Credit cards have reduced friction in commerce by creating the possibility to buy now and pay later. However, there is no free lunch and this reduction comes at a cost for cardholders and merchants, which creates a handsome revenue for card companies. In this blog we look at the credit card business model, analyze its value network, and identify the value propositions that it delivers to its participants.
This blog is accompanied by a White Paper that gives a more complete explanation. Our analysis is based on public information found on the web. If you think we have misinterpreted the information that we found, or that we missed important information, please contact us at firstname.lastname@example.org.
The Credit Card Value Propositions
Richard Gendal Brown provides an excellent rational reconstruction of the credit card business model. Here is the short version of the story.
In the 1950s Bank of America in California wanted to issue a credit card to its customers. This was a new idea with a value proposition for three stakeholders:
- Delayed payment for cardholders: Using the card, cardholders could buy now and pay later. They don’t have to carry around cash, and they don’t even have to have sufficient cash to buy the product. Many people like this.
- More customers for merchants: Merchants could sell products to customers even if the customer does not have the cash on hand to pay for the product. This gives them more business.
- More fees to charge for Bank of America: Customers pay interest on the money advanced to them, and merchants pay a charge for using the credit card.
Later in this blog we will unpack and refine these value propositions. First, where do credit cards come in?
Enter Credit Card Associations
To implement this idea, Bank of America issued cards to customers and signed up merchants to accept this card. However, competitors issued cards too and signed up merchants to their cards. To be able to acquire products from any merchant, as they can do with cash, a consumer must have credit cards from all banks or all merchants must accept credit cards from all banks. This is unworkable.
To solve this, banks create a credit card association that provides Network Access and Brand Usage (NABU) services:
- Brand usage: Consumers and merchants recognize the logo of the Association. This makes it immediately recognizable for consumers and merchants whether they can use the card for a transaction. This is workable as long as there is a small number of brands and each brand is accepted by most merchants.
- Network access: The Association manages the communication of the merchant’s bank and the consumer’s bank and sets standards for payment traffic and fees.
Examples of Credit Card Associations are Visa and Mastercard. There are other Credit Cards that issue their own cards, such as American Express, but here we only look at the Associations.
We now have a two-level ecosystem architecture, as shown in the following diagram.
Credit card associations provide a platform for the issue and use of credit cards. The issuer is usually a bank who advances credit to consumers, the acquirer is usually a bank with which the merchant has an account.
Issuers and acquirers provide a platform on which cardholders can buy products on credit. Credit card associations provide a platform on which issuers and acquirers can authorize payments and transfer funds.
The ecosystem architecture can be more complex, because issuers and acquirers can delegate data processing to third parties, credit card associations use a settlement bank, and some credit cards, such as American Express, are their own issuing bank. But these stakeholders do not change the core business model and we ignore them here.
The Credit Card Value Network
Credit card companies create, deliver and capture value in a value network in which the different stakeholders provide services for which they get paid. Without this network, credit card companies have nothing to offer and so the credit card business model is a network business model. The following diagram shows the services realized in the network.
At the top, we have a cardholder who pays for a product (a good or a service). However, this is a delayed payment, and delaying the payment is a service of the issuer.
The issuer can only provide this service by cooperating with card associations and acquirers. Card associations provide network access and brand usage (NABU), and acquirers provide data processing services to merchants. With their help, the issuer can authorize the credit card transaction and transfer the payment to the merchant’s account at the acquiring bank.
Earlier we saw that NABU is a service of the card associations to the issuer and acquirer. However, these pass on the fee for NABU to the merchant, which is why it appears in the above diagram as a service to merchants.
In addition to the NABU service, card associations deliver additional customers to merchants, which would not have made the purchase without a credit card. We already noted this in the value proposition of credit cards for merchants.
The credit card value network rests on (1) the desire of customers to buy now and pay later and on (2) the desire of merchants to have more customers. Of these two, the customer’s desire for delayed payment is the crucial element that keeps the network alive. In a world where people would abhor late payment, merchants would have to do something else to attract more customers.
By contrast, in a world where merchants would abhor to have more customers, the need for delayed payment would still be sufficient to create credit card services. Even if merchants don’t want more customers, they surely don’t want to lose customers just because they don’t offer credit.
The other services of the payment infrastructure to the merchants are secondary. They do not drive the network but are needed to satisfy the needs for delayed payment and more customers.
The Credit card Profit Model
The services provided by the financial infrastructure are not for free. The next diagram shows the money flows of the network.
Interchange fees are very complicated because there are many of them, dependent on a large number of conditions, such as region, product, risk to the card association, the kind of card, the kind of payment (card present/not present, mobile) and many more. The list of fees for Visa and Mastercard is 32 pages long and contains many unexplained terms. Terminology varies across associations and may be mutually inconsistent or misleading. Luckily, CardFellow and MerchantMaverick provide very clear explanations.
To get an impression, here is a very simple example payment scenario, based on an example given by Richard Gendal Brown.
If a cardholder buys a product of €100 using a Visa credit card, one possible scenario is that the issuer charges an interchange fee of €1.80, Visa charges €0.14 and the acquirer charges €0.33 to the merchant. This gives us a transaction cost of €2.27 for the merchant. In the transaction process this amount is deducted from the amount transferred to the merchant, so the merchant receives €97,73.
Depending on the credit status and payment behavior of the cardholder, the cardholder may pay 2% monthly interest. If the cardholder repays the issuer before the end of the month, he or she pays €102 in total for acquiring the product. Annual interest rates in reality may range from 13% to 24% (which corresponds to 2% monthly), depending on the cardholders’ credit status and payment behavior.
Due to volume, this is a very lucrative profit model for the stakeholders in the payment infrastructure. According to Form 10-K of Visa for 2019, there are 3.4B Visa cards and 61M merchant locations where they are accepted. In 2019 there were 138.3B transactions for a total payment volume of US$8.8T. This generated a gross data processing revenue (the revenue generated by this value network) of US$10.3B for Visa.
Cardholders and merchant experience cross-side positive network effects. If more consumers have a card, merchants benefit, and if more merchants accept a card, consumers benefit. And in both cases, the financial infrastructure benefits.
However, merchants experience a negative same-side network effect. The more competitors accept a card brand, the less the card has the effect of bringing in more customers. Rather, acceptance of the card has the effect of preventing a decrease in customers. This makes the addition of new payment technology somewhat of a Red Queen race for merchants: They must run faster to stay at the same place.
The network scales very well for card associations. The marginal cost of adding a cardholder or merchant to the network is nearly zero. It scales less well for issuers, for whom the cost of customer service and debt collection staff is roughly proportional to the number of cardholders.
Multi-stakeholder value propositions
With this analysis we can refine the value propositions that we started with.
- Delayed payment for cardholders: Cardholders can buy now and pay later. However, products are more expensive.
- More customers for merchants: Merchants could sell products to customers even if the customer does not have the cash on hand. This gives them more business. However, they receive less per product and the add-new-customers effect transforms into a keep-your customer effect when all competitors accept the same credit card brands.
- More fees for the financial infrastructure stakeholders: Customers pay interest on the money advanced to them, and merchants pay fees for accepting the card. Scalability for card associations is excellent, for issuers it scales less well.
In the past five years, tech companies like Apple, Google and Amazon have introduced new payment technology to complement the existing card payment infrastructure. We will analyze the business models of these technologies in our next blog.