Why the two hottest US startups in payments might collaborate to marginalize Visa and Mastercard

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Ben Milne (left) is the founder of payments network Dwolla. Jack Dorsey (right) is the founder of payment services company Square.
Ben Milne (left) is the founder of payments network Dwolla. Jack Dorsey (right) is the founder of payment services company Square.
Image: AP

Dwolla and Square are the two hottest startups challenging Visa and Mastercard’s near-duopoly on how people pay for things. Most coverage of the two paints them as competitors, though their business models are quite different. But it’s almost inevitable that Dwolla and Square will team up, not in a merger, but in a mutually beneficial collaboration. And once they do, they could disrupt retail payment services–which move trillions of dollars a year–in a way that hasn’t been seen since the introduction of the credit card.

What Dwolla and Square do

Square was the first company to make it possible for ordinary people, rather than just stores, to accept credit cards. Square gives you a little plastic box that plugs into the microphone jack on a smartphone or tablet (it works with most Apple and Android devices). You download some software, and you’re ready to go: no special payment terminals or registering with a bank.

But enabling payments between people is actually small beans for Square; what it really aims to do is revolutionize them for stores. The traditional payment services companies that provide the keypad payment terminals you see everywhere aren’t much good at innovation. Square, on the other hand, can give a store a terminal in the form of an iPad that not only takes payments but recognizes when your smartphone is nearby, so that you could pay for something just by saying your name to a cashier. This is the ultimate goal of the deal Square recently struck with Starbucks, whose 7,000 cafes in the US will soon all have their payments handled by Square. (For now, though, Square will just be handling traditional, card-based transactions for Starbucks.)

Dwolla, meanwhile, created the first instantaneous money transfer system in the US. These systems have existed for years in Europe and elsewhere, and were enabled by central banks. But in the US, the only way to transfer money from one bank to another is through a system called ACH, which takes days. Even when you swipe your credit card, all you’ve given the merchant is a promise to pay–the actual transfer of funds takes place up to seven days later. Dwolla’s FiSync system allows any financial institution to instantaneously transfer money to any other institution, or to Dwolla itself. So far it’s live at only one bank, a credit union in Iowa, but many more are about to come online, says Dwolla founder and CEO Ben Milne.

What they could do if they joined forces

So Square and Dwolla are attacking two different parts of the aging, increasingly outdated US payments system: payments, and transfers. But the two don’t currently join up. Square hasn’t replaced credit cards; it’s merely provided a new way to swipe them. That means that merchants are still paying Square 2.75% per transaction, a fee that can’t be tamped down without replacing credit cards altogether.

That’s where Dwolla comes in. It has partnered with banks and other large financial institutions–including the US Federal Reserve–to create its FiSync alternative to ACH. It went live in June of 2012. All transactions on this system happen instantaneously. And here’s the potentially disruptive part: Dwolla charges nothing for transfers less than $10, and a flat fee of $0.25 for everything over that amount. On a $100 purchase, a merchant would save $2.50. For merchants like grocers, who are making only between 1 and 3 percent profit on every sale, that would on average double their margins on a sale.

So: pair an easier way to pay (good for customers) with a cheaper way to transfer money (good for merchants) and you have a winning combination.

So will they join forces?

Four months ago, Michael Schonfeld, Dwolla’s “developer evangelist,” told a developer on customer-service website Get Satisfaction that he was “sure that [Square and Dwolla integration] will happen at some point… I just don’t have a firm date for that yet.” When I asked Dwolla CEO Milne if Square transactions could clear on the Dwolla payment system, he said “they absolutely could.”

Milne also told me that Dwolla is “agnostic whether in the future it’s a phone or a card” being used to complete a transaction over its network, and that he’s open to outside companies creating all manner of services on the Dwolla network, including digital wallets powered by mobile phones. Square doesn’t have a digital wallet yet, but it does have the “Pay With Square” app, which is what makes it possible for customers to walk up to the register at some Square-powered merchants and pay just by saying their name.

There’s one more missing piece. And it’s on its way

The missing piece is credit. In order to be as convenient as a credit card, the Square + Dwolla partnership will need a bank that can extend credit to a customer on the Dwolla network. Fortunately, Dwolla’s already in talks with banks who could do that.

“The way we look at it is, Dwolla facilitates an exchange,” says Milne. “We feel like it won’t be long before third parties start extending credit on the [Dwolla] network. […] We’ve heard from more than one company that wants to do that.” Mastercard and Visa are just electronic networks, and they don’t give credit to people; they’re merely conduits for banks to do so. But now we have a new and more robust electronic network, the internet. And a great deal is possible on the internet that isn’t on traditional payment networks. For example, all the companies competing to provide mobile wallet services take advantage of the large amounts of data present on our mobile phones–location, device identity, etc.–to enable types of fraud protection that are impossible with plastic credit cards.

In summary

First, Square is already taking over as the credit card handling system for every Starbucks in the US. Square’s COO has predicted that a majority of retailers in the US will be using an iPad instead of a cash register within 18 months, and Square’s Register system runs on iPads. That improves the payment part. Then, Dwolla offers a way to transfer money for almost nothing. With Dwolla on board, Square could offer merchants transaction fees so low that they’d be foolish not to accept Dwolla as another form of payment alongside Visa and Mastercard. Finally, once Dwolla has banks extending credit on its network, the combination of Dwolla, Square and banks represent a legitimate alternative to existing credit cards.

But can they make the switch happen?

Visa and Mastercard won’t go away anytime soon. Dwolla and Square would have to institute a massive marketing push to get customers to sign up for and trust an entirely new “payment mark,” namely Dwolla. (Visa, Mastercard, PayPal and others all give merchants payment marks–epitomized by those symbols they put on their doors and by the cash register–to let customers know what kinds of payments they accept.) Dwolla will also have to integrate with many more banks, and–this is further in the future–develop an international presence.

For the merchants, there’s good reason to switch: Existing payment methods don’t work too well for them. Credit cards mean transaction fees that eat into the bottom line, and even cash has its own handling costs.

Persuading shoppers will be the harder part. For consumers, credit cards and cash simply work. Retailers could start offering customers incentives to make the switch to the Square + Dwolla combo, such as loyalty programs. These are already being used to get merchants to switch to Square. To join Dwolla, customers could simply transfer money from their bank account to a Dwolla account via the old ACH method. But it remains to be seen how any mobile payments startup–even the strong combination of Square and Dwolla–will convince users to abandon their old ways.