Mastercard: ‘Chicken and Egg’ problem solved

31 October 2023 | by Ensemble Capital

During our third quarter portfolio update, we profiled portfolio holding, Mastercard, Inc. (MA). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Mastercard: Mastercard is a company that pretty much everyone has heard of. In fact, when we meet with Ensemble’s clients, we occasionally tell them that we’re nearly certain that they are carrying a Mastercard in their wallet or purse as we speak, and if not, they are carrying a Visa. Most people carry both.

People carry Mastercard and Visa because they are accepted nearly everywhere in developed markets. And they are accepted in most emerging economies, at least at locations where higher income people spend money. As a shopper you can show up at a bodega in Peru, a high end hotel in Tokyo, a truck stop in Alabama, or an ice cream cart in Milan, show them a piece of plastic and they’ll let you walk away with goods and services without any worry that they aren’t going to get paid.

Importantly, these companies do not lend any money. If you look at your credit or debit card, you’ll find that it is issued by a bank. If it has the name of a non-bank company on it, such as American Airlines or Apple, these companies have just partnered with a bank to issue the card. In American Airlines case, its Barclays and the Apple credit card is issued by Goldman Sachs. The issuing bank is the one whose checking account a debit card is tied to, and they are the ones lending the money to fund credit card payments.


On the other side of the transaction is the merchant and its bank. No matter whether you swipe your card, or wave your smartphone, or use an online digital wallet to make a payment via your credit or debit card, in each case your bank and the merchant’s bank need to exchange information across a communication network. And that network is almost always provided by Mastercard or Visa. While you might hear about how merchants pay 2% or more in credit card fees, Mastercard or Visa are only collecting between 1/10th and 1/20th of that fee, with the banks, the ones taking the credit risk and covering the risk of fraud, earning the bulk of the fee.

Americans are so used to using debit and credit cards that it is easy to lose sight of how amazing the Mastercard and Visa networks are. The fact is that when you walk into a store anywhere in the United States, you take it for granted that the merchant will allow you to swipe a little piece of plastic with either the Mastercard or Visa logo on it and they will then let you walk out with your purchase. The reason you carry a Mastercard or Visa is because you know they are accepted everywhere. And the reason they are accepted everywhere is because everyone carries one. This is a classic example of a “chicken and egg problem”. Before everyone accepted these cards, it was difficult to convince consumers to carry one. And before everyone carried one, it was difficult to get merchants to accept them.

Having solved this problem, Mastercard and Visa now have a competitive moat around their businesses, which makes it very difficult for any new company to compete with them. Let’s say that some new payment network was launched that offered superior benefits to merchants and customers. To be successful, a new payment network must offer superior benefits to both sides of the transaction because driving a change in the long ingrained behavior of using credit and debit cards demands a change by both sides.

Even if a new network offers superior value to both sides of the transaction, adoption is still difficult. While early adopters might be attracted to the new payment option, they will find it difficult to actually use until there is widespread adoption such that a customer can expect most merchants to accept it, which will only occur once merchants can expect most customers to have adopted the new offering.

Building a globally accepted payment network was hard in the past. But today it is even harder because not only must a new company in the payment industry solve the chicken and egg problem themselves, but now that it has already been solved, a new competitor must solve the problem in a way that is much better than the existing solution. Credit and debit payments were a significant improvement compared to paying in cash and checks for both customers and merchants. But even with so many technological advancements in the payment industry over the last decade, there has been little in the way of significant improvements versus the existing debit and credit card payment networks. The one major improvement has been the increasing ease of use of credit and debit cards for both merchants and customers, such as the ability to carry a card within your phone, or a merchant’s ability to easily set up and accept card payments via tools like Square or online services like Stripe.

While some companies are subject to highly unpredictable changes in macro factors, such as an oil company being dependent on the price of oil, Mastercard’s business is driven by far more stable trends. The key metric for them is global consumer spending trends, which even during recessions does not decline by more than a couple percentage points and which we are confident will grow at a modest, but steady rate over the very long term. On top of that growth driver, the company benefits from the relentless shift of consumer spending from cash and checks to credit and debit. While it might seem that this shift has already played out in developed markets, we can look to near cashless countries like Sweden to see that even US consumers are likely see continued declines in their use of cash and checks.

Despite their incredible ease of use, and the broad based benefits that card-based payments have brought to consumers, merchants, and the global economy as a whole, it is not uncommon to hear complaints from merchants about what they view as the high cost of accepting credit cards. But it is important for observers to understand that these complaints are primarily an argument between merchants and banks about the share of economic value they each capture from the existence of card networks. One way to illustrate this reality is by noting that if accepting credit cards was inferior to getting paid with cash, merchants would simply refuse to accept credit cards. But instead, we see the opposite trend. More and more merchants are no longer accepting cash. Why are they refusing cash and requiring customers to use credit or debit cards?

Cash is expensive to accept.

At first glance it appears that cash has no transaction costs. A customer simply gives cash to a merchant and there are no fees involved for either party. But it turns out there are actually a lot of costs to accepting cash.

  • Cash needs to be counted, stored, and safely brought to the merchant’s bank. It isn’t safe to carry large amounts of cash to the bank. So armed guards or other security protocols must be deployed.
  • Unfortunately, cash is sometimes stolen. By armed criminals attacking employees, which trigger real human costs in addition to the lost money. But also, by employees, as National Retail Federation data shows that despite the media attention on shoplifting, nearly half (44.4%) of theft that retailers experience is from their own employees.
  • Cash is slow. It takes time for customers to count out bills and cashiers to make change. One of the most important things retailers need to do is keep checkout lines short and moving fast. Long and slow moving lines cause customers to simply leave and not make purchases. And at a minimum they impair the customer (and employee) experience. Companies like Starbucks have learned that digital payment solutions built around cards not only make collecting customer payments faster, but they also allow for custom communication with customers that increase sales and improve the customer experience.
  • Cash lacks data. Customer data is a goldmine for merchants. When a customer pays in cash, the merchant has no idea who they are or anything about their shopping experience. Card payments are data rich. They can help merchants understand who their customers are and how they shop. Mastercard provides popular services to merchants that help them process and understand this data to enhance revenue and profitability. The data available with card payments is so valuable, that Target and Amazon both offers customers their own branded credit card that rebates as much as 5% back to the customer, an amount twice the level of credit card acceptance that merchants insist is too high compared to the “free” acceptance of cash.

Retailers are a powerful political interest group. If you track which politicians try to rally support for new laws that reduce acceptance fees, you’ll notice that many of them represent districts that include very large corporate retailers who spend heavily on lobbying. Likewise, the politicians who push back against these proposed regulations often represent districts that include very large banks, the entities that receive the vast majority of credit card processing fees.

Both sides often frame their arguments through the lens of consumer benefit. They argue that their intent is to help consumers, who are the voters after all. But when was the last time you thought to yourself “credit cards are great, but they are too expensive for me to use!” Never. Rather you likely appreciate the benefits you get from using credit cards. Rewards are part of it, but with a credit card you take for granted that if you experience fraud, it will be covered by the bank. Just like if a customer never pays their bill, it’s not the retailers problem. And with credit cards you get data too, that can easily populate household budgeting software, just as retailers benefit from card based data. And with a credit card, you don’t need to keep your checking account balanced constantly. You can spend over the course of a month, and then settle up by tapping your bank account once to pay all credit card charges. We know these benefits are valuable, because in much of the world outside the US, credit card rewards aren’t even a thing. And yet credit card adoption is rising steadily all around the globe.

It is easy for a ubiquitous product or service to be taken for granted. Once in place, it can be easy for the people who benefit to wonder why they have to pay anything at all. But a world without payment cards is a world with less economic activity. Where more resources need to be deployed to processing transactions due to the higher implicit and explicit costs of non-card based payments.

In closing, we note that the COVID era showed an explosion of payment related innovation. Massive amounts of capital were invested in potential payment solutions such as so called Buy Now, Pay Later financial technology companies, and cryptocurrency based systems that were supposed to make payments easy and free and perfect in every way. But in the end, the technological innovations that actually matter, the ones that actually get deployed and used, have again and again been those innovations that make accepting payment cards more often, for more transaction types as easy as possible.

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