A payments letter from America

Having recently been in the United States of America for a month, I have been able to see first hand some of the effects of the polarisation of that society. It is obviously a social issue but it's also evident in payments.

Some in the payments industry in the USA could be described as 'Luddite', others as 'Early Adopters'. With apologies to famed Brit expatriate Alistair Cooke, I thought it worthy of a 'Letter from America'.

"There are some key factors that may mean Apple Pay adoption outside the US is not as smooth."

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Firstly the 'Luddite' behaviour in payments. The 'Luddites' were 19th Century English textile artisans who protested against newly developed labour replacing machinery in the early 1800s and whose mythical leader was Ned Ludd.

In the US payments arena “Neo-Luddism” is displayed by the enduring use of cash; the continued widespread use of paper cheques and, for payment cards, a continued reliance on the magnetic strip and signature for verification at the point of sale (PoS).

A January 2015 paper from the US Federal Reserve, “Strategies for Improving the US Payment System”, talks about 'billions of cheques are still written each year across a variety of use cases and business-to-business cheque writing remains entrenched, especially among smaller businesses'.

As regards cash usage the paper points out 'a persistently large number of people do not use bank accounts or traditional financial services , limiting their ability to access low-cost electronic payments'. According to a 2013 Federal Deposit Insurance Corporation (FDIC) survey, over 28 per cent of US households are either unbanked or underbanked.

The US still relies on magnetic strips and signatures for most credit card transactions and one consequence of this is there is a continuing growth in the production and use of counterfeit credit cards. The Federal Reserve Payments Study of 2013 reported third party fraud on payment cards at US$6.4 billion for 2012, with 'card-not-present' fraud rates by value, not dramatically different from card present fraud rates'.

In an attempt to stimulate the adoption of 'chip and PIN' to replace the magnetic strip and signature, President Barack Obama in October 2014 issued an executive order requiring the federal government to issue new chip and pin credit and debit cards as part of an effort to 'drive the market towards a more secure payments system'.

Thus the cards that the American government sends to millions of people for social security payments, government-employee pensions and veteran's benefits will eventually become chip and PIN enabled. But American retailers currently bear a substantial burden in paying for fraudulent transactions and they have also been victims of data breaches of customer card details following infiltration of their PoS systems, so they are now investing in chip and pin compatible PoS terminals.

The major credit card issuers in the US will from October 2015, require the party in the payment value chain with the least sophisticated payments technology to cover the cost of fraudulent transactions.

The Federal Reserve paper of January 2015 has as one of its Desired Outcomes that 'payment system security is of paramount importance' and 'as new entrants bring to market innovative payment products and services, new security risks may be introduced and they must be identified, monitored and managed'.

One of these innovative payment products is Apple Pay, which has had a rapid uptake in the USA, as 'Early Adopter' consumers respond positively to the opportunity to pay via their mobile phones at the PoS. American card issuers have also been keen to get on board, as have some American retailers, and Apple Pay has consequently been described as the 'tipping point' for the advent of mobile payments.

By December 2014, Apple claimed banks representing 90 per cent of credit purchase value in the US were signed up to its Apple Pay product. In February 2015, Apple's CEO Tim Cook reported more than 700 US banks and other card issuers have joined Apple Pay's payment service and that Apple Pay had accounted for two-thirds of the value of American Express, MasterCard and Visa contactless payments across the US in the December 2014 quarter.

However despite the seeming frenzy of Early Adopter usage there needs to be a few words of caution about Apple Pay. The volume and value of contactless payments in the USA is proportionally far less than in Australia and other countries, such as the UK, who have embraced chip and pin technology at the PoS.

There is widespread penetration of mobile phones in the US but with over 25 per cent of US households 'unbanked or underbanked', they will find little use for the Apple Pay product. And while Apple Pay has succeeded where other mobile payment systems have failed (note Amazon's withdrawal of the Amazon Wallet in January 2015), Apple Pay is nowhere near approaching 'critical mass', with major US retailers still not accepting it at the PoS and, at the time of writing, its usage still limited to the United States. Also research released at the end of March 2015, claimed that two-thirds of the people that use Apple Pay had run into problems at the PoS.

Meanwhile there are some key factors that may mean Apple Pay adoption outside the US is not as smooth. Firstly contactless payment with payment cards is well advanced in Australia and elsewhere, based on the widespread adoption and ever increasing ubiquity of chip and PIN technology.

Secondly recent exposures of the 'hacking' of mobile phones may have left consumers wary about loading too much of their personal financial data onto their phone. The question of customer redress in the event of a fraudulent transaction or a breach of personal information and hence identity theft via a mobile phone, is still to be addressed. There were claims in March 2015 that fraud was accounting for about 6 per cent of Apple Pay transactions and that the weak link was in the card issuer's verification process, as fraudsters loaded stolen credit card information onto iPhones.

Thirdly and of key importance is the business model of Apple Pay and whether this would work outside of North America. According to a publicly leaked version of a 19 page commercial agreement between Apple Pay and US card issuers, Apple will receive 0.15 per cent of credit card transaction values and it also stipulates that issuers must make available at least 95 per cent of the cards in their portfolio to iPhone users.

The fees will be collected by the major card schemes of American Express, MasterCard and Visa, with Apple Pay maintaining the right to audit the issuers Apple Pay records, at least twice a year. Furthermore, Apple is also demanding a large number of data points from each issuer on card usage, including purchase volume; in-store versus app purchase mix; the top 100 merchants by purchase volume and the average purchase amount.

Payment card transactions involve the merchant who accepts the card paying the card transaction acquirer a Merchant Service Fee (MSF), part of which is made up of an interchange rate, which is then transferred to the card issuer.

In Australia the Reserve Bank (RBA) has intervened to cap the credit card interchange at 0.50 per cent of the transaction value. This compares to interchange rates of between 1.25 and 2.4 per cent in the USA. The regulatory caps that exist in Australia and elsewhere outside of the USA leave card issuers and the MasterCard and Visa card schemes little room to manoeuvre in negotiating with Apple Pay over the financial terms of introducing this new payment option.

Furthermore the recent Financial System Inquiry in Australia has recommended the RBA's Payment System Board intervene to further reduce the interchange fee cap to 0.30 per cent, which is the same level as that being suggested by the European Union's Economic and Monetary Affairs Committee. Such proposals would further reduce the room to manoeuvre.

So then paradoxically the USA is both laggard and a leader in payment systems. It embraces both the traditional options of cash, cheques and signature verification of payment card transactions, whilst also warmly welcoming the innovative options of mobile payments, as demonstrated by the uptake of Apple Pay.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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