A Land of Innovation, but How Competitive is the Payments Industry? Part 2: The $161 billion question

The Nilson Report has stated that $161 billion was paid in U.S. merchant card fees in 2022, with most charges concentrated in the unregulated credit card market where fees average 2.24%.

Visa and Mastercard have a combined 76% market share of this market (Figure 1)¹, and both have reported profit margins of around 50%.^2,3 In contrast, retailers can typically expect profit margins below 5%.⁴

In microeconomic theory, high prices and high profit margins suggest a market in which there is limited competition. In this blog – the second of a two-part feature assessing competition in the payments industry – we will analyze market dynamics in the credit card payment industry and outline three options for merchants looking to tackle the problem.

Why are card fees so high and so profitable?

The great majority of credit cards issued in the U.S. today only have one network badged on them, and therefore only one set of rails that their transactions can be sent via. With these single-network cards, most merchants have little or no negotiating power over interchange and network fees. What incentive does a card network, or an issuing bank have to lower their fees for any given transaction if they are the only bank or network available for a merchant to choose whenever a consumer presents their bankcard at a point of sale?

The most obvious lever merchants have here is the power of refusal. This has been tried fleetingly in the past^5,6,7 but for even the very largest merchants it has not proved to be a sustainable strategy because it risks lost sales and is not customer friendly. This is partly because of the global card networks’ Honor All Cards rules, which mean that refusal to accept cards must be truly nuclear; merchants must refuse to accept (for example) Visa credit in its entirety rather than just a subset of expensive, high interchange fee cards.^8,9

What are the options for merchants?

1. Individual Optimization

There is a theory that merchants can solve their own problems today through optimization, and do not need policy intervention. There are plenty of things that even the largest merchants should be doing to ease the cost burden of payments today, but I disagree that this optimization is a solution in and of itself given a large portion of fees remain non-negotiable. For this reason, I strongly believe we need a long-term solution to the market dynamics.

In the shorter-term, I would strongly encourage all merchants to look seriously into card optimization in areas including:

• Processor negotiations with group processing deals available for smaller merchants
• Cost audits which can expose charging errors
• Debit network routing incentives
• Launching merchant co-brand card programs or other financial partnerships
• Payment method diversification, potentially involving steering to low-cost payment methods

2. More Card Fee Caps

Fee caps have been tried in many jurisdictions, including in Australia, the U.S. and the European Union. The most attractive feature of fee caps is that they can address the worst symptoms of a lack of competition and are significantly better than taking no action in my opinion. The debit caps in the U.S. continue to save merchants an estimated $10 billion in fees annually.

The main issue we have seen with fee caps is their practical application. There are different methodologies that have been employed to calculate fair and appropriate caps, but they are all by their nature highly subjective. Caps also need ongoing monitoring and adjusting, which is time and resource intensive. Additionally, we have seen evidence of unregulated network fee hikes following the implementation of interchange caps because the fundamental issues of competition have not been addressed.

3. Sustainable Competition

In my opinion, the current market structure for card payments is somewhat akin to putting an elephant on a seesaw when it comes to bargaining power, and more bargaining power for merchants would balance the seesaw. Rather than a take-it-or-leave it proposition from one provider where the merchant’s only option is either to accept their fees or refuse to accept every credit card from that whole network, and in the process jeopardize a very high proportion of sales, I maintain merchants should have some meaningful choice. If industry requirements were introduced that make sure there were two unaffiliated networks available on each credit card for merchants to route to, like there is for debit cards in the U.S., I believe this would be a positive step towards improving competition.

This is referred to as co-badging and provides merchants with a choice of networks to route each transaction to. In markets such as France¹⁰ and Turkey,¹¹ I understand this practice is commonplace on both credit and debit cards. There is a second component necessary too – which is to make sure merchants have unfettered ability to elect which network to send the transaction to based on factors such as cost, approval rates and fraud protection. I have observed that if network availability is restricted by factors such as authentication method, or channel, or usage of tools such as tokenization, then the pro-competitive effects of co-badging can be nullified.

What would this extra competition do to fees? It would likely put downward pressure on both interchange and network fees, which I think would be good for both merchants and consumers. As previously mentioned, the retail industry is highly competitive, with very low profit margins, so I believe a large portion of these savings would likely be passed on to consumers in the form of lower prices. There would be a knock-on effect on consumer rewards, which Fed research suggests are more heavily yielded by “more educated” and “richer” cardholders¹², but our analysis suggests this is likely to be relatively small (less than 10 basis points of total card spend) and I believe overall consumer value would increase as merchants lower everyday prices to remain competitive.

There’s No Substitute for Competition

Card payments are the most common payment method within the U.S. consumer payments market today. Industry numbers suggest the market for these payments is characterized by high merchant fees, and public 10ks show high profit margins for the credit card industry.

There are optimization opportunities available for merchants today, but many fees remain non-negotiable. Caps have been used as a policy intervention in many countries and continue to generate meaningful savings for merchants despite not addressing competition issues. I believe competition can be increased within the market by ensuring credit cards are co-badged with at least two unaffiliated networks, like we currently see with debit in the U.S., and I believe this solution would work well for both merchants and consumers.