Two-sided markets and credit card interchange fees

In December 2020, New Zealand’s Ministry of Business, Innovation and Employment (MBIE) released an Issues Paper in which it recommended regulating to reduce ‘merchant service fees’ (MSFs).[i] MSFs are levied on merchants by their banks for accepting some types of card payments. Scheme (Visa and MasterCard) credit card transactions and contactless and online scheme debit cards cost merchants more to accept than swiped or inserted debit cards. These higher cost payment methods have been growing as a share of transactions in New Zealand. Although domestic EFTPOS provides some price competition for some scheme debit products, its use is declining.

In its paper, MBIE notes that MSFs are high in New Zealand, compared to some other countries – including those in which those fees have been capped (e.g., the UK and Australia). MBIE sees this as a problem since many merchants pass on the costs of those MSFs in the form of higher prices for the goods and services they supply. In other words, the costs imposed by those MSFs are oftentimes incurred by all consumers, irrespective of whether they have paid with a higher cost payment method. MBIE has recommended intervening in the payments market to place limits on MSFs – including on the so-called ‘interchange fees’ that comprise a sizeable share of those imposts.

Regulating the level of MSFs would give rise to some fairly predictable winners and losers. Merchants would be better off, (due to the ‘windfall gains’ arising from the reductions in MSFs), issuers would be worse off (for the opposite reason), and some consumers would benefit (e.g., lower income consumers who use credit cards less) at the expense of others (particularly those who use credit cards with reward schemes). But would New Zealanders be better off overall? Maybe; maybe not. As I set out in this Explainer, there is no basis in economic theory to presume that MSFs are too high, or that overall welfare would be enhanced by controlling them through regulation. MBIE's proposal may therefore wind up harming New Zealand consumers, on average.

Credit and charge card networks

The credit card networks operated by Visa and MasterCard are commonly referred to as ‘four-party’ or ‘open’ networks. That is because there are four parties involved in each transaction: the cardholder (who is buying the good or service), the merchant (who is doing the selling), the financial institution (e.g., ANZ bank) that issued the card to the cardholder (the issuer) and the financial institution (e.g., Westpac bank) providing services directly to the merchant (the acquirer). The principal roles and responsibilities of issuers and acquirers, respectively, are as follows: 

• issuers are responsible for signing up cardholders, producing and distributing cards, assessing and managing default risk, developing and advertising credit card products, billing and collecting payments, providing credit facilities, handling chargebacks and managing other complaints; and 
• acquirers are responsible for signing up merchants, installing, servicing and providing training in the use of electronic terminal equipment to merchants, relaying authorisation requests to the network and relaying the response to the merchant, settling with issuers and merchants, dealing with chargebacks and managing the risk of fraud. 

The typical payment flows for transactions involving a four-party network card are set out in Figure 1. As this figure demonstrates, the financial flows in a four-party network transaction generally include the payment of:

• an interchange fee, which is paid by the acquirer to the issuer (more on this soon);
• a merchant service fee (MSF), which is paid by the merchant to the acquirer; and
• a cardholder fee, which is paid by the cardholder to the issuer.

As one might expect, there is a strong correlation between MSFs and interchange fees since the latter is the chief component of the former. Namely, the card networks (Visa and MasterCard) levy interchange fees on acquirers (for reasons I shall discuss shortly) and those costs are then recovered by acquirers from merchants via MSFs.

Figure 1: Four-Party Credit Card Transactions

There are also two principal ‘three-party’ or ‘closed’ networks in New Zealand: American Express and Diners Club. The three-party networks offer charge cards and, more recently, credit cards. Charge cards are similar to credit cards – the difference being that the outstanding balance must be paid in full at the end of every statement period. The American Express and Diners Club networks are often referred to as three-party or closed networks because they involve only three parties to each transaction; namely: the cardholder, the merchant and the network owner that plays the role of both issuer and acquirer of all transactions. Figure 2 summarises the usual payment flows.

Figure 2: Three-Party Charge or Credit Card Transactions

One noticeable difference between the three- and four-party card networks is that transactions conducted within the former do not involve the payment of an explicit interchange fee. As I will explain in more detail subsequently, there is no need for such a fee, because there is only one entity that plays the role of both issuer and acquirer. Or, put another way, one entity 'straddles both sides of the market’. The only fee payable in these types of network is the MSF, which is payable by the merchant to the sole acquirer/issuer.

Two-sided markets and interchange fees

It is not possible to comprehend the potential effects of intervening in payments markets without first understanding their ‘two-sided’ nature. A payment card – such as a credit card or an EFTPOS card – is only viable if consumers want to use it and merchants are willing to accept it, i.e., both sides of the market must ‘get on-board’. To accomplish this, it is necessary to account for the strong positive ‘network externalities’ associated with payment networks. Every time a new customer starts using a card or a merchant starts accepting it the network becomes more valuable for all the existing users; namely:

• the more customers there are that want to use a card, the more merchants there will be that want to accept it; and
• the more merchants there are that are willing to accept a card, the more customers there will be that want to use it.

Card issuers and acquirers therefore have a chicken-and-egg problem to solve. They need to encourage a critical mass of both customers and merchants to hold the cards or join the system. And, ideally, they want to ensure that parties account for the positive impacts their actions have on other network participants. The challenge is that, if credit card issuers and acquirers set prices independently of each other, they would not consider these externalities. Instead, they would focus quite rationally on their own private costs and benefits. This means that, for example:

• issuers would not consider the fact that attracting additional cardholders and card usage generates additional revenues for card acquirers; and
• acquirers would not consider that each additional merchant acquired would generate additional transactions and revenue for card issuers.

That being the case, if left to their own devices, issuers and acquirers would tend to set prices to cardholders and merchants at inefficient levels that did not account for the interdependencies across both sides of the market, resulting in too few card transactions. The application of an additional interchange fee, payable by acquirers to issuers (as depicted in Figure 1), seeks to overcome this problem.[ii] Specifically, it reflects the now well-established view that these positive externalities are best captured by attracting additional cardholders or card usage.[iii] The interchange fee therefore:

• increases the costs of acquirers and provides additional revenue for issuers; and
• results in higher fees to merchants, i.e., increased MSFs; and
• reduces fees (or, enhances protections, increases rewards, etc.) to cardholders.

Although the principle is clear enough, setting the interchange fee at the right level is a complex exercise that requires card platforms to consider the potential choices made by multiple parties. Any movement up or down can trigger a series of reactions that can resonate across both sides of the market, altering economic welfare in many ways – often unpredictably so. As Evans and Schmalensee (2005) explain,[iv] the overall impact of changes in interchange fees depends upon a plethora of complicated factors, including:

• the price responsiveness of cardholders and merchants and indirect network effects between cardholders and merchants;
• the degrees of competition in issuing and acquiring and among merchants;
• the form that any fee increases to cardholders would take, e.g., whether they would be fixed or variable fees;
• the marginal social costs of serving cardholders and merchants; and
• how competing systems would respond to changes in prices to cardholders and merchants alike.

Perhaps because of the sheer difficulty of the task, I am not aware of any serious attempts to estimate the ‘socially optimal’ (i.e., ‘welfare maximising’) interchange fee and to compare it to those actually being set by credit card networks.[v] This means that, even if one could look at a particular credit card interchange fee and say with a reasonable degree of confidence that it is ‘too high’ (which would be very difficult, in practice), it is not reasonable to presume that reducing it to some measure of underlying cost would improve overall welfare. As Evans and Schmalensee (2005) explained:[vi]

‘…there is no basis for believing that any particular cost-based formula for determining interchange fees would move one closer to the socially optimal interchange fee and improve welfare.’

Gans and King (2000) reached an analogous conclusion:[vii]

‘Some reasonable assumptions lead us to conclude that regulation of the interchange fee is at best, innocuous and, at worst, could seriously undermine the efficiency of the payments system.’

Before one could be confident that altering the level of interchange fees would enhance overall welfare, it would be necessary to account for the many other factors listed above, e.g., price responsiveness, benefits to cardholders and merchants, the form that new fees would be likely to take, and so on. The complex interaction of these variables means it is entirely possible that such a step could reduce overall welfare. Indeed, most contemporary economics literature seems to agree that cost-based regulation of interchange fees would improve overall welfare only by happenstance. These crucial factors go conspicuously unacknowledged in MBIE's paper.

Potential effects of regulation

Any change to the level of credit card interchange fees would trigger a chain of events that would have wide-reaching effects on both sides of the market and on economic welfare. Some of those outcomes are reasonably predictable - for example, it is relatively straightforward to identify the most likely ‘winners and losers’ from MBIE's proposed intervention, even if is not possible to say for certain whether the wins would outweigh the losses in aggregate, i.e., if welfare would be enhanced overall.

Credit cardholder fees would increase and benefits would decline

If the level of credit card interchange fees was regulated in New Zealand, resulting in a reduction in those rates, then this would decrease the revenues earned by card issuers. Those issuers would be expected to respond by either increasing the fees payable by credit cardholders and/or reducing the value of benefits received from the use of credit cards (e.g., reward dollars, prizes, etc.). This was certainly the outcome when the Reserve Bank of Australia (RBA) regulated the level of credit card interchange fees in Australia in the early 2000s: credit cardholders were made unambiguously worse off. 

What is also interesting is the form that those fee increases took in Australia. Specifically, they manifested primarily in the form of higher annual fixed fees, i.e., fees that were independent of transaction volume. For reasons that shall become clear later, this is important because, unlike usage fees, fixed fees have virtually no effect on the ‘marginal price’ for different payment mechanisms. Once a cardholder has paid that annual fee, she is no more likely to use, say, an EFTPOS card than her credit card when paying for an item (e.g., buying a bottle of milk), since that earlier fixed cost is ‘sunk’ and forgotten.

Merchant services fees would decrease

If credit card interchange fees were regulated in New Zealand, this would translate into reduced MSFs, given the strong interdependences between the two (as depicted in Figure 1). This is certainly what transpired in Australia when interchange rates for the four-party networks were regulated in 2003 (and revisited in 2006). Over the period 2003 to 2009, Visa and MasterCard reduced substantially their MSFs in Australia. American Express and Diners Club also reduced their fees, but by less than half as much.[viii]

The RBA also concluded that both small and large merchants benefitted from the reduction in MSFs.[ix] However, in my view, it is reasonable to expect that, post-regulation, larger merchants would have continued to pay proportionally lower MSFs than smaller merchants for all types of cards. Setting aside the precise breakdown of benefits it seems clear that merchants would be the immediate beneficiaries of any interchange fee regulation in New Zealand. That is plainly also MBIE’s expectation, as is evident throughout its paper.

Merchant fee reductions would not be fully passed through to consumers

Although interchange fee regulation would reduce costs for merchants, it is unlikely that 100% of those reductions would be passed through to New Zealand consumers in the form of lower prices for goods and services. It is only in very limited circumstances that full pass-through of an input cost reduction can be expected in a market. Specifically, if a reduction is market-wide and there is perfect competition,[x] full pass through can be expected either if demand is ‘perfectly inelastic’, or if supply is ‘perfectly elastic’.[xi],[xii]

These conditions are seldom, if ever, seen in practice – and they are certainly not ubiquitous throughout the New Zealand economy.[xiii] There is therefore neither a sound basis in economic theory to support an assumption of ‘full pass-though’ of MSF reductions nor any empirical evidence.[xiv] Predicting a precise share of the reduction in MSFs that would be passed on is not possible. However, it is reasonable to assume that the extent of overall pass-through would be significantly less than 100%.

No material effect on competition in issuing and acquiring

In principle, regulating the level of interchange fees could impact upon the level of competition in the provision of credit card services – both to cardholders and merchants. For example, the RBA anticipated that its interventions would enhance competition between issuers and acquirers alike; primarily by encouraging new entry by ‘non-financial corporations of substance’.[xv] However, the interventions do not appear to have had this effect in practice and I see no reason to think that the experience would be any different in New Zealand if interchange fees were regulated. 

Unclear effect on relative usage of different payment methods

If credit card interchange fees were regulated and credit cards became a less attractive form of payment – because card rewards diminished or fees increased – then this could cause cardholders to reduce their use of those cards and switch to other cheaper forms of payment, such as EFTPOS. However, if fee increases took the form of higher annual fixed fees and the value of reward benefits declined but did not disappear altogether (as was the case in Australia), it is not obvious why there would be significant switching away from credit cards, since:

• once an annual cardholder fee has been paid, it has no effect at all on a customer’s ‘marginal’ payment decision, i.e., whether to use, say, Visa or EFTPOS for any particular transaction;[xvi] and
• some reward benefits are still better than none, which means a customer’s marginal payment decision might still swing in favour of a credit card, even if it is not quite as attractive as before.[xvii]     

In other words, although credit cardholders would face significantly higher costs to use their credit cards, this might not result in sharper price signals. Higher annual fixed fees and reduced reward programs may do little, if anything, to steer customers away from credit cards. The Australian experience is not especially instructive on this point, because the available data do not reveal whether the RBA’s regulation of interchange fees – as opposed to unrelated factors[xviii] – had a material effect on the relative usage of payment cards.

Summary and implications 

Credit card interchange regulation would create several winners and losers. Merchants would be better off, issuers would be worse off, and some consumers would benefit (e.g., lower income consumers who use credit cards less) at the expense of others (particularly those who use credit cards with reward schemes). But the key question is: would New Zealander consumers be better off overall? In my view, the answer could well be ‘no’. There are at least two reasons for thinking so; namely: 

• regulating the interchange fee may not have a significant effect on the variable prices paid by cardholders and therefore on the volume of credit card transactions – which would presumably be the chief reason for intervening; and 
• even if cost-based interchange fee regulation could affect the variable prices paid by both merchants and cardholders, most contemporary economics literature agrees that it would improve overall welfare only by coincidence.[xix]

Indeed, there are many other factors that would influence the overall effect of any such regulatory intervention on economic welfare that would be very hard to predict. These include the benefits that customers obtain from different payment types (which are hardly ever considered), price elasticities of demand and supply, and so on. Taking these varied and potentially counteracting impacts into consideration would be a very complicated and challenging exercise. Unfortunately, MBIE neither grapples with nor even acknowledges these issues in a meaningful way.[xx] In fact, the paper contains virtually no empirical analysis at all - including any quantitative cost-benefit analysis.

Simply put, the scant analysis there is in MBIE’s paper provides no basis at all upon which to conclude that MSFs are currently too high, or that overall economic welfare could be enhanced by controlling the level of those fees through regulation. Accordingly, MBIE's conclusion that MSFs should be brought down has neither a theoretical nor an empirical basis - it is unsubstantiated conjecture. It follows that there is a distinct possibility that regulating to reduce the levels of MSFs could inadvertently reduce overall economic welfare. Moreover, if its foreshadowed intervention did happen to have the desired effect, that outcome would be attributable more to good luck than sound policy design. 

[i]      Ministry of Business, Innovation and Employment, Regulating to reduce Merchant Service Fees, December 2020.

[ii]     The situation is simpler in the case of ‘closed’ or ‘three-party’ systems such as American Express and Diners Club, since the issuing and acquiring functions are undertaken within the same entity. They can therefore directly set their fees to both cardholders and merchants at levels that take the relevant externalities into account. Put another way, they can set an ‘implicit’ interchange fee by directly altering these prices, e.g., by reducing cardholder fees and/or increasing MSFs.

[iii]    This reflects the belief that the benefits arising from these factors exceed the benefits of attracting additional merchants.

[iv]     Evans & Schmalensee, The Economics of Interchange Fees and Their Regulation: An Overview, MIT Sloan Working Paper, May 2005, p.37 (hereafter: ‘Evans & Schmalensee’).

[v]      Most of the existing literature on the topic also makes assumptions (e.g., that competition is perfect, etc.) that do not reflect reality. Moreover, almost all studies focus only on the cost of serving cardholders and merchants and ignore benefits, i.e., they look at only half the picture.

[vi]     Evans & Schmalensee, p.38.

[vii]    Gans & King (2000), The Role of Interchange Fess in Credit Card Associations: Competitive Analysis and Regulatory Issues, December 2000, p.3.

[viii]   As we explain subsequently, this is due largely to the fact that the three-party networks were not formally regulated by the RBA.

[ix]     RBA, Reserve Bank of Australia Bulletin, July 2004, p.12.

[x]          The theoretical ideal of a perfectly competitive market has several distinguishing characteristics. These include many buyers and sellers; no barriers to entry, exit or expansion; homogeneous products; perfect information and zero transaction costs.

[xi]     The elasticity of demand (supply) measures the responsiveness of the demand (supply) for a product to changes in the price for that product. An elasticity of ‘zero’ is a situation of perfect inelasticity and is represented by a vertical demand/supply curve. This implies that a change in price does not affect the quantity demanded/supplied. An elasticity of ‘infinity’ is a situation of perfect elasticity and is represented by a horizontal demand/supply curve. This implies that any change in price will cause demand/supply to drop to zero.      

[xii]    Stennek, J. & Verboven, F., Merger Control and Enterprise Competitiveness – Empirical Analysis and Policy Recommendations, Report for EC Contract III/99/065, February 20, 2001., pp.60-61. See also: Cotterill, R., Estimation of Cost Pass Through to Michigan Consumers in the ADM Price Fixing Case, Food Marketing Policy Center, University of Connecticut, Research Report, No.39, 1998.            

[xiii]   For example, sellers generally are not pure price takers, and parties are almost never perfectly informed. Goods rarely are homogeneous. Barriers to entry and expansion may exist. Firms may not be able rapidly to adjust supply up or down by acquiring or disposing of assets in response to changing market conditions. Entry and exit may not be easy or swift, with supply-side constraints hindering both processes. The two other criteria – perfect elasticity of supply and/or perfect inelasticity of demand – are similarly rare.

[xiv]   For example, there is no empirical evidence to suggest that the reductions in merchant fees that were seen in Australia following the introduction of interchange fee regulation were passed-through fully to final consumers in the form of lower prices.

[xv]    RBA, Payments System Board Annual Report: 2002, 2003, p.15.

[xvi]   In addition, it seems unlikely to us that many customers would be prepared to relinquish their credit cards altogether in response to a higher fixed fee.

[xvii]  Moreover, there may be other reasons why a customer might still prefer to use a credit card even if she received no reward benefits at all – such as to obtain the benefit of an interest-free period.

[xviii] In addition to the two factors described above there are several other ‘confounding factors’. For example, the introduction of interchange fee regulation coincided very closely with the launch of Visa and MasterCard scheme debit cards. It was also introduced at the same time as a long-standing ban on surcharging of Visa and MasterCard payments was lifted.

[xix]   See for example: Evans & Schmalensee, p.38.

[xx]    For example, simply observing that interchange fees are higher in New Zealand than in other places where they have been regulated (e.g., Australia and the UK) is as unremarkable as it is irrelevant.