How are Interchange Fees Set?
Interchange fees are set to maximize network volume. Default Interchange fees are established at levels aimed at ensuring maximum participation in the card network system by both merchants and cardholders. It motivates financial institutions to innovate and issue cards, allows merchants to benefit form accepting them and maximizes the number of cardholders who use them.
It is not in the interest of an association to choose interchange fees that deviate markedly from social optima. Even a monopoly in a two sided market would not benefit from a very high or low interchange fees. High interchange fees result in substantial merchant resistance and would induce many merchants to reject the card. Very low interchange fees would lead to correspondingly higher cardholder fees and discourage consumers from holding and using cards. Network externalities by themselves induce restraint. Merchants want cardholders to spend. Cardholders want their card accepted at merchants.
The business decision is quite complex and takes many factors into consideration.
- Maximize the network (# of cardholders, merchants, transaction volume)
- Establish rates on the value of accepting cards delivered to each industry
- Promote acceptance of both credit and debit cards
- Incentive for merchant acceptance and new acceptance categories (QSR)
- Incentive for best practices (swipe cards or use AVS for example)
- Facilitate a competitive position against other payment networks and payment instruments (i.e. Cash, Check & AmEx)
- Consider member costs of both issuing and acquiring transactions
- Consider cost of introducing new payment card programs and technologies that enable the participants in a four party system to provide leading-edge payment opportunities
The Visa and MasterCard networks aim to set default Interchange rates at a level that encourages banks to issue their cards and merchants to accept those cards. Rates are set to recognize the value of card acceptance and to reimburse issuing banks for some of the risks and costs incurred in maintaining cardholder accounts, including lending costs, such as the cost of funding the interest-free loan period, the cost associated with cardholders that default on their loans, and losses stemming from fraud. Interchange fees help to reimburse issuers for bearing the costs that merchants would otherwise have to bear for the ability to make sales to customers on credit. Both Visa and MasterCard develop and publish Interchange rate tables that disclose the default rates that apply to various types of transactions.
Four main factors determine Interchange rates applicable to a given transaction:
- Type of card—Different Interchange rates apply to different types of card products. For example, both MasterCard and Visa have separate Interchange rates for general purpose consumer credit cards, reward credit cards, commercial credit cards (issued to businesses), and debit cards. The rates vary because the costs, risks, and revenues associated with these different card products vary for issuers; they also reflect the networks’ goal of providing incentives for both issuance and acceptance of cards. For example, reward cards involve higher Interchange fees for a number of reasons: According to network officials, such cards tend to provide greater benefits to merchants (in the form of average transaction amounts that are typically higher than those on standard cards) and to cardholders (in the form of cash rebates or points)
- Merchant category—The card networks classify merchants according to the line of business in which they are engaged. Interchange rates may reflect unique characteristics of different merchant categories, such as average profit margins and the way in which merchants authorize transactions. For example, according to card network officials, because the supermarket industry tends to have very low profit margins, the networks set Interchange rates to encourage supermarkets to accept cards. Also, the method in which a merchant authorizes payments can affect the extent to which a card network’s system is used. (For example, hotels typically must authorize a payment at least twice—once at guest check-in to ensure the customer is authorized for the minimum payment amount, and again at checkout to authorize the final payment amount.) Additionally, some merchant types may qualify for special incentive Interchange rates if a card network determines the merchant category has growth potential for card acceptance. For example, government organizations and utility providers receive lower Interchange rates to encourage them to accept cards.
- Merchant size (transaction volume)—Both MasterCard and Visa set lower Interchange rates for merchants in some categories that conduct high volumes of card transactions over their networks. For example, according to Visa’s default Interchange rates that were in effect as of October 2007, supermarkets that conducted a minimum of about 7 million Visa card transactions in calendar year 2006 qualified for lower rates than supermarkets that conducted fewer Visa transactions
- Mode in which a transaction is processed—Interchange rates also differ depending on how a card transaction is processed. For example, transactions that occur without a card being physically present, such as in Internet transactions, carry a greater risk of fraud; therefore, higher Interchange rates apply to these transactions. Similarly, swiping a card through a card terminal, rather than key-entering the account number, provides more information to the issuing bank to verify the validity of a transaction; therefore, swipe transactions are assessed a lower Interchange rate
This market based system of setting Interchange has begun to be replaced with government price controls.