Credit Cards, A Primer
The First Supper
In 1949, businessman Frank McNamara forgot his wallet while dining out with a client in a fancy restaurant, Major’s Cabin Grill, in New York City. Luckily, his wife came to the rescue and picked up the tab. To make sure this kind of embarrassing moment never happened again, he conceived of a brilliant idea: a charge card which would allow patrons to settle their bills at the end of each month. He returned to Major’s Cabin Grill with a polished business plan, his lawyer Ralph Schneider, and partner Alfred Bloomingdale.
Shortly thereafter, Frank McNamara founded Diners Club International and launched its first charge card with 27 participating restaurants and 200 cardholders, most of whom were the founders’ friends and acquaintances. The convenience brought by the card proved to be immensely popular. Within a year, Diners Club had 20,000 members. The company charged its cardholders a $5 membership fee, and its restaurants a 7% service fee. Two years later, he sold his interest in the company for $200,000.
The original Diners Club charge card is slightly different from today’s credit card. Although they both involved payments with a signature and the card (cardboard at the time), the settlement was handled differently. Credit cards involve a revolving account structured so that upon payment of the minimum balance, the cardholder can defer the remaining balance to later dates, subjected to interest accrual. Charge cards, however, require the balance to be paid in full at the end of each month. Failure to do so would not only incur a late fee, but also make one subjected to the possibility of legal action.
The Players
American Express, mostly known as an express mail and travel services business at the time, decided to join the game in 1957. With a $6 membership fee (that is, $1 or 20% higher than Diners Club), it branded itself as a premium product. It enjoyed a great success and attracted 250,000 members even before its official launch in October 1, 1958. A year later, it began to issue the industry’s first plastic charge card. Despite its early foothold in the credit card business, its first credit card (not charge card) wasn’t issued until 1987. Today, American Express remains one of the largest credit card companies, accounting for 27% of all credit card transactions in the U.S.
BankAmericard, the first modern credit card, was issued by Bank of America in 1958. Unlike its predecessors, which were mainly used by the wealthy and affluent, BankAmericard became popular among middle-class consumers and small-to-medium merchants. Over the next few years, Bank of America licensed its credit card system to various other banks, eventually spinning off as an independent entity, better known as Visa. In the 1970s, Visa introduced the world’s first electronic payment system, the VisaNet, which replaced its existing manual authorization, clearing, and settlement system. The introduction of Visa debit cards soon followed. It allowed foreign transactions to go through the international VisaNet network instead of the debit cards’ interbank network, which often had regional limitations. Today, Visa has 44% of the market share in the U.S., making it the biggest player in the credit card business.
Master Charge, the predecessor of MasterCard, was launched in 1966 by a group of Californian banks. Over the years, it went through a series of mergers and acquisitions to eventually become another major player in the credit card business. Although not known for innovation, its solid user base allows it to boast 24% of the U.S. market share.
Diners Club, the company that started it all, went through years of ups and downs. Eventually, its North American division was sold to Bank of Montreal and its International division to Discover Financial. Discover now has just under 5% of the U.S. market share.
The Mechanism
To understand the inner workings of the credit card system, we need to first identify the parties involved. In a typical transaction, there are five parts to the equation: the cardholder (that’s you), the issuing bank (that’s your bank such as CIBC, not your credit company such as Visa), the merchant (where you spent your money), the acquiring bank (the bank that will hand over your money to the merchant), and the network (the link between the issuing banks and the acquiring banks).
For example, if CIBC issues you a Visa credit card (which would have a PLUS logo at the back of the card), CIBC would be your issuing bank, and all your transactions would be processed on the PLUS interbank network, owned by Visa. On the other hand, when you use an American Express credit card (which would be issued by American Express instead of your bank), American Express would be your issuer, acquirer, as well as the owner of its American Express network.
During the payment process, the customer swipes or inserts the card, the merchant’s card reader (usually issued by the acquiring bank) sends an authorization request to the acquiring bank, which would relay the request to the credit card network, and then end up at the issuing bank. The issuing bank approves or denies such request, and relays the information back to the acquiring bank, across the network. The settlement process is similar, except with money involved. Let’s say you made a $100 dollar purchase at Walmart. Walmart would take the debt and forward it to its acquiring bank. The acquiring bank then forwards the debt to the issuing bank across the network. The issuing bank deducts $100 from your credit account, keeps a fee of $1.75 (hypothetically), then forwards the rest of the money to the credit card network. The credit card company keeps another fee of $0.18 while it delivers the money to the acquiring bank across its network. The acquiring bank once again keeps a fee of $0.07 and finally pays the merchant the remaining $98. The difference ($2.00) between what you paid at the cash register and what the merchant finally received after the settlement and clearing process is called the merchant discount, or the interchange fee. The numbers used here are made up to illustrate the process. The real merchant discount could range anywhere from 1%-6% in the U.S., with an average of 1.79%. This fee is also one of the reasons why your bank is always pushing you to have another credit card and is able to give you cash back and reward points.
Curiously, a number of banks issue credit cards that offer a more generous cash back, especially when you shop at specific merchants such as certain grocery stores or gas stations. For example, BankAmericard, resurrected by Bank of America fifty years after the credit card’s initial launch, offers 3% cash back on all gas purchases, 2% on groceries, and 1% on everything else. It’s counter-intuitive how the banks can afford to dole out more cash than what they collects. Nonetheless, this strategy has been well-researched and is fully backed by studies in consumer behavior. The special status of gas and groceries bestowed by the banks is not coincidental. In fact, gas and groceries have at least one thing in common — they are purchased on a regular basis, if not weekly. The goal is to build up the credit card holder’s muscle memory when they stop at a gas station and ponder which of the half dozen credit cards to use. More often than not, losses incurred by the banks on certain transactions would eventually be made up by other transactions made by the oblivious cardholder, who at this point would be conditioned to swipe that particular card upon seeing any card reader.
The Future
In the summer of 1914, an approximate 150,000 American tourists were stranded in Europe upon the outbreak of the First World War. Urgently in need of cash to return home, the American tourists were refused by local banks to cash out any foreign letters of credit. American Express, after venturing into the money order and travelers cheque business for more than thirty years, had already gained a formidable global presence. It cashed all money orders and travelers cheque in this turbulent time, allowing Americans to book their passage home.
A century later, the most important benefit offered by a credit card is still convenience, especially for those traveling abroad. As banks largely remain regional (even international banks are separated by political barriers, for example, a customer of HSBC Canada cannot easily withdraw money from an HSBC branch in the U.S., because they are separate legal entities), credit cards remain as the de facto way of spending money abroad, unless you don’t mind carrying a pile of cash on you. Because of the extent of the global credit card networks, it is unlikely for credit cards to be replaced by any other inventions in the foreseeable future.
Bitcoin, an anonymous cryptocurrency that suddenly became popular in 2013, might be the credit card’s biggest contender. Being entirely digital, it’s radically different from any kind of payment system that we’ve experienced. Being decentralized, not a single bank can control its supply and demand on the money market. Being peer-to-peer, it can be stored on one’s computer and move seamlessly across the Internet. This means that one can transfer money from Nunavut to Madagascar at 2 am on a Sunday morning. The transaction will only take seconds, completely free of any fees or charges, and best of all, anonymous. In fact, just around the time when bitcoins rallied from $100 a “coin” to over $1,000, an American couple from Utah managed to travel around the world using only bitcoins. Despite its unrivaled convenience, its exoticness has led many governments to place rules and regulations on such a digital currency. Warned of its potential risks by the European Banking Authority and effectively banned in China, it will take sometime before any digital currency can earn its place in the financial arena. In the meanwhile, credit card will remain America’s favorite payment method.
