Interchange is a relatively niche area in card payments. Understanding of the topic amongst the general public is minimal, and rightfully so.  Surprisingly, misunderstanding of interchange is also commonplace in the payments industry.  This general lack of understanding on interchange can partly explain the media’s negative reporting on the news this week that Mastercard plans to increase interchange fees from October 2021 for Card-Not-Present (CNP) transactions acquired in the EEA and made using UK-issued cards.  Whatever your position on the UK’s exit from the European Union, it is incorrect to paint this interchange increase as an unmitigated negative. 

Let us take a quick look at interchange to explore the relevance of this development.  Interchange is a transaction fee paid by the acquirer of a card transaction to the card issuer.  The theory as to why it is necessary is that acquirers’ costs to provide payment services to merchants are lower than issuers’ costs to serve cardholders.  Issuers have no direct commercial relationship with acquirers, so interchange is used to address the cost imbalance within the four-party model.   

Interchange must be set at the optimal rate to incentivise growth on both sides of the four-party model.  Issuers bear the cost of card issuance, fraud if the liability shift is applied to a given transaction, and other costs such as account maintenance or credit losses depending on the card type.  If issuers’ fees to cardholders were too high, they would disincentivise card adoption within their customer base.  Acquirers provide acceptance technology (e.g., POS terminal), as well as a payment guarantee (supporting by the card schemes), and other services to merchants.  Merchants pay a Merchant Service Charge (MSC) for these services.  MSC consists of interchange, network fees and acquirer margin.  If MSCs were too high, acquirers would disincentivise adoption of POS terminals in their merchant base.  A careful calibration of interchange that considers price elasticity on both sides is required to set rates at a level that is equitable to all parties. 

Interchange is regulated in Europe but is typically not elsewhere.  The Interchange Fee Regulation (IFR) introduced by the European Commission (EC) in 2015/16 capped interchange in the EEA (including the UK) at 0.3% for consumer credit cards and 0.2% for consumer debit cards (including prepaid cards) for domestic and intra-regional POS and CNP transactions.  Outside of the EEA, the card schemes typically set interchange rates for transactions within their network[1]. 

The IFR caps decreased revenue for issuers in the EEA significantly.  Estimations of the annual decrease in interchange revenue for issuers after the introduction of the IFR vary between ~€3bn and ~€5Bn per annum[2]. This decrease in revenue has been a huge challenge for issuers, and particularly for established FinTechs and challenger banks struggling to move towards profitability.  It has also made it more difficult for fledging FinTechs to create a positive business case to go to market.

The UK is no longer in the EEA and the IFR no longer applies to cards issued in the UK.  Card schemes have the right to set interchange rates for cards issued outside of the EEA, as long as those rates comply with agreements in place with the EC for transactions acquired in the EEA.  Mastercard’s recently announced increase in interchange on UK-issued cards is consistent with this approach.

From October of this year, UK issuers will receive more interchange revenues on CNP transactions acquired in the EEA.  Overestimating the importance of the interchange revenue increase to most issuers is a possibility.  Cross-border CNP transactions constitute a very small proportion of most issuers’ transaction volumes.  A notable exception would be challenger banks and FinTechs such as Revolut or Caxton whose value proposition is largely predicated upon alleviating cross-border fee pain points for their customers.    

The tone of the media’s response to the Mastercard interchange increase was alarmed and negative, inferring that the primary, if not sole, impact of the increase in interchange will be to cost UK consumers more.  This conclusion is questionable at best.  The increase in interchange can in fact be understood as a positive when its impacts throughout the payments and retail banking industries are understood more holistically.  

Increased interchange will mean competition in the UK retail banking market will continue to improve, reducing the systemic risks to the market that were made evident during the Global Financial Crisis (GFC) of 2008/09.  Issuers in the UK will welcome the revenue increase.  Issuer-side FinTechs in the UK will receive much-needed revenue that will hopefully contribute to their move towards profitability and sustainability and new FinTechs may even launch with a business model targeting this cross-border CNP channel. 

The current crop of successful challenger banks and FinTechs was originally encouraged to enter the market through the introduction of Electronic Money Issuing (EMI) license.  EMI licenses were developed to stimulate improved competition in the European retail banking market following the GFC.  Increased competition was necessary in the UK market more than in most others due to the high risk of systemic failure of some banks during the GFC.  UK FinTechs and challenger banks have expanded to other European markets and have increased competition there also. 

Increased competition leads to lower costs for consumers and improved choice in products and services.  FinTechs and challenger banks offer a lot in terms of improved customer experience and the provision of innovative products and services that are targeted to specific customer segments.  For example, FinTech is a positive contributor to increasing financial inclusion in underserved consumer segments and increasingly helping Small and Medium-sized Enterprises (SMEs) to reduce banking costs. 

Overall, Mastercard’s announcement should be perceived as a positive step for the issuing industry and for UK and European consumers who will continue to benefit from a more diversified retail banking market than they had pre-GFC. 

Conchur Gill is an Associate Partner in Be | Shaping The Future.  He is a strategy consultant with expertise across the payments ecosystem.

[1] This is a general ‘rule of thumb’ but there are exceptions.  Note that the approach to calculating interchange varies by card scheme.

[2] Taken from a number of sources, most prominently the EY study into the impact of the IFR commissioned by the EC