Innovation and Engineering in America

Pay as You Go with Smartphones


Osama Bedier is about to buy a pair of scandalously skimpy size 4 denim cutoff shorts from American Eagle Outfitters (AEO). The beefy, Egyptian-born vice-president at Google (GOOG)—and former bouncer at the Roxbury night club in Los Angeles—is buying the $25 Daisy Dukes to demonstrate a novel way of paying in stores and restaurants: with a cellphone. As about 200 bankers, credit-card executives, journalists, and Googlers watch at the company’s New York building in late May, Bedier waves his Nexus S smartphone in front of a credit-card reader. The device beeps in response, and three things happen at once: The phone submits a $5 store coupon, his Citibank (C)MasterCard (MA) account is charged $20 for the shorts, and his loyalty card with the retailer, also stored on the phone, is credited with the purchase. “And that’s how simple it is,” says Bedier, awkwardly holding a brown paper bag with the short-shorts, which he vows to give to his daughter. “We call that single tap.”

Sixty years after the creation of the plastic credit card, big corporate names are backing a new wave of payments technology—a tap with a phone, rather than a swipe with a credit card. Pretty much every major bank, credit-card company, wireless network operator, and a good number of Silicon Valley players are exploring the cellphone as the next ubiquitous way to spend money. Efforts such as Google’s fledgling service, Google Wallet, which begins trials this summer in New York and San Francisco, are the culmination of a decade of arduous technology development and a multiparty, cross-industry battle over who will control the $20.5 trillion global market for in-store retail transactions. Also pushing their own digital wallets are, among others, Visa (V), American Express (AXP), EBay (EBAY)’s PayPal division, and Isis, a venture of three large U.S. mobile phone carriers.

Should this technology take off, the cellphone could become the central repository of not just bank account information but coupons, loyalty points, and membership cards, allowing companies such as Google to route deals to cellphones at just the right time and place. “Ten years from now, a major portion of marketing is going to go through this personalized media channel,” says Mohammad Khan, who worked at credit-card terminal vendor VeriFone (PAY) before starting what is now a rival, ViVOtech.

If technologists such as Khan sound overconfident, it might be because they’re compensating for the fact that futuristic visions about new ways to pay have so rarely come true. Among the fields where humans have vigorously innovated throughout history, payments pretty much ranks near the bottom, well behind food cultivation, transportation, and online dating. There have been only a few major breakthroughs: the switch from barter to non-precious metal coins in Egypt around 700 BC, the move to paper money in China in 960 AD, and then to checks in the 12th century, courtesy of the Venetians. Credit cards, which emerged in the early 1950s first as dining cards in Manhattan before spreading more widely in the ’60s, introduced the era of electronic money and the idea of buying a completely unaffordable item and paying for it later.

There have been some important, if relatively incremental, innovations since then. Smart cards with microchips, which you can tap at “contactless” credit-card terminals (no swipe needed) in some 300,000 locations around the world, have been widely embraced in Europe and Canada—and largely ignored by most U.S. consumers, who remain committed to a swipe and ensuing signature. PayPal, with 100 million active customer accounts, has caught on as a way for people to send money to each other and pay for items, primarily online. Companies such as Boku and Zong, recently acquired by EBay, have developed ways for shoppers to purchase items by charging them to their cellphone bill.

For any new approach to really catch on, it has to offer some compelling advantage. “If there’s not a significant improvement from the past, either in convenience or in some form of monetary value to the merchant or consumer, payment technologies generally don’t catch on,” says Chetan Sharma, a mobile industry consultant. “There has to be something different about a new technology that makes life better.”

Much of the mobile payments activity centers on a technology called near field communication, or NFC. Apart from being another maddening wireless industry acronym to remember, an NFC chip built into the phone (or added to it via a microSD slot or a carrying case) communicates with a credit-card terminal over a distance of less than two inches. It’s a big upgrade over the magnetic stripe on a plastic card—a format invented in 1960 and now easily feasted on by card cloners and other fraudsters.

Nearly every phone manufacturer, including Nokia (NOK), Samsung, and Research In Motion (RIMM), says it plans to pack its handsets with these NFC chipsets, which in 2011 should cost $2.13 on average, down from $2.57 in 2009, according to ABI Research. Apple (AAPL) has stayed characteristically quiet about its NFC plans, but competitors say Apple is talking with almost every NFC startup—there are a lot of them—exploring whether it should build or buy the necessary technology. Analysts such as Richard Doherty of Envisioneering Group believe Apple will include NFC chips in an upcoming version of the iPhone, likely next year. Since 2008, Apple has applied for 36 patents that involve NFC, including one that describes a way to turn NFC-equipped iPhones and iPads into cashier terminals, and another that involves allowing Apple devices within close proximity to quickly and easily share files with each other.

NFC “is going to come, it’s just a matter of when,” says Mark Beccue, a senior analyst at ABI, which forecasts that the number of NFC-equipped phones worldwide will skyrocket, from fewer than 6 million in 2010 to 172 million by 2013. “The ecosystem is starting to come together,” says Bill Gajda, head of mobile products at Visa. “We are going to create a new payment and commerce experience.”

 

Digital wallets may seem like a solution in search of a problem. After all, withdrawing a credit card or a few dollars from an actual wallet is hardly the most taxing chore. But banks, wireless carriers, and phone makers have a lot of reasons to nudge the smartphone into the center of the payment universe. The companies backing NFC claim it will make financial transactions more secure and get lines at stores moving more quickly. They really start to salivate at the potential marketing bonanza. Companies developing these services plan on packing loyalty cards, coupon folders, and Groupon-like deal-of-the-day offers right into the digital wallet. Retailers could build comprehensive profiles of their customers, targeting them with additional discounts and come-ons at the checkout terminal or when they’re out and about, in pretty much the same way Amazon (AMZN) and other online retailers track shoppers as they browse the Web.

Eric Schmidt, executive chairman of Google—and not, apparently, an especially savvy clothes shopper—described the opportunity this way. “You’re walking down the street,” he said at a mobile conference earlier this year. “You’re confused like I am typically, and your phone remembers that you need new pants or some other product. It knows there’s a store ahead of me, on the left and on the right. It knows one is going to offer me a 20 percent discount, the other a 30 percent discount. It shows me the two offers, and being a cheapskate I always take the biggest discount. I walk into the store, the store knows I’m coming, the pants are ready. I go, boom, and I’m out of the store.” More than likely—Google says the details are still in flux—the merchant will pay a fat commission to the search giant or whoever else greased the deal.

There’s plenty that could go wrong with this mobile vision. While phones may be safer than plastic, they come with their own security challenges: They are susceptible to malware (and certain British tabloid journalists) although some NFC chips are designed to self-destruct if they’re tampered with. Funneling purchases through the phone will also allow Google and its rivals to greatly expand their data collection abilities, a chilling prospect for privacy advocates.

The biggest problem confronting NFC is practical: It may require new phones as well as new point-of-sale terminals, plus software that serves up targeted offers. It’s the mother of all chicken-and-egg scenarios, what economists call a multisided platform problem. Merchants don’t want to upgrade their terminals if there aren’t new payment-enabled phones, and consumers have no reason to buy NFC phones if there aren’t many places to use them.

Overcoming those hurdles is partly why the high-tech and financial industries are whipping up so much hype about NFC; they are, in effect, trying to bluff the world that the bold new age of mobile payments is inevitable. “Publicity and hype have a role to play here, to encourage both sides, the chicken and the egg, that there are some real heavyweights behind this technology,” says Douglas G. Bergeron, chief executive of VeriFone, which sells the majority of credit-card terminals to U.S. retailers—and has had a prime seat at the tortured, decade-long gestation period of NFC.

 

Near field communication was born in the early 2000s, through an unusual partnership between Sony (SNE) and Philips Electronics. Long before the onset of smartphones, both companies had outfitted plain old plastic cards with microchips to communicate using radio waves over short distances with stationary terminals. Back then, Sony’s FeliCa smart cards were becoming widely used in train stations and convenience stores in Japan and Hong Kong, and the company was starting to bring the technology into mobile phones. Philips’s popular MIFARE smart cards, designed by its then-subsidiary, NXP Semiconductors, were being embraced by dozens of regional public transportation systems, including those in Moscow, Seoul, and Kuala Lumpur.

Both companies wanted to ditch the plastic and work this technology into all consumer devices but realized they alone couldn’t persuade the world’s electronics manufacturers to back a proprietary platform. They found another partner in Nokia, whose researchers were exploring ways phones could interact with inanimate objects. They had toyed with the idea of distributing cheap radio tags that could convey snippets of information to cellphones held close by (e.g., put a tag on a photo of grandma; tap the tag with your phone, and it dials her). “To really make it big, and to drive into the market, would require a standards organization,” says Gerhard Romen, director of mobile financial services at Nokia and one of the primary figures in the development of the NFC Forum, which was officially born in March of 2004.

The forum’s founders had high hopes for the quick adoption of NFC in cellphones. Within a year, 20 other companies had signed up, including Microsoft (MSFT), Samsung, MasterCard, and Visa. The dirty work of setting up technical specifications took a few more years. A radio chip built into phones would operate at a 13.56 MHz frequency and work like the RFID chips used in E-ZPass toll-road systems. A second chip with the somewhat cinematic descriptor “the secure element” was designed to work in tandem with the radio chip, but keep the customer’s personal info and payment data safe and encrypted.

Early test runs of the technology didn’t amount to much. In 2004, Nokia released it first NFC-equipped phone, the 5140, an otherwise undistinguished device. In a mobile-payments trial in 2007, Wells Fargo (WFC) gave 50 employees Nokia handsets. After calling an 800 number to activate the payment service, trial participants had to download and run separate applications for each credit card they wanted to use. Participants found that a phone tap was no better than a card swipe. They often left their Nokia phones in the office, and even when they did remember to bring along their test gadgets, they wouldn’t go out of their way to find a merchant whose terminal could accept a contactless payment. The fact that the wireless network Wells Fargo was using for the trial crashed for an entire week probably didn’t help.

At around the same time, fissures were beginning to appear among the NFC Forum’s partners. If phones were to be used for payments, there would be a lucrative opportunity to collect fees associated with these transactions. Cellphone carriers such as AT&T Mobility (T), which joined the NFC Forum in 2007, buy phones from manufacturers and resell them at a subsidized price to consumers. The carriers argued that they should profit from mobile payments, putting them on a collision course with banks and credit-card companies that wanted to protect their turf. In early 2007 a wireless carrier trade group stated that it would embrace NFC only if the carriers got to manage payment transactions and if the secure element sat on the SIM card, which they controlled. “We kind of reached an impasse,” says Dom Morea, a senior vice-president at First Data, the country’s largest processor of payment transactions. NFC-equipped phones trickled out over the next few years, but they didn’t get much attention.

 

Two engineers at Google, Rob von Behren and Jonathan Wall, believed in the potential of the smartphone to break this impasse. In 2009 the two were examining mobile payments using their free “20 percent” time, the company’s famous practice of allowing employees to spend a fifth of their time on the project of their choice. “We saw that tons of people had tried doing mobile payments,” says von Behren, who left a computer science graduate program at University of California at Berkeley after he joined Google in 2004. “But the best they could do with a flip-phone is to turn it into a really thick plastic card.” The iPhone was then just two years old, and the pair wondered if such a device, with its rich user interface and voluminous storage, could also be used to collate receipts, track corporate expenses, and earn loyalty points—and whether that was the key to finally making the mobile phone a compelling tool for in-person payments.

Von Behren and Wall successfully pitched their idea of a digital wallet to Google’s mobile executives and got a green light to develop the concept, but the company didn’t have a logical place to tuck their project. The pair ended up in something of a corporate ghetto—Google Research, a think tank whose long-term pursuits include developing machine translation and artificial intelligence.

Stephanie Tilenius rescued them. A former senior vice-president of EBay and PayPal, Tilenius joined Google at the beginning of 2010 as vice-president for commerce. In one of her first moves, she sent an e-mail to co-founder Larry Page arguing that the company should aggressively enter the market for online purchases via a cellphone. She was quickly routed to von Behren and Wall, and the trio hit it off, agreeing that Google’s open Android operating system gave it a unique opportunity to back the NFC standard and drag the messy network of payment players along with it. Tilenius met with Andy Rubin, Google’s senior vice-president of mobile, and found that the Android group was already planning to embed an NFC chip in the upcoming Nexus S.

At the May 26 press conference at Google’s Chelsea headquarters in New York City, the group, now part of Google’s commerce unit, unveiled its plans for “a new era in commerce.” Google Wallet is designed to let smartphone users tap their phones against credit-card terminals at the nation’s largest retailers—Macy’s (M), Bloomingdale’s, Walgreens (WAG), Foot Locker (FL), and Peet’s Coffee (PEET), among others, have already signed up to honor Google Wallet. Shoppers will also be able to collect Groupon-style daily deals, called Google Offers, meant to spur additional purchases. Citibank, MasterCard, and First Data, the payments processor, are also on board with Google Wallet.

In true Google fashion, the company professes a certain degree of selflessness while positioning itself to profit wildly if its wallet service takes off. Instead of Google taking a cut of the purchase, credit-card issuers such as Citibank will handle the transactions, as they normally do. Google will get paid by sending ads to the phone and when users take advantage of a coupon at a nearby restaurant, for example. Google and its primary partners are also trying to sweeten the deal for retailers by subsidizing their installation of contactless terminals and the software to deliver targeted deals—upgrades that analysts believe could cost hundreds of dollars per terminal.

Tilenius declined to divulge the extent of the subsidy and who has received it, but Bergeron of VeriFone says: “It’s kind of like stimulus spending. Their hope is that they can stimulate the market in the beginning, as a temporary measure to help it gain mass appeal.”

As Google Wallet moves into trials, it will have severe limitations, at least at first. Only owners of the Nexus S smartphone running on Sprint (S)’s new 4G network will be able to program their phones with a Citibank MasterCard (if they have one) or with a Google prepaid debit card, to which they can transfer money using other cards. Then they can use their phone to pay at any of the 24 nationwide retailers. Tilenius says Google is talking to other Android phone manufacturers, banks, and retailers and is convinced they will also embrace the service. (Tilenius also faces a more direct challenge: EBay has sued her, Osama Bedier, and Google, claiming the two former PayPal execs misappropriated its trade secrets when they joined Google. A Google spokesman declined to comment on the suit.)

Another serious test will be persuading wireless networks other than Sprint, the nation’s third-largest carrier, to sell NFC-equipped Android phones. Last fall, AT&T Mobility, T-Mobile USA, and Verizon Wireless banded together to form a venture called Isis to create their own digital wallet in conjunction with Discover Financial Services (DFS). Their original plan was to create a payment network that would compete with MasterCard and Visa, with the carriers collecting fees on every transaction (the plan even called for Isis to distribute plastic credit cards to customers as a backup for their phones).

Merchants reacted coolly to the idea, and after the Durbin Amendment to the Consumer Protection Act of 2010 set the stage for a cap on credit- and debit-card fees, Isis scaled back its plans. The coalition now says that, like Google, it will try to lure other banks and card companies to its wallet without taking a cut of their transaction revenue. Also like Google, it’s exploring ways to make money on coupons and ads and could work with deal companies such as Groupon, says Ryan Hughes, Isis’s chief marketing officer. “These are three companies that are not afraid to spend money to build a brand,” he says of Isis’s joint-venture partners. The first Isis trial is planned for next year in Salt Lake City and Austin, Tex.

And that’s only the beginning. Visa is talking to both Google and Isis but also wants to put out its own competing wallet by this fall. American Express recently introduced a digital wallet named “Serve.” And MasterCard is working with everybody. The idea of putting even a few of these competing services onto a single phone sounds like a nightmare of complexity and competing interests, so it will be up to the major players to win over merchants with the lowest advertising fees and to wow them by luring shoppers into their stores and spurring additional purchases.

 

In the past, it’s taken some expensive stunts to get regular folks to even pay attention to a new form of payment. In 1958, a Bank of America manager named Joe Williams had a novel solution to the multisided platform problem that was stymieing the acceptance of plastic. He sent nearly every consumer in Fresno, Calif.—60,000 households—a new credit card, without even asking that they fill out an application or submit to a credit check. The Great Fresno Drop, as it was later called, soon persuaded some 1,000 area retailers to embrace this strange new form of payment. Although fraud was rampant and delinquent accounts were high, within two years the cards had spread throughout California. The era of plastic had officially begun.

It’s not yet clear whether there’s a company willing to pull off a stunt as ambitious (and reckless) as a Great Fresno Drop to launch the era of cellphone payments. Google, with its hoard of cash, is in a position to seed the market with thousands of subsidized point-of-sale terminals. Apple, too, has the financial heft to engage in such an effort. Other companies are betting on more incremental approaches that can solve real short-term problems in the payments industry.

Square, the brainchild of Twitter co-creator Jack Dorsey, is giving small businesses such as food carts and farmers market vendors a way to take credit cards almost immediately. The startup is freely distributing plastic devices that have a slot for swiping cards. These card readers, which are slightly larger than a Scrabble tile, plug into smartphones and turn them into payment terminals. It’s free for a retailer to sign up, whereas a conventional merchant credit-card account can cost hundreds of dollars.

Square is now processing $3 million in credit-card transactions a day. Based on a recent $100 million infusion of venture capital, the 2-year-old company is valued at $1 billion.

Square has also recently introduced tools to turn iPads into digital registers and to let shoppers use their smartphones to pay for items at local shops as well as store coupons and receipts. It sounds a lot like the capabilities dreamed of by NFC’s backers, but without the hassle of adding chips to phones and changing the behavior of regular people. Not surprisingly, the folks at Square have a skeptical view of NFC. “We believe NFC is a technology in search of a value proposition for both consumers and merchants,” says Keith Rabois, Square’s chief operating officer and a former executive at PayPal. “I’ve yet to meet a merchant that turns around saying, ‘I can’t wait for this NFC stuff.’ ”

PayPal, currently the leader in online payments with more than 100 million users, is thinking beyond NFC while hedging its bets. The company recently said it would allow owners of NFC-equipped Nexus S smartphones to make payments to each other by tapping their handsets together. Sam Shrauger, PayPal’s vice-president for global product and design, wonders if NFC isn’t just an interim step along the path to a universal digital currency. He foresees a day when consumers won’t even walk up to a cashier: They will browse a store; when they find what they need, they’ll pay with their phones by accessing payment information stored securely on the Internet. “The notion of walking to a checkout line and walking up to a point-of-sale terminal doesn’t need to be the way people behave,” he says. “That’s the real promise of a digital wallet. If I want to walk in and pay that way I can, but I should have an easier alternative.”

When the world moved from cash to credit, consumer behavior changed drastically. It altered people’s basic ideas about what was affordable and how much they were willing to spend. James E. Katz, director of the Center for Mobile Communication Studies at Rutgers University, believes we will have even fewer brakes on spending and could drive ourselves even further into debt when these mobile payment tools finally arrive. “The difference between a credit card and a mobile phone is, the credit card is a dedicated instrument people associate with buying. This other is a mobile phone, so you are one more step removed from seeing a change in your financial status.” Early evidence from NFC trials backs this up. Khan of ViVOtech says that in one of the 35 field trials his company has conducted, people’s expenditures jumped more than 20 percent when they used their phone to pay.

Rob Killian of Campbell, Calif., who is testing an NFC-equipped BlackBerry as part of a Bank of America (BAC) mobile-payment trial, isn’t sure that he’s spending more money than usual, but he’s having an awfully good time being an early adopter. On a weekday morning this summer, Killian buys deodorant and a few shaving items at a Walgreens and pays for it with his phone. “That’s just new,” says the cashier. “That’s crazy.”

Outside, Killian holsters his BlackBerry with satisfaction and notes that he still carries a good old-fashioned leather wallet in his back pocket. “You still can’t put a driver’s license on a phone,” he says.


For more on innovation and engineering in America, visit businessweek.com/go/11/innovation2.
Stone_190
Stone is a senior writer for Bloomberg Businessweek in San Francisco. He is the author of The Everything Store: Jeff Bezos and the Age of Amazon (Little, Brown; October 2013). Follow him on Twitter @BradStone.
Olga_kharif1
Kharif is a reporter for Bloomberg News and Bloomberg Businessweek in Portland, Ore.

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