How American Express, Visa, and MasterCard Set Merchant Fees
The world of credit card processing is notoriously opaque. American Express (NYSE:AXP) recently argued before the U.S. government that few of its merchants understand the complicated pricing structures of Visa (NYSE:V), MasterCard (NYSE:MA), or Discover.
But thanks to a recent Department of Justice opinion, outsiders now have an inside look into pricing decisions, and the competition — or lack thereof — in merchant fees.
The Amex oddball
Visa and MasterCard primarily vary their fees based on 1) the industry of the merchant (hotels might pay different rates than gas stations, for example) and 2) the card the cardholder swipes (high-reward credit cards result in higher fees than lower-tier rewards cards).
In all, MasterCard has more than 240 interchange fee categories thanks to a complicated matrix of industry and card combinations. Visa has fewer pricing categories — “over 70” of them, according to Department of Justice filings. Discover uses a similar pricing strategy in which fees are determined by industry and card type.
Interestingly, American Express is in a league of its own in setting the terms under which merchants will pay it a fee. American Express is the only network that does not consider the card in its rates. Whether an Amex cardholder receives 100 or 500 airline miles for a purchase is inconsequential to its pricing tiers. The merchant’s industry is the key variable.
Amex wants to be the most expensive
It’s common knowledge that American Express charges the highest fees to its merchants. What most probably didn’t know is that it is the most expensive by design. It is, quite literally, American Express’ goal to be the most expensive.
In the recent DoJ opinion, American Express’s pricing strategy is explained as follows:
When evaluating its industry-specific rate tables, for example, Amex’s pricing team begins with a baseline rate equal to the Visa/MasterCard all-in credit card rate (i.e., the average rate charged across Visa’s and MasterCard’s various card offerings) and then adds the value of “the incremental business that [Amex] bring[s] to [its] merchants,” which the company equates with the amount of spend attributable to its insistent cardholders.
In other words, American Express intentionally prices its network so that, on average, it earns more from each swipe than Visa and MasterCard. How much more it charges is a function of how loyal it thinks its cardholders are to its card, based on the industry category.
In industry categories where Amex cardmembers are more likely to walk from a purchase or reduce their purchase if they cannot use an American Express card, the company assigns a larger premium over Visa’s and MasterCard’s average rate.
Generally, its strongest categories for pricing have been in travel and entertainment, with “everyday” purchases like gasoline or groceries offering less pricing power. (Discover’s relatively small market share makes it largely irrelevant in American Express’s pricing decisions.)
An epic feedback loop
American Express’ higher prices may have led to a feedback loop in which its premium rates allowed Visa, MasterCard, and Discover to increase the prices they charge their merchants on each swipe.
Court filings show that starting in 2006, Visa and MasterCard introduced new card categories with higher fees for merchants that would support higher rewards for customers. The goal was to better compete against American Express’s more lucrative rewards programs. Almost immediately, the bank issuers of MasterCard and Visa cards began to shift their offerings toward cards with higher merchant fees. The net result was that Visa’s average rate rose 0.15% from 2006 to 2009.
You probably see the feedback loop, here. American Express strives to always charge more than Visa and MasterCard. Visa and MasterCard used AmEx’s premium prices to justify higher fees in the mid-2000s.
Thus, it’s no surprise why credit card stocks — specifically, shares of credit card networks — have historically been excellent investments. For almost the entirety of recent history, certainly for as long as Visa and MasterCard have been public companies, the networks have never truly competed on cost. As long as this friendly dynamic exists, it should be smooth sailing for all involved.
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