Should Credit Card Transactions Be Free? There May Be A Way

Written by Todd L. Michaud
November 3rd, 2009

Franchisee Columnist Todd Michaud has spent the last 16 years trying to fight IT issues, with the last six years focused on franchisee IT issues. He is currently responsible for IT at Focus Brands (Cinnabon, Carvel, Schlotzsky’s and Moe’s Southwestern Grill).

Envision a world where credit card transactions are free. How could we accomplish such an outrageous feat? Well, crazy things can happen when you start to apply IT problem-solving initiatives to business issues.

I just finished reading “Free – The Future Of A Radical Price” by Chris Anderson. Chris, the author of “The Long Tail,” discusses how several factors–including the constant reduction of technology costs–have enabled companies to give away valuable services to their customers. Examples include Google giving away search functions and videos on YouTube, eBay giving away free phone calls with Skype and Linux as a free version of Unix software. But for some reason, the costs of processing credit card transactions have been immune to the same trends that have provided free versions of far more complex technology. Why?

Somehow, the system has evolved in a way that primarily protects the banks at the expense of retailers and, ultimately, customers. From a purely technological perspective, credit card transactions should cost a fraction of what they actually do. Moore’s Law, loosely translated, states that the cost of technology will reduce by roughly 50 percent every 18 months. If this law is true, then why, after decades of credit card processing, does Home Depot pay more for credit card processing than it does for employee healthcare benefits?

A credit card transaction is fairly complicated and involves several different organizations/people:

  • The issuing bank: The bank that provides the credit card to the consumer.
  • The cardholder: The person who uses the card to make purchases at various retailers.
  • The merchant: The retail organization that accepts the credit card in exchange for goods or services.
  • The acquiring bank: The bank that processes the credit card transactions.
  • The bankcard association: Visa, MasterCard, American Express, Discover, etc.

    What is the big problem in this ecosystem? The merchant is the only one hit up for a fee to process a credit card transaction. The merchant pays a “merchant discount” to the acquirer, which then splits up the fee among itself (processing fee), the issuing bank (interchange) and the bankcard association (assessments). In the case of credit cards that offer rewards programs, the merchant also funds these customer perks through a forced higher interchange fee. Ridiculous! So how do we change it?

    Interchange rates should be demolished.
    Issuing banks will no longer be paid an interchange fee; instead, a transaction processing fee will be charged to manage the costs of providing authorizations, settlements and money transfers. The rate should be about equal to the current ACH transaction costs, which should serve as a good benchmark for the costs associated with moving money between two bank accounts. Rewards programs would then be completely funded by the issuing bank.

    Remove Overhead From The System.
    In this crazy New World, the bankcard associations are no longer in the transaction processing business. With 88 percent of all cards issued by the top 10 issuing banks, the acquiring banks should process directly with each issuing bank. They will take on this responsibility in exchange for lower assessment fees.

    Reduce Costs Through Improved Efficiencies.
    And what about the acquiring banks? Because their job will also be one of transaction processing, they will earn a flat monthly fee from each merchant rather than a transaction fee. A flat monthly fee? That is crazy talk! Now, imagine travelling back in time to 1999 and telling Michael Armstrong (then CEO of AT&T) that in just 10 years an Internet company would offer unlimited calling to anywhere in the world for just $24.99 per month. (Vonage recently announced this plan.) I’m pretty sure he would have told you that you were nuts.

    Subsidize The Remaining Costs With Someone Who Gains Value.
    OK, but I said that in this crazy New World credit card processing would be free. Except that the previous examples still add costs. Granted, this solution is a ton better than where we are today. But you were promised free. So, how do we get there? I’m going to leverage more of what I learned from Chris Anderson and his book. In the book, Chris discusses the concept of “free” as a “three party market,” where a third party subsidizes the costs of providing the goods or services between the merchant and the consumer.

    An example is how TV stations can offer you free programming in exchange for broadcasting advertisers’ commercials. In our crazy New World of free credit card transactions, we are going to subsidize the costs of credit card transactions by leveraging a three party market. So how do we do this?

  • Sell Receipt Space.
    Acquiring banks can work with merchants and POS companies to pass along small “banner ads” that are displayed at the bottom of each receipt. The merchant has the opportunity to set parameters for which ads are displayed to avoid conflicts, such as making sure that no competitors’ ads are run. In today’s media-heavy world, eyeballs are worth money.
  • Sell Signature Banners.
    Let the acquiring banks display small banners that are placed above the spot on the electronic signature pad where a customer signs for credit card purchases. This option could be used in conjunction with selling receipt space.
  • Sell Data.
    Allow marketers to access information about spending at your location. Each company would be aligned with a central catalog of different merchant types. The transactions would then be categorized and aggregated in a central system that can be used by marketers for a fee.
  • Sell More Data.
    Provide the line-item details of the transactions to a centralized database. The products and services would also be categorized and aggregated from many merchants. Although most large organizations would not dream of giving away such intimate data, thousands of small businesses would be happy to provide the data anonymously (only the industry would be required) in exchange for lower transaction fees.

    That’s my case. It feels a little like a Sprint/Nextel commercial doesn’t it? (What if IT people ran the world?) Find major holes in my theories? Disagree with the concept? Love it like RockBand? Let me know:

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    21 Comments | Read Should Credit Card Transactions Be Free? There May Be A Way

    1. Jim Johnson Says:

      The one big factor not mentioned in this article is who will take over the risk ?

      Taking credit cards is risk free to merchants and the issuing Banks take the risk if a customer defaults on the payments !

      If you had a “interchange free” payment system will the merchants assume the risk ?

      Also, if there isn’t enough profit for the issuing banks they will stop issuing credit cards which will in turn kill our economy.

    2. Todd Michaud Says:

      Thanks for posting. Let me start with a question. If a home-owner defaults on the mortgage, who is taking the risk? The bank making the loan to the consumer or the person selling the house? It is obviously the bank that takes this risk and is rewarded for that risk through interest rate charges.

      In my mind, we have mixed together two distinict and unrelated transactions. One is the bank that has agreed to lend the consumer money, with it’s own set of terms. The other is a consumer agreeing to pay a merchant on another set of terms. Just because the banks have made it easy for the consumers to access borrowed money (credit cards), does not in my mind mean the merchant should help offset the costs of the risk.

      The merchant is using the system to process a payment transaction, not to help more people have more credit card and higher limits. “Traditional Lending” institutions have existed for years without puting undo pressure on the merchants. Why are credit cards different? Maybe if the merchants stopped funding the “risk”, then banks might be more careful about who they loaned money to, and what interest rates they charged. This is similar to what happened with the mortgage industry. I personally don’t think that would be a bad thing.


    3. Bryan Larkin Says:

      I think Todd has some very valid points. I’ve wondered for years why the price of transactions has been so high. Phone companies long ago started offering unlimited calling for flat rates because they understood that in many cases it cost more to report on the transactions (calls) than it did to fulfill them.

      The reporting is still needed in the credit card space, but the reporting costs have dropped significantly. The costs have been running to zero. And, yes, selling aggregated data, including what products are bundled with others and when in the day/week/month/year they are purchased would make a bundle.

      I’ve always thought the risk in credit card usage was reflected in the credit card lending rates. If it isn’t, it should be. If the bank wants to lend, it shouldn’t care where the user shops.

      On the other hand, if certain stores are known to have a higher than normal rate of invalid transactions (not checking card owner carefully enough) their flat rates to process might go up or they could be dropped from the ranks of those allowed to take cards.

      I think this makes a lot of sense and it will take only one bank/association combo to attempt this before everyone falls into line.

    4. Dan Stiel Says:

      Accepting credit cards are not “risk-free” for merchants, contrary to Jim’s comments above.

      Chargebacks are an expense – both in terms of actual transaction reversals and costs associated with managing the process.

      Chargeback rules and expenses can be everything from a thorny issue to an onerous expense for some merchants, especially for convenience stores that allow customers to pay for gasoline at the pump, or other retailers that allow in-store self-checkout options.

      One of our clients, a major retailer, writes off over $500,000 in chargebacks monthly for a host of reasons.

      From the merchant’s perspective, chargeback rules range from reasonable to ridiculous. While an argument can be made that the risk of accepting plastic over checks and cash may be lower, it is by no means risk-free.

    5. Jestep Says:

      Another factor not mentioned here is the impending costs that the processors and issuers are going to incur when someone decides on an end-to-end encryption method, and it then becomes government mandated. I can guarantee that this is a when question and not an if question.

      The back-end networks are pretty antiquated right now, and it’s going to cost billions to replace everything.

      The cost of tech may be going down, but the cost of replacing millions of servers and hardware, and creating new, proprietary, software is still really expensive.

      As to my argument against free, I don’t think it’s a sustainable business model. Google has shown us that just about everything can be commoditized. One of their biggest failures has been “Google Checkout” as it has never gained traction, and they went to a paid model. Granted they couldn’t get rid of interchange, but their system never took off even when it was free…

      Once people get completely desensitised to a particular advertising medium, it rapidly deteriorates in effectiveness. Why would anyone consider putting something so important at risk? Google realized this a while ago, which is why they’ve entered so many more industries to get a foothold.

    6. Todd Michaud Says:

      Jestep, if it is true that the current transaction processing systems are antiquated, then it should also be true that they have been “written down” for some time and that most of the fees collected have been pure profit. My guess is that while “antiquated”, singifincant investment is still being made and it is probably somewhere in the middle

      I agree that e2e-e and tokenization will increase costs, but I struggle to believe that Google can offer an hour long video for free, but it cost $1.76 to process a credit card transaction. (Mastercard said their average interchange rate is 1.8% and in 2006 the average credit card pruchase was $98 according to the US census burearu survey) Something is out of whack.

      I am not advocating the financial system start giving processing away completely free, I am saying that it should be reduced significantly and then subsidized with other services.

    7. Payments Guy Says:

      An interesting idea, and a fun mental exercise, but it flies in the face of practical reality. It’s not just the stakeholders that prevent free processing. The system evolved as it did because it was the best solution the market could design.

      I’ll take just one of your points – replacing the associations with issuers and acquiring banks – to point out several reasons why this is the case.

      – While 88% of cards come from 10 banks, the rest come from hundreds of other banks who would suddenly, by decree, be out of that line of business.
      – The associations provide a single, common source of connectivity to those hundreds of issuers. Even if there were only 10, every merchant procssor would have to maintain 10x more connections, which would inevitably splinter in terms of message requirements. Costs would go up, not down.
      – Issuing banks are not always in the acquiring business, and don’t want to be.
      – Merchant processing is not the same as acquiring. In many cases, acquiring banks are not in the merchant processing business. In fact, the largest merchant processor, First Data, is not a bank. Among the largest issuers, I believe that only Chase and US Bank have wholly owned merchant processing operations.

      The simple reason that interchange persists is simple: because merchants get value, and they will pay for it. It’s expensive, and they may not like it, but ultimately the benefits outweigh the costs. That’s not to say that there isn’t room for improvement, but in this case, free is not the answer.

    8. Mark Hudnall Says:

      This may be the craziest idea I have ever heard. “Free” payment processing. Along with the risk already mentioned, there would be no incentive to become an ISO or to service the merchant. WHY? There would be NO PROFIT!! If there is no profit, who is the merchant going to call if they have issues? Who is going to pay for underwriting, tech support, risk management, etc?

    9. Mike Vizcarrondo Says:

      Without interchange, which card will my bank offer me Visa or MasterCard? How will they decide? How will Visa & MC compete with each other to create innovation?

      I see not mention here of the global footprint that Visa, MC and Amex have developed. Take the associations and interchange out and you need to find a way to compensate thousands of bank customers from all over the world in multiple currencies. Don’t expect every country to follow one government’s rules….

    10. Whitney Says:

      The fact is until the Bankcard Associations are regulated by our government, no costs will go down. In what other industry do we allow a company to not only set their own fees and rates, but to decide how the cards, that they are issuing, come in? Visa has a multitude of different downgrade reasons so even if a merchant processes a credit card correctly the association can, and more than likely will, find some way to say the transaction was incorrectly processed and downgrade the transaction. Food for thought- Visa actually penalizes retailers who process credit cards for tax exempt customers, if no tax data is submitted to the association during the transaction Visa then takes a perfectly good transaction that easily should have only cost a merchant 1.56% and they downgrade it to cost the merchant over 2%. Visa and MasterCard try to establish that their fees and rates are low and that very few of their rates are increased, however what they actually do is leave the “rates” stagnate and add a million tiny 1 cent fees for anything that they can possibly think of. Visa and MasterCard not only charge a percentage of the transaction, based on the type of credit card used, they also charge $0.04 for the authorization, $0.04 for the transaction, $0.10 if it is processed using the internet, and then the assessment fees on top of all of that,as well as many more fees that would take an entire book to type. Again, until Visa and MasterCard are called out for being the Monopoly that the are, this entire conversation is a moot point.

    11. Deborah Baxley Says:

      Todd- I like the concept. The current model is unsustainable and a renegade player will likely topple it eventually. The root cause of escalating interchange is to fund cardholder reward programs – our airline miles or whatever. This makes us loyal credit card customers but does not benefit the merchant. An emerging business model is merchant-funded reward programs. In this case, the points you accumulate for using your credit card are supplied by the merchant you are shopping at, providing you further incentive to shop there. This results in a 3-way win for consumer, bank and merchant. 2 examples of this business model are and
      Commenting on some earlier posts:
      • Credit risk is covered by the interest on the outstanding balance, not by interchange
      • In addition to transaction processing, interchange funds fraud risk and other cardholder benefits such as zero liability, chargeback/dispute processing and corporate card reporting
      • Disputing Jestep’s comment – end-to-end encryption will not be mandated by the government. The weak link in the payment value chain is the mag stripe card. The US will improve its infrastructure by moving to contactless payments, which are secured by “dynamic cryptogram” far less susceptible to fraud, and then evolving to contactless EMV. The reader upgrades are only a couple hundred dollars per POS
      • Removing card associations from the equation (for point-to-point card processing among banks) would compromise international acceptance of our credit cards, in addition to eliminating smaller banks from the business
      • Our government is not likely to regulate interchange, but the reputational damage being suffered by banks may provide a powerful incentive to collaborate more with merchants

    12. Ken Boekhaus Says:

      The cost of transactions would shrink rapidly if merchants were allowed to surcharge the cost of the transaction to the purchase. The bankcard associations have prohibited such a practice because they know that their margins would shrink dramatically if there were price competition introduced.

    13. Todd Michaud Says:

      I want to thank everyone for their feedback. This has been great.

      I intentionally took an extreme opinion in this article to make a point. For the last seven years I have been working with thousands of small business owners, franchisees, who have very stong opinions about credit card fees. The majority of franchisees that I have supported believe that credit card fees are a huge issue. In this business, with this economy, 1.8% (the average interchange) can be the difference from earning an living and going out of business.

      From a pure technical perspective, a credit card purchase “should be” nothing more than a database lookup (auth) and write (settle). While it needs to be done securely, and involves several different entities, at it’s most basic, it should be two database queries. I have a hard time believing that it costs more than a penny or two to process. So why do merchants pay so much more? For the matter, why do the merchants pay at all?

      Considering how big of an issue this is to so many people, I think it’s time we starting challenging the status quo and “thinking outside of the box”. Hopefully this article provides a good starting point.

    14. Greg Says:

      Enact a gigantic national sales tax and/or value-added tax, but call it a convenience fee.

    15. Trey Gourley Says:

      As a developer of business ecommerce sites, I can tell you that the number one sticking point for my clients are the credit card fees.

      Unfortunately, you cannot “tell” a company with a current pricing structure that they are charging too much without leverage.

      Your example of cell phone charges ($50-100 for unlimited talking and no long distance) only came about because of the introduction of that service by other services (Skype, instant messaging, email, who knows…). There are still some cell phone services that have not been challenged and still exists. Such as paying $0.25 for a text message or an extra $50 for 1GB of data transfer for internet usage.

      We need to find a challenging technology for payment processing (could be totally different). But I think you mentioned the “key” at the beginning of your article… find something “cheaper”.

      “Free” is an illusion. Don’t charge one person but charge double to someone else. I am very skeptical on anyone who says that advertising will create valid cashflow. Just look at the advertising struggles in a TiVo world. And if you sell your customers data, just be warned that the one group that might have issue with that are you customers (which to me is very important to cashflow.)

      Great article to get the mental juices flowing!

    16. Mathieu Says:

      Coming into this thread a bit late … but still …

      This is a very interesting proposition. And has well been pointed out “free” is not truly so, but just about finding a different way of paying the same fee. Especially if you accept that there will always be a need for some kind of merchant handling fee.

      The advertising model IMHO has legs, especially for larger retailers who can sell the space to their suppliers. Many grocery stores already work with the principle: it’s another version of the automatic check-out coupon. The database variant would likely encounter too much consumer resistance to be viable (“opt-out” possibilities would be needed, introducing all kinds of hassles and inefficiences).

      Here in the Netherlands, where the population is notoriously penny-pinching, credit card acceptance is amazingly low. It’s both a result of the consumer not wanting to pay interest on everyday purchases as well as merchants not giving up a slice of the action. It is both legal and common to pass the processing fee onto the customer as a surcharge.

      End result is a payment system that prefers a variant of lower-cost direct bank transfers for internet purchases and debit cards for in-store. Yes, it reduces the risk to all parties (thus cheaper) … but unless you offer in-store financing, it makes it more difficult to sell-up a purchase or do any other impulse selling.

      And heaven forbid you should get a tourist in your shop … most foreigners leave with the perception of NL as one of the most customer-unfriendly places going. It’s not exactly legendary for customer service in the first place, and making it difficult to pay is the straw on the camel’s back for many.

      Now things are moving to leave the credit cards behind: mobile phone payments are becoming more and more common here, and the transaction fees are minimal. Parking and entertainment (movie/concert tickets, nightclubs) have been amongst the first, and it’s rapidly gaining momentum because the market has been hungry for the convenience at a price it is willing to pay.

    17. Kem Owen Says:

      I strongly believe the use of credit cards is strictly a convenience for the buyer/customer, not for us merchants. Any and all costs, including the hardware for processing, should be the at customer’s cost, through the processors and card givers.

      If anything, we should be given a fee for accepting the card, not charged one. Allowing laws against charging customers for card use should never have happened. Lets get behind a law to make them pay us for allowing card use.

    18. Todd Michaud Says:

      The more conversations that I have on this topic, the more that I realize how big of an issue it is for merchants, and how little everyone else (the payment industry or consumers) understands how big of an issue that it is.

      The fact is the now that electronic payments are so much a part of life, the fees associated with the process are out of line with the value received. Something’s got to change.

    19. Evan Schuman Says:

      Agreed, Todd, but with a nitpick. You said “….the more that I realize how big of an issue it is for merchants, and how little everyone else (the payment industry or consumers) understands how big of an issue that it is.” Your consumers comment seems offpoint. How many consumers understand PCI or interchange rates at all? The lack of comprehension among consumers is understandable and not really a concern. It’s the way it’s expected to be. But the lack of understanding among the payment industry, now THAT’s a great concern.

    20. Todd Michaud Says:

      Agreed. The lack of comprehension from consumers in understandable. The lack of understanding in the payments industry is more than concerning.

      Typically this conversation with ‘everyday consumers’ involves talking about how retailers are doing in the recession. Invariably the topic of rising prices for smaller quantity comes up. In these conversations, I often bring up the fact that as money get’s tighter and more and more consumers charge their purchases, it has a negative impact on the retailers profitability. This is not something that most consumers think about (at least often).

      When I quote a typical amount that a restaurant might pay in a year for credit card fees, most people are blown away, never considering how impacting those fees are. While the merchants are responsible for paying the fees, the consumers are the ones who actually pony up the money in increased prices.

      The reason that I think that the consumer angle is important is because if there is to be a disruptive technology in this space, it will have to gain wide-spread consumer adoption. If there is no value for the consumer, they are unlikely to adopt a new platform. I think that at a minimum it will have to be “I can sell things at a lower cost if you agree to pay me with a less expensive currency”

      I do believe that this space is right for a disruption.

    21. Merchant Services Says:

      It has yet to be seen if new ideas will float long enough to work such as the “evolution” card. It took Discover long enough to get noticed and even they are playing third or 4rth wheel to Visa and MC.


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