Interchange: A World of Difference

  Late last year and earlier this year, Mexico's banks implemented reductions in both credit and debit card interchange rates, with an additional reduction in debit card rates set for this June. These reductions were voluntary, though not without pressure from the federal government.
  Although card issuers and merchant acquirers in the U.S. have become conditioned to semi-annual increases in interchange over the past few years, this U.S. phenomenon is quite unique from that of the rest of the world, where interchange levels have been under increasing pressure.
  Mexican interchange has been high by international standards, with rates historically ranging from 200 basis points (2% of the sale) to 350 basis points (3.5% of the sale), depending on the size of the merchant. Arguably, the cost of doing business in Mexico, interest rate risk and the state of development of the Mexican issuing business largely justified high historical interchange rates. But the rapid development of the issuing business in recent years has changed the situation fundamentally.
  In addition, though the issuing business has evolved rapidly in Mexico, card acceptance remains at extremely low levels by international standards given the size of the Mexican market. Mexico has the 11th-largest economy in the world, but it has only approximately 100,000 card-accepting merchants, a level that has not changed much for years.
  Mexican card-acceptance levels are low because of numerous factors. Tax avoidance through the cash economy is entrenched in Mexico, and many merchants avoid acceptance because of the audit trail that it creates. Income distribution also is a factor, as are the investment choices of the handful of dominant acquirers in the market and, of course, the cost of acceptance.
  The Mexican federal government, concerned with the low level of electronic payment acceptance, has taken steps to improve the cost of card acceptance, most notably the adoption of a tax subsidy on the cost of payment terminals that was implemented this year. Interchange reduction in Mexico is part of this same phenomenon.
  Interchange rates fell from between 20 to 80 basis points in the primary credit categories and fell even more in the primary debit categories. In addition, several specialty interchange categories were created in such under-penetrated acceptance categories as quick-service restaurants, government agencies and education. These specialty rates are 25 to 125 basis points below the primary historical credit card rates.
  This sort of category-specific incentive strategy for interchange has been a highly successful tactic in the U.S. and other world markets to help penetrate target merchant categories. Of course, there is no guarantee that the reduced interchange rates will result in lasting reductions in discount rates and other acquirer pricing. Indeed, evidence from interchange reductions in other parts of the world indicates that acquirers often can use interchange reductions to improve their own margins.
  In the initial implementation of the reduced rates, Mexico's largest acquirers have appeared to pass through the overwhelming majority of the benefit to merchants, though acquirers still may benefit from improved margins going forward. It also is unclear what path the smaller acquirers have taken.
  This episode is landscape-changing in Mexico. But it is also interesting because it is one of several such interchange-rate reductions in markets around the world.
  Interchange in different markets primarily reflects local issues and industry conditions. However, it is impossible not to notice the opposite directions in which U.S. interchange and other markets' interchange appear to be going.
  In August 2002, Visa entered into a consent decree with the European Union reducing its intra-regional interchange rates. In October 2003, credit card interchange in Australia fell dramatically because of Reserve Bank intervention.
  In September 2004, Mexican debit rates fell. Two months later, the Office of Fair Trade in the United Kingdom completed its review of MasterCard interchange in the U.K. The OFT criticized the level and structure and launched an investigation of Visa's interchange.
  In January 2005, Argentina (a country that does not have an interchange structure, per se) imposed price controls that capped the discount rate acquirers can charge merchants. In February 2004, Mexican credit interchange fell.
  At the same time in the U.S., credit interchange has been rising steadily with each six-month episode of the card associations' interchange releases. Contrary to the hyperbole at the time of the Wal-Mart merchant class-action suit, however, these increases have resulted from intense competition rather than from the absence of competition-the increases are clearly related to AmEx's price point and AmEx's effort to sign third-party issuers. No matter, growing merchant unrest is well documented.
  So many of the tactics implemented by U.S. issuers and acquirers are based upon an increasing interchange environment. Still, based on what has happened elsewhere in the world, contingency planners may want to consider sensible tactics if this trajectory were to reverse.
  Charles Marc Abbey is a partner at First Annapolis, a Baltimore-based management consulting and merger-and-acquisition advisory firm.