February 2023 - Anatomy of the Swipe by Ahmed Siddiqui

This month we dive back into the world of payments and take a refreshed look at how payments companies work.

Tech Themes

Authorization. How do credit card’s even work? What is on the magnetic stripe? It turns out that each stripe has an alternating set of tiny magnets on it that produce a magnetic field around the card. The card reader on a POS system is a solinoid; when the magnets swipe through the solinoid it creates a change in the magnetic field also known as magnetic flux. The POS processes the changes in current as its swiped through the Solinoid, and is able to understand the credit card via common card standards, created by ISO. The challenge that existed with the internet, is how to ensure safe transactions when you are paying someone you clearly don’t know. The card companies created something called the card verification value (CVV), an extra number directly intended NOT to be written anywhere except for the back of your credit card. CVV codes were originally created by an Equifax employee in the UK, and initially rolled out by NatWest bank, eventually expanding to Mastercard (1997), Amex (1999), and Visa (2001). However, the early internet still had a massive fraud problem, as Roelof Botha discussed about Paypal in his Tim Ferris podcast appearance. In addition, card authorization was still quite difficult in Europe, where you would frequently have to call to provide authentication for cross-border purchases. In 1993, Europay, Mastercard, and Visa formed EMVco, to add additional fraud protection to cards. They were subsequently joined by other key members including American Express, Discover, JCB International, China UnionPay. Europay eventually merged with Mastercard in 2002 prior to Mastercard’s IPO. EMVco creates a standard for EMV chips, which embed small integrated circuits that produce a single-use cryptographic key for a merchant to decrypt and authorize a transaction. It is also incredibly difficult to clone a chip card, whereas magnetic stripes are fairly easy to copy. The increase in fraud protection was so great that it caused a liability shift, whereby the merchant (rather than the issuer) could become liable for fraud if a EMV chip card was not used, and a swipe was used instead. The latest innovation in card security is 3D Secure 2, which “allows businesses and their payment provider to send more data elements on each transaction to the cardholder’s bank. This includes payment-specific data like the shipping address, as well as contextual data, such as the customer’s device ID or previous transaction history.” The 3D Secure 2 also improves the UX of its “challenge flow,” which is an instance when a frictionless authentication wasn’t possible, for whatever reason. The challenge flow forces the user to authenticate the transaction through their banking application of choice, which is much more secure than just approving every transaction the network sees. Every day payments become more at risk and more secure!
Zelle and banks Funded Payments. Similar to Visa and Mastercard, Zelle is a cash transfer system originally created by a consortium of banks. In 2011, Bank of America, JP Morgan, Wells Fargo, and several other banks built a Paypal competitor called clearXchange. The new company would charge financial institutions to use the service, with most banks assuming the charges on behalf of their consumers. At the time, Venmo was beginning to take off with consumers utilizing its simple Peer-to-peer payments service. In 2012, Braintree acquired Venmo for just $26m. The low purchase price was the result of a lack of coherent business model, given Venmo’s founding by college roommates who were looking to send money easily. Later, in 2013, Braintree was acquired by Paypal for $800m. Braintree is an acquirer processor and introduced a business model to Venmo, namely investing the float of customer funds held in the Venmo ecosystem. In 2016, clearXchange was acquired by another bank run service called Early Warning Service, which provides risk management services to many financial institutions. Early Warning was itself created in 1990 by Bank of America, BB&T, Capital One, JP Morgan, and Wells Fargo. Early Warning launched Zelle in 2017, utilizing clearXchange’s underlying technology. Zelle is now massive, processing over $1m in volume a minute, which is more than competitors Venmo and Cash App. Zelle’s most recent stats are mind-blowing: 2.3B payments with $629B in volume. Look at creation of zelle and other examples of banks creating new companies (like visa/mastercard)
Money for Nothing, SaaS for Free. A new brand of payments companies are popping up that seek to turn a traditional SaaS model on its head. Divvy, the spend management platform, gives its SaaS software away for free, instead monetizing just the payments processed through its product. Its quite wild to see a company build complex software just to give it away, right? This strategy has been copied many times over, as we talked about when discussing Netscape and Slack. Whether its open source or just free commercial software, the free-ness of it makes it attractive. However, if everyone is free, then you still have to compete on merit. Ramp, a competitor to Divvy, raised $750m at an $8.1B valuation in 2022, and processed over $5B in payment volume in 2021. Divvy was acquired by Bill.com in 2021 for $2.5B in a mix of cash and stock. At the time of acquisition Divvy was doing just over $100m of annualized revenue, and about $4B of TPV, suggesting a take rate of ~2.5%. Ramp allegedly did about $100m in annualized revenue in 2022. While Divvy was able to find a successful exit through a willing buyer (a buyer who’s stock has declined 65% from all time highs), I’m not sure Ramp will find an easy buyer at $8.1B, but it may find the public markets if it can market itself as a cost-saving, AI, finance play. I’m just not sure that you can build a really big business by only processing payments and giving away complex software for free. We will see in time!

Business Themes

Issuer, Issuer Processor, Acquirer, Acquirer Processor. The arc of an individual payment can be broken into its constituent parts. The Issuer is normally a bank that issues credit cards to its banking customers. A bank may use an issuer processor to manage a connection to the card networks (like Visa and Mastercard) and accept/decline transactions. Examples of issuer processors include Marqeta, TSYS, and Galileo. Global Payments and TSYS merged in 2019, in an absolutely massive $21.5B deal, after Fiserv acquired FirstData for $22B and Fidelity National Services acquired WorldPay for $34B. 2019 was definitely a banner year for payments mergers, but signs of strain are already happening, with FIS announcing they’d be spinning out WorldPay in 2023. Back to our transaction - the merchant will have a payment terminal of some sort, and will use an acquirer processor like Chase Paymentech, Tabapay, or Fiserv, that will also have a fast connection to the card networks to request approval for a transaction. Lastly, we have the acquiring bank, the merchant’s bank account. When we look back at these big deals, its clear that each player was trying to round out its processing capabilities - TSYS (issuer processor) with Global Payments (a merchant acquirer), Fiserv (merchant acquirer) with First Data (issuer processor), and FIS (issuer processor) with WorldPay (merchant acquirer). FIS, Fiserv, and Global Payments have struggled to win over investors over the last five years, following these big deals.
Chargebacks. When a consumer doesn’t want to pay for an item, it can request a chargeback. The reasons for a chargeback can be numerous and valid, including fraud, item not as described, duplicate transactions, and more. In the event of fraud, a cardholder would dispute the charge with their bank. The bank would freeze their card and file a chargeback with the card network (Visa as an example). Visa would send a provisional credit to the customers card and take the money back from the merchant, then it would send the chargeback request detail to the merchant. If the merchant doesn’t dispute the chargeback, it will be assessed a $25-35 chargeback fee by Visa. However, if it does dispute the chargeback, and correctly can identify that the card actually did purchase the goods, then the issuer, the bank that is “underwriting” credit to the consumer, can be put on the hook for the funds used for the purchase. I never knew that both the merchant and issuer can be on the hook for chargebacks, but not the network! Another way in which Visa and Mastercard make money through the ecosystem!
Marqeta’s confusion. For our first payments book, we took a look at several of the new players in the credit card ecosystem, including Marqeta, Adyen, and Stripe. Its been quite a two years! Marqeta went public in June 2021, valuing the company at $15B. Stripe raised additional funds at a $95B valuation, and Adyen’s valuation hit $98B! But oh how the times change! Just two years later, and Stripe’s valuation is back at $50B, including a massively dilutive $6.5B raise to pay for employee taxes in option conversion. Adyen’s valuation sits at $53B today, a close to 50% decline, despite growing EBITDA 16% to 728M in 2022.. Marqeta may have had the worst time of all, which is said because Ahmed Siddiqui, worked at Marqeta for a number of years. Marqeta’s stock fell 85%, its CEO/Founder left the company, its gross margins have compressed from high 40’s back to down to low 40s, and its main customer Block has become an even larger customer, now driving 77% of its revenue. Marqeta went from next generation issuer processor and Stripe wannabe to an outsourced custom development shop for Block. My guess is its actual reputation sits somewhere in between the two. Expectations for Marqeta have fallen off a cliff, and its market cap sits at a tiny $2.6B. I’m not sure Block would be an immediate acquirer, because the market for issuer processing is incredibly competitive and Block has had its own stock price troubles. A spun out WorldPay could make sense as an acquirer. Visa would have made sense as acquirer, because it owns about 2.5% of Marqeta and has for many years, but their recent acquisition of Pismo, believed to be a LATAM focused and better version of Marqeta. It’s unlikely Marqeta will exist long as a small solo issuer processor!
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May 2020 - Hitchhiker's Guide to the Galaxy by Douglas Adams

We want to recognize the craziness of the world today and the saddening police brutality and systemic racism that continues to occur in the US. This month we opted for a fiction book that may provide a minor break from that current, depressing reality. We want to acknowledge that our reality is messed up, and as a book club we are committed to reading more books about diversity in tech and more books written by a diverse set of authors.

Tech Themes

The Computer knows the answer. There is an overwhelming feeling in society today, that the computer should be able to tell us the answer. Predictive models are everywhere, from personalized AI workflows to sports gambling. Society has become accustomed to the idea that computers will solve problems for us. Interestingly, the novel portrays technology in the opposite light. Marvin, the robot on Zaphod Beeblebrox’s ship is so knowledgeable that even the most complex task seems meaninglessly easy. As a result, Marvin is constantly depressed. Deep Thought, the most powerful computer in history, takes seven million years to come up with an answer to the question of what life is all about. The simplistic forty-two answer, prompts the crowd to ask what the question was to which the answer is forty-two. The computer suggests that earth will provide that question. These examples somewhat reverse the expectations of technology to the reader. We normally think of technology as providing the answer, simplifying our lives and dehumanizing us. At the end of the story it is not Marvin’s heroism that saves the crew from being killed by the Blagulon Kappa cops who are after the Heart of Gold, it is his depression. When Marvin seizes control of the cops computer and explains his life-view, they commit suicide. In these instances, the role of technology is reversed - it is emotion and human nature that can help save the world and provide the answers to the universe.
Not so obvious, Space Travel and Towels. “A towel, it says, is about the most massively useful thing an interstellar hitchhiker can have.” Something so simple as a towel - which seems relatively unimportant in everyday life - is an absolute necessity for space travel and hitchhiking through the galaxy. Frequently throughout technological history, the simple and unimportant things are overlooked in favor of tackling more complex problems and solutions. The largest data breach in history occurred when Equifax overlooked an expired certificate. During early development of the ENIAC, one of the first computing machines, software was looked at as unimportant and was relegated to early female programmers. Little did these sexist hardware programmers realize that software would become the most important aspect of computing. When the first iPhone released, Microsoft CEO Steve Ballmer laughed at the the device, saying it was too expensive and unable to cater to business customers because it didn’t have a keyboard. The incredibly sad, failed launch of space shuttle Challenger was due to cold temperatures causing rubber joint rings to become too stiff for appropriate sealing. Sometimes the value of a technology or a towel is not inherently obvious.
The Guide, the Whole Earth Catalog and the Internet. “The reason why it was published in the form of a micro sub meson electronic component is that if it were printed in normal book form, an interstellar hitchhiker would require several inconveniently large buildings to carry it around in.” The Hitchhiker’s Guide to The Galaxy is a massive electronic guide to help hitchhikers move throughout space. This interestingly mirrors the current state of the internet, which didn’t exist when Douglas Adams wrote Hitchhiker’s Guide to the Galaxy in the early 70s. Prior to the internet, this type of alternative information could be found in the Whole Earth Catalog, a famous magazine that Steve Jobs once called “Google in paperback form, thirty-five years before Google came along.” The Whole Earth Catalog was created by Stewart Brand, a famous writer and technologist, who actually participated with Douglas Englebart in the Mother of All Demos, which featured the introduction of the mouse and video conferencing. Brand wanted a way to publish material that wouldn’t be found in traditional textbooks, including product reviews of the latest technology. When the internet was starting to launch, Brand created The WELL (Whole Earth ‘Lectronic Link) to continue to provide interesting alternative articles and essays. The WELL is credited with being one of the first internet forums, which was originally accessed via dial-up bulletin board system. The internet today very much mirrors the Hitchhiker’s guide to the galaxy: its content is enormous, it isn’t necessarily factual (the Guide is not completely factual either, but based on experience), and its content spans all possible information needed to survive. On top of that, the packaging is described as suspiciously similar to modern smartphones: “He also had a device which looked rather like a largish electronic calculator. This had about a hundred tiny flat press buttons and a screen about four inches square on which any one of a million ‘pages’ could be summoned at a moment's notice.” The internet and mobile computing have come a long way in 50 years; it will be great to watch what happens in the next 50!

Business Themes

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The Business of Space: SpaceX / Virgin Galactic. Elon Musk and Chamath Palihapitiya are outspoken, visionary billionaires. Elon has an incredible track record of under-delivering but still exceeding most people’s wildest expectations. Chamath was an early employee at Facebook and is now a part owner of the Golden State Warriors. He is CEO of a VC-firm turned “technological holding company” and the creator of three public SPACs, one of which now represents Virgin Galactic. A SPAC or Specialty Purpose Acquisition Company is a blank-check company with no commercial operations. A SPAC is normally led by experts in a specific space like software or real estate and these executives raise money to acquire a company. The money raised in an IPO sits in an interest bearing account until the blank-check company has found a company to acquire. If no deal is completed after two years, the SPAC will give money back to their investors. Chamath purchased 49% of Richard Branson's Virgin Galactic space company in 2019. Space is impossibly big and its natural to think that someone who can develop the technology to unlock that vastness to humans would also unlock a fortune. As the Guide puts it: “‘Space,’ it says, ‘is big. Really big. You just won’t believe how vastly, hugely, mindbogglingly big it is. I mean, you may think it’s a long way down the road to the chemist’s, but that’s just peanuts to space.’” But the business of space is in its earliest days. SpaceX relies almost completely on government contracted work which means the company needs an incredible amount of funding to survive because of the capital investment and the uncertain, non-recurring nature of these space contracts. Interestingly, the development of early commercial air travel, in the 1920’s, also had a similar funding issue, and it was up to the Guggenheim family, rich from mining profits, to set up a fund to exclusively contribute to the development of Western Air Express, the world’s first commercial airliner. Virgin Galactic is taking a piece out of Tesla’s playbook by selling future space rides ahead of any commercial launch. Public markets investors including reddit’s wallstreetbets community is piling into Virgin Galactic at the literal moonshot risk of it becoming the space company (Income statement above). Space has always been a billionaire passion, the question remains - can it be a business?
Moore’s Law and Murphy’s Law. Murphy’s law states: “Anything that can go wrong, will go wrong.” Hitchhiker’s Guide to the Galaxy explores this notion repeatedly as Arthur continually finds himself in unbelievably bad circumstances; his house is demolished, his planet is destroyed, he is captured by Vogons, and sure-death missles approach the ship as the crew descends on Magarathea. Arthur continues to survive these dangers with the help of the improbability drive, which the book states is a “a wonderful new method of crossing interstellar distances in a few seconds; without all that tedious mucking about in hyperspace. As the Improbability Drive reaches infinite improbability, it passes through every conceivable point in every conceivable universe almost simultaneously. In other words, you're never sure where you'll end up or even what species you'll be when you get there. It's therefore important to dress accordingly.” In comparison to Murphy’s law, Moore’s Law is the idea that computing power doubles every 18 months. A 2006 Economist article explained Moore’s Law as the opposite of Murphy’s Law: “But his law seems safe for at least another decade—or two to three chip generations—which is as far as he has ever dared to look into the future. As things are made at scales approaching individual atoms, he says, there will surely be limitations. Then again, the law has often met obstacles that appeared insurmountable, before soon surmounting them. In that sense, Mr Moore says, he now sees his law as more beautiful than he had realised. “Moore's Law is a violation of Murphy's Law. Everything gets better and better.” While Moore’s Law has surely reached its current limitations, the question remains where do chips go from here? Some have posited that chips will push towards function specific hardware or purpose built for specific computing tasks like NVIDIA’s graphics cards. The space is large and complex - with companies like Apple licensing ARM technology to build their famous A13 chip while other companies have focused on specific parts of the value chain like TSMC. A big question that still remains is how cloud companies will scale hardware to meet continuing demand from customers. Arthur Dent, like Elon Musk, continues to benefit from infinite improbability - maybe quantum computing is the only way to know if Elon will succeed and what happens next in chip design.
Mentorship. Slartibarfast is a wise, old, planet creator who is plopped into the story to provide Arthur with answers to so many incredible questions. Slartibartfast explains the creation of earth and the interaction with Deep Thought. The interactions between Arthur and Slartibartfast are somewhat akin to traditional business mentorship - when you have none of the answers or you have preconceived ideas of how everything came to be, a mentor can quickly dispel your ideas and provide deep answers. Mentorship has been popular in Silicon Valley, with Bill Campbell mentoring Steve Jobs and several others. Bill was also instrumental in several decisions Ben Horowitz contemplated as he took Opsware through its spinout and sale of its managed services division. Mentors help change perspective and provide guidance.

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Business Themes

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