Payments System Board Annual Report – 2008 Regulation of Card Payment Systems

Review of the Payments System Reforms

Over 2007/08, the Board has spent considerable time undertaking an extensive review of the payments system reforms of recent years. As reported in last year's Annual Report, the review process commenced in May 2007 with the release of an issues paper seeking industry submissions on three interrelated questions:

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

The Bank received 27 submissions in response to the Issues Paper and 20 parties took up the invitation to discuss their submissions with the Bank. The Bank also held a significant number of other meetings to discuss the reforms, including with industry participants, associations and consumer groups.

In addition to its bilateral consultation with interested parties, the Bank held an industry conference in November 2007 to discuss the reforms, with the conference being co-hosted with the Centre for Business and Public Policy at the Melbourne Business School. In total, around 90 people participated including all members of the Board.

Following the conference, the Board considered all the submissions and information made available to it and, in April 2008, released Reform of Australia's Payments System: Preliminary Conclusions of the 2007/08 Review (Preliminary Conclusions). Submissions in response to the Preliminary Conclusions were received in June 2008 and have been considered by the Board, which expects to release its final conclusions in late September.

Costs and payment patterns

A major consideration in the Reserve Bank's original decision to regulate credit card interchange fees was that, for many cardholders, the effective marginal price of a credit card transaction was much less than the effective price of an EFTPOS transaction, despite the EFTPOS system having lower underlying resource costs. As part of the Review, both the Reserve Bank and a number of industry participants considered it important that the differences in costs between the two systems be re-examined. In addition, given the wide-ranging nature of the Review, it was also thought appropriate to examine the costs associated with a range of other payment methods, most importantly cash.

Over 2007, the Bank worked with financial institutions and merchants to construct new and more detailed measures of the cost of various payment instruments. The new cost study confirmed the earlier findings on payment instrument costs. In particular, the resource costs involved in credit card transactions are significantly higher than for EFTPOS transactions, even after excluding those costs associated with the credit function. Furthermore, cash was found to be the lowest-cost payment method for the low-value transactions for which it is generally used.

Another consideration in the Reserve Bank's original decision was the assessment that, in many situations, credit and debit cards are close substitutes for one another and that, as a result, price signals to consumers could have a significant influence on payment patterns. It has also been noted that for many payments, cash is a ready substitute for card-based payments. Given the limited existing information on how various payment methods are used, the Bank, as a further input into the Review, undertook an extensive study of how individuals make their payments.

Payments System Review Conference

The Payments System Review Conference, held on 29 November 2007, supplemented the Bank's normal consultation processes by providing an open forum in which the reforms could be discussed by industry participants with the members of the Payments System Board. The Bank's findings from its studies of the cost and use of payment instruments were also presented at the conference.

The conference was in two parts. The first part comprised commissioned papers which together examined three key issues for the Review:

1. lessons from the recent academic literature on payment networks, in particular about the appropriate configuration of interchange fees across payment systems;
2. the extent to which changes in scheme rules and other aspects of card payment systems might add to competitive forces acting on interchange fees, and how such changes might affect the case for regulation; and
3. the costs of the main payment methods (including cash) in Australia and the way in which these various payment methods are used by individuals.

The second part of the conference took the form of two open forums, moderated by Professor Ian Harper of the Melbourne Business School, discussing interchange fee regulation and access and innovation in the Australian payments system.

On interchange fees, some participants saw a strong case for continued regulation, arguing that the reforms have delivered gains in competition and efficiency, and that these would be lost if regulation was abandoned. Some went further arguing that interchange fees in all payment systems should be abolished by regulation, and that cardholders should not be ‘subsidised’ by merchants (through interchange fees) when using various payment methods. An alternative perspective was that interchange regulation could be removed given that the competitive environment has changed in recent years, owing to increased transparency and the removal of various restrictions on merchants. It was also argued that the case for allowing the international card schemes to once again set interchange fees would be strengthened by the development of an EFTPOS scheme (to replace the existing bilateral arrangements) and the establishment of a transparent methodology by industry for the setting of interchange fees. Other participants, however, questioned the practicality of the industry agreeing upon a methodology and no concrete proposals were put forward.

On access and innovation in Australia's payments system, some participants argued that the Bank's regulatory intervention in card markets has created uncertainty about the returns from investment, thereby inhibiting innovation. In particular, the Bank's credit card interchange fee reductions were claimed to have delayed or prevented desirable innovations by reducing the revenue stream to issuing institutions. Others, however, suggested that lower interchange fees may promote innovation if the bulk of required investment is on the acquiring side, and disputed that the Bank's regulatory actions had been responsible for any reduction in investment in Australia's credit card or EFTPOS systems.

It was also argued that new (and especially small) institutions are often the primary source of innovation in networks and that, by improving access to Australia's card payment systems, the Reserve Bank has enhanced the prospects for development of new products in these systems. Some countered this view by suggesting that the Bank's access reforms have had little practical effect. Others, however, stated that these reforms have been important to their own institutions, and that any stepping back from the full suite of regulations by the Bank would undermine their capacity to compete.

The proceedings of the conference, including all papers and summaries of discussion, are available on the Bank's website, www.rba.gov.au.

Preliminary Conclusions of the Review

The Preliminary Conclusions of the Review were released in April 2008 with the Board concluding that the reforms had met their main objectives of: improving price signals in the Australian payments system; increasing transparency; improving access; and creating a more soundly-based competitive environment. The Board also concluded that close oversight of retail payment systems will continue to be necessary. To a large extent, this stems from the way in which competition between merchants affects their ability to decline to accept certain payment cards. The competitive environment means that, in aggregate, merchants are likely to be prepared to pay more for credit card acceptance than the benefit they receive. In the past, this distortion has been amplified by various rules that have been imposed on merchants by the schemes.

The Board saw no case for allowing the schemes to re-impose their no-surcharge rules. Similarly, the Board saw no case for allowing the schemes to re-impose their earlier honour-all-cards rules. Indeed, it proposed further changes to scheme rules to ensure that merchants can make independent acceptance decisions about pre-paid cards, and changes that would prohibit merchants being penalised with higher interchange fees if they do not accept all cards of a scheme. In addition, the Board proposed retaining the various access regimes. While access has been improved as a result of the reforms, further improvements are necessary, particularly to those systems based on bilateral contracts. With the current technology in a number of these systems nearing the end of its useful life, the Board encouraged the industry, as a matter of priority, to examine alternative approaches that would address this issue and possibly allow entry on the basis of one connection only.

The Board also concluded that there is a strong case for further improving the transparency of the payments system, in particular, by the publication of average interchange fees and scheme fees. In addition, the Board saw advantages in clarifying the conditions surrounding bypass of scheme switches.

While the Board's preliminary conclusions noted a strong case for ongoing interchange regulation, the Board indicated that it would be prepared to step back from the regulation of these fees if the industry took further steps to improve the competitive environment. In particular, the Board identified changes in three areas that would, in its opinion, further strengthen the competitive environment. These include: changes to the EFTPOS system that would enhance competition; further modifications to the honour-all-cards rule; and greater transparency around scheme fees and average interchange fees.

In the event that steps to improve the competitive environment were not made within a reasonable time, the Board concluded that interchange regulation should continue and that modifications would be made to the current standards. In particular, the Board would consider establishing a common benchmark for interchange fees in the EFTPOS and scheme debit systems of around 5 cents (paid to the issuer) and a further reduction in the credit card interchange fee benchmark to around 0.30 per cent. A number of technical changes to the operation of the interchange standards would also be made.

In response to the Preliminary Conclusions, the Board received 24 submissions and held meetings with 19 parties. There was broad support from financial institutions for the Board's proposal to step back from interchange fee regulation. Many submissions, however, expressed concerns about further modifications to the honour-all-cards rule to allow merchants to make separate acceptance decisions for any scheme card that had a separate interchange fee. Merchants on the other hand continued to argue for no interchange fees and supported further modifications to the honour-all-cards rule.

International Regulatory Developments

In the time since the Bank first introduced its reforms, regulators in a number of other countries have investigated the setting of interchange fees and competition in payment systems more generally. Over 2007/08, notable regulatory developments occurred in Europe and the United States.

On 19 December 2007, the European Commission (EC) announced that it would prohibit multilateral interchange fees on all cross-border payments made using MasterCard consumer credit and debit cards. The decision followed a four-year review that was conducted in response to complaints from EuroCommerce, an association of European retailers. The EC is now reviewing interchange fees in the Visa scheme and those for MasterCard's commercial cards. Visa was granted an exemption for its cross-border interchange fees in 2002 but that exemption expired at the end of 2007.

In its decision on MasterCard, the EC ruled that MasterCard's interchange fees set a floor under merchant service fees which inflates the fees charged to merchants by banks. While noting that, in theory, interchange fees may be helpful in optimising benefits in a network, the EC came to the view that MasterCard's model for setting interchange fees did not achieve this in practice. In addition, the EC stated that MasterCard has failed to produce any empirical evidence of the benefits from its interchange fees that could balance the negative effects of inflated merchant service fees that flow through to consumers as higher retail prices. MasterCard has appealed to the European Court of First Instance but, until the appeal is concluded, MasterCard has complied with the decision and ceased charging the relevant interchange fees on 30 June 2008.

Another related development in the EC is the commencement of the Single European Payments Area (SEPA) initiative. This initiative requires payments providers to offer solutions that operate throughout the European Union rather than being confined to individual countries as has commonly been the case. The EC is also encouraging the development of a pan-European card system to compete with the offerings of MasterCard and Visa. This is seen as a way of avoiding a decrease in competition that might occur as a result of the SEPA initiative if part of the existing European payment card infrastructure is shut down in favour of using the MasterCard and Visa schemes.

In the United States, interchange fees have been the subject of increased scrutiny. As well as continuing legal actions bought by merchants against MasterCard and Visa, the US Congress has been considering these fees. Proposed legislation affecting the setting of interchange fees was introduced into the US Congress on 6 March 2008. This legislation, known as the Credit Card Fair Fee Act of 2008, arose from hearings in July 2007 by the bipartisan House Judiciary Antitrust Taskforce Subcommittee into the fees, policies and practices of the credit card industry. A key concern highlighted in those deliberations was the imbalance of bargaining power in the setting of interchange fees. The legislation would offer immunity from antitrust laws to allow merchants to engage in collective negotiations with banks to reach agreements on the fees and other terms for their participation in electronic card systems. It would also establish a panel of judges that, in the absence of voluntary agreements, would judge which proposal from those offered by parties to the negotiations would be closest to an outcome reached if there were competition in fee setting.