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Title: The Challenge of Bank Card Interchange

The Challenge of Bank Card Interchange
  • Steve Mott
  • Principal, BetterBuyDesign
  • December 2005

The Burning Questions
  • Where are we now, and how did we get to this
  • What was the original rationale for interchange?
  • Whats the rationale now/how has that changed?
  • Does the new value proposition hold water?
  • What new issues are forced into the open by the
    emerging economics of interchange?
  • How are merchants and consumers reacting?
  • What are the resulting opportunities and

1. Where are We Now?
Attacks on bank card market power and interchange
have been piling up since 2002
  • Antitrust suits (allowing Amex et al to enter
  • Wal-Mart suit settlement
  • Merchant groups formed (Merchant Coalition,
    Merchant Payment Roundtable)
  • International challenges (Australia, EU, UK)
  • May 2005 Fed conferences (KC Chicago)
  • Summer 2005 American Banker articles
  • 4 of the 6 rumored interchange lawsuits this year
    have been filed
  • Congressional Inquiry in wake of Katrina/gas
    price hikes

Bankings Personality Challenges
In many respects, these challenges play upon some
inherent weaknesses
  • Banks tend to be terrible at communicating with
    one another
  • Were worse at communicating to the outside world
    (e.g., ID theft)
  • We let the card networks do their talking for us
  • We dont know our own costs
  • We dont understand their own economics (e.g.,
    direct mail solicitations, charge-offs, etc.)
  • We rarely price on value, so most products drop
    quickly to cost-plus pricing
  • We wont talk about interchange

Now its Winner-take-all Consolidation
On October 20, 14 interchange cases were
consolidated by the same court (and judge, John
Gleeson) which certified the Wal-Mart suit
against Visa and MasterCard as a class action
(Feb. 2002) 21 other potentially related suits
would be treated as tag-along actions)
Scene After the Wal-Mart Suit Settlement
The Wal-Mart suit settlement was seen as a
violent shock to the industry
Was the Court Satisfied with the Results?
But the results were disappointing to manybig
retailers got the benefits, but no structural
change resulted
Guide to Some of the Key Lawsuits
Four of the six big interchange lawsuits rumored
for this year have been issued these suits
strike at the heart of interchange policies and
Wheels of Justice Go Flat
While these developments might bring cheer to
some, for those who look for both fairer rates
AND equanimity in marketplace, the courts have
proved somewhat disappointing
  • Anti-trust suit permitting banks to sell Amex
    Discover products
  • 3.2 billion settlement of Wal-Mart suit,
    rejecting the honor-all-cards dictum of the
    card associations
  • Encouraged Visa/MC to raise interchange to
    compete with Amex rates
  • Top 200 retailers got to negotiate discount
    rates, but smaller merchants got stuck with more

Bad News from the U.K.
Defense of signature card interchange is going
badly in other parts of the world
    Kingdom's Office of Fair Trading, the government
    consumer protection agency, today issued a
    preliminary ruling against Visa's member banks,
    saying that the interchange fees banks charge to
    process transactions are anticompetitive. The OFT
    said Visa's multilateral interchange fee, which
    is applied to consumer credit cards, charge cards
    and unduly high fee being paid to card issuing
    banks by merchant acquirers on every Visa
    transaction deferred debit cards in the UK, leads
    to an "." The cost of these fees is being passed
    on to retailers and ultimately to consumers, the
    OFT added.
  • In a statement, Colin Grannell, Visa UK's
    managing director, said the card association does
    not believe its interchange fees are unduly high.
    The preliminary finding wasn't unexpected in
    light of the OFT's preliminary ruling last month
    that interchange fees set by MasterCard's UK
    members were too high.

Source Cardline, 2005
The Specter of Australia
Now, more than ever before, the specter of a
fundamental change looms in the U.S. If it goes
the way of Australia, change could be massive and
consequences huge
  • RBA concluded that credit card usage was
    artificially high due to loyalty programs and
    interest-free creditwhich were paid for by
  • So interchange rates were halved (to .55), with
    unexpected consequences
  • Issuers shifted to Amex and Diners charge-card
    growth surged
  • Consumers got hit with surcharges for credit-card
  • Only a couple of new participants (Virgin Money,
    GE Money) appeared
  • Issuers lost 300 mil. in interchange, but
    profits went up 16 at ANZ, versus the 40 drop
    they feared
  • Merchants saved US300 mil. Australian CPI
    dropped 0.2
  • RBA has now set its sights on setting debit cards
    at par (free), but large merchantswho receive
    interchange from issuers on some EFTPOS
    transactionsare fighting this new effort

2. The Original Rationale
Credit cards are widely acknowledged as the most
successful consumer financial service product in
the past half-century the original rationale
addressed important societal goals
  • Supported widespread, non-collateralized lending
    to qualified consumers
  • At efficiency levels better than merchants could
    provide (including lower cost of money)
  • With ability to use credit at any accepting
  • And get instant gratification for purchases
  • Facilitated more efficient electronic purchases
  • Provided merchants with guaranteed payment
  • Provided end-to-end electronic processing
  • Moved consumers out of cash and checks
  • Reduced fraud and NSF risk

The Basics of Interchange
The idea was to compensate transaction parties
for the work they did
Source Diamond Cluster, 2005
Original Structure of Interchange
Although little is publicly available about
interchange, it is possible to piece together
some cohesive theories on the original rationale
and structure the structural components had
clear purposes
  • Compensate issuers for costs of lending
  • Compensate acquirers for merchant vetting and
    processing tasks
  • Recover costs of network development and
  • Manage costs of fraud, given guarantees provided

Key Premise Support Electronic Purchases
With signature-based cards, consumers could
afford to make a purchase right away, or make a
bigger purchase than they otherwise would be able
(or want) to make with cash or a check the first
merchant who accepted the card would stand to
benefit from the resulting incremental sales
opportunity by accepting the cards
Original Premise Mission Accomplished
So its easy to conclude that the original
rationale for interchange has been fulfilled
  • 5 million accepting merchants
  • 65-75 of consumers with at least one card
  • Cards now produce a third of consumer purchases
  • Fraud is well-contained and efficiencies of
    electronic processing accrue to many

3. Whats Changed
But so much has changed since signature cards
were introduced four decades agoespecially in
the past 10 years although the card networks
have tried to morph these cards to fit all
applications, theres no doubt that theyre
getting long in the toothalong with many of
their most loyal users
  • Market maturation
  • The shift to rewards to keep growth going
  • A force-fit for online commerce
  • Changing consumer behavior and merchant needs for
    different ways to pay

Maturing into a Convenience Play
Consumer use of credit cards for lending has been
flat for a decade, while spending continues to
Interchange More Important to Issuers
Merchant-side business is now producing a better
return than the cardholder sidenaturally
shifting emphasis to interchange
Credit Cards Leverage Rewards
Bernstein Research estimates that 1 of
interchange goes to financing cardholder
rewardswhich mostly go to affluent
non-revolvers Visa recently reported that 40 of
cards would have rewards by next year
Primary Purpose of Cards Drives Use
A large, but aging core group of credit card
users regards rewards as their primary motivation
for paying with cards debit card usersa rapidly
growing, younger groupwant REAL pay-as-you go
Characteristics of Changing Consumers
New, emerging consumers are different than
todays transactors, and will be extremely
receptive to debit account products that they can
access from anywhere
  • The 18-34 age group is demonstrating a decided
    preference for debit payments over credit
    (Forrester, 2004)
  • 65 of college students have credit card debt
    50 charge them to the limit but a Nellie Mae
    study in 2004 reported that outstanding balances
    had dropped 7 (from 2001) to a seven-year low of
    2,169 per card, as students weaned themselves
    from this product
  • This demographic is highly-evolved toward
    Internet use (e.g., 60 are online bankers), and
    expect debit account access wherever they
  • 92 of high school graduates are Internet
    literate Growing numbers are registering for new
    payment types (e.g. PayPal web site reports
    nearly 80 mil. accounts)
  • A new population bubble is moving through the
    marketplace with unprecedented willingness to
    shop their primary debit account to institutions
    who get it and offer the Internet and wireless
    services and access they demand

Components of Debit Migration
Underlying the shift to electronic payments is a
major migration to debit- account products, away
from the heretofore credit-card centric consumer
economy, to the tune of 40 of all payments by
Shift to Debit Payments
Sources Nilson Report, Dove/ABA Study, BBD
Debit Account Users New Lifestyle
Debit card users are growing in number, and have
clearly different patterns for purchasing
behavioravoiding debt as much as possible

4. New Value-Proposition
The card networks have evolved their arguments
for fostering signature card use and keeping
interchange high to a new set of value
  • High interchange fosters innovation
  • Providers are delivering new services, such as
    charge-back protections for consumers
  • Interchange pays for incentives to usage
  • There are costs for guarding against fraud
  • Payment guarantees cant come free
  • Use of electronic processing provides valuable
  • End-to-end service can be cost-free (once
    interchange is paid)
  • The number of merchants accepting continues to

Innovation Track Record?
The bank card industry is not necessarily
regarded as the seed-bed of innovation but then
again, a BAI research study in 2001/2002
determined that there were only three disruptive
innovations in retail financial services in the
past 40 years (monoline credit, mortgage brokers
and credit-scoring).
New Services Charge-back Protection
In the model of disruptive innovation,
established market participants tend to add
services that users dont necessarily need in
order to keep value (and prices) rising in the
case of zero liability and other charge-back
protections, the industry has trained a
generation of free-riders who routinely
repudiate transactionsmore or less at willat
exactly the moment that the industry needs to
encourage more consumer responsibility and
accountability for online security
Network Operations Costs
Certainly, the costs of running the payment card
networks has continually come down with the
benefits of digital technology
  • Visa just finished a two-year upgrade of the
    Direct Exchange Network, which can do real-time
    authorizations for less than .05
  • Network costs through Private Network?VPN?IP
    evolution have reportedly dropped by more than
    one order-of-magnitude
  • Fraud costs are at an all-time low

Fraud is at an All-Time Low
Card fraud in the banking systems continues to
drop, and bank costs for risk management are
stable so this factor doesnt drive interchange,
High Cost of Sig-Card Risk Management
Saddled with the liability for fraud, online
merchants manually review 1 in five transactions,
and block 4-5 good orders for every bad oneon
top of fraud and charge-backs (especially
friendly fraud) the situation for smaller
merchants who cant afford elaborate risk
management systems is much worse
Source BBD Projections from RTD Business Model
Back-Shop Costs 2 x Interchange
The net result is that even the best and most
competent online merchants are paying twice what
they pay in interchange just to risk-manage
anonymous signature card transactions
Source BBD Projections from RTD Business Model
Meanwhile, Charge-offs Have Soared
In fact, true fraud pales in comparison to the
industrys somewhat self-destructive penchant for
extending credit beyond the logical ability of
incremental users to pay
Source Bank Technology News, March 2004
Merchant Vetting?
And poorly-vetted merchants fuel charge-backs
while generating high interchange
Competing Merchants Forced to Accept
With so many merchants accepting cards in todays
environment, competitors are forced to join-in or
risk missing sales
ResultHigher Cost of Doing Business
The result is all merchants face a higher cost of
doing business
5. Economics Force the Issues
Meanwhile, the economics of bank card usage are
forcing serious examination of the underlying
cost structure and pricing rationale
  • Interchange only goes up (unless youre a
    national retailer with negotiating leverage)
  • But other digital processing businesses
    demonstrate the value to society of open
  • Signature cards are decidedly the most expensive
    way to transact in the merchant space
  • High interchange accrues mostly to the benefit of
    Issuers (not Acquirers)
  • Industry concentration has polarized
    relations/bifurcated strategies

Interchange Rates Trends
For most merchants, interchange just keeps
rising for select merchants with negotiating
power, some relief came in early 2004
Source Visa, MasterCard, Corporate Reports and
Bernstein estimates BBD additions
Bank Card Interchange Rates
Rising interchange has been a fact of life since
the early 1990s in a recent report, Morgan
Stanley predicted an average rate of 1.85 by 2010
Source Nilson Report, May 2005
Telecommunications Counter-Example
International calling prices dropped from 1.34 a
minute in 1980 to .21 in 2003, spurring a hefty
increase in demand
Source FCC
Telecommunications Counter-Example
Basic long distance services are experiencing
normal declines in price expected for a maturing
Enormous Stakes for Merchants
It takes unusual market power to keep interchange
rates rising in a period of digital network
efficiencies for the worlds largest retailer
the stakes are enormousabout 750 million in
2002 and more than a billion by 2007 that would
otherwise drop to the bottom-line
Source Bernstein Research
Credit Cards Provide the Bulk of Fees
Its easy to see why the card industry is so
protective of interchange credit cards generate
the vast bulk of merchant fees paid to FIs
vis-a-vis all other payment types
Sources FMI, Paymentech, NDPS, Nilson Report,
ATM/Debit News, PiperJaffray, BCG
Total Costs for Each Average Ring
Factoring in all the transaction costs, signature
cards remain the most expensive way to transact
Sources FMI, Paymentech, NDPS, Nilson Report,
ATM/Debit News, PiperJaffray, BCG
Proportions of Each Ring Amount
And when ring amounts are factored in, the
signature debit card product emerges at even more
expensive than credit cards
Weighted Average 1.29
Sources FMI, Paymentech, NDPS, Nilson Report,
ATM/Debit News, PiperJaffray, BCG
Bank Card Revenue2002-2004
Looking at bank card revenue components from an
industry level, interest remains the big
driveralthough merchant interchange is becoming
more important
Source Credit Card Management
Card Revenue vs. Demographics
Between 40-60 of revenuemainly in the form of
penalty interest rates and feesis derived
primarily by saturated marketing of cards to the
next-to-lowest quintilewho can least afford them
Penalty Fees Interchange Interest
Non- Revolvers Paycheck- to-Pay- check (Dont
qualify for cards)
Source CCM, plus BBD projections
Bank Card Expenses/Margin2002-2004
Meanwhile, charge-offs vastly eclipse fraud and
other typical network costs and the costs of
cardholder rewards (part of operations/marketing
) and billions of unproductive direct mail
solicitations generate the bulk of industry costs
Source Credit Card Management
Card Costs vs. Demographics
A substantial portion of marketing expenses now
go to rewards, which mainly go to non-revolvers
charge-offs of debt mainly accrue to the
next-to-lowest quintile, who now use credit cards
for day-to-day living
Non- Revolvers Paycheck- to-Pay- check (Dont
qualify for cards)
Opns/Mktg Charge- offs Interest
Source CCM, plus BBD projections
Non-Revolvers Get a Free Ride?
Non-revolvers tend to produce the lowest profits
for Issuers, and are mainly relied upon to drive
interchange revenue but merchants dont see
benefits from serving these customersparticularly
at premium-card interchange ratessince they can
afford to pay by a variety of means
Industry Revenue/Income by Participant
By far, the vast portion of industry revenue and
profit accrues to the Issuers in fact, acquirer
margins have been regularly squeezed
Sources FMI, FirstData/Concord, EFT Report,
PiperJaffray, BCG
Smaller Merchants Foot the Acquirer Bill
SMEs generate the bulk of revenues and fees for
Natl Local Total Txns (bil.)
11.3 7.5 18.8 Vol (T) 0.71
0.47 1.18 All-in fee 13bp 60bp
32bp Procg/txn. 2.5 11
6 Sales/svc. 0.06 0.27 0.14
Source Bernstein Report 4/2003
Concentration in the Card Business
Concentration in issuance has growth markedly
today, eight FIs control 92 of transactions so
the debate over interchange mainly affects a
handful of institutionsbut threatens the entire
FI Concentration Online
The handful of companies that dominate credit
cards dont serve the entire marketplace,
though--e.g., the online marketplace serving
this marketplace fully with the right products
will require many participants
Source Various Research Reports
The Specter of Cannibalization
Banks are frozen from moving to non-card payment
innovations by the challenges of product
Financial impact of converting to
Source Dove Consulting, from VISA Discussion
Documents, FaulknerGray, Nilson Reports, NACHA,
FDIC, BCC Study, Industry Reports
Prisoners Dilemma
From an enterprise standpoint, weaning an
institution off of high interchange might make
perfect senseexcept to the card business units
Merchant Concentration Online
In a similar vein, large merchant strategies
conflict with small merchants
Source Various Research Reports
6. Consumer and Merchant Needs
  • Consumers are clearly shifting to a debit-account
    payment preference
  • Efforts to extend card usage to applications
    where they dont fit (e.g., bill payments) are
  • Merchants have good reason to want additional
    payment options for their customers
  • So they are dabbling in alternative
    paymentslooking for better product functionality
    at justifiable rates
  • Real-time debit alternatives appear to be the
    direction the industry is most likely to take

Consumers Need Payment Flexibility
There is growing evidence that consumers are
frustrated with todays payment products, and are
trying non-bank alternatives
  • Studies continue to show that more and more
    consumers want to pay for purchases with their
    ATM debit cards (or ACH equivalents) to get more
    control and pay-as-you-go option
  • Up to half of adults cant buy a 250 basket on
    the Internet with credit cards (dont have them,
    or are maxed-out)
  • Online billpayment continues to be horse-race
    between bank and biller models
  • Stored value demand for online loading, top-off
    and account management capabilities is growing
  • Micropayments users are constrained by lack of
    viable and cost-effective means of payment
  • Consumersnot just those living
    paycheck-to-paycheckproving quite willing to pay
    1-3 for convenience payment alternatives

Merchants Demand Better Options
Meanwhile, merchant demands for better
alternatives to expensive signature-card payments
online are reaching a crescendo
  • Groups like the Merchant Payment Roundtable
    (representing 56 of eCommerce revenue) are
    actively pursuing real-time, good-funds
    guaranteed payment alternatives for online
  • The Merchant Payment Coalition is researching a
    merchant payment network for POS
  • A cottage industry of Billing Service Providers
    has arisen to help billers gain access to debit
    networks for payment (including PINless debit,
    STARChekDirect, etc.)
  • Stored value processors are rapidly plumbing-in
    eDebit capabilities for transactionson top of
    loading and top-offs
  • Digital content providers are tweaking stored
    value and other debit-account solutions to get
    per-transaction pricing under .20 sig-card
  • Remittance and convenience payees are
    increasingly willing to accept account transfers,
    direct debits, PINless alternatives, and ACH to
    cut transaction costs and speed payments

Merchants Benefit from Multiple Options
Evidence is beginning to surface demonstrating
the benefits of multiple payment optionsled by
PayPal and BillMeLater
PayPalInstant Credit, with Interest
By default, PayPal is offering very convenient
online banking via an increasing array of
Instant Credit Online-BillMeLater
Other instant credit models are gaining
traction as well, producing both incremental
demand and lower interchange costs
Debitman Model
Debitman remains an interesting test of merchant
experimentation blended with provider ingenuity
Pay-by-Touch is another vendor to watch
Merchant Interchange
Debitman introduces the notion of merchant
interchange, providing an incentive for solving
the issuance challenge
7. Opportunities and Challenges
The movement to a debit-account centric payment
society from a credit-account based one carries
substantial political baggage
  • A contrarians view makes the case for more
    thorough examination, debate, and disclosure
  • The financial services industry itself appears
    ready to changeif only to avoid calamity
  • Industry polarization could thwart consensus to
    move forward with appropriate networks

? ? ?
A Different Point-of-View
Aite principal Gwenn Bezard claims there are five
misconceptions about interchange that need
greater understanding in this debate
  • Interchange is only one part of the total cost of
    acceptanceacquiring fees are the other big cost
  • in countries like France, for example, where the
    debit interchange is lower, the acquiring fees
    make total cost about the same as in the U.S.
  • The merchant service charge (MSC) for credit
    cards is lower in the U.S. on average than in all
    but three countries surveyed (e.g., same as UK,
    but higher only than France and Denmark)
  • High interchange is not the result of a lack of
  • Multiple card networks in the U.S. (vs. single
    networks in many foreign countries) tend to bid
    up interchange as networks seek more bank
  • Issuer contention that interchange is necessary
    to develop networks and new products is simply
    wrong, however
  • Most issuers make the most money on outstandings
  • Many debit card networks overseas have developed
    thriving networks with much lower interchange
  • Interchange is a negligible factor for exploding
    stored value card use

Source Aite, 2005
A Different Point-of-View (cont.)
Further examination and scrutiny should go a long
way to balancing out some of the furor
  • High interchange doesnt foster innovation
  • Prepaid card markets are exploding, and
    interchange is a negligible factor (though FI
    pricing weighs against them)
  • Regulatory relief, such as interchange caps,
    havent worked completely as expected in
    countries that have tried it
  • e.g., Australia, consumers pay more though
    merchants have halved Interchange costs
  • rather than push for regulatory relief, merchants
    in the US would be better off backing electronic
    networks they control (e.g., Debitmana similar
    system in Germany now handles 53 of the debit
    traffic with NO interchange)

Source Aite, 2005
Roadmap to The Opportunities
Those these recommendations are antithetical to
the closed and defensive approach of the bank
card associations, there IS a way forward
  • Acknowledge differences in strategies and stakes
    between the big card issues and all other FIs
    ditto for merchants
  • Find an independent arbiter (Fed?) to referee
    examination of costs and value in-depth among ALL
  • Debate the issue and positions openly and
  • Start the process of rationalization before
    merchants abandon bank networks/products en
    masse, and pricing plummets
  • Return to making money the old-fashioned way By
    earning it

Consequences of The Challenges
The stakes of this debate have become
enormousmost especially for the biggest card
issuers, who far and away have the most to lose
  • Amex civil suit plus 47 interchange suits
  • Possible interchange decline
  • Absolute volume loss to merchant-controlled
  • Exacerbated split between the big bank and all
    other FIs
  • One estimate of the expected value of
    settle-ments/damages 15.4 bil.
  • 11 bil. out of 24 bil., if restructuring a la
    Australia happens (Morgan Stanley)
  • Up to 20 of current card volume, or 400 billion
  • Big 8 lose support from rest of the industry
    all other FIs support rival products

Potential Reduction in Interchange
Lower interchange is probably inevitable, and the
least of our worries
Tragic Irony Fight Over Value-Pricing
Ironically, this battle is over one of the few
banking products that havent simply devolved to
commodity, cost-plus pricing value has
conflicted with the notion of market power in
this debate
Value-Based Pricing
Cost-Plus Pricing
Checking Accounts Savings Accounts Investment
Accounts Check deposits ACH Commercial
lending Prepaid cards Online banking Online bill
payment etc.
Signature cards Wire transfer (SWIFT)
Consequences of Getting it Wrong
So maybe, just maybe, the industry should seize
upon the opportunity for getting the interchange
issue right, and use that model for reexamining
all other banking productsmoving the industry
toward a defensible balance of costs and value,
toward a new era of customer relationships, where
FIs are respected, rather than vilified, for the
true contributions they make for secure
transactingbefore its too late
Steve Motts Contact Coordinates
This presentation represents a portion of a
growing body of research and analysis by
BetterBuyDesign. Please dont hesitate to
contact BBD with any questions, comments or
further interests!
Steve MottBetterBuyDesign
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