Payments 101
Foundation Principle
Payment History
High Transaction Costs
The Quick Math
Credit Card Complexity
Electronic Payments in the US
Faster – Real-time Payments
Opportunities for Innovation
Foundation Principle
Most everyone agrees that accepting a credit card is %#&! expensive for a small merchant, and beyond customer convenience, they provide merchants with very little value. Big box retailers like Walmart have been trying to reduce payment costs for years. Honey was initially created to solve this problem, but while working to understand payments, we found a whole new world.
Payment History
The modern credit card was established in the 1950s with the Diner’s Club card. By the 1990s credit cards had become revolving credit lines for personal credit, and after the great recession they became a matter of payment convenience. Not much has changed in the credit card business over the past 60+ years. Payments still run on the same rails (network), still rely heavily on an account number and for physical payments (in-person payments) they still largely require a physical card. Short on vision and low on innovation, the biggest improvement over the past 30+ years is a toss-up between debit cards and mobile wallets. Mobile wallets store credit card information and enable users to make a payment using their mobile phone. In a nutshell, it’s just another way to store a person’s credit card account information. Debit cards on the other hand, don’t use credit, but do use the credit card network to process a transaction.
High Transaction Costs
On average, accepting a credit card costs small merchants a little over 3% of their overall revenue. This cost can increase dramatically depending on several factors, and can be as high as 8%. Outside of Square customers, small merchants rarely know what they will pay for a transaction. Variables that affect costs include contractual agreements, card type, transaction type, terminal equipment rentals, maintenance fees and fixed per-transaction fees. Larger merchants do not bear such a costly burden, and regularly negotiate deep discounts, ultimately paying between 0.85% - 1% of total revenue.
Companies such as Square have become master merchants. In short, they have aggregated volume discounts to gain a price advantage. While Square passes a little of that savings on to the merchant, more importantly they have stabilized costs and given small merchants transaction cost predictability.
Transactions are not only costly, but they provide very little value to small merchants. The real value goes to the customer, who no longer must carry large amounts of cash to fund purchases.
The Quick Math
The average transaction amount per customer for a small merchant is $18.00-$25.00. Let us take the lower end of $18.00 to visit the math: $18.00 x 3% + $0.30 (fixed per transaction fee) = $0.84. That means the realized rate is 4.67%, and that doesn’t include any of the additional costs stated above. Imagine if a $1.00 bottle of water is purchased using a credit card. The bottle of water might cost the merchant $0.33 to sell it to their customer. It’s easy to see why merchants have minimums, and why they have much to say about credit card fees.
Credit Card Complexity
Credit cards are massively complex and few people understand how they work. There are essentially two kinds of networks: “Open-loop” networks (Mastercard, Visa etc.) and “Closed-loop” networks (American Express, gift cards etc.).
Closed-loop cards are straightforward. They issue cards, take on credit risk, process transactions, settle payments, handle customers, etc. They pretty much own the customer and the entire transaction process. Open-loop networks are complex and involve many players to complete the network. Separate companies are responsible for acquiring customers, acquiring merchants and even processing each transaction. For example, banks issue cards to consumers and take on the credit risk. Then there are companies that acquire merchants, and each merchant must have a bank “sponsor.” Then there are companies that supply terminal equipment and customer support, companies that sit between the merchant and their bank, and companies that sit between the merchant and Mastercard/Visa. Suffice it to say, it’s confusing, and in the end, there might be as many as eight companies that get a percentage of every transaction. This requires massive coordination, strict rules and a sophisticated network to accomplish. It also means that Mastercard/Visa cannot control its cost and is heavily reliant on its partner network to work. We think that spells L-E-G-A-C-Y.
Electronic Payments in the US
In the U.S., there are essentially three electronic ways to move money from one entity or person to another: 1) The banking system; 2) the credit system; and 3) cryptocurrency.
We believe the cryptocurrency value system is highly volatile and leaves companies like ours too exposed to valuation fluctuations and regulatory risks. The credit system would require Honey to take on too much risk and utilize the existing legacy structure. This also means that Honey would no longer be in control of the transaction or associated costs. That leaves the banking system as the only alternative to settle transactions. The banking system relies heavily on the Automated Clearing House or “ACH” to move money between banks and accounts. At scale, there are a lot of fundamental settlement problems with ACH that make it an unviable payment methodology. It should be noted that ACH transactions are all batched and take, on average, overnight to settle. This is obviously unacceptable for a merchant, and there are plenty of risks we will not expose here.
Faster – Real-time Payments
More recently, companies like The Clearing House (TCH) have produced products such as Real-Time Payments (RTP) which enable faster payments that cannot be clawed back. RTP is a potentially significant modernization, but it was not built with in-store payments in mind. RTP is essentially a needed workaround to ACH and an inexpensive alternative to Bill Pay, but without volume discounts (which TCH does not give) and massive adoption, the high cost will not enable payments companies to scale and innovate effectively.
Without an effective Federal Reserve solution (which is 5+ years away) to speed up payments, we believe the answer lies in real time intra-bank payment solutions negotiated directly with the largest banks. Intra-bank solutions are essentially a ledger change between accounts at the same bank. It’s similar to how people move money between their savings and checking accounts. Intra-bank transactions would enable innovation at a reasonable cost and enable instant transactions.
Opportunities for Innovation (or Need for Innovation)
Over the years, innovation has come from overseas companies, particularly in China. Alipay and WeChat Pay have essentially created new rails to process payments without the use of the credit card networks. Essentially, they have created private closed-loop networks that use mobile phones as a user interface. In 2017, two thirds of the Chinese GDP was processed through these networks. However innovative, they are little more than an American Express for China and both companies fall short of changing the way payments are processed or paid for. We believe changing the way payments are processed, consumed and paid for is where true innovation will disrupt this legacy space.
As we saw earlier, all transactions in the world charge a percentage of a transaction to process the transaction. This model has aged itself, and we believe that free payments can be had and can be profitable. We also believe the industry would be far better served by deploying a subscription-based model.
Today, cloud computing has created massive opportunities to displace legacy networks and better KYC (Know Your Customer) tools have made fraud much easier to identify and thwart, yet little has been done in the U.S. in either areas. The market is wide open and ripe for disruption.
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