Reform of Australia's Payments System 4. The Review and Consultation

4.1 The scope of the Review

The origin of this Review is a commitment made by the Payments System Board when it released its final reforms for the credit card systems in 2002 that it would review the reforms in five years. The Review is, however, more wide ranging than was envisaged at that time, and covers all the reforms discussed in the preceding section. This wider scope reflects the interconnections between the various reforms, and the Board's view that the individual reforms are best viewed and assessed as part of a package, rather than on a stand-alone basis. Throughout the reform process, the Board's focus has very much been on the payments system as a whole, not just on the operation of individual payment systems within the overall system.

As important inputs to the Review, the Bank undertook extensive projects on the costs and use of payment instruments in Australia. The study on costs extended the work of the Joint Study by examining the end-to-end costs of a number of different payment instruments, including cards and cash. The study of payment patterns involved a survey of consumers on their use of various payment methods and an analysis of data supplied by financial institutions and merchants. The results of these studies were presented at the Payments System Review Conference in November 2007.

The Review is intentionally forward looking. While the Board has considered the effects of the reforms to date in detail, its main focus has been on how best to establish a set of arrangements that are conducive to ongoing strong competition in the Australian payments system and the efficient evolution of the system over the longer term.

4.2 The consultation process

The Board has been keen to ensure that the Review is as open and transparent as possible, and the Bank has consulted widely with interested parties.

The first step in the consultation process was in September 2006, with the Bank seeking submissions from interested parties on the scope and process of the Review. Most submissions called for the Review to be broad in nature and to cover all the Bank's reforms, not just those relating to the credit card system. This is reflected in the broad scope of the Review.

The second step was the publication of Reform of Australia's Payments System: Issues for the 2007/08 Review in May 2007 (the Issues Paper). This paper provided a summary of recent developments in card payment systems and sought industry feedback on three interrelated questions:

1. what have been the effects of the reforms to date?
2. what is the case for ongoing regulation of interchange fees, access arrangements and scheme rules, and what are the practical alternatives to the current regulatory approach? and
3. if the current regulatory approach is retained, what changes, if any, should be made to the standards and access regimes?

In total, 27 submissions were received by the Bank and these are published on the Bank's website; Appendix 1 provides a list of those who made submissions. Twenty parties took up the invitation to discuss their submissions with the Bank. The Bank has also held a significant number of other related meetings with industry participants, including consumer groups.

The third step was the Payments System Review Conference in November 2007, held jointly by the Bank and the Centre for Business and Public Policy at the Melbourne Business School. Around 90 participants were invited, representing financial institutions, merchants, card schemes, industry associations, consultants and academia. All members of the Payments System Board attended. The first part of the conference involved a discussion of two commissioned papers and the results of the Reserve Bank's studies of the use and cost of payment instruments. The second part took the form of an open forum discussing the reforms to the card payment systems, particularly the issues of interchange fee regulation, innovation and access. The conference proceedings are published separately and available on the Bank's website.

4.3 Views expressed during consultation

The Board has found the consultation process very helpful, although in a number of areas the views expressed have been diametrically opposed to one another. In part, these divergent views reflect the fact that the reforms have had quite different effects on the various parties. While it is difficult to accurately represent individual positions without reference to the complete submissions, in general the stances of the key stakeholders on the direction of policy can be characterised as follows:

• large financial institutions supported the relaxation of interchange fee regulation and potentially moving to a self-regulatory arrangement, but argued that the no-surcharge and honour-all-cards Standards should be retained;
• smaller financial institutions had concerns about the impact of interchange regulation on scheme debit and about the honour-all-cards Standard;
• merchants broadly supported the reforms and argued strongly for a move to zero interchange for all card payment systems; and
• the regulated card schemes argued for the removal of all regulations, although one indicated that it could accept an approach in which the no-surcharge and honour-all-cards Standards remained in place in their current form if interchange fee regulation were removed.

Given the strongly held positions there was little explicit support for the status quo.

The three sub-sections below set out the main points made in response to the questions in the Issues Paper.

4.3.1 The effects of the reforms

The consultation process revealed a general agreement on a number of effects of the reforms. These included: a substantial reduction in merchant service fees; a significant change in relative prices facing cardholders for credit cards and debit cards; an improvement in the competitive position of merchants; and a significant increase in the prevalence of surcharging for credit card payments, although the majority of merchants still do not levy a surcharge. In a number of other respects, views on the effects of the reforms were more varied.

On the removal of the no-surcharge rule, a number of parties, including the banks, argued that merchants' capacity to surcharge had increased competitive pressure on interchange and merchant service fees. Better price signals to consumers also resulted when merchants chose to surcharge. In contrast, others argued that, despite improving competition at the margin, surcharging is not yet sufficiently widespread for it to have had a substantial effect. In this context, it was noted that the capacity of merchants to surcharge varied. For instance, it was argued that both retailers with market power and billers are in a better position to surcharge than are many merchants in the retail sector where payments are made at the point of sale. It was also argued that surcharging is sometimes excessive and that there has been substantial damage to scheme brands.

Similarly, there were various views on the benefits of the modification of the honour-all-cards rule. Merchants generally argued that modification of the rule had been beneficial in providing the freedom to choose which cards they accept and, thereby, control costs. Against this, the schemes argued that the removal of the rule had provided no benefits to consumers and, if anything, had increased the potential for confusion. As a result, the change had caused damage to their brands. It was also noted that because the majority of merchants currently receive blended pricing – with a single merchant fee for all scheme card transactions – there is little incentive for most merchants to differentiate between cards and, thus, the modification of the rule has had limited effect.

Submissions put forward a variety of views about the effects of the reforms on individual payment systems. The four-party card schemes argued that the absence of regulation of three-party schemes provided a competitive advantage to these schemes. The fact that merchant service fees for the three-party schemes have declined by less than those for the four-party schemes was cited by some as evidence of this. The three-party schemes disputed this conclusion, noting that there had been a minimal shift in market share to three-party schemes, and that surcharging has had a particularly detrimental effect on their businesses because their surcharges tend to be higher. Furthermore, the decline in merchant service fees for the three-party schemes was argued to be evidence that these schemes have come under competitive pressure.

In relation to competition between the regulated card schemes, some submissions argued that the common interchange fee benchmark limits the ability of these schemes to compete effectively for issuers. Furthermore, it was argued that the backward-looking nature of the weights used in the compliance calculation can provide a competitive advantage where a scheme chooses to apply a high interchange fee to a card category in which it has relatively few cards on issue.

Submissions on the effects of the reforms on financial institutions highlighted the perceived disproportionate effects on smaller institutions. Some argued that the honour-all-cards Standard had a significant effect on smaller financial institutions which typically offer a more limited range of payment products than larger institutions, and rely more heavily on scheme debit products for which interchange fees have declined significantly.

4.3.2 The case for ongoing regulation and alternatives

Submissions tended to focus on the case for relaxing or removing regulation and specific regulatory approaches. The issue that attracted most attention was the regulation of interchange fees. As with other aspects of the reforms, a variety of views were expressed.

Some submissions arguing for a removal of interchange regulation stated that consumers are worse off as a result of the reforms. In support, these submissions cited the rise in annual fees on credit cards, reductions in the value of loyalty programs and surcharges. They also typically argued that merchants have not reduced their prices in response to lower interchange fees, but have instead increased their profits.

In addition, a number of other arguments were raised, including the following:

• the regulations have added significant cost, complexity and uncertainty to financial institutions' businesses;
• it is difficult to implement competitively neutral interchange regulation, both among card systems and against other platforms;
• participants will inevitably find ways around the regulations, leading to the prospect of further distortions and/or further regulation; and
• the regulations have impeded innovation, with effort being diverted to managing interchange fees rather than developing new products.

A number of submissions argued that the increase in competition in the market over recent years means that interchange regulation can be removed or relaxed, or that additional changes could further increase competition sufficiently to allow this to occur. A common argument in favour of this approach was that the combination of regulations on the no-surcharge and honour-all-cards rules means that there is now sufficient competition in the market to address the Board's concerns about the setting of interchange fees. Merchants disagreed with this argument. They argued that despite the removal of the no-surcharge and honour-all-cards rules, regulation is still necessary to ensure interchange fees do not rise substantially. In their view, the competitive forces on interchange fees remain very weak.

In the Issues Paper, the Bank asked specifically whether the no-surcharge Standard alone could address its concerns over interchange fees. The large banks, in particular, suggested that this Standard had sufficiently changed the competitive environment to allow interchange regulation to be removed. In contrast, merchants argued that, while the abolition of the no-surcharge rule has been beneficial, surcharging is not yet sufficiently widespread for there to be confidence that surcharging is effective in constraining interchange fees.

Financial institutions generally supported some form of self-regulation taking the place of formal regulation, although for some (typically smaller) institutions, support was contingent on how representative the governance of those self-regulatory arrangements would be. In contrast, the merchants argued against self‑regulation, and even some supporters of self-regulation said that they could not see it working for interchange fees. There was greater support, however, for self-regulation with respect to technical standards, payment system rules and access, encouraging competition and coordinating innovation.

The main self-regulatory proposal was put by APCA, which envisages a self-regulatory body working in conjunction with the Bank. At this stage, however, details on how such a body might work are still being developed by industry, and no specific model has been put to the Bank.

Another factor identified as having a bearing on the prospects for successful relaxation of regulation is the capacity of the EFTPOS system to provide effective competition to scheme products. Some submissions, including from representatives of the banking industry, argued that competition from EFTPOS had the potential to exert competitive pressure on fees, but that changes to EFTPOS governance arrangements would be required for it to do so. At the same time, some banks indicated a reluctance to spend money on marketing or innovation with respect to EFTPOS, arguing that returns on investment from scheme products were significantly greater than for EFTPOS.

Some submissions also raised the possibility that competition in acquiring could be prompted by requiring three-party schemes to open up acquiring of their cards. Another option raised was allowing merchants, rather than cardholders, to choose the network over which a card transaction is processed.

While interchange regulation drew the most comment, the schemes' submissions argued for the removal of all regulation, including the no-surcharge and honour-all-cards Standards. These submissions cited the benefits of a prohibition on surcharging in terms of ensuring consistency of cardholder treatment regardless of payment choice, as well as protecting cardholders from price gouging by merchants with market power. In addition, some submissions suggested that surcharging inappropriately limited the ability of card systems to use pricing structures to promote network growth and/or provide incentives to engage in cost-reducing practices.

The schemes and the smaller financial institutions argued for the removal of regulations governing honour-all-cards rules. The schemes argued that honour-all-cards rules enhance convenience and competition by reducing search costs to cardholders, and facilitate greater competition among issuers and acquirers. As significant issuers of scheme debit cards, the smaller financial institutions emphasised the detrimental effect of the honour-all-cards Standard on their competitive position.

4.3.3 Changes to the Standards and Access Regimes

The issues addressed under this question included: whether interchange fees should be reduced further, perhaps to zero; the transparency of scheme fees; and a number of technical issues related to the operation of existing regulation.

Merchant submissions advocated a further reduction in interchange fees. Their preference was for these fees to be set to zero (or equivalently abolished), with one submission arguing that, if this did not occur, the costs of the interest-free period and of fraud prevention should be removed from the benchmark calculations for the credit card schemes.

Financial institutions and the card schemes opposed moving to zero interchange, arguing that interchange fees play an ongoing part in developing and maintaining a card system.

Some submissions approached this question from an analytical perspective. One argued that interchange fees are not essential to the operation of card systems and are unlikely to be set efficiently by the schemes. A second argued that econometric evidence supported the ‘neutrality hypothesis’ – that interchange fees have no long-run effect on merchants' and consumers' choices when surcharging is possible. Interchange fees could, therefore, be set at any level, including zero. It was also noted, however, that there are costs of imposing regulation and if a cap is imposed, it should be done in a way that minimises regulatory costs.

A number of parties suggested that the interchange differential between scheme debit and EFTPOS is putting EFTPOS at a competitive disadvantage, especially by failing to provide issuers with the incentive to invest in the EFTPOS system. As such, consistency in the setting of debit card interchange fees would put EFTPOS and scheme debit on a more even footing.

Comments were also provided on the way in which interchange benchmarks are set, with a number of calls for greater consistency between payment instruments. Comments included the following:

• the current credit card methodology should be applied to all card payment systems;
• fraud costs and the cost of the interest-free period should be removed from the credit card benchmark;
• fraud costs should be included in the scheme debit benchmark;
• the methodology should take account of relevant costs of both issuers and acquirers; and
• a cost-based approach is a prerequisite for the survival of new entrants that are only issuers or acquirers because these organisations do not have the capacity for cross-subsidisation between issuing and acquiring functions.

A number of submissions also commented on the current exclusion of cash-out transactions from the EFTPOS interchange fee Standard. Several argued that these transactions should be treated the same as EFTPOS purchases. Among other things, it was argued that the different treatment of cash-out transactions was complicating negotiations over EFTPOS access. Other submissions emphasised that EFTPOS cash-out transactions should receive regulatory treatment that is consistent with ATM transactions.

There were also a small number of submissions suggesting the need to review compliance aspects of the interchange Standards. One submission argued that, if interchange regulation is retained, common weights should be used for determining the schemes' weighted-average interchange fees for comparison with the benchmark. It argued that this would remove schemes' capacity to exploit differing compositions of card portfolios to gain market share in particular segments. Another submission raised concerns that the regulated schemes are exploiting the period between compliance calculations in a way that allows weighted-average interchange fees to rise between compliance dates.

A number of submissions expressed concern that scheme fees could be used in a manner similar to interchange fees – that is, to raise revenue from acquirers and merchants to pay to issuers and cardholders. These submissions called for structural changes to generate competition over scheme fees (for example, allowing acquirers to choose which network routes transactions to issuers) or to subject these fees to greater scrutiny.

The main issues prompting comment other than interchange regulation related to the honour-all-cards and no-surcharge Standards. Some submissions supported further modifications to the honour-all-cards Standard as a way of further improving the competitive environment. One suggestion was to extend the Standard to cover all categories of card with a different interchange fee, rather than simply debit and credit cards as covered currently.

Other submissions expressed concern that an extension of the honour-all-cards Standard would lead to high levels of confusion among consumers, particularly foreign visitors.

A number of parties raised the possibility of imposing a cap on any surcharge imposed by merchants, or requiring that surcharges bear a reasonable relationship to the cost of accepting a card. In particular, it was argued that such a cap could help limit the brand damage that can occur as a result of merchants surcharging excessively.