Making I-Payments Pay

By Lauri Giesen

Bankers see opportunity in person-to-person Internet payments, but developing a profitable business model will take time.

By all rights, Steve Dieringer should be swearing off person-to-person Internet payments. The Bank One Corp. vice president was skeptical of the technology to begin with. And in a pilot program launched last year, Bank One experienced higher-than-expected expenses and fraud.

But the pilot also indicated genuine customer interest in a service that allows them to e-mail funds to each other. So while Bank One backed away from its original program, it plans to debut a new service this fall, complete with changes that address the flaws of its predecessor. "We've proved there's a market," Dieringer says. "There are a lot of people out there who are receptive to sending cash over the Internet, and we already have the infrastructure to assist them."

Dierenger's changing views about P2P Internet payments reflect an industry-wide uncertainty. Since 1999, many bankers have been looking at the rapid growth in these services and wondering if they should jump on the bandwagon. Three major institutions already have: Bank One, Citigroup Inc., and Wells Fargo & Co. But other big online players are holding back, uncertain whether there's enough profit to justify the investment.

The growth of e-commerce at the retail level has been hindered by the reluctance of both consumers and merchants to use credit cards to conduct small-dollar transactions. P2P technology clears away that obstacle by allowing individuals to transmit funds to each other via electronic mail. These payments can be made either on a credit card or through some type of direct debit from a checking account, using online debit cards, automated clearing house debits or "electronic" checks.

TowerGroup, a research firm based in Needham, Mass., predicts P2P transactions will surge from the current annual level of 100 million to four billion by 2005, representing a compound annual growth rate of 149%. While retail customers are the focus right now, particularly at popular Internet auction sides such as the one operated by eBay Inc., bankers involved with the technology think the more lucrative applications will come when small businesses get involved. TowerGroup, in fact, projects the fastest growth in I-payments will come from consumer-to-business transactions, as opposed to P2P.

Banks, however, need to figure out a profitable way to participate in this embryonic market. Bank One, for example, fared badly by charging a flat $1 per-transaction fee regardless of size and whether the customer used a credit card or debit card as the source of cash. Dieringer says the new pricing plan will better reflect the cost of service. Customers who transfer funds out of a Bank One checking account will get the service for free, but the bank will levy a charge for transfers from accounts held elsewhere.

Citigroup and Wells Fargo already use variable pricing. And Wells Fargo has the additional benefit of a 35% stake in Billpoint Inc., a San Jose, Calif.-based P2P payments firm that is also owned by eBay. It's not yet clear, however, how successful these systems really are or when they will become profitable.

Beyond the fact that flat transaction fees don't work, prospective market entrants don't have any tested and validated models to follow. The best approach at this point may be simple trial and error.

Pricing Issue

The P2P market didn't even exist before 1999, the year Billpoint and PayPal were launched. PayPal, the dominant provider, is owned by X.com of Palo Alto, Calif. Bank One's eMoneyMail and Citigroup's c2it services followed in 2000.

Other major players include Yahoo!'s PayDirect, First Data Corp.'s MoneyZap, and eCash Technologies. Bank of America Corp. and CheckFree Corp. are also collaborating on a P2P service that will be incorporated into their online billing program.

About 99% of today's P2P volume stems from online auctions, and that figure is expected to fall only mildly, to 95%, by 2005, according to TowerGroup. If P2P activity remains confined to auctions, as TowerGroup and other analysts expect, then the main I-payments opportunity for banks will come in the C2B category.

"Auctions started the business because participants had an immediate need for this type of payment, but a lot of other opportunities are opening up," says TowerGroup analyst Elizabeth Robertson. "For example, P2P technology will allow many small businesses that cannot currently accept credit cards to receive payments online." Small businesses need an online alternative to credit cards because interchange fees are onerous when applied to small payments, which constitute a major part of retail e-commerce.

The three big-bank players — Citigroup, Wells Fargo, and Bank One — also seem motivated by a desire to protect their positions as online market leaders from upstarts such as X.com. "Banks have to offer this service if they want to retain their franchises," asserts James Wells, a former banker with Citicorp, currently president of Wellspring Consulting, Glen Head, N.Y. "None of the Internet companies can match the banks in payment vehicles and the ability to combat fraud."

Consultant Scott Anderson thinks banks are already too late, however. "Banks are at a disadvantage now," says Anderson, a director with Norcross, Ga.-based Global Concepts Inc. "PayPal is the only company with much volume, and a lot of the early adapters have already chosen a provider. In the near-term, the nonbank players will dominate."

PayPal boasted more than nine million customer accounts in mid-July 2001, up from less than a million at the beginning of last year. How has the company been able to grow so fast? TowerGroup's Robertson says PayPal's current pricing is "below cost," a model the company is unlikely to be able to sustain.

But X.com spokesman Vince Sollito disagrees. True, PayPal doesn't charge for non-commercial applications, basically intended for individuals sending money to family or friends. But for transfers involving sales, including auction purchases, it levies 2.9% of the transaction cost plus 30 cents, paid by the seller. Sollito estimates that only 10% of PayPal's transactions are free and says the firm is covering its operating costs.

Be that as it may, pricing remains a controversial issue. Russell Wehrlin, senior vice president of Speer & Associates, an Atlanta-based consulting firm, says small transaction size makes it difficult to price P2P services profitably. "You need a good-sized transaction in order to justify the costs, particularly if you have to pay interchange rates on credit cards."

Damage Control

Bank One has grappled with this issue ever since it initiated eMoneyMail. At first, it did not require either the sender or recipient to be Bank One customers. The pricing model was based on a $1 per-transaction fee, regardless of payment size or whether the source of the transferred cash was a checking account or credit card.

The $1 flat fee proved insufficient when the size of transactions ran higher than the bank had projected. The mix of credit to debit was also much higher than expected — more than 80% of the volume consisted of credit card transactions. As a result, Bank One had to pay some hefty interchange fees when a transfer was made with a credit card issued by a competitor. On a $100 transaction, for example, the bank would pay $1.50 based on a 1.5% interchange fee paid to the issuer.

Some customers took advantage of these lenient terms to rack up frequent flyer miles by charging transfers to credit cards that provided the mileage points. Bank One, of course, had to pay the interchange. A lot of frequent flyer customers used the program to send large sums to themselves. They'd pay the $1 fee just to get the mileage credits," Dieringer says.

Dierenger declines to say how much money Bank One lost, but suffice it to say that the Chicago-based company is switching to a new business model centered on its own customers. Transactors who send funds out of a Bank One account will get the service free. Those who request funds from an external account will pay 2.5% of the transaction cost if the transaction exceeds $25. Transfers of amounts less than $25 will be free.

For the time being, fund transfers will be permitted only from checking accounts, an arrangement that avoids the whole problem of interchange fees. But Bank One does expect to add a credit card-based product later. Dieringer says it's likely Bank One customers will be able to send funds charged to a non-Bank One card, although those customers will pay a higher fee than if they had used a Bank One card.

The new P2P service is also designed to reduce the fraud problems Bank One experienced with eMoneyMail. The requirement that at least one party to a transaction be a Bank One customer should eliminate some of the threat from non-customers using stolen credit cards or fake accounts, since the bank can verify the customer's account information.

Another provision that should help in the battle against fraud is a requirement that Bank One customers who use the service be enrolled in Bank One's online banking program. This will allow the bank to use its existing authentication technology and passwords, Dieringer says, avoiding the cumbersome verification procedures employed by other P2P providers.

Portal Play

Citigroup and Wells Fargo sidestepped many of Bank One's problems by using variable pricing. Citigroup's c2it, for example, begins with a 30-day free trial, and then charges 1% of the transaction cost with a 50-cent minimum, levied on the sender. The charge is the same whether it involves a debit or credit transaction. C2it chief operating officer Anthony Jenkins expresses satisfaction with this model but acknowledges the possibility of future, unspecified modifications.

Citigroup is able to avoid excessive interchange fees because of its status as the nation's largest credit card issuer, with nearly 91 million card accounts at the end of last year. That penetration — about half of the 80% of c2it customers using a credit card rely on one issued by Citigroup — allows the bank to keep a big chunk of its interchange payments in house. Jenkins says banks that are not large national credit card issuers would most likely have to factor in higher interchange expenses when they set their prices for P2P service.

Citigroup has offered P2P payments at Internet portals owned by America Online and Microsoft Corp. since the fall of 2000. It is also working with several auction sites. These partners broaden c2it's customer base and lessen the fraud potential, according to Jenkins. "We have a good relationship with AOL, and it controls the quality of customers we see. That is not to say we are complacent about fraud, but the partner's customer knowledge helps."

C2it also benefits from Citigroup's far-flung international presence. The service is now available in 30 countries and is likely to be expanded further. Recent immigrants particularly use the service to send money to their families back home. Jenkins says the average size of these international P2P transactions is much higher than for domestic — about $500 versus about $50.

By early June, c2it had 60,000 users. "We've just started to ratchet it up, and we're averaging 1,500 applications per day," Jenkins says. "We expect to see a big step up soon." This fall, for example, Citigroup plans to introduce a debit card-based payment that will include a credit line. Longer term, the bank wants to integrate its electronic bill payment feature into c2it. That would allow customers to pay bills out of a multitude of accounts, as opposed to just their primary checking account.

Small Business Connection

Both Bank One and Citigroup have developed their P2P programs mostly in-house. Wells Fargo has chosen another approach: partnering with a technology firm, in this case, Billpoint. Wells Fargo purchased a 35% stake in Billpoint in 1999; eBay owns the rest.

The advantage of this arrangement is that eBay naturally promotes Billpoint's services to its customers, who are charged a variable fee for transactions that exceed $15. The formula is 2.25% plus 35 cents for credit card transactions and 1.25% plus 35 cents for electronic check payments. Transactions under the $15 limit cost a flat 35 cents each.

Wells Fargo declines to say whether the Billpoint relationship is profitable, but the company does tout the range of expertise brought to bear by itself and eBay. With 10 million customers, eBay understands online selling. Wells Fargo, meanwhile, contributes payments processing experience, including fraud-prevention skills. "We're able to check out the identification of the seller for the buyer, and we're able to confirm for the seller that the buyer is able to pay for the purchase," says executive vice president Debra Rossi.

While most eBay customers are individuals, Rossi notes that the distinction between private buyers and small businesses is blurring as people form small businesses to buy and sell on popular auction sites such as eBay. Capitalizing on that growth, Billpoint plans to expand to other online merchants, particularly small companies seeking Internet payment alternatives to credit cards. "Because our volumes have continued to grow so fast at eBay, we've stayed concentrated there," Rossi says. "Our next step will be other auction sites, and then we'll pursue other B2C applications."

Such optimism conjures up a sense of déjà vu for those bankers who recall how digital cash products were introduced in the mid-90s to facilitate small Internet-based payments between individuals and companies. Frank Trotter, now chief executive officer of St. Louis-based Everbank, an Internet-only institution, piloted the first digital cash program in the U.S. in 1996 as an executive with the former Mark Twain Bankshares of St. Louis. The provider of that system, Netherlands-based DigiCash Inc., filed for bankruptcy in 1998.

Trotter concedes the DigiCash technology was ahead of its time and excessively complex for users, who had to open a separate account. The current P2P offerings, which utilize existing checking and credit card accounts, "are much easier for banks to implement and for consumers to use," he says. "And the auction sites are providing a great place to start."

That's why some banks continue full steam ahead on P2P, despite the obstacles. "We've got the technology and payments systems in place to do this right," says Citigroup's Jenkins. "But we have to recognize that this is a marathon, not a sprint. It's going to take time to develop."

Ms. Giesen is a freelance writer based in Libertyville, Ill.

Copyright © 2003 by Banking Strategies, published by BAI.

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