Guest Opinion: Economic Model: Should a Digital Financial Services System Use Interchange?

June 2015:

Allen Weinberg is a founding partner of Glenbrook Partners, where he leads the firm’s work with the merchant community. Before founding Glenbrook, Allen worked at First Data, Visa International, and Accenture, in new product development, channel strategies, and pricing in the point-of-sale, eCommerce, mobile commerce, and money transfer markets.

I’ve read with interest the material in the Level One Project Guide, and in particular the discussion of interchange fees. I’ve worked on this topic for most of my professional career, and it’s not an easy subject! It has been a source of controversy around the world, and particularly in the developed world as the card payments ecosystem has evolved. And it is particularly challenging to applying these concepts to the developing world, and to the very new payments systems – often operated by non-banks – that are emerging there.

One of the most controversial topics in payments is interchange fees. For decades, interchange fees have been a key aspect of many consumer-focused interbank payment systems, such as debit and credit card, ATM, and increasingly mobile payments. Simply put, interchange fees are some sort of transfer payment from one bank to another bank on each transaction. Those fees are generally set by the network/whoever manages the payment scheme, and in some markets is regulated by a government entity that can set caps on those fees.

Interchange is typically established by government entities, networks such as Visa and MasterCard, or by banks acting as a group. Interchange represents the maximum interbank transfer fee that can be charged for a service – but leaves it up to the network to choose if all participants should operate at a lower fee. While the network or regulators generally set the interchange rates, they do not receive any of the interchange fees; the fees pass from one bank to another.

It is important to note that as banks develop and price services to their senders and receivers, the economic decisions made from the sending perspective generally impact the receiving side, and vice versa. In other words, the way each side prices its transactions will almost always affect the economic well being of the other side.

The primary objective of such fees is to help ensure that both sending and receiving organizations, usually banks, which are by definition dependent on each other, have sufficient economic incentive to develop and promote the service to their customers on an ongoing basis. The assumption is that neither party should lose money on any given transaction. In addition, interchange fees assume that consumers’ and merchants’ banks are not able to make a reasonable profit by directly charging their respective customers.

There are alternative ways in which interchange can be established including cost-based, value-based, market-based, and government-imposed. Most methodologies incorporate a combination of these factors. For example, the interchange fees for a new payment system may be based on senders’ and receivers’ costs, but may be adjusted up or down so as to reflect the prevailing pricing practices already established in the market by competitors.

The big danger of interchange comes in when one or more of the parties – the sending or receiving organization can influence consumer and/or merchant choice. In these cases, it is certainly possible, if not inevitable without specific regulation, that interchange can be used as a competitive weapon such that as competition for say, issuance increases, so do interchange fees in order to make it more attractive for issuers to promote one brand over the other. Unless in this example, merchants can sway consumers to use lower priced, competitive payment brands, then as competition of issuing goes up, so will interchange.

Said differently, unless both sides can influence consumer usage of competitive products, interchange could be driven so high that cost objectives are not met, or conversely (as in the case where the merchants/receivers have all the power) so low as to dilute the intended effect of interchange. In an optimal environment, market forces will allow interchange to achieve its natural equilibrium which in theory, should maximize usage.

If our objective in a developing country is to assure a payments system that is very low cost – so as to enable low prices, to serve the poorest of customers – this is a particular concern.

The system must be free to set interchange at a level such that it is able to compete fairly and effectively with competitors, including those with closed loop systems that may price the sending and/or receiving services below cost.

So is there a “right answer” to:

  • Whether there should be interchange at all?
  • What direction it should flow?
  • What should the rate be?
  • Who should set the rates?
  • What should that rate be?
  • How often should the rate be revisited/reviewed?

In short, “no”, there is no single right answer to any of these questions. The interchange strategy will likely vary from market to market, depending on the objectives so the payment system, the state of its evolution, the underlying economics for the participants, the regulatory environment, as well as the current and anticipated competitive landscape.

I noted in particular the idea in the Level One Project Guide that interchange provisions in a new system might be subject to a “sunset” provision – to ensure that not only the levels of interchange, but the need to have it at all – is regularly reviewed by the participants in the system.