Credit Card Industry: Overview

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Credit Card Industry Overview
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Credit card

• 13 16 digit
• Magnetic stripe storing data
• 11 million merchant location
• 860 billion worth of payment card purchases

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Open-loop vs Closed-loop

• ?Open-loop system
• ?Refers to the joint venture
• ?Closed-loop system
• ?Refers to a single firm

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Diagram open loop system
Merchant
1.Shop
3
4. Bill/Pay
2
American Express Discover Diner Club
2
2
Acquirer
Issuer
3
3
2. Authorization 3. Settlement
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How credit works

• Card Issuer
• ?Financial organizations issue the card
• Acquirer
• ?Signing up merchants
• ?Installing termainal?
• ?Providing authorization services
• ?Keeping track of transaction and providing
  report
• ?Transferring funds
• Customers
• Merchants

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Diagram closed loop system
Merchant
1.Shop
2.Authorization
3. Settlement
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Source of income

• Merchant discount
• (2 of transaction amount)
• Financial charge of outstanding balance
• Card service fee

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Two sided market Network Effects

• Exhibits network effects
• Positive Feedback
• More customers, more merchants
• More merchants, more customers.

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Increasing Returns

• Network externalities result in increasing
  returns in consumption
• The more customers a network gets, the more value
  the network to each customer
• e.g. the more people carry VISA cards, the more
  merchants take VISA cards. Then each VISA
  cardholder is better off by enjoying convenience
  and lower transaction cost

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• Network Externality creates the classic
  chicken-and-egg problem for the industry
• Who is first, merchants or buyers?

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• How to solve the chicken-and-egg problem here?
• Very aggressive competition in the early stage
• May rationally sell below cost for a substantial
  period, hoping to make it up on the volume
  later on
• Thats why many of the early entrants into this
  business lost substantial amounts of money and
  exited quickly.
• HSBCs Mondex disappear

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Visa MasterCard
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Mechanism (Open loop system)

• Visa MasterCard
• These two card systems entered in 1966
• Member responsible for issuing, acquiring and
  setting individual merchant discounts
• Card system responsible for advertising,
  production innovations and setting inter-change
• Different interchagne fee for different
  industries, but the same interchange fee for
  firms in the same industry.

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Mechanism (Open loop system)

• Many independent firms participate in the system
• In the association, individual member engages in
  issuing, acquiring and positioning
• e.g. Many issuing members compete in the issuing
  sector while Visa-system responsible for
  advertising activities

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Market Structure (Cont)

• Large number of competing firms
• No single dominant player
• Entry and exit are relatively easy
• Information is widely available to consumers
• Consumer switching costs seem low

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• In a two-sided market, it is important to adjust
  customers expectation
• it is important to make sure that customers and
  merchants believe that the card system already
  has a large customer / merchant base
• - Credit card systems spend a lot on advertising
• Visa Its Everywhere You Want to
  Be
• MasterCard Master the Possibilities
• Choose the Card that Makes a Difference

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Visa and Master -- Duality

• Virtually homogeneous products, so, competition
  mainly in advertisement
• Multi-homing on both customer and merchant
  sides, maintain the dual system in credit card
  industry

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Common Standard and Co-operation

• Joint venture Visa and Master
• Over time, VISA and MasterCard have negotiated
  corporately the rules for processing transactions
  that allow them to offer services competitive
  with the proprietary systems of AE and Discover

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Economics of Joint Ventures

• 1. Reasons
• conduct research development
• market through advertising or other promotional
  efforts
• exchange information
• establish standards

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Objective of JV - to maximize total value

• Need to provide incentives for members to
  increase the value of the JV
• Systems economic value depends on no. of
  customers who carry the card and the no. of
  merchants who accept it.
• To interact successfully, each company needs to
  trust each other but difficult to achieve
• Different national culture, business conducting
  methods, banks size, geographical regions,
  strategic focuses among members
• Decision-making is very time consuming

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• Divergent Objectives
• Independent entities with separate profit motives
• Major co-branding agreement

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Interchange Fee

• For simplicity, assume that all issuers and
  acquirers costs 0
• In this case, access fee is set by the system.
• Acquirers profit m a
• Under a fully competitive credit card market, all
  acquirers will compete for merchants until m a
  0. That is, m a
• Issuers Profit fa.
• Under competition, f becomes a, subsidy.

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Interchange Fee

• Interchange Fees are paid by acquirers to card
  issuers
• By changing an interchange fee, Visa can provide
  an incentive structure to get both sides on
  board.

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• What is the effect of increasing a?
• Giving more subsidy to cardholders.
• Penalizing more on the merchant side.
• For instance, too few card holders?
• ?In order to give more incentive on the customer
  side, they raise interchange fee.

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Closed loop

• All functions, including issuing and system
  functions
• are integrated into a single entity.
• For example AE make decisions about merchant
  discount, it will think about the impact on
  its profit from both cardholders merchants.

Issuing
Vertical Structure
Acquiring
System Function
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Closed-loop system

• Direct profit maximization by system
• Example Sams Club stores accepted only Discover
  since Discover set a low merchant fee for Sams
  Club, which Visa and Master cannot do. (Please
  note that Visa sets a common interchange fee for
  all stores in the same industry.)

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Advantages of open-loop system

• Innovation by multiple firms.
• Example American Airline idea of airline miles
  cards rejected by American Express but accepted
  by Citibank (joint venture with Visa)

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Disadvantages of the system

• Divergent objectives of individual firm inside
  joint venture
• In open-loop system, each member has its own cost
  and benefit consideration
• Self-interest VS Group interest

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END