When we talk about any delivery system, digital or analog, one of the first questions to ask is whether there’s a central hub, and how many times the information changes hands between the sender and the recipient. The game of telephone we played as kids mocks the loss of fidelity in each (purple) successive (monkey) transfer of (dishwasher) information. Digital technology comes with its own challenges—latency, hiccups, accessibility—but it’s quite good at delivering the same exact bits over dozens of servers and routers and switches in seconds. Take a moment to think about the paths your data takes every day: Phone calls go through cell towers, emails go from one server to another, status updates are pushed to your phone and the web, etc. What about your money? If you’re not using cash to pay for something, you’re essentially making a data transfer.
The History of the Magnetic Stripe
There have always been systems through which checks pass from one bank to another. The same thing is true for debit cards. Take a look at your current debit card, and you’ll probably see either a VISA, MasterCard, or American Express logo. These companies aren’t banks, so what do they have to do with your checking account? VISA, MC, Amex, and Discover all operate payment networks that provide technical infrastructure for electronic funds transfers.
Electronic funds transfers are possible thanks to the magnetic stripe on the back of your debit card. The magnetic stripe contains your account number, and the card reader records your number into the merchant’s point-of-sale system, along with the amount of your transaction. We take this technology for granted every time we make purchases that take a fraction of a second. And it’s easy to take for granted, because magnetic stripes have been ubiquitous for more than fifty years.
As part of a centennial retrospective, IBM outlined the history of the magnetic stripe. Magnetic stripes were originally developed for the CIA, but IBM decided not to patent its new technology in hopes that banks would purchase IBM machinery as they transitioned to electronic transfers. This made sense because adoption has always been one of the greatest challenges in any two-sided market; you wouldn’t sign up for a card on a network that no merchants accept, and IBM wouldn’t sell any equipment to read magnetic stripes if no one had magnetic stripes on their cards.
The Emergence of Payment Networks
If everybody had electronic funds transfer capability, why did the market need payment networks? Why doesn’t swiping your Bank A debit card simply send funds right to Bank B, as if you had written a check that transferred instantly? Why would you need a central “location” for distributing free-flowing data? Economist David Evans describes the early years of credit and bank cards as a Wild West of losses for the card issuers and little choice for consumers. Imagine if your debit card were as limited as your instant messenger: You could only reach other people on the same network, and only those who have decided they want to hear from you.
Enter VISA and the other payment companies. Rather than every bank investing in the technology and infrastructure to connect to an un-standardized network, a few companies emerged who were willing to take on the risk of building a nationwide system. Evans describes the two types of payment networks: open (VISA/MC), and closed (Amex/Discover). Open networks offer their branded cards to banks and non-bank financial institutions and collect interchange fees from merchants. Closed networks offer their own cards to consumers and collect interchange fees as well. These fees are necessary to keep the infrastructure functioning and growing, but the rules regarding interchange fees are a subject of debate among banks, merchants, and the payment networks.
Having a small handful of payment networks to process billions of dollars of transactions has its pros and cons. Even though you never see interchange fees as a consumer, merchants may pass their expenses on to you or simply not allow purchases on some networks. On the other hand, you can take your debit card to almost any country in the world and buy things or withdraw local currency from an ATM. It’s easy to take this for granted. As long as everything works, most people seem glad to continue swiping.