The latest dialogue on interchange.

Cause you love it: more on interchange fees. Lots of people talking about interchange fees recently:

Matt Yglesias: Once you keep in mind the fact that the median household income in 2008 was slightly above $52,000 it’s not at all obvious to me that this is any kind of scam. Instead, it appears to be a classic positive sum business interaction. Credit card companies use interchange fees to cut into retailers’ monopoly rents and then rebate a share of the fee to consumers via reward programs, and on net consumers benefit and the median household appears to benefit….Now it’s true that in this particular case my conscience is pricked by the fact that poor consumers end up losing out. At the same time, do we really think it’s feasible to conduct distributive analysis of every new business model and only accept the ones that are beneficial to poor consumers?

Megan McArdle: I never understood why the progressive consumer finance types got so worked up about interchange fees, which are essentially a knock-down fight between two very powerful business lobbies, not a cosmic injustice perpetrated against the American consumer….To be sure, the current system benefits the wealthy most. But that is broadly true of many business models; shall we outlaw Costco because the poor cannot afford lavish pantries and large chest freezers in which to store their warehouse-club bounty?

Kevin Drum Beyond that, let’s make it clear what I’m proposing. I don’t want to eliminate interchange fees. Card payment networks cost money to operate and there’s nothing wrong in theory with using interchange fees as a way of offsetting those costs. In fact, I’m not sure I even want to limit interchange fees. What I’m opposed to is their invisibility. All I want to do for now is bring them into the open.

So let’s step back for a second. Plastic is becoming the new form of checking for the 21st century. Right now the Federal Reserve steps in and backstops the clearing risks on the checking system to make sure that checks clear at par. If I write you a check from Bank A you can cash it at your account at Bank B for the value of it. This is not a state of nature event; it happens because the government steps in. If interchange regulation is a bad thing at a meta level, then so is this, and we should roll back that checking regulatory enforcement to the late 19th century.

Money is an object that acts as a store of value for payments of debts, goods or services. Is it necessary that a private corporation collects 2%+ of value in order to move this money from place A to place B? If interchange was low and self-regulated through market mechanism, maybe we can hand wave this. But the United States’ interchange fees are among the highest in the world and are increasing.

This is why interchange regulation has always been about debit cards and not credit cards. Debit cards move my money, my value, from place A to place B. A credit card is a short term loan. As a risk manager, I’d advise against using interchange to subsidize the credit risk of a credit card, but that’s a their problem. However, by contract, merchants can’t discriminate between the two.

Now there are additional problems with this outside the generic problems. One is that it functions as an inequality machine. Nobody here seems too moved by this argument, so let’s move on. It’s worth noting that there’s been a debate on whether or not this would really exist, and now we have an additional measurement. Another problem is that it blurs the line between transactional and revolving debt. If you are moved by behavioral arguments about how people function with credit that’s a problem.

I’m more interested in how that blurring destroys the normal supply/demand function. Markets are abstractions over the ability to contract, and once the ability to contract is twisted we can get all kinds of neat distortions later down the road. For instance, competition seems to increase interchange. Since my wallet is filled with plastic cards already, the only way to get me to switch to another card is to promise more rewards. The only way to promise more rewards is to soak the merchants. The merchants would normally charge more for that credit card….except they can’t. By contract. They have to sign these contracts because of the excessive market power. That’s where the problem enters.

Matt mentions “retailers’ monopoly rents” but that’s completely backwards. There’s plenty of reasons to believe that the largest firms pay less in interchange than smaller firms. I tried hard to quantify and confirm this, but nobody releases this data or will go on the record, so I will just say that it is widely assumed places like Walmart’s grocery store pays less in interchange than a local grocer. A grocery runs on razor thin margins and this wipes them out.

And it is small businesses that get hit by these the most, not “retail monopolies.” In fact, it has been a hilarious pleasure of mine to talk about progressive economic reform of finding ways to check monopoly power with owners of small businesses over the past year fighting on this topic. Small business owners! When do they ever get in the fight for regulation!?!? It goes like this:

Small Business Owner: I’m really getting screwed on these rates. I can’t put any pressure on banking system but I also can’t discount or not accept these cards. We’re way past the point where I get “lift” from the new business and I don’t know what to do.
Mike Konczal: It sounds like you think that the government needs to pass a regulation here; that there is a genuine market failure and that only the government can stand in to check the power of finance and monopolists.
Small Business Owner: I can’t even believe I’m talking to you about this. I’m normally very conservative, I don’t do things like this.
Mike Konczal: It’s ok. This is a safe space to experiment. But you just have to tell me what the government needs to do.
Small Business Owner: Ok….it’s like the government needs to….the government should…..it’s like I’m paying a crappy government tax to the credit card companies!
Mike Konczal: Hmmm. That’ll do, I guess.

And notice how elegant of a solution we got with the Durbin amendment. Instead of some complicated mechanism we simply say “merchants can give a discount if you use your debit card.” Maybe they will, maybe they won’t. This will probably open the door to all kinds of new innovation: a check-out line if you use pin debit is one idea just off the top of my mind.

Like Matt, I’m not particularly interested in regulation. But I’m not sure what we’d “tax” here in order to rectify this. Probably the tax-free benefits that cardholders get, which sounds like a nightmare. And I do think when it comes to the means which we use for exchange the government should have a simple mechanism to watch the rate, and give merchant the power to engage the payment system on equal footing by giving them a fair contract and means to price discriminate. Not a bad job for Liberalism.

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13 Responses to The latest dialogue on interchange.

  1. Greg says:

    I understand the arguments on these interchange issues, however, in the exchange, why can’t the SBO offer a discount? I live in Southern California and there are plenty of gas stations which offer a few cents off if I pay by cash and for ARCO (a subsidiary of BP), if I choose to use my ATM/debit card, they’ll charge me 35 cents (and they don’t actually accept credit cards.)

    So, what’s to prevent my local grocer or restaurant from giving me a discount if I pay by cash?

  2. Mike says:

    As far as I understand the law, your local grocer/restaurant/business can offer a discount on cash. However in general they don’t, as cash has downsides – people steal it, you have to carry it to the bank, it gets crumbled, etc. – that plastic doesn’t, so businesses prefer not to incentivize out of cash. Some do, many don’t.

    But from their point of view, debit cards and credit cards are the same, except credit cards offer a line of liquidity that it might be worth taking a surcharge on.

  3. Lucas says:

    Visa interchange charts show that Walmart, etc pay less than small and medium sized businesses for card present transactions on non-premium cards.

    http://usa.visa.com/download/merchants/april-2010-visa-usa-interchange-rate-sheet.pdf

    Look at the categories that end in “Threshold I”, “Threshold II”, or “Threshold III”; then look at page 4 to see what the thresholds are to see that only very large enterprises qualify for those rates. They effectively work as volume discounts on non-premium cards. MC has similar tiers. I believe these tiers came into existence about the time of Walmart settling a major lawsuit with the card brands. Some believe these tiers may have been a result of confidential parts of the settlement. After Walmart gathered many thousands of small and medium sized merchants for the suit, they then negotiated a settlement in which some of the largest benefits only apply to the largest retailers.

  4. Patrick E. says:

    If you want to know of a real-world example of large retailer versus large bank on interchange fees, Discover, famous for it’s cashback bonus, which is basically paid out of their interchange fees, pays less in cashback bonus on transactions with, you guessed it, Wal-Mart.

    I think it’s important to realize that interchange fees are about distributing the costs of operating the payments systems. With the law as it is now, the costs are paid by the merchants, and where they can pass those costs along, to consumers. That process is neither simple, nor transparent. If interchange fees were paid directly by consumers, then the incentives to eliminate those interchange fees would develop.

    However, in both cases, what we’re actually dealing with are diffuse consumers and merchants dealing with the oligopolies. There’s no countervailing power to combat the market power of the oligopolies. Thus, the general market direction will be to have the full costs paid by merchants and consumers, as opposed to the banks. Failing to regulate that is a distributional choice. It is saying that the merchants and consumers should pay the costs of operating the system, plus the oligopoly profit that the banks are getting in addition. And that just seems like the wrong choice to me.

  5. Tony says:

    Credit card companies have two business models: 1) provide a service to merchants. 2) induce consumers to use the payment method most costly to merchants.

    Visa and Mastercard are basically the only two players in the field. They both have margins of 36 percent and 30 percent, respectively. They dictate pricing structures to the US retail industry. That’s not a market, that’s an antitrust case.

  6. Suzan says:

    Another real-world example on interchange fees –

    I had a Costco employee tell me that they (Costco) pay NO interchange fees to American Express, though they aggressively solicit new accounts for them.

    I’m not sure how this works out, though. Do the charges on the cards at other businesses effectively cover the costs of Costco’s transactions?

  7. [I'm also curious about the 16% gap called "unknown"... seems pretty large and begs one (me) to read it again to try and understand what is going on there]

  8. Greg says:

    @suzan – I believe it! I’ve long suspected that AMEX paid little to no interchange fees as COSTCO customers tend to be lucrative customers that AMEX likes for them to sell additional services onto.

  9. Zach says:

    Back when I used to live in Houston, there was a chain of liquor stores that gave a 5% discount for cash or PIN debit. I thought that was already generally permitted — you just couldn’t tack on a surcharge for credit. Am I wrong?

  10. Claire Voyant says:

    @suzan & Greg … correct! Amex is the only plastic accepted at Costco, so it has no competition inside the store.

    In-store offers a terrific prospecting environment, without any competition! On the other hand, if Amex were to lose the Costco account to another card, it would lose 2 million or so cardmembers who would automatically convert to a competitor’s card to keep having plastic they can use at Costco. It’s worth it to lock out competitive cards by giving Costco a sweet deal (0% interchange) that others can’t match.

    Where Amex makes its money is 1) if a customer revolves a balance (not all Amex cards are charge cards, in fact the Amex Costco co-brand card is a credit card) and 2) when that card is used OUTSIDE Costco. Outside Costco the interchange rates can go as high as 3%, depending on the size of the merchant, type of business and customer’s default risk for merchants of similar type.

  11. pebird says:

    “Retailers’ monopoly rents”?!? Does Yglesias have a clue about what he is talking about? He has the whole monopoly rent argument upside down. Banks are the ones collecting monopoly rents via the interchange fees – not the retailers. [I wrote this before I scrolled down and saw that you slammed him on the same point. We need to call out idiocy, especially on financial matters, where ever it rears its head.]

    Without monopoly rents there would be no “rewards” programs. There is no benefit to the consumer to pay with a low cost (no rewards) card – the card agreements forbid retailers from offering any financial incentive to steer consumers toward a particular electronic payment. Durbin’s amendment is a simple, straight-forward first step. It makes too much sense to have a chance of being passed.

    So we all pay for rewards programs via increased costs to retailers. And retailers cannot offer competing electronic payment programs . It is probably cheaper now for a retailer to accept a hand written check than a credit/debit card.

    Megan McArdle continues to amaze – the two “very powerful” business lobbies happen to be battling for a portion of declining consumer income – one are banks, which if they succeed will increase costs for consumers, whereas if retailers win, there will be less pressure on price increases and service reductions (e.g., less labor in stores, higher unemployment). Why would progressive consumer financial types get worked up about this? Get a frigging clue, Megan.

    Kevin Drum comes out for the obvious – “I don’t want to eliminate interchange fees.” What a bold statement! Those radical interchange fee eliminationistas must hate Drum. Bringing them out in the open will do little – so what, you are going to choose your retailer based on the posted interchange fee rate? How exactly would consumers be charged for interchange fees in a transparent fashion?

    No one likes regulation, but we need to realize that we are currently regulated by private financial interests – moving some of that to public regulation is not the end of the world.

    BTW, AMEX does not charge interchange fees because they do not operate a financial clearing network – but their non-interchange fees are higher than banks – so the net cost is roughly the same for a retailer to accept their cards. AMEX has recently (last 2 – 3 years) been creating partnerships with banks to have co-branded cards (AMEX + BoA), which I bet have some interchange fee costs baked in, but not very transparent.

    How about some competition in the electronic payment space? What a concept. Is that so hard for “progressive” bloggers to get their heads around?

  12. pebird says:

    Let me clarify on interchange. An interchange fee is a charge the merchant’s bank (retailer) pays the customer’s bank (credit card or issuing bank) to use the network’s payment system. There is another fee, called the discount fee, which historically has been lower for Visa and MC than the interchange fee.

    AMEX does have a payment network – it is both the issuer and the acquirer – so it does not have a classic “interchange fee” to merchants – but it pays a separate fee to banks to piggyback on their networks – it just does not pass this fee onto merchants as an “interchange fee” since it isn’t strictly one. Discover is the same way.

    But there are other fees to merchants – the discount is the other major fee. The history of this is similar to the classic discount on commercial paper – to accept risk and time value of money (as opposed to a cost of business – like what the interchange fee is supposed to represent). So AMEX and Discover have other fees (higher discount and service fees) to compensate for the fact their transactions do not generate a direct interchange cost – although they do have costs of interchange. Unlike interchange, these fees are not usually reported publicly, but negotiated directly with retailers.

    Now, think about this – does the retailer get a break when the acquiring bank and the issuing bank are the same? Say if Chase is the merchant’s bank and the consumer uses a Chase card? Well, no – the credit card companies are separate legal entities from the merchant banking companies, but we all know it’s all in the family. Chase’s actual interchange costs ARE lower in that situation – they may move accounting transactions between entities, but the actual cost of interchange is much lower. This is a case where financial consolidation does not produce lower costs to consumers (through their merchant agents). Besides the fact that competition is lowered.

    I think that sometimes to sound as if we know more than we do, we like to use technical terms (“interchange”). Which is OK, but if we play that game we need to remember nuances of jargon that can come back and bite us. Like the “AMEX doesn’t charge interchange” line – strictly true, but not very relevant.

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