MoP19Innovation and Disruption in US Merchant Payments

33Innovation and disruption in U.S. merchant payments

For payments and non-payments companies,new merchant services are attractive areasfor growth. For payments companies, rev-enues from new merchant services coulddouble todays market in traditional mer-chant acquiring and transaction processing.For non-payments players, new services rep-resent a major step toward closing the loopbetween investments in advertising and loy-alty programs and consumers ultimate pur-chasing decisions.

At the same time, cloud computing is lower-ing the barriers to entry for software firmsseeking to provide merchant services. It iseasier today to develop inexpensive pay-

ments solutions and to connect various sys-tems and platforms than it was just fiveyears ago. Coupled with hardware advancessuch as smartphones and tablets, point-of-service (POS) systems are transitioning frompayments-only terminals to software solu-tions that help merchants operate their busi-ness, such as practice management softwarefor medical providers or order managementsoftware for restaurants.

These changes will intensify competitionand result in accelerating price compression.According to forecasts from McKinseys U.S.Payments Map, total electronic paymentsvolume is expected to grow by about 7 per-

Innovation and disruption in U.S.merchant payments

The U.S. merchant payments landscape is undergoing a period of rapid,

technology-driven change. Mobile, online and social technologies are revolution-

izing consumer access to information and sparking demand for new services that

can support multichannel commerce, big data analytics, enhanced loyalty pro-

grams and targeted advertising. Consumers use the new tools to move dynami-

cally between computer, mobile device and in-store experiences while shopping.

For merchants, these cross-channel journeys create opportunities to integrate

business-to-consumer (B2C) sales channels and to leverage generated data to

understand consumer behavior. To capitalize on this opportunity, merchants

need payments solutions that integrate adjacent business services and enable

new functionalities that enhance loyalty programs and advertising performance.

Robert Byrne

Jason Hanson

34 McKinsey on Payments May 2014

cent per year over the next five yearsdrivenlargely by continued growth in digital com-merce and increased electronic payments ac-ceptance at small merchants (Exhibit 1).

Despite growing volumes, increased compe-tition will accelerate margin compressionand constrain industry revenue growth. Thiscompression will be felt most keenly in thesmall (less than $5 million in annual elec-tronic transaction volume) and medium-size($5 million to $100 million in volume) mer-chant segments, where margins are rela-tively high today (Exhibit 2, page 36). Forlarger national merchants, whose marginsare already near their structural floor, in-creased processing efficiency will result inmargin compression of 2 to 3 percent peryearslightly below that of prior periods.

As a result, overall processing revenues areexpected to grow by 2 to 3 percent annuallyover the next five years (Exhibit 3, page 36).Low growth in what is essentially a scalebusiness will necessitate consolidationalong the merchant payments value chainin order to sustain current market valua-tions. Firms such as independent sales or-ganizations (ISOs), payments gateways andsubscale payments acquirers and processorswill need to merge to drive efficiency in acrowded landscape.

Lessons from the past

The evolution of the merchant paymentsindustry over the past three decades (seesidebar) leads to two important assump-tions:

2013 2018F2017F2016F2015F2014F20122008

6.2

8.2

10.2

4.6

0.8

0.8

6.3

5.8

1.1

4.0

1.1

1.2

3.1

1.0

3.8

5.4

1.0

0.9

3.5

4.9

0.9

0.8

3.2

3.6

0.6

0.6

2.3

6.6

1.2

4.2

1.3

7.0

1.4

1.2

4.4

7.3% p.a.

$ trillions 2013-18 CAGRPercent

Large merchants1

Medium-size merchants2

Small merchants3

1 Greater than $100 million in electronic sales volume

2 $5 million to $100 million in electronic sales volume

3 Less than $5 million in electronic sales volume

Source: McKinsey U.S. Payments Map

Exhibit 1

Electronic payments volume is expected to grow at about 7% annually over the next five years


1. Innovation in payments technologiesmostly affects merchant-facing functionsin the value chain (i.e., sales and on-boarding rather than clearing and settle-ment) and tends to attract new entrantsbefore incumbent firms adapt. ISOs sup-planted local and regional banks as theprimary distribution channel for smalland mid-size merchants in the 1990s. As aresult of merchant adoption of more so-phisticated POS solutions in the 2000s,value-added resellers (VARs) and pay-ments gateways have become a significantdistribution channel.

2. Scale is fundamental to the competitive-ness of the processing function. The ad-

vent of electronic payments triggered amassive consolidation of merchant pay-ments processing volume toward a hand-ful of firms (e.g., First Data, FifthThird/Vantiv and Elavon) as bankselected to consolidate the cost of local andregional processing operations. Over time,processing economics have declined withthe marginal cost of processing a paymenttransaction. At about five to eight basispoints per transacted dollar, they are nowat a level that would be unattractive tomost new entrants.

Over the next decade, technology will driveevolution in merchant payments that willrival the changes prompted by the intro-

A short history of disruption in U.S. merchant payments

The merchant payments value chain has seen dramatic change before. In the 1980s, VeriFone introduced the electronic POS terminal,which reduced the timeand ultimately the costof payments acceptance. Thanks to this innovation, both merchants and consumers

quickly embraced electronic payments. At the same time, large regional merchants in the U.S. began to expand into national chains. Banks

seeking to build a significant payments processing business established national sales and service capabilities to meet the needs of these

large, high-volume merchants. Competition for this volume drove down processing margins, leading to consolidation of the processing

industry and the formation of large-scale processors like First Data and Midwest Processing Solutions.

In the 1990s, as more and more small and medium-size merchants began accepting electronic payments, electronic volumes grew 14percent per year in the U.S. But banks lacked the sales and service capacity to take on a substantial number of small and mid-size

merchants. Business bankers were comfortable focusing on the higher-return credit opportunities available in the economic environment of

the time. As a result, ISOs stepped in to provide much-needed distribution capacity to this growing segment.

The 2000s marked a third major disruption in the U.S. merchant payments value chain. Already common at large merchants, electronic POSsystems became more accessible to mid-market merchants by the early 2000s, thanks to falling PC hardware prices and expanding

computing power. The availability of local processing power, local data storage, networking and graphical user interfaces made it possible to

develop flexible, highly functional POS systems that could be tailored to payments-intensive industries such as retail, food service and

hospitality. Contemporaneously, Internet use became widespread, and online commerce emerged as a new channel for merchants. These

changes led to the entrance of two new sets of participants in the payments value chain: value-added resellers (VARs) and payments

gateways. VARs distributed POS solutions on behalf of POS software companies such as Micros and NCR and enabled the integration of

payments processing with those systems. Payments gateways enabled connectivity between off-line POS software, online commerce Web

sites and payments processors. Essentially, software developers and VARs could integrate with one payments gateway, which could then route

transactions to various processors, eliminating the need for costly, time-consuming integrations with legacy payments processing platforms.


-0.5%

-2.1%

-3.5%

-2.1% -5.8

-7.6

-5.1

-2.6

2017F2016F2015F 2014F2013201220112010200920080

10

20

30

40

50

60

70

80

2018F

Large merchants

Medium-size merchants

Small merchants

Industry average

U.S. electronic payments acquiring/processing net revenue margin1

bps2013-18 CAGRPercent

Durbin impact and unwind2

1 Merchant electronic payments processing fees net of network interchange, dues and assessments; includes recurring ancillary fees (e.g., annual fees, chargeback fees, compliance fees).

2 Period where Durbin Amendment results in an initial increase in processing margins, followed by a subsequent unwinding of gains as merchant contracts expire and excess rents are competed away.


Exhibit 2

Increased competition will result in accelerated processing margin compression, especially among small and medium-size merchants

12.8

2013

14.3

2018F2017F

14.0

2016F

13.8

2015F

13.4

2014F

12.8

2012

12.9

2008

10.7

3.5

2.0

1.7

2.2% p.a.

2008-18 U.S. electronic payments acquiring/processing revenue$ billions

2013-18 CAGRPercent

2.5

3.7

4.5

2.9

4.3

5.7

3.0

4.3

5.6

3.1

4.3

5.6

3.2

4.5

5.7

3.2

4.6

5.9

3.3

4.7

6.0

3.5

4.7

6.1

Large merchants

Medium-size merchants

Small merchants


Exhibit 3

Margin compression will result in payments processing revenue growth of only 2% to 3% annually over the next five years


duction of the electronic terminal 30 yearsago. As a result, firms providing merchant-facing functionsISOs, VARs and the cap-tive sales forces of banks and nonbankacquirersare likely to see significant dis-ruption. New entrants armed with the lat-est technologies will challenge existingcustomer relationships. Competition forgrowing payments volumes will drive downindustry margins further, requiring incum-bent firms to consolidate to defend andgrow their businesses.

The implications of tech-drivenchange

Changes in the payments industry are affect-ing all participants in the value chain. Thoseclosest to the consumer will experience thegreatest impact.

Traditional terminal manufacturers

Traditional terminal manufacturers who failto adapt to the evolving market may face thehighest potential negative impact. Histori-cally, software embedded in the paymentterminal allowed for the secure collectionand transmission of data onto the network.The device was smart, allowing other soft-ware interacting with the point of sale toavoid handling payments information in amanner that would subject that software tonetwork certification requirements. Today,technologyspecifically cloud computingis making the integration of payments func-

tionality into other software solutions lessburdensome. As a result, a host of differentbusiness software solutions can provide pay-ments functionality on lower-cost hardwaresuch as tablets. To retain their dominant po-sition with merchants, traditional POSproviders must innovate beyond the POS orexpand their products functionality beyondpayments acceptance. Large terminal man-ufacturers are already acting on this prem-ise, as demonstrated by VeriFonesacquisition of Global Bay, a mobile pay-ments solution provider.

POS solution providers

Over the next five years, the vast majority ofmerchant payments processing revenuegrowth in the U.S.more than $1.5 billion ofnew revenuewill be acquired through soft-ware solutions rather than traditional pay-ment terminals (see sidebar, page 39).Transactions via solution providers are ex-pected to grow from 24 to 33 percent, ap-proximately, of total acquiring/processingrevenue during this period (Exhibit 4, page38). In particular, solution providers will be-come more prevalent in middle-market pay-ments, with health care and retail expectedto see the largest increases. Large enterprisesoftware companies will focus on providingholistic, cloud-based process services tosmall businesses.

Traditional independent software vendors(ISVs) that provide POS solutions to the re-tail, restaurant and hospitality industriessuch as Micros and NCRare building orbuying new payments-related capabilities inresponse to growth expectations. NCR, forexample, acquired Radiant, their principalpayments gateway, and developed Silver, acloud-based POS solution. Ventures of this

Over the next decade, technology will drive evolution in merchant

payments that will rival the changesprompted by the introduction of theelectronic terminal 30 years ago.


kind will enable existing POS software com-panies to grow in two ways: by participatingdirectly in payments economics by virtue ofowning the gateway, and by expanding intosmaller merchant segments with lower-cost,cloud-delivered solutions.

Beyond the traditional POS solutionproviders, emerging ISVs and start-ups aredeveloping POS solutions that integrate pay-ments. For example, PayPal is integratingpayments processing with value-added busi-ness intelligence services while leveragingexisting POS hardware. Others, like Squareand Intuit, are reinventing the POS processwith tablet-based systems that offer accessto payments processing solutions with lowup-front costs.

ISVs will become increasingly relevant part-ners for the distribution of payments pro-cessing. Almost all of this growth will occurin the small and medium-sized merchantsegments. Many new, small-business pay-ments solution providers are looking to es-tablished acquirer-processors or ISO salesforces as a potential route to market; theeconomics of this segment, however, will notsupport payments only distribution.

The adoption of cloud-delivered POS solu-tions is a long-term threat to VARs businessmodels, given that these solutions often offerlower up-front installation costs, subscrip-tion pricing and remote servicing. In thenear term, VARs will remain relevant formiddle-market merchants in payments-

4.7(33%)

2013

12.8

8.3(65%)

1.5(11%)

3.0(24%)

7.3(51%)

2.3(16%)

2018F

14.3

U.S. electronic payments acquiring/processing revenue $ billions

Transactions acquired via a software POS solution (non-terminal)

QSI Dental Web

Micros Symphony

NCR Aloha

Card not present (CNP) transactions excluding telesales and other direct marketing transactions

Retail e-commerce

Online travel & entertainment

Online payment of consumer services

Transactions that originate at terminals or merchant data centers and route directly to the payments processor

POS solutionprovider1

Online business-to-customere-commerce

Traditional

8.9

9.4

-2.5 Terminals connecting directly to processors

Direct marketing and telesales

Description

CAGR2013-18Percent Examples

+2.2% p.a.

1 POS solution providers include ISVs, VARs/dealers and gateways that do not serve e-commerce.

Source: McKinsey U.S. Payments Map; expert interviews

Exhibit 4

Over the next ve years, the vast majority of U.S. merchant payments revenue growth will be acquired through software solutions


Square and the micro-merchant segment

Square changed the game in the micro-merchant segment (merchants with electronic sales volume below $250 million) through innovativeself-service distribution and seamless wireless connectivity. Today, Square continues to drive innovation in merchant payments throughincreasingly sophisticated solutions (e.g., Square Register) and partnerships with large merchants such as Starbucks.

While innovative, Squares moves in the micro-merchant segment are far from disruptive for incumbents. In fact, assuming continued volumegrowth in the 30 to 40 percent range, Square is on track to achieve 20 percent market share in the micro-merchant segment by 2018lessthan 1 percent of total U.S. electronic payments volume.

The ability of Square and other emerging ISVs to take real market share from incumbent players in the middle and large merchant segmentsover the next few years will likely foreshadow the intensity of disruption in merchant payments.

POS solution providers

Changes in payments technology make several categories of companies important actors in the payments value chain:

ISVs write business solution software that may or may not include a payments solution (e.g., Micros, Oracle). The software can be distributedand serviced through a direct sales force, by VARs or, if cloud-based, remotely. Historically, only ISVs that focused on POS solutions forpayments-intensive industries (e.g., retail, restaurants) sought to integrate payments functionality into their solution, but as software movesto cloud-based platforms, the integration of payments functionality becomes easier for software companies with less payments expertise.

VARs (sometimes called dealer networks) install POS software and/or hardware solutions at the merchant site and often provide ongoingservices for the merchant (e.g., regional Micros dealers). VARs do not write the software but instead serve as an independent distributionchannel and servicing arm for software companies and existing POS solutions. Payments acquirers/processors often encourage VARs topitch processing services in return for one-time or recurring revenue.

Gateway providers connect merchants to multiple processors and protect credit card information (e.g., Merchant Link, Authorize.net).Gateways have enjoyed strong growth since the emergence of online commerce. A key driver of their rise was the point-to-pointcommunication protocols typically required by legacy payments processing platforms. Since software companies did not want to limit theirproduct to communication with one payments processor, gateways emerged as front-end aggregators that enabled communication betweenmultiple software solutions and payments platforms.

intensive industries who lack national mer-chants IT staff but whose needs are toocomplex for the packaged payments solu-tions available today. However, the generaltrend toward cloud-based delivery of pay-ments functionality will slowly erode VARsrevenue streams from installations, servicingand upgrades.

Over 500 payments gateway companiesenable connectivity and provide othervalue-added services for U.S. merchants.

Historically, gateways have served as animportant link between POS software or e-commerce Web sites and payments net-works; by eliminating the need to inte-grate with multiple processors, they savesoftware developers and VARs time andmoney. Today, payments processors are in-vesting heavily in making their platformseasier to integrate with software solutions.At the same time, software companies witha strong payments focus are building in-house gateway functionality (e.g., Micros)


or buying their primary gateway serviceproviders (e.g., NCR/Radiant). Going for-ward, gateway companies whose primaryvalue lies in connectivity will be underpressure to justify their role and may be-come acquisition targets for upstream ordownstream players. Successful gatewayswill offer specialized services such ascross-border payments or analytics tomaintain their relevance in the paymentsvalue chain.

ISOs

The ISO channel is facing intense pressuredue to declining margins and the emergenceof competitors that augment payments withother revenue streams. Some ISOs, such asMercury Payment Systems, have tailoredtheir business models to specific merchantsegments and distribution channels andhave gained market share as a result. On theother hand, traditional ISOs, whose princi-pal role in the value chain has been to pro-vide distribution reach to small businesses,will likely continue to lose market share.

Merchant acquirers and processors

Growth will be the primary challenge foracquirers and processors over the next sev-eral years. Electronic sales volume growthis decelerating, with about 8 percentgrowth per year expected through 2018 ascompared to the 10 to 15 percent volumegrowth over the past two decades. In addi-tion, intensifying competition for merchant

relationshipsincreasingly from new en-trants who view payments as an adjacentrevenue streamwill accelerate margincompression. As a result, industry revenuesfrom acquiring and processing merchantpayments are expected to grow by only 2 to3 percent over the next five years.

It is important to note that changes in themerchant payments industry will largely im-pact the small and medium-size segments.In general, new competitors pose littlethreat to acquirer and processor relation-ships with their large merchants. Large mer-chants will likely employ new, cloud-basedPOS solutions, but they will continue to in-tegrate these solutions with their existingenterprise technology over the next three tofive years, and will thus continue to main-tain direct relationships with paymentsprocessors. On the other hand, small andmedium-size merchants, unburdened bylegacy enterprise technology, are more likelyto leverage new solutions.

Payments networks

Among all industry participants, paymentsprocessing networks will be least affected bytodays disruptions. Because they are paid ona per-transaction basis, the networks arelikely to ride the wave of continuing volumegrowth unless a new competitor figures outhow to displace them. How that volume willget onto the networks is another question.To ensure a continuous flow, networks arestriking deals (see Chase and Visas decisionto create Chase Merchant Services, whichcould aggregate and lock up merchant pay-ments volumes for the next 10 years).

Banks

As economic and regulatory forces compressmargins, banks will look for ways to improve

Large merchants will likely employ new,cloud-based POS solutions, but they willcontinue to integrate these solutions

with their existing enterprise technology.


their returns. In particular, they will seek totransform small business banking by movingto remote coverage, expanding the breadthof products offered and increasing non-credit revenues. Banks may also renew theirinterest in merchant payments services.

* * *

To succeed in this rapidly changing market,payments players must examine the impactof these trends on their business and makeclear decisions about where and how theywill compete along the value chain. They

may need to rethink what it means to part-ner with otherstodays competitor couldbe tomorrows partner. Finally, companiesseeking success in the evolving environ-ment should strengthen their strategicplanning and mergers and acquisitionsskills so that they can quickly react in whatis likely to be a dynamic environment overthe next several years.

Jason Hanson is an associate principal in the

Chicago office, and Robert Byrne is a principal in

the San Francisco office.

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MoP19Innovation and Disruption in US Merchant Payments