Value Creation and High Finance

The popular discourse these days seems to have turned very squarely against high finance. Banks and hedge funds are largely blamed for causing the financial crisis of 2008 by over-using leverage (the tactical assumption of debt), creating a system of dependencies that caused a massive liquidity crisis when faith was finally lost by the owners of the debt. This is an accurate description of what happened in 2008, but it is not an excuse to completely dismiss the conventional financial system as we know it. As the locus of financial power slowly moves west (to Silicon Valley, where shades of the dot-com era are showing themselves), it is important to remember that banks and hedge funds add value just as angel investors or venture capitalists do.

People gotta get paid

It is a true statement that in our current world order, people expect to be paid for their services. I do not think that is a controversial statement. Businesses that follow the “freemium” model make no secret of the fact that they expect to make money from their customers. Even startups in stealth mode or the pre-revenue stage still expect that at some point they will make money. All of these models expect to make money because they deliver a value to their customer, and startups especially are very loud about defining exactly that value.

Banks, however, are a lot more quiet about the value that they provide. Part of this is because your typical bank has an incredibly large diverse offering of services. So, individual services get drowned out. Let’s take the example of payment cards. When you use a payment card at a merchant, they pay their bank for the privilege of accepting your card, usually in the range of 1-3% of your purchase amount. Their bank takes a small cut, as does their payment processor and the card association that carried the transaction (Visa, MasterCard, and so on…).

The largest cut, however, is taken by the bank that issued you the card that you used to make the payment. They are referred to as the acquiring bank because they acquired the risk of financial loss associated to your transaction. To this day, we still do not have a good way to effect an instantaneous money transfer without delayed settlement of balances (bitcoin is, of course, an example of an attempt at this). So, there is always a risk that a payment that you said you were good for actually turns into a loss for the acquirer. In the case of card-present transactions, the loss associated to the transaction if this happens, or if the card turned out to be used fraudulently, is assumed by the bank.

This is exactly the value that the acquiring bank provides, and this is the reason why they are paid for assuming that risk. Aside from the sheer number of participants in this value chain, it seems to me that the value of the acquiring bank is lost because cards have become so ubiquitous. Banks, in turn, have had to really step up their game and have actually become so good at delivering their value that they never talk about it. Comparing this to the early stage start up that is still trying to define their value and communicate it to the market, it is clear that we are all so used to using payment cards that we don’t appreciate how they work.

Banks… have become so good at delivering their value that they never talk about it.

How much is too much?

The question, then, is how much should the acquiring bank be paid for assuming the risk associated to the transaction? Merchants would tell you that they are paying too much, and the banks would probably argue that they are being paid just the right amount (they are quite good at not rocking the boat too much). Indeed, several large merchants have attempted to form a payment solution (MCX) that cuts out the card associations, and therefore does not incur charges from the acquiring bank. The calculus here isn’t that they believe there is no risk associated to their transactions, but rather that the loss of risk is less than the cost of accepting cards, and that they can capitalize on the difference instead of the banks.

This idea that some level of risk is acceptable and understood has also taken up on the bank’s side. The so-called “Durbin Amendment” to the Dodd-Frank Wall Street Reform and Consumer Protection Act capped the fees that an acquiring bank may charge for certain debit card transactions. This is because debit card transactions are funded directly from checking accounts, and so the acquiring bank who issued the card should have visibility into how much money the cardholder actually has. Hence, less risk. This is a good step forward for merchants because it more clearly delineates the costs of acquiring risk.

However, it’s been the case that only the largest merchants have been able to save money as a result of Durbin. This is because merchants contract with card processors, who often offer smaller merchants a flat percentage based rate for all card transactions, whereas larger merchants have the option of paying the full cost of the transaction, plus an additional premium to the card processor. In the long run, while this is harder to manage, it also costs less. So, in the case of the flat fee, the card processor bets that consumers will use more debit cards then credit cards, which are not tied to a bank account, and are therefore riskier and more expensive. In achieving compliance with Durbin, many card processors were able to pocket the difference.

Due to the sheer number of actors in a payment card transaction, the economics of pricing and profits in the payment card space is hard to determine. There is certainly demand for security, and the newfound frequency of card breaches appear to speak some kind of supply of insecurity. So, assuming quantities are immaterial, what is the optimal price?