The secondary market in gift cards

Patrick McKenzie (patio11)

Gift cards (covered previously in this space) are a form of privately issued money. The U.S. has prior experience with widespread circulation of privately issued money during the free banking era, where “wildcat banks” issued bank notes backed by deposits of precious metals and the general creditworthiness of the bank.

These bank notes were not equal to each other; they traded at discounts to their face value which floated with sentiment about the issuing bank. Newspapers published daily reports of what going market rates were, so businesses could accept them with less risk, and there was a specialized economy of moneychangers in areas where many competing bank notes circulated.

My colleague Sebastian Bensusan at Stripe had a chat with me about gift card marketplaces, a field in which he has substantial professional experience. I was previously aware they existed, but had no idea how deep the rabbit hole went.

Gift cards are, gloriously, privately issued bank notes backed by the full faith and credit of Chipotle.

A sketch of a gift card marketplace

If you’ve never encountered one of these businesses, there are many of them a Google away from you. (I won’t name any in this piece, for social reasons.) They will sell you gift cards at a discount to face value, or buy gift cards from you at a larger discount to face value. They make money on the spread between these two prices.

While they are described as marketplaces, in traditional finance terms they aren’t exchanges but rather are market makers. In the large majority of cases, you are not trading with another person facilitated by the marketplace. You are trading with the marketplace itself, which will trade with another person days before or after trading with you.

There are two really important features of closed loop gift cards which, especially in the United States, uniquely enable this business model.

The first is that gift cards, by regulation, have extremely long expiry periods, cannot be expired, or must be exchangeable for cash at face value, depending on the state. This was instituted to protect consumers from losing money to breakage. This tends to make the cards hold value at least as long as paper currency does (or as long as their issuer is liquid).

The second is that, for user experience reasons, almost all issuers have a website which will, without requiring any sort of account or authentication, allow you to check the balance on a gift card with no information other than the serial number printed on it. This is to allow users to plan their shopping, but it also allows gift card marketplaces (and other participants in the supply chain) to know, with certainty, the value of the thing they are buying and selling, and to update that knowledge in near-real time. (Technologists will correctly predict that there is a fun cat-and-mouse game going on here regarding scraping and that retailers usually do not have sufficient programmers to win it.)

The marketing message of the sites is “Sometimes you get a gift card and it’s just not quite right, perhaps at the wrong store or a bit more than you need. You don’t want to be ungrateful and ask the giver to change it for you. We’ll pay you cash for it or allow you to exchange it for another gift card, for a small fee.”

That has probably happened at least one time in history, but that marketing message could not support an economy in gift card secondary sales, and yet that economy manifestly exists. Sebastian clued me into why.

Successful markets professionalize at least one of demand or supply

A common theme among marketplace startups is that they match two parties, the demand side and supply side, and that often this monetizes “casual” undermonetized assets in the world. Take Airbnb for example: you just happen to have an extra airbed lying around, someone just happens to be in town that week, wouldn’t you both be happier transacting than not if Airbnb could make it easy for you.

A common theme marketplace startups learn as they grow is that casual demand and casual supply are far, far less common than they need to be to support technology companies at typical marketplace take rates (the fees earned on transactions). Kevin Kwok has written about this in far more detail.

So who are the professionals in gift card reselling?

One potential answer is fraudsters, but that is obviously unsatisfactory. A marketplace which doesn’t stay ahead of fraudsters will find itself turned into a money pump, as it pays real money for gift cards, gets paid with stolen credit cards by fraudsters, and then has those purchases reversed by the banks of the defrauded individuals. It’s obvious that a marketplace which doesn’t solve this problem will close doors in a matter of weeks, and indeed fraud management is one of the largest technical and operational concerns of gift card marketplaces.

It turns out that the broader economy contains many individuals and firms which, either through unexpected circumstances or through their own actions, are “naturally long” or “naturally short” gift cards. The naturally long users get far more gift cards than they could ever use personally. The naturally short ones require far more gift cards than they will receive from Santa, even if they’re very, very nice this year.

Where gift cards collect in the economy

Sock drawers, obviously.

No, there are particular individuals and firms who receive a vastly disproportionate number of gift cards.

How do we know? Because, since gift card exchanges need to defang fraud or they will die in weeks, they spend better-than-bank levels of effort on Know Your Customer. This is not because they are specifically required to by regulation but because buying gift cards from an unscrupulous source can see those cards drained after you’ve paid for them.

Cryptocurrency enthusiasts would tell you that simply transferring the number of a gift card doesn’t actually transfer the scarce asset, because the sending party still has the number. The structure of closed loop gift cards requires trust, and that need for trust causes marketplaces to know the business of their suppliers very intimately, and to actually investigate the representations those suppliers make.

Some people receive gift cards as de facto compensation.

For example, an ancient tradition in America is that teachers receive apples and other produce from students on the first day of class. This doesn’t actually happen anymore, but it remains in our cultural memory, so much so that teachers are often associated with the apple (you’ll see a lot of them in e.g. iconography on school supplies).

In the present day, many parents want to “tip” their children’s teachers, but they generally do not do so with cash. It is absolutely verboten in the professional managerial class to accept cash tips; that is the province of cabbies, hair stylists, and restaurant servers. Parents know this, and instead of giving a cash tip might send their child with a holiday card containing a gift card. Sometimes it is explicitly for the use of the teacher; sometimes it is explained as offsetting the cost of classroom supplies. (Many teachers in the United States furnish classroom supplies themselves, at an average cost of around $400 a year. Trust me, in a previous life I sold a lot of bingo card activities to them.)

This can result in teachers getting hundreds or low thousands of dollars of gift cards around the holidays, from a potpourri of stores which do not match their personal consumption needs. So every year, they come in droves to gift card marketplaces to liquidate them.

This is abundantly verifiable by the gift card marketplaces. Mrs. Smith, who represents herself as a teacher from Kansas, may have a Facebook account talking about being a teacher in Kansas, be listed on the website of a school in Kansas, have received a distinguished teacher award from the state of Kansas, and be willing to take a selfie with her last paystub. As any teacher would tell you, there are no stupid questions, not even "Is Mrs. Smith factually a teacher in Kansas?"

A similar example is doormen. In Chicago, where I grew up, it is common practice for residents of buildings with attending staff to give each of those staff a tip at the end of the year. This is apparently also common in New York City. My parents recently lived in a building with one attendant and 90 doors. The typical tip is about $100. You can do the math from there. The doorman earns a substantial portion of his yearly income in the form of tips.

Some tenants make those tips in gift cards, and receiving a substantial portion of one’s annual compensation in a set of unmatched gift cards is inconvenient, so they also turn up to the marketplace in droves.

But individuals are not the primary gift card suppliers. Businesses are.

Businesses which intentionally expose themselves to gift cards they did not issue.

Many people exist in the cash-based economy and at the economic margins of society. Some businesses serve clientele who are composed primarily from that socioeconomic stratum, and they develop strategies to serve them better while making a profit.

Consider the corner bodega, for example. If you go there for a routine purchase, ring up $16.29, and then discover that you only have $15, that might mean you have to return some items. But some bodega owners will ask you “OK, if you don’t have money, what do you have?” And if you have e.g. a $20 Fandango movie theatre gift card, the bodega owner might say “Good enough! See you later.”  (They can, in principle, check the balance in real time using the instructions on the back of the card, or they could just trust someone they’ve known from the neighborhood for years.)

These gift cards go into a drawer for a while, after which the bodega owner sells the “portfolio” in a bulk transaction to a gift card marketplace (or a reseller who will do the same). They have been taking a substantial convenience fee from their customers for this service and will then realize it in cash.

Similarly, pawn shops and currency exchanges are both very prevalent in the economic lives of people in the margins, and a gift card is good for cash at many of them. They also bundle and sell the cards, because they cannot match supply and demand locally in a convenient fashion.

It is worth noting that economic precarity in the United States is generally not characterized by having no access to money, it is characterized by not having consistent access to money. Poor people get and give gifts, too. Gift cards also form part of the economic infrastructure of their neighborhoods. It becomes known that you can text an unbanked relative money by walking into any retailer and buying a gift card in cash, and that they will be able to convert that back into cash in minutes without needing to e.g. show ID that they may not have.

(It is probably also the case that not all of these gift cards are acquired legitimately, but the supermajority of economic activity is legitimate, everywhere.)

Who buys thousands of dollars of gift cards

A few patterns:

Businesses which resell fungible durable goods

Let me sketch a different retailer: a local cell phone kiosk. One important way they make their rent is stocking fungible items where there is perpetually high demand by people who are in a hurry, such as e.g. USB cables or phone chargers.

Where did that item come from? I had always assumed “The store owner has an account with AliExpress and bought a large box of them at $5 each then resold for $20.” It turns out that this is not always the case.

Some stores source their inventory from other retailers. They might drive a few hours from downtown New York City to upstate New York where Best Buy has a collection of perfectly good USB cables available for slightly lower than the market price in New York City. Say, 5% lower. This is classic arbitrage.

They then buy several thousand dollars of USB cables, chargers, etc etc, and drive back down.

This seems like a rough way to make a living, but retail entrepreneurs are often scrappy individuals who will put up with subjectively punishing lifestyles to build lives for their families in America. And they are savvy.

What if, instead of buying from Best Buy for cash, they purchased with a gift card that they got at a 6% discount? That more than doubles their margins. And how are they going to buy that gift card from a marketplace? With the best cash back credit card they can find, of course. Their 5% margins are now 13%, courtesy of other retailers and the payments industry.

And that justifies eight hours in the car followed by weeks of moving USB cables one at a time to stressed businessmen and tourists in Manhattan.

Businesses where inputs are sourced at retail

Home Depot is an interesting case. Many builders and contractors in the U.S. will purchase inputs to their trade, such as e.g. lumber or plumbing fixtures or similar, from Home Depot at retail prices. They might need thousands of dollars of material to do a job, and they might have an agreement with their customer (the client or the general contractor) that they invoice for “time and materials”, with inputs being reimbursed at cost or cost plus a small margin. They may need to show receipts.

Home Depot accepts Home Depot gift cards at par, and will print this on receipts. If you buy $1,000 worth of lumber, you get a receipt saying that you bought $1,000 worth of lumber. If you actually paid $940 for the gift cards that you made the purchase with, you conjure $60 of margin (worth perhaps an hour of your labor) for a few minutes of playing the gift card game.

And if you ever buy $1,000 of lumber… you probably buy an awful lot of lumber over the course of a year.

A lot of Home Depot gift cards are issued to people who e.g. want Dad to have something for his hobby projects, but they end up getting redeemed by business owners in the trades.

Consumers who are stacking discounts

There exists a calendar in clothing, based on seasons, fashion trends, and inventory management needs of stores. Some savvy shoppers, who prioritize price rather than trendiness, are acutely aware of this calendar, and plan for it in advance.

Most discounts in retailing do not stack. Gift cards, however, very much do stack with retailer-provided gift cards. $100 of H&M’s private money is worth $100 of trendy shirts at sticker price or $200+ if e.g. cashed in during the Labor Day sale.

Because clothes are extremely difficult to resell (they are not fungible due to sizes, there are real and perceived cleanliness issues, etc), professionals will not generally source their own clothing inventory at retail. Because clothes are produced at extremely attractive margins (East Asian manufacturing complex go brrrrr), retailers can offer extremely generous discounts at some points during their annual calendar.

This combination causes gift cards of specialty clothing shops to generally sell at large discounts, but be worth a multiple of that discount if used savvily. And so savvy hobbyist shoppers might buy $1,000 face value of gift cards for $600 and turn that into $3,000 of clothes (at sticker price).

Note that this introduces some interesting inventory risk, for the cards not the clothes. Cards enter the system at gift giving holidays like e.g. Christmas, but inventory liquidations are not tied to the gift giving calendar, they’re tied to the retailer operational calendar. So the system accumulates gift cards at Christmas and then discharges them (for a profit) around e.g. Labor Day. (Labor Day marks the “end of summer” in the United States and will typically see retailers liquidate their summer inventory in favor of fall/winter inventory.)

The markets are extremely efficient

If you’re wondering why gift card marketplaces show different discounts for different cards, the above factors are why. Natural supply/demand mismatch is very different depending on retailer-specific factors, and that will influence which cards trade at tight discounts and which trade at wide discounts.

The marketplaces also exist in frothy competition with each other. There is no pretense of customer loyalty, on either buyer or supplier sides. They’re in it for the best offer they can get, and (because both buyers and sellers are largely professionals) they comparison shop. This turns the market into a ruthlessly efficient outpost of finance, like e.g. routing stock trades, instead of something like e.g. bank deposits where many consumers are happy receiving less interest in order to have a branch closer to their home, a teller they have a rapport with, or a color scheme they find attractive.

So why aren’t these markets even larger and more important to the overall economy? Because they are acutely supply constrained.

There will always be a buyer for a dollar sold at 95 cents.

Issuing businesses, though, have very limited incentive to encourage their cards to end up on marketplaces. (“Your opportunity is my margin!”, they might think, misquoting Bezos to their own purposes.)

There are a few closed loop card programs which find it rational to sell large blocks of gift cards at a very modest discount to the marketplaces, but it is a Faustian bargain for the marketplaces. If they’d make that deal with you, they’d make it with anyone, and so your competitive advantage disappears on half of each trade. You’re left with trying to win business on the retail side, where you exist in perfect, fratricidal competition with your peers.

There is also, fascinatingly, a metamarket, where aggregator sites attempt to step higher up in the purchasing funnel (by out-SEOing the marketplaces for e.g. “cheapest Starbucks gift card”), then list the marketplaces. They will, of course, want a cut of the action, and that causes marketplaces to bid down their margins to basis points.

Success as a marketplace involves attempting to attract as many natural accumulators of cards as possible, while avoiding fraudsters, and there just aren’t that many cards escaping into the secondary market as there are people who’d prefer to buy a dollar at a discount.

But there is still enough of an opportunity to support a thriving ecosystem, piggybacking on the marketing needs of retailers, the liquidity needs of consumers at the economic margins, the social anxieties of the American professional managerial class, and the relative difficulty of sending money to a friend via text message.

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