Reform of Australia's Payments System 6. Options Regarding Interchange Fees

6.1 The options

As noted above, the Board sees strong public policy grounds for continued close regulatory oversight of card payment systems. The most contentious issue has been, and remains, the regulation of interchange fees. Looking forward, the Board has considered three broad options regarding these fees.

The first is to maintain the status quo. Under this option, the broad features of the current interchange regulations would be maintained, including the current caps on interchange fees, although modifications would be made to enhance the functioning of the existing regulations. The second option is to further reduce the allowable levels of interchange fees in the credit card system and to further narrow the difference in interchange fees between the debit card systems. The third option is to step back from the regulation of interchange fees on the condition that further changes are made by industry participants to enhance the competitive environment. The three options are set out and discussed below.

Option 1: Status quo

The first option is to retain the current credit and debit card interchange Standards, largely unchanged. This would mean that:

• the weighted-average interchange fee in the MasterCard and Visa credit card systems would continue to be capped at around 0.5 per cent;
• the weighted-average interchange fee in the MasterCard and Visa debit card systems would continue to be capped at around 12 cents; and
• interchange fees in the EFTPOS system (paid to the acquirer) would continue to be between 4 and 5 cents.

If this option were adopted a number of technical changes, aimed at improving the functioning of the existing regulations, would also be considered. These include:

• the removal of the requirement to conduct cost studies every three years;
• requiring that the weighted-average interchange fees be below the relevant benchmarks once a year, rather than once every three years (or when interchange fees are varied) as is currently the case; and
• removing the exemption of cash-out EFTPOS transactions from the EFTPOS interchange fee Standard.

These modifications are discussed in Appendix 2.

Option 2: Reduce interchange fees further

The second option is to retain interchange regulation, but reduce interchange fees further. This option is consistent with the direction that the Board indicated when the original credit card regulations were finalised in 2002. At that time, the Board stated that the reduction in credit card interchange fees (from around 0.95 per cent to around 0.55 per cent) was the first step towards lower interchange fees in Australia.^[1] This option would also eliminate the existing difference in the average interchange fees in the debit card systems in Australia. If this option were adopted, the Board would also consider the technical changes to the Standards noted under Option 1.

If a common average interchange fee is to be established in the various debit card systems, the Board has considered two broad possibilities. The first is to set interchange fees in these systems to zero. The second is to cap interchange fees with a low, but common, benchmark, with fees flowing from acquirers to issuers in both the EFTPOS and scheme debit systems. There are arguments in favour of both approaches.

International experience suggests that debit card systems do not need interchange fees to operate effectively. Moreover, most other payment systems in Australia that draw on transaction accounts do not have interchange fees. This suggests a common fee of zero would be feasible and consistent with existing practice in other payment systems. On the other hand, setting a small positive benchmark for the weighted-average fees would allow the schemes some flexibility in setting different fees for different types of transactions. At the margin this may be useful, and could potentially allow the schemes to use interchange fees in a way that promotes innovation in the system. On balance, the Board considers this latter approach preferable with, perhaps, a benchmark of around 5 cents capping the weighted-average fee in the various debit card systems.

In considering interchange fees in the credit card systems, the Board assessed the case for setting interchange fees to zero, or at levels similar to those in the debit card systems. While it remains unconvinced of the need for significantly higher interchange fees for credit card systems than for debit card systems, it does recognise that there are some plausible arguments that might justify somewhat higher interchange fees in credit card systems. In particular, merchants, in aggregate, may gain some short-term benefit from consumers using credit cards over debit cards, in that sales occur earlier than otherwise. While the Board recognises this possibility, the current difference in interchange fees in the credit and debit card systems is significantly higher than could reasonably be justified by this argument.

Given this assessment, this option involves a substantial narrowing of the existing difference in interchange fees in the debit and credit card systems. In particular, it envisages the benchmark applying to the credit card systems being reduced to around 0.30 per cent.

In summary, this option involves benchmarks which result in:

• a common cap of around 5 cents on the weighted-average interchange fee (paid to issuers) in each of the debit card systems; and
• a cap of no more than 0.30 per cent on the weighted-average interchange fee in the credit card systems.

Option 3: Remove explicit interchange regulation

The third option is for the Board to step back from interchange regulation if the industry is able to address a number of issues that would promote competition and efficiency in a timely fashion. Given its underlying concerns about the competitive forces in the payments system, the Board has ruled out the option of stepping back unconditionally.

If the Board were to step back, one important issue that would need to be addressed is the current structure of the EFTPOS system, given the potentially important role that this system plays as a competitor to the international card schemes. As discussed above, the Board's view is that the existing governance and technical arrangements mean that the EFTPOS system is at a structural disadvantage which limits its ability to provide effective competition longer term. Looking ahead, if the EFTPOS system is unable to provide effective competition (and another widely used and competitive payment system does not emerge), the Board's view is that the case for removal of interchange regulations is relatively weak.

While the Board does not wish to be prescriptive about exactly what is required, a number of developments would strengthen the case that the EFTPOS system was likely to provide meaningful competition in the Australian card payments system over the years ahead. These include:

1. the introduction of a scheme to replace the existing bilateral contracts, with the scheme able to make decisions about multilateral interchange fees;
2. the creation of effective arrangements to promote the development of the system;
3. reform of current access arrangements; and
4. the development of alternative payment instruments for use in online payments (either by the EFTPOS scheme or through another channel).

For the Board to step back, it would need to have reasonable confidence that strong competition exists between the various card-based systems and that the environment is conducive to ongoing strong competition. The Board would want to see tangible progress towards establishing such an environment and not just statements of industry intention to work towards this outcome.

Another issue that would need to be addressed is the honour-all-cards rule. If the Board is to remove the existing interchange regulation, its view is that further steps would need to be taken to improve the ability of merchants to put downward pressure on interchange fees. Accordingly, in addition to the modifications to the honour-all-cards rule discussed in Section 5, the Board sees it as important that payment schemes allow merchants to make independent acceptance decisions for each type of card for which a separate interchange fee applies. This would allow a merchant to refuse acceptance of, say, premium cards if it thought the cost of acceptance was too high relative to the benefit gained. Ideally, such a change would be made voluntarily by the schemes, although the Board would consider imposing this requirement through regulation if the schemes did not change their rules and it was deemed appropriate to step back.

The Board recognises that a number of arguments have been made against this change. One is that it would have little benefit, as most merchants in Australia are charged a single merchant service fee regardless of the card type, and thus have little incentive to refuse acceptance of particular card categories. This may change over time, however, as more merchants move to ‘interchange plus’ contracts. Second, the change would involve additional costs for acquirers, as they would need to alter their systems to allow merchants to accept some cards, but not others. And third, it has been argued that further changes to the honour‑all-cards rule would be confusing to customers and reduce the value of the international card brands.

While the Board recognises that additional costs would be incurred by this change, its judgement is that if interchange regulation is to be wound back, all feasible steps need to be taken to enhance the competitive environment. While this change might not have an immediate effect, over time it is likely to enhance competition, particularly if merchants become willing to threaten to decline acceptance of particular card types.

The Board is not proposing that this change to the honour-all-cards rule be made if either Option 1 or 2 were adopted. Under these options, the costs to financial institutions of making the necessary systems changes are likely to outweigh the benefits, given that interchange fees would be constrained at low levels through regulation.

A third avenue for improving the competitive environment is to further enhance the transparency of the system. In particular, the Board sees a strong case for greater transparency of scheme fees and average interchange fees, as well as the fees and procedures that apply if an acquirer wishes to bypass scheme switches. As discussed in Section 5, the schemes could voluntarily take steps to improve transparency in these areas, or the Bank could require greater transparency through regulation.

One other issue that the Board has considered is whether the case for this option would be strengthened if a framework was in place to ensure that the industry itself addressed issues of competition and efficiency. Some have argued in the consultation process that if such a framework were in place, direct regulation by the Board would be unnecessary.

The Board supports this approach in principle. As has been emphasised elsewhere in this document, the Board's clear preference is for the industry to address issues of competition and efficiency rather than for the Bank to impose regulations. Exactly how this might be done remains unclear. One possibility might be for industry to take meaningful steps to improve the competitive environment and promote innovation in the Australian payments system, perhaps through changes to access arrangements and upgrading of the existing technical infrastructure. Another might be for industry participants, including the international card schemes, to directly address the Board's concerns about interchange fees, transparency and merchant restrictions, reducing the need for regulation. Over the period ahead, the Board is prepared to work with industry on developing appropriate arrangements. However, it is not requiring that such a new framework be agreed and put in place before Option 3 could be considered, although clearly industry steps in this direction would strengthen the case for this option.

In summary, this option involves the Bank stepping back from the regulation of interchange fees subject to other changes to further improve the competitive environment, in particular by:

1. putting in place arrangements that have a high probability of ensuring that there exists a strong effective competitor operating alongside the international card schemes;
2. further modifications to the honour-all-cards rule; and
3. greater transparency of scheme fees.

In the event that transparency of scheme fees is not improved, the Board would consider regulation to require the schemes to provide the relevant information. The Board would also consider imposing the changes to the honour-all-cards rule discussed above as part of Option 3 if the relevant changes were made to the EFTPOS system but the schemes were unwilling to voluntarily change their scheme rules. In the event that the necessary improvements to the competitive environment are not forthcoming, the Board would consider either Option 1 or 2.

6.2 Advantages and disadvantages of the options

6.2.1 Options 1 and 2

Both Options 1 and 2 involve continued regulation of interchange fees.

The main advantage of Option 1 over Option 2 is that it involves minimal change to the existing arrangements. As such it should involve fewer adjustment costs. It also provides a stable and known environment for industry participants in which to make and implement business plans.

There are two main advantages of Option 2 over Option 1. The first is that under Option 2, a common benchmark in the EFTPOS and scheme debit systems would place these systems on a more equal competitive footing with each other than is the case under Option 1. The second is that Option 2 establishes more appropriate relativities between debit and credit card interchange fees than does Option 1.

The Board has had a long-standing concern that the relativities between interchange fees in the EFTPOS and scheme debit systems could contribute to the atrophy of the EFTPOS system, resulting in a diminution of competition and choice. This concern was one factor that led to the introduction of the EFTPOS and Visa Debit interchange Standards in 2006, with these standards narrowing the difference in interchange fees on a $100 transaction from an average of around $0.75 to $0.17. While this change represents a significant levelling of the playing field, the Board remains concerned about the competitive effects of the current difference in interchange fees. In particular, the difference has the potential to lead issuers to promote scheme debit cards, not just on the basis of product characteristics, but also because of the more favourable interchange arrangements. By establishing similar interchange arrangements in the two systems, as is proposed under Option 2, competition between the schemes is likely to be more soundly based.

As discussed in Section 5, the Board's concerns in this area are not driven by a desire to promote the EFTPOS system: like other payment systems, the EFTPOS system should compete on the basis of the services and pricing it offers to cardholders and merchants. Notwithstanding this, an outcome in which the EFTPOS system declined partly because of the structure of interchange fees – and not because of the services it offers – could not be said to be in the public interest. In the Board's view, competition would be diminished if there were not a strong viable alternative to the international card schemes. The demise of the EFTPOS system would lead to higher costs in the payments system and would also lessen the competitive pressure on interchange fees. Indeed, recent experience suggests that the ability of merchants to offer the EFTPOS option to their customers has put downward pressure on at least some interchange fees in the scheme debit systems (see Section 5).

Option 2 would be expected to lead to a further realignment of relative prices of credit and debit cards. With interchange revenue for credit card transactions reduced, issuers would be expected to increase annual fees and further reduce the value of rewards programs. Since the decline in interchange fees would be around half that of the original reforms, the expected price changes would be correspondingly less. The changed interchange fees in the debit systems may also lead to some changes in pricing for debit card transactions. At the margin, these changes would be expected to lead to some further substitution away from credit cards and scheme debit to EFTPOS.

On balance, the Board favours Option 2 over Option 1. This reflects the fact that the benefits from Option 2, in the form of more appropriate interchange fees and price signals, would continue indefinitely while the benefits of Option 1 over Option 2 are relatively temporary.

6.2.2 Option 3

In contrast to Options 1 and 2, Option 3 envisages the Board stepping back from the regulation of interchange fees. The Board sees both advantages and disadvantages of this approach.

The main advantage is that it offers the prospect of a further improvement in the competitive environment, while allowing schemes more flexibility in the pricing of their payment services. It also provides a way for industry to address the Board's public-policy concerns regarding interchange fees, rather than these concerns being addressed through regulation. This is consistent with the Board's general approach.

Allowing card schemes to set their own interchange fees in an environment in which stronger competitive forces exist than has been the case historically would provide the various card payment systems with the flexibility to compete directly with one another for both acceptance and use. In the past the Board has expressed a concern that this type of competition could push up interchange fees, and this concern remains. There is, however, some prospect that the combination of the reforms to date and some further changes would result in an environment sufficiently competitive that interchange fees would no longer be under continual upward pressure.

One concern that the Board has previously expressed is that the same financial institutions effectively operate and control the various payment systems. This has led the Board to question whether competition between the various payment systems has been stifled. Recent changes to the ownership structure of the international card schemes has opened up the possibility of greater competition between these schemes and those operated and controlled by domestic institutions. The development of an EFTPOS system with appropriate governance arrangements may also be helpful in this regard.

In assessing this option, an important consideration has been the possibility that allowing schemes to set their own fees may increase the probability that the EFTPOS system will, over the longer term, remain a central part of the Australian payments landscape. While Option 2 would reduce the current disadvantage of the EFTPOS system in terms of interchange fees, there is a risk that, if the system remains subject to interchange regulation, financial institutions will not invest sufficiently in the maintenance and development of the system, and that ultimately competition may be weakened.

As noted above, the Board sees no evidence that the current arrangements have limited innovation to date. However, looking forward, it is possible that financial institutions may be more prepared to invest in systems which are able to set their own interchange fees. This might be because the regulatory risks are seen to be lower, or because interchange fees can be used to help finance the development of new and enhanced payment options (as has been the case for BPAY View for example). Allowing the EFTPOS system to set its own interchange fees might, for instance, allow it to develop an additional payment method for payments over the internet, with online merchants prepared to pay some of the costs through a higher interchange fee on these transactions.

A second potential advantage of Option 3 is that it removes the costs associated with industry attempting to circumvent the regulations and the Board responding to any circumvention. If interchange fees continue to be regulated, it is likely that the schemes will devote increased resources to seeking out ways of transferring funds from merchants to issuers, possibly through increases in scheme fees combined with a system of rebates to issuers. If such arrangements did emerge, regulation might need to become more far reaching and prescriptive – something the Board would prefer to avoid if possible.

There are also a couple of disadvantages of Option 3 compared to Option 2. The main disadvantage is that interchange fees are likely to be higher than under Option 2. Recent evidence suggests that, despite the improved competitive position of merchants, upward pressure on interchange fees remains. While some interchange fees have been reduced, the cap on weighted-average fees is binding, and indeed average interchange fees have risen above the benchmarks in both the credit and scheme debit card systems. In the Board's view, it is unlikely that the competitive environment will be sufficiently strong under Option 3 to deliver interchange fees lower than those being proposed under Option 2.

Higher interchange fees raise two distinct concerns. The first is that high fees can be associated with significant rent seeking and marketing which serves little useful purpose. The available evidence suggests that issuers’ profits tend to rise with the level of interchange fees (indicating that this market is not perfectly competitive), prompting more marketing to attract cardholders. In the United States, for example, which has substantially higher average interchange fees than Australia, 5.2 billion solicitations for new credit cards were mailed to households in 2007 – an average of around 45 solicitations per household.^[2]

The second is that a potential distortion is created between the card-based systems with interchange fees and those systems without interchange fees. In particular, the direct cost to consumers of using the systems with interchange fees might be lower than that of the other systems, even though these systems might have higher underlying resource costs. This could lead to a migration of payments from these other systems even though such a migration would possibly reduce the overall efficiency of the payments system. It is important to note, however, that under Option 3, the Board's long-standing concerns about the relativity of interchange fees between the EFTPOS and scheme debit and credit card systems would be somewhat lessened. With all schemes free to set their own fees, there would be fewer grounds to be concerned that the resulting interchange fees were causing distortions, at least between these systems.

Another potential disadvantage of Option 3 is that it may provide less legal certainty. If the Board were to step back from regulation of interchange fees, the concerns over the setting of interchange fees that led to investigation by the ACCC over the course of 2000 and 2001 might remain. The exemption that currently exists in the Trade Practices Act 1974 for interchange fees set in compliance with the Bank's Standards would no longer apply. It is therefore possible that the industry would need to seek authorisation from the ACCC for interchange fees. As has been demonstrated, for example in the case of EFTPOS interchange fees and cases currently underway in the United States, this can be a difficult and costly process. Furthermore, it may take many years to resolve, increasing uncertainty and potentially affecting investment and innovation in card payment systems.

6.3 Assessment

In the Board's view, the main consideration in deciding between Options 2 and 3 is whether the competitive environment can be made sufficiently strong to give the Board confidence that, in the absence of interchange fee regulation, the outcome would be one that promotes the efficiency of the payments system as a whole.

This is a difficult judgement. The Board recognises that the competitive forces on interchange fees are unusual and sees a strong case for Option 2. However, the potential advantages of Option 3 are such that the Board is prepared to remove interchange regulation if industry takes further steps to improve the competitive environment. If the necessary steps are not taken, the Board's current thinking is that interchange regulation will remain, and that the Standards will be altered to further reduce credit card interchange fees and eliminate the difference in fees between the various debit card systems as outlined under Option 2.

It is important to note that the Board is only contemplating the possibility of Option 3 as a result of the significant changes in the payments system that have occurred in response to the previous reforms. In particular, the increased transparency in the payments system and the growing prevalence of surcharging have changed the competitive environment and prompted better price signals to consumers. The Board's focus on interchange fees has also served to increase merchant understanding of these fees and this has helped improve the competitive environment.

Notwithstanding these changes, and the further changes required under Option 3, the Board remains concerned about the likely strength of the competitive forces acting on interchange fees. The possibility remains that these changes, while significant, may still not go far enough to create the competitive environment that is required. Therefore, if Option 3 were implemented and average interchange fees in the credit card systems were to increase materially, the Board would consider reimposition of interchange regulation, probably along the lines of Option 2. This reflects the Board's view that a rise in average interchange fees would likely be evidence that, despite its best efforts, insufficient competitive forces had been able to be brought to bear on these fees.

A significant issue with this option is timing. The Board understands that some of the changes being contemplated are substantial and will take time to implement. On the other hand, experience suggests that industry-based reforms can take longer than is strictly required.

The Board is proposing that the current interchange arrangements remain in place for the time being and that at its August 2009 meeting it re-assess the progress made in improving the competitive environment. If at that meeting it was decided that inadequate progress had been made, the Board would consider implementing arrangements similar to those outlined under Option 2. At that point it would release revised Standards for consultation, with a likely implementation date in the first quarter of 2010.

If instead, the various issues had been adequately addressed by August 2009, the Board would take steps to remove interchange regulation, with the likely implementation date in the first quarter of 2010.

In the interim, the Board intends to make a technical modification to the Standards to avoid industry undertaking the currently scheduled cost studies in 2009. The card schemes will, however, still be required to comply with the current benchmark on 1 November 2009.

The Board is prepared to implement any new arrangements earlier than indicated by the above timetable if industry is able to make the requisite changes relatively quickly. It is also prepared to require changes through regulation to the honour-all-cards rule and transparency before August 2009 if it is clear that the schemes are unwilling to make the necessary changes, and that doing so would allow a more timely implementation of a new regime. Achieving such changes voluntarily is, however, preferable.

Footnotes

The Bank stated in Reform of Credit Card Schemes in Australia: IV Final Reforms and Regulation Impact Statement that ‘The Reserve Bank is prepared to include the cost of funding the interest-free period as an “eligible cost”, but only as part of the transition to a lower level of credit card interchange fees in Australia.’ (p 37). [1]

Mail Monitor <http://mailmonitor.synovate.com/news.asp>; US Census Bureau. [2]