This explainer is based on our #NAMA Community meet on the payments ecosystem held in New Delhi on July 31, and supported by FTI Consulting. The piece is based on sessions conducted by Peter T. Dunn, and questions and inputs from the audience. Read the rest of our coverage of the community meet here.
Who are the players in the payments ecosystem? There are two real businesses in the payments ecosystem.
- One is the issuing business. The issuing business’ relationship is with the cardholder or account holder. It may involve an issuing bank, it may use a processor to do some processing,
- Then there’s an acquiring business, whose relationship is with the acquiring bank, and it involves the merchant.
- In the middle of these two, we have the switch or the scheme, which are networks like MasterCard, Visa, American Express.This is essentially the payments infrastructure: its a four-party system. If Amex is involved, the issuer and acquirer collapse, then we have a three-party system with the account holder, the merchant and the scheme.
Where does revenue enter this system? All four players and the government have a common objective: to make the system as robust, effective, and efficient as possible, whether you are scheme, cardholder or account holder. This takes investment. Revenue only enters the system from two places, the account holder and the merchant.
What do the issuer and acquirer do? What are their functions?
The issuer sets up accounts in terms of transaction activities, they authorize transaction when you login or use your card, a message goes from the merchant to the issuer to authorize it, and then you have money either in your current account, checking account, debit account or credit account. It clears, it transacts, it receives the transaction and posts it to your account. It also gets new accounts via marketing and acquisition; it performs credit processing, know your customer, cardholder servicing, billing and payment processing, risk management, and so on.
The acquirer side has a similar set of things that it does with the merchant. It provides authorisation, clears transactions, presenting and settling, acquisition, servicing for the merchant itself, terminal management, and so on.
What do services like MasterCard and Visa do? They process these authorizations. There is interchange clearing which moves funds back and forth and settles those funds. They set the operating rules and procedures for the system, they do brand promotion and marketing, product development, communication changes, member services (members being acquirers and issuers in this case). And, they are global which means it involves all merchants across the world can discuss or communicate with all their account holders.
How do these players make money?
- If you are an issuer, you earn revenue in three ways. One, interest outstanding balances on credit cards, and ; two, you get annual fees (or some kind of fee) from your account holders; third, you get a revenue flow from interchange, it’s part of the revenue that the acquiring bank collected.
- If you are an acquirer, you get terminal rental fees, you get a merchant discount or a merchant service fee, and you get other fees and expenses that relate to the account.
- If you’re MasterCard, Visa or any other scheme, you get fees that you charge to your members or your customers, whether you’re the acquirer or the issuer. These fees can be brand fees or processing fees. Every time the card is used (with a brand on it), there is a fee, whether or not it got cleared through the system.
What’s the interchange fee? Interchange is simply an internal transfer within the system; it creates no new revenue; its simply the revenue that is already there being transferred from one party to another. In case of a PoS transaction, it’s transferred from the acquirer to the issuer. In case of an ATM transaction, it’s transferred from an issuer to an acquirer. But it’s not new revenue.
The risk element and the interchange fee
For context, an on-us transaction is a transaction where the acquirer and the issuer are the same bank. It’s the same kind of transaction that you see in the three-party system with American Express, where the acquirer and issuer are the same organisation. It [the issuing/acquiring bank] has to cover the risk that it won’t get paid. There’s some financing risk, it has to carry that transaction from the time that it gets it until it either starts getting interest for it, or it gets paid.
When the bank gets it, it has to keep track of the acquiring and issuing business, and it will do an internal transfer of some of this revenue on the acquiring side or the issuing side, because it’s the issuing side that incurs the cost of risk, of financing and some of the other processes.
Let’s take the National Bank of India (for example), the main bank of India, and Citibank in New York. You go to a restaurant in New York and you give your card to the restaurant, the restaurant then deposits it’s money at Citibank. Citibank charges the restaurant 2%. Part of that 2% is to cover risk and processing, let’s say its 1.25%.
But it’s the bank in India that incurring the risk. So, Citibank has to transfer 1.25% from itself over to the bank in India, and it does this through MasterCard, Visa, or AmEx. That’s the interchange fee.
So, when someone says they want to reduce interchange fees, that’s wonderful as long as one can reduce the risk and reduce the processing cost. But if you can’t, the issuer has to find some other place to get their revenue.
How is an interchange fee decided?
Interchange fees is calculated on the industry average; so it’s the average losses or the average processing cost. Most small merchants can’t afford to have such a system; and also probably have losses that are a lot higher than the average.
What does the interchange fee do?
Within the payments system, there can also be some flows; for example, the interchange fee is a flow from the acquirer to the issuer to cover costs that the issuer has, where the revenue of the system came in from the merchant. So all it does is matching cost and revenue within the system.
- The acquiring bank is gives you the money for servicing a customer, and therefore, payment networks compensate for transfer from the issuer to the acquirer, to pay them for servicing the customer. Interchange fees are just fees within the system, tends to be, it matches revenue and expense.
60% of credit card holders (which only make about 50% of the sales) are revolving. The risk of that 50% that revolves is more or less twice that what is built into the interchange fee. For a very large number of the card or account holders, the scheme is actually subsidizing them.
As long as we do it on an average basis, then there is going to be some subsidization that takes place. But it’s probably subsidizing the right people, the people who are revolving, the people who can at least afford to pay are getting a deal. If they were being charged the merchant discount rate that reflected their actual risk, it would be much higher.
What’s the relation between interchange fee and Merchant Discount Rate (MDR)? The MDR is not dependent on the interchange fee. Some large merchants like Walmart are able to negotiate pass-through arrangements whereby their merchant discount rate is the sum of the interchange fee for their transaction; some kind of a processing fee and profit for the acquirer.
The cost also involves investment in system security, and why it adds to fees
Because a credit system doesn’t have a big risk factor associated, it’s one of the reasons it’s cheaper. When somebody steals money from the credit card, it is generally not your money, you can get back. When they steal it from your debit card, it is a lot harder to get it back because it’s your money. The investment in in security around the debit system is very important in terms of providing the guarantee to the merchant. Its the cost of this that’s in the MDR or interchange fee.
Why do we have aggregators in the system? How crucial is interchange fee to them? Because you need an entity to get merchants for you, because it would either be cheaper than getting them yourself, or that isn’t the business you are in. In that case, the merchant discount will be allocated at the frontend. The acquirer and aggregator have a separate deal and generally speaking those are going to be smaller merchants, who are going to tend to have higher merchant discounts.
If you are an acquirer and this revenue is reduced or goes away, your cost didn’t change and you have to get revenue from somewhere.
The scheme is providing a system that hangs together, it’s providing innovation that it being take for granted. But they’re essentially doing two things, they are switching, and providing extra services which you pay for, and they’re providing a brand so that when you walk in to a store, you can use your card.
What about data collection and personal data? Networks like whether Visa or MasterCard have no idea who the individual is, because all they see is the 16 digit number, and amount, time of transaction, and merchant name. They have absolutely zero knowledge; the card issuer has those details.
The rates in Merchant Discount Rate
Merchant discount predates the interchange fee. We always had merchant discounts even if we didn’t have interchange fees. Merchant discounts and interchange fees, predates reward programs.
The highest interchange fee is probably in the US and in Latin America and there are probably on an average of 1.7% or 1.75%. Rewards are paid for generally by some kind of a fee that the issuer is charging the card holder. To get a reward, you have to transact a certain amount. As payments get more digitised, merchants’ visible cost of payments goes up because everyone of those payments now has a MDR associated with it. It’s a line item, every month a merchant has to look at it. When there’s a cash transaction, they don’t see any line item, so they are going to see an increase in their payments cost. But that is good thing from everybody’s point of view, as long as the benefits of acceptance are higher than the cost.
What’s the value merchants get to shift to digital payments? When a business shifts from only accepting cash to accepting electronics, the average transaction goes up 10-15%. A debit card user is constrained only by what’s in their current account. A credit card customer by what they’re open to buy. If you are cash customer, you better have it in your pocket. We see incremental transactions coming from bigger transactions and more transactions.
How does data localisation affect operations on a global level? All the data relating to the transaction, including personally identifiable (PII) data lies here at the card issuer level, so RBI already has this data available through the financial institutions they regulate. But by localising data, you will create islands. Leveraging artificial intelligence on a global superset of data is how networks are able to respond more quickly and proactively.
In a global network spread over 210 countries, with over 2500 financial institutions, networks can triangulate and find the point of compromise proactively. When you start localise data and parse it out, the data that is not included as part of that super set is at risk, and hence consumers will be at risk.
The affect of data localisation on fraud prevention
Fraudsters are global and very organised. You can almost guarantee that extent to which payment networks have to fight fraud issues daily globally will go up as soon as you parse out and localise data. It will go up, it has to.