At the heart of card industry economics are interchange fees.
Originally established to compensate credit card issuers for the cost of customer acquisition, float, loss risks, and associated costs of issuance, the per-transaction fees are paid to card-issuing banks by the merchant banks.
The fees were set on a fully allocated basis for decades, until competition from the Discover Card forced MasterCard and Visa to provide "incentive fees."
The pricing structure of the off-line debit cards, MasterMoney and Visa check, mimics that of the bank credit card programs. Generally the off-line interchange fee is about 2% of the transaction and the on-line fee is about 10 cents. On a $100 transaction the difference would be between $2.00 and 10 cents.
For on-line transactions the fees are comparable to those in ATM networks.
Considering that POS debit interchange fees add up to more than $300 million a year, the additional costs to merchants and consumers can be substantial.
If on-line debit is more efficient-less costly and quicker, with lower risk of loss-why is off-line overtaking on-line debit? Why do cost and efficiency not rule, as they would in a technology market?
The interchange-fee structure creates perverse incentives to favor the more costly system. Although banks face a greater risk of loss on off-line transactions, they also have the opportunity for substantially higher revenue. When banks have a choice, they will invest in or promote off-line debit because of the higher interchange fees. In fact, some interchange- hungry bankers have suggested threatening withdrawal from on-line POS networks to force an increase in their interchange fees.
The interchange structure has become a particular bone of contention in the debit card arena, which I have been reviewing because the MasterCard- Visa antitrust decree in the Entree litigation of 1990 expired Wednesday. (Part 1 of this article appeared Thursday.)
Assuming that some type of interchange is necessary in the point of sale debit environment, should it be identical to that on credit cards?
Visa and MasterCard might argue that the prices be virtually identical because both debit and credit transactions are sent through the same system.
However, unlike credit transactions, debits have a much smaller risk of loss, and practically no float. The costs that provide most of the basis of the interchange fee are absent. The card-issuing bank needs much less compensation.
Perhaps an interchange fee significantly above costs is needed to provide adequate incentives for banks to issue and promote debit cards. One could argue this is a new product and faces some risk that consumers may not accept it in sufficient numbers.
But let's be clear-debit cards already provide substantial savings and benefits to banks. They typically replace checks and cash. Checks have significant processing costs, and neither checks nor cash provide any revenue stream.
A larger problem is that the pricing structure of POS debit creates what economists call moral hazard. Banks have an incentive to increase the charges as much as possible and choose the more costly form of transaction.
Retailers cannot affect the consumer's choice in this area. Visa rules prohibit merchants from favoring any payment method over a Visa card (no discounts for cash or on-line debit). The retailers' costs are ultimately passed on to consumers who don't know that the different means of payment entail different costs.
In some ways this is similar to employers' lack of control over health insurance costs. Oblivious to the costs of individual services, employees had little incentive to limit utilization.
In health care a solution was sought in co-payments-requiring employees to pay for individual services, thereby controlling utilization. The problem in POS debit is that merchants cannot send pricing signals to consumers.
What solution then in POS?
Some would suggest that the regional ATM networks increase their on-line interchange fees to card issuers. Merchants already have a difficult time justifying the other costs of on-line debit (for example, the purchase of a PIN pad). Such a result would not benefit anyone but the banks.
Others would call for eliminating the interchange fee altogether. Although the credit card interchange fee survived an antitrust challenge in the 1980s, many prominent economists have questioned the rationale behind the decision. They would argue that a system where merchants charge consumers directly for POS would provide the most accurate "pricing signals."
(Eliminating the interchange fee and replacing it with a system of ATM- like surcharges might have some theoretical appeal, but it faces a painful real-world truth-consumers do not like to pay explicitly for using any payment device.)
Still others suggest permitting merchants to refuse to accept off-line debit. This might force the networks to compete on interchange fees much as they have in the on-line POS world. Several merchants led by Wal-Mart and the Limited and accompanied by some trade associations have filed an antitrust suit seeking exactly this. How that litigation is resolved will have a substantial impact on whether efficiency and competition will triumph in the POS debit market.
In retrospect, the Entree enforcement action provided several important lessons for the courts and antitrust enforcers.
One issue confronting them is whether the seeming increase in efficiency as networks grow larger would justify the creation of a monopoly network. (The Federal Reserve Board has accepted this bigger-is-better argument in approving the mergers of several regional ATM networks).
Entree could have argued that a single national POS network would have offered the opportunity for greater customer convenience by putting all of the POS terminals in a single network. Similarly, aggregating all cardholders in a single network may have persuaded merchants to use the new POS network.
But these arguments were unavailing. The states recognized that even though a single network might present some of these efficiencies, they were outweighed by the loss of potential competition between POS networks.
Courts and regulators often grapple with how to stop the exercise of monopoly power. In network settings, the answer is typically behavioral relief, such as a promise that the network will be nonexclusive.
With Entree, the states considered behavioral relief inadequate and compelled the creation of competing, exclusive networks. The case established an important principle: that structural relief-the creation of competing networks-is necessary to prevent the exercise of market power.
The states' assessment seems to be correct. Separate networks lead to greater competition in price, promotion, and product development.
What will be the ultimate impact of the expiration of the Entree consent decree? The answer depends a great deal on how Visa and MasterCard respond.
Technically, the associations could merge their on-line debit programs, but that might pique the interest of the states or of a more aggressive U.S. antitrust division.
More likely, MasterCard and Visa will make smaller moves, perhaps to some form of duality allowing a bank to issue Maestro as well as Interlink cards.
To the extent that network exclusivity has increased competition through network innovation, product development, and pricing, those benefits could be lost.
But if the card associations' purpose was to eliminate the threat of a low-priced alternative, they may have found a more sophisticated and pernicious means to that end. Instead of controlling and slowing the development of POS, they have engaged in a high-cost masquerade to achieve that result.
Antitrust controversy seems part and parcel of the continued development of POS. Perhaps the problem ultimately stems from having debit products in the hands of all-encompassing associations that are out to protect the more lucrative credit card product.
Antitrust enforcement halted their efforts to create a single program under joint control, but one wonders: Can antitrust serve the same role today?
