In an antitrust decision from the mid-1980s, Nabanco v. Visa, interchange fees were upheld. But that decision was heavily fact-based, and many of the factual and economic conditions underlying it have changed.
Nabanco, an independent merchant processor, had sued Visa, arguing that interchange fees were illegal price fixing. The court rejected the claim for several reasons, each of which is severely weakened today. At the time, credit cards were still in their infancy and accounted for only a relatively small number of transactions. Consumers were just getting used to using credit cards, but cash and checks were the preferred method of payment. ATM networks appeared to be a potential strong rival.
The court held that interchange fees could not harm competition because the market included payment systems, including credit cards, ATMs, checks, and cash. If Visa increased the interchange fee to an anticompetitive level, merchants or merchants' banks could turn to a variety of payment alternatives. Moreover, the court said entry barriers to the credit card market were not substantial.
The court also decided that the interchange fee was not truly "mandatory," because individual banks could enter into alternative arrangements. That is, they could bypass the Visa interchange fee system, and some portion of their transactions, perhaps as many as one-third, did bypass Visa through bilateral agreements.
The court's assessment of the market and the degree of market power bears little relevance to the current market. Credit cards are a predominant form of payment, and consumers and merchants cannot easily turn to alternatives. The prevailing use of credit cards in Internet commerce merely reinforces this reality. From an antitrust perspective, the question is whether merchants, in response to an increase in interchange fees, could effectively defeat or deter the increase by trying to drive consumers to checks or cash or other networks, such as ATMs. There is little evidence that these alternatives limit the ability of the card associations to increase prices. In fact, even if merchants were inclined to steer customers to lower-cost payment systems, their efforts would be curtailed by other association rules that prevent merchants from steering consumers to other payment methods or networks.
Visa's and MasterCard's ability to substantially raise interchange fees for both offline debit and credit cards in the past two years confirms that they possess market power. Under the antitrust laws, market power is often defined as the ability to increase prices by more than 5%. The same is true for credit card interchange, where Visa and MasterCard have imposed similar price increases.
In the Nabanco decision, the court relied on the argument that the fee was not "mandatory" - banks or merchants that were dissatisfied with the level of Visa's interchange fee could bypass Visa and enter into separate arrangements with other banks. Bypass is an important element in all joint venture arrangements, and when it is used on a regular basis, it can be an important safeguard against the exercise of market power.
Though that argument sounded good in theory, these alternatives have proven to be nonexistent. The rules of the card associations make bypass far less than a practical alternative. For example, the associations can charge a separate fee for bypassed transactions that may equal or approximate the interchange fee, thus reducing the incentive to engage in bypass. In addition, if a card-issuing bank realizes it is securing a very lucrative interchange fee, it will have little incentive to bargain against itself and enter into a bypass arrangement. The antitrust agencies and the courts apply a much more realistic standard on the issue of bypass. They permit collective price setting only when firms successfully engage in bypass, and bypass exercises a competitive restraint on the market. Under that standard, interchange fees would fail to pass antitrust scrutiny.
The court characterized interchange fees as a fundamentally benign "transfer payment" that gave equilibrium to the costs and benefits between the merchant and card-issuing sides of the business. Most banks, including practically all of the Visa board members, participated in both the card-issuing and merchant-signing aspects of the business. For these banks, interchange was simply a transfer payment, not a profit center. Thus, it seemed unlikely that banks would use the interchange fee strategically, for example by inflating costs or attempting to extract supracompetitive profits, since as direct payers of interchange fees they would be harming themselves to some extent. Thus, the court concluded "Visa has every incentive to set [interchange] at a level which establishes an equilibrium between the issuer and merchant sides of the business" and this degree of equilibrium diminished concerns over anticompetitive conduct.
Today many factors suggest that interchange has changed from a benign or neutral transfer payment or an "equilibriating mechanism" to a potential substantial profit center for banks seeking wealth transfers from merchants and consumers. Most banks have withdrawn from merchant processing, the vast majority of which is now performed by independent merchant processors. As a result, there generally is now far less balance or representation of the interests of merchants on the Visa board in the setting of the interchange fee. The potential for opportunistic conduct is far more significant.
Since most banks now participate primarily in card issuing, they have far more incentive to increase the fee as much as possible and extract the highest revenue from merchants and consumers. Competition is distorted in favor of the network with an artificially high interchange fee. Moreover, without clearer involvement of merchants in the setting of the fee, there is a greater ability to manipulate costs to increase the fee.
Why should any of this matter to consumers? The reason is that credit card interchange fees account for well over 90% of the merchant discount - the fee netted out and withheld from merchants when banks credit the merchants' accounts for the amount of credit card charges. The non-interchange-fee portion of the merchant discount has fallen dramatically. That is because the merchant processing market is competitive, and merchants can choose between numerous firms willing to provide service with ever-thinner margins. But the situation now is such that most merchant transaction acquiring costs are unavoidable interchange fees, and the average merchant discount has thus increased, even though merchant processing has become far more efficient.
Consumers pay for this lack of competition, because the merchant discount is passed on in the form of higher retail prices. Though passing on these costs to consumers who use credit cards may appear fair, it effectively means that non-credit customers (those who use checks and cash) are subsidizing the costs of credit, as nearly all merchants find it too cumbersome (or forbidding under card association rules) to charge different prices to cash and credit customers.
Interchange fees may also slow the expansion of a network into new merchant areas. For years, grocery stores did not accept credit cards because of the high interchange fees. Only when Discover began developing this segment through lower interchange fees did Visa create an incentive interchange fee for supermarkets. Moreover, for new payment mechanisms such as on-line debit, the collection of interchange fees may actually slow the growth of the network. Some merchants are likely to be unwilling to undertake the costs of the network (e.g., terminal deployment) knowing that they will then have to pay an interchange fee when consumers present debit cards. That may be one reason why on-line debit is far more prominent in Canada (where there are no interchange fees) than in the United States.
Interchange fees have increased because there is little pressure to decrease them. In fact, the card associations have a perverse incentive to compete for card-issuing members by raising the interchange fees they permit those members to collect from merchants. Interchange fees are no longer a neutral transfer payment -- they form a substantial profit center.
In antitrust law there is a well-known maxim: "It depends upon the facts." When the facts and economics change significantly, it is time to re-evaluate precedents. The decision in Nabanco established a quasi-regulatory form of price-fixing that may have been appropriate for infant credit card networks a generation ago. Is it appropriate today? Mr. Balto is director of policy in the Federal Trade Commissions's Bureau of Competition. This article, the second of two parts, presents his views, not the commission's.