The Interchange Conundrum: A Novel Solution

October 2023

Introduction

For the last several decades the notion that the US payment system’s interchange structure is broken has drawn passionate arguments from many in the payments world. The recent re-introduction of the Credit Card Competition Act  (CCCA) has stoked this fire with heated arguments both in favor and in opposition. There is much heat but less light, which prompted a payment geek to write this paper.

I argue the system is indeed broken and offer a solution to fix it. I start with a short (and simplified) overview of payment transaction flow and participants to help readers understand the basics. I then determine if the existing US payments framework is “broken” and, if so, articulate what aspects are broken and why. Finally, I suggest a solution to resolve the major issues driving the heated discussions while maintaining the existing economics for participants. 

I believe a competitive marketplace in payment allows for the best results for all parties. I also believe that, with respect to Visa and Mastercard, the US does not have such a system today, which causes imbalances that limit competition. The proposed solution would increase competition by allowing merchants to shift the cost of rewards cards to consumers using and benefiting from such cards who can then choose what payment product they wish to use.

This paper will explain the thinking behind the proposal.

It is important to note that this paper draws on expertise from all sides of the payments ecosystem.  My experience comprises work on the issuing, network, and acquiring parts of the payments ecosystem, as well as consulting with firms on payment-related issues.  To develop this paper and vet the ideas I worked closely with a long-time retailer as well as a co-brand card issuer. This article is the product of that dialogue and thoughtful consideration of each other’s perspectives.

Background

The US payments system with Visa and Mastercard (V/MC) is complicated with many entities taking part, but it has 5 major participants. They are:

  1. The cardholding customer
  2. The card-issuing bank, which provides payment cards to the customer. 
  3. The card networks (V/MC). The networks:
    1. Connect card issuers with merchant acquirers
    2. Set rules governing how all parties work together (including what they can and cannot do and managing disputes between the parties)
    3. Set Interchange, assessments, and fee pricing (more on this later) 
  4. The merchant acquiring bank, which contracts with merchants to accept card payments
  5. The merchant that accepts cards for payment

To make payments happen, money and information flow between the parties. The following is a highly simplified representation of the parties and flows.

Source: David True

I use the term “card networks” to refer to Visa and Mastercard because they are the dominant payment networks in the US. In 2020 nearly 49% of adult Americans had a Visa card and 39% a Mastercard; they are accepted at approximately 10.7 million U.S. locations in 2019. Further, Americans increasingly prefer to pay with credit or debit cards, as the below chart from the Federal Reserve shows. 

Source: https://www.federalreserve.gov/paymentsystems/fr-payments-study.htm

In short, Americans like to pay with credit and debit cards, that preference is increasing, and V/MC are the most-used networks; merchants must accept these cards if they are to remain viable. 

Now, let’s think about merchants. Their first priority is sales, and since customers want to pay with credit and debit cards, the vast majority of merchants have to accept them; as more and more commerce shifts away from physical stores, the option for accepting only cash disappears. If you accept cards for payment, you might choose not to accept American Express or Discover, but you must accept Visa and Mastercard debit and credit cards. 

This situation gives Visa and Mastercard duopolistic power in the US; they dominate the payment card market, and merchants, with vanishingly few exceptions, have to accept them. This duopolistic power makes for a strong business model: Visa and Mastercard net margins were 51% and 46%, respectively, in 2021. Merchants, in contrast, have much lower margins, rarely over 5% in retail. 

Competition

Consumers have a choice when it comes to card payments. They can choose from credit cards issued by more than 80 banks and debit cards from almost any bank or credit union, and they can choose among cards based on many features including rewards. Some cards offer reward points, some cards offer cash back, and some cards have no rewards at all: there are so many different kinds of cards that services exist to help customers find the card that best suits their needs. 

Indeed, there is competition throughout the US payments ecosystem:

  1. Competition by issuers for cardholders. There is fierce competition for consumers to accept a specific issuer’s payment card. This can be seen in the form of direct solicitation in both the physical and digital realms and takes the form of direct mail, email, website offers, offers via social media, and much more. Consumers can base their choice of cards on many other competitive factors such as introductory APRs, standard APRs, annual fees, personalized cards and much, much more – in short, competition between issuers to attract and maintain consumers in their card programs is robust.
  2. Competition by merchant acquirers. Merchant acquiring is a profitable business on its own, and acquirers aggressively compete to sign merchants, both through their own sales forces and through a vast network of Independent Sales Organizations (ISOs) and sales agents. This is evidenced by 2,791 US Independent Sales Organizations listed by Visa.
  3. Competition by Card Networks for Issuers. An industry of consultants exists for the purpose of helping issuers evaluate competing proposals from Visa and Mastercard for their debit and credit card issuing business – these range from McKinsey to boutique consultancies.

What’s missing? Competition between card networks to attract merchants. There is none. And as shown elsewhere in this paper, merchants have little choice but to accept V/MC.

Card Acceptance Costs

Every business has costs, and someone has to pay. In the payment card world, the costs are known as the “merchant discount”, or “swipe fees”, and it is the merchant that pays them. 

The merchant discount has 3 components, listed below with directional magnitudes:

  1. Interchange is the largest portion, around 70% of the total. This is set by V/MC, and paid to the issuing bank. It is always the largest part of the merchant discount; the actual % of the total will depend on several factors including the type of card being used and the terms negotiated between the merchant and merchant acquirer
  2. Fees and Assessments, also set by V/MC, are about 10% of that total and are kept by V/MC. 
  3. Acquiring Fees, make up the remaining 20%. They are set, and kept by, the acquiring bank.

Source: David True

In short, about 80% of the total amount paid by the merchant is set by Visa and Mastercard, with most of that being interchange. Unless you are one of the largest merchants in the country, these fees cannot be negotiated. So more than 99% of merchants have to accept whatever fees V/MC charge.

That is frustrating. More frustrating is that interchange fees vary depending on multiple factors, including the type of payment card used and whether the transaction is in person or online. 

For example, a rewards card costs a merchant more than a non-rewards card. So if a merchant’s customers begin to pay with more rewards cards, the merchant’s card acceptance costs will increase. If the merchant starts selling online, card acceptance costs will increase even more. Moreover, costs are not transparent: most merchants have no idea what their card acceptance costs are until they receive their monthly statements. 

One point that is clear from this arrangement: rewards cards cost the merchants more. Thus every merchant is paying for programs offered by bank issuers to attract new customers, programs that ultimately benefit the cardholding consumer. Viewed another way, a grocery store pays for airline points that reward the consumer and help the issuer. And the grocery store cannot do anything about it.

For example, a customer purchasing the same goods and services from the same merchant may unknowingly add costs of $0.26 or $2.50 into the system through the choice of payment (regulated debit card or rewards credit card). Debit users are in fact paying for the high rewards credit card users as merchants are unable to target specific card types with surcharges proportional to the cost of acceptance and therefore must uniformly raise prices for all customers to account for the higher rewards card costs.

If this doesn’t seem fair, you’re right. If it doesn’t seem like a competitive market, you’d be right again.

This is a broken system. 

Card Issuing Costs

Interchange fees paid by merchants flow as revenue to card issuers. They are meant to cover the cost involved in running the card program and provide a profit margin to card programs. 

What are those costs? At a high level, they are:

  • Operational, including customer service
  • Marketing
  • Bad debts
  • Fraud
  • Rewards

This is offset by revenues from interchange, card fees, and lending. And this makes for a profitable business– in 2020, according to the Federal Reserve’s 2020 Report to the Congress on the Profitability of Credit Card Operations of Depository Institutions, “Credit card earnings have almost always been higher than returns on all bank activities,” 

The largest single portion of card revenue comes from lending, which depends on the bank issuer’s ability to manage credit risk. But card programs can be profitable without lending; think debit cards or American Express charge cards. 

Merchants certainly get a benefit from accepting card payments. And there are related costs the merchant should share. But I argue that merchants should not pay interchange for costs that don’t benefit them directly, such as rewards programs and marketing incentives. 

How can we know those costs? While we cannot see what an issuer’s cost for a card program is, we do have a good proxy: debit card costs, calculated by the Federal Reserve as required by the Durbin Amendment. Those are enshrined in V/MC interchange tables as rates for “regulated” rates: $0.21 + 0.05%– on a $100 charge, this is 0.26%. This is one approach to determining base-level card costs; there are others, such as those used in the European Union, which are somewhat higher for credit card. 

So if we wished to see what part of interchange is in excess of costs to run a profitable business, we could: it would be interchange less 0.26%. This could easily be done for any transaction and would show the excess interchange cost related to cardholder rewards.

Efforts to Reduce Card Acceptance Cost

Merchants don’t like this broken system, and over the year have tried in different ways to reduce their card acceptance costs:

  1. Litigation – there have been (and are) several anti-trust lawsuits in the US accusing V/MC and Issuers of anti-competitive behavior such as illegal price setting, including the suit over interchange filed in 2005 and a lawsuit brought by Block in July of 2023.
  2. Legislation – the Durbin Amendment to the Dodd-Frank bill, regulates the cost of debit card acceptance and became law in 2010; the Credit Card Competition Act, meant to extend some features of the Durbin Amendment to credit cards, has been introduced twice in the US Senate.
  3. New productsMCX, founded in 2012, was a failed attempt to create a merchant owned/operated payment network.

At best, these attempts have been marginally successful. Any successes have been largely thwarted by issuer and network rule changes, new and incremental non-interchange fees or outright refusal to comply. An example of this is the recent Federal Reserve determination that the networks’ failure to allow dual routing for Card Not Present (CNP) debit transactions is inconsistent with requirements under the Durbin Amendment.

Given the difficulty of reducing the cost of payment acceptance or shifting volume to a lower-cost tender type, some merchants have started adjusting their prices to reflect the difference in payment acceptance cost. Methods for doing this include offering cash discounts or surcharging for card usage. Card network rules previously prohibited this ability; those rules were changed several years ago due to the aforementioned litigation and legislation.

However, doing so in today’s environment is enormously complex. A merchant must consider changing federal and state laws and regulations, understand any prohibitions in their acquirer agreements, limitations of their POS systems, and requirements for adequate consumer disclosure. Surcharging is further complicated and risk is added by ISOs that encourage merchants to surcharge more than their payment cost. Card network rules clearly prohibit this and it is, in my view, inappropriate.

In today’s environment, virtually all but the smallest merchants have shied away from cash vs. credit pricing with the notable exception of gas stations, which may offer cash vs. credit pricing at the pump since there are only a handful of products in play (diesel, regular, premium, ultra fuels), but not in their attached convenience stores with hundreds or thousands of items for which separate cash and credit prices would have to be managed. 

Recap and Recommendation

As demonstrated in the paper, from the merchant’s perspective, the current US payment system is broken: there is no competitive market for card networks – Visa and Mastercard form a duopoly – which results in merchants paying an unfair share of system costs, chiefly to support rewards programs and marketing expenses. These costs are reflected in merchant pricing, which leads to all customers subsidizing benefits that only some (those who get rewards) receive.

Efforts to directly reduce that cost of payment acceptance overall (as has happened in the EU and Australia, for example) are wildly unlikely in the US: the Fed doesn’t get involved in private-market prices on its own, in contrast to central banks in other parts of the world.

So how to reduce the merchant cost burden and insert competitiveness into the system? I argue the best way would be to formalize a system that allows merchants – at their option – to pass the transaction-specific cost of cardholder rewards to customers. 

What would this accomplish? It would:

  • Allow merchants to stop paying for card-related programs that do not benefit them. 
  • Allow merchants and consumers to see the amount of interchange associated with any given transaction.
  • More accurately assign the cost of a reward to the different types of payment cards
  • Maintain transaction economics to issuers, the card schemes, and acquirer/processors.
  • Not undermine card rewards programs
  • Standardize the currently messy use of surcharging
  • Consumers
    • who receive payment card rewards pay for them – rewards are not subsidized by other parties.
    • would have the option to “opt out” of transactions for which they perceive the cost to outweigh the value of rewards.
  • Merchants
    • Would have the option to surcharge or not, but would be limited to surcharging only the actual rewards-related interchange cost of each transaction. 
    • If surcharging, would have more flexibility to compete on core goods/services pricing.

Some merchants may perceive that maintaining one price for all tender types reduces friction at the point of sale and enhances competition in other ways – for example, quick-service restaurants may be unlikely to adopt surcharging as it will add time to the checkout process. Other merchants may want to recover some of the interchange fees they pay but not want to modify their POS system or add friction to the customer checkout process. 

This solution allows the competitive market to better function with payment cards. Consumers have many options for paying, and can easily switch at the time of purchase; this ability is getting easier with mobile wallets. 

In practice, some merchants would do this and others would not, depending on competitive factors. Again, market forces can work. 

How would this work?

1 – Federal law would be enacted which allows all merchants to surcharge for payment card transactions. The surcharge would be limited to the actual interchange the merchant would pay for the specific transaction less the regulated debit interchange cost for the same transaction. The law would preempt all state and local laws, card operating regulations, and provisions in merchant agreements that would prohibit or limit surcharging. 

2 – When first tendering any payment card, the acquirer/processor would return the actual amount of interchange in excess of the regulated debit cost for that transaction. If merchants wish to increase the amount of the sale by this incremental interchange cost (i.e. surcharge), the merchant would be required to inform the customer of the surcharge amount and allow the customer to affirmatively accept the surcharge or cancel the transaction and provide an alternate payment method for the transaction.

3 – If the customer cancels the transaction, the merchant would send a reverse authorization request for the authorized amount and the issuer would reverse any authorization hold on the consumer’s account.

Conclusion and Summary

While there is competition in much of the US payments ecosystem, there is no competition by card networks for merchants. Interchange fees are set by Visa and Mastercard exercising their duopolistic power – this part of the system is broken. 

In particular, costs associated with rewards credit cards are not borne by those who receive benefits – the rewards cardholders – but rather by merchants and holders of non-rewards cards.

Previous merchant efforts to curtail payment costs have floundered and current efforts are met with impassioned arguments, lobbying, and spending in an attempt to create fairness and competition. I see the political and practical realities of the current efforts as unlikely to fix the system.

Instead, we offer a solution that maintains the economics for issuers and acquirers and reduces the economic burden by asking those who benefit from rewards credit cards to pay for those rewards. 

Should the US adopt this framework, merchant competition will be enhanced and industry verticals will have the flexibility to determine pricing and surcharging models that best meet their own and their customers’ needs. Market forces will determine winners – just the way it should be.

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