Regulating Debit Cards: The Case of Ad Valorem Fees

Article excerpt

Debit cards have become an indispensable part of the U.S. payments system, accounting for more than a third of consumer payments at point of sale. With this development has come controversy: Card networks charge merchants fees that merchants believe are too high. And most of the fees are ad valorem - that is, based on transaction value - rather than fixed fees per transaction.

Merchants are critical of the ad valorem debit card fees. They argue that debit cards, unlike credit cards, do not extend credit to card users, and the risks of debit fraud are small. So, there should be no cost rationale for debit cards to charge ad valorem fees. In fact, fixed pertransaction fees are the norm for debit cards in many countries around the world.

This controversy raises interesting questions. Given that debit cards incur a fixed cost per transaction, why do they charge cui valorem fees? How do ad valorem fees affect payment market participants, including consumers, merchants, and card networks? And should policymakers consider regulating debit cards by requiring fixed per-transaction fees?

These questions are a part of a broader debate on payment card markets. In recent years, researchers, market participants, and policymakers have been scrutinizing payment card fees and rules. As a result, a large body of literature, called "two-sided market theories," has developed, most of which focuses on the level of card fees on merchants and cardholders, but few have touched on fee structure issues.

This article explores a major controversy about debit card fee structures, namely, ad valorem fees versus fixed per-transaction fees. The analysis shows that, when card networks and merchants both have market power, card networks earn a higher profit by charging ad valorem fees than fixed per-transaction fees. At the same time, merchant profits are reduced, but both consumer surplus and social welfare are increased.1 Merchants complain that the current ad valorem fees charged by debit cards deviate from a cost basis. However, policymakers may have difficulty direcdy setting card fees at cost-based levels due to various information and implementation constrains. As an alternative, should policymakers regulate the debit fee structure simply by requiring fixed per-transaction fees (but allowing card networks to freely set the fee levels)? Our analysis suggests that this alternative may increase merchant profits at the expense of card networks, consumers, and social welfare. Therefore, caution should be taken when policymakers consider intervening in the debit card market.

The first section of the article provides some background on the debit card industry and related policy debates. The second section analyzes why card networks prefer charging ad valorem fees. We show in some circumstances ad valorem fees and fixed per-transaction fees are equivalent, but they are often different. The analysis considers how card networks, merchants, and consumers are each affected by ad valorem fees versus fixed per-transaction fees. The third section discusses policy implications.


The U.S. payments system is changing rapidly as electronic payments replace paper transactions. This section briefly describes how rapidly the debit card industry has evolved - along with the fees charged to merchants. The section then ouûines the debate over the ad valorem fees that most card networks charge merchants for making debit transactions.

The rise of debit card use

The growth of U.S. debit card usage has been striking. Debit card use increased 23 percent annually from 1996 to 2008, exceeding 34 billion transactions in 2008. Debit cards now account for 37 percent of consumer retail payments, compared to 21 percent in 1999.2

Debit card payments are authorized either with a PIN or by the cardholder's signature. Growth has been sharp for both signature-based and PIN-based debit. From 1 996 to 2008, signature debit transactions increased 24 percent annually, and PIN debit transactions increased 20 percent annually. …