Episode 6: Where do Visa and Mastercard go from here?

Catherine: [00:00:05] Welcome to The Signal, a podcast presented to you by Third Bridge, the world’s leading independent research provider, exploring how some of the world’s most investable industries are facing upheaval and reviewing key markets developments with some of Third Bridge’s most eminent clients. My name is Catherine Ford, and I’m a journalist with a 20 year track record of reporting on a wide range of financial topics such as capital markets developments and M&A. In this episode of The Signal, we’re going to explore developments in the card payment sector. And joining me today are Peter Hobson, Third Bridge’s VP US and Eric Grover, Principal of Intrepid Ventures. Hello, Peter and Eric, I’m delighted that you can join me today for what I’m sure will be a really interesting conversation. Can I ask you for brief introductions? Peter, you first, please.

Peter: [00:00:45] As mentioned, my name is Peter Hobson. I’ve been with Third Bridge Forum for now for about six and a half years. I lead the Forum team in New York that covers North American financials. Relevant to today’s session, since the start of 2021 our team has conducted over 100 interviews on the card networks with experts such as Eric, who I’m excited to be speaking with again today.

Catherine: [00:01:08] Fantastic. Eric, tell us about yourself, please.

Eric: [00:01:12] So I’ve now spent about four decades in payments. I was with G Capital’s credit card business, with Visa, with Bank of America, with Nations Bank. I was the first to publicly call for banks to spin off MasterCard and Visa and have been a relentless commentator on the commercialization of the global payment network space.

Catherine: [00:01:28] Fantastic. Now, not everyone listening to this podcast will be an expert like you guys are. So I thought we’d start off by exploring the economics of a $100 card payment transaction. Peter, talk us through that one.

Peter: [00:01:42] Catherine, it may sound elementary. One of the first questions I asked when I look at business is how does this business make money? So there are several ways that I think people would describe Visa or MasterCard. The most common one is think of these as a toll road, right? They are essentially just the infrastructure over which payments flow. So if you look at Visa, for example, two thirds of the company’s revenue come from consumer payments. And really the lifeblood of that is what we call interchange, which again, is that toll fee that they collect. And at the risk of oversimplifying it, I will use an illustrative example. So let’s say Eric here owns a gift store and maybe I’m looking to purchase a gift for my nephew. So I go to the register and I’m going to buy this $100 toy. I pull up my card. Maybe it’s a credit card for the sake of this example, but Eric doesn’t receive the full 100 when he swipes it. Eric gets maybe $97, and the $3 is essentially the toll fee that gets split up by the other parties to the transaction. So I think a lot of people are surprised to learn that in a typical transaction you have about five different parties. So again, me, the consumer in this case, Eric, the merchant, the merchant acquirer who is essentially Eric’s bank, that could be JP Morgan, Worldpay/FIS, Pfizer global payments, etc.. The issuing bank who’s my bank, right? And again, could be JP Morgan, Wells Fargo, etc.. And then the network and literally all the network does is just help facilitate that transaction. And in the US it’s probably most likely Visa or MasterCard.

Peter: [00:03:04] Marc Rubenstein had a good write up last year on ? autobiography where he kind of explained what the network does. And the first primary function was to identify the buyer and seller and then the seller to the buyer. And that’s just based on the set of numbers. When the card gets swiped, where does this transaction go? The second primary function was as a guarantor of value data, and then the third one being kind of the origination and transfer of value data. So at the end of the day, the easiest way to think about these businesses is they’re essentially in the business of the exchange of monetary value. The other thing that’s interesting, so we mentioned there’s call it $3, again just for the sake of this example, that gets collected. Visa and MasterCard collect the smallest amount. Sometimes it’s literally pennies, whereas most of the $3 is actually going to the issuing bank. That’s how they pay me the 2% I get in cash back in terms of the rewards and also the merchant acquirer. So in summary, again, Visa and MasterCard are essentially collecting a very small toll on each of these transactions. But in Visa’s case, if that’s 165 billion transactions a year, you know, those numbers get quite large. Now, I did mention two thirds of the revenue coming from that. The other one third comes from other payment flows, additional services, which both of these, despite being a smaller percentage of revenues today, are actually growing faster than that core consumer business and have the potential to become a larger percentage of revenues over time as well.

Catherine: [00:04:25] Fantastic. Thank you so much. I think we’ve all got a really solid understanding now of how the economics of such a card payment works. Eric, can I ask you to add a little bit of colour to it for me?

Eric: [00:04:34] Yeah. So I think in thinking about these businesses, one needs to think about them as networks and they’re networks that enjoy enormously powerful network effects, which is to say, the more end points you have the more acceptance points, the more consumers and business is spending, the more powerful the network is. And Visa and MasterCard are open networks, meaning they don’t deliver any of their payment products directly to the end user or the consumer or the merchant. They rely upon a global web of licensees. They leverage a global web of licensees, typically banks. And then in terms of their business model, you know, Peter’s quite right, they take a relatively small fee, at least for domestic transactions. They take processing fees and they earn licensing fees. So it’s variable. They enjoy generally absent regulatory constraints, significant pricing power on the acceptance side of their network, both domestically and for cross-border payments. On the issuing side, smaller banks tend to be price takers to pay rack prices. The large issuers can and do squeeze the networks because they have the ability to shift share. It’s also worth noting the network business model. Conceptually, their costs are substantially fixed, their people and their revenue is almost entirely variable. And so that’s a very nice business model. 

Catherine: [00:06:01] Tell us what other players are out there and how do they differ from region to region? I mean, someone like Visa, MasterCard, I think it’s fair to say that wherever you go in the world, you will be able to pay with either of those cards. But what other players do we have, say, in Asia, maybe even Africa and in Europe?

Eric: [00:06:18] Yes. So Visa and MasterCard are the only two genuinely global payment networks. However, there are half a dozen or so tier two global or aspiring global card payment systems, among which I would include American Express, Discover, China UnionPay, JCB. There are hundreds of traditional card payment systems and so-called alternative payment systems at the national level. So if you think about retail payment networks or schemes, it’s a patchwork. And we have two genuinely global payments’ networks that half a dozen tier two and then hundreds, which, generally speaking, have no relevance outside of their home market except for e-commerce. And there there is some relevance. And relevance comes insofar as if I’m an e-commerce site and I think my market is global. I want to present the payment systems that I think my prospective customer is most predisposed to use. So in that case, if there was a national dominant national payment system and I know that I’ve got an inbound consumer from China, let’s say I might present Alipay and WeChat Pay first rather than Visa, Mastercard.

Catherine: [00:07:27] Peter, can I ask you to add your thoughts to the question of what we’re seeing internationally, aside from Visa and MasterCard when it comes to payment systems?

Peter: [00:07:35] Yeah, I mean, look, maybe I’ll take it a little bit differently here. So, Visa and MasterCard, as Eric mentioned, both global in nature. Between the two of them, at least at the time of this recording, you’ve got about three quarters of a trillion in market cap value. Compare that to, at least regionally more so here in the US, we also have American Express, Discover both a bit smaller, although also important to note, those are closed loop networks who actually keep some risk on the books. So not perfect comps, at least in that aspect. American Express obviously a little bit more focused on businesses making more further inroads there, whereas you have Discover also diversified with student loan payments. I think the only other interesting thing to mention that Eric didn’t hit on is UnionPay, and this will maybe tie into a little bit some of the comments later, is really a regional entity but also a state backed entity out of China and in 2015 actually passed Visa and MasterCard in total value payments made by customers. But also important to note that obviously largely those volumes coming within China, not necessarily outside of China.

Catherine: [00:08:30] So what makes this space so interesting? What is so fascinating about the business model that people are looking to invest in it?

Eric: [00:08:36] Barriers to entry in the payment network market are enormous in any market. Unless there is some fundamental problem in that market, it’s very difficult for a challenger to enter. So notwithstanding a whole range of payment systems that were putatively cheaper, more secure, almost all new payment systems fail. There is a graveyard full of well-funded, conceptually, reasonably well thought out payment challengers, and where the existing market is well served, where penetration is good payments are habit for merchants, for banks, for consumers. So that’s very appealing once you have critical mass as a network. Of course, the flip side is if you if you have an idea of a better mousetrap, the barriers to entry are enormous.

Catherine: [00:09:26] And Peter, who of those players that we spoke about earlier on in the conversation has that critical mass? I mean, is it everyone that’s in there at the moment or are there actually players in there where you say, well, hang on a minute, you know, give them five or ten years and I don’t think they’re going to have that critical mass?

Peter: [00:09:38]. I mean, look, Eric is spot on in that it is an oligopolistic market. There’s only a handful of players. You’ve got deep competitive moats, strong network effects. I think the other thing to highlight too, why the business model people are quite optimistic on it is strong revenue growth outlook. I mean, you have long term secular tailwinds here like the digitization of payments. And again, as Eric hit on very high structurally sound margins of 60% plus.

Catherine: [00:10:04] I want to pick you up on the digitization because I wanted to move on to sort of looking at where the growth opportunity in the market obviously is. We’ve seen that. You’ve illustrated that quite nicely, but obviously there’s challenges out there as well. Digitization being one of them, export recovery, services opportunities, new payment flows. Talk to me about that a little bit, Eric.

Eric: [00:10:23] Well, so first off, in the developed world, payments are already substantially digital, right? So if you think about North America, Northern Europe, Korea, physical cash has been losing share for a long time. It’s not going away. But. But physical cash is a relatively small piece of the payments puzzle. And if I’m paying using a Visa card, a MasterCard, a card bank here, that is a digital payment if I’m paying using Zelle there. So both for retail and for B2B payments in the developed world, payments are almost entirely digital, system works quite well. However, worldwide physical cash remains the primary, the leading retail payment system in most countries, and that’s for a variety of reasons. In most countries worldwide, there is a steady displacement of physical cash by electronic payment systems. There are few markets where it’s problematic because the grey economy is so enormous. You know, a market like Bolivia, two thirds of the economy is gray, so it’s hard to displace. But even in Europe, you know, we think about Europe as being relatively mature payments market. Per capita card payments in Europe, the European Union in 2020 were about 140. To contrast that with the US over 400. If you look at Eastern Europe, Southern Europe, substantially cash payments at the physical point of sale. So there’s still a lot of growth headroom in in Europe, Africa. I mean, hugely cash based economies and some interesting alternative payment systems have gotten traction there. Latin America, by and large, following the cards, the quote unquote card centric model, enormous growth, but cash remains king for the time being. So, you know, I think that’s good for the industry. It’s easy if you’re spending in New York or London, you can go a long time without ever having recourse to cash. But that’s not the world.

Catherine: [00:12:12] Well, I was just about to say that’s not the world. I mean, I’m sitting here talking to you from Germany. And while we have an online payment or a bank card payment system, credit cards like American Express, a Visa and MasterCard is definitely not the way to be paying here. There’s still an awful lot of cash. And this I, I would classify Germany definitely as one of the developed economies. So I think it’s really interesting the point that you make about that there’s lots of room to grow, not just in the emerging markets, but also in some of the more established markets that we see in Europe. Peter, can I have your take on that? But also talk to me about some of the challenges that you see for the space.

Peter: [00:12:49] Yeah, of course. Look, I’ll break kind of the growth story out maybe into three key parts. So first, as Eric mentioned, more cash and check volumes move to digital. The total number of digital transactions will grow, which means the interchange, basically the total fee that Visa or MasterCard collect, those revenues will grow as well. The second really comes from new payment flows. So Visa and MasterCard are both saying they can go out and capture B2B, which is business to business, but also potentially B2C, business to customer G2B, government to business, G2C government to consumer and P2P, which would be peer to peer. So lots of three letter acronyms for you there. And then lastly, really the third leg of kind of the growth story is can they roll out and charge for additional services? So whether that’s risk and identity advisory solutions, etc.. You know, back to Eric’s earlier point, they have a very extensive, well-entrenched network of consumers and merchants. What else can they do to kind of further monetize some of those relationships? So kind of building off Eric’s comments, that’s a little bit of the growth story. Now to your point, when we speak to our clients who are largely by side investors, there’s also really two main areas of concern, and these are topics that Eric and I have spoken about several times over. But the first one is really regulation, and I know we’re going to unpack this a little bit later, whether it’s the European Payments Initiative or any sort of challenges to debit or credit. Change in the US regulation tends to kind of loom large over some of these entities. And the second one is really around new technologies. And probably the most viable one here is A2A or account to account payments. Some will bring up cryptocurrencies or other items that basically could disintermediate the networks from participating in that transaction and essentially collecting their toll fee.

Catherine: [00:14:28] Peter, you’ve brought us on to regulatory risks and you’ve also spoken about new technologies, but I’d like to loop back to the payment flows that you describe, the government to business and the government to consumer as citizen. How is that going to work and why would the government do that? And why would the average citizen like me use a payment system rather than pay directly to the government?

Peter: [00:14:49] Speed, ease and convenience. I mean, even look at, so G2C being an example. Look at what happened during the pandemic when you had stimulus payments going out or tax returns or benefits. Being able to place that money directly into someone’s account gets it there easier and quicker. And if you look at Visa management in particular, they estimate that there’s $185 trillion in new flows that could be captured. And it’s important to maybe break that out into a couple of different categories there. The first 65 trillion is B2C, right, which could be gig economy, peer to peer. So remittances, you’re splitting a pub fare with a buddy, G2C we just mentioned. Et cetera. And a lot of those are actually kind of served today by Visa Direct, which is kind of a pay to card service, Earth Port, which is kind of a pay to a bank account service. And the idea is, is that Visa can, at least in theory, capture more of those revenue streams. Now, the second component of that, which is larger, and that’s the other 120 trillion are B2B payments. I think a lot of people on the phone today or on the on the line today would be surprised to hear that depending on what estimates you look at, 40% plus of all B2B payments in the US are still made via cheque. 

Catherine: [00:15:52] Via cheque? Do people still have a chequebook, that’s amazing. I don’t think I’ve ever owned a chequebook. I really don’t.

Peter: [00:16:00] Small businesses in the US, and again, you need to maybe split out and we could split out, you know, global versus domestic. One of the experts we spoke with in May said he expects the proportion of cheque based B2B payments to decrease 10% over the next year and continue decreasing at an accelerated rate thereafter. So, again, this is an opportunity for Visa to potentially capture some of these flows. Now within B2B, and sorry if I’m being long winded here, you know, you’ve even got several categories there, right? So you’ve got card based solutions, which they think is $20 trillion in terms of addressable payments, volume opportunity. That’s going to be things like driving growth and established card businesses or card based businesses. You’ve got 10 trillion or so potentially coming from cross border, so needing to kind of execute and scaling Visa B2B Connect. And then lastly, domestic AR and AP. So that’s accounts receivable and accounts payable is the remaining 90 trillion, the volume opportunity they present. This is still early on and needless to say, there are a lot of businesses going after that B2B opportunity. Bill.com Avid Exchange. The list goes on. I think the verdict is still out on, it’s one thing to kind of put a big number out there on potential new payment flows they could capture. Yeah, I think one of the questions we commonly hear from clients that come up in our interviews is okay, but what’s the actual addressable revenue opportunity, right? Visa says 70 to 100 billion, but what’s feasible over the next 3 to 5 years versus ten years plus? Eric, I don’t know if you have anything to to add on the B2B side.

Eric: [00:17:26] Yeah. You know, they throw out enormous numbers and, you know, the potential market is humongous. However, it’s all being served by something I mean ACH systems, paper cheques which are diminishing and those whatever the systems are that are serving those payments work. You know, the advantage that Visa has and MasterCard has in addressing these are leveraging their existing global network of financial institutions and the existing network of merchants. So, you know, where they try and address spillover into adjacent payment markets, one of their strongest advantages is leveraging the existing network. You touched on Visa Direct and the MasterCard Send Credit Push products. I mean, these are unbelievably simple features, functions that have existed for decades that are essentially leveraging the entire global infrastructure and saying that they will support a real time credit push payment to any Visa account worldwide. And that’s good for consumer payments, it’s good for business for government payments, it’s good for money transfer networks. So very, very simple. The use cases are unfolding quite naturally. Are they going to, you know, develop 125 trillion or so of B2B payments? No. Is there a significant chunk within that that is addressable by their various payment assets? Yes.

Catherine: [00:19:17] Peter, I’d like to come back to you because you teased at the topic of regulatory risks, and I’d like to dig a little deeper on that one by starting with a closer look at the European Payments Initiative. How do you think that will impact the space?

Peter: [00:19:32] I think there’s kind of a question of how serious are the European banks about the European Payments Initiative and also what’s their incentive? I mean, we’ve already seen some of them pull out. There’s a chance that maybe this never even gets off the ground. You know, as actually Eric had commented on a prior Third Bridge interview we ran. Let’s assume they do get off the ground, though, right? It’s not necessarily going to be a scale network or pose material threat to Visa or MasterCard on day one. You know, if anything, they might see modest share losses, but probably not material. I do think, too. And Eric, I’ll throw it over to you now. But there are also questions outside of the European Payments Initiative, maybe whether European regulators would also potentially look to cap other fees or put on other sanctions and maybe more of a question of kind of when and how as opposed to if.

Eric: [00:20:17] Right. So the European Payments Initiative is a purely political project. The idea basically stems from the European Commission and to a lesser extent, the ECB are viscerally hostile to Visa and MasterCard in much, much the same way they’re hostile to dominate American domiciled tech giants, the European Commission and the ECB, to a lesser extent, view payments as a kind of a public utility. They have implemented a variety of regulations over the last several decades intended to, frankly, to hurt Visa, MasterCard, which have had the unintended consequence in general of advantaging them relative to national competitors. The European Payments Initiative doesn’t offer any compelling business case for banks that are participating in it. They’re participating simply to be good European banks. This is much like Monet (?), which was a payment network of a consortium of 24 Western European banks. The European Commission and the ECB cheered it. They refused to give the 24 banks that were participating in Monet any forbearance on interchange. And so essentially with the API and with Monet before it, the regulators are asking banks to shell out billions of euros to build a payment system that out of the gate and for the foreseeable future would be inferior to the existing systems that they use. If there is a bright note here, EU regulators have been unwilling to take the measures that some regulators in other countries have taken to ensure the national champion succeeds. So in China, Chinapay is the biggest card payment network in China because it’s the only card payment network in China.

Eric: [00:21:52] Notwithstanding China’s 2001 WTO commitment to open up the Chinese market, I believe it’s still the case that there hasn’t been a single Visa or MasterCard domestic transaction in China. Chinapay lost in 2002. It’s not hard to build critical mass if you have a state enforced monopoly. But the European regulators are torn because they have their professed liberal principles and explicitly banning or disadvantaging. They can’t they can’t go there. You know, Peter touched on other things they might do. They have capped interchange fees at 30 basis points to 20 basis points for credit debit, respectively. It’s harmful for the system. But Visa and MasterCard certainly and the national systems can weather that they have looked at or looking at payment network fees. And I think one has to worry they have a greater comfort than U.S. regulators in being very prescriptive and imposing price controls and mandates on pieces of the ecosystem. But Visa and MasterCard in Europe are the only genuinely pan-European payment systems, and there are national systems in most of the Western European markets, a number of national systems is shut down, unable to, banks were unwilling to support them. Essentially, if you think about them as their redundant cost and if the banks aren’t willing to continue to underwrite that cost, they can convert to the global systems, get all the utility, they all have to co-brand all of their card products anyway to have pan-European acceptance and global acceptance.

Catherine: [00:23:20] Peter, I saw you chuckling when Eric spoke about China and the protectionism that we’re seeing there for their own local payment system. Is that something that we’re seeing in other markets as well, this sort of rise of payments, protectionism?

Peter: [00:23:33] Russia and Ukraine and the conflict there could be a defining moment. Think about this way. Card networks are systemically important. Imagine if in the US or Catherine, in Germany. Imagine if for a day you couldn’t process card payments. Think about how disruptive that would be for almost all consumer facing businesses, right? And I think given the reaction we’ve seen in the form of regulatory band sanctions, you if you’re a government, you may be thinking about how to mitigate that risk, how it will materialize a little bit to time, but certainly something to keep an eye on.

Catherine: [00:24:03] When we were sort of thinking about this conversation, we were thinking about some of the regulatory risks that the space might be having to deal with. We also spoke about interchange pressures in the US. Eric, what is your take on that?

Eric: [00:24:16] So, you know, the war on interchange in the US and globally being waged by the merchant lobby, by regulators and by some self-anointed consumer activists is never going to end. I mean, there’s no victory here. There’s no like, you know, kumbaya moment where we all get along. Right now, the activists are claiming that interchange is driving inflation, which is preposterous, of course. There is a push to, there was a movement, there was an attempt during COVID to have credit card interchange tucked into the first COVID relief bill that didn’t go anywhere, thankfully. There is a attempt by large banks in the US so Chase, B of A, Wells Fargo, Citi to persuade the Fed to deny market debit interchange to co-branded debit cards that FinTechs and Neobanks are using. This is where a Square, a Chime, a Paypal Venmo partners with the community bank so that they can enjoy market interchange, which is the primary source of revenue for these products. And there are quite many of these are quite successful and the large banks are rightly worried that this will cost them transaction share if not accounts. And rather than lobbying for repeal, the Durbin amendment, which is the piece of Dodd-Frank which imposed debit interchange caps or lobbying to extend it to these programs, almost certainly the Fed is going to pretty soon make an adjustment downward in the existing debit interchange caps.

Eric: [00:25:43] The Fed, the statute calls for the debit interchange price caps to be reasonable and proportional to issuers incremental processing costs. The existing caps are set at $0.21, plus $0.01 fraud recovery plus five basis points. The Fed has surveyed US issuers on their cost five times since the law took effect. Every time the Fed has surveyed issuer banks, their reported issuer processing costs have fallen. Nevertheless, the Fed has not made adjustments adjustment. So I expect we’ll see something there. Will there be credit card interchange regulation? I think that would be very politically difficult right now to implement. If there were 60 Dick Durbin’s in the Senate, yes, we’d have it. And I suspect this administration would be fine. But we don’t. 

Peter: [00:26:28] Yeah, look, you know, to Eric’s point, I think the merchants had their way, right, there would be a cap on interchange tomorrow. I think what’s interesting and Eric kind of alluded to it being maybe the most politically sound thing to do today. As much as the merchants want it, it may not lead to benefits for the consumer, but I’m personally sceptical if interchange got cut tomorrow that consumer prices would be lower, for example, at least not in the US. And you also have the consumer. We love our credit card points here in the U.S. How does that get paid for, right? 

Eric: [00:26:57] Peter, it’s anti-consumer. And the industry has not made that affirmative case. But in Europe, if you looked at changes to credit debit card programs after the price caps took effect, they were universally negative. They were increased fees on cardholders. They reduced benefits, rewards say. Same thing in Australia. When the Australian Central Bank imposed an interchange, a credit interchange reduction, banks raised fees, they reduced rewards. And so, you know, interchange funds, issuer innovation, it funds consumer benefits. And tellingly, some of the folks who voted for debit interchange price caps understood that. So House Financial Services Committee Democrats chose to exempt government benefit cards and general purpose reloadable prepaid cards because government for them was a sympathetic constituency. And the general purpose reloadable prepaid cards are targeted at serving the un- and underbanked. And they understood this was an acknowledgment that if you cut interchange, you make these products which are doing good things less economically viable.

Peter: [00:28:02] I’m not going to say we’re addicted. But there was even a piece in the Wall Street Journal this weekend about ways to maximize travel points from credit cards. There are several full service businesses who all they do is help you optimize points. Now, I think there is one other important thing to note here, and the last thing I would add, let’s assume a scenario where there is a hard interchange cap, right? Regulators come in interchange for debit and credit maybe gets cut. I mean, who does that hurt the most, though, aside from consumers? It’s probably the issuing banks. I mean, the networks themselves take the smallest part of the transaction. It’s more so the issuing banks, potentially the merchant acquirer that are likely to be materially hurt from that.

Catherine: [00:28:40] I feel we’ve hit a nerve here with the conversation around interchange pressures. I’d like to, gentlemen, however, move us along a little bit because I want to give our listeners an opportunity also to hear your thoughts about some of the new technologies that we’re seeing coming into this particular space. Can you, Peter, first of all, give us an overall technology outlook. Where do you think things are going?

Peter: [00:29:03] Maybe I’ll start with A2A or account to account payments. I think that that seems to be kind of the most prominent one. So for those unfamiliar, the idea of this is, is why do we need a card network or anyone else, for that matter as an intermediary. Why can I just send money directly from my account to yours? As you could imagine, if I was able to do that, that presents a bit of a disintermediation risk for Visa or MasterCard. You know, you’ve seen Visa take action here, material move they made when they purchased Earth Port in 2019. That gives them actually one of the largest kind of independent FX networks with cross-border reach, which is a very, very tough element to build out. They also tried to acquire Plaid last year, although that was blocked by the DOJ. That would have given them access to a network that connects FinTech apps to bank accounts. So they’ve taken action to mitigate that risk. And they’ve also been focused on this idea of how do I become kind of the network of networks, so supporting any type of payment from anywhere. So whether acquiring, building, partnering these companies or looking to address that risk, wherever that may be. Now, even in a day, let’s assume that’s an option at the checkout. Now there’s another good question here of how do you incentivize the customer to actually use it? Again, we’ll go back to the previous discussion interchange and the benefits. Even if I could give my money directly to a retailer, why would I do that if I’m getting 2% cash back from using a Visa credit card? 

Catherine: [00:30:21] Eric, give me your take on let’s start with crypto and digital currencies. What are your thoughts when it comes to the future of those two asset classes?

Eric: [00:30:31] So cryptocurrencies were hyped by evangelists and still are hyped to some extent as revolutionary payment systems that we’re going to disrupt upend, Visa, MasterCard, Western Union, MoneyGram, Fiat currencies, the euro, the dollar. Nonsense. They’re not fit for purpose as payment systems. There are no compelling listed use cases. They don’t have critical mass. Their governance or in many cases, lack of governance is a bug, not a feature. They have performance issues. You can’t find a well served, rich developed market where cryptocurrencies have a rounding error in retail payments. So crypto is not a meaningful threat to the existing digital payments ecosystem. As an asset class, you know, it’s an interesting speculative, I would underscore quote unquote investment. I guess my view has always been a bit of the greater fool theory that there’s someone who’s willing to pay more for it next month than I paid for it this month. But I would just say with conviction, cryptocurrencies are not fit for purpose as payment systems in terms of other digital currencies, you know, stablecoins, which is electronic tokens that are attached to something that is more stable, typically a fiat currency. The idea being that if they are not volatile, that overcomes one of the deficiencies of crypto. It’s early days. Stablecoins today are principally used or almost exclusively being used to trade in and out of crypto.

Eric: [00:31:59] They’re not being used for retail payments. Libra Diem, this is the Facebook Diem Association, stablecoin, The Diem Association threw in the towel on that earlier this year. That was interesting. It had promise because of the size of the platform of Facebook, but that failed. And then we have to, I guess, touch on CBDCs, Central Bank Digital Currencies. There are a couple of central bank digital currencies which are live, one in Nigeria, there’s one in the Bahamas, there’s one, the eastern Caribbean Central Bank has launched one. And this is a token issued by the central bank. So it’s a central bank liability, just like physical cash is. And the idea is that this will displace some physical cash which compete with electronic payment systems. I think it’s early days. I think that there really are a lack of compelling use cases. So the argument there is an argument at the Fed in the US about whether the Fed should launch a digital dollar. The case that the advocates make really doesn’t bear scrutiny, which doesn’t mean they won’t do it. They will be congressional authorization. So I think the existing payment system works very well. And at least the technologies that we’ve cited here are not real threats anytime soon, if at all.

Catherine: [00:33:15] Peter, Eric mentioned or Eric spoke about crypto and digital currencies as disruptors in the space. First of all, do you agree with that assessment? And then second of all, what are the disruptors? What have come and been successful, come and gone because they weren’t successful? And what do you see sort of coming up on the horizon?

Peter: [00:33:35] Even in markets like El Salvador, right, where they basically force merchant acceptance, they made it a currency. They even went out and bought Bitcoin raising debt and then also gave everyone in the country the Chivo, the national virtual wallet that was preloaded with Bitcoin. I would struggle to find anyone that said that project’s been a dramatic success. So in summary, I don’t think we’ve seen material adoption by consumers and merchants and customers kind of prefer payment methods where there’s almost certainty of acceptance.

Peter: [00:34:03] Imagine how tough it would be today to build out a competing network to Visa or MasterCard. You would need to establish billions of consumer relationships, albeit largely through issuing banks. Millions of merchants globally. It’s just really tough to replicate a business like this at scale. And again, when you think about the network effects that Visa and MasterCard have, the more merchants who accept the cards, the more consumers want them, and the more consumers who use them, the more likely merchants are to accept them. So high barriers to entry. And then also really from a regulatory and commercial perspective, each additional payment method a merchant chooses to accept adds complexity. And as much as I like to joke that, particularly on some of these e-commerce sites today, the checkout looks like a NASCAR car with the number of logos plastered around it. You know, there are only so many types of payments that they’ll take on at the end of the day. And Visa and MasterCard are already well entrenched at the checkout. So is it possible? Yes, look, absolutely. But, you know, business is kind of forever over the arc of time. I just don’t see anything near-term that poses a serious threat. The only other thing, Catherine, that does get brought up from time to time, or at least again it did and people would give me more pushback six months ago is buy now, pay later? And I wouldn’t say it’s failed yet, but, you know, a lot of people viewed it as potential threat, younger generations prefer to use buy now, pay later over kind of traditional debit or credit card rails. But we’ve been hearing from experts even back in 2020 that made us kind of a little bit sceptical, right. So whether that’s intense competition, hurting MDR, merchant discount rates, which is essentially the revenue that the BNPL providers receive and eventually rising interest rate environment, which we’re in now pressuring funding costs. There were a lot of concerns around the path to profitability, you know, even before, by the way, a potential recessionary environment where your defaults start to climb. So verdict’s still out. The markets, I think, have started to speak a little bit. Klarna was just written down from 45 billion to 15 billion in private markets. Firms been hit hard in public ? with the share price and also their convertible debt now busted. It’s funny, we spoke to an expert who formerly worked at some of the private label and co brand names and he basically commented, buy now, pay later, it’s just sales finance, all dressed up with no recollection of a recession. 

Eric: [00:36:17] It’s also worth mentioning that most of these systems and their weak payment systems and their, you know, maybe sketchy credit, short term credit systems, most of them generate incremental transactions, in fact, for the traditional card networks, both at retail. So if we look at the Apple Pay later construct, a typical Apple Pay later transaction is going to generate up to six card payments. So is it competing? Yes. Are they leveraging the existing networks? Absolutely.

Catherine: [00:36:46] Thank you very much to both of you on that one. We like to wrap up our conversations on the podcast by giving our listeners an outlook on what the space might look like in 5 to 10 years time. And I know it’s really mean putting you on the spot and asking you to do a sort of a crystal ball gazing exercise when we all know we don’t have that crystal ball tucked away safely in the corner cupboard in our study. But Eric, when you think about how the space is developed over the last 15 to 20 years, what are your expectations for the future?

Eric: [00:37:17] Well, I think what the last couple of decades provide pretty good trajectory. So the dominant payment systems are now for profit, no longer shackled by bank association culture. They are in a world that is chock full of payment growth opportunities. I think that over the next decade or so, ten years from now, there will still be two dominant retail payment networks, the same ones we have today. They will be bigger. Will they be boxed out of some markets? Yes. Will they have broken into some domestic markets? Yes. Will they have been successful in developing some of these adjacent opportunity spaces? Absolutely. Will some of them perhaps disappoint? Probably. The regulatory environment ten years out will probably be more negative. But the existing payment landscape patchwork of networks won’t look that different. More electronic payments, less physical cash. But physical cash will still be with us.

Catherine: [00:38:08] Peter, do you share that optimism when it comes to the space?

Peter: [00:38:11] Not to give an anticlimactic answer, but yeah, probably similar to the trend line you see today. I mean, the world’s almost certainly going to be more digital like Visa and MasterCard will probably make some inroads on new payment flows and services, albeit kind of gradual progress. And I think not that the big loser is cash, but I don’t know that cash will be king. You know, maybe a little bit more junior down the line. Catherine, the other thing too, and this is less of a kind of a five year plus view, more of a next 1 to 3 year view. Look, obviously, a recession would have an impact, right? So the most notable one being on discretionary spend and transaction volumes. That being said, it could also be an opportunity for Visa and MasterCard. And the reason why I say that is, you know, both of these companies have been fairly acquisitive over the last several years and they’re going out and purchasing, whether it’s companies that give them additional reach or kind of new technologies. There are a lot of fintech names and I put fintech in quotations because not all of them are truly fintech. They want the tech for the higher, the higher multiple. But there are a lot of names that are going to fall into trouble here and could get a lot cheaper and potentially go up for sale. And that could actually be a large opportunity for Visa, MasterCard or really any other large strategics in the space as well.

Catherine: [00:39:23] Now, both of you throughout the conversation have frequently referenced Visa and MasterCard. I think we’ve established very clearly that they are the two dominant players in their space. But can I ask you what else or who else should investors be watching beyond those two players? Peter, from your perspective?

Peter: [00:39:40] I think out of the kind of the remaining two, at least in the US, I would watch American Express. They have made very concerted efforts to become a more holistic banking offering for businesses. They acquired a company called Kabbage a couple of years ago, which is essentially an SME lender. They’re trying to move more into kind of debit and checking accounts for businesses. So I would just keep an eye on what they do with with small businesses in particular in the US. Might be interesting.

Catherine: [00:40:06] Fantastic. Thank you very much. Eric, you’re one to watch.

Eric: [00:40:09] One to watch, I guess rather than say one to watch, I would watch some of the traditional processors that are trying to build some platform economics into their businesses. Some of the processors, in fact, own weak payment systems. The larger processors process on both sides of the payments ecosystem serving issuers, serving merchants and if any, are truly successful in engaging and adding value on both sides. I think you start to get some interesting network effects there. And I say if because culturally the traditional players have trouble with this and we can see this with Square Cash app and with Venmo, more clear attempts to do that. But if you look within FIS and Pfizer and within Global Payments, you look at Worldline in Europe in Nexi, they have assets across the payments value chain. There should be more leverage in those businesses and I say should be. I mean, I could have made the same observation, you know, five, ten years ago.

Catherine: [00:41:08] Thank you very much. As usual, I feel we’ve only just scratched the surface of what is an incredibly interesting, but also an incredibly complex sector. And unfortunately, that’s all that we have time for today. So I’d like to say a huge thank you to both Peter and Eric for sharing your experiences and your insights, and thank you to all of you listening to this episode of The Signal presented to you by Third Bridge, the world’s leading independent research provider. Join us in a fortnight for the next episode. And in the meantime, please rate review and follow our podcast. And indeed, if you like it, tell a friend. Find us on Spotify, Apple Podcasts and wherever else you get your podcasts from. Also on thirdbridge.com/signal. From me, Catherine Ford, that’s goodbye and until next time.