Interchange Fees: Why Some Jurisdictions Have Regulated Successfully, But Most Haven't

There are two stages necessary for the implementation of a successful reform of interchange fees.

Stage one:

Policy makers are required to identify that Multilateral Interchange Fees (MIFs) are anti-competitive. (MIFs are fixed, nonnegotiable interchange fees set by the card networks and paid by merchants to card issuers via the merchant’s acquirer. These are in contrast to bilateral interchange fees, or BIFs, which are interchange fees bilaterally negotiated between merchants/ acquirers and issuers.) This has been the case in some jurisdictions (such as the EU), but in others (such as the US), the lobbying of the banks and the card networks has been strong enough to influence policy. In recent EU litigation cases, the card networks have been keen to point out that interchange is lawful for three main reasons:

1. They would cease to exist in the absence of interchange because issuers would migrate to their competitors.

2. Interchange is integral to the delivery of the benefits of the card system.

3. The benefits of interchange received by merchants are less than, or equal to, the level of the fee paid.

Stage two:

Once a decision has been made on the lawfulness of MIFs, regulators are required to determine an appropriate approach. We have identified three possible remedies – regulation, competition and breaking up the card schemes.

1. Regulation

Regulation involves setting appropriate caps for interchange fees. This can address the fundamental problem of excessive interchange fees but in practice tends to return a disappointing outcome. There are two main methodologies employed to determine the level of the cap: (issuer) cost-based, and benefit-based (i.e. the cost of cash, or the MIT MIF1 approach).
Interpreting these studies is not an easy task; both have their strengths and weaknesses and can return very different outcomes. Therefore, a high level of subjectivity is required to determine what, if any, a fair level of interchange should be. Unfortunately, regulators are often too close to the industries they are regulating, and the studies required to implement these methodologies are rarely conducted by independent economic experts. From the map on figure 1, we can see that the EU, China and Australia have implemented relatively low caps while the US, India and Canada have high caps.

2. Competition-based

Our analysis suggests that the regulation adopted by the United States was the least effective of all major countries analyzed. However, in addition to interchange caps, US regulators implemented a no-network exclusivity clause that mandated that issuers co-badge debit cards with at least two unaffiliated networks. This opened up the opportunity for significant savings for merchants by routing transactions through the lowest cost network. It also removed the incentive for networks to set very high interchange and network fees and so can be considered a market-based solution.

The main issue with this approach is that it is also subject to circumvention. In the US, networks have signed many behind-the-scenes incentive agreements with card processors and issuers. This means that processors, who are usually responsible for transaction routing, are often not incentivized to route to the lowest cost network in the merchants interest and merchants miss out on savings.

3. Break up the card networks

This is perhaps the strongest option. It would involve breaking up Visa and Mastercard and introducing smaller networks that would engage in healthy competition in their place.

The attraction of this option is obvious. The card networks are now amongst the largest companies in the world and have proven adept at sidestepping both regulation and competition-based solutions. It is very hard to see the networks’ astonishing 50%+ profit margins being addressed in any other way than a break up.

The biggest potential issues are practical – it is difficult to see what this solution would look like in practice. Additionally, economies of scale enjoyed by Visa and Mastercard (albeit currently resulting in corporate profit rather than tangible benefits for end users) would be greatly reduced, and regional monopolies may emerge in the networks’ place, yet with higher costs.

No country has yet mandated the break up of the card networks and it is hard to see this happening in the near future. However, precedents in other industries include the break up of the railroads and Standard Oil in the US in the late 19th and early 20th centuries respectively and, more recently, the break up of the Bell System in the 1980s.

Figure 1 : Interchange rates by country