Economics of Two-Sided Markets and MasterCard

I pitched MasterCard on this blog (here) in Dec 2010 when it was trading at $225. My thesis worked out as I had laid out then, Federal Reserve came out with its final ruling on Durbin in July 2011 and it was more lenient than their original proposal in Dec 2010. Mr. Market responded to these news quite favorably and the stock is up 65% from the price at which I initiated my position. Today, I view MasterCard as being a bit overvalued, so I have no plans to add to this position. But since I have been talking about two-sided markets (here and here), I thought it would be a good idea to talk about how this applies to MasterCard.

When a consumer swipes her debit (or credit) card issued by a bank to pay for a $100 merchandise at Walmart, an entity known as the merchant acquirer charges Walmart an interchange fee in the range of 20-25c for the debit transaction. The setting of the interchange fee is a complicated matter and it's set by MasterCard. The merchant acquirer retains a small percent of the interchange fee and passes off a large portion to the issuer bank. MasterCard charges the bank a very small transaction fee for using the network, but net MasterCard is essentially letting the bank make the most from the interchange fee, hence the banks are on the subsidy side. MasterCard also makes a very small transaction fee from the acquirer. So, even though the merchant is not compensating MasterCard, I still consider it to be the money side of the network since it's the one paying for the subsidy MasterCard is providing to the banks.

I believe that understanding the pricing model is really important for one to understand MasterCard (or Visa's) competitive advantages to any possible threats from new entrants. When I talked to people about MasterCard, most people would just say - "plastic is a dying business, mobile payments will displace them". So, I want to address this issue. 

Plastic or wireless, businesses don't exist just purely on technology in any two sided market (remember the Adobe example). The economics matter for them to come into existence. So, let's conjure up some wireless payment company (Verizon, AT&T, Google, Apple or someone else) that is going to compete with Visa/MasterCard/Visa.

Can they get the banks to co-operate with them without Visa and MasterCard in the picture?

Why would Chase give up its huge revenue stream from the interchange fee (thanks to Visa/MasterCard) and  partner up with some cute technology company? They have no incentive to do so, unless these new networks provide a compelling reason - meaning interchange fee that is healthy enough to force them to upset their big money center, MasterCard/Visa. Where exactly is this network going to come up with this money to compensate the banks from? Either they are willing to lose billions for years or charge the merchants a fee even higher than the MasterCard/Visa's interchange fee. So, then why would merchants be enthusiastic of accepting this new technology if it costs of them more than traditional technology? I doubt banks will co-operate with the new networks if MasterCard/Visa are not part of the network.

Can the new networks compete without Visa/MasterCard and the banks?

Where are they going to make the money from? Executives at Apple are not sitting around conjuring up new ideas to go into without have a proper model of where the revenues are going to come from, are they? So either they charge the consumer on a per transaction basis or they charge the merchants. Let's explore the first idea - charge the consumers. This pricing model is like Adobe charging each reader of the PDF document a 5c viewing fee. Are you willing to pay such a fee? You can always find suckers for anything, but I doubt that the network can grow big enough to make any economic sense with this model. Then, the only place they can make money from is by charging the merchants. It can probably get traction with the merchants only if Apple  charges transaction fees that are lower than the current interchange fee (why would Walmart want to install new point-of-sale systems that accept Apple payments otherwise). But Apple has way fewer transactions when it starts out. So, it has to amortize the fixed costs of running a payment network over a much smaller revenue stream. 

Let's compare this to the cost structure of MasterCard/Visa. As per data put out by the Fed in Dec 2010, MasterCard/Visa make less than 2c per transaction from the big banks (which control 80% of payments) on debit transactions and my guess is that they make less than 10c on credit transactions from the big banks. Combine with the fact that they capture trillions of transactions (over 70% of all transactions) and hence they are able to cover the costs of running a business and make healthy margins. 

Apple (or any other mobile network that wants to do it on its own) basically must be willing to lose money for a long time before they can capture volumes that make the business economically viable. One may say that isn't running a payment network no incremental cost to running a voice network and the argument that Apple needs a large volume to amortize costs is incorrect? Payment networks are very different relative to voice networks. You can have missed calls on voice network, but not on a payment network. When was the last time you were stuck at a grocery line because the payment network was down. Most of the times it's because of a hold on the card, but not because the network is down. Payment networks need to be more secure than voice networks. I have had my credit card stolen online quite a few times, but every time it happened I didn't detect the theft, but a representative from MasterCard would call me to tell me that certain suspicious transactions were detected. As per data by the Fed, the costs of running fraud detection are not something you can just ignore. Would you be willing to use a payment network that didn't have this protection? 

Lastly, there is nothing from a business point of view that is stopping MasterCard/Visa to partner up with another technology that competes with the ones that goes out on its own. MasterCard/Visa can take a margin cut for a few years and subsidize the technology partner for acting as a replacement for plastic. Who would not want to get this low risk revenue stream that starts on day one? In fact, that is what MasterCard exactly did by partnering with Telefonica for mobile payments in Latin America. The margin squeeze is not even permanent, because MasterCard/Visa can probably make it up by raising the interchange fees over time. 

I know the word "moat" gets thrown around a lot, so its really important to understand the underlying reason for the "moat" before one declares a business to have a moat. Without this kind of understanding, it's hard to monitor if the moat of the business is growing or decaying. If I can't do this type of analysis, I don't want to call the business to have a moat or rely on it. 

I say both MasterCard/Visa have a moat and I encourage you to challenge my reasoning I laid out here. Feel free to leave a comment or email me at rgosalia at gmail dot com.