The Weird Economics of Swipe Fees

Over at WonkBlog, Lydia DePillis has an interesting piece about "swipe fees" -- what merchants pay banks and card companies every time a customer swipes plastic. A court recently found that the Fed's limit on these fees for debit cards is too high. But the piece suggests that, as customers become used to paying for things with their phones, cards and swipe fees may become a thing of the past.

What's really fascinating about swipe fees is this: While the customer decides which card to use, and the customer benefits from card rewards programs, it's merchants who pay the fees. These fees are passed on to all customers, not just the customers who pay with cards. It's not unlike the "third-party payer" problem in health care; the person making decisions about cost doesn't actually bear the costs. If anything, customers are attracted to cards that have higher fees and thus can pay better rewards.

As a result, competition is strongly curtailed. If a new card came out tomorrow that had ridiculously high fees, merchants could refuse to take it and nip it in the bud. But for many businesses, it's pretty much impossible to avoid taking a card that's already popular -- most notably, Visa -- and thus Visa can raise its fees with near-impunity absent government regulation.

Even if a new card came out that charged no fees at all, merchants couldn't switch to it the way a consumer would switch to any other superior product. They could merely take it in addition to Visa, or risk losing all the customers who pay with Visa. And a low-fee card would have trouble tempting customers away from high-fee competitors with good rewards programs.

Between court rulings and the Dodd-Frank law, various attempts have been made in the last few years to address this. Obviously, the Fed is setting limits for debit-card fees and courts are deciding whether those limits are adequate. Merchants can now set minimums for credit-card purchases and even charge customers more for paying with cards. But can mobile phones solve the problem once and for all?

As DePillis notes, there is a ton of competition in this area -- from Square to Google Wallet to a forthcoming payment system created by merchants. Right now, there is no entrenched mobile payment method that virtually all retailers have to take, so merchants can use the leverage they have to squeeze out high-fee options. Their ideal is probably something like Dwolla, which requires consumers to fund purchases with a bank account instead of a card and thus charges very low fees. If merchants use this leverage well -- and if, over time, consumers give up their card rewards to use their phones -- swipe fees could slowly die.

Still, as long as a high proportion of consumers insist on paying by card, fees aren't going anywhere. When credit-card rewards can amount to a 1 percent discount on every single purchase, it might be difficult to transition to mobile payments without giving customers a similar incentive. And if the major players in the mobile market aren't the ones actually run by merchants, they will have the same incentive that Visa has to increase fees and use the proceeds to attract customers -- even if they initially became big players by charging low fees.

So, it's anyone's guess.

Robert VerBruggen is editor of RealClearPolicy. Twitter: @RAVerBruggen

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