Interchange fact, fiction and myths

Interchange a word that describes a method that allows cars and truck to move from one road to another. Interchange a
word that describes the exchange of ideas or data between two or more individuals. Interchange a fee paid to an Issuer of a payment card.

It is this third definition that this blog will explore.  A fee or income paid to an Issuer of a payment card.

Some would call it a tax on merchants.  Merchants who wish to sell products and services to individuals and corporations who wish to pay with moneys loaned to them by a financial institution (credit card) or held on deposit by a financial institution (debit card and pre-paid card). Wikipedia offers the following; Http://en.wikipedia.org/wiki/Interchange_fee.  To add to this sound Wikipedia definition, I offer a little story of how Interchange was described to me was a way of helping people appreciate the way interchange has changed over the years.

In 1991 I joined EPSS, a technology company then owned by Eurocard International (50%), Eurocheque International (35%) and MasterCard International (15%). EPSS or European Payment System Services ran and managed a set of technologies designed to support the authorization, clearing and settlement of payment transactions initiated by a payment card being presented to a merchant. We supported both credit and debit card transaction and would when they emerged also supported pre-paid card transactions.

As part of the settlement process we calculated and assured acquirers (merchant bank service provider) were paid, less interchange and scheme fees, for those payment card transactions they had submitted on behalf of the merchants they serviced. Therefore understanding and assuring the accuracy of these calculations were essential to assuring the successful operation of those systems we managed.

In the first few weeks of starting, general counsel sat me down and described Interchange. What I learned is that on a biannual basis we hired a consulting firm, Edgar Dunn; to conduct an anonymous survey of the member organizations, the banks that issued credit cards.  Their role was to ascertain what it cost the issuers to support the processing of payment card transactions.  Three elements were key to these calculations:

• Cost of Carry – The interest charge or income the bank had to pay or forego in order to to fund payment card transactions conducted on the credit cards they issued to their customers.  This cost was calculated based on the reality that the issuing bank paid to payment network (MasterCard, Eurocard or Eurocheque) either immediately or within a few days of submission; and, the  fact that credit
  card charges are billed to the cardholder periodically.  This time between paying the merchant and the card holder paying their credti cards bill was assumed to be about 45 days.
• Systems costs – The depreciation of assets and cost of operation of the systems necessary to process these payment card transactions.  These systems included those that authorize, in real time, payment card transactions and receive, each evening, the clearing transactions and reconcile the moneys the Issuer had to settle, daily, with the payment network.
• Fraud costs – The loses the issuing bank incurred for payment card transactions where the consumer claimed they did not recognize the charge and the merchant proved that they had accepted the card and followed all the rules and procedures associated with the acceptance of that brand of payment card.

Our consultant then would amalgamate all the data they collected from the issuing members and submit a recommendation of what interchange should be for the next two years.  These recommendations recognized that interchange must vary based on two key characteristic:

1. Location of Merchant and home country of cardholder
   1. Global
   2. Regional
   3. Domestic
2. Nature of transaction
   1. Card present and electronically read
   2. Card present and paper voucher with card imprint
   3. Card Not Present (mail order telephone order and in time eCommerce)

We then discussed how the Issuer earned income from payment cards.  I learned; yes for those efficient issuers there were profits, whereas for inefficient issuer they might actual lose money. Bottom line the calculation was designed not to create profits.  It was designed to cover cost.

Management then took these recommendations to their board to seek approval.  At this stage the boards where a balance view with both the issuing and acquirering institutions represented.  Unlike today when it is fundamentally the Issuers that sit on these boards.

In 2002 I joined Visa and again was asked to visit with general counsel to make sure I understood what interchange was.  My first statement was that I understood and explained what I had been taught all those years ago.  I was informed that although I understood the foundation, things had changed.  Two additional components had been added to the calculation and moreover instead of being limited to a few easy to understand categories, the structure of interchange has been MADE complex.

While it still was calculated through the use of anonymous survey of issuers, interchange now included:

• Rewards – this was meant to cover the cost of the reward programs Issuers used to entice cardholders to adopt a particular card product.
• A Reasonable Profit

As to the characteristics used to identify what interchange fee would be earned by the issuer, the original two categories of transaction location and the presence of the card continued.  Yet now to complication matters  two new ones were added:

1. Type of card – In order to justify the addition of the cost of rewards into the formula the payment network attempted to sell merchants
   on the idea that corporate cards and premium “Gold” cards where used by people or organizations who would be more loyal, spend more hence more valuable customers for the merchant.
2. Merchant size and category – This distinction was driven by the reality that certain merchant categories are prone to fraud.  But more importantly, certain merchant segments where essential to the expansion of card usage and were known to sue or complain about the cost of interchange.

Interchange had morphed from a cost recovery mechanism to a complex formula that takes into consideration the complexity of the payment ecosystem and a source of revenue  to financial institutions.

With all this change there are also challenges.  With only two global “4 party” payment brands (Visa and MasterCard) regulators, merchants and politicians seek to manage and control interchange.  Words like monopolistic powers are used to describe the way interchange is calculated.   Therefore you find lobbyist speaking on behalf of merchants, arguing these fees create excessive profits for the issuer.  You here people complaining that the fees and the rules not allowing them to charge consumers for the use of these more expensive payment products, ends up that interchange simply gets embedded into the cost of sale and cash paying customers are seen to be subsidizing card paying customer.

As a prime example Wal-Mart and a consortium of merchants, banded together and successfully won an argument against both Visa and MasterCard. They argued that interchange associated with debit cards processed through the credit card networks should not be the same as credit card interchange given that the cost of carry was near euro.  When all was said and done  3 billion dollar was paid by the payment networks to the merchants and their lawyers.

The Australian Central Bank also decided to regulate interchange, although the benefit a reduction in the price did not occur thus the perceived benefit to the consumer was not achieved.  Currently the European Union continues to evaluate interchange with the argument that domestic and regional interchange must be the same and that monopolistic powers are used to manage interchange.

Here in the United States Senator Durbin succeeds in imposing significant change to debit interchange.

Interchange will continue to be scrutinizes.  My hope, let us return to original definition of interchange and focus on being a mechanism designed to simply cover the issuers’ cost of processing payment transaction and offer a reasonable profit for their efforts.

Let the issuer earn the core of their income through revolving Interest charges, annual card fees and other services paid for by their customer the Cardholder.  Why should the merchant subsidize the rewards offered to entice cardholders to take an issuers product without also garnering a demonstrable increase in sales?