02. Mobile Payments: Sustainability of Business Models Payment Cards: Trends, Challenges and Innovations 25

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1 IN THIS ISSUE Mobile Banking and Payments Security and Usability: What's in Your Mobile Wallet? Innovation in Retail Payments Electronic Invoicing: How to Increase E-Invoicing B2B Transactions

2 CONTENTS Preface From the Editor s Desk Retail Payments 01. Innovation in Retail Payments Mobile Payments: Sustainability of Business Models Payment Cards: Trends, Challenges and Innovations Mobile Banking and Payment Security and Usability: 35 What's in Your Mobile Wallet? Wholesale Payments 05. Wholesale Payments: Trends and Transformation Electronic Invoicing: How to Increase E-Invoicing B2B 49 Transactions 7. Centralizing Wholesale Payment Services: The Key to 55 Improved Growth, Efficiency and Risk Management 08. Money Movement Automation: A Case Study Financial Institution Opportunities in Healthcare Revenue 73 Cycle Management Payments Transformation 10. Enterprise Payments: Breaking Barriers Top Transformational Trends in Check Processing SEPA: Outsourcing - The Key to Changing Times Payments Fraud 121

3 3 PAYMENT CARDS: TRENDS, CHALLENGES AND INNOVATIONS AMIT LOHANI SHASHI BHUSHAN BALWANT C. SURTI The US Payments Industry is continually moving away from paper payments to electronic payments (i.e., cards). Cards are usually classified into two categories - credit cards and debit cards. In the near future, rapid growth is expected in the debit card space. The card industry has always been innovative in its offerings, such as the Contactless Card, the Decoupled Debit Card, technology and product innovation, and changes in the business model. This paper looks into the key trends, the challenges faced by the industry and a few innovations of the industry.

4 Introduction When Capital One introduced the Decoupled Debit Card last year, the payment industry, considered well established with little scope for innovation, was challenged by this paradigm shifting debit card business model. With the innovation of the Contactless Debit Cards and Revolution Cards, the once mature payment card market was suddenly inundated with innovative new products. All of these new payment products have catalyzed innovation in the industry and challenged the established business models. Now, product innovation characterizes the payments space. In addition to innovation, the evolving payment industry has paved the way for increased use of cards in retail payments. Key trends in the payments industry include: a. Continued movement from paper to electronic payments Retail payment, other than paper (currency notes, checks, etc.), is finally becoming as acceptable as paper. It is proving to be more convenient and sometimes, the preferred means of payment (e.g., try renting a car with cash). Although the debate over whether electronic payment (this includes cards) can completely replace paper will continue, it is quite clear that the day of electronic payment has arrived. b. The debit card transactions are growing at a fast rate As electronic transactions grow, debit cards will correspondingly grow at a faster rate than credit cards. As per a TowerGroup report, between 2005 and 2007, the growth in debit card transactions has surged three times that of credit card transactions. Consumers use credit cards for higher ticket purchases, while debit cards are used for numerous small day-today purchases like gas, grocery, movie tickets, etc. The average transaction size for debit card purchases are US$ 40 compared to the US$ 84 purchases on credit cards. Debit cards have also been popular among the growing US Hispanic population. While the credit card market is largely mature and saturated in the US, the debit card space is a growing market. On an average, 50% of debit cards are actively used and active users conduct about 17 transactions per month. Transaction Volume Trends Fig % 80% 60% 40% 20% 23% 27% 31% 36% 42% 48% 56% 77% 73% 69% 64% 58% 52% 44% 0% Transaction Volume Credit Cards Debit Cards Paper Electronic Source: Celent Communications Source: ATM/Debit News EFT data book 26

5 However, the potential of debit cards is yet to be fully realized Competition, in the debit card space, is not intense as the rewards programs are not attuned to the programs found with credit cards. c. Customers are looking for new experiences and conveniences Card customers, are exposed to a world of convenience through the internet and have been surrounded with innovations, such as social networking. The old set ways of doing business no longer fit into this world, so changes and innovations are required. Contactless Cards offer convenience and save time. Decoupled Cards offer better rewards and choice. Chip embedded cards on mobile phones create the potential for the mobile phone to be the do-it-all device - voice, text, photos, videos, payments, internet, and music. The 'killer card' or the 'card killer' is still not here, but the crowd waiting for its arrival keeps on growing. These changes and innovations lead us to believe that we are undergoing an interesting phase in the world of cards, with a potential for change like never before. Key Challenges and Strategic Responses In recent years, the credit card market has witnessed slow growth and there is fear that the sub-prime crises will eventually cascade, affecting the market. The debit card space has been growing, but from a profit standpoint, it remains a subsidized product, not able to generate sufficient revenue to cover costs for the issuers. Such conditions explain the existence of poor rewards programs for debit cards. They also offer justification as to why the established players have not swiftly responded to the challenges posed by the Decoupled Debit Card. Prepaid Cards have evolved and continue to grow, offering better features and rivaling, in some Card Industry Key Challenges Fig - 2 Credit Cards Debit Cards Prepaid Cards Subprime credit crisis Decreasing growth of credit card industry Growing Competition Product Cannibalization Attrition New regulations and litigations Emerging Payment Models How to stop subsidizing the debit card product Increasing growth in the movement of customers from ATM to POS usage Competition from De-Coupled Debit Bank Card Industry Challenges Regulatory Obstacles - Anti-Money Laundering Laws - USA PATRIOT Act - FDIC - Regulation CCE - Some states restrict Payroll Cards - Money Transmitter Laws Increasing Customer Acquisitions Decreasing Margins Fraud & Security Breaches 27

6 Strategic Initiatives Fig - 3 Payment Environment (Before) Challenges Increasing Customer Acquisitions Decreasing Margins Fraud and Security Breaches Strategic Initiatives Product Innovation - Focus on Micro-payments - Reduced signature requirements and introduction or contactless cards Defining Micro segments with customized strategies Creating winning loyalty programs Adopting customer centric transparent business practices Developing predictive capabilities for fraud prevention Refined risk based pricing and credit scoring to increase availability of credit cards to all households Leveraging technology for reduced costs and greater scalability cases, established products - such as checking and savings accounts. They have proved to be quite popular with the 30 million strong nonbanking population of the US. However, there are concerns on their use for money laundering and other statutory regulations. The challenges faced by the US credit card industry are substantial. The largest US merchants are now able to negotiate lower interchange rates from all networks, and may force other participants in the credit card transaction to lower their costs. In addition to lowering cost, there is a movement to develop innovative arrangements so that the larger US merchants can retain a greater portion of the revenue stream. If successful, these developments could lead to a decline in pricing flexibility for the interchange rate structure on which the multiple card issuer networks are based. The key challenges in the card industry are summarized below: Innovations in Payment Cards Industry Payment innovations can be divided into two primary categories: Technology Innovations Service Innovations Technology innovations use technology to modify an existing process or product, or to create a new one. For a example, new technology confers the ability to view and pay bills online. The introduction of the Contactless Card is a perfect example of technology transformation used innovatively, just as Infrared, Bluetooth and RFID technologies are utilized to increase the speed of card transactions. Service innovations are changes in the product or process that do not necessarily involve changes in the underlying technology. An example of this would be the use of loyalty enhancements, such as the offering of frequent flyer miles on credit card products. Often, innovations may be both technological and service-related. Decoupled Debit Card innovations, discussed in this paper, fall into the service-led innovation category. This is because the business model for debit card changed due to the new product. Also, technology allows two different payment systems (Cards & ACH), which contributes and make possible the creation of the 28

7 Decoupled Debit Card. T he two aforementioned card innovations hold promise for upsetting the established order of things and merit a more detailed look. Contactless Card Payments Contactless payments are an extension of the banks card business. They provide the opportunity to capture additional wallet share and new interchange revenue from unexplored markets. Amongst the emerging card innovations, Contactless payments hold the greatest promise. Recently, the usage of Contactless Cards has been increasing for merchants that are offering the technology. The factor behind the implementation of Contactless Cards with small merchants is the processing cost of credit cards, which is about 3 times higher than handling cash. Consequently, the answer to such a problem is Contactless Cards. With Contactless cards, transactions can be Market Share of Cash Spent at Target POS in US Payment Environment (Before) Fig - 4 Micropayments of under $5, accounts for more than $1.4 trillion at POS across more than 450 billion transactions in US Market Share of Cash Spent at Target POS in US $1.4 trillion in 2005 In 2004, credit & debit transactions under $5 totaled $13.5 bn leaving much room for greater electronification of micropayments Contactless payment devices will play a crucial role to capture macropayments market Gas Stations with Convenience store 35% Limited Service Restaurant 12% Grocery Stores 34% Convenience Stores and Gas Stations 2% Movie Theatres 1% Drug Stores 12% Video & Game Rentals 1% Vending Machines 3% More than 15% market is suitable for electronic payments which is around $200 bn Key Challenges Speed & Convenience like Cash Cost associated with electronification Flat transaction fee component Actions taken by key players New pricing structure Reduced signature requirement Introduction of Contactless Cards Source: Infosys Research, Celent, Federal Reserve Bank of Philadelphia 29

8 made without swiping the card. Various technologies like Bluetooth, INFRARED and Radio Frequency Identification (RFID) are supporting the new product. In the United States RFID has been gaining more momentum than the other mentioned technologies. All the network associations have come out with Contactless products, which are available in card, fob, cell phone, etc. Contactless Cards are likely to take a big share of Cashless payments in the next five years. Benefits and Costs The benefits provided by Contactless Cards are: Fast, convenient and secure transactions Greater control of payment device for consumers Reduced loss for merchants and issuers The costs associated with the implementation of Contactless Cards are: Increase in merchant processing cost New POS terminals are required Cards are more expensive to issue Additional training for employees is required At present, approximately 32,000 merchant locations in the US accept Contactless Cards, a small fraction of the possible 5 million merchants across US. The success of Contactless Card will depend on how much investment value a merchant can see in the POS device. Decoupled Debit Card The introduction of Decoupled debit has posed a challenge in the US card industry and it is becoming a focus area for major card issuers. Decoupled debit is a mechanism in which the card issuer does not hold the cardholder's bank account (i.e., decoupling the relationship between the card account and bank account). To make the Decoupled Debit Card attractive, the card issuer will: 1. Have to offer better reward programs than the checking account bank does for its own debit card. Fig - 5 Offers Rewards Points Credit Card Features Authorization by Issuer New Risk Management Merchant's Co-branding 30

9 2. Accept lower earnings per transaction (Interchange fees minus ACH fees). Assuming that the overheads are similar, the Decoupled Credit Card issuer will need to have larger volumes of transactions to make the same profit. So why would they consider the Decoupled Debit Card? 1. New Customers: The credit card market is a saturated market; the debit card market is a new and growing one. 2. Stickiness: Empirical research suggests that the more products a customer has from a financial institution, the less likely she is to change to another financial institution. 3. Cross Selling: Decoupled Debit Card customers can be targeted for credit cards and other products. 4. Additional Revenue: The margins from the Debit Credit Card are currently derived from the Interchange Fees, less ACH and overheads. However slim these margins may be, it is an additional source of revenue. 5. Full Service: Some mono line issuers are looking at moving up to be full service banks in the future. A Decoupled Debit Card may be a good way of building future customers for checking accounts and other banking products. 6. Future Revenue Potential: The Decoupled Debit Card is in its infancy. As it grows and matures, it will develop other features and provide additional revenue streams. Process Flow In a typical debit process, the POS terminal sends the transaction to the payment network via the acquirer. The network requests the issuer bank to authorize for the transaction. The issuer authenticates the transaction (by The Decoupled Debit Card provides a number of advantages and a few inherent disadvantages. Fig - 6 Advantages Disadvantages Customer Ability to link debit card with the desired checking account Flexibility to choose desired reward program Inviting penalties and fees for spending beyond the balance Issuer Allow issuer to issue debit card without DDA with issuer Settlement Risk Revenue mainly from Interchange Fees Merchant Lower interchange fees Additional revenues through Co-branding Closer contact with customers Higher approval rate for card customers 31

10 Typical Decoupled Debit Card Process Flow Fig - 7 (1) Data transmits to Acquirer Bank (6) Bank forwards the approval to merchant's terminal Merchant Customer Payee Bank (11) Bank submits the information to payment network (14) Send confirmation by setting the transaction between Acquirer and Issuer (5) Network forwards the approval to Acquiring Bank (7) Routes the transaction to Customer Bank Payment Network (Master/VISA) (2) Acquirer Bank forwards the request to the Payment Network Acquirer Bank (8) Payee Bank debits the customer account and sends the information ACH (13) Sends the confirmation and makes funds available to Acquirer (3) Network requests the cardholder bank for approval (9) Sends confirmation by settling the Transaction between payee and issuer (12) Routes the transaction to Issuer Bank (4 A) Rates an offline transaction and submits the information to ACH (4) Issuer Bank validates / authenticates the transaction and sends confirmation with authorization code Issuer Bank 32

11 checking the balance on the account) and sends the approval to the payment network, which then sends the POS via the acquirer. The Decoupled debit process is slightly different from the typical debit process in that it encompasses a few additional transactions. Once the issuer gets the authentication request from the payment network, the issuer bank not only authenticates and forwards approval to the payment network, but also generates an offline transaction for the payment network. The authentication process is also different from a normal debit card transaction. In the debit card transaction, the authentication is done by checking the balance on the account real-time. For a decoupled debit process, the issuer does not have the ability to check the current balance real-time. The issuer takes a decision, based on the payment amount and other factors - such as credit limit - and creates an offline transaction for the payment network. The payment network forwards the offline transaction to the cardholder (payee) bank. The cardholder bank then sends the authentication back to the payment network, settling the requested amount with the issuer. The Road Ahead As the Decoupled Debit Card has remained in its infancy, since its launch by Capital One and HSBC, a few card issuers have followed suit and taken the lead in increasing the prominence of the product. The key selling proposition of a Decoupled Debit Card is a better rewards program. To override the threat that could be potentially imposed by Decoupled Card, banks may be required to offer rewards similar to their credit cards. Is this happening? Not really. As of now, there has not been a rush of new rewards programs from the banks. One reason may be that banks are following a wait and watch policy. The other reason could be that the debit card in the US, unlike in Europe and elsewhere, has often been a drain on revenue rather than a source of revenue for banks. To stay competitive and relevant, the Decoupled Debit Card will need to evolve and provide a better revenue model than the current availability. Limiting credit risk is a major requirement that is not adequately addressed by issuers. The debit card customer needs to be provided means to avoid the debt trap from the credit card. This can be done by creating a scenario where overdrawing is never possible as is the case in a debit card. Otherwise the Decoupled Debit Card may remain a small niche player, lacking universal appeal to the card customer. What is the future for Decoupled Debit Cards? By now, it is quite clear the product has caught the attention of issuers, but has not excited or threatened any major issuer. There has been no rush of the initial me too products and there is no last ditch effort from the coupled debit card players to retain their market. Conclusion The most successful products and innovations will be judged upon the value that they create for all the stakeholders in the payment chain: consumers, merchants and member financial institutions. A new payment device or some other big shiny object may be exciting, but it will only drive value if - consumers enjoy maximum convenience and security, merchants see added sales or throughput, and banks either increase their revenue streams or enhance their relationships with cardholders. The key to success (in adopting alternative payment methods) lies in the strategy of switching to e-payments, using existing infrastructure - 33

12 such as the current credit card system with merchant relationships. Even without merchant upgrades, contactless payment methods might still be used with legacy equipment through a simple swipe. In short, the highly competitive card industry is in a state of flux. Card associations, controlled by a diminishing number of large card issuers, are caught between cardholders seeking greater rewards and merchants trying to lower the cost of accepting payments. At the same time, the card associations are not only incurring increasing expenses because of fraud and fraud prevention, but they are also bearing the costs of recent and pending litigation. The card industry has responded to challenges by continuing innovations in products, business models and technology. References 1. Wonglimpiyarat, Jarunee(2007), E-Payment Strategies of Bank Card Innovations, Journal of Internet Banking and Commerce, December 2007, vol. 12, no.3 2. Crowe, Marianne,(2008) Emerging Payments - The changing landscape, Federal Reserve Bank of Boston 3. Bradford Terry, Davis Matt, Weiner Stuart (2003), Non Banks in the Payment System, Federal Reserve Bank of Kansas City 4. Riley,Brian (2008), Deciphering Decoupled Debit: Deign, Deflect, Despond,or Deflate?, Tower Group Research 5. Grossman, Mike(2008) The lowdown on D e c o u p l e d D e b i t, U S B a n k e r ( rticle.html?id= yt4c7qyw) Amit Lohani Consultant Infosys Technologies Limited Amit is a Consultant with the Banking & Capital Markets Group at Infosys. He has over 6 years of business analysis and consulting experience. His main areas of focus are Retail Banking and Payments. Shashi Bhushan Senior Associate Infosys Consulting Shashi is a Senior Associate with the Banking & Capital Markets Group at Infosys Consulting. He has over 10 years of experience, spanning Banking and IT Consulting. His main areas of focus are the Cards and Payments industry. Balwant C. Surti Principal Consultant Infosys Consulting Balwant is a Principal Consultant with the Banking & Capital Markets Group at Infosys Consulting. He has over 26 years of experience, spanning Banking and IT industry. His areas of expertise are Core Banking, Retail Lending and Payments. The authors would like to thank Manishi Varma and Sabitha Vupalla for their insights. Manishi is a Senior Associate and Sabitha is a Principal Consultant with the Banking & Capital Markets Group at Infosys Consulting.

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