The economics of interchange fees

There is a new paper by Todd Zywicki, which, due to my quick trip to Trento, I have not had time to read:

Fresh off of the most substantial national liquidity crisis of the last generation and the enactment of sweeping credit card regulation in the form of the Credit CARD Act, Congress continues to deliberate, with a continuing drumbeat of support from lobbyists, a set of new regulations for credit card companies. These proposals, offered in the name of consumer protection, seek to constrain the setting of “interchange fees”– transaction charges integral to payment card systems–through a range of proposed political interventions. This article identifies both the theoretical and actual failings of such regulation. Payment cards are a secure,  inexpensive, welfare-increasing payment mechanism largely unlike any other in history. Rather than increasing consumer welfare in any meaningful sense, interchange fee legislation represents an attempt by some merchants to shift costs away from their businesses and onto card issuing banks and cardholders. In particular, bank-issued credit cards offer a dramatic improvement in the efficiency and availability of consumer credit by shifting credit risk from merchants onto banks in exchange for the cost of the interchange fee–currently averaging less than 2% of purchase value. Merchants’ efforts to cabin these fees would harm not only consumers but also the merchants themselves as commerce would depend more heavily on less-efficient paperbased payment systems. The consequence of interchange fee legislation, as Australia’s experiment with such regulation demonstrates, would be reduced access to credit, higher interest rates for consumers, and the return of the much-loathed annual fee for credit cards. Interchange fee regulation threatens to constrain credit for consumers and small businesses as the American economy begins to convalesce from a serious “credit crunch,” and should be accordingly rejected.


Interchange fees are essentially a private tax in a monopolistic setting, complete with deadweight losses.

The paper cited doesn't adequately address these issues.

Or maybe I'm not right. You CAN give a discount for cash, but CAN'T charge more for credit cards. Who the hell knows what that means? It's probably intended to be confusing.


I'll take the nickel back.

Here is the rest of the citation you omitted: "However, businesses are allowed by law to offer a discount for purchases made by cash or check. Check your bankcard agreement to see what it says regarding these transactions."

Oh, but they can't give the cash discount because of the Visa/Mastercard rules.

The surcharge rules are there because consumers would see one price, and be charged another.

Hmm...I never thought of those fees as a compensation for risk. It makes sense since the credit card network pays the merchant before the customer pays the bank. I always visualized the fees as a convenience surcharge for rapidly getting the money into the merchant's bank account.

I.e., the network puts money into the merchant's bank accounts nearly immediately, why money from checks needs to wait to clear before the money shows up in the merchant's account, and cash can easily walk out the door.

We accept credit cards, including corporate and government cards. The highest rates charged to us, between 2.96% and 3.96%, are charged for corporate and government cards. All government and many corporate cards are categorized as "non-qualified" and charged at 2.96%.

Reward cards and some corporate cards are charged at 3.96%

The "regular" rate for "qualified" cards for similar transactions for us is 1.99%.

Where is the "risk" that justifies a higher rate for government cards? (The reward card rate at least makes some "sense" as the merchant is paying for the reward, not the person/company using the reward card....) Without doing any research we concluded that the card issuers are giving a rebate (reward) for credit card usage to GSA, or charging GSA a higher rate because GSA didn't negotiate well and GSA doesn't bear the burden of the higher rate.

And when dealing with the government and some corps, you effectively have no choice but to accept the credit card. Many government agencies will not issue checks and many of the employees have no clue how EFT/ACH works.

Regardless, these higher rates are factored into all prices and the higher price is charged to all customers, not just government and reward card users. Including those that pay with checks (very few b2b and b2g firms accept cash, as many transactions are larger and not done in person).

Andrew and Bill, it's hard to assess the current SYSTEMS OF PAYMENTS because of the many rules regulating services and because there is too much credit involved in how the accounting system of payments today works. To assess them you have first to outline the main features of the best combination of accounting and monetary systems of payments and one of those features is the separation of the service of payment from the service of credit. Indeed, this separation has always been the main advantage of a monetary system of payment (any payment with "money" is final in the sense that there is no credit involved, as when you use a five dollar bill to pay for your coffee). In an accounting system of payment modern technology allows to separate the two services-- as when you pay by transferring funds via internet to a seller that has an account with your bank. Unfortunately modern technology is not yet used as much as possible for a number of reasons, most related to profits that can be made by NOT separating the two services (profits that are partly/largely the result of barriers to entry). In my view the best combination of the two systems of payments is one in which small amounts can be paid by "money" (the largest denomination must be $20, and in a decade it has to be reduced to $10) whereas the accounting system can be used to pay for all transactions but cannot provide credit (credits and debits to accounts of parties to a transaction must be immediate and completed simultaneously --that is, the payments must be real-time payments). The challenge is how to organize this accounting system of payments worldwide.

Please note that some rules that today regulate the accounting system of payments are due to the provision of credit. To discuss the current system, first we need to identify which rules are related to each of the two services.

Note: I have not read this paper yet, either, so it is possible that some of these issues are considered there. In addition to the huge and purposeful confusion related to how and when merchants can offer discounts for cash, I think the following issues are important:

1) It sounds like the paper is making the claim that the 2% charge covers all of the credit risk here, but that sounds truly weird given that we know recently banks have lost a *lot* of money on bad credit card debt and that, of course, banks charge substantial interest, and add a series of penalties and fees to the bills of many consumers. I think it is naive to suggest that the merchant charges are being made so that the banks can absorb the credit risk. The charges are there because the banks can get away with charging them.

2) The article suggests that if the banks couldn't get this merchant fee, that they would need to make credit less available, charge higher interest rates, or add back annual fees. What it doesn't say is that, within the limits of what the law enables them to do, they are going to have to do most or all of these things anyway, given that their current loss rates on consumer credit appear to be unsustainable, at least for some groups of debtors. Is there really a good argument to be made for further expanding consumer credit in the current environment?

3) I have substantial sympathy with the notion that Congress, when it dabbles in issues like this, tends to mess things up. But I think it is important to note that banks played a considerable role in rewriting many statutes affecting them in the past 10-15 years, and the recent results do not give me great confidence in non-regulated scenarios, either.

I'm not certain that whether regulation is needed or not, but the situation would certainly seem a candidate for regulation.

In a competitive environment, prices tend to be a function of costs (otherwise someone undercuts you). Given that prices of interchange fees have been going up as data processing fees have been going down, it's pretty clear this is not a competitive market. Given that the person buying the service is not the person paying, this is scarcely surprising.

Whether this merits regulation is a different, and rather more complicated question.

This is a whack a mole issue as to fees.

In network industries--characterized by nodes of a distribution system in which each node is both a supplier and a buyer and charges fees for access or for distribution--you squeeze one place and the other place pops up.

One of the issues here, though, is assymetrical bargaining power that is a result of past Visa/Mastercard restrictions.

I don't think mandating limits on interchange fees is the answer just on regulatory imperfection grounds, and I am happy to let the antitrust consent decrees and other conduct oriented relief take its course first. If that fails to introduce competition, then you need to assess all options.

You will also notice that legislative proposals such as this often occur at the end of the legislative season, and at a time when it is unlikely anything would be passed.

But, it is good for headlines. And probably support from local merchants so you can say "I feel your pain."

And, evidently it is good for academic papers.

The only thing I know for sure is that IF the Congress acts, there will be unintended consequences that will enrich trial lawyers.

Xmas: "I always visualized the fees as a convenience surcharge for rapidly getting the money into the merchant's bank account."

Last I checked it takes a three full business days before a typical merchant gets a deposit for a given days credit and debit card transactions.

There are a lot more effective things that Congress could do than regulate interchange fees. In the age of the Internet it could direct the development of standards for payment terminals and interchange networks such that any terminal could accept a card from any network, up to some interchange fee limit specified by the merchant.

Cash discounts are helpful, but they do not really engender price competition between card networks, because the discount necessarily has nothing to do with which card is not being used.

Ultimately though this is a third party payer problem that is the reverse of that for something like title insurance. The party making the choice of the card type and the party paying the interchange fee are not the same, leading to poor competition.

So it would seem that the most effective thing to do would be to allow merchants to charge a portion of the interchange fees as a surcharge on the receipt, similar to the way sales tax is handled. Then there would be a healthy market where consumers would seek out banks and credit card companies that charged the lowest interchange fees.

One further step would be to develop a standard for payment cards such that a bank could switch interchange networks without reissuing all its existing cards. A system such as DNSSEC could be used by the payment terminal / merchant bank to determine which interchange network to use for card authorization and settlement services.

First, to the guy who talked about paying Non-qualified fees of nearly 3% for the business and government cards - do yourself a favor and get an interchange-plus credit card processing contract - -- your processor is building extra markup into the downgrades, the wholesale rate is only ~2.2% for those transactions - go look at the visa interchange rate schedule -

There is very little fraud / chargeback risk to the issuing bank (the party that receives interchange revenues) in credit card processing. If there is a loss / chargeback the liability is first to the merchant, second to the acquirer, third to the acquirer's bank, finally to the issuing bank. A big acquirer, Heartland Payments, includes their losses in their 10-k -- they are about 0.45% of their net revenue -- or about .002% of the total discount rate inclusive of interchange (assumed 2.5% cumulative discount rate and 0.5% net revenue to the acquirer).

The issuing banks also bear risk that their customers won't pay their bill, but the interest rates and fees they charge those consumers should (and are) be set to justify that risk.

I don't want to see more regulation, but v/mc and their member banks are acting in a monopolistic fashion.

Zywicki is one of the most doctrinaire voices there.

That's why I'm reading this thread. I don't think Z. believes that business can do any wrong, because if it does, that's not "wrong," that's "the market."

I would like to address the post by q.

You should NOT be paying these high rates for GSA and commercial card transactions. Your merchant account is not set up correctly.

GSA, purchasing, corporate and business cards, including card not present transactions, can qualify for incentive Interchange rates (Visa calls it Level 3, MC calls it Data Rate 3). They offer even lower Interchange rates for large ticket transactions.

No merchant should pay non-qualified surcharges for corporate or rewards cards. But this is especially true for B2B and B2G merchants who must insist on a direct Interchange pass-through rate structure and specifically shop for a Level 3 merchant account.

There are lots of resources on the web. Keyword search "level 3 merchant services" or "merchant Interchange rate quote. "

Andrew- You're viewing the problem the wrong way if you don't think there's a monopoly- sure you can avoid using a credit card- but what's your incentive- to save a merchant 2%? The evil brilliance of the credit card interchange fee model is that the merchant simply passes on that 2% to consumers- all consumers, not simply credit card ones. Thus, a consumers marginal benefit for using cash is virtually zero- and the consumer is the one deciding which form of payment to make. The merchant may benefit, but h

Merchants dislike the fees because the bank takes 2% of their profit- but I assure you that the merchants simply pass on as much of those costs as they can on to consumers. Which is most of the fee, since the costs all merchants have the same 2% fee to deal with there's no reason for the merchants to compete on price there(there's the monopoly- no merchant can reasonably refuse to accept credit cards, its too much business they're giving up)- plus these costs are completely hidden and a merchant is contractually forbidden from directly charging credit card using consumers the interchange fee. As a consumer you can't use cash as a alternative to credit cards and avoid interchange fees- interchange fees are passed on to both credit card and non-credit card using consumers.

Interchange fees benefit only the merchant.

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