With respect to large merchants–many of them negotiate separate agreements (what we’re talking about in all of these discussions is a default rate, but many merchants–especially large ones–do negotiate deviations from these rates). And I have no doubt that some of the lower interchange fees they are able to negotiate reflect precisely the dynamic you describe.

I don’t know about the existence of third party insurers, but I agree that in principle this could be more efficient–it need not be the case that any of the direct participants in card networks is in fact the least cost insurer. But this is a Coasian world, and my first-cut guess is that either such entities do exist and do affect the interchange rate in certain cases, or that they are not, in fact, the least cost alternative, taking transaction costs into account. Does anyone have more info on the presence and/or effect of third-party insurers?

Ron: Of course these rules exist–my point is that because side payments are not allowed in the system (banks are required to process checks at par), the system may be inefficient. The inability to make side payments in fact makes complicated rules more rather than less likely, as a second-best effort to compensate for the difficulty in re-allocating risk through price.

With respect to credit cards, it is surely not true that merchants bear the majority of direct fraud costs on credit cards. Merchants do bear those costs in card-not-present transactions, but even now that is a relatively small share of all transactions. I would love to see (or hear more about) the study that Mr. Van Dyke references.

Fraud can be difficult to measure, but it is clearly an important issue. All payment methods are subject to fraud, and one can debate the best method for measuring fraud. Overall, I believe that there is a general consensus that PIN debit has the lowest fraud rate of the major electronic payment methods.

On a related note, there are private mechanisms for reallocating fraud costs. For example, merchants may choose to self-insure against bad checks, or they may purchase check verification services where the risk is shifted to the insuring party. Some merchants do one, some the other. As Omri notes, if efficient insurance is the theory supporting interchange fees, the existence of self insuring and third party coexisting for other payment methods is an interesting alternative.

It is possible to imagine, however, that some large merchants can self insure in a more efficient manner. First, they are big enough to be risk-neutral. Second, they can uniquely take some measures to reduce the risk, in real time, at the point of transaction. If efficient insurance is the theory supporting interchange fees, it seems to suggest that merchants who want to self insure ought to be allowed to negotiate such arrangements.

Moreover, it is far from clear that interchange fees are priced to reflect merely the risk. I take it that the the basis for the regulatory concern is that the price reflects a substantial component of profit. If that is the case, then some insureds might prefer to buy risk coverage from a less efficient insurer, which is priced more competitively. I don’t know if there is direct insurance product for the fraud “peril” but, again, self insurance can turn out to be more desirable than the overpriced coverage provided through the interchange scheme.