Review of Card Payments Regulation 3. Interchange Fees and Transparency of Card Payments

3.1 Issues for the Review

This Review has addressed a number of issues relating to the regulation of interchange payments. These include: issues relating to the level of interchange fees; the widening range of interchange fees and implications for the transparency of payment costs; the coverage of the interchange benchmarks (most notably questions concerning prepaid cards and transactions on foreign-issued cards); and the current system for ensuring compliance with the benchmarks. It also raised the issue of whether interchange-like payments to issuers from three-party schemes (notably in the American Express companion card system) should be regulated in the same way as interchange fees in standard four-party business models; this issue is addressed in Chapter 4.

The Issues Paper noted the Board's view that the weighted-average interchange fee benchmarks introduced in the early 2000s have constrained the potential for interchange fees to distort efficient payment choices and have underpinned a fall in the overall resource cost of payments. However, it raised the question of whether the current benchmarks might be inefficiently high; indeed, the Board had considered the possibility of lowering the benchmarks to 0.30 per cent for credit and to 5 cents or even zero for debit when it last reviewed the benchmarks in 2007–08. The FSI Final Report had also concluded that lower interchange fees would improve the efficiency of the payments system. Lower interchange fee caps would likely lead to a reduction in merchant service fees and to product prices being lower than they would otherwise have been for all consumers.

In addition, the Issues Paper noted that average interchange rates, especially for credit cards, have tended to rise to levels significantly above the benchmarks within three-year compliance cycles as schemes and issuers have taken greater advantage of the flexibility offered by the three-year framework. Accordingly, the Bank asked for stakeholder views on moving towards more frequent observance of the benchmarks.

Another development in the schemes' setting of interchange schedules has been the increase in the number of categories and the widening of the range of the rates applying to the categories. The schemes' schedules specify the interchange rate to be paid on a transaction, based on the category of merchant (‘strategic’, service station etc), the type of card (various types of premium cards, corporate etc) and the nature of the authentication (contactless, SecureCode etc) or value of the transaction. There is a hierarchy of categories, which determines how the merchant, card and transaction categories interact. Typically, the relatively low ‘strategic’ interchange rates for large merchants take precedence over the interchange category for the type of card, so that the same relatively low rate for strategic merchants applies for all their transactions, including for those using premium cards with high interchange rates. However, merchants who do not have access to strategic or merchant-specific rates will face different rates based on the type of card presented.

One consequence of these developments in interchange schedules is that there are now large differences in the average interchange rates paid on the transactions of strategic or qualifying merchants compared with other merchants. For example, the Bank estimates that the average credit card interchange rate for non-preferred merchants (i.e. those not benefiting from strategic or other preferential rates) was around 55 basis points higher than the interchange rate applying to preferred merchants in the September quarter of 2015. For MasterCard and Visa debit cards, the average interchange rate paid by the non-preferred group of merchants is estimated to have been around 13 cents per transaction higher than the rate applying to the preferred group.^[9] These differences in interchange rates have a corresponding effect on the merchant service fees faced by the two groups. A second consequence of the complex interchange fee schedules is that the non-preferred merchants have little transparency over the cost of particular transactions. In the case of a MasterCard or Visa credit card transaction, the interchange rate is currently around 0.25–0.30 per cent on a standard card but will be 1.80–2.00 per cent if the transaction involves the highest level of premium card. In the case of an average-sized debit transaction, the interchange payment would be around 6 to 8 cents on a standard debit card transaction but around 45–50 cents on a premium or commercial card. Without any visibility over the cost of the particular card used in the transaction, a merchant that wishes to charge to reflect the much higher cost of some cards is unable to do so.

The Bank also considered the types of transactions covered by interchange caps. The Issues Paper noted that there was a degree of ambiguity on interchange arrangements for prepaid cards (which are not explicitly regulated) and that it would be useful to clarify this as part of the Review. Subsequently, consultations with stakeholders have also focused on whether commercial cards should continue to be subject to the same interchange regulation as personal cards. In addition, the Bank has raised the question of whether transactions in Australia on foreign-issued cards should be subject to the same regulation as transactions on domestically issued cards. The Consultation Paper noted both the consideration being given in the European Union to regulation of interchange fees on foreign-issued cards acquired in Europe, as well as the Bank's concern about the possibility of circumvention of Australian regulation by foreign issuance.

3.2 Options presented in consultation

The Consultation Paper outlined a range of potential policy measures to address efficiency and competition concerns and improve the transparency of payment costs for merchants. The Board reached a preliminary view on its preferred options in November and incorporated these in the draft standards published with the Paper.

In the case of the interchange benchmarks, the Board considered a range of options including: leaving the current framework unchanged; removing interchange regulation but introducing other measures to increase the transparency of interchange fees to merchants and strengthen their ability to respond to high-cost cards; retaining a weighted-average framework for the benchmarks, supplemented by a ceiling on individual interchange rates; and reducing the weighted-average benchmarks. For credit, the Board's preliminary view, as reflected in the draft standards, was that it would be appropriate to retain a 0.50 per cent weighted-average benchmark for interchange and to supplement this with a 0.80 per cent ceiling on individual interchange rates. The Board seriously considered the case for lowering the benchmark to 0.30 per cent but came to the view that supplementing the benchmark with a ceiling would bring about a meaningful reduction in certain interchange fees, particularly when combined with tighter compliance and the inclusion of transactions on foreign-issued cards in the calculation of the weighted-average interchange fee. For debit, the Board's preliminary view was that it would be appropriate to reduce the weighted-average benchmark to 8 cents, supplemented by a cap on individual interchange categories of 15 cents, or 0.20 per cent of the transaction value if the category was specified in percentage terms.

On the coverage of the interchange standards, the Board considered the option of exempting transactions on commercial cards from regulation, but reached the preliminary view that it remained appropriate to continue to include such transactions in all aspects of the regulatory framework. Regarding transactions on foreign-issued cards, the Board decided to consult on a draft standard that included transactions on these cards in the regulatory framework, in terms of both inclusion in the calculation of the weighted-average benchmarks and being subject to the caps on individual interchange categories. For transactions on prepaid cards, the Board considered both retaining the current regulatory approach (where interchange arrangements are expected to be ‘broadly in conformity’ with debit interchange arrangements), or making it explicit that transactions on these cards were not subject to any interchange regulation. The Board's preliminary preferred option was to formalise the current ‘expectation’ and make prepaid cards subject to the same interchange regulation as debit cards.

The Board also considered the option of moving from the current three-year compliance cycle to more frequent compliance, to ensure that schemes adhere more closely with regulatory benchmarks. It decided to consult on draft standards that require quarterly compliance with the weighted-average benchmarks. In the event that a scheme's average interchange rates in a quarter were above the benchmark, a reset of interchange schedules within 45 days of the end of the quarter would be required.

3.3 Stakeholder views

Stakeholders expressed a range of views on the appropriate level of interchange caps. End users, such as merchants and consumer groups, were generally supportive of measures to lower interchange fees for both debit and credit, with the growing divergence in interchange rates faced by small and large merchants a particular concern for merchants. Indeed, some end users considered that regulatory caps should be set below the levels proposed in the draft standards; it was observed that the current review presented a ‘rare opportunity’ to implement substantial reforms to interchange regulation. Consumer groups, for example, suggested that a 0.30 per cent cap on credit interchange fees would be appropriate and argued for significantly lower caps on debit interchange than proposed in the draft standards. The domestic debit scheme, eftpos, supported the proposal for a lower benchmark for debit transactions. A few respondents suggested that interchange fees be eliminated altogether.

Conversely, the international four-party card schemes and financial institutions tended to argue that interchange caps should not be lowered. While in some cases noting their in-principle opposition to any interchange regulation, these stakeholders generally welcomed the Board's preliminary intention to retain a 0.50 per cent weighted-average cap for credit interchange fees. However, most of these entities expressed the view that the proposed 0.80 per cent cap on individual credit interchange rates was too low and would limit flexibility in the setting of interchange fees.

A particular issue in this context was the view of the international four-party schemes and financial institutions that commercial credit cards should not be subject to the 0.80 per cent cap on individual interchange categories; some argued also that transactions on these cards should not be included in the calculation of the weighted-average for benchmark compliance. These entities argued that four-party commercial credit and charge cards would be unviable or marginally viable with a hard cap of 0.80 per cent. They argued that commercial cards operate differently from personal cards in that the company holding the card is typically charged neither interest nor account fees, so interchange fees constitute a large share of the issuer's source of revenue. While financial institutions had previously reported to staff that rebates are often paid to holders of commercial cards, submissions from banks and the four-party schemes argued that these cases are relatively few and are available only to the largest corporations. Banks and schemes argued that commercial cardholders receive substantial other benefits in the form of reporting tools, integration with expenditure management software and ongoing relationship management, which are costly for the issuer to deliver.

In contrast, submissions from merchants and a consumer group opposed any differential treatment of commercial cards. Several submissions expressed concerns that any difference in regulatory treatment of commercial and consumer cards could result in circumvention. One merchant submission argued that commercial cards are ‘must-take’ products, difficult to distinguish from consumer cards, and that the benefits to merchants claimed by the schemes and banks were overstated.

On debit, issuers and the international four-party schemes were opposed to a reduction in the weighted-average interchange benchmark and the introduction of a cap on individual debit interchange rates.^[10] According to these stakeholders, lower interchange fees would impede innovation in this segment of the market. Some cited the desirability of avoiding a reduction in revenue to the banking sector at a time when there were many industry projects (the New Payments Platform, eftpos' eHub, and online and contactless acceptance of eftpos) underway. Representatives of smaller financial institutions argued that lowering the caps on debit interchange would increase the incentive to issue credit cards rather than debit cards; this could place relatively small issuers at a competitive disadvantage because their product mix is more oriented to debit products. There was a range of views – but limited strongly held opposition – on the question of whether prepaid cards should be explicitly included within the debit card interchange cap.

Merchants and consumer groups were generally supportive of the proposal to bring domestic transactions on foreign-issued cards within the scope of the Bank's interchange regulation, with some pointing to the growing importance of cross-border transactions.

However, a number of submissions from the industry argued that this was a new issue that had not been raised in the Issues Paper and that it should be subject to further consultation with the industry. MasterCard and Visa were strongly opposed to the proposal, suggesting it was ‘globally unprecedented’, could raise serious concerns from Australia's trading partners and that ‘international comity’ issues may arise. The schemes also suggested that higher interchange rates are needed on cross-border transactions because they are more costly to provide (e.g. because of higher fraud and chargeback risks) and that moving away from a single rate on all international transactions would be computationally burdensome. They argued that reducing the interchange payable to foreign issuers could lead them to implement higher ‘decline’ rates (especially on card-not-present transactions) and harm for the Australian tourism industry, other exporters and the economy broadly. The schemes also suggested that they would be hurt in issuance decisions in foreign markets if competitors in those jurisdictions were not also subject to interchange regulation on transactions with Australian merchants. The schemes acknowledged the Bank's concern about possible circumvention of domestic interchange caps by offshore issuance into Australia and both have committed to preventing this through their scheme rules. Domestic financial institutions have also expressed concern about the proposal, in part because interchange yields on domestic transactions might have to be lowered to accommodate higher international fees within the weighted-average framework. They also noted the potential for other jurisdictions to reduce interchange fees on Australian-issued cards in response to regulation here. The schemes and some banks have also noted the potential for seasonal and other variations in foreign card transactions to make the proposed quarterly compliance methodology more challenging.

In their submissions, most stakeholders accepted that there was a case for more frequent observance of benchmarks, with end users particularly supportive of tighter compliance. The international four-party schemes and financial institutions were, however, generally opposed to quarterly compliance, mainly on the grounds that more frequent resets of fee schedules would be costly. Some respondents argued for annual compliance, noting, among other things, that seasonal variations or unexpected changes in the pattern of transactions could potentially complicate quarterly compliance. Others commented that requiring a reset within 45 days was a potentially onerous requirement.

A number of submissions expressed concern that American Express proprietary cards would remain outside the regulatory framework. A number of submissions, most notably from the international four-party schemes also argued for the designation and regulation of some other systems, including UnionPay, or for publication of explicit thresholds that would trigger designation.

The Consultation Paper asked respondents to provide views on implementation timeframes for the proposed regulatory changes. End users were typically supportive of accelerated implementation. Some financial institutions and schemes argued for significant time to prepare for the new framework, noting the time that would be required for renegotiation of contracts with partners, internal systems changes, rethinking of product mixes and pricing to customers, and notification of customers. Some merchants indicated that they would require time to adjust to any changes in the surcharging standard.

3.4 The Board's assessment and conclusions

3.4.1 The case for interchange regulation

The Board has carefully considered the views of stakeholders and acknowledges that opinions differ on the role of interchange payments and the case for interchange regulation. However, after extensive consultation, and with the benefit of the evidence since the 2003 reforms, the Board remains of the view that interchange regulation has contributed to a more efficient and competitive payments system. It is noteworthy that following a comprehensive review of the financial system, the FSI Final Report reached a similar judgement, endorsing the Bank's overall approach to interchange regulation and recommending that the Board consider further reductions in interchange fees. The current Review has also indicated that end users – both consumers and businesses – support the reforms that the Bank has undertaken since 2003. In addition, regulators and competition authorities in a significant number of foreign jurisdictions have implemented similar reforms over the past decade.

Nevertheless, the Board has again considered whether its concerns about the adverse impacts of high interchange fees on the efficiency of the payments system could be mitigated through policy measures that did not involve direct regulation of interchange fees. In principle, it might be possible to seek to strengthen the power of merchants to respond to high interchange rates in their acceptance decisions, for example by ensuring that merchants were provided with real-time information on payments costs and greater ability to respond when high-interchange high-cost cards were presented by cardholders. However, consultation with stakeholders suggests that this would involve significant costs to the industry. In addition, merchants in a range of sectors have indicated that the principle of merchant surcharging for higher-cost means of payment is still not fully accepted, so that they find it very difficult to surcharge to offset the higher cost of particular ‘must-take’ payment methods. Accordingly, the Board does not consider that it would be possible to step away from interchange regulation and rely on other measures.

3.4.2 The levels of the interchange benchmarks

During the current review, the Board has considered both the case for lowering the interchange benchmarks and changing the nature of the benchmarks from weighted-average caps to hard caps on all interchange fees within a scheme's schedule; the latter now apply in the European Union, with hard caps of 0.20 per cent for debit card transactions and 0.30 per cent for credit card transactions. While the Board has decided to place some constraints on the highest interchange fees that schemes may set (see section 3.4.4), it decided against moving to benchmarks that are hard caps. Accordingly, the draft standards released for consultation in December 2015 continue to specify the benchmarks in weighted-average terms, which will continue to provide schemes with significant flexibility in the setting of interchange fee schedules. The ability for schemes to set higher and lower interchange fee categories may be appropriate in certain situations, for example, where they are seeking to encourage actions such as fraud prevention by issuers, acquirers or merchants.

Regarding the level of the weighted-average caps, the Board accepts that there may be a role for interchange fees in emerging payment systems in encouraging the use of a system by one side of the market or the other. However, the case for significant fees is much weaker as the system becomes well established. The latter conditions clearly apply in Australia; payment cards are now the dominant means of making retail payments, with the relative use of cash declining rapidly (Graph 2). Visa and MasterCard are the two largest schemes and jointly account for around 67 per cent of the value of all card payments (debit, credit and charge). This market share has grown over the past few years, but there has been no tendency for interchange rates in these systems to fall as system volumes have risen and average costs have fallen.

Overall, the current review has not altered the Board's view that there appears to be little justification for significant interchange fee payments in mature card systems. It notes that lower interchange rates would have a number of benefits including: a reduction in the distortion to price signals and therefore an improvement in the efficiency of the payments system; a reduction in payment costs of merchants; reduced cross-subsidisation across consumers paying with different payment methods and downward pressure on retail prices of goods and services for consumers; reduced need for merchants to consider surcharging of more expensive cards; reduced focus on rewards programs and reduced incentives for the use of payment methods with higher resource costs; a reduction in barriers to entry for potential new methods of payment; and a reduction in the extent to which current arrangements in the card payment systems favour large retailers and higher-income consumers.

The Board also notes that there are instances internationally of card systems that function effectively without interchange fees (and, in fact, with ‘negative’ interchange fees, as was previously the case for the eftpos system) and also recent cases where regulators and card schemes have set lower interchange caps than exist in Australia, including by seeking to align interchange fees with the transactional benefits that merchants derive from card payments (the merchant indifference test).^[11]

In the case of debit cards, the Board has decided to reduce the benchmark to 8 cents.^[12] The evolution of the payments system over recent years has seen increasing use of card payments for low-value transactions. This has resulted in the average value of a transaction in the MasterCard and Visa debit card systems falling by around 43 per cent since 2008, which implies that average interchange fees have increased as a percentage of the average debit transaction. A reduction in the weighted-average benchmark could be expected to reduce interchange payments on low-value transactions and may help drive greater acceptance of debit cards for those transactions; currently some merchants do not accept cards for low-value transactions because they consider the transaction costs to be too high. It would also be expected to bring down payment costs for merchants who do not benefit from strategic interchange rates.

In the case of credit cards, the Board considers that there are good arguments that can be made for a lowering of the weighted-average benchmark. Indeed, if there is a case for interchange fees on credit cards to be higher than on debit cards, it is likely to be by only a small amount:

• The existence of significant credit card rewards programs suggests that credit card interchange fees are currently materially higher than is necessary for banks to provide payment cards with credit functionality. The Bank's 2013 Payments Cost Study shows that – for the average-size transaction for each payment method – the existence of the interest-free period and rewards means that the effective price paid by a cardholder to use a credit card is lower than that for a debit card, even though the resource costs are substantially higher.
• While the existence of rewards and the interest-free period provide a significant incentive for cardholders to use credit cards rather than debit cards, the payment functions of debit and credit cards are essentially identical for cardholders and merchants. Thus, it is not surprising, for example, that the work of the European Commission (EC) based on the merchant indifference test suggests interchange fees that are quite similar for debit and credit (and typically relatively close to zero).^[13]
• Card schemes and their participants sometimes cite the benefits to merchants and the broader economy from the credit function of credit cards, which relaxes credit constraints and enables consumers to bring forward the timing of their purchases. However, simple calculations would suggest this aspect can justify only a small interchange differential relative to debit cards. For example, if credit cards allow 10 per cent of annual credit card spending to occur a year earlier than otherwise (presumably an extreme assumption), if merchants' average profit margin is 10 per cent, and if the relevant interest rate is 6 per cent, the aggregate benefit to merchants of credit cards over debit cards and other payment instruments would be just 0.06 per cent of the annual value of spending on credit cards. This would imply an interchange differential of 6 basis points.

Accordingly, the Board has seriously considered a reduction in the weighted-average benchmark to 0.30 per cent, which would be consistent with the cap implemented for all intra-European transactions in the new EU regulations. On balance, however, it has decided against doing so, partly to reduce the risk of unexpected effects on the competitive balance between three- and four-party schemes or of a significant increase in circumvention efforts. It notes, however, that another element of the new credit card standard, the tighter compliance requirements discussed in section 3.4.8, will result in a reduction in average interchange payments. While the Board's objective in undertaking this Review has been to develop a regulatory framework that will not need to be revisited for some time, it will continue to monitor the appropriateness of the 0.50 per cent benchmark, along with other aspects of the regulatory regime.

3.4.3 Interchange fees and innovation

One of the arguments that some stakeholders have used in the Review is that controls on interchange payments are harmful to innovation in the payments system or will stymie the growth of electronic payments. The Board sees no merits in such arguments for a number of reasons.

First, the evidence of the past decade and a half indicates that there has been very strong growth in card payments in Australia. Contrary to the 2001 submission of one of the international four-party schemes, the cards market did not enter into a ‘death spiral’ following the introduction of interchange regulation and the removal of no-surcharge rules (MasterCard International 2001). A comparison of the Australian payments system with other markets suggests that there is no shortage of innovation, including in areas such as the adoption of contactless payments, where Australia leads the world. Indeed, a submission on the recent Consultation Paper from the same four-party scheme noted that ‘Australia is a leader in electronic payments’ (MasterCard Australasia 2016). More broadly, the Bank's regulatory actions do not appear to have made credit card issuing unprofitable; the prevalence of balance transfer offers that offer zero interest for periods of a year or more suggest that financial institutions continue to find the Australian credit card market very attractive notwithstanding the Bank's reforms.

Second, from a conceptual point of view, it is far from clear why a reduction in interchange payments should be viewed as hindering innovation. Innovation in the cards market occurs on both the issuing and acquiring sides. With interchange payments in the international systems flowing always from the acquirer to the issuer, it follows that whether high interchange payments will facilitate or hinder innovation at a particular time will depend on whether the spending that is required at that time is on the issuing or acquiring side.

Third, the Board's view is that a strong case can be made for the Bank's reforms having been supportive of innovation and new entry into the Australian payments system. In particular, as discussed in section 2.4, the nature of competition between mature card systems is for interchange payments to rise to incentivise financial institutions to issue cards from one scheme rather than another and for issuers to use part of those payments to reward cardholders for using cards from that scheme rather than other payment methods. Caps on interchange payments can limit these dynamics and increase the prospects for new payment methods that could emerge and compete with existing systems, based on their underlying costs and benefits to end users.

3.4.4 The widening of the interchange schedules and effect on transparency of costs to merchants

Consistent with the draft standards in the Consultation Paper, the Board has decided to supplement the weighted-average interchange benchmarks with ceilings on the interchange rates that can be applied to particular interchange categories. For credit, the 0.50 per cent benchmark will be supplemented by a cap of 0.80 per cent on any individual interchange category. For debit, the 8 cents benchmark will be supplemented by caps of 15 cents if the interchange fee for a category is specified as a fixed amount and 0.20 per cent if the fee is specified as a percentage amount. Relative to the current interchange schedules, these ceilings will require reductions in interchange fees on commercial cards and on some premium personal cards. The issues with respect to commercial cards are discussed in section 3.4.5.

These ceilings should result in a significant narrowing in the range of interchange fees faced by those merchants who do not benefit from strategic or preferred rates. The Board considers that this means there is little need to consider facilitating differential surcharging of different credit categories or different debit categories; there is also less of a case for requiring schemes to remove their ‘accept all colours’ rules. In addition, there is likely to be a meaningful reduction in the interchange disadvantage of non-preferred merchants, though this will depend on how the schemes choose to reset their interchange schedules in response to this element (and others) of the changes to the standards. The Bank will be considering publishing data on the average interchange rates paid by preferred and non-preferred merchants.

3.4.5 Commercial cards

In deciding to set the ceiling for all credit card interchange rates at 0.80 per cent, the Board has decided against providing special treatment for commercial cards. The Board was not attracted to the option of leaving commercial cards outside of the weighted-average benchmark framework as this would have implied a significant increase in overall average interchange rates. It considered the possibility of allowing a higher cap for these cards while leaving them in the weighted average but decided against doing so.

The Board is not convinced of the arguments that four-party commercial cards will not be viable for issuers unless a materially higher interchange cap is permitted. First, it notes that while MasterCard and Visa currently have interchange rates for commercial cards that are as high as 1.80 per cent, most of their commercial card transactions are currently at interchange rates that are only moderately above 0.80 per cent. Second, as schemes and issuers have pointed out, commercial cards programs provide significant benefits to cardholders and their corporate purchasing departments, especially in terms of reporting tools, integration with expenditure management software, and ongoing relationship management. Providing this functionality may be costly, and by allowing schemes flexibility to set interchange rates up to 0.80 per cent, it will be possible for schemes to ensure that part of the cost of providing it falls on the merchant. But with the benefits of corporate card programs falling mostly to the cardholding side, it should be expected that much of the cost of these programs should fall on that side. This may involve the introduction of fees on these cards, the reduction of the interest-free period, or a reduction in rebates in cases where these are paid.

The Board acknowledges that American Express has a significant presence in this sector, and currently does not typically charge annual fees (and may be more able to pay rebates). However, in choosing a card program, corporate purchasing departments can be expected to take account of all the flows associated with card payments, not just issuer charges and rebates. In particular, they will be aware of the higher cost of acceptance of American Express and the likelihood of higher surcharges than for the four-party schemes. Surcharging is more common in merchant sectors where commercial cards are frequently used, and surcharge differentials between three- and four-party schemes are likely to become larger and more apparent with the new regulatory framework, which is likely to reduce the incidence of blended surcharging.

While raised by a number of parties, the decision to leave commercial cards out of the EU interchange framework is not relevant for Australia, because, among other reasons, it occurred in the context of a hard cap of 0.30 per cent on all credit cards.

3.4.6 Transactions on foreign-issued cards

While the Bank's interchange regulation to date has only covered transactions in Australia on domestically issued cards, the Bank proposed in the draft standards to also include transactions in Australia on foreign-issued cards.

This would be consistent with the likely direction of policy in Europe, where the EC has a competition case outstanding against Visa's setting of its ‘inter-regional’ interchange fees.^[14] The EC has also issued a statement of objection with respect to MasterCard's inter-regional interchange fees.^[15] In each case, the EC's concerns are that the schemes' cross-border interchange fees are collectively set fees that harm competition between merchants' banks, inflate payment costs for merchants and ultimately increase prices for all consumers, including those who are not paying with high-interchange cards.

The Bank's proposal also reflected concerns about possible circumvention of Australia's interchange regulation if transactions on foreign-issued cards are not subject to the same regulation as transactions on domestically issued cards. Indeed, with the reduction in the highest domestic interchange rates to 0.80 per cent for credit and 0.20 per cent (or 15 cents) for debit, there would be a significant incentive for issuers to take advantage of higher foreign interchange rates (which are typically 1½–2 per cent). This prospect is especially relevant for issuers marketing ‘virtual’ cards to Australian corporates. The result would be an increase in costs to Australian merchants and prices faced by Australian consumers and businesses.

More fundamentally, as occurs with domestic interchange fees, cross-border interchange fees are set at high levels to influence the issuance decisions of banks and usage decisions of cardholders. The latter decisions in the most part are not the concern of Australian regulators. However, the direct effect on the Australian jurisdiction is the artificially inflated cost of international cards to Australian merchants, with no competitive process available to place downward pressure on those internationally-set fees. Such effects will become more significant as cross-border transactions inevitably increase.

The Board welcomes the willingness of the card schemes to prevent circumvention of regulation through cross-border issuance. However, it is not persuaded by the objections of the two large international four-party schemes regarding possible jurisdictional issues. While the Bank is sensitive to the international nature of the card schemes, it has a legislated obligation to promote competition and efficiency in the Australian jurisdiction within the limit of its powers. Domestic regulation in many fields affects foreign parties: the Bank, as with other regulators, is mindful that in addressing issues of domestic concern, foreign entities should not be treated adversely relative to domestic entities. The Board notes that it would be odd if countries were increasingly taking actions to address public policy issues in their domestic payment systems but were somehow unable to address such issues in their jurisdictions simply because they involved foreign entities.

In relation to the schemes' arguments regarding fraud, the Board acknowledges that fraud rates on international transactions – and more specifically on online transactions – are higher than on other transactions and encourages the industry to work to reduce such fraud. However, the Board was not convinced by arguments from the schemes that an extension of the scope of interchange regulation would result in a significant increase in ‘decline rates’ on transactions at Australian merchants, particularly given the other revenue streams available to issuers on cross-border transactions.^[16] Furthermore, to the extent that fraud remains an issue, it was not convinced that an interchange fee that falls on Australian merchants and is passed on to all consumers is an appropriate response; in most cases it is actually the merchant accepting online cross-border transactions that would be expected to bear the cost of chargebacks on fraudulent transactions, with the foreign issuer typically bearing only the administrative costs of dealing with the chargeback.

In summary, the Board's judgement is that there is an efficiency case for considering whether Australian interchange regulation should apply similarly across all types of transactions. However, it notes that the international schemes have committed to use their scheme rules to prevent possible circumvention of domestic interchange caps by offshore issuance. It also notes that transactions on foreign-issued cards currently account for a relatively small share of total card transactions in Australia. Accordingly, for the time being, the Board will not be bringing transactions on foreign-issued cards into our regulatory framework. It will continue to watch developments in this area, including regulatory developments in other jurisdictions, trends in the share of cross-border transactions in overall transactions and whether circumvention of the Bank's standards is occurring.

3.4.7 Prepaid cards

When the Board considered issues relating to prepaid cards in 2006, it determined that it was not necessary to regulate prepaid cards at that time. However, the Board noted its expectations regarding their treatment, including 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 if they chose.^[17]

In most respects, prepaid card interchange rates have, to date, been set consistently with the debit card standard, with similar decisions about categories being made by the schemes: both MasterCard and Visa have ‘strategic merchant’ rates that apply to prepaid transactions at particular merchants and in recent years both have introduced ‘premium prepaid’ categories with relatively high percentage interchange rates. However, with significant growth in premium prepaid transactions, average prepaid interchange fees for the international schemes have recently been above the 12 cents benchmark applying to debit cards. In addition, the Bank has received queries from a number of payments system participants about the meaning of ‘broadly in conformity with’, with some parties suggesting that the ambiguity in the wording might contribute to an unlevel playing field. Growth in the use of prepaid cards has meant that the ambiguity associated with the current approach raises more risks than previously and, in addition to the Bank's general concerns about the effect of interchange fees on price signals and incentives, it would be undesirable if the two international schemes were to interpret ‘broadly in conformity with’ in quite different ways.

The Board's view is that it remains appropriate to treat prepaid cards and debit cards as similar products for the purposes of interchange fee regulation, and that the public interest is best served by formalising the regulatory arrangements, compared with the current approach where the Board has set expectations that may leave room for ambiguity. Different regulatory arrangements would allow scope for regulatory arbitrage, while leaving prepaid cards outside formal regulation appears likely to encourage an upward drift of interchange fees (such a drift in prepaid rates has been apparent since 2013). However, consistent with the general approach to interchange regulation of using a weighted-average benchmark rather than a fixed cap, the drafting of the standard allows for some variation between debit and prepaid rates, subject to ensuring that the overall benchmark is met.

3.4.8 Changes to benchmark compliance

When the benchmarks for credit card interchange fees were introduced in 2003, the Board's aim was to limit the tendency for competition between schemes to drive up interchange fees. By setting the benchmarks in weighted-average terms, the Bank allowed schemes significant flexibility to set different interchange fees for different transactions, some of which could be over the benchmark. Schemes have taken advantage of this, and of the current infrequent compliance arrangements, to develop commercial strategies that encourage issuers to maximise interchange revenue. The result has been that actual average interchange fees have tended to be higher than the regulatory benchmark and have drifted further above the benchmark between the three-yearly compliance points. Accordingly, the benchmark has not represented an effective cap on average interchange fees.

To address this, the draft standards proposed moving to quarterly benchmark compliance. Under this proposal, schemes would be required to reset interchange fee schedules within 45 days of the end of any quarter for which weighted-average interchange fees exceeded the benchmark. Given that frequent resets would be costly for schemes and their members, the Board's expectation was that schemes would set their interchange fee schedules conservatively so that average interchange fees were sufficiently below the benchmark to avoid the need for frequent resets. In addition, the proposed system, with its frequent compliance and ceilings on individual interchange categories, would imply that average interchange fees could not drift far above the benchmark, so any required changes to interchange fee schedules were likely to be more incremental and more easily implemented than under current arrangements.

Consultation responses from the international schemes have referred to the costs of frequent resets, the possibility of compliance breaches due to unexpected changes in transaction patterns, the effect of seasonality in transaction patterns and the issues involved in resetting schedules within 45 days. For the most part, responses suggested that schemes had not fully digested the Board's desire to ensure that the benchmarks serve as an effective cap on average interchange rates nor taken note of the Board's observation that quarterly compliance does not imply quarterly resets; a straightforward way to avoid frequent resets would be to set their schedules in a manner that does not imply frequent breaches. In discussions with Bank staff about possible alternative annual compliance methodologies, the schemes were not attracted to some form of ‘claw-back’ mechanism, by which a significant breach of the benchmark in one year would require meeting a lower target in the following year.

Accordingly, the Board has decided on the following compliance methodology. Schemes will be required to keep their rolling four-quarter average interchange fee below the benchmark. At the end of each quarter, the weighted-average interchange fee over the previous four quarters will be calculated. If this is over the benchmark, schemes will be required to reset their rates so that the weighted-average interchange fee under the new schedule, using the transaction mix of the most recent four quarters, would have been below the benchmark.

With compliance being checked at the end of each quarter, the scope – as has occurred under three-yearly compliance and which, in the Board's judgement, might still continue to occur under annual compliance – for average interchange fees to drift significantly above the benchmark should be removed.^[18] And by using a four-quarter rolling average interchange fee, the new compliance method will remove any effect of seasonality that would result from compliance based on quarterly averages. Furthermore, schemes will have 60 days, rather than 45 days as proposed in the draft standards, to undertake a reset. In addition, given that at any time they will have full knowledge of their interchange flows and transaction volumes over the prior year, schemes should be better equipped to respond proactively to potential breaches – including to do interchange resets at times that are most suited to their scheduled network releases.

3.4.9 Implementation timeline

In deciding on an implementation timeline, the Board has been mindful of submissions by industry that they would prefer some time to prepare for the new regulatory framework.

Schemes covered by existing regulation will remain subject to the requirements of the current interchange standards until 30 June 2017. The new interchange standards will be effective from 1 July 2017 for compliance with the new interchange benchmarks and the rules on net payments to issuers.

However, there will be elements of the calculations used for compliance that will be backward-looking (as is the case for the current standards). In particular, the first ‘reference period’ under the new standards will be the period from 1 July 2016 to 30 June 2017. If the weighted average of interchange rates in a scheme over this period is above the relevant benchmark, the scheme will have until 60 days after 30 June 2017 to reset its schedule of interchange rates to comply with the benchmark; i.e. to undertake a reset that, using the new interchange schedule and the transaction mix of the previous year, yields a weighted average of interchange rates that is below the benchmark. With the ‘rolling quarter’ model, the second reference period will be from 1 October 2016 to 30 September 2017 and any reset required would need to take place within 60 days after 30 September 2017.

Schemes will have to certify annually that they have complied with the interchange benchmarks and rules on net payments to issuers (discussed in section 4.4.2). The first certification will be due 31 July 2018 and will relate to the 2017/18 financial year. However, the Board wishes to ensure that the intent of the standard with respect to net payments to issuers is not thwarted by large incentive payments or arrangements that are entered into prior to the new standard taking effect. Accordingly, the calculation of net payments to issuers that becomes effective 1 July 2017 will take into account any incentive payments, rebates or other benefits made between the date that the standards have been registered on the Federal Register of Legislation and 30 June 2017, if those incentives relate to transactions, activity or issuance after 1 July 2017.

Footnotes

For eftpos, the gap is estimated to be much smaller. The interchange schedule for eftpos Payments Australia Limited (ePAL) is much simpler, with all merchants eligible for an interchange rate of zero on transactions of less than $15, and then subject to a rate of between zero and 5 cents on larger transactions, depending on whether they qualify for a strategic rate. ePAL does not have ‘premium’ category cards and therefore does not have any such interchange rates. [9]

The Bank has noted that the proposed reduction in the debit benchmark broadly matches the decline in the average value of debit transactions since the debit standard was introduced. A few submissions suggested that the paper had mis-estimated this decline and referred to data that include eftpos transactions. However, the 2006 benchmark of 12 cents was introduced for the multilateral interchange fees of the international systems and was based on data for costs in those systems. Accordingly, the Bank's statement about the fall in transaction values refers to the fall in average transaction size for the international systems (from $80 in 2006 to $54 in 2014/15). [10]

The merchant indifference test is the proposition that interchange fees be set at a level that results in a cost of card acceptance that makes the typical merchant indifferent between accepting a card payment and other widely used forms of payment. For further details, see Rochet and Tirole (2011) and European Commission (2013). [11]

The Board has also determined that the Debit MasterCard system will be formally subject to the standard on debit interchange; previously MasterCard has provided a voluntary undertaking to comply with the Visa Debit standard. [12]

See European Commission (2015a). [13]

See European Commission (2015b). [14]

See European Commission (2015c). [15]

Cross-border transactions through the international card systems typically involve charges, in addition to the international interchange fee, that are levied on cardholder and merchant and do not apply to purely domestic transactions. The cardholder will typically pay a foreign transaction fee (around 3 per cent is common, though this is sometimes waived on premium cards) and the merchant will most likely face the international transaction fee that is levied by the scheme on the acquirer. [16]

See RBA (2006). [17]

The Bank has, however, continued to allow a significant degree of flexibility in the way that schemes set their interchange schedules and it might be possible for schemes to set their schedules strategically in ways that – despite the requirement that they would have to reset their schedules every quarter – leave weighted-average interchange rates continually over the benchmark. In the event that schemes were to continue to ‘game’ the benchmarks, in particular by introducing new, higher interchange categories that initially have zero weights for benchmark purposes following resets, the Board would need to consider a significant tightening of the standards. [18]