When put into competitive deals, Chase’s processing arm has an unfair tactic to win:
They eliminate the cost of interchange on Chase cards.
And since Chase cards are often 20% of the card mix, it’s meaningful enough to affect the outcome.
Turns out nobody likes to pay a tax to move money.
Shocker.
It’s with this lens that we think Capital One could actually dominate the payments market.
If they find their balls.
There are three pillars of card processing:
The issuing bank (e.g. Chase bank), the card scheme (e.g. Visa), and the acquiring bank (e.g. also Chase bank but Fiserv, et al. are the usual suspects who are trending to become their own acquiring banks.)
Image below courtesy of Infinicept.
The tax charged by the issuing bank and card schemes is called interchange, and it’s non-negotiable.
The tax added by the acquirers (with the word processor used interchangeably even though it might be technically imprecise) is negotiable and often the most abused at the expense of merchants (and John Q Public with outrageous surcharging premiums foisted by the processors).
The card schemes take about 20 bps per roundtrip, which is hilarious when you realize that the inefficient, bureaucratic government of Brazil (which is probably only 10x MORE efficient than our US government) built Pix, a real-time payment rail used by nearly 90% of Brazilians, for a negligible $4M.
LOL.
You could run Visa and Mastercard for single digit millions.
What a joke of a duopoly.
How are these card schemes not legislated like utilities?
Anyhow, the issuing banks take a higher percentage of interchange – often 100 bps or higher – to “pay for rewards”.
Except that the issuing banks make a ridiculous amount of money on credit card interest and non-interchange fees.
According to a CFPB estimate, Americans pay $120B annually in credit card interest and fees annually.
And that was using data from 2018-2020, a lower interest rate environment.
Average APRs were 22.8% in 2023, a full 37% higher than the average APR from 2018-2020.
To add to this, American’s credit card balances are 25% higher than they were during 2018-2020:
This means that banks can expect to earn $206B in credit card interest this year.
Chase would stand to make $40B in fees alone.
By comparison, the top 6 largest US issuing banks paid out $67.9B in rewards in 2022 (they also represent about 68% of card-issuing market share by coincidence).
If we round up the cost of issuing rewards to $100B to account for the long tail of banks, credit cards are producing >100% IRR for issuing banks, even net of interchange revenues.
Interchange revenue can be relatively small by comparison depending on the demographics of the cardholders: Bank of America will make $4.5B in interchange and $20B in card interest.
See below:
Generally, banks stand to make more revenue on card fees than they will on interchange, and growing issuing market share at the expense of interchange should be the priority.
With this as the goal, here’s what Capital One should do.
It looks like 2% cash back is the highest cash back reward card across all spend categories.
US interchange averages to about 1.8% for credit cards and the rate for debit cards is directly proportional to the integrity of the processor. Once acquiring margins are added, Clearly Payments estimates that the total cost of payments acceptance for North American merchants falls around 2.2%, which feels about right for the average merchant, with smaller merchants paying more, and larger merchants paying less.
Right out of the gate Capital One should tell their consumers they will get an automatic 2% cash back on every purchase.
This matches the highest cash back rewards to US cardholders.
Capital One should just take this discount out of the settlement stream.
For example, if a Capital One cardholder buys something for $100, $98 goes to the merchant and the cardholder’s bank account similarly shows a $98 charge.
This does several things.
First, by automatically applying the cash back rewards, Capital One avoids the entire nonsense that is a points system. It’s overly complicated and comes with serious costs to the banks.
Remember that there are negligible rewards in countries that have legislated interchange costs and consumers aren’t dying as a consequence.
Second, this positioning automatically makes every other card scheme look like a bunch of money-grabbing assholes who are increasing customer costs.
By default, Visa, Mastercard, and Amex appear like they’re surcharging consumers at LEAST 2%. When you add in the 3% additional surcharging encouraged by the processors (and that’s IF it’s compliant surcharging with Visa’s arbitrary-and-probably-illegal surcharging limit of 3% – many merchants are surcharging 5% or more).
Now you’re talking about a Capital One card transaction that’s 5-6% cheaper for a Capital One cardholder than it would be if they used their V/MA card.
Would love to see this positioning in a commercial by the way:
Talk about having great fodder on the Hill when pressed by legislators about the cost of card acceptance and hardship on American families.
Third, this lowers the cost of interchange for the average US merchant. The average US merchant eats a tax of 2.2% to take card, and 2% drops the tax 20 bps lower.
This third point is actually the most important in our minds.
Here’s why.
Discover Networks is unique from the other card schemes (sans Amex) in that it owns both the consumer and merchant relationships.
Visa and Mastercard rely on an army of (often morally-devoid) processors to acquire the merchants.
Discover already has these relationships.
In fact, Discover counts over 60 million merchants that accept their cards, or said differently, 99% of establishments that take card also take Discover per the February 2023 issue of the Nilson Report:
Discover Global Network is the fastest growing global payments network with more than 280 million cardholders, more than 60 million merchant acceptance locations and 1.8 million ATM and cash access locations. It includes Discover Network, Diners Club International, PULSE® and more than 25 alliance partner networks across the globe.
https://investorrelations.discover.com/newsroom/press-releases/press-release-details/2023/Discover-Global-Network-Launches-Transit-Solution-Internationally/default.aspx
Discover should use these merchant relationships to explain how they intend to drastically bring down the cost of merchant card acceptance so long as merchants push Discover/Capital One.
Look, surcharging is only growing as the economy tightens. See the below data from Zeller, an Australian payments company:
According to Zeller data, nearly 60% of all transactions now include a surcharge. Since June 2021, the percentage of transactions with a surcharge applied has increased eightfold. Now, nearly three in every five payments that your customers make, include a card payment surcharge.
https://www.myzeller.com/blog/rise-of-the-surcharge-should-you-follow-the-trend
This means that Visa and Mastercard cardholders are going to keep seeing rising costs associated with using their cards – far beyond the nominal rewards that these cardholders think they’re earning.
In fact, to further encourage even higher surcharging limits, a contingent of ISOs and payments processors are actively suing Visa for their arbitrary 3% surcharge cap.
(For the record, we agree that Visa’s surcharge cap is in defiance of the spirit of the surcharge ruling from 2013. That said, the more merchants surcharge, the faster the federal government will crack down on acquirers and ruin their party.)
But nobody ever accused payment bros of being smart.
What Discover needs to do is get their merchants to 1) agree that they won’t surcharge Discover cards, and 2) actively market Discover cards to their patrons.
In exchange, Discover will work to bring down the cost of acceptance by gradually lowering the spread between what the merchant charges prima facie and what Discover settles into the merchant’s account.
Discover should be able to do this given the surcharging tailwinds at their backs: while Visa and Mastercard will be getting sued to allow uncapped surcharging (cuz every consumer should pay 100% more to use their V/MA card so a payment bro can make 98% of the surcharge), Discover will look like an absolute hero to consumers (and Washington) by comparison.
If successful, there will be two very different pricing structures at those 99% of merchants that accept Discover:
One price for Discover users, and another price, at least 5% higher, for cardholders dumb enough to keep using their Visa or Mastercard.
Visa and Mastercard will bitch and moan, and Discover needs to nut up.
V/MA: Wah, wah, wah, it’s not fair that your cards are treated differently than ours. If a merchant can surcharge our cards then they should be FORCED to surcharge your cards for the same amounts!
Discover: We were smart enough to own the entirety of our network distribution. This gives us full control over pricing. Who distributes your solutions to merchants?
V/MA: Payment bros…
Discover: What irony considering you guys are the biggest payment bros of all. Everyone with a brain knows you could run your businesses for literal single-digit millions while employing a paltry 20 people.
V/MA: F*ck. Please don’t tell Congress, okay?
Can you imagine how many merchants would absolutely love Discover if they did away with the tax that is payment processing?
Discover would successfully (and rightly) shift the costs of payment processing (which naturally rests at ~zero) to cardholders who are now underwriting the cost of payments through credit extension for their purchases.
Discover would likely become the major beneficiary of the $12B co-branded card business as retailers flocked to save on interchange taxes.
Discover would be bestowed with enormous credibility – and claim – to offer merchants additional financial products as their preferred financial institution. This will be a massive boon: McKinsey estimates the TAM of “performance solutions and commerce enablement” (i.e. financial products that are related to payments processing but not payments processing directly) for US merchants at over $1T by 2025.
The data Discover aggregates would hold enormous potential as well.
This move would take 5-10 years to pull off, far beyond the quarterly optimization that finance bros exalt, but if executed right Discover would become the leading card network while driving payment taxes towards zero.
This would mean that if a consumer pays $100 for something with Discover, the merchant will GET $100, and Discover will make its money on the increased underwriting volume they see as a lender.
Discover would rewrite the rules of the card network: the barrier to entry is no longer connecting two sides of a market through your platform, but owning the direct relationships with both sides of the market WHILE doing so for zero direct costs.
Visa, Mastercard, and Amex would be in big trouble.
But you don’t find cahones of this magnitude on people hired to passively manage large companies.
These “executives” are much more about “make myself a lot of money doing very little to ensure the status quo stays the status quo”.
No new products.
No R&D.
No customer obsession.
If only.
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