36 McKinsey on Payments June 2012 Card processing in Europe: Dead or alive? Core processing for the European card market appears strong by a number of measures. It is a big market, handling a quarter of global card transactions and generating 9.2 billion in annual revenues. Margins are generally healthy. Other indicators, however, suggest that the industry model is at risk: margins have been shrinking at an average annual rate of 4 percent since 2004, as investments in new platforms with cross-border capabilities have outpaced SEPA-driven integration, resulting in surplus capacity and fierce price competition. In addition, the composition of outsourced volumes is shifting, posing new risks for third-party processors. If these trends continue and in all likelihood they will processors in Europe will face difficult choices about where to focus their investment and development efforts. This article examines the forces eroding margins and outlines three options for securing new sources of value in the difficult period ahead. Vaibhav Dayal Massimiliano Merlini Olivier Denecker Florent Istace Mieke Van Oostende In 2010, the European card processing industry handled approximately 39.7 billion transactions for nearly 951 million credit, charge and debit cards. Transaction volumes grew by 8 to 8.5 percent annually from 2006 through 2010 and are expected to rise 4 to 5 percent annually between 2011 and 2015. Total revenues for all card-based services approach 49 billion, and are comprised mainly of interchange fees, membership fees and interest income. Core processing activities (i.e., transaction handling, authorization, clearing and settling, and exception handling) capture approximately 20 percent of this amount. Overcapacity and shrinking margins Despite the positive outlook for volume and revenue growth, the steady downward pressure on margins is a clear warning of future turmoil. New platforms are adding capacity, rather than replacing legacy systems Creation of the Single European Payments Area (SEPA) raised expectations for signifi-
Card processing in Europe: Dead or alive? 37 cantly enhanced competition and triggered an initial consolidation wave for card processors in Europe. Many processors invested heavily in new platforms designed for flexibility toward international rules, the consolidation of volumes across national borders and currencies, and the implementation of value-added services according to client specifications. This robust functionality is expensive to build and requires huge volumes to reap economies of scale. The European market remains fragmented: The top 10 processors today handle less than 60 percent of European card transactions. However, payments integration in Europe has progressed more slowly than expected, and the influx of cross-border volumes required to run these new platforms cost-effectively has yet to occur. To date, few players have achieved critical scale, and even fewer have managed to consolidate processing volumes on a single cross-border platform. The investments have not paid off so far. Few banks have moved to the more robust systems, as migration costs are high and the simpler, more focused platforms of national incumbents are adequate for banks processing needs, which have remained largely domestic. Thus, slow progress toward payments integration has, in effect, extended the life expectancy of legacy platforms. With low regulatory urgency regarding cross-border integration, single-country platforms provide issuers with the required products and functionalities, at low risk, high security and very low cost. Domestic schemes, such as girocard in Germany, Bancomat in Italy and Dankort in Denmark, operate at low cost because they have simple fee solutions, leverage the incumbent ACH system, incur little if any charge-back, and are highly integrated (all the technical work is handled centrally by the processor, and only the financial check is done at the bank level). Most of these platforms are also fully amortized. Despite the enduring competitive strengths of the incumbents, a number of players have built volumes adequate enough to form an industry league table, with First Data, Equens, NETS and AWL at the forefront. The European market, however, remains fragmented: The top 10 processors handle less than 60 percent of transactions. The overall result is that the new platforms have added capacity rather than forcing the retirement of older platforms. The cost of overcapacity Overcapacity has a significant cost to the card processing industry on the acquiring side. If the industry achieved a severe platform reduction on the merchant acquiring side, it would potentially generate 18 percent in additional cost savings, assuming a distribution of volumes allowing each player in the consolidated market to operate at critical scale (2 billion acquiring transactions on debit cards and 3 billion on credit cards) (Exhibit 1, page 38). The cost of surplus capacity will become increasingly difficult to absorb. The trend among banks is to bring issuing volumes inhouse and to outsource the processing of acquiring transactions. This threatens the revenue of independent processors, because issuing revenue per transaction is four times
38 McKinsey on Payments June 2012 greater than acquiring, due to the additional issuing requirements of client servicing, exception processing, billing and account handling. Acquiring activities address a narrow range of merchant needs and capture significantly less revenue. The increase in highly standardized (and hence low-value) outsourced acquiring volumes cannot, at present, compensate for the revenue hit associated with the decline of high-value issuing volumes. Processors who observe a decline in issuing volumes should act to drive costs down (reach critical scale) and identify new sources of revenue on the acquiring side. Homogeneous offerings trap processors in commodity business Overcapacity in the processing industry has created a market where client retention has become the highest priority. Looking across markets, processors deliver largely identical functionalities and products, and current value-added options neither provide a source of distinction in the eyes of end-users nor create new revenue streams for banks. Seeing little to distinguish one service from another, clients are left with pricing and efficiency as the only sources of distinction. The result is that the processing market has become highly commoditized, and incumbents retain their client base at the cost of decreased prices and continued erosion of margins. The shift of volumes among rival processors is at best marginal. A review of recent tender decisions shows that only one in ten requests for proposal results in a change of processor. Exhibit 1 Overcapacity costs the merchant processing industry up to 18% in untapped efficiency gains Core acquiring processing cost base Europe 1 2010 millions 2,600-10% 2,300-18% 2,100 1 EU27 excluding Cyprus, Malta including Norway, Switzerland and Turkey 2 Top 10 players process 57% of combined credit and debit volumes Source: McKinsey Card Profit Pools Current cost base Top 10 players 2 at critical scale Simulation All players at critical scale
Card processing in Europe: Dead or alive? 39 The absence of value-added services not only limits processors ability to reverse the trend toward thinner margins, but it also leaves them dangerously unprepared to meet the digital challenge. Will inertia prevent them from developing into the service providers of the future digital and mobile payments world? Although the commodity play may appear to be little more than a continuation of current core skills, longer-term success will require expertise spanning all payment types and a cost-cutting mindset. Choices for the future Margins are unlikely to improve until processors begin to present offerings that set them apart from the competition. A trade-off can be observed between three distinct strategic options: the commodity play, the merchant play and the digital play. Success in any of the three will require both an extension of current skills and profound changes in an organization s culture and mindset. 1. Commodity play: Becoming the commodity provider of choice Businesses in infrastructure-intensive sectors, such as energy or transportation, can create substantial value and deliver superior growth, despite earning low returns on high investments. To become the commodity provider of choice in the payments processing business requires a strong focus on cost-efficiency, limited investment in value-added features, and maximum reach and scale. Scale is critical, and players that choose this path must compete aggressively to consolidate transaction volumes across both geographies and products. Cards alone represent only 41 percent of cashless transactions in Europe, creating substantial opportunities for players that can deliver cards as well as other electronic payment services, such as billing, transfers and e-payment solutions. Flexibility toward different payment types not only helps to achieve scale; it also allows for future growth. Innovation should be focused on improved efficiency, not toward differentiation. Value-added features should be limited to those carried by the entire community of users. Although the commodity play may appear to be little more than a continuation of current core skills, longer-term success will require expertise spanning all payment types and a cost-cutting mindset. 2. Merchant play: Delivering services directly to merchants A processor pursuing the merchant-oriented strategy should focus equally on product innovation, service quality (few errors, high responsiveness) and sales capabilities. Scale and consolidation would be much less relevant. Processors in Europe have traditionally served issuing and acquiring financial institutions. The value of payments is concentrated, however, in serving end-users. Processors in the U.S. have a strong footing in the merchant services business, which is also the focus of a large number of emerging payment service providers (PSPs) in Europe. In addition, several incumbent acquirers, international attackers (e.g., First Data) and specialists (e.g., POINT) are targeting mer-
40 McKinsey on Payments June 2012 chant needs in order to tap into the larger value concentrated in the merchant-facing parts of the card business. In addition to merchant financing, the merchant play could comprise new services to boost merchant sales and enhance sales reporting. These services would form a new column between terminal services and financial underwriting (or merchant service charges). Loyalty programs, which can be fulfilled at the point of service, are particularly attractive to small and medium-size merchants. Expanding beyond in-store card transactions, a processor could develop a one-stop shop where merchants implement new collections avenues (such as e-billing) and new sales platforms (such as integrated in-store and online and digital channels). Additional services could include integrated cash management reporting and sales analytics by channel (in-store, online, and mobile) (Exhibit 2). The merchant-oriented strategy will require a shift from the current expertise in systems and processes toward a mindset centered on client needs. In addition to product development skills, sales and service will become more prominent in the organizational culture. 3. Digital play: Unlocking the value in the data The digital and mobile revolution is changing the way consumers shop. It is also opening new avenues for processors eager to extend their offerings across the increasingly integrated stages of search, shop, buy. Exhibit 2 New merchant offerings in sales and cash management could boost acquiring revenue by more than 6 billion Alternate sources of acquirer revenue, Europe 1 2010 billions 8.7 2.6 1.9 Additional sources of revenue include e-billing, online sales, integrated reporting, and analytics 4.2 1 EU27 excluding Cyprus, Malta including Norway, Switzerland and Turkey 2 Defined as MSC revenue less interchange Total acquiring revenue Processing revenues Terminal revenues Net MSC revenues 2 Source: McKinsey European Payment Profit Pools
Card processing in Europe: Dead or alive? 41 There is significant value to be harvested from the data surrounding transactions (e.g., time, location, frequency, liquidity source). Winners will likely be those organizations that best merge transaction and customer profile data. The processor pursuing the digital play must devise ways to maximize its store of varied types of customer data in addition to the relatively limited data associated with transactions. For example, processors could build digital marketing solutions under their own brand, with the possibility of offering white-labeled services on behalf of local players such as banks and telecommunications companies. Select network processors are already reaching beyond payments to support digital marketing activities, including couponing solutions for local merchants (e.g., Spaar & Pluk, offered by Atos Worldline, or the American Express partnership with foursquare) and Big Data CRM solutions for merchants (e.g., Master- Card Advisors). Services such as these will help to prepare established players for competition with digital attackers. A processor that chooses the digital play will arguably face the biggest change. Scale and operations will not be the primary concerns. To create a credible alternative to international Internet giants for local services, processors will necessarily face a fundamental change of focus. The key factors for digital players are: Agility: No longer focused on system stability, but on the ability to create, test and evaluate new solutions quickly. Speed: Build products in weeks instead of years; have the ability to launch dozens of applications (as opposed to one or two) and the willingness to kill any that are not successful. Partnerships: Leverage partners for new skills rather than develop all skills in-house. Possibly outsource core processing to other players that pursue the commodity play. End-user focus: Create services and products inspired by customer needs, rather than by system capabilities. (Many Internet innovators have been known to run trials where the back-end process is completely manual and consumers are given the impression of seamless automation and straight-through processing. Only when trials are successful is the scalable solution developed.) * * * The current combination of overcapacity and declining margins in the European card processing sector is unsustainable, and many players will soon find themselves at a critical crossroads, as the industry reshapes itself with changed business models and new competitive dynamics. Each player whether incumbent or challenger will have to decide which path they will follow and on which part of the value chain they will play. Choice is essential; being excellent in each play is not a credible alternative, as each requires different skills. Vaibhav Dayal is a research analyst in McKinsey s Gurgaon office and Massimiliano Merlini is an associate principal in the Milan office. Olivier Denecker is a senior knowledge expert, and Florent Istace is a knowledge expert, both in the Brussels office. Mieke Van Oostende is a principal in the Antwerp office.