Review of the Regulatory Framework for the EFTPOS System: Consultation on Options for Reform – June 2012 4. Interchange Fees Standard

Issues with the Current Standard

When the EFTPOS interchange fees Standard was amended in 2009 to allow for the introduction of multilateral interchange fees, the Bank took the decision not to harmonise regulation of multilateral and bilateral interchange fees. Instead, the Bank left in place the existing floor and cap on bilateral interchange fees of $0.04 and $0.05, paid to the acquirer. This decision was intended as a transitional measure, to reduce the likelihood of disruptive bilateral fee negotiations ahead of an expected move by the system to a multilateral interchange fee schedule.

The subsequent introduction of a multilateral interchange fee schedule by EPAL has substantially changed the way in which interchange fees are set in the EFTPOS system. In particular, a multilateral interchange fee schedule set by a central scheme allows interchange fees to be altered relatively easily, whereas they have previously been very difficult to renegotiate. EPAL is therefore able to coordinate the setting of interchange fees in response to competitive pressures and with a view to the benefits to the EFTPOS system as a whole. The multilateral fee schedule also avoids the need for new entrants to negotiate fees with existing participants who might otherwise have an incentive to offer unfavourable interchange fee terms.

Bilaterally negotiated EFTPOS interchange fees, as currently regulated under the Bank's interchange fees Standard, place a constraint on EPAL's capacity to set interchange fees in what it considers to be the best interests of the EFTPOS system. The current interchange fees Standard constrains any remaining bilateral fees to between $0.04 and $0.05, payable to the acquirer, which is significantly different from the multilateral rate set by EPAL. This difference, of between $0.09 and $0.10 for most transactions, has the potential to distort behaviour over time, potentially undermining EPAL's capacity to set multilateral fees.

In the Board's preliminary view, the very different approaches to the current regulation of bilateral and multilateral EFTPOS interchange fees are no longer appropriate. It is, therefore, seeking views on how this should be addressed.

Multilateral Interchange Fees in the EFTPOS System

Under the interchange fees Standard, the weighted average of multilateral interchange fees must comply with the $0.12 cap.[⁸] This offers a degree of flexibility regarding individual transaction types. For example, EPAL, like the other debit card schemes, has the flexibility to set interchange fees of greater than $0.12 on some transactions, provided that enough other transactions attract interchange fees of less than $0.12 to ensure that the weighted average of all multilaterally set interchange fees remains under the cap.

The multilateral interchange fees set by EPAL currently remain well below the cap set by the Standard. The highest interchange fee payable is $0.05, while purchases under $15, charity payments and Medicare rebates do not attract any interchange fee. Interchange fees on transactions with a cash-out component remain payable to the acquirer, currently at $0.14. EPAL has also recently announced a differential point-of-sale rate range of between $0.00 and $0.05, and a differential cash-out rate range payable to the acquirer of between $0.14 and $0.23, to take effect from 1 October 2012. These rates will apply to transactions with merchants that satisfy certain criteria set by EPAL.

EPAL has established ‘interchange fee principles’ that guide its setting of its interchange fee regime. Underlying these principles is EPAL's belief that ‘interchange fees should be set in a way that is transparent and reflects the interests of all stakeholders’.[⁹] In particular, Principle 2 states that its interchange fee regime will ‘promote usage, issuance and acceptance of EFTPOS’.[¹⁰] This might suggest that multilateral interchange fees are set well below the cap in order to maintain the system's appeal to merchants. However, partly reflecting the fact that EPAL is still developing functionality for the EFTPOS system – such as chip and online capability – it is possible that EPAL might choose to set higher interchange fees on some transaction types in the future. Indeed, while all three debit card systems currently set their comparable basic electronic transaction rates well below the $0.12 cap, the Debit MasterCard and Visa Debit systems have a number of interchange fee categories that are above $0.12, with these schemes relying on lower interchange rates in other categories to comply with the benchmark (Table 1).

Options for the Future Regulation of Interchange Fees

Section 18(1) of the Payment Systems (Regulation) Act provides that the Bank may determine standards to be complied with by participants in a designated payment system if it considers that determining the standards is in the public interest. Under section 18(3) the Bank may also revoke a Standard. Section 8 of the Payment Systems (Regulation) Act sets out that in determining whether a particular action is in the public interest, the Bank is to have regard to the desirability of payment systems:

1. being (in its opinion):
1. financially safe for use by participants; and
2. efficient; and
3. competitive; and
2. not (in its opinion) materially causing or contributing to increased risk to the financial system.

The Reserve Bank may have regard to other matters that it considers are relevant to assessing the public interest, but is not required to do so.

Given the Bank has imposed a new designation on the EFTPOS system (as newly defined), it is of the view that, if required, the regulation of interchange fees would need to be put in place via a new interchange fees standard that applies to the newly designated EFTPOS system. Nonetheless, the starting point for considering the provisions of a potential new standard for the EFTPOS system should be the provisions of the current interchange fees Standard. On this basis, the Board has identified five broad options to address issues concerning the current regulation of interchange fees:

1. leaving the current form of regulation unchanged
2. imposing a bilateral interchange fee benchmark that is closer to the benchmark for multilateral interchange fees
3. placing bilateral and multilateral interchange fees under a common benchmark
4. eliminating bilateral interchange fees by preventing the payment of any interchange fee other than a multilateral interchange fee set by EPAL
5. revoking the interchange fees Standard without imposing a new standard in its place.

Under all but Option 5, the current $0.12 weighted-average cap on multilateral interchange fees would remain unchanged.

Option 1: Leaving the current form of regulation unchanged

Under this option, the new interchange fees standard would be substantively unchanged from the current interchange fees Standard, with minor alterations to clarify the application of multilateral or bilateral interchange fee benchmarks where this is ambiguous. This approach would require the least adjustment for the industry, and it would keep in place the regulatory framework that has delivered the current interchange fee settings.

The weakness of this approach is that it does not address the potential for bilateral interchange fees to constrain EPAL's ability to set interchange fees in the best interests of the system. Bilateral interchange fees within the range set by regulation before the establishment of EPAL are significantly different from current multilateral fees for most transactions and provide an incentive for acquirers to seek to access these fees rather than the multilateral fees set by EPAL. The narrow band for bilateral fees was established in order to allow new entrants to access the system at interchange rates similar to those of the existing participants. However, given that new entrants can access the system at the multilateral rates established by EPAL, and that those multilateral rates have been adopted by most participants, this is now less of a concern.

Option 2: Imposing a bilateral interchange fee benchmark that is closer to the benchmark for multilateral interchange fees

The second option considered by the Board involves changing the current regulation of interchange fees to bring the bilateral interchange fee benchmark closer to the multilateral interchange fee benchmark. For example, in its conclusions to the 2007/08 review of the payments system reforms, the Board considered the option of varying the bilateral cap and floor to a range between $0.05 paid to the acquirer and $0.05 paid to the issuer.[¹¹]

This option could potentially bring bilateral and multilateral interchange fees closer together, partly reducing the constraint that bilateral fees may place on EPAL's ability to adjust pricing. Nonetheless, there would remain some difference between the regulation of the two types of interchanges fees under this model, meaning that there would be the possibility of some participants being able to retain or negotiate more favourable bilateral interchange arrangements within the provisions of the Bank's standard.

Option 3: Placing bilateral and multilateral interchange fees under a common benchmark

A third option, considered as part of the 2009 review of the interchange fees Standard, is to bring the regulation of bilateral interchange fees into line with the $0.12 cap, paid to the issuer, that is currently placed on multilateral interchange fees. Some distinction would need to be retained between bilateral and multilateral fees in a new standard, as bilateral fees would largely be outside EPAL's control, complicating the task of meeting the weighted-average cap. Similarly, participants operating on bilateral fees would have control only over their own agreements. While it might be possible for each pair of participants on bilateral rates to be subject to a separate weighted-average cap, a simpler solution would be for all bilateral fees to be subject to a $0.12 cap.

A key advantage of this approach is that it would largely harmonise the regulation of interchange fees across all three debit card systems. It would also remove the regulatory requirement for bilateral interchange fees to flow to the acquirer.

However, similar to Option 2, a potential drawback of Option 3 is that participants with bargaining power may be able to retain or negotiate bilateral interchange fee agreements more favourable to them than the multilateral interchange fee schedule set by EPAL. This could potentially limit EPAL's flexibility to set interchange fees competitively. Under EPAL's Scheme Rules both parties need to agree to a bilateral interchange rate, otherwise the multilateral interchange fee schedule applies.

Option 4: Eliminating bilateral interchange fees by preventing the payment of any interchange fee other than a multilateral interchange fee set by EPAL

Another option is for a new interchange fees standard to prevent the payment of any interchange fee other than a multilateral interchange fee set by EPAL. The multilateral interchange fee cap would remain the same as in the current Standard – $0.12, paid to the issuer. This option could significantly increase EPAL's ability to set interchange fees in the interests of the system, though it would nonetheless be possible for parties that wished to agree to exchange debit transactions at a bilaterally negotiated fee to do so outside the designated system.

Option 5: Revoking the interchange fees Standard without imposing a new standard in its place

The final option considered by the Board is for the Bank to revoke the interchange fees Standard without imposing a new interchange fees standard in its place. This would remove the current cap and floor for bilateral interchange fees and would allow EPAL to determine the appropriate level of interchange fees in the EFTPOS system without a regulatory cap. This option recognises that EFTPOS multilateral fees are currently well within the regulated cap. The Board, however, is conscious that EPAL's business is still evolving and therefore that its interchange fee schedule and transaction mix might evolve over time. It is also conscious of the tendency for competition between card schemes in other circumstances to drive interchange fees higher over time.

As for Options 1 to 3, acquirers may retain or negotiate more favourable bilateral interchange arrangements; placing some constraint on EPAL in setting its multilateral interchange fee schedule.

Discussion of the Options

The Board is seeking comments on the various options, with a view to determining its approach to EFTPOS interchange fee regulation later in the year. Its preliminary view is that, by constraining bilateral interchange fees to a range of $0.04 to $0.05, paid to the acquirer, while multilateral interchange fees on most transactions flow in the other direction, the current interchange fees Standard has the potential to inhibit competition between the EFTPOS system and the scheme debit systems. On this view, continuing the current form of regulation for interchange fees (Option 1) would not be in the public interest.

The Board is also of the preliminary view that Option 5, revoking the interchange fees Standard without replacement, is not in the public interest. This is based on the consideration that while the Board recognises the significant progress made by the industry in establishing EPAL and the fact that at this stage EFTPOS interchange fees are well below the current cap, the EFTPOS offering and business model may evolve over time. Therefore, consistent regulatory treatment between debit card schemes may be likely to promote more competitive and efficient outcomes than a system in which one type of debit card system is unregulated (in relation to interchange fees), while another is not. For this reason, the Board sees it as appropriate for all three debit card systems to face a similar regulatory landscape.

The Board's preliminary assessment, therefore, is that there is a case for putting in place a new interchange fees standard that would change the current form of regulation for bilateral interchange fees. Options 2 to 4 all accommodate this approach. An important consideration here is that it would most likely be possible for EPAL to either prevent the negotiation of bilateral interchange fees among its members (Option 4) or limit interchange fees to a new range (Option 2) via its Scheme Rules. It is therefore not obvious that a regulatory response along these lines is warranted. Option 3, however, would allow EPAL to restrict bilateral interchange fees if it so chose, but would continue to apply an overall cap consistent with both EFTPOS multilateral interchange fees and Visa Debit interchange fees. Indeed, when the Bank varied its interchange fees Standard in 2009, it considered the option of a common benchmark for bilateral and multilateral fees; however, at that time it wanted to reduce the likelihood of disruptive bilateral fee negotiations ahead of an expected move to a multilateral interchange fee schedule.

On balance, based on the above considerations, the Board's preliminary view is that Option 3, placing multilateral and bilateral interchange fee regulation, as far as possible, on an equal footing, would be the most effective approach to regulating EFTPOS interchange fees in the public interest. Under this option, all interchange fees for all debit card systems would be subject to a $0.12 cap.

Option 3 would recognise EPAL's mandate to manage the EFTPOS system in the best interests of that system, while ensuring that constraints on the level of interchange fees – aimed at promoting the efficiency of the payments system overall – apply equally across debit card systems. While it would not force any change in bilateral interchange fees or prevent acquirers with bargaining power from negotiating favourable fees, it would remove the regulatory requirement for bilateral EFTPOS interchange fees to flow to the acquirer and be constrained to between $0.04 and $0.05. Cash-out arrangements, which have typically involved a payment to the acquirer, would be consistent with the benchmark under Option 3. Accordingly, there would be no need for an exemption for cash-out transactions (as is the case under the current interchange fees Standard).

A draft of a new interchange fees standard that would apply to the newly designated EFTPOS system, based on Option 3, is set out in Attachment 2 to this paper. As a technical matter, it should be noted that it is not possible to be entirely consistent in the treatment of bilateral and multilateral interchange fee regulation because it is not workable to ensure a weighted average of bilateral interchange fees complies with the Standard. This is because no single entity would have control over those fees in a way that would allow them to be adjusted to bring the weighted average into line with the benchmark. For this reason, regulation of bilateral interchange fees under this approach would require that each bilateral interchange fee be below the $0.12 cap.

Footnotes

Multilateral interchange fees cited here are assumed to be paid to the issuer, unless otherwise indicated. Under the interchange fees Standard, multilateral interchange fees flowing to the acquirer are treated as negative amounts. All interchange fees cited are exclusive of GST. [8]

See <http://www.eftposaustralia.com.au/corporate/resources/interchange-fee-principles>. [9]

See <http://www.eftposaustralia.com.au/corporate/resources/interchange-fee-principles>. [10]

Reserve Bank of Australia (2008), Reform of Australia's Payments System: Conclusions of the 2007/08 Review, September. The change to regulation of debit card interchange fees was suggested as an alternative if the improvements to competition that would allow the Board's preferred option of removing regulation did not emerge. [11]