Visa Mastercard Dominance: Who Loses?

Visa and Mastercard have significant dominance in the attractive business of payment processing. Aided by secular trends of moving from cash to plastic, both companies have seen rapid growth in their businesses. In addition, both companies have continued to invest in technology to make it easier, more secure and less expensive to make transactions. The question is, "who loses?"

Consumers have never been happier with their plastic card options and continue to utilize them. Online options would be impossible with a cash-centric model. Further, the reforms after the Great Recession of 2008 did provide increased transparency on the fees and costs of using a credit card. Rarely are their complaints voiced. However, merchants are much different.

In a striking parallel to what I was discussing on the Netflix post, current technologies seem to favor the consumer while putting increased pressure on the suppliers. Merchants naturally chafe at paying 2% of their revenues out to the card costs while supplying goods, products and services in a world of decreasing profit margins. The internet provides increased price comparison and bottom line margins reflect this with the continuing drum beat of closed retailers.

Most networks beyond  those of Visa and Mastercard are called PIN debit networks. When consumers shop in stores and type in their PIN at checkout, those transactions generally travel over a PIN network. These PIN networks charge lower fees, but are obviously not used much when consumers are hesitant to touch anything to type in a PIN. As a result, merchants are seeing increased routing of transactions over the Visa and Mastercard networks.

The merchants are arguing that the dominance of Visa and Mastercard means that the PIN networks hardly get used. Visa and Mastercard argue that they have invested in superior technology and deserve the higher transaction volumes and revenues they generate. Both arguments are valid and, to me, point to what is happening in industry after industry.

The participants with scale are able to invest in rapidly developing technologies in such a way that new competitors with lower cost structures for suppliers are unable to compete. With the consumer winning, it seems unlikely that current laws will act to help suppliers at the expense of consumers. So what kind of change could emerge? Could we see a movement towards treating these "winner take all" companies as a new kind of utility? If so, how would costs, benefits and returns on capital be regulated?

Netflix: An Emerging Monopolist?

For years it was interesting to observe the dominance of UPS, driven by a "network" effect. This effect was simply that the "network," that is, the entire UPS system, grew in value as each customer was added to its network. The reason for this was simply that the huge capital costs of the UPS delivery system was amortized more effectively with more customers. This cycle of increased profitability allowed for an expansion of the network and the acquisition of more customers. The beauty was that the addition of each customer did not cost as much as the value added by that customer. Despite having a union whose motto is "you make more, we take more," UPS grew solidly and appeared unstoppable.

These "network" effects are on steroids in reviewing the Netflix dynamics. The internet has removed so many frictional costs and barriers that scalability is possible at levels I previously could not imagine. Netflix will pass 200 million subscribers this year after passing 100 million only three years ago. Those are truly astonishing numbers. Further, nearly 30% of global internet traffic is utilized by the viewing of Netflix product. That's even more amazing. If, like UPS in its capital costs, Netflix had to build out the percentage costs of the internet utilized, then it would be so capital constrained that these monumental growth rates would be unachievable.

However, by piggybacking on the existing infrastructure, utilizing all of the improvements, Netflix is able to scale up rapidly and dedicate its revenues to the acquisition and development of content. Its rapid scale up has allowed an advantage that means that people go to Netflix to watch what's available as opposed to the other services where people go to watch a specific show. This dynamic is even more forceful than the old days when viewers were limited to ABC, NBC and CBS. It is difficult to see how others can compete and how the flywheel of this "network" effect is stopped.

If Netflix were defined as a "monopolist," traditional anti-trust would not apply. Standard Oil's products were more expensive to the consumer but more favorable to the suppliers. Under John D's "cooperative capitalism," the oil and gas industry thrived. However, in a world of Netflix, the power shifts to the favor to the consumers and the suppliers, the manufacturers of content, are squeezed. A quick review of content providing companies reveal astonishingly low valuations. Anti-trust laws are pro-consumer. Will that focus change as this industry is Netflixed?

China: a TikToking time bomb?

For the first half of my career, the idea of investing in China could be dismissed as absurd. How should one invest privately held funds into a system that disregards typical private property rights? Yet China proceeded to navigate rapid economic growth that attracted the envy of the world and with that envy came foreign capital.

Many high-quality U.S.-based companies have invested heavily in China, most notably Apple. I have never found this feature particularly troubling, as companies regularly invest as active participants where passive investors should fear to tread. But the question continues to arise about the investability of the Chinese market.

Samuel Quesada, the witty and thoughtful host of "The Pod is Cast," is extraordinarily well-versed in military history. His view of the rivalry with China is not as optimistic as my fellow capitalists. He sees nothing friendly in this global competition. Rather he points to the nature of countries as entities that view all others as vassals or enemies. He is a difficult foe to top in argument.

If he is correct, then the continuing emphasis of putting more capital to work in China seems naive. The likely pathway forward is not towards collaboration. Hong Kong seems to be Exhibit A supporting Samuel's dark view of China's increasing and relentless animosity to liberalism. The past pathway has been a function of China fast-tracking to some type of technological parity.

As Canada dials its total investment commitment in China to 17%, I think they could use less business school professionals and more thought leaders like Samuel. As for me, I'm going to let his military framework give me a deep pause before I jump into any ownership of Taiwan Semiconductor (TSM) as I question whether the current political climate in the U.S. has any real conviction about protecting allies so physically close to China.

Nature of Capitalism? Self-destruction

Today I spoke with a group of friends and the topic of capitalism arose. One of my friends posited that capitalism was not compatible with monopolies. I laughed because capitalism is essentially about the allocation of privately held capital and in that process it is all about monopolies.

Capitalism is an inherently problematic system because it allocates private capital to extract returns. Competition is built into capitalism because private capital is plural. Capital is allocated to the highest prospective returns. Initially these allocations are generally made to areas of limited competition. Like the person who first stands up at an event, the view is great. Soon enough, high returns invite others in a "monkey see, monkey do" world and the view is degraded. The brutal truth is that capitalism always competes to zero profits.

Just as profit-seeking behavior and competition is inherent to capitalism, so is "monopolistic" behavior. Monopolies prevent capitalism's obsessive self-destruction. For this reason, water and electric utilities are often for-profit, but highly regulated. Every area of capitalism is either protected in some monopolistic behavior or it is in the process of self-liquidation.

Capitalism extracts value for society by facilitating productivity. But this productivity is not the goal of a capitalistic enterprise. Its real focus is similar to that of every non-profit enterprise: just staying in business. In the early periods, before competition shows up, for-profit enterprises try to show how much they can do for a consumer. As time passes and the excitement builds, these same enterprises try to make themselves sustainable. This is the monopoly building phase and is an essential component of a business. It must exists in some form. Finally the monopoly phase builds a culture of extraction and "doing to the customer." Inevitably these excess profits sow the seeds of future destruction. In a reversal of Napolean Hill's famous quote, it might be said that "Every benefit, every success, every triumph carries with it the seed of an equal or greater adversity."

Spend a Deflation Dividend?

When the Soviet - U.S. conflict was reduced during the Gorbachev years, many spoke about a "peace dividend" for the economy due to a decline in required military expenditures. The current pandemic has a similar potential benefit of a "deflation dividend."

The Federal Reserve has a three part mandate: full employment, low stable inflation and control of long-term interest rates. While making monetary policy much more important, the pandemic has in some ways made the Fed's job easier. The typical foe of the Fed is inflation. In order to fight inflation, the Fed regularly introduces recessions through monetary tightening. But the pandemic actually allows the Fed to do just the opposite and take loosening actions.

The pandemic is unusual in that its impact is to increase utilization of high productivity tools, such as using internet-based communication rather than travel or internet-based shopping rather than real estate-based shopping. Normally an economic slowdown is accompanied by a slowdown in new technologies, whereas this slowdown is accelerating the adoption of them.

The combination of reduced demand and increased technology usage is a potent brew for deflation. While the 19th century U.S. economy flourished under deflation, our debt-based economy cannot withstand these dynamics. As a result, we potentially can spend a "deflation dividend." It seems like an excellent time to think about the best approaches. I can see the following ways:

1) increase social justice, with a program like reparations payments to slave descendants or Native Americans. This is my top idea because these payments would immediately increase demand and increase the general standard of living. Of course, the implementation is daunting.

2) increase globalization of with "utility"- like regulations for companies like Microsoft, Google and Apple in order to limit their role as platforms - while decreasing globalization in supply chains as well as news. The combined effect would be inflationary, but would encourage more economic diversity in local areas. Again, implementation would require a rethinking of anti-trust as well as import-export policies.

 3) make a massive investment in science and math-based education by closing all student loans and making them student grants in the science and math fields. At the same time eliminating all student loans for anything outside science and math-based education fields. While the overall impact would be inflationary by the creation of large educational debt, the restructuring of the U.S. workforce would reduce a desire for the "good old days" of manufacturing jobs that will never return.