Why Free Market Economics and Interchange Regulation Are Not Mutually Exclusive

25th June 2017
Callum Godwin
Callum Godwin
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The Trump administration is known to be very keen to enable as much free market activity as possible. So it seems natural that its focus will be on repealing red-tape regulations such as Dodd-Frank, which includes the Durbin amendment, to allow free markets to flourish. A closer analysis of competition economics reveals that interchange regulation is actually required to enable competition to function. This sounds like a paradox, but here’s why.

Numerous regulatory bodies and courts in other jurisdictions have found that interchange fees restrict competition in the card processing market by creating a price floor. Given that interchange fees typically constitute 70-95% of the total merchant service charge/discount rate, it is difficult for processors to differentiate themselves on fees. In other mature industries, this usually means that players differentiate through innovation, but the high switching costs (integrating a new processor can be complex) prevent churn and dampen any incentive to innovate. Large banks that run credit card processors also benefit from the scale of their commercial and personal banking portfolios. These characteristics have generated operating margins of 30-40% for processors and 50-60% for the card brands, while merchants’ costs have soared and profit margins stagnated.

Figure 1: Average Profit Margins

However, just because interchange fees as currently set are anti-competitive does not mean that interchange at a certain level may be unjustified; indeed, no regulator has yet mandated a level of zero interchange. In the defence of interchange, cases have focused around the benefits that it potentially delivers to the entire card system, including merchants. It is also potentially an effective mechanism to cover issuer costs. Both are areas regulators need to consider. But what is often ignored are the benefits that merchants afford to banks – not only in interchange income, overdraft fees and other revenue streams but, as The Economist recently noted, ‘More treasured than the bullion in its vaults are the data on its servers… In effect banks have a monopoly over data that has helped them get away with lousy service and fend off newcomers with better ideas.’1

Scrapping Durbin would mean more of the same, but with the added pain of a significant increase in merchant fees. In every other developed market around the world, interchange fees are significantly below the levels experienced in the US, and almost all of those markets enjoy stronger innovation and lower overall fraud: think EMV smart cards, PIN authentication and near-field communication (NFC)/contactless.


One of the primary provisions of the Durbin amendment was the no-network-exclusivity rule, and this needs retaining. The no-network-exclusivity rule has created competition between card networks by mandating that debit card issuers must include at least two nonaffiliated networks on every card. This has delivered significant benefits for merchants, and it’s easy to see why. Without co-badging, the two major card networks are able to operate parallel monopolies at the point of sale – as they still do for credit and (until recently) signature debit. As a merchant, there is little choice but to accept the fees or risk a significant loss of sales. This, of course, provides networks with a direct incentive to charge very high fees. With co-badging, there is competition – if a network is aware that at least one other network sits on the card, and that merchants will route to the cheapest network, then there is a clear incentive to offer competitive fees. In practice, CMSpi has observed that merchants can save more than 10% on their PIN debit interchange and switch fee costs as a result of the no network exclusivity clause.

To counter this point, some bank advocates have argued that handing transaction routing choices over to merchants can harm consumers by potentially sending transactions via less secure, lower-cost networks. This could not be further from the truth: consumers are not liable for transaction fraud and alternatives to Visa and Mastercard are typically processed using a PIN, which is considered far more secure than signature. Networks are very much a homogeneous good from a consumer and merchant perspective – the key consideration being cost, not security or speed.

International Comparisons

Numerous jurisdictions have succeeded in regulating interchange on both credit and debit cards at levels far lower than Durbin. This resulted from regulators’ ability to identify the fundamental issues. For example, the European Commission determined that interchange fees are a competition question and, as a result, European regulation has been far more effective than Durbin. Other jurisdictions regulating interchange successfully include China, Australia and Malaysia.

Conclusion – How Can We Achieve a Fair Regulation?

The banking card industries have deep pockets. They have already seized the opportunity created by November’s election result to fund an expensive lobbying campaign – with articles in national broadsheet newspapers that have propounded a number of factual inaccuracies and fundamentally flawed logic. Politicians and regulators need to display the strength to stand up to this lobby and assess the arguments presented on their merits.

Meanwhile, merchant advocates must resist the blandishment of bank lobbyists who are keen to divert attention away from the real issues. What merchants need to do is campaign for a proper interchange solution which sets caps at reasonable levels and mandates competition between networks for all card transactions. They will not be able to do this until they make it clear to regulators that this is solely a competition issue.

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