Interchange fees and innovation
in retail payment systems
Marc Bourreau,Telecom ParisTech
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Introduction

Slow pace of innovation in retail payment systems
for decades…
◦ Paper check for 700 years, plastic card for 50 years
◦ Role of the interchange fee (IF): allocation of costs
between the acquiring and the issuing sides, etc.

… but acceleration of innovation due to the
development of web and new digital devices
◦ At POS: contactless cards (Visa PayWave), mobile
phone as payment card (NFC), mobile phone as POS
terminal (Square), etc.
◦ E-commerce: web checkout (Paypal), telephone bill as
payment account, …
◦ P2P: SMS-based money transfers, …
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Introduction
1200
Year 2000
Patents submitted to the European
Patent Office (EPO) for “payment”
technologies, per year
600
400
200
0
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Introduction
 Question
addressed in this presentation:
What is the impact of IF on innovation in
retail payment systems?
 Main message: the IF affects innovation
in payment systems through two
different (but related) channels,
◦ Issuers’ and acquirers’ (and potential entrants’)
incentives to invest in innovative payment
solutions
◦ Merchants’ and consumers’ incentives to adopt
innovative payment solutions
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Innovations in payment systems


Innovation = product innovation (introduction
of new payment services) + process
innovation (cost reductions + quality of service
improvements)
Cost reductions:
◦ security/reduction of fraud
◦ transaction costs, etc.

Quality of service improvements:
◦ convenience, simplicity
◦ customer relationship management
◦ possibilities of differentiation, etc.
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Innovation in payment systems

Two-sided nature of retail payment
systems
◦ Membership and usage externalities between
two distinct groups of users: consumers and
merchants
◦ Implies adoption externalities: the innovating
firms might have to solve the “chicken and
egg” problem

Economies of scale and network effects
◦ Strong incentives for standardization and
cooperation between competitors
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A model of innovation (B&V 2011)
payment system
Interchange
Incentives
to
innovate?
competition
between issuing
banks
competition
between
acquiring banks
consumer fee
Incentives to
adopt the
innovation?
consumers
Interchange
retail
prices
merchant fee
merchants
adoption externality
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Adoption incentives

Adoption externality between consumers
and merchants
Consumers’ adoption
incentives depend on…
• the price of the new
payment instrument,
• its quality,
• the number of
merchants who adopt the
innovation
Merchants’ adoption
incentives depend on…
• the merchant fee,
• the adoption cost of the
innovation,
• the number of
consumers who adopt the
innovation
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Adoption incentives

example with a
uniform distribution
of merchants
Short-term perspective: the innovation has been
developed. Effect of a lower IF on users’ adoption
incentives?
consumers
merchants
Price effect (higher
consumer fee):
adoption 
Price effect (lower
merchant fee):
adoption 
Externality effect (higher
# of merchants):
adoption 
Externality effect (lower
# of consumers):
adoption 
Consumer adoption…
 for low degrees of externality
(if IF not too high)
 otherwise
Merchant adoption…

9
Innovation incentives

Long-term perspective: the innovation has to be
developed. Effect of a lower IF on issuers’ incentives to
innovate (= invest in quality improvements)?
Example with
uniform
distribution
Effect of a lower IF
on quality
investments
Low degree of
adoption
externality
(if IF not too high)
High degree of
adoption
externality
+
• Low externalities: a high IF softens competition
• Strong externalities: a low IF stimulates merchants’
adoption
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Cooperation and Innovation


Historical examples of cooperation between
banks to create common networks (e.g.,
Visa)
Many recent examples of partnerships or
Research Joint Ventures for the development
of new payment solutions:
◦ JV MasterCard + Smart Hub (MNO), 2010
◦ Alliance Visa + Monetise, 2009


Should cooperation for innovation be
encouraged in retail payment systems?
What is the effect of the IF on the incentives to
cooperate for innovation in payment solutions?
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Cooperation and Innovation

Should we encourage cooperation for
innovation in retail payment systems?
◦ Yes, if strong adoption externalities between
consumers and merchants  higher
investments in quality of service with
cooperation compared to no-cooperation

Effect of IF on incentives to cooperate?
◦ With a high degree of adoption externalities
between consumers: incentives to cooperate
increase with the IF
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Conclusion
Acceleration of innovation in payment services,
driven by the development of digital devices
(computers, smartphones, tablets, etc.)
 Effect of IF on innovation in payment systems?

◦ Short-term perspective (effect on adoption
incentives) vs. long-term perspective (effect on
innovation incentives)
◦ Effect depends on the magnitude of adoption
externalities between merchants and consumers


Cooperation socially desirable if strong adoption
externalities
Incentives to cooperate higher with high IF
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References
Bourreau & Verdier (2011), “Cooperation
or Competition: Innovation in Payment
Systems,” work in progress.
 Bourreau & Verdier (2010), “Cooperation
for Innovation in Payment Systems: The
Case of Mobile Payments,” Communications
& Strategies.

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