Payment Card Interchange Fees: An Economic Assessment
Payment Card Interchange Fees:
An Economic Assessment
September 3, 2008
Walter W. Eubanks
Specialist in Financial Economics
Government and Finance Division
Payment Card Interchange Fees:
An Economic Assessment
Interchange fees in the processing of credit and debit cards have become
controversial. An interchange fee is paid by the merchant’s bank to a cardholder’s
bank (that issued the card) after the cardholder purchases goods or services with a
payment (credit or debit) card. Merchants and cardholders asserts that they must
accept excessive and increasing interchange fees set by the card associations such
as Visa and MasterCard and member card-issuing banks. Interchange fees have been
rising since the 1990s, despite diminishing fraud losses and technological advances
in communications that lower the costs of accessing the electronic payment system.
Merchants argue that the card associations have not negotiated these fees with them
but instead present the fees as “take it or leave it” offers.
Economists who have studied the payment card markets attribute the higher
interchange fees to the nature and structure of the market. This is not the traditional
market, they point out, but a two-sided market where suppliers compete for two
types of customers with different demand responses, like a newspaper that must
attract both readers and advertisers. In the payment card market, banks must attract
cardholders and merchants, and a transfer of revenues is usually necessary to provide
card-issuing banks an incentive to issue more cards, which provide more payment
card users to merchants. This is similar to newspapers, where the lower the
subscription rates, the higher the readership and the higher the advertiser revenues.
For a payment card system that needs more cardholders to achieve the optimal
benefits to cardholders and merchants, more revenue transfers may be needed to
offset the cost of issuing more cards to cardholders. There could be cases, however,
where the revenue transfers are excessive, which would mean that the interchange
fees are providing excess profits to issuer banks.
A potential issue relates to possibly imposing legal or regulatory caps on the
interchange fees the associations and issuing banks receive, as in the case of
Australia and the United Kingdom. Specifically, the concern is whether there is a
mechanism that will be used to make sure that merchants lower their prices to pass
the excess revenues back to the cardholders. In countries where interchange fees are
capped, the governments have been relying on merchants to voluntarily lower prices.
Yet, there is no formal evidence that merchants have lowered their prices because of
the lower interchange fee caps.
This report focuses on the Visa and MasterCard card associations, which
account for three-fourths of the payment card market in the United States in 2008.
The report begins with a discussion of the nontraditional structure of the payment
card market. The next section is an analysis of the problem of the optimum level of
payment cards to achieve the highest social welfare benefit for cardholders and
merchants. The third section discusses the provisions of the Credit Card Fair Free
Act of 2008 (H.R. 5546). The last section discusses some implications of the
This report will be updated as financial and legislative developments warrant.
In troduction ......................................................1
The Cost Structure in a Payment Card Transaction .......................3
The Optimal Payment Card System ...................................5
The Problem with Cost Regulation................................5
Allowing Merchants to Pass Through the Interchange Fees.............6
Credit Card Fair Fee Act of 2008 (H.R. 5546)...........................8
Reaction to H.R. 5546..........................................8
List of Figures
Figure 1. Visa or MasterCard Payment Card Network.....................5
Payment Card Interchange Fees:
An Economic Assessment
Payment card interchange fees, which were paid without contention for almost
seven decades, are now the source of a controversy. An interchange fee is paid by
the merchant’s bank to a cardholder’s bank (that issued the card) after the cardholder
purchases goods or services with a payment (credit or debit) card. House Judiciary
Chairman John Conyers Jr. has established a congressional task force to look into
interchange fees because some merchant and consumer groups have complained that
these fees are cutting into merchants’ profits and are costing the cardholders and non-
cardholders, who ultimately pay the fee in the price of the goods or services.1
According to Chairman Conyers, “In 2005, U. S. families paid an average of more
than $300 for hidden interchange fees including households that do not even use2
credit cards.” Another source estimated that, “In 2007, retail merchants in the
United States will pay banks issuing Visa and MasterCard payment cards more than3
$30 billion in collectively set per transaction interchange fees.” At issue are
increases in interchange fees set by the credit card associations like Visa and
MasterCard and card-issuing banks or companies like Discover and American
Express to enable merchants to gain access to the associations’ and issuers’
electronic payment network.
Interchange fees have been rising since the 1990s, despite diminishing fraud
losses and technological advances in communications that lowered the costs of4
accessing the electronic payment system. Merchants argue that the card associations
have not negotiated these fees with them but instead present them as take it or leave
it offers. Economists who have studied the payment card market attribute the higher
1 Non-users of payment cards pay interchange fees because merchants usually raise their
prices to compensate them for the costs of accepting payment cards. These higher prices
are paid by all their customers.
2 Michael Posner, “Credit Card Interchange Fee Negotiation Bill Advances,” Congress
Daily, July 16, 2008. p. 1.
3 James M. Lyon, “The Interchange Fee Debate: Issues and Economics,” Federal Reserves
of Minneapolis, January 19, 2006 [http://www.Minneapolisfed.org/pubs/regional/0606/
4 Steve Semeraro, “Credit Card Interchange Fees: Three Decades of Antitrust Uncertainty,”
Thomas Jefferson School of Law, San Diego, California, Legal Studies Research Paper
Series, March 6, 2007. p. 70, and Adam J. Levitin, Payment Wars: The Merchant-Bank
Struggle for Control of Payment System, working paper, September 5, 2006, p. 3.
interchange fees to the nature and structure of the market, which is not the traditional
market but a two-sided market.5 Within this structure, they have identified two
conditions that, combined, could lead to high interchange fees. The conditions are
where the payment card issuers have market power and merchants have an inelastic
demand for accepting payment cards.6 Some commentators note that if it is
determined that interchange fees are excessive as a result of issuing banks’ marketing
power, those circumstances could lead to the government imposing legal or
regulatory caps on interchange fees, as was the case in Australia and the United
Kingdom. Related questions have been raised concerning the mechanism the
government might use to induce merchants to lower their prices and pass the excess
revenues back to the cardholders.7 In these two countries, the pass back of the fees
through price reduction has been voluntary, and there is no formal evidence that
merchants lowered their prices.8
This report focuses on the Visa and MasterCard card associations that account
for three-fourths of the payment card market, with Visa accounting for 44% and
MasterCard accounting for 31% of the market in the United States in 2008.9 The
report does not discuss unitary payment card systems such as American Express and
Discover cards that issue virtually all their own cards and sign up their own
5 Two-sided markets compete for two types of customers with different elasticities of
demand. A good example is a newspaper that must attract both readers and advertisers. To
optimize output in both markets, the equilibrium price depends on the price elasticities of
demand of customers on both sides, the network effect, and the marginal costs resulting
from changing output on each side. In this example, newspapers usually provide
newspapers to readers below their marginal production and distribution costs in order to
build sufficient readerships to attract advertisers. Raising the subscription rates for the
newspaper will not only lead to fewer readers, but also less advertising revenues because
revenues are a function of the number of readers. The two-sided market limits a firm’s
ability to retain excess profit. A monopoly newspaper might be able to increase subscription
rates to readers, but in doing so it might have to compete away its profits to attract
advertising revenues. Two-sided markets differ from ordinary markets. In most markets,
price collusion generally leads to harm to consumers by enabling competitors to restrict
output and raise prices. Two-sided markets cannot be presumed to behave anti-
competitively based on the assumptions applied to standard markets, but they can be anti-
competitive nonetheless. See Steve Semeraro, “Credit Card Interchange Fees: Three
Decades of Antitrust Uncertainty,” Thomas Jefferson School of Law, San Diego, California,
Legal Studies Research Paper Series, March 6, 2007. p. 43.
6 Ibid., Steve Semeraro, p. 45.
7 Fumiko Hayashi and Stuart E. Weiner, “Interchange Fees in Australia, the UK , and the
United States: Matching Theory and Practice,” Economic Review of Federal Reserve Bank
of Kansas City, Third Quarter 2007, pp. 75-112.
8 Congressional Quarterly, “House Judiciary Subcommittee on Antitrust and Competition
Policy Holds Hearing on Merchant Credit Card Payment Fees,” May 12, 2008, p. 81.
[ h t t p : / / www.c q.c om/ d i s pl a y.do?docke y= / c qonl i ne/ pr od/ dat a / docs / ht ml/transcripts/congr
essional/110/congressionaltranscript s1 1 0-000002878244.html @c ommittees&metapub=C
Q-CONGT RANSCRIPT S&s e a r c h Inde x= 0&s e qNum= 34] .
9 William Bishop, Kyla Malcolm, and Nicole Hildebrandt, Regulatory Intervention in the
Payment Card Industry by the Reserve Bank of Australia: Analysis of the Evidence, CRA
International, April 21, 2008, p. 2.
merchants. This report does not analyze the application of antitrust statutes to
interchange fees. The report begins with a discussion of the nontraditional structure
of the payment card market. The next section is an analysis of the problem of the
optimum level of payment cards to achieve the highest social welfare benefit for
cardholders and merchants. The third section discusses the provisions of the Credit
Card Fair Free Act of 2008 (H.R. 5546), and the last section discusses the
implications of the analysis.
The Cost Structure in a Payment Card Transaction
There are several components of cost in a payment card transaction. When a
consumer makes a purchase with a payment card, the merchant’s account at the
merchant’s bank, the acquirer bank, is credited with the purchase amount, less an
amount called the merchant discount fee. The merchant discount fee consists of a
flat rate in the amount ranging from a few cents to a dollar or a percentage amount
of the purchase. The total fees usually range from 1% to 3% but could be as high as
15% for merchants who are of high risk because of low transaction volume, limited
credit history, or the nature of their business.10 The acquirer bank retains part of the
merchant discount fee, and the remainder is remitted to the network association. The
interchange fee is this remittance to the network association. The remittance to the
card issuer is also called the interchange fee. The network association that receives
the remittance from the acquiring bank keeps a small portion of it for the costs of
authorization, clearing, and settling the transaction. The association remits the rest
to the issuer bank to cover the costs of funding the purchase, chargebacks (returns),
and fraud risks.
The network association sets the interchange rates annually. The level of the
fees charged by the network is partially based on the interchange rate, which is set
by the issuing and acquirer banks. Thus, the merchant discount fee is the interchange
rate plus an additional percentage taken by the acquirer bank. However, the
interchange rate does not vary much on the basis of the cost of the transaction. It
varies mainly on the merchant’s type and the level of bundled reward points attached
to a particular payment card. As mentioned above, the merchant’s discount fee varies
by the merchant’s risk profile and the acquirer bank profit component of the fee.
Overall, the interchange rates are lower in stable, low-margin industries like groceries
and higher in small volume, high-risk businesses like adult Internet websites.
Explicit costs in the Visa or MasterCard association network reflect the
associations’ rules. These rules include merchant restraints that are designed to
increase card usage at the expense of all other types of payments and to maintain
higher interchange rates: (1) Merchants are forbidden to impose a surcharge for the
use of payment (credit or debit) cards [no surcharge rule], even though card
transactions cost merchants more than some other payment methods. The effect is
10 PSW, Inc., Merchant Services Agreement, available at [http://www.pwsbilling.com/
contractno-ccas-all.pdf] at 4.
to prevent merchants from passing on the cost of the payment card directly to their
customers, who use the card, which would give their customers a disincentive to use
the card. Thus, the merchants absorb the payment card transaction costs. (2)
Merchants are required to take all credit cards bearing the card association brand
[honor-all-cards rule], and they are required to accept these cards at all outlets [all-
outlets rule]. In addition, (3) merchants are prohibited from offering discounts to
particular types of cards [non-differentiation rule]. These rules prevent merchants
from operating at overall minimum cost because the rules force them to accept all [all
or none rule] the association’s cards, even though different cards have different
costs attached to them.
To summarize the description of the mechanism, Figure 1 shows an example
in which the merchant discount fee is 2.6% as set by the banks and the card
association. For this discount, the merchant may attract cardholder customers and
potentially higher sale volume, guaranteed payments, and reduced administration
and accounting costs, as well as increase checkout efficiency. On the cardholder
side, the card issuer bank issues payment cards to cardholders at its own costs,
including card production and advertisements. In the beginning of card issuance,
cardholders paid an annual fees for most cards. Today, issuer banks are profitable
enough from the lines of credit attached to their cards as well as related fees (such as
late and overdraft fees) that they generally no longer demand annual fees. More
important, issuer banks are in highly competitive markets where the elasticity of
demand for payment cards is high enough to force the fees to practically zero.
In a card association network, the association serves as an active umbrella
organization for four parties: (1) the acquiring bank and (2) the merchant, on one
side, and (3) the issuing bank and (4) the cardholder, on the other. Starting at the
bottom of Figure 1, the cardholder purchases goods or services for $100.00 with a
payment card. The accounting information goes to the merchant’s acquirer bank as
an account receivable. The acquirer bank credits the merchant’s account $97.40,
which is the merchant discount that was agreed to by accepting the card. The
acquirer bank takes a 0.5% fee for its services and asks the card association for
authorization for the $100.00 payment. The association sends the acquirer bank a
payment of $97.90 as the association deducts its 0.1% for authorization, clearing and
settling fees from the amount it receives from the issuer bank. The card association
then requests authorization from the payment card’s issuer banks, which sends the
card association $98.00, after deducting its 2% interchange fee from the $100.00.
Figure 1. Visa or MasterCard Payment Card Network
Source: Adam J. Levitin, Payment Wars: The Merchant-Bank Struggle for Control of Payment
System, working paper, September 5, 2006, p. 7.
The issuer bank usually extends the $100.00 credit to the cardholder if the
payment card is a credit card, and there is no balance on the credit card, in which
case, the cardholder enjoys the $100.00 float. The float is the use of the funds in
transition of payment until the payment is actually collected by the issuer bank. The
value of the float to the cardholder depends on the market rate of interest and when
the purchase is made in the cardholder’s payment cycle. On the other hand, if the
payment card is a debit card, the issuer bank may deduct the $100.00 from the
cardholder’s deposit account immediately. In either case, processing is done
electronically in seconds where all five parties are credited and debited the
The Optimal Payment Card System
Students of the process of setting interchange fees, which include regulatory
authorities, economists, and lawyers, have offered two proposed solutions to rising
interchange fees. The first would regulate the cost that a card system may use to
calculate its interchange fees. The second would permit merchants to put a
surcharge on payment card transactions so that interchange fees could be passed on
directly to the cardholder using the credit card. Each of these solutions has its own
problems in terms of maximizing the overall social benefits of a payment card
The Problem with Cost Regulation
It is argued that interchange fees based on card issuers’ cost (which is now
implemented in several countries, such as Australia) could solve the problem of
rising interchange fees. Others argue that interchange fees should be abolished, set
to zero. Issuers can cover their costs by raising interest rates and annual fees for the
card. However, economists have pointed out that price regulations based on costs
have historically been plagued with practical problems even in industries in which
theory would predict that the optimal price can be based on cost. The practical
reason for these theories’ failure to determine the optimal price based on costs is that
a firm has little incentive to cut cost if its revenues are tied to those costs. However,
in the case of interchange fees, economic theory also suggests that cost-based
regulation would not be expected to produce the optimal interchange fee.
Economists have shown that, because of the nature of the credit card market, it
would be very unlikely that the optimal interchange fee could be reached by setting
it at zero or determining it strictly on a cost-based measure. As we can see from
Figure 1, the credit card market is two-sided: services are being sold to cardholders
and merchants, and each side affects the other.11 Costs play a significantly reduced
role in determining the optimal interchange fee or price. There are effectively two
demand and supply curves to determine the optimal price. Maximizing output
requires issuers and acquirers to set prices in a way that will provide proper
incentives for cardholders to use and merchants to accept the payment card.
Balancing costs in some fashion would achieve this result only if the elasticity of
demand on both sides were equal. Furthermore, setting the fee to zero would
maximize output only if on both sides of the two-sided market costs and demand
were equal. Because neither is likely to be true, one should not expect either a cost-12
based or zero interchange fee to be optimal. This conclusion is supported by the
newspaper subscription and advertising revenues described in an earlier footnote. In
both the newspaper and the payment card cases, revenue transfers are necessary to
maximize overall social welfare.
Allowing Merchants to Pass Through the Interchange Fees
Some analysts would lift the prohibition that keeps merchants from surcharging
card transactions. They believe that this would be fair because it would place the
costs of the interchange fee on the party generating the costs. If the merchant was
free to charge extra for using a particular card, cardholders would be paying the
interchange fees that card issuers charge to the merchants. The card issuer would
lose transaction volume, if the cardholders shift to another card with lower
11 There are partial demand curves and that unless the partial demand curves are identical,
using cost-based regulation to determine the per transaction fee to maximize the payment
card system’s output would only occur by chance.
12 David Evans & Richard Schmalensee, “The Economics of Interchange Fees and Their
Regulation: An Overview, MIT Sloan School of Management, MIT Sloan Working Paper
Three Decades of Antitrust Uncertainty,” Thomas Jefferson School of Law, San Diego,
California, Legal Studies Research Paper Series, March 6, 2007. p. 17.
interchange fees or pay by cash as a result of the surcharge. This would give issuers
an incentive not to raise the interchange fee above the optimal levels. However, a
surcharge solution has practical as well as theoretical concerns. There is empirical
evidence that suggests that high-volume merchants are reluctant to impose surcharges
because of the administrative costs associated with alternative methods of payment
such as the cost of handling cash.13 Most important, merchants will not impose
surcharges because of fear of losing customers to competitors who do not surcharge.
Theoretically, to maximize welfare in a two-sided market, a seller needs a way
to discriminate between the two sides. When the rule prohibiting surcharge is
eliminated, the division of benefits between merchants and cardholders becomes
irrelevant. Only when the surcharge is constrained [with the no surcharge rule] does
the payment card system concentrate on its charges on merchants and provide rebates
to cardholders to induce card use.14 In a case where greater volume is needed to
optimize the efficiency of the payment card system, the surcharge would raise costs
to the cardholder equal to at least the benefits that the issuer can provide to the
cardholder from the interchange fee income. Consequently, merchant surcharging
of card transactions would prevent issuers from stimulating card use in the
circumstances where greater volume is needed to optimize the efficiency of the
A third solution to the interchange fee issue is the antitrust aspect of the
payment card association, which is currently tied up in the courts. This solution is
beyond the scope of this report. However, below, the report presents a summary of
H.R. 5546 that is related to the antitrust solution. In that regard, the economic
assessment of the issue may contribute to the judicial and legislative determination
of whether the Visa and MasterCard associations are monopolies and whether the
domination of these associations warrants granting limited antitrust immunity to
providers and merchants to negotiate interchange fees. Even though Visa and
MasterCard have dominated the payment card volume since the 1970s, some analysts
argue that it is difficult to see how banks are able to control the system and
collectively harm social welfare. The reason is that within the association, individual
banks set virtually all their own fees and compete with each other. And, although
interchange fees are set collectively, the associations are open to any bank or
federally insured financial institution.16 Others argue, however, that larger banks
dominate the association, because larger issuing banks have lower costs than the
13 Steve Semeraro, “Credit Card Interchange Fees: Three Decades of Antitrust Uncertainty,”
Thomas Jefferson School of Law, San Diego, California, Legal Studies Research Paper
Series, March 6, 2007. p. 70.
14 Marius Schwartz &Daniel R. Vincent, Same Price, Cash or Card: Vertical Control by
payment networks, Working Paper 0201, February 2002, p. 47 at 3. Once the surcharge is
unrestricted, only the payment system’s aggregate share would matter, because the market
would no longer be a two-sided market.
15 Steve Semeraro, p. 20.
16 MasterCard and Visa have converted from associations to publically held companies, but
merchants challenging the interchange fee have alleged that the banks have retained the
same level of control as before the associations went public.
thousands of smaller issuers in the system. The more favorable cost structure enables
larger banks to charge higher fees.
Credit Card Fair Fee Act of 2008 (H.R. 5546)
On March 6, 2008, H.R. 5546, the Credit Card Fair Fee Act of 2008, was
introduced by the Chairman of the House Judiciary Committee, and the committee’s
task force on competition policy and antitrust laws held a hearing on this bill on May
after which the bill was reported as amended to the full House.
The provisions of the bill would authorize providers in a single covered
electronic payment system (e.g., Visa and MasterCard payment card associations)
and any merchant to negotiate and agree upon rates and terms for accessing their
electronic payment network. It defines the covered electronic payment system as any
system that has been used for at least 20% of the combined dollar value of U.S.
credit, signature-based debit, and PIN-based debit card payments processed in the
applicable year. It grants limited antitrust immunity to such providers and merchants,
as well as to those providers who determine among themselves the proportionate
division of paid access fees. H.R. 5546 sets forth a procedure to determine rates and
terms for access to a covered electronic payment system. It prohibits any other rates
and terms from being imposed upon merchants for accessing a covered electronic
payment system except as specified in a voluntarily negotiated access agreement. It
creates a panel of three full-time Electronic Payment System Judges, appointed by
the Antitrust Division of the Department of Justice and the Federal Trade
Commission Bureau of Competition, to determine the schedule of rates and terms for
three-year periods. H.R. 5546 subjects any determination of such judges to judicial
review. And, it authorizes providers and merchants to enter in voluntarily negotiated
access agreements and declares that such voluntarily negotiated access agreements
shall be given effect between the signatories in lieu of any determination by the17
Reaction to H.R. 5546
The bill is generally supported by merchant and consumer groups and opposed
by payment card companies and the banking community, including credit unions.
Merchant support for the legislation is reflected in a statement by John J. Motley of
the Food Marketing Institute, “ a major milestone in our long-standing campaign for
a fair, competitive and transparent credit card interchange fee system. The credit card
company cartels fix the fees at levels that far exceed actual transaction costs. This
legislation gives retailers the right to negotiate reasonable fees with the Visa and
MasterCard networks.” Consumer groups also supported the bill at the Task Force
hearing on the bill. U.S. Pubic Interest Research Group consumer program director,
Ed Mierzwinski, argued,
17 CRS summary of H.R. 5546 at [http://www.congress.gov/cgi-lis/bdquery/D?d110:1:./
t e mp / ~ b d C s i P : @@@D&s u mm2 = m&: d b s = n : |/ b illsumm/ billsumm.php|].
“An oligopoly of issuers dominate the marketplace. They can do whatever they
want. I am completely unconvinced that there is any competition in this
marketplace. We are fortunate [the Antitrust Task Force] is shining light on the
issue. This act would create a non-price control mechanism. It is a
commonsense approach to the problem that will force the two sides to the18
The general council of Visa argued that the bill would suppress competition and
innovation and result in unintended and harmful consequences for consumers. The
American Bankers Association points out that the bill contains provisions that violate
fundamental antitrust principles and will ultimately result in less competition and
increased costs and reduced benefits for consumers. Despite receiving an exemption
for most credit unions, the Credit Union National Association (CUNA) opposes19
government intervention in setting interchange fees. The Federal Trade
Commission (FTC) opposed the bill because the commission has long discouraged
exemptions from the antitrust laws, and the Justice Department’s Office of
Legislative Affairs opposes the bill on similar grounds as the FTC.20
One important issue raised at the hearing on H.R. 5546 that remains unresolved
is whether merchants would pass on to their customers the savings they obtain from
lower interchange fees. The representative from Visa suggested that there is no
evidence that merchants have lowered their profits by passing on the lower cost of
interchange fees to their customers.21 According to the testimony, there is little
evidence that customers benefitted from the lower interchange fees, including the
lower interchange fee case that was settled with Wal-Mart. 22 In the case in Australia
where the interchange fees were capped by regulation, the Royal Bank of Australia
has not offered empirical estimates that savings from lower interchange fees have23
been passed on to consumers in terms of lower prices.
18 Shane M. Walter, “House Judiciary Reports Bill to Allow Merchants to Negotiate
Transaction Fees,” BNA Daily Report for Executives, July 17, 2008. p. A14.
19 Credit Union National Association, “Interchange Bill May Be Dead for ‘08,” CUNA News
Now, July 17, 2008, p. 1.
20 Shane Walter, “Credit Card Companies Respond to Interchange Fee Criticism, Oppose
Bill,” BNA’s Banking Report, May 19, 2008. p. 935. [http://ippubs.bna.com/NWSSTND/
IP/BNA/BAR.NSF/Sear chAllV iew/27B1829A452582998525744C0000D2B4?Open&h i
gh l i ght = INT ERCHANGE,FEES] .
21 Congressional Quarterly, “House Judiciary Subcommittee on Antitrust and Competition
Policy Holds Hearing on Merchant Credit Card Payment Fees,” May 12, 2008, p. 85.
[ h t t p : / / www.cq.com/ d i s pl ay.do?docke y= / c qonline/prod/data/docs/html/transcripts/congr
essional/110/congressionaltranscript s110 -000002878244.html @c ommittees&metapub=C
Q-CONGT RANSCRIPT S&s e a r c h Inde x= 0&s e qNum= 34] .
23 William Bishop, Kyla Malcolm, and Nicole Hildebrandt, “Regulatory Intervention in the
payment Card Industry by the Reserve Bank of Australia: Analysis of the Evidence,”CRA
International, April 28, 2008.
The economic assessment of the two-sided market is a critical part of analyzing
the interchange fee issue. Merchant complaints are focused on the rise of the
merchant discount rate, indicating that the acquirer banks’ costs do not justify the
merchant’s discount fee that they collect from them. However, it is not clear that the
merchants fully account for the costs of the issuing banks that are included in the
discount fee. There is some evidence that the amount of the merchant discount fee
that the acquirer bank keeps is competitively determined; it is estimated to be about
0.5% of the transaction amount for most payment cards, including Discover and
American Express. However, empirical evidence suggests that merchant’s acceptance
of payment cards has little to do with the acquirer bank’s fees, because raising the
acquirer fee did not show a reduction in card acceptance.24 Consequently, the focus
turns to the cardholder and the issuing bank’s side of the market. On this side, there
is evidence that payment card pricing has a dramatic effect on card usage because of
the ease of switching to another card or method of payment. Cardholders avoid using
a card rather than paying more, which may justify the card association making larger
payments to the issuer banks, which lowers the costs to the cardholder but provides
little perceived benefit to the merchants.
Another implication concerns the market mechanism that would reverse any
anti-competitive behavior existing in the payment card industry. For example, if it
is determined that the interchange fee is currently the result of anti-competitive
behavior on the part of the card associations and issuing banks, interchange fees
should arguably be lowered. What mechanism might be used to make sure that the
price of the goods and services is lowered to reflect the lower interchange fees?
Although experience has shown that interchange fees can be lowered by regulatory
caps and other government restrictions, there has been little discussion of how to pass
the excess fees back to the cardholders. If the government just lowers the fee with
the expectation that merchants will pass the savings back to cardholders, it might not
occur. The government’s regulatory caps would be redistributing revenues from the
issuing banks to merchants. The result could be that the social benefit of the
electronic payment card system is lowered, because the government’s action would
lower revenues to the card-issuing banks, causing them to issue fewer than the
optimal number of cards to cardholders. With fewer cardholders using the payment
system, merchants may not see the growth in customers they had in the past.
24 Steve Semeraro, p. 70.