insight

Credit and debit cards have been a major profit engine for issuing banks, but legal and possible regulatory challenges to the interchange model spell trouble for both issuing banks and the card associations that support them, MasterCard and Visa. The $150 billion card industry must recognize this threat to earnings and position itself for ongoing success.

A New Business Model for Card PaymentsBy Amy Dawson and Carl Hugener

The Current State of the Card Payments Industry . . . . . . . .4

Pressures on Interchange . . . . . . . . 7

The Collapse of the Interchange Model . . . . 9

A New Business Model . . . . . . . . . .11

Preparing for the Future . . . . . . . . . 12

About the Firm . . . . . . . . . . . . 15

About the Authors . . . . . . . . . . 15

table of contents

Executive Summary

The traditional payments marketplace is transforming. Merchants are increasingly vocal about what they consider to be unreasonable credit card fees, and are taking serious steps to minimize that expense, both in court and at the point of sale. Increased regulation of interchange overseas may have an impact on the U.S. market, and the Federal Reserve, which so far claims no interest in regulating interchange, is nonetheless paying more attention to it than ever before. The balance of power between merchants and banks has in fact shifted, as we have seen from the willingness of merchants to confront the card industry in court and serious moves by some toward alternative payment products.

We believe these challenges to the current credit card business model will result in greater transparency to the components of the interchange model, and ultimately, to the unbundling of interchange pricing and shifting of roles in the payments value chain among current and new players.

Consider the components of interchange pricing. Paying for issuer rewards programs consumes about 44% of interchange costs, but merchants get nothing out of these programs; they are competitive tools for issuers. Merchants likewise pay about 3% of their interchange dollars for association branding costs. Meanwhile, processing— the original reason for interchange—comprises only 13% of interchange costs.1 Given the merchants’ lack of perceived value for what they pay, the situation is clearly unstable.

As a result, a transformation of the card payments industry has begun. And unsurprisingly, the payments market is responding. Very workable—and much cheaper—ACH-based alternative payments vehicles are appearing that have the

potential to siphon payments volume away from credit cards and magnify the bargaining power of merchants at the expense of issuers and the associations. As these alternatives become more and more prevalent, issuers and associations will likely be forced to lower interchange rates to keep their products competitive.

Issuing banks will ignore this trend at their peril. Aside from losing a large fraction of their $19 billion in interchange fees2, they stand to lose a significant slice of the transaction volume that drives their card interest income, usually estimated as 70% of total credit card revenue.

This market trend raises important questions about the future of the credit card business model and, we believe, will facilitate new interchange pricing, followed by the dis-aggregation of the traditional payments value chain within three to five years.

But issuing banks can protect revenue by adjusting their business models now. They can develop new consumer card pricing models, forge new value propositions for merchants and consumers, and expand or discard legacy business models. They can leverage the data embedded in the payments stream, not only providing additional services to merchants, but also creating new businesses for themselves. By emphasizing their DDA account/debit card operations, they can not only deepen their relationships with their customers, but also replace much of the revenue lost from credit card operations. And it is hardly out of the question that one or more large issuers will take the card business full circle and create a bank-owned closed-loop network, directly controlling the entire value chain and therefore pricing to the merchant.

2

For more information contact:

Carl J. Hugener Partner—Financial Services carl.hugener@diamondconsultants.com

Amy Dawson Principal—Financial Services amy.dawson@diamondconsultants.com

3

As a practical matter, banks should:

• Identify revenue at risk, and current assets that can be leveraged for future uses.

• Develop a customer-centric business model for payments with strong value propositions for both consumers and merchants.

• Invest in growing DDA accounts to replace lost card revenue, deepen

relationships with the customer, and capitalize on the growth of debit cards.

In the same spirit, associations should:

• Separate processing from the brand, and develop separate growth strategies for each business.

• Invest in flexible, integrated processing platforms that can support future growth areas and new payment types. This may include identifying partners or merger and

acquisition targets that will complement their processing assets.

• Aggressively pursue new markets where their processing expertise can be leveraged (e.g., healthcare and new geographies).

• Invest in point-of-sale relationships to build influence over how future transactions get routed.

The Current State of the Card Payments

Industry

4

The card payments industry itself is not at risk: It is projected that its market share will grow 10% per year between now and 2009, with debit growing faster than credit —14.4% versus 8.5% CAGR, respectively (See Exhibit 1).

The irony for the card industry is that the problems it faces are a direct result of its enormous success. Having worked

diligently for over 30 years, Visa and MasterCard issuers have captured a dominant 49% share of the merchant fee revenue, as shown in Exhibit 2.3

That kind of market share should be good news. But success has meant a saturated market for payment cards that is damping future growth, while banks’ investors demand higher and

Source: Nilson

Projected Purchase Volume Growth

Purchase Volume ($ Trillion)

2004 Purchase Volume ($6.4 Trillion)

Electronic$.5 T8%

Paper$3.4 T54%

Cards$2.4 T38%

2009 Purchase Volume ($8.2 Trillion)

Electronic$1.1 T14%%

Paper$3.2 T38%

Cards$3.9 T48%

$02004 2009

$9

$8

$7

$6

$5

$4

$3

$2

$1

$6.4 B

$8.2 B

Cards$2.4 T38%

Cards$3.9 T48%

Checks –31%Cash 27%Money Orders –2%Official Checks 13%Travelers Cheques –27%Food Stamps –100%Credit Cards 46%Debit Cards 95%Prepaid Cards 132%EBT Cards 42%Preauth. Payments 97%Remote Payments 151%TOTAL 30%

Transaction Volume (B)

02004 2009

160

140

120

100

80

60

40

20

$128 B

$152 B

Cards$46 B36%

Cards$71 B47%

Checks –15%Cash –4%Money Orders –17%Official Checks 7%Travelers Cheques –44%Food Stamps — Credit Cards 24%Debit Cards 79%Prepaid Cards 108%EBT Cards 37%Preauth. Payments 87%Remote Payments 167%TOTAL 19%

Checks Cash Money Orders

Official Checks Travelers Cheques Food Stamps

Credit Cards Debit Cards Prepaid Cards

EBT Cards Preauth. Payments Remote Payments

Exhibit 1

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higher performance. As a result, the card associations and their bank issuers are pursuing revenue growth through higher

interchange rates (Exhibit 3), increased transaction volume per card, and increased purchase volume per card.

Not surprisingly, the first of these tactics is unpopular with merchants, who have the same performance challenges as issuers

Source: Diamond analysis; CIBC World Markets, “Payments Processing and the Network Effect,” October 5, 2005; “Merchants Tackle Credit Card Fee Policies”Cards & Payments, January 2006, Various Nilson Reports (cards & outlets).

Fees Paid by US Merchants (2004)

Fees paid by US Merchants (2004)

Estimated Distribution of Feespaid by US Merchants (2004)

Fees Paid ($B)

Purchase Vol ($B)

Weighted Average

Cards (Mil)

Outlets (Mil)

$21.2 $1,044 2.03% 2,062.0 24.6$7.4 $304 2.42% 65.4 8.9$6.4 $460 1.39% 228.0 24.6$1.6 $269 0.61% n/a n/a$1.3 $74 1.73% 53.6 12.2$1.1 $98 1.10% 495.0 n/a$0.3 $10 2.89% 8.5 8.7

$39.2 $2,259 1.74%

Estimated Distribution of Fees Paid

Acquirer / Processor

($B)Network

($B)

CardIssuer($B)

$4.2 $2.1 $14.8$1.8 $0.0 $5.6$1.3 $0.6 $4.5$0.6 $0.2 $0.8$0.3 $0.0 $1.0$0.0 $0.0 $1.1$0.1 $0.0 $0.2

$8.3 $3.0 $28.0

Visa & MasterCard generate the largest total fees paid. Under an open loop system (V/MC), Card Issuers capture the greatest portion of the fees paid by merchants (49%). Closed loop networks like American Express and Discover act as both acquirer and issuer and therefore capture all fees paid. The weighted average fee (fees paid divided by purchase volume) is the highest with Diners Club at 2.89% and American Express at 2.42%. EFT Systems (PIN debit) charge the lowest fees, 0.61%

Card Type

V/MC CreditAmerican ExpressV/MC DebitEFT SystemsDiscoverPrivate LabelDiners Club

TOTAL

Visa & MC

n/a = not available

$27.6 $1,504 1.84%

70% 67%

MC/V Credit

EFT Systems

Diners Club

AmericanExpressDiscover

V/MC Debit

Private Label

$5.5 $2.8 $19.3

66% 94% 69%

$0Acquirer/Processor

$25

$20

$15

$10

$5

Network CardIssuer

Exhibit 2

Source: “Competition and Credit and Debit Card Interchange Fees: A Cross-Country Analysis,” Fumiko Hayashi and Stuart E. Weiner, November 30, 2005; Nilson; Visa’s 2003 credit card functional cost study; Finance Tech Magazine, Former FTC Chair Defends Card Industry in House Testimony, Feb 21, 2006.

US Interchange Fees for a $50 Transaction at Non-Supermarket

Since 1999, interchange fees have continuously risen (with the exception of signature debit which decreased in 2003 due to the elimination of the “honor all cards” rule, but has subsequently increased)

MasterCard (credit)

Visa (credit)

MasterCard (offline)

Visa (offline)

Star (online)

NYCE (online)

Pulse (online)

Interlink (online)$0.00

$1.00

$0.80

$0.60

$0.40

$0.20

1999 2000 2001 2002 2003 2004

Exhibit 3

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and associations. Merchants are especially irked because market forces as they understand them should be driving fees lower, not higher; and this is especially true for interchange. Their objections to this situation include:

• Card acceptance has reached a critical mass that no longer requires the same degree of brand building;

• Transaction volume has grown enormously and resulting economies

of scale have driven down transaction processing costs;

• Fraud has decreased as a percentage of volume.

The issuers and associations have not responded the way the merchants think they should; instead of lowering the fees, they’ve been trying to justify them in ways that ring hollow to the merchants. Frustrated with the increasing expense, merchants have started looking for ways to minimize card payment

acceptance costs as well as demand more value from card associations to compensate them for interchange fees.

This pressure on the card associations and issuers can only intensify. Driven by investor demands for improved performance, merchants can be expected to take advantage of the low-cost alternatives to the status quo that already exist—Debitman, Pay By Touch, PayPal and routing electronic check images. Innovations from other quarters can also be expected because of this market opportunity.

Pressures on Interchange

7

Regulatory and litigation pressure Regulation and litigation should be understood not as an either/or proposition, but as a combined force. Even if the Federal government never chooses to intervene—likely, but not a guaranteed outcome—the current spate of more than 40 lawsuits before the courts may well produce some sort of settlement that includes reducing interchange. Added to that are regulatory intentions, in place or being contemplated in jurisdictions as far apart as Australia and Great Britain— as well as in the European Union—intended to bring the cost of interchange into line with transaction costs. And while the Federal Reserve has so far resisted being drawn into the fray, that posture may change with the political winds. Already, various Fed banks have been giving the subject much more study than before, creating a knowledge base that could be used to inform any future steps towards regulating interchange.

Merchant pressure for more transparency into interchange pricing components Today’s large merchants understand the credit card business very well, and in today’s hyper-competitive retailing environment merchants, especially large, publicly-held merchants, are being forced by their investors to demonstrate continued cost reductions. Thus they are unlikely to accept less than full explanations about what they are paying for, especially when payment costs represent a high percentage of their profit.4 Already we have seen both Visa and MasterCard move to reconstitute their price-setting bodies in ways that are likely to be more friendly to merchants.

Threats of non-acceptance and increased competition from new lower cost and merchant-friendly entriesConsolidation of retailing has led to fewer, larger, more influential merchants. Not only are these companies under constant pressure to improve performance, but they are also equal partners in the payment cards equation. It will eventually be a small step for one of them to decide they need a particular card company less than the reverse. When one or more major merchant stops accepting general purpose credit cards and signature debit, it will send a shudder through the card industry.

These same pressures are provoking a classic response from the marketplace: Demand exists for a low-cost, merchant-friendly payment alternative, and businesses like Debitman already exist to fill it. New competitors in this space are almost guaranteed.

New authentication methods that separate the authentication from the payment typeEmerging competitors like Pay By Touch, PayPal, and Google Payments pose yet another, genuine threat to dominant card operations. One way to look at a credit card is that it is an authentication device that proves who its user is and gives access to the consumer’s account. The process through which the user is authenticated begins the routing of the transaction over the card network. But separating authentication from the card would allow merchants to drive consumer payments to low-cost avenues like the Automated Clearing House. History tells us that once models are taken apart this way, more and more alternatives arise, and the system eventually falls apart.

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One particular threat to issuers is in the area of contactless payments. The banking industry is making a significant investment in rolling out this technology, but it is very easy to imagine that once there is critical mass at the point of sale, consumers will migrate to RFID-enabled cell phones as their

device of choice for initiating contactless payments. Since consumers will want to maintain payment choice, this will likely be supported by mobile wallets. The path of least resistance for this? PayPal, which already has 114 million people signed up for its e-wallet, and works diligently

to get its subscribers to settle directly to their checking accounts, bypassing the card networks5. A strong player at the front-end of the transaction chain routing transactions away from the credit card networks is not the outcome issuers want from their contactless investments.

The Collapse of the Interchange

Model

9

Card issuing banks and the card networks can’t be blamed for trying to maintain, or at least prolong, the current interchange fee model. It accounts, after all, for over $22 billion in annual fee income for MasterCard and Visa issuers and the associations.6

But the pressures on the fee model discussed in the previous section make its future cloudy at best. It will be very hard for issuers and the networks to maintain—in court, before regulators, or in the marketplace—that the world’s largest credit card market should somehow be a special case, exempt from the forces acting in other parts of what they are otherwise pleased to see as a global economy. Issuers and the associations alike need to admit this to themselves, and prepare for a world with much lower interchange revenues.

The first casualty in a world of lower interchange will likely be issuer rewards programs. Rewards are very useful as a competitive weapon in the fight for issuer market share, but as Exhibit 4 shows, they also account for as much as 44% of interchange costs—costs paid for by merchants without directly benefiting them or their customer relationships. In fact, these rewards programs drive consumers to payment choices that are the most expensive for merchants.

Issuers rely heavily on these programs for their marketing, but the experience of Australia, where banks charged cardholders for rewards programs when the Reserve Bank of Australia cut interchange fees to the bone in 2003, demonstrates that credit card use continues growing even without this type of subsidy.

Source: Diamond analysis.

Estimated Components of Interchange

Rewards account for 44% of interchange cost. Merchants are charged approximately 3% to pay for network branding costs (advertising, marketing, etc.). However issuers are not. Processing only accounts for approximately 13% of the interchange cost. Thirty-five percent of costs pay for other issuer costs and profit margin.

Network Processing 4%

Other Issuertransaction costs & profit margin 35%

Issuer Processing 9%

Network Rewards 1%

Network Brand 3% Issuer Rewards 44%

Network Servicing 4%

Brand = advertising and marketingProcessing = transaction processingRewards = reward programs administration and benefits (assumes approx. 1% of transaction costs)

Network Servicing = network value added services like risk and fraud protection information and investment in infrastructure

Other Issuer costs and profit margins costs and or profits not covered by net interest margin

Exhibit 4

Merchants really have little idea where their interchange dollars go. In addition to the 44% of interchange cost that goes toward rewards programs, our analysis shows that network branding takes 3% of the cost, and 35% goes to cover things such as cost of funds and profit margins. None of these costs really goes toward benefiting the merchants.7 Transaction processing, a service for which merchants receive clear value, consumes only 13% of interchange.

In addition to a lack of transparency into where the money goes, the fee

structure itself can be confusing to merchants. Fees can be charged at more than 100 different rates, depending on the card, who is accepting it and many other factors. The price paid is determined by card type, transaction type, transaction size, and qualification and the merchant’s industry. Our view is that this level of complexity and confusion is not sustainable in the current legal and competitive environment.

Once transparency comes to credit card pricing models—as it ultimately does to virtually every industry and now may be

beginning here with the recent decision by MasterCard to publish interchange tables—merchants will use the information to force an unbundling of interchange fee structures, The interchange structure as we know it will disappear, replaced by a system where merchants pay directly for value they receive. Before this happens, issuers and associations need to begin seeking alternative business models—without subsidized rewards programs and brand building—to maintain profitable operations.

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The post bellum payments card world will look very different from the industry we have grown up with. The balance of power among merchants, card issuers, and the associations will have changed, setting off a long series of adjustments down the value chain. Even if, as is most likely, merchants merely increase their bargaining strength versus the associations and issuers, the pressure to decrease merchant fees, the growth of payment alternatives, and a new premise for interchange pricing will disaggregate the traditional card payments value chain and un-bundle existing payments pricing.

The transformation of the industry will mean that issuers will lose the “easy revenue” from increasing interchange fees they have grown used to, while needing to expand their spending on customer retention and growth programs to stay competitive. Emerging players will make inroads into the market, and introduce new payment types, markets and pricing models that will erode the traditional general purpose credit card business.

We believe this transition will unfold over three to five years, taking place against a backdrop of legal trench warfare in the numerous interchange lawsuits. By the end of that time we see the following as characteristic of the New Business Model for Card Payments:

• Merchants will have gained in strength and forced an unbundling of pricing— in effect the end of the interchange model. Pricing based on an exchange of agreed-upon value between merchants, processors and issuers will be the norm.

• The separation of authentication from the payment type will allow merchants to route transactions in a way that makes best sense for the circumstance. Higher-risk situations may well continue to see the authorization model we have today. But other situations (e.g., an authenticated repeat customer) will lead to merchants assuming increased

settlement risk and routing through cheaper channels. This will go hand- in-hand with the continued emergence of ACH as a settlement mechanism for point-of-sale transactions.

• Merchants will selectively accept different payment mechanisms. A discount retailer, for example, may accept only PIN debit or private label credit transactions, but not general purpose credit cards.

• Large merchants will assume more of their own payment processing. Wal-Mart Stores Inc. is taking this step now, and while no other retailer has anything like Wal-Mart’s market clout, the savings in merchant acquiring fees will be too large for its smaller (but still large) competitors to ignore.

• Associations will un-bundle their functions as well as their pricing. As new technologies enable the separation of authentication and routing of the transaction, card associations will get into the business of processing more and more payment types. The transparency of interchange components (brand, processing, and other costs) will require associations to manage those components as separate businesses in order to justify the costs and grow revenues.

• New bank-owned networks may emerge as big players move to own more of the value chain and improve pricing power. Bank of America has already expressed interest in owning its own network. Large-scale players such as JPMorgan Chase and Citibank might also be expected to show interest. If this took the form of big players buying the current associations it could cause a huge transformation in the current interchange world.

These disruptions will set in process other changes that cannot be foreseen. It is clear, however, that issuing banks and the associations need to prepare for a world of change.

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A New Business

Model

12

Preparing for this Future

Banks and networks need to take action to deal with this prospect, and plan their strategies for improving revenue and mitigating risk now. At a minimum, banks must:

• Take an enterprise view of payments. Identify current assets that could be leveraged for future uses, including thinking broadly about new uses for old technologies. Emerging players in the payments business are doing this— in particular looking for ways to leverage the ACH network.

• Look for ways to add value to merchants. Offer bundles of products to merchants, matching the right payment type to the right solution. This will lead to a risk-based pricing model that is both sustainable and beneficial to both sides.

• Provide real incremental value to consumers. Develop rewards programs based on the value of the overall relationship, and use the bank’s knowledge of the consumer to tailor solutions. Information and data analysis platforms have the potential of improving

the bank’s ability to serve both consumers and merchants.

The card associations, in turn, should:

• Increase focus on the value of processing assets. These are likely to be real value drivers in the future.

• Invest in platforms that will handle the processing of more payment types and in improving merchant capabilities at the point of sale. Improving capabilities in these areas may require buying emerging players.

• Aggressively pursue processing opportunities in new industries (such as healthcare) and new geographies.

• Continue down the more conciliatory path with merchants that seems to have begun with the appointment of new bodies governing interchange pricing.

The credit card business has been a bonanza for banks over the past several decades. It will continue to be a great business if the industry recognizes the coming change and adapts before emerging competitors do.

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Source: Federal Reserve Interchange conference, May 2005; Diamond analysis.

Credit card usage continues to increase

0

100

80

120

140

160

$ billion

60

40

20

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Regulated InterchangeFees Introduced

2003 vs 2002 +11%2004 vs 2003 +12%

Exhibit 5

The Australian Experience

As the merchant challenges to interchange in the United States have gathered steam, MasterCard and Visa have pointed at their experience in Australia as an example of how wrong matters can go, at least from their perspective.

After a period of study that began in 2000 with a paper entitled Debit and Credit Card Schemes in Australia: A Study of Interchange Fees and Access, the Reserve Bank issued final reforms in 2002 that among other things stated that the bank “...does not accept that continued growth in the use of credit cards at the expense of alternate payment instruments necessarily adds to the community’s welfare. In particular, it remains of the view that the benefits of credit cards to cardholders and merchants as a whole-in the form of a permanent increase in sales or a reduction in transaction costs-are overstated.”8 Final regulations based on the 2002 reforms were issued in 2003.

Thanks to these steps, cost-based interchange became the norm in Australia, and merchants were allowed to impose surcharges on consumers for credit card use. In addition, non-financial

companies were allowed to become members of the card associations in Australia, and merchants, subject to regulation, were allowed to become acquirers.

The result: Interchange plummeted in that country, falling from an average 0.95% per transaction to about 0.5% today. Free rewards and loyalty programs vanished, replaced by fee-based programs. Annual cardholder fees rose.

What did not happen was a drop off in credit card use (see chart); card use actually exploded around the same time as the Reserve Bank issued its landmark paper in 2000, and continues strong growth.9

A key difference between the Australian experience and what is likely to happen in the United States is appetite for regulation. In Australia, the Reserve Bank has regulated payment cards since 2001. The Federal Reserve Board—the US equivalent of the Reserve Bank of Australia—has expressed no such interest in the regulation of interchange. As a consequence, the future of credit cards may well be decided in the courts.

Credit Card Spending—Australia

14

Endnotes

1 See detailed discussion below and in Exhibit 4

2 See Exhibit 2

3 Calculated as credit fees going to card issuers ($14.8 billion) plus debit fees going to card issuers ($4.5 billion) as a percentage of total merchant fees ($39.3 billion).

4 For example, the National Association of Convenience Stores stated in a 2004 report that payment fees in 2003 represented 80% of pretax profits for the industry.

5 Source: eBay investor presentation, July 25, 2006.

6 Over $19 billion for the issuers plus almost $3 billion for the associations. See Exhibit 2.

7 It could be argued that network branding is the cost of “acceptance,” and therefore of direct value to the merchants. We would counter by pointing to card saturation and the fact that if the merchant is paying, it is clearly already accepting cards.

8 Final Reforms and Regulation Impact Statement, August 2002.

9 What also did not happen was a decrease in consumer prices. In general, the merchants kept the difference for themselves.

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About the Firm Diamond (NASDAQ: DTPI) is a premier global management consulting firm that helps leading organizations develop and implement growth strategies, improve operations, and capitalize on technology. Mobilizing multidisciplinary teams from our highly skilled strategy, technology, and operations professionals worldwide, Diamond works collaboratively with clients, unleashing the power within their own organizations to achieve sustainable business advantage. Diamond is headquartered in Chicago, with offices in Washington, D.C., New York, Hartford, London and Mumbai. To learn more, visit www.diamondconsultants.com.

About the Authors Carl J. Hugener is a Partner in Diamond’s Financial Services practice and a frequently quoted expert on the cards industry. Carl has broad experience in credit cards, consumer banking, commercial banking and financial markets. His experience includes extensive time on projects in Latin America and Europe.

Carl helps financial services companies plan and execute complex business initiatives that are strategically dependent on technology. He has managed and participated in a variety of projects to define growth strategies centered on electronic payments, develop technology strategies, design and develop large-scale application systems, define and implement new business ventures, assess troubled technology projects and improve IT effectiveness. This experience includes a number of projects in which Carl served as interim chief operating officer.

Amy Dawson is a Principal in Diamond’s Financial Services practice. Her experience includes business strategy and planning, new business venture development, operational improvements, product management, and portfolio management. Amy’s experience with Diamond includes both strategy and execution; she has led teams in strategic planning, development, implementation, product management, business process engineering, new business ventures, merger and acquisition integration, market entry strategy, customer acquisition strategies, outsourcing, strategic partnership selection, and financial analysis. Prior to joining Diamond, Amy spent five years at Ford Motor Company, where she held positions in corporate finance, marketing and sales, and manufacturing operations.

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