Interchange and the major factors that can influence it

Have you ever wondered why some merchants enforce an additional fee when customers pay with credit cards? Or why do some merchants politely request customers to pay by cash when a purchase is less than $5? Or why can some fintech startups offer debit cards with rewards when big banks don’t seem to bother?

The answer is Interchange. Cash has been the medium of transactions for centuries. When a shopper hands cash to a merchant in exchange for goods or services, the merchant takes 100% the amount of such exchange and deals with taxes when the time comes. The problem with cash is that 1/ storing a large amount of cash requires a lot of effort for merchants and 2/ not many customers find it convenient to carry cash around, especially for large transactions. Card transactions bring convenience. Merchants get paid in the form of increased balance in a bank account while consumers can spend without carrying a thick purse or wallet. With credit cards, consumers can transact on the credit line extended by a financial institution. But as the old saying “there is no free lunch” goes, such convenience comes at a cost and that cost is Interchange.

Interchange is a small fee that merchants have to pay on every card transaction. The recipient of interchange is financial institutions (FIs) that issue debit or credit cards to shoppers. These FIs use this revenue stream to either pay for their operational expenses or fund rewards that are promised to consumers. Since doing business nowadays always involves card payments, interchange is one of the expenses that merchants can’t avoid.

How much do merchants have to pay on every transaction? The amount of interchange is determined by interchange rates mandated by networks such as Visa, Mastercard, Discover or American Express. There are a lot of factors that can influence these rates and below is a list of factors that I know (by no means, it’s an exhaustive list):

Merchant Category Code

Merchant Category Code (MCC) is a 4-digit code that represents the type of business area in which a merchant operates. For instance, 5411 refers to grocery stores while 5300 represents wholesale clubs. Some companies such as Walmart or Amazon can span across multiple MCCs because of the breadth of their offerings while others like mom-and-pop restaurants have only one MCC. In some industries, including airlines or hotels, a merchant can have its own code. For instance, 3000 and 3001 are assigned to United Airlines and American Airlines respectively.

High frequency categories such as Gas and Grocery carry low interchange rates while others such as Dining or Travel fetch higher rates. Whenever there is a push to promote a specific area, networks raise the interchange rates as an incentive for card issuers. Take Electric Vehicle Charging 5552 as an example. Its rate for consumer cards is 3%+ which is much higher than the average 1.7% across other categories.

Sometimes, it’s easy for consumers to guess MCCs of their purchases. However, it’s much trickier when it comes to big merchants such as Walmart or Amazon. The only way to know is to wait for the transaction to be posted.

Merchant

Giant merchants such as Costco, Walmart or Amazon command great bargaining power and can negotiate a special low rate with the networks. Think about it this way. The rates that I have seen for these companies are around 0.7%. At $500 billion in annual revenue that the likes of Amazon or Walmart generate, interchange expense amounts to $35 million a year. If they had to pay 1.4% in interchange, the expense would double to $70 million. Their retail business margin is not big enough for them to ignore that difference.

Card-Present or Card-Not-Present

A transaction is considered as “card present” only if a card is swiped or tapped or if an EMV chip is processed. A transaction by fax, Internet, mail or over the phone is considered “card not present”. Since card-not-present transactions do not require a cardholder or a physical card to be present at the time of the transactions, the risk of fraud is higher. Hence, issuers receive higher interchange rates on CNP transactions for taking on additional risks.

Networks

There are a few major networks such as Visa, Mastercard, Discover, American Express and JCB. Each has its own pricing schemes and that can affect the rates that merchants have to pay.

Plastic Type

The type of your card also influences interchange rates significantly. On the Visa Consumer side, there are usually three types of cards: Visa Classic, Visa Signature and its highest tier, Visa Signature Preferred. Visa Signature Preferred comes with much higher rates than Classic or Signature. Normally, if your credit limit is above $5,000, your card is qualified for Signature. To qualify for Signature Preferred, a cardholder typically needs to meet a certain spend threshold. To my knowledge, an issuer sends a list of cardholders that meet certain criteria to Visa so that they can flagged as Signature Preferred. If successful, the issuer can earn a decent amount of additional interchange revenue. On the Mastercard, there are also similar schemes and tiers.

Consumer or Commercial

The rule of thumb is that commercial credit cards have higher interchange rates than consumer cards.

Credit or Debit

Credit cards command higher interchange rates than debit cards, simply because credit cards are much riskier as a product than debit cards.

Purchase Volume

Sometimes, the size of a transaction can affect how much merchants have to pay. For instance, American Express has different rates for different ticket size tiers across key categories. Typically, the bigger a transaction, the higher the interchange rates.

Point of Entry

If you shop in store, whether you use an EMV chip, swipe your card, tap your plastic on the card reader or pay with a mobile wallet can affect the interchange rate of that transaction. To make it more complex, the type of mobile wallet that consumers use is also a factor. For instance, staged wallets (PayPal, Cash App) which break down a transaction into funding and payment stages command slightly higher rates than pass-through wallets (Apple Pay, Samsung Pay) that pass payment details directly to merchants. The alleged reason why there is such a difference is that staged wallet providers do not provide as much information regarding payments as the networks would like and that could make the verification task a tad more challenging.

Regulations

To help smaller banks compete, the US government allows debit card issuers with less than $10 billion in assets to charge significantly higher interchange rates than bigger issuers. That’s usually known as the Durbin Amendment. Fintech companies use this loophole to partner with small less known banks to offer debit cards with rewards. In many countries, including the European Union, interchange rates are capped by laws and much lower than what we see here in the US.