By Russ Jones

Peppercoin 2.0 extends the notion of transaction aggregation into both the physical world of small point-of-sale payments as well as across multiple merchants. Through this new “universal aggregation” capability, Peppercoin plans to aggregate individual consumer purchases at multiple merchants into a single card transaction. By doing this aggregation, the per-transaction fees that would otherwise be paid on each purchase are reduced—with the resulting savings shared between Peppercoin and merchants participating in the Peppercoin network. This research note analyzes how Peppercoin 2.0 actually works, explores its new value proposition, and offers an initial assessment of its potential strengths and weaknesses.

Peppercoin Revisited

Peppercoin is a venture-backed payment company that has retooled its approach to tackle the challenges of small payments. The company, based in Waltham, Massachusetts, was founded in late 2001 by MIT Professors Silvio Micali and Ron Rivest (the “R” in RSA Security). After initially launching a micropayments online payment service in December 2003 to disappointing market acceptance, Peppercoin has redefined its mission, recruited a new CEO, and announced a major overhaul of its strategy with Peppercoin 2.0.

What’s New in Peppercoin 2.0

We give Peppercoin credit for reacting quickly to the negative market feedback on its initial offering and changing its focus accordingly. Peppercoin 2.0 includes a number of enhancements designed to increase customer adoption:

• Familiar User Experience. At the heart of Peppercoin 2.0 is a familiar consumer purchase experience that requires no wallet download, no registration or account setup, and no use of prepaid funds. Consumers transparently provide their payment card information to the merchant and, in fact, need never know that they are using Peppercoin until they receive their monthly card statement from their card issuer.

• Universal Aggregation. Using the card information provided by the consumer, Peppercoin aggregates transactions from individual cardholders making small-value purchases across a range of online content providers, as well as vending machines, parking meters, and physical world POS merchants. This approach significantly expands the potential addressable market for the Peppercoin 2.0 service. Peppercoin refers to this online/offline multi-merchant aggregation model as “universal aggregation”.

• Customer Self Service. To minimize the cost of handling customer inquiries—one of the major cost components in any payment system, but particularly significant relative to small dollar transactions—Peppercoin attempts to drive consumers to a “smalltab.com” website where they can drill down on the specifics of aggregated charges (from their monthly card statement) and see the original merchants and actual purchase activity. Any consumer disputes are also handled via this self-service approach.

In an effort to lower merchant adoption hurdles, Peppercoin is offering merchants the ability to either run the required software directly on their own commerce server or to use a hosted service provided by Peppercoin. To maximize its market coverage, Peppercoin plans to make its aggregation gateway available to other payment service providers interested in offering small payment support to merchants.

How It Works

To understand how Peppercoin 2.0 works, let’s step through an example of how a transaction would be completed.

• The consumer purchases an online song for $0.99 and pays with their credit card or signature debit card as they normally would (Visa, MasterCard, American Express, and Discover are all supported)
• The online ecommerce merchant sends the purchase transaction to Peppercoin (via a secure SSL connection) for payment processing
• Once the consumer’s aggregate purchases across all participating Peppercoin merchants reaches a predefined trigger point, Peppercoin submits a single card transaction to its acquiring bank for authorization and settlement processing on the aggregated transactions. Peppercoin appears to the card payment systems as the “merchant of record” for all of the aggregated transactions
• Subsequently, Peppercoin receives payment from its acquiring bank, disaggregates these funds, deducts their aggregation/processing fees, and sends the net proceeds to the originating merchants
• The consumer eventually receives a monthly card statement where all of the purchases from participating merchants are grouped together into a one (or more) line item entries containing the smalltab.com URL, a reference number, and the total transaction amount for that particular group of aggregated transactions

If additional details are required, consumers are directed by the statement detail to smalltab.com where they can enter the transaction reference number from their statement and then view purchase details as well as disputing charges, request refunds, etc.

Let’s explore several additional considerations to help us better understand the Peppercoin 2.0 approach:

• The consumer is not required to do anything special to use Peppercoin; their active buy-in or support of Peppercoin is not required and—as a result—is not a barrier to market adoption
• With payments decoupled from access control, online content providers can mix and match pay-per-use, subscription, and prepaid access business models to meet consumer preferences
• Because Peppercoin 2.0 uses a card-centric approach, transactions can be aggregated across consumer purchases at physical POS magnetic card swipe devices, at vending machines (unattended or attended), and at online or MOTO (mail order/telephone order) merchants
• Merchants can set their own aggregation thresholds, effectively directing small payments into the aggregation bucket while still processing larger payments as normal
• Merchants can define their own policies for handling complaints, replaying downloads, and honoring refund requests (e.g., refunding any purchase under $0.50 for example)—hopefully prior to the card holder picking up the telephone and contacting their card issuer
• Transaction aggregation is done based on matching card numbers across multiple purchases at multiple merchants. A consumer using different cards to make multiple small payments would see several smalltab.com line items on their monthly statement for each card they’ve used
• If the consumer’s monthly card statement is out of alignment with the firm’s aggregation cycle, heavy spenders may see multiple smalltab.com purchases on their monthly statement

Peppercoin has not made its 2.0 aggregation algorithm public. As a result, the duration of the window or the specific threshold limits triggering the aggregated transaction are not yet known. The Apple iTunes algorithm, for example, aggregates purchases whenever the aggregated amount reaches $20.00 or 12 hours have elapsed, which ever comes first.

Value Proposition

Peppercoin positions its 2.0 service as providing benefits to all of the stakeholders in the payments value chain:

• Consumers. Peppercoin believes that as merchants begin to adopt the payment service, card-enabled end users will have access to premium content and services that are not currently available. They also stress that consumers will also continue to earn their card-based loyalty rewards while making small purchases, and will be able to resolve disputes without having to pickup the phone to talk to their card issuer.

• Merchants. Peppercoin stresses to small payment merchants that they will gain access to consumers that do not have to preload accounts or download wallets or even be online. They also believe that merchants will benefit from lower transaction costs (due to aggregation), lower support costs (due to the self-service capabilities), and the flexibility to offer consumers pay-per-use, subscriptions, or prepaid access.

• Payment Processors. Peppercoin’s message to payment processors is that after licensing the technology, processors will be able to satisfy the needs of the many merchants wanting to offer small payments and micropayments capabilities alongside their more traditional card processing services. Peppercoin also believes that payment processors may benefit from increased transaction flow from non-aggregated transactions.

• Acquiring Banks. Peppercoin points out that without really having to do anything, acquiring banks will benefit from the increased payment volume coming from participating payment processors.

• Card Networks. Peppercoin’s believes that their new system offers Visa, MasterCard, American Express, and Discover a complementary micropayment strategy that encourages consumers to use their cards as logical replacements for low-value cash and paper checks.

• Issuing Banks. In addition to advocating that consumers shift low-value cash transactions to cards, Peppercoin believes that issuing banks will benefit from an automated dispute resolution system that will attempt to resolve complaints before they become chargebacks.

Peppercoin positions its 2.0 system as appropriate for many transactions under $20.00—something the company refers to as “small payments”.

Availability and Pricing

Peppercoin has not publicly announced its full merchant pricing schedule. For marketing purposes, it characterizes the cost to merchants as $0.10 or less on a $0.99 purchase.

Ron Rivest has described the company’s fee structure as a net 7 to 8% off the item purchase price—$0.0035 on a $0.05 purchase for example.

In trade press interviews the management team positions this fee structure against a typical card transaction that has two components: a $0.20 to $0.25 per transaction fixed component and a 2-3% variable component based on the purchase amount.

Availability of Peppercoin 2.0 is scheduled for Q3 2004.

Glenbrook Opinion

Peppercoin 2.0 is a complete—indeed much needed—overhaul of the original Peppercoin vision. The following table contrasts the differences between the systems.

Attribute	Peppercoin 1.0	Peppercoin 2.0
Target Transaction Range	Micropayments (less than $5.00)	Small payments (less than $20.00)
Target Market	Online content	Online content, physical POS, vending machines, MOTO
Consumer Experience	Wallet download and installation required	Normal shopping cart interface for standard card transactions
Consumer Relationship	Pre-registration required; terms & conditions give Peppercoin the right to pull consumer credit report	No account setup up; no special rights or terms other than a standard merchant/ consumer relationship
Consumer Support	Merchant are responsible to resolve nickel-level consumer disputes	Peppercoin provides automated customer self-service
Content Business Models	Pay per download only	Pay per use, subscriptions, and prepaid access
Settlement	Merchants are paid based on complex statistical sampling algorithm	Merchants are paid based on what they actually sell

In early 2003, we argued that the emphasis Peppercoin placed on its own internal transaction processing efficiency (see “The False Promise of Frictionless Commerce”) was dwarfed by the cost to move money into the system and the costs required to support customers. Peppercoin appears to have reached the same conclusion—Peppercoin 2.0 places a heavy emphasis on reducing cost of payment acceptance (through aggregation) and on reducing support costs (through providing online customer self-service.)

Economics

To illustrate the economic efficiency of transaction aggregation lets go back to our earlier example and say the consumer purchased three $0.99 songs over five days. If each purchase were processed separately as a card transaction a large merchant might pay $0.20 plus 2.2% or roughly $0.22 per transaction; three transactions would total $0.66 (22% of $2.97) in processing fees, which would be withheld later in settlement from the merchant acquirer.

Using Peppercoin 2.0, the merchant might only pay $0.30 in processing costs (10% of $2.97), which would be withheld in settlement from Peppercoin. Because it’s a zero sum game at a per transaction level, the card issuer would lose the difference in terms of interchange revenue.

While this $0.36 savings might seem small in absolute terms, it could have a significant impact on merchant profitability—particularly if there are royalty or other cost of goods issues.

Availability of funds is also a critical issue to merchants. Using a traditional merchant acquirer (without Peppercoin) the online merchant would receive its funds in a few business days. Peppercoin has not made any public statements about its settlement policy. If settlement is driven by the timing of a multi-day aggregation cycle, Peppercoin may be competitively disadvantaged (because merchants would have to wait longer for funds.)

What We Like

Economics aside, there are a number of things to like about the new Peppercoin Version 2.0 vision:

• Simplified adoption model. Eliminating the consumer adoption hurdle is a breakthrough concept that directly tackles the chicken and egg problem (“no buyers because there are no sellers; no sellers because there are no buyers”) that has plagued alternative payment systems over the last decade. While there are risks in the approach selected (see below), most startups have been unable to solve this seemingly intractable problem.

• Card-centric aggregation. Aggregating lots of little card transactions into a larger card transaction should work for customers and makes sense economically for merchants. This is the same approach used successfully by Apple (see “Micropayments Redux at the iTunes Music Store”) and it is now being generalized by Peppercoin for use by both online and offline merchants.

• New card payment market. Tying the payment handle to existing card numbers and eliminating the need to pre-enroll opens up a new and untapped market for small-value physical goods and services. While there is little sizing on this opportunity, our hunch is that this is an underserved market space that could prove attractive if it takes off. In effect, Peppercoin has identified a new market for card payments.

• Automated customer support. Customer support is the soft underbelly of payment systems—working in small payments (with small margins) just makes getting it right more important. Peppercoin should look to PayPal for inspiration—the firm has been quite successful with its automated dispute resolution solution that connects buyers and sellers to directly resolve the problem. Good idea for PayPal, good idea for Peppercoin.

Of course, it’s always easy to like a vision. The devil, as they say, is in the details.

What We Worry About

In spite of attractive merchant economics and several compelling features, there are several risks that Peppercoin should be worried about:

• Customer confusion. The flip side of the consumer not having to know anything about Peppercoin is just that—when the smalltab.com charge shows on up on their statement, they will not know anything about Peppercoin. Many consumers manically balance their card statements the same way they balance their checking account. Those that don’t are currently being coached to do so to combat identity theft!

Signature debit transactions show up in the consumer’s checking account statement and are reconciled along with checks and ATM transactions. While some consumers may recognize and use the smalltab.com service, many won’t know what it is, will have never agreed to its use, and are likely to complain to their card issuer about unknown charges. Card issuers don’t like any increases in customer support calls—particularly when those calls are related to transactions that may actually reduce their interchange income because of the service’s aggregation design. Perhaps customers would not be as confused if merchants took it upon themselves to educate consumers about how their purchases will appear on the monthly card statement.

• Chargeback exposure. By aggregating multiple consumer purchases into a single transaction, Peppercoin becomes the merchant of record and, as a result, may be exposed to chargebacks and associated fees. While Peppercoin 2.0’s automated customer self-service is a step in the right direction, it only helps mitigate the dispute resolution problem for consumers that are online and Internet savvy. Internet usage in the U.S. is now saturated with an estimated 21% of the adult population unlikely to ever go online. These consumers will likely complain (loudly) to issuers about unauthorized Peppercoin 2.0 charges that they simply don’t recognize.

• Short-term economic viability. While transaction aggregation should be attractive to merchants, a critical mass of transaction volume is required for aggregation to be economically profitable for Peppercoin. Initially, there will be little opportunity to aggregate transactions across multiple merchants, because there just won’t be enough merchants using the system. Consequently, aggregation in the initial phase is likely to only be applicable to multiple purchases from the same merchant. As a result, Peppercoin must be prepared to underwrite a lot of transactions before reaching scale and deriving any associated efficiencies.

• Inconsistent customer demand. While some merchants pay processing fees that make small transactions uneconomical, not all merchants are in the same boat. Visa, for example, segments interchange fees for consumer cards into some 31 different categories, depending on the type of merchant and the purpose of the transaction. Unfortunately for Peppercoin, many of the obvious small payment opportunities (gas pumps, parking garages, movie theaters, taxis, parking meters, quick service restaurants, grocery stores, etc.) are already benefiting from nickel and dime level card processing costs. In other words, the physical world merchants that might seem mostly likely to adopt Peppercoin may actually have the least need. What’s worse, these rate categories change over time at the discretion of the card associations; Peppercoin’s value proposition for any class of merchants could be eliminated with the stroke of a pen.

• Increased competition. As Peppercoin moves outside of the digital content realm and begins competing for purchases over $5.00, it should expect increased competition from existing payment systems. Ironically, the cost advantage that Peppercoin enjoys over traditional card payments in the micropayment realm (because of its ability to aggregate per-transaction fixed fees) become less pronounced as the transaction value increases.

• Unrealistic value proposition. While we applaud Peppercoin’s attempt to address the needs of all stakeholders, we are dubious whether it is realistic. Peppercoin is clearly attempting to meet the needs of merchants and is promising a strong set of benefits. While the value proposition for payment processors and acquiring banks is clear, it also only matters once the transaction volume becomes significant. While some might argue that small payments are all incremental in the current card payment environment, some issuing banks may believe they are actually losing the fee income they would otherwise receive on the individual transactions if not for the aggregation.

• Card association operating regulations. Universal aggregation is a concept that is, at best, undefined; at worst, it flies in the face of card association operating regulations. The main problem is that aggregation of physical world transactions requires Peppercoin (as the merchant of record) to capture and store magnetic stripes from the back of the card, likely not to be in compliance with bankcard association rules. While may exist certain well-defined exceptions, such as offline POS devices, universal multi-merchant aggregation isn’t currently one of them. On the other hand, aggregation of several online transactions does not require magnetic stripe data, is more conventional, and potentially less risky.

While it is difficult to anticipate how the card associations and their issuing and acquiring member banks will ultimately view this approach of universal aggregation, it is safe to say that some reaction is likely. Initially, there may not be any close scrutiny of universal aggregation.

Unfortunately, it may be only success that drives closer scrutiny. The universal aggregation concept pushes the envelope with respect to how the card system was designed to work. The approach results in many more questions than it answers.

Consider, for example, aggregating card-not-present and card-present transactions together. Can a consumer’s card-not-present transactions be grouped with their card-present transactions, and then aggregated together to be processed at card present rates with card-present chargeback protection? Or are these two separate aggregation categories that potentially reduce the economics possible with universal aggregation? Other questions include resolving how online transactions with CVV2 get aggregated with other transactions without CVV2 as well as examining the implications of the various U.S. Federal Reserve Board regulations to this aggregation approach.

Final Thoughts

Peppercoin 2.0 is innovative in a number of important ways. The company has clearly listened to the feedback it received from prospects and responded with a new system that better meets the needs of merchants wanting to sell low-cost digital goods and to deliver low-cost value-added services.

Potential concerns with Peppercoin’s new approach include transaction aggregation across online and offline transactions and supporting customers that don’t know they are customers. While this may be possible in a perfect world, is that the world we all live in?

Instead, Peppercoin may want to initially focus its resources on delighting digital content providers, building initial market traction, and not getting lost in the challenges associated with extending their small payment aggregation approach to physical world merchants.

References

1. For information on Apple’s aggregation algorithm, see:
   http://docs.info.apple.com/article.html?artnum=93010
2. "The False Promise of Frictionless Commerce", see:
   https://glenbrook.com/opinions/micropayments.html
3. “Internet Penetration Flattens Out”, see:
   http://www.mediamark.com/mri/docs/pr_6-16-04_internetplateau.htm

Acknowledgments

Several of my partners at Glenbrook (Carol Coye Benson, Bryan Derman, Scott Loftesness, and Allen Weinberg) helped shape this paper. Reviewer Janey Place also provided helpful comments.

Publication History

Initial Publication Date: July 15, 2004

An new Research Brief on Peppercoin was published June 23, 2006. Contact Russ Jones for a copy.