Books on Payments

The payments industry is one of the most complex and interesting out there to me. A lot happen behind the scenes whenever we send out a rent payment through a checking account or buy a coffee with a swipe of our credit card. As consumers, we don’t know much about such complexities. Plenty of innovation over the years has gone into providing optionality as well as a smooth experience to consumers while helping out merchants and financial institutions achieve their business goals. It can be daunting and difficult to start learning about an industry as complex as payments, especially when there are numerous abstract concepts and jargon. But if you are really interested, I’d recommend these three books. They touch upon the general concepts, operational details of each payment method and more importantly, these books are written for laypeople like you and myself

The Anatomy of The Swipe

This book is focused more on credit and debit cards. You’ll learn about key concepts such as interchange, settlement, authorization, chargebacks, Know-Your-Customers (KYC), the parties involved in a card transaction and so on. You’ll learn about how money moves in a card transaction and how a merchant gets paid ultimately. The author did a great job explaining abstract concepts in an easy-to-understand manner. In fact, I gave this book to our intern who had had zero knowledge on payments as a crash course to our industry. He loved it. Hence, I think you too can learn a lot about card payments from this book. Check out my review here.

The Field Guide To The Global Payments

Launched earlier this month, The Field Guide to Global Payments covers more payment methods than just cards and it touches up on other countries than just the US. Because of the number of topics that it tries to cover, in my opinion, I don’t think it has the same depth as the other two books. Nonetheless, there are very interesting facts, stats and concepts covered that will trigger more research and investigation.

One of the earliest noted uses of the term “credit card” dates all the way back to 1887. In his utopian novel Looking Backward, Edward Bellamy described the concept of using a card for purchases; he used the term “credit card” eleven times in the novel. In 1946 the first bank card, Charg-It, was introduced by Brooklyn- based banker John Biggins. A user’s bill was forwarded to Flatbush National Bank, and the bank settled the amount with the merchant directly and collected the funds from the user’s bank account. Only a small number of merchants were supported by the program – those in a specific two-square-block radius – and the card could only be used by those who banked with FNB.

On the checkout page, the shopper fills in their payment details. Typically these are the PAN (payment account number, the sixteen digits on their card), the expiry of their card, the CVV (the three or four-digit security code), and their billing address. Pro tip: if you don’t send the AVS data (billing address information) in the authorization, you may get an interchange downgrade, which means, in short, that the transaction will cost you more as a merchant.

Taking on PCI compliance is a large decision – there are more than 1,800 pages of documentation and more than three hundred security controls, alongside yearly audits. There are four levels of PCI, which each have their own requirements that apply to different use cases. Partnering with a gateway, PSP, or standalone vendor to outsource PCI scope is the decision many merchants make because of this.

Merchants do, however, have a lot of agency in improving decline rates. Overall, in-store (POS) transactions tend to have very low decline rates, while ecommerce transactions can have 5 to 10 percent decline rates. Note that the prevalence of declines goes up for recurring transactions, like a subscription payment, or for cross-border transactions. High-risk merchants, like gambling or escort services (what many dating apps are considered by the card networks!), have even lower benchmark auth rates.

Visa’s excessive chargeback program is called the VDMP – Visa Dispute Monitoring Program. They divide the previous month’s chargebacks by that month’s total Visa transactions. If a merchant has 100 chargebacks and a chargeback ratio of at least 0.9 percent they are added to the program to be monitored. Mastercard has the ECP – Excessive Chargeback Program. The ECP divides the number of chargebacks in a single month by the total number of transactions in the previous month over Mastercard. Their threshold for entering the program is one hundred chargebacks and a ratio above 1.5 percent. In the event that a merchant hits these thresholds, they are notified by their acquirer who may also help them to get fraud levels below the threshold.

Signature debit cards get their name from the fact that a customer must sign the receipt during an in-store payment, and a merchant must subsequently authenticate that the signature on the receipt matches the signature on the back of the card. Signature debit transactions clear funds from the cardholder’s checking account same-day and are usually processed over Visa or MasterCard’s networks. PIN debit cards, however, are authenticated when the cardholder enters their PIN number on a point-of-sale device. Though the funds are also pulled from the cardholder’s checking account, they don’t always clear the same day. These transactions are also eligible for cashback. When you buy groceries and ask for $20 cash back, that transaction will be processed as a PIN debit transaction. There are many more PIN debit networks than the signature networks.

Payments Systems in The US

This book provides an overview of payments systems in the US with great details. First, it talks about payments and payments systems in the US in general. Then, it discusses each core system in details, ranging from the history of the system to what happens behind the curtain and what it is like today. The systems discussed in this book include checking, cards, ACH, wire transfer and cash. Then, it also provides the perspective of consumers as well as the banks before closing out with thoughts on payments innovation. It’s quite a long book, but if you are nerdy about payments, I’d recommend it.

In a net settlement system, the net obligations of participating intermediaries are calculated by the payment system on a periodic basis—most typically daily. At the end of the day, a participating intermediary is given a net settlement total and instructed either (a) to fund a settlement account with that amount, should it be in a net debit position, or (b) that there are funds available to draw on in its settlement account, should it be in a net credit position. Checking, card payments systems, and the ACH are all net settlement systems in the United States.

In a gross settlement system, each transaction settles as it is processed. With the Fedwire system, for example, a transaction is effected when the sending bank’s account at a Federal Reserve Bank is debited and the receiving bank’s account at a Federal Reserve Bank system is credited. No end-of-day settlement process is necessary in a gross settlement system.

Signature debit card interchange is lower than credit card interchange, and PIN debit interchange is even lower for unregulated debit card issuers. Larger debit card issuers (with over $10 billion in assets) receive regulated interchange rates that do not distinguish between signature or PIN debit usage.

Debit card authorization is more challenging than credit card authorization, as the bank must check against an ever-changing account balance. In the early days of debit, banks would authorize transactions (or have a processor authorize them) against a “shadow file” that could be hours or even days out of date. Now, however, most large banks handle authorizations dynamically against the “real” balance in the checking account.

Some payments networks are heavily resourced (i.e. have lots of money), enabling network-level investment in product definition, brand, risk management, and exception processing requirements. Visa, Mastercard, American Express and PayPal are all examples of what we call “thick model” networks. Other networks are thinly resourced, and manage only minimal interoperability issues, leaving functions such as product definition and brand to intermediaries. Check clearing houses, the ACH, and PIN debit networks are all examples of this “thin model.”

Closed loop networks, such as American Express, have card issuance policies similar to some provisions of the open-loop card network rules, so as to ensure interoperability for merchants and other users of the payments system. Merchant agreements, for similar reasons, are much like those of open-loop card networks. But a closed loop network is free to change such policies and agreements without the involved processes used by open-loop networks.

Closed loop systems have the advantage of simplicity. As one entity sets all of the rules and has a direct relationship with the end parties, it can act more quickly and more flexibly than the distributed open loop systems, which must propagate change throughout the system’s intermediary layers. The disadvantage of closed loop systems is that they are more difficult to grow than open loop systems; the payments system must sign up each end party individually.

Weekly reading 18th June 2022

What I wrote last week

Interchange and what influences it

Apple and Major League Soccer

Business

($) What Do Chinese Consumers Want? Walmart Can’t Figure It Out. Almost 30 years in the country and decades of experience in this industry, Walmart seems to lose grip in China. The stores aren’t an appeal that they once were. Walmart doesn’t seem to be able to offer what consumers want. Competitors are fierce. For good measure, the tension between America and China shows no signs of abating. Trouble is awaiting the largest retailer in the world in China.

Elon Musk’s regulatory woes mount as U.S. moves closer to recalling Tesla’s self-driving software. I admire Tesla, Musk and everything they have achieved. But I think it’s dangerous to create marketing materials touting full self-driving abilities when the vehicles are nowhere near that capabilities.

($) FanDuel CEO Amy Howe Wants to Help the Sports-Betting Business Grow Up. An interesting read into the market leader of sports betting. TIL, FanDuel had 70% of all sports betting platforms’ revenue generated in the state of Michigan in 2022 through April. Typically, it’s only about 5% of the amount wagered.

Maybe Bob Chapek Was Right. The tumult at Disney continues with the recent departure of Rice, a senior executive. Outsiders may not know the full story of what went down. Perhaps, Bob Chapek was right. Perhaps, it was just another example of how difficult life at the top is for him. Nonetheless, it really doesn’t matter how fair or unfair the criticisms on him are. The fact is that he is the CEO and the stock went down by almost 50%. Right or wrong, it’s on him and his record. I look forward to seeing whether they will adjust their subscriber target in the long run now that they no longer have the rights to the cricket league in India. Some said that Disney might lose 20 million subscribers in India. Others argue that it’s a blessing in disguise as a subscriber pays like 70 cents over there. Hence, losing a bunch of low-paying subscribers may boost ARPU and profitability, a premium in this market. The market’s reaction to a new target, if any, may influence Chapek’s tenure a lot.

($) Amazon CEO Andy Jassy’s First Year on the Job: Undoing Bezos-Led Overexpansion. A fascinating piece on Amazon that is unquestionably favorable to Andy Jassy and much less so to Jeff Bezos. I find it interesting that Amazon seems to shift the blame from Jassy onto Bezos for recent trouble with excessive fulfillment capacity. The founder and former CEO did make the decision to expand the capacity, but this sort of public admission while he is still the Executive Chairman definitely raised eyebrows.

($) One Grocer Wanted to Give Up Plastic. It Got Rotting Bananas. “When one of the best-known supermarket chains in the U.K. decided to remove plastic from its products, it hadn’t anticipated a spike in shoplifting. The zero-plastic drive also produced a series of unintended consequences that demonstrate how difficult it is for any company to shed plastic packaging entirely. When Iceland wrapped bananas in paper bands instead of plastic bags, the fruit rotted more quickly or snapped off. When it packed bread in opaque paper bags, sales fell as shoppers balked at buying something they couldn’t see. When it punched holes in paper bags filled with potatoes to make the contents more visible, the bags ripped. Bacon that isn’t wrapped in plastic quickly discolors, salad leaves wilt and unwrapped cucumbers rot more quickly.

Other stuff I find interesting

($) Biden Administration to Pursue Rule Requiring Less Nicotine in U.S. Cigarettes. FDA estimates that tobacco use costs the country $300 billion in direct healthcare expenses and lost productivity. A study published on the New England Journal of Medicine estimates that lower nicotine level will lead to 5 million additional adult smokers to quit smoking. If mandating a lower nicotine level in cigarettes results in fewer smokers and lower economic damages, FDA should press ahead and exercise their authority, knowing that the tobacco industry will take legal actions to protect their own interests

Downtown S.F. on the brink: It’s worse than it looks. The article goes into why remote work drives folks away from San Francisco and the downstream effects that such a migration can have on the city. I spent a few days in San Francisco last month. At no time did I ever feel safe due to the homeless folks on the streets. My team and I went around a bit by Uber and agreed that some areas were just too sketchy to live. Drivers there were just unbelievable. We had to report one Lyft driver because he literally scared us to death with his reckless driving. The living expense is so high there. One croissant and a small cup of coffee cost me $12, easily double what I’d pay in Omaha. It’s no wonder that white-collar workers moved away whenever they had a chance. When the engine that generates your city’s economy is leaving, it’s a serious challenge that demands different thinking.

Exclusive: inside Apple’s iOS 16 remake of the iPhone’s iconic Lock Screen. One thing you’ll notice from this piece is that the road to this Lock Screen feature started a while ago with work on its neural engine, chip and personalization effort on the Home Screen in iOS14. That’s typical of Apple. Have a product roadmap, put the pieces together and release only the things that work.

Opening a Restaurant in Boston Takes 92 Steps, 22 Forms, 17 Office Visits, and $5,554 in 12 Fees. Why? “The American Dream is besaddled by byzantine regulations. As the report shows, for example, opening a restaurant in Boston is a 92-step process. In Detroit, it’s 77 steps. In Atlanta, it’s 76. The report goes into great detail. That 92-step process to open a restaurant in Boston requires that 22 forms be completed, 17 in-person visits be made to government offices, 12 fees be paid, and nine government agencies be involved, at a total cost in government fees of $5,554. Opening a restaurant in San Francisco requires that 17 government fees be paid at a total cost of $22,648.” Indeed, why?

Stats

There were 31 million cigarette smokers in the US in 2020

1.5 billion users watch YouTube’s TikTok clone every month

14% of the U.S. population lives within rural communities

Interchange and the major factors that can influence it

Have you ever wondered why some merchants enforce an additional fee when customers pay with credit cards? Or why do some merchants politely request customers to pay by cash when a purchase is less than $5? Or why can some fintech startups offer debit cards with rewards when big banks don’t seem to bother?

The answer is Interchange. Cash has been the medium of transactions for centuries. When a shopper hands cash to a merchant in exchange for goods or services, the merchant takes 100% the amount of such exchange and deals with taxes when the time comes. The problem with cash is that 1/ storing a large amount of cash requires a lot of effort for merchants and 2/ not many customers find it convenient to carry cash around, especially for large transactions. Card transactions bring convenience. Merchants get paid in the form of increased balance in a bank account while consumers can spend without carrying a thick purse or wallet. With credit cards, consumers can transact on the credit line extended by a financial institution. But as the old saying “there is no free lunch” goes, such convenience comes at a cost and that cost is Interchange.

Interchange is a small fee that merchants have to pay on every card transaction. The recipient of interchange is financial institutions (FIs) that issue debit or credit cards to shoppers. These FIs use this revenue stream to either pay for their operational expenses or fund rewards that are promised to consumers. Since doing business nowadays always involves card payments, interchange is one of the expenses that merchants can’t avoid.

How much do merchants have to pay on every transaction? The amount of interchange is determined by interchange rates mandated by networks such as Visa, Mastercard, Discover or American Express. There are a lot of factors that can influence these rates and below is a list of factors that I know (by no means, it’s an exhaustive list):

Merchant Category Code

Merchant Category Code (MCC) is a 4-digit code that represents the type of business area in which a merchant operates. For instance, 5411 refers to grocery stores while 5300 represents wholesale clubs. Some companies such as Walmart or Amazon can span across multiple MCCs because of the breadth of their offerings while others like mom-and-pop restaurants have only one MCC. In some industries, including airlines or hotels, a merchant can have its own code. For instance, 3000 and 3001 are assigned to United Airlines and American Airlines respectively.

High frequency categories such as Gas and Grocery carry low interchange rates while others such as Dining or Travel fetch higher rates. Whenever there is a push to promote a specific area, networks raise the interchange rates as an incentive for card issuers. Take Electric Vehicle Charging 5552 as an example. Its rate for consumer cards is 3%+ which is much higher than the average 1.7% across other categories.

Sometimes, it’s easy for consumers to guess MCCs of their purchases. However, it’s much trickier when it comes to big merchants such as Walmart or Amazon. The only way to know is to wait for the transaction to be posted.

Merchant

Giant merchants such as Costco, Walmart or Amazon command great bargaining power and can negotiate a special low rate with the networks. Think about it this way. The rates that I have seen for these companies are around 0.7%. At $500 billion in annual revenue that the likes of Amazon or Walmart generate, interchange expense amounts to $35 million a year. If they had to pay 1.4% in interchange, the expense would double to $70 million. Their retail business margin is not big enough for them to ignore that difference.

Card-Present or Card-Not-Present

A transaction is considered as “card present” only if a card is swiped or tapped or if an EMV chip is processed. A transaction by fax, Internet, mail or over the phone is considered “card not present”. Since card-not-present transactions do not require a cardholder or a physical card to be present at the time of the transactions, the risk of fraud is higher. Hence, issuers receive higher interchange rates on CNP transactions for taking on additional risks.

Networks

There are a few major networks such as Visa, Mastercard, Discover, American Express and JCB. Each has its own pricing schemes and that can affect the rates that merchants have to pay.

Plastic Type

The type of your card also influences interchange rates significantly. On the Visa Consumer side, there are usually three types of cards: Visa Classic, Visa Signature and its highest tier, Visa Signature Preferred. Visa Signature Preferred comes with much higher rates than Classic or Signature. Normally, if your credit limit is above $5,000, your card is qualified for Signature. To qualify for Signature Preferred, a cardholder typically needs to meet a certain spend threshold. To my knowledge, an issuer sends a list of cardholders that meet certain criteria to Visa so that they can flagged as Signature Preferred. If successful, the issuer can earn a decent amount of additional interchange revenue. On the Mastercard, there are also similar schemes and tiers.

Consumer or Commercial

The rule of thumb is that commercial credit cards have higher interchange rates than consumer cards.

Credit or Debit

Credit cards command higher interchange rates than debit cards, simply because credit cards are much riskier as a product than debit cards.

Purchase Volume

Sometimes, the size of a transaction can affect how much merchants have to pay. For instance, American Express has different rates for different ticket size tiers across key categories. Typically, the bigger a transaction, the higher the interchange rates.

Point of Entry

If you shop in store, whether you use an EMV chip, swipe your card, tap your plastic on the card reader or pay with a mobile wallet can affect the interchange rate of that transaction. To make it more complex, the type of mobile wallet that consumers use is also a factor. For instance, staged wallets (PayPal, Cash App) which break down a transaction into funding and payment stages command slightly higher rates than pass-through wallets (Apple Pay, Samsung Pay) that pass payment details directly to merchants. The alleged reason why there is such a difference is that staged wallet providers do not provide as much information regarding payments as the networks would like and that could make the verification task a tad more challenging.

Regulations

To help smaller banks compete, the US government allows debit card issuers with less than $10 billion in assets to charge significantly higher interchange rates than bigger issuers. That’s usually known as the Durbin Amendment. Fintech companies use this loophole to partner with small less known banks to offer debit cards with rewards. In many countries, including the European Union, interchange rates are capped by laws and much lower than what we see here in the US.