With more and more regulators demonising payment interchange, it’s probably about time that we as an industry looked wholesale at the fee & charging models we have and bought them into line with core benefits and the genuine value that each party brings to the business.
If we take the four-party model cards market, for example, which is being hit hard by EU regulators at the moment (here) then the old fashioned concept was that without cards in market, the acceptance of cards was impossible – and so Issuers needed to be paid by Acquirers for performing that task (and taking on credit risk etc…) – this is the idea of interchange (here). Likewise, when an Acquirer gives out cash via an ATM, the cost of this is passed on to the Issuer of the card as the Acquirer is performing cash out services that used to happen in the Issuer’s branches. These are known as Multilateral Interchange Fees (MIFs), Interchange, Balancing Fees or a host of other names.
This is all pretty simple stuff. However, Interchange isn’t the major component of the cards business model any more – and hasn’t been for quite a while. Most Issuers will base their models on FX rates, annual fees, late fees, interest, exceptions fees and many other components that usually leave interchange as about 1/3 of their revenue model rather than the bulk of it. Their costs are all the standard stuff – cost of plastic, marketing, customer acquisition, fraud management et al… – but typically the cost that surprises and surpasses others for new issuers is the so-called ‘scheme fees’. This is the costs associated with being connected to the central facilitating body known as the payment scheme (or brand or network) – organisations such as Visa, MasterCard, Discover, UPI, Cartes Bancaire, NYSE, Bancomat and the like that create the regulatory framework and provide the central switching infrastructure that make card payments in multi-party, multi-country schemes possible. Likewise for the Acquirers, they have these same costs, which in turn are passed on to their customers – the merchants.
So for a regular card payment transaction in Europe, the Merchant pays the Acquirer a fee (or Merchant Service Charge) which is essentially comprised of the interchange that Acquirer owes to the Issuer of the card; the Scheme Fees that the Acquirer must pay to the Payment Scheme; the cost of the infrastructure to acquire the transaction; a cost to offset losses due to fraudulent transactions; and of course a VERY small margin for the Acquirer. This means that a Merchant can expect to pay somewhere between 1 and 3% of the value of the transaction value, depending on the parameters of the transaction and their own volumes.
But what value does the Merchant receive for this cost? Well, the first benefit is the fact that their customer has a card at all – a tool that enables them to access all of the money available to them directly in the store without having to carry risky cash sums. Next, when the transaction enters the payment infrastructure there is a pile of validation that takes place – most of this is for fraud prevention, which isn’t an advantage over cash, but the most important piece of validation is Authorisation, where the Issuer confirms that the cardholder has sufficient funds at that moment (or not) and returns a guarantee to the Merchant that, barring certain conditions, they will be paid the amount requested and can go ahead and make the sale. The final benefit to the Merchant being that they don’t have the cost or issues associated with handling cash to make the transaction – which is why so many merchants globally are striving to become cash-free (example here).
So in a world where card issuance is near universal – such as most of Europe, the US, LAC and large parts of APAC – is there still value for a Merchant in paying an Issuer to say thank you for issuing the card? Probably not. However, for a Merchant there IS still massive value in what the Issuer does when they say Yes or No to a transaction – intrinsically, the value of Issuers is in Authorisation. And it is this Yes or No that should really be the underpinning of the financial model for payments rather than the mere act of making them available – after all, availability for certain payment types in the EU was enshrined in law with the 2009 regulation on reachability in SEPA schemes (here) and if mobile card emulation takes off as the industry expects, cost of issuance will dramatically decrease.
OK, so that deals with the Issuer’s part – they should get paid for saying yes or no – but what about the scheme/brands/networks? Where is the value in a MasterCard or STET or Fedwire in all of this? Essentially they have a couple of important roles in making electronic payments possible. The first, and perhaps most important role is in managing the multilateral nature of the electronic payments – rules; switching; standardisation; transaction security; brand marketing; clearing and settlement – all the stuff that they’re really good at. The next big ticket item is in keeping the payments flowing 24/7/365 – the rest of the world doesn’t stop for bank holidays any more and so payments need to happen, always. Finally – and perhaps most debate is over this piece – the schemes/brands/networks play a huge role in technological evolution. Not so much in doing the evolution themselves, but by integrating it into this rules and standards environment along with industry vendors so that things can move forwards in a stable and secure way. All of this would lead you to suspect that the schemes/brands/networks would have a per transaction model – which isn’t typically the case. In fact, the simple fact that most of these organisations began as associations and cooperatives means that they typically have cost sharing models as a basic underpinning of their fee structure. Essentially, when Visa International became Visa Inc. it didn’t fundamentally address the way it was funded for day-to-day business (and wasn’t alone in that!).
Fundamentally, what we’ve got today is organisations that do a REALLY good job of helping Merchants and their customers to transact in a secure and assured way – but using a business model that is outdated and no longer focused on the value that the payment or participants bring to commerce. The associative origins of the schemes/brands/networks means that they still don’t fully compete – and that new competitors have a hard task of convincing people to do things in a different way. So if the regulators around the world truly want to make payments more competitive, then what they need to do is address this component rather than a single item in the business model.
My vision of the future is that a consumer would pay (or fund somehow) their Issuer to hold their funds or credit lines. A ‘trusted balance holder fee’ so to speak. Every time a Merchant requested authorisation, with either a positive or negative result, they would pay the Issuer a small fee. The Issuer would pass a percentage of this fee on to the scheme/brand/network for facilitating the transaction by connecting them with the Acquirer and Merchant. The Merchant would also pay a network connectivity fee and potentially a settlement fee to cover the costs of the Acquirer. The Acquirer would typically only pay connectivity fees to the scheme/brand/network to cover interfacing costs rather than transactional traffic. This model, based on ‘pay for what you use’ would create a fairer payment network and a more competitive landscape. It probably wouldn’t lead to a great drop in the costs for a Merchant, but it would create a fairer environment and provide greater transparency. It would also make merchants a lot more careful about what they request authorisation for and so should impact fraud in the network greatly. Overall, I know that this is a lightweight answer to a heavyweight problem, but a value-based business model is clearly the route forwards and Authorisation should be the New Interchange.