Cover Story

   Unraveling the Interchange Web

�During the weeks we paid residuals to our agents, I used to spend an extraordinary amount of time explaining and reconciling interchange pass-through fees to them and these were good, experienced salespeople,� says Michael Kopp, Chief Operating Officer for Electronic Data Resources (EDR), a third-party processor based in West Palm Beach, Fla. �We have since gone to a bundled rate scenario.�

Basic Definitions

Before we get into the meat of the topic, its important to clarify a few basic terms.


The exchange of transaction data between acquiring and issuing institutions.

Interchange Fees

Fees paid by the acquirer to the issuer to compensate for transaction-related costs. Interchange fees are established by Visa and MasterCard.

Discount Rate

The fee an acquirer charges the merchant to cover the costs of providing deposit credit and handling the merchant�s bankcard sales transactions.

Effective Rate

The final bundled rate after combining the interchange rate, assessments and other per item transaction fees.

Interchange Basics

   In a typical credit card transaction, the merchant�s processor pays an interchange fee, collectively determined by all participating banks, to the cardholder�s bank. Interchange represents the cost of the card transactions, including processing, risk and other costs.
   The bankcard associations, ie. Visa and MasterCard, administer interchange fees on behalf of their member banks/card issuers. They apply the fees as part of the clearing and settlement process and the fees are passed through the associations� settlement systems from acquirer to issuer. Processors mark that amount up for acquirers, which in turn set the prices for which they will acquire transactions from ISOs. The final charge to the merchant, the discount rate, includes interchange, assessments, per item fees and additional fees added by the various players as a part of their pricing strategies. Merchants may also pay a transaction fee. To confuse matters more, sometimes processors, acquirers and issuers are the same, or subsidiaries of the same, entity.
   Interchange fees are reviewed annually by the associations, with the help of independent consultants, to determine the cost to issuers of providing guaranteed card transactions. Survey data from members is combined with the associations� own data to calculate the costs. As costs increase, so do the interchange fees.
   The fees have increased recently, yet are still far lower than they once were. In general, the acquiring community regards interchange increases as a necessary evil imposed on them by the associations. Many ISOs we spoke with feel that the interchange pricing process is actually a collusion by Visa and MasterCard to take advantage of their monopoly and is, very simply, price-fixing. However, according to Marc Abbey, Principal Consultant with First Annapolis Consulting, 99 percent of acquirers are interchange neutral as their contracts provide for direct interchange pass-through. It is also a standard acquirer practice to adjust their pricing schedules at the same times of the year that interchange revisions occur. By providing a basic outline of the topic, we hope to help ISOs better understand the components of pricing, including interchange.

Interchange History

   Back in the days when imprinters, or knuckle-busters, were considered state-of-the-art, there was one discount fee charged to merchants, upwards of 3.5 percent, double what some merchants pay today. Interchange and other fees fell considerably in the mid-1980s � largely due to interchange incentives offered by the card associations to spur the use of electronic terminals. This enabled ISOs to give merchants better rates while earning a comfortable living. However, with the ISO apparently ripe with profit opportunities, competition stiffened, driving prices down further.
   �Eventually, the price to the merchant fell to the point that there was little, if any, profit from the discount rate portion of the merchants fees,� according to Kopp.

Standard Fees

   The card associations and processors started imposing fees for additional items, most of which reflect additional risks or additional processing services and other administrative costs. As we are all well aware, the card associations closely guard their rates. Visa and MasterCard declined to comment, or provide input on this article. Processors also refused to discuss the matter, citing association rules that the Visa/MasterCard rates are confidential between the associations and their members.
   The interchange fee include a percentage rate and a per-transaction fee, which are generally based on risk and the cost of doing business. Assessments, charged quarterly to processors, are the other component of the discount rate. To recoup these quarterly assessment fees, processors apply a small fee to each transaction.
   �Most processors offer a buy rate of about 1.49 percent plus 20 to 25 cents per item for �qualified� transactions, according to Kopp. This fee structure gives the processor a marginal profit after paying Visa/MasterCard percentage and per-item fees and overhead costs.
   �What I can tell you about actual interchange and cost components is that any buy rate to an agent less than a 1.49 percent and 20 cents an item, is generally going to be a loss for the processor to fully handle that transaction,� Kopp added. That is why we have seen the addition of 10 or more additional pricing components to secure the profits.�
   The rates mentioned earlier are only for the �best� transactions, typically consumer cards that are physically present at the point-of-sale, magnetically processed in a terminal, electronically authorized and settled daily. Other transactions, such as those manually entered, corporate cards and items not settled within 24 hours, result in higher interchange fees. The higher fees are largely related to increased risk. With a card-not-present, key-entered transaction, for example, there�s a higher likelihood that the true owner of that card is not making the purchase, yet the transaction may still receive authorization.
   Items that don�t close within 24 hours also pose an increased risk, as the longer it takes a transaction to go through the settlement process, the higher the risk of a return � buyers are more likely to change their minds or the product won�t be what they expected, so they will return it.
   Corporate cards, though they may be considered less risky than cards held by individuals, are more expensive for the associations due to the itemization reports provided to the cardholder at the end of payment periods or at the end of the year.
   When all of the different nuances are considered, there are nearly 50 different rates and fees merchants pay, far too many rate structures for the typical ISO to track. So processors, who are much larger and work with several different ISOs, tend to bundle these interchange rate structures into basic rate tiers. These tiers are defined by many as �Qualified,� �Mid-Qualified� and �Non-Qualified.� Different processors use different terminology to refer to their interchange bundles. (For more information on these different rates, see accompanying charts.)
   Though there are subtle differences in the categorizing of these tiers among different processors, typically qualified rates are for those merchants who capture credit card information electronically and close transactions within 24 hours. Mid-qualified rates apply to the most common exceptions (such as manually keyed transactions for a retail merchant that normally swipes most transactions). Non-qualified rates are applied to those few transactions that are not pro-cessed within the guidelines specified (such as settling a batch more than two days after an authorization is obtained or processing a corporate card).
   For Visa, there are higher fees for �emerging markets� such as government, school, utility and insurance. Most companies in these industries recently began to accept credit cards, so there is a limited payment history, hence, higher risk.
   In addition to the discount rate, merchants typically pay additional charges for additional items such as statements, monthly minimums, authorization fees, etc. There are also additional fees for American Express (which is the acquirer and issuer of AMEX branded cards) and Discover Card transactions.
   �These additional charges are where the processors make a significant portion of their profits,� according to Kopp. �The additional items also provide profit opportunities for ISOs.�
   These additional income opportunities are where processors � and many ISOs � actually earn their profits. Identifying these add-on charges can help the resourceful ISO maximize his profits.
   Additional fees continue to grow in complexity and in number. A recent survey by First Annapolis Consulting, Linthicum, Md., looked at 13 different additional merchant charge types. (There were others that weren�t on the survey.) The same survey only two years ago covered only seven fee types. The growth in the survey reflects the growth in the importance and complexities of these additional charges. These fees now account for anywhere from 40 to 50 percent of a merchant�s total charge card-related fees.

   The following are the different fee types covered in the most recent survey.

Visa/MasterCard transaction fees
Monthly minimum fees
American Express transaction fees
Statement fees
Authorization fees
Annual fees
Other card type fees
Chargeback fees
PIN debit transaction fees
Interchange downgrade fees
Voice authorization fees
Termination fees
Application fees

   While most acquirers (81 percent) charged a per-transaction fee, far fewer (46 percent) charged the authorization fee. The percentage of acquirers charging other fees fell in between that range, according to the First Annapolis study. The study also said that 78 percent of acquirers charged between 9 and 13 types of fees, with only 17 percent charging for all of the fee categories.
   Just like the base percentage and per transaction fees, the processor marks up these additional charges, so may also the acquirer and ISO, so that they can increase their respective profits. With the keen competition in the industry, there may be little or no room to offer the merchant a better rate on the percentage or per-item transaction fee, but there may be room to give the merchant a better deal on the additional fees than he is currently receiving and win the merchant�s business while still making a profit.
   While prospecting, ISOs should examine the bottom, or the foot, of a merchant�s statement, to spot additional fee areas that might be able to be reduced to give the merchant a better deal and land the sale.
   Knowing a merchant�s average ticket is also one of the more important elements in trying to win his business, while remaining profitable.
   For example, the average ticket for a breakfast and lunch restaurant might be $10, with annual sales of $50,000, while the average ticket for a company selling air conditioners might be $500 with annual sales of $500,000. If the ISO�s goal is to make a $300 from each merchant, he will need to charge the two businesses very different rates. This example doesn�t consider any of the potential add-on fees.
   Assuming the ISO�s buy rate is 1.49 percent plus 20 cents per item, he could charge the restaurant owner 1.59 percent plus 25 cents per item and the air conditioner company owner 1.52 percent plus 20 cents per item. In each instance, the profit would be $300. The lower per item and percentage fee in the later example is offset by the higher average ticket and total sales amounts.
   However, remember that price alone won�t move some merchants. Some might prefer a higher discount rate and less additional charges on the back-end. Other merchants are more concerned about service. Still others may be too willing to change providers and could be a potential fraud risk (see Transaction World, September 2001).
   �It�s a very complicated process and I think that is why it is getting more difficult to bring new salespeople in the business,� Kopp said.

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