Interchange Fee and the Universal Acceptance of Cards
Payment is fundamentally a two-sided market1. Cardholders want more merchants accepting their cards. Merchants want more cardholders. Increasing the number of merchants in the network comes with costs on the acquirer2 but also benefits the cardholders, and vice versa. In economic terms, it is called externalities.
We, therefore, cannot analyze the payments industry by looking at only one side. The total cost of payment equals the sum of the issuer’s cost3, the acquirer’s cost, and other frictions. Unfortunately, the cost structure is quite imbalanced for credit payment. The marginal cost of processing an additional transaction to issuers typically includes the cost of funds, cost of risk4, payment fraud, and customer incentives5. The marginal cost to acquirers is essentially zero once the infrastructure, such as a POS machine, is set up, ignoring transaction fees paid to the card scheme and issuers6. Increasing the number of cardholders benefits acquirers more because the acquirer keeps the MDR7 from more transactions without doing anything extra.
Negotiations between issuers and acquirers on cost sharing are infeasible if universal acceptance is the goal. The number of bilateral agreements needed in the network, assuming only pure issuers and acquirers exist and their numbers are the same, is n². Card schemes, such as VISA and Mastercard, internalize externalities and reduce the transaction costs of negotiating bilateral agreements, thereby making universal card acceptance possible. In the court case between National Bancard Corporation (NaBANCO) and VISA in the 1980s8, the court concluded that “The IRF9 is a mechanism by which VISA ensures the universality of its card, not a price fixing device to squeeze out entrepreneurs,” and “redistribution of revenues or costs is a must for the continued existence of the product.”
The court case also addressed the market in which VISA operates. NaBANCO believed there were three distinct markets: card issuing, merchant servicing, and interchange for receivables. VISA believed there was only a single market that included substitutes, such as cash, cheque, ATM cards, Amex, and Diners Club. The market definition dispute matters because interchange costs cannot be viewed solely as merchant costs. If customers can switch among substitutes, charging interchange fees shifts usage across payment instruments rather than simply lowering merchant cost.
In some markets, regulators cap interchange fees, including Spain, Australia, the United States, and the European Union. The International Center for Law & Economics has written a paper on The Effects of Price Controls on Payment Card Interchange Fees: A Review and Update. The empirical evidence is mixed and institutionally contested. Critics of interchange caps argue that caps reduce issuer revenue, weaken rewards, and lead to incomplete merchant pass-through. Regulators such as the European Commission, however, argue that caps lowered merchant service charges and produced consumer benefits through lower prices or improved retail services.
In Southeast Asia, QR payment has become an important digital payment method. Unlike China, Central Banks in the Region act as intermediaries, providing national QR infrastructure and effectively setting the interchange fee to zero and capping the MDR to a very low level. The inclusion of credit issuers inevitably reduces. However, the Central Banks seem to optimize for payment-rail inclusion more than credit-rail inclusion and are determined to transition from a cash economy to a digital economy.
The framework, therefore, predicts which side has a structural advantage in each market. Where MDR and interchange are high, credit issuers can participate profitably in off-us transactions10. Where MDR is compressed, and interchange is zero or near zero, acquirers and payment-rail operators may still benefit from transaction volume, but credit issuers face weaker unit economics unless a separate credit monetization layer exists, such as higher consumer interest, merchant-funded BNPL fees, on-us ecosystems, or issuing credit cards.
Two-sided market does not mean it involves two parties: a buyer and a seller. It means the total volume depends on the number of participants on the other side.
Enabling merchants to accept cards.
Availing buyer the means to send payments. Be it debit, credit, cheque, or cash.
Payment methods involve credit facilities, such as credit cards.
Individuals tend to be more price-sensitive than merchants.
VISA or Mastercard charged acquirers a card scheme fee for using the network and an interchange fee to balance the costs.
Merchant Discount Rate: the fee charged to merchants for processing the payment.
National Bancard Corp. (NaBanco) v. Visa USA, Inc., 779 F. 2d 592 - Court of Appeals, 11th Circuit 1986.
Issuer reimbursement fee: another name for interchange fee.
The merchants are not acquired by the issuers.