View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Payments Pricing: Who Bears the Cost?—A conference summary
by Katy Jacob, policy research specialist, Financial Markets Group, Carrie Jankowski, business economist,
Financial Markets Group, and Anna Lunn, associate economist, Financial Markets Group

As consumers and merchants increasingly adopt electronic payments, the pricing of
these services has generated substantial scrutiny by public authorities around the world.
To discuss these developments and related issues, the Federal Reserve Bank of Chicag o
hosted its ninth annual Payments Conference on May 14–15, 2009.
For some time now, merchants have spoken out about their inability to influence their customers’ payment choice
or to pass along the costs of payment instruments such as credit cards to their customers. The card networks,
such as Visa and MasterCard, have received the brunt of the pricing criticism across the globe as public authorities
seek to restructure payment costs. Yet, the networks argue that the fees they charge reflect the market value of
their products. Consumer advocates often claim that consumers are unaware of the impact of their payment
decisions and that some consumers end up subsidizing the payment choices of others. Adding to the mix, many
nonbank payment providers are bringing innovative payment products to the market to satisfy changing
consumer and merchant preferences and needs.
In an efficient market, prices and benefits are aligned in a way that provides all participants with proper incentives to
maximize social welfare.1 If the costs and benefits of the payments system are not aligned in such a way, will
regulation be required to bring the system into the proper balance? Or will the market resolve the problem through
innovation? In this Chicago Fed Letter, we summarize this year’s Payments Conference, where the participants
discussed these and related issues.
The current environment
In his keynote address, David Stewart, of McKinsey and Company, described how the weakened U.S. economy
and growing regulatory pressures are influencing the payments landscape. Payments revenues saw a 5.9%
compounded annual growth rate over the period 2002–07, according to Stewart, but in the next five years, this
growth may slow to 1.3%. Such a decline might be expected in a sizeable downturn, but there are particular factors
in play this time that suggest the impact might be felt differently by different players. Deposit balances were the
highest ever in 2008, Stewart said, as people cut back on consumption; and the supply of credit also diminished
greatly, since risk aversion increased throughout the market. Debit card usage was growing much more rapidly
than credit card usage before the downturn, and current conditions may bolster this trend. Furthermore, with
consumer spending weakening, merchants may attempt to reduce costs by steering consumers toward payment types
with lower merchant fees.
In addition to such pressures, pricing practices for payment products are becoming increasingly scrutinized by
public authorities globally. Financial institutions are now struggling to find pricing models that replace their reliance
on traditional sources of revenue, such as interchange fees2 from merchants and penalty fees from some
consumers, including overdraft fees3 and finance charges on credit cards. Penalties currently make up a large
portion of the consumer revenue stream from payment products as a result of competitive developments in the
payments space. Forty years ago, when checks were the primary noncash payment instrument, consumers paid
for them, explained Richard Oliver, Federal Reserve Bank of Atlanta. This model gave way to differential pricing
based on minimum balances, which rewarded consumers who kept more money in their accounts. Once that model
became ubiquitous, financial institutions introduced today’s indirect pricing model, which removed upfront fees
(e.g., free checking and no annual fees on credit cards), to retain customers, according to Oliver. But this model
is difficult to sustain, since it effectively shields many consumers from the consequences of their payment
choices while adversely affecting others.
The debate over pricing issues
The two-sided4 nature of payment products makes it difficult to determine whether the costs of such products are
being properly distributed to promote social welfare. Duncan Douglass, of Alston and Bird LLP, described several

components of this market, such as consumer protection and fraud prevention, whose costs are particularly hard to
define and thus correctly allocate. Eric Grover, Intrepid Ventures, pointed out that asymmetric pricing often is
needed in two-sided markets to get both sides on board. While this may be ultimately the case, this imbalance
fuels the perception that certain participants are bearing a disproportionate share of the cost.
Merchants complained about the lack of transparency in the fee-setting methods for certain payment products, as
well as the sheer complexity of the fee schedules; many questioned whether the costs justify the benefits they
receive for accepting these products. Dwaine Kimmet, The Home Depot, pointed out that interchange fees are
his company’s third largest operating cost, even larger than its costs for health care. Josh Peirez, MasterCard
Worldwide, argued that the pricing of payment products is just like the pricing of any other product; prices are set
to maximize the throughput over the network. Peirez argued that the benefits merchants receive by accepting credit
cards, such as guaranteed credit, far exceed the interchange fees. Mallory Duncan, National Retail Federation,5
disagreed, suggesting that the high fees and complex rules of card payments add friction to doing business rather
than facilitating it. For example, Duncan said single entity rules require merchants to make payment acceptance
decisions uniform across all their locations, forbidding any local flexibility. Moreover, the general consensus
among merchants is that they have little or no recourse when it comes to challenging the interchange fees and rules
set by the card networks. Instead of competing for merchant participation, these networks bid for consumers using
merchants’ money, argued Michael A. Cook, Wal-Mart Stores Inc.
Some merchants contended that the tension between merchants and card networks over fees and rules hampers
their own ability to design pricing strategies that properly reflect these costs. Wendy Sutton, The TJX
Companies, noted that when the price of a particular payment product goes up, passing the cost on to the
consumer through higher merchandise prices is not always an option. In addition, the general complexity of
payments pricing makes merchants reluctant to adopt explicit pricing for different payment mechanisms. As a result of
uniform pricing for all payment types from the consumer standpoint, Adam Levitin, Georgetown University Law
Center, and Jean Ann Fox, Consumer Federation of America, argued that consumers who use lower-cost payment
types, such as cash or entry-level credit cards without rewards, subsidize others by bearing a disproportionate
share of payment costs. Cook stated that, as consumers move toward more expensive electronic payments and
away from cash and checks, they do not see the impact of this switch. Because generally the pricing of payment
products is not explicit, this makes it difficult to engage consumers in the pricing debate. Stewart countered that
recent McKinsey research reveals that merchants’ preferences were quite effective in influencing consumers’
While much of the discussion revolved around the expense of electronic payment instruments, particularly credit
cards, it also revealed that the costs of some traditional paper-based payment products, such as cash and check,
may actually be harder to quantify. Several conference participants argued that cash is cheaper for various
constituents, but others suggested that this is only because cash is subsidized.6 Tom Brown, of O’Melveny and
Myers LLP, pointed out that even the U.S. Treasury Department claims there are cost savings for the U.S. as we
move from paper-based payments (e.g., checks) to electronic payments. This example complicates the case made
by merchants for charging their customers different prices based on their payment choice.
Responses to pricing issues: Regulation
Conference participants debated the role of public authorities in regulating the pricing of payment products. Jean
Allix, European Commission (EC), remarked that ideally it should not be up to one entity to decide which
payment forms are most effective; rather, society as a whole must determine the benefits of different types of
payments through a democratic process. While this is an admirable goal, it is difficult to achieve in practice.
Consequently, several foreign authorities have intervened directly in the market for payment card services.
Within the past five years, the EC, Reserve Bank of Australia (RBA), and Banco de México have opted for
regulation to promote market efficiency. John Simon, Reserve Bank of Australia, described how the RBA
prohibited ―no surcharge‖ rules and narrowed interchange fee differentials between card payments systems. In the
European Economic Area (EEA),7 MasterCard lowered its multilateral interchange fees for cross-border transactions,
temporarily, in response to inquiries from the EC.8 Furthermore, Allix recounted, the EC now requires banks to
inform retailers of the different costs associated with different cards and allows explicit pricing in order to

increase competition in the EEA. According to Simon, as a result of the Australian reforms, price signals are
now better at providing the necessary incentives to increase social welfare, and the narrower range of interchange
fees better reflects the similarities of the card products.9 However, since direct regulation is costly, the RBA is
considering negotiating voluntary targets for interchange fees with the private sector or pushing the industry to find a
solution under the threat of greater regulation if it fails to find one.
Because the card market is less developed in Mexico, Banco de México encouraged pricing that would increase
overall card usage, according to Jose Negrin, Banco de México. Banco de México allowed merchants to choose
whether to accept debit, credit, or both types of cards, and pressured card networks to reduce interchange fees and
adopt a fee schedule that encourages card acceptance by small merchants. The bank announced targets for
interchange fees for the private sector, indicating regulation would follow if targets were not met. As a result,
Negrin explained, the fees decreased and card usage and acceptance increased.
U.S. public authorities have not regulated interchange fees. Wilko Bolt, De Nederlandsche Bank, cautioned that
because it is so difficult to determine the true costs and benefits of payments, regulatory initiatives may produce
unintended consequences. Many U.S.-based conference participants advocated a more hands- off approach by public
authorities. Some, like Grover, said that direct intervention, such as price controls, will stifle value creation. Many
of those who saw a role for the government envisioned it more along the lines of removing the barriers that exist
in the current payments market—e.g., allowing differential pricing at the merchant level and leveling the
bargaining power of the major participants.
Responses to pricing issues: Innovation
Whether or not government regulation is necessary to increase social welfare, merchant complaints that
interchange fees are too high and too complicated, as well as consumers’ fears of unpredictable interest rates on
credit cards and overdrafts, provide opportunities for innovation. In fact, consumers are more willing than ever to
adopt new payment devices that bring them increased value, according to Scott Grimes, Cardlytics. He cited the
growth in online consumerism, 80 million underbanked consumers,10 and the mainstream transition from cash to
debit for everyday purchases as opportunities for payment innovations. Since banking relationships are
becoming more multilateral and financial institutions are no longer depending on physical locations, the
industry appears ripe for such innovations, Grimes said. Moreover, Steve Mott, BetterBuyDesign, presented data
indicating that, although Generation Y has not adopted online banking to the extent that baby boomers have, the
younger cohort is more receptive to alternative payments such as mobile payments and potential payment
instruments in virtual social networks like Facebook.
In addition to seeking out such opportunities, payment providers are targeting underserved markets, particularly
underbanked consumers, with products that offer more value to these segments than the status quo. Steve Streit,
Green Dot Corp., said that prepaid cards provide transparency and financial control because they automatically
prevent consumers from overspending. In the past, debit cards were like prepaid cards in that they limited spending to
the available balance, but now debit card consumers are allowed to exceed their balance (with an overdraft fee of
up to $35). Streit said that because Green Dot limits spending to the card balance and is forthright in its pricing,
its products attract consumers concerned about overspending and expensive debt.
Retailers have also innovated their payments processes and offerings in order to reduce costs. Cook detailed how
Wal-Mart improved the technology for cash handling and used point-of-purchase (POP) conversion of checks into
electronic payments to reduce its costs. Kimmet and Sutton discussed how their stores’ private label credit cards
help them reduce their payments acceptance expenses while generating loyalty from their customers.
The conference also addressed how innovation can build on existing systems. Gloria Colgan, Discover
Network, described how finding a new profitable balance between consumers and merchants can lead to a more
sustainable approach. For example, Discover partnered with over 100 merchants to offer enhanced cash-back
bonuses redeemable with participating merchants. According to Colgan, both sides need to find value, or the
market risks ending up with intrusive regulation. Instead of competing directly with legacy systems as Discover
does, Dickson Chu, PayPal, explained how PayPal extends the utility of these systems. According to Chu, PayPal
appeals to consumers because it allows them to make fast, easy, and secure payments using their preferred payment

method, such as a debit or credit card. PayPal also provides smaller merchants that cannot get merchant accounts at
banks access to electronic payments systems.
Innovations may also be needed to offset forthcoming declines in the usage of some legacy products. Both Mott
and Richard Crone, of Crone Consulting LLC, described the opportunities that new technologies are providing
to increase the value of traditional products. According to Mott, many financial institutions have failed to embrace
new technologies, such as mobile phones and social networks; this has allowed alternative payment providers, such
as Obopay and PayPal, openings to the market. Crone touted the opportunity for financial institutions to get on
board with mobile payments to reduce transaction costs and promote loyalty through mobile self-service,
payments, and banking. One drawback of mobile payments for financial institutions, he warned, is that mobile
carrier networks will naturally expect to receive part of the revenues.
At some level, we all bear the costs of payments, Sujit Chakravorti, Federal Reserve Bank of Chicago, stated, but
how these costs are passed on to consumers and merchants may affect the adoption and usage of mature and emerging
payment instruments. Participants at the conference recognized that because the real benefits and real costs of
payments are often hard to discern, efficient pricing structures are naturally difficult to define. Still, given the
weakened economy and changing consumer preferences, many players are searching for ways to lower the cost
of payments while remaining competitive. Overall, participants agreed that an increase in transparency in
pricing would help the payments system to function more efficiently. This may be achieved through innovation—both
directly, by introducing more-transparent products, and indirectly, through the competition generated by these new
products. However, if too many participants in the U.S. continue to think that they are being shortchanged by the
card networks, they are likely to turn to the regulators and the courts to redress what they regard as an
unacceptable imbalance in the market.

Social welfare is defined as the sum of the economic surplus realized by each participant. Economic surplus is
defined as the difference between the willingness to pay and the price paid for the good or service.
Interchange fees are per debit or credit transaction fees paid by the merchant’s bank to the card network’s
bank; these fees are typically passed on to the merchant via merchant discount fees. The value of interchange
payments has become quite large partly because of the success of card payment products. This expense is a
major source of contention between merchants and the credit card networks.
Overdraft fees are paid by the consumer either as a flat fee for overdrawing a checking account or as interest
paid on the overdraft amount.
Two-sided markets are economic networks having two distinct user groups that provide each other with network
benefits (e.g., credit cards with cardholders and merchants). For more discussion on two-sided markets and
payment networks, see Wilko Bolt and Sujit Chakravorti, 2008, ―Economics of payment cards: A status
report,‖ Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 32, No. 4, Fourth Quarter, pp. 15–27.
The National Retail Federation represents 1.6 million retail establishments in the U.S., and its members are
primarily smaller merchants.
Cash is subsidized in part by the resources the Federal Reserve uses in supplying genuine currency to financial
institutions and ultimately the general public.
For details on the EEA, see content/legal-texts/eea/EEAtext/ EEAagreement.
See a recent MasterCard Worldwide press release at commission_announcement.html, as well as the
EC’s earlier press release at 07/1959.
For more details on the RBA’s review of its actions, see 2007_2008_review.pdf.
Underbanked consumers are those who supplement some or many mainstream financial services with services
from alternative providers, such as check cashers.

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102