1  Credit Card Industry: Overview

2  Credit card  13 – 16 digit  Magnetic stripe storing data  11 million merchant location  860 billion worth of payment card purchases

3  Open-loop vs Closed-loop  ۰ Open-loop system  Refers to the joint venture  ۰ Closed-loop system  Refers to a single firm

4  Diagram – open loop system Merchant Customer American Express Discover Diner Club 1.Shop Issuer Acquirer Authorization 3. Settlement 4. Bill/Pay

5  How credit works  Card Issuer  ۰ Financial organizations issue the card  Acquirer  ۰ Signing up merchants  ۰ Installing termainal۰  ۰ Providing authorization services  ۰ Keeping track of transaction and providing report  ۰ Transferring funds  Customers  Merchants

6  Diagram – closed loop system Merchant Customer 1.Shop 2.Authorization 3. Settlement

7  Source of income  Merchant discount  (2% of transaction amount)  Financial charge of outstanding balance  Card service fee

8 Two sided market: Network Effects  Exhibits network effects  Positive Feedback  More customers, more merchants  More merchants, more customers.

9  Network externalities result in increasing returns in consumption  The more customers a network gets, the more value the network to each customer  e.g. the more people carry VISA cards, the more merchants take VISA cards. Then each VISA cardholder is better off by enjoying convenience and lower transaction cost Increasing Returns

10 Network Externality creates the classic chicken-and-egg problem for the industry  Who is first, merchants or buyers?

11  How to solve the chicken-and-egg problem here?  Very aggressive competition in the early stage  May rationally sell below cost for a substantial period, hoping to “make it up on the volume” later on  That’s why many of the early entrants into this business lost substantial amounts of money and exited quickly.  HSBC’s Mondex disappear

12 Low annual fee low interest rate Low annual fee low interest rate Large consumer base for credit cards Large consumer base for credit cards More merchants More convenience More merchants More convenience Drive down operation cost Drive down operation cost Visa & MasterCard

13 Mechanism: (Open loop system) Visa & MasterCard These two card systems entered in 1966 Member responsible for issuing, acquiring and setting individual merchant discounts Card system responsible for advertising, production innovations and setting inter-change Different interchagne fee for different industries, but the same interchange fee for firms in the same industry.

14 Mechanism: (Open loop system) Many independent firms participate in the system In the association, individual member engages in issuing, acquiring and positioning e.g. Many issuing members compete in the issuing sector while Visa-system responsible for advertising activities e.g. Many issuing members compete in the issuing sector while Visa-system responsible for advertising activities IssuingFirm AFirm B AcquiringFirm CFirm B System Function Visa

15 Market Structure (Con’t) Large number of competing firms No single dominant player Entry and exit are relatively easy Information is widely available to consumers Consumer switching costs seem low

16 In a two-sided market, it is important to adjust customer’s expectation it is important to make sure that customers and merchants believe that the card system already has a large customer / merchant base --> Credit card systems spend a lot on advertising Visa – “It’s Everywhere You Want to Be“ MasterCard – “Master the Possibilities“ – “Choose the Card that Makes a Difference“

17 Visa and Master -- Duality Virtually homogeneous products, so, competition mainly in advertisement Multi-homing on both customer and merchant sides, maintain the dual system in credit card industry

18 Common Standard and Co- operation  Joint venture: Visa and Master  Over time, VISA and MasterCard have negotiated corporately the rules for processing transactions that allow them to offer services competitive with the proprietary systems of AE and Discover

19  1. Reasons  conduct research & development  market through advertising or other promotional efforts  exchange information  establish standards  Economics of Joint Ventures

20 Objective of JV - to maximize total value  Need to provide incentives for members to increase the value of the JV  System’s economic value depends on no. of customers who carry the card and the no. of merchants who accept it.  To interact successfully, each company needs to trust each other but difficult to achieve  Different national culture, business conducting methods, banks size, geographical regions, strategic focuses among members  Decision-making is very time consuming

21  Divergent Objectives  Independent entities with separate profit motives  Major co-branding agreement

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23 Interchange Fee  For simplicity, assume that all issuers’ and acquirers’ costs = 0  In this case, access fee is set by the system.  Acquirers’ profit = m – a  Under a fully competitive credit card market, all acquirers will compete for merchants until m – a = 0. That is, m = a  Issuers’ Profit = f+a.  Under competition, f becomes –a, subsidy.

24  Interchange Fee  Interchange Fees are paid by acquirers to card issuers  By changing an interchange fee, Visa can provide an incentive structure to get both sides on board.

25 What is the effect of increasing a? Giving more subsidy to cardholders. Penalizing more on the merchant side.  For instance, too few card holders?  In order to give more incentive on the customer side, they raise interchange fee.

26 Issuing Acquiring System Function Vertical Structure Closed loop All functions, including issuing and system functions are integrated into a single entity. For example: AE make decisions about merchant discount, it will think about the impact on its profit from both cardholders & merchants.

27  Closed-loop system  Direct profit maximization by system  Example: Sam’s Club stores accepted only Discover since Discover set a low merchant fee for Sam’s Club, which Visa and Master cannot do. (Please note that Visa sets a common interchange fee for all stores in the same industry.)

28  Advantages of open-loop system  Innovation by multiple firms.  Example: American Airline idea of airline miles cards rejected by American Express but accepted by Citibank (joint venture with Visa)

29  Disadvantages of the system  Divergent objectives of individual firm inside joint venture  In open-loop system, each member has its own cost and benefit consideration  Self-interest VS Group interest

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