Analysts expect global payment revenues to grow to $2.5 trillion by 2025, according to McKinsey after returning to their historical 6 to 7 percent growth rate following the pandemic, which saw drops in global payment revenues of 5 percent, to $1.9 trillion in 2020.
The future of payments is changing, and many believe that cash is dead. The trend towards electronic payments only accelerated during the pandemic; a change that was already underway.
Many investors have taken advantage of this change by jumping on board the payments train by investing in such companies as PayPal (PYPL), Square (SQ), Visa (V), and Mastercard (MA), among countless others.
The payments space is crowded, competitive, and the pace of change is only accelerating. In today’s post, I wanted to unpack some of the players in the space to understand who is who and why they are growing in relevance. Today we will discuss the different terminology and how they interact along the payment processing chain so you can better understand the economics of that chain, along with any investment opportunities.
It can get a little confusing with the terminology such as payment processors, merchant banks, issuing banks, interchange fees, and payfacs, to name a few.
But, after reading today’s post, you will have a better understanding.
In today’s post, we will learn:
- What Is Involved in Payment Processing?
- Breaking Down the Payment Fees
- Key Players in the Payment Processing Flow
- Investor Takeaway
Okay, let’s dive in and learn more about the key players in the payment processing flow.
What Is Involved in Payment Processing?
Credit Suisse estimated in 2020 that the total opportunity, or TAM (total addressable market), for global payments totals $240 trillion across card payments, with the greatest expansion in Asia/Pacific, Latin America, and Eastern Europe.
That is a tremendous opportunity for a variety of players across the board.
So what is involved in payment processing?
Payment processing is the operation that occurs when we use a payment method such as a debit or credit to buy something online or in-person.
What does that look like when we swipe our card?
It all revolves in a cycle from the buyer (us) to our bank and back to the merchant, with a few stops along the way to ensure accuracy and fraud prevention.
The payment cycle begins with our decision to buy that present for our significant other for $100 from the jewelry store. From the moment we press the confirmation or buy button on the POS (point-of-sale) terminal or online, the process of authorization begins.
Next, the merchant (jewelry store) forwards a request to the acquirer, which the acquirer passes along to the card scheme (Visa/Mastercard) associated with our debit/credit card.
The card scheme or Visa/Mastercard forwards that request to our card issuing bank (JP Morgan), and JP Morgan checks to ensure we have the $100 in our account to pay for the gift.
If we clear that hurdle, the confirmation is sent back through the loop to the jewelry store, which submitted the request originally.
Along that path, there are several players:
- Merchant (jewelry store)
- Acquirer (Fiserv)
- Card Scheme (Visa)
- Issuing bank (JP Morgan)
All of those above players split up the associated fees by enabling the above transaction, and each player gets a different slice of the pie.
For example, the merchant that charges us the $100 for the item receives back $98, and the acquirer, card scheme, and issuing bank divvy up the balance of the $2.
Breaking Down the Payment Fees
The payment fees or that $2 is the slice of the pie that each component of the payment flow receives for their actions in the flow.
In many cases, it breaks down to pennies or fractions of pennies, but when you consider that Visa transacted over 188 billion transactions in 2020, and PayPal processed over 14 billion in the year to date 2021, those pennies will add up to substantial sums.
The total processing fees breakdown into three main groups:
- Interchange fee: the issuing bank takes the largest slice of the pie, called the interchange fee. These interchange fees will vary depending on various factors, such as the type of card used (credit/debit), industry, and sale amount.
Visa and Mastercard set the interchange fees, which they update on a bi-annual basis. At last check, there were well over 300 interchange fees and many breakdowns like this simple example; 2% of the sale volume + $0.10 per transaction. For our example above, that would work out as $100 x 2% + $0.10 equaling $2.10.
- Assessment fees: the fees that the card schemes such as Visa and Mastercard charge for their services. Visa and Mastercard include the assessment fee in the interchange fee, and many confuse the interchange and assessment fee as the same.
The typical rate for the assessment fee is 0.10% + $0.02 per transaction, so returning to our jewelry store purchase would work out as $100 x 0.10% + $0.02 equaling $0.12. They bundle the assessment fee with the interchange, meaning no additional fees to the merchant for processing a Visa/Mastercard card. The issuing bank (JP Morgan) pays Visa their assessment fee out of the interchange fee.
- Markup fee: this is the fee that the merchant acquirer or the payment processor charges the merchant for enabling the payment through their POS. The amount of the markup will depend on the type of industry, monthly processing volume, amount of sale, card type, and type of transaction (present or not present).
The typical structure for markup fees is as a percent of the sale plus a per-transaction fee. For example, 0.25% + $0.10, or back to our example, $100 x 0.25% + $0.10 equaling $0.35.
To further delineate the fees, both the interchange rate and assessment fee are non-negotiable, meaning that if you choose to process debit cards or credit cards with a Visa or Mastercard logo on the card, those fees are mandatory, and there are no negotiating them, with either your bank or Visa/Mastercard.
They are the cost of doing business if you are a merchant, and to allow payments; you need to accept both Visa and Mastercard branded cards because those are the cards your customers carry in their wallets, real or virtual.
The markup fees are the only negotiable fees, and you can work out different rates with the merchant acquirers or companies that help you process your electronic payments. Many acquirers will offer you different rates to get the merchant’s business, from lower rates if you process higher volumes to different rates for online payments versus in-person checkouts.
Let’s look at these economics in a chart to explain how this works for the different players along the chain.
At the end of the payment process, the jewelry store receives $97.55 after running the payment through the payment process, with the various players receiving their slice of the pie through the cycle.
Keep in mind the time from submitting payment to approval takes seconds, which is mind-boggling.
For a deeper dive into the mechanics behind the payment processing flow, check out the below link.
Remember that many of the different fees, over 300, depend on what card you use and how that payment processes. For example, there are different rates for debit cards versus credit cards, and whether they process in-person or card-not-present.
These rates also depend on which bank issues the cards, and the requirements behind the Durbin Amendment, which regulates debit card usage, and the fees charged for that usage.
Ultimately, you don’t have to memorize every type of transaction and fee; instead, it is important to understand the process and flow, the economics behind the transactions, and how those economics drive the different players in the flow.
Key Players in the Payment Processing Flow
There are five major players in the payment processing flow, some with different names, doing the basic job described in our jewelry store example.
Some players occupy more than one role in the payment processing flow, which can get a little convoluted, but I will try to clarify everything into a tidy box.
According to Worldpay, cards and digital wallets occupy more than 70% of e-commerce and 79% of in-store transactions, and across the payment value chain, there are five main players:
- Card network
Also known as the cardholder if they pay with a credit card or debit card. Customers are the end-user who begin the payment processing chain by initiating the payment with the merchant. Customers gain from the convenience of using electronic payments for goods and services online or in-person, sometimes in the form of rewards or cash-back on their purchases.
Think of the customer as the starting point of the payment cycle, and visualize yourself paying for your items at Target, online or in-person. We all know you can’t get out of Target without spending at least $100.
To accept any electronic payment, online or in-person, the business needs to open a merchant account. The merchant establishes an account with the acquirer to settle the funds or push the transaction through the cycle and back to Target.
Target gains from participating in that network by attracting and retaining customers with a fast and efficient checkout. Merchants are the customers at this point of the payment cycle; for example, Target uses acquirers to enable payments online or in-person to receive payments for their goods and services from us, the customer.
Examples of merchants abound, but here is a sample:
- Home Depot
The issuing bank, or issuer, is the financial institution, typically a bank, that issues cards to the customers. The issuing bank provides either debit or credit cards and makes payments on the customer’s behalf. The issuers also manage the payment authentication process, ensuring there are adequate funds to complete the purchase.
The issuers receive the transaction information from the acquirer and respond by either approving or declining the transaction. For approvals, the process involves making sure the transaction is valid, guaranteeing the card belongs to a cardholder, and that the account has enough funds or credit to complete the requested transaction.
And finally, the issuing bank or issuer sends a response code back to the acquirer through the payment network.
The issuer receives the largest part of the payment pie, receiving the lion’s share of the interchange fee, which Visa and Mastercard set.
The issuer receives the largest portion because they take on the largest share of risk in the transaction flow; by guaranteeing the payment, they assume any default risk.
The issuing bank often distributes their cards to cardholders with a particular brand, Visa or Mastercard, which allows them to process over those networks. There are other branded cards, such as American Express and Discover, which have their networks.
For example, Bank of America could issue their debit and credit cards with a Visa logo, while Capital One might issue their credit cards with a Mastercard logo.
The acquirer, or acquiring bank, is the bank or financial institution that enables payments for the merchants. They provide the merchant with the software and hardware to enable payments for the customers via a POS in the store or online through the merchant’s website.
The acquirer, also known as the merchant acquirer, is customer-facing, and they have a personal connection with the merchant to provide payment services. In many cases, they physically go to the merchant to sell them on processing their payments with their services.
The merchant acquirer uses their software/hardware to capture the transaction information and route it through the appropriate card network (Visa/Mastercard) to the cardholder’s issuing bank for transaction approval.
After approval of the transaction by the issuing bank, the merchant acquirer settles the payment with the merchant, typically within two business days. The amount settled with the merchant (Target) is less than the interchange fees, card scheme fees, and acquiring fees. Any additional fees associated with any refunds, reversals, and disputes will settle at the same time.
Here is where it can get a little confusing, the merchant acquirer can also be the issuing bank or issuer acquirer. That means that the same financial institution that issues your debit card also acts as the processor for Target.
In other words, they occupy two slots in the payment processing cycle and also take a larger portion of the processing fees they charge Target. So when looking at the processing cycle, JP Morgan occupies two slots, merchant acquirer and issuing bank.
Here is a list of stand-alone merchant acquirers, which at this point don’t offer their own plastic cards, for the most part:
- Fidelity National Services (FIS)
- Fiserv (FISV)
- Global Payments (GPN)
- Adyen (ADYEY)
- Square (SQ)
- PayPal (PYPL)
Below are acquiring banks or issuing acquirers; the terms are interchangeable, all of which also offer their own branded cards:
- Wells Fargo (WFC)
- Chase Paymentech (JPM)
- BMO Harris (BMO)
- Citibank (C)
To help make it a little more confusing, Square and PayPal, for example, also offer their own branded (Visa) cards, but because at this point they don’t have their commercial banking charters, they can offer their cards through a partner bank. That means the partner bank receives the lion’s share of the interchange fee as the issuer, but Square gets a small cut for enabling the use of the card through its platform.
Both Square and PayPal occupy different parts of the payment cycle, acquirer and issuer, depending on the merchant and the customer’s card use. That allows both companies to retain bigger parts of the interchange fee.
The card network is the payment rail that allows all payment activity to flow across those rails between the customer, merchant, and issuer.
There is the payment rail, also known as the card brand or scheme for every card swipe, chip-and-pin, contactless, online, or card-not-present. These card networks provide the means for all card transactions to occur, and in exchange for that access, all acquirers and issuers must pay a toll or fee.
The card networks pass along information and help settle funds between the acquirer and issuer. They also set the standards that all acquirers and issuers communicate (or protocols) and define all rules by which acquirers and issuers handle disputes.
The two most common card networks or schemes are Visa and Mastercard, which offer an open-loop system. The open-loop system connects to the customer’s account, credit or bank, and allows multiple payment options.
The other two common card networks are American Express and Discover, both of which are closed-loop systems. The closed-loop system links the card to a pre-paid account, typically a credit account. Both American Express and Discover act as acquirers, issuing banks, and set their interchange fees for merchants.
The final two terms you might hear thrown about in conversations about payment processing are:
- Payfacs or PSP: These providers offer merchants connections with multiple acquirers and payment methods like debit cards, credit cards, bank transfers, and others. The payfacs also integrate their technology with the merchant’s POS to seamlessly collect and manage their payments.
The payfac’s biggest benefit is the ease of use for the merchant; they offer simple turnkey solutions for payments for merchants, without the headaches of setting up all the technology and systems.
The two biggest providers of these services are Stripe and Adyen, with Square offering the same services to small and micro-businesses.
- Payment gateways: these companies offer a technical layer that collects the clients’ payment credentials on the merchant side and securely sends them to an acquirer. The leader in this space is Braintree, owned by PayPal.
The payments space is an exciting segment, and there is a ton of innovation and money spent to improve the way customers pay for their products and services.
The way we consumers pay for stuff is changing almost daily, and it is exciting to see how innovation and change are coming in the payments arena.
The main goal of new innovators is to remove friction for the consumer and increase the size of the wallet capture for merchants.
As investors, it is important to understand the economics of the payment space and the terminology so we can understand who is doing what and how that changes the economics of different companies.
For example, Square is creating a closed-loop system that would allow them to retain a larger portion of the fees associated with payment processing. If they can control the entire payment cycle, then they can capture that entire fee structure. In part, they want to do this to help grow their profitability, but they also want to lower their fee structure to allow the merchants greater profitability, which is a noble gesture.
PayPal is working towards the same idea, and many others, as they come online, will as well.
A great resource if you want to dive deep into this space is:
And with that, we will wrap up our discussion on the key players in the payment processing flow.
As always, thank you for taking the time to read today’s post, and I hope you find some value. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,