Will Smartphones Make Credit Cards Obsolete?
Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Sitting at a Starbucks today, I realized I'd forgotten my wallet – but I had already paid for my coffee. As always, I had used the Starbucks app on my phone to pay, which displays a code that scanners can read, deducting the purchase from the balance on your Starbucks account. Flashing my phone is faster and more convenient for me and for Starbucks. If you're a credit card company, that should terrify you.
Credit card companies make money by taking a small cut of every purchase made on their cards. That comes out of the merchant's profits, so in my case, Starbucks (NASDAQ: SBUX) is making more money per transaction when customers use the app as opposed to a card. The Starbucks system doesn't pose an immediate threat, because it requires users to have a Starbucks gift card. However, existing technologies like Near Field Communications (NFC), already widely deployed in Japan, make it possible to securely link a chip in your phone directly to your bank account. That has the potential to bypass the credit card companies altogether and cut the industry off at the knees.
Certain firms are better prepared to weather this sea change than others, though, because they employ different business models. Credit card companies come in two flavors, open-loop and closed-loop. Open-loop companies have the lion's share of the market, with Visa (NYSE: V) and MasterCard (NYSE: MA) accounting for 60% and 30% of all cards, respectively. Open-loop networks make money by facilitating transactions between issuing banks and merchant banks. Issuing banks provide branded cards to consumers, and extend the line of credit itself. Merchant banks provide stores with the physical and digital infrastructure required to accept payment through a card. The primary function of Visa and MasterCard is to administer the payment between the banks; and their most valuable asset is the communication and transaction network they've built between various clients.
Closed-loop systems, notably American Express (NYSE: AXP) and Discover (NYSE: DFS), cut out the middlemen. These firms are themselves the issuing bank, the merchant bank, and the network. They issue cards to customers, extend a line of credit, sign up merchants for their programs, and charge a fee to merchants for use of their system. Recently, both firms have been opening up their operations by cooperating with issuing and merchant banks, but the distinction remains that closed-loop operators have the capacity to extend credit and work directly with card carriers and merchants.
Many smartphones already have NFC capabilities, and we should expect NFC deployment to accelerate. Issuing banks and stores will be able to go around the open-loop companies and their fees by allowing smartphone users to pay for products directly from their bank account or bank credit line. This opens up the card companies to competition not only from their previous clients, but from existing brands with experience and a good reputation in handling secure financial transactions, like PayPal and Amazon.
With revenue coming not only from fees but from consumer lending, the closed-loop systems are currently better positioned to survive a fiercely competitive environment. If the open-loop systems don't adapt, they will quickly find their revenue streams dry up as banks and consumers realize their service provides no value. But can they adapt?
The card systems have a solid competitive advantage, through capacity, reputation, and brand loyalty, in processing financial transactions. It isn't free for banks or merchants to build their own secure payment networks, and credit cards could still find a place for leveraging their abilities by migrating to a mobile platform. Creditors and storefronts may find it more advantageous to outsource their mobile payment transactions to Visa or MasterCard, perhaps through a uniform Credit App, than to attempt to build a proprietary system. Barriers to entry in the payment business will be much lower, so the credit card companies should expect to command lower fees and earn smaller margins. However, the primary competitor to credit cards is still cash, especially in the emerging world. The migration to smartphones can add convenience and security to the payment experience. If credit card companies can capture a growing market for cashless payments, they could make up on volume what they lose on profit margins.
A recent Pew study of technology experts found that smartphone payments are expected to outpace credit card usage by 2020. The card purveyors, especially Visa and MasterCard, face an existential threat in smartphones. They could capitalize on this opportunity, but in order to do so, they will need to be at the leading edge of mobile payment technology and adoption. Right now, they're being beaten in their own industry by a coffee store. The credit card companies don't have long to hit on a strategy for survival, and shareholders should watch closely to see that they do.
Daniel Ferry is long Starbucks. The Motley Fool owns shares of MasterCard and Starbucks. Motley Fool newsletter services recommend American Express Company, Starbucks, and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.