Mandated reductions in interchange fees in Australia were supposed to cause retail prices to drop, directly benefiting consumers. Instead, interchange regulation has redistributed wealth in favour of merchants, with no other tangible benefits. The whole idea is that interchange is a “hidden fee” that retailers bundle into their prices, and that a reduction in fees charged to merchants would benefit customers. Sounds like basic, logical thinking that you would find in a high school economics and civics class, doesn’t it? As it turns out, the regulatory experiment resembles a high school lab experiment gone wrong.

Here’s another report, this one by CRA INTERNATIONAL (summary,detailed report) that shows how mandated reductions in interchange fees have had the opposite effect of those that regulators were expecting. Retail prices are not lower. Instead, merchants enjoy stronger margins thanks to the lower cost of accepting cards. To make matters worse, banks have pretty much recovered their lost revenue by charging higher cardholder fees and cutting investments in payment innovation. Customers are the losers in this messy experiment.

Robert Stillman, Vice President of CRA INTERNATIONAL, writes, “We believe that the RBA’s intervention has redistributed wealth. There is no evidence that the undeniable losses to consumers from higher cardholder fees and reduced card benefits have been offset by reductions in retail prices or improvements in the quality of retail service. The RBA’s intervention has redistributed wealth in favour of merchants.”

The worse thing about this is that European Commission watchdog Neelie Kroes sees the Australian experiment as a success and wants to reproduce it in Europe. This makes me feel more and more that regulators are simply reacting to pressure from retail lobbyists, cloaking their decisions in some vague benefit to customers (and in Europe, some vague need to create a European payment scheme to compete with US brands Visa and MasterCard). I can’t for the life of me see why any regulator would possibly be doing this if they were not primarily interested in helping retailers improve their margins. What a mess.

At the same time, I can understand how merchants feel powerless as they see interchange fees imposed upon them with no ability to negotiate. “You don’t like our fees? Then stop accepting our cards.” That’s not the right answer. The irony is that a viable solution already exists in a growing number of countries. Leaving fees unregulated, but giving merchants the ability to easily surcharge card brands which are too expensive in relation to their value, creates a powerful incentive for schemes to make their products and services more useful to merchants. In response to this pressure, and to avoid having their cardholders subjected to surcharges, some payment brands will manage to create enough value to convince merchants to accept the higher fees, while others will simply have to reduce their fees. In practice, customers should see little if any surcharging, and merchants will get more value for their money.

This solution is echoed in a Wall Street Journal article by economist Leo Van Hove, titled “Regulating in the Dark”. Mr. Van Hove first tears apart the arguments for interchange regulation put forth by the European Commission, then offers the following conclusion:

“So if regulating one payment instrument can have unintended repercussions on substitutes, and a prohibition of interchange fees would be a leap in the dark, what are enlightened policy makers to do? They could simply try to ensure that market forces work, and in particular that merchants cannot be locked in by card networks. To that end, retailers should be allowed to ‘surcharge’ and pass on interchange fees to consumers. Promoting competition among card networks as well as among various payment instruments should also be high on regulators’ lists. More generally, we need policy makers who have a comprehensive vision of the future of our payment system – and who have the political courage to make cash more expensive in order to lower its cost to society.”

Here is a link to my prior post on why an unregulated interchange model is crucial to fostering competition between payment schemes, where I describe several ways in which payment schemes can innovate and create valuable new features and services for merchants.