Interchange Fees: The Economics and Regulations of What

4 INTERCHANGE FEESin the United Kingdom. 7 While American Express played a significant role in the United States,globally most cards were associated with multi-party systems that had interchange fees. In theUnited Kingdom, for example, an influential report on the banking industry issued in 2000—the“Cruickshank Report”—addressed interchange fees in multi-party systems, concluding that “[t]here is a strong case for reform of the interchange fee system.” 8For retailers, merchant discounts (which included interchange fees in the bank card systems)had become a growing portion of their costs, as more people paid with cards. Some retailers hadperiodically complained about merchant discounts; hotels had gone so far as to create their owncard system in the United States in the mid-1950s to avoid the merchant discount of Diners Club(a unitary system). However, with increases in interchange fees and perhaps other legal and politicaldevelopments, various organizations of retailers around the world sought regulatory relief fromthe fees. For example, EuroCommerce, a retailer association, filed a complaint with the EuropeanCommission in 1997. This led to an investigation of Visa Europe and ultimately a settlement inwhich Visa Europe agreed to lower the interchange fees. Interchange fee levels have also been underactive attack and/or regulated in a number of other countries, including Australia and the UnitedKingdom. 9Why has interest in interchange fees surged among economists in recent years? Some, includingus, were exposed to the topic through their involvement in litigation and/or regulatory proceedings.But the same could be said for many other legal and regulatory issues that have spawnedmuch smaller literatures over longer periods of time. The large volume of theoretical literatureon interchange fees has arisen for the simplest of reasons: understanding their determination andeffect is intellectually challenging. As the discussion below indicates, this is not necessarily goodnews for policy-makers.B. This EssayThe remainder of this essay is organized as follows. The next section provides context by consideringthe operation of unitary payment systems, such as American Express, in the context of therecent economic literature on two-sided markets, in which businesses cater to two interdependentgroups of customers. The main focus is on the determination of price structure. We then discussthe basic economics of multi-party payment systems and the role of interchange in the operation ofsuch systems under some standard, though unrealistic, simplifying assumptions. The key point ofthis discussion is that the interchange fee is not an ordinary price; its most direct effect is on pricestructure, not price level. While it is clear that an unregulated monopolist or a cartel in a one-sided7Visa International (2001). Measures of consumer expenditures may not be entirely consistent across countries but aresufficiently comparable to provide a rough sense of importance. See also Weiner and Wright (2005).8Cruickshank (2000, p. 272).9See Reserve Bank of Australia (2002), European Commission (2002 and 2003), Office of Fair Trading (2003), and Gandal(2005). Weiner and Wright (2005) provide a useful overview of government involvement.