Thesis: Card Rewards – A Realistic Use Case for Blockchain

There have been many suggestions for use cases for Blockchain, the underpinning technology for many cryptocurrencies. Loyalty programs have been specifically proposed as potential use cases by several credible and reputable firms such as  Deloitte, and Oliver Wyman. Most of what has been written about loyalty blockchains describe benefits in very simplistic terms – Blockchain can make loyalty programs more valuable for end users by increasing transferability of rewards or can increase satisfaction by making rewards programs more real-time. But the addition of a proprietary cryptocurrency could be the game changer which moves blockchain for loyalty from concept to reality.

There is one type of loyalty rewards program that stands to gain the most by replacing its own underpinnings with a proprietary cryptocurrency on a closed blockchain, credit card rewards. To understand why we need to pull back the curtain on how these programs work. Card rewards have been around since at least 1990 when AT&T’s Universal Card entered the market with a big splash, offering credit towards the cardholder’s phone bill for each purchase. People understood the concept of collecting rewards currency from the early days of S&H Green Stamps, but for the very first time, a cardholder was getting money back, in this case in the form of a phone credit, for using a plastic card when shopping. The Universal Card was partially in response to the success of Discover, which launched in 1986, but added the unique feature of cash-back rewards to its credit card a few years later, setting off the escalating card rewards war that continues to date.

Rewards quickly evolved; most rewards programs used a proprietary “points” system. Cardholders accumulated points for purchases at a rate that was set by the issuer. Cardholders could use the points to purchase merchandise at a redemption ratio set by the issuer. Often times, the redemption ratio was (and in many cases still is) somewhat obscured to make the program seem richer. Some programs operated at a standard penny for point, but not all. Redemption for gift cards and travel soon became the most popular options in many card rewards programs. Although the points were held in accounts associated with the card, they were not portable and the issuer carries on its financial books a liability for unused points.

Redemption is usually handled by a third-party fulfillment center, especially for merchandise and gift cards, and still for some travel rewards. Issuers outsource the redemption function to these third-parties to host the user redemption website, maintain and keep fresh the catalog of rewards, administer point balances, manage promotions, ship rewards, and deduct the points. The fulfillment vendor gets a redemption request through the website, verifies with the system-of-record that the points are available and with the issuer what the current redemption ratio for that cardholder is for that type of reward (travel certificate have different redemption ratios than toasters). The vendor then fulfills the reward request. Some fulfillment centers maintain warehouses of popular merchandise, which it buys in bulk. Fulfillment centers mark up the cost of the merchandise and travel certificates, as well as charge the issuer fees for its activity. The issuer, in turn, sets the redemption rate for merchandise to be as favorable as possible, while still balancing the need to off a rewards program that keeps cardholders happy. This multi-party, somewhat cumbersome, system has been in place for over 20 years and is ripe for disintermediation. The introduction of technology, and blockchain, in particular, seems like an ideal solution.

Blockchain came into popular understanding as the enabling technology powering bitcoin, Ethereum, and other popular cryptocurrencies. The name blockchain refers to how “blocks”, which contains transaction records, are added to a chain. A record of each transaction is added to a block once consensus is achieved by the majority of parties, and when a block of transactions is full, it is added to the chain. All parties can view all records. Blockchain inherently provides a verifiable and auditable history of all information stored on that particular dataset. Blockchain used for most cryptocurrencies are open to any entity wishing to participle, also known as permission-less. However, for a closed-loop rewards program, only those parties involved in the loyalty program, issuers and merchants, would be allowed, or “permissioned”.

Instead of generic points typically associated with most rewards systems, the issuer would deposit the rewards program cryptocurrency into the cardholder’s wallet, which would be immediately available to spend at any of the merchants that accept that cryptocurrency and participate in that closed blockchain. The issuer would no longer need to carry the liability for all unused points on its books. Granted, in this model, issuers would not benefit from “breakage”, which are rewards points held by the issuer that are never redeemed. Deloitte estimates that the reward industry has become accustomed to a 10 percent leakage of rewards that expire and can be written off with no redemption costs. But if the blockchain-based solution reaps more than 10% cost savings overall, then the issuer comes out ahead.

These cost savings come from sweeping changes in the next step – redemption. Specifically, the need for the third-party fulfillment function, along with the associated fees for those services, is eliminated in this model. The cardholder would no longer need to log in to the fulfillment website to redeem points for merchandise or travel. Instead, the rewards currency could be used to purchase from any merchant, e-tailer, travel site or brick and mortar that accepts that rewards currency. Presumably, this would be a closed loop of possibilities, to avoid the problems that merchant consortiums such as Plenti had to deal with. Each merchant would then need to balance their prices, in the rewards cryptocurrency, in order to increase the potential for the cardholder to spend with them, but still maximize profitability. The inefficiencies arising from the issuer paying fees to a third party could be put back towards the issuer’s reward program, the payback for giving up the “breakage”. This, in turn, would allow the issuer to increase its rewards.

The problems associated with cryptocurrencies that keep this topic in the news can be avoided. The rewards currency would not be tradeable on exchanges, thereby eliminating the wild bitcoin-like fluctuations. The blockchain would be permissioned; only card issuers who participate in the program, and merchants who are willing to redeem, could be nodes. This keeps the expense and time delay of each transaction, both of which are notoriously high for bitcoin transactions, to reasonable costs and near-real-time. Rather than expensive proof-of-work or even less-computationally intensive proof-of-stake mining, the participating nodes would perform proof-of-cooperation calculations to maintain the integrity of the transaction. The operational costs associated with running a cryptocurrency exchange, whereby issuers convert fiat dollars into rewards currency to fund the cardholder’s rewards wallet, and where the merchant converts rewards to dollars to purchase an airline ticket, would be a cost borne equally by all participants.

In this next-generation model of card rewards and redemption, the issuer no longer sets redemption ratios, removing any ambiguity as to what a point is worth; merchants price their goods at market rates to encourage purchase, removing hidden markups; and loyalty truly becomes a currency.