Digital Payments Monetization Part I: A Brief Primer on the Merchant Discount Rate
In our recent post, “Bips and Takes vs. SaaS: the Battle for the Future of Commerce and Fintech”, we argued that SaaS pricing strategies provided a better way forward than the traditional “bips and takes” most of the commerce and finance industry rely on. The prevailing models are not necessarily the best monetization schemes for each financial product. Instead, we believe monetization schemes are thriving mostly due to path dependency and long-established industry norms that make it painfully difficult for large incumbents to change.
To illustrate, we will dive into the world of digital payments, which plays a critical role in fintech and is highly complex.
The Importance of Digital Payments
Digital payments connect commerce and finance, providing valuable insights into consumer behavior and enabling businesses to access proprietary data. If in the world of health, “you are what you eat”, then in the world of commerce, “you are what you buy”. Payment data uncovers how much we spend, how often, on what type of items and so much more. In an economy where ~70% is driven by consumer spending, this is extremely valuable data. This has led to the rise of embedded fintech, where companies integrate themselves into the money flow and data flow of customer payments.
The Complexity of Digital Payments
Scaling a digital payments company is not simple. The payments industry continues to rely on virtually the same underlying infrastructure and monetization scheme (the merchant discount rate) that dates back to the 1950s. A significant concern is that a single party, the card network (like Visa, Mastercard, or American Express), determines around 70% of the fees earned by the key parties in the digital payments ecosystem. This creates fierce competition among fintech companies for a smaller share of the revenue. As a result, consolidation plays a critical role in the payment processing industry, with companies needing to scale to survive. We double-click on the merchant discount rate below.
Anatomy of the Merchant Discount Rate
The Merchant Discount Rate (“MDR”) is a fee charged to a merchant for accepting payments through a credit or debit card. It is expressed as a percentage of the total spend volume. The MDR can vary widely depending on a variety of factors such as the industry, the type of card used, the merchant’s transaction volume (i.e. larger merchants have more pricing leverage), and the type of transaction (i.e. card present vs. card not present) to name a few. In credit card transactions, the MDR typically falls between 1% and 3%. Assuming a Merchant Discount Rate (MDR) of 2%, here is a rough breakdown of how the economics are typically split:
Interchange Fee and Issuer Processor Fee: The Issuing Bank is the financial institution that provides customers with a credit card or debit card. The Issuing Bank earns the “gross interchange fee” every time that card is used to make a purchase offline, online, or in-app. The bank takes on the KYC, underwriting, and fraud risks, as well as account maintenance for their customers. As a result, they receive the largest share of the economics in digital payments. In credit card transactions, this fee is typically between 1% to 3%. In our example, we assume a gross interchange fee of $1.35 (or 1.35% of the purchase volume). The gross interchange fee is set by the card networks.
Banks typically outsource the card processing to a third-party issuer processor. The issuer processor is a technology service provider that manages the issuance of cards and connects the issuer directly with card and bank networks for transaction processing. In this example, the issuer processor receives $0.10 (10 bps) for its services. This fee is negotiated directly between the issuer and the issuer processor. We summarize this below:
Card Network fee: This is the revenue earned by the card networks, such as Visa and Mastercard. The networks provide the rails for payment and data flows that are necessary to authorize, clear, and settle (“ACS”) transactions. The fee can range from about 0.05% to 0.30%. For the purposes of this example, we assume a fee of 0.15%. This fee is set by the card network.
Merchant acquirer markup and merchant processor fee: The gross merchant acquirer markup is the fee earned by the merchant acquirer (or acquiring bank), which is the actor responsible for “acquiring” the merchant into the digital payment value chain. This also involves some underwriting, KYC, fraud, and default risk. Thus, merchant acquirers typically earn the second largest piece of the MDR economics. The fee can range from 0.1% to 0.5%. For this example, we assume a gross merchant acquirer markup of $0.50 (or 0.5% of the purchase volume). This fee is determined by the merchant acquirer.
Merchant acquirers often outsource the transaction processing to a third-party merchant processor. The merchant processor provides technology that collects sales information, relays authorization transactions to merchants, and collects funds from issuer banks. We assume a merchant processor fee of $0.10 in our example. This fee is negotiated directly between the merchant acquirer and the merchant processor. We summarize this below:
We note that merchant acquirers play an interesting role in the payments value chain as they are responsible for charging the merchant the entire MDR. The largest of merchants (i.e. Walmart, Costco, Amazon, etc…) demand to see the acquirer markup specifically laid out on invoices so they seek out the most competitive offers. This is called direct pricing (or cost-plus pricing). For most merchants, however, the merchant acquirer markup is a blur because merchant acquirers just charge one fee that bundles the acquirer markup together with the interchange fee and network fee. This is called bundled pricing.
Bundled pricing is one of the key points of contention in the industry as merchants push back on the lack of price transparency. This is just one reason why we recommend new entrants and early-stage fintech to explore alternative models to the MDR. We will address this and other issues with the MDR in our next post.