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Credit Card Industry: Overview

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Credit card

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

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Open-loop vs Closed-loop

۰Open-loop system Refers to the joint venture

۰Closed-loop system Refers to a single firm

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Diagram – open loop system

Merchant

Customer

American ExpressDiscover

Diner Club

1.Shop

IssuerAcquirer

3 2

2

3

2

3

2. Authorization 3. Settlement

4. Bill/Pay

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How credit works

Card Issuer ۰Financial organizations issue the card

Acquirer ۰Signing up merchants ۰Installing termainal۰ ۰Providing authorization services ۰Keeping track of transaction and providing report ۰Transferring funds

Customers Merchants

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Diagram – closed loop system

Merchant

Customer

1.Shop

2.Authorization

3. Settlement

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Source of income

Merchant discount (2% of transaction amount)

Financial charge of outstanding balance

Card service fee

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Two sided market: Network Effects

Exhibits network effects

Positive Feedback More customers, more merchants More merchants, more customers.

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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

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Network Externality creates the classic chicken-and-egg problem for the industry

Who is first, merchants or buyers?

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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

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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 merchantsMore convenience

More merchantsMore convenience

Drive down operation cost

Drive down operation cost

Visa & MasterCard

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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.

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Mechanism: (Open loop system)• Many independent firms parti

cipate in the system• In the association, individual

member engages in issuing, acquiring and positioning

e.g. Many issuing members e.g. Many issuing members compete in the issuing sectocompete in the issuing sector while Visa-system responsir while Visa-system responsible for advertising activitiesble for advertising activities

Issuing Firm A Firm B

Acquiring Firm C Firm B

SystemFunction

Visa

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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

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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“

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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

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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

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1. Reasons

conduct research & development market through advertising or other

promotional efforts exchange information establish standards

Economics of Joint Ventures

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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

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Divergent Objectives

Independent entities with separate profit motives Major co-branding agreement

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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.

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Interchange Fee Interchange Fees are paid by acquirers to card issu

ers By changing an interchange fee, Visa can provide

an incentive structure to get both sides on board.

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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.

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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 d

iscount, it will think about the impact on its profit from both cardholders & merchants.

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Closed-loop system

Direct profit maximization by system Example: Sam’s Club stores accepted only Discov

er 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.)

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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)

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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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END