2126122, 4:39 PM Choosing a Profit Strategy for Merchant Payments (CGAP ° Choosing a Profit Strategy for Merchant Payments October 2019 hitps:wwn.cgap.orgiresearchipubliction’choosing prott-sategy-merchant-payments ane2128/22, 4:39 PM Choosing a Profit Strategy for Merchant Payments The digital merchant payments space in emerging markets and developing economies is defined by several important and interrelated trade-offs in the business model. Providers should go into merchant payments with a clear view of what these trade-offs are and a long-term commitment to an explicit strategy for managing them. «The apparent contradiction between short- and long-term profitability. Providers need to invest heavily in building scale to reach critical mass. At the same time, charging fees for digital payments would hurt their position of encouraging digital payments over cash, because cash is entrenched and free to use. Most providers are under strong pressure to achieve profitability right from the start, which can undermine their long-term vision in important ways. * Who to charge and how much to charge. The industry is still a long way from arriving at a consensus. Most providers struggle with this question, and it is not uncommon to alternate between different approaches. * The balance between focusing on the payments aspect and focusing on the broader set of opportunities that a successful digital payments ecosystem can enable. This ends up being a choice between a revenue model that is simple but problematic and one that is more complex but has greater potential. Most providers have some sense of that potential, but they tend to launch with an exclusive focus on payments and leave the rest for later. Ironically, the limitations of a straight payments model may end up meaning that "later" never comes. « The cost and capabilities of different acceptance technologies. Most providers find it difficult to decide which technology strikes the right balance between ubiquity, usability, features, and price tag. The choice has major implications for the cost and revenue sides of the strategy. A digital payments provider looking to enter the merchant payments space in a developing economy would typically look at two main examples when considering its profit strategy and business model: mobile money and credit/debit cards. But while there are useful lessons to learn from both, providers will be better off pursuing a third model—one that looks more toward the digital payments ecosystems in China. hitps:lwwn.cgap.orgiresearchipubliction’choosing prott-strategy-merchant-payments 222128122, 4:39 PM CChoasing a Profit Strategy for Merchant Payments Digital merchant payments differ from the remittance-oriented mobile money business model in important ways. It is a two-sided market. Digital merchant payments have to meet the needs of two dis inct groups of users—merchants and their customers—who may have different needs, motivations, and preferences around payments. Success in such a market is heavily defined by the so-called cross-side network effect, in which demand on one side of the market is directly (and exponentially) dependent on uptake on the other side. The Two-Sided Market in Merchant Payments MMM Cross-Side Network Effects in Merchant Payments Value for customers depends on the number of merchants who accept digital payments. Value for merchants depends on the number of customers who use digital payments. Click on image to enlarge This has implications for the product, which needs to combine two distinct value propositions that speak to the respective sides of the market. It also has implications for the revenue model, since any pricing that discourages uptake on either side of the market will exponentially reduce demand on the other. For more about the two-sided markets challenge, see “The Challenge of Two-Sided Markets in Merchant Payments.” hitps:lwwn.cgap.orgiresearchipubliction’choosing prott-strategy-merchant-payments ana2726/2, 4:99 PM choosing a Prof Sirategy fr Merchant Payments It faces far stiffer competition from cash. When it comes to the predominant mobile money use case—peer-to-peer (P2P) remittances—the value added by digital payments is clear: it helps customers avoid the cost, risk, time, and other frictions that tend to plague cash-based remittance approaches. These pain points are very real to customers and avoiding these pain points is well worth the fees charged for mobile P2P transfers. But in retail commerce, cash tends to work perfectly well for both merchants and their customers, so the value added by digital payments is far less apparent. This has implications for the digital merchant payments revenue model because willingness to pay is driven by perceived value. Simply put, if customers already don't see a compelling reason to prefer digital over cash, they will be even less likely to do so if it incurs a fee. Customers have cash available, and it's free to use. So why would they pay for digital payments? If providers don’t have a clear and genuinely compelling answer to that question—for merchants and their customers—then charging any fee is likely to result in failure. For more on the challenges around cash, see “Cash Is a Fierce Competitor: Underestimate It, and You Will Fail” Digital merchant payments in developing economies differ from the card payments in important ways. Digital merchant payments do not require expensive hardware. Card payments in retail commerce require point-of-sale (POS) devices that often cost many hundreds of US. dollars to buy and are typically leased to merchants for a monthly fee. This is worthwhile only for merchants who have enough turnover on electronic payments to make up for the cost of the hardware, which can be several thousand dollars. This has immediate implications for merchant-acquiring strategy because it rules out the vast majority of retail shops in most developing economies. That is a central reason why card payments have so far reached only limited penetration across large parts of the developing world. One advantage of adopting digital merchant payments based on mobile technology is precisely that it can avoid this major problem. hitps:lwwn.cgap.orgiresearchipubliction’choosing prott-strategy-merchant-payments ane2726/2, 4:99 PM choosing a Prof Sirategy fr Merchant Payments However, digital providers would still be wise to heed this hardware lesson: even far cheaper POS devices can result in prohibitive costs for the provider if merchants are not willing to pay for them. If they are willing to pay anything at all, it will be only because they are offered a truly compelling value proposition and a sizeable customer base that wants to use the technology. In early markets, it can be hard to persuade merchants of either. If merchants are not willing to pay for the hardware, the provider needs to cover the cost across what will inevitably amount to hundreds of thousands—and in many markets, ultimately millions—of acceptance points. Several African mobile money providers learned this lesson the hard way: they initially opted for NFC (near-field communication) technology, only to realize that they were not prepared to sustain the hardware spending this would require. For more on the trade-offs around acceptance technology, see “Acceptance Technologies for Merchant Payments? Transactions are less risky. A card transaction is known as a debit pull, where a merchant initiates a payment against a customer's account by claiming that the merchant has been authenticated to do that. This claim is supported by various bits of information, which may be no more than the details printed on the card. Such a trans: ction is risky because it did not originate from the customer and the merchant may be submitting the information fraudulently. This risk translates into cost, which is baked into the pricing model, hence increasing fees. A payment made via mobile money and many other digital wallets is known as a credit push, where the customer initiates the transaction by instructing his or her bank to send money to the merchant's account. While such transactions could also be fraudulent, the risk tends to be lower because a credit push typically requires access to the customer's phone or other physical payments instrument as well as authenticating via personal identity number. This has implications for pricing levels. Because credit push transactions are much less risky, the baseline cost of a merchant payment from a digital wallet is lower than that for bank cards—and it should be priced accordingly. hitps:wwn.cgap.orgiresearchipubliction’choosing prott-stategy-merchant-payments 5122726/2, 4:99 PM Choosing Prot Strategy for Merchant Payments There is no legacy pricing model. The revenue model, fee structure, and pricing levels in the card space have evolved over more than half a century. As a result, there is a high degree of acceptance from all parties around its A merchant in Guinea who accepts mobile money waits for customers. basic tenets. In Photo: Vincent Tremeau / World Bank addition, payments providers have become very good at fine-tuning key aspects of the model, which entrenches it even more. Perhaps most notably, card issuers have become so adept at driving consumer demand for credit and debit cards that merchants have little bargaining power. In a market like the United States today, it is difficult for a merchant to choose not to accept cards, because it would almost certainly result in lost revenue. That means card acquirers don't need to worry as much about creating a compelling value proposition for merchants, and they are freer to set the pricing they choose —the merchants have no choice but to accept it. This is clearly visible in, for example, the difference in pricing to small merchants versus very large ones. The bargaining power of huge retail chains has translated directly into substantially lower transaction fees. In some markets, this power imbalance has become so great that regulators have taken measures to level the playing field, while in others, small merchants have brought (and won) class action lawsuits against the card networks, Digital payments providers in developing economies don't have this legacy to rest on, for better or for worse. This has direct implications for the product. Providers need to be far more concerned about creating compelling value for merchants because they cannot simply leverage the massive consumer demand that the card companies have managed to build over decades. It also has implications for hitps:lwwn.cgap.orgiresearchipubliction’choosing prott-strategy-merchant-payments siz212822, 4:39 MA Choosing Prot Sraegy for Merchanl Payments pricing and the underlying revenue model because it is far less obvious that they can get away with charging merchants anything at all, let alone 2-3 percent of the transaction value like credit card providers do. The point here is that digital payments providers should not default to looking at the card model for pricing levels or a revenue model. Instead, they should create a new model based of the unique characteristics—advantages as well as limitations —of their own markets, technologies, and business model opportunities. The revenue side As discussed above, and in more detail in “If What You Are Selling Is a Solution to the Cash Problem, Don't Bother? most providers struggle with the question of how to generate revenue from merchant payments while competing with cash, which is ubiquitous and free. Transaction fees are particularly problematic, simply from a behavioral standpoint. Regardless of which side is being charged, transaction fees are a constant, tangible disincentive against the very action providers need to promote —paying with a digital instrument. It is difficult enough to compete with the “zero cost” of cash without reminding customers of the fee every time they transact. Aless problematic way to charge such fees would be through a subscription model that delinks the choice of paying for the service from the choice of which payment instrument to use in each individual moment of transaction. Providers like Vodafone Ghana have been testing such a model to good effect. While this avoids half the problem, it still suffers from the other half—charging a fee for solving a problem people don’t have, since cash is not broken. Another way to generate revenue is by selling value-added services (VAS) based on the data generated from payments transactions. This creates a revenue source that solves both problems. First, it does not have the behavioral problem the transaction fees do. Second, it is linked to a clear source of value for the user, which increases willingness to pay. Put differently, it beats cash by offering solutions that cash-based systems cannot offer. There is considerable anecdotal evidence from markets around the world that merchants are happy to pay for a solution that gives them real value. hitps:lwwn.cgap.orgiresearchipubliction’choosing prott-strategy-merchant-payments m222a, 439 Choosing a Prost Sraegy or Merchant Payments WeChat and Alipay in China provide credit scores and customer information to financial services companies that want to offer tailored services to their customers. Similarly, Visa and Mastercard have generated entire industries around the analysis and sale of their customer data. The opportunities for building compelling VAS are likely to be greater for merchants, who have many pain points in the course of running their business that could be addressed through solutions linked to digital payments. For more on what this could look like, see “Digitizing Merchant Payments—What Will It Take?” and “VAS Playbook” On the consumer side, the most common source of added value used by payments providers is some form of loyalty scheme, although it is also possible to imagine personal financial management tools and similar solutions. This is particularly true in the credit card space, but more recent entrants like Alipay, WeChat Pay, and Google Tez have also used loyalty rewards to effectively drive consumer use. For more on what loyalty reward schemes might look like in merchant payments, see “Loyalty Overview” and “Loyalty Playbook” Regardless of which side is being charged, it is essential to remember that willingness to pay for a solution will be only as great as the genuine value it brings. While this may sound obvious, many merchant payments providers don't appear to have sufficiently taken this to heart. The cost side Another contradiction between short-term and long-term profitability derives from the significant cost of building a sufficient critical mass of users on both sides of the market. This cost is particularly acute Fish merchants. Photo: Mahabub Hossain Khan, 2016 CGAP Photo Contest hitps:wwn.cgap.orgiresearchipubliction’choosing prott-stategy-merchant-payments a22726/2, 4:99 PM choosing a Prof Sirategy fr Merchant Payments around merchant POS hardware and is an essential part of choosing the right acceptance technology. Providers have to pick the technology they and/or other acquirers are able to distribute at sufficient scale from day one and one that enables them to keep scaling up substantially over time. At the same time, providers need to bear in mind other central aspects of the acceptance technology, including any hardware requirements on the consumer side and the inherent usability of the solution for merchants and their customers. USSD is clearly the cheapest acceptance technology, but it also comes with significant drawbacks that could doom the business from the start. For more on the trade-offs around acceptance technology, see “Acceptance ‘Technologies for Merchant Payments” The capital expenditure (capex) for providers to build out acceptance networks also depends on the extent to which merchants are willing to shoulder the costs. If merchants don't find digital payments alone worth paying for, providers going to market with a simple payments offering may find themselves forced to bear the entire cost of any acceptance devices. However, those that offer merchants a genuinely compelling solution to address important pain points in the business may find merchants perfectly willing to take on that cost themselves. This trade- off is a central one for merchant payments providers to explore and understand. For more on how to create value for merchants, see “For Merchants, the Real Value Lies beyond Payments? Also, the capex involved in building and maintaining acceptance networks can be slashed by enabling interoperability and third-party merchant acquirers. By enabling their customers to transact at third-party merchants, providers get an immediate positive network effect that helps drive momentum and build critical mass, And by enabling their merchants to accept payments from third-party customers, they boost the basic value proposition and the utility of any VAS. solutions powered by digital transaction data. In fact, providers should consider whether they want to do the acquiring piece themselves at all or focus on the issuing side, serving the wallet customers that already tend to be their core user base. All banks in developed markets issue hitps:wwn.cgap.orgiresearchipubliction’choosing prott-stategy-merchant-payments on2228i, 429 Mt Cheosng 2 rot Strategy for Merchant Payments cards, but the vast majority do not acquire merchants. The ones that do primarily use it as a means to cross-sell other services, not for the sake of the payments business. And even then, acquiring banks tend to rely on third-party merchant aggregators to find, recruit, and service the majority of the merchants. These aggregators specialize in giving merchants value, including by building solutions highly ized to the needs of restaurants, gas stations, supermarkets, and so forth. This degree of specialization to serve the particular needs of different merchants is something most acquiring banks would be neither interested in nor well-placed to create. This is why banks in the card space rely heavily on third-party aggregators like independent sales organizations and payment facilitators to acquire the majority of small and medium-sized merchants. Source: McKinsey, Driving Merchant Acquiring and Digital Commerce. For more on the role of third parties in the merchant acquiring value chain, see “Acquiring Models” The bottom line If providers accept all of this—transaction fees are problematic; free transactions will help substantially to drive volumes; digital payments alone are not compelling enough to users; VAS create better customer value and better opportunities for revenue; interoperability and specialized acquirers are necessary—then they have a foundation for a very different type of profit strategy than the classic card and mobile money models. The strategy will be closer to the route taken by Alipay and WeChat Pay, which have unleashed a rapid shift away from cash in China in just a few years. (See “China: A Digital Payments Revolution”) hitps:wwn.cgap.orgiresearchipubliction’choosing prott-stategy-merchant-payments sonesreaee «0 Choosing a Prot Seay for Merchant Payments This strategy is entirely centered on scale and the richness of the ecosystem created by the provider. It means the provider should aggressively focus on driving uptake and use on both sides of the market, potentially as a loss leader. At the same time, the provider should equally aggressively create a wide array of services available to custome gain on both sides of the market, through which they can generate revenue. This implies an ambitious, proactive strategy for developing partnerships with other companies—some of which may be willing to provide the revenue in lieu of the customer. It also implies an open approach to technology, including APIs. Needless to say, reaching that vision takes time, and the typical developing economy does not have all the advantages that China has, including a high penetration of bank accounts, smartphones, literacy, etc. But if this vision is the future that providers are aiming toward, then it will shape central decisions about the business model, operational model, and partnerships strategy from day one. All of the same basic principles can be applied even if the solutions are simpler in some ways. And indeed, this realization is precisely what is enshrined in, for example, the recent emphasis of GSMA, the global association of mobile network operators, on mobile money evolving into payments as a platform. ‘Topic: Business and Markets ‘Tag: Payments Featured Collection DIGITIZING MERCHANT PAYMENTS Related Research PUBLICATION 06 JUNE 2021 Fintech and Financial Inclusion: A Funders’ Guide to Greater Impact hitps:wn.cgap.orgiresearchipubliction’choosing proft-stategy-merchant-payments ane228i, 429 MA Cheosng 2 rot Strategy for Merchant Payments ‘This practical guide, based on two years of global research, describes how development funders can identify promising fintechs and maximize the impact of their support. 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