The purpose of a payment system:

Currency and Checks

Checks Direct Presentment

Check Customer (Drawer)

Merchant

Drawee (Issuer)

Bank

Payable at par

Checks Interbank Presentment

Check Customer (Drawer)

Merchant

Drawee (Issuer)

Bank

Presenting (Acquirer)

Bank

Issuer could withhold fee if presented remotely (by mail).

Checks Monopoly Bank Towns

Check Customer (Drawer)

Merchant

Drawee (Issuer)

BankPresenting (Acquirer)

Bank

Fee constrained only by (high) transport costs for direct presentment.

Checks Correspondent Presentment

Check Customer (Drawer)

Merchant

Drawee (Issuer)

Bank Presenting (Acquirer)

Bank

Competition limited fees to transport costs using mail.

Correspondent Bank

Checks Clearinghouse Settlement

Check Customer (Drawer)

Merchant

Drawee (Issuer)

Bank

Presenting (Acquirer)

Bank

Clearinghouse

Most efficient organization. But created market power and bank cartels.

Clearinghouse Cartels

Perfect Competition NeutralityMerchant Bank

Pays $1 Exchange Fee to Consumer

Bank

Consumer Pays $1 in Higher Retail

Prices

Merchant pays $1 More in Bank Fees

Competition Among Issuing

Banks Rebates the $1 to Consumer

Greshams Law

Acceptance at par in retail transactions enhances market power of monopoly banks and clearinghouse cartels.

95% of non-par banks were towns with only 1 or 2 banks.

Then, electronic checks were adopted.

No effective competition to eliminate interchange fees in card payments.

Four-Party Payment Card Systems

Visa Card Customer Merchant

Issuer Bank

Acquirer BankX

Collective Market Power

In some countries, banks instead formed acquirer monopoly.

Interchange fee is a Revenue-Sharing Arrangement: Merchant Pays Its Own Bank Plus All Other Banks

Economically equivalent to price fixing cartel, but competition among banks will not erode interchange fee.

Transbank: Monopoly Card Acquirer

Merchants

Merchants

Merchants

Merchants

Merchants

Merchants Merchant fees

Net paid to bank(implicit interchange fee)

Interchange Fee = Most of Merchant Fee

Acquirer Fees, 19%

Interchange Fee, 81%

Acquirer Fees, 42%

Interchange Fee, 58%

Anti-Steering Rules

typesbrandsbank issuers

Enhance market power and lead to higher merchant fees, costs and prices.

Card Issuers steer with rewards

Merchant pays resulting fees, cannot steer.

Defenses for Interchange Fees

Defenses for Interchange Fees

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

Mar

-01

Jun-

01

Sep-

01

Dec

-01

Mar

-02

Jun-

02

Sep-

02

Dec

-02

Mar

-03

Jun-

03

Sep-

03

Dec

-03

Mar

-04

Jun-

04

Sep-

04

Dec

-04

Mar

-05

Jun-

05

Sep-

05

Dec

-05

Mar

-06

Jun-

06

Sep-

06

Dec

-06

Mar

-07

Jun-

07

Sep-

07

Dec

-07

Merchant Discount Rate (Left Scale)

Merchant Locations (Right Scale)

Australia Reduced Interchange Fees by ~Half

Defenses for Interchange Fees

Merchant cash cost Merchant card cost

Mer

chan

t Cos

t

Efficient Pricing When Merchant Costs Are Lower For Cards(No Interchange Fee)

CashPrice

Net Card Price

Discount for card use(or surcharge for cash)

Merchant cash cost Merchant card cost

Mer

chan

t Cos

t

Efficient Pricing When Merchant Costs Are Higher For Cards

CashPrice

Net Card Price

Surcharge for card use(or discount for cash)

Merchant cash cost Merchant card cost

Mer

chan

t Cos

t

Price Coherence: Claim Cards Save Costs, But Merchants Cannot Discount Card Transactions:

Everyone Pays Intermediate

Price

(Merchants would prefer to encourage more card use)

Merchant cash cost Merchant card cost

Mer

chan

t Cos

t

Theoretically Efficient Interchange Fee When Merchant Costs Lower For Cards, Merchants Cannot Steer, and

Issuing is Perfectly Competitive

CashPrice

Net Card Price

(Accomplishes efficient discount for card use)

Interchange Fee Rebated to Cardholder

Merchant cash cost Merchant card cost

Mer

chan

t Cos

t

Theoretically Efficient Interchange Fee When Merchant Costs Lower For Cards, Merchants Cannot Steer, and

Issuing is Perfectly Competitive

CashPrice

Net Card Price

(Accomplishes efficient discount for card use)

Interchange Fee Rebated to Cardholder

European Union: 0.3% for credit, 0.2% for debit

Merchant cash cost Merchant card cost

Mer

chan

t Cos

t

But What if IF is Set Too High, Funds are Kept by IssuersAnd No Surcharging is Permitted?

Price to Everyone

With IF

Interchange Fee Kept by Issuer

Price to Everyone With No IF

Externalities Caused, not Solved, by Unregulated Interchange Fees

$0.30

$0.42 $0.44

$0.61$0.68

$0.57

$0.43

$0.64

$0.47

$1.22

$0.82

$0.57

$0.00

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

$1.40

Cash Non-VerifiedCheck

Verified Check Credit/Charge Signature Debit PIN Debit

Average cash transaction size

Average check transaction size

Merchants not indifferent:

Merchant costs, $USD

Source: Visa consultants Garcia-Swartz, Hahn, and Layne-Farrar.

U.S. Credit Card Access by Family Income

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1970 1977 1983 1989 1995 1998 2001 2004 2007

< 20% 20%39.9% 40%59.9% 60%79.9% 80%100%Income percentile:

Intervention in many regions

Argentina Estonia Israel Poland

Australia E.U. Italy Portugal

Austria Finland Latvia Romania

Canada France Malaysia S. Korea

Chile Germany Mexico Spain

China Greece Netherlands Switzerland

Columbia Hungary N. Zealand U.K.

Denmark India Norway U.S.A.

Australia Estonia Germany Spain

Belgium E.U. Netherlands Switzerland

Austria Finland N. Zealand U.K.

Canada Hungary Poland U.S.A.

Cyprus Ireland Portugal

Czech Rep. Israel Slovakia

Denmark Malta Slovenia

Card networks work without high interchange fees

Australia 0.50%

China 0.30%

European Union (2016 generally) 0.30%

France 0.28%

Hungary 0.30%

Malaysia 0.21%

Netherlands 0.30%

Poland 0.30%

Romania 0.30%

Spain 0.30%

Australia 0.22%

Canada 0.00%

Denmark 0.00%

European Union (2016) 0.20%

Hungary 0.20%

Malaysia 0.15%

New Zealand 0.00%

Norway 0.00%

Poland 0.20%

Spain 0.20%

Lessons from History and Regulation

Designing Competitive Payments MarketsCentro de Estudios Pblicos, Santiago de Chile6 October 2015The purpose of a payment system:Currency and ChecksChecks Direct PresentmentChecks Interbank PresentmentChecks Monopoly Bank TownsChecks Correspondent PresentmentChecks Clearinghouse SettlementClearinghouse CartelsPerfect Competition NeutralityGreshams LawCompetition Led to Par SettlementFour-Party Payment Card SystemsCollective Market PowerInterchange fee is a Revenue-Sharing Arrangement: Merchant Pays Its Own Bank Plus All Other BanksTransbank: Monopoly Card AcquirerInterchange Fee = Most of Merchant FeeAnti-Steering RulesCard Issuers steer with rewardsDefenses for Interchange FeesDefenses for Interchange FeesDefenses for Interchange FeesSlide Number 23Slide Number 24Slide Number 25Slide Number 26Slide Number 27Slide Number 28Externalities Caused, not Solved, by Unregulated Interchange FeesU.S. Credit Card Access by Family IncomeIntervention in many regionsCard networks work without high interchange feesLessons from History and Regulationalan.frankel@coherentecon.comwww.coherentecon.com