Review of Card Payments Regulation 4. Competitive Neutrality and Net Payments to Issuers

4.1 Issues for the Review

The Board reviewed issues pertaining to the competitive neutrality of card payments regulation; that is, the implications of regulation applying to some card schemes but not to others. In this regard, a particular focus was on the emergence of American Express ‘companion card’ arrangements subsequent to the Bank's regulation of interchange fees in four-party card schemes (e.g. Visa and MasterCard) in the early 2000s.^[19] The fees paid by American Express to banks that issue these cards are currently not regulated by the Bank, whereas the interchange fees paid in four-party schemes are regulated.

American Express has traditionally operated as a ‘three-party’ scheme whereby it both issues and acquires card transactions; there is therefore no role for interchange fees, and American Express and other three-party schemes have not been subject to the Bank's interchange regulation. In a companion card arrangement, American Express acquires transactions but partners with financial institutions to issue cards. As part of the arrangement, bilaterally negotiated fees are paid from the scheme to the issuer and, in many respects, these are economically equivalent to the interchange fees paid in traditional four-party arrangements; both are aimed at encouraging banks to issue cards, and support rewards programs and other benefits that promote use by consumers. In particular, some (referred to here as ‘issuer fees’) are related to transaction flows in much the same way as interchange fees.

It has been argued for some time that the different regulatory treatment of payments in companion card arrangements has created incentives for banks to issue companion cards, which, in turn, has contributed to an increase in the market share of American Express. The popularity of companion card arrangements means that average payment costs in the economy are higher than envisaged under the Bank's weighted-average interchange cap of 0.50 per cent. It has also been argued that, because companion cards have led to American Express cards being more widely held than in the past, fewer merchants are willing to decline American Express. Nonetheless, American Express cards are not as widely accepted as Visa and MasterCard cards and are more often surcharged, or surcharged at a higher rate. This means that American Express is likely to have less market power overall than the other two international card schemes, although this may not be the case in certain industries or segments of the market.

A connected issue is that, in addition to interchange (or interchange-like) fees, both companion card and traditional four-party arrangements may involve the payment of other incentive or marketing fees to issuers. Such fees may incentivise the issuance of particular types of cards. Rather than flowing directly from acquirers, as occurs with interchange fees, these are funded by scheme fees collected by the scheme itself. Schemes can potentially structure non-interchange payments to issuers in ways to circumvent interchange regulation. The Review has therefore considered whether these other payments should also be subject to regulation.

Finally, the Board has considered whether regulation of any other scheme that is not currently designated is warranted.

4.2 Options presented in consultation

The Bank consulted on three approaches to companion cards and associated issues of competitive neutrality:

1. Retaining the current arrangements: companion card issuer fees and other payments to issuers would remain unregulated; interchange fees in four-party schemes would continue to be regulated.
2. Removing regulation of interchange fees for four-party schemes: the four-party schemes would be able to set their interchange fees at their preferred levels to directly compete with American Express companion card arrangements.
3. Regulating issuer fees and other payments to issuers: under this option, payments to issuers of American Express companion credit cards would be regulated. Interchange-like American Express issuer fees and interchange rates in four-party schemes would be subject to the same regulatory benchmarks. Other payments to issuers – in both three- and four-party schemes – would be subject to rules on ‘other net payments’. The implication of the latter is that schemes would not be able to make non-interchange payments to issuers in excess of any payments that they may receive from issuers.

The Board's preliminary view, expressed in the December Consultation Paper, was that regulating all payments to issuers (the third option) would be in the interest of payments system efficiency and competition. This view was reflected in the draft standards, which also proposed the introduction of a general and objective anti-avoidance provision to minimise the possible circumvention of the Bank's standards.

With regard to other payment systems, the Consultation Paper noted that some additional systems had been designated in October 2015, in the context of this Review. This raised the question of whether designation and regulation should be considered for other systems. One approach would be to publish thresholds for when a payment system would be subject to regulation, potentially based on market share as suggested in the FSI Final Report.

4.3 Stakeholder views

There were stakeholders on either side of arguments for and against the regulation of interchange-like payments in companion card arrangements. The international four-party schemes argued that if four-party card systems continue to be regulated, all the payments associated with bank-issued companion cards from three-party schemes should be subject to interchange regulation. Consumer groups and most merchants, along with some financial institutions that do not issue companion cards, were supportive of the proposed change in regulation.

American Express argued that the proposed regulation would be detrimental to competition between card schemes because it would benefit the international four-party schemes, which together already account for a large share of the cards market. Some issuers of companion cards focused on the potential disruption to their business models if companion card arrangements were regulated. More generally, it was argued that concerns about ‘competitive neutrality’ had been overstated because American Express had a much smaller share of the cards market than the two largest four-party card schemes; and because American Express cards are not considered ‘must-take’ cards by many merchants and are more often subject to a surcharge.

Several submissions argued that, in addition to companion cards, American Express proprietary cards should be regulated. One argument was that leaving American Express three-party cards outside the regulatory framework would lead to growth in higher-cost schemes and negative outcomes for merchants and consumers. A number of submissions, most notably from the largest four-party schemes, also argued for the designation and regulation of other systems – for example, PayPal, JCB and UnionPay – and/or for the publication of explicit thresholds that would trigger designation.

4.4 The Board's assessment and conclusions

4.4.1 American Express companion cards and competitive neutrality

The Board considered companion cards when they were first issued in the mid 2000s and again at the time of the 2007–08 review of payments system reforms. It decided against regulation at that time, partly because it believed that imposing ‘interchange’ regulation would have relatively little effect on merchant charges, given that these were negotiated directly between the merchant and American Express as the sole acquirer. Since then, companion cards have become a more significant part of the market, with issuance by two more of the major banks, meaning that shifts in issuer and cardholder behaviour will have a more significant effect on merchant costs. Furthermore, at the time the Bank acknowledged that, to be effective, regulation would need to capture both interchange-like payments and other payments to issuers. The Bank's view was that regulating the latter payments would be a major step that it was not prepared to take at that time. However, as discussed in section 4.4.2 the Board has reconsidered that view, partly reflecting the implementation of similar restrictions in other jurisdictions.

The Board accepts that the absence of regulation of payments between American Express and its partner banks in companion card arrangements has influenced the development of the market. Over the past decade, issuance of companion cards has grown faster than that of four-party schemes' cards and of traditional three-party cards. Adjusting for series breaks, the combined share of credit and charge card transactions accounted for by American Express and Diners Club has increased by around three percentage points since the early 2000s and currently stands at around 19 per cent.^[20] This change largely occurred in two steps, around 2004 and 2009, which coincided with the introduction of bank-issued American Express companion cards by the major Australian banks. While these figures do not separate American Express companion cards from traditional three-party cards, household survey evidence indicates that bank-issued American Express cards have steadily increased their market share since their introduction.^[21]

The Board's assessment is that issuer fees in companion card arrangements play a very similar role to interchange fees in influencing payment behaviour. The same can be true of marketing and other payments to issuers from schemes – both three- and four-party. Together, these payments have promoted the issuance by banks of companion cards with comparatively generous cardholder benefits (rewards programs), and provided incentives for cardholders to use these cards ahead of other payment methods. For example, the spending required to earn a reward of a $100 voucher is typically one-half to two-thirds lower with an American Express companion card than with a MasterCard or Visa card linked to the same account. The Board's assessment therefore is that these payments are distorting payment patterns and promoting the use of products with relatively high resource costs, through means that are very similar to the interchange fees that the Board determined in 2002 that it was in the public interest to regulate.

The Board considered the argument, made by American Express and some other stakeholders, that the bilateral nature of negotiations between issuers and the scheme in companion card arrangements justifies companion cards remaining outside the regulatory perimeter. As discussed above, the Board's assessment is that the flow of fees in companion card arrangements influences behaviour in much the same way as credit card interchange payments, regardless of the manner in which they are negotiated. The Board also noted the argument that companion cards should remain unregulated because American Express has a much smaller market share than MasterCard and Visa. However, American Express companion cards hold a sufficient market share that the effects of interchange-like payments on payment behaviours are material. Further, an expansion in market share of the credit and charge card market and an increased cardholder base appear to be influencing merchant behaviour. Consultation has indicated that a wider cardholder base and acceptance by large retailers, such as major supermarkets, has put pressure on smaller competitors to also accept American Express, and to not surcharge when doing so. Moreover, American Express has a strong presence in particular segments, meaning that American Express is likely to be considered a ‘must-take’ card among businesses that cater to customers that are more likely to hold American Express cards (e.g. high-end retailers) or in particular sectors of the economy (e.g. travel).

The Board acknowledges that regulation will likely result in a reduction in benefits to holders of companion cards. However this reduction itself represents an improvement in price signals; a cardholder's choice of payment method will be less influenced by differences in the level of payments flowing from schemes and acquirers to issuers, and better reflect the relative attributes of the payment systems themselves. This should result in more efficient payment choices and, based on the Bank's estimates of the relative resource costs of payment systems, a lower-cost payment system overall. The Board notes that regulating companion cards, similar to the ceiling on the highest interchange rates, will also have distributional implications. American Express companion cards, like high-rewards four-party cards, are more commonly held among higher-income individuals. As a result, people on lower incomes are often effectively subsidising those on higher incomes. To the extent that this effect is reduced, equity will be enhanced in the payments system.

Because merchant service fees on all American Express cards (companion and proprietary) are negotiated bilaterally between American Express and merchants, regulation of companion cards may not affect merchant service fees directly. Initially, merchants are more likely to see reductions in their payment costs as a result of changes in payment patterns brought about by the improved price signals discussed above. Over time, the competitive forces that have seen American Express merchant service fees decline steadily since the Bank first regulated payment cards can be expected to continue, including as a result of elements of the current regulatory package.

4.4.2 Non-interchange payments to issuers

As discussed above, the Board's view is that placing schemes on an equivalent footing in terms of the relative incentives that can be provided to issuers and cardholders (funded by merchant fees) would require both the application of ‘interchange fee’ regulation to all schemes and a broadening of the type of payments that are captured in that regulation. The Board's assessment is that, for competitive neutrality and more broadly to prevent possible circumvention of the interchange regulations, it is appropriate for there to be equivalent limits on payments from both three-party and four-party schemes to issuers. The inclusion of a broader range of flows between issuers and schemes is consistent with recent changes to the regulatory framework for credit and debit cards in the European Union and also the regulation on debit card interchange fees in the United States under the Durbin Amendment.

4.4.3 Regulation of other payment systems

As noted in chapter 2, the Bank designated the bank-issued American Express companion card system, the Debit MasterCard system and the eftpos, MasterCard and Visa prepaid card systems in October 2015. These decisions were taken in the public interest as the first of a number of steps that the Bank is required to take to exercise its regulatory powers. Decisions in relation to the regulation of these systems are discussed in chapter 3 (interchange) and chapter 5 (surcharging).

The Board also further considered whether other payment systems should be designated, including the case for introducing regulatory thresholds as recommended by some stakeholders and the FSI Final Report. The Consultation Paper noted the Board's preference not to publish explicit numerical thresholds at that stage. Following further consultation, the Board remains of the view that it would not be appropriate to establish this type of automatic trigger for the application of the Bank's power to set standards under the PSRA.^[22] While automatic thresholds could have the benefit of providing greater clarity to market participants, fixed thresholds are unlikely to be entirely consistent with the public interest requirements of the PSRA. That is, it is the Board's view that judgements about competition and efficiency involve more complex considerations than just metrics such as market share.

With regard to specific payment systems, the Bank received representations both for and against the regulation of a number of additional (typically smaller) participants. Some argued, for example, that American Express three-party arrangements should be subject to interchange regulation. As has been noted in the past, American Express proprietary cards do not involve the payment of interchange fees (or their equivalent as in companion card arrangements), therefore equivalent regulation is neither possible nor justified. Some parties also noted the potential for three-party schemes to establish outsourced distribution agreements for their proprietary cards, including through banks. The Bank sees this as a normal commercial arrangement that could be put in place with any company with a significant retail distribution capability. Notably, payments under these arrangements are from the issuer (in this case the three-party scheme) to the outsourced provider, rather than to the issuer to promote issuance and cardholder benefits. The underlying card product remains a three-party product, as discussed above.

While the Board does not see a need to extend interchange fee regulation beyond four-party schemes and companion cards, it nonetheless wishes to ensure that competitive forces apply to the pricing of three-party products to merchants, including through the application of appropriate surcharges. The Board is confident that issues in relation to surcharging and American Express proprietary cards can be effectively dealt with via a voluntary undertaking. As discussed in section 5.4.9, American Express has previously made a voluntary undertaking to remove its no-surcharge rule and has agreed to provide an updated undertaking. In the event that the voluntary undertaking – in combination with the regulation of companion cards and the Government's ban on excessive surcharging – was not delivering desirable outcomes on surcharging, the Board would reconsider designating the American Express proprietary card system.

More generally, the Board's expectation is that there would likely be a case for designation if a new four-party card scheme were to undertake any significant domestically focused issuance in the Australian market. This could be relevant in the event that there was significant domestic issuance of UnionPay, a large foreign scheme that is already widely accepted in Australia. In addition, the Board would expect to consider designation of any new companion card arrangements akin to the current American Express model.

Footnotes

Bank-issued American Express cards were initially offered as standalone products. They are now issued as part of a companion arrangement where customers are provided an American Express card as part of a package with a MasterCard or Visa credit card, with both cards accessing the same line of credit. [19]

Within these data, a fall in Diners Club's market share has partly offset an increase in American Express's market share. [20]

See Ossolinski, Lam and Emery (2014). [21]

The Bank has implemented thresholds in relation to the regulation of purchased payment facilities (PPFs), as intended by the provisions of the PSRA that relate to PPFs (e.g. section 9 and section 25). However, equivalent provisions do not exist for the powers used by the Bank to regulate card payments. [22]