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Paper or Plastic?

The eye-popping growth in the use of credit and debit cards over the last decade means that credit card companies will play a critical role in the effort to facilitate microcommerce. Enticing consumers with countless rewards and loyalty programs—everything from cash back to air miles—the credit card companies were able to persuade U.S. consumers to use their credit and debit cards for 34.6 billion transactions in 2003, according to a study by the Federal Reserve. That's a 45 percent increase over 2000. During that same period, the number of debit card transactions nearly doubled, from 8.3 billion to 15.6 billion.

Why the sharp increase in plastic? One reason: According to Visa USA, more than 80 percent of American households are enrolled in some kind of credit card rewards program. "Consumers look to be rewarded in everyday life," says Niki Manby, vice president of product innovation at Visa USA. "You have a relationship with your bank, and an opportunity for the bank to reward you for being a customer, and that doesn't happen with cash or checks."

Meanwhile, as consumers have grown more comfortable buying on credit, they are increasingly willing to make smaller purchases using the same means—a pack of gum, a cup of coffee, a digital song. In 2004, Visa saw roughly $40 billion in what it considers small-ticket transactions—charges of less than $25. And according to consumer research group Ipsos Insight, consumers' willingness to use cards for purchases of less than $5 has grown 24 percent in the past year. More than half of those surveyed said they're willing to use credit or debit cards to pay for convenience-store items. And the percentage of Americans that have made online purchases of $2 or less has increased 28 percent since September 2004, from 15 million to 19 million.

The exploding popularity of credit card networks has made them indispensable in enabling the coming wave of microcommerce. But ironically, high credit card processing fees have traditionally made the prospect of accepting plastic for small purchases pointless for merchants. Credit card companies, and the banks they work with, charge merchants a host of confusing fees, including a one-time application charge (up to $500), monthly processing and statement fees (up to $60), a flat per-transaction fee (usually $.30) and, finally, a "discount rate," which is essentially a slice of the actual sale, usually around 2 percent. Taking all other costs into account—the cost to purchase goods, ship them, store them, market them and so on—it's likely that a merchant will end up losing money on a small sale.

But given the growing popularity of business models based on small payments—think iTunes and Starbucks—the credit card companies are finally coming around, says David Robertson, publisher of the Nilson Report, a newsletter that covers the payments industry. "Debit cards have already surpassed checks at the point of sale, so now we're down to cash. The last bastion of paper-based payments are these small transactions."

Some credit card companies are starting to lower fees to make small credit and debit card payments look more attractive to merchants. Visa announced in November 2005 that, come April 2006, it would extend its small-ticket program—previously available only to fast-food restaurants, video-rental companies, movie theaters and parking lots—to bus lines, tolls and bridges, news dealers and newsstands, laundries and dry cleaners, copy services and car washes. Visa's new rate for credit charges under $15 is 1.65 percent plus a $.04 per-transaction charge, while MasterCard International charges 1.9 percent with no per-transaction fee. American Express Co. has no plans to lower fees for small payments.

It's a step in the right direction, but even the lowered fees aren't enough for some merchants. That's where the third-party micropayment processors such as eBay Inc.'s PayPal, BitPass Inc. and Peppercoin Inc. fit in. These firms have come up with several creative work-arounds that make small payments profitable. First is the aggregation model, whereby small charges are accumulated over a set period of time—say a month—and then sent to be processed by the credit card company as one large transaction. The aggregation model is particularly well suited for merchants that have frequently returning customers who buy small-ticket items, such as Apple Computer Inc.'s iTunes Music Store. MasterCard announced a marketing partnership with Peppercoin in December to accelerate the use of aggregation among merchants.

Micropayment Models
Aggregation Payments are batched together and processed only after a temporal (20 days) or monetary ($20) threshold is reached. iTunes Music Store
Direct Payment Micropayments are added to a monthly invoice for existing services such as a cable or telephone bill. Time Warner Cable, cell phone carriers
Stored Value Upfront payments stored in a debit account are deducted as purchases are made. Starbucks, 7-Eleven, EZPass
Subscription Upfront, buffet-style payments cover access over a defined period of time. Wall Street Journal, New York Times
À la Carte Merchants process customer transactions as they occur using economies of scale to negotiate lower credit card processing fees. McDonald's, Golden Tee Golf
Sources: Mercator Advisory Group, CIO Insight

The stored value model allows customers to pre-fund a debit account with a specific merchant or payment service (such as Starbucks Corp.'s Duetto card, which combines a traditional Visa card with a reloadable debit account), and the small payments are automatically deducted as they're spent. Another option, called direct payment, adds the small charges to bills that customers already receive on a regular basis (such as ringtones on your cell-phone tab, or pay-per-view charges on your cable bill).

"We are very cognizant of the fact that consumers want to use their cards more and more for all payments, because they are more convenient," says Art Kranzley, MasterCard's executive vice president of advanced payments. "We want to make it clear to merchants that MasterCard is endorsing smaller payments."

All these models save merchants money because they lower the number of actual credit transactions. Still, they may not be enough, because they don't work together. An account set up with BitPass, for example, can't be funneled into a PayPal account. Ultimately, consumers will want a seamless way to pay for things online and off, using whichever payment method they choose. Since the credit card lenders already have the worldwide systems in place, they are the best positioned to create the much-needed standard that would make micropayments seamless. But the fees will have to come down even more. "The credit card companies have to make this happen," says Jeff Reed, CTO of Logicalis, which helps companies set up microcommerce systems. "They are vital because they have the infrastructure. And they are driven by market forces to do it."

This article was originally published on 01-06-2006
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