Changing power dynamics in the payment processing sector
March 16 2021
by Jordan McKee
In the words of Bob Dylan's 1964 hit, The Times They Are a-Changin'
in the payments industry. New distribution channels, new core competencies and new challenges to economics are increasingly disrupting the status quo for payment processors, as well as the balance of power within the ecosystem.
The 451 Take
The way merchants adopt and leverage payment-acceptance technologies is evolving. Increasingly, payments are viewed as something that should be 'baked in' instead of 'bolted on.' This is having a profound impact on the distribution model for payment processing, as well as the skill sets needed to succeed. It's also resulting in long-term implications to revenue and profit dynamics within the industry. To adapt, a technology-first mindset and strategies for aligning with both large enterprises and vertical SaaS providers are becoming essential.
Evolution of the distribution model
For many years, financial institutions served as a primary on-ramp for merchants into the payments industry. The reason is simple. As new businesses signed up for financial products (e.g., loan, bank account), adding payment processing and a merchant account was a natural next step. For those merchants that didn't sign up for payments at the branch, feet-on-the-street sales forces – ISOs and agents – served to extend the reach of the bank.
While these dynamics are still at play, the payments industry on-ramps are both multiplying and shifting. Large vertical SaaS providers such as Toast (restaurants), Mindbody (health and wellness) and Jobber (services) are capturing significant mindshare in their respective verticals and have effectively become operating systems for the businesses they serve. Scores of smaller ISVs tout similar propositions. This is leading many new merchants to begin exploring verticalized software packages early on in their evolution. Naturally, these software providers have extended into payment processing to provide SMBs with a comprehensive and tightly integrated package to run their businesses.
There are now dozens of SMB-focused software vendors that have either become payment facilitators (payfacs) or leverage hybrid payfac models. Hundreds more have integrated payments into their software and operate on referral or revenue-share models. Offering a payment processing service embedded into a broader software proposition has allowed these companies to enhance the user experience, further entrench themselves in their customers' operations and capture a lucrative new revenue stream.
As more SMBs turn to software to run their businesses, selling payment processing directly will no longer be the layup it once was for financial institutions and their processing partners. Software is replacing branches, ISOs and agents as the payment distribution model of the future.
Shift to technology-centricity
Payments has traditionally been a finance and risk management business. While these are most certainly important core competencies today, the role and influence of technology is increasing exponentially for payment processors. Engineering, developer and design expertise are the new skill sets that are increasingly needed to fortify their businesses for the future.
The growing role of technology in the payments industry is in part being fueled by a mindset shift occurring with enterprises. More than ever, enterprises are looking to tightly weave payments into their digital experiences and are prioritizing payments as a growth catalyst for their business. This is especially the case for digital transformation (DX) leaders (see exhibit below). As a result, a number of the core problems to be solved in payments are highly technical in nature. They include tasks such as integrating new payment methods, harnessing machine learning to improve authorization rates, and leveraging contemporary APIs and UX designs to create a modernized checkout flow. It's a key reason why recent entrants to the payment processing sector position themselves as technology companies that happen to operate in the payments industry.
The shift to technology-centricity in the payment processing sector is particularly important when considering the evolution of the distribution model for payments. With SaaS platforms and marketplaces fast becoming mission-critical entities to align with to reach SMBs, payment processors must have strong technical chops to position themselves as attractive partners. Many high-growth software companies simply lack the patience to work with a payments partner that fails to keep up with their agility and pace of innovation.
Challenges to traditional economics
Payment processors have been contesting with margin compression in the enterprise segment for years. The dirty secret of the industry is that SMBs historically have softened the impact of pricing pressure coming from large enterprises. Consider that net yields for a merchant processing $1m in volume can be 20 or more times higher than for a merchant processing north of $1bn. Credit Suisse, for instance, estimates that, while SMBs account for just 17% of US payment volume, they drive 55% of processing revenue for the industry.
The revenue dynamics and profit pool surrounding SMB payments is undergoing transformation. Transaction volume from individual merchants on main street is increasingly becoming aggregated within large marketplaces (e.g., Shopify, eBay, Amazon), delivery services (e.g., Uber Eats, Postmates, DoorDash) and SaaS platforms (e.g., Toast, Mindbody). In some instances, volume is also flowing away from main street merchants and to enterprise retailers (e.g., Walmart, Home Depot, Target). These factors are likely to create volume erosion for certain processors as SMBs eschew stand-alone payment relationships (e.g., they move their processing volume to Shopify) or lose sales to mega-merchants. Another outcome is that more payment volume becomes concentrated across fewer merchants (and vertical SaaS payfacs), increasing their bargaining power and ability to command razor-slim transaction pricing.
For payment processors, there are several implications of this trend. The first is that the enterprise segment (including serving marketplaces and SaaS platforms) and ISV segment are increasing in importance as a means of securing future payment volume. The second is that value-added services (e.g., fraud prevention, loyalty products) and adjacent offerings (e.g., card issuance, POS software) are becoming critical tools to diversify revenue streams in the face of margin or volume compression. We anticipate new revenue models emerging in response to this trend as processors look to differentiate themselves and rely on their technical expertise to drive margin growth (e.g., transaction pricing or revenue share based on authorization lift).