Geoffrey A. Manne is Executive Director of the International Center for Law & Economics and a Lecturer in Law at Lewis & Clark Law School.
I take to heart Jim’s claim that fraud is too-little discussed in this realm given its cost, and thus I’ll try my hand at it.
Every discussion of the industrial organization of credit card networks owes a debt to Bill Baxter. Baxter, a law professor and former Assistant Attorney General in the Antitrust Division of the DOJ, was one of the first (maybe the first?) scholars to discuss the economics of two-sided markets, in a paper, as it happens, on the economics of interchange fees in credit card networks.
In simple terms, the essence of Baxter’s analysis is that the role of the interchange fee in credit card networks is to balance and maximize demand for credit card transactions on both the consumer side and the merchant side–optimizing the system by drawing in as many consumers on the one side and merchants on the other as possible while still matching up demand for credit transactions on each side (thus maximizing network benefits). The lever of the interchange fee allows the system to re-allocate some of the costs that are otherwise born by only one side of the market in order to effect this optimization. One of these costs is the cost of fraud–and the interchange fee is, it seems to me, an essential lever for re-allocating the costs of fraud within the credit card system to where they can best be born.
Fraud costs are an important, if oft-neglected, component of payment systems’ functioning. Every payment system by its nature includes the risk of fraud, and every payment system, by design or by default, imposes the risk of fraud on one or more parties in the system. For example, a merchant that accepts cash in exchange for goods bears the risk that the cash will be counterfeit. The cost of counterfeit currency to merchants is substantial. (Although, speaking of cross-subsidies, the cost to merchants likely captures barely a fraction of the full cost of counterfeit currency—a cost born mostly by the government (and passed on to taxpayers) in policing and deterring counterfeiting). The cash system, essentially by default, imposes the residual fraud costs on the merchant. Checks present an even greater fraud problem than cash and, again, the costs are allocated essentially by default: A merchant that accepts a fraudulent check will bear the cost of the fraud.
In principle, the fraud costs of checks or cash could be allocated differently. The government could offer some sort of guarantee, or the issuing bank could agree to bear the cost. But in part because the government requires banks to clear checks at par—has, in other words, fixed the interchange fee at zero for checks—there is little opportunity for the system’s lever to operate to reallocate these costs, ensuring that the costs lie where they fall, and that redistribution is made only in the parts of the system governed by explicit contracts (thus, for example, depending on a host of factors, some of this cost may be redistributed from merchants to merchants’ banks via reductions in various fees in the agreement between merchant and bank).
In contrast, the flexible interchange fee in the credit card system allows fraud costs to be allocated differently throughout the system, presumably ensuring not that the costs lie where they fall, but rather that they are born by the party best positioned to bear the costs. In the case of credit cards, assuming the merchant complies with the network’s rules for seeking authorization of payment, the issuing bank, in fact, guarantees the payment (and thus bears the risk of non-payment). As Bill Baxter noted, “[t]his shifting of risk under the [credit card] system obviously increases [the issuing] bank’s cost, enhances [the merchant’s] demand for the system, and increases the amount of discount [the merchant] is willing to pay to [the acquiring] bank.” It is this re-allocation of costs, facilitated by the interchange fee, that helps to optimize the system.