September 15, 2014 - Financial Companies Will Benefit from Credit Card Switch
Americans love their credit cards, but unfortunately, using credit cards can be risky. I am not talking about the risk of abusing your cards and running up big debts… I am talking about the risk associated with your card being targeted by hackers looking to make a quick score with your money.
The ramifications of having your credit card compromised are a nightmare. Not only will you have to deal with charges you never made, but you may also discover that your credit rating has been ruined, and repairing your credit can be a long and tedious process.
One of the main reasons so many data breaches have occurred in the U.S. as of late, such as the one at Target (TGT) last year, and most recently Home Depot (HD), is that American card issuers and retailers are using antiquated technology for credit card processing. That is about to change, and the change should come as a relief to American financial institutions.
Hackers and thieves will always target the weak, and right now the weakest link is in America. The U.S. is the only country in the G-20 that still relies on magnetic strip credit cards, which are far more vulnerable to the alternative, which are called EMV cards. EMV stands for Europay, MasterCard and Visa.
There are two primary reasons why Americans have been using magnetic strip cards. Firstly, chipped cards are more expensive to make. Secondly, retailers will have to upgrade their point of sale devices in order to accept the chipped cards. The result has been a vulnerable system that hackers have been able to target.
The tide is shifting though, and by the end of 2015, it is expected that 70% of all credit cards, and 41% of all debit cards in the U.S. will be equipped with security chips.
Even still, most issuers are still not taking the most secure route. There are two different types of chipped cards. There is chip and PIN, and then there is chip and signature. Chip and pin is more secure, but also more expensive, so most issuers are going to go the chip and signature route. Still, change is coming, and any added layer of consumer safety will be welcomed.
So how does it work? In simplest terms, when you shop with a magnetic strip credit card, retailers and card processors store card data in their systems, and that makes the information easy to obtain for hackers with the know-how. With chip cards, the information is read off a secure chip located on the card, and the card number itself is never revealed.
While there are already millions of these cards in circulation in the U.S., most are not being used to their full potential because retailers have been slow to update their systems. If you have a chipped card, and visit a retailer that is unable to read the chip, it can still be used with the magnetic strip on the back, so there has not been much reason for retailers to update their system.
That has changed, for a couple of reasons. The recent data breaches that have made headlines and spread fear among consumers, and no company wants their name attached to that sort of activity. Target learned its lesson the hard way when its data was breached, and exposed around 40 million customers to credit card fraud. The retailer suffered big consumer backlash from the incident, and revenues and earnings were negatively impacted. Understanding that their businesses simply cannot handle such negative publicity, a lot of retailers will now start to update their systems to take more secure payments.
A second reason why the transition is going to pick up so quickly moving forward is that a liability switch is going to take effect next year. Basically, what this means is that when data is breached, the responsible party will be the one that has failed to update its system.
For card issuers, the switch will be expensive, but fairly easy. They will simply need to issue new cards with chips on them to their cardholders. For retailers, it will be more of a challenge. Consider a company like Wal-Mart (WMT). Now imagine how many different card machines they have spread out across the nation in their stores.
Banks will likely be quicker to get new cards issued than retailers will be to update their systems, so it will take some liability away from big banks and card issuers, which is always a good thing for the banking industry.
Chart courtesy of stockcharts.com
Ultimately, consumers will be the biggest winner from the transition, but banks and card issuers will also benefit. While there will be some costs up front, lower liabilities down the road will be a positive for the sector. A great way to play the sector moving forward would be with a trade on Financial Select Sector SPDR ETF (XLF). The ETF holds some of the biggest issuers including Wells Fargo (WFC), American Express (AXP) and Capital One (COF).
A nice hedged trade on XLF would be the November 18/22 bull put credit spread. To set up this trade, you would sell the November 22 put while buying the same number of November 18 puts for a credit of 20 cents. The trade has a target return of 5.3%, which is 27.1% on an annualized basis (for comparison purposes only). XLF is currently trading at $23.37, which gives the trade 5.0% downside protection.