Card Network Fees and Interchange Flow over a Four-Party System
The figure below illustrates a typical transaction over a four-party system.
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.
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.