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Interchange Week on the Slips

posted by Adam Levitin

Let's call this interchange week. With efforts to bring the Credit Card Fair Fee Act to vote in Congress picking up steam, I'm going to do a few postings on different aspects of the interchange debate this week. Coinciding with this, the printer proof of my recent article on the economics and origins of interchange is available on SSRN (spoiler: interchange and merchant restraints are less about network effects than about evading TILA, usury laws, and branch banking restrictions).

So as a primer for the rest of my posts, who's up for some good ol' fashion credit card network economics?

Here's the deal. You purchase $100.00 of goods at a merchant on a credit card. The merchant receives $100 minus the "merchant discount fee," of say $3.00 which is taken out by the merchant's bank (the "acquirer bank"). The acquirer bank keeps perhaps $.40 and remits $.10 to the credit card network (MC or Visa--Amex and Discover are a little different so I'll leave them out of this) as an authorization, clearing, and settlement fee, and $2.50 to your card issuer (the "issuer bank"), which is the interchange fee. The interchange fee is thus technically a fee paid by the acquirer to the issuer, not by the merchant or the consumer. But leaving this formalism aside, it is a fee on merchants and consumers. The interchange fee sets a floor for the merchant discount fee (often it is explicitly priced to merchants as "interchange plus"), and merchants pass along at least part of the interchange fee to consumers.

The interchange fee is set by the card network. Fees are typically a flat fee of a 5-15 cents and a percentage fee of 1-3 percent. The precise fee depends on (1) the merchant's industry, (2) the size of the merchant, and (3) the level of rewards on the consumer's credit card (more rewards-->higher interchange fees). In other words, the interchange fee, which is technically not a fee paid by merchants, but an interbank fee, as the card networks emphasize in their literature, is set based on merchant and consumer characteristics. How often does an interbank fee depend on the characteristics of third parties?

Credit card network rules restrict merchants' ability to pass on interchange fees to cardholders. (For shorthand, let's call these rules "merchant restraints".) Merchants are required to accept all (credit or debit) cards bearing a card association's label, to take them at all of their locations (web, brick and mortar), to treat all cards the same, and are forbidden from surcharging for credit. Federal law gives merchants the right to offer cash discounts, but merchants are forbidden from doing the mathematical equivalent of surcharging for credit. Of course, the right to discount for cash largely misses the point--such a right would be valuable if merchants didn't want to take credit cards. Merchants generally do want to accept credit cards (and in certain businesses, like Internet retailers, they must). What merchants don't like is having to accept high cost rewards cards on which they see no benefit. And merchants also don't like that interchange rates have been marching steadily upwards without any increase in benefits of card acceptance (and arguably an increase in liability because of PCI data security standard rules).

So that set's the stage for my next post--interchange and the price of gas.


Steve Semeraro over at the Commercial Law blog has been offering interesting posts on interchange fees for a few weeks--you might expressly invite him into the conversation if he's not lurking already . . .

See, e.g., http://ucclaw.blogspot.com/2008/06/ubiquity-of-interchange-fees.html

It looks as though merchants are not allowed to charge an extra "processing" fee to their customers, is that correct? If so, how does McDonalds get away with it?

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