Acquiring: Fee Fight

Elizabeth Whalen

Merchants focus most of their attention on interchange when they think of card-acceptance costs, but now network fees and related charges are in the spotlight. Are such charges an expression of oligopolistic power?

When MasterCard Inc.’s new digital-wallet fee takes effect this month, it will join a growing list of other fees imposed by the two largest payment card networks.

These fees and related charges, which are separate from interchange, generate billions of dollars for MasterCard and Visa Inc. and please their investors, but critics say they impose unjustified costs on merchants and consumers, and may even pose risks to the networks themselves by encouraging new, lower-cost competitors to challenge them.

The fees give the appearance of acronym soup. They include Visa’s Fixed Acquirer Network Fee (FANF), Acquirer Processing Fee (APF), and Transaction Integrity Fee (TIF). Master­Card’s price list includes its Network Access and Brand Usage fee (NABU) and Acquirer License Fee (ALF).

In addition to what MasterCard in general terms calls transaction-processing fees and Visa data-processing fees, which typically are charged on a per-transaction basis, the networks also get income from so-called service revenues (Visa’s terminology) or domestic assessments (MasterCard’s), which are based on charge volume, as well as cross-border and other charges.

Those income sources produced $7.39 billion in operating revenues for MasterCard last year and $10.4 billion for Visa in fiscal 2012 ended last Sept. 30. The costs are divided among the networks’ customers and former owners—banks and credit unions that issue cards with their brands and merchant acquirers that sign up businesses for acceptance of those cards. How much issuers versus acquirers pay depends on the type of fee or charge.

‘The Wrong Noise’

MasterCard’s so-called Staged Digital-Wallet Operator Annual Network Access Fee is the newest of the bunch. It’s generated a huge amount of debate since eBay Inc., parent company of online-payments leader PayPal Inc., revealed it in a February regulatory filing.

News of the fee caused some observers to wonder if MasterCard perceives digital-wallet providers as competitors and is trying to squeeze them with it. Wallet providers enable consumers to fund online or mobile purchases by tapping general-purpose card accounts linked to the wallets, or use other funding mechanisms.

MasterCard’s fee is likely to hit PayPal hardest. PayPal processed nearly $145 billion in volume last year, including an industry-leading $14 billion from mobile payments, beating its own predictions by $4 billion. PayPal is shooting for $20 billion in mobile volume this year.

Neither MasterCard nor PayPal has released details about the fee, other than that it will be tiered and based on volume. A PayPal spokesperson did say that the San Jose, Calif.-based firm is one of the card networks’ largest customers and that negotiating fees is a normal part of doing business.

“Historically, our transaction expenses have been relatively stable over time, averaging just 1.06% over the past six quarters, despite underlying pressures from different components that comprise this metric, like the MasterCard fee,” he said in an e-mailed message.

MasterCard declined to comment for this story. But during the company’s first-quarter earnings conference call with analysts on May 1, chief executive Ajay Banga criticized the “noise” around the fee, saying in effect that commentators focusing on the fee’s financial effect on both MasterCard and digital-wallet providers were missing the point.

“I think that is completely the wrong noise,” Banga said, adding that the fee would generate “a relatively de minimis number for a company of our size and scope.” He went on to say that “it is more about the principles of creating the right rules and the right operating methodology to allow us to operate with … digital-wallet operators.”

Later that same day at Visa’s quarterly conference call, new chief executive Charles W. Scharf said the company currently is not planning to implement a similar wallet fee. Scharf called PayPal “a very important customer” but said Visa’s relationship with PayPal and other wallet providers “is complicated.” Visa is considering “the right way to restructure the ecosystem in a way that works for everyone” and will announce specific plans later, he said.

A Visa spokesperson declined further comment, saying the company generally does not discuss its fees.

‘Targeting PayPal’

MasterCard could be using the wallet fee to compensate for the transaction data it loses when customers use PayPal or other electronic wallets, or it could be something more, says Jeff Zimmerman, vice president of product management and marketing for St. Louis-based merchant acquirer Clearent LLC.

“It could be that, if they’re going to give up something like the detail of what’s really happening, at least they’ll offset that by making some money on it,” he says. “It could be yet another on the long list of fees that have been slowly introduced because they think they can.”

Although MasterCard may indeed want to make up for losing transaction data, the new fee appears to be directed mainly at PayPal and possibly fast-growing mobile-payments provider Square Inc., says industry analyst Gil Luria, managing director at Los Angeles-based Wedbush Securities.

“They certainly would like to collect all the information they can,” he says. “That is true, but PayPal is by far the most-used staged wallet by a factor of 100, so even if their intent was more general, they were clearly targeting PayPal.”

Despite that, PayPal probably will absorb the fee because in-house balances and accounts reached via the low-cost automated clearing house fund half of its payments, according to Anand Goel, chief executive of Atlanta-based Optimized Payments Consulting Inc. Thus, the fee probably will not have a significant direct impact on merchants, he says.

“It will increase PayPal’s cost very incrementally, but MasterCard is only a small piece of PayPal’s overall tender mix,” Goel says. “I think, for the most part, merchants don’t know about it, and they probably won’t because PayPal will simply absorb the cost.”

Market Power?

Interchange remains merchants’ biggest component of card-acceptance costs by far, but network fees in general can account for as much as 18% of expenses, Goel says.

Unlike interchange, which the networks set but is paid by the acquirer to the card issuer, the networks retain the revenue they get from fees charged to acquirers, which usually pass the expense on to their merchant clients.

Visa and MasterCard collectively control about two-thirds of the U.S. general-purpose credit card market, and they also dominate debit. Attorney Matt Cantor, partner in the New York City office of law firm Constantine Cannon LLP, says such a big share gives the two networks market power, and he points out that prices for goods or services generally change when input prices change.

“That’s not what you have here,” says Cantor, whose firm is representing merchants in a massive case challenging credit card interchange that is in the midst of controversial settlement proceedings. “The telecommunications infrastructure we have now is as cheap as it ever was. There are no significant costs that Visa and MasterCard began to incur.

“Merchant welfare hasn’t gone up. In fact, merchant welfare has decreased,” he continues. “There’s no new demand that merchants have had for the transactions. And these fees were not in place for decades while merchants and consumers rode the rails of Visa and MasterCard, so the only explanation for these fees is to quash competition.”

Goel notes that with an increasing number of transactions, networks such as Visa and MasterCard should increase efficiency.

“It’s unreasonable to expect that, as transactions grow, so will fees. In absolute dollar amounts, yes, but on a per-transaction basis, they should decrease,” he says.

Yet, says Zimmerman, “there are more fees, outside of pure interchange, relative to the volume than there were three years ago.”

‘A Different Calculus’

One way to gauge the networks’ pricing power is to look at the relationship between revenue growth and transaction growth. Data for the past three years give a mixed picture, though revenues generally have been growing faster than processed transactions.

At Visa, the increase in transactions exceeded growth in operating revenues—fees, service revenues, cross-border charges, and miscellaneous income—in fiscal 2010. At MasterCard, revenue increased faster than transactions in 2010 and 2011.

Zimmerman believes that both merchants and consumers benefit from the ability to accept and use cards and points out that other businesses, including mobile-phone carriers, charge customers an increasing number of fees and have not suffered reduced demand as a result.

Retailers as well as independent sales organizations that sell card-acceptance services to millions of merchants, however, will not tolerate unlimited fees, he says. In the long run, these fees risk inviting competition, despite the difficulties involved in establishing a viable competitor to the major card brands.

“Even the new things that have come around in the last couple of years, almost all of them still end up riding over MasterCard or Visa because it’s so difficult to get something going. But I think that sooner or later, maybe if these fees get too high, it will be worth it for someone to solve that. I don’t think we’re there yet, but I think that is a long-term risk,” he says.

Merchants don’t have to contend with just a growing number of digital wallets and network fees, but also with the differing methods used to calculate those fees, says Doug Kantor, counsel for the Washington, D.C.-based Merchants Payments Coalition, a retailer group advocating for lower card-acceptance costs.

While some merchants understand exactly how each fee is determined, others do not, he says. Some network fees, such as Visa’s FANF, are fixed; others are charged per transaction. And that difference further complicates merchants’ fee analyses, Kantor says.

“With these fixed fees, there’s a whole different calculus that goes into it because now it’s not just ‘What do I get charged on this transaction?’ but ‘What’s essentially my country-club membership fee just to be able to take the card in the first place?’ And that’s one that merchants just haven’t been used to in the past, and I’m not sure they have figured out how to factor that in entirely,” he says.

Exacerbating that problem, Kantor says, is the poor disclosure to merchants by many acquirers and ISOs of the various pricing components that go into card acceptance.

“The statements that merchants get are difficult to understand. They happen at the end of the month, when it’s hard to know what types of cards were used and why certain fees are charged. At the time of the transaction, merchants don’t have a clue what fees they’re about to pay.”

As a result, many small-to-medium-size merchants don’t differentiate between network fees and interchange and instead simply think about their overall cost of payments acceptance, Kantor says. Large, sophisticated merchants, in contrast, closely analyze how the different fees are calculated.

‘Trickier’ Pricing

Consumers, not surprisingly, are largely ignorant of card-acceptance costs.

“In fact, if you take a look at disclosures consumers get about their cards, nowhere anywhere will you find even a bare disclosure that says, ‘By the way, when you use this card, we will charge whoever you use it with interchange fees, network fees, you name it,’” Kantor says.

Kantor claims that in percentage terms, network fees have increased more than interchange has over the last several years. Consumers ultimately pay the fees, he says, because retailers cannot afford to: Their profit margins are generally between 1% and 3%, leaving little room to absorb additional costs.

Clearent’s Zimmerman adds that, “It has become more challenging for ISOs in terms of how they price their merchants. It gets much trickier for an ISO to use traditional discount or tiered pricing because you not only have to figure out how to cover a rapidly growing number of different interchange rates but now all these other fees, too. So it’s much more difficult for them to forecast what their profit will be.”

Analyst Luria says the networks are focused on growing their earnings every quarter because they are now publicly traded companies. (MasterCard went public in 2006 followed by Visa in 2008.)

“Therefore, they need to introduce these fees to continue to do that, but I think the fact that they’re no longer owned by banks also means that banks don’t have a problem competing with them any more,” he says.

Luria views big U.S. and European banks as the parties in the best position to create a viable competing network. A number of big U.S. merchants, meanwhile, are in the process of creating a new mobile-payments network called Merchant Customer Exchange, or MCX.

‘Pools of Money’

For now, all the fees could help PayPal, according to Goel. Assisted by Discover Financial Services, PayPal is making a major push to be accepted in brick-and-mortar stores and is shooting to be in 2 million point-of-sale locations by year’s end.

“It gives even more of an impetus for merchants to look for alternative-payment vendors, and that’s one of the reasons I think PayPal is going to be successful at the point of sale,” he says. “They can go in and offer merchants a rate that’s below interchange because half of their payments are funded by non-card sources.”

While network fees might encourage banks to create a competing network, on the flip side they may also support bank loyalty, says Jeffrey Shinder, managing partner of Constantine Cannon’s New York office.

“We believe the fees create additional pools of money that the networks can then use to reward the banks and keep them loyal,” he says.

Both Visa and MasterCard pay billions of dollars every year in rebates and incentives to card issuers to pump out cards with their respective brands, and to merchants to promote dollar volume on their cards.

MasterCard’s first-quarter earnings release says the firm paid $657 million in rebates and incentives, up 12% from $589 million a year earlier. Visa paid $567 million on incentives in its second quarter of fiscal 2013 ended March 31, up 14% from $497 million.

Clearly, network fees and related charges are moving into the limelight. What happens next will depend on how the networks balance the interests of their customers and investors, and any of their plans could face disruption by new competitors or regulators.