Nov 7, 2007

Protecting interchange fees through marketing solutions

The following text is a combination of several recent blog posts, expanded with additional information on privacy issues. It was published in the latest issue of the E-Finance & Payments Law & Policy newsletter.


Working with banks and payment schemes across the globe, Welcome has developed a new card applet for payment schemes, called SPICED, which makes it possible for merchants to deliver targeted promotions at the bottom of credit or debit card receipts. SPICED is designed to make payment scheme brands more attractive and useful to merchants, so that brand acceptance and usage are encouraged and pressure on interchange fees is reduced. When a payment brand offers valuable features to merchants, there is a higher chance that merchants will encourage customers to use that brand over others, interchange fees are easier to justify, and the brand becomes more attractive to banks keen on receiving more interchange.

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 fees it would continue to assess the legality of current fee levels. The solution usually evoked consists of some form of leveling 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 the level of 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 fees and, in consequence, the ability to attract banks.

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 key is to focus on leveraging payment data to help merchants solve major problems. SPICED accomplishes this by helping 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). Retailers spend tens of billions of dollars each year on tactics such as direct mail, premiums and incentives, retail in-store promotions, couponing, loyalty marketing, games and sampling. These can be made more effective by leveraging customer behavior data. But obtaining that data is difficult and costly and, in addition, existing techniques that rely on sending offers by mail require customers to provide personal details that many prefer not to divulge.

When a payment scheme is SPICED, merchants can use data stored inside the cards to deliver targeted messages and promotional offers at the POS, at very low cost. For example, a coffee chain can recognize an infrequent customer that has not been to the chain in over 30 days, and print an offer at the bottom of the card receipt encouraging the customer to come back soon. Alternatively, merchants can avoid giving high value promotions to all customers by delivering their most valuable coupons after a certain number of visits or cumulative spending.

It is difficult and expensive for merchants to achieve similar results through data mining and direct marketing techniques, whereas with SPICED, the feature is built into the payment transaction and the offer is simply printed at the bottom of the card receipt. There is no need for merchants to operate a separate database, perform complicated and sensitive integration with bank systems, or use equipment other than traditional payment terminals. Merchants simply accept payment brands with the SPICED applet built-in and ask their acquirer to set up the campaigns of their choice. Also, since the data available at the moment of payment is anonymous and non-sensitive, payment schemes can avoid the privacy and security issues which occur when payment data is used for direct marketing purposes.

There are three major drawbacks with offers sent by mail:

1 - Cost. Offers sent by mail must be printed then inserted into envelopes, often bank statements. In contrast, an offer at the bottom of a card receipt adds a few centimetres of paper and is otherwise free.

2 - Privacy. Imagine finding an offer from Carrefour in your bank statement, which you receive at home several weeks after you last went to Carrefour. You probably understand that your bank is tracking your buying habits and is encouraging you to go to Carrefour, a retailer that you perhaps don’t often shop at. Did privacy warning bells just go off? Compare that to receiving the offer on your debit card receipt while paying at Carrefour. The effect is completely different.

3 - Contextual relevance. When you receive an offer by mail, there are chances that it won’t go into your wallet since you are examining your mail, not your wallet. When you receive it at the POS, your wallet is open, waiting for your card to go back in. The probability of keeping the offer is much higher.

Promotional marketing is one area in which payment schemes can help merchants. There are others. For example, fraudulent and abusive returns cost US retailers $16 billion annually, much more than bank losses due to card fraud, estimated at $3 billion. 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. Instead, why not take advantage of payment data to identify potential abuse? A solution which leverages payment data at the POS, with no need for the cost and effort of operating a database and authorization service, and no need for a picture ID, would directly benefit 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. The current interchange model, with adjustments for fully market driven fees, is a powerful tool to foster innovation for the benefit of merchants. 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. Some payment brands will manage to create enough value to convince merchants to accept the higher fees without applying surcharges, while others will simply reduce their fees. In practice, customers should see little if any surcharging.

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 and will simply cause the current payment infrastructure to ossify at essentially the present level of functionality. Schemes will put little 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.

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