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(NB:  We have consulted with Visa U.S.A. Inc. on a variety of issues; the views expressed herein are our own.)

In our earlier post, we observed that the GAO report on interchange got off on the wrong foot when it concluded that interchange fees were rising.  We infer from the silence which greeted our post that everyone agrees with this criticism.  Indeed, yesterday’s posts and comments appear to agree that the GAO’s report does very little to advance the discussion of interchange or the cost of electronic payment.  But we suspect that greater disagreement lies just around the corner.

A number of posts yesterday promised to address the claim on which the criticism of modern payment systems rests–the extent to which the discount that merchants pay to accept most electronic payment systems in the U.S. imposes a tax on legacy payment instruments such as cash and check  Mark Seecof seized upon this point in his comment on Ron Mann’s post.  According to Mark, the “big problem” with the payment card industry is that discount fees are used to fund rewards programs, and he claims that society as a whole would be better off if the government simply forbid networks from enforcing their honor all cards rules and force networks to negotiate acceptance on a program-by-program, issuer-by-issuer basis.  The claim that increasing transaction costs will produce more efficient outcomes is a curious one.  But we’ll save that issue for a later day.  Rather, with this post we intend to take up the predicate of Mark’s post–that discount fees on electronic payments shift costs to users of legacy payment instruments.

At the outset, we note that discount fees, unlike interchange, are a feature of virtually all private payment instruments.  Thus, if there is something to the notion that discount fees tax other forms of payment, then the criticism applies as much to American Express and Discover as it does to MasterCard and Visa.  In our view, however, although this criticism is oft repeated, repetition obscures a number of problems.

First, cross-subsidies are ubiquitous in any complex economy.  Consumers receive free refills on drinks in restaurants, free parking at shopping malls, goods below cost in supermarkets (via loss leaders), relatively inexpensive newspapers because advertisers pay most of the costs, and many similar benefits.  To bring buyers and sellers together through such intermediaries as newspapers, supermarkets, and credit cards, one side frequently receives inducements to participate.  These inducements help maximize the joint value of the ultimate transaction for the parties.  Rather than an inefficient “subsidy,” these inducements are the lubricant necessary to make the economic machine work at its best.

Second, from a social policy perspective, whether interchange forces legacy buyers to pay more should raise a concern only if legacy is more efficient.  But it’s not.  It is hard to believe, as some people suggest, that credit cards and other electronic payments are more expensive than cash and checks.  In fact, legacy payments have several limitations that create costs for both consumers and merchants.  Cash only works well when the good and payment are exchanged simultaneously.  And the technology of cash does not support the instantaneous decision to give credit to the person buying; rather, the buyer has to arrange credit separately with a financial institution.  In addition, with cash, you have no recourse against fraud, other than bringing suit.  (On the costs of cash, see Daniel D. Garcia Swartz, Robert W. Hahn, and Anne Layne-Farrar, The Move Toward a Cashless Society: A Closer Look at Payment Instrument Economics, Vol. 5, Issue 2, Review of Network Economics 175, 192 (June 2006) (describing cash as “among the most costly payment method[s] for society”)).  Similar transaction costs and risks accompany the use of checks.

By contrast, there are numerous benefits to using credit cards and other electronic payments.  For consumers, these benefits include the extension of credit real-time, the reduction of risk, automated dispute resolution, and better record keeping, as Garcia-Schwartz, Hahn and Layne-Farrar demonstrate.  For merchants, accepting credit cards allows them to make sales on credit at a generally lower cost than operating their own credit program.  And merchants can receive faster and more certain payment from customers using cards than from customers using other means, such as checks.

Third, and most significantly, the rapid growth of online payments within the retail industry is rendering legacy payments obsolete.  The GAO itself seems generally aware of the shift from legacy to electronic payments.  Indeed, it cites the Federal Reserve’s recent estimate that the use of both checks and cash have declined, or at least grown more slowly than credit and debit card use, since the mid-1990s as more consumers switched to electronic forms of payment.  Since 2005, more than half of total retail transactions have used either credit or debit cards.  Large national merchants report that sales made with cash and checks have decreased in recent years, while sales made with credit and debit cards have increased.

But the GAO ignores that the argument in favor of regulating interchange to protect cash and check users, whatever its overall merits, is logically limited to areas where legacy forms of payment can be used.  And those areas are quickly vanishing.  For example, even if a study of the 1980s retail gasoline market were to suggest the existence of cross-subsidies then—a debatable conclusion—that study cannot be read to suggest the existence of such a subsidy among people who shop on-line or who buy their gas at automated fuel dispensers.  According to scholars, we are rapidly moving towards a cashless society where no one uses legacy instruments such as cash or check.  And there is simply no reason to believe that this move is driven by the inherent inefficiency of electronic payment or an implicit tax on users of cash or check.

The GAO’s misplaced concern for users of legacy payments is yet another example of a theoretical objection to unregulated interchange that finds no support in the facts.  According to Garcia-Schwartz, Hahn and Layne-Farrar, “the shift toward a cashless society appears to improve economic welfare,” with consumers the party most likely to benefit.  But, if history repeats itself, we will likely have to continue to endure the interchange debate regardless of the facts.  As the GAO’s report again reminds us, merchants simply want to pay less for the benefits that credit cards provide.  Not surprisingly, they are in this debate for themselves, not their consumers.

Thomas Brown is a partner in O’Melveny and Myers’ San Francisco office.  Timothy J. Muris is Foundation Professor of Law at George Mason University School of Law and Of Counsel in O’Melveny & Myers’ Washington DC office.

Next summer, the World Cup, the world’s most watched sporting event, marks its quadrennial return.  Although thirty-two teams will compete in South Africa, the list of favorites begins with the two teams that have won half of the previous eighteen tournaments and three of the last four—Brazil and Italy.  Brazil plays an open and flowing brand of soccer.  Italy sits back and pounces when its opponents stumble.  Although Brazil and Italy follow different philosophies, they have achieved similar success because both have adopted strategies to overcome the adversity that inevitably arises in a major tournament.  Even a weak opponent can manage to score a single goal when a referee blows a call.  But good teams find a way to overcome.

Long-running legal and policy debates have the feel of the World Cup.  Firms on either side of an issue develop their arguments for and against particular policies, and they stage matches between their respective positions in journals and before Congress, courts and administrative agencies.  Legislators, judges and administrators observe those skirmishes and, ultimately, render decisions.  One hopes that these decisions reflect the relative merits of the parties’ competing positions.  But even well-intentioned officials make mistakes.  The challenge for a firm engaged in a long-running debate is to develop persuasive arguments even in the face of mistakes by the decision makers.

We found ourselves thinking about the ability of generations of Brazilian and Italian soccer players to overcome adversity as we read the GAO’s much anticipated report on interchange.  Although we agree with the report’s ultimate conclusion, we were surprised at how the GAO reached this result.  The GAO accepted as true the point from which critics in the U.S. launched their attack on interchange—that “rising interchange fees have increased costs for merchants.”  The GAO nevertheless recognized, correctly in our view, that the government should neither set rates nor prevent the networks from enforcing the many acceptance rules about which merchants complain.  And the fact that the GAO reached this conclusion notwithstanding its flawed analysis of the changes in interchange rates over the recent past is yet more evidence that the networks have the better of the argument.

Interchange is a function of network architecture, not product design.  When a payment network supports multiple issuers and acquirers (i.e., allows multiple financial institutions to issue payment products to consumers and to sign merchants to accept those cards), it needs some mechanism that enables those issuers and acquirers to exchange their transactions.  This design explains why Discover, but not American Express, has adopted an interchange mechanism.  Discover has opened its network to third-party issuers and acquirers.  And like Visa and MasterCard, it sets the rate at which issuers and acquirers on its network exchange transactions.  American Express now supports third-party issuers, but it remains the sole acquirer on its network.  It compensates issuers for providing transactions, but it does not need an interchange device.

Interchange fees are as much a feature of the transactions that consumers initiate with pre-paid and debit transactions on the Visa, MasterCard and Discover networks as the fees are on the networks’ credit transactions.  But the GAO limited its analysis of the change in interchange rates over time to credit transactions, rendering useless this aspect of GAO’s analysis.  The centerpiece of the analysis of the change in rates over time is found in Table 2 at page 15.  There, the GAO reports that 43% of Visa rates and 45% of MasterCard rates increased between 1991 and 2009.

But the GAO neglects to mention a significant intervening event—the resolution of the Wal-Mart litigation.  That settlement allowed merchants to accept Visa and MasterCard credit cards without also accepting the network debit cards.  (See In re Visa Check/Mastermoney Antitrust Litig., 297 F. Supp. 2d 503 (E.D.N.Y. 2003), aff’d, Wal-Mart Stores, Inc. v. Visa U.S.A. Inc., 396 F.3d 96 (2d Cir. 2005)).  And the settlement must be considered when comparing the post-settlement rates to the pre-settlement rates.  Prior to the settlement, credit and debit transactions were offered in a bundle.  Post-settlement, the transactions were offered independently.  Although the system-wide average rate did not change following the settlement, the prices of the components moved in different directions.  Credit rates increased, while debit rates fell.  (See Chart 3 here).

The report offers no explanation for the GAO’s decision to limit its analysis of changing interchange rates to credit transactions or omit discussion of the Wal-Mart litigation.  Although the legislation commissioning the report sought an analysis of the effect of interchange on credit cards, the report as a whole discusses interchange more generally.  And Visa and MasterCard tried to persuade the GAO to examine changes in all fees.  The report acknowledges that both Visa and MasterCard told the GAO that “their average effective interchange rates applied to transactions have remained fairly constant in recent years when transactions on debit cards, which have lower interchange fee rates, are included.”  The GAO’s response to this observation is a non sequitur:  “[h]owever, our own analysis of Visa and MasterCard interchange rate schedules shows that the interchange rates for credit cards have been increasing and their structures have become more complex.”

Moreover, interchange fees relate to but are different from the prices that merchants pay to accept payments.  Changes in rates often but do not always affect the prices that merchants pay to accept particular forms of payment.  (See chart 4 here).  Whether a given rate applies to a given merchant turns on the nature of the rate (i.e., whether it applies to all merchants or just some), the investments that the merchant has made in its acceptance technology, and the merchant’s skill in negotiating with its acquirer.  And the net effect of increases in some rates and decreases in others depends on the mix of transactions at that merchant.  The weighted average interchange rate may have declined over time for merchants with proportionally more debit transactions than credit transactions.  The first clause of the title of the GAO report should thus read “Changing Interchange Rates Have Had Varying Effects on the Prices That Different Merchants Pay to Accept Different Types of Payments.”  (The first clause of the title of the GAO Nov. 2009 Report actually reads:  “Rising Interchange Fees Have Increased Costs for Merchants.”)

But the larger point for purposes of this comment is that the alleged increase of interchange rates and its effect on merchant costs merely opens the inquiry.  Many questions follow.  Higher interchange rates may drive additional sales for merchants, enable electronic payments to displace less efficient (or more expensive) legacy forms of payment, or reduce the costs of electronic payment for consumers.  The GAO report documents the existence of each of these benefits.  And it confirms that efforts to regulate interchange rates or reform acceptance rules have shifted costs from merchants to consumers.  For these reasons, the GAO’s report, on balance, provides little comfort to interchange critics.