Future Threat?

By Jack Milligan

To preserve their dominance and fend off new competitors in online payments, banks must leverage their strengths.

If banks are serious about maintaining their dominance in the payments system, they had better keep a sharp eye on the online space, because that's one area where competition is heating up.

Exploiting the impressive growth of e-commerce and the desire of many merchants to provide their customers with more online payment options at a lower cost, nonbanks like PayPal and BillMeLater are carving out a niche in the Internet payments business. At the same time, the e-check is emerging as an attractive payments alternative for merchants tired of paying high credit card interchange fees. The e-check is essentially a debit against the customer's checking account that travels over the Automated Clearing House network.

These and other technologies threaten to wrest more payments revenues from banks, which still rely on the credit card as their primary online payments product.

To be sure, there's no immediate crisis. The credit card remains the overwhelming payment method of choice for online purchases, and that dominance should last for several more years, given the cost of establishing new payment systems. Indeed, there are some experts who see no threat at all. "I don't think we need a new payments infrastructure," says Richard Cornelius, a financial service partner at the New York-based consulting firm Accenture. "The credit card works really well."

But complacency among banks could be a mistake. Only about 73% of U.S. households have credit cards, meaning that one-quarter of consumers are effectively cut off from the online marketplace. Meanwhile, large national retailers like Wal-Mart Inc. would like to offer their customers more online payment options, largely to help drive their Internet sales volume. And small merchants that do a modest amount of business through online auction sites like eBay Inc. are eager to utilize low-cost alternatives to credit cards, which many customers can't use anyway.

"Merchants are agitating for something different," says Steve Mott, chief executive officer at BetterBuyDesign, a Stamford, Conn.-based consulting firm. "They want a cost-based payment system. Credit cards are too expensive."

At some point, as merchants make their wishes known, banks will have to respond. Some have already tried. Both Citigroup Inc. and Bank One Corp. experimented with online person-to-person payment systems before pulling the plug in the face of PayPal's dominance.

The game isn't over, however. Banks can still prepare themselves for the electronic marketplace of the future by strengthening their core Internet banking product, particularly the online billing feature, which leverages banks' direct link to the customer's core checking account. There are also a growing number of electronic funds transfer services that banks can offer through third-party providers, which may be crucial if they want to continue being their retail customers' primary financial institution. The good news is that the online payments business remains in an embryonic state and banks still have time to adjust to the new competition.

Card Dominance

One of the most startling developments of the past few years has been the rapid growth of online retailing. The bursting of the Internet bubble in 2000 may have sent many dot-com companies to an early grave, but the business of e-commerce is alive and well.

The U.S. Department of Commerce estimates that online sales totaled $17.2 billion in the fourth quarter of 2003 (1.9% of total sales) — up 25% from the same period in 2002, and 29.7% ahead of the third quarter of 2003. By comparison, total retail sales advanced just 4.2% and 6.2%, respectively, over these same periods.

The plastic card is still the dominant payment option for online purchases. And card issuers (banks and nonbanks) have been rewarded handsomely by the growth in e-commerce. Gwenn Bezard, senior analyst with Boston-based research and consulting firm Celent Communications LLC, estimated in a recent report that issuers generated $5.7 billion in revenues from online payments in 2003, compared to just $1.4 billion in 2000. And by 2005, this same revenue stream is projected to hit nearly $9 billion.

Right now, the main challenge to this dominance comes from another form of plastic — debit cards, which are issued mostly by banks, since they're linked to the checking account. Bezard says that over 35% of all Visa and MasterCard transactions conducted on the Internet in 2003 were performed with debit cards, versus just 10% in 2001. Issuing banks earn interchange fees on these transactions, as with credit cards, but overall profitability is less.

Celent believes the growth of debit card issuance will plateau in the next few years as banks finish converting customers from ATM cards to check cards. This should halt the market share erosion of credit cards vis-à-vis debit cards. But then there are other potential challengers on the horizon.

Consider so-called person-to-person payments, or P2P, originally envisioned as primarily a way for someone to use e-mail to send a friend an electronic payment, say, $15 to settle a lunch bill. In practice, much of the activity in this space has actually been person-to-business in nature, i.e., consumers sending small online payments to merchants.

The largest P2P provider is nonbank PayPal, a unit of online auctions company eBay. The service claims to have over 40 million account members in 38 countries worldwide, although only a third of these are believed to be active.

PayPal's success, while undeniable, is more a testimony to the growth of e-commerce than to the depth of the P2P payments market today. According to TowerGroup analyst Elizabeth Robertson, 69% of PayPal's total payment volume in 2003 consisted of auction-related transactions. Rival services that lacked a strong auction affiliation like eBay have either been discontinued or grown more slowly than PayPal. For example, both Bank One with its eMoneyMail service and Citigroup with a P2P product called c2it tried to compete with PayPal and failed.

Wells Fargo & Co. remains in the P2P game, but with lowered expectations. The San Francisco-based bank provides a P2P-like capability to its own customers through its online bill payment service, which is set up to handle business-to-business transactions but can accommodate person-to-person transfers as well.

Mitch Christensen, an executive vice president for traditional payment strategies at subsidiary Wells Fargo Services Co., says the bank has seen only a modest volume of P2P transactions, although customers like it when they can be encouraged to use it. "I don't know that I'd say it has been a giant success," Christensen says. "I'm somewhat dubious whether, in the short term, there will be a lot of value created around this space."

For now then, P2P payments can't be said to represent much of a threat to banks. While PayPal is trying to sign up small merchants in an effort to capitalize on the growth of e-commerce (and lessen its dependence on eBay-related activity), the company doesn't directly compete with plastic, particularly since merchant acceptance outside of eBay is still low. In fact, many PayPal accounts are funded with credit cards.

There is a subcategory of the P2P market that may actually present banks with a major opportunity, since it's expected to grow rapidly. This might be broadly defined as electronic funds transfers that go directly from a customer's bank account to locations outside the bank. One example would be international remittances that are sent from the United States to recipients in other countries. TowerGroup estimates the global remittance market is growing approximately 10% a year, and should expand from $160 billion in 2004 to $194 billion by 2006.

Not surprisingly given the global nature of its business, Citigroup offers an international remittance service to its retail customers. Wells Fargo also provides a remittance service through an arrangement with Bancomer — Mexico's largest bank — in which funds are automatically transferred from a Wells' sweep account to a recipient Bancomer account. And Bank of America's SafeSend service enables any U.S. consumer to transfer money through a Visa or MasterCard credit or debit card to Mexico, with same-day availability.

E-Check Challenge

An online payments market with probably greater potential than P2P is the electronic check, which is essentially a debit against the customer's checking account that travels over the ACH network. Customers simply type the information contained on their paper check into the online order form. A growing number of merchants are providing e-checks as a payment option because it costs them less than a credit card or signature debit card transaction.

In his report, Celent's Bezard predicts that check authorization companies — which authorize e-check transactions and settle them through the ACH — will experience the fastest growth in the emerging online payments market over the next couple of years. That is a welcome trend for these companies, since the declining volume of paper checks has cut into their revenue.

It's also a welcome trend for merchants, who gain an additional payment option for customers who can't or won't use a credit card. Approximately one-fourth of U.S. households, or about 50 million adults, don't have credit cards and would have a difficult time shopping online, according to Margaret Weichert, vice president in the Internet services group at First Data Merchant Services, a subsidiary of Denver-based First Data Corp. "E-checks are ripe for growth because it's a good economic deal for the merchant, and because the market has matured for e-commerce," Weichert says.

According to Celent, the value of e-check-related transactions grew to $7.3 billion in 2003, from just $800,000 in 2000, and the firm expects volume to hit $17.9 billion in 2005. This would place e-check's share of the e-commerce market at 9% — a big jump from just 3% in 2000.

It's not hard to see why credit card issuing banks would look at the growth of e-checks with some trepidation. A card issuer receives between $1.50 and $1.80 for every credit card transaction, but nothing for an e-check that is processed as an ACH payment. "ACH is a good deal for merchants and customers," Bezard says. "But for many banks, it's not a good deal."

For that reason, banks may have to adopt a new pricing structure for ACH transactions if volume continues to grow as expected. Wells Fargo's Christensen says the growth of free checking — which includes free debit card transactions — could become a profitability issue for the industry as consumer deposits begin to flow out of the banking system and into the equities market. "As balances get siphoned out, and as the volume of ACH transactions increase, we may have to look at charging a fee," he says.

Others aren't so sure if this is a good idea. "We haven't had any discussions about charging for ACH," says Sara Hartman, executive vice president of electronic banking at Cleveland-based National City Corp. Hartman adds that banks have a strategic interest in doing what's best for customers, who have "said over and over they want pricing structures to be simpler, not more complicated."

"Who would pay?" asks Donald MacLeod, director of payment strategies at Charlotte-based Wachovia Corp. "Some would argue that the originator should pay. Some argue that consumers should. But I don't think that consumers will ever want to pay."

Yet another assault on card primacy comes from "instant loan" companies like BillMeLater, an online payment option developed by Timonium, Md.-based I4Commerce Inc. When a consumer shops at a participating merchant, all he or she has to do is provide a Social Security number and date of birth so that an immediate credit check can be performed. If approved, BillMeLater will send the customer a bill just as if a credit card had been used. I4Commerce settles with the merchant — just like an acquiring bank with a credit card transaction — and bears all credit and collections risk.

BillMeLater is 30% to 40% less expensive for the merchant than cards, according to Mark Lavelle, vice president for business development at I4Commerce. Merchants that have signed on with BillMeLater include eToys.com, Ross-Simons, Earthlink, 1-800-flowers.com and the ShopAtHome Network.

While 14Commerce might still be considered a niche player, this whole area of alternative payments is beginning to attract some bigger players. Earlier this year, for example, First Data began marketing a product called "First Data Encompass," which bundles several alternative online payment options, including BillMeLater, the Telecheck Internet Check Acceptance service and Verified by Visa, Visa's authentication service.

First Data is the largest processor of credit card transactions in the U.S. and could be hurt if card transactions decline. Yet it sees merit in positioning itself just in case these other payment options gain momentum. Weichert says that alternatives like e-checks and BillMeLater are bound to grow because they promise to lower the merchant's costs while driving up sales. "It's foolish to try to stand in the way of a market movement toward efficiency equilibrium," she says.

Leveraging the DDA

First Data's stance, in fact, could serve as a model for the banking industry. Although the profitability of many banks is closely tied to credit cards, it would be a mistake to defend that position at all costs. Consultant Mott, in fact, says card-based revenue has acted as a kind of "narcotic" on banks by increasing their dependence on cards and lessening their desire to create "faster, cheaper payments systems."

A better strategy would be to exploit some of the newer technologies for banks' own purposes. Wachovia, for example, is currently evaluating both P2P and international remittance services and may offer them at some future date, according to MacLeod.

The experience of Citigroup and Bank One in the P2P arena shows the risk involved in entering the alternative payments market in a big way. But banks can take the lower-risk route of preparing for an electronic marketplace in which their customers will be able to take advantage of all these new payment options.

For example, since banks still control the demand deposit account of their customers, it makes sense to leverage that access to the DDA in a way that allows customers to link to outside accounts and alternative payment systems. Any bank that doesn't offer online bill payment through its Internet banking product is probably missing out on an important opportunity to reduce customer attrition and build deeper relationships with its customers. Wells Fargo, as previously noted, offers its P2P service through online billing.

"There's still an incredible amount of untapped market in terms of bill pay from a bank site," says Carl Rutstein, a vice president at the Boston Consulting Group and leader of the firm's North American payments practice.

National City's Hartman says her bank has about 300,000 customers signed up for its online bill payment service, with about 100,000 active users. "It's definitely growing, although it's still not a huge number — not as large as check cards, for example," she says.

To leverage this online service, National City is now looking closely at providing its retail customers with an account-to-account transfer capability through a third-party provider. Hartman understands that National City could end up facilitating the flow of funds out of the bank, but says this will probably happen anyway.

"If a customer is going to transfer funds between institutions, they're going to do it whether you enable them or not," she says. "We don't see it as a huge risk. We know that how the customer transacts business is changing and we want to support that."

Some similar thinking can be seen at Citigroup. When the New York-based bank discontinued its c2it experiment, it found a way to offer customers a similar service by providing an account-to-account capability through third-party provider, CashEdge Inc., in Milpitas, Calif. The bank does not charge a fee for handling incoming transfers, but does charge $10 for all outgoing transfers, which is still cheaper than a wire transfer.

"It provides Citi with a revenue opportunity," says TowerGroup's Robertson, "but they also see it as an opportunity to consolidate their position as the customer's primary financial institution."

Examples such as this suggest that banks can preserve their dominant role in the online payment system if they're willing to take a creative approach and leverage their existing strengths.

Mr. Milligan is a freelance writer based in Charlottesville, Va.

Copyright © 2004 by Banking Strategies, published by BAI.

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