What is Interchange, and What Factors Impact the Interchange Rate?

Understanding Interchange Fees

Every time a consumer swipes their card to make a purchase, the merchant incurs an interchange fee. This fee is divided among various entities that facilitate the transaction, including the issuing bank, the acquiring bank, the card network, the payment processor, and, increasingly, fintech companies and businesses that incorporate payment systems.

Breakdown of Fees

To illustrate, consider a scenario where a user swipes a card issued by a Neobank. In this case, $1.70 of the interchange fee goes to the issuing bank and the card network, while $0.50 of the acquiring fee goes to the acquiring bank. However, interchange fees are not static and can vary based on several factors.

Factors Influencing Interchange Rates

1. Credit vs. Debit Cards:

- Interchange rates for credit cards are generally higher than for debit cards.

2. Rewards Programs:

- Higher interchange rates often fund rewards programs, which are very popular among consumers.

3. Online vs. Offline Transactions:

- Online purchases typically incur higher interchange fees due to increased security risks compared to in-person transactions.

4. Consumer vs. Commercial Cards:

- Cards associated with business or corporate accounts have higher interchange rates compared to consumer cards.

5. Merchant Category Code (MCC):

- Merchants are classified by major card networks using MCCs, resulting in varying interchange rates depending on whether the purchase is made at a supermarket, retail store, gas station, or another type of merchant.

6. The Card Network:

- Different card networks have varying fee structures. Visa and Mastercard usually charge lower rates, while networks like American Express (AMEX) are known for higher rates.

7. Network Partner Programs:

- Programs like the Visa Partner Program (VPP) and Mastercard Partner Program (MPP) offer specific retailers lower interchange rates than the standard rates published by these networks.

8. Size of the Issuing Bank (U.S. Context):

- Larger banks in the U.S. are regulated by the Durbin Amendment, which caps interchange rates on consumer debit transactions. Smaller banks are exempt from this cap, allowing them to earn more revenue from interchange rates, which benefits fintech companies and embedded finance businesses partnering with them.

#### Interchange Fees in the European Union (EU) Context

The interchange fee landscape in the EU has its unique characteristics due to specific regulations and market dynamics:

1. EU Regulations:

- The EU has implemented strict regulations on interchange fees through the Interchange Fee Regulation (IFR). This regulation caps interchange fees at 0.3% for credit card transactions and 0.2% for debit card transactions to promote transparency and reduce costs for merchants.

2. Cross-Border Transactions:

- Interchange fees for cross-border transactions within the EU are also subject to the same caps as domestic transactions, fostering a more integrated and competitive market.

3. Regulatory Impact:

- The regulation of interchange fees in the EU has led to increased competition among card issuers and payment processors, resulting in more innovative payment solutions and better pricing for merchants and consumers.

4. Market Variations:

- Despite the regulatory caps, interchange fees can still vary slightly between EU member states due to different levels of market maturity, consumer behavior, and local regulations.

5. Fintech Influence:

- The rise of fintech companies in the EU has introduced new dynamics in the interchange fee structure, as these companies often partner with smaller banks that are not subject to the same regulations as larger institutions.

Understanding these factors helps clarify why interchange fees vary and highlights the complexities of the payment processing ecosystem both in the U.S. and the EU.