No Free Lunch: A Primer on Interchange and Debit
This note comments on the WMT suit filed yesterday against Visa in the context of the broader impact of interchange on the structure of the card payments industry, particularly in debit. The dynamics are more involved than in many industries and it is plain, not least from the extraordinary comments in last Friday’s appellate Court ruling (see our “Quick Thoughts” note of this Monday), that merchants have not been able to convey an adequate understanding of the competitive and economic realities of the US card system through the Court system. Our object is to provide investors with a sense of how these competitive and economic realities work in practice, of how they have caused the US payments system to evolve in a dysfunctional way (particularly with respect to signature debit) in absolute terms and relative to overseas markets, and how the partnership of the merchants’ payments consortium, MCX, with FIS (which is a partner of the more secure and efficient debit networks in both Canada and Australia) is likely looking to shape the US market.
- Yesterday, WMT filed suit against Visa with a key allegation being that network-set interchange rates, particularly in combination with the honor-all-issuers rules, represent horizontal price-fixing between issuers. This claim has been advanced in the past and the Courts have consistently ruled that interchange fees are reasonable and essential for a payment card system.
- This Court position is puzzling given experiences in other markets. Canada has a zero-interchange debit model in the (not-for-profit) Interac payments system which performs more strongly than the US system on several important measures: it is real-time, has fraud rates just one-third of those in the US (because, with issuer incentives aligned around reducing cost rather than maximizing interchange, it has adopted chip-and-PIN), and runs on network fees of less than 1 cent versus 6-7 cents for US.
- Critics of zero-interchange systems suggest consumers pay more for debit cards (and, indeed, in Canada there is tiered pricing for checking accounts based on customer use of debit card transactions) and receive fewer benefits (and, indeed, in Canada there are no charge-backs). The merchant counter that lowering US interchange would provide an equal-or-better consumer benefit in the form of savings at point-of-sale is dismissed as if interchange generates a (merchant-subsidized) free lunch to consumers.
- The economic reality in the US is that, through interchange, some consumers are getting a benefit they do not pay for (because either merchants do not raise prices or, if they do, the higher prices are typically borne by all consumers even those offering other tender). It is hard to see how this creates a more efficient allocation of payments resources than the Canadian system where consumers pay more transparently for the debit transactions that they use.
- We understand the role of transfer prices, such as interchange, in two-sided markets such as payments. Our issue is not with network-set interchange in theory as with its US implementation in practice. The root problem is that V and MA exploit their power in the credit card market and hence (at one time through the now-defunct honor-all-cards rules and now through FANF) in the debit market through setting supra-competitive interchange with object not of optimize the payments system as a whole but maximizing their volumes through locking-up the issuer distribution channel.