Your network or mine? The economics of routing rules.

In many markets, including payment cards and telecommunications, service providers operate networks that support customer transactions with each other. When the two sides of a transaction belong to more than one network in common, the question arises as to which network will carry the transaction. We show that the answer depends on a combination of who has the formal authority to choose and the parties' network subscription decisions. Our central finding is that granting formal authority to one side of the market can increase the extent to which transactions run over the network preferred by the other side of the market. We also characterize competing networks' equilibrium choices of routing rules and prices.

1. Introduction

* In many markets, service providers operate networks that support the interactions of their customers. Examples include payment systems, telecommunications networks, advertiser-supported media, and social clubs. (1) Absent network interconnection and interoperability, two users must belong to the same network in order to transact with one another. Often, however, a single user can participate in multiple networks. When two users wish to transact with one another and they participate in multiple networks in common, a question arises: Who decides which network carries the transaction? The answer is the subject of this article. (2)

An example helps fix ideas. A credit or debit card network can be thought of as facilitating transactions between retail merchants on one side and card-issuing banks or card-holding consumers on the other. (3) A notable feature of the credit and debit card industries is that a typical merchant accepts cards that run over several different networks and a typical consumer holds a portfolio of cards that are collectively capable of running over multiple networks. Indeed, in the United States, at least, many financial institutions issue debit cards that are capable of running over multiple networks. Consequently, when a consumer presents his or her debit card to a merchant to make a purchase, it is often possible to complete a given transaction over several different debit networks. This raises the issue of who chooses the specific network used.

The answer depends, in part, on the technology used to authenticate the cardholder at the time of the transaction. The leading authentication methods today are signature and personal identification number (PIN). It is estimated that between 65% and 80% of debit cards are both PIN and signature enabled, and the choice between modes of authentication is typically made by the consumer, subject to incentives provided by merchants and card issuers. (4) If the consumer chooses signature authorization, then there is no additional network choice because any given card is associated with at most one signature network. But if a consumer chooses to use PIN authentication, then there typically is a second choice to be made. The average merchant location that accepts PIN debit accepts the cards of approximately three different PIN debit networks. (5) And the average debit card can be run over 1.7 PIN debit networks. (6) Hence, when a consumer presents his or her PIN debit card, there is often a choice of which PIN debit network to use. This choice is determined by contractual agreements between debit networks and their merchant and issuer members, not the holder of the debit card. (7) The specification of which PIN network is used when there are multiple networks available is known as a routing rule.

There are several types of routing rule:

(i) Issuer routing. Transactions are routed according to issuer instructions.

(ii) Merchant routing. Transactions are routed according to merchant instructions.

(iii) Network routing. A network requires that any transaction that can go over it must go over it; that is, if both the issuer and merchant are affiliated with a network utilizing this routing rule, then they must transact over it. (8)

Although not formally a routing rule, it is evident that if a merchant or issuer participates in only one debit network, then that exclusivity has the effect of choosing the routing. (9) Hence, we will also explore the effects of a network's imposing the requirement that a merchant or issuer or both belong uniquely to that network.

Below we present our model using language appropriate to debit card networks. However, the same issue also arises in part in other contexts. As noted above, for example, merchants often accept the credit cards of multiple networks. Although credit card issuers typically pick a single network for a given card to run over, a consumer may carry multiple credit cards in his or her wallet and choose which card to present when making payment to a merchant. Hence, credit card networks can be thought of as having cardholder routing. The broader issue of choosing among payment instruments (e.g., cash versus check versus debit card versus credit card) can also be viewed in these terms.

Similar issues arise in communications networks. For example, many people subscribe to both wired and mobile telephone networks. The costs and benefits of message exchange incurred by the sender and receiver may depend on which network is used to complete a call. In this case, there is caller routing: through his or her choice of the number to dial, the caller determines whether the call is completed over a fixed-line or wireless network. The called party can influence the choice of routing both through his or her network subscription choices and by the choice of how widely to disseminate his or her different telephone numbers.

Routing issues also arise on the Internet because many local Internet service providers (ISPs) and web-hosting services are connected to multiple Internet backbone service providers. (10) Shipping represents another example of routing choice; sometimes merchants choose the routing, sometimes consumers are given the choice, and the parties have some choice as to which networks they belong (e.g., in the United States, a consumer with a post office box has effectively chosen not to belong to the DHL or FedEx networks). Retail stores, which are distribution networks that allow consumers to transact with manufacturers, provide an additional example of routing choices. Lastly, the choice of the word processing program in which to write a collaborative paper on routing rules is a further example in which parties have to choose a common network over which to transact.

As the above examples illustrate, the choice of routing is determined by a combination of formal authority (i.e., which party is delegated the right to choose a network), network subscription decisions, and the distribution of information about available options. Our focus is on the interplay between formal authority and subscription decisions. We assume that the party with routing authority (or its agent) knows the set of options available for completing any given transaction. In the payment card industry, consumers rely on point-of-sale signage, and merchants and issuers rely on electronic databases. Similarly, electronic and paper directories are generally available in the telecommunications sector. (11)

We characterize users' equilibrium, membership decisions for each of the routing rules identified above. Our central finding is that granting formal authority to one side of the market can increase the extent to which transactions run over the network preferred by the other side of the market. Intuitively, the side that does not have formal authority has stronger incentives to subscribe solely to its preferred network, which trumps the other side's formal authority.

We also characterize the networks' equilibrium choices of routing rules. Our focus is on the case in which all of the routing rules above are available to the networks, as is true of the debit card industry. We establish conditions under which competing networks adopt routing rules that delegate the choice to one side of the market rather than imposing network routing or exclusivity. Intuitively, a delegated routing regime serves to get many people on both networks, which lessens the all-or-nothing type of competition that exists with network routing or exclusivity. Moreover, because many people join both networks, the volume of trade is greater.

In some of the industry examples discussed above, not all of the routing options that are logically feasible are technically, legally, or politically feasible. For instance, suppose that a merchant accepts a variety of payment instruments, including cash, checks, and specific brands of credit cards. The merchant typically will lack both the knowledge of which of those payment instruments are held by a given customer and the authority to demand that the customer reveal that information. Consequently, merchant routing and network routing will be infeasible. Similarly, with retail stores, only consumer routing and manufacturer exclusivity are generally feasible. Nonetheless, the insights of our analysis with respect to the interplay of formal authority and network subscription decisions continue to apply. Moreover, we present a simple normal-form game for routing-rule choices, and one can readily strike rows and columns from this analysis to apply it to specific market settings with more limited sets of potential routing rules.