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ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK
OF CHICAGO

SEPTEMBER 2009
NUMBER 266a

Chicago Fed Letter
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 Chicago
hosted its ninth annual Payments Conference on May 14–15, 2009.

Materials presented at the
conference are available at
www.chicagofed.org/news_
and_conferences/conferences_
and_events/2009_payments_
conference.cfm.

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

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

It is hard to engage consumers in the pricing debate because
they typically do not see the costs imposed on others by their
payment choices.
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

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’ choices.
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 handsoff 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
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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
1

2

3

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.

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.

4

7

For details on the EEA, see www.efta.int/
content/legal-texts/eea/EEAtext/
EEAagreement.

8

See a recent MasterCard Worldwide
press release at www.mastercard.com/
us/company/en/newsroom/european_
commission_announcement.html, as
well as the EC’s earlier press release at
http://europa.eu/rapid/
pressReleasesAction.do?reference=IP/
07/1959.

9

For more details on the RBA’s review of
its actions, see www.rba.gov.au/
PaymentsSystem/Reforms/
RevCardPaySys/Pdf/conclusions_
2007_2008_review.pdf.

10

Underbanked consumers are those who
supplement some or many mainstream
financial services with services from alternative providers, such as check cashers.

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.
Conclusion

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 twosided 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.

5

The National Retail Federation represents
1.6 million retail establishments in the
U.S., and its members are primarily
smaller merchants.

6

Cash is subsidized in part by the resources
the Federal Reserve uses in supplying
genuine currency to financial institutions
and ultimately the general public.