Interchange Fees: The Economics and Regulations of What

vi INTERCHANGE FEESaround the world have intensified their examination of these fees. For example, the US Congresspassed legislation in 2010 that required the Federal Reserve Board to regulate debit card interchangefees; the Reserve Bank of Australia decided to regulate credit card interchange fees in 2002after concluding that a market failure had resulted in merchants paying fees that were too high;and in 2007 the European Commission ruled that MasterCard’s interchange fees violated the EU’santitrust laws.The controversy raises two broad issues. The first relates to how payment card systems decidehow much merchants should pay for taking cards either through the interchange fee for four-partysystems or the merchant discount for three party systems. The second concerns whether the settingof interchange fees by private businesses results in a market failure and if so what if any regulationshould be adopted to correct this market failure.This interchange fee debate helped stimulate a new literature on multi-sided platforms orwhat are sometimes called two-sided markets. Payment card systems serve as intermediaries betweenmerchants and consumers and operate a platform that enables these two different kindsof customers to interact. It turns out that there are many other businesses that have similarfeatures including software platforms like the iPhone OS, shopping malls, search engines, andexchanges. Economists have developed general models of multi-sided businesses and appliedthem to payment cards.This volume consists of seven articles on the economics and regulation of interchange fees.All rely on the multi-sided platform framework. The first two chapters examine whether there isa market failure in setting interchange fees and present principles for considering correction to amarket failure. One of the themes of these articles is that regulating one side of a two-sided marketnecessarily has effects on the other side of the market: lower prices for merchants means higherprices for consumers. Chapters 3-5 address that tradeoff which is sometimes called a “waterbedeffect”. Chapter 3 presents an empirical study of what happened following the imposition of pricecontrols on interchange fees in Australia in the mid 2000s. Chapters 4 and 5 estimate the prospectiveimpact on consumers in the US and EU of interchange fee caps. These chapters rely heavily onthe economic concept of pass-through, which concerns the extent to which business change theirprices in response to changes in costs. The net impact of reductions in interchange fees on consumersdepends on the extent to which issuing banks raise fees and merchants lower prices in responseto a reduction in interchange fees which are revenues to banks and ultimately costs to merchants.Chapter 6 examines a related question: how do interchange fee price caps affect investment and innovationfor payment systems. Chapter 7 examines arguments that merchant representatives havemade concerning debit card interchange fee regulation. That is followed by a short chapter with afew concluding thoughts.