Paying with Plastic: The Digital Revolution in Buying and Borrowing
Payments economics: interchange, closed loops and why Amex's model differs.
Summary
Evans and Schmalensee provide the economics and history of the payment card industry: how Diners Club, American Express, BankAmericard and Master Charge developed, how the four-party interchange system works, why interchange fees exist and what they do, and how the industry's competitive and regulatory battles have proceeded.
The analytical content is the two-sided market treatment, which the authors did much to develop. A card system must attract both cardholders and merchants, and neither joins without the other. Interchange, the fee paid by the merchant's bank to the cardholder's bank on each transaction, is the mechanism that transfers value from the merchant side to the cardholder side so that both sides participate. This explains why cardholders receive rewards and free credit while merchants pay, and why the profit-maximising and welfare-maximising fee structures are asymmetric between the two sides.
The institutional history covers the associations' structure as bank-owned cooperatives, their conversion into public companies, the American Express and Discover models which are three-party systems without interchange, and the litigation and regulation in the United States, Europe and Australia over interchange levels and over merchant restrictions on surcharging and steering.
The authors have served as economic experts for card networks in litigation, which readers should factor into the treatment of interchange regulation, where they argue against caps. The book predates mobile payments, real-time payment systems and the current fintech structure, so the industry description is dated while the two-sided economics is not.
Key takeaways 7
- A payment card system must attract cardholders and merchants simultaneously, and neither side joins without the other already being present.
- Interchange fees transfer value from the merchant side to the cardholder side, which is what funds rewards and free credit periods.
- The profit-maximising price structure across the two sides is asymmetric, so charging each side its own cost destroys the system.
- Bank-owned cooperative associations built the networks and later converted to public companies, which changed their incentives on interchange substantially.
- Three-party systems such as American Express have no interchange because the same entity holds both sides of the transaction.
- Merchants accept cards despite the cost because refusing them loses sales to competitors who accept, which is the source of the networks' pricing power.
- Regulating interchange downward shifts costs to cardholders through reduced rewards and higher fees rather than producing a net consumer gain, which is the authors' contested position.
Who should read it
Fintech founders and investors who need the economics of interchange and two-sided payment networks before building or assessing a payments business.
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