Payments System Board Annual Report – 2005 Introduction

The Payments System Board was established in 1998 with a legislative mandate to promote efficiency, competition and stability in the Australian payments system. Since its establishment, much of the Board's time has been taken up with the first two elements of this mandate. While stability issues have also been addressed, the process of promoting efficiency and competition has proved to be more difficult and time consuming than that of promoting stability. In part, this reflects the fact that changes to the payments system that promote overall competition and efficiency have been opposed by those who see their commercial interests as being adversely affected by the reforms.

The Board has largely focused on two central issues. The first is the promotion of price signals to users of payment services that encourage efficient payment choices. This has largely, although not exclusively, involved the regulation of interchange fees. And the second is the removal of various restrictions in the payments system that effectively limit entry and stifle competition.

In addressing these issues, the Bank has undertaken a number of major studies and has also undertaken extensive consultation with industry. At various stages since the Board was established, the Bank has sought public comment on the need for reform of the credit card systems, the EFTPOS system, the Visa Debit system and the ATM system. It has also considered the public interest case for regulation of the American Express, Diners Club and BPAY payment systems. Where the Bank calls for submissions from the public, the submissions received are published on the Bank's website and the Bank has announced and explained its decisions either in media releases or the publication of reports.

Interchange Fees and Efficient Price Signals

The Bank has sought to promote price signals to users of payment services that encourage efficient choices by those users. Of particular importance are the signals facing consumers, for in most situations, once a merchant has decided what payment methods the business will accept, it is the consumer who decides what method will be used for any particular purchase.

At a relatively early stage in its investigations, the Bank identified what appeared to be a distortion in the pricing of card payment services to consumers. In particular, for many cardholders, the effective per-transaction price they faced for using a credit card was significantly lower than for using an EFTPOS card, despite the credit card system having considerably higher operating costs. One result of this was that by the late 1990s, the use of credit cards was growing extremely rapidly, as consumers found it more attractive to use credit cards, rather than debit cards, to pay for goods and services. In a similar fashion, consumers were being offered lower per-transaction prices on debit card transactions through the Visa Debit system than through the EFTPOS system, despite the Visa Debit system having higher operating costs.

When the Bank examined why the higher-cost payment systems were being offered to consumers at lower per-transaction prices, one of the central factors that it identified was the existence of interchange fees. These are fees that are paid between the cardholder's bank and the merchant's bank every time a payment is made with a Bankcard, MasterCard or Visa credit card, or made with an EFTPOS or Visa Debit card or through BPAY.

In the credit card and Visa Debit systems, the fee is paid from the merchant's bank to the cardholder's bank. Prior to the Bank's reforms, this fee averaged around 0.95 per cent of the transaction value. In contrast, in the EFTPOS system the fee flows the other way – that is, from the cardholder's bank to the merchant's bank – and averages around 20 cents per transaction.

Not surprisingly, these fees have had a significant influence on pricing to cardholders. With banks that issue cards receiving almost $1 in interchange revenue for every $100 spent by one of their cardholders on credit cards (prior to the reforms), but having to make a payment of around 20 cents every time an EFTPOS card was used, it was not surprising that per-transaction credit card prices were considerably below per-transaction EFTPOS prices. The result was that the EFTPOS system was being underutilised.

For many cardholders, the effective per-transaction charge for using a credit card was, and remains, negative, due to a combination of interest-free credit and reward points. Issuers of credit cards cover the cost of this effective per-transaction subsidy through a combination of annual fees, interest earnings from those cardholders who do not pay the balance by the due date, and from interchange fees. While in the first instance, the interchange fees are paid by the merchant's bank, they are passed onto the merchant through the fee that is charged for providing credit card services. In turn, merchants pass this fee through to consumers in the form of higher prices for goods and services. The end result has been that non-users of credit cards, including users of the EFTPOS system, have been subsidising those using credit cards by being charged higher prices for the goods and services that they buy.

After examining the various justifications for interchange fees, the Bank came to the conclusion that the overall efficiency of the payments system would be improved by a lowering of interchange fees in both the credit card and EFTPOS systems. By lowering these fees, relative prices that consumers faced when choosing among various payment methods would more closely reflect the relative resource costs involved in making those payments. While the Bank has viewed the reforms to the credit and debit card systems as a package, the reforms have been proposed and implemented at different times. In large part, this reflects the need for the Bank to pursue voluntary reform before it uses its regulatory powers, but legal challenges have also delayed reforms (see Table 1 for a summary of the reform process).

In the case of credit cards, it became clear at a relatively early stage that voluntary reform of interchange fees was unlikely to occur. Reflecting this, the Bank used its powers under the Payment Systems (Regulation) Act 1998 to set a standard that has cut interchange fees substantially in the Bankcard, MasterCard and Visa systems.^[1] The standard, together with the Bank's other regulation of the credit card systems, were subject to legal challenge by MasterCard and Visa in the Federal Court in mid 2003. The challenges were unsuccessful and MasterCard and Visa were ordered to pay the Bank's costs.

The interchange standard, which came into effect from the end of October 2003, led to a reduction in average interchange fees in the credit card system of around 40 basis points; from 0.95 per cent of the transaction value to 0.54 per cent (see Graph 1). The credit card reforms, and their effects, are discussed in detail in the second chapter of this Report.

In contrast to the credit card system, industry participants in the EFTPOS system, after much discussion, agreed to voluntary reform. In particular, in early 2003 a group of banks and other financial institutions took a proposal to the Australian Competition and Consumer Commission (ACCC) to set these fees to zero. The proposal was authorised by the ACCC in December 2003, but the authorisation was subsequently overturned by the Australian Competition Tribunal (ACT) following an appeal of the decision by a group of merchants.

After considering the ACT's judgment, the Board, however, remained of the view that a lowering of interchange fees in the EFTPOS system was in the public interest. Given this assessment, and the fact that the voluntary reform process had reached the end of the road, the Board designated the EFTPOS system in September 2004^[2], and subsequently released a draft standard^[3] that, if implemented, would have the effect of lowering average interchange fees in the EFTPOS system from around 20 cents to around 5 cents.

Like the credit card regulations, the decision to designate the EFTPOS system has been challenged in the Federal Court. On this occasion, the challenge has come from a group of merchants, concerned that a reduction in interchange fees in the EFTPOS system would increase their costs of accepting EFTPOS or, in some cases, reduce the revenue flow that they receive from their acquirer every time an EFTPOS card is used in their business. The hearing was held in mid 2005, and at the time of writing the judge had reserved his decision. The Bank has indicated that it will not make any final decisions regarding the regulation of interchange fees in the EFTPOS system until the outcome of the case is known.

The Bank has also proposed reducing interchange fees in the Visa Debit system.^[4] These fees are the same as those in the Visa credit card system and thus fell when credit card interchange fees were reduced. The Bank, however, sees no justification for the same interchange fees to apply in both the Visa credit and debit systems. Moreover, it has been concerned at the potential for users of debit cards to migrate, over time, from the EFTPOS system to the Visa Debit system, simply because the different interchange fees allow financial institutions to offer more attractive pricing of Visa Debit to cardholders.

Given the relationship between EFTPOS and Visa Debit, the Bank has indicated that it will not make any final decisions about interchange fees in the Visa Debit system until the outcome of the current court case challenging designation of the EFTPOS system is known. The Board's proposed reforms to both the EFTPOS and Visa Debit systems are explained more fully in the third chapter of this Report.

Over the past year, the Bank has also considered the case for regulating the payments between American Express and the banks that issue American Express cards, given that these payments have some of the characteristics of interchange fees. It concluded that, at this stage, there was not a strong public policy justification for such regulation.^[5] In particular, it judged that reducing these payments would not lead to a reduction in the fees that American Express charges merchants. This is in contrast to the situation in the Bankcard, MasterCard and Visa schemes, where regulation of interchange fees led to an immediate reduction in the fees charged to merchants for accepting these cards.

The Bank also considered the case for regulating interchange fees in the BPAY system. It concluded that reducing these fees through regulation would be likely to lead to an increase in the price charged to consumers for using the BPAY system. In the Board's view, one effect of such a change in pricing would have been a shift away from BPAY towards other methods of bill payment, including credit card payments directly to billers, cheques and over-the-counter cash payments. Given the current relative prices and resource costs of the alternative payment methods, the Bank's view is that such a shift could not be said to be in the public interest. As a consequence, it concluded that there is currently not a strong case to regulate the interchange fees in the BPAY system. The BPAY system is discussed in more detail in the fourth chapter of this Report in the context of a broader discussion of the bill payments market in Australia.

In examining the case for regulation of interchange fees in the various payment systems, the Board has been conscious that these fees are not subject to the normal forces of competition. In the credit card systems, the fees are centrally set and, as experience in the United States has illustrated, competition between the schemes can force fees up, not down, even though costs might be falling. By increasing its interchange fee, a scheme can offer more revenue to issuers, who are then able to offer larger rewards to cardholders, and thus attract more business. Similarly, in the EFTPOS system, while interchange fees are bilaterally determined, they are subject to little competition, and, in most cases, have been unchanged for many years, despite significant changes in costs.

With interchange fees not subject to normal competitive forces and having a major effect on pricing of some payment services to cardholders, the Bank will continue to monitor their effects on the Australian payments system. When, in August 2002, it announced its reforms to the credit card system, the Bank indicated that it would undertake a major review of credit and debit card schemes in Australia after five years. That process will commence in the second half of 2007 and will include an examination of the interchange fees in the credit card schemes, the debit card schemes and the BPAY system.

Restrictions in Payment Systems

As well as the misalignment of relative prices and costs, the Bank identified a number of restrictions imposed by the card schemes and financial institutions that effectively limited competition and innovation. These restrictions can be classified under three broad headings: those that restrict access to a payment system; those that restrict merchants' actions when accepting particular means of payment; and those that restrict information about the payment systems.

Restrictions on access

The Bank has spent considerable effort investigating the rules of the various payment systems, as well as aspects of the payment systems' architecture, that might act as barriers to entry by new participants. In many markets, new entrants are the source of the increased competition and innovation that can generate more efficient outcomes over time.

The credit card schemes had longstanding rules that have had the effect of limiting participation to banks, building societies and credit unions. Visa, for example, limited membership to those institutions that were authorised to take demand deposits, while MasterCard required that a member be a financial institution authorised to engage in financial transactions.

In assessing the effects of these rules, the Bank accepted that the schemes had a legitimate need to control membership to protect existing members from the financial and operational risks that could arise from new members joining the scheme. Existing members need to be confident, for example, that a new card issuer will be able to pay acquirers whenever the issuer's cardholders use their credit cards. Despite this, in the Bank's view, the membership rules were unnecessarily restrictive, limiting the entry of institutions that might specialise in credit card issuing or acquiring.

In response, the Bank and the Australian Prudential Regulation Authority (APRA) worked together to develop more appropriate access arrangements.

The first step in this process was the creation by APRA of a new class of Authorised Deposit-taking Institution (ADI) known as a Specialist Credit Card Institution (SCCI). SCCIs are ADIs under the Banking Act 1959 but may only perform those activities associated with credit card issuing and/or acquiring. APRA has also indicated that it has no objection to SCCIs undertaking debit card acquiring. SCCIs are supervised by APRA and are required to meet prudential requirements consistent with the risks they incur.

The second step in the process was the Bank imposing an access regime under the Payment Systems (Regulation) Act 1998 that required that credit card schemes not discriminate between SCCIs and other ADIs when considering applications for membership. This access regime came into force in February 2004.^[6] Since then, APRA has authorised four SCCIs, three of which already issued credit cards in Australia through an overseas affiliate (and one of which has since returned its authority). The fourth SCCI is currently seeking membership of the credit card schemes in order to provide credit card services to merchants.

The Bank's access regime also required the schemes to remove two other rules that had the potential to limit competition.

The first were the rules that penalised scheme members if they concentrated on providing credit card services to merchants rather than issuing cards. Given that the business of dealing with cardholders is quite different to that of dealing with merchants, these rules represented a potentially important barrier to the introduction of new business practices and technology by specialists on the merchant side of the market. The second were the rules that imposed a blanket ban on merchants joining the schemes to ‘self acquire’ their own transactions.

The Bank has also had a longstanding concern about access to the EFTPOS system, although the nature of the concern is different to that in the credit card system and emerges largely because the system is built around a series of bilateral linkages. If a new participant wishes to join the system (and not use the services of an existing ‘gateway') it needs to conduct negotiations with each of the existing principal participants (of which there are currently nine). Each of these participants is likely to be a competitor with the new entrant and has little incentive to establish a connection within a reasonable time frame and at a reasonable cost.

Accordingly, the Bank has been working with members of the Australian Payments Clearing Association (APCA) on the development of an access code that would provide greater certainty and transparency regarding the process for joining the system. APCA's members have now agreed to a code that: places a reasonable cap on the price of establishing a connection to existing participants; establishes a clear timetable for the testing of connections; and removes a previously proposed requirement that entrants must meet a minimum volume before the new arrangements would be applicable.

Restrictions on merchants

At an early stage in its investigations into competition in the payments system, the Bank noted a number of restrictions imposed on merchants by the international credit card schemes and the schemes operated by American Express and Diners Club. These restrictions had the effect of limiting the ability of merchants to negotiate effectively with the card schemes about the terms under which the cards were accepted and/or limiting the ability of merchants to send appropriate price signals to consumers about the costs of various payment methods.

The first of these rules to be examined were the so-called ‘no surcharge’ rules. These rules were imposed by all schemes, with the exception of Bankcard, and prohibited merchants from charging a fee to cardholders who paid with a credit or charge card. They meant that merchants had limited ability to signal to cardholders the relative costs of various payment methods, and hence had limited ability to induce cardholders to use cheaper forms of payment. The rules also weakened merchants' negotiating power with acquirers, for they were unable to use the threat of imposing a charge when negotiating the level of their merchant service fee. MasterCard and Visa were not prepared to voluntarily remove the no surcharge rule and so the Bank required them to do so using its powers under the Payment Systems (Regulation) Act 1998. In contrast, American Express and Diners Club removed the rules voluntarily after discussions with the Bank.

A second restriction, with similar side effects to that of the no surcharge rule, were clauses in American Express' merchant contracts that had the effect of prohibiting merchants from steering customers away from American Express towards less expensive means of payment. Following discussions with the Bank, American Express agreed to remove these clauses. Merchants are now free to say to customers that, while they do accept American Express or Diners Club cards, they would prefer to be paid by a less expensive means of payment.

A third restriction on merchants – in this case imposed by Visa – requires that if a merchant accepts Visa credit cards it also accept Visa Debit cards (the so-called ‘honour all cards’ rule), and, at present, the same interchange fee applies to both credit and debit cards. MasterCard has a similar rule but currently does not have a debit card product in Australia. The honour all cards rule has received heightened scrutiny in recent years and, in addition to the Board's investigations, has been the subject of legal proceedings in the United States and an investigation by the European Union.

While the Bank recognises that there may be some benefits to this rule, on balance, its preliminary view is that this tying arrangement is not in the public interest, as it effectively limits competition and forces merchants to take a payment method they might not otherwise accept, and at a price that they have limited ability to negotiate. These concerns are reinforced by experience in the United States, where the combination of higher interchange fees and the honour all cards rule has enabled Visa Debit and the similar MasterCard product to significantly increase their market shares at the expense of alternative debit products that are cheaper for merchants to accept.

Visa has opposed removal of this restriction and so the Bank has issued a draft standard that, if implemented, would require the rule to be removed.^[7] The Board does not propose the removal of the rule that requires merchants to accept credit cards from all issuers of a particular scheme once the merchant has decided to accept any credit cards issued under that scheme.

Restrictions on information

Throughout the reform process the Bank has sometimes found it difficult to obtain information, and a number of participants have been strongly opposed to the publication of certain information. In the Bank's view, competition in the payments system, as well as analysis of developments in the system, are promoted by public disclosure of timely and accurate information. Accordingly, the Bank has promoted greater transparency in the Australian payments system.

The Bank has focused on three types of data – interchange fees, merchant service fees and market shares.

As part of its regulation of interchange fees in the credit card systems, the Bank has required that the regulated schemes publish on their websites all interchange fees set by the schemes. For some time, the Bank had also been encouraging BPAY to disclose publicly its interchange fees. After initial reluctance, BPAY recently agreed to the Board's requests and its interchange fees have been published on its website since 1 September 2005.

The Bank has also commenced publishing data on average fees charged to merchants. American Express and Diners Club agreed to the Bank's request for them to publish their average merchant service fees on their websites and have done so since September 2004. These data, together with back data supplied by American Express and Diners Club, are now being published in the Bank's Bulletin. The Bank is also publishing data on the average merchant service fees charged by banks in the Bankcard, MasterCard and Visa systems.

Finally, the Bank has secured the agreement of American Express and Diners Club to publish their combined market share of the credit and charge card market. These data, together with the combined market share of the Bankcard, MasterCard and Visa schemes are also published in the Bank's Bulletin.

Collectively, these data will provide a factual basis for public analysis of the competitive position of the three-party schemes relative to the four-party schemes. They will also provide merchants with better information when deciding what payment methods to accept.

Innovation in the Australian Payments System

As the Bank has considered issues of competition and efficiency in the Australian payments system over recent years, it has become clear that in some cases innovation can happen quite quickly, while in others, it can be resisted by organisations that see advantage in delay. Similarly, there can be reluctance to embrace change that will result in new participants who might threaten the position of incumbents. The relative importance of bilateral payment linkages in Australia – ATMs, EFTPOS, cheques, direct entry – and the governance of those systems raise particular problems whenever questions of change and new investment arise. In the period ahead, the Bank will be working with the industry to explore whether changes to current arrangements might promote a more efficient and dynamic payments system.

Footnotes

See Media Release 2002-15 (27 August 2002). [1]

See Media Release 2004-08 (9 September 2004). [2]

See Media Release 2005-02 (24 February 2005). [3]

See Media Release 2005-02 (24 February 2005). [4]

See Media Release 2005-02 (24 February 2005). [5]

See Media Release 2004-02 (23 February 2004). [6]

See Media Release 2005-02 (24 February 2005). [7]