Economic Model: Should a Digital Financial Services System Use Interchange?

Every financial services provider has their own economic relationship with their customer – whether that customer is a consumer, a merchant, an enterprise or a government. How providers price their services depends, of course, on a wide variety of factors – including the costs of operating the payment system.

In some payments systems, scheme rules use a mechanism known as “interchange” which provides an additional source of revenue to one participant and is paid by another on a transaction basis. As the most common example, in card payments systems the merchant’s bank pays interchange to the cardholder’s bank: this cost is passed on to the merchant by their bank. Some ACH-type systems use a similar mechanism. The general rationale for interchange is that the party incurring costs should be compensated by the party receiving value. In some emerging mobile person-to-person (P2P) schemes, the sending bank pays interchange to the receiving bank, to compensate the receiving bank for costs incurred in receiving the payment. Note this is the opposite flow from that of card payments, in which the payment receiving bank (the merchant’s bank) pays compensation to the paying bank (the cardholder’s bank). Interchange is a flow of funds between two scheme participants. The scheme itself does not receive any portion of interchange.

Considerations around interchange

Without interchange, some participants may not be willing to join the scheme, or will discourage certain uses of the system. Interchange is an efficient way to ensure that compensation is made to the party incurring the costs.

Larger merchants and billers are receiving value from having access to consumer payments accounts: they should be willing to pay for this value. Interchange is simply a mechanism that permits the transfer of payments from the value-receiving party to the value-providing party.
Arguments against the use of interchange include the fact that interchange sets a “floor” cost into a system: providers paying interchange at a minimum will always need to price services to cover this cost. Since they are not in control of the cost (that is, it is a “tax” leveled on them by the scheme), there is no incentive, on either parties side, to lower actual costs. This may cause end-user prices to be unacceptably high to poor users (merchants and/or consumers) of the system. Interchange may perpetuate this cost structure long after the “ramp up” of the system is over.
In this section we consider the question of whether or not interchange is a useful mechanism for a digital financial services system serving the poor.

The Financial Inclusion Perspective: A system without interchange is preferred

Interchange is both unnecessary and counter to desired economics for most consumer uses of a digital financial services system. For payments made to large merchants, however, interchange may play an important role in the growth and sustainability of the payment system. By nature of their size, larger merchants are more likely to make and receive more payments than other participants and as such gain the greatest value from the system. If a digital financial services system opts in favor of large merchant interchange, it should be sure to exempt small and especially micro merchants who are currently almost entirely cash-based: these merchants will often refuse to use a system that they pay for, therefore undermining one of the key goals of the digital financial services system – to reduce the use of cash. The Level One Project Guide recommends that “sunset” provisions be put in place for any instance of interchange, so that both the level of interchange and the need for it are regularly reviewed by system participants.