Tuesday, June 24, 2008

Congress & Interchange

An Opinion from a Reformed Libertarian.

There’s good news and bad news.

The good news is that sales of my training manual, Understanding Credit Card Interchange in Card-Not-Present Environments, have increased dramatically. The bad news is that a lot of these sales have been driven by congressional interest in regulating the Interchange rates merchants must pay on credit card sales.

I am often accused of being in the right place at the right time. Better lucky than good – as the saying goes.

Mixed in with the usual merchant and processor want-to-learns, I have been seeing a greater number of sales from the beltway crowd in DC, Virginia and Maryland. They never purchase using their company names. I think they are lobbyists.

Being a merchant, and having been involved in the direct marketing industry for some time, I welcome some type of Interchange relief. Being a libertarian, I get an uncomfortable sensation in my gut every time congress tries to fix anything.

The credit card systems, at least from a technical perspective, are a modern marvel. These “small-i” internets grease the skids for billions of commerce transactions worth trillions of dollars. My guess is that roughly 99.7% of these pass through the system without any type of consumer dispute. Do you really want congress going anywhere near that machine?

That machine, however, is not perfect and Interchange happens to stick out as one of the areas ripe for improvement. In particular, those Interchange rates having to deal with Customer-Not-Present transactions. For years, CNP merchants have paid a “risk premium” on their Interchange rates because of real and perceived fraud concerns. These premiums generally run between 30 and 80 basis points (.30% - .80%), depending on merchant category and transaction type.

This is an expensive premium. In many regards, fraud can be measured by chargeback rates. Across the entire CNP spectrum, fraud as represented by chargebacks is less than 0.5%. What’s more, about half of this fraud is “friendly fraud:”

“I told my husband not to use my credit card! He’s not authorized to use it, and I’m not paying for the charge.”

This, my friends, is not fraud. Dividing 0.5% in half, the real CNP fraud rate approaches 25 basis points. So, you have this average risk premium of about 55 basis points, covering a 25 basis point problem. Things like this need to be fixed. Things like this need to be negotiated. So, Senator Durbin and Congressmen Conyers and Cannon have a good idea! Negotiation. You have to be smart to get into congress. Having congress and the courts run the process, however, is risky business in my opinion.

This problem needs to solved directly between the card Associations and a centralized merchant association. Let’s try like heck to leave government out of it – both Congress and the courts. This is an important warning. Many pundits say that these bills are dead-on-arrival. Every once and a while, though, Congress serves up a surprise. And I can tell you this, Congress is not particularly happy with the banking industry these days. Between “greedy” card-issuer fee policies and the mortgage crisis, Congress might just act with a certain amount of prejudice.

In the mean time, I am commercially happy with this new interest in Interchange. One way or the other, I hope these bills take a long, long time winding their way through Congress.


lanmatt said...

Sure there is some government buzz around interchange relief but there will not be any relief coming. In fact, as new cards come down the pipe, there will be increased fees to cover the points programs attached to these cards.

Most merchants that complain about non qual fees also carry cards with rewards programs.

Merchants should be sourcing procesors that have a transparent non qual model - in particular a provder that charges non quals at cost. The interchange adjustment on a domestic VISA for CNP is only 11bps, and 13bps for MC.

Processor like Moneris and Global Payments are adjusting for 50 to 105 bps on these transactions.

Mike said...

I believe you are correct. However, a provision in The Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 requires the GAO to conduct a study of interchange fees and their effects on merchants and consumers. Once delivered, no other government entity is compelled to react to the report under the law.

With regard to your other statement, I am all for straight pass-through pricing. It's the only way to fly.

Matt Robinson said...

I am confused why you cut the 0.5% in half? Isn't the risk premium specifically tied to the number of chargebacks not to fraud? If fraud goes unnoticed, it won't cost the the companies anything, only the consumer. And even if a charge back doesn't come from "real fraud" it still costs the credit card company to deal with the call from the customer and process the refund. So isn't true to say that fraud only costs the company if it is caught and refunded, but a charge back will always cost the company no matter what? So it seems correct to use the percentage of charge back instead of the percentage of actual fraud.

Am I missing something?

Matt Robinson said...

I think you are correct to think that congress should not get involved with the interchange rates.

Now I don't know for sure, but I would venture to guess that a much better place to look would be into why the whole industry is dominated by Visa and Mastercard. It seems like things could be a lot better with more competition. It is only because they dominate the industry that they are able to do things like put it in the contract that companies can not charge more for accepting credit cards. It is only logical for companies to charge more for paying in manner that has a higher transaction cost. If there was more of a free market, there would be more opportunity for new companies to emerge and cater to those businesses that wanted to maybe give a discount for paying cash (some companies already resort to this, but I believe it is technically breaking the contract). The whole financial sector is so tied into the government system, regulations, and the Federal Reserve that it is no where near a free market now. Instead of regulating interchange rates, congress should abolish the Federal Reserve, FDIC, SEC, and FINRA.

Mike said...

I cut the .5% in half because I believe half of this number is represented by friendly fraud, "I told my husband not to use my credit card! He’s not authorized to use it, and I’m not paying for the charge." This is not a merchant problem. This is an issuer problem. Once a card is compromised - even by a family member - the bank is supposed re-issue the card according to the regs. They are not always doing it in the case of friendly fraud because it's not a real threat per se, and it is expensive. But the merchant shouldn't have pay either. So, I discount (pardon the pun) the friendly fraud percentage from the premium.

Mike said...

BTW, this legislation died with the end of the 110th session of congress. That's a civics lesson that most people can't remember. Sessions end -- unfinished business dies.

Matt Robinson said...

For the case of "friendly fraud", I had not considered the fact that the Issuing Bank might not have to re-issue the card, thus making it less expensive than real fraud. I think you have a point there, but I still do think "friendly fraud" does increase costs to some extent and so it can't be completely taken out of the equation. There are still the costs of customer service and refunding the charge. And it does seem like some types of business would be more prone to friendly fraud then others. It would be easier for that rogue husband to take his wife's card for a minute and make a purchase online, then to take it out to a store where he'll have to take it for a longer period and use a card with someone else's name on it. So it still seems logical for the "friendly fraud" to be factored into the interchange rates of businesses. It probably shouldn't be weighted as heavily as real fund, but it is still part of the equation.