The Merchant Security Blog

By Tim Kridel

ISOs can count on continuing uncertainty as the battle rages over interchange rates. No one knows when the National Retail Federation and the card brands will resolve their differences or how that resolution might affect ISOs and agents. Meanwhile, most merchants know little and care less about how the card brands set interchange rates.

The battle centers on the retailer group’s claim the United States has the world’s highest interchange fees, which are fees paid by the merchant bank to the card brands for processing transactions, not including fees and rates charged by ISOs and processors.

The Merchants Payment Coalition, a branch of the retailers’ association, says the fees cost consumers $50 billion annually. That leaves the coalition pushing to force deep reductions in interchange rates.

A year ago, state legislatures were pondering more than a dozen bills to regulate rates. Some sought clearer disclosure of the rates, while others wanted to create caps-0.75% in Tennessee, for example. The battle also is playing out in the courts.

“The most likely scenario is that the [card] associations are going to have to basically give in and have some kind of concessions about the amount of the interchange rate and the future increases,” says Paul Rianda, who spent three years as an ISO chief operating officer before founding an Irvine, Calif.-based law firm specializing in the payments industry.

“The alternative is legislation that dictates what happens, and that could be catastrophic for the industry’ Rianda says.

Some favor settling merchant lawsuits against the card brands as the fastest route to resolution. “It seems to me that those lawsuits-hopefully will progress quickly and come to some resolution…that will take care of the legislatures’ interest in this whole process,” Rianda says.

Resolving the lawsuits would yield a better solution than legislation would provide, he says. “I think that’s the most likely outcome, and that’s the one that probably would be the safest for everybody concerned,” he says.

When a resolution may occur remains uncertain. “I feel any serious change is way down the road” says Douglas Mack, president of Payex, a Columbus, Ohio-based ISO.

CAUTIONARY TALES FROM ABROAD

The United States is not the only place with a battle over interchange. In Australia, where the Reserve Bank reduced interchange rates by 40% in2002, from 0.95% to 0.55% regulators argued that interchange subsidized credit card users and thus stifled innovation in other payment types. The industry responded by increasing other charges, particularly annual fees, to offset those losses.

“I can’t imagine what would happen to our industry and all of the ISOs if that happens,” Rianda says of the Australian situation. “That would wipe out ISOs and agents and make everybody go with a more direct approach from the processor level.”

Although the payments markets differ in Australia and the United States in terms of structure and types of players, what happened there provides clues about what deep, mandated interchange rates cuts could do here, observers say. One example is the argument that merchants would pass on the savings to customers.

“Some of the research shows that since [the Australian rate cut], 70% of merchants didn’t even notice that there was a reduction in the interchange fees, which means it probably wasn’t even passed on to [the customers],”says Mike Preuss, an international payments-processing associate at The StrawheckerGroup, an Omaha,Neb.-based consultancy.

The U.S. payments industry also is watching Europe for clues. In December 2007, when the European Commission ordered MasterCard and its banks to eliminate the fees within six months, the National Retail Federation issued a press release comparing the two markets.

“European authorities say MasterCard is double-dipping in Europe, and that’s exactly what we think both MasterCard and Visa are doing here in the U.S.,” Mallory Duncan, association senior vice president and general counsel, said in the release. The NRF did not respond to repeated requests for comment for this article.

The association release stated, however, that MasterCard’s interchange rates for cross-border transactions in Europe are 0.8% to 1.2% of each transaction, while in the United States, MasterCard and Visa average nearly 2%. MasterCard and Visa did not respond to interview requests.
Comparisons of rates in Europe and the United States aside, the two markets differ enough that some observers do not think legislators or courts here could use Europe as a template for resolving the interchange debate.
“The whole business model from a European perspective doesn’t really feature ISOs,” says Kevin Murphy, a Strawhecker Group international payments processing associate.” MasterCard and Visa in Europe now publish their interchange fees on their Web sites, which they’ve done kicking and screaming.”

Despite conflicts over U.S. interchange rates, some view the situation as just another step in the evolution of payments here, “Many industries have had their share of the spotlight, and now it’s simply our turn,” Mack says. “I don’t see the NRF being any different than the National Federation of Independent Business [a Washington,D .C.-based trade group for small business owners] in that it is trying to be advocates of their member base, as membership drives their revenue. It’s business.”

Interchange Ignorance

In the United States, interchange rates have been widely available to merchants in print and online for more than a year. In theory, that information should give merchants an edge when comparing ISOs. In practice, however few merchants have even a basic understanding of interchange rates or know that they are available.

“I don’t have my clients complaining that whenever they walk into a place, the merchants are demanding a certain interchange level,” says Rianda, the lawyer who specializesin payments.’ Also, the problem is that there are so many interchange levels and different cards that the merchants really can’t make a demand on the ISOs and agents other than to give them straight interchange.”

Large, national merchants often know about interchange rates and sometimes have someone on staff who specializes in rates. But they are the exception, ISOs say.

“l don’t think that many small to mid-size merchants are aware that those [published rates tables] even exist,” Rianda says. “lf you’re Wal-Mart, you probably know what interchange is. I don’t think that publication changed a whole lot in terms of what the average merchant is able to negotiate or is charged.”

Mike Fox, the interchange specialist at Group ISO Inc., an Irvine, Calif-based ISO for Wells Fargo Bank, shares that view.

“A lot of merchants don’t even know that [publication] happened,” Fox says. “They still don’t know what interchange is.”

They are not the only ones. “Bankcard sales representatives re ally don’t understand all of the idiosyncrasies of interchange,” says Jamie Savant, a StrawheckerGroup partner.” lt’s very complicated.”

ASSESSING THE IMPACT

Merchant awareness of interchange rates is noteworthy because it is one way to assess how merchants might react if the brands slashed or eliminated the fees. For example, large merchants typically mark up prices to cover interchange.

“If interchange was abolished, would they bring prices back down?” Fox says. “I’ve asked my personal sources and they say, ‘No. Why would people do that?’ So if that were the case, merchants would keep their prices the same yet be paying less and putting more money into their pockets.”

That could help the economy and Wall Street by increasing retailer’s profits. But would it help ISOs? The answer depends partly on the size of the ISO and the size of the merchants in its portfolio.

“Those things that happen will impact ISOs, but they’re going to impact more of the bigger accounts,” says Susan Horne, a StrawheckerGroup associate.

“There are so many small accounts across the United States. They don’t understand interchange. They don’t want to understand interchange. A lot of ISOs also are smaller and have a lot of small accounts. So it all comes down to…everybody has got to pay, but they don’t understand necessarily why they have to pay.”

Payex is another ISO that says it was not affected when the card brands published interchange rates.

“I see every little difference,” Jack says.” Most merchants still don’t know what interchange is and are not aware it is publicly available until we educate them of such. Admittedly, I had my concerns, but anymore I’m a fan of an interchange-plus pricing structure as I believe it is in our clients’ best interest and having their best interest in mind will hopefully result in a longer-term relationship.”

If so many merchants remain unaware that interchange rates are in the public domain, are they also unaware of the battle over the future of those rates? Horne says some have heard about it but do not understand how it will affect them. That could change if the press trumpets the resolution of the dispute. Meanwhile, more merchants are paying attention to interchange.
Some observers believe a gap of about one year may occur between the time the combatants reach a truce and merchants find out the war has ended.

“The first thing that would happen is the ISOs’ profit probably would triple because interchange would just drop,” says Group ISO’s Fox. “But as
soon as merchants found out, it would turn into a mouse hunt.”

Fox and his colleague, Theodore Svoronos, believe most merchants will search for the lowest rate. The sudden pressure to compete primarily on rate could damage individual ISOs and the ISO industry as a whole.

“The industry may have a hard time keeping up the level of professionalism and service [while] educating merchants,” says Svoronos, the firm’s e-commerce expert.

If rates change drastically or cease to exist, the shock could rock the industry.

“You’re going to have a lot of merchant dropoff’ Svoronos says. “The people who can’t meet rates are going to lose business.”

For now, though, ISOs are conducting business as usual because most merchants remain unaware of the battle over the future of interchange rates.

“The impact of what’s going on behind the scenes has not hit us yet,” Fox says.” The outcome whatever it may be-will.”

KNOWLEDGE MEANS OPPORTUNITY
Because it is so complex, interchange can create opportunities for ISOs willing to master it. That knowledge could give them a competitive advantage once the players resolve the interchange-rate battle.

“It will turn into a payment card industry revolution, where everything basically starts from the ground up again,” Fox says. “When it happens, the little guys could become the big guys. And the big guys, if they’re not up on it, may lose half their portfolio.”

He makes those predictions because ISOs, large or small, that have not developed strategies for dealing with changes in interchange rates will find themselves caught short.

As merchants scramble for the best deal, ISOs that have adjusted their business models to meet that demand could pick up a lot of business.

“You’re going to run into a situation of first-come, first-served,” Svoronos says.

As knowledge, or at least awareness of interchange rates trickles down to small and mid-sized merchants, some ISOs believe that it is creating an opportunity regardless o f how the battle is resolved.

Group ISO, for example, already is teaching its merchants about interchange as a preemptive strike against competitors looking to poach.

“lf they find [the published rates], they’ll start asking their provider,” Fox says. “We educate our merchants on it because when someone comes along and tries to educate them and make a value-add above what we already offer, they’re going to say: ‘l already know this. Sorry.”

Making retailers aware of interchange rates is just the latest value-added feature some ISOs are using to minimize merchant churn and reduce the need to compete on rates.

In Group ISO’s case, that means educating merchants on PCI compliance and new technologies. Group ISO also provides a 24-7 call center staffed by employees with enough industry knowledge to answer questions on the spot instead of taking messages.

“We’ve built a loyalty factor by educating our merchants,” Svoronos says. “We keep them abreast of what’s happening in the marketplace. Selling a rate is not what gets you a merchant these days. It’s the customer support. It’s the education. It’s the handholding. It’s the consulting.”