In the marketplace today, we speculate 10 out of 10 merchantlevel sales people would report an increase in competitive intensity and a dramatic decrease in the price point necessary to sign a new merchant. Yet merchant acquirers continue to grow and generate highly attractive profit margins. Further, at First Annapolis Consulting Inc., we believe we can measure stable all-in pricing in the regional and local merchant market.
Declining pricing to attract new regional and local merchants but stable pricing overall? How can these observations both be true? Our research points to portfoliomanagement tactics and fee-based pricing as the key swing factors in acquirer performance, but our research also calls into question how much longer this approach can last. Merchant acquiring is a business with an economic structure that suggests price competition will be a central competitive element. Acquirers have utilized scale economies effectively to drive down variable processing and back-office costs precipitously over the past decade, but large players are benefiting to a greater degree from scale than small ones.
Every year, at First Annapolis, we have conducted research on acquirers’ list pricing for small merchants, dating back to 2001. The data in the research are self-reported and have other limitations, but they provide a time series on fee-based pricing, collected with consistent methodology over a period of time, with what is a material industry sample size. Our 2007 data came from 19 acquirers representing 60% of industry charge volume. Comparing our most recent 2007 research to the 2001 version yields interesting observations, all pointing in the same direction.
In 2001, only 47% of acquirers used an authorization fee, instead generally using transaction fees applied to purchase transaction volume. By 2007, 79% of acquirers used authorization fees rather than purchase transaction fees, in part because there are inherently more authorizations than purchase transactions, and acquirers generate more revenue with the same per-item price point.
In 2001, none of the acquirers participating in the research had a surcharge of more than 100 basis points (for downgrade surcharging, also known as enhanced bill-back), but by 2007, 37% of acquirers reported pricing the surcharge above 100 basis points as a matter of pricing policy. The percentage of acquirers with a monthly minimum discount greater than $20 increased from 30% to 53%.
In 2001, none of the acquirers reported an application fee greater than $100, but by 2007, 32% of acquirers had application fees at this level or higher. In 2001, 41% of acquirers did not use a termination fee, charged to a merchant who broke a merchant agreement before its contractual end. By 2007, only 5% of the acquirers in our research continued not to use a termination fee. The proportion of acquirers charging chargeback fees greater than $20 grew from 11% to 36%, and the fraction of acquirers assessing an annual fee of some sort increased from 29% to 63%.
Life Is Good
Not every fee type in our research has had the same pattern, but what emerges in totality from this research is clear. Acquirers are charging fees at a greater incidence and the price points on the fees have been increasing. And many of these fees have been introduced and/or increased through targeting the existing merchants in a portfolio.
At the same time, acquirers have become adept at managing interchange and have developed pricing structures that have significant margin opportunity. Acquirers almost universally tie their price increases to the bank card networks’ interchange releases. Though not every acquirer increases effective pricing with every interchange release, enough acquirers do change pricing sufficiently to create a great deal of turmoil and, frankly, cover.
There’s a rough consensus in the industry that so-called three-tier discounting (and its cousins, four-tier, six-tier, nine-tier, etc.) creates the most margin opportunity. This pricing model involves an acquirer quoting three discount rates—dubbed qualified, mid-qualified, and nonqualified— with interchange rates bucketed and associated with one of the three discount rates.
Downgrade surcharge pricing, however, which traditionally is the charge imposed when a transaction does not get the best interchange rate for which it is eligible, also creates significant margin opportunity. Yet any price point could be the so-called peg rate upon which the pricing is based. Some acquirers are discussing using reward cards interchange rates, which are higher than non-rewards rates, as pegs because of the rising number of rewards cards.
Both of these pricing structures have their pros and cons, but critics would argue that each relies on the merchant either not caring about the details or not being able to figure them out. All of this pricing evolution has occurred in what has, since 2001, been a generally rising interchangerate environment, where the total cost of acceptance has increased at a rate beyond just the rate of increase acquirers have effected.
There are alternative arguments, but First Annapolis believes that this pricing evolution points to the merchant behavior that we referred to above. Because acquirer pricing is not a material financial issue for most small merchants, merchants have great inertia in their current acquiring relationship, inertia that provides acquirers wiggle room to adjust pricing. (We believe merchant behavior Acquirers continue to have fixed and semi-fixed costs in sales and certain servicing functions. So for most acquirers, merchant pricing covers variable costs and generates very high contribution margins, creating what in most industries would be a huge incentive to compete on price to generate incremental volume and market share. Further, a small number of large acquirers have developed huge all-in cost advantages over the rest of the pack and could compete on price aggressively and still maintain profit margin, due to the cost advantage. So why is price competition not more prevalent?
Small Beer
Well, first we should say price competition is plenty prevalent in the national merchant market, where acquirer pricing has been in free fall for a decade or more—plummeting somewhere on the order of 8% to 10% annually, according to our best research. Further, there is rising evidence that a few of the large players have determined that they are going to lead the market with lower pricing, up and down the merchant spectrum. And of course, the freeterminal phenomenon is in many cases an aggressive form of price competition, impacting some parts of the acquiring business more than others (“No Such Thing as a Free Lunch,” March, 2006).
Merchant behavior, however, slows the rate of change considerably in the regional and local merchant market.
In the acquiring business, managers worry all night about a basis point (one one-hundredths of a percentage point) because a basis point is material to the performance of a portfolio. But few, if any, regional and local merchants let worries about a basis point disturb their slumbers. They stay awake worrying about merchandising. For the most part, acquirer pricing for the small merchant is small beer.
This has led to a highly inefficient market. The standard deviation in pricing in any given merchant segment, controlling for merchant size, is enormous. This is true in the industry overall, but it is also true within most acquirers’ portfolios. Some longstanding acceptance markets such as retail have lower standard deviations than new acceptors like business-tobusiness segments, but even in retail the standard deviations are huge.
Also, merchants have tended to under-value the impact of fee-based pricing, focusing instead on discount rate as the headline pricing element. is driven mostly by life-cycle factors that make a business more receptive to an acquiring pitch at certain times: at start-up, when it hires a finance professional, when it opens multiple outlets, when it changes control, etc.) So, life is good in the acquiring business. Acquirers can prosper by implementing higher effective pricing over time, and these pricing increases are generally not material to a customer base, which, by the way, cannot live without the service. In all these trends and evidence, however, we see risk in change.
Tottering Top Line
Our first argument is that because acquirer pricing strategy has converged, acquirers are no longer gaining competitive advantage or differentiation from these historical pricing strategies. Everyone has a chargeback fee, so it is no longer differentiating to substitute a chargeback fee for a reduced discount rate, or so the argument goes. This has become, rather, conventional wisdom.
In fact, quite the opposite—the most remarkable finding of our recent research is the percentage of acquirers that have migrated to actual or de facto interchange-plus pricing strategies, and have done so very recently, in most cases. On the order of a third of the acquirers we surveyed last fall reported using a form of interchange-plus as their primary discount approach. Interchange-plus is a more complicated but more transparent pricing approach that offers less opportunity for hidden margin. So in some parts of the business, acquirers are breaking in a different direction from conventional wisdom, and one that could result in lower margin.
Second, anecdotally, we feel there is a greater level of diversity in strategic objectives among acquirers now than there has been in the past. Some acquirers have seemingly concluded that the market is heading toward greater price competition and that they are going to beat the market to the bottom and at least enjoy the growth advantages that would likely accrue. Other acquirers appear to be targeting share growth as their primary strategic objective, and it is a smaller community of acquirers (though still the strong majority) managing to current-period earnings.
Third, these historical pricing approaches have been in play for a sufficient amount of time now that acquirers might be training merchants on how to evaluate the nuances of this pricing. Consider that for many independent sales organizations, the process of statement analysis is the primary consultative sales approach. In statement analysis, the sales person is inherently educating a merchant about how to interpret an acquirer pricing structure.
Though there are already apparent stresses in the ISO community in which a minority of ISOs are showing the strain of higher acquisition costs upsetting the financial algebra, I would not care to predict the timetable over which historical pricing strategies begin empirically to lose their effectiveness across the industry. It won’t be next year and probably not the next.
Acquirers, however, cannot ignore this possibility over a strategic time horizon. A great number of managerial sins are hidden by an environment where pricing on small merchants is stable, allin, and profit margins are wide. A less friendly top-line environment will offer acquirers less margin for error.
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