Reform of Australia's Payments System: Issues for the 2007/08 Review – May 2007 III. The Bank's Reforms and Rationale

26. This section provides an overview of the main conclusions and policy decisions of the Payments System Board. More extensive discussion and analysis can be found in the documents previously released by the Bank.^[1] A summary of the current regulatory arrangements is contained in Table 1.
27. The Bank's various reforms have addressed four general areas of the Australian payments system. These are:
    1. the effects of interchange fees on price signals, particularly to cardholders;
    2. the effects of restrictions placed on participants (most notably merchants) in payment systems;
    3. access arrangements for the credit and debit card systems; and
    4. the availability of comprehensive information about the payments system.

The discussion below considers the reforms in each of these areas.

Price signals and interchange fees

28. An early finding of the Bank was that for many consumers, the effective price of using a credit card to make payments was less than that of using EFTPOS. This was despite the EFTPOS system having lower underlying (or resource) costs.^[2]
29. While a number of factors contributed to this pricing structure, the Bank concluded that one important factor was the structure of interchange fees – the fees paid between the merchant's and cardholder's financial institutions each time a transaction is made. At the time, in the credit card (and scheme debit) systems, the interchange fee averaged around 0.95 per cent of the transaction value flowing from the merchant's financial institution to the cardholder's financial institution. In contrast, in the EFTPOS system the interchange fee flowed in the opposite direction – from the cardholder's financial institution to the merchant's financial institution – and averaged around 20 cents per transaction.
30. The Bank also concluded that interchange fees were not subject to the normal forces of competition. In the case of credit card and scheme debit systems, these fees were set collectively by the members of the scheme, and overseas evidence suggested that competition between schemes is more likely to put upward, rather than downward, pressure on fees. In particular, by increasing its interchange fees, a card scheme may be able to increase usage of its cards by providing issuers with additional revenue to support more attractive pricing to cardholders, most notably through reward points. This is more likely to be so if merchants’ decisions to accept particular payment methods are not very sensitive to the costs involved.
31. While the Bank concluded that interchange fees were having a significant effect on price signals to cardholders, and that the nature of competition in card payment systems was unusual, it also recognised that there were views that interchange fees could, under some circumstances, play a role in promoting an efficient payments system. In particular, it considered the argument that, in principle, interchange fees could promote efficiency where significant externalities exist, or where incentives are required to encourage the establishment and growth of a payment system.
32. The Bank's assessment, however, was that this argument did not support the view that the then current configuration of interchange fees was promoting efficiency. In particular, it judged that many of the externalities said to exist in card payment systems are equally applicable to both credit and debit card systems, and that these externalities could not justify the large differences in interchange fees in the credit card and EFTPOS systems.
33. In 2001, when the Bank first assessed the case for regulating interchange fees in the credit card system, it considered whether just requiring the removal of the no-surcharge rule would be sufficient to establish price signals that better promoted the efficiency of the system. Some submissions to the Bank suggested that if merchants were permitted to surcharge, then any benefit that cardholders received from high interchange fees – particularly in the form of reward points – would be offset by a surcharge at the point of sale. The argument was that by allowing surcharging, the net effective fee charged to cardholders would be independent of the interchange fee – the so-called ‘neutrality’ hypothesis.
34. The Bank agreed that removing the no‑surcharge rule would be a positive step (see paragraph 43), but was not convinced that surcharging would become sufficiently commonplace within a reasonable time frame to materially alter the then current price signals facing cardholders. A particular concern was that surcharging was likely to develop only slowly given the strong expectation by cardholders that no surcharges would apply – an expectation built up over a number of decades in which the schemes prohibited the practice. In the end, the Bank came to the conclusion that both the removal of the no‑surcharge rule and a reduction in credit card interchange fees were necessary to establish more appropriate price signals to cardholders.
35. The reduction in interchange fees has been achieved through the imposition of a Standard under the Payment Systems (Regulation) Act 1998. This Standard specifies a cost-based benchmark, and requires that the weighted-average interchange fee of each scheme be no higher than the benchmark at specific points in time. The use of a benchmark based on costs does not reflect a view by the Bank that interchange fees in the credit card system should be set in a way that compensates issuers for their costs in providing credit card accounts to cardholders. Rather this approach was adopted as a transparent and objective means of achieving lower interchange fees that is consistent with the powers the Bank has been granted.It was also an approach advocated by a number of industry participants. The inclusion of specific costs in the Standard does not reflect a view that there is some particular merit in these – and always these – costs being used to determine interchange fees.
36. As part of the package of reforms designed to promote more appropriate price signals, the Bank had long argued that a reduction in EFTPOS interchange fees was also appropriate. For a time, it appeared voluntary reform was likely, with a group of banks taking a proposal to the ACCC in February 2003 to set interchange fees to zero. The proposal was eventually approved in December 2003, after the ACCC was satisfied that concerns about access would be adequately addressed. A group of merchants then appealed the ACCC's decision in the Australian Competition Tribunal (ACT), with the ACT finding in the merchants’ favour. This decision effectively ended prospects for voluntary reform and, after extensive consultation, the Bank designated the EFTPOS system and imposed a Standard on interchange fees.
37. Again the approach adopted was to establish a benchmark based on costs. This Standard has led to a significant reduction in the average EFTPOS interchange fee for transactions without a cash-out component from around 20 cents to around 5 cents. While the Bank has stated a number of times that it did not see a strong case for any interchange fees in the EFTPOS system, it adopted a small ‘negative’ fee largely due to uncertainty over whether a standard could be used to abolish the fee or, equivalently, set it at zero.
38. Unlike the credit card interchange Standard, the EFTPOS interchange Standard imposes both a floor and a cap on interchange fees (currently 4 and 5 cents respectively). This reflects the bilateral nature of the EFTPOS system in which interchange fees are negotiated between each of the direct connectors in the system. The Bank was concerned that these bilateral negotiations could be used to frustrate access or limit competition, with existing participants offering arrangements to new participants on less attractive terms than were established with existing participants. This issue was also addressed in the EFTPOS Access Regime (see paragraphs 51 and 52).
39. Another element in establishing more appropriate price signals was a reduction in interchange fees in the scheme debit systems. Historically, these fees have been the same as those for credit cards and, while the Bank did not initially regulate them, they fell when the credit card interchange Standard became effective. Notwithstanding this fall, the Bank could not see a case for interchange fees for scheme debit transactions being the same as those for credit card transactions – a view shared by many industry participants. A particular concern was that the EFTPOS system was at a significant disadvantage to the scheme debit systems, simply because of the structure of interchange fees, which themselves were not subject to the normal forces of competition. The narrowing of the difference in interchange fees between the two types of debit card systems has been seen as an important step in promoting more soundly based competition between the systems.
40. The Bank's focus on the configuration of interchange fees in the credit card, scheme debit and EFTPOS systems has reflected concerns about the effect of these fees on the overall efficiency of the payments system. It has not, as has sometimes been suggested, reflected concerns about the level of credit card debt, or a desire to promote the use of the EFTPOS system because it has lower resource costs. The Bank has repeatedly acknowledged that an outcome in which individuals use a payment method which involves higher resource costs can be efficient, particularly if the prices individuals base their choices upon are broadly reflective of the costs of providing the payment method.
41. Further details of past and current interchange fees are provided in Section V.

Price signals and merchant restrictions

42. Early on in its deliberations, the Bank also concluded that price signals in the Australian payments system were being distorted not only by interchange fees, but also by restrictions placed on merchants by the card schemes. These restrictions included rules that:
    1. prevented merchants from surcharging for credit card transactions (the no‑surcharge rule);
    2. required a merchant to accept a scheme's debit card if it accepted its credit card and vice versa (the honour-all-cards rule); and
    3. prevented merchants from steering customers to other forms of payment (the no‑steering rule).

43. In the Bank's view, the no-surcharge rule dulled the price signals to cardholders about relative costs of different payment methods. The rule also limited the ability of merchants to put downward pressure on fees by threatening to charge the customer for using a credit card. It also contributed to the subsidisation of credit card users by all other customers, with the uniform prices charged by merchants for goods and services needing to cover the relatively high costs associated with credit card acceptance.
44. Neither MasterCard nor Visa agreed to voluntarily remove their no-surcharge rules for credit cards and, as a result, the Bank imposed Standards requiring the removal of these rules. In contrast, American Express and Diners Club voluntarily agreed to remove their equivalent rules.
45. The honour-all-cards rule in the MasterCard and Visa schemes had two distinct aspects: one relating to honouring all issuers and the other to honouring all products. The Bank recognised the merits of the honour all issuers aspect of the rule, but concluded that the honour all products aspect was not in the public interest. It concluded that the tying of credit and debit card acceptance adversely affected competition, particularly between EFTPOS and scheme debit, by forcing merchants to accept a payment method they might not otherwise accept, at a price they might not otherwise pay.
46. Visa did not agree to voluntarily modify its honour-all-cards rule and, as a result, the Bank imposed a Standard requiring that the rule be modified in the Visa system. MasterCard provided a written undertaking to voluntarily comply with the requirement to modify the honour-all-cards rule. While American Express does not issue a debit product in Australia, it has agreed to voluntarily comply with the Standard if it introduces debit or pre-paid products in the future.
47. Finally, the no-steering rule prevented merchants that accepted American Express cards from encouraging customers to use another method of payment (equivalent rules did not exist in the MasterCard, Visa and Diners Club schemes). Again, the Bank saw this rule as inappropriately restricting competition and, after discussions, American Express agreed to remove the rule.

Access

48. Another major area of reform has concerned access to payment systems, reflecting the Bank's view that access arrangements for a number of payment systems were more restrictive than was necessary to ensure the financial stability of those systems.
49. In the credit card system, the access rules effectively restricted membership of MasterCard and Visa to authorised deposit-taking institutions (ADIs) supervised by the Australian Prudential Regulation Authority (APRA). The credit card schemes argued that this was necessary for both their own protection and that of their members. While the Bank accepted the need for some entry criteria, it concluded that the existing criteria were unnecessarily restrictive. It also concluded that the scheme rules that prevented institutions acting as acquirers only, or levied penalties on institutions that were significant net acquirers, unduly restricted competition.
50. Given that the schemes were unwilling to address these issues voluntarily, the Bank imposed Access Regimes on both the MasterCard and Visa credit card schemes. In doing so, it worked closely with APRA, who established a new class of supervised institution known as a Specialist Credit Card Institution. The Access Regimes require the schemes to treat applications for membership from these specialist institutions on the same basis as those from the traditional ADIs, and prevents the schemes from imposing penalties on institutions on the basis of their issuing or acquiring volumes. Given the linkages between the credit and debit card schemes operated by Visa, and the structure of Visa's rules, it was also necessary for the Bank to impose a corresponding Access Regime on the Visa Debit system.
51. The Bank also concluded that access arrangements for the EFTPOS system were more restrictive than was necessary, largely reflecting the bilateral nature of the system. Potential entrants could either negotiate access through an existing participant or they could establish their own direct links to existing participants. Existing participants were, however, under no obligation to establish the necessary connection on reasonable terms and conditions, and to do so within a reasonable amount of time.
52. Following prompting by the Bank and the ACCC, industry participants spent considerable time developing an EFTPOS Access Code to improve access arrangements. Under the Code, which was adopted in September 2006, existing participants have agreed to procedures and timetables under which they will negotiate connections with new participants. The industry also agreed to set a cap on the price that current participants can charge for new connections. The industry was concerned, however, that such an agreement might require authorisation by the ACCC, a potentially lengthy process, and asked the Bank to set the cap in an Access Regime. After consultation, the Bank did impose an Access Regime, establishing an initial cap of $78,000 on the price that could be charged to establish a new connection. The Access Regime also limits the ability of existing participants to use negotiations over interchange fees to limit competition, by imposing ‘no discrimination’ requirements on existing participants.

Publication of information

53. Throughout the reform process, the Bank has been keen to improve the transparency of the payments system. When the Bank first started investigating interchange fees in the credit and debit card systems, information on these fees was not publicly available. Similarly, scheme rules, particularly those setting out the conditions on which new entrants could participate, were held to be confidential to the schemes. There was also very limited information on market shares of the various card schemes and the costs to merchants of accepting various payment methods.
54. The Joint Study provided, for the first time, comprehensive reporting of interchange fees in Australia, as well as a description of the card schemes’ rules dealing with access. The Bank has also engaged in other data gathering exercises. It publishes average merchant service fees for the Bankcard, MasterCard and Visa credit card schemes, and separate figures for American Express and for Diners Club. The Bank also publishes the combined market share of the American Express and Diners Club schemes and the combined market share of the Bankcard, MasterCard and Visa schemes. It also encouraged BPAY to publish its interchange fees. The Bank also reports regularly on developments in the payments system.

Additional investigations

55. Over recent years, the Bank has also investigated a number of other payment systems but decided not to formally regulate these systems. Given the wide-ranging nature of the review, the Bank will once again examine these systems.

BPAY

56. Other than the card systems, the only other payment system in Australia that has interchange fees is the BPAY system. In 2005, after investigating these fees, the Bank decided that there was not, at that time, a strong case to regulate these fees. In announcing its decision, the Bank noted that BPAY's interchange fees had: been reviewed regularly; fallen steadily; and were expected to fall further. In assessing the case for regulation, the Bank also considered likely changes in the relative pricing of various bill payment methods that might arise if BPAY's interchange fees were reduced through regulation. In particular, it concluded that such a reduction in BPAY's interchange fees (which flow to the ‘issuing’ bank) would be likely to lead to higher costs to consumers for BPAY payments, and thus would be likely to encourage greater use of more costly means of payment.
57. While the Bank decided not to regulate interchange fees in the BPAY system, it strongly encouraged BPAY to publish its interchange fees, and BPAY now publishes its interchange fees (known as Capture Reimbursement Fees) on its website.

The ATM system

58. The Bank has taken an interest in ATM interchange fees, pricing regimes and access since the time of the Joint Study. The Study noted that while the cost of providing a cash withdrawal averaged around $0.50, interchange fees averaged around $1.00 and foreign fees charged by financial institutions when their customers withdrew cash from another institution's ATM averaged around $1.35. Furthermore, there appeared to be no competitive pressures driving prices closer to costs. Since that time, foreign fees have increased further with a number of institutions now charging $2.00 per transaction despite there being no change in interchange fees.
59. In the Joint Study, the Bank suggested that direct charging could be an alternative to the current arrangements that could introduce more competition into the provision of foreign ATM services. Since then, participants in the ATM industry have had a number of attempts at designing alternative arrangements. During that process, the Bank has not sought to regulate to impose a particular solution, but has emphasised the importance of improved access, of ensuring that negotiations over interchange fees do not restrict access, and of allowing ATM owners that wish to direct charge the ability to do so. The industry is currently discussing with the Bank its plans for dealing with these issues.

American Express and Diners Club

60. When the Bank initially investigated the setting of interchange fees in the Bankcard, MasterCard and Visa systems, both American Express and Diners Club operated as three-party systems, with no interchange fees being paid. As such, the interchange fee regulation implemented for the Bankcard, MasterCard and Visa systems was not applicable to the three-party systems. Subsequently, both American Express and Diners Club entered into partnerships with a number of Australian banks which, although quite different from one another, had some similarities to arrangements in the other systems.
61. At the time these partnerships were announced, the Bank investigated whether there was a case to regulate the payments between American Express/Diners Club and their partner banks. It concluded that, ‘at this stage, such regulation would not improve the overall efficiency of the payments system. In its view, regulation of these payments would have relatively little effect on merchant charges. Further, the existing incentives facing issuers of these cards could only be addressed through considerably more extensive regulation than that currently existing in the credit card schemes.’^[3]
62. In the MasterCard and Visa systems, interchange fees are an important determinant of merchant service fees, while in the American Express arrangement with its partner banks, the causation runs the other way – merchant service fees are an important determinant of interchange fees. This reflects differences in the nature of competition for acquiring services. In the MasterCard and Visa systems there are many banks competing for merchant acquiring business, with the interchange fee effectively putting a floor under merchant service fees. In contrast, in the American Express and Diners Club schemes, there is no competition in acquiring; merchants that wish to accept American Express cards, for example, must strike a deal with American Express. In these circumstances, the merchant service fee is determined by the ability of a merchant to bargain with the scheme. Interchange fees paid by these schemes to issuers are, in turn, not fixed but depend upon by the amount of revenue that can be earned through merchant service fees.
63. In the Bank's view, regulation of interchange payments by American Express to its partner banks would have had little effect. Instead the Bank's focus has been on ensuring that there are not inappropriate restrictions in place that distort competition. The Bank has therefore concentrated on removing restrictions imposed on merchants, including the no-surcharge and no-steering rules.

Pre-paid and gift cards

64. Pre-paid cards – particularly those that are reloadable – currently have substantially the same functionality as the scheme debit cards that were included in the Bank's reforms. The Payments System Board decided in August 2006 not to regulate pre-paid cards at that time. This reflected an expectation that interchange fees for transactions on these cards would be published and set broadly in conformity with the Standard on interchange fees in the Visa Debit system, and that merchants would not be prevented from surcharging transactions on these cards. The Bank also expected that, if a pre-paid card were to be introduced with features substantially different from a scheme debit card, merchants would not be required to accept that card.

Footnotes

These documents can be found on the Reserve Bank's website in the section on payments system reforms. [1]

The Joint Study collected and published extensive data on the average costs incurred by financial institutions in the credit card and EFTPOS systems. It found that the effective price to many consumers of a $100 credit card transaction was between -$0.72 and -$1.04 (reflecting the availability of reward points and an interest-free period) while the per‑transaction charge for an EFTPOS transaction was between $0 and $0.60. [2]

Reserve Bank of Australia (2005). [3]