The acquiring model for a digital payments provider can be broken down into two broad pieces. One is the overall payments acquiring model, which determines how transactions flow, which parties are involved, and who gets paid what. The other is the merchant acquiring model, which determines whether or not the provider has its own merchant network and, if so, how those merchants are found, on-boarded, trained, and supported, as well as how the risk associated with them is underwritten. These models are closely related but they are quite distinct pieces of the business model where payments providers face important choices.
Payments Acquiring Models
When it comes to acquiring and processing transactions, the payments industry typically uses either the four-party or the three-party model. Notably, this is how the world of bank cards operates, with a highly standardized division of key roles among the players involved.
The four-party model
In the four-party model, exemplified by Visa and Mastercard, four main entities are involved in transactions: (i) the customer making a purchase; (ii) the customer’s bank or issuing bank, which holds the customer’s funds and has issued the payments instrument (typically card) being used; (iii) the merchant accepting the payment; (iv) and the merchant’s bank or acquiring bank, which holds the merchant’s account, ensures that the merchant has the necessary facilities, such as point-of-sale (POS) hardware, and initiates the processing of transactions.
In a transaction, (1) the customer swipes the card and authenticates the payment, after which (2) the merchant sends the transaction to the acquiring bank, (3) which in turn processes the transaction by passing it to the relevant payments network (e.g., Visa or Mastercard), and the network, which also sets the overall rules for the payments scheme, runs automated fraud checks and forwards the transaction to the issuing bank for authorization.
If the issuing bank authorizes the transaction, (4) it debits the customer’s account and (5) settles the payment to the acquiring bank, minus an interchange fee. Finally, (6) the acquiring bank pays the merchant, minus a merchant discount fee, which covers the acquiring costs, including interchange, terminal depreciation, risk, merchant servicing, operating expense, and some profit margin for the acquirer itself.
The three-party model
In a three-party model, exemplified by American Express and by e-wallet providers such as M-PESA, WeChat, and Paytm, the same payments provider plays the role of both issuer and acquirer, providing accounts and payments hardware to both merchants and consumers. Hence it sets the rules and prices, authorizes and processes transactions, moves funds from the customer to the merchant, and so forth—all in-house.
In a given transaction, after (1) the customer authenticates a payment (2) the merchant submits it to the payments provider, which authorizes the transaction directly; (3) the payments provider then debits the consumer’s account and (4) credits the merchant’s account, minus the merchant discount fee.
Differences between the models
Several notable differences between the models are readily apparent. For one thing, the transaction is slightly easier to process in a three-party model because it doesn’t involve bridging two separate banks: the acquiring bank has direct, internal visibility on the balances in the customer account on the issuing side. The revenue model also looks a little different. In both models, the merchant pays a percentage (known as the merchant discount rate [MDR]) of the total value of the payment as a transaction fee, which is then shared among the players.
In a four-party model, the transaction fee relating to a merchant payment typically must be split among the issuer, the acquirer, and the payments network. In a three-party model, the payments provider doesn’t need to share revenue with anyone else; it retains the entire transaction fee. Since MDRs are not necessarily lower for three-party models, this can mean higher margins for payments providers. However, the three-party model also requires the issuer to grow its own merchant network, which increases the cost and challenge of scaling.
In a three-party model, the provider can draw value from having control and visibility over both sides of the market. For instance, having full insight into transaction records for both merchants and consumers can enhance data analytics capabilities, including fraud monitoring. The provider can also make selectivity a source of competitive advantage, allowing American Express, for example, to negotiate MDRs from merchants on the acquiring side thanks to having pursued a higher-income clientele on the issuing side of the business.
The interchange rate is typically set by the payments networks, perhaps in conjunction with the national bank association. In some markets, including the United States, the European Union, India, and China, the government regulates interchange by setting caps and, in some cases, even by setting rules for the distribution of fee revenue across the parties involved in the transaction.
MDRs typically also depend on many other variables, including the type of merchant engaged in the transaction, the type of card used, whether or not the card is physically present, the acceptance technology and form of authentication used, and so forth.
Among e-wallet providers, the MDR tends to be lower than in the card industry, for example, 0.3–0.4 percent in India (as mandated by government) and 0.5 percent via M-PESA in Kenya. In some cases, providers may rebate this fee for low-value transactions, as is the case in China, or the government subsidizes part of it to promote uptake of digital payments, as in India.
Merchant Acquiring Models
The second aspect of the acquiring model is how merchants are signed up, set up, and served within the system. The merchant acquiring model has the following key elements:
Potential merchants (individuals or chains) are identified, assessed, pitched on the digital payments service, and signed up to offer it to their customers.
Merchants are validated and registered, receive the appropriate information on terms, pricing, etc., and receive the training necessary to execute digital payments.
Merchants are activated with any point-of-sale device, merchant accounts, software solutions, and other materials needed to start accepting transactions.
4. Relationship management
Merchant networks are managed on an ongoing basis to resolve problems, etc.
Initially acquiring banks played all of these roles themselves. However, over time the merchant acquiring value chain has become increasingly disaggregated, with third-party providers taking on parts of the process.
Today, only one in five merchants in the United States is acquired directly by banks. The remaining 80 percent of merchants are acquired by a vast ecosystem of specialized nonbank actors that come in different forms and offer various combinations of services to merchants.
Independent sales organizations (ISOs). The most well-known category of third-party provider is the ISO, which is sometimes called a member services provider. ISOs were the earliest to appear in merchant acquiring value chains. Emerging out of the need to integrate POS devices with tills in multilane supermarkets, ISOs were initially used by acquiring banks to outsource the sales process of identifying, assessing, and recruiting prospective merchants for the bank. Many have evolved to take over on-boarding, training, and management of the merchants. Some deploy their own hardware and software, which puts further distance between the bank and the merchant.
Payments facilitators (PFs). PFs are similar, but whereas ISOs help merchants set up an account and merchant ID at an acquiring bank, PFs hold a single merchant account and ID with the acquirer while the merchants operate under subaccounts—which are similar to how individual stores in the same retail chain might operate. Because merchants don’t need to go through a lengthy vetting and due diligence process by the acquiring bank, PFs get merchants up and running far more quickly than ISOs do. However, PFs have to shoulder all the risk, cost, and complications arising from charge backs, disputes, fraudulent transactions, or other problems with merchants.
ISOs and PFs compete by offering the most attractive end-to-end solution for merchants to accept electronic payments. Key aspects of the value proposition range from speed of on-boarding, features of software packages, and range of acceptance technologies—such as magstripes, EMV, QR, NFC—to merchant discount rates, speed of settlement into merchant accounts, and processing capabilities (e.g., whether they enable merchants to accept PayPal, Apple Pay, or Amazon Pay).
Third-party merchant acquirers have come to play an important role in expanding and developing the merchant payments ecosystem for cards:
- By specializing in merchant acquiring, they can build leaner processes that drive down costs in the value chain and enable them to acquire merchants too small for banks to deal with—significantly expanding the reach of digital payments.
- By often focusing on different segments of the market, such as taxis, restaurants, or supermarkets, they develop a deep understanding of different merchants’ needs and build specialized solutions to meet them—thus creating stronger value propositions that make merchants more committed to a digital payments system and more willing to pay for it.
- By typically serving multiple acquiring banks, they build horizontal scale within their niche—thus creating efficiencies that help to further bring down cost and expand reach.
- By belonging to multiple payments networks, they create front-end interoperability despite the fact that the various networks themselves don’t interoperate. This enables merchants to accept payments from Visa, Mastercard, Discover, UnionPay, and others without requiring multiple acquirer relationships, sets of hardware, merchant accounts, and so forth.
- By competing with each other, they drive innovation and a strong focus on value for merchants—which also makes merchants more committed to a digital payments system as they see more value in it and are thus also more willing to pay for it.
Because of the advantages these players have and the value they create in the ecosystem, banks have increasingly ceded the merchant acquiring space to them. Banks typically choose to directly acquire mainly large and valuable merchants like major retail chains. Acquiring banks have therefore shifted into the upstream parts of the payments value chain—processing transactions and meeting the compliance and other requirements for membership in the payments networks. Indeed, most banks today do no merchant or transaction acquiring at all. Instead, they focus on the issuing side: selling various types of cards to consumers and managing those relationships.
As the transaction processing part of merchant payments has become increasingly divorced from the merchant acquiring part, processing itself has also evolved. In response to relatively low margins, the industry has pursued efficiencies of scale through consolidation and is now dominated by a small number of specialized players. Seventy percent of card transactions in the United States today go through just four major processors.
Square is probably the best-known example of a payments facilitator. It leveraged the model very effectively to set up merchants instantly, which is a key aspect of the facilitators’ appeal to merchants. Other payments facilitators include iZettle and SumUp, which are rapidly scaling new entrants to the merchant acquiring space.
Beyond ISOs and PFs, there are myriad variations, including integrated software vendors, value-added resellers, gateways, merchant account providers, and others that offer different combinations of the many roles involved in the payments value chain. While these types of third-party merchant acquirers can be seen as working for acquiring banks, they can equally be seen as repackaging processor services—often from multiple acquirers—and selling them to merchants in a variety of bundles and combinations.
Kopo Kopo is a Kenyan merchant payments aggregator that exemplifies the opportunity for outsourcing to third parties in a mobile money context. It is not an issuer—it focuses exclusively on the merchant acquiring side, selling solutions for businesses to accept payments from the prevailing mobile money wallets in the markets where it operates. Kopo Kopo undertakes all four steps in the merchant acquiring model described above: finding, vetting, and signing up merchants; on-boarding them; setting them up with the necessary apps and accounts; and providing ongoing relationship management and support. The mobile money provider processes and settles the transactions. In Kenya this is primarily Safaricom’s M-PESA: merchants are charged a 1 percent MDR, which is split between Safaricom and Kopo Kopo. The mobile money provider gains a larger merchant network and in return gives up a share of transaction fees paid by those merchants—fees that might otherwise never have existed.
Kopo Kopo also illustrates other benefits of having a company dedicated to merchant acquiring operating on that side of the market. Since the merchants are their primary customers, its business relies on delivering strong value to those customers. Given that digitizing payments alone is not compelling to most merchants, Kopo Kopo has developed a suite of value-added services (VAS) for its merchants that leverage data collected from the payments to address key pain points for the merchants. There is a clear link between these VAS and higher transaction volumes, indicating that merchants have bought into digital payments and are driving the business as a result.
One notable example is Grow, Kopo Kopo’s working capital product. This is underwritten based on data generated from the digital transaction history, which provides sufficient visibility on cash flow in the business to assess credit risk and extend a loan.
This can be an important way to unlock credit for merchants who previously could not reliably indicate their income. For Kopo Kopo, it has proven to be an important source of revenue as well as an important driver of customer loyalty, as merchants actively drive digital payments volumes to improve their loan limit. Credit risk is mitigated because repayments are deducted directly from payment transactions on an ongoing basis, which also means Kopo Kopo can see in real time if repayments slow down, which enables it to react early.
For merchants, the off-the-top payments mean that they don’t need to worry about saving up for installment repayments—and that loan repayments are proportionate to their (digital) sales, meaning they pay less when business is slow. That is why in an interview a Kopo Kopo merchant said, “With Grow you hardly feel the burden of repaying” and why merchants are loyal users. The median time between paying off one Grow loan and starting another one is just three days.
Alipay and WeChat Pay in China largely use a three-party model, directly enrolling both merchants and customers on the service. Alipay and WeChat Pay have managed to drive scale in a very low-cost fashion, by creating on-boarding processes that enable merchants and consumers to self-enroll. This is possible thanks to the high degree of smartphone uptake, mobile internet use, and banking penetration in China.
To register for the mobile payments services, customers use the app to submit ID information and link the e-wallet to a bank card or account. The mobile wallet provider is thereby able to leverage the customer due diligence information collected by the banks. However, the Chinese payments space is also seeing the emergence of third-party merchant acquirers for mobile payments such as Wowoshijie, which offers a comprehensive solution for merchants that includes the ability to accept both Alipay and WeChat Pay through a single QR code and merchant account.
When it comes to choosing a payments acquiring model, DFS providers should consider how transactions will be processed and settled. While there are benefits to a three-party model, it means the provider must shoulder the entire burden of developing both merchant and consumer sides of the market. This makes it harder to drive scale and creates more fragmented markets that may result in weaker uptake and profitability for all providers. Given the many challenges that mobile money providers and other DFS players already face in building the critical mass needed to drive a meaningful shift away from cash, they would most likely be better served by adopting four-party models. For more on the importance of interoperability for getting traction with merchant payments in emerging markets, see “Interoperability: Why and How Providers Should Pursue It.”
When it comes to merchant acquiring, providers must decide what parts of the acquiring value chain to execute themselves and where to involve partners or outsource to third parties, such as payments networks or merchant aggregators. While keeping things in house gives providers more control over processes and revenues, working with partners will facilitate a more rapid scaling of the business. Importantly, it will also reduce both the cost and the risk associated with acquiring, since the partners will be responsible for the appropriate targeting, on-boarding, training, and servicing of merchants and will be the first to suffer if their merchants fail.
Aside from helping to promote scale, third-party merchant acquirers can also play an essential role in driving engagement, by developing and operating compelling value propositions for merchants. As the wants and needs of merchants vary substantially across the main verticals in the retail economy, the payments provider itself is very unlikely to have either the inclination or the capacity to tailor its solution to each and every one. By building a business specifically around creating those tailored solutions, third-party acquirers can help unlock value and create higher engagement from merchants across the space. For more on the importance of creating compelling value propositions for succeeding with merchant payments, see “The Real Value for Merchants Lies Beyond Payments.”
Indeed, providers should reflect on whether they want to be on the acquiring side at all or whether to cede that space to others like PFs and ISOs while they focus on the issuing side and on serving their primary customer base: the end consumers. Since this is clearly how the card space has evolved, it seems likely that mobile money providers and other DFS players will in time reach the same conclusion.
Irrespective of the strategic choices a merchant payments provider wants to make, the realities of the market in which it operates may limit the options and force the provider to adopt a certain approach in the short term. Notably, the lack of existing third-party merchant acquirers will in many markets mean that the payments provider has no choice but to start building an acceptance network directly, even if it would prefer to minimize its role in merchant acquiring. Even so, it should lay the foundations of a medium-term strategy by actively working to nurture the establishment and growth of third parties that can gradually assume the merchant acquiring role over time. This may include general catalytic strategies around open APIs as well as more targeted efforts specifically aimed at actors in the merchant space.