Changing Consumer Spend-Mix Continues to Disrupt Issuers, Merchants

Last spring, AQN’s Caio Mattos wrote a piece discussing the hidden impacts of COVID-19 on credit card issuers. While the most obvious and potentially largest concern issuers face is when and how losses may increase, shifts in spend have already impacted interchange revenue.

Nearly a year later, we have seen consumer spend bounce back to pre-pandemic levels but redistributed across different industries and transaction types.  These changes in spend behavior have been the silent assassin impacting economics for both issuers and merchants. The question is – are these changes here to stay? What steps might the networks take to ease the pain? How can affected issuers and merchants work to alleviate it on their own?

How does spend-mix shifts impact issuers?

Issuers are concerned about top-line interchange revenue and spend margin, which is most heavily influenced by merchant mix. Consumer credit interchange rates vary massively by merchant category– by more than 100 basis points from the lowest rate category to the highest, using Visa’s pricing tables.

Most issuers already experience moderate variation here – the networks adjust their rate tables annually, bumping up some categories while reducing others. Seasonality also plays a factor, with interchange margin eroding a bit during the holiday seasons when spend is concentrated at low-rate merchants like Amazon. On a macro-level, consumer spend market share continues to move toward these merchants, so overall spend-margin will continue to decline unless other changes arrive to bolster interchange rates.

The Covid-19 pandemic has been a different beast entirely, introducing more pronounced mix shifts. Spend distribution moved away from high-interchange categories, concentrating even more heavily amongst Amazon and other lower-rate merchants like Walmart and Costco.  AQN’s research shows spend at low-rate merchants is up 10% YoY, reaching as high as 50% during the height of the pandemic. Meanwhile, Amex quotes a 69% decrease in T&E spend YoY as of Q3, while BofA puts this number at a 40% decrease.  T&E merchants carry some of the highest interchange rates of any spend category (2.30% for a Mastercard world card compared to 1.77% at most retailers). The industry-standard 2.00% rewards card already teeters on the edge of a negative spend-margin without losing out on T&E spend.

Who should be worried about this?

Issuers with super-prime rewards cards aimed at transactors face the greatest spend-margin risk. With low APRs and revolve rates, this market segment relies on interchange revenue and annual fees to drive revenues. From an interchange perspective, these cards are typically able to achieve the highest rates from the most premium network products – the result of high credit limits, high spending customers, and meeting the necessary criteria from the networks in terms of card benefits. This premium interchange is counterbalanced by rich rewards offers, 2.00% is the floor for this segment, while many issuers feature even better offers.

Reduced interchange threatens these cards' economics – a negative spend margin on customers spending $50-$100K annually can quickly eclipse most of an AMF. Stiff competition challenges issuers in this space, and leads customers to expect the best benefits. You cannot reasonably reduce rewards without losing customers – not when so many online aggregators make it trivially easy to compare offers side by side. Issuers could raise annual fees – but they may be similarly concerned about attrition. Where does this leave the market? Will we see some financial institutions lean further into the idea that premium rewards cards should be used as a loss-leader for other financial products?

How do changes in transaction type impact merchants?

2020 was a rough year for merchants, particularly small businesses. While many folded, some merchants managed to reinvent their business model to fit within the constraints of the Covid-19 pandemic. Restaurants leaned on delivery and takeout, while other retailers focused on online ordering and curbside pickup – often building online capabilities from scratch. Together, these moves drove a significant increase in the density of card not present transactions (CNP transactions are up 20% YoY according to Visa, 30% YoY if you exclude travel).

CNP transactions carry higher interchange rates and introduce incremental complexity to payment processing. This adversely impacts small businesses and merchants without much experience selling online – they are less likely to be optimized to process CNP transactions and more susceptible to experiencing transaction downgrades. Unfortunately, these businesses reinvented themselves only to discover that their margins are worse, putting them even further behind large merchants with existing online processing infrastructure or ones that pay the same rate regardless of transaction method.

Merchants can leverage various data-driven strategies to mitigate interchange expense by understanding network rules and working with processors to achieve discounted rates where possible and avoid pitfalls that might result in downgraded transactions.

Where does this leave the market?

As April 2021 approaches, both issuers and merchants need to be aware that the networks have promised changes to their rates. Some of these were slated for implementation in 2020 and delayed as a result of Covid-19. The fully finalized updates are yet to be announced and may depend on how consumer behavior continues to evolve in early 2021 and on any new regulations instituted by the Biden administration.

Visa publicly stated that rate changes scheduled for April 2021 include decreased rates for some CNP transactions, as well as forgoing previously announced increases for card-present retail, benefitting merchants but potentially leaving issuers with a bit of ground to make up.

In the longer term, this highlights the threat to rich card reward programs that have been in the background for some time.  Over the last decade, interchange has slowly drifted down due to merchant pressure.  At the same time, rewards programs for high spend customers have become richer as banks compete for those clients.  But this can’t go on forever in a world where issuers lose money on every transaction.  If these trends continue, either rewards will need to come down, or revenue will need to come into the system from other sources like higher fees and lower sign-on bonuses.

AQN has advised merchants, issuers, and processors through the pandemic on strategies to bolster margins through analytics and understanding of network rules and programs. Every interchange problem is unique, but AQN continues to identify present opportunities for large issuers and small businesses alike. Don’t let interchange be the reason why your business model is struggling – and reinvest those savings into solving other problems.