Why Are Credit Card Merchant Fees So High?

A month back I was complaining on Twitter that credit card merchant fees have stayed the same for the past 60 years. The fees which retailers have to pay for accepting credit cards is known as the merchant discount rate which has hovered between 2-3% since the 1950’s. You would think with the increased volumes, technology and innovation that the rates would have been pushed lower. But they haven’t.

It’s easy to complain about something you know nothing about. It’s also a very populist attitude – “yeah man, they should lower the rates.” I decided not to be stupid about the topic and do a little research to understand why no one has tried to upend the current system and lower the transaction costs for retailers.

If I were to ask you who makes the most money from a typical 3% (300 bps) merchant discount rate fee that is charged to the retailer, who would you pick?

1. Issuing banks such as Citibank who issues the credit card
2. Acquiring banks where the retailer has their account
3. Network payment processors such as Visa and MasterCard

The answer might surprise you and it explains why the system has never been attacked by lower priced competitors. Below is the breakdown on a typical 3% merchant discount rate:

1. Issuing bank – 2.4% (240 bps) – interchange fee
2. Acquiring bank – .50% (50 bps) – acquiring bank fee
3. Visa/MasterCard – .10% (10bps) – payment processor fee

I was surprised by the answer as well. I was 99% sure that Visa and MasterCard were taking the biggest piece of the pie. It also explains why no one has challenged them. If you had to target any one of those 3 segments, why would anyone go after the payment processors which makes the least amount of money in the value chain.

The fee that the issuing banks collect is called the “interchange fee.” Banks are pretty happy to be getting the largest piece of the pie by a wide margin and have no economic interest to rock the boat. In fact, banks like issuing American Express cards because they get an even larger interchange fee then from Visa and MasterCard branded cards. The flip side is many retailers hate AmEx because they get charged more for using the AmEx payment network. (EDIT – AmEx is a bank. Clarification provide by Sheel Mohnot who heads the business development team for payments at Groupon.)

The only way to lower the overall merchant discount rate is to dramatically cut the interchange fee. That might seem impossible but there are a couple rays of hope from some unlikely places – China and India. China’s answer to the Visa and MasterCard duoploy is something called UnionPay. Like everything else in China the rates that UnionPay can charge are handed down by the government, in this case the central bank of China called the People’s Bank of China (PBC). Interchange fees are capped at 80 bps and can go all the way to zero bps for certain government services.

While in India they are rolling out a service called RuPay. (I wrote a post about 4 months back about RuPay and the various payment systems in India). Back then I was pretty sure the fledgling system would be killed off by Visa and MasterCard to protect their turf. But the government is pretty serious about providing a low cost transactional platform to its residents. I would imagine this is all part of the governments effort to switch from cash based transactions to electronic transactions and to get residents into the banking system. Today when you apply for an Aadhaar card, a universal ID card, you can connect a bank account and in the near future they will probably issue a RuPay card as well.

The other bright news for India is that its central bank – the Reserve Bank of India (RBI) has set a cap on the merchant discount rate for debit card transactions. If the transaction is under Rs. 2,000 then its 75 bps and anything over that is capped at 100 bps, which is really good. Remember that is the merchant discount rate which encompasses the interchange fee, acquiring bank fee and payment processor fee. A major win for retailers and consumers alike.

The market is ripe for disruption but where exactly it will come from is anyone’s guess.

Note: Many small retailers pay even more then 3%, hence the rise of startups like Square (2.75%), MasterCard Simplify (2.85%) and Stripe (2.9%).