Swipe Fees and Free Markets: How Durbin Can Help Payments

Warnings of turmoil and banking pain followed a ruling last week by Judge Richard Leon (a George W. Bush appointee) that the Federal Reserve had incorrectly implemented the Durbin amendment’s requirements on debit interchange and transaction routing. A correct implementation – taking rates to the 7-to-12 cents per transaction originally proposed from the current 22-to-24 cents – could reduce interchange on most debit card transactions a further 50%.

Comments followed swiftly. Merchants celebrated. Mallory Duncan of the National Retail Federation crowed “the rest of the world is beginning to understand that this is a game Visa, MasterCard and the banks are playing.”

Banks moaned. The National Association of Federal Credit Unions said in a statement: "As it stands, the Court’s ruling will have an irreparable, detrimental impact on credit unions’ ability to ensure their members receive the services they need.” And Richard Hunt, president and CEO of the Consumer Bankers Association, sounded a common theme by decrying government intervention: “Congress ought to save families from this uncertainty by repealing this government mandated price-fixing. We certainly hope retailers return to their free-market principles …”

One hears that frequently: bad government versus good free markets. Like most things, the reality is more complicated — so let’s unpack it in relation to interchange.

I believe that a free market sets prices better than any central body. But a lack of government involvement does not a free market make. Rather, a free market is where, per Wikipedia, “… the distribution and costs of goods and services, along with the structure and hierarchy between capital and consumer goods, are coordinated by supply and demand unhindered by external regulation or control by government or monopolies.” Simply put, a free market is where buyers and sellers mutually determine prices.

Interchange is not set in a free market. The payers of interchange – merchants – have little or no say in the price they pay. They don’t negotiate with Visa, MasterCard, or PIN debit networks, which, prior to the Durbin amendment, set debit interchange. Credit interchange continues to be set by Visa and MasterCard. It’s not quite a monopoly, more a duopoly, but certainly not a free market. So rather than a market price, interchange is a transfer of value from merchants to card issuers, with prices being set by a third party (the networks). What does that sound like? It sounds like a tax.

No one likes taxes except the parties receiving them. So we need to replace interchange taxes with prices set by a market.

Prior to the Fed’s first run at implementing Durbin, three economists (David Evans, Robert Litan and Richard Schmalensee) submitted a paper to the Fed arguing that bad things will result from Durbin’s requirements: “Consumers and small business will face higher retail banking fees and lose valuable services as banks rationally seek to make up as much as they can for the debit interchange revenues they will lose under the Board’s proposal.”

Note the implicit reasoning: banks have to maintain their margins, and if they can’t do it by indirectly charging merchants, they will do it by directly charging their customers or cutting services.

Of course, banks and networks must be compensated for what they provide to merchants, but they should be compensated just for that – as was the case in the early days of the interchange system – not for cardholder benefits such as loyalty programs and lounge access. The increases in interchange to fund cardholder benefits are one reason for merchant dissatisfaction.

If we want market-set prices, charging customers sounds like a good thing: the buyers see the price of product (say a rewards card) and what they get for that price. They then compare that price/benefit with what other sellers offer before making a decision to purchase.

As to customers losing valuable services, it would be more accurate to say services provided by banks. But innovators, unburdened by the internal costs and quarterly return pressures of legacy financial institutions, are stepping up and providing services those institutions cannot or will not. A fine example of markets at work.

Many banking products, such as rewards cards, have been subsidized with money from others, which allow those products to be offered as free when their standalone P&Ls would never support it. So bank customers have grown accustomed to getting many products for free.

Now the pressure is on banks to operate in different ways: develop creative new products and services, change revenue expectations from merchant interchange to customer fees (as used to be the case) and more simply, work harder at showing the value of their products.

Moving customers from free to paid products sounds daunting, but is wholly possible. How many people would have thought, 30 years ago, that a company called HBO would have 28 million subscribers paying a monthly fee for television?

Pricing products to more accurately reflect their value (and cost) will move payments further toward a well-functioning market. It is much easier for consumers to change the payment cards they use than it is for merchants to change the types of payments they accept.

The gnashing of teeth and rending of hair we hear is nothing to fear—it is the sound of creative destruction, a process fundamental to economic vitality and one that, in this case, might lead payments to a something closer to a free market.

David True is the president of NYPAY, managing director at Broadly Curious Advisors and a former MasterCard executive. Opinions expressed here are his own.