Square’s deal with Starbucks is exciting and groundbreaking. The innovation and convenience Square is bringing pairs with the fact that this agreement signals a milestone for Square as it moves into the broader point-of-sale merchant arena.
But while Square seems to be hitting the mark roundly, when you look at the actual economics for low value payments (LVP, the vast majority of payments at Starbucks), there’s a fundamental challenge around the business model which is not being addressed, and which will eventually turn into a roadblock. The transaction costs of LVPs are so high that they translate into a money-losing proposition — in this case, for Square.
[See also: A breakfast with Square and Starbucks: CEOs Dorsey and Schultz explain their unique partnership]
Now, we admit right up front that we’ve got a stake in making this particular observation — but unlike most critics, we have a working solution that doesn’t tarnish the shine on the Square/Starbucks deal in the least.
The problem: Low value payment costs add up
Currently, the costs for processing and handling card purchases make it impossible to handle low value payments at the rates published by Square without taking significant losses on any transaction below $10, the bulk of purchases at Starbucks. For an average transaction of $5, the loss to Square per transaction ranges from 4 cents on a credit card to 14 cents on a regulated debit card. And even if the payment schemes would lower the interchange fee rates, it would only move those losses to the banks, something they clearly can’t sustain.
Of course, there is an example of low value payments handled electronically, (an example that many people are familiar with) in Apple’s iTunes. If you’re one of the millions of people who’ve bought a song from the iTunes store you know how it works: for a small fee (usually $1.29) you download a song, perhaps using a gift card, but perhaps using a debit or credit card. What you may not have noticed is that your debit or credit account might not charged right away.
Apple delays its billing on the assumption that most customers will make more purchases soon, either more songs or even a whole album. That way, when the payment is processed, Apple pays for only one transaction fee for a whole group of small purchases. This approach is called aggregation, and many think it offers the best approach to dealing with LVPs.
Could Merchant Aggregation Work?
This approach — where the merchant aggregates each customer’s purchases — is able to work for Apple because of its enormous scale: about 10 million songs per day, and about five times that many apps. For most merchants, however, the amount of time needed to wait between purchases, presents too much of a conflict with the need for a constant, and daily, cash flow.
The failure of regulation
It is clear that the Startbucks/Square partnership, and a variety of other mobile and contactless payment forms, offer consumers unprecedented convenience. But because they still rely on the traditional card payments model, the underlying economic issue is left unaddressed.
Could it be solved through regulation? It’s doubtful. By eliminating a “two-tier” scheme for interchange fees, the Durbin agreement effectively set a standard $0.22 cent interchange fee on debit transactions, exacerbating the problem, rather than solving it. Government regulations could, theoretically, mandate a substantial cut in fees, but to get them to a level where merchants would accept them for LVPs would result in the banks and networks losing money on each transaction — an equally unsustainable outcome.
One possible solution
But there’s some good news for Square: an innovation can be added to Square’s own technology to fill in this missing piece and make the economics of LVPs work. We address this fundamental issue without upsetting any of the great advances Square has made, or the convenient experience that Starbucks is anticipating for its customers.
A workable solution must actually reduce the cost of processing these low value transactions. Can this be done? We took a look at this challenge at Cardis International and found a way: by aggregating LVP transactions and eliminating the need to process each transaction individually through the value chain.
So instead of incurring processing costs for each transaction being processed through the network, you now have the cost being incurred only for aggregated amounts, and that allows for an overall reduction in costs by a factor of ten, creating economic benefits that can be distributed among all parties: Square, merchants, networks and banks. It works for mobile phones and NFC as well as EMV chip enabled cards.
Only a quantum leap in the processing model can build consumer and merchant innovations like Square into a sustainable solution for electronic low value payments. This solution is being piloted right now in Europe. And it can work at a Starbucks location near you.
Nebo Djurdjevic is CEO of Cardis International. He has 18 years of experience in senior business and technology management roles in electronic payments, having developed and marketed advanced electronic payment solutions based on chip card and mobile technology. Nebo has experience with international payments technologies companies and with founding and building start-ups.
Photo: Square CEO Jack Dorsey, Starbucks CEO Howard Schultz, by Devindra Hardawar
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