Explaining Business

As part of the settlement of a lawsuit, Visa and Mastercard have agreed to a $38 billion deal with US merchants.

What was the issue?

Well, US merchants or sellers that accepted Visa or Mastercard as a mode of payment accused Visa, Mastercard, and banks of monopoly. The merchants argued that card networks like Visa and Mastercard, as part of their rules, didn’t allow them to offer cheaper modes of payment (like cash or debit cards) to their customers. The merchants also claimed that Visa, Mastercard, and banks conspired to set high card swipe fees.

Merchants said they lost money because of these monopolistic practices and wanted to be compensated. Hence, this settlement of $38 billion. Note that this isn’t a cash settlement. Instead, this settlement is about Visa and Mastercard changing future rules and lowering swipe fees which can result in $38 billion in future savings for merchants over the next 8 years.

Sounds complicated? Let me simplify and break down the basics.

Credit cards involve 3 key backend players:

• Issuing bank
• Acquiring banks or payment processors
• Card networks (like Visa and Mastercard)

Issuing banks are the banks that give you your credit card. Example: JP Morgan Chase or Citibank. They fund your credit, handle your account and decide your credit limit. And they also assume the risk in case you don’t pay your credit card.

Acquiring banks are the banks that set up merchant accounts to accept payments. In other words, they help merchants accept card payments from their customers. They handle merchant accounts, swipe machines or terminals, and settle funds. Example: JP Morgan Chase Merchant Services or Wells Fargo Merchant Services.

Payment processors like Square, Stripe and PayPal also can also help merchants accept payments. But in the backend, these payment processors need to tie up with an acquiring bank to handle merchant accounts and settle funds. Think of them as a front-end user interface that moves data between issuing banks and acquiring banks. They don’t hold any fund and hence they don’t have any risk.

Payment processors are like an optional add-on in the credit card workflow. They aren’t necessary. A merchant can open a merchant account directly with an acquiring bank or sign up with a payment processor that further ties with an acquiring bank in the backend. Merchants may prefer payment processors over directly signing up with an acquiring bank because of the better user experience, such as onboarding, dashboards, metrics, APIs, etc.

Card networks (like Visa and Mastercard) are like digital infrastructure that connect issuing banks and acquiring banks. They don’t issue cards, keep funds or take any risks.

But why’re they necessary? Can’t the issuing banks and acquiring banks talk directly to each other?

No, they can’t because they do not understand a common language. Each bank has its own way of recording and communicating transactions. The issue becomes more complicated when international banks are involved. For example, what if you’re based in the US and buying from an online store based in the UK? So, these card networks have created a standard infrastructure that any bank can plug into and start communicating with any other bank located anywhere. Also, these networks act as a clearing houses between banks since after every credit card transaction, funds must move from the issuing bank to the acquiring bank.

Let’s better understand the role of each of these 3 or 4 players with an example.

Imagine there’s a merchant who runs a grocery store and accepts card payments via a Square (payment processor) terminal and swipe machine. Square has the merchant account set up with Wells Fargo (acquiring bank). You visit the grocery store and buy $100 worth of groceries. During checkout, you pay using your credit card issued by JP Morgan Chase (issuing bank) and powered by Visa (card network). So, as soon as the merchant swipes your credit card for a $100 payment, Square sends the transaction data to Visa. Visa routes it to JP Morgan Chase for approval and funds. JP Morgan Chase approves the transaction and sends $98.50 ($1.50 deducted as fees) to Wells Fargo. Wells Fargo then deposits $98 into the merchant’s account ($0.50 gets deducted as fees, which gets shared among Wells Fargo, Visa, and Square). Square shows $98 as the payout in its app or dashboard. That $2 deduction from the $100 payment is a swipe fee. The merchant bears this swipe fee.

Makes sense?

This swipe fee is at the center of the lawsuit that was filed by the merchants. They claimed they were not allowed to add a fee for customers who paid with credit cards, even though those transactions cost more because of swipe fees. Continuing with the above example, the merchant has to bear the $2 swipe fee. They cannot ask you to pay $102 instead (that means you, not the merchant, will bear the swipe fee) as per the rules of card networks. Alternatively, the merchant cannot selectively increase the prices of products for customers who pay via credit cards. For example, the merchant can’t offer a product at $102 to credit card users while charging $100 to cash or debit card users.

Also, the merchants claimed the card networks didn’t allow them to encourage their customers to pay via cash or debit cards. For example, the merchant cannot say to you, “We prefer cash” or “We prefer debit card”.

A point to be noted here: with debit cards also, merchants have to pay a swipe fee, but that fee is quite less than compared to the credit card fee. Reason? Credit cards involve more risk, so the fees are higher.

Card networks had another rule for merchants. If a merchant accepts one card from the network, they must accept all cards from that network. What that means is the merchant can’t tell you, “We only accept basic credit cards and not premium or corporate credit cards.” This was a problem for merchants because of the higher swipe fees charged to premium credit cards.

What are your thoughts? Comment below.