Modern Monetary Systems of exchange vs Cash

I recently read this outstanding priceonomics blog post and couldn’t help but think about the differences between modern monetary systems of exchange and cash. The article is very well researched and includes a brief history of how credit cards evolved so I highly recommend it.

The original monetary system/system of value exchange was cash. Cheques/Credit cards/Debit cards represented the first major shift in monetary exchange systems. Recently mobile payment solutions, Google wallet, Apple Pay, Paypal, etc. represent modern variations of monetary exchange systems.

Credit Cards charge 2–3% fees to the merchant for every transaction that goes through their networks. The issuing banks, acquiring banks and the networks (VISA/Mastercard) all take a cut off of these transaction fees. Some of these fees pays for the free credit period provided for by the credit card. This free credit is actually provided by the issuing bank of the credit card. The networks/acquiring banks have no credit component in their fees. So even if we isolate out the credit expense inherent in the fees we’re talking of atleast 2–2.5% of fees for just moving electrons across servers.

Preventing Credit card fraud is one of the other responsibilities of these stakeholders in the credit card monetary exchange system. Online merchants can expect to pay between 1 and 2% more since the likelihood of credit card fraud is higher online. So while they bombard you with ads regarding how secure their credit card processing systems are, they stick you with a premium on transaction fees so that they can finance that security.

This is the cost of the monetary system of exchange that is borne by the merchants (in terms of fees) and customers (in terms of annual credit card fees and potentially increased prices that merchants charge). VISA has revenues of $12.93B annually. For MasterCard it was $9.47B.

Let’s now contrast with the original monetary exchange system — Cash! If a transaction was done between a purchaser and a merchant in cash, what is the transaction fees incurred by either? $0. Cash has 0 transaction fees. Well not actually, it cost some non-zero number to actually print that note that one uses to perform the transaction. Those costs for the US can be found here.

Let’s now try and calculate the transaction cost for a $100 transaction done using cash. We’ll use the most expensive note out there, the $1 bill. Let’s assume a printed note has the lifespan of 10 years and the note changes hands (is in a transaction) once a month during this lifespan. Hopefully these are reasonable assumptions.

  • Total cost of producing $100 in 1 dollar bills = $5.5
  • Total transactions these 100 bills participate in = 10 years x 12 months = 120
  • Total transaction volume = 120 x $100 = $12,000
  • Transaction fees % = $5.5/$12,000 = 0.04%

This 0.04% includes ‘fraud protection’, in terms of the extra money it took to print a bill with anti-counterfeit protection.

Most importantly, the merchants/customers did not pay this transaction fees. It was in effect subsidized by the govt. The greatest shift that happened when we moved to credit cards was that transaction fees were now borne by the users and the merchants.

Most of the modern payment systems like Apple pay work on the same transaction fees and in fact add an additional middleman (Apple) into the transaction. We should expect that with more adoption the transaction fees should go up to pay for this additional middleman.

How was the govt. able to provide a monetary system of exchange so efficiently and the biggest best companies in the world can’t do 25% of that efficiency numbers?

Has the institution of credit cards (and consequently this transfer of transaction costs) allowed for greater economic growth? In other words if we continued to use just cash would our economy be stifled?

Could governments running Credit Card networks reduce transaction fees to levels unseen today. The Indian govt. had a collection of banks start a Credit Card network named Rupay to do exactly that. Of course it’s going to be argued that governments shouldn’t be in the business of doing business, but is the credit card network really a business or infrastructure? I would argue that it is really the infrastructure like banking on which the nation’s economy runs.

One thing is for sure, there is an amazing level of innovation potential in the global payments industry. The inefficiency exists, now we just need a startup to disrupt this industry by solving this inefficiency.

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