Authentication & Security

Should EMV and Tokenization Drive Interchange Fees Lower?

TD Bank

Every time when we use our debit, credit or prepaid cards at a store, online or over the phone, the Merchant bank (Acquirer) is the one paying an interchange fee (or “swipe fee”) to the bank that issued the payment card (Issuer). The interchange fee is then passed on to the merchant by the Acquirer, as pretty much the main component of the Merchant Discount Rate (MDR = interchange fee + Acquirer’s margin). The MDR is basically the fee that Merchant pays to its Acquirer for enabling them for acceptance of the payment cards.

The interchange fees are set by Visa and MasterCard and vary in regards to the perceived security risk:

  1. a) Card type: Debit cards have the lowest interchange fees, while high-limit signature rewards cards carry the highest interchange fee.
  2. b) The payment channel: Card-not-present transactions (buying online or over the phone) naturally have higher fees, while in-store, proximity or face to face transactions have lower fees.
  3. c) The merchant's negotiating power: Gas stations, small restaurants and small business owners pay the highest fees, while big box retailers like Wal-Mart are usually able to negotiate lower prices.

The original purpose of interchange fee was to mainly cover the risk of fraud, transaction processing, clearing and settlement processing and 'other' overhead costs of card Issuers. However due to the lack of transparency into the process of setting the fees by the payment networks and also chronic lack of negotiating power on the merchant side (exceptions are large and powerful merchants), the interchange fees evolved over time and became a major source of profits at almost every bank that issues credit, debit and prepaid payment cards. Banks quickly realized they can take advantage and use these lucrative earnings for competing with each other - through subsidizing premium services (like offering free checking accounts), offering surcharge-free ATMs and offering all kinds of debit / credit card rewards to further incentivize card usage and earn even higher interchange profits.

After US Durbin amendment to Dodd-Frank financial reform legislation in 2010, debit card interchange rates got capped at 22 cents plus 0.05% of the transaction in the US. Even after Durbin, debit interchange fees cross Canada, EU and Australia are still significantly lower.

Since Durbin only caps the debit card interchange fees, the US card issuers are able to continue earning highly profitable interchange fee revenue on credit card transactions. Whether US government follows the footsteps of Canada, EU and Australia to also impose caps on credit card transactions remains to be seen, but for now those are mainly left unregulated by the US government.

Can Taming Fraud Justify Lower Interchange?

If the original purpose of the interchange fee was mainly to cover the transaction processing, clearing, settlement costs, plus to offer the card issuers a healthy financial cushion to be able to protect the cardholders from fraud, it is understandable that US still has disproportionately higher credit and debit card interchange fees than the rest of the developed world. In the end US payment infrastructure is currently still mainly based on 'fraud prone' magnetic stripe technology.

However since US is now introducing EMV and payment networks are in parallel pushing and introducing their payment tokenization services, we shall naturally expect that the fraud levels across all payment channels should significantly diminish in the next 2-3 years. Should we expect also, as a consequence, to see interchange fees on debit, credit and prepaid cards falling to the same levels observed in the Canadian, EU and Australian markets?

I am afraid this may be wishful thinking of course, at least in the short term, but I also expect that merchants and their associations will keep pushing harder for something similar to happen, sooner rather than later. Long term, they will for sure have much more ammunition in their hands to challenge the current interchange fee levels across the board, especially once the fraud levels significantly start dropping down. This is for sure something to watch in the next several years.

Milos Dunjic

TD Bank

Milos Dunjic is a technology executive fascinated with and focused on payments innovation. He currently leads and is responsible for TD Bank’s Payments Innovation practice. All opinions are purely his own and not of his past and current employers.

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