Aug 29, 2006

Card fraud is a nuisance, interchange erosion is life threatening

I am now so obsessed with interchange that I often forget that most people in our industry have not yet looked into this problem in much detail and don’t yet see how big it is. Ram mentioned the other day that he thought the major problem facing the payments industry is fraud and security, by far, and that interchange must be a tiny problem because nobody ever talks about. I got to thinking about that.

Ram is right to think that fraud is THE major problem facing card issuers and that interchage is not. EVERYBODY in our industry talks like fraud is the top priority. It is the driving force for payment technology vendors. When Visa and MasterCard talk about EMV they talk almost entirely of fraud and only secondarily of “all the other things you can do with chip cards”. When the associations discuss technology with the vendor community, their main focus is fraud and security.

I promised Ram that I would provide more information on how interchange erosion is a much bigger problem than card fraud.

Fraud is considered a major problem when it reaches 10 to 20 basis points, the level at which banks accelerate their adoption of EMV standard chip cards and payment terminals. According to MasterCard, credit card fraud in the Asia-Pacific region has dropped from 18 basis points in the 1990s to below 8 basis points in 2005, thanks in large part to the roll out of EMV cards.

The entire payments industry has put tremendous effort, resources and money into bringing fraud down from 18 basis points to 8. Card vendors are selling lots of EMV chip cards. POS vendors are on a roll, replacing terminals everywhere so merchants can accept EMV cards. Core payment software suppliers are busy upgrading banks' back end systems to make them capable of authorizing and processing EMV transactions.

Now let’s look at interchange.

Interchange fees have grown to represent an important revenue stream for banks. People pay with plastic more than ever before, but many choose to pay off their balances each month. Interest income has decreased as share of total revenues, and interchange has increased. Interchange is now estimated to represent a third of a typical card issuer’s revenues, and almost half of American Express revenues.

Interchange represents 75 to 80 percent of the total fees merchants pay for card acceptance. To save money, merchants are pressuring banks to slash interchange and are encouraging customers to use low cost payment methods such as debit cards and cash. Interchange in Australia has been slashed by around 50 basis points, while in Mexico banks agreed to unilaterally cut interchange by 43 basis points for credit cards and 134 basis points for debit cards. These figures don’t take into account the impact of merchants steering customers towards cheaper payment methods, for example through credit card surcharges or cash discounts. When that happens, interchange revenue will decrease even further.

These are very big numbers. American Express last year earned $11.7 billion in merchant fees at an average rate of 2.57% of each transaction. A rate cut of 40 basis points would result in the loss of $2 billion of revenues each year.

Card fraud is a nuisance. Interchange erosion is a much bigger pain. Yet payment technology suppliers focus entirely on security and efficiency and neglect interchange erosion. I remember something a boss of mine used to say 20 years ago (actually more than that, but I'm not yet ready to refer to past work experiences using timeframes greater than two decades). He would say, "We're swatting at mosquitoes while crocodiles are chewing on our a _ _." That's exactly what we're doing today in the payments industry.

When banks wanted to fight fraud losses of 18 basis points in the Asia-Pacific region, an entire industry was created around EMV, transforming the vendor community and having a deep impact on banks.

When banks decide that they need to fight interchange erosion of 40, 50 or 60 basis points or more, the impact on the vendor community and on banks themselves will be much, MUCH bigger.

What a fantastic opportunity for us.


Dave Birch said...

Card fraud is important to issuers because of the confidence factor: no-one wants consumers to lose confidence in the payment system. But in business terms, it comes along way behind bad debt (at least in the UK) and interchange income.

Bruce Cundiff said...

This dovetails very nicely with the arguments you are constantly making for ADDED VALUE to merchants.

It warrants further mentioning here. The way to fight 'interchange erosion' is providing additional value to merchants with card products. Too much emphasis has been placed on the adversarial role that merchants are playing (and fighting merchants tooth and nail to maintain the status quo), as opposed to the proactive measures that card networks and issuers could take to satisfy merchant needs and essentially eliminate objection (well...mitigate...there will always be objection) to interchange costs.

John Januszczak said...

Yes, further to Bruce's comments, it almost goes without saying that the cost of card acceptance for merchants has probably been going up without a compensating benefit - one sees the symptoms of this in the litigation and lobbying for regulations on the part of merchants. I am just wondering if the objections to the nature and setting of the current interchange fees are simply too fundamental to be mitigated by "proactive measures".