks (not to mention interchange fees if those survive the current regulatory and legal onslaughts). The card networks could try to be like the cable companies and squeeze a lot from everyone who tries to use their rails. That has worked, although it is getting ugly, in cable because there isn’t much competition. It is unlikely to work in payments where there are multiple sets of payments rails and lot of opportunities (see PayPal above) to shift transactions in response to cost differences.
The card networks could also take the middle way. They could embrace the idea of creating applications that use their network services but do that themselves, but more aggressively than they have in the past and with a clear eye on what’s being built on the open platforms, or enlist business partners to that with them. This has several advantages. For one, it allows them to keep tight control over what’s built on their networks, make sure it is consistent with their overall business objectives, tightly integrate the applications, and prevent applications that could degrade the performance or reputation of their networks. For another, it allows them to make money from the applications directly rather than limiting themselves to access and transactions fees. They will own customer relationships and data as well. The chief disadvantage of the closed-platform approach is that it does not generate the sorts of indirect network effects that have powered the growth of the iPhone and seem to be working well so far for PayPal. The networks would have to hope that they make up in quality of apps what they lose in quantities.
Finally, the card networks could adopt an invisible engine strategy. That would generally involve creating a software layer above their networks, developing features for that layer that use their rails and provide other services as well, and making these features available through APIs. Following the PayPal X approach they would need to evangelize their platforms and provide developers with the tools and encouragement to create successful applications. There is a huge upside potential here. They could, as I’ve described throughout this series, become the centre of a ecosystem of applications that would drive value back to the centre and in doing create barriers for rivals. See Windows.
Like most things in life that have major payoffs, there are at least two related and significant risks: First, it is highly unlikely that all four of the card networks could succeed in establishing successful software payments platforms. One could easily imagine that only 2-3 platforms emerge and that at least one of those is one of the alternative payments providers. That would mean that if all four networks tried 2-3 of them would probably fail. Second, there can be a wide gulf between aspiration and ability as every little boy who wants to play pro-ball soon finds out. The card networks have much experience developing sophisticated software systems and communications platforms. So it isn’t like a car company wanting to get into the software platform business. But the card networks have evolved slowly from mainframe based companies and don’t, at least obviously, have demonstrated skills in doing internet-related development work. They may lack the genetic matter to go up against PayPal or other companies that were born in the internet world. Thus, the card networks could make significant investments of financial and reputational capital in trying to become one of the software payments platforms and fail in succeeding.
The rise of invisible engines in payments therefore presents significant opportunities and risks for the traditional card networks. One or more of them could distance themselves from their rivals by becoming one of the surviving software payments platforms with a robust set of applications driving traffic. Those that don’t develop a successful platform could find themselves as service providers to much more interesting and robust businesses. It is beginning to look like this is the way the mobile communications business could evolve—with the iPhone, the Android, and perhaps another software development platform driving applications and the carriers settling for charging for carrying traffic.
The traditional card networks are clearly trying to navigate what to do. Visa’s acquisition of CyberSource for $2 billion may be an important step in its developing an open software platform. CyberSource is the e-commerce engine for about 300,000 merchants. It mainly helps these firms with key back office tasks—risk and fraud most importantly, call centers, and then processing. Combined with other technology it could help Visa challenge PayPal X. American Express’s acquisition of Revolution Money for $300 million is another example. Revolution Money has a payment platform based on internet technology. It could also provide some useful building blocks for a larger efforts.
The decisions these networks make on how to proceed, and how to meet the Pay Pal X challenge, will determine the course of payments over the next decade.
David S. Evans is an economist and a business advisor to payment companies around the world. His recent work has focused on helping companies create, ignite and profit from payments innovation. He is the originator of the Innovation Ignition Framework® , a tool provides a systematic way for companies to evaluate and implement innovative ideas and achieve critical mass.
I. The Invisible Engines that Drive Innovation and Transform Industries
II. How the iPhone Invisible Engine Provided a Catalyst for the Mobile Phone Industry
III. The New Age of Invisible Engines: How Software Platforms Will Drive Growth in the Next Decade
IV. What’s in the Cloud for Payments?
V. Why the Payments Industry Needs a Catalyst to Drive Payments Innovation
VI. Can IP Commerce Create the Apps Store for Payments?
VII. PayPal X’s Global Payments Development Platform
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