Oct 23, 2007

Why an unregulated interchange model is crucial to fostering competition between payment schemes

Statements from regulators indicate that their focus is less on abolishing interchange than on exploring ways to deal with the variations in levels of fees in different markets and for different card products. EU competition commissioner Neelie Kroes recently said that while the commission would not abolish interchange it would continue to assess the legality of current fee levels. The solution usually evoked consists of some form of levelling of fees across the EU, through regulation which would result in payment schemes all adopting the same legislated fee levels. This would be unfortunate. Regulating interchange fees would eliminate a powerful incentive for payment schemes to create innovative products and services which benefit merchants. Payment schemes should be able to compete with each other to make their products more useful and valuable to merchants, their incentive being the ability to generate higher interchange and, in consequence, the ability to attract banks keen on receiving more interchange.

With SEPA, European banks will be able to choose between multiple debit brands for their cards. Payment schemes are competing fiercely to have their brands chosen by banks. Interchange is a powerful differentiator. As competition between schemes increases, there will be a growing desire to raise interchange fees to attract issuers. If the system functions properly, brands that don’t offer enough value to merchants should find it more difficult to raise fees than brands that provide more value.

The current interchange model, with some adjustments, is a powerful tool to foster innovation for the benefit of merchants. If merchants were able to negotiate interchange fees and choose freely between payment methods which give them the most value in relation to their cost, then normal market forces would automatically force card fees to their acceptable levels. However the nature of the payment industry makes it difficult for merchants to negotiate interchange fees.

Capping fees through regulation does not solve the problem because it will not create a market driven system. It will simply cause the current payment infrastructure to ossify at essentially the present level of functionality. With little incentive to innovate for the benefit of merchants, payment schemes will not put much energy into new merchant-centric features. The system will remain essentially as it is today, with innovation focused on new cardholder-centric features. It might be hard to imagine today the types of new payment features which will be attractive to merchants, but this does not mean that payment schemes will not discover them in the future. Abolishing the incentive to search for these new capabilities will guarantee that they are never found.

A viable solution already exists in a growing number of countries. Leaving fees unregulated, but giving merchants the ability, for example, to easily surcharge card brands which are too expensive in relation to their value, creates a powerful incentive for schemes to make their products and services more useful to merchants. In response to this pressure, and to avoid having their cardholders subjected to surcharges, some payment brands will manage to create enough value to convince merchants to accept the higher fees, while others will simply have to reduce their fees. In practice, customers should see little if any surcharging, and merchants will get far more value for their money.

There are many ways in which payment schemes can innovate to make their cards more valuable to merchants. The most effective solutions will focus on leveraging payment data to help merchants solve major problems at the point of sale, in the store, as the card is being used. For example, payment schemes are already beginning to help merchants improve the efficiency of their promotional marketing activities, an industry estimated at $342 billion in the US alone (dwarfing US interchange fees of $40 billion). These budgets can be made more effective by leveraging customer behaviour data available at the moment of payment, for delivery of targeted promotions on credit and debit card receipts. This is my company’s area of expertise.

Another area in which payment schemes could better help merchants is by addressing the issue of fraudulent and abusive returns, which cost US retailers $16 billion annually, eclipsing the $3 billion that banks lose due to card fraud. Over half of returns fraud is attributed to customers “renting” merchandise for free by purchasing a product, for example an expensive camcorder, using it once to record a wedding or graduation, then returning it for a refund. Some retailers now require a picture ID when customers return merchandise, so clerks can check a database for possible abuse. This is the only solution available today. It is inconvenient and obtrusive to customers, the vast majority of whom return items in good faith. A solution which leverages payment data at the POS to identify potential abuse, with no need for the cost and effort of operating a database and authorization service, and no need for a picture ID, would be very valuable to merchants.

It is reassuring to see that regulators accept interchange as an important part of an efficient payment system. It would be even more reassuring to see regulators recognize the importance of interchange as a competitive weapon between schemes. Competition is fiercer than in the past, what with developments such as SEPA and with MasterCard and Visa becoming profit-driven companies that must show strong growth to investors. There is an opportunity for regulators to leverage this growing level of competition in a way that creates more value for all players. Capping or cutting interchange fees would cause that opportunity to be wasted.

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