Reform of the EFTPOS and Visa Debit Systems in Australia:
Final Reforms and Regulation Impact Statement – April 2006 3. The Key Issues

The Reserve Bank has identified four features of Australia's card payment systems that, taken together, have inhibited efficiency and competition in the Australian payments system. These are:

  1. the relationship between interchange fees in the credit card and EFTPOS systems;
  2. the relationship between interchange fees in the scheme debit and EFTPOS systems;
  3. the difficulties faced by both new and existing participants in the EFTPOS system in establishing direct connections with existing participants; and
  4. the requirement (imposed by the international card schemes) that merchants accept scheme debit cards on the same terms as scheme credit cards, even though the two products offer potentially quite different benefits.

The Bank has set out in considerable detail the implications of these features of the payments system for competition and efficiency in numerous documents over the past six years (see Reserve Bank of Australia and Australian Competition and Consumer Commission (2000) and Reserve Bank of Australia (2002), (2004), (2005a), (2005b) and (2005c)). The following provides a summary of the analysis set out in those documents.

The relationship between interchange fees in the credit card and EFTPOS systems

A central concern of the Bank has been that payment patterns in Australia were being distorted by the configuration of interchange fees in the credit card and EFTPOS systems.[1] These fees are not subject to normal competitive pressures and the Bank's view is that they have not been set in a way that promotes efficiency and competition in the payments system.

In the credit card systems, interchange fees are agreed between members of the schemes and the same interchange fee is paid by every acquirer in the scheme. While there are two main credit card schemes, competition between these schemes does not ensure that interchange fees are set at a level that promotes efficiency.

While in principle it might be possible for a scheme to lower its interchange fees to attract more merchants, in practice competition does not typically work in this way. This reflects the two-sided nature of the credit card market and the fact that the demand elasticity for a particular brand of credit card is much higher on the cardholder side of the market, than it is on the merchant side. Merchants find it difficult to refuse acceptance of a particular payment instrument if a competitor accepts it because they may lose customers to the competitor. In addition, merchants are less sensitive to credit card charges than are cardholders as they can pass on the costs of accepting credit cards in the general level of prices that they charge. Furthermore, many acquirers offer ‘bundled' pricing to merchants, so that a reduction in interchange fees by one scheme would be unlikely to generate greater merchant acceptance of that scheme's card, relative to competing cards.

In contrast, on the other side of the market, cardholders are quite sensitive to the pricing of credit cards and are typically prepared to switch credit card brands, if one brand offers a more attractive proposition. As a result, the card schemes effectively compete more strongly for cardholders than they do for merchants. A reduction in the interchange fee by one scheme to attract new merchants would mean that its issuers would not be able to offer as attractive product offerings to cardholders, and thus would be likely to harm, rather than improve, the scheme's competitive position. In fact, in the United States, competition between card schemes has led to a series of increases in interchange fees as the schemes compete for cardholders.[2]

While interchange fees are not subject to normal competitive pressures, banks do compete for merchants' business through the margin they charge over the common interchange fee for acquiring credit card transactions. While the acquiring market is reasonably competitive, the Bank's access reforms should further promote competition. Merchants cannot exert competitive pressure on the interchange fee by threatening to move acquirers, given that all acquirers pay the same interchange fee. In this way, interchange fees place a floor under the merchant service fee.

Similarly, in the case of EFTPOS, normal competitive forces do not act on interchange fees even though they are set bilaterally. Once these fees have been set, it is very difficult to renegotiate them, again because of the two-sided nature of the market. In general, neither acquirers nor issuers are willing, or able, to initiate a process of competition over these fees.

The main reason for little competition emanating from the issuing side is that in any negotiation with an acquirer, an issuer cannot credibly threaten to end the current agreement if a lower interchange fee is not agreed to. Ending the agreement would mean that the issuer's cardholders were not able to use their cards at merchants serviced by the acquirer. For even the largest issuers, this would be seen as unacceptable, as it would effectively mean that they could not offer a full-service transaction account. Indeed, during the genesis of the EFTPOS system, issuers did not offer universal merchant acceptance but were driven to make arrangements with other banks to offer that service.

Similarly, an acquirer attempting to expand its business would have difficulty doing so if it were to offer, or agree to, a lower interchange fee. If the acquirer were receiving less revenue from interchange payments than its competitors, it would be unlikely to be able to offer merchants as competitive pricing as other acquirers. Accepting a lower fee can hurt, not improve, the competitive position of acquirers.

Given the nature of these negotiations, it is therefore not surprising that the bilateral interchange fees in the EFTPOS system have been essentially unchanged for many years.

The Bank has been concerned that the nature of competition in the EFTPOS and credit card systems has resulted in a structure of interchange fees that is leading issuers to price credit card transactions to cardholders much more attractively than EFTPOS transactions. This is despite evidence that the EFTPOS system has lower resource costs than the credit card system. Data available from the Joint Study and from retailers suggest that due to lower fraud costs, shorter transaction times and the lower cost of processing, EFTPOS transactions consume fewer resources than equivalent transactions conducted through the international credit card schemes. The structure of interchange fees in the systems has meant that these relative costs are not reflected in prices faced by cardholders who make the decision about which means of payment to use.

This apparently paradoxical pricing – in which the relatively low-cost scheme was offered to cardholders at the higher price – was encouraging substitution towards credit cards and away from the EFTPOS system. While the Bank recognised there were arguments that could potentially justify such divergent pricing, it was not convinced by these arguments. As a result, in August 2002, the Bank took a significant step towards establishing less distortionary price signals by introducing an interchange Standard for credit cards, effectively reducing the interchange fee from around 0.95 per cent of the transaction value to around 0.55 per cent. Notwithstanding this reform, current interchange fees still significantly favour credit cards, and the Bank has seen little justification for the current level of interchange fees in the EFTPOS system.

Interchange fees in competing debit systems

A related issue is the relationship between interchange fees in the EFTPOS and scheme debit systems. As noted above, in the EFTPOS system, interchange fees are paid by the cardholder's bank to the merchant's bank, while in the scheme debit systems interchange fees flow in the opposite direction. As a result, issuers have an incentive to promote the use of scheme debit cards over EFTPOS, and some cardholders face higher prices for EFTPOS transactions than for scheme debit transactions.

As discussed above, the Bank's view is that interchange fees in the EFTPOS system are subject to limited competition. Scheme debit interchange fees are set in the same way as those for credit cards and, for the same reasons discussed above, are also subject to limited competition. Just as the relatively high price faced by cardholders when using the EFTPOS system has contributed to the growth of the credit card system at the expense of EFTPOS, current interchange fee arrangements appear to provide strong incentives for financial institutions to promote scheme debit systems at the expense of EFTPOS. The Bank's concern is that the different interchange fees might lead to the higher-cost scheme debit systems growing at the expense of the lower-cost EFTPOS system. If this were to happen, merchants' payment costs would rise, and so too would the overall level of goods and services prices in Australia.[3]

Access to the EFTPOS system

The third issue is that of access to the EFTPOS system. Arrangements in this system make entry more difficult than is the case in many equivalent systems overseas.

Typically, in other countries, there is a single point of entry to the system for new participants, who must meet a single set of technical and business requirements. Where there are entry fees, these fees are usually known in advance and, where there are interchange fees, they generally apply uniformly to all participants.

In contrast, in Australia, the EFTPOS system is built around a series of bilateral connections and interchange contracts between direct connectors (there are currently eight such connectors) and there is much less standardisation of the terms of access. Smaller participants typically gain access to the system through gateway arrangements provided by one of the organisations that has already established a series of direct connections and business arrangements. By entering the system this way, the significant costs of establishing a series of direct connections can be avoided, but higher variable costs for each transaction processed through the gateway apply.

The current arrangements complicate access in three ways:[4]

  • A new participant wishing to establish direct connections must separately approach each of the existing direct connectors to negotiate the technical and business arrangements for exchanging EFTPOS transactions. Each existing participant may require the new participant to meet different technical and business requirements, increasing the costs of entry.
  • Existing direct connectors have little incentive to facilitate the entry of a new participant, particularly when the entrant is likely to be a direct competitor in at least some business lines. If a potential new acquirer seeks to establish a bilateral connection with a financial institution, the institution may be reluctant to establish the connection in a reasonable time frame, or at a reasonable cost, if it itself has a substantial acquiring business. At present, existing participants have no obligation to establish direct connections with new participants.
  • Negotiations over interchange fees could also be used to frustrate entry. Interchange fees are negotiated bilaterally and are typically in a range from 18 cents to 25 cents. These fees are usually reciprocal, with the same fee being paid irrespective of which institution is the issuer. If, however, an existing issuer were prepared to pay only a much lower interchange fee to a new acquirer, that acquirer might find it difficult to compete for the business of merchants against other acquirers receiving a much higher interchange fee.

These complications provide the large incumbents with the ability to frustrate access to the system by new and smaller participants. The result has been that competition, particularly on the acquiring side, has been less than might otherwise have been the case.

These concerns are longstanding and have been raised in discussions with the Bank over a number of years.

Acceptance of scheme debit cards

Under current arrangements, whenever merchants accept credit cards issued under the MasterCard or Visa brands, they are required by the schemes to accept the scheme's debit cards on the same basis. As a result, competitive forces cannot bear directly upon the price of, or acceptance of, the scheme debit product.[5]

An important effect of the honour all cards rule is that it distorts the relative competitive positions of the EFTPOS and scheme debit systems. As noted above, in most situations, scheme debit and EFTPOS offer cardholders a very similar service. In particular, for domestic point-of-sale transactions, which represent the largest segment of card-based transactions, the two types of debit systems are effectively interchangeable. Scheme debit, however, has a competitive advantage over EFTPOS because merchants are forced to accept the card when they make the decision to accept scheme credit cards, and the higher interchange fee encourages issuers to issue and promote scheme debit in preference to EFTPOS. This raises the possibility that, over time, the scheme debit systems will take the place of the EFTPOS system, not because of differences in functionality, but because of the combined effect of the honour all cards rule and the configuration of interchange fees. This concern is reinforced by the experience in the United States, where the combination of the honour all cards rule and higher interchange fees has enabled MasterCard and Visa to significantly increase their shares of the debit market at the expense of alternative debit card systems that pay lower interchange fees to issuers.

In addition, although the no surcharge rule was removed for credit card payments, it technically still applies to scheme debit card payments. Since the merchant service fee is currently the same for scheme debit and credit card transactions, and merchants are unable to distinguish between scheme debit and credit products, this has not been an issue to date. It could, however, become an issue if the honour all cards rule were removed.

Footnotes

For a fuller discussion, see Reserve Bank of Australia, 2001. [1]

Macfarlane, 2005. [2]

For a detailed discussion of these issues, see Reserve Bank of Australia, 2005a. [3]

For a more detailed analysis of the difficulties of access, see Reserve Bank of Australia, 2005c. [4]

For a more detailed discussion, see Reserve Bank of Australia, 2005a. [5]