Digitization of Retail Payment Systems

Rapid advancements in computing and telecommunications have enabled us to interact with each other digitally. Instead of visiting a travel agent for information regarding our next vacation, we can purchase our vacation package online in the middle of the night. Prior to boarding, we can purchase and download a book to our Kindle to read during the flight. We no longer have to return home to share our vacation experience with our friends and family but can instead share our digital pictures taken with our iPhone via email or post them on Facebook. Despite the digital economy being upon us, we still rely on paper payment instruments such as cash, checks, and paper giros for a significant amount of face-to-face and remote bill payments in advanced economies. While we have not attained the cashless society, we have made significant strides to adopt electronic payment instruments.

The proliferation of payment cards continues to change the way consumers shop and merchants sell goods and services. Recently, some merchants have started to accept only card payments for safety and convenience reasons. For example, several U.S. airlines only accept payment cards for inflight purchases on all their domestic routes. Also, many quick service restaurants and coffee shops now accept payment cards to capture greater sales and increase transaction speed. Wider acceptance and usage of payment cards suggest that a growing number of  consumers and merchants prefer payment cards to cash and checks. Furthermore, without payment cards, Internet sales growth would have been substantially slower.

The increased usage of cards has increased the value of payment networks, such as Visa Inc., MasterCard Worldwide, Discover Financial Services, and others. In 2008, Visa Inc. had the largest initial public offering (IPO) of equity, valued at close to $18 billion, in US history (Benner, 2008). The sheer magnitude of the IPO suggests that financial market participants value Visa’s current and future profitability as a payment network.

Over the last decade or so, public authorities have questioned the underlying fee structures of payment networks and often intervened in these markets. The motivation to intervene varies by jurisdiction. Public authorities may intervene to improve the incentives to use more efficient payment instruments. For example, they may encourage electronic payments over cash and checks. Public authorities may also intervene because fees are “too high.” Finally, public authorities may enable adoption of payment standards that may be necessary for market participants to invest in new payment instruments and channels especially during times of rapid innovation and competing standards.

In this chapter, we emphasize regulation of certain prices in the retail payment system. To date, there is still little consensus—either among policymakers or economic theorists—on what constitutes an efficient fee structure for payments. There are several conclusions that we draw from the academic literature. First, there are significant scale economies and likely scope economies in attracting consumers and merchants and payment processing. Second, cross-subsidies between consumers and merchants may be socially optimal suggesting that there are benefits to having a limited number of networks. Third, allowing merchants to price differentiate among different types of payment instruments generally more accurately reflect underlying costs to all participants. Fourth, merchant, card issuer, or network competition may result in lower social welfare contrary to standard economic principles. Finally, public authorities should not only consider the costs of payment processing but also consider the benefits received by consumers and merchants, such as convenience, security, and access to credit that may result in greater sales if they choose to intervene in payments markets.

The rest of our article is organized as follows. We first explain the structure of payment networks. Having established a framework, we discuss consumer choice and the migration to electronic payments. Next, we describe the provision of payment services emphasizing the economies of scale and scope that are generally present. Then, we summarize the key contributions to the theoretical payment card literature focusing on economic surplus and cross subsidies and their impact on social welfare. In the following section, we discuss several market interventions by public authorities. Finally, we offer some concluding remarks and suggest future areas for research.