Wednesday, June 18, 2008

The Ubiquity of Interchange Fees

I am very pleased to join the Commercial Law Blog as a guest, blogging about credit card payments. Before discussing the economic effects of current fee structures and how card pricing might be improved, this post lays some groundwork, suggesting that these fees are best understood as the portion of the merchant discount fee that a credit card system uses to support card issuing. Viewed in this way, all credit card systems in the United States charge the economic equivalent of interchange fees.

Back in the early days of credit cards, virtually all banks in the associations both issued cards and signed merchants to accept them, a function known as merchant acquiring. The systems then required that the entire merchant fee go to the issuing bank. Over time, this fee structure, channeling all revenue to the issuer, did not provide sufficient incentives to add merchants to the network. To remedy the problem, the two bank associations that became Visa and MasterCard adopted a system-wide formula for dividing the merchant fees between issuers and acquirers.

Functionally, acquirers paid merchants a discounted price for credit card paper and then sold that paper to the card-issuing bank at a somewhat lower discount. The total merchant fee came to be called the “merchant discount” and the portion passed on to the card-issuing bank was labeled the “interchange reimbursement fee.” The amount retained by the acquirer never got a formal name, but might have been called the short-end-of-the-stick fee. From early on, interchange raised antitrust concern because it enabled card-issuing banks to avoid competition on the fees that they effectively charged to merchants. Nevertheless, it has withstood legal challenge for more than three decades.

Over the years, the interchange fee has evolved. Although Visa’s and MasterCard’s fees differ in some ways, they have both followed a similar path. Initially, each charged a single fee to all merchants. In the 1980s, the associations developed separate fees for paper and electronic transactions. The 1990s brought different fees for certain merchant types, as the systems sought to bring in lower margin retailers such as supermarkets. They also added a separate fee for situations in which the magnetic stripe could not be swiped, reflecting perceived fraud risks. Today, interchange fee schedules are a complex array of charges that vary depending upon the type of merchant and its card sales volume, the type of transaction, and the type of card used. The most significant factor may now be what one might term the incremental reward fee, a higher interchange fee that applies when a customer uses a card that rebates cash, awards airline miles, or provides some other benefit for using the card. In addition, as technology has improved and merchant acquiring has become more competitive, acquirers have reduced their margins at the same time that the systems have increased interchange fees. As a result, the percentage of the merchant discount paid to issuers has increased.

Because the phrase interchange fee was created by the bank-card associations, and antitrust challenges -- including the on-going merchant litigation -- principally attack the lack of competition among Visa and MasterCard issuers, it is often assumed that the economic implications of interchange are limited to the bank card associations. But that isn’t true. Although American Express and Discover do not have a formal interchange fee, they have the functional equivalent: A merchant fee that exceeds the marginal cost of providing the retailer with card-acceptance services plus normal profit.

The four-party (issuer/cardholder & acquirer/merchant) nature of a Visa or MasterCard transaction makes this economic equivalence in fee structure apparent. Visa/MasterCard acquirers now operate profitably on about one quarter of the merchant discount that they take from retailers, passing the remaining three quarters to card issuers. Three-party systems (joint issuer-acquirer/cardholder/merchant), such as American Express and Discover, charge merchant fees that exceed substantially the revenue that Visa and MasterCard acquirers retain. Surely, the three-party systems, like Visa and MasterCard banks, use this excess merchant revenue to stimulate card use. For example, American Express now uses some of its merchant revenue to pay banks to issue AmEx cards. Although the percentage of the merchant fee used to support card issuing varies across systems, in all cases more than half of what retailers pay probably supports card issuing. Next time, I will blog about the economic effects of generating revenue from merchants that is used to stimulate card use.


David Watts said...

What is a "normal profit?" Why shouldn't American Express and Discover be able to charge fees at the level that they believe will maximize profit, even if it substantialy exceeds their marginal cost? If they don't deliver value to merchants in excess of the fees, merchants will stop accepting the card.

Dan Stiel said...

My recommendation is to mandate card issuers to disclose the cost of interchange to their cardholders (e.g., Reg. Z, Schumer boxes, Reg. E, etc.), and allow/enable merchants to pass along interchange costs in the form of a surcharge at the point-of-sale.

With surcharging, consumers will then be empowered to choose the form of payment most relevant to them - be it low cost or extravagant perks. Merchants will be empowered to accept all forms of payment in an egalitarian method.

The visibility of interchange cost will invariably result in lower costs to the consumer, as card issuers will be motivated to lower their costs to remain competitive, without government intervention in pricing controls.

Banks and card networks already allow surcharging for "foreign" ATM transactions, so it will not be an insurmountable paradigm shift.

While there will be a significant amount of development work for networks and merchant acquirers to build the tables to pass along the surcharge, the probable savings to merchants will reach into the billions of dollars annually, and will drive motivation to get it done.

Anonymous said...

The most interesting thing in all this is that merchants must be getting some value from taking cards or they never would have taken them to begin with. Another sign of this is that American Express and discover charge on average 3% + $0.25 acquisition cost for taking the cards, while Visa is significantly lower with a 1-2% interchange and typical 0.5% acquisition cost, but merchants jump all over that.

Credit/debit card acceptance is the number one way to tap into people with money since the demographics for card users are higher paid, and educated purchasers. Thats why merchants take them.

Before we start trying to remove the fee we should evaluate why it is there, and that is because merchants have volunteered to pay it and consumers love the free perks they get on their cards when they use them.