MasterCard Takes a Swipe

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On Friday, the European Commission (EC -- the lawmaking body of the European Union) criticized MasterCard (NYSE: MA) for its cross-border interchange fees, asserting that they restrict competition between member banks "by pre-determining a minimum price retailers must pay for accepting MasterCard and Maestro (MasterCard's leading debit card brand)."

Although the statement is only a "preliminary view" to which MasterCard will have the opportunity to respond in an oral hearing, the developments will bear close watching by MasterCard shareholders. Why? To understand the EC's opinion, let's take a look at the way in which this transaction-processing giant makes money.

Suppose you buy a new DVD player for $100 at Best Buy (NYSE: BBY) and you pay with a MasterCard. There are four parties to the transaction: you, your bank (the "Issuer bank"), Best Buy, and their bank (the "Acquirer bank"). The Acquirer bank receives from the Issuer bank the purchase price ($100) less the interchange fee (say 2%), or $98. The Acquirer bank then takes its merchant discount (say 1%), before crediting Best Buy's account with $97. The interchange fee, which is set by MasterCard, is a sharing of payment system costs between Acquirer and Issuer. MasterCard does not earn revenues directly from the interchange fees, but it charges transaction fees and dollar volume-based fees to both the Issuers and Acquirers for facilitating (and in some cases, guaranteeing) payments.

While the European Commission has apparently ruled out a fine as punishment, a decision against MasterCard could prohibit interchange fees on cross-border transactions. The EC is concerned that MasterCard restricts competitive activity by setting these fees in advance, so "prohibiting" them could mean any fees would be allowed to "float" (i.e., they would be negotiated on a case-by-case basis). While I don't see the EC's preliminary opinion as favorable to MasterCard's activity in Europe (45% of all payment cards issued in the European Economic Area are under MasterCard brands), we shouldn't expect a final ruling in the immediate future (the previous EC opinion on this matter dates back to September 2003). Furthermore, it's not clear to what extent eliminating pre-set interchange fees would affect MasterCard's ability to extract fees from acquirer and issuer banks.

As Motley Fool Inside Value pick Microsoft (Nasdaq: MSFT) was forced to do, MasterCard is coming to terms with the fact that natural monopolies attract a lot of negative attention from regulators and competitors alike. OK, I admit the comparison is imperfect. MasterCard and VISA are closer to an oligopoly model. Economics, schmeconomics.

The EU's action is one of several significant legal challenges that MasterCard faces (the Legal and Regulatory Proceedings section of its IPO prospectus is 13 pages long!). Although the company's late May IPO is a success so far -- as of last Friday, the stock is up roughly 20% from its offering price -- I believe the stock is bearing a "legal risk" discount. As these actions are resolved and related uncertainty is removed, it will be easier for investors to determine the value of what I think is a terrific franchise.

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Best Buy is a Motley Fool Stock Advisor pick.

Fool contributor Alex Dumortier has a beneficial interest in MasterCard and Microsoft, but none in any of the other companies mentioned in this article. He welcomes your constructive feedback. The Motley Fool has a strict disclosure policy.