Credit and debit cards have become increasingly prominent forms of payment. From 1984 to 2005, the share of US consumer expenditures paid for with cards has increased from about 6 percent to 38 percent. In 1995, credit and debit cards accounted for less than 20 percent of noncash payments; by 2003, they exceeded 40 percent.
Currently, the US card industry is a mature market: in 2001, an estimated 76 percent of US households had some type of credit card. Recent estimates suggest that among all households with income over $30,000, 92 percent hold at least one card, and the average for all households is 6.3 credit cards.
With this growth has come increased scrutiny of both the benefits and costs of card use. In particular, the growth in card transactions has been paralleled by an accelerated trend of legal battles and regulatory actions against the credit card networks worldwide. At the heart of the controversy are the interchange fees (IFs) the fees paid to card-issuing banks (issuers) when merchants accept their credit or debit cards for purchase. Although interchange fees seem to account for a small percentage of each transaction (e.g., interchange rates, varying by merchants’ business type, average approximately 1.75 percent of transaction value in the US), they are significant in absolute terms. In 2005, American card issuers made $30.7 billion (about $270 per household) from interchange fees, an increase of 85 percent since 2001.
Interchange fees are set by credit card networks. The two major card networks, Visa and MasterCard, each set their interchange fees collectively for tens of thousand member financial institutions that issue and market their cards.6 For one simple example of how interchange functions, imagine a consumer making a $100 purchase with a credit card. For that $100 item, the retailer would get approximately $98. The remaining $2, known as the merchant discount fees, gets divided up. About $1.75 would go to the card issuing bank as the interchange, and $0.25 would go to the merchant acquirer (the retailer’s merchant account provider). For the credit card networks, interchange is the key of the entire enterprise, as we will show, interchange pricing increases the card transaction volume, thus increasing interchange revenue to card issuers as well as their revenue from interest and other finance charges.
Industry participants tend to agree that collectively determined interchange fees may help eliminate costly bargaining between individual card issuers and acquirers (Baxter 1983). However, they disagree on the levels of the fees. Merchants, on one hand, have become increasingly critical of interchange fees, claiming they are higher than necessary and can not be justified by the costs of card services.
In fact, interchange rates in the US have been rising over the last ten years and are among the largest and fast-growing costs of doing business for many retailers (see Figure 1). However, on the other hand, card networks disagree, arguing interchange fees represent an essential effort to coordinate the demands in the two-sided card market, balancing incentives to issuers to issue more cards with better rewards against the need to bring an optimum number of merchants into the card systems.
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