Digital Payments Monetization Part II: Why Fintech Startups Should Consider Alternatives to the MDR

In Part I of our series on Digital Payments Monetization, we presented a brief primer on the economics of the Merchant Discount Rate (“MDR”) model. In this article, we shed light on the limitations of the MDR model and advocate for a strategic shift toward diverse revenue strategies for fintech startups and new entrants. In an era of rapid advancements in fintech and commerce, relying solely on the traditional Merchant Discount Rate (MDR) model for revenue generation is proving to be a risky proposition for new entrants and early-stage startups that are sub-scale.

We sum up the Merchant Discount Rate (“MDR”) formula in the chart below.

• Formula 1 applies when the issuing bank does not outsource the card processing to an issuer processor and the merchant acquirer does not outsource the transaction processing to a merchant processor.
• Formula 2 applies when both an issuer processor and merchant processor were involved in the transaction, which is often the case.
• We exclude other participants that might be involved in the economics of certain transactions (i.e. a loyalty service provider, BNPL provider, point-of-sale hardware provider) for simplicity.

Reasons to Approach the MDR with Caution
We believe it will be increasingly difficult to build a sustainable business by solely relying on the MDR economics. Early-stage fintech startups and new entrants should consider deploying different pricing strategies due to several reasons, including:

• Intense Competition and Limited Pricing Power. With most of the payment economics determined by card networks, fintech companies face tough competition for a smaller share of the revenue pie. Both the interchange fee and the network fee are largely set by the card networks (highlighted in blue above). This means 70% — 75% of the payment economics is set by the card networks, limiting innovation within the confines of the MDR framework. Scaling as a payment processor is now a daunting task, favoring only those companies that can achieve substantial market penetration. Reaching scale in digital payments, moreover, is capital intensive, which is not an ideal model in the current VC environment.
• Merchant pushback and regulatory pressure will compress the MDR over time. Merchants have increasingly expressed discontent with prevailing pricing schemes and are advocating for greater price transparency and regulatory oversight of interchange fees, a prominent component of digital payments economics. This industry pushback tends to pick up steam in tough economic times when consumer spending slows. For instance, Visa and Mastercard recently reached an agreement to lower domestic credit card interchange fees for both in-store transactions and online transactions. A similar reduction in the US is likely on the table.
• But increased regulatory oversight is by far a bigger risk. For example, the Durbin Amendment, which capped US debit interchange at 12 cents for most transactions, was enacted as part of the banking regulatory overhaul following the financial crisis of 2008/2009. Credit interchange was spared back then. After a string of banking failures in 2023, however, another banking regulatory overhaul is likely on the horizon. This might create another opportunity for merchants to push for credit card interchange reform.
• In addition, we expect merchants to push back against bundled pricing and/or gravitate towards offerings with more transparent pricing. The Durbin Amendment did not generate the entire cost savings intended for most merchants due to the prevailing use of bundled pricing, where merchant acquirers charge a single price that includes the gross interchange, network fee, and merchant acquirer markup. Bundled pricing enabled merchant acquirers to pass on some of the cost savings while keeping a portion of the savings as a higher margin. This was an opportunity that many small and micro merchant aggregators (such as Square, iZettle, SumUp, and others) seized as they offered simple and often fixed pricing to customers.
• Cyclical Nature of MDR Models. MDR models are inherently vulnerable to economic cycles due to their reliance on transaction volume. During economic downturns or periods of declining transactions, payment companies face challenges in sustaining revenue growth. While the shift from cash to digital payments has partially mitigated this cyclicality for card networks given their global reach, issuing banks and payment processors remain exposed to domestic economic fluctuations. Recognizing these limitations, alternative pricing strategies, such as SaaS models, present a more sustainable approach for long-term growth in the fintech industry.

Expect A Gradual Decline in the MDR
Below, we show how the MDR for American Express has evolved over the last decade. We believe American Express’ MDR is a bellwether for the card industry for three key reasons. First, American Express is a closed-loop network — where American Express is both the bank issuer and the card network (Visa and MasterCard are open-loop networks as they work with many banks). Second, we estimate that the American Express cardholder on average spends 2x — 2.5x more than the average Visa or MasterCard cardholder. Third, the majority of American Express spend volume is through credit, which continues to benefit from premium MDR pricing relative to debit.

As a result, American Express has enjoyed more pricing leverage than Visa or Mastercard historically. But the American Express MDR has steadily declined over the last 10 years. While the gradual decline is a function of several factors, we believe merchant pushback is the key driver of the 20 bps reduction over the last decade.

Building a sustainable business on the MDR alone is complex and increasingly difficult. There are a growing number of participants (processors, payment gateways, payfacs, VARs, digital wallet providers to name a few) splitting a shrinking MDR. Intense competition, regulatory pressures, the cyclicality of MDR models, and the changing demands of merchants call for a strategic shift. New entrants and early-stage fintech startups must embrace innovative diverse revenue streams to unlock the full potential of digital payments, foster sustainable growth, and shape the future of monetization in this dynamic industry.

There are, of course, some bright spots in the industry, which continue to enjoy premium pricing. Cross-border payments remain the most lucrative opportunity within the industry. We will turn to this in the next part of our series.