Post
The Interchange Model is Evolving
The economic relationship between the major US card networks, merchants, and consumers has fundamentally changed. Visa and Mastercard settled with US merchants, and will now allow them to charge consumers additional fees at the checkout for using their cards, and push their customers to lower cost cards with different pricing strategies:
Visa Inc. and Mastercard Inc. agreed to cap credit-card swipe fees — a deal that US merchants say will save them at least $30 billion over five years — in one of the most significant antitrust settlements ever, following a legal fight that spanned almost two decades…
… The legal fight over credit card swipe fees dates back to at least 2005 — before both Visa and Mastercard were spun off from the banks that owned them to become publicly traded companies. The fees, also known as interchange, are a key driver of profit for card-issuing banks and they are the primary mechanism used to fund popular rewards programs… As part of the settlement, Visa and Mastercard agreed to reduce the swipe fees they charge each merchant by at least 4 basis points for at least three years, lawyers for the retailers said. And, for a period of five years, the average systemwide swipe fee for both networks must be at least 7 basis points below the current average, subject to review by an independent auditor.
Interchange fees are at the heart of payment networks like Mastercard and Visa. These fees are integral to the infrastructure that supports credit card transactions, connecting merchants, cardholders, and FIs. As a quick refresher: interchange fees or “swipe fees,” are transaction fees that a merchant’s bank (acquirer) pays to a cardholder’s bank (issuer) for each transaction made with a credit or debit card (typically ~2%, totaling ~$100 in 2023). The fee compensates the issuer for the cost of handling the transaction, including the risk of fraud and non-payment. Visa and Mastercard, as network operators, set these fees. The concept of interchange fees originated in the early days of credit cards in the 1960s, as a mechanism to balance costs between issuing banks and acquiring banks within a fledgling payment network. This system was crucial for the widespread acceptance of credit cards. And unsurprisingly, as credit and debit card usage skyrocketed, the structure and implications of interchange fees grew in complexity and significance. Dee Hock, who founded the Visa card network, wrote an excellent history of the organization and its founding principles titled One from Many: VISA and the Rise of Chaordic Organization.
By the turn of the century, interchange fees had become a significant revenue stream for issuing banks, often contributing to the funding of reward programs for cardholders. Visa and Mastercard, the titans of payment networks, played a pivotal role in setting these fees, although they themselves did not directly benefit from the collected fees. Instead, their revenue stemmed from network fees paid by the banks. The intricate fee structures varied widely, influenced by factors such as the type of card used (i.e., credit, debit, premium), the merchant’s industry category, and the transaction’s nature (i.e., in-person, online). The rising complexity of interchange fees (almost always to the detriment of merchants) did not go unnoticed by regulators and lawmakers. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act introduced the Durbin Amendment, legislation aimed at capping debit card interchange fees and widely cited as kickstarting a wave of fintech opportunities for new entrants. It limited fees to a maximum of 21 cents plus 0.05% of the transaction amount (for banks with assets over $10B), a significant reduction from the previous average of 44 cents per transaction. The goal was to alleviate the financial burden on merchants, although its impact on credit card interchange fees remained limited. Legal battles have continued, nonetheless. Merchants, increasingly aggrieved by what they perceived as exorbitant fees, launched a series of lawsuits against Visa and Mastercard. These legal skirmishes culminated in several other high-profile settlements, with the payment giants agreeing to pay billions in compensation to merchants. Still, these settlements often stopped short of fundamentally altering the interchange fee structure. That changed with this settlement.
As this impacts fintech opportunities, we have been concerned for some time about new fintech entrants that primarily rely on interchange fees as a primary revenue source. For years, fintech startups have leveraged this revenue stream, understandably drawn by the $ volume of card transactions and monetization potential (ex. Chime’s model). And many growth stage payments companies have been successful in using this as a wedge into building a diversified software services business. Fintechs anchored in card payment revenues and who do not have a path to value-added services, will encounter a critical juncture where adaptation is imperative for survival – the interchange fee pool available to them is going to shrink due to this new settlement. Additionally, noncard consumer payment methods (ex. BNPL) have increasingly taken share from traditional card payment methods, especially online. Interchange fee models can be a wedge, but diversification must follow to include a mix of value-added services, software, and/or lending (ex. Stripe and Adyen’s product roadmaps). The evolution beyond a singular focus on interchange fees is imperative to mitigate the risks associated with this soon to be lower growth fee pool due to regulatory changes and continued shifts in payment methods. Additionally, this week we saw Robinhood go the other way, using its base of trading customers to launch a credit card product where it will earn revenue from interchange and fees. There are clearly still monetization opportunities with interchange, but the model is evolving.
If they haven’t already, consumers might soon see signs at the checkout saying “4% fee for all credit cards” – this is happening in NYC now. We expect there to be significant behavioral changes and shifts in consumer payment preferences (B2B is a very different situation), accelerated and enabled by this settlement. The interchange model has long been, and will continue to be, the foundation for the credit card ecosystem. But merchants will continue chipping away (slowly) at fees, which ultimately means a smaller pool as a % of dollar payment volumes. Fintechs will have to adjust their monetization strategy accordingly.