CardsFTW #51: Interchange is essential but not a business model
Visiting Points Less, Kansas
When a merchant accepts a payment card, they pay the discount fee to their acquirer. After a few different parties take their share of the discount fee, what remains is called interchange, paid by the network (e.g., Visa or Mastercard) to the issuing bank.
I’ve written about interchange before. Merchants don’t like paying for it. Consumers benefit indirectly, as it is a key part of funding rewards on high-end credit cards and challenger banking products.
Following the financial crisis of 2008, the Durbin amendment to the Dodd-Frank Act legislated limits to debit card interchange in the United States, where previously it was set by the market. Durbin limits interchange fees earned by large financial institutions defined as those with more than $10 billion in assets.
The Durbin amendment launched challenger banking in a new way, with benefits and challenges (touched on in CardsFTW #50 last week).
Since the Durbin amendment, merchant groups have also been lobbying Congress to regulate credit card fees. Hat tip to Andrew Davidson at Mintel, who highlighted a new effort in this battle from a group called American Free Enterprise Action that launched a million-dollar-plus campaign to fight efforts to regulate interchange.
You can read their official press release, read some coverage of the pending legislation, or even get into the ad campaign itself.
The argument tends to go as follows:
Merchants have to pay the networks to accept cards
Visa and Mastercard are a duopoly and overcharge
Merchants raise prices to cover the payment processing
Affluent consumers ultimately benefit because they get rewards
Poor consumers transfer wealth to affluent customers because they pay higher prices
There is no evidence that the Durbin amendment shifted any value to consumers from merchants. It is hard to believe that regulating additional interchange will shift value to consumers rather than provide marginal improvements to small businesses (many of which also benefit from the even higher interchange on their own corporate or small business credit cards).
Merchants are using the wealth transfer argument to save money. No merchant will transfer that money to consumers, especially in today’s environment, even if credit card interchange is regulated. While the American Free Enterprise Action campaign is cringe-worthy, I believe it is accurate because Americans love credit card points.
We would be better off without rewards credit cards if we had slightly lower prices, paid less interest on more predictable loans, and used those savings to buy plane tickets. If we didn’t earn rewards, we would miss out on the obsessive consumption behaviors that yield not paying for our vacation.
On the other side, numerous fintech startups have based their business model entirely on interchange. Credit cards earn higher interchange than debit cards but are substantially more complex of a product to deliver and manage. Challenger debit card products (aka neobanks) such as Chime innovated with free offerings and interchange-driven revenue models. In practice, interchange only is a business model that doesn’t appear sustainable. It may work at a very large scale. Still, between acquisition costs, fraud, and operating costs, most fintech companies have found that they need other products (such as lending) or other models (such as membership fees or merchant-funded rewards).
Consumers may be paying merchants more but can access a free checking account. People love free with hidden costs more than they love transparent fees. Irrationality rears its head again.
Either way, from the affluent credit card consumer at a big bank, to the everyday user of a challenger neobank product, interchange funds valuable services consumers love. I don’t expect this to change.
What do you think of Points Less, Kansas? It has a point.
Thanks for reading CardsFTW, an occasional newsletter about debit and credit. It is written and curated by Matthew Goldman, President at Apto Payments. If you’re looking for insights into everyday payments, subscribe free at cardsftw.substack.com. If you enjoyed this, please share it!
This is spot on. It makes sense that this is probably why a lot of the major Digital Banking Fintechs that basically built an interchange-payments business model have been hammered in 2022.
I think the Rewards point is correct too. It seems like a Customer Acquisition tool really in the end for either a) other products or b) more leverage in the future with banking partners.
"Generally in the fintech world banks expect ~1.5 - 2.5% (i.e. 150-250 bps) in interchange, so hypothetically Ramp would collect ~250 bps (2.5%) per transaction, give 200 bps back to the bank, and keep 50 bps as revenue. Most banking platforms (like Ramp, Chime, etc.) will often have negative margins because they’re keeping 50 bps for revenue but then giving back ~150 bps to the customer as rewards or cash-back. Over time as they scale they expect that 200 bps they share with the bank to go down and for their margins to improve" https://research.contrary.com/reports/ramp
Good article. I tend to agree that lower interchange gets banked by the merchants rather than being passed on to the consumer. Therefore if that argument is who get this wealth, I still am on the side of merchants rather than a smaller group of financial companies. Merchants also have to compete and can use these funds to deliver better value for consumers.