Following last week’s blog, where we discussed the basics of interchange fees – what they are and why they are controversial – we will now focus on possible ways in which they will evolve as all parties involved – regulators, merchants, issuing & acquiring banks, networks and consumers – seek to improve card payments systems.

All of the options being considered aim to solve one or more of the reasons why interchange fees are controversial (list included in previous blog).  Below I list a number of these options:

1)   Do nothing.  It would only make sense to change the status quo if we can ensure that the resulting outcome will be more efficient.  It is very difficult to develop this type of quantitative ‘proof’ given the complexity of the system, so how can we determine the best alternative if we cannot measure and compare the different outcomes?

2)   Further enable differential pricing across payment methods (affecting the no-surcharge rule).  When considering this alternative, it is important to remember that most merchants in countries (or states within the US) that are already allowed to apply differential pricing have chosen not to do so.  The reason for this is probably the unknown effect it has on sales.  If faced with higher prices at a store to use, for example, an AmEx card, will the consumer just use a different card (if he does indeed have another card)?  Will he go to another store instead?  How many impulse purchases will be lost?  There may be too many unknowns for retailers to feel comfortable with experimentation, particularly within the current economic environment.

3)   Allow bank / merchant determination of interchange fees.  This option would (a) eliminate anti-competitive concerns (external third party setting up fees in a way that may encourage higher prices) and (b) allow large merchants to leverage their size in negotiations, potentially giving consumers a more efficient system. 
The main draw-back would be complexity – Each issuer would, potentially, need to negotiate fees with each merchant, raising the number of contracts each issuer needs to manage into the thousands.  The same would be true for each merchant.

4)   Regulate fee level.  Given that the general perception is that interchange fees are too high, this option would probably equate to lowering them.  The problem the regulators would face is the same banks and merchants are struggling with today:  How to set this level so as to ensure that it reflects benefits / costs borne by the parties?  What level will make the credit card system most efficient and beneficial for the consumer (for example, in the way it would affect acceptance and rewards)?

5)   Relax card acceptance requirements (affecting the honor-all-cards rule).  The honor-all-cards rule has become very controversial in the last few years as the networks have introduced premium cards that have higher interchange fees attached.   It could make sense to allow merchants to decide which cards, within each network, they wish to accept. 
The main issue is that we could run into similar problems as those described in the second option above:  What would a consumer do if his preferred card is not accepted at a store?  How much would be lost in sales?  Furthermore, how can a merchant describe the credit card programs it does and does not accept in a way easily understandable to consumers?

6)   Allow multi-bugged cards.  The idea in this case is to provide consumers with one card that connects to all networks.  Then, at the point of sale, based on the specific purchase, the retailer will choose the best network (probably cheapest) to carry out this transaction.  It would mean each issuer would need to enter contracts with multiple networks.
This option may be the one that will result in the most efficient outcome since it allows for direct competition among networks at the point of sale.  At the same time, it would be difficult to implement.  For example:  What info would the merchant provide to the consumer regarding routing (or would it not be relevant)?  What logos would the card carry?  Would this result in less brand recognition for networks and therefore fewer incentives to innovate?

Whatever option is taken, except for the ‘Do nothing’ alternative, change will come slowly since:

1)   The effects need to be detailed and quantified:  Because of the number of players and the complex relations among them, any change will have numerous implications, some of which are difficult to anticipate. 
Also, up to this point, regulators and industry players, have been able to describe some of the qualitative effects of these changes but have had difficulties in creating credible and comprehensive quantitative models.

2)   Revenues – whether more or less – need to be re-distributed.  As we have previously discussed, interchange fees are meant to reflect the benefits of the merchants and acquiring banks while covering the expenses of the issuing banks.  Both things are extremely difficult to measure – some may even argue impossible to measure.  How then should a new revenue and fee structure be built? 

3)   Three-party networks and debit-card transactions also need to be included in the conversation.  So far, the conversation has focused on four-party credit card networks but the full spectrum of payment options should be included in the conversation to avoid networks migrating from more to less regulated service options. 
Furthermore, with new payment systems constantly being developed, any new rules and regulations should be flexible enough to allow for new options and challenges.

Interchange fees are a controversial topic.  Changes will be implemented slowly given the difficulty in determining the cost / benefit the credit card structure provides to issuers and merchants and in quantifying the effects of any change.  Controversy is here to stay!

Sources:
1)  'Payments Systems in the U.S. - A Guide for the Payments Professional' by C. Coye Benson and Scott Loftesness.  Glenbrook Payment Essentials.
2)  'Finance and Economics Discussion Series.  Division of Research & Statistics and Monetary Affairs.  Federal Reserve Board, Washington, D.C. - Interchange Fees and Payment Card Networks:  Economics, Industry Developments, and Policy Issues' by Robin A. Prager, Mark D. Manuszak, Elizabeth K. Kiser and Ron Borzekowski.
3)  'Theory of Credit Card Networks:  A Survey of the Literature' by Sujit Chakravorti from the Federal Reserve Bank of Chicago.
4)  'Working Paper 03-10.  An Introduction to the Economics of Payment card Networks' by Robert M. Hunt from the Federal Reserve Bank of Philadelphia

One of the most controversial fees within the four-party card system is the interchange fee.  In the next few paragraphs we will review what interchange fees are, why they are in place and ways in which they may evolve in the future.



Card Network Fees and Interchange Flow over a Four-Party System

The figure below illustrates a typical transaction over a four-party system.

Note to Illustration: There are other fees charged by the acquirer, issuer and network that are paid on a regular basis (monthly or yearly) not included in this illustration and not discussed in this blog.

Edit (06.10.2012) - Note II to Illustration:  Interchange fees flow from the Acquirer to the Issuer through the Network, without the Network keeping any part of it.

Focusing on the fees involved in every payment card transaction:  
1)  Interchange fee:  Interchange flows from the acquiring bank to the issuing bank on purchase transactions and is entirely covered by the merchant (main element of the merchant discount fee).  Interchange is applied on a transaction-by-transaction bases and depends on many variables including the purchase amount, card type and merchant type.  

The rationale for this fee rests on the concept that the merchant (and the acquiring bank) benefits from the use of the card; meanwhile the card issuer incurs costs in making this use possible.  With interchange, the merchant, as the beneficiary of the service, compensates the issuer for the costs and expenses it incurs to generate this benefit.  

2)  Switch (or assessment) fee:  Fees paid by the acquirer and issuer to the network on each transaction.  These fees will cover the real-time authorization and the end-of-day (or batch) clearing/settlement of the transaction.

3)  Card usage fee:  In some cases consumers pay fees in card transactions to receive rewards.

4)  Merchant discount fee:  Acquirers typically quote prices to merchants based on 'interchange plus' pricing.  This means that interchange fees, along with card network switch fees, are passed through to the merchant with the acquirer's additional fees priced on top.  Interchange fees can account for over 80% of the merchant discount fee.  

Why is Interchange controversial?

Although the arguments are complex, some of the key points to consider are:

1)  Interchange are non-negotiable fees paid by the acquirer to the issuer and set by the network.  Fees will vary based on a number of factors including type and size of merchant, size of purchase and type of card (refer to the graph below).  The fact that the fees are defined and enforced by a third-party raises pricing concerns.     

2)  Once a merchant agrees to accept cards from a certain network, it will need to accept all cards (honor-all-cards rule) and cannot surcharge (no-surcharge rule).  

This means the merchant will need to cover all levels of interchange fees (i.e. fees associated with premium and standard credit cards and also signature and PIN debit cards) and will not be able to use surcharge to modify customer behavior by directing them towards cheaper (and more efficient) methods of payment. 

Edit (06/10/2012):  This rule has been softened in recent years in some states across the US and some countries across the world (such as The Netherlands and Australia).  It is interesting to note that, in most countries where the rule has changed, few merchants have taken the opportunity to apply surcharges in an attempt to influence customer behavior. It may be that customers’ expectations with regards to card usage are so ingrained that retailers fear a backslash.  For example, if faced with higher prices at a store to use, for example, a MasterCard card, will the consumer just use a different card (if he does indeed have another card)?  Will he look for it at another store?  How many impulse purchases will be lost?  There may be too many unknowns for retailers to feel comfortable with experimentation, particularly within the current economic environment.

3)   Although interchange is independent of the issuer, it is meant to help issuer costs and expenses associated with the provision of the service that are difficult to measure and that will be different for each issuer.  Examples of the costs / expenses it is meant to cover:

a.  Cost of guarantee - Payment to the merchant is guaranteed.
b.  Cost of funds - The merchant receives payment before the issuer does.
c.  Operating expenses.
d.  Marketing:  Main costs relate to reward programs.

4)   Interchange should also be in-line with the benefit the merchant receives from the use of the cards (i.e. increased number of transactions and ticket size), which is also difficult to measure.

5)   The network competition for issuance leads to rising, rather than falling, interchange prices. 
Although for a network to be successful it needs to have consumers and merchants on board, it views the consumers as the key drivers in network expansion.  For this reason, it values issuers, with their distribution capabilities, as its key customers. 
With interchange, the network’s customers (the issuing banks that decide which network to use) receive the price that the network sets.  That is, the network's customer is paid, rather than pays, for the service. 
In order to attract more issuers, the network will raise interchange fees, so that banks can develop more attractive card programs.  This will immediately increase the cost for merchants.

Next week we will cover possible policy interventions for the payment cards industry to solve the issues surrounding interchange fees.  The list of options we will discuss include actions taken and / or discussed by authorities around the world.



Sources:
1)  'Payments Systems in the U.S. - A Guide for the Payments Professional' by C. Coye Benson and Scott Loftesness.  Glenbrook Payment Essentials.
2)  'Finance and Economics Discussion Series.  Division of Research & Statistics and Monetary Affairs.  Federal Reserve Board, Washington, D.C. - Interchange Fees and Payment Card Networks:  Economics, Industry Developments, and Policy Issues' by Robin A. Prager, Mark D. Manuszak, Elizabeth K. Kiser and Ron Borzekowski.
3)  'Theory of Credit Card Networks:  A Survey of the Literature' by Sujit Chakravorti from the Federal Reserve Bank of Chicago.
4)  'Working Paper 03-10.  An Introduction to the Economics of Payment card Networks' by Robert M. Hunt from the Federal Reserve Bank of Philadelphia.