The Network ChallengersPeter Lucas

Capitalizing on merchants’ anger over bank card interchange, four upstart payment

networks are wooing retailers with the promise of lower costs and merchant-friendly

management. But will they really offer merchants viable alternatives?

It’s no secret that retailers hate interchange. Each time Visa and MasterCard raise interchange rates, merchants cringe as another bite is taken out of their bank card charge volume to pay card issuers. Then they make a lot of noise about embracing alternative, lower cost payment networks.

Historically, those threats have proved empty, as merchants had no ready-made alternative. Nor have many been willing to band together to undertake the cost and administrative headaches to build a rival network. If they take action at all, merchants typically seek redress in the courts.

But now four merchant-centric networks have appeared on the horizon: Debitman, FastLane, PayPilot, and Pay By Touch. Each is preparing this year to expand or launch operations, giving merchants hope that their acceptance costs can be substantially reduced.

By announcing their intentions to compete for volume at the point of sale, the four networks are marketing themselves as more than just low-cost alternatives to the bank card networks. Three of the chief selling points are merchant control over branding of the customer access device, customer account data, and tighter security to reduce fraud losses.

Merchants in Revolt

It’s an enticing proposition for merchants, because control over the customer account allows them to steer the consumer to the lowest-cost payment method. Even more encouraging for these upstart networks is that market conditions seem ideal. Merchant disgruntlement over interchange has reached a crescendo; by last count, some 47 merchant lawsuits challenging interchange were pending.

“Merchants are in revolt against interchange, which means the time for alternative payment networks to succeed is now,” says Gwenn Bézard, director of research for Aite Group LLC, a Boston-based consulting firm. “The conditions aren’t going to become any more favorable.”

Still, success is far from assured. The key will be signing up enough merchants to make the new networks legitimate alternatives, as opposed to niche offerings. Visa USA and MasterCard International have about 6 million merchant locations in the U.S. In contrast, though they’re guarded about their numbers, the new players, some only in start-up mode, currently have just a handful to maybe 200,000 locations at best.

Besides signing a critical mass of merchants, the networks must persuade consumers to use new payment devices, then generate millions in monthly transaction volumes.

To achieve that goal, Debitman, FastLane, PayPilot, and Pay By Touch must sell merchants more than lower costs; they must have value-added propositions such as customer-loyalty programs that attract consumer interest. Ease of terminal use and network connections also will be central to each network’s marketing strategy.

“Loyalty is a big issue with merchants, because it costs anywhere from $50 to $500 for a merchant to win back a customer, depending on the type of customer,” says Dan Schatt, a senior analyst for Celent LLC, a Boston-based research and consulting firm. “As merchant margins shrink due to higher operating costs, which includes card acceptance, they want customer retention vehicles that are easy to implement, don’t cost a lot, and will enable them to boost profits.”

It’s an immense challenge, but one which the newcomers are confident they can meet. “We are solving the problem merchants face when it comes to acceptance costs, while providing a neutral and autonomous infrastructure,” says R. Scott Hatfield, president and chief operating officer of Chico, Calif.-based Debitman Inc. “We are giving them their cake and letting them eat it too.”

Perhaps, but at the very least, the four networks finally are giving merchants something to back up their threats of shifting volume away from the bank card networks. “Some of the merchant-centric networks are making impressive strides, but what it is ultimately going to define their success is their value proposition,” says Aite’s Bézard. “The technology is only one component. There needs to be something else.”

In most cases that is either a loyalty program that gives the merchant full access to cardholder transaction data or tighter security to reduce fraud and chargeback disputes, or both. Network executives consider ownership of customer data and better security attractive selling points with merchants because today banks, as issuers of general-purpose cards, own their cardholder data while merchants carry most of the liability for fraud and chargeback resolution.

Debitman, which was formed in 2002 and began actively marketing to merchants in 2004, is pegging its future in large part on delivering merchants the data they need to create a better loyalty program. Merchants issue payment/loyalty cards on the network featuring their brand, which can then be used at any merchant in the Debitman network unless otherwise specified by the card issuer. The open-loop concept is intended to provide card issuers with a fuller picture of their customers’ spending habits, rather than just the snapshot that occurs at their store.

“Once merchants have control over the cardholder transaction data, they can develop loyalty programs and gain marketing insights at a potentially lower cost than they already do,” says Celent’s Schatt.

Debitman merchants pay 15 cents for each transaction, each of which is routed through the automated clearinghouse, and earn 6 cents every time their card is used elsewhere within the network, à la the Visa/MasterCard interchange model. Hatfield contends the only way for merchants to force the card associations to lower interchange is to beat them at their own game.

Last year, Debitman secured $3.5 million in equity funding, which will be used to position the network to compete directly with Visa and MasterCard, according to Hatfield, who prior to founding Debitman built payment processor National Data Funding Corp. Debitman also has signed four leading merchant acquirers that can provide access to hundreds of thousands of merchants, though so far this access has been limited. They are: Fifth Third Bank, RBS Lynk, Chase Paymentech, and a fourth processor yet to be announced.

“Our objective is to create a true competitive network to Visa and MasterCard, because direct competition is the only way merchants will get interchange relief,” says Hatfield, who declines to reveal the number of merchants signed and monthly volume generated. “If merchants don’t get the payment network they’ve been clamoring for, there will be no competitive pressure on Visa and MasterCard.”

The key stumbling block facing Debitman, according to payments experts, is the classic chicken-and-egg conundrum. Its chief problem right now is that it hasn’t been able to entice enough merchants to issue cards for all the acceptance points it’s recruited. Indeed, though the network scored a coup late last year by signing Wal-Mart Stores Inc. to accept its cards, the giant chain made no indication it intends to issue Debitman. If Debitman can’t create a truly interoperable network by signing more national and regional merchants to issue cards, it is likely to end up being little more than a series of closed-loop merchant networks that can make some noise, but probably not enough to compete with the bank card networks.

“Merchants aren’t necessarily keen on issuing cards that can be used outside their stores,” says Aite’s Bézard, who points to the wild popularity of closed-loop gift cards.

Hatfield insists he will let merchants issue and accept cards in a closed-loop environment if that is what they want, but remains confident his message of interoperability will prevail. “There is still of lot of merchant education that has to be done,” he says. “But if merchants want to compete for real estate in the consumer’s wallet, they are going to need to issue interoperable cards. There is value in interoperability; some merchants just need to remove their blinders.”

‘Merchant Community’

Better positioned coming out of the gate to challenge Visa and MasterCard is San Francisco-based Pay By Touch Solutions, which offers a biometrically secured ACH payment service but also allows consumers to bill their credit or debit card. Pay By Touch’s system uses fingerprint identification to authenticate customers, linking their payment accounts to mathematically derived templates of their prints.

Infused last fall with $130 million of investor capital, the network quickly raised its profile by going on an acquisition binge. First, Pay by Touch bought a substantial slice of merchant processing business in the remnants of processor CardSystems Solutions Inc., which included 120,000 merchant contracts, for $47 million. Prior to the acquisition, Pay By Touch had 7,000 merchant locations.

Next, Pay By Touch plunked down $82 million to buy a direct competitor, Herndon, Va.-based BioPay LLC, which had put its biometric POS system into 1,600 stores. BioPay got its start offering merchants a biometric-based authentication solution for payroll check-cashing at the point of sale.

“Pay By Touch isn’t buying the BioPay solution as much as it is building a merchant community,” says Ariana-Michele Moore, a senior analyst for Celent. “BioPay expands their business.”

Pay By Touch says it will be focusing on signing the country’s largest multi-location retailers, a market segment that includes supermarkets. The company says is adding about 100 merchant locations a week.

One area where Pay By Touch has gained a clear edge over its rival upstarts is in wrangling concessions from the card companies on merchant fees. Pay By Touch has secured an agreement with Morgan Stanley’s Discover Card Services to qualify a transaction made over its network with a Discover-branded card for its lower-cost card-present rate. That is considered a small coup for the network, since Visa and MasterCard still charge transactions made through Pay By Touch at their card-not-present rates, which are higher than card-present interchange rates. “As Pay By Touch takes hold, it will be interesting to see what Visa and MasterCard do in response,” says Moore.

Pay By Touch thinks it eventually will be able to convince the card associations to follow Discover’s lead. Carolyn McNally, chief marketing officer for Pay By Touch, says she has spoken with MasterCard about the subject, and says officials there acknowledged merchants’ concerns about being charged card-not-present rates in highly secure environments such as Pay By Touch’s.

“MasterCard recognizes that there is pressure mounting in the merchant community to modify card-not-present rates,” says McNally. “There are already a lot of complaints about the card-not-present rate attached to card numbers on file in drug stores. It’s clear that rates need to change.”

Even if the bank card networks grant a special dispensation to Pay By Touch, the network must still clear other several hurdles. Like any highly secure technology, consumers first have to become comfortable with it before they’ll use it for payments. The longer it takes for consumers to embrace biometrics at the point of sale, the greater the chance the technology will remain rooted in a closed-loop environment.

“It is hard to cheat a biometric system, but many merchants still approach biometric solutions conservatively,” says Moore. “Plus, biometric standards are evolving, which leaves the technology about a decade away from becoming a mainstream payments solution.”

By some estimates, that would open the door for a merchant-centric network to be built around another technology such as radio frequency identification, or RFID. This technology uses radio waves for data transmission between the payment terminal and a transponder that acts as an access device to the consumer’s payment card data. RFID, which was first introduced to consumers by Exxon Mobil Corp., and later by MasterCard, American Express Co., and Visa, has already cleared the consumer acceptance hurdle.

Hoping to leverage consumer acceptance of RFID, Seattle-based Accelitec Inc. last year launched PayPilot, an RFID-based merchant-centric network. The network currently is in beta test with an unidentified merchant and expects to begin expanding the merchant base in 2006. Accelitec is targeting merchants that place a premium on speed and convenience, such as quick-service restaurants, gas stations, and supermarkets.

Part of PayPilot’s appeal to merchants is that it offers the potential to reduce transaction costs by shifting some volume to the ACH. Accelitec contends that if merchants move just 10% of their payment volume to the ACH, they can substantially lower their acceptance costs.

The other key selling point is that merchants have control over branding of the payment device, be it a key fob or other device fitted with an RFID transponder, and the cardholder data.

“This is a 21st Century, closed-loop, private-label network,” says Alan Schultheis, a director at Edgar Dunn & Co. and former a MasterCard executive who has been hired as a consultant by PayPilot.

To ease technical issues at the stores, Accelitec is building PayPilot on Microsoft Corp.’s .Net platform. The aim is to connect seamlessly to the integration pathways most merchants have established between their POS terminals and back-office servers. Most merchants run Microsoft-based applications, such as the Excel spreadsheet program, on their servers.

Accelitec envisions using the .Net platform through its PayPilot system to allow merchants to download transaction and consumer information captured over its network directly to merchant servers and view it in real-time. On the flip side, consumers can access their account data using a personal computer and download them into Money, Microsoft’s personal-finance application. The ubiquity of the Microsoft platform also makes it easier for merchants to send messages to their customers on their cell phones.

“We are focused on integration,” says Fred Miller, director of business development for Accelitec, who adds the company has hired several former Microsoft developers. “The .Net platform provides the integration paths and the tools commonly used by merchants and consumers.”

Still, questions loom about the network’s long-term viability, even though MasterCard and AmEx are making gains with their RFID products, PayPass and ExpressPay, respectively. “RFID is a good vehicle for a payments solution and it is showing strong signs of becoming widespread and getting consumer attention, but it is going to be the value equation, not the technology, that drives merchant acceptance,” says Bézard.

Paying Merchants

Keeping that in mind, Boulder, Colo.-based Combined Payments Network LLC has developed a value proposition for its FastLane network based on converting driver’s licenses into loyalty/payment cards. A merchant that enrolls a customer in the network receives between 5 and 10 cents for each FastLane transaction performed by that customer. The fees will offset the transaction fee charged by FastLane, which the network has yet to determine. FastLane plans to formally unveil its system at the annual Electronic Transactions Association meeting in April.

The network’s initial focus will be on loyalty and gift programs. In the case of the latter, a consumer would log onto her FastLane account using a PC and deposit funds into the account of a registered FastLane user via the ACH. Once notified the funds are available, the recipient goes to a FastLane merchant, swipes the card, enters a personal identification number, follows the prompts, and prints out a payment voucher that is cashed by the merchant

Merchants can offset their FastLane acceptance costs with advertising revenues generated by the network. FastLane merchants agreeable to having a short marketing message appear on their POS terminal will get 50% of the proceeds if the consumer hits the “Yes” button. FastLane recently signed a $2 million deal with a mortgage lender. Participating merchants will earn $2 on every positive impression.

FastLane is even looking at having merchants print out coupons for FastLane users good at other local merchants. Carl Towner, FastLane’s chief executive, envisions the program gaining traction within malls, where retailers may print up a coupon for a nearby fast-food restaurant. Merchants printing the coupons would receive a placement fee.

“Focusing on low transaction pricing leaves you vulnerable to being undercut,” says Towner. “Creating other revenue streams for the merchants improves our value proposition.”

Indeed, but until alternative networks can demonstrate the ability to generate the necessary consumer acceptance and enough ACH volume to make a noticeable dent in retailers’ acceptance costs, they will not prove to merchants they can compete with the heavyweight bank card networks.

“What will win out is the ability of a merchant-centric network to grab customers and lock them away for the merchant with value-added offers that hold their attention,” says Celent’s Schatt.

Until that happens, merchants may well be stuck with bank card hegemony at the point of sale and the interchange status quo.

There at the POS Terminal, It’s Debitman

Intent on beating the bank card networks at their own game, Debitman Inc. is telling merchants it will guarantee all transactions. The network says it will cover any transactions bounced after the fact for non-sufficient funds or potential fraud.

“We offer this guarantee because we don’t want to be just another network,” says R. Scott Hatfield, president and chief operating officer. “We are PIN-based because it is more secure, but not even banks will authorize a PIN transaction if there are non-sufficient funds. We will.”

Debitman minimizes its risk by collecting from the cardholder $5 for the first overdraft, $15 for the second if it occurs within 60 days of the first, and $25 for a third within 60 days. If a cardholder is deemed too high a risk or likely to be perpetrating fraud, Debitman can deactivate the account until it is brought current or concerns over suspected fraud are resolved.

“We are truly merchant-friendly, we don’t want merchants getting stuck from those types of transactions,” says Hatfield.

Debitman’s payment function is tied directly to the card issuer’s loyalty program. Network merchants reissue existing loyalty cards with a magnetic stripe containing the cardholder’s bank-routing and checking account information. The cards also feature a bar code that contains loyalty account data. To initiate a transaction, the cardholder swipes his card and enters a personal identification number.

Retailers can use the customer data to deliver discount coupons at the point of sale or other incentives, such as loyalty points that can be redeemed later or at the time of transaction.

“To be truly merchant-friendly means being neutral and autonomous,” says Hatfield.

Pay By Touch: Liberation Through FingerprintsRather than attempt to push its payment device to the forefront of the consumer’s physical wallet, Pay By Touch is going one better by creating an electronic wallet. Pay By Touch’s e-wallet liberates consumers from having to carry a payment card or checkbook with them when shopping at a Pay By Touch merchant.

Consumers create an e-wallet by first enrolling in the Pay By Touch program. After showing the merchant valid identification, they swipe a finger several times over a biometric reader, which scans an image of their fingerprint. Next, they swipe whatever cards they intend to use at the point of sale, such as credit, debit, or loyalty. All account data are stored at a secure IBM Corp. data center, and the biometric image is encrypted.

When a customer wishes to access her wallet, she is cued through each payment option in her wallet. Some payments experts call it a subtle but effective marketing move, as most consumers are unlikely scroll down very far. Clever merchants can show the lowest-cost option—the customer’s checking account—first.

“We are giving merchants more opportunity to influence the type of payment vehicle customers use,” says Carolyn McNally, chief marketing officer. “Lower acceptance costs are a big motivator for them.”

So far, users are loading 50% of their e-wallets with the ACH option only and the other 50% are loading full wallets, according to data from research firm Celent. Such statistics would suggest merchants are doing a good job steering consumers toward ACH payments, but that can’t be confirmed because Pay By Touch does not reveal the size of its user base.

A Pay By Touch terminal costs $1,000 and merchants pay 12 cents per transaction in addition any other network fees, such as an ACH fee or interchange. While the latter is a potential turn-off to merchants

because bank card transactions made over the Pay By Touch network qualify for higher card-not-present interchange rates, McNally is confident it will be a non-issue.

“Merchants know what impacts their operating costs,” says McNally. “We offer a low-cost ACH option, better security, and greater customer convenience. We’ll even show merchants how to get consumers to shift their payment habits to the ACH.”

PayPilot’s Security Pitch

While most consumers may equate radio-frequency identification (RFID) technology with convenience, security is a major selling point being pitched by PayPilot to potential merchants.

Leveraging Microsoft Corp.’s .Net platform, PayPilot allows merchants and consumers account access via personal computers. The system makes it possible for merchants to call up the photo identification for each user in the system at the point of sale to verify their identities. Photo IDs are taken at the time of enrollment.

PayPilot supplies the complete POS system, including enrollment kiosks, tokens, and transceivers. Parent Accelitec Inc. runs the network, switching transactions as required to merchant acquirers (Digital Transactions News, Aug. 16, 2005).

Consumers can freeze their accounts using a PC if they have lost or misplaced their RFID transponder. “We can suspend activity on the account until we know it is gone for good, and then issue another transponder,” says Fred Miller, director of business development for Accelitec.

Like the Pay By Touch model, PayPilot offers consumers the opportunity to set up an e-wallet. Consumers can load their checking account data, create prepaid accounts, and designate credit cards to be billed. When a cardholder initiates a transaction, he designates the account(s) from which to draw the funds. The cardholder can designate a percentage to come from more than one account.

“Merchants can choose what types of payment options they want to offer and put their own brand on the payment device, whether it be a key fob, card, or attachment to a cell phone,” explains Miller. “Our aim is to give merchants a lower-cost payment option they can brand, rather than compete against the bank card networks.”

In the FastLaneAs part of its efforts to create a ubiquitous cardholder base, FastLane is tying access to its network to something nearly everybody over the age of 16 carries: a driver’s license.

And it’s a card base ready-made for electronic payments. About 70% of all driver’s licenses have a magnetic stripe to which merchants can tie loyalty and gift card offerings. In states that don’t issue licenses with mag stripes, cardholders can enter an ID code and PIN at the point sale after registering their licenses with the network. FastLane will require a software download by client retailers.

“Merchants aren’t so keen about issuing another card to compete with the five or 10 that are already in a consumer’s wallet,” says FastLane chief executive Carl Towner. “Our model converts a piece of plastic consumers deem valuable and always carry with them into a merchant card that can push the merchant’s brand to top of mind.”

By April, FastLane expects to be operating three data centers to support consumer enrollment, route messages to POS terminals, and switch transactions. FastLane will transmit encrypted transaction messages from terminals to the secure data centers, with critical information handled only on offline servers. The network also is contemplating excluding Visa and MasterCard acceptance on its network as a way to keep merchant acceptance costs down, according to Towner.

“We have set a pretty lofty goal of competing with Visa and MasterCard,” he says. “We think we can do that by not requiring merchants to make a capital investment to connect to our network.”

Towner says FastLane plans to offer lines of credit as well, which will turn the government-issued pieces of plastic into credit cards. The company is also in discussions with two unnamed automated teller machine networks about allowing consumers to access accounts into which person-to-person payments have been deposited.

“Security, convenience, and price is our marketing message,” says Towner.