The Economics and Future of Interchange (#14)

A peek into what drives trillions of dollars of card payments every year

This article covers the very basics of card transactions and focuses on the revenue driver — interchange — that allows such transactions to take place.

Wherever we travel in time, an exchange of goods or services has required a transfer of some form of money. That is why, when anything new moves the needle for payments, we stand up and take notice. The entry of card networks such as Visa and Mastercard in the 1960s was one such change.

Before cards, a customer would enter a store with cash in hand or sometimes even with a chequebook. For the customer, there was little convenience in it. More so, the cost of carrying cash and the possibility of non-sufficient funds (NSF) with cheques added high risk to this lack of convenience.

There are, without doubt, plenty of cash-rich economies still today. However, the possibility of swiping a card and calling money off a credit line or bank account would be preferable, if accessible, for most consumers. So would be the immediate authorization on a transaction for the merchant. There are many such benefits of using cards, but few dominate the rest:

• Cheaper and convenient: the operational costs of carrying cash and of managing cheques have been well-documented. Cards not only reduce such costs but also allow the convenience of purchases over the internet or phone.

• Credit provision: credit card has been the most profitable banking product over the last hundred years, and the possibility of purchasing on a credit line over an interest-free period has been the cause of its profitability

• Global acceptance: cards are acceptable in most geographies and offer better exchange rates on travel than other payment methods

• Access and track: consumers and banks can better track expenses with cards, and this allows issuers to assess the credit-worthiness of individuals as well

These benefits come at a cost, however. And interchange is part of the cost that consumers and merchants share for the facility. But before you understand the nuances of interchange fees, it is crucial to learn how card payments work.

Authorization, Clearing, and Settlement

On the face of it, a card transaction is simple. You present a card to the cashier or enter your details on an e-commerce website, wait for the authorization from your bank, and done! But a lot is happening behind the scenes within those few seconds. And this is much before the transaction is settled and funds are transferred. The four-party model on which open-loop card networks operate helps us understand this better.

Image: Four-party model for card transactions

NOTE: the actual card transaction process involves other parties as well, as banks outsource processing and authorization, but this model is sufficient to understand interchange

For a cardholder to pay and for a merchant to accept payment, both must be associated with banks. The bank from which a cardholder is issued a card is, as the name suggests, called the issuing bank. And the bank accepting payments and standing behind the merchant is the acquiring bank. In between the two banks stands a card network, acting as the intermediary, such as a Visa or Mastercard.

Authorization: The purchase is good-to-go

Once a card is swiped/tapped at the point-of-sale (PoS) terminal, the transaction and card details get routed through the acquiring bank to the card network, which checks the card for security features and further forwards it to the issuing bank for authorization. Once the issuing bank verifies that the cardholder has sufficient funds in the savings/checking account or overdraft coverage (in the case of debit cards), or has the necessary credit facility (in the case of credit cards) — the transaction is authorized. And with the authorization, the cardholder’s duties are over, and he/she can walk back with the good or can avail the service. This is what we experience at the time of purchase, and no fees or funds are transferred/collected yet.

Clearing: issuing statements to cardholders and reconciliation to banks

The immediate next step after the authorization is clearing, which requires an exchange of transaction data between processors and issuers. Once the information is validated, the issuing bank registers the transaction to the cardholder’s statement, while the card network’s clearing system provides a reconciliation of the clearing to both banks. This clearing gets done on the same day, either in batches of transactions or at the point of purchase. If this seems too much jargon, just remember that this step involves necessary documentation to give the go-ahead for the transfer of funds, and the workload of the card network and issuing bank increases in this clearing stage.

Settlement: exchange of funds and fees

Finally, funds or fees are settled within two days of the transaction. This is where all the parties see the fruits of their work. I have not touched at the interchange rate yet, but the detailing of the earlier stages was important to understand why the parties demand the revenues that they do.

1. Who makes what?

The acquiring bank charges a merchant discount fee or rate (MDR) on each card transaction from the merchant, which the merchant often transfers to the customer through retail price. This fee, around 1–3% of the transaction value for credit cards and <0.5% for debit cards , differs across card types, card networks, merchant categories, etc. and is based on quite complex pricing models.

But the acquiring bank keeps only a small portion of this. An even smaller part of this, say 0.05%, is transferred to the card network and is called switching fees — mainly for routing the transaction. The majority, however, is settled to the issuing bank, and this is what we call the interchange fee. Also, MDR is usually quoted to merchants by acquirers on an “interchange plus” pricing, implying that any fluctuations in the interchange rate set by the card network would be passed to the merchant. Overall, the interchange fee is usually above 70% of the MDR.

2. Why is interchange so high?

Interchange is the incentive for the issuing bank to participate in the card transaction process. Also, it has been previously called Issuer reimbursement Fee (IRF) for all the costs associated with making it possible for the issuing bank, as the merchant (and the acquiring bank) on the other side benefits from increased merchant sales due to the convenience of cards. What are these costs?

• Cost of Guarantee: the issuing bank extends a payment guarantee to the acquiring bank even if the cardholder fails to pay back his/her credit availed

• Cost of Funds: in the case of credit cards specifically, the merchant bank receives the settlement funds from the issuing bank much before the cardholder pays back its bank

• Operating Expenses: as noticed in the description of authorization and clearing processes, the issuing bank faces expenses in operating its authorization network, in producing cardholder statements, etc.

Based on all these costs, the card networks define the appropriate reimbursement (published usually twice a year, in April and October) from the merchant bank to the issuer to ensure that the economies of card transactions work out for different cards.

Calculating Interchange

In the simplest of ways, the interchange rate is often calculated as a percentage of sales plus a fixed fee. But the more in-depth we go, the more complicated it gets. Even in the final interchange rates we see, say for Mastercard in the U.S., the differences for card types (Debit or Credit; Core or World Elite) can be significant.

Image: Example of sales plus fixed fee interchange pricing; Source: Mastercard Merchant Rates

Beneath the final pricing are hundreds of variables, and I will highlight a few that matter most:

• Form of transaction: an e-commerce transaction attracts a different price compared to a bill subscription or a mail-order transaction, based on the risk and effort. An online card payment, for example, would be riskier than a point-of-sale (POS) swipe. In fact, Visa only recently increased the interchange rates for card-not-present transactions, which include online, mail-orders, and such card transactions.

• Merchant categories: card networks aim to maximise the volume of transactions since the revenue is dependent on it. For the same reason, a supermarket or a grocery transaction would see lower interchange — to encourage such merchants to accept cards

• Type of Cards: a premium card naturally expects a higher interchange rate due to the higher costs of operating and managing funds versus a traditional card. Similarly, a commercial card often demands a higher interchange due to the risk of business credit as opposed to a consumer card.

• Payment system: Finally, the rails on which the transactions run — signature debit, credit card, PIN debit, or PINless — play a part in defining the end interchange rate. As a rule of thumb, the rate on PIN debit < signature debit < credit card.

The interchange fee is decided separately across regions as the assumptions for the above considerations differ. The entirety of interchange pricing is tough to digest, but if you are a cardholder or a merchant, understanding the rationale should do.

Future of Interchange

The interchange rates have constantly come under criticism from merchants for price-fixing by card networks, with settlement in billions announced at instances. Increasingly, the shadow of regulation has become larger on the industry with the European Union capping interchange rates to 0.2–0.3% and networks held guilty in the UK as well. Something similar has followed in Asia-Pacific, with Australia almost halving the rates and New Zealand fighting the surcharges. This white paper offers good depth of insights on these challenges.

To add, alternate payment systems such as RuPay and UPI have started to put tremendous pressure on card volumes. Especially with the mandated no-MDR on RuPay and UPI in India, and with the wide acceptance of e-wallets that gives merchants the option to choose the cheapest acquirer elsewhere.

Saying that, the threats have been present for decades. What keeps card networks afloat, however, are constant innovations such as contactless payments, soft POS, wearables equipped with payments, and so on, along with a large population still untouched by payments technology, giving card networks a tremendous opportunity for secular growth.

My view is that regulations will continue to push interchanges thin in certain geographies, especially where exist strong trade unions. But at the end of the day, interchange rates will contribute to an increasing revenue source for issuing banks as card networks adopt new technologies and gain even wider consumer acceptance. All in all, these are interesting times for the payments industry!

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