Defined Terms and Documents

THE ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS: AN EMPIRICAL INVESTIGATION ON PAYMENT CARDS

Santiago Carbo´ Valverde, Sujit Chakravorti, and Francisco Rodrı´guez Ferna´ndez*

transaction volumes increased when interchange fees were reduced. Our results suggest that a 10% reduction in the rate of decline per quarter in the

average interchange fee by an acquirer resulted in a rate of increase in merchant acceptance per quarter of up to 1.4%. In addition, a 10% increase in

the rate of interaction of merchant acceptance and the total number of cards increased the rate of quarterly issuer transaction volumes up to 1.7%.

I. Introduction

networks allow buyers of products and services to transfer monetary value to sellers. Increasingly, these monetary

transfers are initiated with payment cards. Payment cards are generally characterized as a two-sided market. Rochet

and Tirole (2006b) define a two-sided market when the price structure, or the share that each type of end user pays

externalities and how fee structures are able to internalize these externalities. Often platforms subsidize the participation

of one type of end user by extracting surplus from another type of end user to internalize this externality.

Payment card networks are composed of consumers (one type of end user), their financial institutions (known as

issuers), merchants (the other type of end user), their financial institutions (known as acquirers), and a network operator

or platform. A consumer makes a purchase from a merchant.

Generally the merchant charges the same price regardless of the type of payment instrument used to make

the purchase. Consumers often pay annual membership fees to their financial institutions for credit cards and may pay

service charges for a bundle of services associated with transactions accounts, including debit card services. Merchants

pay fees known as merchant discounts. Acquirers pay interchange fees to issuers.

The level of interchange fees continues to receive attention around the world by public authorities. A small but controversial

section of the Dodd-Frank Wall Street Reformand Consumer Protection Act passed by the U.S. Congress and signed

into law by the president in 2010 gives the Federal Reserve the authority to regulate U.S. debit card interchange fees to

promote a more efficient retail payment system. The Reserve Bank of Australia regulated interchange fees in 2002 after

concluding that consumers did not face the correct incentives to use the most efficient payment instrument. The European

Commission in 2007 ruled that MasterCard’s interchange fees violated the EU’s antitrust laws. Additionally, the European

Alternatively, the reduction in interchange fees may also occur without regulatory intervention, as occurred in the United

States when card networks convinced large department stores and grocery stores to accept payment cards by reducing

interchange fees, which resulted in lower merchant fees.

The economic theory regarding interchange fees predicts that by lowering the optimal interchange fees, some merchants

not currently accepting card payments may start to accept them. However, lowering interchange fees would increase

cardholder fees, and some of them may abandon their payment cards or use them less frequently. However, changes in external

factors such as greater awareness of the benefits of payment cards or reductions in processing and credit intermediation

costsmay result in greater adoption and use by consumers even when consumer fees increase resulting from interchange fees

being lowered by the card network or by government mandate.

Using a unique Spanish proprietary bank-level data set, we study the impact of interchange fee reductions from 1997 to

2007 on merchant acceptance, consumer adoption, payment card transaction volumes, and issuer and acquirer revenues.

Our main results are as follows. First, we find strong evidence suggesting that merchant acceptance has increased because of

a reduction in interchange fees. Second, consumer adoption of debit cards did not significantly decrease over the period

because of lower interchange fees, as would be predicted by theoretical models absent changes in external factors. Credit

card adoption increased dramatically during the period of interchange fee reductions, suggesting the value proposition for

those consumers previously not having credit cards improved despite higher fees. Third, most important, reductions in interchange

fees resulted in a dramatic increase in payment card transactions during this period. Fourth, bank payment revenues

from debit and credit card services increased as a result of lower interchange fees. Our results for bank revenues suggest

that the increase in the number of transactions appears to offset the decrease in the per transaction bank revenue.

Our paper is organized in the following way. In the next section, we survey the main theoretical and empirical studies

on interchange fees. Section III analyzes the industry and the data. We discuss our empirical strategy in section

IV. In section V, we present our results. We offer some concluding remarks in section VI.

II. Payment Card Markets and Interchange Fees:

Literature Background

The theoretical literature on payment cards, along with

the broader two-sided market literature, stresses the balancing

of two different types of end users. In the case of payment

card services, the two types of end users are consumers

and merchants. When markets are competitive, the optimal

level of total fees (the sum of consumer and merchant fees)

occurs when the sum of benefits of consumers and merchants

is equal to the sum of the costs to consumers and merchants.

However, the price structure or the proportion of the

total fee paid by each type of end user matters. Baxter

(1983) concluded that a side payment from one type of end

user to the other type of end user might be required to reach

the optimal level of payment card use. Thus, while a

decrease in interchange fees may result in greater merchant

adoption, the increase in price to consumers may result in a

decrease in consumer adoption and use. In this paper, we test

if consumers decreased their adoption and use of payment

cards when the cost of payment services increased even

when the number of accepting merchants increased.

The implementation of this side payment between merchants

and consumers occurs through the interchange fee. If

the interchange fee decreases, the cost to consumers will

increase and the cost to merchants will decrease. The impact

on adoption and use by consumers and merchants is dependent

on demand elasticities of each end user type. Furthermore, a

critical component of each type of end user’s demand is critically

dependent on the level of adoption by the other type of

end user. Consumers will not adopt and use payment cards

unless a sufficient number of merchants accept cards. Like

consumers, merchants will not accept cards unless a sufficient

number of consumers on the other side adopt and use payment

cards. Hence, there is a level of interchange fees that ensures

that the optimal level of payment card adoption and usage

occurs. If the interchange fee is lowered from the optimal one,

consumers will decrease their use and adoption, and if it is

raised, merchants will decrease their acceptance or be reluctant

Since Baxter’s initial study, researchers have extended

this analysis in various directions. Schmalensee (2002) considers

issuers and acquirers with market power but still finds

a similar role for interchange fees. Rochet and Tirole (2002)

consider strategic reasons for merchants to accept payment

cards, such as business stealing from other merchants, and

finds that the socially optimal interchange fee may be lower

literature does not consider changes to the price level. An

exception is Chakravorti and Roson (2006), who consider

the effects of competition on price level and price structure.

In particular, they examine three types of market structures

for payment networks: cartel, non-cooperative duopoly under

product differentiation, and Bertrand duopoly (price competition

for homogeneous products). They find that competition

unambiguously improves consumer and merchant welfare

while reducing the profits of payment networks.

However, the theoretical literature solves a static problem

without consideration to potential exogenous environmental

changes such as lower technology costs and increased

awareness by consumers and merchants of the benefits,

along with the benefits of scale and scope economies that

may further drive costs lower with increased payment

volumes. These environmental changes and scale and scope

economies are likely to affect the price level along with the

price structure. During the ten-year period that we study,

there were likely improvements to technology that may have

reduced payment-processing costs and increased awareness

of card benefits that may have also increased perceived consumer

benefits of card adoption and use.

Unfortunately, empirical research on the impact of

changes in interchange fees on use is limited. Hayes (2007)

uses structural break analysis to study the impact of interchange

fee regulation in Australia. An important difference

between Australia and Spain is that in Australia, the authorities

regulated interchange fees to reduce the incentive to use

credit cards instead of debit cards. Hayes uses aggregate level

monthly data and looks at the changes in interchange

fees on the share of credit card purchases of all payment purchases.

Given the maturity of the Australian market, he finds

no evidence of structural breaks resulting from an almost

50% mandated decrease in interchange fees. While the

change in interchange fees may not have affected the longrun

trend of credit card use, the distribution of economic surplus

among agents may have shifted.

Chang, Evans, and Swartz (2005) explore the impact of

interchange fee reduction in Australia. They use quarterly

data from Visa Australia to calculate loss in interchange

income per card. Most of their analysis is based on descriptive

comparative statistics based on annual aggregate data,

and their main econometric analysis focuses on how the

decreasing trend in interchange fees accelerated as a consequence

of anticipation to the regulatory changes. Their

4 Rochet and Tirole (2011) call this the tourist test.

5 For a review of this literature, see Bolt and Chakravorti (2008), Evans

(2011), and Evans and Mateus (2011).

368 THE REVIEW OF ECONOMICS AND STATISTICS

descriptive analysis shows that while merchants benefited

from interchange fee reductions, merchants did not pass on

these benefits to consumers.

Rysman (2007) studies the interaction of consumer use

and merchant acceptance in the context where consumers

hold more than one credit card. He finds a correlation

between consumer use and merchant acceptance at the

network level, which suggests a positive feedback loop

between consumer use and merchant acceptance consistent

with our results.

There are some empirical investigations of other twosided

markets (Argentesi & Filistucchi, 2007; Dubois, Hernandez-

Perez, & Ivaldi, 2007; Kaiser & Wright, 2006; Rysman,

2004). Our approach is similar to Rysman (2004),

who uses a simultaneous equation estimation technique to

study the trade-offs between consumers and advertisers in

the market for Yellow Pages. He estimates the consumer

demand for Yellow Page use as a function of advertising

and the inverse demand for advertising as a function of consumer

use. He is able to identify a positive network effect.

III. The industry and the Data

Spain provides a unique natural experiment to study the

effects of reductions in interchange fees on consumer and

merchant payment card adoption and use. Very few other

countries have experienced such a rapid reduction of interchange

fees over a short time frame resulting in significant

changes in acceptance, adoption, and use. In 2000, Spanish

residents relied more on cash to make purchases than their

neighboring countries did. Carbo´ Valverde, Humphrey, and

Lo´pez del Paso (2003) report that Spain had a currency-to-

GDP ratio of 8.9% compared to 6.2% for Germany, 4.7%

for Portugal, and 3.2% for France.

One strategy to increase merchant acceptance of payment

cards is to reduce interchange fees. However, whether greater

merchant acceptance increases card adoption by consumers

or payment card transactions generally is an empirical question

that we address in this paper. Four important events have

significantly affected the setting of interchange fees in the

empirical perspective, estimating the impact that such events

could have had on the level of interchange fees is difficult

because it is not possible to identify a precise date for each

intervention; most of them took place over a long time period

and did not have an immediate and clearly identifiable effect

on fees. In addition, the interventions had short-term and

long-term effects that interact with other macroeconomic and

microeconomic factors. In our empirical analysis, we control

for the effects of such events, although we acknowledge that

it is difficult to disentangle the effect of mandatory reductions

in fees from industry trends. Therefore, we focus on the

effects of the reductions themselves regardless of their origin.

A. The Data

We use proprietary quarterly payment card data from 45

Spanish banks from 1997:1 to 2007:4. These data are

adjusted to reflect mergers during our sample period to create

a balanced panel by backward aggregating all premerger

data on merging banks prior to their merger. In total, there

bank-level (acquirer and issuer) information on payment

cards, ATMs, and POS terminals, as well as fees for

debit (interchange and merchant fees) and credit card transactions

(interchange fees, merchant fees, and annual credit

card fees). Our data also include merchant acceptance and

transaction volume by acquirer and number of cardholders

and transaction volume by issuer. Our data allow us to test,

for the first time, some of the fundamental predictions of

the two-sided market theoretical payment card models

regarding the impact of interchange fee reductions on payment

card adoption and use.

B. Adoption and Use: Main Figures

From 1997 to 2007, debit card transactions increased

from 156 million to 863 million and credit card transactions

increased from 138 million to 1.037 billion according to the

Bank of Spain data (2007). Figure 1 depicts the evolution

of some of the main variables from 1997 to 2007 from our

proprietary data set. Interchange and merchant fees are

highly correlated (simple correlation is .94). Besides, the

evolution of these fees seems to be asymmetrically related

to the evolution of annual fees. Although credit card annual

fees increase over time, merchant acceptance (percentage

of merchants accepting cards) grows over the whole period.

Overall, the number of POS and cards and related transaction

volumes also increase significantly. From 1997 to

2007, the number of debit cards increased by 40.9% while

the number of credit cards increased by 207.1%. Furthermore,

the average number of POS transactions per card per

year increased from 7.1 to 27.8 during the same period.

6 The first regulatory decision on interchange fees took place in May

1999. The Spanish government promoted an agreement between the three

payment networks and the main merchant associations to reduce maximum

multilateral interchange fees to 2.75% in July 2002 from maximum

interchange fees of 3.5%. From July 2002 to January 2003, the maximum

interchange fee in Spain was reduced from 2.75% to 1.85%. In May 2003,

the Spanish Congress requested the TDC investigate the setting of interchange

fees and follow the basic principles that the European Commission

adopted for EU-wide cross-border interchange fees. The TDC refused several

proposals from the networks regarding their setting of interchange

fees. The maximum interchange fee was progressively reduced from

1.85% in January 2003 to 1.75% in December 2005. The most important

regulatory action for the Spanish payment card industry took place in

December 2005, when the Spanish government promoted an agreement

between payment networks and merchant associations to establish a timetable

to progressively reduce interchange fees from 2005 to 2009, with different

schedules for debit and credit cards. Average debit card interchange

fee declined from 0.39 to 0.31 euros per transaction from 2005 to 2009,

while the average credit card interchange fee fell from 1.23% to 0.67%.

7 Banks in our sample represented 56.7% of total card payment transactions

in 1997 and 64.8% in 2007 when compared to the Bank of Spain

(2007) aggregate data.

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 369

Consumer preferences for debit and credit cards differ.

Adoption for debit cards by consumers reached a saturation

point earlier than credit cards because they were adopted

for their ATM functionality more than a decade before. In

particular, as also shown in figure 1, the number of debit

cards reached its peak in 2006 (33.1 million) and decreased

to 31.5 million in 2007. It is important to note that the number

of cards increased monotonically during the period,

reaching 43 million in 2007, according to the Bank of

Spain. Spanish consumers increased their holdings of credit

cards even though card annual fees increased. According to

our sample data, average credit card annual fees increased

from 18.53 euros in December 1997 to 28.16 euros in

December 2007. We also observe that interchange fees

decreased on average from 3.42% in 1997 to 0.90% in

2007.

C. Definition of the Variables

Table 1 provides the main definitions of the posited

explanatory variables and their scope (bank level, network

level, and dummy variables). Banks in our sample belong

to two of the three Spanish networks, Euro6000 and Servired.

variables is important for our empirical purposes. For

example, a consumer’s decision to adopt an issuer’s payment

card is dependent on the total number of merchants

that accept the payment cards. Similarly, a merchant’s

acceptance of debit cards is dependent on the total number

of cardholders who have debit cards. From the data, we

observe that most of the issuers and acquirers operate in different

regions. We capture the regional effects in various

ways. Merchant acceptance by acquirer has been computed

as a branch-weighted average of merchant acceptance in

the different regions where the acquirer operates. Similarly,

the variable for merchant acceptance at the market level has

been computed as a branch-weighted average of the percentage

of merchants accepting cards for purchase transactions

in the regions where the bank or any other banks belonging

to the same network operate over the total number of merchants

in those regions.

In addition, although the maximum and minimum thresholds

of interchange fees for different merchant activities are

set at the network level, the average acquirer-level merchant

fee varies depending on the actual fee charged and

the proportion of the bank’s POS debit and credit transactions

by merchant sector. Therefore, the merchant discount

fee charged by an acquirer is computed as a transaction

weighted average of merchant discount fees charged by the

bank in the different merchant sectors using the acquirer’s

POS machines.

Our data also permit us to consider some nonmonetary

costs that may affect decisions regarding adoption and use

by consumers and merchants. In particular, there are nonmonetary

costs that affect the adoption of a card such as the

‘‘shoe leather’’ costs involved in the distance to reach a

cardholder’s bank branches to withdraw cash, the main

alternative to payment cards. We use population density as

a proxy for the availability of payments infrastructure.

When a consumer chooses to use a payment card, the

density of ATMs from other issuers affects her decision to

use a debit card. To capture the opportunity cost of using a

debit card, we compute a rival ATM density variable as a

proxy of the relative costs of withdrawing cash at rivals’

ATMs.

We also consider other variables, such as region-specific

control variables that may influence card transactions. For

example, our crime data are region specific and measure

robberies and assaults per 1,000 residents in a given region.

If the acquirer or issuer operates in more than one region,

FIGURE 1.—ADOPTION, TRANSACTION VOLUMES, FEES, AND REGULATORY EVENTS

Rxx: regulatory event and year (xx).

8 Cardholders belong to only one payment network. However, some

merchants belong to more than one of these three networks.

370 THE REVIEW OF ECONOMICS AND STATISTICS

we use a weighted average by the number of bank branches

in the region.

The summary statistics for the variables that we use for

our empirical model are shown in table 2. Over the sample

period, the average percentage of merchants accepting debit

cards of merchant banks in the regions where these banks

have branches is 55.36% compared to 57.23% in the case of

credit cards. At a network level (including all banks integrating

the networks), the average acceptance is a bit

higher: 58.02% for debit cards and 59.37% for credit

cards. As for prices, in line with the trends shown in figure

1, average merchant discount fees are found to be larger for

credit cards (2.03%) than for debit cards (1.36%). Similarly,

average credit card interchange fees (1.96%) are larger than

debit card interchange fees (1.24%).

Along with the trends in prices and transactions shown in

figure 1, table 2 shows some interesting features related to

the market size and infrastructure. In particular, each bank

has 480,000 debit cards and 550,000 credit cards issued on

average over the sample period. The average number of

POS transactions is 11.14 million for debit cards and 12.28

million for credit cards. In addition, rivals’ ATM density is

0.9 ATMs per square kilometer for a population density of

83.3 inhabitants per square kilometer.

TABLE 1.—VARIABLE DEFINITIONS

Variable Definition Scope

acquirer

Computed as (branch-weighted) average of the percentage of

merchants accepting debit cards for purchase transactions in the

regions where the bank operates over the total number of

merchants in those regions

Bank level

acquirer

Computed as (branch-weighted) average of the percentage of

merchants accepting credit cards for purchase transactions in the

regions where the bank operates over the total number of

merchants in those regions

Bank level

network

Percentage of merchants accepting debit cards where the network

operates

Network level

network

Percentage of merchants accepting credit cards where the network

operates

Network level

charged by the bank computed as the (transaction-weighted)

average discount fee charged to the merchants accepting the

bank POS device

Bank level

charged by the bank computed as the (transaction-weighted)

average discount fee charged to the merchants accepting the

bank POS device

Bank level

the bank computed as the (transaction-weighted) average

interchange fee paid by the bank

Bank level

computed as the (transaction-weighted) average interchange fee

paid by the bank

Bank level

perspective)

Debit card transactions per card by issuer Bank level

perspective)

Credit card transactions (month end/no interest) per card by issuer Bank level

operates

Bank level

where the bank operates

Bank level

bank

Bank level

inhabitants in the regions where the acquirer or issuer operates

Bank level

growth in the regions where the bank operates

Bank level

annual fees

Bank level

All monetary magnitudes are expressed in real terms. All variables (except for regulatory dummies) are in logarithms.

Sources: All variables related to card payments have been provided by a payment network of 45 Spanish banks. The crime rate variables have been obtained from the Spain’s Statistical Office (INE).

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 371

IV. Empirical Strategy

Our empirical analysis focuses on how decreasing interchange

fees affected merchant and consumer adoption of

payment cards, as well as issuer and acquirer transaction

volumes and revenues. We compare the impact of lowering

interchange fees on two types of payment cards: debit and

credit. In our empirical analysis, an issuer or an acquirer is

our unit of study. In other words, we study the impact of

lowering interchange fees on an acquirer’s changes in merchant

acceptance in the region that it operates in and its

transaction volume and an issuer’s changes in its number of

cardholders and its transaction volume.

A. Merchant Acceptance and Consumer Adoption

Lowering interchange fees is likely to increase merchant

acceptance of payment cards because some merchants previously

not accepting payment cards would choose to

accept payment cards at a lower fee. In addition to the level

of fees, merchants also consider consumer adoption in their

acceptance decisions.

Lowering interchange fees is also likely to increase cardholder

card fees is difficult to measure because of the bundle of

services offered with a transaction account or a line of

credit. Unlike debit cards, credit cards have explicit annual

fees. Facing higher fees, some cardholders may abandon

their payment cards. But if the increase in fees is associated

with greater merchant acceptance, cardholders may value

credit cards more and continue to hold them, or new consumers

may adopt them even if fees increase. Alternatively, if

the demand for payment cards is sufficiently inelastic, consumers

may continue to hold their payment cards Our

empirical analysis is unable to distinguish between these

two explanations. However, the addition of new cardholders

as evidenced by greater card adoption would be due to additional

benefits associated with the cards such as increased

merchant acceptance.

We estimate equations (1) and (2) that identify merchant

acceptance and consumer adoption decisions:

merchant acceptance and consumer adoption decisions,

to both equations. All control variables are expressed

as the difference between the logarithms of current quarter

as quarterly growth rates.

TABLE 2.—SUMMARY STATISTICS

Mean SD Minimum Maximum

9 Furthermore, consumers may face higher costs other than annual fees

from their financial institutions that we are unable to capture, such as

reduction in frequent-use rewards or higher interest rates on credit card

debt.

10 Our assumption is that consumer and merchant adoption decisions

are not immediately observed. If we use two or four lags instead of one

lag, the results are very similar but quantitatively higher (which would be

predicted, as they are capturing the effects for a longer time period). The

one-lagged approach is similar to other empirical models dealing with

payment price structure and network effects such as Kaiser and Wright

(2006) and Rysman (2007).

372 THE REVIEW OF ECONOMICS AND STATISTICS

We study the impact of interchange fees separately for

debit and credit cards. Merchants face an explicit per transaction

fee, the merchant discount fee, to process a debit or

credit card transaction that is strongly correlated with the

interchange fee. Merchant debit and credit card acceptance

exclusion restrictions include the merchant discount fee and

the number of cards in the network by type of payment

card. Consumer debit card exclusion restrictions are population

density and lagged merchant acceptance. For credit

cards, the consumer exclusion restrictions are credit card

annual fees and one-period lagged merchant acceptance.

There are some key differences in how issuers charge

customers for debit and credit cards. Cardholders do not

generally pay a fixed or per transaction fee for their debit

cards. The pricing for debit card services is often bundled

with other banking services such as access to ATMs. Thus,

to isolate a fee for debit card services separately is not possible.

Instead, we use an instrument to proxy for debit card

benefits. The instrument that we use is population density.

When population density is high, consumers are more likely

to have a debit card because the availability of merchant

acceptance terminals and ATMs is higher. Higher population

density would most likely positively affect the adoption

of ATM and debit cards.

In addition, there is the indirect network effect: as merchant

acceptance increases, the value of having a debit card

increases. If the direct marginal cost of holding a debit card is

close to zero, we would expect an increase in debit card issuance

as the proportion of merchants that accept debit cards

increases. Eventually debit cards may reach a saturation

point (i.e., when most residents already have adopted ATM/

debit cards). Merchant acceptance enters the cardholder

adoption decision as a lagged explanatory factor. The logic

behind this specification is that merchant acceptance and fees

may be contemporaneously related, while transactions, issuance,

and use may be determined by observed previous

acceptance.

Unlike debit cards, credit cards are stand-alone products

that usually have explicit fees. Reductions in credit card

interchange fee revenue should result in higher annual fees

for cardholders to offset lost issuer interchange revenue as

predicted by the two-sided market literature. As mentioned

before, credit card annual fees indeed increased in Spain

during our sample period.

Our control variables for all regressions are acquirer and

issuer size, the crime rate, and a time trend. Given that payment

processing is a scale business, we take bank size (the

log of bank’s total assets) to control for any increase in

bank size during the sample period. We use crime statistics

to capture the effect of crime on the decisions of merchants

that as crime increases, the adoption of payment cards will

increase because payment cards are more secure than cash

in the event they are stolen or lost. In order to control the

(mainly upward) trend in the data for merchant acceptance,

number of cards, and number of transactions, we use a GDP

growth.

B. Acquirer and Issuer Transaction Volume

Unfortunately, our data do not allow us to study transaction

per card or per merchant. Instead, we have transaction

volume data by acquirer and issuer. However, changes in

acquirer and issuer transaction volume are ideal instruments

to study the impact of changes in payment card use resulting

from changes in the interchange fee. Our dependent

variables for use are average quarterly transactions per

POS terminal by acquirers and average quarterly transactions

by card by issuers separated into debit and credit card

transactions.

Unlike adoption and acceptance decisions, we estimate

acquirer and issuer transaction volumes separately. Given

that our units of study are acquirers and issuers, estimating

the volumes separately is appropriate for transaction

volumes. In other words, the number of issuers does not

affect the acquirers’ volumes and vice versa. Our regressions

for debit and credit card issuer and transaction

volumes are:

the acquirer transaction volume and the issuer transaction

same as in equations (1) and (2).

For acquirer transaction volume, we use an acquirer’s

quarterly transactions per POS terminal as our dependent

variable. The exclusion restriction that identifies the

acquirer transaction volume is an interaction term of its

merchant acceptance and the total number of debit or credit

cards in that network. The probability of a transaction on an

acquirer’s terminal increases when the number of merchants

served by the acquirer increases or the number of

total debit or credit cards increases.

Next, we analyze what factors affect issuer transaction

volume. The dependent variable is the number of transactions

per issuer per card. The key explanatory variable is an

interaction term of the merchant acceptance in the network

and the number of cards issued by the bank. We include the

same control, except for own rival ATM density for debit

cards instead of population density. The use of density of

rival ATMs in the transaction volume equation seems to be

particularly useful as a proxy for the benefit of using debit

cards as it captures the use costs. Given that ATM owners

impose surcharges for cards issued by competitor banks’

ATMs, as the likelihood of using one of these ATMs

increases, the benefit to having a debit card increases.

11 Some theoretical money models suggest that crime may motivate the

substitution of cash by more secure payment alternatives (He, Huang, &

Wright, 2005).

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 373

C. Identifying Issuer and Acquirer Revenues

Although we are unable to measure acquirer and issuer

profits directly, we are able to study the impact of changes

in interchange fees on bank revenue. As we discussed in

section IIIA, average total issuer and acquirer revenues

increased during our sample period despite reductions in

interchange fees. The loss in per transaction revenue may

be made up by a greater number of transactions. If costs

remain constant or grow more slowly than revenues,

acquirer or issuer profit may increase with increasing revenue.

Given large economies of scale and scope, one might

expect that costs would not grow as fast as revenues.

As before, we separate banks into issuers and acquirers

for debit and credit cards. Our dependent variables are

issuer and acquirer payment card revenue by type of card.

For issuers, this would be the product of the average interchange

fees and the number of transactions, along with total

annual fees collected (only for credit cards). For debit cards,

we use only interchange fee revenue. For acquirers, this

would be the difference between the merchant discount

charged and the interchange fee paid multiplied by the

number of transactions. Similar to our transaction volume

regressions, our explanatory variable for acquirers is a onequarter

lag of the interaction of merchant acceptance of a

specific acquirer and the total number of cards in the network.

Our exclusion restriction for issuers is the number of

cards issued by each issuer the quarter before times the proportion

of merchants accepting in the whole network. Our

exclusion restriction for acquirers is the proportion of merchant

acceptance of debit and credit cards, respectively,

times the number of debit and credit cards, respectively, in

the network.

D. GMM Approach and Endogeneity Issues

The identification of equations (1) and (2) and of issuer

and acquirer revenues has potential cross-equation restrictions,

as well as endogeneity concerns that need specific

treatment.

As for cross-equation restrictions, the error terms for consumer

adoption and merchant acceptance are assumed to be

correlated across the equations. This correlation implies

that even if a separate equation-by-equation estimation

would be consistent, it would not be as efficient as the

simultaneous equation method. Since our model specification

allows acceptance and adoption variables to interact

with variables related to the number of transactions, this

may create nonlinear cross-equation restrictions on the specified

parameters. In order to deal with these restrictions,

the simultaneous equations are estimated using a general

method of moments (GMM) routine with acquirer and

issuer specific fixed effects (Hansen, 1982; Wooldridge,

2002).

As for the endogeneity concerns, although it is not possible

to eliminate all sources of potential endogeneity completely,

we introduce several instruments to try to reduce

these potential effects. The main endogeneity concern

refers to the (classical) problem of relating prices to quantities

in the demand equations. In particular, the level of

interchange fees may be a result of the optimal choice by

payment networks, possibly to changes in demand conditions

on the two sides of the market. For example cardholders’

willingness to pay might increase, and this would

enable the platform to charge higher cardholders’ fees and

lower merchant fees, thereby lowering interchange fees. If

this is the case, merchants’ fees are potentially endogenous

in equation (1).

In order to solve this problem, we instrument the fees

and correct a major portion of that potential endogeneity

bias. A first assumption is that the costs associated with

bank-specific efficiency levels partially drive prices charged

to merchants and cardholders, but they are not correlated

with the error terms of the demand equations. Therefore,

we can use the cost/income ratio (operating costs/net

income) as instrument for cardholder fees. Similarly, we

consider the regional market share of deposits of the

acquirer bank as instrument for merchant fees. The idea is

that a bank may build an ongoing relationship with a merchant

due, for example, to long-standing relationships or

cross-selling of products. These contractual relationships

may affect fees charged to these merchants, but they are

uncorrelated with the demand equations. Following the

same logic, we also specify some instruments for the variables

at the network level. The natural logarithm of the

growth in loans and deposits managed by that network is

We use both current and lagged values of all the instruments.

The appropriateness of the instruments is also

checked by using a standard test for the orthogonality of the

instruments with the residuals. The null hypothesis of the

orthogonality of the instruments cannot be rejected at the 5%

level in all cases. The standard test of overidentifying restrictions

is also reported in the tables.

We cluster standard errors at the bank level, as Petersen

(2009) suggested. We also introduce bank fixed effects and

time dummies. In addition, we use dummies to control for

the regulatory events that took place over the sample period

even if, as discussed above, it is not possible to clearly identify

such potential effect. Importantly, our results do not

change significantly in the signs of the coefficients or their

magnitude when these regulation dummies are present.

V. Main Results

The main results of our analysis are shown in tables 3 to

7. We also discuss some robustness tests on the results in

the appendix.

12 Our instrumental variable approach is similar to the one of Berry,

Levinsohn, and Pakes (1995), Kaiser and Wright (2006), and Rysman

(2007).

374 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 4.—CONSUMERS AND MERCHANTS ADOPTION: CREDIT CARDS

SIMULTANEOUS EQUATION ESTIMATION (GMM WITH FIXED EFFECTS)

Merchant Adoption of Credit Cards Consumer Adoption of Credit Cards

Merchant Acceptance

Number of Credit Cards

Constant 0.22E06 0.24E06

(0.001) (0.001)

(0.063)

(0.061)

(0.042)

(0.376)

(0.004) (0.003)

(0.059) (0.055)

(0.002) (0.003)

Number of observations 1,354 1,354

Bank fixed effects Yes Yes

Regulation dummies Yes Yes

Time dummies Yes Yes

Sargan test of overidentifying restrictions 151.26

(0.306)

(0.115)

Clustered standard errors by bank in parentheses. Statistically significant at **5%, ***1%.

TABLE 3.—CONSUMERS AND MERCHANTS ADOPTION: DEBIT CARDS

SIMULTANEOUS EQUATION ESTIMATION (GMM WITH FIXED EFFECTS)

Merchant Adoption of Debit Cards Consumer Adoption of Debit Cards

Merchant Acceptance by

Number of Debit Cards

Constant 0.21E11 0.17E12

(0.001) (0.001)

(0.052)

(0.022)

(0.003)

(0.007)

(0.011) (0.012)

(0.194) (0.162)

(0.007) (0.005)

Number of observations 1,354 1,354

Bank fixed effects Yes Yes

Regulation dummies Yes Yes

Time dummies Yes Yes

Sargan test of overidentifying restrictions 76.88

(0.831)

(0.379)

Clustered standard errors by bank in parentheses. Statistically significant at **5%, ***1%.

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 375

A. Debit and Credit Card Adoption

Table 3 shows the results corresponding to consumers

and merchant adoption of debit cards. We find that a 10%

reduction in the rate of decline per quarter in the average

interchange fee by an acquirer resulted in a .44% rate of

increase in merchant acceptance per quarter. Importantly,

we observe that by instrumenting the merchant discount fee

with the set of instruments described in the previous section,

we correct the (typically downward) bias in the fee

coefficient since the coefficient estimate when the merchant

discount variable is not instrumented is 0.031.

TABLE 6.—CREDIT CARD TRANSACTION VOLUME FOR CONSUMERS AND MERCHANTS

Acquirer Transaction Volume: Credit Cards Issuer Transaction Volume: Credit Cards

Credit Card Transactions per POS

Credit Card Transactions per Card:

Constant 0.13E07 0.14E06

(0.001) (0.001)

0.2063*** —

(0.066)

— 0.1699***

(0.064)

(0.188) (0.021)

(0.039) (0.030)

(0.014) (0.013)

Number of observations 1,354 1,354

Bank fixed effects Yes Yes

Regulation dummies Yes Yes

Time dummies Yes Yes

Sargan test of overidentifying restrictions 187.3 107.19

(0.461) (0.329)

(0.184) (0.152)

Each equation is estimated by 3SLS with fixed effects. Clustered standard errors by the bank are in parentheses. Statistically significant at **5%, ***1%.

TABLE 5.—DEBIT CARD TRANSACTION VOLUME FOR CONSUMERS AND MERCHANTS

Acquirer Transaction Volume: Debit Cards Issuer Transaction Volume: Debit Cards

Debit Card Transactions per POS

Debit Card Transactions per Card

Constant 0.05E13 0.07E10

(0.001) (0.001)

0.0273*** —

(0.010)

— 0.0494***

(0.016)

(0,014) (0.023)

(0.016) (0.014)

(0.144) (0.113)

(0.004) (0.006)

Number of observations 1,354 1,354

Bank fixed effects Yes Yes

Regulation dummies Yes Yes

Time dummies Yes Yes

Sargan test of overidentifying restrictions 140.43 163.26

(0.147) (0.164)

(0.161) (0.193)

Each equation estimated by 3SLS with fixed effects. Clustered standard errors by bank are in parentheses. Statistically significant at **5%, ***1%.

376 THE REVIEW OF ECONOMICS AND STATISTICS

While we are unable to isolate a price effect for consumer

adoption debit card services, we find strong evidence to

support our hypothesis that consumers value greater merchant

acceptance and react to increases in the price of the

main alternative payment instrument: cash. Specifically, a

10% increase in the rate of merchant adoption per quarter

resulted in a 4.4% increase in the quarterly adoption rate of

debit cards by consumers. As population density increases,

consumer adoption of debit cards increases. Specifically, a

10% increase in population density resulted in a .139%

increase in the quarterly growth rate of debit card adoption.

As mentioned before, the underlying dynamics of credit

card adoption are significantly different from debit card

adoption because credit cards are stand-alone products.

Reductions in credit card interchange fees increased merchant

acceptance of credit cards (see table 4). Specifically,

a 10% percent increase in the rate of decline of the average

interchange fee increased the growth rate of merchant

acceptance of credit cards by 1.4%. As for the number of

credit cards in the network, a 10% quarterly growth rate in

this variable resulted in a 1.7% quarterly growth in the

acceptance of credit cards by merchants.

As our priors suggested, the number of cards issued is

positively affected by the number of merchants that accept

credit cards (table 4, column 3). Specifically, a 10%

increase in the quarterly growth rate in merchant acceptance

increases the quarterly growth of credit card issuance

by 2.8%.

A key result is that growth in the number of cards issued

is not affected by increases in the annual fee. We are unable

to disentangle two potential reasons for this insignificance.

First, existing consumers may be fairly inelastic to

increases to credit card annual fees and not give up their

credit cards. Second, they are willing to pay higher fees if

more merchants accept credit cards. Regardless of why consumers

do not respond to increases in annual fees, there

may be benefits to more credit card–accepting merchants,

resulting in greater consumer adoption. These benefits stem

from the network externality of merchant acceptance. In

any case, that consumers who previously did not have credit

cards have adopted them suggests that the benefits of having

a credit card has increased despite the increase in the

annual fee.

The fact that consumers do not react to prices may appear

a bit surprising. Following the hypothesis that consumers

may be willing to pay higher prices as merchant acceptance

increases, we run separate yearly OLS regressions of this

equation from 1997 to 2007. We find that the yearly estimated

coefficient of prices decreased over time, suggesting

that price sensitivity (in absolute terms) decreases as merchant

acceptance increases. The coefficient of credit card

annual fees changed from 1997 to 2007 as follows: 0.83,

TABLE 7.—IMPACT ON BANK ISSUING AND ACQUIRING REVENUES

Bank

(Debit Card)

Acquiring

Revenues

Bank

(Debit Card)

Issuing

Revenues

Bank

(Credit Card)

Acquiring

Revenues

Bank

(Credit Card)

Issuing

Revenues

Constant 0.10E07** 0.09E10** 0.08E08** 0.08E09

(0.001) (0.001) (0.001) (0.001)

0.0460** — — —

(0.012)

— 0.1405*** — —

(0.016)

— — 0.0683*** —

(0.007)

— — — 0.1706**

(0.013)

(0.006) (0.031)

(0.047) (0.059) (0.014) (0.016)

(0.073) (0.064) (0.035) (0.025)

(0.006) (0.004) (0.005) (0.004)

Number of observations 1,354 1,354 1,354 1,354

Bank fixed effects Yes Yes Yes Yes

Regulation dummies Yes Yes Yes Yes

Time dummies Yes Yes Yes Yes

Sargan test of overidentifying restrictions 218.12 231.15 165.23 191.01

(0.544) (0.419) (0.331) (0.535)

(0.503) (0.426) (0.326) (0.323)

Each equation is estimated by 3SLS with fixed effects. Clustered standard errors by the bank are in parentheses. Statistically significant at **5%, ***1%.

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 377

The impact of lower interchange fees on merchant acceptance

is positive for both debit and credit cards. Merchants

increase acceptance when their fees fall. The impact of

lower interchange fees on debit card consumer adoption is

less clear for two reasons. First, debit cards also serve as

ATM cards, and isolating their debit functionality is difficult.

Second, debit card services are bundled with other

transaction services because identification of direct debit

card fees is difficult.

B. Debit and Credit Card Transaction Volumes

We now turn to payment card transaction volume. First,

we consider the impact of interchange fee regulation on

merchant debit card transactional volume from looking at

acquirer transactional volume per POS terminal as the

dependent variable (table 5, column 2). The interaction of

merchant acceptance at an acquirer and the total number of

cards—showing network effects—is significant and positive,

suggesting that the rate of growth of debit card transactions

has increased because there are more merchants and

consumers on board. Specifically, a 10% quarterly growth

rate in this interaction resulted in a debit card transaction

quarterly growth rate of .27%. In addition, a 10% increase

in the quarterly growth rate of rival ATM density, which

proxies for the cost of cash withdrawal, resulted in a .26%

increase in the quarterly growth rate of debit card transactions

at POS terminals.

The increase in issuer transactions proxies for the

increase in consumer use. The key explanatory variable is

the interaction of merchant acceptance and cards issued by

the issuer. The interaction term is significant and positive,

suggesting that increases in consumer and merchant adoption

growth rates lead to a higher rate of growth for consumer

transactions (table 5, column 3). Specifically, a 10%

increase in the quarterly rate of growth of the interaction of

network merchant acceptance and debit cards issued by an

issuer resulted in a .49% quarterly growth rate in an issuer’s

debit card transactions per card. Furthermore, a 10%

increase in the quarterly growth of rival ATM density

resulted in a .60% increase in the quarterly growth rate of

issuer debit card transactions per card. In other words, an

increase in cash acquisition costs strongly encourages use

of debit cards.

We report credit card acquirer and issuer transaction

volume regressions in table 6. A 10% increase in the quarterly

growth of the interaction term of acceptance by merchants

using the same acquirer and total credit cards in circulation

results in a 2.06% increase in the growth of

acquirer transactions at the point of sale (table 6, column

2). Interestingly, the crime rate is also positive and statistically

significant. One cautious interpretation would be that

credit cards, unlike debit cards, are used for large purchases,

and merchants are more willing to accept them

because carrying large amounts of cash is undesirable in

high-crime areas.

We report the issuer transaction volume in table 6, column

3. We find that a 10% increase in the quarterly growth

rate of the interaction term of merchant acceptance in the

network and credit cards issued by an issuer results in a

1.70% increase in issuer transaction volume. The coefficient

on the crime rate is also significant and positive, suggesting

that higher crime rates induce shift from cash to

credit cards, which are generally used for higher-value

purchases.

C. Issuer and Acquirer Revenues

In table 7, we report our results for issuer and acquirer

revenues. In the second and third columns, we report debit

card acquiring revenue and debit card issuing revenue

regression results, respectively. In the fourth and fifth columns,

we report credit card acquiring and credit card issuing

revenue regression results, respectively. In both sets of

regressions, the increase in the quarterly growth of number

of transactions is positively correlated with the quarterly

growth of bank revenues, suggesting that while per transaction

revenue may have decreased, overall revenues

increased because the revenue from increased transactions

volume offset the decrease in per transaction revenue for

the time period of our sample. This evidence also seems to

be supported by descriptive data, as shown in figure 2,

where transaction volume increased in parallel to revenues.

FIGURE 2.—ACQUIRER AND ISSUER REVENUES AND TRANSACTIONS, 1997–2007

Rxx: regulatory event and year (xx).

13 Even considering these empirical tests, the fact that consumers do not

react to prices is a puzzling one. Although it is not the main purpose of

our analysis, it is an interesting avenue of future research.

378 THE REVIEW OF ECONOMICS AND STATISTICS

This result is consistent with the fact that the acquiring side

of the business may be more competitive, and any reductions

in interchange fees would result in an equal magnitude

decrease in the merchant discount. We reported earlier that

the correlation between the movements in merchant discounts

and the interchange fees is close to 1. On the issuing

side, the quarterly rate of decrease in interchange fees is

positively and significantly related to the quarterly rate of

bank revenues.

VI. Conclusion

The structure of fees in Two-Sided Markets has been addressed in the theoretical literature, but there has been little empirical analysis regarding the impact of changes to fee structures. Theory predicts that Network Platform in Two-Sided Markets may subsidize the participation of one type of end user (Purchaser) by extracting surplus from another type of end user (Merchant) to internalize indirect network externalities. We find evidence that reducing interchange fees may have a positive effect on consumer and merchant adoption and use when merchant adoption is far from complete.

We also find that bank revenues increased following interchange fee reductions because the increase in the number of transactions appears to offset the decrease in the per transaction revenue. However, there is most likely a critical interchange fee below which revenues no longer increase.

Unfortunately, given our data limitations, we are unable to quantify the critical interchange fee.

We acknowledge that Payment Card Networks may lower interchange fees to increase merchant acceptance.  For example, in the United States, interchange fees for new entrants such as grocery stores in the 1990s were reduced significantly by Payment Card Networks to encourage merchant acceptance of payment cards. Such market-based strategies also internalize the merchant adoption externality.

Once merchant and consumer adoption is complete, interchange fee regulation may only result in redistribution of surplus among participants, most notably between banks and merchants. In this case, we are agnostic about the distribution of surplus among payment card market participants.

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APPENDIX

Robustness Tests

We conduct several robustness tests to consider alternate explanations

for increased adoption and use of payment cards.

Other Empirical Specifications

We have tried other specifications for the simultaneous equations estimations.

In particular, we estimated the system using two-stage least

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 379

squares, three-stage least squares, and seemingly unrelated regressions.

Although the results were overall qualitatively similar, the goodness of fit

of these estimations was far poorer than our GMM estimations.

In the GMM baseline results, autocorrelation tests are included to

examine the possibility that lagged values of the dependent variables

might affect, at least partially, the current values of these variables. In this

case, a dynamic specification with lagged dependent variables as regressors

could address these feedback effects. However, the values of these

tests in all our regressions suggest that the null hypothesis of no serial correlation

cannot be rejected and therefore do not warrant using dynamic

specification. In any event, regressions using dynamic panel techniques

were also undertaken, and the coefficients of the lagged dependent variables

were not found to be significant in any of the equations.

In addition, our results suggest that consumers and merchants benefit

from reductions in interchange fees during our sample period because an

increase in merchant card acceptance results in greater adoption and use

of payment cards. This result is dependent on relatively low adoption of

payment cards as a starting point. Rochet and Tirole (2006a) suggest a

couple of reasons that merchants may choose to accept cards even if they

are made worse off by doing so. They argue that merchants may accept

cards as a strategic tool to steal customers from their competitors. Second,

their acceptance decision is based on the average consumer benefit and

not the marginal benefit. While we are unable to test whether cards are

being used too much, we do find that lowering fees increases use in a market

where card use is relatively low compared to other countries in the

region, as noted above. In any event, we run year-by-year OLS regressions

on the impact of merchant acceptance on consumer adoption and

find the coefficient (.44 in table 4, column 3) remains relatively stable

over the period (between .42 and .48). It would be interesting to analyze

these relationships in more mature markets where adoption is close to

complete and consumer choice at the point of sale determines use.

Estimations for Different Subperiods

A simpler (although less informative) approach to likely changes in

merchants’ and consumers’ adoption and use of debit and credit cards is

to estimate our main equations for four time periods: 1997–1998, 1999–

2001, 2002–2004, and 2005–2007. The effects of changes in interchange

fees on merchant adoption and of merchant acceptance in the network on

the number of debit cards are from one to three times higher in the 1999–

2001 and 2005–2007 periods than in the other two periods. These results

are summarized in table A1. These differences are statistically significant

according to Wald tests of differences in the estimated coefficients and

TABLE A1.—CONSUMERS’ AND MERCHANTS’ ADOPTION OF DEBIT AND CREDIT CARDS OVER FOUR TIME PERIODS

SIMULTANEOUS EQUATION ESTIMATION (GMM WITH FIXED EFFECTS)

Merchant

Adoption:

Debit Cards

Consumer Adoption:

Debit Cards

Merchant Adoption:

Credit Cards

Consumer Adoption:

Credit Cards

1997–1998 Merchant

Acceptance

by Acquirer

(MACCDit)

Number of

debit cards by

Merchant

Acceptance by

Number of

credit cards by

Merchant acceptance in

— 0.7213*** Merchant acceptance

in the network

— 0.1953**

(0.043) (0.072)

Debit card interchange

interchange

(0.018) (0.043)

1999–2001 Merchant

Acceptance by

Acquirer

(MACCDit)

Number of

Debit Cards by

Merchant

Acceptance by

Number of

Credit Cards by

Merchant acceptance in the

— 0.2736** Merchant

acceptance in the

— 0.3107***

(0.039) (0.066)

Debit card interchange fee

(DIFEEDit)

interchange fee

(CIFEEDit)

(0.020) (0.064)

2002–2004 Merchant

Acceptance by

Acquirer

(MACCDit)

Number of

Debit Cards by

Merchant Acceptance

Number of

Credit Cards by

Merchant acceptance in the

— 0.2007*** Merchant

acceptance in the

— 0.2046**

(0.055) (0.053)

Debit card interchange

interchange fee

(CIFEEDit)

(0.017) (0.038)

2005–2007 Merchant

Acceptance by

Acquirer

(MACCDit)

Number of

Debit Cards by

Merchant Acceptance

Number of

Credit Cards by

Merchant acceptance in the

— 0.5603*** Merchant

acceptance in the

— 0.3219***

(0.050) (0.068)

Debit card interchange

interchange fee

(CIFEEDit)

(0.024) (0.066)

Only the main coefficients are shown for simplicity. Clustered standard errors are by bank are in parentheses. Statisfically significant at **5 %, ***1%.

380 THE REVIEW OF ECONOMICS AND STATISTICS

suggest that the dynamics of prices, adoption, and use particularly

increased in the periods when interchange fees were reduced to a larger

extent due to government interventions. In the case of credit cards, related

differences in the magnitude of the coefficients for the above mentioned

subperiods are a bit lower (from 1 to 1.5 times higher), although also statistically

significant according to Wald tests (not shown).

Alternative Control Variables

The results also seemed robust to alternative specifications of the control

variables, particularly in the time trend. A potential weakness of the

proposed specification is that the trend is not appropriately capturing over

time changes that may overlap with the identified impact of regulatory

dummies. In particular, factors such as nonlinear trends, business cycle

influences, or technological changes may affect our results. In order to

control for these potential influences, we also tried other types of variables

to pick them up, such as a quadratic time trend and Internet penetration.

It may also be the case that the dynamics of adoption and use may

be different in territories with different levels due to idiosyncratic features

such as differences in the presence of tourists that may make adoption

and use potentially heterogeneous across regions, thereby affecting to a

larger extent banks, merchants, and consumers in more touristic regions.

We have considered these influences by estimating our main equations

for two subsamples separating regions over the median value of tourism

revenues over GDP and below that median value. The results for all these

alternative specifications (not shown but available on request) suggest that

none of these alternative specifications significantly change our baseline

results and conclusions since our main variables exhibit the same signs

and similar coefficient magnitudes.

ROLE OF INTERCHANGE FEES IN TWO-SIDED MARKETS 381