America's small business owners have long endured a broken credit-card and debit-card processing market and its attendant ills. Visa (V), MasterCard (MA), and issuing banks have long charged merchants interchange—or "swipe") fees every time a consumer makes a payment with a credit or debit card. The fees are excessive for merchants of all sizes, but tier pricing disproportionately affect small companies because their transaction volume is lower than that of their large competitors.
Relief is finally at hand, at least in terms of debit cards. Last year, Congressional reforms required the Federal Reserve to ensure that interchange fees charged for debit-card transactions were "reasonable and proportional" to their actual processing costs. To the great relief of the small business community, the Federal Reserve issued a proposal in December to implement the new law by July 2011.
If enacted, merchants' swipe fee costs will drop considerably, from the variable percentage-based cost (an average of 1.5 percent of every transaction processed) to a fixed cost of 7¢ to 12¢ per transaction. What small business owners see as relief, however, MasterCard and others have begun referring to publicly as a type of "price control" that stifles a competitive market. The claim is remarkable, given that the whole interchange system was built on industry price-fixing perpetuated by an anticompetitive market.
Swipe Fees Tripled as Costs Plunged
For more than 40 years, Visa and MasterCard focused their business models on their ability to centrally set the swipe fees that card-issuing banks charge merchants that accept their cards. Since merchants pay these fees to the banks, the banks sought to issue the cards with the highest fees. This led to a price war of sorts between Visa and MasterCard: Which company could set the highest fees?
For example, Visa sets its swipe fees high enough to entice banks to issue more Visa cards. In turn, MasterCard raises its swipe fees to get banks to issue more MasterCard cards. "The fact that Visa and MasterCard have market power over merchants—but compete for issuers—implies that they have strong incentives to exploit their market power over merchants to subsidize issuers," Georgetown Law professor Steven C. Salop and co-authors wrote in a 2010 report. This perverse form of "competition" resulted in a tripling of swipe fees since 2001, according to the Merchants Payments Coalition. To repeat: Fees more than tripled in less than a decade, just as technological advances slashed the processing costs for credit- and debit-card transactions to roughly a penny.
In a functioning market, competition drives efficiency. To be successful, one business must either offer a better-quality product or service to a customer at an equal price or provide the equivalent quality at a lower price. Businesses succeed or fail based on their ability to compete in such a market, with consumers benefiting from the outcome. In the broken electronic-payments market, the incentives were reversed. The market failed.
Why did this situation persist? Because Visa and MasterCard together represent more than 80 percent of the market. The sole meaningful competition in this "market" was to see which card network could raise its fees to the highest level.
Pay Plastic Rates or Settle for Cash
Merchants sign a contract when they decide to accept credit and debit cards, requiring them to agree to all current and future operating rules. This leaves merchants with the extortive choice of accepting plastic and all the fees that go with it or declining to accept plastic altogether, which in today's economy is not much of an option.
For decades Visa, MasterCard, and the biggest banks have profited mightily—to the recent tune of about $48 billion a year—from this anticompetitive market. (Be sure to peruse this release about the related lawsuit filed by the Justice Dept. in October.) With Congress and the Federal Reserve finally attempting to introduce some semblance of balance to the market, you can be sure that the big banking lobby and its allies on Capitol Hill will be pushing for a return to the lucrative, anticompetitive status quo.
They will decry "price control," only so they can resume their own cartel-like price-fixing. Those who believe in competitive markets should ignore their cries: When you zap a cash cow, you must expect mooing.