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Understanding e-Transaction Fees

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March 01, 2009
Credit Card Fees
Michael Kasavana, Ph.D., NCE, CHTP - kasavana@msu.edu

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© 2009 Hospitality Upgrade. No reproduction without written permission.

Cashless payments continue to dominate the hospitality industry as guests, driven by convenience, reward programs and innovative financial strategies, migrate from cash to electronic settlement. The Smart Card Alliance estimates there are more than one billion transaction payment cards in circulation in the United States, while electronic payment processors claim consumers average 10,000 transactions per second. This extremely high volume of activity requires a complex and costly infrastructure designed to capture, authorize, settle and manage payment reconciliation.

Each time a guest uses a credit or debit card, hospitality firms incur a variety of processing and gateway fees, many of which are not transparent, leading to reductions in the settlement amount. Intricate financial networks claim such fees are necessary to cover expenses associated with transaction processing, data transmissions, fraud protection, receivables aging, account management, technological innovation and related expenditures. J P Morgan estimates the annual volume growth of electronic transactions will continue to increase by 11 percent to 16 percent per year through 2010.

Electronic transactions involve at least four participants: issuers, acquirers, card associations and payment network. The issuer is the financial institution (third-party entity) that establishes a credit or debit account for an account holder and bears the risk of account fraud and/or default. The acquirer is the financial institution accepting payment for goods and services on behalf of a retailer (also referred to as the merchant bank).  The card association  is the organization that establishes contractual requirements for account holders, retailers, issuers and acquirers. Major card associations include MasterCard, Visa, American Express and Discover. Lastly the payment network  provisions connectivity for approving, transmitting, processing and reconciling electronic transactions. Some of the payment networks include: Shift4, Elavon, Cardnet, Nabanco, Paymentech, POST and VisaNet.

A recent bank association study revealed that about 13 percent of the collected processing and gateway fees actually get allocated to the costs of authorization, security and network transmission. The remaining funds are apparently applied to support rewards programs, cash-back payments, chargebacks and research and development efforts (contactless media, near field communications, m-commerce, etc.). What are the real costs of electronic transactions? How do charges based on type of transaction, volume of transactions and transaction revenue impact hospitality businesses? Can hotel and restaurant segments re-negotiate transaction fees? The answer to these and related questions requires an understanding of transaction criterion, settlement schemes and industry segmentation.

While there is little universal agreement on the history of the evolution of transaction payment technologies, most industry observers divide the first 50 years into three broad technology generations. Although the concept of a credit card was first launched much earlier, the general acceptance of the credit card as a payment instrument was not widely recognized until the distribution of plastic credit cards in 1959 (previously cards were made of cardboard or celluloid).

At the time of the plastic card launch, cash and checks accounted for nearly all (over 95 percent) business transactions. Sometime later, with the adoption of uniform magnetic stripe standards, second-generation technology began. The second generation is unusually lengthy and is therefore typically segmented into two stages: the beginning portion dated around 1979 with the installation of bulky electronic data capture terminals in concert with multiple track magnetic striping placed strategically on the back of the plastic card. During this portion of the second generation, account holders were offered revolving accounts that enabled partial payment with carry-over balances.

In 1995, the second portion of the generation featured the incorporation of an embedded, integrated circuit chip placed inside the body of the card (referred to as a chip card). During this generation, the use of cash and checks to settle business transactions declined to less than 55 percent. The third payment technology generation is pegged as having begun in 2005 with the implementation of radio frequency identification (RFID) technology used to power contactless payment media. Currently, cash and checks are used to settle fewer than 30 percent of business transactions. While the plastic card has been the standard platform for payment technology for a half century, recent developments show alternative forms of payment media are increasing in prominence, from online services to biometrics, to cell phones and other mobile devices. In each instance, transaction fees arise to mitigate the costs associated with infrastructure, financial networking and related security.

A merchant discount rate, or discount rate, is applied to every electronic payment transaction and is composed of two distinct rating categories: interchange fees and merchant fees. Interchange fees, sometimes termed interchange reimbursement fees, are paid by the retailer (hotel or restaurant) each time a guest makes a deferred purchase using an external credit or debit account. Merchant fees, often labeled provider fees or merchant service provider fees, may be applied by the acquiring bank for enabling the retailer to accept electronic payments and/or may represent charges imposed by an independent card processing network to cover the costs associated with monitoring and managing transaction settlements.

Interchange fees are set by credit and debit card associations and are the largest component of the MDR. Banks deduct interchange fees from every electronic payment transaction, representing 70 percent to 90 percent of the fees. Both interchange and merchant fees may be established as a percentage of each transaction, a fixed charge per transaction, or a combination of these two (referred to as a blended rate). See Figure One for an illustration of the MDR fee structure. (page 126)

Interchange Fees
Interchange fees are determined by the major credit and debit card associations (Visa, MasterCard, American Express and Discover). The interchange rate is established to reimburse the customer’s bank for expenses associated with exchanging payment with the retailer’s bank and is spilt between the two banks (acquirer and issuer) during transaction processing. Interchange fees are based on a complex structure and vary among a set of differentiating criteria, including account (card) brand, card type, data capture method, transaction volume, transaction revenue, transaction type, and additional factors. Interchange fees are also designed to cover a portion of the risks associated with fraudulent account usage and failure to make payment by the account holder. Card associations claim they do not profit from interchange fees.

Interchange rates are not easy to negotiate, decipher or avoid. In fact, some electronic transaction specialists claim card associations have contrived more than 100 possible interchange rate categories. Overall rates are somewhat loosely applied based on the type of retail business, industry segment, type of card presented, transaction amount, data capture format, processing network, retailer chargeback history, and other factors. On average, Visa and MasterCard claim to collect just over 1.7 percent plus 4 cents per transaction in interchange fees, although rates vary based on a number of elements. Despite recent publication of interchange fees on card association Web sites, these fees remain difficult to comprehend.  

In general, fees vary by industry, card acceptance, type of card, transaction volume and special arrangements. Face-to-face transactions are typically charged a lower fee than card not present transactions. Card swiping is charged a lower rate than hand keying. Traditional credit/debit cards typically are subject to a different interchange fee than a rewards card or cash-back card. In other words, a hotelier or restaurateur will actually receive a fraction less of a payment if a guest uses a rewards card.

Additionally, a large retailer or retail segment may successfully negotiate a unique interchange fee based on exceptional volume. Since an interchange fee is charged per transaction, it can be calculated as a percentage of the sales price (ranging from 1.5 percent to 4 percent) plus a fixed per transaction fee (from 10 cents to 60 cents). It is important to note that as part of the interchange fee many banks/networks may also charge monthly statement fees, report fees, inactivity fees and other fees as defined by contractual agreement. 
Rate Tiers
Merchant service providers have identified and separated more than 125 interchange categories into three rate tiers:
1) qualified,
2) mid-qualified and
3) non-qualified.

Generally, interchange rates are averaged in specific categories by tier. The lowest interchange rate, and therefore the most desirable, is termed the qualified rate. It is the lowest rate a retailer can pay for any transaction. To receive the qualified rate for transaction reconciliation, certain criteria must be met, including but not limited to, card swiping or card keying with address verification service (AVS) as well as batch processing at close out for each POS terminal every day. The mid-qualified rate is reserved for specialized account types and is extremely competitive given it is influenced by an association with an account holder rewards program. The non-qualified rate is a premium priced rate assigned to higher risk accounts, such as accounts issued by non-domestic banks. In addition, non-qualified rates are often assigned as a penalty for failure to adhere to the specifications of another rate category. For example, a retailer that fails to batch process on a daily basis may be downgraded from a qualified to a non-qualified rate.

While specific criteria for each rate tier will fluctuate among processors, as a general guideline, the rate tier and positioning within a tier, are predicated by the overall dollar volume of the business. Rate reductions can represent significant savings. For example, a 120-seat restaurant that does roughly $2 million a year in revenues, 80 percent of which are settled electronically, by reducing the processing fees on those transactions by 1.5 percent equates to a savings of $24,000 a year.

Payment Fees
The retail industry claims that Visa and MasterCard together control 85 percent of the market share for electronic payments. MasterCard explains its interchange fee structure in this way: “MasterCard interchange rates are established by MasterCard, and are generally paid by acquirers to card issuers on purchase transactions conducted on MasterCard cards. Interchange rates are only one of many cost components included in a MDR, and are a necessary and efficient method by which MasterCard maintains a strong and vibrant payments network. Setting interchange rates is a challenging proposition that involves an extremely delicate balance. If interchange rates are set too high, such that they lead to disproportionately high discount rates, merchants’ desire and demand for MasterCard acceptance will drop. If interchange rates are set too low, card issuers’ willingness to issue and promote MasterCard cards will drop, as will consumer demand for such cards.”

Merchant Fees
Essentially, an electronic payment is a series of purchases among four parties; account holder, retailer, acquirer and issuer. First, the transaction is initiated when the account holder purchases goods or services from a retailer. Next, the retailer sells the transaction to its bank (acquirer). In turn, the acquirer sells the transaction to the bank that issued the card (issuer) via a processor interchange network. Lastly, the issuer receives payment from the account holder.

One of the factors that helps explain the variance among merchant discount rates is the merchant fee. While allowing the banking system to handle electronic payment transactions seems convenient, such convenience often comes at a high price. Selecting an intermediate financial entity from among the more than 400 third-party service providers (e.g., Heartland Payment Systems, Global Payments) usually is a much less expensive alternative. Additionally, fees should not be the only consideration when choosing a processor. Service and speed also are important concerns. Third-party terms tend to be more flexible and negotiable than banks, as processors typically seek increased business volume to average operational expenditures. 
Credit Card Processing
Both Visa and MasterCard publish interchange fee breakdowns, although critics claim the structures are too complex to be easily understood. Visa defines its use of interchange fees as follows: “Visa uses interchange reimbursement fees as transfer fees between financial institutions to balance and grow the payment system for the benefit of all participants. Merchants do not pay interchange reimbursement fees; merchants pay merchant discounts to their financial institution. This is an important distinction, because merchants buy a variety of processing services from financial institutions; all these services may be included in their merchant discount rate, which is typically a percentage rate per transaction.”

MasterCard explains interchange fees this way, “In response to these competitive forces, MasterCard strives to maximize the value of the MasterCard system, including the dollar volume spent on MasterCard cards, the number and types of MasterCard cards in circulation, and the number and types of merchants accepting MasterCard cards, by setting default interchange rates at levels that balance the benefits and costs to both cardholders and merchants.”

Rates are affected by the following variables: volume of business, value of transaction, type of card, presence/absence of card and other considerations, and therefore may vary even within published industry segmentations. 

Debit Card Processing
Unlike credit cards, there are two distinct forms of debit cards: offline and online. An offline debit card transaction most closely approximates the sequencing of credit card processing.

Offline (signature) debit. Offline debit transactions are handled identically to a credit card in that the account holder signs for the transaction at the point of sale. Offline debit card processing rates typically are charged at 30 to 40 basis points lower than a standard qualified credit card discount rate. Industry statistics indicate 60 percent of all debit card transactions are processed offline; offline transactions cost retailers more than online debit transactions and flow through the ACH. The debit card must have either the Visa, MasterCard or Discover network logo, which allows it to work in any card-present or card-not-present purchasing situation including mail order, telephone order, wireless and Internet. Cash back (Discover) is not available with a signature debit transaction.

Online (PIN-based) debit. One of the cheapest and most secure processing methods, online transactions require that both the account holder and card be present as a PIN number must be entered by the consumer. Online debit transactions do not follow the network path of an offline transaction. The PIN number is encrypted (by the merchant processor), sent to the processor, then the account holder’s bank for PIN verification and transaction reconciliation. PIN debit transactions utilize electronic funds transfer (EFT) networks and provide immediate access to the account holder’s funds (analogous to an ATM transaction). The authorization and the transaction amount are processed in real time. PIN pad technology encrypts the information and keeps the transaction secure. As a general rule, PIN-based debit incurs the lower interchange fees. For example, a processor may handle online debit card transactions for a flat fee of 65 cents per transaction compared to an assessment rate of 1.65 percent plus 25 cents for each offline debit transaction. For a $100 online debit transaction, the processing cost is 65 cents compared to $100 offline debit transaction incurring a $1.90 ($1.65 plus 25 cents fee). As a result, retailers are wise to encourage online debit transactions for larger dollar transactions.

Online Transactions
Google estimates that more than 90 percent of online business is transacted via credit card. Online credit card processing tends to follow this cycle:

A customer enters credit card information to purchase a product or service online.

The data is passed to the merchant Web server and a payment gateway through a secure socket layer (SSL). The SSL encrypts the credit card data in order to pass it down through the network and to protect it from hackers.

The payment gateway receives the transaction data, verifies the credit card information and accepts or declines the transaction. In turn, the payment gateway initiates an e-mail receipt to the merchant Web server as well as simultaneously to the customer.

Along with the e-mail receipt, the payment gateway sends the online order to the merchant bank. The value of the transaction is subtracted from the purchaser’s credit card account and placed in a 30-day merchant holding account.

Given that there is no way for a physical exchange of payment information with verification, online transactions will be processed at a significantly higher discount rate than the identical transaction conducted at a POS terminal. For example, the published rates of UniBul Merchant Services (unibulmerchant services.com) for processing fees illustrate the differences associated with a physical POS location versus an online (virtual) POS. The identical transaction, settled to a Visa card, will be processed for 1.65 percent of the purchase value plus 20 cents per transaction at a POS location. The identical credit card transaction conducted online will incur a rate of 2.15 percent plus 25 cents respectively. Rate differentials are often justified by the processor based on the fact online transactions (i.e., no card present, unattended POS) have a higher risk of fraudulent use and non-payment.

Hidden Costs
Since, as a practical matter, retailers are not able to offer both a cash price and an electronic payment price, product prices tend to be influenced by the added costs of credit and debit card transactions; thereby causing an inflationary effect. As a result, electronic payment schemes are often referred to as a hidden tax on consumers, interchange fees represent an additional expense incurred by a retailer for accepting electronic payments. In turn, these added costs lead to increases in the price of goods and services without consumer knowledge. The National Retail Federation (NRF) estimates that interchange fees cost the average American family $350 per year. Essentially, consumers pay interchange fees equal to two percent on all credit and debit card transactions. Comparatively, the NRF claims, the amount paid is higher than any industrialized nation in the world. Consumers, of course, are generally unaware of electronic payment interchange fees since the fees are incorporated into the total price of items purchased; they are not disclosed on transaction receipts. But retailers are becoming more acutely aware of such fees that often force merchants to raise prices on all items in order to yield a profit. As a result, interchange fees effectively penalize cash-paying guests who don’t incur acquisition or processing fees of any kind.

Credit card interchange fees are used to reimburse credit card companies for processing transactions. While credit card companies contend that consumers and businesses receive great benefits from the current system, merchants are concerned that card issuers are pushing the cost of credit card incentives and rewards programs onto businesses and consumers through interchange fees.

Fair Fee Act of 2008—H.R. 5546
In 2007, credit card companies reported collecting $42 billion in interchange fees, up from $36 billion in 2006. Recently retailers supported and received legislation granting an antitrust exemption, thereby allowing for direct negotiation of interchange fees with the card associations. During the legislative battle, card associations argued that competition already existed in the market since interchange rates are balanced to protect retailers from experiencing rates that are too high or too low. The argument being that if the rate is set too high, retailers would not accept its cards and if the rates are too low, banks would not offer the cards to customers. The exemption argument reached the U.S. Congress and was passed as the Fair Fee Act of 2008.

The concern of retailers over the hidden costs related to the acquisition and processing of electronic payments is by no means a new issue. In fact, interchange fees have been the subject of concern and criticism for as long as there have been credit and debit cards. For too long financial institutions have benefitted while business operators have sacrificed profitability caused by excessive interchange rates. Critics of interchange fees cite secrecy and anti-competiveness as major concerns. In March 2008, Representative John Conyers and co-sponsors moved Congress to amend the antitrust laws to ensure competitive market-based rates and terms for merchants’ access to electronic payment systems. This new legislation enables retailers to negotiate the fees related to the acceptance and processing of credit and debit card transactions. The Fair Fee Act of 2008 requires banks possessing substantial market power to negotiate with merchants on terms for fees paid when processing card transactions. The act was not intended to regulate the financial industry as it does not mandate any particular outcome; however the legislation enhances competition by allowing merchants to negotiate with dominant banks for the terms and rates of the fees. In simple terms, the act is aimed at providing transparency and competition for an industry that has been criticized for not displaying either. The Fair Fee Act does not set rates; instead it requires that fees be set in a transparent manner so other companies can compete for business. Antitrust laws were amended to ensure competitive market-based rates through passage of this act by the House Judiciary Committee on July 16, 2008.

The act provides flexibility and a basis for transaction processors to negotiate fees with retailers. If an agreement isn’t reached between these parties, then a panel of judges is to determine reasonable interchange fees based on a competitive marketplace. Legislators warn that the legislation is intended to give retailers a role in the establishment of fees and not an attempt at regulating any industry.

Gift Cards
When an off-premise gift card is purchased at a non-hospitality location, such as a supermarket, mall or pharmacy, the customer chooses the value and brand and the local cashier enters the transaction and validates the electronic payment card.Similar to a credit or debit card transaction, there are several payment networks involved including the retailer, hospitality entity and gift card processor (if any). In other words, there is an acquiring and issuing entity as the retail transaction is processed by a third party that collects payment for issuing the card and subsequently transfers payment to the hospitality gift card processing company. Store-branded gift cards typically are transacted through a private payment network that enables hotel and restaurant gift cards to be used systemwide without any interchange fee, regardless of the value of the transaction. By comparison, a retailer gift card is akin to a debit card, except that it carries no interchange or merchant fees. While there are costs to market, produce, merchandise and process the transaction, unlike a credit or debit card transaction there typically are no hidden or added fees (unless the gift card is a Visa or MasterCard-branded gift card, and therefore is processed through an external network).

The major payment card association brands have combined to form the Payment Card Industry Security Standards Council, LLC (PCI SSC).  PCI SSC was launched in 2006 to manage the ongoing evolution of the Payment Card Industry Data Security Standard (PCI DSS), which focuses on improving payment account security throughout the transaction process. With the launch of PCI SSC, the major payment card brands developed a single security standard for all entities that process, store or transmit account holder data. This scheme is designed to safeguard all transaction-related data. 

As previously mentioned, a merchant discount rate is applied to electronic payment transactions and is composed of two rating criteria: interchange fees and merchant fees. Interchange fees are established by card associations and represent fees paid by acquirers to card issuers on purchase transactions. Interchange fees are usually the most significant among transactional cost components within an electronic payment network and pay the costs associated with transaction reconciliation. The interchange process makes it possible for customers with diverse credit and debit cards from several different banks to transact business at numerous merchant locations. Interchange fees make up the largest portion of the merchant discount rate. The other part of the discount rate is the merchant fee intended to compensate the bank that provides authorization, deposit and settlement services for electronic transactions. Since electronic transactions are expected to continue to dominate hospitality industry transactions, and the passage of the Fair Fee Act of 2008 provides flexibility, industry leaders are encouraged to negotiate reasonable fees that provide stability for retailers, consumers and financial institutions.

Michael Kasavana, Ph.D., NCE, CHTP, is a NAMA Professor in Hospitality Business for the School of Hospitality Business at Michigan State University. He can be reached at kasavana@msu.edu.

Complete Visa schedule of interchange fees


Transaction payment technology (TPT) involves a sequencing of processes including: authorization, batching, settlement, funding and possibly chargebacks.

Authorization: A guest charges a transaction and the retailer (hospitality service provider) submits the transaction to its bank (acquirer). The acquirer, in turn, verifies account validity, transaction type and amount with the issuer (guest’s bank) and reserves that amount of the transaction against the account holder’s credit limit (for credit transaction) or cash on deposit (for debit transaction) for the retailer. The authorization process automatically generates an approval code number, which the retailer uses to prove transaction authentication, should the need arise.

Batching: Typically, authorized transactions are aggregated, held and batched for subsequent transport to the acquirer. Batches are typically submitted at the close of each business day. Transactions with a value falling below the retailer’s floor limit (dollar amount beyond which authorization is mandatory) may be included in the batch.

Settlement: The acquirer transmits batched transactions through a processor network (card association or third party) that debits the issuer for payment while crediting the acquirer. Essentially, the issuer pays the acquirer for the transaction.

Funding: Once the acquirer has been paid, the acquirer pays the retailer. The retailer’s account receives the amount totaling the funds in the batch minus a merchant discount rate (MDR), a bundled fee the retailer pays to the acquirer for processing an electronic transaction.

Chargeback: A chargeback is a transaction for which money in a retailer account is held due to a dispute relating to a transaction. Chargebacks are typically initiated by an account holder. In the event of a chargeback, the issuer returns the transaction to the acquirer for resolution. The acquirer then forwards the chargeback to the retailer who either accepts the chargeback or contests it.

For some credit/debit card processors, the list of possible interchange categories fills several pages.  Here are a few examples:

Type of business – Industrial characteristics and profiles are associated with levels of dollar and transaction volumes and risks (e.g., lodging operations, dining services, vending machines, taxis, casinos, clubs and supermarkets).

Type of card presented – Credit card, debit card, ATM card, check card, corporate card, rewards cards, cash payback cards and elite cards each have a separate indexing.

Transaction amount – Large ticket as opposed to small ticket items, total retail revenues, average transaction values, and the like, are  influencing factors on a designated interchange fee.

Number of transactions – The volume of incidents can also influence the interchange fee, as a higher volume will represent a higher frequency for the transmission and may warrant a lower overall fee.

Card present/card absent – Interchange fees will vary based on whether the transaction is conducted without the physical presence of a card (e.g., e-commerce, phone or mail) or with a card, such as at a retail store.

Data capture format – Swiped (card present), signature, online PIN-based, contactless, unattended point of sale and related factors.

Chargebacks – A chargeback describes a transaction that is returned as a  financial liability to a merchant bank by a card issuer, usually because of a  disputed transaction. The merchant bank may then reverse or charge back the transaction to the merchant.

Transaction Cycling

Visa and MasterCard — The initiation of an electronic transaction involves account data capture and relay from a POS terminal,  or via an intermediary called a processor, to the issuer. The issuer moves funds to the retailer’s bank account after application of a merchant fee, which may be as high as 5 percent of the transaction value, attributable to network connectivity. The processor in turn pays an interchange fee to the issuer. Visa and MasterCard are separate worldwide payment services composed of member institutions. Each sets and enforces its own rules and regulations governing operational and interchange procedures for bankcards and advertise and promote branded programming. Both Visa and MasterCard supervise bankcard processing within member banks.
Together Visa and MasterCard account for 83 percent of all electronic credit and debit transactions in the United States.

American Express — American Express deposits the transaction value into the merchants’ accounts minus interchange fees it directly charges merchants. American Express initially began as a travel and entertainment card in 1958 but has evolved into a widely accepted credit card, like Visa and MasterCard, with worldwide acceptance. Despite the fact American Express usage is far less then Visa and MasterCard, many business travelers prefer to use AmEx to conduct purchase transactions. Unlike Visa and MasterCard, AmEx is not comprised of member banks but is an independent entity, and therefore only American Express can authorize a retailer or member account.
American Express accounts for about 13 percent of all credit card transactions in the United States.

Discover – Originated in 1986 by the Sears Corporation, the Discover card is the newest of the four major card associations. Although Discover has more account holders then American Express, it has much smaller volume than any of the major card providers. Like AmEx, Discover is not comprised of member banks but is an independent agency requiring retailers and members to deal directly with Discover for account creation and maintenance. Unlike AmEx, retailers accepting Discover accounts can bundle transactions with Visa and MasterCard to streamline and simplify transaction processing.
In 2008, Discover purchased Diners Club thereby increasing its member base. It is estimated that Discover accounts for 4 percent of all credit card transactions in the United States.

Related Web Links:

Credit Card Nation

CreditCards- provide a resource where consumers can search, compare and apply for the best credit card offers



Smart Card Alliance- an industry resource for information on smart card markets and technology


Card Ratings

COMDATA Payment Innovations

The Credit Card Fair Fee Act

Criticism of electronic transaction processing falls into four broad areas.

Hidden taxation
Since retailers’ costs are higher for electronic transactions due to interchange and merchant fees, customers who pay by cash tend to subsidize purchases by account holders.

Processing costs
By comparison, costs associated with electronic transactions are higher in the United States than almost anywhere else in the world; a difference that is difficult to reconcile given the volume of transactions.

Few industries or industry segments have sufficient business volume or clout to enable fee negotiations; a lack of transparency further complicates the fee structure.

Evolving fees
Increases in interchange fees bear no reasonable relationship to the declining costs for card processing and data transmission or the reduced frequency in fraudulent use or chargebacks.

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