Smartphones Might Kill Credit Cards but Not the Industry
Alvin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Near field communication (NFC) technology allows close (a few centimeters) range wireless communication between two NFC enabled devices. The transfer of information through NFC is fast enough that briefly bringing two NFC enabled devices close together allows the transfer of a few kilo-bytes of relevant data. The technology, while not new, has the potential to drastically change the modern world. The NFC forum, which was formed in 2004 to promote the use of the technology, now has currently over 160 member companies.
Most notably, NFC chips have been making their way into smartphones. The inclusion of NFC allows smartphone users to exchange digital data, such as photographs, by simply bringing two devices into close proximity. Smartphones with NFC can even be used like contactless credit or debit cards to make purchases. Yes, smartphones have the potential to replace the plastic credit or debit card. So why are the biggest credit card companies, Visa (NYSE: V), MasterCard (NYSE: MA), and American Express (NYSE: AXP), part of the NFC forum and promoting the adoption of the technology that could lead to their doom?
The answer, contrary to what many people believe, is that NFC technology can actually make the credit card industry more money. Huh? To understand the answer, investors must first understand how a credit card transaction takes place. When consumers make a credit card purchase, companies like Visa do not pay for the goods or extend them credit. The bank that issued the card is the one that makes the payment. The role of Visa and other credit card companies is to use their proprietary networks to communicate the transaction between the banks and earn a fee in return.
Visa and MasterCard are called open loop companies, meaning they do not physically issue the cards. Closed loop companies issue both the card and process the payments. Basically, banks and credit card companies work together. The banks provide the funds and credit and the credit card companies provide the network. The real values of companies like Visa, MasterCard, and American Express do not lie in plastic cards, but in their proprietary networks that allows banks (even small foreign community banks) to issue cards that can be used to make purchases around the world.
It is clear why NFC is not a threat to credit card companies. NFC, through the convenience of only having to carry a phone, has the potential to change how consumers pay at the register with smartphones replacing plastic credit or debit cards. However, the underlying nature of the credit card industry does not change. Banks are still needed to fund the purchases and credit card companies are needed to provide the network. The perfect example is Google (NASDAQ: GOOG) Wallet. It is a virtual wallet. On the surface, it looks like Google Wallet is a threat to the credit card industry. However, Google Wallet actually relies on MasterCard to provide the network and Citigroup (NYSE: C) to provide the financing. As usual, Google makes money through advertising. Citigroup and MasterCard make money by taking a cut of the actual transactions.
Similarly, Apple (NASDAQ: AAPL), by adding NFC to its next generation iPhone, appears to be a threat to credit card companies. However, Apple is only changing how people pay at the counter not how the payments are processed. The communication between banks, during a credit purchase, is still handled by credit card networks. Credit card networks are crucial because credit is a very complex business. For instance, in 2011, Visa processed 50.9 billion transactions on its network with a total amount of $5.9 trillion of money being moved. The huge volume of money and transactions requires a network that would take years and billions of dollars to build. Not to mention, the level of security and agreement with banks needed. In short, NFC will not kill the credit card industry.
Contrary to what many people believe, the adoption of NFC in smartphones will actually benefit the credit card industry. The cost of issuing plastic cards will be converted to the cost of adding NFC chips into smartphones. This is a cost that is borne by the smartphone manufacturer. Furthermore, the addition of NFC chips into smartphones creates potential credit cards that are waiting to be activated. Since the smartphone market is booming, this is a potentially lucrative market. The transition to a completely digital wallet, will only create more money for credit card associations because credit card associations take a cut out of almost every single digital purchase. Thus, the emergence of NFC might kill plastic credit cards, but it will only make credit card companies stronger.
Alvin has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Citigroup Inc , Google, and MasterCard and has the following options: short OCT 2012 $55.00 calls on American Express Company, short OCT 2012 $60.00 calls on American Express Company, and long OCT 2012 $65.00 calls on American Express Company. Motley Fool newsletter services recommend American Express Company, Apple, Google, 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.