common ground
  Does the
  Money Go?

     Analyzing Merchant
     Discount Rates & Fees
by Greg Cohen

    The rates merchants pay to accept credit cards have recently come under much scrutiny. The media has been filled with reports of alleged collusion and price fixing. Merchants have complained publicly and filed a number of well-publicized lawsuits. As a result, both businesses and the public are now much more aware of the costs of accepting credit cards. As Acquirers and ISOs, we are in the trenches, feeling, hearing and seeing our merchants’ pain every day. Many often complain to and even blame us for the high costs, or pressure us to lower our rates and fees. In the midst of this environment, it’s only natural to wonder exactly where the various fees go, and how much of the situation we can actually control.
    The average merchant cost to process a credit card transaction is 2.99%. This fee can be broken down into three primary categories: 1) Issuer costs, in the form of interchange; 2) Visa and MasterCard network fees; 3) Acquirer costs. Together, these three components make up the total cost of accepting a credit card.

    The card issuer derives the majority of its revenue from interchange, revolving balances and other fees. The latter two costs are charged directly to the cardholder while interchange is paid directly by the merchant. According to First Annapolis, the average interchange cost for a merchant is 1.95% of the purchase price, or 195 basis points (bps). This includes all downgrades and the per-item fees associated with interchange. These 195 bps, as well as the issuer’s other revenue streams, go towards covering the costs of issuing cards. This includes the cost of the miles and rewards programs we now take for granted, managing consumer lines of credit, write-offs and deploying the cards themselves. Of course, it also includes some basic level of profit for the issuer. As consumers demand more and more “value” from their credit cards, issuers are forced to increase rates to cover the costs of those additional services. Interestingly, 65% of the total cost of merchant acceptance—nearly 2/3 —goes to the issuer.
    The “open” networks, Visa and MasterCard, also derive revenue from card transactions (Discover’s new model will position them somewhat differently as they are both the network and the issuer). The majority of the networks’ revenues are derived from charging the acquiring banks “assessments” per transaction of approximately 9.5 bps and the processors a small fee—approximately $0.005—for each transaction processed through their networks. The effective revenue stream the networks receive is 0.10%— or 10 bps—of every transaction. Spread over the billions of dollars equates to a large amount. However, this works out to be a mere 3% of the total cost of acceptance.
    The last major piece of the pie is the Acquirer. For the sake of ease, I am referring to acquiring banks, processors and ISOs all as stakeholders in the Acquirer revenue stream. According to the industry consultants at First Annapolis, a merchant with a gross annual processing volume between $250,000 and $500,000 will earn an acquirer revenue of 0.94% of the processing volume. Obviously, this figure will vary greatly based upon average ticket size, business type and so on but those 94 bps, commonly known as the “Acquirer Spread”, represent 31% of the total cost of merchant acceptance. As we further break down the Acquiring Spread, we see some very interesting dynamics.
    The Acquiring BIN/ICA Sponsor and the processor together make up only 15% of the Acquiring Spread, or 14 bps. This is interesting to note as the underlying risk is held solely by the sponsoring financial institution. True, some ISOs do maintain liability for their merchants, but in the event of a true disaster, the financial institution is the entity on the hook. In addition, the greatest share of technology and intellectual property in a payment transaction is housed with the processor. The processor certifies hundreds, if not thousands, of POS systems, maintains authorization systems and communication networks and settles billions of dollars annually. It also ensures that all of its systems (authorization, clearing and settlement) remain compliant as the networks request numerous changes throughout the year. Both of these services have been reduced to commodity levels as we evaluate the percentage of Acquiring revenue available. The Acquiring bank that provides the BIN and ICA averages 2 bps and the processor only 12 bps.

    The majority of the Acquiring revenue—85%— lies in the distribution channels, and as we all know, the ISO is the king of distribution. In the traditional Super-ISO model, which includes both a sale office and sales agent, the ISO too must pass a share of his 80 bps downstream. On average, a Super-ISO will pass 45 bps through the channel and retain 35 bps as gross profit to run his business. In turn, the sales office must recruit and incent sales representatives, paying as much as 25 bps—or 56% of the sales offices’ revenue— downstream. The model works similarly to any good multi-level business, as the upstream entity makes less per sale, but collects revenue from multiple sources.
    An emerging trend is the collapsing of layers in the distribution channels. Many processors and Acquirers have come to realize the majority of the revenue lies in distribution, and have developed large and often sophisticated sales organizations. By eliminating levels of the distribution channel, they are able to create efficiencies in the market. Similarly, Super-ISOs may sell directly to the merchants and remove sales offices and merchant-level salespeople, creating additional market efficiencies. (see graphic below.)

    It’s amazing to watch the Acquiring world fight merchants and margin when the majority of the revenue actually goes to the Issuers. The current model is amazingly efficient, but constantly comes under scrutiny in the courts and the marketplace. Lower cost payment networks are being introduced to the market, and the traditional networks and infrastructure are under attack. I don’t believe that any one individual can change the dynamic of a payments system that has been this successful for so long—although some companies are certainly trying. However, it is incumbent upon all of us to understand the current system and look for opportunities within it.