Submission to the Financial System Inquiry 8. Developments and Innovation in the Payments System

A safe, competitive and efficient payments system is essential to support the day-to-day business of the Australian economy. Following the recommendations of the Wallis Inquiry, the regulatory structure around the payments system was updated with the aim of improving competition and efficiency in the payments system, while ensuring that stability and confidence in the system were not compromised. Central to this was the creation of a dedicated payments regulator, the Payments System Board (PSB).

This Chapter discusses the regulatory structure put in place following the Wallis Report and the approach to regulation that the PSB and the Reserve Bank have taken, describing the key reforms implemented by the PSB and the Bank, the effects of those reforms, and how the methods Australians use to make payments have changed since 1997. As innovation in payments was a particular focus of the Wallis Inquiry and is identified as a theme for the current inquiry, this Chapter also discusses the PSB's Strategic Review of Innovation in the Payments System and recent industry progress on objectives identified by the Strategic Review.

The key points of the Chapter are as follows.

• The Wallis reforms to payments system regulation were innovative and have proved effective. The approach of the PSB has been to encourage industry to undertake reform, only using its powers when it judges this to be necessary for managing risk and promoting efficiency, competition and stability. For example, shorter clearing times in the cheque system and the proposal for the New Payments Platform (NPP) were introduced by industry with the encouragement of the PSB. In contrast, the Bank's reforms to card payment systems were only introduced after it became clear that a self- or co-regulatory solution was unlikely to emerge.
• The Bank's reforms to card payment systems have realigned incentives and enabled market mechanisms to work better, as well as making fees and the costs of payments more transparent for users. Many other jurisdictions have since undertaken payments system reforms along the lines of those implemented by the PSB and the Bank.
• As foreshadowed in the Wallis Report, there has been a gradual decline in the relative importance of cheques and cash, and strong growth in electronic payments, such as via debit and credit cards and direct debits and credits. This has been supported by considerable customer-facing innovation in the payments system, with electronic transactions becoming faster, more convenient, more widely accepted and available via a greater range of devices.
• To facilitate greater collaborative innovation in the payments system, the PSB undertook a Strategic Review of Innovation over 2010 to 2012 and established strategic objectives for the payments system. In response, industry is now working on enhanced governance and a project that will provide the capacity for consumers and businesses to make payments with real-time funds availability to the recipient on a 24/7 basis.
• The Wallis Report promoted a number of reforms to the design and regulation of financial market infrastructures (FMIs) that have contributed to financial stability. The introduction of real-time gross settlement (RTGS) in 1998, as supported by the Wallis Inquiry, has dealt with the bulk of domestic settlement risk. More recently, the commencement of same-day settlement of direct entry (DE) payments in 2013 has mitigated much of the remaining settlement risk. Inclusion of the Australian dollar in CLS Bank International (CLS) has addressed the bulk of foreign exchange settlement risk. Such reforms, along with a strong regulatory regime for clearing and settlement (CS) facilities introduced under the Corporations Act 2001, ensured that FMIs continued to operate soundly and remained a source of stability during the global financial crisis.
• Looking ahead, the increasing systemic importance of FMIs, as well as competition and cross-border provision of FMI services, present regulatory challenges. Key recommendations from the Council of Financial Regulators (CFR) arising from its 2011 review of FMI regulation (following the rejection of the proposed merger of ASX and the Singapore Exchange) should be progressed as a matter of priority (CFR 2012c). In particular, with reforms in over-the-counter (OTC) derivatives markets increasingly concentrating activity in central counterparties (CCPs), it is crucial that the official sector has the power to deal with problems in FMIs should they arise. Further, with increased cross-border provision of FMI services, there may be circumstances in which it is desirable to bring an overseas facility under the primary regulation of ASIC and the Bank, under Australian law, and within the scope of a prospective FMI resolution regime. Should these recommendations be progressed, in the Bank's view the regulatory framework will provide a sound foundation to deal with foreseeable challenges.

8.1 The Wallis Inquiry and New Powers for the Reserve Bank

A key theme in the Wallis Committee's Final Report was the need to achieve the right balance between increasing the efficiency of the payments system through promoting contestability and the public policy objective of maintaining financial stability.

The Committee recognised the potential for innovation in payments to deliver efficiency and competition benefits, while noting the importance of ensuring that deposit-like funds of customers were appropriately protected. The Report noted that the Australian payments system at that time could be characterised by relatively high overall costs and that there was scope for substantial efficiency gains, including greater use of electronic payments and reduced use of cash and cheques. It noted that cheques – at the time used extensively – were a much more expensive means of making payment than electronic credits or debits, and that public policy should seek to ensure that pricing and regulation did not impede a shift to lower-cost payment instruments. It also noted, however, that the card payment systems were characterised by opaque fee arrangements, distortionary incentives for certain cardholders and restrictive entry criteria and trade practices.

The Committee supported progress being made in implementing RTGS in Australia, identifying the importance of RTGS in decreasing settlement risk associated with large value payments, and endorsed legislative action to address some legal uncertainties relating to payment and settlement systems. It further noted that subject to cost-benefit considerations, there was scope for extending real-time settlement to other payments.

The Committee noted that the existing governance arrangements for the payments system had not resulted in the setting of appropriate performance benchmarks for the system, so that a revised approach was needed, with a greater emphasis on efficiency. The Report recommended new regulatory arrangements for the payments system, including the creation of a second board at the Reserve Bank, the PSB, which would focus on payments system issues. It also identified some specific issues for the PSB and the Australian Competition and Consumer Commission (ACCC) to focus on as part of their work. In particular, the Report recommended that the Bank and the ACCC undertake a review of interchange fee arrangements in the card systems, and that access arrangements in the payments system be liberalised, including access to Exchange Settlement Accounts (ESAs) at the Bank and access to clearing systems managed by the Australian Payments Clearing Association (APCA).

In 1998, the government implemented a range of reforms that were generally in line with the broad structure and powers recommended by the Committee. The responsibility for oversight of the payments system was entrusted to the PSB. The PSB's responsibilities and powers are set out under four key pieces of legislation: the Reserve Bank Act 1959, the Payment Systems (Regulation) Act 1998 (the PSRA), the Payment Systems and Netting Act 1998 (the PSNA), and Part 7.3 of the Corporations Act. The Bank's policy-making role is one of the four different roles of the Bank in the payments system (see ‘ Box 8A: The Roles of the Reserve Bank in the Payments System’).

The Reserve Bank Act (as amended) formally establishes the PSB, with a mandate to direct the Bank's payments system policy to the greatest advantage of the people of Australia. The Act specifies that the PSB's powers under the PSRA and PSNA are to be exercised in a way that will best contribute to:

• controlling risk in the financial system
• promoting the efficiency of the payments system
• promoting competition^[1] in the market for payment services, consistent with the overall stability of the financial system.

The PSRA sets out the main powers of the Bank in respect of payments system policy and the factors that the Bank must take into account in determining the public interest. These include that payments systems should be financially safe, efficient and competitive, and that the Bank's actions should not contribute to increased risk to the financial system. Part 3 of the PSRA allows the Bank, among other things, to:

• ‘designate’ a particular payment system as being subject to regulation
• impose an access regime for any designated system (an access regime is a regulation that seeks to ensure that new participants are able to access a network on fair and reasonable terms)
• set standards with which participants of a designated system must comply.

The PSNA is concerned with the legal enforceability and certainty of settlement in payment systems. It grants the Bank the power to approve RTGS systems and multilateral netting arrangements in order to provide a level of legal protection and certainty to transactions settled through approved systems.

As is discussed further in Section 8.6, the Reserve Bank Act states that the powers and functions of the PSB under the Corporations Act are to be exercised in a way that will best contribute to the overall stability of the financial system. Reflecting the importance of CS facilities to the payments system and for financial system liquidity and stability more generally, the Corporations Act gives the Bank a regulatory role alongside ASIC. The Bank, under the governance of the PSB, is responsible for setting and overseeing financial stability standards for CS facilities and advising the Minister on decisions relating to CS licences.

Some other jurisdictions have established or proposed regulatory arrangements similar to the framework implemented following the Wallis Report. Most recently, the United Kingdom has announced a new framework after an extended review. This review was prompted by a dissatisfaction with previous governance arrangements, including the role of the industry-dominated Payments Council. The UK Government has recently announced the establishment of the Payments System Regulator (PSR), a separate body under the Financial Conduct Authority, with a mandate to promote competition, innovation and the interests of end users, while having regard to the stability of the UK financial system. To address the latter, the Bank of England and the Prudential Regulation Authority will have powers of veto over PSR decisions. Alongside this, the Bank of England retains its oversight responsibilities for systemically important interbank systems and FMIs. Under the new legislative framework, all retail systems active in the UK will be within the potential scope of regulation and the PSR will have very strong powers, more extensive than those of the PSB in Australia.

8.2 Payments System Trends since 1997

Payment systems in Australia can be broadly divided into retail payment systems, which settle a large number of relatively low-value payments, and wholesale payment systems, which settle a relatively small number of high-value payments.

8.2.1 Retail payments

In recent decades there have been significant changes in the way that individuals, businesses and government agencies make and receive retail payments. As anticipated by the Wallis Report, technological and business innovations have contributed to strong growth in various types of electronic payments, with end users able to choose between a wider range of options for their payments than they could in 1997. Consequently, use of paper-based cheques has fallen, and there is some evidence that in recent years individuals are reducing their use of cash.

For non-cash payments, since 1997 there has been a marked increase in the absolute and relative use of debit and credit/charge cards (Graph 8.1; Table 8.1). Credit card use grew strongly in the late 1990s, before moderating somewhat over the past decade. Use of debit cards has grown particularly strongly since 2007; in addition to use in in point-of-sale purchases, cardholders can also use these cards to obtain cash-out at the point of sale, and certain types of debit cards can now be used in a card-not-present environment (e.g. online). Card networks play an important role in determining the overall efficiency of the payments system, given they account for over 60 per cent of the number of non-cash payments (though only around 3 per cent by value when higher value payments by businesses and government are included).

Since 1997, consumers and billing businesses have also rapidly adopted BPAY, an electronic bill payment system. In fact, in 2013, the value of payments processed through BPAY exceeded the value of credit/charge card payments, partly reflecting the high average value of bill payments for services such as utilities, education and investments. More generally, growing online access to banking services and commerce has been a key driver of change in the way individuals and businesses pay and receive payments (including the growth of BPAY). Consumers have a number of options to make internet-based payments: they can enter their card details directly into a merchant website, or can use internet banking to initiate ‘pay anyone’ or BPAY payments.

In recent years, a number of specialised online payment providers (such as PayPal, Paymate and POLi) have emerged; these systems facilitate individuals' online purchases by funding the transaction through the established card schemes (with individuals' details stored with the online payments provider), by accessing stored-value balances held with the payments provider, or by providing easier access to online banking transfers. As discussed later in this Chapter, in the last few years consumers have increasingly been using smart phones for payments, with financial institutions and a number of non-financial institutions offering mobile applications, or ‘apps’, for making payments via the internet.

Direct entry payments are a key part of the Australian payments landscape. A DE payment is an instruction from a bank account holder to their bank to pay (or collect) an amount directly to (from) another bank account. These payments continue to account for the bulk of the value of non-cash retail payments (87 per cent in 2013). In addition to consumer-initiated ‘pay anyone’ internet payments and the direct debit arrangements consumers establish with service providers, DE payments are extensively used by businesses, corporations and governments for payments such as wages, bill collection and welfare benefits.

Another trend evident in Graph 8.1 is the ongoing decline in the use of cheques, which were a major part of the payments landscape in 1997. The number of cheque payments per capita has fallen from 42 per year in 1997 to 8 in 2013.^[2] A significant share of remaining cheque use is related to business payments and financial institution (‘bank’) cheques, which are typically used for certain types of transactions (e.g. property settlements). Even though their use has declined, cheques still play an important role in the payments system; while now accounting for only 2½ per cent of the total number of non-cash payments, they account for nearly 8 per cent of the value of non-cash payments – more than debit cards, credit cards and BPAY combined.

One of the early initiatives of the PSB was to encourage the industry to shorten the clearing cycle for cheques, in line with a recommendation in the Wallis Report. APCA has continued work in this area and the industry is looking to move to digital cheque clearing and to end the physical transport of cheques in 2015. Further decline in the importance of cheques is expected given use among younger Australians is very low. In addition, innovative alternatives to cheques are likely to continue to emerge. For example, as discussed in Section 8.4.3 the NPP will potentially allow businesses to attach more detailed information to payment instructions, and electronic property settlement systems are emerging that will provide an alternative to existing paper-based (bank cheque) arrangements. As the use of cheques continues to fall, both the unit cost of cheques and the price to end users are likely to continue to rise.

The use of cash remains widespread, though trends are difficult to measure because most cash transactions typically take place directly between payers and payees, without intermediaries being involved. However, one good source of data on the use of cash by individuals is the Reserve Bank's Consumer Payments Use Study. The study was first undertaken in 2007 and was repeated in 2010. The results of the third study in late 2013 are expected to be published shortly. Preliminary results of the 2013 Study indicate that cash remains the most important payment method for low-value transactions (around 70 per cent of payments under $20) and is still widely used for payments up to around $50 (Graph 8.2). The latest study shows, however, that the use of cash has declined relative to other means of payments, with cash accounting for 47 per cent of the number, and 17 per cent of the value of all payments recorded by individuals in the 2013 Study, down from 70 per cent and 38 per cent, respectively, in 2007. Part of the substitution away from cash reflects Australians' adoption of new technologies such as contactless card payments and mobile banking/payment apps.^[3]

While the use of cash in transactions may be declining, there are no signs that holdings of cash are doing so. An alternative indication of the trend in the relative importance of cash can be obtained by comparing the growth of currency on issue with the growth in the broader economy. This suggests a role for cash that is broadly unchanged, with currency in circulation fairly steady for the past several decades in the range of 3–3¾ per cent of annual GDP (Graph 8.3). The contrast between the data for use of cash and for holdings of cash suggest that it has maintained its role as a store of value and there is some evidence – from demand for larger denomination notes – that this increased following the global financial crisis (Cusbert and Rohling 2013). A number of other countries have had a similar experience.

Even though its use in transactions has declined in recent years, cash is likely to remain an important part of both the payments system and the economy more broadly for the foreseeable future. While cash's traditional benefits of speed of transaction and immediate settlement of obligations are being challenged by new technologies, it has a number of attributes that are likely to continue to underpin demand. Cash is fungible – cash received from one person can immediately be used to settle an obligation with another person. This means that cash is a good back-up in situations where electronic payment methods may not be available. It also retains a role as a store of value – unlike some new e-cash systems, its value does not vary significantly over short time periods. Finally, it remains the only anonymous payment mechanism and is therefore likely to remain in demand in particular segments of the population.

The trends evident in Australia since 1997 are broadly similar to international developments. For example, in countries such as the United States, France, Canada and the United Kingdom, use of card payments has also grown rapidly while cheque use has contracted significantly (Table 8.2). Cross-country data suggest that Australians are among the most frequent users of payment cards. Australia is more towards the middle of the pack in terms of cheque usage, with less use than in the four other countries shown in Table 8.2, but more than in most of the northern European countries where cheques have historically been little used or have been phased out. More comprehensive data on payment systems in a range of countries are published by the Bank for International Settlements (CPSS 2013).

8.2.2 Wholesale payments

A key development since the Wallis Inquiry has been the introduction of RTGS for high-value payments through RITS and payment-versus-payment settlement for foreign exchange transactions through CLS. The use of these payment systems allows participants to control for settlement risk, consistent with a recommendation of the Wallis Report.

8.2.2.1 The Reserve Bank Information and Transfer System (RITS)

RITS is Australia's RTGS system and is operated by the Bank. In RTGS systems, which are viewed internationally as best practice, individual payments are processed and settled continuously and irrevocably in real time. RITS was launched in 1998 and replaced a deferred net settlement system under which interbank obligations accumulated throughout the day and were not settled until 9.00 am the following day. In contrast, since RITS is an RTGS system, it prevents the build-up of unsettled obligations, significantly reducing interbank settlement exposures.

RITS settles transactions across participants' ESAs held at the Bank. Settlement across ESAs, and therefore in central bank money, is a service that only the Bank can provide. Accordingly, RITS sits at the heart of the payments system. In addition to settling individual RTGS payments, it also facilitates the settlement of interbank obligations arising from a number of linked payment systems and FMIs (Figure 8.1).

• Debt securities transactions arising in the Austraclear system operated by ASX are settled on a delivery-versus-payment basis – that is, the transfer of title to the security is contingent on the final settlement of the associated funds payment – with the funds payment settled in RITS. The ASX CCPs' margin payments are also submitted via Austraclear and settled in RITS.
• Australian dollar-denominated obligations arising in the foreign exchange settlement system operated by CLS are also settled in RITS.
• The funds payments associated with cash equity transactions that settle in ASX Settlement are settled in RITS in a multilateral net batch at around noon each day (known as the CHESS batch).
• The interbank obligations that arise in retail payment systems are also settled on a deferred net basis in RITS.

Reflecting the central role played by RITS, around 70 per cent of the value of non-cash payments in Australia is settled on an RTGS basis in RITS. In 2013, RITS settled on average around 41,000 RTGS transactions each day, with an aggregate daily value of around $161 billion (Graph 8.4).

8.2.2.2 CLS Bank International (CLS)

CLS is an international payment system for settling foreign exchange trades in 17 currencies, including the Australian dollar. CLS began operations in 2002, with the Australian dollar one of its seven initial currencies. Since its inception, Australian dollar settlements in CLS have grown strongly to be on average around $250 billion per day in 2013 (Graph 8.4).

By operating a PvP settlement mechanism, CLS allows participants to eliminate foreign exchange settlement risk (the risk that one party settles its obligation, while the other subsequently does not), a risk that was highlighted in the Wallis Report. Payments submitted to CLS are settled on a gross basis across accounts on CLS's book, but members only receive or pay a net settlement amount vis-à-vis CLS in each currency. Members meet any net Australian dollar-denominated payment obligation (known as a CLS pay-in) by making payments to CLS via RITS. CLS pays out net Australian dollar receipts in a similar way. The effectiveness of netting is illustrated by the fact that the value of these pay-ins and pay-outs is only around 1 per cent of the gross value of trades involving the Australian dollar that are settled by CLS.

8.3 The Payments System Board's Work on the Retail Payments System

Following the introduction of RTGS in 1998 and the accompanying reduction in settlement risk, much of the PSB's work over the past 15 years has related to retail payment systems and its mandate to promote efficiency and competition. Over this period the Bank has consulted widely and undertaken a range of studies to shed light on the functioning of the payments system. This section outlines the Bank's activities in documenting various aspects of the payments system and the regulatory initiatives that have followed.

8.3.1 Research into the Australian payments system

The Bank closely monitors trends and developments in the payments system. It collects regular data on payments activity from financial institutions and payments system operators and publishes these monthly on its website. It also provides an overview of domestic and international trends in the PSB's Annual Report. The Bank's staff conduct regular liaison with industry – especially APCA, the industry's self-regulatory organisation – and with end users. In addition, the Bank has regular contact with overseas regulatory bodies, in particular with other central banks via its membership of the Committee on Payment and Settlement Systems (CPSS). It has also conducted a number of major studies, as outlined in the remainder of this section.

Some early work of the Reserve Bank and the PSB involved a detailed analysis, together with the ACCC, of the pricing, rules and access arrangements of card payment systems. This work had been suggested by the Wallis Report and culminated in the publication of the ‘Joint Study’ in October 2000 (RBA and ACCC 2000).

The Joint Study found that there was very little transparency in the arrangements underlying card payment systems. It found that the card systems, exercising market power, tended to have arrangements that detracted from the efficiency and competitiveness of Australia's payments system:

• Relative prices to cardholders for card payments in Australia did not generally reflect relative costs. In particular, the resource costs (the cost of ‘producing’ a payment) of a $100 credit card transaction were around 201 cents, but the cardholder usually faced a negative price for this transaction – an interest-free period and reward points to the value of around 90 cents. Meanwhile, the resource costs of a transaction in the domestic debit (i.e. eftpos ^[4]) system were around 41 cents for that same transaction, but the cardholder faced a positive price of up to 60 cents. The effect of these relative prices was that it was likely that consumers were using credit cards more frequently, and eftpos less frequently, than they would if prices more closely reflected costs. Consequently, the overall cost of making payments was higher than it might otherwise have been.
• Restrictions on merchants impeded competition and efficiency. Specifically, the card schemes had rules in place that: (a) prohibited merchants from charging more for accepting their cards than for other payment instruments – the ‘no-surcharge’ rules; and (b) required merchants to take all cards associated with a particular scheme's brand – the ‘honour-all-cards’ rule.
• Access arrangements for a number of payment systems were more restrictive than necessary to ensure the stability of those systems. In the Bankcard, MasterCard and Visa systems, participation was restricted to authorised deposit-taking institutions (ADIs), and rules discouraged ‘specialist acquirers’ (i.e. firms specialising in providing card acceptance to merchants and not issuing cards to cardholders). In addition, access to the eftpos system was complicated by the bilateral infrastructure and institutional arrangements that applied in the system, meaning that new entrants were required to negotiate and establish connections with multiple entities in order to gain effective access.
• Information on pricing and access in the card systems was not always available. In particular, there was no transparency of interchange fee rates, nor were there publicly available criteria for access for prospective system participants.

In 2007–08 the Bank conducted a review of its earlier card payments reforms and undertook two further studies. The first gathered detailed information into household payment patterns in Australia – a study of how consumers use various payment methods (Emery, West and Massey 2008). This study provided particular insight into the use of cash by consumers for transaction purposes. The study also gathered demographic, payments channel and merchant information, providing a very detailed picture of how Australians make payments. Follow-ups to this study were undertaken in 2010 (as an input to the Bank's Strategic Review of Innovation) and in late 2013 – detailed results of the third consumer study are expected to be published shortly.^[5]

As noted above, preliminary results from the 2013 study indicate that the trends identified between 2007 and 2010 have continued, with Australians using less cash, fewer cheques and making more card and other electronic transactions.

The second of the studies undertaken in the 2007–08 Review was a payments cost study, which was a broader and more detailed study of resource costs in the payments system than the study done for the Joint Study with the ACCC (Schwartz et al 2008).

The key findings of the study were as follows:

• In aggregate, the costs incurred by financial institutions and merchants in processing the payments of individuals were equivalent to at least 0.8 per cent of GDP. This aggregate cost estimate is around the middle of the estimates from studies in a number of European countries done in the years before and after the Bank's study. The study did not include business-to-business payments, so the total costs involved in the payments system as a whole would have been higher.
• In terms of the average cost of point-of-sale payments, the ranking of the various payment instruments was reasonably clear, with cash being the lowest cost, followed closely by eftpos (i.e. the domestic debit network), with more of a gap to credit cards and then cheques. The cost of cash payments, however, increases with the value of the transaction, so that for larger payments, eftpos payments had a lower cost.
• For all transaction sizes, credit card payments were more costly than for eftpos payments. This not only reflected the higher costs associated with the extension of credit and the operation of reward schemes, but also higher fraud costs, scheme fees and the higher capital costs associated with operational risk.
• While cash was a relatively low-cost payment instrument for the bulk of transactions for which it was used, a significant share of the total costs of the payments system arose from cash payments. This reflected the fact that cash remained the predominant payment instrument in the economy, accounting for around 70 per cent of all payments by individuals.
• For payment methods not used at the point of sale, the DE system had the lowest cost, followed by BPAY, credit cards and cheques.

The Bank is currently consulting with financial institutions and retailers about a new cost study which is expected to be completed in late 2014. It will take account of the significant change to payment patterns and technologies since the 2007 study, for example the growth of contactless and mobile payments and in Visa and MasterCard's debit card networks. The study will update the 2007 data, provide a new benchmark for the cost of providing payments in Australia and will help guide the Bank's thinking about the efficiency of the Australian payments system.

Over 2010–2012, the Bank undertook the Strategic Review of Innovation in the Payments System, a wide ranging review of the degree of innovation in the payments system and of factors influencing innovation. The Strategic Review followed an earlier study of payments technology and architecture discussed in the PSB's 2006 Annual Report. This review is discussed in more detail in Section 8.4.2.

8.3.2 The Bank's regulatory reforms in retail payments

In general, payment systems in Australia operate without regulatory intervention. The PSB has not opted for regulation as a first resort but initially seeks to encourage industry initiatives to address areas of concern; only intervening on public interest grounds when the industry is clearly unable to do so.

However, one area where the PSB has implemented wideranging reforms is to Australia's card payment systems and its ATM system. Broadly speaking, these reforms aimed to address the PSB's concerns regarding pricing in and access to these systems, as well as restrictions on merchants that hindered competition in the case of cards. Most of this work has derived from the PSB's responsibilities under the PSRA (described above). In the case of the reforms to interchange fees in the credit card systems, the Bank's work was in response to the recommendation in the Wallis Report that the PSB and ACCC should review interchange arrangements. This reflected the Wallis Report's finding that ad valorem interchange fees on credit cards meant that the cost (to merchants) of providing credit card acceptance to consumers could be very high. The report noted that the cost of interchange fees was not transparent and was ultimately borne by consumers in the form of higher prices. The Bank's decision to invoke its new regulatory powers reflected the assessment that there was little prospect of voluntary measures by industry to address the concerns of the PSB and the Bank. Indeed, the PSB's initial reforms were challenged in court by both MasterCard and Visa, with the Federal Court upholding the Bank's actions.

The remainder of this section summarises some of the more important regulatory reforms implemented by the Bank.^[6]

8.3.2.1 The Bank's reforms to card payment systems

The Bank's approach to regulatory reform of the card payments market has been holistic and has included a range of measures directed at improving the efficiency of the payments system, such as reforms to interchange payments and to various aspects of the rules of the card schemes that had placed restrictions on merchants and financial institutions.

Interchange reforms

Interchange fees are wholesale fees paid between a merchant's financial institution and a cardholder's financial institution when a cardholder undertakes a transaction (see ‘Box 8B: Interchange Fees’). The Bank's reforms in this area reflected concerns about the lack of transparency around these fees. The Bank also considered that the large gaps that existed between the fees charged in the eftpos, scheme debit^[7] and credit card systems were not justified by costs and sent inefficient price signals to customers and merchants.

In April 2001, the PSB designated the Bankcard, MasterCard and Visa credit card schemes, enabling it to set standards for these schemes.^[8] In August 2002, the PSB decided that from July 2003 the schemes would be subject to a standard which set an interchange fee benchmark for each scheme and increased transparency of these fees. The benchmark was based on the average costs of the issuers of each scheme. Since November 2006, there has been a common cost-based average interchange fee benchmark of 50 basis points for both MasterCard and Visa.

Reforms of the debit card systems began in 2004, with the PSB designating the Visa Debit system in February and the eftpos system in September. In July 2006, the PSB introduced interchange standards for each system and in 2013 a new standard took effect for the eftpos system to reflect structural changes to that system. The current standards set a common benchmark of 12 cents. The Debit MasterCard system has not been formally designated but MasterCard has given a voluntary undertaking to comply with the standards applying to Visa Debit.

The standards on interchange fees for the MasterCard and Visa systems set benchmarks for the average interchange fee that can be paid in those systems. In practice, the schemes have set a large number of different interchange fee rates for different types of transactions, with the weighted average interchange rate subject to the benchmark. The standards require that every three years, or at the time of any other reset of interchange fees, the average of the new interchange rates does not exceed the benchmark, with weights based on the transactions of the most recent financial year. In practice, reflecting the backward-looking compliance calculation, the setting of the international schemes' interchange fee schedules and the issuance strategies of financial institutions, the weighted-average interchange fees for the two schemes have tended to be a little above the benchmarks, albeit well below the average levels of before the reforms.

For the eftpos system, prior to the reforms interchange rates were around 20 cents per transaction, paid by the cardholder's bank to the merchant's financial institution – that is, in the opposite direction to the MasterCard and Visa schemes. With the creation of a scheme to govern the eftpos system and interchange regulation now in line with that applying to the MasterCard and Visa debit systems, eftpos interchange fees now typically flow to the issuer, the highest rate being 5 cents – well below the 12 cents cap.

Taken together, the interchange fee reforms have brought down the average interchange fees paid in the international systems and have reduced the gap between interchange fees in the credit card, scheme debit card and eftpos systems (Graph 8.5). The broader effects of the interchange reforms are discussed below.

Scheme rules

The PSB has also introduced regulation to address several scheme rules that it considered acted to hinder competitive forces. One such rule was the ‘no-surcharge’ rule, which prevented merchants from passing on the costs of accepting cards to consumers. Another was the ‘honour-all-cards’ rule, which required merchants that accepted one of a scheme's payment cards (e.g. credit cards) to also accept all that scheme's other products (e.g. their debit cards). The effect of these rules was to lessen the ability of market forces to place downward pressure on the cost of payments to merchants.

To address these concerns, the PSB introduced a standard that came into force in January 2003 which has the effect of enabling merchants, if they choose, to charge customers for Visa and MasterCard credit card transactions: American Express and Diners Club subsequently agreed voluntarily to comply with this standard. In January 2007, the PSB introduced an additional standard which extended the right of merchants to charge for the use of Visa Debit cards, and which also allows merchants to choose whether to accept Visa Debit cards independently of their choice to accept Visa Credit cards (and vice versa): MasterCard has undertaken voluntarily to also comply with this standard.

In 2012, the PSB decided to amend the standards relating to surcharging (the amendments took effect in March 2013). The decision reflected the PSB's concerns about surcharging practices that had developed over the period since no-surcharge rules were removed. In particular, the PSB was concerned about the increase in cases where charges appear to be well in excess of card acceptance costs or where surcharges are ‘blended’ across card schemes even though merchants' acceptance costs may be higher for some cards than others. The amended standards allow card scheme rules to limit charges to the reasonable cost of card acceptance, while continuing to ensure that merchants can fully recover their card acceptance costs. The Bank issued a guidance note to assist schemes, participants and merchants to determine the acceptance costs that might be considered reasonable.

Removal of the honour-all-cards rule has given merchants another tool to use in negotiations over merchant service fees. A merchant can, for example, decline to accept debit cards from MasterCard and Visa while continuing to accept their credit cards, and vice versa. To date, only one large merchant has carried through with action to decline acceptance of MasterCard and Visa debit cards, although the possibility of such action being taken has likely been used in negotiations in other cases.

Access

As noted above, the Wallis Report identified several areas of the payments system where there was scope for liberalisation of access. Following the Joint Study and subsequent work, the Bank identified some restrictions on participation imposed by the card schemes that unnecessarily inhibited competition and could not be justified as protecting the safety of the system. The PSB therefore established an access regime for the Visa and MasterCard credit card schemes in February 2004. The regime required that a new class of financial institutions, specialist credit card institutions (SCCIs), be eligible to apply for membership in the schemes on the same basis as other ADIs. The Access Regime also required the removal of certain restrictions and penalties regarding the credit card acquiring activity of members of the two systems. Soon after the reforms, two entities gained access to the MasterCard and Visa systems as SCCIs. One of these has specialised in providing card acceptance services to merchants, a business model that was prohibited under the previous scheme policies.

In May 2013, the Bank announced a public consultation on whether the existing access regimes for the Visa and MasterCard systems remain appropriate, given the change in the ownership structures of the schemes (from member associations to listed companies) and the interest shown by some niche players, which might not warrant full prudential regulation, in seeking access to the card systems. In March 2014 the PSB announced a decision in principle that will allow the systems greater flexibility to expand membership. The implementation of this decision will be contingent upon changes to the Banking Regulations 1966 and consultations with APCA.

The PSB also implemented an access regime for the eftpos system in September 2006. This aimed to address problems that arose when new entrants had to undertake bilateral access negotiations with multiple incumbents who might prefer to prevent the entry of new competitors: for example, the Wallis Report noted that regional banks had been frustrated in their efforts to become direct participants in the eftpos system. The Bank's reforms facilitated access by constraining the scope for existing participants to offer unfavourable bilateral interchange fees to new entrants and by limiting the charge that existing participants could levy for establishing a new connection. This was the result of cooperative work between the Bank and APCA over several years. Recently, however, the establishment of a common network (the Community of Interest Network or COIN) has removed the need for new eftpos entrants to establish a series of physical bilateral connections. Furthermore, business arrangements (such as for common multilateral interchange fees) have been centralised in an eftpos scheme. Access will be further facilitated by the introduction of a genuinely hub-based architecture for the eftpos system. Accordingly, the PSB made an in-principle decision in November 2012 that it will revoke the Access Regime if the scheme puts satisfactory access arrangements in place.

In recent years the PSB has also noted concerns relating to ‘dual-network’ debit cards, i.e. ATM/debit cards issued by banks and other financial institutions with point-of-sale debit functionality from two payment networks. The PSB has viewed the longstanding practice of issuing dual-network cards as providing convenience for cardholders and enabling stronger competition between networks at the point of sale. The PSB was concerned that actions by particular networks with respect to these cards had the potential to inhibit competition, limit consumer choice and increase costs. Accordingly, it encouraged the industry to work towards voluntary agreement on principles relating to dual-network cards, and in August 2013 welcomed the outcomes of discussions between ePAL, MasterCard and Visa regarding the PSB's concerns. The outcome will safeguard the rights of Australian card-issuing banks and institutions to maintain existing dual-network arrangements in the contactless environment. Where an issuer wishes to include applications from two networks on the same card and chip, the networks have agreed to work constructively with the issuer to allow this. The networks have also agreed not to prevent merchants exercising choice in the networks they accept, in both the contact and contactless environments.

8.3.3 Effects of the Bank's card payment systems reforms

When the Bank announced its regulation of the credit card schemes in August 2002, it indicated it would conduct a review of its reforms after five years. The review, which was released in 2008 and covered the Bank's reforms to the credit card and debit card systems, as well as interchange fees and access arrangements in other payment systems, concluded that the reforms had been beneficial to the Australian economy. In particular, the PSB was of the opinion that the reforms had increased transparency, improved competition by removing restrictions on merchants and liberalising access, and promoted more appropriate price signals to consumers. With the benefit of further evidence from the past five years, the Bank's view remains that the reforms have been in the public interest and helped contribute to a more efficient and competitive payments system. The importance of these reforms is reinforced by the major role of card payments in the Australian economy, with total card transactions growing to around $480 billion in 2013. The reforms put in place by the Bank have been followed by similar reforms in a large number of other jurisdictions (see ‘Box 8C: Retail Payments Reforms in Other Jurisdictions’).

It is important to note that the Bank's reforms, while consisting of a series of individual measures, were designed to work as a package:

• a benchmark was established for interchange fees so that prices faced by merchants and consumers more closely reflect relative costs
• transparency of these interchange rates, plus the capacity for merchants to charge for the use of particular cards and the ability to not accept all types of cards, gives merchants negotiating power that can help ensure that lower interchange fees are reflected in lower merchant service fees
• the expansion of eligibility to participate in the card systems promotes competition in providing card acceptance services to merchants
• reductions in interchange rates have reduced the scope for issuers to offer incentives for consumers to use high-interchange, high-cost cards, shifting payments behaviour towards lower resource cost methods.

A decade after the reforms it is clear that the Australian cards market has remained vibrant, contrary to the arguments by the international schemes that the reforms could send the cards market into a ‘death spiral’.^[9] Innovation has continued: the adoption of contactless payments, PIN authorisation and EuroPay, MasterCard and Visa (EMV) security are all far ahead of the United States, for example.

Furthermore, the value of card transactions has grown by an average of 8.8 per cent per annum over the past decade, significantly above the 5.9 per cent average growth in the value of household spending over this period. Within this total, growth in debit cards has outpaced growth in credit cards (average growth of 11.9 and 6.9 per cent, respectively), which is not surprising given the broader trend towards more prudent household behaviour, as witnessed by the increase of around 10 percentage points in the household saving ratio over this period.

The reforms to interchange fees and the various reforms to strengthen the rights of merchants have had the effect of bringing down the cost of payments services to merchants. Without the Bank's reforms, it is likely that the perverse incentives discussed in ‘Box 8B: Interchange Fees’ would have led to an increase in interchange rates, and it is possible that credit card interchange rates in Australia could instead have risen close to the much higher levels seen in the unregulated US market (Table 8.3 shows some indicative rates).^[10]

Looking across the different card systems:

• Average merchant service fees for MasterCard and Visa transactions have fallen by around 60 basis points relative to their levels prior to the reforms (Graph 8.6). This is a larger fall than the reduction in interchange fees for the MasterCard and Visa credit card systems.
• Despite there being no direct regulation of the ‘three-party’ schemes, American Express and Diners Club, merchant service fees in these systems overall have fallen by slightly more than for MasterCard and Visa.^[11]
• Average merchant service fees for eftpos transactions have risen by around 12 cents (or by 0.21 per cent of transaction value) from their levels prior to the 2006 eftpos interchange fee reforms, though eftpos remains the lowest-cost scheme for merchants in terms of average merchant service fees. The increase in the cost of eftpos reflects the reversal of the direction of interchange payments in the eftpos system. While fees to merchants have risen, the change in interchange arrangements means – as would be suggested by ‘Box 8B: Interchange Fees’ – that fees to account holders for eftpos transactions have tended to fall. Previously, many account holders had monthly limits on the number of fee-free eftpos transactions they could make in a month: such transactions are now typically unlimited.
• Combining transactions across all card systems, average merchant service fees in Australia have fallen by around 37 basis points from their level prior to the Bank's reforms. Furthermore, the latest available annual data show that average merchant service fees are around 75 basis points lower than in the United States, where reforms to card systems have been much more limited (Graph 8.7).

Overall, based on these data for average merchant service fees for the different schemes, the effect of the reforms has clearly been a reduction in merchant costs: one simple estimate of these savings is a total of $11 billion relative to the amount merchants would have paid over the past decade if merchant service fees had remained at the rates existing prior to the reforms.^[12] To the extent that interchange fees might have risen significantly in the absence of the Bank's reforms – for example towards the levels now existing in the United States – any estimate of the savings to merchants would be far larger.

It is impossible – given the imprecision in any econometric model of inflation – to measure exactly how these reductions in merchant service fees have flowed through into prices for consumers. However, just as with reductions in any other business costs – such as wages, taxes, the cost of energy etc – that influence the prices charged by business in other competitive industries, it seems reasonable to assume that they have mostly flowed through to lower retail prices for consumers, just as it is reasonable to assume that increases in merchant costs are similarly passed on to consumers over time. While the presumption that interchange rates influence the retail prices for goods and services faced by consumers has been questioned by the international schemes, it was certainly clear in the Wallis Report (see Financial System Inquiry (1997), p 396).

The caps on interchange in the credit card systems have, as would be implied by the discussion in Box 8B, led to some reduction in the generosity of cardholder rewards programs on average. Based on a sample of cards analysed by the Bank, the effective average rebate in a ‘standard’ rewards program – as calculated from the spending on a Visa/MasterCard required for a shopping voucher of a given amount – has fallen from around 0.81 per cent in June 2003 to 0.49 per cent in December 2013. Together with the reduction in interchange fees which will have fed through into lower prices charged by merchants, this implies that there has been a reduction in the extent to which those consumers that benefit from rewards programs are being subsidised by all other consumers.

While the benchmarks applying to weighted-average interchange rates have resulted in average interchange rates being much lower than prior to the Bank's reforms, the past decade has seen an evolution in the range of credit card products offered, as card-issuing financial institutions have responded to the introduction of new higher interchange rate categories by MasterCard and Visa. These new categories provide card issuers with considerably greater interchange fee revenue for ‘platinum’ (or equivalent) card transactions than for standard or ‘gold’ card transactions, which can be used to fund more generous rewards programs. Consequently, there has been significant growth in the premium segments of the credit card market. The growth in higher interchange categories has been accompanied by a reduction in some other interchange categories, including the introduction of lower ‘strategic’ rates applying to the transactions of some favoured classes of merchants. The cost to a merchant's financial institution (ultimately passed on to the merchant) of the highest fee category is now nearly double the rate applying in November 2003.

The PSB noted in its 2013 Annual Report that the cost of these higher interchange categories tends to fall on medium-sized and smaller merchants and other merchants that do not benefit from preferred rates. Given the operation of the hierarchy of the interchange fee schedules, a premium card will always carry an interchange fee as low as 0.20 or 0.23 per cent when presented to a merchant with the lowest strategic rate, but will have an interchange payment of up to 2.0 per cent for a merchant that doesn't benefit from preferential arrangements. The Bank will be reviewing this aspect of the operation of the credit and debit interchange systems in the period ahead. It will also be reviewing the issuance of American Express companion cards by financial institutions and considering whether some change to the regulatory treatment of these cards (or those of any other scheme that is not currently designated) might be warranted.^[13]

With respect to surcharging, the removal of the no-surcharge rules in 2003 appears to have had many of the expected effects:

• Survey data show that the proportion of merchants surcharging for transactions on American Express and Diners Club cards, which tend to be more expensive for merchants, is higher than for transactions on MasterCard and Visa cards.
• Although the level of surcharge varies across merchants, the average level of surcharge (for those merchants that surcharge) is higher for American Express and Diners Club. Calculations by the Bank for the PSB's 2013 Annual Report indicated that American Express and Diners Club surcharges averaged around 2.7 per cent, compared to around 1.5 per cent for surcharged MasterCard and Visa transactions.
• Within each scheme, there is a tendency for surcharging behaviour to reflect cost differences to merchants: for example, the large supermarkets and other preferred merchants which benefit from lower strategic interchange rates tend not to surcharge, while other merchants that face higher payments costs due to higher interchange rates on premium cards are more likely to surcharge.
• The ability of merchants to surcharge has made the cost of particular payment methods more apparent to consumers and enabled merchants to encourage the use of lower-cost payment methods. The Bank's 2010 Consumer Payments Use Study found that around half of consumers that hold a credit card would seek to avoid paying a surcharge by paying with a debit card or cash, payment methods that typically do not incur a surcharge. The survey indicated that a surcharge was actually paid on only around 4 per cent of transactions.

Overall, the Bank's assessment is that the removal of no-surcharge rules and the reduction in costs to merchants has applied downward pressure on prices in a range of industries, to the benefit of all consumers. Similarly, a recent study by the Commonwealth Consumer Affairs Advisory Council (CCAAC 2013) concluded that ‘Credit card surcharges that reflect the reasonable costs of card acceptance are generally beneficial to consumers as they support wider acceptance of payment options that are convenient for Australian consumers while facilitating efficient outcomes within the payments system. CCAAC notes that since the removal of the “no-surcharging” rules in 2003, there has been a significant reduction in the service fees applied to merchants upon a consumer's use of their credit card.’

The Bank notes, however, that there is so far only limited evidence of an effect from the recent regulatory changes to allow card schemes to limit surcharges to the reasonable cost of card acceptance. While there have been a few high-profile reductions in surcharges, surcharging in the taxi industry remains very high, and there appear to be cases where surcharging in some other industries (most notably air travel) is excessive. In addition, surcharges (like some other ‘service’ or ‘ticketing’ charges on transactions) are often poorly disclosed. The Bank considers that the solution is not to ban all surcharges: some means of payment (e.g. high interchange/high rewards credit cards) can be very expensive for merchants and merchants should be able to recover their costs on such transactions. The PSB will, however, be studying this issue over the coming year, with a view to whether further action by the Bank, ACCC or ASIC may be appropriate.

8.3.4 The Bank's reforms to the ATM system

In December 2008 the PSB designated the ATM system, following a request by industry. The Bank:

• had been concerned for some time about the role of interchange fees in this system, in particular that they were not transparent, were inflexible and bore little relationship to the cost of a transaction at a ‘foreign’ ATM transaction (an ATM not part of the network of the cardholder's financial institution)
• was of the view that a continuation of this inflexibility could over time result in the number of ATMs in Australia declining, if owners – most notably the independent non-bank deployers of ATMs – found it uneconomic to provide ATMs, particularly in high-cost and low-volume locations (e.g. rural and remote communities)
• was concerned about the difficulty that new providers faced in gaining access to the ATM system and the possible implications for competition.

In March 2009, the PSB implemented an access regime that caps the access charge (the one-off new connection cost) that can be levied on a new ATM provider by existing participants and in most cases eliminates interchange fees for ATM transactions. The Access Regime operates in conjunction with an access code developed by APCA with support from the Bank. In August 2012, the PSB amended the Access Regime to extend the Bank's powers to grant exemptions for ATM arrangements that would otherwise be counter to the Regime's interchange provisions. This was prompted by the work of a Reserve Bank–Treasury taskforce, which had looked at access to ATMs by residents of remote Indigenous communities. The PSB used its powers to grant an exemption to an arrangement proposed by ATM industry participants that will help reduce the high expenditure on ATM fees by residents of selected very remote Indigenous communities.

The Bank's ATM reforms have resulted in the elimination of fees charged by a cardholder's financial institution on ‘foreign’ ATM transactions (and typically notified only in the subsequent monthly statement). While cardholders may now be charged directly for transactions by the ATM owner, the charge must be notified and the cardholder given the the opportunity to cancel the transaction. A 2011 review of the reforms by the Reserve Bank–Treasury taskforce found that the reforms had resulted in changes in consumer behaviour, with cardholders shifting to making withdrawals from their own network and saving $120 million in fees in the year after the reforms were implemented. While the cost of ‘foreign’ transactions rose at some ATMs, it fell in others, with the average fee unchanged. The reforms have also made it easier for new deployers to participate in the ATM market and resulted in an increase in the growth rate of the number of ATMs in the two years following the reforms.

8.4 Retail Payments Innovation in Australia

The rapid advancement of information and communications technology has had a profound impact on many industries over the past two decades. It was inevitable that this would also be the case in the area of retail payments given its heavy reliance on these factors. Retail payment systems are currently the subject of substantial customer-facing innovation as well as an industry project that will deliver large increases in the speed and convenience of payments. If managed appropriately, these changes also have the potential to deliver greater security and increased competition.

This section provides further discussion of the nature of innovation in the Australian retail payments system, drawing on the work done in the Bank's Strategic Review of Innovation in the Payments System.

8.4.1 A framework for understanding retail payment systems and innovation

In order to understand innovation in retail payment systems, it is necessary to understand the nature of different types of payment systems and their implications for how innovation might occur.

In a country like Australia, with a well-developed financial system and a high proportion of the adult population holding bank accounts, many retail payments systems are so-called ‘open-loop’ systems.

• These typically involve the movement of customer funds at one financial institution to a customer account at another institution: for example, from a consumer's deposit or credit account to the account of a merchant when a purchase is made in a store. An open-loop system must provide a mechanism for both funds and information about payments to be exchanged between different financial institutions. Open-loop payment systems therefore require some form of coordination among financial institutions in order for this to occur; in other words, collaboration between entities that are otherwise competitors.
• The rules and telecommunications arrangements that support such systems can be provided in different ways. Many of the longer-standing payment systems in Australia (e.g. the cheque system, DE and eftpos) have traditionally been based on a combination of bilateral agreements and bilateral communication links between participant institutions, combined with some cooperatively agreed rules set via APCA. In contrast, other open-loop systems – for example, BPAY, MasterCard and Visa – are more centralised, with centrally set rules and a hub-based network as part of a commercial scheme.^[14]

An alternative type of system is a ‘closed-loop’ system, where customers hold funds with a single system provider and payments occur by making transfers between customers' accounts within that system. This type of system is much simpler to operate and adapt because there is no need for cooperation across different entities. Of course, unless the system is very widely used and users are prepared to hold their savings in the system (equivalent to all Australians banking with one financial institution), funds need to be transferred in and out of the system to be readily usable.

Developments in the payments system over recent times suggest that innovation is easier the fewer parties there are involved in change decisions.

• Closed-loop systems tend to be able to innovate relatively easily because the degree of coordination required is limited relative to an open-loop system. And among open-loop systems, innovation is easier in a hub-based system than in one with many bilateral links. Indeed, the Wallis Report noted this problem with bilateral systems.
• The ease of innovation in an open-loop system depends on the level at which it is occurring. Individual institutions participating in a payment system typically can innovate freely in the way in which they interact with their own customers. For instance, Australian financial institutions have been very active in developing internet and mobile phone payment applications, in part because they can do this without the need to cooperate with any other financial institution. Financial institutions have actively pursued this type of ‘customer-facing’ innovation in recent times, largely driven by competitive forces.
• By contrast, innovation in the cooperative elements of payment systems, where common rules, standards and network arrangements apply, is significantly more difficult because there are more parties and interests involved. As the Bank has noted previously, the Australian payments system was at the global forefront in the delivery of the eftpos system and a universal ATM system in the 1980s, but the difficulty of cooperative or collaborative innovation in those bilateral systems meant that further development of those systems (along with the DE system) was extremely slow over the ensuing decades. A commercial scheme, however, will often have a greater capacity to innovate at this level because the scheme can impose mandates on its members. For this reason, the eftpos system has now been established as a scheme, and significant innovation is currently underway.

The difficulties in ensuring successful collaborative innovation were seen a few years ago in the MAMBO (Me @ My Bank Online) project. This project was initiated in 2007 and involved the four major banks and was led by BPAY. The project was intended to extend the concept of BPAY identifiers to facilitate person-to-person and a wider range of person-to-business and business-to-business payments, including through payment requests. It would also have provided an increased capacity to exchange non-payment information. However, the combination of a number of factors – the complexity and high cost of the project, the challenges for banks that were already undertaking significant modernisation projects for their own internal systems, and the different investment cycles and commercial interests of the banks – led to the abandonment of the project in 2011.

8.4.2 The Strategic Review of Innovation in the Payments System

In recognition that cooperative innovation in the Australian payments system had lagged, and that as a result there were some increasingly apparent gaps in the services that the payments system could provide, the PSB announced a Strategic Review of Innovation in the Payments System in mid 2010. The Strategic Review involved an extensive consultation process, which included several published documents, opportunities for formal and informal input from interested parties and an industry roundtable. The conclusions from the Strategic Review were published in June 2012 and are highly relevant for the Financial System Inquiry in that the Review gave lengthy consideration to issues and trends associated with payments innovation and has set in train possibly the most significant changes in the Australian payments system since the immediate aftermath of the Wallis Inquiry.

The problems that the Bank has focused on in this area are important ones, as is witnessed by a similar initiative that is now underway in the United States. The Federal Reserve initiated a consultation in September 2013 where it shared its perspectives on some key gaps in the US payments system. The Fed plans to release a paper in the second half of 2014 which will define and prioritise initiatives to improve the speed, efficiency and security of payments.

8.4.2.1 Gaps in the payments system

The Bank sought to add some structure to the process of identifying current or prospective gaps in the payments system by setting out the factors that are valued by users of the system. Those factors included:

• timeliness: this may relate to the speed with which funds from a payment instruction are made available to the recipient. It may also relate to the speed with which confirmation is received that a payment has been authorised and funds will be received, even if they will not be available until a later time; with this knowledge transactions can be completed and goods or services supplied.
• accessibility: this includes the ability to access the payments system when and where required and make payments to whoever required.
• ease of use: this can reflect factors such as the number of steps in the payment process, the amount of information that must be provided (such as account and BSB numbers), and the process by which it is provided. These factors are relevant for convenience, but may also influence the prevalence of errors that can be costly to correct.
• ease of integration with other processes: payments are often made as part of a process that requires some form of information exchange and reconciliation. Payment systems should ideally be able to integrate efficiently with these processes. Examples are the capacity of payment systems to carry additional information relevant to the payment and the ability of payments to be easily integrated with accounting systems.
• safety and reliability: end users of a payment system need to have confidence that the system will be available when expected and that payments will reach the intended recipient at the time promised. They also need to be confident that the system is secure, so that using it will not expose them to future losses due to fraud.

Based on its consultations and the attributes identified as being valued, the PSB identified the following gaps in the payments system, which it anticipated would become increasingly pressing in the years to come.

Real-time payments

The PSB noted the inability of individuals, government agencies and businesses to make retail payments with the recipient having visibility and use of those funds in near-to-real time. Currently, in cases where the sender and receiver have accounts with different institutions, Australian retail payment systems can at best guarantee next day availability of funds to recipients. The PSB considered this to be well behind international best practice and inconsistent with both public expectations and the needs of a modern economy.

Payments out of hours

The PSB also considered the lack of availability of payment systems out of normal banking hours to be out of step with broader developments in our society and economy, where more and more services are expected to be available both seven days a week and around the clock. In particular, it noted that the DE system, which underpins most business payments and internet banking transfers, did not (at the time of the review) operate out of hours. Therefore, while an internet banking transaction to a customer of another financial institution could be initiated on a Friday night, the recipient of those funds would not be able to access them until Monday at the earliest. Accordingly, the PSB considered that there should be the capacity to make payments (with quick availability of funds) to the recipient during evenings and on weekends. It further considered that this should be able to occur without generating credit risk between financial institutions; that is, there should be the capacity for interbank settlement out of hours as well.

Transmission of data with payments

The DE system allows only 18 characters of additional free-form information to be transmitted with a payment. This means that there is little capacity to provide an explanation of an electronic payment. While this is inconvenient for households, it can be much more significant for businesses. Businesses will often deal with this problem by avoiding electronic payments and sending a cheque with a physical document attached. Alternatively, they may separate remittance information from a payment and rely on the recipient's capacity to reconcile them later.

Addressing of payments

A key element determining the ease of use of a payment system is the process by which the recipient's details are provided by the payer. Currently, in order for a payment to be made into a bank account, the recipient's BSB number and account number must be provided. In many cases, individuals will not remember these details and the need to correctly enter up to 15 digits means that there is a significant risk of error. A number of systems internationally are adopting identifiers that are more easily remembered, such as phone numbers or email addresses.

8.4.2.2 Conclusions of the Strategic Review of Innovation

At the end of the Strategic Review, the PSB concluded that removing some of the barriers to cooperative innovation in the Australian payments system had the potential to deliver significant public benefits over time. In its June 2012 Conclusions document it proposed two means by which to improve cooperative outcomes. First, the PSB would be more proactive in setting strategic objectives for the payments system. These would reflect services or attributes that the PSB believes the payments system should be able to provide by a specified time. The PSB would seek to establish these objectives from time to time and the industry would be expected to determine how they could be met most efficiently.

The initial set of strategic objectives set by the PSB reflected the gaps identified above:

• same-day settlement of all DE payments (by end 2013)
• the ability to make real-time retail payments (by end 2016)
• the ability to make and receive low-value payments outside normal banking hours (by end 2016)
• the ability to send more complete remittance information with payments (by end 2016)
• the ability to address payments in a relatively simple way (by end 2017).

The second proposal to improve cooperative outcomes was the establishment of an enhanced industry coordination body that could help to identify and achieve strategic objectives as well as providing coordination on other strategic issues for the industry. An appropriately constituted coordination body would in turn facilitate a more direct dialogue between the PSB and the industry.

8.4.3 Progress since the Strategic Review of Innovation

Good progress has been made in the period since the Strategic Review conclusions were released in June 2012.

The Bank and APCA have been consulting on the structure and scope of a new industry coordination body, to be known as the Australian Payments Council. The Council will be a senior-level body capable of taking a strategic perspective on issues of importance to the payments system, as well as engaging in a dialogue on those issues with the PSB. Reflecting its focus on improving industry coordination, the Council will be made up of diverse parties from within the payments industry, including financial institutions, payment schemes and other payment and service providers. However, the Bank considers it equally important that users of the payments system (consumers, merchants, businesses and government agencies) also have an effective mechanism for contributing to decisions about the payments system. Accordingly, in conjunction with the establishment of the Payments Council, the Bank will also launch a new User Consultation Group. This will provide a more structured mechanism for users of the payments system to express views on payments system issues as an input to the Bank's policy formulation process. The Bank expects that both the Payments Council and User Consultation Group will begin to meet this year and looks forward to working with both bodies.

The first of the PSB's strategic objectives – same day settlement of DE payments – was achieved in November 2013 following an industry project coordinated by APCA and facilitating work carried out by the Bank. Previously DE payment files had been exchanged between financial institutions through the day, with settlement between banks occurring at 9 am the following business day. A benefit of the move to same-day settlement will be that funds can be made available to recipients on a timely basis without the receiving financial institution taking on credit risk.

The payments industry has decided to meet the remaining strategic objectives by establishing a completely new payment system – referred to as the New Payments Platform (NPP). This was agreed initially by an ad hoc industry committee, the Real-Time Payments Committee (RTPC), which has now been replaced by a broader committee (the New Payments Platform Steering Committee – NPPSC) to manage the design and implementation of the NPP.

• As requested by the PSB, the industry's NPP solution will be based on a hub infrastructure, which will be more efficient and access-friendly than the existing bilateral payments architecture. The hub will link ADIs and other approved entities and be capable of supporting the exchange of fast flexible payments messaging. It will be linked to a Settlements Service built by the Bank to provide real-time interbank settlement of each NPP payment. Both will be available on a 24/7 basis. This ‘Basic Infrastructure’ will be accessible by commercial ‘overlay’ services that can be tailored to particular payment needs of customers.
• While multiple overlay services could potentially be connected to the NPP in competition with one another, the first will be an ‘initial convenience service’ developed cooperatively by the industry. This might, for instance, be a system where funds can be exchanged between customers of different banks using a mobile phone ‘app’ and the recipient's phone number or email address, with the funds available for use by the recipient within seconds. While some banks currently provide a service like this, it is effectively only for customers of the same bank.
• The NPP will be one of a small number of retail payment systems in the world capable of providing real-time payments and one of an even smaller number to provide real-time settlement of those transactions, removing the need for financial institutions to deal with credit risk in settling payments. Its design is intended to make it a flexible and ready platform for future innovation in payments. The real-time nature of the system, combined with the flexibility of the payment messages, ability to carry additional remittance information and the easy addressing capability, will be a fertile platform for innovation and will help payments to be much better integrated with many other electronic systems. The Bank's expectation is that the NPP will ultimately allow business to achieve substantial efficiency gains and will offer significant improvements to the timeliness, accessibility and usability of the payments system for consumers.
• The NPP has broad industry support, with seventeen institutions initially funding the development phase, with participation from not only the large banks but also foreign banks, regional banks, service providers for the mutual sector, and PayPal. The design of the NPP – with core functionality provided by the Basic Infrastructure and value-added commercial features provided by ‘overlay’ services – means that the business requirements for the core service are not excessively complicated, increasing the scope for a successful industry project. The project is expected to be completed in late 2016.

Reflecting the good progress that has been made following the Bank's Strategic Review of Innovation, the Bank does not consider that there are particular legal or structural issues for the Inquiry to address in the area of innovation or industry governance. The Inquiry may wish to encourage the payments industry to build on the strong progress made so far in the development of the NPP and the efforts made to address the PSB's strategic objectives.

8.5 Likely Trends and Issues in Retail Payments

As has already been noted, recent innovation in the customer-facing elements of retail payments has been relatively rapid. This can be seen in the shift to EMV (chip-based) card payments for point-of-sale transactions, followed quickly by the rapid roll-out and adoption of contactless payments. The latter technology is likely to be widely adopted on mobile phones in the relatively near future. More broadly the shift in mobile phones from an internet banking device to a point-of-sale payment device is likely to generate vigorous competition both between solutions and solution providers and between payment systems, including some not previously associated with point-of-sale transactions.

This section identifies some of the likely trends in retail payments over the next few years and considers whether any potential regulatory issues may arise. For the most part, the Bank considers that its existing powers leave it well placed to deal with most challenges arising from the likely future evolution of the payments system. The Bank notes, however, that it may be desirable for the Inquiry to consider the appropriateness of the current regulatory framework for purchased payment facilities.

8.5.1 Mobile payments

The term ‘mobile payments’ can be used to refer to a wide variety of financial transactions initiated with a mobile device (Flood, West and Wheadon 2013). These can include transactions with different economic purposes (e.g. purchases, remittances), technological interface (e.g. SMS, mobile internet, Near Field Communication (NFC)), funding source (e.g. deposit or credit account, stored value) and payment network (e.g. open-loop, closed-loop). The differences between them are important for understanding why mobile payments have tended to develop in different ways around the world and for understanding likely future trends in Australia.

Mobile payment systems have grown to be very important tools for financial inclusion in developing economies where handset ownership tends to be high but engagement with the formal financial sector is low. In many developing countries, systems where value is stored in accounts with a mobile phone operator, and transfers can be made between those accounts, have become de facto banking systems. The best known example is the M-Pesa system in Kenya, which has over 18 million account holders. Generally these are closed-loop systems, although there are examples where there is interoperability (or links) between systems or where the technology has been used to broaden access to traditional financial institutions, rather than a mobile network operator effectively holding deposits.

However, the developing economy ‘mobile money’ (stored-value) model seems far less relevant to Australia. Australia has a very highly banked population, with reasonably broad access to electronic payment systems. While mobile stored-value systems, such as those operating in developing countries, might offer some apparent benefits (e.g. immediacy of transfers) because they operate as closed-loop systems, this comes at the cost of customers holding transaction funds outside a supervised financial institution and having to periodically move funds into their mobile stored-value account from their main savings account. Systems that facilitate electronic payments directly between financial institution accounts are expected to have greater appeal to customers in Australia, which (as discussed previously) will be made significantly more convenient by the NPP.

Two other types of mobile payments are expected to become increasingly important in Australia:

• Mobile banking ‘apps’ have already come into widespread use – effectively moving internet banking to a mobile environment. Payments (predominantly remote payments) are part of this process. A consumer, for instance, might pay a bill using BPAY or transfer funds to another person or business, with their financial institution processing this using the DE system. Alternatively a system such as PayPal might be used to make a payment, or card details might be entered directly into a merchant's website.
• A second model that is likely to become more prominent in the period ahead is the use of mobile phones for payment at the point of sale. In many cases this will occur through the use of contactless (NFC) chips either attached to or embedded in a phone. At one level this will simply replicate a contactless card payment, but it provides an opportunity for greater interactivity in the payment process. For instance, the consumer could choose which of several payment options to present to the merchant via the phone, while loyalty points or discount coupons could be managed as part of the same process. It is also likely that point-of-sale payment options that do not rely on NFC will be available; PayPal for instance has been offering a service that allows a customer to ‘check in’ at a merchant and make a web-based PayPal payment through an enabled POS terminal.

The current push to develop ‘wallets’ and ‘mobile wallets’ will be important for both of these models. ‘Wallets’ are systems that securely store a variety of customer payment details (for instance credit card, debit card or prepaid account details). Customers can use a password (or potentially other credentials) to make a payment using any one of those payment methods. This is effectively the model used by PayPal, but both MasterCard and Visa are now promoting their own wallets and it is likely that other wallets will emerge as well.^[15] While initially these wallets will be largely focused on online transactions (websites will carry buttons branded for various wallets), it is likely that the wallets will also be able to initiate point-of-sale payments through NFC (or other means).

The potentially rapid evolution of mobile payments means that regulators will need to monitor developments closely. There are several potential areas where concerns could arise.

• Should ‘mobile money’ solutions gain traction in Australia (counter to the discussion above), there should be consideration of the regulatory status of the providers, given that they will be holding customer funds. Some broader issues with stored-value systems are discussed below.
• Mobile-based NFC systems may require the storage of payment information locally on a handset, and mobile payments require payments information to be transmitted in some form. The new technologies being used may bring new risks of payments data being compromised. Further discussion of security issues can be found below.
• Mobile payments are an area of active competition, with a number of competing models and many competing parties. For instance, financial institutions, payment schemes, telecommunications providers and handset manufacturers all have an interest in how mobile payments are rolled out. The array of varying interests is likely to delay the introduction of some forms of mobile payments (and probably already has). One question that should periodically be asked is whether there are efficiency benefits that could be gained from greater coordination. To date, a strong case has not been made, though there are some initiatives overseas, such as that to create a single trusted service manager in New Zealand. Some newer smart-phone operating systems are reportedly enabling the secure remote storage and access of personal information, including payment card details, rather than storing it in the secure element on the handset. This may help overcome some of the coordination problems, reducing the need for trusted service managers to manage access to the handset's secure element.

8.5.2 Stored-value payment systems

The Wallis Inquiry anticipated the development of stored-value cards and ‘smart’ cards, including arrangements in which customers using smart cards for transactions could benefit from the sharing of data between various financial service providers that a cardholder had a relationship with: an example given at the time by Stan Wallis involved the purchase of whole-wheat bread and skim milk facilitating a discount on health insurance. The focus on stored-value cards was no doubt influenced by initiatives such as the Mondex and Visa Cash systems which were the subject of various pilots during the 1990s. It was anticipated that smart cards and stored-value systems would begin to displace cash and ‘traditional’ card usage over the ensuing years. Policy concerns at the time focused on the safety of the stored value, given its deposit-like nature and the fact that ADIs might not be involved. The enactment of the PSRA addressed such concerns by setting out, inter alia, a framework for the authorisation of ‘holders of stored value’ in a ‘purchased payment facility’ (PPF).

Stored-value systems have not taken off in Australia in the way anticipated, though there has been gradual adoption in some sectors discussed below. They have had more notable success in other countries, for instance the Octopus card in Hong Kong that has over 24 million cards issued and the ‘mobile money’ systems discussed above that are widely used in some developing countries. There appear to be at least two reasons for the limited success of such systems in Australia.

• First, Australia has a highly banked population and most adults hold payment cards linked to accounts that can be used both at the point of sale and online. A stored-value product would need to provide a demonstrable benefit over the customer's existing card products in order to gain widespread adoption, particularly given that an additional step is required to transfer funds into a stored-value account (although the latter might not be a large cost where a direct debit arrangement can be set up, as for example in electronic road-tolling systems).
• A second factor has been the relatively late development of smart-card-based transportation systems in Australia. Hong Kong's Octopus system was originally for public transport payments, but over time its use was broadened to encompass other types of purchases. This overcame the ‘chicken and egg’ problem often seen with payment systems; merchants had confidence in accepting the card because they knew it was already widely held by consumers. While smart-card systems for public transport are now becoming more common in Australia, the systems differ across states. In addition, card payment systems have also moved to chip and contactless technology, making the case for the extension of transport cards to general payments less obvious. Indeed, in some overseas cities, transportation systems are moving to accept contactless payment cards (e.g. MasterCard and Visa) in lieu of transit cards, rather than transit cards being used for general-purpose payments.

While a push to stored-value products has not occurred in Australia, many observers continue to see prepaid cards (which are likely to migrate to mobile devices) as a growth area. ePAL's 2013 Annual Report noted that there were over 1.5 million proprietary prepaid cards on issue in Australia, having grown at nearly 20 per cent from the previous year. Rather than being a general replacement for either cash or existing card products, current prepaid products typically target particular niches. Some are gift cards issued by a particular merchant or group of merchants for use at those stores. Others, however, are general-purpose products, designed to operate through the eftpos, MasterCard or Visa systems. These may be marketed as gift cards, or issued as part of a promotion (e.g. as a cash-back on a purchase), by governments to cover emergency spending, or by businesses (or governments) as part of expenditure-control mechanisms. The products might also appeal to those worried about online security or anonymity, or to parents wishing to provide funds to children. Most recently, airlines and financial institutions have begun issuing stored-value products, largely targeted at foreign-currency spending, but nonetheless capable of allowing Australian dollar purchases.

While stored-value products are unlikely to emerge as a dominant part of the Australian payments system, it will be important to have an appropriate regulatory approach to the protection of consumers' funds held in PPFs. Currently, the Banking Regulations determine that providing a PPF that is widely available and redeemable upon demand for Australian currency constitutes ‘banking business’. Therefore, the provider of such facilities must be an ADI, either a traditional ADI or an ADI within a special class that provide such facilities and do not conduct other banking business. Under the PSRA, any other holders of stored value in a PPF must be authorised by the Bank, unless they are granted an exemption. To date, the Bank has granted such exemptions to facilities where the stored value is guaranteed by governments or ADIs. It can also make declarations that the PSRA does not apply to specified facilities or classes of facilities. It has done so in relation to a range of facilities where either the total stored value is low (below $10 million) or where the facility is narrowly used, in that it can be used to make payments to no more than 50 persons. In most cases, the declarations operate in concert with ASIC class orders that exempt certain PPF providers from certain requirements under the Corporations Act. Current declarations cover loyalty schemes, gift-card facilities, electronic tolling and prepaid mobile phone accounts.

The combined effect of the Banking Regulations and the exemptions and declarations put in place by the Bank is that the Bank has not authorised any PPF providers to date. It is nonetheless possible that this could occur. A widely available general-purpose facility that was not redeemable for currency (and therefore not considered banking business) would need to be authorised by the Bank before stored value of over $10 million could be held.

The Bank believes that there is scope for the Inquiry to consider the suitability of the current framework for the regulation of PPFs for the following reasons.

• The involvement of three regulators (APRA, ASIC and the Bank) in the current framework seems unnecessarily complex.
• Should a PPF emerge that requires authorisation under the PSRA, the Bank would not be well placed to undertake the assessment and subsequent monitoring of the holder of stored value as it currently has no supervisory or enforcement capacity. Establishing and maintaining that capacity would be difficult and costly if were called upon only infrequently.
• A PPF that is considered to be undertaking banking business faces full prudential supervision as an ADI, with the associated regulatory costs. This creates an incentive for providers to structure their offerings in a way that avoids regulation, for example by making the product not redeemable for currency.
• In many cases consumers may not be aware of when the holder of stored value in a PPF is an ADI and when it is not.
• The definition of a PPF in the PSRA – a facility under which a holder of stored value makes payments to another person on behalf of the user of the facility – is a source of uncertainty, with terms that are potentially very wide or somewhat ambiguous, making enforcement difficult.
• Entities that at the time of the passage of the PSRA in 1998 issued travellers cheques were grandfathered so that they do not require authorisation. These instruments have largely evolved into card products providing the same service and are therefore very similar to other prepaid cards. Consideration should be given to whether this grandfathering remains appropriate.

The Bank believes that it is appropriate for there to be some regulation of general-purpose PPFs to ensure that consumers' funds are adequately protected. However, where the provider is not undertaking broader banking business and the value held by each individual is not high, APRA's ADI framework may be too onerous. The Bank believes that a lighter-touch framework, separate to the ADI framework, might be best suited to this purpose. An alternative to this arrangement would be to make it very clear to consumers which products are provided by ADIs and that caveat emptor applies to the remainder. The Bank sees this predominantly as a consumer protection issue.

8.5.3 Virtual currencies

Some attention has recently been focused on so-called ‘virtual currencies’ and the ways in which they can be used as a means of payment. These are essentially electronic transaction ledgers that record claims and changes to the ownership of each unit of the ‘currency’. A virtual currency system can therefore be used to facilitate payments between people choosing to use that system. Currently, all issuers of virtual currencies are non-government entities and virtual currencies are not considered to be legal tender in any jurisdiction.^[16]

One class of virtual currency is designed largely for purchases within a particular online ‘ecosystem’ such as Amazon Coins, Microsoft Points and (for a time) Facebook Credits. These allow funds to be transferred into the system from a card or bank account at an exchange rate (against a traditional national currency) determined by the operator, sometimes with the rate dependent on the amount converted; the quantity of virtual currency units within each virtual currency system is determined solely by the operator of that system.

A second class of virtual currency has been designed as a more general purpose means of exchange and store of value, often offering anonymity and low cross-border transaction costs. One example was run by Liberty Reserve, which was closed down by US authorities in mid 2013 due to money-laundering concerns. Some systems have exchange rates that are determined by the operator, while other systems have sought to remove any operator discretion in respect of exchange rates for the currency and have some form of market-determined rate. These tend to be decentralised ‘peer-to-peer’ systems in which the entire network takes part in processing transactions (see ‘Box 8D: Cryptocurrencies’).

Virtual currencies have been used in a range of contexts as a means of exchange, and can represent a store of value, although volatility in the price of some virtual currencies may make users reluctant to maintain holdings in these currencies. Virtual currencies have tended not to be used as a unit of account: rather, merchants typically price goods and services in another currency (e.g. the US dollar) and convert that price into a virtual currency amount at the time of the transaction (and then convert the receipts back into US dollars).

Virtual currencies raise a number of potential concerns for policymakers. First, to the extent that they are a form of stored value, the safety of those funds is at risk in the event of fraud or the collapse of the system. Second, investor protection concerns may arise due to the potential for the value of the currency to significantly change – either through a decision of the provider in the case of operator-managed systems, or through market mechanisms. The wide fluctuations in Bitcoin values are an illustration of this. Third, the anonymity offered by some virtual currencies might make them a tool for money laundering, terrorist financing or tax evasion. Fourth, the cross-jurisdictional nature of these systems presents challenges, raising questions about how well they can be brought within the coverage of domestic legislation.

In Australia, use of virtual currencies is currently very limited, so risks posed by virtual currencies to the Australian payments system are therefore limited. Of those in use, most are usable only within closed systems such as merchant-specific loyalty programs or those created by merchants to encourage consumers to prepay for virtual goods (e.g. additional features within online games or applications). Very few Australian merchants currently accept open-loop virtual currencies such as Bitcoin as a means of payment. This presumably reflects the fact that they involve nascent technology and are a relatively untested means of payment. More generally, many payment attributes of virtual currencies are already available in the ‘traditional’ payments system so in many cases it is not clear what gaps these new currencies are filling. The Bank will continue to monitor developments in this area as part of its monitoring of the payments system. To the extent that there are indications that virtual currencies are becoming more widely used, the Bank will assess whether its powers in relation to payment systems and purchased payment facilities are able to address public interest issues arising from the operation of virtual currencies in Australia.

8.5.4 Security issues

The threat of fraud is an ever-present issue in payment systems. It arises even in traditional payment instruments (e.g. counterfeiting of bank notes and forgery of cheques). In many cases, the lags in processing transactions in existing payment systems help to control fraud: for example, the relatively lengthy cheque clearing process allows for a cheque to be repudiated days after it has been presented. However, innovation can bring new fraud risks.

The changing nature of fraud as payment systems evolve can be seen in card markets.

• Traditionally most card payments were made at the point of sale and security measures largely involved the checkout operator physically comparing the signature on the card with the signature of the person making the payment. Card data were initially just embossed on the card and were subsequently also stored on a magnetic stripe; these were subject to the risk of copying for the manufacture of counterfeit cards. Over the years this risk has been reduced by the move to the much more secure EMV chips, while the risk of counterfeit signatures has fallen with the move to PIN authorisation.
• At the same time, online card payments have grown rapidly. Confirming that the transaction is being made by the authorised cardholder is significantly more difficult in this case; a signature cannot be verified nor is an EMV chip being presented, and the details exchanged for a payment can relatively easily be stolen and traded online. As a consequence, online card fraud has risen significantly in recent years. Australian issuers have attempted to address fraud rates by introducing their own risk-based anti-fraud mechanisms that identify when the pattern of card use changes (either for online or POS transactions), allowing a query to be raised with the cardholder or the card to be cancelled. In some jurisdictions, card schemes have introduced ‘3D Secure’ solutions, which are designed to increase the security of online transactions, including through the use of an additional customer authentication step, most often the use of a password.
• Most recently, changes in point-of-sale technology (the move to contactless transactions with no customer authentication for transactions under $100) have again brought point-of-sale fraud into focus. At one level, consumers have expressed concern about contactless functionality allowing card data to more easily be stolen or fraudulent transactions to be made by scanning the chip while it remains in the customer's wallet or pocket. Card schemes and issuers argue that these are not significant risks given the application of security on an individual transaction basis. At the same time, however, these developments may have encouraged an increase in more low-tech fraud, in the form of stolen or intercepted cards, given the reduced requirements for cardholder verification.

Developments in other means of payment will also raise security issues. The move to mobile payments means that payments information may be exchanged by new channels, potentially including between the phone and the merchant via Bluetooth Low Energy (BLE) and sound waves, in addition to NFC and mobile data networks. These developments may raise new issues for the security of payment messages. Likewise the move to real-time clearing and settlement of payments via the NPP will mean that the time available to detect and address fraud will be very significantly reduced, requiring more of a focus on real-time fraud detection and other means of managing fraud risk. However, offsetting these risks, it is likely security technology will continue to advance over the coming years, for instance via the use of biometrics to authenticate the payer.

While in the past the Bank has pushed for greater transparency of fraud data (now published by APCA) the Bank has not directly intervened at a policy level in fraud issues. The Bank's view has been that regulatory intervention in this space should only occur if some form of market failure is preventing fraud from being properly addressed or if fraud is at a level that undermines confidence in the payments system. Two types of market failure have the potential to prevent efficient investment in anti-fraud mechanisms.

• Coordination problems might mean that a group of parties could collectively benefit from implementing anti-fraud mechanisms, but are unable to do so individually. For instance, online merchants tend to bear the cost of online card payment fraud and might benefit collectively from adopting additional authentication measures for online payments. However, doing so means that the transaction process will be slightly more complicated and if a merchant acts alone, the merchant might lose business to competing merchants that have not implemented the technology.
• The second type of market failure is where the costs of fraud and the ability to address fraud are not ‘aligned’ and reside with different parties. Where the cost of fraud and the means of addressing fraud reside with the same party, that party has an incentive to address the issue if its costs from fraud outweigh the cost of implementing fraud mitigation techniques. For instance issuing banks bear much of the cost of point-of-sale fraud and as a result have generally introduced real-time risk-based fraud monitoring systems to reduce the incidence of fraud. More generally, payment systems have generally been reasonably good at achieving the appropriate alignment, using ‘liability shifts’ to help achieve desired outcomes: for instance merchants that have not implemented a particular security measure (e.g. EMV terminals) might be made liable for fraud losses where they would not be otherwise. In some cases, this will occur via rule-based mandates.

Given the terms of reference for the Inquiry, it is appropriate to consider whether there is any case for regulatory change in relation to payments security issues, for example for the Bank to be more active in setting security standards for payment systems. The Bank notes, however, that the payments industry has made a range of efforts to reduce fraud; indeed, as liability typically does not fall upon the cardholder or other end-users of the payments system but is often borne by one of the financial institutions in the payments chain there are strong incentives in place for industry participants to take steps to reduce fraud and ensure high levels of payment security. Accordingly, the Bank considers that, provided that it is clear where the liability for fraud lies, there should be a presumption that regulation is not necessary. It is also likely to be the case that where technology is developing quickly it may be difficult to maintain appropriate regulation. However, should cases arise where the security of payments is not being adequately addressed due to a market failure, the Bank believes it has sufficient powers under the PSRA to set the necessary standards.

8.5.5 Operational resilience

In light of the continuing trend away from cash towards non-cash payments, the smooth functioning of retail payment systems is of increasing importance. This was highlighted in late 2010 and through 2011, when a number of retail operational incidents caused considerable disruption to customers of particular ADIs, as well as to other ADIs and their customers. While the senior management of individual institutions are primarily responsible for the operational resilience of their organisations, the Bank has reviewed how it can best strengthen its oversight of operational resilience in retail payment systems and contribute to the ongoing integrity of retail payments systems.

As part of this, in 2012 the Bank conducted an informal consultation on retail operational incidents. In general, the Bank observed an encouraging level of industry attention to operational resilience issues, with a number of payments system participants citing commercial pressures as a driver of increased investment in payments infrastructure. The consultation also indicated that payments operations are increasingly perceived as a strategic priority within financial institutions.

As a result, the Bank plans, at least for the time being, to limit its role to monitoring retail operational incidents and working with industry on initiatives around the disclosure of data on incidents. Since April 2012, RITS members have been obliged to notify the Bank on a timely basis of any retail incidents that meet specified criteria for severity. RITS members are also required to provide regular updates to the Bank during such an incident, and to deliver a post-incident report detailing the cause and follow-up actions taken. In addition, the Bank has more recently commenced a broader quarterly statistical data collection on retail payments incidents, covering both significant and less serious incidents. The Bank has also sought information on the system architecture supporting institutions' retail payment activities.

The data collected under this reporting framework will be used to identify trends and follow up with any payments system participant that is persistently underperforming. The Bank is also considering how aggregate data might be shared with industry to facilitate performance benchmarking by payments system participants. Aggregate data could also potentially be published to provide the public with reliable information on the prevalence of retail operational incidents. Over time the Bank expects that the analysis of information obtained from these sources will provide sound evidence as to whether further action is necessary.

8.6 The Bank's Oversight of High-value Payment Systems, Central Counterparties (CCPs) and Securities Settlement Facilities (SSFs)

Alongside its work on access, pricing and competition in retail payment systems, the PSB has in recent years focused increasing attention on its responsibility to promote stability in the Australian financial system.

Recognising the systemic importance of FMIs, as described in Chapter 4, the reforms that followed the Wallis Inquiry gave the PSB responsibility for determining payments system policy so as to best contribute to controlling risk in the financial system. The reforms also gave the Bank a formal role, under Part 7.3 of the Corporations Act, in the regulation of licensed CCPs and securities settlement facilities (SSFs). In accordance with these responsibilities, the Bank has for more than a decade carried out rigorous oversight of FMIs.

Chapter 4 observed that shortcomings in the design of FMIs, or interruption to critical FMI services could have systemic implications. This section describes the FMI landscape in Australia and illustrates how sound regulation and oversight can help to ensure that FMIs are a source of stability rather than a source of systemic risk. It goes on to describe how the Bank executes its oversight role in respect of both high-value payments and CS facilities, before highlighting some important areas of focus for the PSB in recent years and identifying some regulatory challenges stemming from changes in the market environment.

8.6.1 FMIs operating in Australia

The Bank has an oversight role in respect of three types of FMI that operate in Australia: high-value payment systems, CCPs and SSFs. High-value payment systems support wholesale funds transfers, while CCPs and SSFs – collectively known as CS facilities – clear and settle transactions in securities such as bonds and equities, and in derivative instruments such as options and futures.

8.6.1.1 High-value Payment Systems

High-value payment systems are systems that provide for the settlement of wholesale interbank payments. The principal domestic high-value payment system is the Reserve Bank Information and Transfer System (RITS). RITS, which is owned and operated by the Bank, sits at the heart of the Australian payments system (Section 8.2.2). The international foreign exchange settlement system, CLS, also plays an important role in Australia's financial system.

8.6.1.2 Central Counterparties

A CCP acts as the buyer to every seller, and the seller to every buyer in a financial market. It does so by interposing itself as the legal counterparty to all purchases and sales via a process known as novation. Following novation, the exposure of all parties – whether it be for the few days until an equity trade is settled, or for the several years of payment flows under a longer-term swap contract – is to the CCP, rather than the bilateral counterparty in the original trade.

These arrangements provide substantial counterparty risk management benefits to participants as well as greater opportunities for netting of obligations. At the same time, however, they result in a significant concentration of risk in CCPs. This risk would crystallise if a participant defaulted on its obligations to a CCP, since the CCP would have to continue to meet its obligations to all of the non-defaulting participants (Chapter 4). Accordingly, it is critical that CCPs identify and properly control risks associated with their operations and conduct their affairs in accordance with regulatory standards that promote the overall stability of the financial system.

Three CCPs are currently licensed under the Corporations Act to operate in Australia.

• ASX Clear Pty Limited (ASX Clear) provides CCP services for a range of financial products traded on the ASX and Chi-X Australia Pty Limited (Chi-X) markets, including cash equities, pooled investment products, warrants, certain debt products and equity-related derivatives.
• ASX Clear (Futures) Pty Limited (ASX Clear (Futures)) provides CCP services for derivatives traded on the ASX 24 market, including futures and options on interest rate, equities, energy and commodity products. In July 2013, ASX Clear (Futures) also began offering a clearing service for Australian dollar-denominated OTC interest rate derivatives.
• LCH.Clearnet Limited (LCH.C Ltd) was licensed in 2013 to provide CCP services for OTC interest rate derivatives and to act as the CCP for trades executed on a newly licensed derivatives exchange, FEX Global Pty Limited (FEX). FEX is not yet operational.

8.6.1.3 Securities Settlement Facilities

A SSF provides for the final settlement of securities transactions. Settlement involves transfer of the title to the security and transfer of cash. These functions are linked via appropriate delivery-versus-payment arrangements incorporated within the settlement process. Given their central role in the functioning of the markets they serve, it is critical that SSFs identify and properly control risks associated with their operations and conduct their affairs in accordance with regulatory standards.

Two SSFs (both part of the ASX Group) are licensed to operate in Australia:^[18]

• ASX Settlement Pty Limited (ASX Settlement) provides for the settlement of cash equities, debt products and warrants traded on the ASX and Chi-X markets. ASX Settlement also provides a settlement service for non-ASX listed securities.
• Austraclear Limited (Austraclear) offers securities settlement services for trades in debt securities, including government bonds and repos.

8.6.2 The international framework applying to FMIs

Both in Australia and internationally, FMIs were a source of stability during the global financial crisis, operating reliably throughout this period. In part reflecting significant enhancements to the design of FMIs in the two decades prior to the crisis, market participants retained confidence in the infrastructure, allowing financial trading to continue even in an environment where financial institutions were reluctant to assume exposures to each other. Nevertheless, this period shone a light on potential issues that could arise in extreme stress. Accordingly, work on the international and domestic standards applying to CCPs and other FMIs has continued since the crisis, including on measures to ensure continuity of critical services in circumstances in which an FMI faces a threat to its ongoing financial viability.

8.6.2.1 Regulatory and oversight standards

Regulation and oversight promote the sound design of FMIs, helping to ensure that they act to mitigate systemic risk (Chapter 4). The Australian regulatory framework for FMIs is summarised in Sections 8.6.3 and 8.6.4, focusing primarily on the Bank's role and the standards to which it holds FMIs. These standards have drawn, after extensive consultation, on the international framework set out by the Principles for Financial Market Infrastructures (CPSS-IOSCO 2012; the PFMIs), which were published in April 2012 by the international standard-setters, CPSS and IOSCO (Chapter 3).

The PFMIs are a unified set of standards promoting sound risk management and operational resilience across the full range of FMI types. They have a broader scope and are more detailed than the standards that preceded them (CPSS 2001; CPSS-IOSCO 2001; CPSS-IOSCO 2004). Some international regulators have nevertheless expressed concerns that the PFMIs may be drafted at too high a level of generality (i.e. with insufficient ‘black-letter’ detail), and that this could lead to different interpretations and outcomes across jurisdictions. The Bank does not share this view and has argued in international groups that the PFMIs appropriately allow flexibility to adapt to the circumstances of particular FMIs or jurisdictions. An implementation monitoring exercise underway by CPSS and IOSCO aims to identify any inconsistencies in the implementation of the PFMIs across jurisdictions. An initial progress report was published in August 2013, reporting that at that time Australia had introduced measures to implement the PFMIs in all but one of the categories assessed (CPSS-IOSCO 2013).^[19]

8.6.2.2 Continuity of services

To ensure continuity of critical FMI services, even in the event of extreme financial shocks, international regulators are developing guidance for the recovery and resolution of FMIs (Chapter 3; Section 8.6.4).

• CPSS and IOSCO have been working on guidance on recovery planning: actions that an FMI itself could take if, notwithstanding its adherence to international regulatory standards, it experienced a shock to its ongoing viability (Gibson 2013). The PFMIs require that an FMI establish plans to allocate any uncovered losses it may experience in the event of the default of one of its participants, promptly replenish its financial resources to restore regulatory minimums, and continue its operations uninterrupted. The guidance, once completed, will identify a range of tools that an FMI may use to meet these objectives.
• Recognising that, in some circumstances, even a comprehensive recovery plan may be difficult to fully implement in practice, international policymakers are encouraging jurisdictions to establish special resolution regimes for FMIs, with continuity of service a core objective. To support this work, the Financial Stability Board (FSB) has consulted on guidance as to how to apply its Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) to FMIs (FSB 2013).

Both the guidance on recovery planning and that on FMI resolution are close to being finalised.

8.6.2.3 FMI design and risk management

Internationally, regulation and oversight of FMIs have delivered significant enhancements to their design and operation over the past two decades. These enhancements, promoted by international policy and standard-setting bodies such as CPSS and IOSCO, were instrumental in ensuring that by the time of the global financial crisis, participants were confident in FMIs' settlement models, risk management frameworks, and operational arrangements. Importantly, they regarded them as sources of stability rather than systemic risk.

• Settlement models. Perhaps the most fundamental change since the 1990s has been the introduction of RTGS in high-value interbank payment systems around the world (including Australia), replacing the pre-existing deferred net settlement model that allowed interbank credit exposures to build up during the settlement process. Acknowledging that RTGS systems require participants to hold sufficient liquidity in the settlement asset to be able to settle payments individually, the transition has been accompanied by measures to guard against liquidity risk. These include liquidity-saving features in the design of RTGS systems and the availability of central bank liquidity intraday (against eligible collateral). Enhancements have also been made to settlement models for securities and foreign exchange transactions: delivery-versus-payment, which makes the exchange of title to a security contingent on the simultaneous transfer of funds and ensures that principal risk does not arise in the securities settlement process; and payment-versus-payment in foreign exchange settlement (as in CLS), which similarly makes the transfer of a participant's settlement obligation in one currency contingent on the receipt of the foreign currency.
• CCP risk management. Crucial to the resilience of a CCP is its capacity to measure its risk exposure accurately and collateralise accordingly. In recent decades, industry-wide advances in risk modelling have been reflected in CCPs' margin methodologies and stress-testing capabilities, reducing the probability that a CCP would be left with a shortfall in financial resources in the event of a participant default.
• Operational resilience. Operational resilience standards for FMIs have risen over the years, in part reflecting more sophisticated information technology and a better understanding of the risks, but also due to lessons learned from practical experience of operational shocks (e.g. terrorist attacks and power failures). Enhancements have been observed in areas such as change-management protocols, information security, participant testing and business continuity planning.

8.6.3 The Bank's Oversight of High-value Payments

A key element of the PSB's responsibility for the safety and stability of payment systems in Australia is oversight of systemically important payment systems. To date, RITS is the only domestic system identified by the Bank as warranting oversight as a systemically important payment system. This reflects the fact that RITS is the principal system in Australia (by aggregate value of payments), mainly settles high-value and/or time-critical payments, and is used to effect interbank settlements arising in other FMIs (Section 8.6.2).

As part of its oversight of RITS, the Bank periodically conducts self-assessments of RITS against relevant international standards. These self-assessments are reviewed by the PSB and published on the Bank's website. Prior to the publication of the PFMIs, the relevant standards were the CPSS Core Principles for Systemically Important Payment Systems. Following the release of the PFMIs, the Bank committed to carrying out annual self-assessments against the PFMIs. In the most recent self-assessment, published in December 2013, the Bank concluded that RITS observed all of the relevant standards and committed to continuing work to ensure that RITS's operations remain in line with international best practice (RBA 2013b). The PSB also reviews any material developments occurring between assessments.

The Bank has also identified CLS as a systemically important international payment system. CLS is chartered in the United States and is regulated and supervised by the Federal Reserve. The Federal Reserve has established a cooperative oversight arrangement for CLS, in which the Bank participates.

8.6.3.1 ESA access

Linked to the PSB's oversight role in high-value payment systems is its responsibility for the Bank's policy on access to ESAs. One of the recommendations arising from the Wallis Inquiry was that access to ESAs should be liberalised, subject to appropriate conditions. Accordingly, in March 1999, the PSB widened access to ESAs to all providers of third-party payment services, irrespective of their institutional status, provided that an applicant could meet appropriate risk-based requirements. ADIs remained eligible with no additional risk-based requirements. In 2012, the Bank announced the creation of a specific category of ESA for Australian-licensed CCPs and SSFs that have Australian dollar settlement obligations.^[20]

8.6.3.2 Payment Systems and Netting Act

The Bank, under the governance of the PSB, has powers under the PSNA to remove two important legal risks in the Australian payments system:

• the risk that a court may apply the ‘zero hour’ rule and unwind any payments that have settled since midnight of the day preceding a bankruptcy order
• the risk that a court may unwind net payment obligations, restoring gross obligations.

Practically, this is achieved through the Bank having the power to ‘approve’ an RTGS system or a netting arrangement. Any RTGS system approved under the PSNA is protected from zero hour risk, while any netting arrangement approved under that Act is protected from both zero hour risk and possible unwinding of netting. In assessing an application for approval, the PSNA sets out a number of tests including that, without such approval, the bankruptcy of a participant could cause systemic disruption. To date, the Bank has approved three RTGS systems, including RITS and Austraclear, and six multilateral netting arrangements, including all of the retail payments clearing streams and the CHESS batch.

8.6.4 The Bank's Oversight of Central Counterparties and Securities Settlement Facilities

The Corporations Act establishes conditions for the licensing and operation of CS facilities in Australia and gives the Bank powers and responsibilities relating to these facilities. These powers are exercised under the governance of the PSB. The Bank and ASIC have joint responsibility for CS facilities under the Corporations Act, and have worked effectively together since the introduction of the regime. The regulators' respective roles under the Corporations Act are well defined and understood both by the regulators themselves and CS facility licensees.

• The Bank is responsible for ensuring that CS facilities comply with the Financial Stability Standards (FSS) that it has determined, and that facilities take any other necessary steps to reduce systemic risk.
• ASIC is responsible for ensuring CS facilities comply with other obligations under the Corporations Act, including for the fair and effective provision of services.

As cross-border provision of FMI services becomes more widespread, it will be increasingly important for regulators in different jurisdictions to work effectively together. Bilateral and multilateral cooperative oversight arrangements are important vehicles for host authorities to exert regulatory influence over FMIs that provide systemically important services in their jurisdictions. The Bank has established bilateral cooperative arrangements with the Bank of England to support its oversight of LCH.C Ltd, and sits on a Bank of England-led multilateral oversight group.

The remainder of this sub-section provides an overview of how the PSB has exercised its responsibilities as overseer of these facilities.

8.6.4.1 Financial Stability Standards (FSS)

In accordance with its responsibilities under the Corporations Act, the Bank first determined FSS for licensed CCPs and SSFs in 2003. The 2003 FSS were drafted at a high level, establishing an obligation for licensees to conduct their affairs ‘in a prudent manner’ so as to contribute to ‘the overall stability of the Australian financial system’. Each FSS was supported by a set of measures and guidance that the Bank would take into account in assessing a licensee's compliance. Minor variations were made to the FSS in 2005 and 2009.

Following the release of the PFMIs, the Bank updated its FSS to bring them into line with the stability-related PFMIs, and ASIC took steps to implement measures relevant to its mandate (ASIC and RBA 2013). The new FSS also include some additional and varied requirements to reflect the Australian regulatory and institutional context. These include measures to ensure that regulators can maintain appropriate influence over cross-border facilities (Section 8.6.5).

Consistent with the higher level of detail of the PFMIs relative to the previous international standards, the new FSS are specified at a more detailed level than the earlier standards. They cover matters such as legal basis, governance, credit and liquidity management, settlement models, operational resilience, and management of business and investment risks. Reflecting standards introduced in the PFMIs, the new FSS include enhanced requirements for financial resources held to cover any losses incurred by CCPs in the event of a participant default, and a requirement to develop a comprehensive and effective plan for the recovery or orderly wind-down of a CCP or SSF, in the event that it experienced a threat to its continued viability.

The Bank assesses CCPs and SSFs annually against the FSS. Given the growing systemic importance of these facilities, the Bank strongly supports high standards for the design and risk management of CS facilities operating in Australia. International consistency is also essential in light of the increasing cross-border provision of FMI services; cross-border recognition of regulatory rules is important where domestic institutions participate in overseas FMIs and where international institutions participate in Australian FMIs. Acknowledging the importance of international consistency, while at the same time recognising the need to ensure that regulatory settings fit the Australian context, the Bank continues to contribute to the development of relevant international standards and guidance through its representation on the CPSS.

8.6.4.2 Oversight of Domestic CS Facility Licensees

To date, the Bank's oversight of CS facilities has focused on the four licensed domestic CS facilities in the ASX Group. These facilities have been operated by the ASX Group since the merger of ASX and the Sydney Futures Exchange in 2006. The Bank carries out ongoing monitoring and assessment of these facilities through regular meetings and the collection of data and other information on the facilities' activities. Since 2006/07, the Bank has published its annual assessment of each licensed CS facility against the applicable FSS.

The first assessments against the new FSS were approved by the PSB in August 2013, and published in September 2013 (RBA 2013a). All four ASX facilities were found to have either observed or broadly observed all relevant requirements under the standards in the assessment period. The Bank did, however, make a number of recommendations to strengthen the ASX facilities' observance with the relevant standards and encourage continuous improvement. During the assessment period, the Bank also examined closely two new services introduced by ASX: a new OTC derivatives clearing service launched by ASX Clear (Futures) and a centralised collateral management service, ASX Collateral.

The PSB also carries out specific reviews from time to time, reflecting live issues in the operation of the facilities, specific requests from government, or developments in underlying markets. In the past few years, such reviews have considered the appropriate level of participation requirements for Australia's licensed clearing facilities, settlement practices in the Australian equities market, and disclosure of equities securities lending. Some of the design and risk management enhancements arising from the Bank's oversight of domestic CS facilities are described in ‘Box 8E: CS Facility Oversight’.

8.6.4.3 Oversight of Overseas-based CS Facilities

Section 824B(2) of the Corporations Act provides for an alternative licensing route for overseas-based CS facilities. It is available only where the regulatory regime in the licence applicant's home jurisdiction is deemed to be ‘sufficiently equivalent’ to that in Australia. A CS facility licensed under the alternative route remains subject to primary regulation by its home regulator, but it also faces licence obligations in Australia. In particular, an overseas licensee must comply with the applicable FSS. However the Bank will, subject to certain conditions, place reliance on reports and information from the overseas licensee's home regulator.

To further ensure that Australian regulators retain appropriate influence where a facility operates on a cross-border basis, the CFR has developed a framework for imposing additional regulatory measures depending on the importance of the facility for the Australian economy and financial system (see Section 8.6.5). Ensuring appropriate regulatory influence over cross-border CS facilities will be increasingly important given recent and likely future developments in the financial market infrastructure, both in Australia and overseas (see Section 8.6.5). These are likely to result in increased cross-border provision of clearing and settlement services. In 2013, the London-based CCP, LCH.C Ltd, became the first CS facility to be granted an overseas licence and fall within the scope of the CFR's cross-border regulatory influence framework. The PSB's first annual assessment of LCH.C Ltd as a licensee will be published later in 2014.

8.6.4.4 Review of FMI regulation

Cross-border issues and associated regulatory challenges featured prominently in the government's consideration of the proposed merger between ASX and the Singapore Exchange in 2010. Subsequent to the rejection of the merger proposal, the then Deputy Prime Minister and Treasurer asked the CFR to conduct a review of potential measures to strengthen the regulatory framework for FMIs. The CFR released a consultation paper in October 2011 and provided recommendations in February 2012 (CFR 2012c). Among the conclusions most relevant to the PSB's responsibilities for CS facilities, the CFR recommended that the Government:

• provide regulators with powers to deal with a distressed FMI and ensure the continuity of critical services
• streamline and clarify the application of ‘location requirements’ for FMIs operating across borders.

The recommendation on powers to deal with a distressed FMI reflected the CFR's observation that ‘the absence of a specialised resolution regime for FMIs represents a gap in the current regulatory framework’. A Treasury-led working group of the CFR has since been developing proposals for a special resolution regime for FMIs consistent with the FSB's Key Attributes (see Section 8.6.2). In conjunction with this work, proposals for enhanced directions and enforcement powers are also being developed, including a proposal that the Bank be given independent directions powers in relation to its particular regulatory responsibilities.

As noted, continuity of FMI services is critical. The official sector should therefore be able to articulate clearly to market participants what actions would be taken in such circumstances so as to underpin market confidence in the ongoing reliable provision of FMI services. Furthermore, as international reforms to OTC derivatives markets increasingly concentrate activity in CCPs, it is particularly crucial that the official sector has the power to deal with problems should they arise. The Bank therefore encourages the Government to progress the CFR's proposals in this area as a matter of priority.

On location requirements, the CFR published a paper in July 2012 (CFR 2012b) setting out additional safeguards to ensure that ASIC and the Bank retain sufficient regulatory influence over cross-border clearing and settlement (CS) facilities operating in Australia. This framework is discussed further in Section 8.6.5.

8.6.5 Developments in the financial market infrastructure and the PSB's responsibilities

In recent years, a number of important trends have emerged in the financial market infrastructure, both domestically and internationally. These are having implications for the exercise of the PSB's responsibilities in the regulation of CS facilities. Notable among these trends are:

• Competition between trading venues, also giving rise to competition and in some cases interoperable links between CCPs. Over the past decade there has been an expansion in the number and types of trading venues both overseas and in Australia. In large part this trend reflects the increasing sophistication and declining cost of technology, the associated rise of automated trading strategies, and the continued globalisation of finance. As competition between venues has intensified and trading volumes have risen, market operators and participants have sought to lower costs of clearing. This has led to competition between CCPs, and in some overseas markets (most notably in European cash equity markets) has led to the creation of links or ‘interoperability’ between CCPs to facilitate trade between users of different CCPs.
• Cross-border consolidation and cross-border provision of trading and post-trade services. Where competition in both trading and clearing has emerged, it has often come from FMIs seeking to leverage capabilities in other markets. Participant demands have also been a relevant driver, with globally active financial institutions seeking to reduce costs by consolidating activity with fewer FMIs.
• Over-the-counter (OTC) derivatives clearing. Even before the 2009 commitment by the G20 to migrate all standardised OTC derivatives transactions to central clearing (Chapter 3), OTC market participants had already begun to make increasing use of CCPs. This trend has accelerated since 2009, with around half of the notional outstanding amount of all OTC interest rate derivatives globally now centrally cleared.

In light of the PSB's mandate to ensure that FMIs are operated in a way that promotes financial stability, the PSB has given close consideration to the potential stability risks arising from these changes in the market structure. An obvious stability risk is that competition, possibly through a ‘race to the bottom’, leads to lower-quality or less reliable provision of critical FMI services. ASIC and the Bank seek to address this through the due diligence that is conducted ahead of any recommendation to the Minister on licensing, and through ongoing oversight of licensees against regulatory standards.

There are at least three additional stability risks that could arise:

• materially reduced regulatory influence for Australian regulators over critical CS services in the Australian market
• materially increased complexity in the post-trade market structure that created opacity or introduced channels for contagion that could not be managed effectively
• greater likelihood of frequent and potentially disruptive entry and exit of CS service providers.

Accordingly, consideration has been given to how the powers of ASIC and the Bank could best be deployed to ensure changes in the market structure deliver efficiency and innovation without posing unacceptable risks to financial stability. In the Bank's view, subject to the recommendations arising from the CFR's 2011 review of FMI regulation being progressed, the regime for FMI regulation in Australia provides for effective oversight, an appropriate balance between efficiency and stability considerations, and a sound foundation to deal with the regulatory challenges arising from each of the themes identified.

8.6.5.1 Regulatory influence

Further to the review of FMI regulation discussed in Section 8.6.4, the CFR published a paper in July 2012 setting out additional safeguards to ensure that ASIC and the Bank retain sufficient regulatory influence over cross-border CS facilities operating in Australia. The paper develops a graduated framework for imposing additional requirements on cross-border CS facilities proportional to the materiality of domestic participation, their systemic importance to Australia, and the strength of their connection to the domestic financial system or real economy (CFR 2012b).^[21] In response to a desire for further clarity from existing and prospective CS facility licensees the CFR recently released a further paper setting out how the regulators would expect to apply the framework in various alternative scenarios (CFR 2014).

One such additional measure is to require that any systemically important CCP use an ESA at the Bank to manage its Australian dollar-denominated obligations, and also that it maintain a portion of its liquid assets in Australian dollar-denominated liquid assets. A holder of an ESA with the Bank is entitled to central bank liquidity against eligible collateral assets, which may be important in some market circumstances.

Additional requirements would apply where a facility was not only systemically important, but also had a strong domestic connection. Such a facility would be required to incorporate locally and hold a domestic licence, such that:

• ASIC and the Bank would be the primary regulators
• the activities of the facility – including the location and administration of collateral – would be under Australian law, which may be particularly important for participants with largely domestic activities
• the facility would fall within the scope of the proposed special resolution regime for financial market infrastructures in Australia.

The policy is flexible and allows triggers for particular measures to be set on a case-by-case basis. It has already been applied in the case of LCH.C Ltd, and it will need to be applied in considering the appropriate regulation of any future cross-border licence applicant.

Importantly, however, there is at present no specific legal provision for imposing a requirement that a licensee incorporate locally and transition from an overseas to a domestic licence. Further to the CFR's recommendations to the government arising from the review of FMI regulation in 2011, a working group of the CFR has developed legislative proposals to remove this impediment. The Bank strongly encourages the government to progress these alongside proposals to introduce an FMI resolution regime.

8.6.5.2 Complexity

Multiple providers of clearing services for a given product class and the dynamic of competition inherently add complexity to the infrastructure landscape. A further potential source of complexity is interoperable links between FMIs – and, in particular, links between CCPs. As noted, a link between two CCPs allows a participant of one CCP to centrally clear transactions executed with a participant of the other CCP. A link therefore lowers the cost to traders of expanding their product range and their access to trading networks. At the same time, however, links could provide a direct channel for contagion between CCPs and careful risk management of financial risk exposures between linked CCPs is therefore essential.

A framework for managing the risks arising from FMI links has been developed and is reflected in the PFMIs. This framework has accordingly been written into the Bank's FSS and will form the basis for the Bank's assessment of any future proposal for an FMI link. Given the relative novelty of FMI link arrangements, it is likely that the PSB would apply a conservative interpretation of the relevant standards in the event that cross-border links were proposed.

8.6.5.3 Entry and exit

Frequent entry and exit of FMIs such as CS facilities is undesirable, given the high costs to market participants of transitioning between providers. Connecting to a new provider entails significant legal, technology and operational costs. It is also a time-consuming process, which for some participants can take several months. Should a provider subsequently exit, forcing participants to transfer to a new provider, these connection costs would be borne again. Also, in a competitive setting, participants may shift between competing providers at different times, potentially fragmenting liquidity and leaving a CCP with unnetted exposures.

Entry and exit was considered in a review by the CFR of competition in clearing and settlement of Australian cash equities. The CFR recommended that any competing providers be required to give the regulators at least one year's notice of any planned commercially driven exit and maintain additional capital to cover operating expenses for that notice period. This would be expected to facilitate an orderly transition to a new service provider.

Also on the recommendation of the CFR, the government announced in February 2013 that no licence applications from competing CCPs for ASX-listed securities would be considered for two years, as feedback from consultation indicated that the transition to a competitive environment would impose high operational costs on an already stretched industry (CFR 2012a). In the meantime, ASX was called upon to develop a Code of Practice (the Code) for its cash equity clearing and settlement activities, based on a set of principles around user input to governance, transparent and non-discriminatory pricing, and access. The Code was published in July 2013. At the end of the two year period, the CFR will carry out a public review of the Code's implementation and effectiveness. At the same time, the CFR will review the prospect of granting a licence to a competing CCP, or of pursuing other regulatory outcomes. If competition were to be ruled out indefinitely, a regulatory response might be appropriate.

Footnotes

While the Australian Competition and Consumer Commission (ACCC) has broad responsibility for competition and access issues in all industries under the Competition and Consumer Act 2010, the Bank and the ACCC have entered into a Memorandum of Understanding (MoU) to ensure appropriate coordination between the two agencies in the payments system. The legislation and MoU are designed to ensure that there is no regulatory overlap between the two agencies. [1]

An early contribution to this decline was made by the introduction of RTGS in 1998, which allowed the clearing and real-time settlement of high-value payments with richer data, thereby replacing a range of high-value cheques. [2]

Other proxies for cash usage for which longer-run data are available suggest that the substitution away from cash is a longer-run phenomenon. For example, ATM withdrawals as a share of nominal GDP have been declining since the early 2000s. [3]

References in this document to eftpos are to the domestic debit scheme, now operated by eftpos Payments Australia Limited (ePAL) rather than to the broader concept of electronic funds transfer at the point of sale. Prior to the formation of ePAL, ‘the EFTPOS system’ referred to the series of bilateral arrangements which governed the relationships between participants in the domestic debit system. For consistency, this document adopts the lowercase usage. [4]

See Bagnall, Chong and Smith (2011) for the 2010 study. [5]

Further discussion of the Bank's reforms can be found in Bullock (2010). [6]

The term ‘scheme debit’ refers to the debit card schemes of MasterCard and Visa. [7]

With the closure of the Bankcard scheme, the Bank revoked its designation and regulations in 2007. [8]

Frankel (2008) evaluates both claims in some theoretical literature that interchange fees play a beneficial and necessary role in card payment systems and claims that lower interchange fees would result in cardholders abandoning their cards and the eventual ‘death spiral’ of schemes. The author throws doubt on many such claims, concluding that payment systems ‘… can instead work well without interchange fees …’ (as is the case in a number of European card networks). [9]

The structure of the schemes' interchange fee schedules in the United States is a little different to their structure in Australia, making comparisons complicated; the US fee schedules are more complex and contain significantly more interchange fee categories. [10]

See ‘Box 8B: Interchange Fees’ for a description of how a ‘four-party’ credit card scheme operates. The transaction flows in a three-party scheme are similar, but the scheme fulfils the role of both issuer and acquirer, providing card acceptance services and charging merchant service fees to merchants while collecting funds from – and charging fees, interest (if applicable) and offering rewards to – cardholders. In such a three-party scheme, no interchange fees apply. However, three-party schemes have in recent years entered into ‘companion’ card arrangements with financial institutions to issue their cards. These arrangements have interchange-like fees, and – as with traditional four-party arrangements – may involve other incentive or marketing payments to issuers. [11]

Similar estimates can be obtained from comparing total merchant service fees paid between November 2003 and December 2013 for observed transaction volumes to two counterfactuals which both assume that average merchant service fees had remained at their starting level: the first scenario assumes that each scheme's share of the total value of card transactions was the same as actually occurred; while the second scenario assumes that schemes' market shares remained at their starting levels. [12]

The combined American Express and Diners Club share (by value) of all credit and charge card transactions has risen by around 4½ percentage points from its 2003 level. Since 2010, this share has been broadly stable at 19–20 per cent. The share of these two schemes in all (debit, credit and charge) card transactions is unchanged since 2003, and is below the share observed in the US market. [13]

eftpos is now also organised as a scheme and is transitioning to its own centralised or hub-based arrangements. [14]

For instance, Google offers a wallet product in the United States. [15]

However, the Canadian Mint has announced trials of MintChip, government-backed ‘digital cash’ for Canada that resembles a prepaid product. [16]

Transaction volumes for on-exchange Bitcoin-Australian Dollar trades averaged around 340BTC at a value of $160,000 per day on MtGox in the six months prior to its demise. This compares with Australian dollar foreign exchange turnover (AUD against all foreign currencies) averaging more than $350 billion per day in six major markets, according to the most recent semi-annual survey in October 2013. [17]

There is also one other licensed SSF, IMB Limited, which operates a small SSF for settlement of its own securities. [18]

ASIC rules implementing the PFMIs for trade repositories had not yet been finalised at the relevant assessment date. [19]

The Bank's Exchange Settlement Account Policy is available at <http://www.rba.gov.au/payments-system/esa/>. [20]

These measures would apply both where an overseas-based facility sought to provide its services in Australia and where a domestic facility sought to outsource certain operations offshore. [21]

References

ASIC (Australian Securities and Investments Commission) and RBA (Reserve Bank of Australia) (2013), ‘Implementing the CPSS-IOSCO Principles for Financial Market Infrastructures in Australia’, February. Available at <http://www.rba.gov.au/payments-system/policy-framework/principles-fmi/implementing-principles-australia.html>.

Bagnall J, S Chong and K Smith (2011), ‘Strategic Review of Innovation in the Payments System: Results of the Reserve Bank of Australia's 2010 Consumer Payments Use Study’, Reserve Bank of Australia, June.

Bullock M (2010), ‘A Guide to the Card Payments System Reforms’, RBA Bulletin, September, pp 51–59.

CFR (Council of Financial Regulators) (2012a), Council of Financial Regulators Advice on Competition in Clearing of the Cash Equity Market, December. Available at <http://www.treasury.gov.au/PublicationsAndMedia/Publications/2013/competition-of-the-cash-equity-market>.

CFR (2012b), ‘Ensuring Appropriate Influence for Australian Regulators over Cross-border Clearing and Settlement Facilities’, July. Available at <http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2012/cross-border-clearing>.

CFR (2012c), ‘Review of Financial Market Infrastructure Regulation: Letter to the Deputy Prime Minister and Treasurer’, February. Available at <http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2012/CFR-Financial-Market-Infrastructure-Regulation>.

CFR (2014), ‘Application of the Cross-border Influence Framework for Cross-border Central Counterparties’, March. Available at <http://www.cfr.gov.au/publications/cfr-publications/2014/pdf/app-reg-influence-framework-cross-border-central-counterparties.pdf>.

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CPSS (2013), ‘Statistics on Payment, Clearing and Settlement Systems in the CPSS Countries: Figures for 2012’, Bank for International Settlements, Basel. Available at <http://www.bis.org/publ/cpss116.pdf>.

CPSS-IOSCO (Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions) (2001), Recommendations for Securities Settlement Systems, Bank for International Settlements, Basel.

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CPSS-IOSCO (2012), Principles for Financial Market Infrastructures, Bank for International Settlements, Basel.

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Commonwealth Consumer Affairs Advisory Committee (2013), Credit Card Surcharges and Non-transparent Transaction Fees – A Study, July.

Cusbert T and T Rohling (2013), ‘Currency Demand during the Global Financial Crisis: Evidence from Australia’, RBA Research Discussion Paper No 2013-01.

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Frankel A (2007), ‘Towards a Competitive Card Payments Marketplace’, in Payments System Review Conference, Proceedings of a Conference, Reserve Bank of Australia and Centre for Business and Public Policy at the Melbourne Business School, Sydney, pp 27–69.

Financial Stability Board (FSB) (2013), ‘Application of the Key Attributes of Effective Resolution Regimes to Non-bank Financial Institutions: Consultative Document’, August. Available at <https://www.financialstabilityboard.org/publications/r_130812a.pdf>.

Financial System Inquiry (1997), Financial System Inquiry Final Report (S Wallis, chairperson), Australian Government Publishing Service, Canberra. Available at <http://fsi.treasury.gov.au/content/FinalReport.asp>.

Flood D, T West and D Wheadon (2013), ‘Trends in Mobile Payments in Developing and Advanced Economies’, RBA Bulletin, March, pp 71–79.

Gibson M (2013), ‘Recovery and Resolution of Central Counterparties’, RBA Bulletin, December, pp 39–48.

Hayashi F (2013), ‘Public Authority Involvement in Payment Card Markets: Various Countries August 2013 Update’ Payments System Research Department, Federal Reserve Bank of Kansas City. Available at <http://www.kansascityfed.org/publicat/psr/dataset/pub-auth_payments_var_countries_August2013.pdf>.

RBA (Reserve Bank of Australia) and ACCC (Australian Competition and Consumer Commission) (2000), Debit and Credit Card Schemes in Australia: A Study of Interchange Fees and Access, October.

RBA (2013a), 2012/13 Assessment of ASX Clearing and Settlement Facilities, September. Available at <http://www.rba.gov.au/payments-system/clearing-settlement/assessments/2012–2013/>.

RBA (2013b), Self-assessment of the Reserve Bank Information and Transfer System, November. Available at <http://www.rba.gov.au/payments-system/rits/self-assessments/2013/>.

Schwartz C, J Fabo, O Bailey and L Carter (2007), ‘Payment Costs in Australia’, in Payments System Review Conference, Proceedings of a Conference, Reserve Bank of Australia and Centre for Business and Public Policy at the Melbourne Business School, Sydney, pp 88–138.

United States Government Accountability Office (2009), ‘Credit Cards: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges’, Report to Congressional Addressees, GAO-10-45, Washington, DC, November. Available at <http://www.gao.gov/assets/300/298664.pdf>.