- Global payments revenue pool grew 11% in 2017 to reach US$1.9 trillion driven by strong growth within emerging markets;
- Going forward, growth is expected to moderate to 9% p.a. with revenue pools reaching ~US$2.9 trillion by 2022;
- In this first of a five part series, I will share some interesting insights into the market dynamics, revenue pools and how they are shared, future trends and key growth opportunities;
- I will specifically zoom in on interchange fees, which are currently worth ~US$400 billion and growing at 12%;
- Although the U.S. market is the biggest, contributing ~US$90 billion of the global interchange fees, Asia Pacific is the fastest growing region as the adoption of non-cash payments increases, specifically mobile payments. Interchange revenue pools within the region are expected to grow at 24% p.a. between 2018 and 2026
The cookie smells too good, even for the Oracle of Omaha
Warren Buffett just couldn’t resist the lure! In the last two months, Berkshire Hathaway deviated from its tradition and invested over US$600 million into two payment companies: Brazilian fintech, StoneCo and India based mobile payment company Paytm. To be fair, it wasn’t Mr. Buffett who led the two transactions but he surely gave them his blessing. Berkshire Hathaway has historically shied away from early-stage tech plays but these fintech companies gave the company an irresistible opportunity to nibble at one of the fastest growing industries in the world and more importantly, within two of the fastest growing regions.
According to consulting firm, McKinsey & Company, global payment revenue pools grew 11% in 2017 to reach US$1.9 trillion driven by strong performance from emerging markets, specifically Asia Pacific and Latin America. As technology and mobile penetration advances, the transition to a cashless society is gathering momentum. In most countries today, consumers can now swipe/tap their credit cards and cellphones to pay for anything and anywhere, negating the need to carry cash. Furthermore, rising e-commerce volumes as companies migrate online are providing secular tailwinds towards the noncash market segment and with it, a strong growth in interchange fee revenue pools. The graph below provides a depiction of the growth in the global payment revenue pools since 2006.
Interchange fees: Understanding the dynamics
Every time you swipe a credit or debit card or click “buy” on a website, a series of events are triggered to move the money from your account to the merchant’s account. These events generate ~US$400 billion in revenues each year, in the form of interchange fees, which are shared among the various parties including the your bank, the merchant’s bank, payment networks like Visa or MasterCard, payment processors (either independent or the acquiring banks themselves) and payment aggregators and gateways like StoneCo, Paytm, Stripe and Square Inc. As the world moves towards a cashless society, growth in interchange fee revenue pools remains robust and is expected to average 12% p.a. over the next five years, reaching US$700 billion by 2023.
Interchange fees usually amounts to 2-3% of the purchase price for credit card and US$0.24 cents for debit card. Most countries have a four party system: 1) the customer, 2) the customer’s bank, 3) the merchant and 4) the merchant’s bank. Payment networks like Visa or MasterCard and the payment aggregators and gateways sit in between to facilitate the payments.
Below is a high level description of how the process works:
- The customer submits their card details for payment. The payment aggregator or gateway provides the technical components needed to accept the payment e.g. a physical PoS terminal or a payment gateway on a website;
- The aggregator / gateway sends the card details securely to the payment processor, who is either an independent company or the merchant acquiring bank;
- The processor passes it to the payment network who in turn routes it to the cardholder’s bank for approval;
- The transaction result will be relayed back to the payment network, processor, and eventually the payment gateway;
- The gateway will store the transaction result and will present them to the client and merchant. Simple indications will show this transaction as approved or denied (with a certain explanation, e.g. “insufficient funds”);
- As soon as this process completes, the settlement process starts. The issuer’s bank will send the approved funds to the payment network, which in its turn sends it to the merchant’s bank;
- The merchant’s bank completes the settlement by depositing the funds to the merchant account. This settlement process usually takes 2–4 business days.
So who pays the fee?
Well, it depends who you ask. On paper, the retailer pays the fee in the form of a merchant discount but in practice, the customer ultimately foots the bill in the form of higher prices. Consider for example, on a R100 transaction, the retailer is charged a 2.75% processing fee (R2.75), meaning they take home R97.25. Retailers are happy to pay the interchange fees because:
- Multiple research by consumer organizations has shown that customers spend more money when they are swiping, compared to when they use cash; and
- The cost and risk to the retailer of handling cash is 2 to 4 times higher compared to the interchange fees they are charged for card swipes.
Ironically, banks normally use these swipe fees to finance their lavish rewards system for example, eBucks or Ucount rewards, which they offer to their credit-card holders, who in turn are more willing to pay hefty annual fees for the privilege.
How are the revenues split between the various players?
The majority of the 2.75% fee goes to the customer’s bank. This is because for credit card purchases, the issuer bank assumes most of the risk by loaning the consumer the money for the purchase. On average, card issuers charge ~1.75 to 2.20% (about R1.75 to R2.20 in this example). The payment networks take their cut, about 0.13% which translates to R0.13 here. The merchant’s bank and/or payment processor also charge 0.13% + R0.06, meaning they take home R0.19. The remainder of about R0.55 goes to the payment aggregator/gateway. The diagram below gives a visual depiction of how the cake is sliced up, courtesy of Plaid
Long term growth opportunities
Is cash still the King? Well, at least for now it is but its sinking. According to a report by the Federal Reserve of San Francisco, 32% of all consumer transactions are in cash, down from 40% in 2012 as consumers increasingly adopt electronic payments methods in their daily routines. In terms of volumes, households make approximately 78.6 non-cash payments per month, about 95% more than the 40.3 non-cash payments they made per month in 2000. In total, this corresponds to 117.5 billion consumer payments now versus 50.7 billion in 2000, a compound annual growth rate of 5.8%.
North America, Western Europe and developed Asia-Pacific regions are leading the adoption of non-cash payments. Approximately 55% of consumer transactions in the U.S. are now non-cash payments, developed Asia-Pacific and Europe are both about 35% with Sweden for example, aiming to be cash-free by 2023. The table below by research house Statista, shows the proportion of cash and non-cash payments worldwide by region. It highlights the scope of opportunities in Africa, emerging Asia-Pacific, Eastern Europe and Latin America
Proportion of cash and non-cash payments worldwide by region
A comparison by BCG revealed that average annual payments revenue per capita in North America is US$900, whereas in Asia-Pacific , its only US$100. There is significant potential upside to grow interchange fees revenue pool within Asia as the adoption of non-cash payment methods picks up and real disposable income rises. Consulting, technology and outsourcing services company, Capgemini forecast that growth will average 10% p.a. between now and 2028 with much of it coming from mobile payments and contactless technology.
How fintechs are getting involved
Hungry for a slice of those interchange fees, at least 10 companies have joined the global payments market since 2015, a research by payments consultancy firm, Blue Leviathan, revealed. There are broadly three types of fintech start-ups entering this space:
- Pure play offline payment aggregators like Square Inc. and PagSeguro
- Online payment gateways like Stripe and Adyen N.V.; and
- Mobile payment gateways like Alipay, WePay and Apple Pay.
Other companies like StoneCo and PayPal play in both the offline and online segments.
Offline payment aggregators: Doing a piranha on the banks
Payment aggregators are disrupting the industry by enabling smaller businesses to accept credit card payments which they have historically been unable to. This is primarily due to acquiring banks requiring merchants to meet certain volume threshholds in order for them to qualify as customers. I have previously written about this, you can read my thoughts here.
Through using credit card readers which can be plugged into any smartphone or tablet and effectively turn them into a portable PoS terminal, small businesses can now accept non-cash payments. Although individually they typically have low transaction volumes, but when you aggregate them, they provide a lucrative market segment. Today, the two fastest growing fintechs in the space, Square and iZettle are processing over US$130 billion in combined payments each year generating over US$1.4 billion in revenue.
Online payment gateways: Riding the e-commerce wave
E-commerce is on the rise. The U.S. non-food retail market is the largest in the world at US$1.7 trillion and growing at 3% p.a. driven by robust consumer demand and rising household wealth. Of that, the offline (in-store segment) is still the largest at ~US$1.4 trillion but the online segment, at ~US$300 billion, is growing rapidly at 15% p.a. over the next 10 years and is expected to reach US$1.2 trillion by 2028.
As more companies migrate their businesses online, there is money to be made by online payment gateways. Every time you hail an Uber ride, pay your monthly Netflix or Spotify subscription, book a holiday on Booking.com, buy a plane ticket or purchase anything on eBay to name but a few; fintechs like Adyen, Stripe and StoneCo with their end to end payment infrastructure enable these companies to accept credit card payments on their websites. They provide full payments intermediation, processing the back-end payment services for businesses using their technology, which means users never interact with them directly.
Over the last three years, payment gateway companies have grown their Gross Payment Volumes (GPV) by at least 40% year on year. In 2017, online global card purchases totalled ~US$3.45 trillion, a growth of 15% compared to the previous year. According to research firm eMarketer, as more transactions shift online, this segment is expected to maintain its current growth rate until 2025. In essence, we are looking at a Total Address Market of US$10.5 trillion and assuming a 0.5% transaction fee, this will translate to a revenue pool of over US$50 billion
Mobile payment offerings: Asia is leading the way
Further shaking things up are mobile payment offerings like Apple Pay, Alipay and WePay which enable people to pay for anything by simply tapping their phones. The mobile payment business is booming in China with Alipay and WePay dominating the space and account for over 90% of the mobile payments market. In the Asia-Pacific region as a whole, online sales reached US$1.4 trillion in 2017 driven by higher internet penetration and rising real disposable income. Mobile payment solutions open up digital payment services to the wider population and enable retailers to offer more payment options to their customer. Growth in Asia is robust and is showing no signs of slowing down; the market expects it to grow at 30% p.a. over the next five years which will translate to an interchange revenue pool of ~US$25 billion.
Payments continue to be one of the most important and fastest growing areas of the financial services sector. The segment presents an interesting investment play for investors across all four vectors. Offline payment aggregators, online payment gateways, payment networks and mobile payment offerings. Looking forward, the future looks so appetizing that even the Oracle of Omaha couldn’t resist the lure…
In Part 2 of this series, I will look at the investment case for Square Inc, one of the fastest growing payment aggregator in the U.S. Part 3 will cross the Atlantic and analyse online payment gateway Adyen N.V. and in Part 4, I will look at the two Brazilian payment companies StoneCo and PagSeguro. Lastly, Part 5 of the series will look at the investment case of Visa and MasterCard, the payment network duopoly which controls over 80% of that market segment.
 McKinsey Global Institute – Global Payment Trends
 Inkwood Research – Asia Pacific Mobile Payment Market Forecast 2018-2026
 Source: https://fin.plaid.com/articles/major-players-in-payment-processing
 BCG Global Payments 2017 Report