In our guide, Revenues in Financial Features, we take a deep dive into the five main revenue streams and how fintech companies should think about them: interchange, interest, payments, financing, and software fees. This guide will focus on interchange, the fee that fintech companies generate after funds are spent from the cards they issue.
There are two reasons we’re choosing to focus on this topic. The obvious one is that in the absence of meaningful interest rates, interchange remains the most important revenue stream in fintech. Our model shows that fintech companies usually derive more than 75% of their revenues from interchange fees. Most companies that seek to issue cards therefore must understand and optimize the interchange they generate. Another reason we’re choosing to cover interchange is that the economics around it are still poorly explained and understood. We hope that this guide will change this.
If you are interested in offering a card product and seek advice on planning and maximizing your interchange revenue, this guide is for you. In the sections below, we’ll explain:
What exactly is interchange and how it’s calculated
How the interchange value chain works in different infrastructure environments;
What you can do with interchange;
What you can do to capture more interchange.
What is Interchange?
To help you understand the basics, we’ll use one example throughout this guide.
Joe has recently signed up for Outlay, a trendy new financial technology startup that launched recently to offer checking accounts and debit cards. He received his Visa debit card by mail and funded his Outlay account with $100. Joe walks into a Nike store to buy a pair of sneakers and uses his debit card to pay for the purchase. He swipes his card and pays $100. Nike, as the merchant, gets $97 for the sneakers. You can think of the other $3 as a processing fee that Nike pays for the ability to accept Joe’s card payment.
The $3 fee is actually split between many different parties, including Nike’s bank and even the maker of the physical terminal that the card was swiped at. One component of this fee is known as interchange, and that’s the component that goes back to Outlay, the financial technology company that issued Joe’s debit card. Think about interchange as roughly 1.5% of the purchase amount, or $1.50.
There’s a lot to unpack around this $1.50. Let’s get started.
The First Rule of Interchange: It Varies
In the above example, we assumed the interchange stands at 1.50%, but in reality the numbers vary. Interchange is always a small fraction of the amount spent, but this fraction varies from transaction to transaction.
So really, there is no way for Outlay to fully predict the interchange revenue that Joe’s card purchases will generate over time. However, to estimate its future revenues, Outlay may assume an average interchange of 1.50% for the purchases that Joe and other customers make.
To get a sense for how much interchange really varies, you can consider the long and complex interchange tables published by Visa and Mastercard.
Here are the most important variables that affect interchange and that Outlay should consider:
Individual Card vs. Business Card
Individual cards have significantly lower interchange fees than business cards. Throughout this guide and for your future modeling, we encourage you to assume the following:
Business debit cards generate gross interchange revenue of 2.2%–2.4%per transaction
Consumer debit cards generate gross interchange revenue of 1.4%–1.7% per transaction
If Joe ran a small business as a basketball coach and used a business debit card on the business’s name to buy the same Nike sneakers as a business expense, the interchange would have been roughly $2.40 instead of $1.50.
If you read the interchange tables we mentioned above, you’ll notice that interchange is composed of two components: (1) percentage from the purchase amount (2) a small fixed amount.
For example, one line in the Visa interchange table reads as follows: 2.50% + $0.10. Consider the effect that the fixed amount ($0.10) has, depending on the purchase amount:
A $10 purchase would yield $0.35 in interchange, or 3.50%
A $100 purchase would yield $2.60 in interchange, or 2.60%
This means that smaller transactions generate higher interchange as a percentage of purchase amount (3.50% in a smaller purchase compared to 2.60% in a larger purchase).
Online vs. Offline
Online card purchases generate higher interchange fees than offline card purchases, in order to “compensate” the issuing institution for potential fraud risk. If Joe made the exact same purchase at Nike’s online store and not a physical store, the interchange would have been roughly $1.60 instead of $1.50.
Based on the concept of Merchant Category Codes (or MCC), purchases at certain merchants may generate less interchange. For example, purchases at merchants that belong to a specific category (“Grocery Stores, Supermarkets”) could generate less interchange. If Joe made the exact same purchase at his local supermarket, the interchange could have been $1.10 instead of $1.50.
Debit vs. Credit
Debit cards have lower interchange fees than credit cards due to lower credit risk for the issuing institution. As a rule of thumb, the difference stands at 0.50%. If the card Joe used was an Outlay credit card, the interchange would have been roughly $2.00 instead of $1.50.
Even though the brand on Joe’s card (and Nike’s terminal) is Visa, some offline transactions like Joe’s purchase at the Nike store may be routed to a second network you probably haven’t heard of, such as Accel or Interlink. Those networks tend to have unique interchange rates. Joe could walk into another physical shop that happens to use one of them, and his purchase would generate a different interchange.
Large merchants (like Walmart or Amazon) have enough influence to close bespoke deals with the card networks. If Joe made the exact same purchase at Walmart and not Nike, the interchange could have been $1.30 instead of $1.50, leaving Walmart with more and Outlay with less.
Size of issuing bank
In the US, large banks (such as Chase or Citi) get much lower interchange than smaller banks. In simple terms, banks with less than $10b in total deposits have access to numbers like the 1.50% above, while bigger banks like Chase will see less than 0.30% if they issued Joe’s card. This huge difference is the result of a specific regulatory change that was enacted after the 2008 financial crisis, in an attempt to strengthen smaller banks in the US. The change is known as The Durbin Amendment within the Dodd-Frank Act.
If Joe used his Chase debit card for the exact same purchase, Chase would get $0.30- significantly less than Outlay. Companies like Outlay therefore choose to partner with smaller banks to maximize interchange.
From Raw to Net Interchange: What Happens After the Purchase
So far, we discussed the variable nature of interchange and explained that every transaction generates a certain interchange that goes back to Outlay. This includes the $1.50 for Joe’s purchase at Nike. This amount is known as the raw interchange.
In our example, Outlay is technically a financial technology company and not a bank, as are Chime, Current and others. Outlay will get to keep part of the $1.50 in raw interchange- typically the majority- but how much exactly will be determined by the type of infrastructure it’s built on.
There are 2 common infrastructure options, and we’ll explain both of them next.
Option 1: Outlay is Built on a Bank + Middleware
If Outlay was started before 2018, it’s very likely that it was built on a direct bank relationship that involves the use of a middleware component.
As our guide to banking infrastructure explained, this means working directly with at least one partner bank, owning a large set of compliance activities and cobbling together 13 infrastructure components on average. Those components include:
A middleware component, the component that helps Outlay open accounts within the bank’s legacy core system.
A card processor, the component that processes the purchase transactions as they arrive from Visa, looks into Joe’s balance in real time and updates it after the transaction is approved.
There are many costs to that legacy setup, including engineering, fraud, legal, day-to-day management challenges and the lower flexibility that’s inherent to working with multiple vendors. Importantly, it also has a strong impact on the interchange economics, since Outlay has to share the raw interchange of $1.50 with 4 different companies:
The card network (e.g. Visa)
The middleware component
The card processor
The partner bank
What happens next is that all the above companies take their share from the raw interchange. What’s left at the end of this process is the net interchange.
The partner bank typically lets companies like Outlay keep 70-90% of the net interchange. Let’s assume that Outlay has a great deal that lets it keep 90% at scale.
Interestingly, the bank typically “double dips”; it takes a piece of the raw interchange (e.g. $0.10) and then also shares in the net interchange (e.g. 10%, while Outlay keeps 90%).
Outlay will have to negotiate a per-transaction fee directly with all the above companies, and the deals it is able to get depend mostly on volume. Even in the most competitive environments, the different per-transaction fees add up to an inefficient value chain that typically looks like this:
In this option, the final interchange that Outlay keeps from Joe’s purchase at Nike is $0.98, or 90% of the net interchange of $1.09.
Option 2: Outlay is Built on a Platform
Platforms like Unit represent a newer generation of infrastructure.
As our guide to banking infrastructure explained, platforms are a complete solution that lets Outlay open bank accounts and issue cards. They have the bank relationships built-in, streamline compliance (e.g., PCI-DSS requirements), and expose a modern API / Dashboard that Outlay could use to build its product and run its day-to-day operations.
The integrated nature of platforms helps companies like Outlay go to market faster and get support from experts for key fraud/compliance responsibilities. Importantly, it greatly improves the interchange economics, since Outlay has to share the raw interchange with two entities, instead of four:
The card network (Visa)
Platforms typically let companies like Outlay keep 70-80% of the net interchange. Let’s assume that Outlay has a great deal that lets it keep 80% at scale.
With platforms, net interchange is calculated differently, which favors Outlay. The net interchange is what you get after deducting the card network fee (Visa) and the platform’s at-cost processing fee. Platforms may need to pay an underlying processor, but their relationship with the processor is optimized for cost, which typically ends up being less than $0.02. This number will go into our calculation, but as you’ll see, it ends up having a very minimal effect on the net interchange.
Given the above, the interchange economics typically look like this:
In this option, the final interchange that Outlay keeps from Joe’s purchase at Nike is $1.06, or 80% of the net interchange of $1.33.
Summarizing The Difference Between Option 1 and Option 2
It’s worth pausing and reflecting on the difference in outcomes for Outlay between the two options above:
In option 1, the bank gave Outlay a seemingly attractive 90% of the net interchange pie, but didn’t explain the value chain that contributes to a smaller pie.
In option 2, the platform gave Outlay 80% of the net interchange pie, but created a value chain that makes the pie much bigger.
The result is that Outlay keeps $1.06, or 8% more, by choosing a platform. In our example, Joe spent a relatively large amount ($100) on the sneakers. In the case of smaller transactions, the difference can be as large as 50%. If Joe made a $50 sneaker purchase, Outlay would keep $0.46 vs $0.31, or 50% more, by choosing a platform.
What Can You Do With Interchange Revenue?
Whether Outlay was built on a platform or on a bank + middleware, it has one last business decision to make: what should it do with the interchange it earned?
Assume the final interchange that Outlay keeps for Joe’s purchase is $1.06. Here are some examples of what may happen next:
Outlay can keep the entire amount to itself. Many financial technology companies, including Chime, choose this as their main monetization path.
Outlay can give a portion of this amount back to Joe as cash-back. In this case, Joe may get notified that he received a cash-back amount of $0.56 at the end of the day. Outlay would keep the other $0.50.
Outlay can give the entire amount back to Joe as cash-back. In this case, Joe may get notified that he received a cash-back amount of $1.06 at the end of the day.
The infrastructure that Outlay is built on plays a big role in achieving the above. Here are things you should consider around infrastructure and interchange economics:
Can you assign different cash-back tiers for different users? Outlay may want to offer 100% interchange as cash-back to Jenny, a VIP client that regularly sends her paycheck into Outlay, while Joe gets no cash-back at all. It may also want to promote Joe to the VIP level once he’s been a loyal customer for long enough. In Unit, you can achieve that by specifying a set of terms (for example: “VIP”) when creating an account. It also lets you update an account later to change the user’s terms.
Can you implement both automatic and programmatic cash-back? Simple policies like “always give VIPs 100% of interchange as cash-back” should be a matter of settings. But in the case of more complex rules, like “only offer cash-back once a user exceeds $500 in monthly spend” or “offer 100% cash-back for purchases within the user’s city of residence”, your infrastructure should make it easy to implement programmatic cash-back via API.
Can you keep track of how interchange flows? Your team will need a way to track all interchange economics at a high level. For example, Outlay may want to understand how much interchange has been generated from its entire user base yesterday and how much of it was paid to its users as cash-back. It will also need visibility into account-level and transaction-level interchange flows to answer questions from users. Unit lets your team keep track of all things interchange from the Dashboard.
Can you make better business decisions with interchange data? Outlay will need to measure the engagement levels of VIPs or users who signed up during a special cash-back offer this month. Having API access for all engagement data, including interchange rules and transaction-level insights, can inform better business decisions at Outlay’s management and marketing teams.
How much of your time is spent on compliance around cash-back? Outlay, like every company that offers accounts and cards, needs to be mindful of regulatory guidance around communicating and implementing cash-back terms. Working with a platform like Unit helps ensure that you meet compliance requirements around marketing and that your cash-back policies are properly reflected in your terms and conditions.
Tips on Maximizing Your Interchange Revenue
As we mentioned above, there are many variables that impact per-transaction interchange. Some variables, like the balance between online and offline transactions, are hard to control or predict.
However, there are a few tips you can implement that will greatly impact your interchange revenue:
Try to capture business interchange when possible. If you serve freelancers, sole proprietors, or even individuals that spend to support their income (e.g. landlords), you may be able to classify them as businesses when it comes to interchange. As we explained above, this can increase your interchange revenues by ~70%. Make sure to work with partners that can help you examine your customer base and optimize for business interchange when possible.
Understand your infrastructure’s value chain. As outlined above, platforms can ensure you capture a greater share of interchange. We recommend spending time modeling out interchange revenues (you can use Unit’s revenue projection tool). Make sure you understand your infrastructure’s value chain and ask yourself exactly what happens to a $30 or $50 transaction that your customer makes.
Make sure you get more of the net interchange. The percentage of net interchange you’re able to keep is obviously important. It can range from 60-90%, depending on the infrastructure type you’re looking at, and will often include tiers that give you more interchange at higher monthly volumes. Numbers that seem high could be deceiving, so put any number in the context of the full value chain.
Ask for all the data and focus on actionable data. Even if interchange is your main revenue stream, understanding it is hard: it’s often made of millions of transaction-level revenues and the variables change from one transaction to the next. Having a complete data set, and the tools to make sense of it, will help you understand how much of the interchange you’re seeing, and how much flows to your users. It will also help inform critical commercial decisions- for example, adding custom cash-back terms or launching a new VIP plan for your most loyal users.
If you are considering offering cards as part of your product offering, we hope this guide has helped you navigate interchange and how to think about maximizing interchange revenue. We explained:
What exactly is interchange and how it’s calculated;
How the interchange value chain works in different infrastructure options: (1) bank + middleware (2) platform;