Unpacking Interchange and its $100B+ Effect on Fintech
Senator Chris Dodd and Congressman Barney Frank have been called a number of things, but godfathers of today’s fintech nation is not one of them. However, unknowingly and hidden deep within their sweeping, 800-page Dodd Frank Act, under Title X, Subtitle G, section 1075 was a stipulation that would perhaps be one of the most effective vessels of government funding towards innovation of all time.
Specifically, the Durbin Amendment was a provision within Dodd Frank aimed at reducing card interchange fees for merchants while limiting big banks’ stranglehold on competition. It is this loophole that allowed interchange to support an explosion in challenger banks, next generation payment processors, and virtual card issuers and the billions in capital invested that ensued. However, the ability to decouple interchange and innovation in the Fintech ecosystem is becoming increasingly important as soaring valuations for these models are reliant on what could be considered transactional revenue backed by a small, albeit impactful, provision of legislation.
First, though, what is interchange and how has it affected the world of fintech as it is known today?
Breaking Down Interchange
Banks, both challenger and incumbents, collect interchange every time a consumer swipes a card. With each swipe, interchange is paid by a business owner to a card issuer, say a Chime, Dave or even Bank of America after being processed by a card network (Visa, Mastercard). For example, if a gas station accepts a Chime Visa card on a transaction, they would pay interchange on the purchase price to Visa, that would then take a small cut for processing the transaction and route the majority to Chime for issuing the card to begin with, hence “net interchange”.
In 2010, interchange fees paid to big banks came under fire under the Dodd-Frank financial reform legislation. Of concern, big banks were profiting too much at the expense of retailers and merchants and creating unfair competition for regional banks and credit unions. To level the playing field, the Durbin Act was passed as a part of Dodd-Frank, capping interchange fees for big banks or those with more than $10 billion in assets. As a result, financial institutions with under $10 billion in assets could collect interchange fees at multiples higher than big banks, incenting disruptive business models to work with smaller banks to build their startups or to exist in the first place (i.e. Marqeta with Sutton, Chime with Stride).
High Growth or Innovation?
Of course, underpinning all of this is the notion that this allowance of higher interchange may not be a permanent fixture in the ecosystem as the Durbin Amendment has continually come under fire from merchants and big banks alike. In response, many parts of the world such as the European Union have capped interchange rates for all financial institutions and areas of Asia-Pacific have followed suite in recent years with similar caps.
Whether or not interchange stays or goes, the industry’s reliance on the form of revenue has taken center stage. And while the Durbin Amendment has been a beacon for innovation in fintech, is it alone enough to justify double digit trading in public markets? Specifically, interchange led businesses are not isolated to the 250+ global neobanks as unicorns across the sector such as Marqeta and Brex also receive a substantial portion of their revenue from interchange. Even more notable is the sheer magnitude of models reliant on interchange fees — of the ten largest fintech fundraises of 2021, representing a collective valuation of over $150 billion, almost $100 billion was attributable to businesses reliant on or with exposure to interchange.
Though some may consider all of this ephemeral, in some ways the Durbin Amendment propagated interchange as a form of fintech revenue. In this context, it can be viewed as inadvertently one of the most effective government funding mechanisms for innovation to date. Under a more quantitative lense, take for instance that Chime generated $600M in revenue from interchange in 2020 alone. Additionally, without insight into Chime’s exact research and development spend, assume arbitrarily that it might be similar to Robinhood’s 23% of 2020 revenue. Under these assumptions, $138 million would have been allocated directly to innovation by one company in 2020 alone — dollars made possible by the Durbin Amendment. Now imagine the value created for innovation across the ecosystem of startups utilizing interchange as revenue.
For the most strategic platforms this means the ability to build innovative technologies in fintech while not having to charge software subscription revenues off the bat. This has created opportunities for groundbreaking products, such as fee free accounts and overdraft protection, or advanced underwriting technologies that may not have previously been possible. Take for instance that many expense management and corporate spend platforms such as Divvy and Ramp forgo charging for their software to rather eat off of interchange fees. With access to an alternative means of revenue, startups have more firepower to build on their technology and eventually charge subscription fees to create a more stable revenue stream and insulate against any fluctuations in interchange.
But without realization of this subscription software, how can constituents across the ecosystem discern between disruptive tech and fleeting regulatory arbitrage? Public markets still value growth over almost all else, but without true disruptive technology backing this growth, a startup’s convergence to incumbent solutions is inevitable once it reaches scale. To prepare for a world where an advantageous interchange loophole doesn’t exist, the most durable companies will have used interchange to their advantage in investing in tech and business model moats along the way.
While detractors might argue that revenue reliant on interchange is a risky bet, is that not the name of the game when chasing category creators with unproven, albeit groundbreaking ideas? Whether the Durbin Amendment lasts in its current state for the next year or twenty years, its impact on the financial world around us is inarguable, and for that, kudos to you Mr. Dodd and Mr. Frank.
Disclaimer: Views are my own and may not reflect those of my employer.