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Update Newsletter: Summer 2008

The Merchant-Acquiring Side of the Payment Card Industry: Structure, Operations, and Challenges

The PCC hosted a workshop on the merchant-acquiring side of the payment cards industry led by Marc Abbey, managing partner at First Annapolis Consulting. The workshop was organized to provide professionals from various areas within the Bank with a better understanding of this generally less familiar side of the industry. A subsequent analysis written by one of the PCC's industry specialists, Ann Kjos, "The Merchant-Acquiring Side of the Payment Card Industry: Structure, Operations, and Challenges," PDF draws from the workshop discussion and outlines factors that have affected the evolution of the industry. Her paper also describes Abbey's view of current industry dynamics and provides commentary on several emerging issues that will likely have a significant impact on the merchant-acquiring function. When credit cards first entered the market, banks typically functioned as both issuers and acquirers; that is, they both issued the cards to their customers and acquired the transactions from local merchant clients. Beginning in the 1980s, the issuer/acquirer bank structure began to evolve into two generally separate and specialized business lines. As many commercial banks exited the business, they were often replaced by nonbank firms, especially on the data-processing-intensive acquiring side of the business. As in other areas of payments innovation, technology had an important role to play in the evolution of the acquiring business. Chief among these was the introduction of electronic terminals at the point-of-sale, an innovation that eliminated the need to process paper receipts. The transition from paper to electronics decreased the cost of processing transactions just as the number of transactions was increasing and allowed acquirers to service a broad segment of merchant customers without regard to geographic location. Soon, acquiring became a scale-driven business, with acquirers focusing on transaction volume and competing for relationships with large merchants.

Ann Kjos, Industry Specialist, Payment Cards Center, Federal Reserve Bank of PhiladelphiaAnn Kjos, Industry Specialist, Payment Cards Center, Federal Reserve Bank of Philadelphia

Acquirers provide a broad range of services to their merchant customers either directly or via subcontracting with specialized service providers. These activities include everything from installing terminals and operating help desk hotlines to, most important, processing transactions. Payment for many of these services comes from the discount taken on each sales transaction. The largest portion of this merchant discount goes to the card-issuing banks in the form of an interchange fee. A relatively smaller portion of the fee goes to the network, and the remainder accrues to the acquiring bank. Reflecting the scale nature of the acquiring business, competition has driven the profit margins for large volume merchants to relatively low levels, with small to medium-size merchants accounting for most of the acquiring industry's profitability. First, Annapolis estimated that small merchants generated 42 percent of the acquiring industry's net revenue but represented less than 10 percent of its sales volume in 2004. The largest merchants, on the other hand, provided 6 percent of the industry's net revenue but 52 percent of its sales volume. As is typical in low margin scale-oriented businesses, efforts to reduce costs and increase productivity are high priorities for all acquirers and help explain the growth of outsourcing in the industry.

While, to date, the merchant-acquiring side of the credit card business has received scant public attention, Abbey suggested that this might be changing. For one, recent data security breaches at national merchants have become a well-publicized concern of regulators, policymakers, and the industry. The payment networks have taken strong actions to protect cardholder data at the merchant level based on guidelines produced by the Payment Card Industry (PCI) Security Standards Council and its resulting PCI Data Security Standard (DSS). These new data security standards have added a significant cost burden for many merchants because merchants must make investments to upgrade systems. Merchants' failure to comply with the standards can expose the merchant-acquiring banks to network fines and penalties. The second potentially influential impact on the acquiring industry noted by Abbey is the changed ownership structures of the Visa and MasterCard networks. Historically structured as bankowned associations, both networks recently converted to publicly traded corporations. While it is too early to predict the effect of ownership changes at MasterCard and Visa, Abbey speculated that market demand for financial performance could lead them to compete more directly with their previous bank owner-partners for processing activities, forging closer relationships with merchants and potentially disintermediating some of the traditional acquiring functions of banks.

In conclusion, Abbey's presentation emphasized that the often overlooked merchant- acquiring functions are integral components of the payment cards industry. Recent developments in the industry, particularly the challenges posed by data breaches and the emergence of the PCI standards, have brought greater awareness to the sensitive role played by the acquirers and their agents. Similarly, as the industry structure evolves and merchants continue to push for changes in traditional payment system relationships, it will be important for policymakers and others to closely monitor and evaluate these developments.