When it comes to making a purchase, most consumers and businesses reach for their wallet or mobile phone and pay with a card — prepaid, debit, or credit. Cards are the most convenient method of payment — more so in the last year due to the shift to eCommerce (and all those DoorDash orders!). This benefit is ultimately paid by the merchant selling to the customer through interchange processing fees (which are deducted total of the sale amount).

The issuing bank (of the card swiped), card network associations (e.g. Visa, Mastercard, AMEX, Discover) and processor receive part of these fees for facilitating the transaction. Interchange fees guarantee you receive payment, help cover the cost of fraud protection and provide a convenient buying experience for your customers. The increased volume of sales by merchants accepting card payments offsets the transaction fees.

For banks (and now neobanks and challenger banks), revenue from interchange fees (or interchange revenue) represents a significant stream of revenue. For card issuance platforms (such as Marqeta), this is the main source of revenue. The amounts vary by card type, transaction category, and other factors. In the US, regulation (from the Durbin Act) also impacts the percentage an issuing bank receives in fees.

Let’s explore the history, factors, card transaction timeline, and outlook on interchange revenue.

HISTORY & FACTORS IMPACTING INTERCHANGE

Back in the 1950s, the first credit card launched publicly through Bank of America’s BankAmericard. The magnetic stripe technology used help create the payment network behind Visa. MasterCard would launch its own network to compete with Visa a few years later. Interchange fees were first introduced in the 1970s — Bank of America charged a 1.95% per transaction.

This new merchant fee was implemented to cover processing costs and credit risk. New competitors emerged through Discover and American Express. All companies charged interchange, with AMEX charging the highest rates in serving a high net worth customer base. For ATM cash withdrawals, the (card) issuing bank pays out an interchange fee to an acquiring bank network (providing the cash). Issuing banks receive their own version of a monthly statement showing the interchange revenue and fees paid out in a monthly period. For today’s neobanks (powered by licensed partner banks), bank partnership agreements determine the amount of interchange revenue received — this can vary by volume OR be a fixed split (i.e. 70/30).

The card networks set their own interchange rates, typically between 1% - 3% of the total transaction amount. To stay aligned with market conditions, these fees are reviewed and adjusted on an annual basis. During the pandemic, merchants pushed back on card networks looking to increasing fee — the downturn in payment volume plus higher fees were seen as a hurdle to struggling businesses. As a result, changes to interchange rates are postponed until April 2022.

Multiple factors determine the interchange fee charged on the transaction level:

Card network: Each sets their own table of interchange fees, typically similar in overall cost to stay competitive;

Card owner: Consumer and business (commercial) cards have different rates, often higher for non-individual entities;

Line of business: Fees can vary by merchant business type due to certain transaction activities (such as travel and high-dollar purchases) being higher risk. Everyday purchases are retail stores are generally lower risk and therefore lower fees;

Business volume: Merchants with large payment volumes month-over-month provide considerable income to issuing banks, which gives them leverage to negotiate lower fees. The opposite is true for new businesses with low payment volumes, who accept the standard rates from Stripe, Square, and other payment processing companies;

Transaction type: In-person card transactions represent less risk for chargebacks (or disputes from an accountholder) — resulting in less interchange fees. eCommerce and online purchases in general must pay higher rates for the added risk. The same can be said for PIN-verified transactions from debit cards charge less than non-PIN credit card purchases. The offsetting benefit for credit card issuers is that users spend more on a per transaction and total volume basis;

Durbin Amendment (exemption): known as Regulation II, requires the Federal Reserve to limit fees charged to retailers for debit card processing. The law specifically applies to banks with over $10B in assets (such as the top financial institutions — JPMorgan Chase, Bank of America, Wells Fargo). Community and regional banks have an advantage in earning higher interchange revenue for the same transaction.

To expand on this last point further, most card programs from fintech companies (such as neobanks) are delivered through partnerships with credit unions and community-based banks. Over 30 partner banks in the US currently support platforms with card programs either through a Banking-as-a-Service provider OR direct bank partnership. Popular partner banks are Sutton Bank, Evolve Bank & Trust, Metropolian Bank, Bancorp, GreenDot, and Coastal Community Bank.

End-to-end process of a card payment transaction

Authorization: A cardholder swipes their credit card (issued by their card-issuing bank) at the point-of-sale (POS) terminal of a restaurant (merchant) to pay for dinner. The terminal sends a payment request to a processor, who then contacts the card network (e.g. Visa, Mastercard). The card network contacts the issuing bank to confirm the card is in good standing (i.e. not lost or stolen), an has sufficient funds (or credit) to cover the amount of the transaction.

With the confirmation from the issuing bank, the card network then informs the processor (and the merchant through the POS terminal) that the transaction is approved. The entire process typically takes less than 10 seconds to decision;

Batching & Clearing (by the merchant): At the end of the business day, the restaurant would process a batch request through its POS terminal to the processor. The processor then sends the batch to the card network, who would then contact the respective issuing banks to clear the payments and send the funds to the merchant;

Funding: Once the batch request has been received and cleared, the transfer of funds commences from the issuing bank (and their cardholder’s account) to the restaurant (or merchant that provided goods or services). The funds from the issuing bank are net of its interchange fees — in the graphic above this would be $0.18 of the $10 transaction, which is $9.82 sent to the card network. The processor then takes sends a net amount to the merchant after taking out its own processing fee ($0.02 in the graphic above) and the fee for the payment facilitator (PayFac) that provided the POS terminal.

If there’s a lag in the authorization response from the issuing bank, the request can time out and result in a card decline. Card networks may charge fees for declined transactions and place restrictions on issuing banks with high decline rates due to potential fraud risk (similar to the ACH network mitigating against high return rates).

This legacy framework has largely remained unchanged for over 40 years and has benefited card networks and issuing banks with fixed revenue source.

FINTECH success tied to INTERCHANGE REVENUE

As fintech disruptors emerged over a decade ago to compete with established banks, minimizing monthly maintenance and overdraft fees was a key differentiator. However, less fee income restricted how these new platforms were able to monetize from users — interchange revenue from card programs became the main revenue source for top neobanks in the US. Here’s a breakdown of the interchange fee on various purchase transactions of $100 (based on a consumer debit card with a Durbin-exempt issuing bank, from Mastercard):

• Gas (Petroleum Service Station): 0.70% + 0.17 (0.95 max) = $0.87

• Restaurant: 1.19% + 0.10 = $1.29

• Online (Standard): 1.90% + 0.25 = $2.15

• Groceries (Supermarket): 1.05% + 0.15 (0.35 max) = $0.35

The fixed fee amount after the % is generally what the payment processor and card network receive — the remainder goes to the issuing bank.

For the Gas and Groceries categories, there is a max interchange fee paid once a transaction reaches a certain amount. Other categories (such as ‘restaurant’ and ‘service industries’) have no cap. When discussing total estimates of interchange revenue for neobanks and other fintechs, understanding where users will use the card most is critical. The amount of total spend in capped categories lowers the range closer to 1%. The use of ATMs for withdrawals is an interchange cost, which would also reduce monthly income. A conservative estimate would be 1.5% of card spend as interchange revenue — for a consumer spending $300 monthly, this would be $4.50. Based on the revenue share agreement with a partner bank, a fintech neobank can capture up to 90% of this amount, or $4.05 per user. The ability to incentivize more monthly spend (especially for primary account relationships receiving direct deposit or wages) leads to a strong monetization path.

The best example comes from Marqeta and their filing disclosures related to their IPO. The card issuance leader only partners with Durbin-exempt issuing banks in order to maximize interchange revenue share as a program manager. The majority of this income comes from US-based platforms (less than 5% from international companies) — specifically one platform in particular: Square. 70% of net revenues came directly from the business volume processed by Square (and its Cash App). Losing Square would be catastrophic. A change in interchange fees by the card networks would also impact revenue growth.

Marqeta and other fintechs are working towards diversifying revenue streams through more partnerships, international expansion, and program fees. As the choices in card options increases for users, competition is mounting to improve rewards and cardholder benefits — both of which reduce the interchange revenue pool. Platforms will be looking towards alternative products and structures that keep customers engaged and making recurring purchases.

ALTERNATIVES and challenges FOR fintech card programs

Fraud detection and prevention with card payments is the largest obstacle for card networks. Fraudsters are constantly on the hunt to exploit and sell stolen consumer data, such as names with credit card numbers. Data breaches and the rising rate of compromised information keep retailers and customers concerned about protection. The steady rise of interchange fees is meant to cover the cost in defending against fraudulent attacks and financial loss suffered by card networks.

For merchant associations around the world, fraud protection is a welcomed benefit that should be balanced with a stable interchange cost. Regulators are encouraging card companies to make longer commitments with current rates (instead of annual increases) and find ways to minimize the amount of increases going forward. In order to compete with faster, lower cost alternatives, card networks need to optimize the end-to-end payment cycle. .

Payment facilitators and processors are offering wholesale transaction fees on a frequent basis that provide lower interchange fees. There are also fintech startups leveraging other payment rails (such as ACH, checks, and wire transfers) in conjunction with funding verification to charge flat, lower transaction costs (such as $0.05 for any ACH payment). Cryptocurrency, especially the use of stablecoins, is a compelling alternative for faster, transparent global payments — by reducing the need for payment facilitators, processors, and issuing banks. Many FX and remittance platforms are already leveraging this new payment rail to manage cash flow for top banks and enterprises around the world.

The most pressing challenge for card program providers has to do with recurring card usage from users. So many card offers exist that offer similar rewards and lack differentiation. The switching costs for consumers and businesses is low. Increasing the amount of types of cashback rewards provides short-term relief, but isn’t sustainable. Rising interchange rates are pressuring merchants to find cheaper ways to transact.

Banks and fintech startups must discover other value drivers outside of card benefits. The recent focus is on transitioning to other areas within banking services to manage more of a customer’s financial life. This means credit card platforms offering checking and savings accounts, and deposit platforms adding credit products. Within lending, emerging companies are focused on credit building through daily purchase activity — specifically with credit builder spend cards that feel like a debit card (with an open credit limit based on balances in a deposit account) but report monthly payments to credit bureaus.

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