Summary
The GAO’s study on interchange was thoughtful, balanced, and light on recommendations. The inconclusive nature of the report reduces the likelihood meaningful legislative action will impact interchange in 2010. However, the combination of DOJ investigations, merchant class action litigation, and continued legislative efforts will collectively put increased pressure on these parties to enact payment system reform. Likely outcome could be a major interchange rate reduction in 2011.
Analysis
The title of today’s GAO report said it all: “…Options for Reducing Fees Pose Challenges.” Overall, the report presented a fairly comprehensive assessment of small and large stakeholders throughout the payment food chain. Although the GAO identified a number of problems in the current system, it always seemed to balance the merchant ire with the banks and network perspective. Despite their efforts to spin select points after the report’s release, the merchant coalition was certainly hoping for a stronger indictment of the current system. They didn’t get it. Independent observers who were hoping for clarity on a path forward were also disappointed.
The report itself was fundamentally light on a couple of levels. Although section 501 of the CARD Act required the GAO to review “other jurisdictions where the central bank has regulated interchange fees”, the report was surprisingly weak on the benchmarks from anywhere other than Australia (with its 50 bps rate). They could easily have found the following rates on MasterCard’s European website: UK (100 bps), France (50-80 bps) or inter-country Europe (20-30 bps). While other countries (such as Canada and Mexico) have blended rates comparable to the U.S., the GAO would have a hard time finding rates higher than the U.S. in other industrialized countries. A low-effort benchmarking analysis would have benefited the merchant viewpoint.
The report also had very limited coverage of Discover (NYSE: DFS) and American Express. Both companies should be cheering – being ignored in a government watchdog report is a blessing.
The GAO’s assessment of four alternatives for reforming the current system identified numerous implementation challenges – and a likelihood of unintended consequences. If anything, the report seemed biased toward interchange caps and loosening restrictions on network rules (such as honor all cards and surcharging). It was decidedly negative on allowing merchants and issuers to directly negotiate fees.
Such sentiment will further reduce the waning momentum of the Conyers bill. Most rational economists and industry observers had viewed direct issuer-merchant negotiations as unworkable and filled with bad externalities for small merchants. The GAO report will help move legislators to move beyond the poorly-crafted Conyers proposal and focus future congressional efforts on rates and rules approaches that have been trialed in other countries.
But congressional efforts are just one element of a multi-factor storm that is making major interchange reform likely. The DOJ’s investigation into Visa Inc. (NYSE: V) and MasterCard rules, the continued progression of the class action merchant litigation, and the activity in Congress are feeding off each other. The worst fear of the banks and networks is a double (or triple) whammy: Congress reduces rates dramatically; the DOJ requires major rules changes; and they lose in court with an astronomical treble damages bill and a further reduction in rates. The desire to avoid such a nightmare scenario – and find a negotiated settlement – make it increasingly likely that interchange rates will fall in coming years. Not a given, not something I favor – just reasonably likely. The key issues:
A. Rates: how much will they fall?
B. Who will be directly regulated? In particular, will Amex (and to a lesser extent Discover and PIN debit brands) be part of legislation or regulation?
C. What rules will change? Such change could refine rules on surcharge prohibitions, merchant liability and chargebacks, and honor all cards.
While a variety of permutations are possible, I have been advising clients to think how their business would be impacted by the following scenario:
A. An 80 bps reduction in Visa and MasterCard interchange.
B. Amex remains outside any government supervision. Regulators in the US and other countries have had difficulty finding a basis to regulate closed-loop schemes.
C. The “honor all products” rule is eliminated, allowing merchants to cease acceptance of higher interchange premium or corporate products. Payment brand price discrimination is allowed.
Imagine the “Obtaining Copies of the GAO Report” section reading: “Orders may be paid for using Discover (1.5% surcharge), MasterCard (2% surcharge), Visa (1% surcharge), check, or money order. No Visa Signature or Amex cards accepted.”
I’m not saying such an outcome is wise or desirable. It certainly would have unintended consequences – many of which might negatively impact the merchants it was intended to benefit. There will be winners and losers in every sector. Investors, banks, processors, networks, and merchants should think through the consequences – and develop Plan B.
Banks need to rigorously review programs that are dependent on interchange revenue. Purchasing, corporate, prepaid, debit, and reward cards would be most impacted. Some products would need minor tweaks to pricing – while others would be completely terminated in select customer segments. Certain high-spend transactors might be lost to Amex. The merchant landscape may also change as new categories (such as rental and micro payments) become more penetrable as acceptance costs decline.
Interestingly, the competitive landscape would also be impacted in unexpected ways. Rate cuts will probably increase the market share of Visa and MasterCard at the expense of cheaper and technologically innovative solutions. Even at today’s interchange levels, emerging competitors (such as Mazooma, Noca, Moneta, and Revolution Money) have been unable to generate meaningful merchant traction. Lower interchange will make it harder for these upstarts, and even PIN debit providers, to offer compelling competitive value propositions.
Overall, the GAO report didn’t accelerate the likelihood of major interchange reductions. If anything, it created some breathing room. However, the combination of future legislation, ongoing litigation, regulatory investigations and competitive developments make major interchange reductions increasingly probable in the next 24 months. Unfortunately, that may be too distant a horizon for an industry already focusing on the imminent challenges of CARD Act implementation, regulatory scrutiny and a bad economy.
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
