Ultimately, Banks are ‘Big Data’ and Technology Companies

The Financial Times published a letter of mine:

From Mr Zachary Townsend.

Sir, Banks are “Realising the promise of new technologies” (The Connected Business, FT.com, September 30), despite being saddled by outdated and outmoded core banking technologies. Some of the best but least studied innovation is happening inside treasury management and commercial banking groups. There, far from the public eye, new technologies – such as application programming interfaces – are allowing financial institutions and businesses of all sizes to interact in new, faster ways. These technologies speed the flow of transactions for the business while decreasing risk and delivery costs for the bank.

Unfortunately, Eric Openshaw and Larry Albin continue the false dichotomy between the business and technology functions of banks. Ultimately, banks are “big” data and technology companies. At the centre of every bank is simply a data store that records who has how much money and the rules governing transaction processing. We call this data store a core banking system, which is then surrounded by delivery channels, risk management and other technologies. Banks, their boards and their shareholders will come to realise that huge portions of bank budgets and headcounts can be replaced by modern web technology if architectured correctly. Those financial institutions that remake themselves fastest in the model of software engineering first companies such as Google or Facebook, including picking a forward-thinking technologist as chief executive, will be the true benefactors of this new era in finance.

Zachary Townsend, Co-founder, Standard Treasury, San Francisco, CA, US

Credit Card Processing as a Commodity Business

I wanted to expand on my post from yesterday after some great feedback. When I said that credit card processing is a commodity business, I was not saying that it was a bad business. It is just a hard market to be in exactly because processors need to get to a huge processing volume to generate meaningful revenue. In the credit card processing business, volume is the only metric that matters.

Companies that operate well in credit card processing are to be praised and any industry that is producing multiple companies with multi-hundred-million-dollar valuations is a very healthy one.

Having said that, many companies create something that is heavily differentiated from their competitors and are able to charge for that differentiation. Apple creates laptops that are 10x better than PCs running Windows, so many folks are willing to pay 2-3x as much for their laptops. Apple is able to take their differentiation and convert that into increased revenue and better margins.

In the world of credit card processing one cannot charge more if one says they are in the card processing business. Even if someone created an idealized solution for dealing with the payments system, once a user reaches sufficient scale they will be more concerned with the variable components of the processor’s cost than the lower fixed costs of development and set up.

That makes perfect sense. Most business wants to commoditize all of their inputs and differentiate their outputs. Technology businesses, and big businesses that rely on contractors or system integrators, will eat a month’s worth of horrifically painful engineering as it is much cheaper over the long-term than paying even an extra few basis points (hundredths of a percentage point) on each transaction. That is, if a business is doing enough processing that even small increases in marginal cost matter then increased upfront fixed costs won’t.

To succeed in credit card processing, a processor can succeed in one of two ways.[1]

The first is to clearly be in the credit card processing market, have razor thin margins, drives toward massive volume, and create a much better product so folks use the product at all. Businesses will not pay the processor more for a better product though. The processor will invest more and more money in their product but with margins that get more and more squeezed on the one hand by knowledgeable large enterprises, the processor’s most valuable customers, that want things like an interchange plus basis points pricing. And, on the other hand, processors will get squeezed by the absolute fixed costs of what the banks and card networks charge the processor. Adding insult to injury, as the processor gets better known fraudsters pay more attention to it, increasing the cost of simply operating

That is a hard place to be. That is the place that Braintree, Stripe, WePay, and Balanced operate in as well as a ton of companies that we are not as fortunate enough to have heard of. Ultimately, Square is there too — although their situation is slightly more complicated. It is not necessarily a bad business to be in: any entrepreneur would be happy to be added to the list of successful processing companies.

The other way to succeed in credit card processing is to figure out how to be a payments company without appearing to be one so you can just charge much more. That is what most marketplace companies succeed at doing. They have built a better and better product experience, whose heart is credit card processing, and they can charge for that something better. What they have done commoditize their input — credit card processing — and differentiated their output into “booking blackcars” or whatever it might be. Ultimately, their core business is having their customer pay with credit card and then paying it out to a wide set of merchants, e.g. drivers, via electronic checks (ACH). That’s Airbnb, Eventbrite and others. Whether or not those companies go on to use Braintree or Stripe as their payments gateway does not matter because they are making such a large percentage of every transaction.

Addendum: Braintree’s Revenue

Braintree is actually a gateway, rather than a full-stack processor, for many of their best known and largest customers. That is a high-margin game with little risk. In this world, they make $49/month and $.10/transaction from those customers. That might make their margins higher than I suggested yesterday. It is actually hard to calculate the precise difference or relative value of those different business models without knowing how much they would make on a percentage basis, the average ticket size for those customers, and how much risk the company’s processors take on.

If this is all mumbo jumbo to you, dear reader, then keep your eyes peeled for future posts explaining various parts of the payments system.

[1] This is a model for argument. I think it’s useful but I also know that I’m simplifying important and complex businesses into gross categories.

Thank you to Daniel Kimerling, Jim Brusster, Brent Goldman, and Spencer Sugarman for suggestions and edits.

Credit Card Processing is a Hard Business

Braintree sold to PayPal (Ebay) this morning, which reminded me that I am a payments skeptic and especially skeptical of credit card processing.

Credit card processing is a commodity business. Companies advertise fees like 2.9% but the vast majority of that goes to the card networks and to the issuing and acquiring banks. On top of that, the majority of processing does not actually happen anywhere near the posted rates. Most processing is by large merchants (following the ubiquitous 80-20 rule) and those merchants get volume pricing and other discounts.

The margins in the card processing business are incredibly small. A company would be very lucky to make .5%. That’s not discounting the money lost to risk or the cost of acquiring customers.

Let’s take the biggest online example. PayPal processed $144.973B last year. If that was entirely processed over credit cards than they would have made - assuming 0.5% - $0.724B on processing itself. $724 million isn’t all that much.

PayPal actually made more like $5.6B last year because they make most of their money by having people use electronic checks (ACH) while charging them credit card like fees, and by charging customers high, and opaque, foreign exchange and transfer fees.

Compared to the high margins of other software companies it isn’t all that great to be in the credit card processing business. One needs a lot of infrastructure to make not all that much money, and ultimately the biggest player in online processing business gets most of their revenue from other parts of their business.

Braintree is processing $12B a year with few revenue streams outside processing. A generous reading of their net income would put them at $60M a year. I doubt they are actually near that number and, as mentioned in the press, I assume that their purchase price is so high because of a generous understanding of the value of the Venmo network.

A bunch of folks have asked me what the acquisition means for Stripe. Having worked at Stripe I think they are the best online processor on the market. They have the best solution and certainly the best team.

But is the acquisition good for Stripe? Yes and no. Yes because over the next few months Stripe is going to have an influx of great customers and their transactional volume.

The one caveat is that, inside payment circles, Braintree was known for bidding ridiculously low in bake-offs between them and other processors for hot companies like Github, Airbnb, etc. So low that they might be losing money on the deals just to secure them. Some of these customers might not move over to Stripe exactly because they’re being given an unreasonable deal, one that PayPal can sustain. Those companies have also already built their payments systems on top of the Braintree’s infrastructure.

On the other hand, this deal pegs Stripe's short-term market value. Stripe is growing faster than most YC companies but let’s assume, given their time in market, that they are processing single digit billions a year. If Braintree sold for $800M and is processing $12B than the deal depresses Stripe’s implied valuation. I don’t think that matters since they have plenty of cash but the sale highlights how hard it is to be in the processing business. And, Stripe is the best there ever has been in the business.

I actually think that there are two interesting places to play in the credit card processing system these days. One is to be what I call a vertically specific payments company. That’s Airbnb, Uber, and Eventbrite and a different blog post entirely. The other is if you can own more than one layer of the processing stack like Credorax does in Europe.