Paper or Plastic? The Transition from Cash to Payment Cards
Credit and debit cards have come to play a significant role in today’s economy, with consumers owning more than 566 million MasterCard and Visa cards alone as of 2004.1 Indeed, the use of these payment methods has long since outpaced the role of checks and even cash for most consumers. By 2004 electronic payments had exceeded payments with checks by 7.8 billion transactions.2 Plastic payment methods provide a great number of benefits for consumers, including convenience, the safety that comes with carrying less cash, and fewer trips to the bank. At the same time, merchants enjoy the benefits of a network that can clear transactions from consumers anywhere in the world. A traveler from Tokyo can purchase an item in New York in a credit card transaction that is completed with the swipe of a card.
While the process may appear simple to the consumer—in fact, that is one of the reasons for the growing popularity of credit and debit cards—there is actually a complex network required to facilitate these transactions. The market involves several intermediaries between the consumer and the merchant, including issuers, processors, and card networks. And while the benefits to consumers and merchants are significant, providing the services required to complete a transaction are not costless. Fees are paid both by merchants and consumers for the benefits provided by the networks.
There has been a growing debate over these fees, with some claiming the fee structure has been set in an anticompetitive environment, resulting in excessive fees or unnecessary restrictions that harm the marketplace. Yet the widespread usage of these cards and the benefits they provide suggest that the market is functioning well. Competing networks exist, consumers and retailers are free to use whichever cards they like, and the market continues to grow at a substantial pace. Visa, MasterCard, American Express, and other card networks compete vigorously among themselves and with PIN-debit networks (Star Interlink, NYCE, Honor, MAC, and so forth) and emerging payment networks such as PayPal and soon, Google Wallet. At the same time, consumers and merchants have a more basic choice
between using a card or simply paying with cash or check. The primary objections to the existing market have been raised by merchants, who enjoy the benefits of the system, but may not like the prices paid to use it. Price is an important issue, but, as in any competitive marketplace, prices are best established by negotiations between willing buyers and sellers, not government mandates. To understand these concerns, it is important to develop a deeper understanding of this market, both in terms of identifying how transactions are structured and how fees are established.
Understanding a Transaction
There are two primary types of transactions that occur when a customer presents a credit or debit card to purchase an item. The first is a four-party transaction, which is the standard transaction involved when using Visa or MasterCard. Upon receiving the card from the customer, the retailer (or merchant) transmits this information to its bank, known as the acquirer, or merchant bank. To complete the purchase, the merchant bank transfers the information to the bank that issued the card to the consumer, known as the issuing bank. The issuing bank then charges the consumer’s account and pays the merchant bank which, in turn, provides funds to the retailer.
Clearly, there are a number of services provided at various steps of the process, and the cost of those services must be covered. Visa, stands between the issuing bank and the merchant bank, processing the requests from the merchant bank to the cardholder’s issuing bank. The fee charged by issuing bank for this function is known as the interchange fee. Typically, the interchange fee averages 1.75 percent of each transaction’s price. In addition, the merchant bank, which deals with the retailer, charges the merchant a fee for the transaction as well. This fee, plus the interchange fee, is known as the merchant discount. Overall, the merchant discount averages 2.15 percent per transaction.3 Finally, issuing banks that provide consumers with access to credit charge consumers a fee for credit and services of the network, which is collected through the interest rate on the card and annual fees. In recent years competition among issuing banks has led to interest competition, frequent flyer mile programs, cash back programs, and other incentives to attract consumers.
The other type of transaction is a three-party transaction, in which card providers such as American Express and Discover process transactions for their customers. This is a closed system, and rather than a number of competing banks serving as issuing banks and other banks as merchant banks, these companies handle both sides of the transaction by issuing cards and signing up merchant banks. This drops the number of relevant actors to three. In this case the interchange fee is an implicit fee that is incorporated into the merchant discount. The merchant discount for most three party transactions has typically been higher than the fee for four-party transactions—an average of 2.5 percent versus a merchant discount averaging 2.15 percent for a four-party transaction.4 Three-party transactions account for much less of the total volume of transactions, which means, from the merchant’s perspective, the four-party transaction of Visa and MasterCard provides a majority of the business at a lower rate.
Credit and debit card networks coordinate between the two sides of the market, allowing the transactions between cardholders and retailers by processing the requests between their respective banks. In addition to processing the transaction, Visa and MasterCard manage risk by agreeing to reimburse merchant banks for all transactions. In this market, American Express, Discover, MasterCard, Visa and others compete to provide this coordination service.
Nonetheless, the most controversial aspect of these transactions has been the interchange fee, or the fees collected by the issuing bank for processing requests from merchant banks. Four-party transactions have led to allegations of abuse for two primary reasons. First, while the fee for each transaction is clearly lower than the fee on three-party transactions, the overall volume of four-party transactions is much higher, making total fees paid a greater expense for many merchants. Second, in four-party transactions, card networks like Visa establish the price for the thousands of issuing banks, which has led to charges of collusion and price fixing.
To date, however, the courts have not found that the interchange process violates American antitrust laws. In fact, interchange plays a valuable function, allowing transactions between disparate parties throughout the world. Without interchange, there would need to be thousands of agreements established between the individual issuing banks and merchant banks in order to achieve the same degree of universal acceptance. Interchange fees clearly reduce these transaction costs and expand the scope of the market for merchants and consumers alike.
Another allegation often made by those challenging interchange fees is that these fees force those who pay cash to subsidize those who use cards for their purchases. Because the merchant establishes prices to cover the costs of doing business—which includes interchange fees—those who pay cash are paying higher prices than they otherwise would because of the cost of interchange fees.
Such arguments are specious at best. Any merchant is free to accept cards or not, and the decision to do so is premised on the expectation that accepting cards will boost profits. And interchange fees are like any other business expense that must be incorporated in the merchant’s pricing strategy. To say that it subsidizes one form of transaction ignores this larger question of pricing. There are many services or products offered by merchants that customers may or may not use; that does not mean that those who refrain from use are subsidizing the others in any meaningful way.
For example, a family without children who shops in a department store would have no need to purchase children’s clothing. Yet a fair amount of square footage in most department stores is allocated to children’s clothing, along with employees to serve customers. Does this mean that families without children are subsidizing those with children because prices are higher than they otherwise would be in order to cover the costs of the children’s department? How much shelf space in a grocery store is devoted to things that any one shopper will never use? Is the consumer paying higher prices to cover the costs of that useless shelf space?
Merchants must balance the needs of a wide range of customers by offering an array of competitively priced goods and services. These prices must cover the merchant’s costs as well as provide a return. Interchange fees are simply a cost of doing business, and if the merchant believes card transactions will increase profits, that fee will be incorporated into pricing strategies, just as rent, wages, and utilities are included.
Understanding the Market
To properly understand interchange fees and assess the existence of anticompetitive practices in this market, it is important to understand how the payment card market operates. This market is an example of what recent economic literature has described as a two-sided market.5 In a two-sided market, two different groups interact with each other through a shared platform. For example, a newspaper provides a platform for both readers and advertisers, and a broadband provider offers a platform for Internet users and content providers hoping to attract customers.
Unlike the standard market of economic analysis, the two-sided market raises new questions about costs and pricing. In a standard market, prices are set to cover the costs of all inputs, as well as normal profits for the entrepreneur whose capital is at risk. But the two-sided market adds a new element to the analysis. Namely, how does the platform allocate costs between the two markets? In the newspaper example, the reader pays a very low price for the product, while revenues from advertisers are a more important stream of income. However, what the newspaper can charge the advertisers is a function of how many readers can be claimed. In effect, the question of pricing becomes an exercise in joint maximization, where both sides of the market must be considered simultaneously.
This interaction between the two sides of the market is the result of what economists call “network effects” and makes the optimal pricing strategy a more difficult issue than the standard market. In short, the value of the network increases as the number of people who use the network increases. Consider the simple example of a phone, which is only valuable because it allows the user to connect with others on the network. The more users, the more value the phone provides. It is the same with payment cards. The more merchants willing to accept the card, the greater the benefits created for the cardholder. But in this two-sided market, the reverse is true as well: the greater the number of cardholders, the more attractive it becomes to honor the card. The fundamental question then becomes how to maximize the overall value of the network to both merchants and consumers.
Prices on each side of the market affect the other side, which means the costs of the network must be allocated across both sides of the market in a way that increases the value for everyone. As Rochet and Tirole note, “Platforms [such as payment card providers] must perform the balancing act between the two sides along various policy dimensions and not only with respect to the price structure. They therefore often regulate the terms of transactions between end-users, screen members in non-price related ways and monitor intra-side competition. In all instances, they sacrifice profit by constraining one side to boost attractiveness for and recoup losses on the other side.”6
From the card networks perspective, this means balancing both sides of the market and establishing prices to optimize the overall value of the network. Pricing decisions are based upon the types of transactions, geographic regions, the specific market segment in question, and the type of card being used. Such prices are tempered by competition between payment networks and with alternative forms of payment.
Importantly, competition occurs on both sides of the market. Consumers are looking for a card with universal acceptance at the best price. This means providing a combination of annual fees, interest rates, and bonuses (such as frequent flyer miles) that appeal to consumers. Services such as protection from unauthorized use are also included. Merchants, on the other hand, are looking for a universally accepted at the lowest price.
Clearly both sides of the market have different demands that must be addressed. Prices are set by companies such as Visa and MasterCard based on the economic characteristics of demand by both consumers and merchants. One important component for establishing interchange fees is the elasticity of demand on both sides of the market. This is nothing more than a measure of how sensitive both sides of the market are to price changes. Using this joint methodology, interchange fees are typically set at a point where more revenues are generated from merchants rather than consumers.
In the end, the interchange fee attempts to reflect the value of the service being offered to merchants and consumers, who both clearly receive a great number of benefits from the availability of card transactions. Consumers gain greater control over expenditures, more efficient credit markets, ease of use, and less need to carry cash, among other things. For merchants the benefits include faster transactions, more efficient billing systems, and importantly, the ability to outsource issues of extending credit and loans to consumers. And for both merchants and consumers, cards provide access to a wider market and a degree of risk management, with issuing banks assuming liability and managing risk in terms of nonpayment and fraud.
The interchange fee optimizes the value of the card network. However, quantifying the benefits of the network to merchants is often difficult. This has led many merchants, who would prefer to pay less for accessing the card networks, to call for cost-based regulation, which is nothing more than price controls for interchange fees. Historically, price controls have performed poorly, generating market distortions and market inefficiencies. These dangers are even greater in a two-sided market, where the economic theory is still unsettled. In fact, Australia provides a good example of the potential hazards of regulating interchange prices.
The Australia Example
In 2003 the Reserve Bank of Australia imposed price caps on interchange fees, dropping the rate from 0.95 percent per transaction to 0.55 percent per transaction on four-party transactions such as Visa and MasterCard, and the Australian card network, Bankcard.7 The regulations were released based on concerns about market power and the distributional impact of interchange fees (that is, how these fees affected groups other than card users). It was asserted that interchange fees subsidized cardholders, leading to excessive use of card payment relative to other payment mechanisms. To alter the subsidy, the Bank reduced the interchange fee and permitted the use of surcharges by retailers on those customers who paid with credit cards.
The price cap had a two-fold impact on the market. First, despite the fact that three-party cards such as Amex provide an identical function (and include what many call an implicit interchange fee), these networks were not affected by the ruling. Second, the price caps were a clear attempt at redistribution within the marketplace, lowering the prices paid by merchants for the use of the card payment networks. While the intended goal may have been to make the system more efficient and reduce overall costs, like any regulation, there have been unintended consequences that have had an adverse impact on Australia’s consumers.
As noted earlier, in a two-sided market costs are apportioned to the different parties according to demand characteristics of each side of the market. With respect to card payment networks, cardholders have paid less than merchants. The price cap on interchange fees has distorted the prices set in the marketplace, leaving consumers with higher prices, and no significant savings in the retail sector. Indeed, even though the regulations have been in place for relatively short period of time, the impact on consumers has already become visible.
Most notably, the biggest change has been a transfer from consumers to merchants. In particular, there have been two negative effects on consumers. First, in order to recover losses imposed by the cap on interchange fees, card issuers have increased fees on the cardholder side of the market. One assessment found that card issuers have recovered more 30 percent to 40 percent of lost interchange revenues by raising costs for individual cardholders, or a total of AU$197 million.8 Much of the increase has been in the form of reduced bonus programs, such as caps on reward points or bonus miles. In another unintended consequence, banks are now partnering with three-party cards to offer better rewards programs without caps. While this may appeal to some, it must be remembered that three-party cards carry a higher merchant discount, which could ultimately drive up the costs of card networks.
Second, consumers have seen little in the way of lower retail prices. There has been little interest in surcharges, and very few retailers are charging customers more for the use of credit cards. Despite the fact that the transaction fee for merchants fell by 0.43 percent, the reduced costs are not reflected in lower prices at the cash register. It has been estimated that merchants have saved almost AU$600 million a year due to the cap on interchange fees, but there is little evidence that any savings have been passed on to consumers.9
Ultimately, the Australian example shows the dangers of intervention in the marketplace. Whether the intentions were high-minded pursuit to improve public policy or an example of rent seeking by the merchants’ powerful interest group, the policies have failed to achieve their stated objective. Instead, consumers are bearing the cost in terms of higher prices, while merchants and bankers have benefited from the new system. It is not surprising that consumers bear the brunt of this policy; they are a diffuse and dispersed group, which makes it difficult to compete with the organized special interests seeking to use the political process to achieve gains unavailable in the marketplace.
Conclusion
Ultimately, there are only two ways to allocate resources, either through a central authority or through the dispersed knowledge of all the producers and consumers in the market. Those who advocate price controls on interchange fees are opting for central planning—a model that hardly has proved effective for allocating resources efficiently. The alternative is to rely on the dynamics of the market, which coordinates the activities of individuals throughout the economy, alerting producers to shortages and surpluses while helping consumers express their demand for various goods and services. This dynamic coordination occurs spontaneously, without the oversight of a central authority, allowing participants to take advantage of local knowledge and adapt to new exigencies while finding new and more efficient ways to do things.
Regulating interchange fees is actually the first step towards greater government control over a system that, ironically, may reduce consumer benefits. Strict controls on interchange fees could reduce the value of the card networks to both merchants and consumers alike, increasing the costs of commercial transactions. Since their inception, card payment systems have expedited commerce while expanding the relevant size of the market for all participants. Sound policy should promote such innovations and expansions, not restrict them through a new layer of regulation and government oversight.
To date, there is little empirical or theoretical evidence to support an intervention into the market for card payments. In fact, there is ample empirical evidence to suggest such an intervention can have adverse effects on consumers. Theoretically, the case is far from being made. As Rochet and Tirole note:
Proponents of a regulation of the IF [interchange fee] must first build a theoretical paradigm that gathers broad intellectual consensus and demonstrates a clear market failure, show that the resulting distortions have a clear sign and a sizeable impact on welfare, and propose a form of regulation that is consistent with the underlying theory and is better than nonintervention. So far, no such theoretical paradigm has been achieved. On the contrary, recent academic work concurs to establishing that there is no systematic bias in the IFs selected by cooperative networks: there is no reason to think that privately optimal IFs are higher or lower than socially optimal ones. Misunderstanding the economics of the problem and imposing cost-based regulation could impose substantial distortions in the industry.10
Interchange fees have provided a vast array of benefits to consumers and merchants alike. The extent of the market has been broadened significantly, and card payments systems provide for geographically dispersed markets that connect buyers and sellers across the globe. The value of card payment networks must be considered before imposing arbitrary caps or restrictions on how these markets function. Regulating this market could harm consumers, innovation, and the economy as a whole. Consequently, regulators and legislators would be wise follow the standards of any practitioner considering intervention: “First, do no harm.”
* Wayne T. Brough (wbrough@freedomworks.org) is the chief economist at FreedomWorks.
1 The Federal Reserve, The Profitability of Credit Card Operations of Depository Institutions, June 2005, available at http://www.federalreserve.gov/boarddocs/rptcongress/creditcard/2005/ccprofit.pdf.
2The Federal Reserve, 2004 Federal Reserve Payments Study, Analysis of Noncash Payments Trends in the United States: 2000 – 2003, December 15, 2004. Available at http://www.frbservices.org/Retail/pdf/2004PaymentResearchReport.pdf
3Kenneth Posner and Camron Ghaffari, The Empire Strikes Back, Morgan Stanley Industry Overview, March 8, 2005, p. 11..
4 Ibid.
5 Jean-Charles Rochet and Jean Tirole, “Two-Sided Markets: An Overview,” Mimeo, IDEI, Tolouse, France, March 12, 2004.
6 Ibid, p. 41.
7 See, Richard A. Epstein, “The Regulations of Interchange Fees: Australian Fine-Tuning Gone Awry,” Columbia Business Law Review, p. 551, 2005.
8 Howard Chang, David S. Evans, and Daniel Garcia-Swartz, “The Economic Effects of Australia’s Regulation of Interchange Fee Setting after Two Years” presentation at Antitrust Activity in Card-Based Payment Systems: Causes and Consequences, Federal Reserve Bank of New York
9 “Card Refom Savings ‘Not Passed On’,” The Australian, p. 21.
10 Jean-Charles Rochet and Jean Tirole, “An Economic Analysis of the Determination of Interchange Fees in Payment Card Systems,” Review of Network Economics, Vol.2, Issue 2, June 2003, p. 71, available at http://www.rnejournal.com/articles/rochet_and_tirole_june03.pdf.
