nterchange, once a minor fee levied to cover the costs of processing a credit card transaction and the risk assumed by the issuing bank that the credit will not be repaid, has skyrocketed to a flashpoint that industry experts say is certain to change the industry, although opinions are divided on exactly what the fallout may be.

Interchange fees on all U.S. purchases average about 1.56%, according to a Federal Reserve study issued in May 2005. Although less than 2% seems insignificant, due to the sheer volume of credit card transactions and the compressed margins card issuers and merchants face, interchange fees have become a major revenue stream for issuers but a major expense for merchants. ISOs and merchant level salespeople (MLSs), largely spectators pinned in the eye of a storm of controversy, still stand to be affected by its aftermath.

According to investment firm Morgan Stanley, MasterCard International and Visa U.S.A. collected $17.4 billion in interchange fees in the United States last year, and it projects interchange costs will reach $32.4 billion by 2010. "One indicator of how important interchange has become to issuers was that in the wake of the Wal-Mart settlement, Bank of America estimated that lower signature debit interchange fees would cost it $200 million in 2004, or about $0.12 a share, approximately 2% of its net income," said Aaron McPherson, Research Director of Payments at research and advisory firm Financial Insights. (McPherson is also the author of a new research report on interchange titled "Waging the Interchange Wars.")

"That doesn't include Bank of America's share [as a member bank] of the $3 billion payment that Visa and MasterCard agreed to pay merchants," he said.

Interchange is also a significant, and growing, expense for merchants. According to the National Association of Convenience Stores (NACS), credit and debit card fees are the third largest expense convenience stores face after store rent and labor costs.

These fees are anticipated to match the cost of store rent by 2020.

NACS points out that in 2004, credit card issuers earned more profits in interchange fees from the sale of gasoline than gasoline retailers earned off those same sales. "Out-of-control interchange fees for credit card transactions are a $25 billion tax on retail transactions that goes straight into the pockets of the card issuers," said Mitch Goldstone, lead plaintiff in a merchant class action antitrust lawsuit filed in June against Visa and MasterCard.

Goldstone is also Co-editor of "The Credit Card Interchange Report" ( www.waytoohigh.com.) "We're not opposed to a cost-based interchange," he said. "The problem is the banks got greedy and raised the rates just to make more money."

Jeff Lenard, NACS Director of Communications agrees. "We are not suggesting that interchange should be eliminated," he said. "What we want is interchange that reflects the cost. However that is achieved, we don't really care, as long as it is a long-term solution to a long-standing problem. The biggest issue around interchange is that the rates retailers are paying do not seem to be justified."

This sentiment, shared by a host of retailers and trade organizations, has led to a barrage of lawsuits against Visa and MasterCard and their member banks, as well as pressure from consumer groups for legislative or regulatory action. (The most recent were class action suits filed on Nov. 14, 2005 by the American Booksellers Association and the National Grocers Association.)

"It is clear that interchange is a controversial issue, not just in the U.S., but internationally," said Stuart E. Weiner, Vice President and Director of Payments System Research with the Federal Reserve Bank of Kansas City. "It stirs up such strong feeling that it seems clear that the status quo will not hold up for long."

McPherson said the recent increase in interchange fees is not sustainable, and they may well decrease. The drop will occur either as a result of a settlement or because of regulatory or legislative action. "Issuers need to prepare for this possibility by identifying other sources of income now, while there is time to prepare for a gradual transition," he said.

Most of the lawsuits are still pending, but they have already had some effect. Many point to MasterCard's recently announced initial public offering as an attempt to insulate itself from liability (analysts say Visa could soon follow suit) and to Visa's recent changes to its board of directors as an attempt to forestall regulatory efforts to overhaul the system.

Interchange Around the World

Although most of the interchange litigation appears to be primarily based in the United States, globally interchange fees are in the middle of a massive overhaul.

More than 10 countries have capped or banned interchange fees, either through regulation or the threat of it (such as in Australia, Mexico and EU cross border) or in collective agreements (e.g., in Spain, where banks, networks, merchants and the Ministry of the Economy reached an agreement in 1999; or in Mexico, where members of the Mexican Bankers Association set limits).

"Certainly, the fact that interchange fees are typically higher in the U.S., and have been trending up, is one of the reasons it has gotten so much attention," Weiner said. "Five years ago this was a pretty esoteric, behind-the-scenes issue.

"Some argue that in the U.S. the volume of credit and debit card transactions, as well as efficiencies and economies of scale, should have decreased the interchange rates. Also, competition appears to have increased fees, which is unusual to say the least, and has also attracted attention."

Merchants point out that interchange fees have declined or are declining in most other countries but are steadily rising in the United States. "If interchange was actually cost based, it would effectively disappear," Goldstone said. "In Australia it is less than half a percent. And Canada is a great example: Business is thriving even though the interchange rate is zero."

"Nilson reports that both fraud and the cost of processing are steadily decreasing in the United States while U.S. interchange rates continue to increase," Lenard said.

"Other countries have taken action to address the market problem created by these monopolies. Australia and countries in Europe, for example, now require interchange rates to be cost-based.

"Since this change, interchange rates have plummeted. For example, rates in Australia fell from an average of about 0.95% to about 0.55%.

In some cases, the decrease in interchange rates has been a result of recent regulation or the threat of regulation. The bottom line is that it makes no sense that the U.S. has the strongest financial system in the world but still pays much higher interchange rates than other countries."

According to Gwenn Bézard, Research Director of the Aite Group LLC and author of a research report titled "Five Misconceptions about Interchange in America," a typical misconception put forth by issuers is that interchange is necessary to develop a healthy card industry.

"We believe this view is ill-founded," Bézard said. "On the credit card side, issuers make most of their revenues and profits by lending money. The interchange accounts for only 15% of Visa and MasterCard issuers' revenues. Seventy percent of their revenues are driven by finance charges, and a remaining 15% by late fees.

"Also, with credit card-based loyalty programs, issuers are passing their interchange revenues on to consumers anyway. Banks and their card Associations cannot seriously argue that the interchange is vital to the system. The credit card industry would survive in the unlikely event interchange is prohibited."

Will an interchange system that appears to work in one country work in another?

"It is striking how diverse interchange is," said Weiner, who recently co-authored a working paper with Julian Wright on interchange across 10 countries.

"It is fascinating and extremely complex. There are so many factors involved that it's difficult to take a model that appears to work in one country and apply it to another, even another that shares many other economic similarities."

"Arguing that the U.S. has very high interchange rates compared to other countries is a misrepresentation of reality," Bézard said.

"In a number of countries, consumers foot the bill directly for using debit cards. In the U.S., consumers eventually support the cost of debit card acceptance to the extent that merchants include that expense into the price of goods and services.

"The cost of card acceptance is somewhat hidden to [U.S.] consumers. But in some other countries, consumers pay directly for using a debit card. In France, consumers pay annual fees, and in countries such as Canada and Norway, they pay transaction fees each time they make a purchase with the card.

Increasing in Complexity

This complexity is one factor that is fueling the debate. "I know exactly what my cost of goods sold are, what every cost involved with my business is, but I don't have a clue what my interchange fee is," Goldstone said.

"For the most part the system is overly complex," said Jared Isaacman, Chief Executive Officer of United Bank Card Inc., a payment processor and merchant acquirer.

"Every change now requires an extensive amount of programming and development for the various back-end networks around the country. The amount of interchange categories has literally doubled and then doubled again in the last five years alone.

"The complexity of the system continues to grow with all the additional debit and now rewards card categories. The rest of the world has a far more simplified interchange system, making the entire process of accepting credit cards less confusing for the merchant.

"In the U.S., merchants sometimes have to attempt to decipher a 10-page merchant statement riddled with various rates, billing elements and downgrade types."

"The fee schedules have become very, very complicated in the U.S," Weiner agreed. "The actual fee for a single transaction can vary by quite a lot."

Depending on card type, merchant category code and card attributes, the interchange rate can vary by more than 1%. In regulated countries, these fees, whether they are actually lower or just distributed differently, are transparent.

The Impact of Regulation

Although the threat of regulation is frequently discussed in the United States, most of the parties involved view it as a solution of last resort. Regulation could substantially change the industry according to some analysts.

Even the government agencies that could conceivably regulate payments acquiring (such as the Federal Reserve, Federal Trade Commission or the Department of Justice) view regulating interchange as a hot potato.

"The Fed has stated that we do not have the authority to regulate credit or debit cards, so if regulation comes, it's not coming from the Fed," Weiner said.

"There would have to be obvious market failure for the Fed to even advocate regulation. That doesn't mean we're not watching closely. These are markets that need to be studied and better understood."

"There is no legitimate basis to call for regulation of interchange fees," said MasterCard General Counsel Noah J. Hanft in a keynote address at a Federal Reserve conference on global interchange held in May.

He added that regulation, or successful litigation, would "disrupt a system that has been providing benefits to both consumers and merchants for the last 40 years ... No one understands this better than the merchants themselves.

"They certainly do not want the government setting the prices for goods and services they sell. So why do they argue for government intervention here?"

"Regulating the interchange could have adverse consequences," Bézard said. "Regulating the interchange may simply force a reorganization of the industry."

Some of the possible adverse scenarios she cites are:

1. Large issuers breaking apart from the major card Associations and negotiating deals directly with merchants (leading to increased discount rates);
2. Banks charging consumers more for checking accounts and credit and debit card usage;
3. Accelerating consolidation of the acquiring industry (leading to higher acquiring charges for merchants).

Referring to the pending lawsuits against the card Associations and their member banks, McPherson said, "A settlement that permanently reduces discount fees for merchants is the most likely outcome of the litigation, since none of the parties will want to risk a court-imposed remedy or new regulation."

The Effect on ISOs and MLSs

McPherson also said reductions in interchange could make ISO's lives harder. "They would be under pressure to cut their portion of the discount fee in line with the reduction in interchange," he said. "Consolidation would be the most likely outcome."

"I can't foresee any changes, regardless of what may happen with regulation to the interchange system, on how a merchant is sold," Isaacman said.

"The processors will probably have to spend less time accommodating complicated interchange increases and system changes, which will ultimately improve the efficiency of their operations."

Card processors should look for ways to increase value for merchants, McPherson advised. "One option is to provide more information about cardholder spending patterns and work with merchants to create more customized rewards," he said.

"The card network has the potential to be a powerful marketing and customer relationship management tool for merchants, giving them a greater stake in the success of the system."