Did you hear it? That collective sigh of relief from the bankcard business that 2005 is coming to a close. This was the year that changed the image of payment processing. This was the year that brought attention to an industry that heretofore may have been one of the most lucrative, powerful and invisible in America. Not anymore.
    Arguably, the most significant occurrence in 2005 was the megabreach at CardSystems Solutions and the chain of events that followed.  It started back in June when it was learned that 40 million credit/debit card accounts had been compromised at CSSI.  Processing near $15 billion annually for domestic and international merchants, CSSI allegedly had stored data in violation of association rules.  That data had been hacked and instances of fraud triggered awareness of the massive breach.  While management scrambled to control the crisis, the bankcard associations threatened steep fines  - which as of press time have not yet been assessed - against CSSI’s sponsor bank, Merrick.  Issues of non-compliance, poor security, lack of disclosure and unauthorized data storage were openly discussed by every major news organization from The New York Times to The Wall Street Journal.  Politicians weighed in with concerns and asked for new disclosure legislation.  A sub-committee hearing was called.  A lawsuit was filed in California.  The veil of secrecy that the payment processing industry had worn for so many years was lifted.     
    Following the breach, Visa announced it would cease accepting transactions from CardSystems as of October 31.  In September, CyberSource announced it was planning to acquire CardSystems.  Visa extended its October 31 deadline to January 31, 2006 to accommodate the acquisition.  It was a short-lived dream for CyberSource.  In October, the deal fell through but a new player, some industry experts believe all to conveniently,  quickly stepped up to the plate—Pay-By-Touch. 
    By the end of October, Pay-By-Touch had a signed purchase agreement in place.  According to the deal, Pay-By-Touch becomes the new owner of all CSSI assets including systems, channel relationships, merchant ownership and revenue streams.  Although Pay-By-Touch assures the industry that CardSystems will continue to exist for a bit in order to wrap up old liabilities,  many, especially CSSI ISOs who are concerned that they may be left to pick up the association fines when CSSI as an entity ceases to exist, see this purchase as a simple repackaging of a defunct processor. Says one such CSSI ISO,  “The jockeying for position between Merrick Bank, CardSystems and Pay-By-Touch has one predictable result. We are the lowest on the totem pole in the VISA/MasterCard world. Stuff runs downhill and we are about to get it all over us.” 
    Additional speculation that Merrick Bank, in seeking purchase by an issuer, is planning to exit the acquiring side of the business (and may thus be less concerned with preserving ISO relationships than other interested parties), leads many concerned ISOs to believe that Merrick will hold CSSI ISOs liable for fines uncollectible from a non-existent CardSystems corporation. Cries for a CSSI  escrow fund to cover such future fines and threats of class action suits are the latest segment in this escalating saga as the Pay-By-Touch deal is set to close and association fines have yet to be levied.
    Is this CardSystems' easy way out and a chance for a new life in the industry - or is it an example of brilliant strategizing by CSSI management, making the best of an unfortunate situation that, industry experts profess, could have happened to anyone? Certainly time will tell as events continue to unfold.
    “We expect the deal to close in a few weeks,” Eric Bachman, Chief Operating Officer of Pay-By-Touch told Transaction World in early October, shortly after the purchase agreement was announced.  “Visa has established a number of hurdles we have to clear and contingencies we have to meet, but we anticipate no problem in doing so.  We have not been informed of any impediments.  It’s important to realize that after the breach, CardSystems spent $2.5 million to insure security.  As for our procedures, Pay-By-Touch has always been extremely security conscious.  That philosophy has not changed.  We will surely continue to improve CSSI’s existing systems.”
    While Pay-By-Touch may ultimately benefit from the breach at CardSystems, the industry as a whole may not be so lucky.   The resulting publicity that the bankcard business received as a result of CSSI led to precedent-setting events, the least of which were Congressional hearings. 
    “The biggest outcome of the CSSI breach may well be the raised awareness of our industry and that of ETA’s role in it,” says noted industry esquire Holli Hart-Targan.  “Committee staffers actually interviewed ETA executives this past year to get background information.  We have flown under the radar for so long.  The average person doesn’t understand how our industry works.  Now we have stepped into the spotlight.  Here’s an opportunity for ETA to make a positive contribution to these committee hearings by letting them know who the players are and how they are interconnected.”
    Another change to come about as a result of increased focus on security in 2005 was the widespread implementation by the card associations of a single security standard.  Known as the Payment Card Industry Data Security Standard (PCI) and first introduced in December 2004, this requirement united security compliance and practices across the board.  2005 saw the beginning of what will be more regulation, investigations and assurances that organizations are in compliance with card association rules.  In fact, three bills are currently pending before the House and Senate that will regulate breaches and what needs to be implemented if they occur.  All good bets are on that they will pass.
    For the many who were initially attracted to the industry because of low cost-of-entry, few government regulations and little  administrative intervention, this is not necessarily good news. Says one ISO, “We have long been an industry that has thrived on self-regulation, within the parameters issued by the card associations – now that we are under such scrutiny by government administrators who don’t understand the nuances of the industry, costs of doing business will increase and we run the risk of being hampered by unnecessary legislation.” Like a game of dominoes, the CSSI breach has and will continue to have lasting effects on electronic transactions.
    Speaking of card associations, it should be mentioned that MasterCard picked 2005 to announce it was going public.  This summer, as part of a plan for new corporate governance and open ownership structure that will include a new Board of Directors, an establishment of a charitable foundation and a transition to being a publicly traded company, MasterCard filed a registration statement with the SEC for a proposed IPO of its Class A common stock.  The Class A common stock is expected to trade on the New York Stock Exchange under the symbol “MA.”   Other bankcard business entities that traveled the IPO road this year were Heartland Payment Systems and VeriFone. 
    2005 also witnessed an unprecedented proliferation of merchant-related lawsuits.  Attorney Targan sees this as a trend toward merchants feeling they finally have a seat at the table and can exercise their voice.  The flip side of that may be the lack of voice by ISOs.  “From the ISO perspective, fewer sponsoring banks are willing to take a chance,” says Targan.  “This is forcing smaller ISOs to partner with bigger organizations that already have established relationships with member banks.  It became difficult this past year for the smaller guys to join a member bank.  Barriers of entry are higher. Banks that do sponsor ISOs can force more stringent terms and conditions.  Implications will be felt in pricing and service.  Consolidation of players will rise and competition will fall.”
    Consolidation of players was certainly a big part of 2005.  Just look at the year’s scorecard – NPC and Bank of America; Chase/First Data and Paymentech; Lynk and Royal Bank of Scotland; TransFirst and Fifth Third; Certegy and Fidelity; UBC and Optimal; Retriever and Iron Triangle. 
    According to Jared Isaacman, President/CEO of UBC, he chose to broker a deal with Canadian-based Optimal to take advantage of the current market, keep his organization debt free and continue its fast-track growth while funding sales programs for future years.
    “Our deal with Optimal strengthened us,” says Isaacman.  “Every month since January of 2005 has been our best month.  Our market position has grown.  Our reputation has improved.  Together with the incredible success of our free terminal program, we’re signing 2,500 new accounts each month.”
    Isaacman’s overall view of this past year focuses on a number of events – the landmark lawsuits and settlements that reshaped interchange and the fact that the industry is poised to seed new programs such as contactless payments and biometrics…as well as the CSSI breach. 
    “It may take years for them to become a way of life but 2005 saw an emerging trend towards contactless and biometric products,” says Isaacman.  “People are talking about the CardSystems breach as a major event.  What I hope it will encourage is a movement towards more accountability for processors and banks.  Visa and MasterCard became more proactive this past year.  The sponsor banks have to start doing the same.  I am concerned about the next breach.  I am going to be far more selective of my processing platform but I don’t see it as my obligation to insure against breaches.  That is the bank’s.  They need to step up in 2006.”
    As with UBC, another leading ISO, Retriever Payment Systems, also looked for and found liquidity in 2005.  Iron Triangle purchased Retriever in the spring and helped it expand distribution capabilities, increase strategic investments in technology as well as people in order to position it for future growth.   “We were very fortunate to acquire such a well-known and respected brand,” says Tom Wimsett, newly crowned President/CEO of Retriever.  “By bringing additional capital to the table, Retriever is in a great position for significant growth opportunities.”
    Was every acquisition in 2005 as successful or did some negatively impact the already shrinking landscape?  Wimsett believes the NPC/BOA was significant in that it showed the willingness of financial institutions to expand their merchant business, such as in the case of  Chase.  But what happens to the little guys while the big get bigger?  Wimsett is quick to point out that consolidation in the bankcard business creates new opportunities for some sales groups.  He compares it to similar mergers and acquisitions in the financial institution arena.
    “Every time a new merger occurs, there is typically some fallout from entrepreneurs and managers within those organizations,” says Wimsett.  “Their opportunity is better off on their own—selling and servicing local merchants—like community banks that spring up after displacement of executives from a major bank merger.” 
    When asked what other events of 2005 stand out in his mind, Wimsett also points to the increased number of lawsuits from the merchant community.  “Ultimately, they will impact how we do business,” says Wimsett.  “We have enjoyed structural advantages for years but now we are going to see changes in merchant processors and acquirers who really focus on operational excellence.   Historically, one had to be part of the industry for years to experience strong growth.  Now, the industry is maturing.  Focus is shifting from sales and marketing to quality of service with complimentary operational excellence.”
    When consolidation was not the optimal path, some acquirers and processors looked beyond their domestic borders.  Internationalization was an important trend this past year.  What made this global-centric strategy so appealing in 2005?  It’s all about avoiding the home-court squeeze.  ”Internationalization is about the need for growth,” says Stuart C. Harvey, President of Nova and Chairman of Euroconnect.  “The U.S. market is significantly consolidated.  Look at the charts, the data and the number of consolidations in the past few years.  Large organizations have been through this country with a rake.  The pipeline is running dry.”
    With expectations of double digit growth, acquirers were forced to leave their comfort zone in 2005.  Companies like Nova successfully ventured overseas where consolidations are in infancy stages.  “The landscape in Europe is very different,” says Harvey.  “Banks are provincial and don’t venture outside their borders.  They are reticent to outsource their acquiring to third party providers or sell off their portfolios because they are concerned those purchases will compete on their cash management side.   These banks are under the same pressure U.S. acquirers are – the need for scale to grow.” 
    According to Harvey, the key to successful internationalization is scale and volume, coupled with a professional team with proven battle scars.  Those companies that successfully made the leap across the pond in 2005 did it with experience of execution, a strong management team and knowledge of currency, language and regulations.
    “The opportunities for organic growth in America have dried up,” says Harvey.  “The biggest trend is towards acquisitions outside the U.S. footprint.  But it must be done right.  Compliance, regulations and security are vital.  Ours is a $120 billion business.  That’s a lot of money on the table.  If there is a breakdown in the system, it goes directly to the integrity of our commerce.  In 2005, the breaches that occurred were just part of a litany of things that point towards the need for more compliance and regulatory controls.” 
    Leaving the breaches aside, 2005 also showcased positive trends, innovative programs and new products and services.  Was there any program more talked about than free terminal offerings?  Optimists say this program idea was born from supply and demand; skeptics, from over commoditization of processing and hardware products. The jury is still out on whether offering free terminals can cultivate a massive enough increase in processing  revenue  to cover the costs – real and opportunity – of giving terminals to merchants  for free . Where agents were previously able to collect a nice fee on terminal sales, and hardware companies developed iteration after iteration of new and improved terminal products to facilitate additional and upgrade sales, now these terminals are provided free of charge to merchants  - but someone still has to pay the terminal provider…and the agent commission. A recent ETA conference speaker referred to “the race to the bottom.” Is this what we are seeing now as ISOs rush to offer bigger and better and freer programs to their target markets? Transaction World went directly to the source of one of the largest free terminal providers to learn more.
    “Initially, our internal sales force kept asking for it,” says Edward Freedman, President/CEO of Total Merchant Services, one of the forerunners in free terminals.  “They were attempting to utilize similar programs to build individual sales but were complaining about hidden fees and catches like proprietary service that defeated the concept of free.  We responded by introducing a truly free program.  It not only resulted in incremental growth but doubled and tripled our accounts in a few months.” The implementation of a free terminal program didn’t increase the number of people Total Merchant Services did business with—it increased the number of merchants their existing sales reps did business with.  It decreased attrition.  It increased revenue.  It was clearly a hit for Total in 2005.
    “We’ve seen free terminal programs impact the industry in a big way this year,” says Freedman.  “ISOs that were sitting on the sidelines and wrestling with the decision to offer free terminals have now thrown their hats into the ring just to keep up with the competition.  Some are being forced to take on debt they cannot support.  It is changing the industry.  ISOs that were operating profitably and didn’t have lines of credit to support such programs are now having to borrow money and/or consolidate to keep up the pace.  Programs like these are positive for merchants and sale reps and only negative for those ISOS that can’t access financing.  Everyone was on the same level playing field.  That field is no longer level.  One must have financial resources to compete with these new types of programs.”
    And speaking of financing - a trend that ramped up with a vengeance in 2005 was that of ISOs obtaining working capital by selling residual rights in exchange for cash.  A leading company that partners with ISOs, agents and processors to generate and infuse working capital into their businesses is Dallas-based Calpian. Judging from their numbers, it’s been a win-win for all participants.  In  January 2005, Calpian had 8,000 merchants on their books that had sold residuals rights.  By October of  this year , that figure had risen to over 25,000 merchants upon which Calpian has acquired residual streams.  
    Is there a downside to this innovative practice?  According to Harold Montgomery, CEO of Calpian, they haven’t found one yet.  “While you are giving up future residual streams, the proposition we enable is two steps forward and one step back,” says Montgomery.  “You sell off some or all of your residual base in order to invest in your business and, hopefully, grow back twice as big.”  Calpian has various programs that help ISOs set and meet strategic goals to ensure that their payoff is a rewarding one.
    Montgomery sees this program as a necessary liquidity vehicle in the bank card business since financial institutions don’t lend money to sales organizations and predicts it will only gain in popularity in 2006.   Other options, which include venture capital and friend and family investment are generally either limited, require giving up business ownership and control and tend to have a long close cycle. Spending months trying to obtain financing can mean career death for many agents and ISOs in this super competitive industry. Companies like Calpian understand how the industry works, where the value is created and are willing to buy non-portable residuals streams in order for ISOs to get the capital they so desperately need.
    Working capital or the lack thereof, is also an issue for many merchants. 2005 was ripe for the break out of credit card receivable funding.  Turning an asset that is not normally recognized, namely the merchant’s future credit card sales, into working capital is quite bold.  The practice calls for the provider to buy a portion of the business’ future credit card sales in exchange for an up-front cash purchase price. The purchased receivables are automatically retrieved through the credit card processor as credit card transactions are settled, generally within 12 months.
    Goldman believes the super ISOs and processors have watched this product become a very effective tool for attracting merchants, reducing attrition and extending the average life of customer relationships.  According to AMI research, at any point in time, between 10 to 20% of merchants need capital.
    “The industry now realizes that cash advancement is more than a flash in the pan,” says Goldman.  “It satisfies a real need in a way that is friendly to merchants.  It is becoming a true differentiator for ISOs and processors that offer it.  The issue is that it can be deceiving.  There are very few entry barriers.  The perception of margins and risk is such that it attracts many.  The reality is that there are significant barriers to scale without the right amount of capital and credit scoring models as well as investment in infrastructure.  It is critical to partner with a provider that will deliver quality of service. With the recent sensitivity about security breaches, the ground is fertile for increased awareness.  CardSystems was a watershed moment for our industry.  It caused a significant shift towards best practices and quality of communication with merchants.  We are under a microscope now so it is imperative to erase negative aspects of our business.  If the government’s intervention will lead to more accelerated and robust regulations, then this past year was a defining one for the industry.”
    Finally, what year in review would be complete with a leading consulting firm weighing in?  This year, Tower Group obliged with colleagues Theodore Iacobuzio, Managing Director, and Dennis Moroney, Senior Analyst.
    Interest rates and interchange caught their attention in 2005.  While most banks boasted earnings in the black, they were challenged to support certain business models.  Margins have been squeezed as a result of lower interest rates and now financial institutions are depending on revenue from increasing fees on a variety of products from credit cards to mortgages. 
     “Take Chase for example,” says Moroney.  “They showed a 37% increase in profitability but 79% of that was boosted by strong stock trading and bonds.  The earlier part of that headline is that retail is declining and the pressure is on the banks and issuers.  The current credit card business has a large component of its model that relies on balance transfer.  The industry is directly dependent on banks to finance their own receivables at no rate of interest.  If the rates rise, that model becomes less and less viable.”   
    “You are also seeing consumers shift credit card debt to other products,” says Iacobuzio.  “Overall household debt is rising at significant and historic levels.  When faced with changing interest rates and fees, from a cash flow standpoint, disposable income will shrink and adversely impact spending and retail sales.  When married with recent events in 2005 like high energy costs, natural disasters and a potentially disasterous flu season, it all translates into uneasiness on the part of consumers.  When consumers are uneasy, merchants are uneasy.” 
    These two industry insiders also see a negative impact on consumers from the big mergers this past year like NPC and Bank of America or the Chase/First Data deal with Paymentech.
    “When competition goes out of the marketplace, it doesn’t bode well for consumers,” says Iacobuzio.  “It eliminates options from the marketplace and allows the remaining players to drive the price.  Where once an ISO could walk into a merchant with ten plans to choose from, now they walk in with only three or four.  On the other hand, the bigger the merchant, the more on the acquirer side he is going to be fixed on a per transaction fee.  A bigger processor ought to be able to deliver economies of scale.  The real news this past year regarding mergers and acquisitions is less from the standpoint of economies of scale and more from the ability of financial institutions on both ends of the loop to be tied together.”
    So what should the industry be watching for in 2006?
    “It needs to watch its back,” says Iacobuzio.  “There’s clearly going to be continued focus on interest rates and interchange.  There’s no way to predict what will happen now that lawsuits have been initiated in certain areas.  Once you toss a business issue to the courts, all things being equal, I would rather have a court of law decide what to do with interchange than a regulatory body.”
    Indeed…watch your back…but remember that this industry, despite its challenges, changes and unknowns, has been and continues to be one of the most profitable, entrepreneurial and opportunity-filled industries of our time. It has been good to us and, although it will no doubt look very different in years to come, is still a place none of us would leave even if we could.
    Happy 2006.