Priceonomics

Photo by Frankieleon

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How much money did you send your bank this year when you used your credit card? 

Did you notice that you paid a $400 fee—one of the highest in the world?

Paying with a credit card seems simple. You swipe your card, wait a moment, and then grab your groceries and go. Yet behind the scenes, your trip to the grocery store initiates a complicated transaction—a vestige of a time when banks had to communicate by phone. 

Over the next several days, two banks, Visa or Mastercard, and multiple intermediaries will communicate back and forth until money is moved from your bank to your grocer’s bank. And each bank and middleman charges a fee for their role.

You won’t notice this fee. It’s charged to the merchant, and your credit card is seemingly free to use. An issuer probably sent it for free, and promised you free stuff like cash back or airline miles if you use it. 

But there’s a reason companies reward you for using credit cards. In America, credit cards are banks’ most profitable lending business. This is the aspect of credit cards that consumer advocates usually criticize: banks charge interest rates of 15% to 20% on $700 billion in outstanding credit card loans.

Yet even if you pay your bill on time, Visa, Mastercard, and the banks still make lots of money off you. Every year, they earn more than $40 billion from transaction fees. At 2%, the average credit card fee can seem small. Sixty-three percent of American adults have a credit card, though, even more have debit cards that work similarly, and Americans use both to spend trillions of dollars each year. It adds up. 

Those fees infuriate store owners and merchants. Some industries only make a few cents in profit from every dollar you spend. The profit margin of the average convenience store, gas station, or supermarket, for example, is under 2%. Credit card fees are 2% or more of nearly pure profit. The results can be absurd: banks and credit card issuers making more from a restaurant’s burgers, a bookstores books, or a corner store’s groceries than the store owners and employees.

For an individual, it can be smart to use credit cards and take advantage of credit card rewards—if you can avoid going into debt and paying high interest rates. (And that’s a gamble banks happily take.)

But collectively, the existence of credit cards—from the transaction fees alone—costs Americans serious money. Every store—Walmarts and corner stores, online retailers and brick-and-mortar stores—raises its prices to account for credit card fees. On average, we pay an extra $400 per year.

There’s no reason Americans should be paying such high fees, which are among the highest in the world. Credit cards were an amazing invention—in the 1950s. But today they are an outdated technology that cost us serious money. 

So why won’t they die?

The Invention of the Credit Card

The key to understanding credit cards is to appreciate what an achievement they were when banks first introduced them.

In the 1950s, Visa and Mastercard did not exist. In order to pay on credit or without cash, consumers had “a dozen or more” cards specific to one company—a Sears card to use at Sears, a card with a specific airline, a gas card with an oil company. Americans also kept running tabs at local stores like groceries and pharmacies, and had several small loans, each negotiated in person at a bank.

As journalist Joseph Nocera recounts in his book A Piece of the Action, many banks saw the potential to replace all these transactions with a universal credit card. But they faced the ultimate chicken-and-egg problem: Merchants would only bother with the card if customers used them, and customers would only bother with the card if stores accepted them.

Bank of America, which only operated in California at the time due to regulations that prohibited banks from operating in multiple states, introduced the first true credit card in Fresno, California, in 1958. The bank staff called their solution “the drop.” In mid-September, they planned to mail 60,000 working credit cards, which they called BankAmericards, to the residents of Fresno—a city they chose because 45% of its residents used Bank of America. Executives also appreciated Fresno’s relative isolation—they were worried this whole credit card idea would bomb. 

With their plans for the drop, Nocera explains, bank staff pitched stores by promising that 60,000 Fresno residents would soon have working credit cards. 

Large businesses like Sears said no. They saw Bank of America’s card as a competitor to their own and saw no reason to pay the 6% transaction fee the bank demanded. 

Corner stores, though, loved the idea. “When I explained the concept of our credit card” to a drug store owner, one alum of the drop told Nocera, “the man almost knelt down and kissed my feet.” The man employed 3 bookkeepers who sent out letters requesting payments of as little as a few dollars. The owner saw a 6% fee in exchange for avoiding this hassle—and the bank paying him within several days—as a bargain.

The drop did not go smoothly. Almost as soon as credit cards were invented, so too was credit card fraud.Delinquency rates were 18% higher than expected, and Bank of America, whose chief pusher of credit cards naively expected everyone to pay on time, struggled to collect payments from customers. 

When Bank of America later did a drop in Los Angeles, its staff put together a list of customers who should not receive a credit card, and then accidentally sent everyone on that list a card. Similar chaos marred most every drop.

This is Wilmington, Delaware. It's a lovely little city, and—due to a friendly regulatory environment—a leading center for the banking and credit card industries. Photo by Tim Kiser.

Credit card drops also unleashed the kind of moral outrage usually reserved for companies that fleece military veterans. What Bank of America saw as a convenient tool, Nocera writes, Congressmen and journalists viewed as a means to tempt people into debt. One Bank of America executive heard his minister denounce credit cards in a church sermon. Congress held hearings to speculate about credit card addiction.

But Bank of America’s BankAmericard was fixable, which eventually made credit cards, despite Americans’ distrust of banks and easy money, too powerful an idea to stop. Banks raced to introduce them, and by 1970, when Congress banned drops, they had sent out 100 million credit cards. 

Other changes helped make credit cards more universal. To get large chains like J.C. Penney to accept credit cards, banks dropped credit card fees to as low as 3%. Bank of America also began franchising its BankAmericard to banks around the country, which issued Bank of America cards to their customers. In response, other banks created competing credit card networks. 

By 1970, the networks had consolidated into two dominant cards. They were later renamed Visa and MasterCard.

***

Before Visa became Visa and MasterCard became MasterCard, credit cards were increasingly accepted and used. But their future looked in doubt. Banks had spent or lost hundreds of millions of dollars on credit card drops, advertisements, and fraudulent purchases. Many bankers doubted they could ever recoup their investment. 

Bank of America’s credit card network suffered from two related problems.

The first was that its interchange system—the way banks settled their accounts, since customers and stores often had different banks—was a mess. As Nocera writes in A Piece of the Action, each bank had to mail letters to thousands of other banks each day to ask for payment. It was a slow, burdensome process made worse by the fact that banks cheated each other. Banks argued over who should pay for fraudulent purchases, paid other banks late to inflate their balance sheets, or lied about the rates they charged merchants to underpay other banks.

The second was that the credit card’s main selling point—convenience—rang hollow. When customers pulled out a credit card in stores, it could be a long wait. Nocera explains:

The merchant had to call his bank, and while he was put on hold, his bank would make a long distance call to the bank that had issued the credit card, and while it was put on hold, the clerk on the other end of the line would pull out a fat printout of names and numbers and look up the customer’s balance… And that was when the system was operating smoothly.

The solution was Visa, an organization originally named National BankAmericard Inc., which the banks in the BankAmericard network created to run the interchange system. Visa would be an honest broker that ensured each bank dealt with the others fairly. It would also make both the interchange system and the process of using a credit card more efficient. 

The banks chose a man named Dee Hock to head Visa. Nocera describes Hock as a man who screamed and bullied to get his way, yet who inspired employees to feel that they were changing the world. To contemporary ears, Hock sounds like a Bitcoin advocate. While the banks just wanted Hock to get their system running smoothly, Hock saw himself as creating the future of money. When challenged on this, he’d define money as a “medium of exchange” and explain how money had evolved from shells to paper currency—and now to credit cards. 

Under Hock, Visa computerized the credit card system. This made managing credit card transactions much easier and profitable for banks, and it sped up the process of paying by credit card. A credit card transaction still involved multiple banks and intermediaries communicating back and forth, but once computers started doing the work, in 1973, it took less than a minute. There were no more phone calls to ask a clerk to look up a credit limit. It felt like magic.

Visa, along with its main competitor MasterCard, also introduced debit cards in the mid-1970s, as ATMs became common. By the 1980s, credit cards were wildly profitable, and Visa and MasterCard expanded overseas. They signed up banks and stores and advertised globally. Eventually customers all over the world knew the names Visa and MasterCard, and they could pay with Visa or MasterCard.

Credit cards had become a universal wallet.

The Transaction Fees are too Damn High

Today, store owners no longer want to kiss the feet of people who work on credit cards.

Sixty years ago, Bank of America’s 6% fee seemed like a great deal to the owner of a small store in Fresno, California. More than 35 years ago, national retailers like J. C. Penney started accepting credit cards for transaction fees of 3%.

Today, the average credit card transaction fee in the United States is roughly 2%—and significantly more for online stores.

That’s not necessarily how much Safeway gives up when you buy your groceries. Each credit card network has dozens of potential rates that range from under 1% to more than 5%. 

And yet, decades later, credit card fees remain almost as high as they were when banks wooed large department stores in the 1970s.

The result is that—in an age when dozens of free services allow you to instantly send money to friends—retailers pay dearly to accept credit cards. 

Banks, Visa, MasterCard, American Express, and other companies that profit from credit card transactions say that the fees reflect the cost of a valuable service. 

Store owners and merchants, however, say they simply can’t risk not accepting a major brand of credit card, which keeps fees outrageously high. “Just two companies, Visa and Mastercard, so dominate the business of processing debit- and credit-card payments,” Lyle Beckwith of the National Association of Convenience Stores has written, “that – without competition – they have price-fixed these swipe fees at staggeringly high levels.”

It's entirely possible, thanks to credit card fees, that banks make more from the Whoppers sold at this Burger King than the employees and franchise owner. Photo by Anthony92931

It’s not just mom and pop stores that oppose big fees. Walmart, Target, and other major corporations joined representatives of small stores in a lawsuit against Visa and MasterCard. The merchants claimed the credit card companies set artificially high prices, and they ultimately won a $3 billion settlement in 2012. 

High fees affect everyone, because retailers, especially restaurants, gas stations, and other merchants whose profit margins barely cover the cost of credit card fees, have higher prices due to transaction fees. It doesn’t matter if you don’t use a credit card. You still pay higher prices; you just don’t get the rewards—a fact that hurts the poor and unbanked most of all.

The Merchants Payments Coalition, an interest group, has claimed that this costs every American, on average, $400 per year.

The truth is often hard to find among this kind of he said she said argument. Are the fees set at a reasonable price for the service provided? Or do credit card companies use their market power to demand unreasonably high fees?

Yet we have some clarity about transaction fees thanks to the Durbin Amendment, a part of the Dodd-Frank Act that regulated transaction fees. 

Although the amendment only regulates debit card fees, the credit card system is similar. Debit cards don’t offer credit. But Visa, MasterCard, and others credit card companies power many debit cards—look for the Visa or MasterCard name on your debit card—which means they use the same payments network and also suffer from high fees. For this reason, the research and debate surrounding the Durbin Amendment shine a light on the workings of credit card fees.

When Dodd-Frank passed, the amendment charged the Fed with setting a cap for debit card transaction fees. The Fed’s studies put together a clear picture of monopoly power: the cost of processing debit transactions had decreased, yet fees kept increasing. 

The cost of debit transactions had decreased even while accounting for the costs of rising fraud, which is the justification given by banks and Visa for fee increases. (This justification feels doubly dishonest given that banks pass along the cost of fraudulent purchases to retailers.)

Using Federal Reserve data, for example, economist Robert Shapiro found that while the cost of handling debit transactions decreased 26% between 2009 and 2011, debit card issuers had increased fees 5 cents (or 0.11% per transaction). Shapiro’s estimates of banks’ profits from credit card transactions, meanwhile, line up with the $400 per year figure. It's not an exact figure, but it approximates the average cost per person if you divide the banks' profits from transaction fees by the number of American adults. 

But extending the Durbin Amendment’s reach to credit cards won’t necessarily decrease the cost of transactions.

For starters, there’s the banks’ and credit card industry’s lobbying prowess. The Fed staff initially decided to cap debit transaction fees at roughly 12 cents, leaving a healthy 7 cent margin. Banks lobbyists succeeded, however, in raising that cap to more like 24 cents. 

The change was still a significant decrease in costs, and it would have saved merchants and consumers an estimated $8.5 billion.  

But it’s not easy to take monopolists’ profits away. Since banks earned less from people using debit cards, they sought the money elsewhere. After the Durbin Amendment, banks increased fees on bank accounts 3% to 5%, raised minimum balances, and decreased debit card rewards. This wiped out the savings for many consumers. Since merchants also only passed along a minority of the savings, both analysts and (perversely) banks have argued that the reform actually hurt consumers. 

And then there’s the little matter of fraud. Because the problem with credit cards is not just the cost.

The Struggle to Kill the Credit Card

“The more transactions take place on your phone,” says Kaz Nejatian, “the less credit card transactions make sense.”

Nejatian is the CEO of the payments startup Kash. He has a novel way to describe the promises of improved security made by stores like Target and Home Depot after they acknowledge, every several months, that hackers have gained access to, say, 56 million credit cards.

“They keep trying to make better doors,” Nejatian said in an interview, “but they don't have walls.”

The reason why is that credit cards are insecure. Once someone has your credit card number, they own your card. It’s like if someone could steal your house by knowing the address, or, as pointed out by Alexis Ohanian in an interview with Nejatian, use your money by memorizing the serial numbers on the cash in your wallet. This is why banks so readily freeze your credit card when you make an atypical purchase (out of fear that it is stolen) and employ armies of reps who respond to claims of fraudulent purchases. 

Those signatures you’re asked for when paying with credit? Once banks compared them to the original; now they disappear into a black hole. The introduction of credit cards with chips, which produce unique codes for each purchase, will reduce fraud, but only in stores. Online purchases are just as vulnerable, which is why online retailers often pay 4% or 5% transaction fees. 

The Starbucks app exists because coffee shops can lose money when you pay for a small coffee with a credit card.

Nejatian’s company, Kash, is an interesting example of a company that processes transactions by using a technology that was not available when the credit card network was set up in the 1970s: smartphones.

Kash partners with stores and websites looking to avoid credit card fees. The retailers begin accepting payment through the Kash app for a fee of 0.5%, and they incite customers to pay with the Kash app by offering customers loyalty rewards or 5% to 10% cash back. 

Nejatian says they’ve had no cases of fraud, and unlike paying with a check or credit card, the money does not take days to transfer. The key is Kash’s algorithm, which uses information like your phone’s IP address, to make sure you are who you say you are. In comparison, credit cards require a chain of communication between merchants, intermediaries, and multiple banks. “Google doesn’t go around asking what’s the best website,” Nejatian tells us. “It has an algorithm.” 

“It’s like: Would you like to string up two tin cans with a piece of string? Or would you like to use a fiber optic cable?”

That’s how Jordan Lampe, the Director of Communications and Policy Affairs at payments startup Dwolla, describes the current state of credit cards. He describes making payments as a simple matter of sending messages. All that needs to happen during a purchase is for the retailer’s bank to tell the customer’s bank about the purchase.

Lampe says Dwolla’s founder got into payments because he hated paying credit card fees on his online speaker manufacturing company, and Dwolla’s solution is an API for banks. Lampe compares it to how anyone can use Facebook to log into another app—or give a dating app permission to access information from Facebook like your pictures and friends list. 

If your bank uses Dwolla’s API, you can similarly tell your bank, “Hey, I want to use Dwolla to move money in real time.” Dwolla can then quickly send those messages (about purchases) between banks, and if both your bank and a store’s bank use Dwolla, there’s no need for credit cards.

In comparison, why would you ever use a system with multiple middlemen who identify you by an easily stolen, 16-digit number? And take days to move the money? And communicate over a phone line?

But Dwolla struggled to overcome an area where credit cards reign supreme: ubiquity. People around the world recognize the names Visa and MasterCard. “They’ve done an excellent job over the past 50 or 60 years. They have banks onboard and the trust of customers,” says Jordan Lampe. He points out that Visa and MasterCard spend hundreds of millions of dollars advertising each year.

Another problem? Lampe says that Dwolla could save retailers money, but having an extra payment option for Dwolla was a distraction. Merchants want payment to be as simple and frictionless as possible, so Dwolla moved on to a different use-case: allowing businesses to send money to each other via Dwolla rather than paper checks. “The payment system is so effed in the U.S. that there’s a lot of opportunity,” Lampe says.

This point—that the entire American payment system, not just the credit card networks—have not developed significantly for decades is key to understanding credit card’s continued existence. 

Think of Apple Pay, which allows you to pay at a store by waving your phone around. Or Stripe, whose API powers payments for many websites and apps. (If you’ve paid for a Lyft, you’ve used Stripe’s API.) Both of these new payment methods run on the decades-old networks of Visa and MasterCard.

One major reason why Apple Pay, Stripe, and others don’t bypass credit cards and simply move money directly between bank accounts is that the system for moving money between bank accounts, the Automated Clearing House, is just as outdated. “It takes 3 days to clear,” says Lampe. “It was designed in the 1970s for paper checks.” 

Like credit card networks, the Automated Clearing House was designed before banks could communicate in real time or use APIs. With credit cards, Visa and MasterCard at least give the illusion that the transaction takes place instantly—by taking on the risk of the transaction not clearing.

For companies like Apple and Stripe, it’s not yet worth trying to cut out credit cards. The alternative is slower and unworkable. 

***

The tyranny of the credit card system is not inevitable.

Companies like Kash could mount a challenge. Like Dwolla though, Kash and its peers both have to build a good system and overcome the huge advantages held by the incumbents: the ubiquity of Visa and Mastercard and the huge profits banks can spend on advertisements and lobbying. 

There’s also another alternative to credit cards that has received a lot of press: Bitcoin, the digital currency that cuts out banks entirely. Instead of trusting a central institution like a bank to keep track of everyone’s money, Bitcoin users trust an algorithm, which keeps track of how much bitcoin everyone has and every transaction that takes place. 

People have understandably focused on an extreme use-case for Bitcoin—the Silk Road, a counterculture version of eBay where people bought and sold weed, shrooms, and other illicit drugs. But in the future, people may love Bitcoin’s ability to avoid credit card fees more than its utility in anonymously buying drugs. The founder of Coinbase actually left his job at Airbnb to start a Bitcoin company once he realized that credit card fees ate up nearly half of Airbnb’s profit margins. 

But if you look beyond the United States, you’ll notice something. Getting gouged by transaction fees is another area where America is #1: we have some of the highest credit and debit card transaction fees in the world. And a big reason why is a lack of government action.

This is partly due to the fact that other countries have much stronger versions of the Durbin Amendment. In Europe, for example, the government has capped transaction fees at 0.2% for debit cards and 0.3% for credit cards.

Photo by Frankieleon

More importantly, other governments have led efforts to create modern payment systems, while the United States has not made the same effort to upgrade its Automated Clearing House. 

On NPR’s Marketplace, finance reporter Kevin Wack makes this point:

In the United Kingdom, you log into your online banking account, hit send, and the money arrives in your friend’s account within 10 seconds. In Sweden, you pick up your mobile phone, and the transaction takes only about six seconds to process. Even less wealthy countries like Mexico and South Africa have moved to near-real-time payments.

In contrast, the U.S. still relies on infrastructure that dates back to the 1970s. If you pay your cable TV bill online on a Thursday, the payment may not be completed until the following Monday.

The U.S. government does recognize the problem. Jordan Lampe of Dwolla sits on a task force that represents tech companies in talks with the Federal Reserve, which has made it a goal for the United States to create a similar, real-time financial system. 

There’s just one problem. The Federal Reserve, both Lampe and Wack say, doesn’t want to pick winners or be heavy-handed. Its officials want to leave it to the market to create a new system—a market that is dominated by banks profitably making billions of dollars from the current system. 

“That’s never been done,” says Lampe, who notes that in every other country, the government had a strong mandate to push a new system. “We are in uncharted waters.”

Wack quotes a U.K. payments consultant who says, “The banks were being bullied into doing it here."

If the Fed does help upgrade to America’s payment systems, credit cards won’t disappear. Many Americans use credit cards as a kind of small loan, and credit cards are still around in countries with real-time payment systems. 

But millions of Americans commonly use credit cards simply as a way to pay, and the problem is equally applicable to debit cards, which are the most popular form of non-cash payment. 

Individuals and companies have linked their bank accounts to innumerable methods of sending and receiving money: PayPal, Stripe, iTunes and Apple Pay, Square Cash, Venmo, Snapcash. But their potential to blow up credit card and debit card fees is muted without an upgrade to the underlying system. 

The credit card networks are slow, expensive, and outdated. It’s time for something new.

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This post was written by Alex Mayyasi.  You can follow him on Twitter at @amayyasi.


Published Jan 8, 2016


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