At Gordon Dean’s small-town grocery stores in Ontario and Quebec, the rattle of coins in the checkout tills is a more infrequent sound than it used to be.
The five stores in the Mike Dean Local Grocer chain are seeing customers pay with credit cards much more often. Before COVID-19, about 40 per cent of purchases were made in cash; these days, it’s closer to 18 per cent. And that has taken a bite out of the bottom line.
“It’s chewed it up,” Mr. Dean said. “It basically increased our monthly processing-fee bill by 30 per cent.”
Credit cards are the most common form of payment in Canada, and their use has skyrocketed during the pandemic. But how the credit-card system actually works is something most of us rarely think about – to the chagrin of some business owners, who subsidize the cost of that system.
“Your travel points or your rebates – the consumer needs to understand that those aren’t free.”
Now, the end of a long-running legal battle, and new government efforts to cut credit-card fees, are highlighting the web of players in the system: merchants who pay each time a card is used, payment processors and card networks that take a cut, and financial institutions that issue cards and collect a high margin off the fees.
Over the next three months, Ottawa will convene many of these players for a series of negotiations, with a goal of reducing fees, especially for small businesses. If a deal is not reached, the government says it will table legislation to set the fees itself.
There’s a lot at stake. The outcome could weigh on the profits of credit-card companies and Canadian banks, and even compromise the value of the credit-card reward programs that so many Canadians use.
Here is how credit-card payments actually work and why the system is so complicated – and how that could soon change.
How the system works
There is no single credit-card swipe fee for every transaction. When a customer pays with a credit card, the money flows to a series of parties – starting with the merchant taking the payment, but also a payment processor, a credit-card company and the bank that issued the card – with each taking a bite.
The bank gets the largest bite, called an interchange fee. In one example provided by the Canadian Bankers Association, a merchant selling a $100 item might only keep $98 if the customer pays in credit. Of the other $2, the bank that issued the card might collect $1.40.
Another fee of roughly 51 cents would go to the “acquirer” that processes the payment, such as Moneris or Chase, while an assessment fee (amounting to perhaps 9 cents in this case) goes to the credit-card company, such as Visa or Mastercard. Credit-card companies have other sources of revenue as well, such as technology licensing fees and currency-conversion services.
These numbers are just a rough example, as the fees are not set. They fluctuate based on a number of factors, including the size of the merchant, its industry (a cab driver would pay a higher fee, for example, than a grocery store) and the type of purchase, such as whether it was done in-person or online.
But it wasn’t always this way.
In 2007, Visa and Mastercard set one interchange fee for consumers. But as the card companies fought each other for market share, they offered special rates to different merchant segments and financial institutions. Then, under pressure from governments and businesses, they lowered rates for specific groups.
The result is a multitude of different fees.
“It’s become an increasingly complex matrix,” said Scott Lapstra, a former executive at Mastercard and Tangerine who now works as an industry consultant. “I get why the regulators and industry lobby groups are frustrated by it. It’s not transparent.”
Before 2014, the average interchange fee was 1.74 per cent. That year, during two rounds of voluntary negotiations with the Canadian government and industry, Visa and Mastercard agreed to set an average rate of 1.5 per cent; this was later lowered to 1.4 per cent in 2020.
Visa and Mastercard keep track of the average rate they charge, making adjustments as needed to ensure they adhere to those average-fee commitments.
That can be a complicated balancing act. For example, when the pandemic led to an online shopping boom, the number of “card not present” transactions soared. The interchange rate for those transactions is typically higher, the card companies say, to account for a greater fraud risk.
Mastercard adjusted those rates to keep the overall average at 1.4 per cent, according to Martin Leman, the company’s vice-president of strategic initiatives and partnerships in Canada.
Credit-card companies and banks say this current system works because merchants have access to a widely used form of payment and receive funds right away; financial institutions are compensated for the risk they take that a customer won’t pay them back; and shoppers can make convenient, cashless purchases – even if they don’t currently have the funds in their bank account.
And there is one more reason why banks say customers benefit from interchange fees: rewards programs.
Rewards v. interchange fees
In 2001, when Patrick Sojka launched Rewards Canada, a website that compares credit-card reward programs, the typical earning rate for card users was generally about 1 per cent (or one reward point per dollar spent). These days, he sees cards rewarding users with three, four or even five points to the dollar for some spending categories. But point values vary among different cards, so while those rewards have grown, three points does not always equal a 3-per-cent return.
“In general, credit card rewards have become richer over the years,” Mr. Sojka said – adding that the points some cards offer as “welcome bonuses” for new cardholders have also spiked, as the number of cards on the market has grown. “Competition has grown, and everybody’s vying for a piece of the pie.”
Mr. Sojka says this is good for consumers, who would not otherwise be rewarded for purchases they make anyway. He has heard from some savvy users who carry five or six cards, choosing one at each checkout based on the best rewards offer for that purchase category.
He regularly fields questions from readers who want to benefit from the system. But one question that does not come up often, is how interchange fees work.
Retail industry groups wish people would inquire more.
“People honestly think their annual credit-card fee funds their trip to Europe, or whatever they use their points for,” said Anne Kothawala, president and chief executive of the Convenience Industry Council of Canada, which represents convenience store owners. In reality, she said, the banks that issue cards are compensated for the value of those points with interchange fees – which erode retailers’ profit margins as people use cards more.
This is not to say that other forms of payment are free for merchants. Accepting cash slows down checkout lines, takes up staff time doing end-of-day tallies and bank deposits, and may cost money in counting errors. Many business owners say they prefer debit, which is just as convenient as credit but carries a much smaller fee. But rewards offer a powerful incentive for shoppers to reach for a credit card instead.
In lobbying the federal government for changes to the system, the Retail Council of Canada has argued that this contributes to inflation because merchants pass on some of those fees in the form of higher prices – which affects even those customers paying cash.
“It is beggar thy neighbour,” said Karl Littler, RCC’s senior vice-president of public affairs. “The person who gets the most generous awards – who has the highest-priced card – that’s driving the highest interchange costs.”
Businesses get new power on fees
Over the last decade, as industry groups pressured the government to reduce credit-card fees, a parallel process played out in court.
In 2010, a group of small businesses launched class-action lawsuits in five provinces against Visa, Mastercard and some banks over the interchange fees. A series of settlements gave businesses a new power: the option to pass those transaction fees to customers through a surcharge.
The new surcharge rules took effect on Oct. 6. If widely implemented, they could upend the current system by exposing the hidden fees to customers. Shoppers might even switch payment methods to avoid the fees, which would mean less revenue for banks and credit-card companies. (A 2021 CIBC report estimated 2 per cent of bank revenues came from interchange fees; banks also make money from credit cards through interest and annual fees.)
But so far, few companies have said publicly they plan to add surcharges. A survey released by the Canadian Federation of Independent Business in October suggested just 19 per cent of respondents would pass on fees; another 26 per cent said they would do it if their competitors did, too.
Businesses are stuck in a collective action problem: It could be advantageous if they all adopted surcharging, but it could have negative consequences for those going it alone.
“It would be a disaster,” said Jim Hamilton, owner of Hammy’s grocery store in Ponoka, Alta., explaining that a surcharge could drive customers away. “Loblaws isn’t going to do it, which is my competition in town.”
One major company has publicly announced its intent to add a surcharge: Telus Inc. wrote to the Canada Radio-television and Telecommunications Commission in August seeking approval to levy the fee for customers in certain regulated markets, and introduced the fee for customers in all other markets. Opposition was swift: the CRTC received thousands of letters from the public decrying the surcharge as a cash grab.
What comes next
On Nov. 3, the federal government announced in its fall economic statement that it would convene new meetings among credit-card companies, banks and business groups with the goal of lowering the interchange fees for small businesses. Ottawa also took a step the financial industry had been dreading, by releasing draft legislation to regulate the fees if the voluntary talks don’t work out.
Whatever the result, all of this noise around fees could cause consumers, for the first time, to see credit cards as complex financial products, said Laurence Ashworth, a business professor at Queen’s University.
“The current system doesn’t allow people to assess credit cards as what they are,” Prof. Ashworth said.