It may not have the historic implications of the break up of Ma Bell, but the credit card industry soon could be remade. The once-obscure topic of interchange, the fee ultimately paid by merchants to card issuers, has generated some 40 merchant lawsuits against MasterCard International, Visa and several of their largest issuers.
The disputes pit two powerful, deep-pocketed interest groups against one other, after more than 30 years of working together to build an efficient, ubiquitous and profitable payments industry. If the merchants succeed in their lawsuits, it could mean a dramatic change in the second-largest revenue line item for issuers. A loss by merchants probably would lead to an expansion of their attempts to steer consumers to alternative payment options.
The lawsuits are not all identical, and many merchants are staying out of the fight. But the core argument in the litigation is that Visa and MasterCard violate antitrust laws with their interchange policies, merchants have no say in interchange pricing, and retailers deserve damage payments for operating under the association's allegedly unfair system.
"Visa and its members set the fees, as do MasterCard and its members. We argue there is collusion," says K. Craig Wildfang, an attorney with Robins, Kaplan, Miller & Ciresi LLP, a Minneapolis-based law firm representing the National Association of Convenience Stores, several other national retail trade groups, and a consortium of merchants.
Merchants say that the alleged collusion should be clear to anyone reviewing the interchange fees. Both associations charge the fee for several dozen categories broken down by various merchant segments and processing methods. Visa's and MasterCard's fees and categories are similar, but not identical.
To merchants, that indicates there is little or no competition between Visa and MasterCard on interchange fees. "It's not a defense to price fixing to say prices are not identical," says Wildfang. "If interchange were competitive, (prices) would drop by 50%."
MasterCard contends the associations must balance a four-party, two-sided market to best serve everyone. The four participants are card issuers, cardholders, merchants and merchant acquirers, according to a MasterCard attorney. The issuer and cardholder represent one side, and the merchant and acquirer the other. Issuers charge the merchant acquirer interchange as a percentage of each transaction conducted with a card. The acquirer typically passes this fee on to the merchant.
"The four-party system needs pre-arranged interchange," says the MasterCard attorney. "The interchange system provides a default so the transaction can proceed. [It ensures] the card is honored by the merchant, the acquirer and the issuer."
Visa will lower interchange or change its policies for merchants in certain categories to expand card acceptance, says Adam Eaton, Visa vice president and director of litigation. For example, fast-food merchants do not need to get a signature when the bill is less than $25, he says.
"We worked with merchants to increase card use in small tickets," says Eaton. "Card use is proven to increase ticket lift, and it's popular with customers. That benefits the consumer, the merchant and the bank (issuer)," he says.
(MasterCard and Visa representatives were skittish discussing the interchange lawsuits. MasterCard insisted questions be provided in writing and made an attorney available on the condition the attorney not be named. Visa begged off answering most legal questions, saying it was not appropriate at this time to discuss its strategy.)
Major issuers named in the suits have been laying low. Capital One Financial Corp. and MBNA Corp. did not return C&P calls, while Providian Financial Corp. and J.P. Morgan Chase & Co. declined to comment.
In a statement, Citigroup Inc. denied it "engaged in any unlawful conduct as alleged in the complaint and will vigorously defend the lawsuit."
Too Much Information?
In October, 14 of the merchant suits were combined in a case to be heard by Judge John H. Gleeson of the Eastern District of New York in Brooklyn. At press time, Wildfang was among several attorneys vying to lead the merchant group in the litigation. In December, MasterCard notified Gleeson that it planned to ask to disqualify Wildfang because he had worked at the U.S. Department of Justice in an antitrust suit the regulator filed against the associations.
MasterCard contended Wildfang had the authority to review as many as 180,000 confidential MasterCard documents, many with proprietary information on interchange policies. Wildfang responded that he had not reviewed the documents, the Justice Department case was nearly a decade old, and the documents no longer were confidential.
Gleeson has experience with the card industry, having presided over the so-called "Wal-Mart case" that challenged the associations' "honor-all-cards" policies. In the spring of 2003, Visa and MasterCard settled that class-action suit by paying merchants a combined $3.05 billion and dropping the policy.
Clearly, the latest interchange cases have the associations feeling some heat. MasterCard announced plans this fall for an initial public offering of stock and acknowledged one reason was to raise money for its legal challenges and another was to try to immunize it from litigation. Shortly thereafter, Visa said it would remake its board of directors in 2006 and name eight independent directors that would oversee interchange.
The foundation of today's interchange system goes back to a case decided nearly 20 years ago.
In 1979, an independent merchant processor called National Bancard Corp. (Nabanco) sued Visa, claiming that interchange represented illegal price fixing. In 1986, Nabanco lost, with the court ruling that interchange does not harm competition, as merchants had alternatives to credit cards if interchange fees kept rising, including cash and checks.
The court noted that interchange was a transfer payment, giving both the issuer and the merchant a fair balance between the costs and benefits of the payments industry.
The court also cited aspects of the then-nascent industry that justified giving the authority to set fees to a central organization such as Visa.
Today, MasterCard stands by Nabanco. "The court ruled that interchange is essential, and it remains essential today," says the MasterCard attorney. "We don't see this changing."
Wildfang disagrees. "The market is different today. At the time of Nabanco, Visa had a 2% to 3% share of the entire payments market," he says. Earlier this year, the Federal Reserve reported that payment cards were used for about 50% of all transactions. Card issuers also have consolidated, with the 10 largest issuers holding 90% of credit card receivables ("Issuers Go on a Buying Spree," September).
Market Changes
Visa also argued in Nabanco that interchange fees were created from a formula that combined such costs to the association and its members as card float, fraud, marketing, payment guarantees and processing costs.
Wildfang notes that many of those costs have declined because of the electronification of the telecommunications infrastructure and drops in fraud, while today's payments volume generates considerably more income. "Nabanco is no longer applicable," he says.
Merchants pay other fees for a card transaction, including processing fees and a fee to MasterCard or Visa. However, interchange accounts for about 75% of merchant card costs in the U.S., according to a May study from the Federal Reserve Bank of Kansas City.
In 2004, merchants paid on average $2.15 to its acquiring bank to accept a $100 credit card transaction, according to a Morgan Stanley report last March. The card issuer receives $1.75 in interchange, and the acquirer receives 40 cents for processing the transaction, Morgan found.
Interchange was the second-largest revenue generator for credit card issuers in 2004, according to the Cards&Payments annual Bank Card Profitability Study in May. C&P found that interchange generated $16.6 billion in revenue, trailing interest payments at $72.2 billion.
Morgan Stanley predicted that interchange revenues could rise to $32 billion by 2010 if current rates and transaction-volume trends continue.
Morgan analyst Kenneth Posner crunched the numbers to prove what many had long assumed-an increase in interchange fees leads to an increase in large issuers' market value and a decline in the value for large merchants.
A 25-basis-point rise in interchange would equate to a $2.3 billion decline in the market capitalization of Wal-Mart Stores Inc., while adding $2.4 billion to the market capitalization of Chase (see chart, page 33).
Another major gripe for merchants is the rise of rewards cards. Visa and MasterCard have added richer rewards for cards targeting the valued high-earning household demographic. The tradeoff is that merchants pay a pricier interchange fee to accept the cards.
The Visa Rewards 2 credit interchange category in April carried a cost of 1.9% of a transaction plus 10 cents compared with the CPS Retail card rate of 1.54% plus 10 cents. The MasterCard World Merit III-Base interchange rate in April was 1.73% of the sale plus 10 cents compared with 1.63% plus 10 cents for the standard Merit III-base rate.
Merchants say these fees are added into the cost of all their products and are paid for by all their consumers, whether they use plastic, cash or checks.
"Merchants pay, and those who don't use cards are all paying for these reward programs," says Mitch Goldstone, owner of 30 Minute Photos Etc. in Irvine, Calif., and lead plaintiff in the merchant suits to be heard by Gleeson.
Merchants also insist that card acceptance is a necessity to do business today. In September, the Association of Financial Professionals surveyed its members on interchange, and half reported that their companies would suffer a significant drop in sales if they stopped accepting Visa and MasterCard credit cards.
And the courts generally have agreed with retailers.
In October 2001, U.S. District Judge Barbara S. Jones ruled the associations have "market power" for general-purpose card network service "because they have the power to raise prices and lower output and/or innovation, either jointly or separately."
Indeed, Jones wrote, merchants cannot refuse to accept Visa and MasterCard, "even in the face of significant price increases," because "customers would choose not to shop at merchants who do not accept them."
In another card-related case, the U.S. Court of Appeals in 2003 ruled that the authority of MasterCard and Visa, jointly and separately, met a U.S. Supreme Court definition of market power because it had the "power to control prices or exclude competition."
Independent studies suggest the dominance of MasterCard and Visa. The Kansas City Fed reported in November that the associations' credit cards in 2004 accounted for more than 75% of the transactions and more than 70% of the purchase value of all credit card transactions. American Express Co., Discover and Diners Club cards accounted for the rest.
Visa points to just that kind of statistic in arguing that merchants are free to accept cards from AmEx and Discover and drop its cards. AmEx charged merchants, on average, a 2.56% discount rate to authorize and process its transactions in 2004, while Discover charged about 1.5%, according to industry analysts.
"The American Express and Discover discount rates are at opposite ends of the spectrum. That demonstrates a free market," says Visa's Eaton.
Some of the merchants facing off against the associations are large and influential.
The National Association of Convenience Stores claims its members sold $262.6 billion in gas last year, or about 75% of all the gas in the U.S. Interchange is the third-largest cost for convenience-store owners after rent and personnel, according to the association.
The association asked its members recently to help it build a $7.2 million bank to fight interchange in court, educate the public about the fees, and lobby legislators. Bill Douglas, the association's chairman, told a congressional committee this spring that the percent of each sale going to interchange had risen in tandem with the rise in the price of gas. His testimony was an impetus for legislation calling for a Federal Trade Commission study of interchange fees and the price of gas at the pump ("Judicial Panel Combines Interchange Suits," November 2005). The U.S. Senate has not passed a similar measure.
Merchants asked the Federal Reserve to address interchange, but the central bank shrugged off the idea, indicating it believes the marketplace should determine rates. The U.S. Department of Justice reportedly gave merchants the brush-off when it was asked to join in various antitrust suits.
Payment Alternatives
Regulators around the world have not been so hesitant. In 2003, The Reserve Bank of Australia, the country's central bank, ruled that credit card interchange fees were too high and cut them from 0.95% of a typical sale to 0.55%.
This fall, the United Kingdom's Office of Fair Trading issued a preliminary ruling that interchange fees are anticompetitive. The office said current interchange-fee policies lead to an "unduly high fee being paid to card issuing banks by merchant acquirers on every Visa transaction." The costs are then passed on to retailers and ultimately to consumers, according to the regulator.
The U.S. case is just beginning, as Judge Gleeson had not yet scheduled the discovery phase as of the December holiday season.
Meanwhile, merchants continue to seek payment alternatives. Wal-Mart announced in November it would begin accepting cards from Debitman Card Inc., the PIN-based point-of-sale network that uses the automated clearinghouse system to process cards. Merchants pay 15 cents per transaction, a share of which goes to the merchant that issues the card. Banks play no role Debitman transactions.
And biometrics is gaining traction when cheaper fees are used. San Francisco-based Pay By Touch has announced this year a string of grocery chains that are linking its fingerprint technology to the ACH payments system. ACH fees can be as low as 10 cents per transaction.
On paper, it appears the trend favors the merchants. But MasterCard and Visa barely have begun to spar. Paper don't count. Only a fight will determine the winner of this match.
INTERCHANGE - A BRIEF HISTORY
1986
Court rules against merchant processor National Bancard Corp. (Nabanco) in its suit against Visa charging that interchange was illegal price fixing. Court rules interchange does not harm competition because payment system offers credit cards, ATMs, cash and checks.
1990
U.S. credit card volume totals $337 billion.
2003
Reserve Bank of Australia rules that credit card interchange fees must be lowered and Visa and MasterCard must publish their fees.
2004
U.S. credit card volume totals $1.45 trillion on 635 million credit cards.
2005
Merchants file more than 40 lawsuits against Visa and MasterCard over interchange pricing, other policies.
September - MasterCard files for an initial public offering of stock.
September/October - United Kingdom regulator rules that MasterCard and Visa interchange policies are anticompetitive.
October - Fourteen merchant cases against Visa, MasterCard and their largest member banks are combined in the court of Judge John H. Gleeson in the Eastern District of New York.
November - Visa announces it will remake its board and name eight independent directors to oversee interchange policy.
Source: Cards&Payments, Card Industry Directory.
INTERCHANGE'S BOTTOM LINE IMPACT
How rate increases affect underlying value of merchants, banks.
Impact on Market Capitalization (in billions).
10 basis 15 basis 25 basis
Merchants point rise point rise point rise
Wal-Mart -$0.9 -$1.4 -$2.3
Home Depot - 0.2 - 0.3 - 0.5
Kroger - 0.1 - 0.2 - 0.3
Target - 0.2 - 0.2 - 0.4
Costco - 0.2 - 0.2 - 0.4
Issuers
Citigroup $0.7 $1.0 $1.7
Bank of America 0.4 0.6 0.9
Chase 1.0 1.4 2.4
MBNA 0.4 0.6 1.0
Capital One 0.3 0.4 0.7
Notes: Results do not include Bank of America's purchase of MBNA Corp.
Source: Morgan Stanley
(c) 2006 Cards&Payments and SourceMedia, Inc. All Rights Reserved.
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Merchants Tackle Credit Card Fee Policies
January 01, 2006, 12:23 p.m. EST 13 Min Read
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