For analytical purposes, Standard & Poor's Ratings Services classifies pure payment service network providers such as Visa International Service Assn. (A/Negative/A-1) and MasterCard International (A-/Negative/A-2) as clearinghouses and applies its criteria for exchanges and clearinghouses when analyzing such entities.
The methodology treats exchanges and clearinghouses as financial institutions operating on a "going concern" basis. The rating analysis takes into consideration the competitive dynamics, regulatory parameters, and institutional factors that define exchange and clearinghouse roles in the markets. The analysis also incorporates their financial performance and operational capacity that support or impair their ability to meet their counterparty and debt obligations. Most important, Standard & Poor's focuses heavily on the financial and operational safeguards that clearinghouses have developed to protect themselves from credit and market risks in meeting their clearing and settlement obligations.
In particular, Standard & Poor's looks at the ownership structure of such clearinghouses to assess the level of financial resources and incentives of the owners to support the clearinghouse in times of need. An important element is the diversity and financial soundness of its owners/members. Furthermore, it is crucial to examine any kind of loss-sharing arrangement or formalized mechanism for assessing members to indemnify the company for any operating losses beyond credit losses. This means that a strong owner/member base is insufficient without clearly defined rules and procedures to access its financial resources. Loss-sharing mechanisms could include a separate clearing fund to which clearing members must contribute, liquid assets on the clearinghouse's balance sheet, mutualization of risk, or the possibility to assess the owners/members (for an in-depth description of these criteria, please see "Standard & Poor's Methodology for Rating Exchanges and Clearinghouses," published Oct. 6, 1999, on RatingsDirect, Standard & Poor's Web-based credit analysis system).
For a detailed commentary on the payment service providers, please see "Visa And MasterCard Tread Cautiously Through A Changing Landscape" published June 1, 2005, on RatingsDirect.
Major Risk Components And Rating Factors
The primary risk for a payment network provider is with the card-issuing bank. In a typical credit card transaction, the network provider receives a payment from the cardholder's bank (issuing bank) and makes a payment to the retail merchant's bank (acquiring bank) on the same day after the credit charge is submitted by the acquiring bank to the network provider for reimbursement. As a result, a network provider's risk is limited to the inter-bank clearing of funds.
Also, the network providers usually indemnify their members for any losses suffered due to failure of any other member to honor drafts, travelers checks, or other instruments processed in accordance with the operating regulations. The networks also provide protection to members and merchants who have incurred losses as a result of counterfeit travelers checks. Thus, the first line of defense for companies like Visa and MasterCard is a strong, healthy, and well-diversified member base. This requires a rigorous selection process and adequate risk management functions to constantly screen and assess the financial strength of its members. In the case of higher risk members, collateral in the form of cash, LOCs, or securities is typically used to mitigate the counterparty risk. Additional member risk reserves set up by the network providers are used to cover any residual risk that might arise from this indemnification.
In its analysis, Standard & Poor's evaluates the companies' member base with a focus on granularity on one side and quality, that is, financial health or credit risk, on the other. In addition, Standard & Poor's takes a closer look at the network providers' risk management functions, selection procedures for members, surveillance processes and history of member defaults.
As a result of the billions of transactions that Visa and MasterCard process, there is a high degree of operational risk which is typically addressed and covered appropriately. Both associations invest heavily in maintenance, development, and security of their systems and a large portion of their earnings serves to support this area. Standard & Poor's conducts regular on-site visits to evaluate the systems and procedures in place.
Appendix
What is the payment services industry and who are the players?
The payment services industry provides a variety of services in the areas of credit, debit, electronic cash, and related payment programs. This covers a wide range of payment solutions, including but not limited to various consumer and corporate credit and debit card programs, prepaid programs, travelers checks and chip-based, electronic cash programs. There are essentially a handful of players, of which three dominate the markets worldwide in general, and North America in particular. Using the first appearance of the companies' names as a proxy, the most seasoned player is American Express (A+/Watch Neg/A-1), which issued its first charge card in 1958, followed by Visa in 1976, and MasterCard in the late 1970s (both companies have predecessor institutions with different names; see table for a chronology of events). Those three companies make up the lion's share of the general-purpose card business worldwide. Also in the late 1970s, Citibank founded its own payments processing company called Diners Club while in 1985, Dean Witter, now part of Morgan Stanley, spun off Sears, Roebuck Co., together with Discover Bank. Since fourth-quarter 2004, Diners Club started its conversion to run on the MasterCard network. In April 2005, Morgan Stanley announced intensions to spin off Discover. Both Diners Club and Discover operate in niche markets catering to a very specific clientele without a significant impact on market share distribution.
Focusing on the 'big three', Amex, Visa, and MasterCard, there is a very significant structural difference, which should be borne in mind when analyzing the current market dynamics. Whereas Visa and MasterCard are two joint ventures that are open associations operating so-called four-party payment systems, Amex is based on what the industry calls a closed-loop proprietary issuer.
As membership associations, Visa and MasterCard are owned by thousands of participating banks worldwide. (Technically, MasterCard is not an association since its conversion to a private share corporation in 2002. The change, however, only affected its legal structure, not the way it operates. It still exhibits most of the attributes of an association and for the purpose of this article is referred to as an association.) Visa has currently about 21,000 participating financial institutions, while MasterCard cooperates with 2,200 principal members and 21,500 affiliate members. The four-party payment system means that Visa and MasterCard, as the network providers, link issuers--that is, financial institutions, that issue the respective associations' branded cards, and acquirers, those that enrol merchants into programs to accept Visa or MasterCard cards, around the globe for transaction processing services. Through their massive global technology and operations systems, the associations provide the following payment related services:
Authorization
This is the process by which a transaction is approved by the issuer or, in certain circumstances, by the association or others on behalf of the issuer.
Clearing
Clearing is the exchange of financial transaction information between the issuer and the acquirer after a transaction has been completed.
Settlement
Once transactions have been authorized and cleared, funds are exchanged along with the associated fees. This settlement service takes place between a clearing bank chosen by the customer and approved by Visa or MasterCard, and a settlement bank chosen by the associations.
The four-party payment system limits the associations' role to providing the massive clearing and settlement functions as stated above and promoting and managing the Visa or MasterCard brand for the benefit of all customers to maintain and grow the value of their respective franchises. It is important to note that neither Visa nor MasterCard maintain direct relationships with the cardholders and merchants or extend any loans. All customer (cardholder or merchant) relationships are 'owned' by the issuing or acquiring banks that are members of MasterCard and Visa.
In contrast to Visa and MasterCard, American Express has a vertically integrated business model in which it can issue cards as well as purchase or "acquire" merchant charge receivables, while also acting as its own clearer and settlement agent. In cases where third parties issue cards and/or purchase merchant charges, American Express may also clear and settle the transactions. It can therefore capture revenues all along the transaction chain.
Principal factors affecting the network business
The following list identifies the principal drivers of the network business as described in Amex's 2003 10-K:
The number of cards in force and amount of spending on these cards;
The quantity and quality of establishments that accept the cards;
The economic attractiveness to card issuers and merchant acquirers of participating in the network;
The success of targeted marketing and promotional campaigns;
Reputation and brand recognition;
Innovation in systems, technology and product offerings; and
The quality of customer service.
The good news: there is macroeconomic value in payment cards. The cash-based system is a physical system driven by variable costs, so that transaction costs decline only slightly as volume increases. The payment card system, however, is more of an information system, whose cost structure is driven primarily by the fixed costs of setting up its interconnected components. The greater the volume of transactions carried over an electronic network, the lower the average cost per transaction. This way, the payment industry provides a true economic value to the financial system.
Milestones In The Payment Services Industry
Year
American Express
Visa*
MasterCard International
1958
American Express (Amex) issues first charge card.
Bank of America, based in San Francisco, issues BankAmericard.
1966
Bank of America expands its bankcard program by forming the BankAmericard Service Corp., licensing banks outside of California to issue cards to their customers. The Interbank Card Assn., which later becomes Master Charge, is formed.
Interbank Card Assn. (ICA) starts; it later becomes MasterCard International.
1968
ICA starts a global network by forming an association with Banco Nacional in Mexico. Later that year, they form an alliance in Europe with Eurocard and the first Japanese members join.
1970
BankAmericard transfers control and ownership of the BankAmericard program to the banks that issue the cards, forming National BankAmericard Inc. (NBI). At this time, more than 1,400 banks offer either BankAmerica or Master Charge credit cards.
1974
International Bankcard Co. (IBANCO) is formed to administer the BankAmericard program internationally. The card encounters some resistance because its name is identified too closely with the U.S. and the Bank of America.
1976
BankAmericard changes its name to Visa. NBI is renamed Visa U.S.A. and IBANCO is changed to Visa International.
1978
Visa launches co-branding programs.
Late 1970s
To reflect the commitment to international growth, ICA changes its name to MasterCard.
1987
Visa establishes a computerized card transaction processing network in China.
MasterCard issues payment card in China.
1988
Visa member issues bankcards in Soviet Union.
MasterCard issues payment card in Soviet Union.
1990
MasterCard unveils co-branding strategy.
1991
Adoption of Visa’s exclusionary rule, Visa U.S.A. by-law 2.10(e).
MasterCard, in partnership with Europay International, launches Maestro®, a global online debit program.
1996
MasterCard adopts its Competitive Programs Policy (CPP).
1996
U.S. merchant litigation --Wal-Mart Stores Inc. sues Visa and MasterCard for violating the Sherman Antitrust Act with its ‘honor all cards rule’.
U.S. merchant litigation--Wal-Mart Stores Inc. sues Visa and MasterCard for violating the Sherman Antitrust Act with its ‘honor all cards rule’.
1998
The Department of Justice (DOJ) files suit against Visa and MasterCard.
The Department of Justice (DOJ) files suit against Visa and MasterCard.
2000
DOJ trial begins.
DOJ trial begins.
February 2000
An action is filed against Visa and MasterCard seeking injunctive relief and restitution in connection with Visa’s and MasterCard’s practice of charging its members a 1% currency conversion fee (Schwartz vs. Visa).
An action is filed against Visa and MasterCard seeking injunctive relief and restitution in connection with Visa’s and MasterCard’s practice of charging its members a 1% currency conversion fee (Schwartz vs. Visa).
August 2000
Roger M. Lindmark (“Lindmark”) files an action alleging that class members were improperly charged daily compound interest on revolving credit cards and that Amex improperly applied credits for returned merchandise against balance transfer balances.
September 2000
European Commission issues Statement of Objectives challenging Visa’s multiple interchange fee (MIF).
2001
Judge Jones issues decision and final judgment confirming the pro-competitive nature of dual governance.
Judge Jones issues decision and final judgment confirming the pro-competitive nature of dual governance.
September 2001
The Office of Fair Trading (U.K.) issues a Rule 14 Notice challenging the MasterCard MIF, and the multilateral service fee (MSF).
2002
Amex announces CIBC will issue Amex cards in Canada.
MasterCard converts to a private share corporation, in connection with its merger with Europay. Integration of Europay into the global organization as MC Europe.
June 2002
British Airways files an action in the United States District Court of New York against Amex.
July 2002
Visa agrees to change calculation method for MIF and reduces fees to get exempted by European Commission. A group of merchants files a class action suit against MasterCard and Visa alleging that Visa’s and MasterCard’s interchange fees contravene the Sherman Act.
A group of merchants files a class action suit against MasterCard and Visa alleging that Visa’s and MasterCard’s interchange fees contravene the Sherman Act.
2003
Amex is named in a number of class actions in which plaintiffs allege an unlawful antitrust tying arrangement between the company’s charge cards, credit cards, and debit cards in violation of various state and federal laws.
2003
Amex is named in several class actions in various state courts in the U.S. alleging that the company violated the respective state’s laws in connection with its foreign currency conversion charges and for failing to properly disclose such charges in its cardmember agreements.
April 2003
Amex settles the Lindmark suit and agrees to reimburse customers.
Schwartz case--the court requires Visa to provide adequate disclosure of currency conversion fees and orders restitution of the 1% currency conversion fee to customers for the period from February 1996 to April 2003.
Schwartz case--the court finds that MasterCard’s currency conversion practice is deceptive under California state law and orders MasterCard to require issuers to disclose the process to cardholders, and also orders restitution to California cardholders.
May 2003
Visa settles in the U.S. merchant litigation case. Agrees to pay the plaintiffs $2 billion in 10 equal, annual payments and temporarily reduces U.S. debit interchange fees.
MasterCard settles in the U.S. merchant litigation case. Agrees to pay the plaintiffs $1 billion in 10 equal, annual payments and temporarily reduces U.S. debit interchange fees.
May 2003
Complaint is filed in the State of California against MasterCard, focusing on MasterCard’s practice of so-called excessive charge-backs.
September 2003
The European Commission issues a Statement of Objections challenging MasterCard’s cross-border multilateral interchange fee (MIF).
December 2003
The excessive charge-back related complaint is withdrawn in California and re-filed in the Eastern District of New York.
January 2004
Amex and MBNA announce card-issuing alliance.
March 2004
Opt-out merchants file an amended complaint to include that MasterCard’s and Visa’s interchange fees contravene the Sherman Act and that the opt-out merchants were harmed by MasterCard’s and Visa’s CPP.
Opt-out merchants file an amended complaint to include that MasterCard’s and Visa’s interchange fees contravene the Sherman Act and that the opt-out merchants were harmed by MasterCard’s and Visa’s CPP.
May 2004
Two further cases are filed against Visa alleging similar claims as in the Schwartz case (currency conversion fee) as to use of debit cards.
October 2004
Amex is granted preliminary approval for settlement to resolve all lawsuits and allegations by depositing $75 million into a fund to reimburse class members with valid claims and also change the disclosure in its cardholder agreements and billing statements regarding its foreign currency practices.
U.S. Supreme Court announces it would not review previous lower court decisions, thus putting an end to a three-year appeal process. The exclusionary rules CPP and 2.10(e) are found anti competitive. Issuers are now allowed to offer additional general purpose credit or debit cards such as American Express or Discover.
U.S. Supreme Court announces it would not review previous lower court decisions, thus putting an end to a three-year appeal process. The exclusionary rules CPP and 2.10(e) are found anti competitive. Issuers are now allowed to offer additional general purpose credit or debit cards such as American Express or Discover.
October 2004
Discover files a suit against Visa and MasterCard seeking recovery of treble damages arising out the exclusionary rules.
Discover files a suit against Visa and MasterCard seeking recovery of treble damages arising out the exclusionary rules.
2004
CIBC discontinues its issuance of Amex cards in Canada.
Diners Club runs on MasterCard network.
November 2004
Amex sues MasterCard, Visa, and eight banks, seeking recovery of treble damages arising out the exclusionary rules.
The Office of Fair Trading (U.K.) broadens its inquiry to include Visa (challenging the MIF and the (MSF).
December 2004
Amex announces card-issuing alliance with Citibank.
MasterCard settles last of the cases brought by opt-out merchants.
January 2005
MasterCard wins debit card business from Washington Mutual.
February 2005
JP Morgan Chase announces it will continue issuing credit cards under the Visa and MasterCard logos but move debit card business to Visa.
*Visa refers collectively, to all Visa group members.
