Saturday, March 12, 2011

The End of Interchange?

Last week, the Federal Reserve Board requested comment on proposed regulation that would “establish debit card interchange fee standards and prohibit network exclusivity arrangements and routing restrictions.” The proposal is an outcome of the Dodd-Frank Act, which stipulated that interchange fees be “reasonable and proportional” to the cost incurred by debit card issuers.

The Fed proposed two schemes for setting interchange rates, but effectively capped interchange at 12 cents per transaction. Today net debit interchange is around 40-45 cents. In effect, the Fed is planning to reduce interchange by at least 70%.

The cap was lower than many people expected and came as a surprise for the industry. In response to the announcement, shares of Visa and Mastercard plunged more than 12%. While this may hurt our own bottom line, we support the direction of the Fed’s proposal.

Because most people who regularly use debit cards are unaware of the associated interchange fees, it’s difficult to decipher what this proposal means for consumers. Doing so requires an understanding of the history of interchange.

History of Interchange
In the 1950’s, when credit cards were introduced, most people bought with either cash or checks. Regular customers with good credit would frequently have accounts at stores, and would get a bill at the end of the month for all their purchases. Credit cards allowed people to buy stuff from more stores without having to carry cash around. They were also safer to user and more convenient than carrying checkbooks around, so consumers loved them. Merchants liked them too, since they brought in new customers who merchants otherwise wouldn’t have been able to extend credit too.

Of course, building this system and marketing it to customers was extremely expensive in an era when calculators were just beginning to catch on. So the credit card companies charged merchants a fee for accepting payment via a credit card: instead of getting 100% of the value of a credit card transaction, the merchant would get 95%-97%. The credit card companies also charged customers interest if they didn’t pay on time, and the combination of interest and merchant discounts was enough to make the business profitable.

Over time, the industry grew and evolved. Banks got into the game and begin to issue credit cards through associations that eventually became Visa and Mastercard. Credit card acceptance usage and acceptance exploded in the 1960s and 1970s to the point where they were ubiquitous. The card associations were owned by the banks, and paid them most of the discount fees that they earned from the merchants, which became known as an interchange fee.

Success of Debit
The success of credit cards demonstrated the need for a safe and convenient alternative to cash. But it wasn’t until the emergence of debit cards when card based payment became commonplace.

Debit cards began as a byproduct of ATM cards in the 1980’s. Because ATM usage was immediately popular, banks began engineering a method for customers to use ATM cards as an alternative to credit cards. Because few merchants had terminals that could accept PIN based ATM cards, debit cards were designed to work with merchant’s existing credit card terminals, and to route transactions over the existing credit card network.

Today, debit cards transactions are still routed through two separate payment networks---signature debit, where customers provide their signature and the transaction is routed over the credit network, and PIN debit where the customer enters their ATM PIN code and the transaction is routed over an ATM network. Regardless of how the transaction is routed to the card issuing bank, the money always comes out of a user’s checking account.

Debit cards also had interchange fees associated with them, just like credit cards. Initially, the interchange fee that merchants paid on debit card transactions was much lower than what they paid on credit card transactions. While cash and checks didn’t have any fees associated with them, they had hidden costs. They had to be stored under lock and key to prevent them from being stolen, somebody had to deposit them at the bank, and there was always the risk of getting a bad check or counterfeit cash.

Compared to the alternatives, debit cards were relatively cheap for merchants to accept. Debit cards were also available to everybody with a bank account, regardless of their credit history. Furthermore, banks loved having an additional source of revenue from card fees, especially from customers who either wouldn’t or couldn’t get a credit card. So everybody loved debit cards. Not surprisingly, debit card usage grew rapidly throughout the 1990’s and 2000’s. A whole segment of the industry, prepaid cards, came into existence to provide debit cards to people who didn’t even have bank accounts. It wasn’t long before most Americans had a debit card in their pocket. In 2009, debit cards overtook both credit cards and checks to become the most widely used payment mechanism in the US.

However, as debit card usage grew, the industry structure changed. Mastercard and Visa realized that debit was a huge growth opportunity and began to compete aggressively for customers. Most people already had checking accounts by this time, so Visa and Mastercard were competing for the right to be the logo on a bank’s debit card. The quickest way to win a bank over was to offer it more interchange revenue from merchants. So Visa and Mastercard consistently raised interchange fees charged to merchants on debit card transactions.

Merchants didn’t like these ever increasing fees, of course. Because most merchants had a terminal that can accept a debit or credit card with the Visa or Mastercard logo, the networks had enormous market power. The merchants had no ability to negotiate with Visa and Mastercard, who up until recently were owned by the banks. Visa and Mastercard logically deployed their market power in the interests of their shareholders and customers, the banks.

These changes were hidden from cardholders. Marketing and rewards programs persuaded customers to use cards rather than cash. The cost was paid by merchants in the form of increasing interchange fees. Even when the cost of processing declined---as payment processing switched from paper to electronic---interchange fees continued to rise.

Congress to the rescue
The system as it stands today is clearly broken. Banks benefit as the cost of processing decreases and interchange fees increase. With their tremendous market power and lobbying capabilities, banks ensured that nothing much could be done about it for a long time. In this, as in many other things, the financial crisis changed everything.

Last summer, Senator Dick Durbin from Illinois attached an amendment to the Dodd-Frank Act that required the Federal Reserve Board to regulate interchange fees. As soon as the banks realized what had happened, they lobbied furiously to have it removed, but the financial crisis had weakened their position. With minor exceptions for small banks, government benefits cards, and prepaid cards, the amendment became part of the final act.

The Durbin amendment is clearly a flawed piece of legislation. For one thing, it completely ignores credit interchange. Furthermore, the precedent of the Fed setting prices in a private market is troubling, and it’s not something the Fed likes doing. The Fed also doesn’t have complete freedom to regulate interchange, but must look only at the incremental costs of processing transactions. There is a serious risk that over-regulation will kill the flexibility and innovation that the banking world badly needs.

How this impacts consumers
The Board’s proposed regulation will change the debit card industry. Interchange fees will no longer be a significant money-spinner for large banks. Because most rewards programs are funded by interchange revenue, they might disappear entirely on debit cards.

To compensate, the large banks will be forced to charge higher fees to some customers, especially those who only open up a low balance checking account.

Merchants should see big cost savings, running into the billions of dollars. But if the experience of Europe or Australia is any guide, little if any of this will be passed on to customers.


  1. Shamir,
    Thanks for this great post. I was discussing this at lunch today with two colleagues, and I was explaining to them the differences between signature debit and pin debit. Now I'll just point them here.

    I had a long comment that I lost here, but I'll try and summarize. I think the key point is your last line. I sincerely doubt that any of the savings will be passed along to the consumer, and ultimately, they'll end up getting charged more.

    In your intro, you said that the average savings that a merchant will have will be somewhere in the neighborhood of $0.35 per transaction. Suppose we had a merchant like a gas station where the candy inside is priced at $1.99 a bar/bag. Is he going to start changing his pricing from $1.99 to $1.93 in response to this? We are a culture that prices to the 99s. I don't see this changing.

    But that's fine. He keeps his profits, so if all else remained equal, we'd have customers being flat, merchants up, banks down. No problem.

    But banks won't accept being down. They have infinite ability to dream up new fees and new revenue streams. In the WSJ this morning, this article was posted:

    Banks are going to try like hell to find new ways to fee themselves out of the interchange hole. Inactivity fees! Multiple card fees! Lost card fees! Buy something too big? Fee. Buy something too small? Fee. Etc. Etc. Etc.

    It was either Josh or you that said (paraphrasing) in the CMU article about BankSimple: "The greatest innovation in finance has been a smaller font size." And it's true. They will try and "Gotcha!" their way out of this hole.

    Durbin has its heart in the right place, but went about it wrong. The real revolution for the consumer will come when legislation outlaws "gotcha!" banking. Elizabeth Warren talks about this all the time.

    The real revolution for banks? That will come when they realize there are win/win ways to generate revenue. Right now it's not a question of ability (the revenue streams are there, I know it, and would love to discuss further), it's simply a question of desire.

    Thanks again for the post.

  2. It's clear that the payment processors have outsized power (and there's an obvious breakdown in the market there), but it seems no more evident than when merchants charge anywhere from a few cents to a dollar to use pin debit in lieu of signature debit on the same card. It encourages me to sign instead of use my pin, which saves me a few cents while costing the merchant more in interchange fees than if I used my pin. If the merchant had more power to charge card-use fees (or offer discounts, like a few gas stations that I've seen do) based on the interchange they have to pay to the processors, both the consumer and the merchant would be much better off.

  3. Durbin had his heart in the right place, but went about it in the wrong way. Giving the Fed more latitude to put legislation in place, while giving them an explicit goal (maximizing efficiency, minimizing total costs, reducing distortions,etc) would probably have been better.

    In the short term, big banks will extract more money from customers any way they can, and use interchange legislation as an excuse. I don't see more regulation as the answer to that problem. We need more competition, especially from newer companies that take radically different approaches. The current bank regulatory environment is just not setup to encourage that.