What is interchange?
The interchange fee, often referred to simply as “interchange,” is what debit and credit card issuers charge businesses when those businesses process card payments. For example, if you use a debit card issued by Acme Bank at the local coffee shop, a small percentage of your purchase—the interchange fee—will go to Acme Bank. That's why some people call interchange a "swipe fee."
In 2020, the average interchange fee was 0.3% for debit card transactions and 1.8% for credit card transactions. Any business that accepts debit or credit card payments from customers has to pay interchange fees to the bank that issues the card, making interchange fees one of the hidden (but often inevitable) costs of doing business.
Why is interchange necessary?
Interchange fees make sense, from a financial infrastructure perspective; when a business accepts a credit card payment from a customer, the bank that has issued the customer's card is transferring money to the business’ bank (also called an acquiring bank or merchant bank), and that process costs money. After all, there are operating fees for maintaining payment infrastructure, and there’s always the risk that fraud or other payment-related issues might come up later. Interchange is the toll that keeps the payment highway in working condition.
For a long time, there was nothing terribly controversial about interchange fees. But with the steady rise of challenger banks and the success of companies like the newly public Marqeta, which generates most of its revenue from interchange fees, interchange has become a hot-button issue for fintechs, big banks, and regulators alike.
How did a change in interchange rules lead to the rise of challenger banks?
As TechCrunch notes, over the 2010s, many financial technology startups tried to create new banking options for consumers (i.e., challenger banks or neobanks). These challenger banks often made much of their money off of interchange fees, which enabled them to offer customers free services (e.g., no-fee debit cards). Neobanks made their money from the merchants where their customers shopped, not from the customers themselves.
Why did this strategy work for challenger banks and not traditional banks? It starts with the 2010 passage of the Dodd-Frank Act and the introduction of the Durbin amendment, which put a ceiling on the interchange fees that large banks could charge businesses. Importantly, this interchange ceiling did not apply to small banks.
So financial technology companies decided to partner with small banks when they issued debit or credit cards, and were thus able to charge merchants higher interchange fees (10-20 times higher, in some cases, than big banks). Challenger banks like Chime built infrastructure on top of community and regional banks and were able to generate significant revenue through interchange fees while offering free or low-cost offerings to their customers.
In other words, interchange fees were the wedge that enabled new fintech players to get involved in banking, and to take market share from big banks, who felt that the new rules of the game worked to their disadvantage.
What's next for interchange?
So what’s next for interchange? Or, to put it another way, how are large financial institutions responding to the success of new players?
Not surprisingly, big banks have pushed for the government to change interchange rules. Big banks argue that the current setup favors neobanks at the expense of traditional banks. They’re pushing for regulators to cap the amount of money that small banks (and, by proxy, their fintech partners) can collect from interchange.
If regulators cap interchange fee revenue for small banks (the kind that fintechs often partner with), then challenger bank fintechs may have to rethink their revenue models entirely. If regulators decide not to act, you can expect more startups to enter the already-crowded challenger bank space using interchange as a primary revenue generator.
Want to learn more?
If you're scaling a fintech that generates revenue from interchange, you may need to raise debt capital as well in order to finance customer card purchases. That debt capital will come with a host of new capital markets compliance and reporting obligations. If you're interested in learning more about software that can help you manage your debt capital effectively, just request a demo of Finley here. We look forward to chatting!