By Patti Murphy and Dale S. Laszig
Editor's Note: Interchange is unique to bankcards – credit and debit cards issued by banks and credit unions that carry Visa and MasterCard logos. We reached out to Visa and Mastercard requesting interviews for this report. Both companies declined.
Interchange is the economic engine that powers the bankcard business. And like any other mechanical engine, interchange's power and functionality have evolved over the years. This two-part series will explore how payment card interchange has influenced the payments ecosystem, global markets and, more importantly, acquirer and merchant relationships.
Despite efforts by retail trade groups and others to dumb-down interchange with catch phrases like "swipe fees," interchange is not easy to understand or calculate. It hasn't always been this way, however.
"Originally, there was just one interchange rate, and you could calculate it," said long-time payments industry consultant Paul Martaus. The calculation included an interest charge (based on the overnight Fed Funds rate) and a risk component (assessing the likelihood of cardholder default) that compensated card-issuing banks, plus a network processing fee that compensated the bankcard brands for making the transaction possible. "When they terminalized everything, that calculation went out the window," Martaus said.
Terminalization – the migration from paper receipts to electronic card authorization and draft capture – began in the late 1980s and early 1990s, as electronic settlement gradually replaced merchants' daily trips to local banks. "To help incent merchants, [card brands] lowered interchange for those who went electronic," noted Mark Dunn, President of Field Guide Enterprises LLC.
Visa and Mastercard built state-of-the-art networks to support electronic card payments, while assigning merchant category codes (MCC) to different merchant segments based on risks and opportunities. The card brands perceived some merchants (for example, jewelers) as inherently riskier than others (grocers, for example), and adjusted interchange rates accordingly to account for these different levels of merchant risk. Merchant size was also a consideration. "The large retailers generated a lot of transactions; they were the bread and butter. They were able to command lower rates," Martaus said.
So began the stratification of interchange. What started as a simple means of encouraging banks to issue and merchants to accept credit cards evolved into a complex set of rules and objectives. Actual rates can vary by several percentage points depending upon merchant categories; card type (for example, corporate or consumer, credit or debit); channel (card present or card not present); method of authorization (signature versus PIN); and card attributes (no frills versus rewards).
When Visa and Mastercard introduce new interchange categories, the rationale given is often the creation of additional opportunities for growth. "Both merchants and acquirers benefit when emerging markets are added to the interchange chart," said Todd Ablowitz, President of Double Diamond Group LLC. "Merchants and industries that have not achieved full market penetration can improve their market presence and revenue streams. Small and midsize acquirers can find new ways to differentiate by specializing in these verticals."
Over the years, Visa and Mastercard have adjusted interchange to bring numerous new vertical markets into the fold. Payment providers have responded by demonstrating how accepting electronic payments can help these merchants increase average tickets, simplify back-office management and enhance operational efficiencies, Ablowitz added.
Schools, governments and charitable organizations have benefited from this go-to-market strategy. "In this mature and competitive industry, especially if you're not the biggest acquirer, new and emerging interchange categories can be a great resource and guide," Ablowitz said. "There are riches in niches; find your niche and make it happen." A few examples follow:
Legal wrangling, which led to Visa and Mastercard transforming from bank-owned consortia to public companies, and technology advances also have brought about significant changes in interchange. The earliest POS card terminals merely captured basic data about cardholders and issuing banks to facilitate processing (contained in Track 1 of a card's magnetic stripe).
Advances in data capture and management and network communications, along with countless other technological innovations (low-cost miniaturized computing power, the Internet and mobile phones among them) have continually enhanced the power, speed, reach and functionality of POS devices. Upgrading terminals to read Track 2 data, for example, allowed for the capturing of data that matched transactions to an expanding list of interchange rates, noted David Holman, Division Sales Director at Beyond Inc.
Many experts interviewed for this series suggested the card brands, as well as some issuers, acquirers and ISOs, bank on the complexity of interchange. Holman referenced the proliferation of acquirer pricing models as evidence of this. "The more creative they are the easier it becomes to charge more than you possibly should," he said.
Martaus pointed to Mastercard and Visa moving from bankcard associations to publicly traded companies (2006 and 2008, respectively) as a turning point for interchange pricing. "Prior to that, the boards were made up of [card] issuers, and increases in interchange were intended as incentives for them to issue more cards," Martaus said. "When they [Visa and Mastercard] went public they lost the bank influence, but they kept doing things that way."
The IPOs occurred in a climate of vigorous public debate over interchange that included Wal-Mart Stores Inc. and millions of other merchants suing Visa and Mastercard for allegedly conspiring to fix interchange rates in violation of federal anti-trust laws.
A settlement was reached that included cash payouts to retailers and allowed retailers to surcharge card payments. Former U.S. District Judge John Gleeson, the presiding judge in the case, expressed hope that the settlement agreement would unleash a competitive spirit in the bankcard market by permitting credit card surcharging at both the brand level (that is, Visa or Mastercard) and product level (that is, different kinds of cards, such as consumer cards, commercial cards and premium cards).
Acknowledging limitations of law, Gleeson said the court could only provide relief from anticompetitive business practices, and "cannot regulate interchange fees or enjoin nonparties or preempt state laws or reform network rules that do not violate the antitrust laws." The final outcome of that case is still in limbo, however. An appeals court scrapped the settlement in 2016, after thousands of retailers claimed the agreement banned them from future litigation involving interchange and related rules. In early 2017, the U.S. Supreme Court declined a request to review the appeals court's decision.
Lawmakers entered the fray over interchange in 2010. Responding to vocal retailer lobbying, Congress added the Durbin Amendment to the Dodd-Frank Act, which instructed the Federal Reserve Board to regulate debit card interchange. The Fed imposed a cap ($0.21 to $0.24 per transaction) that primarily applies to large issuers of signature- and PIN-authorized transactions.
In a May 1, 2017, op-ed piece published in Morning Consult, executives from leading bank and credit union trade associations claimed the cap, to date, has siphoned upwards of $42 billion in interchange revenues from bank and credit union issuers of debit cards.
Apparently, much of that money was pocketed by retailers, particularly those specializing in large-ticket items – despite assurances that reprieves on interchange would result in lower consumer purchase prices.
A 2015 survey of merchants by the Federal Reserve Bank of Richmond found that most (75 percent) of merchants had not reduced product prices after the Durbin Amendment caps took effect, and 22 percent raised prices. That same study also revealed that a significant share of merchants specializing in small-ticket items (about 25 percent) saw interchange costs rise. Many of these merchants had sweetheart deals pre-Durbin under which they paid less than $0.21 per debit card transaction, the study noted, but those deals were largely scrapped after the cap went into effect.
All of these changes have created problems while also presenting new opportunities for acquirers and their sales partners. POS terminals, once considered cash cows, don't generate much income anymore. "A lot of ISOs cut their teeth in this business leasing terminals," Holman said. The total of monthly lease payments typically far exceeded the cost of the devices. As interchange evolved and became more complex, however, most ISOs discarded that practice, Holman added. The emergence of free terminal deployments further eroded lease revenues.
Now the trend is toward winning contracts with new pricing models created around interchange. "Early on, everything was a race to the bottom; everyone just kept lowering rates," noted Anne Mellin, Division Sales Director at Beyond. "Then all of a sudden they started padding [prices], adding fees all over the place."
Wells Fargo Merchant Services, for example, recently began charging an "interchange clearing fee" over and above its standard interchange-plus pricing for transactions that don't qualify for its base markup under that pricing model. The move has been controversial. "We've seen the charge for the interchange clearing fee range from 0.25 percent to 0.50 percent, but Wells is able to charge whatever it wants, so I assume it has been assessed at percentages outside this range," Ben Dwyer, Chief Executive Officer at CardFellow LLC, recently blogged.
Interchange-plus is one of several pricing models employed by acquirers and ISOs that effectively form the basis for calculating overall merchant discount rates. The next installment of this series will explain these different pricing models and examine how ISOs and merchant level salespeople are taking these models into the marketplace. Editor's note: Interchange is unique to bankcards – credit and debit cards issued by banks and credit unions that carry Visa and MasterCard logos. We reached out to Visa and Mastercard requesting interviews for this report. Both companies declined.
Mastercard defines payment card interchange as "a small fee paid by a merchant's bank (acquirer) to a cardholder's bank (issuer) to compensate the issuer for the value and benefits that merchants receive when they accept electronic payments. It enables banks that issue electronic payments to deliver tremendous value to merchants, governments and consumers."
Visa describes interchange as transfer fees between acquiring and issuing banks for Visa card transactions. "Visa uses these fees to balance and grow the payment system for the benefit of all participants," Visa's website stated. "Merchants do not pay interchange reimbursement fees —merchants negotiate and pay a 'merchant discount' to their financial institution that is typically calculated as a percentage per transaction. Merchants can receive a variety of processing services from financial institutions that may be included in their merchant discount rate." 
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