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The Economic Impact of State Restrictions on Interchange Fees

Introduction 

In a world where the use of cash is becoming increasingly scarce , interchange fees serve a vital role by funding the security and infrastructure of payment card systems, which in turn facilitates trade in our modern economy. However, initiatives set out to restrict these fees – another instance of government price controls – are becoming more abundant and have even been passed into law in states like Illinois.

While these laws are sold as a necessary intervention to save merchants and consumers money, focusing solely on the costs associated with card acceptance ignores the benefits that accrue to merchants, consumers, and the economy more broadly. More importantly, the costs and technical burdens associated with modifying what is currently a global payment system to facilitate regulatory changes in one state of one country would likely render the issuing and acceptance of debit and credit cards in that state infeasible, bringing about significant economic harm.

This report serves to both educate and inform the public about interchange fees, their role in the payment card system, and the impacts of payment cards on the economy. Given the novelty of many state specific restrictions on interchange fees that have gained popularity in recent years, such as Illinois’ Interchange Fee Prohibition Act (IFPA) that passed in 2024, little information exists on the potential economic impacts of such legislation. Using the Colorado economy as a case study, this report will detail the economic impacts of implementing an IFPA-like restriction on interchange fees in the state through the use of dynamic macroeconomic simulation, providing a glimpse of what other states can expect should they go down a similar path.

Key Findings

  • The implementation of an IFPA-style restriction on interchange fees in Colorado will lead to economic declines and job losses. CSI estimates that the law would result in a 5.5% reduction in Colorado’s cumulative job growth over the next five years, with employment in the retail sector experiencing a 75.9% reduction in employment growth by year five. Other critical sectors like construction and the financial sector would likely experience significant hits as well.
  • Overall, the Colorado economy would contract by 0.2% by year five relative to baseline simulations, representing a $1.4 billion dollar loss to the economy. Coloradans would also experience an overall loss in personal income exceeding $1 billion.
  • These overall costs to the state’s economy surpass the potential savings to Merchants as a result of not having to pay interchange on taxes and tips. CSI estimates merchants in the state could expect to save $118.8 million in fees in year one – only roughly 0.07% of total taxable sales made in the state –  with the total, cumulative savings over five years reaching $635.3 million by year five. However, the costs to the state’s GDP in dollar terms reaches 226% of these potential savings, with the overall income losses in the state reaching 168%.
  • Given the structure of the typical interchange fee for debit and credit cards, the savings to smaller merchants is likely to be smaller as a portion of the interchange fees they currently pay, meaning those retailers – particularly those that engage in frequent, small-ticket sales – are likely to experience smaller savings as a proportion of their overall fee expenses. Similarly, the lost interchange fee revenue for issuers in the state is likely to disproportionately impact smaller banks and credit unions, whose entire revenue base is limited (or at least heavily concentrated) to that one specific state. As a result such a law is likely to lead to market concentration in both the card issuing and retail sectors.

Key Terms and Definitions

Acquirer – The financial institution that facilitates electronic payment transactions for merchants. Often referred to as the acquiring bank, or merchant’s bank.

Clearing – The process where acquiring and issuing banks exchange payment information regarding a transaction. Once the issuing bank validates the transaction and provides the card network with necessary financial information, the transaction is said to have “cleared” and can proceed to settlement.

Gateway – A service provider that securely facilitates the transfer of payment information between a merchant’s website or point-of-sale (POS) system and the payment processor or acquiring bank.

Issuer – The financial institution that provides payment cards (credit, debit, or prepaid cards) to consumers and businesses. The issuer manages the cardholder’s account and is often referred to as the issuing bank.

Network – Networks facilitate the transfer of payment information between the acquirer and the issuer, and ensures funds are transferred from issuer to the acquirer.

Payment Processor – A company that provides technology services to process electronic payments for merchants. Payment processors are responsible for sending the payment card data and other information to the card network and to the issuer. Both acquirers and issuers can act as payment processors, but both can also utilize third-party companies to handle payment processing.

Settlement – The final process in a payment card transaction where funds are electronically transferred from the issuer to the acquirer. Often occurs at a later time or date than the original transaction, whereas the clearing process takes place when the transaction is performed.

The Card Payment Landscape

What are Interchange Fees?

Interchange fees are charges paid by a merchant’s bank (acquirer) to the cardholder’s bank (issuer) each time a credit or debit card is used for a transaction, and are based on the type of card used, and the payment method for which the card was used (in person, online, or manually keyed in). While the acquiring bank is responsible for paying these fees, they are typically passed down to the merchant who ultimately bears the cost. Interchange fees are usually calculated as a percentage of the transaction amount, including taxes and any gratuity, but often includes a small, fixed amount per transaction. As a percentage of the average transaction, interchange fees averaged 0.73% and 1.80% for debit and credit card transactions, respectively.[i]

Revenue from interchange fees is used by the issuing bank to fund various services, such as covering fraud prevention costs and the numerous rewards and cash-back programs offered through some debit and credit cards, both of which can impose significant costs to issuing banks.

In 2022, for instance, the six largest issuers of credit cards in the U.S. alone paid $67.9 billion in rewards – a 23.7% increase from the previous year – and reported billions more in liabilities for rewards not yet claimed by cardholders.[ii] Fraud losses for that year reached billions for issuers as well[iii][iv], with losses expected to exceed $165 billion over the next ten years.[v] Beyond the losses themselves, financial institutions expend countless resources preventing fraud in the first place, and investigating it when it does occur. Lexis Nexis reported in its seventh annual True Cost of Fraud Study that each for each dollar lost to fraud, financial institutions in the U.S. and Canada lose $4.41.[vi]

Interchange fees also serve as compensation for issuing banks for assuming the risks associated with debit and credit card transactions, such as when a cardholder has insufficient funds in their account to pay for a transaction, or when issuers need to write off outstanding balances they can no longer recover (also called bad debt).

In the case of debit cards, transactions can sometimes pass the clearing process despite not having sufficient funds later during settlement. With credit cards, cardholders use issuer funds to make purchases with the promise to repay at a later date, and in many instances, fail to pay back those liabilities in a timely fashion, if at all. For instance, the New York Federal Reserve notes that as of Q3 of 2024, 3.23% of all credit card debt was delinquent with banks writing off another 4.69% as uncollectable, with both rates reaching their highest levels since 2011.[vii] In both cases card issuers assume the risk associated with the transaction.

 

A common misconception[viii] is that payment networks like Visa and Master Card receive revenues from interchange fees. Although payment networks such as Visa and Master Card set the level of interchange fees, they are paid by acquiring banks, who pass down those costs to their merchant customers.

Networks must balance the level of interchange fees between the interests of acquiring banks (and merchants) and card issuers. If interchange fees are set too high, acquiring banks – and their merchant customers – will not accept that network’s cards as a form of payment. Set rates too low and issuing banks will not issue a network’s card.

 

How Card Payments Work

When a consumer uses their debit or credit card to make a purchase, the merchant’s payment gateway or payment processor – often in the form of a point-of-sale (POS) device – collects essential information such as the debit or credit card number, expiration date, Card Verification Value (CVV), and the transaction amount. Business-to-consumer transactions utilize level 1 data, which is limited in scope and the information that is transmitted, and most importantly, does not transmit tax data.

Card and purchase information is then securely transmitted in encrypted form to the merchant’s bank (acquirer) or, in many cases, a third-party payment processor. The acquiring bank or processor forwards the transaction details to the relevant card network (e.g., Visa, MasterCard), which in turn sends the request to the issuing bank or their third-party processor. Upon receiving the request, the issuing bank verifies the card details, checks the availability of funds, ensures the card’s validity, and performs fraud prevention checks. After reviewing these elements, the issuing bank either approves or denies the transaction. The payment gateway or processor then promptly notifies the merchant of the decision, allowing the transaction to proceed, all of which happens within milliseconds.

Who Pays What?

The payment card system is designed to securely handle sensitive information, facilitate data exchange between parties, and reduce the risk of fraud. To support this system, fees are applied whenever a credit or debit card is used in a transaction, which funds the various entities and components that make the system function. These typically include gateway fees, acquirer fees, network fees, and interchange fees.

Card Acquirer: The card acquirer – or merchant's bank – is responsible for the payment of network and interchange fees. However, these costs are typically transferred to the merchant in the form of a Merchant Service Charge (MSC) or Merchant Discount Rate (MDR), which is often subject to negotiation between the acquirer and the merchant. In addition to network and interchange fees, acquirers may also charge merchants additional acquirer fees for their services.

Merchant: Merchants bear the cost of the MSC or MDR, which covers both the network and interchange fees, as well as the acquirer fees. Merchants are also liable for gateway fees or merchant service provider (MSP) fees.

Card Issuer: Card issuers, typically banks or other financial institutions, are responsible for paying network fees and providing rewards or cashback incentives to cardholders. In return, card issuers receive interchange fees from merchants and may also collect fees from cardholders, such as annual fees or late payment charges. Many issuers also pay a third-party to process their card payments.

Cardholder: Cardholders are responsible for interest and other account fees associated with their debit or credit card.