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European Commission Rules MasterCard's Interchange Fees Are Illegal

posted by Adam Levitin

In December, the European Commission antitrust authority, the Directorate General Competition, ruled that MasterCard's interchange fees are illegal. (I realize it is now mid-January, but I wasn't blogging when it the ruling came out.)  MasterCard is, of course, appealing

Although ruling this made page 4 of the Wall Street Journal, it has gotten very little attention otherwise in the business or general press.  ( The ruling has huge ramifications for consumers and merchants.  The underlying issue is technical, however, but well worth understanding.   

Interchange is the fee charged on every credit card transaction by the bank that issues the credit card to the merchant's bank. It is usually a combination of a flat fee of a few cents and a percentage of the total transaction amount.  In other words, on every credit card transaction, the bank that issues the credit card gets a cut, separate and distinct from any fees or interest it charges the cardholder directly. 

It is important to note that interchange is not charged to merchants directly.  Instead, it comprises the bulk of the "merchant discount fees" that merchants pay to their acquiring banks.  To illustrate, on a $100 transaction, the merchant might pay the acquirer $3 in merchant discount fees.  Of this $3, the acquirer keeps 50 cents, and it gives 10 cents to the card network (authorization and clearing fee), and give the card's issuer $2.60 (interchange fee). That's not an insignificant cost for merchants, especially those in low margin industries.

More importantly, perhaps, various credit card network rules, often called merchant restraints, prevent merchants from knowing what the interchange fee is before the transaction is completed and then from passing along the costs of interchange to credit card consumers alone.  Merchants must either absorb the cost themselves or pass the cost along to all customers, regardless of whether they use credit cards or other payment methods.  [For cognescenti:  yes, MC technically rescinded its no-surcharge rule unilaterally, but as long as merchants accept higher cost cards, like American Express, but cannot surcharge for those cards as well, they will almost never surcharge for MC, as it could encourage consumers to use more expensive cards.]

The interchange fee on MasterCard and Visa credit cards is determined by the card network, not by the individual banks. (It might be possible for individual banks to opt-out of the general rate schedule, but MC and Visa's complete bylaws are not public, and I have never heard of this happening.)  Interchange fees vary by merchant size, industry, type of credit card (corporate card, consumer card, etc.), and level of rewards on the credit card. 

There is some debate as to purpose of the fee. As I show in a forthcoming article, the card industry's explanation for the fee has changed over time. Originally, at least, interchange fees seem to have been a way for card issuers to impose higher effective fees on consumers while still avoiding usury laws and Truth in Lending restrictions. Today, however, the typical explanation for interchange is that it is the mechanism that allows credit card networks to adjust their costs to according to the price elasticities of their two types of consumers (cardholders and merchants) so as to maximize the size of the network.  Consumers benefit when a network grows because it means that the card is accepted in more locations and hence more useful.  It is less clear how merchants benefit from the network growing, unless one assumes that consumers not in the network are unable to make the same purchases.

As I argue in my article, there are several problems with this justification of interchange fees, but Neelie Kroes, the European Commissioner for Competition Policy, could hardly have put it better in her speech announcing the ruling:

"It is not sufficient that a MIF [multilateral interchange fee] simply increases the sales volumes of a [credit card network] scheme to the sole benefit of the member banks. Rather, a MIF should contribute to objective efficiencies such as to promote more efficient payment means to the detriment of less efficient ones. Also, the proceeds from a MIF should not just increase bank's revenues – they should be clearly dedicated to the achievement of efficiencies."

Instead of achieving net efficiencies, as the DG Competition's press release notes:

"Multilateral interchange fee agreements such as MasterCard's inflate the cost of card acceptance by retailers. Consumers foot the bill, as they risk paying twice for payment cards: once through annual fees to their bank and a second time through inflated retail prices paid not only by card users but also by customers paying cash. The Commission will accept these fees only where they are clearly fostering innovation to the benefit of all users."

The DG Competition's ruling only applied to MasterCard; Visa had an exemption (long story), but that exemption expired at the end of 2007, so it is now in the same boat as MasterCard.  We'll see how this all gets resolved in the European court system now, but if MC/Visa lose, their business model will be drastically upset.  Not only are interchange fees a significant part of card issuer's revenue, but they also help credit cards compete with other consumer payment systems, because they finance the rewards programs that make credit card use more attractive.  The trick to making this all work for the card networks are a set of network rules known as merchant restraints (see my earlier related blog post, here) that prevent merchants from passing on the cost of interchange (the bulk of merchant discount fees) to credit card consumers.  Instead, merchants must absorb the cost themselves or pass it on to all consumers.

I have yet to be able to find a published ruling, rather than a press release on the matter, so we don't know all of the DG Comp's reasoning.  Unless it is the collusive setting of interchange that is at issue, I have trouble understanding why having an interchange fee at all is problematic; I've always argued that it is the merchant restraint rules protecting the interchange rate that are the problem.   Absent these rules, the existence and level of interchange fees should just be a function of the market.   It'll be interesting to see the DG Comp's explicit logic. 

It's interesting to contrast the EC's proactive regulatory approach with that of US antitrust regulators.  The DOJ and FTC have been dormant on interchange issues and the related issue of credit card merchant restraints (various network rules that insulate the interchange fee from market discipline).  The Fed claims not to have regulatory jurisdiction on the matter (but has nonetheless hosted conference on the topic).  Congress has held some hearings, but where the issue is really being addressed in the US is in private antitrust litigation.  Merchants have brought antitrust suits over interchange fees and the merchant restraints that shield these fees from market discipline.  The suits have been consolidated in multidistrict litigation consolidated in the Eastern District of New York (MDL 1720).  MDL 1720 includes both putative class actions and suits brought by large individual retailers. 

The interchange issue illustrates the fundamental divide in American and European approaches to antitrust law.  In Europe, it is the regulatory authority, rather than private parties leading the way.  In the US, although DOJ has been active in other areas of payment system antitrust (with the unforeseen result of increasing pressure on interchange rates).  We may well achieve the same outcome as the Europeans, but I can't help but feel that the US federal antitrust authorities have really dropped the ball on this one.  Maybe some state attorneys general will want to get into the mix, however, either representing their states as merchants or under parens patriae powers. 


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"MC technically rescinded its no-surcharge rule unilaterally" MC only allows surcharging in Europe, not in the US.

Discover allows surcharging in the US, but only if other cards are surcharged also, which is not allowed by the other networks (in the US).

None of this affects your larger point, just a matter of clarification. Good post.

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