CHASE MERCHANT SERVICES

Financial Services POINT OF VIEW CHASE MERCHANT SERVICES HOW WILL IT DISRUPT THE CARD PAYMENTS BALANCE OF POWER? AUTHOR Andy Dresner, Partner

JPMorgan Chase has taken a first step towards creating a new 3-party network similar to American Express and Discover. The new entity, Chase Merchant Services, will leverage the Visa infrastructure, but won t be subject to Visa rule sets or pricing terms. It will allow Chase to self-settle any transactions executed at Chase Paymentech merchants using Chase credit or signature debit cards while leaving the Visa network to process transactions at merchants who have not signed onto the new mini-network. This move has been a long time coming. The payment card market today consists of six mega-issuers (JPM, BAC, Citi, COF, AXP, DFS) processing on four major networks (Visa, MasterCard, AXP, DFS). Since Visa and MasterCard went public in the early 2000s, issuers have gradually lost influence over the payment card system. The networks have much higher valuations than the issuers, are less exposed to regulation and credit conditions, and have global growth opportunities that the issuers lack. The networks also have pricing power with both issuers and merchants. And when merchants pushed back in court, it is not network fees that were reduced, but interchange merchants can now deploy surcharges, discounts and product discrimination to influence card choice. Furthermore, the networks continually commoditize the market by providing Tier II & III issuers with functionality that approaches what the megaissuers spent millions to pioneer. Much of this came to a head during Durbin implementation. Issuers expected the networks to share the Durbin pain in two ways: 1. Accept that it was in the issuers interest to drop the networks affiliated PIN brands (Interlink, Maestro) to avoid network-on-network interchange competition 2. Reduce issuer-side processing fees to reflect the new economic reality Exhibit 1: TOP ISSUERS AND NETWORKS RELATIVE VOLUME SIZE, AFFLIATION Capital One US Bank Citi PNC Credit volume Mastercard Visa Total volume (credit & debit) American Express 3-PARTY NETWORKS Discover JPMorgan Chase Bank of America Wells Fargo Credit volume Top 7 issuers Total volume Top 7 issuers (credit & debit) Total volume all issuers (credit & debit) Note: Volumes represent consumer credit and debit as of 2011 year end Source: The Nilson Report Copyright 2013 Oliver Wyman 2

Yet the networks dug their heels in to protect their own revenue streams and, in the case of Visa, introduced a new stealth debit network (PAVD) that issuers could not opt out of even though it would be more costly to them than unaffiliated PIN debit. This was a wakeup call for the mega-issuers that the power balance had shifted to the networks. The only way to gain back leverage is to shift volume to the other network. This is expensive and disruptive for customers and only a handful of issuers took that route. Exhibit 2: SPEND SHARE OF MAJOR CARD ISSUERS (VISA/MC ONLY) ISSUING SHARE CREDIT DEBIT TOTAL ACQUIRING SHARE* JPM 25% 8% 15% 13% BAC 16% 13% 14% 18% Wells 4% 11% 8% 4% Citi 13% 1% 6% 4% COF 8% 0.6% 4% <1% USB 6% 2% 4% 6% PNC 0.5% 2% 1% 1% Paymentech (Wholly owned) JV with FDC (Minority stake) JV with FDC (Minority stake) JV with FDC (Minority stake) COMS (Wholly owned) Elavon (Wholly owned) JV with FDC (Minority stake) * Some large acquirers are not issuers (e.g., Vantiv, Heartland and GPS). First Data also acquires under its own brand Source: The Nilson Report Enter JPM. Of the major MC/Visa issuers, only Chase is both a scale issuer and a scale acquirer. Most other banks have either small issuing scale or JV acquiring structures that limit their flexibility. US Bank has large issuing and acquiring businesses, but at only one-fourth JPM s issuing scale and one half its acquiring scale. Note that FDC, with its alliances, has over 50% share in acquiring and its alliance partners collectively have a big position in issuing. While FDC could form a club of these JV partners to negotiate a similar deal, this would be complex, given the different equity shares in each JV, and the different mix of Visa/MC affiliations among its partners. Such a club would remain a 4-party network, but with fewer parties on each side it would lack the nimbleness of a 3-party design. The press release announcing the deal suggests that Chase aims to improve its positioning with both cardholders and merchants: For merchants, Chase can be more flexible in interchange terms and rules sets at least as it relates to the volume from Chase-branded cards. Chase can also develop proprietary data sharing protocols that provide the merchants with more customer insights than is possible via a standard network For cardholders, Chase may offer proprietary deals from its merchants. For example, by using Chase data to target offers to narrow segments, a merchant may be willing to offer better deals than it does to the general public The question that arises is how this will impact Chase s competitors and its customers (merchants and cardholders), as well as the networks themselves. ACQUIRING IMPACT The clearest advantage from this deal accrues to Paymentech, Chase s merchant acquiring arm. To the degree that Chase is able to offer a lower total cost to the merchant than another acquirer, it will generally win the contract. Paymentech already has competitive scale and services, but this is a unique differentiator. In the POS world, Paymentech could simply charge a lower network fee than Visa does and outperform all other competitors. Large merchants typically face three major components of card acceptance costs: the acquirer fee of 0.2-1, the interchange fee that goes to the issuer and the network fee that goes to Visa or 3

MasterCard. The network fee is typically 11bp plus 1.5-2.5 which works out to 5-6 on the average debit transaction and 10-11 on the average credit transaction. If Paymentech simply undercuts the network fee by a penny on Chase card volume, their average acquiring fee per transaction would be substantially lower than the market level charge. This leaves interchange unchanged. Paymentech can also offer this deal on a partial basis. A merchant could use Paymentech to process its Chase cards while leaving all other volume to the incumbent acquirer (similar to how merchants operate with AXP and Discover). In this case, Chase reduces its competitors volumes and revenues even without winning the entire contract (most merchant acquiring contracts have a carve-out for 3-party networks). Furthermore, Paymentech gets to integrate with these merchants, making it easier to displace the incumbent the next time the contract comes up for bid such transition costs are one reason large merchants rarely leave their incumbent acquirer. This will have different appeal to different merchant segments depending on their payment mix and geography. Debit-centric verticals, like supermarkets and gas stations, will have a smaller share of their volume from Chase cards than credit-centric verticals such as airlines, hotels and department stores. Further, lowaverage ticket verticals, like fast food, already pay low absolute network fees that would be harder to undercut. Finally, Chase s branch footprint is concentrated in certain metro areas, giving stores in those cities a much bigger debit impact. The network fee advantage doesn t help directly with smaller merchants who pay via a merchant discount. For these SME merchants, a penny per transaction reduction would not be noticeable. Further, selling acquiring to small merchants is as much a function of distribution as it is of price. Instead, Paymentech might invest its network fee savings to pay ISOs an improved buy rate and grab the lion s share of their sales without any particular differentiation to the merchant. Paymentech could also use its new freedom to offer superior rule sets and pricing policies. One example is ecommerce, where Card Not Present (CNP) interchange is substantially higher than POS interchange even for merchants with very strong fraud monitoring and prevention programs. Paymentech specializes in ecommerce and must be very aware of this. A deal that offers lower interchange on Chase volume to reward higher levels of card security would reinforce Paymentech s position as the acquirer of choice for CNP and put pressure on the legacy networks to reexamine CNP policies. While this would reduce interchange revenue to the issuing side, ecommerce is still a small enough portion of total spend that the tradeoff may be worth it. At bricks and clicks retailers, such a concession on the clicks side may be enough to win the larger bricks business. There may also be areas like friendly fraud where closer collaboration might result in material reductions in merchant costs without reducing interchange at all. Finally, by working directly with merchants in a closed loop, Chase can develop analytics that provide merchants with greater insights into customer behavior. Issuers like Chase have data on customer spend and demographic profiles that merchants lack. Using these data, merchants can target offers to niches of Chase cardholders. AXP has exploited analytics of this kind historically to justify premium discount rates from merchants and there is no reason Chase couldn t do the same thing. The net result could be a large increase in Paymentech share at both large and small merchants. At large merchants they could win more contracts outright or take a share of volume at the expense of the incumbents. At small merchants they will appeal to the best ISOs because they can pay more without undermining core economics. These share increases could be highest in verticals with high credit spend and average ticket as well as debit-centric verticals that are in-footprint for the Chase branch network. Copyright 2013 Oliver Wyman 4

ISSUING IMPACT The impact on Chase issuing share is much more speculative. 1. Chase and its merchants need to find a proposition that leverages cardholder spend and demographics data to make proprietary, targeted offers to their joint customers 2. The offers have to be differentiated enough either from a value or exclusivity perspective to differentiate Chase cards from other cards 3. The offers have to be rich enough so that cardholders use them more than they have used other, less targeted and differentiated offers from specialists like Groupon or Cardlytics. Visa and MasterCard are also moving into this space Chase was clearly thinking along these lines when it purchased Bloomspot recently. Bloomspot specializes in daily deals in upscale venues like restaurants, spas and hotels. This gives Chase an engine for capturing merchant offers and distributing them to cardholders and it focuses on just the kinds of merchants that the acquiring proposition will most appeal to. However, it is not clear how important merchant offers are to either merchants or cardholders. AXP has done this for a long time, but it is not clear how much of its market position among affluent cardholders is due to this rather than its service quality, rewards proposition and product differentiation (no pre-set spending limit). The effort required to craft and target offers is nontrivial and many merchants lack the sophistication to take advantage of the rich data that Chase might put at their disposal. Chase could develop advisory services to work with merchants on this opportunity, but these would only be affordable in collaboration with the very largest merchants. The other advantage for cardholders is the availability of reward redemption at the point of sale. Chase cardholders would be able to pay with points at selected merchants; this may be combined with targeted offers or it may be a routine payment option. Redemption at the POS offers liquidity to the cardholder, but the actual value depends on how many merchants choose to adopt the mechanism and what exchange rate Chase adopts for these redemptions. Historically, points redeemed this way have a lower exchange rate than those redeemed using the standard menu of redemption options and low exchange rates discourage usage. Chase may also need to restrict the universe of merchants allowed to participate there simply isn t enough redemption volume to make it material to any merchant if it is deployed too broadly. In short, the impact on Chase issuing fortunes is highly contingent on getting enthusiastic merchant participation. This will take time and investment by both the merchants and Chase. It also requires merchants to adopt unique processes to make offers to Chase cardholders who might account for only 20% of so of their overall customer base. This is a tall order. NETWORK IMPACT While Chase is a winner in this deal, the impact on the networks is clearly negative. Visa will lose the network fees that merchants would ordinarily pay on Chase volume. Chase will likely pay some fee to Visa for the use of Visanet, but this will no doubt be much lower than the typical 11bp + 1.5-2.5. On the other hand, Chase has committed to migrating more of its volume from MasterCard to Visa this will backfill some of Visa s lost revenues at MasterCard s expense. So MasterCard may be the biggest short term loser here. To the degree that Chase succeeds in growing issuing share, both networks will see an absolute reduction in volume over the longer term. Furthermore, there may be merchant pressure to match any interchange or network fee reductions that Chase Merchant Services might offer. To the degree that any other banks form similar mininetworks, the losses will be compounded. 5

IMPACT ON OTHER LARGE BANKS BAC is potentially large enough to cut a similar deal with the networks. But first, they may need to claw back controlling share in their acquiring JV, so they are at least a year behind Chase in getting there. Collectively, BAC and JPM account for 41% of Visa debit and credit spend, so moving this volume to private mini-networks would vastly reduce aggregate network revenues and scale. Exhibit 3: CREDIT CARD MARKET 100% No other issuer is positioned to cut a similar deal without further M&A. Citi, US Bank, PNC and Wells all have much smaller issuing and acquiring businesses and would have difficulty monetizing their volumes even if they could cut similar deals. While they might club together to do this, it is hard to see how they could deliver the shared network from multiple acquiring arms and even then, would operate on a 4-party model which undermines some of the advantages of such a move. Capital One is particularly challenged as they have material issuing share but almost no acquiring volume. A logical move could be to align with Vantiv to gain acquiring scale. 80% 60% 40% 20% 0% Today JP Morgan Chase Bank of America Consortium (other top issuers) Potential future Discover Amex Chase BoA Consortium MC Visa CONCLUSION If the leading issuers do all move to mini-networks, it is hard to see how Tier II/III issuers and acquirers stay relevant. Pure-play acquirers will lose to large merchants on cost and to smaller merchants on distribution. MasterCard and Visa will have fewer funds to promote their acceptance brands and build out their services which are disproportionately used by Tier II/III issuers. Additionally, these issuers will lack the differentiation that comes from ads, offers and POS redemption. This could lead to another round of consolidation on both sides of the cards business. Note: Assuming the top 7 issuers break away to set up their own networks Source: The Nilson Report Copyright 2013 Oliver Wyman 6

Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. For more information please contact the marketing department by email at info-fs@oliverwyman.com or by phone at one of the following locations: AMERICAS +1 212 541 8100 EMEA +44 20 7333 8333 ASIA PACIFIC +65 6510 9700 www.oliverwyman.com Copyright 2013 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.