One thing many people do not know about the Durbin amendment is that it exempts small banks (defined as banks with less than $10B of assets).  For debit cards tied to checking accounts at those banks, the interchange rate will remain the same.

But what share of debit card transactions are from big banks?  Around 70%.  The FDIC reports that 73% of deposits are held at banks with more than $10B in assets.  It stands to reason that the ratio of transaction volumes is about the same.

This is great news for businesses that accept credit and debit card payments, provided that their processors are actually going to pass on the cost savings.  If you are worried that your processor may not pass along the savings, use FeeFighters to find a new one, all of our customers will have the Durbin savings passed along in their entirety.

Pulse, one of the big debit card networks (which is owned by Discover) recently published that the average debit account generates $87 per year for the bank in interchange revenue.

So now you know how much your bank makes in interchange from your account.

That source of revenue will be greatly diminished by the Durbin Amendment to the Dodd-Frank Wall Street Reform Act, which will cut that interchange revenue by around 80%. This explains why banks are upset.

Banks also have other sources of revenue, like net interest margin and overdraft fees, but interchange is often around 30-50% of the banks revenue from checking accounts.

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Compared with the public markets, where tech company valuations are still pretty modest, the private rounds seem unrealistically bullish.  Is that a sign of a private market bubble?

Maybe.  One thing to consider though, is the valuation the journalists talk about rarely captures the true economic value of the investment.  When a VC invests, the investment comes with extra features that public shareholders don’t get, such as the liquidation preference. When the real value of those extra features is factored in, the actual valuation of these rounds is much lower.  As much as 50% lower.

It is difficult to quantify the exact value of a liquidation preference, but one way is to treat is like a financial option and use a binomial option pricing model.  More sophisticated versions of that model are used to value tradable options on wall street.

By making some assumptions about the volatility of the underlying asset (in this enterprise value of the company), we can come up with a value for the liquidation preference feature of the preferred stock that the investors are buying.

My (very quick) calculations, which are attached in a spreadsheet, indicate that a 1x non-participating liquidation preference on a round of $100M on a pre-money of $1B is worth an additional $75M.  In other words, the investors are getting 16% of the economic value of the company when you fully take into account the value of the liquidation preference, rather than only 10% of the value.  If the round is participating preferred (ick!) the investors get 21% of the value, more than twice the value that the simple math implies.

If you want to play with my assumptions, here is the spreadsheet —> binomial-pricing-venture-capital-v2

Disclosure – I am not a pro at this, I am just an entrepreneur who went to a business school where they talk about option pricing a lot.

Photo courtesy of tracy_olson.

Square is attempting to create an alternate payment network to compete with Visa and Mastercard.  Creating a new payments network is incredibly hard but, if successful, very lucrative and defensible.  The hard part about creating a payment network is controlling both sides of the transaction – the customer and the store.

1. Register will become popular – existing POS systems are too expensive and complicated for most businesses.

Traditionally installing a new POS system is such a big project that it requires hiring outside consultants.  Such projects can easily cost $10,000 or more of consulting time, in addition to the expensive license fees for the software itself.

For example, Intuit POS costs $999 for the starter edition (Pro is $1499) – And that product is simple and cheap relative to other POS companies… Though it locks you into Intuit merchant services, which are a very bad value (compared to rates that you’d get on FeeFighters)

The brokenness of the existing POS market bodes well for Register, and for all the other startups going after that market – including ERPly, CashierLive, Facecash, VendHQ, Shopkeep, Revel Systems, POSLavu and OwnPOS.  It is not obvious that Square will win that battle, it is safe to say that Register will probably increase Square’s adoption among somewhat larger merchants than those that are currently using the Square app to accept payments.

2. Square Currently Is Not Profitable on Small Transactions and is Expensive for Large Transactions

Credit card transactions typically have both a per-transaction and percentage fee.  Since Square dropped its per-transaction fee it is actually losing money on small transactions even thought the overall rate of 2.75% sounds high

On larger transactions (and squares average transaction size is $83), they make good margin but are more expensive than a good deal on a traditional credit card processing account (but still cheaper than a bad deal with a traditional processor).

3. Register + CardCase = Aggregation and Internalization of Transactions

Credit card transactions have two parts- a per transaction part and a % part.  For small transactions the per-transaction part is more significant.  By combining several transactions into one transaction you can save a lot of money.

For example, consider what Apple does with iTunes.  Rather than paying $0.10 per transaction (or more) to Visa and Mastercard every time I buy a $1 song, Apple saves up a few transactions and passes them through together.  My favorite coffee shop should do this too – I typically buy three coffees / day  so they could cut their transaction cost by 66% by combining the transactions from a single day, but they don’t.

Then Square can internalize transactions, which is basically how Paypal makes money.  If Square can convince customers to fund a Square account using a low-cost transaction (like an ACH transfer from a bank account) they will lower their own cost of processing a payment dramatically, almost to zero.

4. Endgame – Compete with Visa and Mastercard

Once Square is internalizing transactions they are effectively a new payments network, in competition with Visa and Mastercard.  Throughout history only a few payments networks have reached critical mass and the prize for doing so is huge.

There is additional upside if they can build additional features into payments.  Credit card transactions haven’t really changed in 30 years and already Square is working on streamlining the order process, using other data for security (faces) and generating new business for its customers through the social features of CardCase.

More competition will be good for both businesses and consumers.

• Banks argue that interchange fees subsidize free checking, which is a benefit to consumers, and free checking on accounts with small balances will go away if Durbin is passed.
• Retailers argue that they pass along higher interchange rates to their customers, which results in higher prices.  If Durbin is implemented, they argue, prices for consumers will decrease.

The Durbin amendment will cost banks $3.6 billion and $9.1 billion in interchange revenue / year and reduce expenses for retailers by the same amount.  This is a fight between those two parties, and doesn’t involve consumers, except that politicians care about consumers because they vote.

Why Isn’t It a Consumer Issue?

If retailers get a giant decrease in credit card costs, will they pass it on?  Will banks, who face competition from each other actually start charging for checking accounts en masse?

Nobody knows.  In fact, if either party is truly passing on the entirety of the savings (retailers) / revenue (banks) it begs the question – why do they care at all?  If they are passing it all along, it shouldn’t impact their bottom line.

It will be very tempting for retailers to use the windfall to pad their bottom lines.  It will also be very tempting for an aggressive bank that wants to expand (especially online banks – ING, Schwab, BankSimple) to keep checking account cheap/free and steal market share from the competitors.

Australia mandated an interchange reduction a few years ago and the results were very ambiguous – no increase in consumer’s well being could be measured.

Is Durbin Good?

Yes.  For three reasons:

1. When someone pays for something that someone else consumes it leads to inefficient allocation of resources.
2. Interchange is confusing and there are lots of middle men (banks, credit card processors and visa and mastercard) taking their cut in the middle of the payment stream, which reduces efficiency.  Felix Salmon from Reuters makes this argument very well.
3. Monopolies tend to abuse their market power.  The banks, acting through Visa and Mastercard have a near-monopoly on the payments infrastructure.   No retailer, not even Wal-Mart, commands the same degree of market power as Visa and Mastercard.  The government should regulate to reduce monopoly power, which in this case means against the bank+Visa+Mastercard.

Durbin is good because it will reduce economic inefficiency and control an abusive monopoly, it won’t have a big impact on consumers in either direction.

Photo courtesy of Alphasix.

The Verifone Payware Mobile solution consists of several parts:

• Hardware device for swiping credit cards.
• An account with Payware Connect, which is Verifone’s online gateway (kind of like Authorize.net).
• A merchant account – Verifone actually isn’t a credit card processor, so you need to get a merchant account from a credit card processor.

Payware Connect is sold through the merchant account provider / credit card processor channel and they can set their own pricing for the product (although presumably they have to pay Verifone for the service).  Merchant accounts, of course, have very confusing pricing (made simpler and cheaper by FeeFighters!!).

Verifone issued a press release that said:

Pricing for PayWare Mobile, which includes software for Apple Inc.’s iPhone and other smartphones and a card reader, started when the product rolled out last January with a $15 monthly gateway fee plus 17 cents per transaction in addition to the normal discount rate, which includes interchange and other processing fees.

In the revised system, low-volume merchants with less than 1,500 monthly transactions pay a suggested retail rate of 2.75% of the sale plus 15 cents, but no monthly fee. They pay $99 for the accompanying card reader, which continues to sell for $149.95 on Apple Inc.’s website.

The suggested retail rate for higher-volume merchants is 1.65% plus 20 cents, but with $19.99 monthly fee, VeriFone says. The card reader is free with a two-year commitment, but there is a $29 activation fee.

But that is just the suggested retail rate.  There are plenty of merchant account providers that are selling it for much more than that, for example IphoneMerchants which is charging 1.59% for debit and regular credit cards but 3.01% for rewards and business credit cards plus $0.20 per transaction (more than half of credit cards are rewards cards).

On slideshare I was able to find some sales documents from TASQ, which is a division of First Data, the biggest credit card processor, that explained the wholesale rates that Verifone charges the credit card processors and other resellers.

Sol Trujillo seems like a really cool guy, I would totally like to meet him, except that he doesn’t like Australia very much, whereas I think Australia is pretty cool.  To be fair, I have never been to Australia, so perhaps it actually isn’t as nice as I imagine it.

I am so curious as to what caused Google to place those particular ads in my email.

Here is an example of a really really bad deal that a relatively large ecommerce company had with Wells Fargo, their bank.  They were paying an effective rate of 4.8%, much more than what is reasonable for an ecommerce company.

Here is a another great example of dumb advertising (see a video on the same topic).

Bluepay is an ISO (independent sales organization), basically a reseller of credit card processing that recently got in trouble with Google for gaming search results by buying links from Forbes.

Offers like “Credit card processing for as low as 0.95%” are too good to be true and should be ignored.  It would be deceptive advertising except for the technicality that they add “as low as” and do not actually say that is the rate, only that it *could* be the rate.  In my opinion it is still sneaky and not a good business tactic.

• Even for the cheapest kind of transaction, a debit transaction that occurs in person, a processor has to pay 0.95%+0.20 in interchange fees to the banks that issue the debit cards and another 0.11%+0.02 to Visa and Mastercard in assessments, APF and NABU.  As a result, the credit card processor faces costs of at least 1.06%+ 0.22, or about 1.61% on the average debit card transaction size of $40.  In my opinion it is unlikely that any credit card processor would actually provide services at such a steep loss.  More likely, they are neglecting to mention that there is also a per-transaction fee, which in my example $40 transaction, is more than 30% of the total cost.

• Even if they are passing along at cost or taking a loss on those in-person debit transactions, the advertised 0.95% rate would not apply to any card-not-present transactions.  It also would not apply to the 70% of transactions that are not debit card transactions, even if they occur in person.  A common trick that credit card processing companies and their resellers play is called Marking Up Downgrades.  They pass along one transaction type at a loss, which they advertise heavily.  They then build in lots of extra margin into the other transaction types, which are much more plentiful, which they do not disclose.

I hope nobody falls for such a sneaky trick.

To get fair apples-to-apples comparisons between credit card processors, use FeeFighters.