Interchange fees are an integral part of the pricing structure of credit and debit card industries. While in recent years the theoretical literature on interchange fees, and payment cards in general, has grown rapidly, the empirical literature has not. There are several reasons for this. First, comprehensive data are hard to obtain. Second, the industries are very complicated, and empirical models need to incorporate many industry-specific features, such as payment-card network rules and government regulations. And third, empirical studies may require a generalized empirical model since, typically, only a few payment card networks exist in a given country. However, because of the first and second reasons, generalizing empirical models may prove problematic.
This article seeks to provide a bridge between the theoretical and empirical literatures on interchange fees. Specifically, the article confronts theory with practice by asking: To what extent do existing models of interchange fees match up with actual interchange fee practices in various countries? For each of three key countries-Australia, the United Kingdom, and the United States-models that "best" fit the competitive and institutional features of that country's payment card market are identified, and the implications of those models are compared to actual practices. Along what competitive dimensions is there alignment? Along what competitive dimensions is there not alignment? What country-specific factors appear to be important in explaining deviations from theoretical predictions? The results suggest that a theory applicable in one country may not be applicable in another and that similar interchange fee arrangements and regulations may well have different implications in different countries.
The first section of the article briefly describes the mechanics of interchange fees. The second section surveys existing theories of interchange fees. The discussion focuses on assumptions regarding the degree of network competition, the degree of intranetwork (issuing and acquiring) competition, and the behavior of consumers and merchants. The third section attempts to match the theory with practice by examining in some detail interchange fee developments in the three countries. These case studies provide useful insight into interchange fee competition issues.
I. MECHANICS OF INTERCHANGE FEES
Credit and debit card industries are examples of two-sided markets. The distinguishing feature of two-sided markets is that they contain two sets of end users, each of whom needs the other for the market to operate. In the case of credit and debit cards, the two end-user groups are cardholders and merchants.
Payment card systems take one of two principal forms. They may be three-party systems: cardholders, merchants, and a single financial institution that offers proprietary network services, for example, American Express. Alternatively, they may be four-party systems: cardholders, merchants, card issuing banks, and merchant acquiring banks, using the services of a multiparty network such as MasterCard, Visa, or a domestic debit card network. In four-party systems, the interchange fee is an instrument that networks can use to achieve a desired balance of cardholder usage versus merchant acceptance across the two sides of the market, in the same way that proprietary systems can achieve directly. In other words, interchange fees are a mechanism that can be used to transfer revenues from one side of the market to the other to generate the desired level of card activity.
In most cases, interchange fees are paid by the merchant acquiring bank to card issuing banks.1 Typically interchange fees are a component of a larger set of fees charged by merchant acquiring banks and therefore are indirecdy paid by merchants.
Interchange fees are set under a variety of arrangements. In some networks, they are collectively set by the members of the network; while in others they are set by network management. …