Response to Matt Harris’ Square Puck

Matt Harris wrote a thought-provoking post over the weekend, where he tries to break down how today’s offline payments landscape is reacting to Square and makes some bold predictions on where we’re headed.

I personally enjoyed reading it and wish more VCs were as thoughtful on the topic of financial technologies. That being said, I want to address a few key assertions Matt makes in the post where my view differs.

Are the payments incumbents actually heading in the wrong direction, wasting their resources and time?

While I agree that the specific piece of the value chain (i.e. acquiring processing) that incumbents are targeting in Square’s backyard (i.e. the micro-merchant segment) is unprofitable, we cannot underestimate the intentions underlying this approach. Of course BofA and TSYS know it’s unprofitable – in the same way that Square clearly views the play as a loss leader to get merchants on the platform, the incumbents view it as a loss leader to maintaining market share in the face of a new model built around the disaggregated payments stack that threatens to undermine their vertically integrated approach.

Even though Square still processes 0.3% of US market throughput compared to BofA’s 18.3%, BofA had to retaliate because the cost to BofA of retaining existing or acquiring new merchants that would otherwise embrace Square’s new model that better caters to their needs is negligible compared to the lost revenue they would realize if Square’s disaggregated payments model took hold in the market and pigeonholed them along with the other incumbents as the transaction processing “dumb pipes” infrastructure providers in the value chain. In this way, we have to empathize with the fact that they don’t view these resources as wasted so much as a short to medium-term investment to prolong their antiquated vertically integrated payments stack from the impending threat of disaggregation. In fact, they may even argue that they have a fiduciary duty to their shareholders to not sit around quietly waiting for the new ecosystem to come turn them into utilities, as we saw in mobile telecom.

Is Square more elegant than LevelUp because it controls its own payments infrastructure, while the latter outsources to Braintree?

While I certainly agree that Square is more elegant than LevelUp, it’s hard to argue that it’s because Square controls its own payments infrastructure. In fact, Square itself outsources to Chase Paymentech and even used to leverage IP Commerce’s APIs to plug into Paymentech’s infrastructure. It’s not as if Square is now processing for Starbucks – the merchant acquiring processor just shifted from BofA / First Data to Paymentech, while retaining the existing IBM POS hardware.

This is by no means a criticism of Square’s model – in fact, I believe Square’s disaggregated payments stack will be the predominant model going forward (following the precedent of what we’ve seen in mobile telecom). In this scenario, each player focuses on what they’re good at, e.g. Square (user experience) and Paymentech (cost efficiency). Given that the majority of the pain today is felt by customers in the front-end user experience at the application layer (therefore resulting in the largest revenue opportunity), it’s no surprise that the vertically integrated incumbents are fighting hard to avoid being converted into utilities at the infrastructure layer while new entrants like Square are happy to pay a small toll to leverage the incumbents’ infrastructure rather than waste their own resources rebuilding the underlying rails.

Is Verifone, as a hardware player, missing the point and should it do a comprehensive business development deal with Square?

In my view, Verifone is not avoiding a deal out of pride – I believe this is Verifone’s play at becoming relevant again. Putting aside the fact that I believe they’ll be unsuccessful (too far out of its core competency to be a leader in user experience), the hardware business is not where you want to be in payments today – riding the dongle fad is just Verifone’s way of getting into the processing game and getting into the processing game is just a loss leading foot in the door (see: Square) to upselling other services to merchants. As long as Verifone believes it has a shot, no deal will get done because they’re head on competitors. Once we see a few more deals like Paymentech / Square and Wells Fargo / Stripe, where incumbents acknowledge their new role in the ecosystem and new entrants start capturing more significant market share, more incumbents will have to give serious thought to partnering. Before that however, you better believe they’re going to defend their market share and take the losses doing so.

In 6-12 months, will conventional wisdom reflect that Square is primarily a consumer-facing mobile wallet provider like Google Wallet?

I would actually argue that Square’s game is genuinely a merchant play (though of course not acquiring processing), with the opportunity for a consumer flank. In 6-12 months, I predict that despite losing money hand over fist in the Squarebucks deal (at a 1.9% gross merchant service fee, I estimate the loss to be ~0.8% per coffee on Starbucks’ $6 billion in throughput), Square will have successfully gained a consumer foothold large enough to put the chicken / egg problem in Square’s merchant sales pitch to rest, thereby allowing the company to ramp up merchant acquisition and prepare to start upselling advanced analytics and better inventory management through Square Register. The consumer flank would be to push more loyalty and discovery offerings through Pay With Square, but this only highlights my subsequent advice. What I would advise them to do at that point (though I fear they wouldn’t, opting to justify controlling UX), would be to open up the platform to third party developers (platform on a platform), recognize that they’re not going to be the best service provider across the entire consumer retail experience to the myriad industries they’ll cater to and keep a significant cut for themselves (see: iOS).

And for what it’s worth, I would never wish the fate of becoming a “wallet provider” a la Google Wallet on any friend!