A Short History of Credit Cards and Loyalty Programs

It is easy to see why retailers have loyalty programs to encourage repeat visits; “Here is a little something to encourage you to come back and spend again; let me know with this membership card when you do.”

However, credit card issuers¹ already know who you are and where you spend; have you ever wondered why they reward you for using the card you requested? Is fifty-five days of interest-free, unsecured credit not enough to encourage regular use? Are they so keen to compete for your debt that they volunteer a share of their profits to reward you?

The rewards industry funded by credit card use is immense. 1% of US GDP goes through just one airline reward credit card, Delta/Amex, and 35% of all credit card use in Australia earns points in the Qantas Frequent Flyer program. How did that happen? This brief history of an industry that started on September 18, 1958, with a drop of 60,000 cards in Fresno, California, will also look a little forward to the future. We will try to minimise ‘payment speak’ and define terms when first used.

The organisations issuing credit cards do not own and manage the network that links merchants, cards, and Issuers to complete a purchase. Schemes² run the networks, manage approvals, control fraud and act as clearing houses for purchases; Card Issuers provide the money and manage the accounts. Issuers initially established the two schemes, Visa and MasterCard, as centralised service companies to process credit card payments and owned them as a Cooperative.

Fundamental to credit card loyalty is Interchange; the fee issuers charge merchants for sending them the money when you make a purchase.

Interchange dates to the early days of credit cards, when Issuers worried that customers might take the credit and pay it back on time without interest³, meaning the business would lose money. Charging merchants for the service mitigated this risk; there would be income even without interest charges⁴.

Interchange fees were acceptable when payment by credit card was a small portion of the merchant’s sales, but as card popularity increased, they found they no longer had a choice: it was “accept card payments or go out of business”.⁵ Interchange began to look like a tax, set arbitrarily by the schemes at the class level, not through individual negotiations. Since the schemes were owned by the Issuers who benefit directly, merchants viewed this as an abuse of monopolistic market power.

The schemes also flexed their muscles by making rules for merchants if they wanted to be able to accept cards as payment for goods or services.

No surcharges. Even though credit cards cost the merchant, they could not charge the customer extra. As a result, many merchants put up prices for all customers to cover the extra expenses to avoid earning less profit.

Accept all cards. If a merchant accepted any credit card, they had to accept all. This was important because Issuers released premium credit cards with more generous rewards and higher interchange fees that the merchant would prefer to avoid. No chance.

Rewarding card customers supercharged card popularity, and while reward costs were kept below interchange, even interest-free transactors were profitable for the Issuers. Imagine the scene: a credit card manager pitching to the executive team in the bank, “We can increase card volumes and make more money by rewarding customers for paying with their credit cards, and it will cost us nothing; we can use the interchange money the schemes send us!”

Citi, a founding member of MasterCard, determined that free holidays were a popular reward, so it launched the first frequent flyer credit card with American Airlines’ AAdvantage program, using interchange to buy airline points, creating a high-profile branch of the multi-billion-dollar loyalty industry.

The merchants (retailers) objected to paying a non-discretionary tax as they could not realistically refuse to accept card payments, and the fees were substantial, eating into net profit margins. In 2005, in the US, they lodged a class action with the monopoly regulators, claiming non-competitive and collusive behaviour.

The schemes were Cooperatives owned by the card Issuers, making each independently liable for the outcome of the legal dispute. As this liability involved significant risk, the Issuers took the schemes public, with Mastercard’s initial public offering in 2006 and Visa’s in 2008. Safely behind the corporate veil, they could fight on6. Eighteen years later, on March 15, 2023, the case was completed, with the largest ever anti-trust penalty, a US$5.54B settlement to be paid to the merchants in the suit, “The case claims that merchants paid excessive fees to accept payment via Visa and Mastercard credit and debit cards, and that Visa and Mastercard and their member banks violated antitrust laws.⁷”

• Financial regulators in the EU and Australia have also voiced concern that credit card rewards were:
  
  
• Encouraging customers to use a more expensive payment method than other electronic options and discouraging new entrants, limiting competition.
  
  
• Using networks operated by foreign enterprises, competing with domestic alternatives⁸.
  
  
• Funded by increased merchant prices for all customers but only rewarding those affluent enough to access rewards credit cards. Customers paying in cash subsidise the credit card users in a reverse Robin Hood that the Australian Central Bank considers socially unjust.
  
  

Regulators consequently made changes in the credit card loyalty market, including permitting surcharges, the removal of ‘accept all cards’ and limiting interchange to 0.03% of transaction value in the EU, 0.05% in Australia and 0.08% in NZ. This has put a dent in the generosity of rewards, the addition of earning caps and increases in annual fees for Rewards Cards. Canadian regulators have followed suit, in May 2023, announcing interchange caps at 0.95% for small merchants, taking effect late 2024⁹.

US interchange rates are still over 2%, though debit interchange was regulated to a maximum of “…21 cents plus five basis points multiplied by the amount of the transaction” in 2011.

Congress is under pressure to cap credit card interchange^{10 11}, and the arguments advanced by the payment industry against the cap are:

• Interchange cuts will damage or devalue credit card reward programs¹² (the intended result)
  
  
• It will stifle innovation in Fintech and payment companies¹³. This is partly true as most payment innovators live off interchange as they expand their offerings – think Stripe, Adyen, and Revolut.
  
  
• Interchange cuts will not be passed on to consumers; “greedy merchants will pocket them” is the claim, as if excess fees pocketed by payment vendors are better for the consumers. This is also perhaps true; the consumer always pays; the evidence in the EU is that card acceptance costs went up for merchants as interchange was cut, with the schemes and acquirers increasing their service fees.

Transaction routing is a relevant but different issue facing payments now. Australia has a domestic payment network called EFTPOS that is often cheaper for processing, and the regulator is pressuring the industry to allow merchants to choose the lowest-cost route rather than defaulting to the V/M networks. The US government is also planning to require alternative routing to break the stranglehold Visa and MasterCard have in that market. The ACCC has accused MasterCard of subsidising credit card processing fees if merchants use their network for debit processing, which is, if true, a violation of the Central Bank’s rules about optimising payment productivity and minimising costs.

What is the Future of Credit Cards and Loyalty Programs?

The Gordian Knot of self-interest makes this a complex question in search of Occam’s Razor [cannot fit any more metaphors in this sentence]. When 1% of US GDP is charged to one Delta Airlines loyalty linked American Express credit card¹⁴, there is a good chance that the horse called ‘Self-interest’ is in the race¹⁵ [we managed]. No wonder the ‘swipe fee’ regulation bill in the US Congress has struggled to be passed into law, but Senator Durbin keeps trying¹⁶.

Regulators are determined to remove credit card rewards' market-distorting (and socially unjust) effects and minimise the power wielded by the Visa/MasterCard duopoly. The Chinese regulator denied them market access, enabling the massive WePay and a mobile payment revolution.

Regulators do not object to payment processors charging merchants a fair fee for servicing digital payments. They object to charges levied ‘because they can’ and then applied to reinforce payment choices in the best interest of those imposing the fees: credit card rewards programs. It is the reverse Robin Hood or national interest most often motivating the regulations because, as we have seen in the EU, payment processing costs do not automatically decrease when the rules change to ‘user pays’.

What options do Issuers have?

• Easy access to unsecured, revolving credit significantly benefits customers, but familiarity has devalued this incredible convenience. Helping customers manage the optimum mix of savings, investments, debit, and credit to achieve their financial goals requires Issuers to step back from a single-minded focus on maximising credit card portfolio profitability. Issuers, especially banks, must deal with responsible lending imperatives and offering rewards for incurring more debt is not always responsible behaviour.
  
  
• Most of the profit from credit cards comes from interest paid as customers pay off their debt over time. Issuers could use some of this margin to pay for rewards rather than obsessing about interchange cuts. The 5%+ cash-back rewards cards common in the US must be doing this.
  
  
• Issuers could exit card loyalty and focus on the customer benefits of frictionless, unsecured, and on-demand credit. This is the result in much of the EU (and the UK?).
  
  
• Issuers could seek other funding sources for their loyalty programs, with most paths leading to ‘Merchant Funded Offers.’ Issuers have an audience, so offering access to cardholders in exchange for promotional offers should appeal to merchants and make the program look generous again. The challenge is that other organisations have been aggressively building audiences and competing for the same merchant money. Cash Back loyalty programs, Affiliate Malls, and Discount Aggregators (looking at you, Amazon) all beat the Issuers to the punch. Issuers are stuck with the same offers as everyone else because they cannot offer merchants a unique audience. Buying the program competitor was the fashionable answer for a short while – ANZ purchased Cash Rewards, and Westpac invested in ShopBack. Commonwealth Bank went the next step and purchased equity in key merchants like More and Tangerine in telecommunications and Amber in retail electricity.
  
  Generally, the jury is still out on the performance of merchant-funded offers; CashRewards, when they were publicly traded, were unprofitable. Consumers seem to prefer better prices when they buy, not through a more complicated earn and redeem process.
  
  

We think the Phoenix strategy is to step back and recognise that if the Issuer is also a full-service bank, the relationship the customer wants is not as siloed as the internal departments that separate mortgages from credit cards from deposit-taking. All these lines of business make profits, and they would be better off reinvesting some of it in recognising and rewarding customers' loyalty and depth of relationship. Or decide to compete on lower fees and better products. Credit card loyalty is only one aspect of the broader banking relationship if you are a full-service provider.

Or sensibly acknowledge that merchants have always paid for customer rewards (initially through interchange) and that Issuers should retire from the field and become coaches. Use their infrastructure to make merchant loyalty frictionless and automatic, a byproduct of making a digital payment. Bink and Slyp are examples in the UK and Australia, respectively. Help customers manage their loyalty interactions at the source, the merchant.

We are Ellipsis, the Loyalty Experts. We help you measure, manage and grow customer loyalty​. We’re here to help, please get in touch…

References:

1. ‘Issuers’ are the companies that provide you credit, take the risk you will pay back, bill you regularly, charge interest & fees and pay for your purchases as you spend. They are often but not always, banks. They must be licensed as credit card providers.
2. The most famous schemes are Visa, MasterCard, and American Express. They do not issue any credit cards or extend any credit, but they service the organisations that do, Issuers.
3. These customers are known as ‘Transactors’.
4. These customers are known as ‘Revolvers’ since they revolve their balance as they pay it off.
5. Especially as Visa and MasterCard leveraged their networks to process debit payments alongside credit.
   
6. As a nod to the pending liability from $49.6 billion in merchant class actions, JPMorgan Chase, Bank of America, Citibank and Wells Fargo were restricted from selling their shares in Visa until the legal questions were resolved. Fifteen years later, shareholders are asked to remove this restriction so these banks can sell their shares before the disputes are resolved, making other arrangements to cover the potential liability. https://www.paymentsdive.com/news/visa-stock-exchange-litigation-merchant-claims-debit-credit/700558/
7. https://petapixel.com/2023/12/01/a-small-film-scanning-shop-just-won-businesses-5-5-billion-after-18-year-court-battle/
8. China did not let the US schemes open in the country, creating a domestic monopoly, Union Pay.
9. https://www.cbc.ca/news/business/visa-mastercard-fees-1.6848082
10. https://www.durbin.senate.gov/newsroom/press-releases/durbin-gooden-request-accounting-for-exorbiant-swipe-fees-being-paid-by-federal-government The US Senate has asked the treasury to total all the interchange paid by the government (funded by US taxpayers), including the merchant in chief, IRS.
11. https://www.pymnts.com/news/loyalty-and-rewards-news/2023/amid-great-interchange-debate-what-happens-rewards-programs/
12. https://www.bankrate.com/finance/credit-cards/credit-card-competition-act-would-harm-consumers/
13. https://notes.mtb.xyz/p/interchange-is-a-burning-platform?ref=this-week-in-fintech
14. https://www.fastcompany.com/90934980/how-much-do-we-charge-to-our-delta-air-american-express-cards-its-a-lot Remember that most of the money used to pay for the Delta loyalty points comes from interchange paid by other merchants who have accepted the Amex card as payment.
15. From the saying, “Always bet on the horse called Self-Interest because you know it is trying”.
16. https://www.congress.gov/bill/118th-congress/senate-bill/1838/text?s=1&r=1&q=%7B%22search%22%3A%22Credit+Card+Competition+Act%22%7D