April 21, 2024 ☼ Payments
In today’s digital age, money flows frictionlessly from one digital transaction to another. Invisible to consumers though, is a contentious commission called the “interchange fee” that banks and payment networks levy for each transaction processed.
Imagine making a $50 purchase using your credit card. The merchant pockets $49, after losing about 2% in interchange fees. When the merchant spends that $49 with another seller, another 2% is lost. Extrapolate this, play this out for a hundred exchanges, and your initial $50 dwindles to a mere $5. The rest is gobbled up by the banking system, resulting in 90% of the original monetary value ostensibly disappearing into financial ether.
In the face of this gradual erosion, a pertinent question arises: Are digital payments even worth it? Why shouldn’t cash still be king when digital payments clearly don’t make economic sense?
Naturally, the sequential transaction model I’ve drawn oversimplifies real-world economics. First, digital payments aren’t as uniformly costly as I’ve made them seem. Some exchanges, like card transactions over the internet, can indeed cost over 2% of a purchase. Others, like bank transfers between merchants, cost much less. This is critical considering that most subsequent transactions from the initial $50 purchase are unlikely to involve cards.
Moreover, as we progress up the payments chain towards larger entities like corporations, transactions start to aggregate. Just as a retail store procures goods in bulk from a wholesaler, corporations transact in large volumes with their suppliers. In other words, it costs much less to process a $50,000 transaction once than it does to process a thousand $50 transactions. Working out the exchange of money through a sequential transaction model therefore doesn’t make sense.
Even if such a model did hold true, consumers regain a significant chunk of the money lost to interchange through rewards points, debunking the 2% value erosion assumption.
Next, despite its drawbacks, digital payments have revolutionized transactional behavior. Would you have made that $50 purchase in the first place had it not been for the convenience of your credit card? Greater transactional frequency doesn’t just shift money, it stimulates value creation within the economy. It also helps to view interchange as a valuable service, not a mere cost. Would you rather lose hours of your time (and as a result, economic output) visiting multiple shops or pay that 2% to purchase multiple items with a few clicks on Amazon?
Lastly, does the banking system really “gobble up” money? Interchange fees charged by banks and payment networks are channeled back into the system, bolstering availability of credit, which when judiciously distributed, aids in value creation. Moreover, imagine a physical $50 bill changing hands a hundred times and consider the expenses tied to its transport, storage and security. A digital transaction of $50 doesn’t lose its value. Rather, its worth amplifies.