Interchange fee

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Interchange fee is a term used in the payment card industry to describe a fee that bank card networks such as Visa and MasterCard require merchants to pay card-issuing banks when merchants accept their credit and debit cards for purchases. The card-[issuing bank] in a payment transaction deducts the interchange fee from the amount it pays the [acquiring bank] that handles a credit or debit card transaction for a merchant. The acquiring bank then pays the merchant the amount of the transaction minus both the interchange fee and an additional, smaller fee for the acquiring bank. Interchange fees have a complex pricing structure, which is based on the card brand, the type of credit or debit card, the type and size of the accepting merchant, and the type of transaction (e.g. online, in-store, phone order). Further complicating the rates schedules, interchange fees are typically a flat fee plus a percentage of the total purchase price (including taxes). In the United States, the fee averages approximately 2% of transaction value.

In recent years interchange fees have become a controversial issue, the subject of regulatory and antitrust investigations. Some countries have established significantly lower interchange fees. The fees are also the subject of several ongoing lawsuits in the United States.

1 Overview
2 Controversy
3 Outside the United States
4 References

[edit] Overview

Image from a GAO report explaining how the interchange fee works.

Interchange fees are set collectively by the financial institutions which are stakeholders in Visa (currently an association of banks and other credit card issuers and acquirers) and MasterCard (a public company). Many of these banks issue both credit and debit cards. JPMorgan Chase is the largest issuer of both.

While the credit card market in the United States continues to grow, exceeding $1.3 trillion annually, the number of card-issuing banks has shrunk. The top five credit card issuing banks (J.P. Morgan Chase, Citigroup, Bank of America, Capital One and HSBC) now control about 90% of all credit card accounts. Card issuers now make over $30 billion annually from interchange fees, an increase of 85% since 2001.

Originally, banks operating under the Visa or MasterCard umbrellas, set interchange fees to maintain balance in the incentive structure between issuing and acquiring banks. Typically, the bulk of the fee goes to the issuing banks. Issuing banks’ interchange fees are extracted from the amount collected by the merchants when they submit credit or debit transactions for payment through their acquiring banks. Interchange fees collected by Visa and MasterCard totaled $26 billion in 2004. In 2005 the number was $30.7 billion, up 85 percent compared with 2001.

Interchange rates are established at differing levels for a variety of reasons. For example, a premium credit card that offers rewards generally will have a higher interchange rate than do standard cards. Transactions made with credit cards generally have higher rates than those with signature debit cards, whose rates are in turn typically higher than PIN debit card transactions. Sales that are not conducted in person, such as by phone or on the Internet, generally are subject to higher interchange rates, than are transactions on cards presented in person.

For one example of how interchange functions, imagine a consumer making a $100 purchase with a credit card. For that $100 item, the retailer would get approximately $98. The remaining $2, known as the merchant discount and fees, gets divided up. About $1.75 would go to the card issuing bank (defined as interchange), $0.18 would go to Visa or MasterCard association (defined as assessments), and the remaining $0.07 would go to the retailer's merchant account provider. If a credit card displays a Visa logo, Visa will get the $0.18, likewise with MasterCard. Visa's assessment is fixed at 0.0925% of the transaction value and MasterCard's assessment is fixed at 0.0950% of the transaction value. On average the interchange rates in the US are 179 bps (1.79%) and vary widely across countries.

[edit] Controversy

Regulators in several countries have questioned the collective determination of interchange rates and fees as potential examples of price-fixing. Merchant groups in particular, including the U.S.-based Merchants Payments Coalition, also claim that interchange fees are much higher than necessary, pointing to the fact that even though US technology and efficiency has improved, interchange fees have more than doubled in the last 10 years. Issuing banks argue that reduced interchange fees would result in increased costs for cardholders, and reduce their ability to satisfy rewards on cards already issued.

Merchant lawsuits claim that interchange fees in the U.S. are out of line with falling technology costs and similar fees charged outside the United States, resulting in higher prices, lower profits and harm to the consumer. The lawsuits allege that these high fees represent collusion and price fixing among the bank card networks and their card issuing banks, in violation of antitrust laws. Bank card networks disagree, claiming interchange fees represent an effort to balance incentives to issuing banks to issue more cards with better rewards against the need to bring an optimum number of card-accepting merchants into their credit card systems. They also claim that the interchange fees bring consumer benefits such as more rewards, reduced fraud, lower interest rates and system innovations.

Senate hearings in the United States have focused on the secrecy surrounding interchange fee schedules and card operating rules. In 2006 Visa and MasterCard both released some fee schedules and summary reports of their card rules, though pressure continues for them to release the full documents. In January 2007, Senate Banking committee chairman Chris Dodd cited interchange fees at a hearing on credit card industry practices and again in March the fees were criticized by Sen. Norm Coleman. In January 2007, Microsoft chairman Bill Gates cited high interchange fees as a significant reason Microsoft believes it can be competitive in online micropayments.

In March 2007, MasterCard announced it was changing its rate structure, splitting the lower, "basic" tier for credit cards into two new tiers. The Wall Street Journal reported [1] that the document outlining the shift "makes it difficult to determine if the new rates, on average, are rising." MasterCard spokesman Joshua Peirez said the new structure "allows us to have a more sophisticated way to break up our [credit-card] portfolio," while National Retail Federation general counsel Mallory Duncan said, "They are pricing each tier at the absolute most they can so they can maximize their income."

[edit] Outside the United States

In 2003, the Reserve Bank of Australia required that interchange fees be dramatically reduced, from about 0.95% of the transaction to approximately 0.5%. One notable result has been the reduced use of reward cards and increased use of debit cards. Australia also removed the "no surcharge" rule, which prevented merchants from charging a credit card fee, has also made changes to the interchange rates on debit cards and has considered abolishing interchange fees altogether.

As of November 2006, New Zealand is considering similar actions, following a Commerce Commission lawsuit alleging price-fixing by Visa and MasterCard. In New Zealand, merchants pay a 1.8% fee on every credit card transaction.

The European Commission has pressured Visa to reduce cross-border interchange fees, and in the United Kingdom, MasterCard has reduced its interchange fees while it is under investigation by the Office of Fair Trading. In January 2007, the European Union's Competition Commission issued the results of a two-year study of Interchange fees. Upon publishing the report, Commissioner Neelie Kroes said the "present level of interchange fees in many of the schemes we have examined does not seem justified." The report called for further study of the issue.