Card network fees, EMV regulations and merchant liability are creating an opportunity for crypto payments to become a serious thing.
At first glance, you wouldn’t expect to encounter much technological nuance amongst the bustling corridors of the crowded Wushan Night Market in Hangzhou, China. I remember browsing vendors in those crowded streets one humid evening, considering the purchase of fidget spinners and misspelled English t-shirts (the equivalent of Americans with Chinese symbol tattoos).
They claim that sense of smell is closely related to memory, and one particular fragrance immediately takes me back to that scene. It was an invasive aroma permeating from a street vendor cooking 臭豆腐 (chòudòufu), which literally translates to “stinky tofu”. If you’ve spent any time in China, you’re familiar with the dish. The vendor, an elderly man with grey hair, was skillfully frying, tossing, and stirring his batch of ingredients with expert touch. I could tell he was a man who had spent years honing his craft.
It wasn’t until the customer who ordered the meal began discussing payment with the older gentleman that I noticed anything special about the transaction. It seemed like a foregone conclusion that this vendor, wheeling his mobile mini-kitchen through the streets on a shabby fruit cart, would deal exclusively in cash. Yet when the customer pulled out her phone and presented a mobile payment application to the man, his reaction seemed as natural as putting the finishing touches on a dish.
I glanced around his small work station, wondering where he could have stashed a point-of-sale (POS) terminal. Instead, the man presented a laminated piece of paper with nothing but a QR code printed on it. The customer, activating a scanner from her payments application, pointed the rear-facing camera of her phone at the QR code. Once the app recognized the code, she input the price, confirmed the payment, and displayed the digital receipt to the street vendor.
I was fascinated by what I had just witnessed. The old man accepted payment-in-full using the amazing technology of paper. No screens, internet bandwidth or even electricity was required on his end — and somewhere out there in the cloud was a ledger balance of all his payments being routed into his bank. This transaction the street vendor made is part of a larger payments trend in China.
Antiquated Systems of Payment
As with the example of the street vendor in China, it’s apparent that mobile payments are beginning to catch on in some parts of the world, but the U.S. is not one of those parts.
Amazingly enough, in countries like China, customers have skipped from cash directly to mobile payments, whereas Americans continue to pay overwhelmingly with cards. This could partly be due to the robust retail banking establishments in the U.S. However, the current payments process in the U.S. is complicated at best.
Blockchain or cryptocurrency payments sound like another complexity amidst a saturated marketplace of mobile wallets, evolving card technology, and an endless supply of POS system providers. But consider the amount of players involved in modern card payments in the U.S., and crypto could actually offer simplification.
The Card Payment Process
Many of us take for granted the amount of heavy lifting that actually goes into making a payment with our credit or debit card. What you might not know is that when you pull out your card at the grocery store to pay $100, the grocer will likely receive closer to $97.
Whenever you swipe or insert your card into the POS terminal, the merchant must make a connection to their processor who then opens a channel between the merchant bank and your bank using card networks like Visa or MasterCard. This is the authorization process. Notice how many different players are involved in this one transaction.
The authentication process looks very similar to the authorization process except the arrow is going in the opposite direction. Essentially once the merchant bank understands you have enough money to pay for your groceries, they must send a message back to the merchant to signal the transaction was approved. All of this happens before you’ve even stuffed the credit card back into your wallet, but it doesn’t necessarily mean the payment was made yet.
There’s still one more step involved called the settlement process. Settlement is the process of sending the transaction data back to the bank so that they can be funded. To make this happen merchants must present approved card transactions to their bank. Keep in mind that this is a very simplified explanation of how a credit card transaction works.
Does all of this look like it’s free? Because it’s not. Whenever you pay a merchant with a credit card, that merchant is paying off every single hand in the cookie jar along the way. I’m sure you’ve encountered plenty of merchants who have minimums on card purchases or offer discounts to those who pay with cash because of the fees associated with this process.
The Fee is The Key
I began working on a project developing QR-code based loyalty programs for small retailers and restaurants in 2016. During that time, I quickly learned that credit card processing fees are a massive pain point, and a solution that can reduce these fees and deliver payment in a timely fashion is a huge opportunity.
Credit card fees vary depending on the platform the payment is made on, the type of merchant, and the credit card network. The fees that are charged to merchants are broken down and distributed among the actors within the payments process shown above.
From Wallet Hub:
Interchange Fees: The acquiring bank and acquiring processor pay this fee to the issuing bank. It is market-based and set by each credit card network. Most interchange fees are assessed in two parts: a percentage to the issuing bank and a fixed transaction fee to the credit card network. For instance, the per-swipe fee might be 2.35% plus $0.15.
Interchange fees vary and are categorized through a process called “interchange qualification,” which determines the rate based on several criteria:
Physical presence or absence of the card during the transaction
Processing method used (e.g., swiped, manually entered or e-commerce)
Credit card company
Card type (e.g., regular, premium, commercial, rewards or government-issued)
Merchant’s business type (as determined by merchant category code)
Assessments: Credit card networks charge this fee for transactions that are made with their branded cards. Assessments generally are charged per transaction but can vary depending on the pricing model the merchant follows. Combined with the interchange fee, assessments constitute between 75% and 80% of total card-processing costs.
Markups: Acquiring banks and acquiring processors usually will include a markup over interchange fees and assessments partly as profit and partly to cover the cost of facilitating credit card transactions. It constitutes between 20% and 25% of total card-processing costs.
Chargebacks: Customers reserve the right to dispute a charge on their credit card billing statement within 60 days of the statement date. When the issuing bank receives a complaint from a customer, it charges the merchant between $10 and $50 as a penalty and for issuing a “retrieval request.” If the merchant doesn’t respond to the retrieval request within a certain timeframe, it could incur additional fees. The merchant may appeal, but the process is long and likely to favor the customer. If the merchant loses, the issuing bank will recover, or charge back, the customer’s payment.
Does this all seem like a pain in the ass for merchants? That’s because it is. But it’s also an opportunity for blockchain to make things easier.
Exploring the Opportunity with Large Retailers
According to MarketWatch, Kroger Co. did roughly $110 billion in sales in 2016. According to TSYS, one of the world’s leading payments processors, consumers in supermarkets paid with cards at a rate of 80% during that same year. Therefore, we can estimate that roughly $88 billion in card payments were made at Kroger in 2016.
With average card transaction fees in the 2.5% to 4% range, we can conservatively project that Kroger took a $2.2 billion haircut from their bottom line in card processing fees alone.
If a blockchain-based payments platform could remove the overhead associated with third party networks, processors and banks, then charging even a 1% payment fee would more than halve the costs for these companies. In Kroger’s case, that payment provider would still gross $880 million in 2016….and that’s just for one retail brand.
“But wait!” you say. Many times, like in Target or Walmart’s case, commercial retailers deploy their own custom POS systems or open their own acquiring banks which saves them large amounts on their payment fees. This is true, but it also begs the question: if a company like Walmart is willing to invest millions of dollars into custom payments software, mobile applications and the opening of their own bank, how much money could a lightweight blockchain solution save them on development costs alone?
Opportunity vs. Adoption: Paying your barber with bitcoin?
There are dozens of solutions in the marketplace offering crypto-backed credit and debit cards, and while this is convenient for crypto-users, the solution is simply converting crypto to fiat and running the payment through the same old network.
True universal crypto payments would mean that the barber, the grocer, your niece on her 8th birthday and that cop who just wrote you a parking ticket all accept some form of crypto as payment.
Those are some lofty hurdles to leap over.
Hurdle 1: Merchant Adoption
Partnering with Kroger-sized companies is one thing. Unlike the fragmented merchants on main street, they have uniform POS systems, processors and banks. Ask anyone who has ever tried opening a restaurant or boutique shop — there are hundreds, if not thousands of POS, processing providers, loyalty add-ons, banking solutions and options to choose from.
Moreover, owners of coffee shops on main street are concerned about keeping their lights on and paying their employees. Anything that might add friction to how their business accepts payment is especially worrisome, and simply developing blockchain or crypto payment platforms doesn’t guarantee a broader acceptance from society.
Not all is bleak, however. We’ve seen some strong signs of willingness to adopt cryptocurrency as payment from small merchants using Square. The results of this survey are particularly exciting because of Square’s execution in defragmenting the small merchant POS space. Additionally, with flexible APIs, it’s possible that developers could battle it out to deploy the best crypto payments solution. Please note that the CEO and founder of Square, Jack Dorsey, has also been bullish on bitcoin as of late.
Hurdle 2: Payer Adoption
If merchant adoption is the chicken, then payer adoption is the egg. Although mobile payments haven’t hit their stride yet in the U.S. or Europe, there is reason to believe that crypto-payments could expose the technology to more adoption.
According to a 2017 Global Cryptocurrency Benchmarking Study from Cambridge, 81% of wallet providers are based in North America and Europe, [and] 61% of wallet users are based in these two regions. If a large portion of crypto wallets are held in the U.S., then the logical next step would be to convert those wallets into a tool for payment. And there are plenty of crypto-based startups planning to do just that.
Hurdle 3: Payment Volume
Processing payments is a voluminous endeavor. According to The Nilson Report in 2017, credit and debit cards were used for 102.5 billion transaction in 2016. That’s over 3,000 transactions per second, every second of the year. This is volume that current blockchains aren’t equipped to handle.
Plenty of folks in the blockchain space have heard of the bottleneck on the Ethereum platform caused by the popular crytopkitties application. Vitalik Buterin, founder of Ethereum, has described the scalability issues as a trilemma.
The “Scalability Trilemma” as seen on Ethereum’s github:
This sounds like there’s some kind of scalability trilemma at play. What is this trilemma and can we break through it?
The trilemma claims that blockchain systems can only at most have two of the following three properties:
Decentralization (defined as the system being able to run in a scenario where each participant only has access to O(c) resources, ie. a regular laptop or small VPS)
Scalability (defined as being able to process O(n) > O(c) transactions)
Security (defined as being secure against attackers with up to O(n) resources)
Alas, there are platforms claiming to have the technological firepower to beat the trilemma. For more information on those, and how they could potentially be leveraged into a payments system, check out Peter Keay’s series entitled “The Ethereum Challengers” wherein he covers the newest renditions of blockchain 3.0.
Hurdle 4: Compliance
In 2015, Americans were introduced to the “joyous” technology of EMV chips and the process of inserting cards into chip readers. The new method of payments was so enjoyable that CVS simply shut it off during the holidays, exposing themselves to potential liabilities associated with card skimming and fraud.
The new wave of EMV rollouts was costly for small merchants who needed to replace their card readers to prevent card-skimming. Some of the larger gas retailers still haven’t gotten around to replacing them yet; opting instead for mobile wallets and tokenized NFC payments. Now where have I heard the term “token” before?
Is EMV a hurdle for crypto payments? Not really. But continual additions of safety mechanisms for payments imposed by governments are making it harder and riskier for merchants to ignore upgrading their systems. It could turn out to be an opportunity. The hurdle will be whatever future regulations come down from the high and mighty governments of the world.
Guessing what kind of regulations might come out of crypto payments at this point are speculative at best. I reached out to members of the Payment Card Industry Data Security Standard Council (or PCI for short) for comment on how they plan to adjust to blockchain and mobile payments, but all I got was the run-around. It could be that I’m not important enough to warrant an answer, or it could be that they don’t have a plan. Because blockchain doesn’t need to use cards, and it doesn’t need a council of people telling it how to stay secure.
Every challenge is an opportunity. With the growing amount of headaches and risk surrounding card payments, and the explosion of crypto adoption, we may have the perfect recipe for a change in the way payments are made.
My Bold Prediction: Ubiquitous crypto payments by June 2026.