Justifications of interchange from the economic theory

Christoph Strauch (cstrauch@paysys.de), Consultant with PaySys Consultancy GmbH, Frankfurt

Abstract

In this article, we will discuss some of the economic basics of interchange. Three different views on the function of interchange are presented very briefly. From the acceptance of one of these views, conclusions can be drawn regarding actual setting of interchange. These are not carried out in this article. 

Introduction

The Commission has sent a Statement of Objections to Visa International in relation to its interchange fee, on the grounds that this fee is a restrictive collective price agreement. (IP/00/1164, date: 2000-10-16.) 

In the statement of objections, the Commission states: "As has also bee pointed out by Eurocommerce, other payment card schemes, such as ec-Karte in Germany may function without interchange fees." 

"Germany's ZKA has decided to introduce a fee of DEM 0.35 for the in the retail sector widely implemented electronic direct debit scheme. ", Press release of HDE, Germany's retailer association, date: 2000-08-10.

One may derive, from these press clips that either Eurocommerce is right and the German banking industry is trying to exercise market power or, that ZKA's plans are a hint, that ec Karte in fact is NOT functioning without interchange fees and for a sound functioning in the future, the extension of interchange is a (economic) necessity. According to ZKA's plans, to introduce a fee of approx. € 0.18 (+ € 0.05 for POZ only) for the signature based schemes ELV and POZ would amount to additional revenues of round € 93m (based on an estimation of 520m transactions in 1999). Revenues in 1999 from ec cash and POZ scheme can be estimated to round € 71m. Without further reasoning, it is evident that "interchange fee" is a hot and controversially discussed topic in the payment cards industry. On the one hand, actual implemented interchange rules are challenged as (or at least considered to be) anti-competitive from Eurocommerce and others (Cruickshank report, Reserve Bank of Australia), on the other hand, the payment schemes insist on, that interchange is a necessary mechanism for a functioning payment scheme. 

In this article, we will discuss some of the economic aspects of interchange fee. We remember the definition of interchange fee as a fee, which is in four party payments schemes (eg Visa, Mastercard) paid by the merchant's bank to the cardholder's bank, when processing a transaction. Given that definition, one may ask, why the participants in four party schemes agree to such kind of "side payment" instead of charging their respective customers alone. Further, one may consider, whether an actual (possibly: zero) set interchange fee results in economic efficiency, and if so, whether there would be other (better) methods than interchange which would result in economic efficiency as well. We will ask for basic economic justification of the concept of interchange fees rather than considering actual calculation methods or actual setting. In particular, we will introduce three basic principles (P), which may be accepted for an justification for an interchange fee at all, namely:

P1	the issuer of a payment card delivers a service to the acquirer, when a card transaction takes place and interchange is the compensation for that service.

P2	card based payment schemes inhere particular network externalities and interchange is an appropriate method of internalising these externalities.

P3	in card based payment schemes, issuers and acquirers together deliver a transaction processing service to cardholders and merchants, and there is a "imbalance" between the issuer's and the acquirer's costs / revenues and interchange settles this imbalance.

Key for an assessment of the proposed justifications, is a clear understanding of the economies of a payment scheme. In a payment scheme, the following agreements are made:

card acceptance - 	with signing a merchant contract, the merchant is granted by the acquirer to 

-	accept liabilities against cardholders which result from rule compliant presentment of a payment card as a means of payment and to 
-	sell such liabilities against cardholders to the acquirer at a pre agreed price (the merchant discount)

card issuing - 	with buying a payment card, the cardholder is granted by the issuer to 

-	access his account by using the card, i.e. to instruct the issuer to pay for presented liabilities, which result from rule compliant usage of the card. 

So, the acquirer sells to the merchant the opportunity, to accept card payments. The price for this service is mainly based on actual usage of this opportunity (i.e. ad valorem or transaction fees). The issuer sells to the cardholder the opportunity, to access his account by a dedicated device, namely the card. The account may be exclusively attached to the card (T&E cards, credit cards) or it may be accessible by other means as well (debit card --> giro account). The price for the issuer's service is mainly a fixed price p.a., the annual card fee. 

1st View

Now, in a four party scheme, where acquirer and issuer are not (necessary) the same, an acquirer obviously, only is able to deliver the service, if there is a framework in place, which allows him, to present the bought liabilities to issuers and to get paid. Hence, the issuer may be considered as a supplier of the acquirer. Now, it is a straightforward conclusion, that P1 gives an acceptable justification of interchange in four party schemes, as Visa or Eurocard / Mastercard are. Because there is no competition between issuers to supply service for a particular transaction to a particular acquirer marginal price setting would be an appropriate method for actual setting of interchange. (Note that the issuer in a particular transaction is determined by the cardholder and not at the acquirers choice. From this it follows, that a bi-lateral agreed interchange rate between an issuer and an acquirer would have no impact on the output of transactions between both of these, hence there is no competitive price determination!) However, some issues remain to be solved: e.g., when actually processing a transaction, which part of service (in the value chain) does an issuer supply to acquirers and which part the issuer is delivering to the cardholder? Especially, taking into consideration, that the cardholder benefits from each single usage of the card, one may argue, that acquirers should pay only a part of the marginal cost. By processing a card transaction, the issuer delivers value to both, the cardholder, namely the grant to initiate transactions at all and the merchant (via the acquirer), namely the guarantee to pay a presented transactions provided rule compliant processing of the transaction. 

2nd View

Further, four party schemes inhere specific network externalities: Issuers and acquirers act on separated market places. Issuers sell cards to consumers, where acquirers sell acceptance contracts to merchants. Both are producing externalities (E) to the respective other market as follows (interchange and prices disregarded!):

E1:	The value of a card for a cardholder increases with the number of accepting merchants, hence acquirers are producing an external benefit to issuers by signing merchants. I.e., at a given price, an issuer will be able to sell the more cards, the more merchants are accepting the card. 
E2:	The value of acceptance of a card mark increases with the number of issued cards of this mark, hence issuers are producing an external benefit to acquirers by issuing cards. I.e. at a given price (per acceptance at all!), the merchant will be able to sign the more merchants, the more cards are issued.
E3:	Increasing number of merchants will increase activity of cards and this yields to increasing costs for issuers (for processing etc.). Hence, acquirers are producing an external cost to issuers.
E4: 	Increasing number of cards will increase activity at a given merchant and this yields to increasing costs for acquirers. Hence, issuers are producing an external cost to acquirers. 

E1 is assumed to be obviously true. To see that E2 is true, one may consider, that merchants wouldn't accept activity based prices for acceptance, if the marginal benefit of activity wouldn't be positive. 

Now, due to these externalities, common equilibrium prices for both of the markets are impacted by the output of the respective other market. It is theoretically not a necessity, that there exists a set of merchant and cardholder prices, where both markets are in equilibrium, if acquirers and issuers would act completely independent of each others. I.e. at a given price, output of one of the markets could lead to an under-/oversupplying of the other market. Interchange may be considered as a mechanism to "calibrate" both markets to a common equilibrium. Issues to be solved when this view is adapted are, whether interchange is the only / best method to reach an equilibrium and if so, how interchange needs to be calculated (with an outcome which may be positive, negative or even zero).

3rd View

Issuers and acquirers in a four party scheme may be considered as acting "on behalf of a three party payment scheme". In this view, both parties are taking over particular tasks, which together make up the complete product, namely a "payment service". The "scheme" is building / maintaining an infrastructure, consisting in regulative and technical framework and commissioning the delivery of service to its members, issuers and acquirers. In this theoretical model, costs and revenues are passed on to the scheme and than re-distributed to the members according to any agreed appropriate or "fair" principles. Basically, this means to consider four party schemes as an extension of three party schemes. Today's four party payment schemes have their roots in three party schemes, and we suggest (for the sake of argument) to consider them as three party schemes, which have outsourced large parts of the value chain to their members. Interchange within this model has the function of a distribution of costs / revenues between acquirers and issuers, while letting both the freedom, to act as "profit centre" and hence having incentives to improve profitability. To give an example, a very rough calculation shows, that in the German credit card industry issuers bear approx. 80% of costs but collect only 40% of revenues (before interchange!), where acquirers bear 20% of costs and collect 60% of revenues. This situation would result in an interchange to be paid from acquirers to issuers, which settles the imbalance. Another example is Germany's ZKA's statement, that issuer's losses in the ec debit card schemes amount to round €132m annually. Issues to be solved, when adapting this view are, clearly to define, to which extent imbalances should be settled by the scheme, and what principles are appropriate for a distribution of costs / revenues. Again, in this model the direction in which the interchange will flow depends on the actual market situation and is not determined by the theory.

For an assessment of this view, one should recognise that on the one hand, three party schemes have elements of four party schemes (eg merchant acquiring of Italian Bankamericard for Amex and issuing of Amex cards by NatWest in the UK) and on the other hand, four party schemes have elements of three party schemes (eg exclusive domestic acquirer licenses for Eurocard in Germany until 1999, Switzerland, Austria...).

Conclusions:

To come back to the cited press clips at the beginning, what can one learn from the discussion about the German ec Karte:

1.	It should be noted, that the German ec Karte based EFTPOS schemes electronic cash and POZ, both are still three party schemes, where interchange is a four party concept. Within both of these schemes, there is a collectively set issuer fee. In the so called ELV scheme, which is basically not a card based payment scheme, there is indeed no issuer fee. (In the ELV scheme, the account number from the ec card is read and a direct debit record is generated, but there are no card specific contractual rules in place for processing of such transactions, neither between merchant / merchant bank, nor between merchant bank / issuer bank or issuer bank / cardholder.)

2.	From the above presented theoretical outline of the economies of payment scheme, we believe one can conclude, that in general there are some reasonable arguments for the concept of a collectively set interchange in four party payment schemes (which is not a defence of the actual implemented setting).

3.	Each of the three above mentioned views on interchange may yield to different results for the actual setting of interchange in a given scheme. Hence any assessment needs to survey carefully the given framework and market.