With over 600 participating users, the Federal Reserve’s FedNow instant payments service poses a threat to credit card interchange fees and by extension the customer reward programs they fund – and merchant funded rewards are poised to fill that void.
While the availability of instant payments is becoming more widespread, credit cards remain ‘top of wallet’ for consumers’ everyday purchases. This could change in the future, considering that instant payments have far lower average utilization fees than credit cards.
The credit card industry in the US operates on interchange fees, the per transaction fees (averaging around 2%1) levied on merchants by bank card issuers, networks and processors to cover processing and other costs – and as such represent a significant source of profit for financial institutions and credit card companies.
While some businesses encourage customers to pay with cash by highlighting the additional surcharge applied to credit card payments, an estimated 41% of Americans do not use cash for any of their usual weekly purchases.2 Instant payments – which virtually eliminate interchange fees, with a flat rate of US $0.045 per customer credit transfer – now offer a convenient alternative for customers and merchants alike, and look set to reduce the current reliance on credit cards for everyday transactions.3
As noted, interchange fees are a key revenue stream for card networks, processors and issuing banks, financing the operation of payment networks and systems, fraud prevention, authorization, clearing and settlement processes – along with funding rewards programs and loyalty incentives.4 While FedNow was not established to alter the credit card landscape, if it reduces merchants’ appetite or need to accept credit cards, the issuer revenue generated by interchange fees will drop, perhaps significantly – posing an immediate threat to credit card rewards programs.
Industry apprehension around the potential impacts of such a reduction in interchange fees was evident when the bipartisan Credit Card Competition Act (CCCA) almost passed in 2023. The bill seeks to open up competition by requiring that merchants processing payments have the option of using another card network other than Visa or Mastercard.5 Merchants support the legislation, while card issuers argue that fee reductions will jeopardize rewards, miles, and points programs.6 JPMorgan Chase has noted that “banks…invest more than 90% of all interchange fees they receive into credit card reward programs and benefits for cardmembers”, so reducing fees would negatively impact such offerings.7
The impact on credit card rewards of reduced interchange fees can already be seen in the European Union, where regulations cap credit card interchange fees at 0.3%.8 As a result, card companies operating in the region offer extremely limited cashback and points compared to the US. Whether or not legislation reducing interchange fees is passed in the United States, wide usage of instant payments will still reduce overall revenue earned from interchange fees. When credit card spending decreases, card issuers’ revenue decreases as well.
Rewards percentage rates and other points programs have historically been an incentivizing driver of credit card use, but as banks and card companies make less money off credit cards, they won’t be able to offer as many generous programs.9 Credit card rewards are important to American consumers, with the American Bankers Association noting that “96% of rewards cardholders characterized their rewards programs as very or somewhat valuable.”10
If credit cards and their reward programs become less desirable to consumers, merchant funded rewards (MFRs) are poised fill that void. An alternative to cardholder incentives, MFRs see businesses – from a local bakery to a global fashion label – partnering directly with financial institutions to offer retail consumers rewards, points, or discounts.11
The merchant benefits from enhanced brand marketing and exposure while the partner financial institution can offer perks to its cardholders. American Express cardholders, for example, receive a range of MFR offers: they can spend US$120 and get US$20 back on Asics products, for instance, or receive 6,000 bonus points if they spend over US$3,000 at Marriott Bonvoy, or get 20% off a single Hello Fresh purchase.
Furthermore, MFR allows brands to target consumers who are more likely to purchase their products or services, based on bank analysis of their purchasing habits and statement history. A symbiotic relationship is thereby created between banks and merchants: merchants gain brand recognition and a potential increase in sales, while banks can offer free rewards to their customers with no hit to their own bottom line.
MFR programs can be used in conjunction with both debit and credit cards, and some banks also currently offer rewards on checking account transactions – so it seems logical that such programs could be extended to instant payments in the future.12 Through affiliate link-based MFR programs, banks and their customers can earn rewards regardless of what payment method is used for purchase, meaning that even non-card banking customers can easily take advantage of MFR benefits.13
Although MFR programs offer benefits to consumers and issuers, the current customer journey has room for improvement. A typical MFR experience for cardholders in the US requires them to ‘activate’ offers they want to leverage. This could include finding and selecting offers in their banking app, activating through an email link, or installing a browser plug-in that shows pop-up MFR discounts while they shop online. So, if a customer wants to take advantage of a 5% cashback offer at a retailer, it will involve multiple steps that create unnecessary friction in the user journey.
In 2024, consumers desire seamless user experiences, and requiring them to activate MFR offers each time a new reward is available does not meet this expectation. A technological solution that automates extra cashback on partner merchant purchases would give issuers an opportunity to differentiate themselves in a competitive market.
A study of over 3,000 US consumers, conducted by payments processing company PYMNTS, found that “rewards programs with lengthy redemption processes or no personalized offers drive consumers away,” and that roughly a third of consumers see lengthy credit card rewards redemption processes as a significant issue.14
Gen Z consumers generally possess high technological literacy and expect frictionless user interfaces, so if issuers want to attract the next generation of buyers, they will need to implement modern MFR strategies to secure future growth. As tech journalist Tom Groenfeldt notes in a recent Forbes article: “While existing loyalty programs attract many users and offer rewards, widespread friction and dissatisfaction present a significant market opportunity for a solution that smoothly delivers tailored rewards.”14
The future of payment rewards is ripe with potential for change, with FedNow serving as a catalyst for both disruption and innovation. As instant payments adoption continues to expand, the credit card ecosystem looks set to suffer collateral damage – and issuers, processors and networks would be advised to explore revenue loss mitigation strategies. While MFR programs offer a variety of use cases and capabilities and present an (increasingly) attractive option for financial institutions, merchants, and retail consumers alike, they also leave room for improvement. Institutions that can leverage technological advancements to improve the MFR user experience will gain a competitive advantage.
1 https://www.creditdonkey.com/interchange-rates.html
2 https://www.pewresearch.org/short-reads/2022/10/05/more-americans-are-joining-the-cashless-economy/
3 https://www.frbservices.org/resources/fees/fednow-2024
4 https://www.capitalone.com/learn-grow/money-management/interchange-fees/
5 https://www.paymentsdive.com/news/credit-card-competition-bill-legislation-battle-durbin-marshall-unions/700713/
6 https://www.forbes.com/advisor/credit-cards/credit-card-rewards-safe/
7 https://www.chase.com/personal/credit-cards/education/rewards-benefits/could-ccca-impact-credit-card-rewards
8 https://cms.law/en/bgr/publication/eu-cap-on-interchange-fees-for-card-based-payments201
9 https://www.chicagofed.org/publications/working-papers/2010/wp-19
10 https://www.aba.com/news-research/analysis-guides/the-benefits-of-credit-card-rewards
11 https://medium.com/@PulseiD/pivoting-from-incentive-driven-growth-to-merchant-funded-rewards-pulse-id-1da8bc93475f
12 https://loyaltyrewardco.com/3-types-of-merchant-funded-loyalty-programs/
13 https://www.finextra.com/blogposting/21755/rewards-programs-help-banks-retain-customers-and-drive-new-revenue
14 https://www.forbes.com/sites/tomgroenfeldt/2024/03/13/outdated-credit-card-rewards-annoy-gen-zwhats-on-your-phone/?sh=69a3cc6912eb