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December 18, 2007

Competition heats up in the US

The US card market could be entering a new era of competition, as the changes wrought by the 2004 decision by the US Department of Justice to repeal rules that kept Visa and MasterCard members from using other networks, combined with the associations initial public offerings (IPOs), mean that the major bank networks are vying with American Express and Discover for issuers.A new report by Gwenn Bzard, director of research at financial services consultancy Aite Group, The Future of Card Networks: Gauging Battle-Readiness for a Post-Visa IPO World, predicts that American Express will emerge as a powerful competitor with Visa and MasterCard in the US.Bzard traces the fast-moving changes ushered in following the Justice Departments repeal of the exclusionary rules preventing Visa and MasterCard members from using other networks

By Verdict Staff

Regulatory changes and the initial public offerings of MasterCard and Visa are changing the competitive landscape for card networks in the US. A battle for issuer business has broken out between the major bank networks, American Express and Discover. Charles Davis reports on the potential outcomes.

The US card market could be entering a new era of competition, as the changes wrought by the 2004 decision by the US Department of Justice to repeal rules that kept Visa and MasterCard members from using other networks, combined with the associations’ initial public offerings (IPOs), mean that the major bank networks are vying with American Express and Discover for issuers.

A new report by Gwenn Bézard, director of research at financial services consultancy Aite Group, The Future of Card Networks: Gauging Battle-Readiness for a Post-Visa IPO World, predicts that American Express will emerge as a powerful competitor with Visa and MasterCard in the US.

Bézard traces the fast-moving changes ushered in following the Justice Department’s repeal of the exclusionary rules preventing Visa and MasterCard members from using other networks. The rules change meant that the major bank networks were suddenly competing directly for issuers’ business with American Express and Discover.

Interchange war

The most immediate consequence of the ruling, Bézard said, was an interchange war between the networks: Visa and MasterCard raised their rates in 2005 in a bid to fend off issuers’ defection to American Express. The higher interchange rate, in turn, further infuriated the merchant community, prompting a series of lawsuits challenging the nature of the interchange rates. Concern over the potential litigation liabilities gave rise to a growing number of banks warming to the idea of turning over their card networks to the public markets – and the rest is history.

Since then, MasterCard went public in 2006, and Visa followed with a major reorganisation and later announced its intention to become public in 2008. Morgan Stanley finally spun off its Discover Financial Services subsidiary, which became traded on the New York Stock Exchange in 2007.

By early 2008, this means that most American consumers should be using card brands operated by four publicly traded card networks – Visa, MasterCard, American Express and Discover. The change will not mean much to those shoppers, but it could have long-lasting effects on the issuance side.

Bézard wrote that although the business models of Visa and MasterCard are nearly identical, Amex and Discover are very different. “Visa and MasterCard make most of their money by enabling issuers to leverage their networks and global brand: they don’t issue cards themselves, and seldom acquire merchants themselves,” Bézard wrote. “In contrast, American Express is a card issuer at heart, and is very picky about which customers it targets. American Express makes most of its money by delivering affluent cardholders to merchants and charging high transaction fees for that service; incidentally, it uses its own network and brand to that effect.”

While Discover’s roots also are in card issuing, and while it also typically uses its own network and brand for its credit card-issuing business, Bézard noted, that’s where the similarities end. Unlike Amex, which is focused on the upper end of the card market, Discover focuses on targeting credit card revolvers and making money from their card balances.

One thing in common

Despite differences in their core business models, all four companies have one thing in common: they all compete for issuers’ business today. Visa and MasterCard, which make most of their money from issuers, square off against one another while fending off incursions by Amex and Discover, which make most of their money from their proprietary credit card business. The challenge, then, is to grow third-party issuers’ use of their networks, notably in the US, where they generate a significant portion of their revenues.

The competition for issuers’ business is incumbents Visa’s and MasterCard’s to lose, but consolidation is making those players increasingly vulnerable to the risk of a major customer defecting. Five major MasterCard issuers accounted for 34 percent of the company’s revenues in 2006, for instance.

While a relative upstart in third-party issuing in the US, Amex gained valuable experience abroad before the rules were repealed, opening the domestic market. Amex has already managed to attract selected portfolios of some major issuers, including Bank of America, Chase and Citibank.

To date, Discover has not been much of a player in the third-party issuing market, but Bézard expects that to change as the US market tightens. “Leveraging the network and brand Discover once strictly used for the benefit of its proprietary issuing business to serve other banks seems the natural path to long-term growth,” Bézard wrote.

Risky move

For Visa and MasterCard to counter Amex and Discover, Bézard found, one option would be for them to turn themselves into issuers, becoming more like American Express and Discover. Such a move would not be without risks, however. While Visa and MasterCard would likely be in a strong position from a branding standpoint to start their own issuing business, they would risk damaging relationships with their issuers. Given their increasing reliance on a few large issuers, upsetting just a few major customers could spell significant trouble for them.

Another option for Visa and MasterCard would be to expand in merchant acquiring. This is a less likely scenario, as intense competition and consolidation among larger merchants is squeezing profit margins. The networks would also risk alienating their acquiring partners, pushing them to further encourage adoption of Amex and Discover.

Aite Group believes Visa and MasterCard will stick to their core proposition and focus on building their network business. This would build on the association’s core competencies, allow them to continue to capitalise on the volume of switching that is done outside Visa’s and MasterCard’s networks around the world, and allow them to leverage their unique global processing and acceptance capabilities.

Bézard concluded that a major wildcard affecting the strategy of Visa and MasterCard is likely to be the approach taken by other major networks, including China UnionPay and JCB, the domestic networks dominating a number of countries, and many other card as well as non-card payment networks.

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