The stranglehold of payments networks

By Felix Salmon
March 29, 2012

I’m mostly offline today, since I’m attending a payments conference at the Kansas City Fed. (And tomorrow I’m attending an econobloggers’ conference at the Kauffman Foundation: how jealous are you?) There’s a lot to digest here, but one thing already seems clear: if you look at the main players in the payments industry, whether they’re incumbents or new innovators who aspire to disrupting the status quo, everybody seems almost unthinkingly resigned to working on and within the present architecture, where consumers pay with their credit or debit cards, and merchants require some kind of way of accepting those payments.

Exhibit A, in this regard, is “The Credit Card Is The New App Platform“, a piece by Reid Hoffman and his colleagues at Greylock Partners, talking in a very smart way about all the value that can be added to credit cards as we move to a world of mobile apps and payments. The idea, basically, is that right now you have a dumb piece of plastic where all the real value is in that Visa or Mastercard logo; in the future, there’s a lot of opportunity in terms of making that piece of plastic much smarter.

Most of the most exciting innovation in payments, including companies like LevelUp, not to mention the iTunes store, is built on credit or debit card accounts: the first thing you do, when you download one of those apps, is type in your card number, and when you pay, the payment is ultimately made on your card — which means that it necessarily involves making substantial payments to those payments networks. iTunes, the conference was told this morning, has some 150 million card numbers on file, which is one reason why it’s so attractive to people looking to sell content or apps or music. Similarly, one of the great attractions of the Amazon Marketplace, for both buyers and sellers, is that Amazon already has the buyer’s card information on file. Other innovators, like Square and Stripe, are also innovating around credit and debit cards, specifically by making it much easier for the payee to accept those payments.

Visa and Mastercard, of course (and American Express, too) are very happy with this. They can work on innovations themselves, or they can outsource innovation to the likes of Reid Hoffman; either way, they get paid, because they’re the default payments architecture. But what we’re missing here is any kind of threat to their dominance. And that’s a great shame, because these dominant companies have an enormous amount of pricing power. The interchange fees that they charge merchants only ever go up; it took an unbelievably hard-fought act of Congress to bring those fees down just for bank debit cards. (Which is one reason why the number of prepaid debit cards is rising fast: they’re exempt from Durbin rules, and can charge very high interchange fees.)

The keynote speech at the payments conference today came from Joseph Farrell, the director of the bureau of economics at the Federal Trade Commission. He talked at great length about the importance of lowering the transaction cost of payments, and the way that would benefit both consumers and society; he also suggested that this was a key aspect of what the conference was about.

He’s right about the first: transaction costs are too high, and should come down, and there would be large positive externalities were that to happen. He’s wrong about the second, however: there’s actually precious little discussion at the conference about how transaction costs might come down. There’s much more talk about the way in which they go up far too easily: Visa and Mastercard have enormous pricing power, and can raise their prices as much as 30% without noticeably losing any customers at all. Merchants feel forced to accept such cards, no matter what the cost, while the costs to consumers, in the form of higher prices, are extremely well hidden. Visa and Mastercard essentially levy a non-negligible tax on a huge percentage of retail payments, and do so in a largely invisible manner; they then rebate some of that tax revenue back to consumers, bribing those consumers to force the merchants to pay the tax.

At one point last year, I got very excited about a new payments service called clearXchange, which promised the ability for people to pay each other without going through the Visa or Mastercard networks. And because it is backed by giant banks — Wells Fargo, Chase, and Bank of America — it has the potential to be really huge.

The problem is, it doesn’t actually work: it hasn’t taken off, for technical reasons I don’t pretend to understand. All I know is that when I meet executives from those three banks and bring up clearXchange, they tend to change the subject very quickly. It’s certainly not something which they seem to think is going to revolutionize anything, any time soon.

There is some innovation around payments which doesn’t involve Visa and Mastercard in some way. One peer-to-peer payments app I was shown today, which isn’t publicly available yet, is built on the EFT network, the one you use when you withdraw money from an ATM. And another delegate told me that fully 26% of revenue at Starbucks comes from its mobile app, which can be (and often is) funded directly from your bank account, without having to go through Visa or Mastercard.

But that kind of thing is laborious and expensive for startups: one of PayPal’s big competitive advantages, for instance, was the fact that it found a way to link PayPal accounts to individual members’ accounts at thousands of banks around the country. That’s non-trivial, and it’s much easier to deal with just two or three payments networks.

So color me pessimistic, here, at least in the US. There really is a huge public interest in bringing down transaction costs, and moving the locus of payments-related innovation away from the Visa and Mastercard networks, and towards cheaper and more direct bank-account connections. But I see no indication that’s going to happen. In that sense, I have the same view now that I had in 2010, when I said that there wasn’t much prospect of real competition in payments. It would be great were that to happen. But I’m not holding my breath.

As a consequence, the government really has to get involved here, lest the payments networks simply continue to raise their interchange fees and extract ever-higher rents from everybody else. But the obvious entity to do that is the Federal Reserve, and, at least judging by this morning’s remarks from Kansas City Fed president Esther George, that’s not going to happen any time soon. No one really wants new regulation. Which is surely music to the ears of Visa and Mastercard.

Update: One other intriguing idea I was given at the end of the conference: what about using the check-clearing architecture as a payments mechanism? With Check 21, in theory everything could be electronic, you don’t actually need paper checks. (Although some lawyers apparently say you do.) The problem, I think, would be ensuring funds were available. But if you can do that, it could work very well — and much more cheaply than the Visa and Mastercard systems.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
18 comments so far

Were you shown Dwolla? If so, don’t understand why you can’t name it. Would like to hear your thoughts on it.

Posted by MickWeinstein | Report as abusive

Felix – other than that your gut, where is your evidence that interchange fees are too high? Also, don’t the “cheaper and more direct bank-account connections” that you desire exist in the form of debit with a PIN?

Posted by realist50 | Report as abusive

@realist50: Even if PIN debits are cheaper that signature debit/credit, why does “cheaper and more direct bank-account connections” have to come in the form of a VISA/MC card? That’s Felix’s point.

As to “too high”: here’s a good chart of interchange fees in the U.S. vs. Europe: http://blogs.reuters.com/felix-salmon/20 12/01/12/will-us-courts-take-aim-at-cred it-card-interchange/ (note: you commented on that article).

“Too high” is in the ear of the beholder, but if Europe can do consumer payment processing for a lot cheaper than the U.S., then the U.S. interchange fees are “too high.” It’s just that with an entrenched oligarchy, competition doesn’t erode the rents in the system.

Another article with data: http://www.csmonitor.com/Business/new-ec onomy/2011/0413/Credit-card-swipe-fees-U S-firms-pay-too-much-and-it-hurts-consum ers

Posted by SteveHamlin | Report as abusive

Felix,
It seems that the dominant problem is the fact that, from the consumer perspective, the transaction cost is “extremely well hidden” and thus, to me, the easiest solution would be to make the transaction cost explicit to the consumer. Specifically, simply require that all businesses split out interchange fees on receipts just like they do sales tax. My guess is that once the interchange fee is explicit, there will be an overwhelming desire on the part of most businesses to treat it like sales tax and add it on as an additional fee. Higher interchange fees would then be directly passed onto the consumer leading to downward pressure on the interchange fee itself (the consumer can either choose the card with air miles or with a 1% interchange fee).

Of course, the downside to the policy implementation for the government is that cash will also become much more attractive, and my guess is that from a sales tax/ income tax revenue perspective the government doesn’t want this to occur. After all, the real reason why my hair stylist doesn’t accept credit cards is not because of the interchange fee. It’s because he doesn’t want to pay income tax!

Posted by naiveideas | Report as abusive

What’s to keep the Federal Reserve from going to plastic money? They run the check-clearing system, why can’t they create a digital payments-clearing system?

Posted by Setty | Report as abusive

@Steve Hamlin – thank you for the links. U.S. fees do like high, though a full study of the issue needs also to consider the costs imposed (or funds rebated) on the consumer side. It’s a 2-sided market, so in theory the total cost could be similar but split differently between merchants and consumers (which was my comment to the prior post).

@naiveideas – I think that merchants have plenty of reasons that they prefer paying the interchange cost to trying to move customers to other forms of payment (though they obviously still prefer lower interchange cost). Checks have drawbacks of fraud losses and the time required for customers to write checks, slowing down lines at retail. Cash has handling costs and “shrinkage” from employee theft, plus the loss of impulse buys that exceed the cash that customers are carrying on them.

Posted by realist50 | Report as abusive

“look high”, not “like”

Posted by realist50 | Report as abusive

The surprise is more that there is anno 2012 still a country in which people write checks for their shopping.

Posted by Panley | Report as abusive

Realist50–while it’s true that checks and cash are not perfect from the merhcants’ point of view, it’s also true that merchants feel that the interchange fees are too high, to the extent that I have seen more and more local merchants *asking customers to pay cash* rather than use plastic. And when the interchange fees were being fought over in Congress, which side were the merchants on–even the big boys, Walmart, Target, etc.? Merhcants want the fees to come down, and I agree that making them visible would make it an issue that consumers would pay attention to. Heck, in today’s political rhetoric, you could even get away with calling it a “tax”!

Setty–do you really want a payment system where the Fed can track every nickel you spend on anything? Where that information could conceivably be considered a public record subject to FOIA (at some expense, I suppose)?

Felix–Why would ClearXchange be an improvement? A system where Visa and Mastercard have oligopoly pricing power is exchanged for one where Wells Fargo and BofA have that power? Given all that we know of Wells Fargo and BofA’s scrupulously honest and thorough business practices, that doesn’t seem like a great idea (see also: frying pan, fire).

Posted by Moopheus | Report as abusive

Apparently it is too early in the morning to type “merchants” correctly.

Posted by Moopheus | Report as abusive

Moopheus – I don’t question that merchants, big or small, would rather pay less interchange than more interchange. Clearly they’d rather pay less for the same service and availability of payment options. I was addressing whether a merchant would rather pay current interchange rates or deal with cash/checks. I could see a difference between mom and pop local merchants and larger chain retailers on this point. If I’m a local mom and pop, I’ll assume that I have a limited risk of employee theft (if me or a close relative is always minding the till) and may look at the handling costs of cash as “I go to the bank every day whether my cash receipts are $x or $5x” I also may, as naiveideas pointed out, not report all of my cash for sales tax or income tax (I don’t mean to say that’s true in every case, but it certainly happens sometimes). All of these dynamics are different for a large retail chain.

For what it’s worth, a sizable liquor store chain here in Texas (Spec’s) is an interesting example, as Spec’s offers a 5% “cash discount”, which is prominently displayed on every price label in store. For their purposes, PIN-based debit also counts as “cash” (I’m not sure of their policy on checks). I don’t know the origins of this discount, or if regulations specific to liquor stores had anything to do with the policy at some point in time, but it’s interesting since the discount is obviously greater than the cost of interchange.

Posted by realist50 | Report as abusive

clearXchange = ACH. Cheap.

Posted by jimmyzane | Report as abusive

Realist50–I wouldn’t assume that the 5% discount is greater than the cost of interchange. For one thing, cards that offer benefits to the customer–cash back, points, etc.–cost more for the merchant. The banks make the merchants pay for that. I was talking with one local businessperson (my bike mechanic) who told me her fees can go as high as 6% on those cards.

I pay her in cash.

Posted by Moopheus | Report as abusive

Why don’t leading non-finance companies enter the picture?

In the developing world telecoms have “leapfrogged” financial services firms by creating payment systems that (initially) targeted the unbanked. As these payment & money-transfer systems took off a few things happened: (1) mainstream (i.e., the “banked”) users joined in, (2) merchants started accepting them at point-of-sale, (3) the telecom companies started to add features slowly transforming these simple services into sophisticated financial products. I’ve written about this in a few places, including here:

http://radar.oreilly.com/2009/09/mobile- banks-in-the-developing-world-prove-simp ler-is-better.html

Posted by datascientist | Report as abusive

The article was excellent and as were the comments.

Posted by M.C.McBride | Report as abusive

That’s a good point. What did happen to ClearXChange? In the UK they have Faster Payment Service (FPS) so you can send money from bank account to another instantly and its free for consumers. Why is that so hard in the US?

Posted by CaycePollard | Report as abusive

Moopheus, I hope your paranoia also extends to the check-clearing system, which is already run by the Fed. Do you really think that your check details are susceptible to FOIA requests? And do you really think the Fed is less trustworthy than Visa or Mastercard?

Also, the Fed won’t track every penny I spend, as I live in Chile. What I’d like is a way to send money to vendors, friends and family in the USA without the expense of wire transfers or PayPal and without making other people have to jump through the hoops imposed by bank systems like Chase QuickPay. It’s really silly that anyone can do a free interbank transfer in Venezuela and Chile and it’s still impossible in the USA. Faced with that market failure, I’m all for a quasi-government agency like the Fed stepping in and taking over the task.

Posted by Setty | Report as abusive

I’m a PayAnywhere user. Their device plugs right into your phone and their app has easy to use features. I would definitely recommend it to anyone with a small business or salesmen on the go! http://www.payanywhere.com/home

Posted by me315b | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/