Review of Card Payments Regulation 4. Issues for the Review

With the benefit of further evidence since the time of the 2007–08 Review, the Bank's view remains that its reforms have been in the public interest and helped contribute to a more efficient and competitive payments system. Contrary to the ‘death spiral’ predicted by some who opposed the reforms of the early 2000s, the Australian cards market has continued to grow and innovate, with the value of card transactions growing from $187 billion in 2002 to $510 billion in 2014. Furthermore, as outlined in ‘Box B: Retail Payments Reforms in Other Jurisdictions’, the Bank's reforms have been followed by similar reforms in many other jurisdictions.

However, the previous chapter has touched on some developments that raise concerns from the perspective of competition and efficiency in the payments system. Accordingly, the Bank considers that there would be benefits to a review of the current regulatory framework for the cards system.

Issues that might be addressed in such a review include:

• The decline in transparency for some end users of the card systems, in part due to the increased complexity and the wider range of interchange fee categories.
• Whether there is scope for interchange fees to fall further, consistent with falls in overall resource costs and as was contemplated in the conclusions to the 2007–08 Review.
• Widespread perceptions that card surcharges remain excessive in some industries.
• Perceptions that the growth of companion card arrangements may indicate that the current regulatory system is not fully competitively neutral.
• Some uncertainty in the regulatory treatment of prepaid cards.
• Clarifying arrangements for cards offering access to more than one payment network (whether presented physically or virtually via a wallet application) and more broadly for competing payment options in a single device or application.

Issues in the Transparency of Card Payments

This section describes some areas where there has been a decline in the transparency available to many merchants about the cost of cards. These merchants are hindered in their ability to control their payment costs, given that they are typically unable to see the cost of different cards, are restricted by card scheme rules from choosing to accept only some types of debit or credit cards, and in practice are unable to differentially surcharge to reflect the difference in payment costs. As a result, cardholders may not face the correct price signals associated with their choices, which is likely to result in cross-subsidisation and less pressure to reduce the cost of payments.

One example of the lack of transparency in the card systems concerns the inability of merchants to distinguish between debit and credit cards in some contexts. In the card-present/point-of-sale environment, a merchant should have full visibility over whether a physical card is a debit card or a credit card, given that the relevant Standard requires that all debit cards must be visually identifiable as such. In principle, cards should also be electronically identifiable as debit rather than credit in the card-not-present environment, given that the Standard requires that debit cards are issued on identifiable Bank Identifier Numbers (BINs) and that acquirers are required to provide these to merchants on request. In practice, however, some merchants in the card-not-present environment report that they are unable to distinguish between debit and credit. One reason that has been reported is that acquirers are unable to obtain reliable and timely lists of debit and credit BINs from the international schemes.

Based on follow-up on some of the consumer complaints about surcharging that the Bank receives, the inability of merchants to distinguish between debit and credit cards appears to be a fairly common phenomenon. It may not, however, be that surprising, given that until now many merchants have been presented with a single merchant service fee applying to both credit and debit transactions, and may not have perceived an incentive to distinguish debit from credit cards.

A second example of the lack of transparency stems from the increase in the number of interchange categories in the MasterCard and Visa credit and debit systems and the widening in the range of different interchange rates, both described in Chapter 3.^[25] Schedules of interchange rates are set by the two international schemes and specify the interchange rate to be paid based on the category of merchant (‘strategic’, service station, etc), the type of card (various types of premium cards, corporate, etc) and the nature of the authentication (contactless, SecureCode, etc) or value of the transaction (Table 1). There is a hierarchy of categories, which determines how the merchant, card and transaction categories interact. Typically, the relatively low ‘strategic’ interchange rates for large merchants have precedence over the interchange category for the type of card, so that the same relative low rate for strategic merchants applies for all their transactions, including for those using premium cards with high interchange rates. However, merchants that do not have access to strategic or merchant-specific rates will face different rates based on the type of card presented.

There have been significant changes in the average credit card interchange rates that apply to particular types of merchants since the introduction of merchant-based interchange categories in 2006 (by Visa) and 2007 (by MasterCard). Interchange rates for ‘strategic’ and some other specific types of merchants have been lowered over this period, while the interchange fee rates that apply to the various types of premium cards have risen. Visa and MasterCard initially each had a single tier of premium interchange rates in 2006, but Visa now has six different premium fee categories for consumer cards and five commercial fee categories, while MasterCard has three consumer premium categories and three commercial categories. Based on the hierarchy of interchange rates, the cost of the high interchange rates for consumer premium and commercial cards falls entirely on small merchants and other merchants that do not benefit from special rates.

Broadly similar developments have also occurred with respect to the debit interchange rates of MasterCard and Visa. The schemes have introduced low strategic or special rates for particular types of merchants as well as high rates for commercial cards. They have also introduced high rates for premium cards, though there has been relatively little issuance of such cards, with rewards programs hitherto being much less prevalent and less generous than for credit cards. For both schemes, the precedence hierarchy is such that merchants receiving strategic and other special rates receive low rates on all their transactions, so that only non-qualifying merchants are subject to the high commercial and premium rates.

There are two significant consequences of these developments in interchange schedules. First, there are now large differences in the average interchange rates paid on the transactions of strategic or qualifying merchants compared with other merchants. The Bank estimates that the average credit card interchange rate for non-preferred merchants (i.e. those not benefiting from strategic or other preferential rates) was more than 50 basis points higher than the interchange rate applying to preferred merchants in the December quarter of 2014. For MasterCard and Visa debit cards, the average interchange rate paid by the non-preferred group of merchants is estimated to have been around 12 cents per transaction higher than the rate applying to the preferred group.^[26] These differences in interchange rates have a corresponding effect on the merchant service fees faced by the two groups which is in addition to the higher margin that acquiring banks would normally apply to small merchants relative to large merchants. For both debit and credit cards, the tendency has been for the differences in interchange fees applying to the two groups to have widened significantly since merchant specific rates were first introduced.

The second consequence of the complex interchange fee schedules is that the non-preferred merchants have little transparency over the cost of particular transactions. In the case of a MasterCard or Visa credit card transaction, the interchange rate will be 30 basis points on a standard card but will be 200 basis points if the transaction involves the highest level of premium card. In the case of an average-sized debit transaction, the interchange payment would be around 8 or 9 cents on a standard debit card transaction but around 50 cents on a premium or commercial card. Without any visibility over the cost of the particular card used in the transaction, a merchant that wishes to charge to reflect the much higher cost of some cards is unable to do so.

At present, there is no requirement that credit and debit cards should be identifiable to merchants in terms of their interchange cost, either visually or electronically, and the Bank is not aware of any acquirer in the Australian market that provides such information to its merchants at the time of the transaction. In any case, while BINs for each card type have traditionally been associated with a particular interchange category and rate, this is becoming less so with the recent introduction of ‘account-level processing’ for premium cards. This allows issuers to upgrade (or downgrade) the benefits and interchange rate associated with a card without changing its BIN and account number. More broadly, the issue of the lack of transparency of the cost of payments to merchants is likely to grow based on some ongoing changes in payments technology. In particular, as card-present transactions shift from involving physical cards to information stored on mobile phones, the ability of merchants to observe the nature of the ‘card’ declines. Similarly, if the share of card-not-present transactions continues to rise, problems with the lack of transparency may increase.

Interchange Fees and Payments System Efficiency

While the regulatory changes implemented by the Bank starting in 2003 reduced the potential for interchange fees to drive inefficient payment choices, it is nonetheless possible that at current levels interchange fees continue to distort decisions to some degree.

Potential distortions from interchange fees come about because many merchants may feel that they have no choice but to accept the cards of a large scheme – that is, the cards are regarded as a ‘must-take’ form of payment – and have no capacity to influence a significant component of the cost in the form of the interchange fee. With little downward competitive pressure on interchange fees and little capacity for many merchants to refuse acceptance, interchange fees can be focused largely on providing incentives to issuers to issue the cards of a particular scheme and to cardholders to use those cards. These incentives are independent of the resource costs of a particular card scheme and may distort payment decisions, leading to overuse of some higher-cost payment methods and inefficiency in the payments system more generally. For instance, the Bank's 2013 Payments Cost Study shows that – for the average-size transaction for each payment method – the effective price paid by a cardholder to use a credit card is lower than that for a debit card, even though the resource costs are substantially higher. While these tensions are most evident in competition between card schemes, the same principle is valid more broadly; it is entirely possible that interchange fee flows are leading to card payments being overused relative to non-card systems, for instance the Direct Entry system which was estimated to have the lowest cost of any system in the Payments Cost Study. Similarly, a new, low-cost payment system might have difficulty establishing itself in the face of existing interchange fees in mature card systems.

The Bank's reforms starting in 2003 have served to bring the average interchange fees of the different card systems closer together (and closer to zero), meaning that decisions about the choice of payment method are more likely to be based on the relative attributes of the different systems themselves, rather than being driven by price signals underpinned by centrally set interchange fees. The Bank's assessment is that the caps on card interchange fees have limited the potential for those fees to disrupt efficient payment choices, and have contributed in a significant way to the fall in the overall resource cost of payments that is apparent in the Bank's recent Payments Cost Study.

However, as suggested in the recent Financial System Inquiry (FSI 2014b, p 173), it is possible that existing caps are still inefficiently high. It is apparent from the data shown in Chapter 3 that the reduction in interchange fees for the international systems has not prevented continued strong growth in the card systems in Australia. Indeed, given that one of the justifications often cited for interchange fees is that they may be helpful in stimulating growth in a payment system in its early phase, it is noteworthy that the significant increase in card payment volumes and the accompanying fall in average resource costs have not been associated with a fall in interchange fees in Australia. In addition, there are instances internationally of card systems that function effectively without interchange fees and also recent cases where regulators and card schemes have set lower interchange caps than exist in Australia, including by seeking to align interchange fees with the transactional benefits that merchants derive from card payments (the Merchant Indifference Test).^[27]

Furthermore, there continue to be indications that the differential in interchange fees between the eftpos system and the international scheme debit products is influencing behaviour. While cardholder rewards have not generally been used to drive adoption of debit cards, issuers appear to have responded to interchange fee differentials and other incentives from payment schemes. For instance stand-alone ‘proprietary’ ATM/eftpos cards, which once were a standard offering for financial institutions, have in most cases been replaced with MasterCard or Visa branded dual-network cards over recent years (often with a sticker urging the cardholder to use the MasterCard or Visa network rather than eftpos). It is also notable that, once placed on the same interchange cap as MasterCard and Visa debit products, ePAL has moved eftpos interchange rates closer to those of the international schemes, suggesting that it considers the interchange differential to be detrimental to its capacity to compete and confirming that there are few forces constraining interchange fees beyond regulation.

In addition, the current mechanism used for capping interchange fees raises some issues in regard to the level of interchange fees over time. Interchange regulation for both credit and debit cards involves the Bank setting a benchmark for the weighted-average interchange rate. Credit card schemes' benchmarks were initially scheme specific, but since November 2006 have been set at 50 basis points for both MasterCard and Visa. The Standard requires that at the time of any reset, the weighted average of each scheme's interchange fees – based on applying the new interchange rates to the transactions of the most recent financial year for which data are available – does not exceed the benchmark. The combination of the infrequent and backward-looking nature of benchmark compliance and the schemes' management of their interchange fee schedules has meant that in practice the weighted-average interchange fees for the schemes (using the current mix of transactions) have almost always been above the benchmark.

By setting different interchange fees for different card types, card schemes encourage card issuers to issue and promote those cards with the highest interchange rates. This leads to a tendency for average interchange fees to increase between benchmark compliance points. However, a more active strategy employed by the schemes has been to introduce completely new, higher interchange rate categories. These initially have a zero transaction weight for benchmark purposes and thus provide the opportunity for issuers to increase interchange revenue received from acquirers by modifying the mix of their card products following the reset – replacing standard cards with ‘premium’ cards, premium cards with ‘super-premium’ cards, and so on. Of course, after three years of upwards interchange drift, the schemes must then reduce some rates to ensure compliance with the benchmark, and they have tended to again set their schedules in ways that will cause interchange rates to rise again during the next three-year period. The resulting expansion in the number of categories and the range of fees is illustrated in Chapter 3 (Graph 8 and Graph 9). As noted in footnote 25, the broader tendency to an expansion in the number of fee categories is not purely a reflection of the Australian regulatory framework – the unregulated US credit card market provides a much stronger example of this tendency.

The behaviour resulting from the current benchmark approach means that average interchange fees (at least in the case of credit cards) have been consistently over the benchmark. This implies that credit card interchange fees should be thought of as loosely anchored around an average of something over 0.5 per cent over a three-year compliance cycle, rather than capped at 0.5 per cent. Of more concern is the fact that there has been a tendency for the upward drift relative to the benchmark to increase over time, so that the average interchange rate for each compliance cycle is increasing.

A separate issue is whether the specification of interchange fee caps remains appropriate. In particular, the current debit benchmark is specified in cents per transaction. The evolution of the payments system over recent years has seen increasing use of card payments for low-value transactions. This has, for instance, resulted in the average value of a MasterCard or Visa debit card transactions falling by around 40 per cent since 2008. This in turn has meant that average interchange fees have increased as a percentage of the average debit transaction and, while the schemes have some pricing arrangements that accommodate it, interchange fees can in some cases be very high relative to the value of a small payment.

Excessive Surcharging

The right to surcharge is an important mechanism for improving payments system efficiency. It allows merchants to signal the cost of different payment methods to users, influencing payment choices, and allowing merchants to pass costs directly on to those using more expensive payment methods so that the general level of merchants' prices can be kept lower. Surcharging is also one means by which merchants can exercise some pressure on merchant service fees and interchange fees; for example, the removal of the no-surcharge rule in the American Express system is likely to have contributed to the decline of merchant service fees for that system.

While ensuring that merchants have the ability to pass on the cost of expensive payment methods has been beneficial for the payments system, the Bank has been concerned that in a small number of cases, merchants have been able to apply surcharges that are well in excess of acceptance costs, leading to poor price signals. While this should not be sustainable in a competitive environment, circumstances appear to exist in a small number of industries that allow it to occur.

The Bank responded to these concerns with changes to its Standards that became effective in 2013; these changes allow the card schemes to use their rules to limit surcharges to the reasonable cost of acceptance. There has, however, been limited effective enforcement of these rules. There have been suggestions that the schemes and acquirers (who have the direct relationship with the merchant) have insufficient visibility of merchants' acceptance costs and, in the case of acquirers, little incentive to create a conflict with a customer. This was a focus of the FSI, which noted that current rules may be difficult for schemes to enforce, potentially complex for merchants to comply with and can cause frustration for consumers. There has also been public concern about surcharging in particular sectors, including the 10 per cent surcharges that have typically applied in the taxi industry (though this has recently been addressed by state legislation in some cases). In the airline industry, fixed-dollar surcharges can amount to a very high proportion of the purchase price for lower-cost airfares. For example, payment surcharges for return domestic fares range from $2.50 to $17 for debit cards and $7 to $17 for credit cards, implying surcharges of up to 8½ per cent on a $200 return fare (Table 2).

More generally, there are concerns that some sectors may be more susceptible to excessive surcharging. This may be where a high proportion of payments are made using credit cards, for instance where they offer a significant advantage in speed and convenience over other payment methods or where cards are used to provide security deposits. It might also be the case where online price comparisons are common and merchants have an incentive to hold down the headline price. These factors mean that online commerce is likely to be more susceptible to excessive surcharging than ‘bricks and mortar’ retailers. A contributing factor is the lack of ubiquitous and convenient online payment alternatives that are low cost to the merchant.

Competitive Neutrality and Companion Cards

In a typical ‘three-party’ scheme such as American Express or Diners Club, the scheme is both issuer and acquirer, with no role for interchange fees. Accordingly, while American Express and Diners Club are subject (by voluntary undertaking) to the Bank's standard on merchant pricing which prevents them from having no-surcharge rules, these schemes have not been subject to the Bank's interchange standards. However, companion card arrangements, where the scheme continues to acquire transactions but partners with financial institutions to issue cards, do have interchange-like fees that are paid from the scheme to the issuer, and – as with traditional four-party arrangements (such as MasterCard and Visa) – may involve other incentive or marketing payments to issuers.

The emergence of American Express companion card arrangements is likely to have led to an increase in the overall issuance of American Express cards and increased the average number of credit cards consumers hold. This may have adversely affected the competitive position of other card schemes. As

noted, in Chapter 3, there has been an increase in the share of American Express and Diners in the credit and charge card market over the past decade. However, American Express cards are not as widely accepted as MasterCard and Visa cards, and are more often surcharged, or are surcharged at a higher rate. Merchants appear to be more comfortable declining acceptance or surcharging because they can be reasonably confident that an American Express cardholder is also holding a MasterCard or Visa credit card; the Bank's 2013 Consumer Use Survey indicated that this was true in around 95 per cent of cases. These factors mean that the market power of American Express is less than that of the other two large international schemes, although there are industries where this may not be the case (e.g. some businesses oriented to overseas visitors, like hotels in major tourist destinations).

The Bank foreshadowed in its initial submission to the FSI (RBA 2014) that it would review whether any changes to the regulatory treatment of American Express companion card arrangements (or of any other scheme that is not currently designated) might be warranted. In addition, several submissions to the FSI have argued that the lack of formal regulation of companion card arrangements results in a lack of ‘competitive neutrality’ in the Bank's regulation.

Prepaid Cards

In many respects, prepaid cards are similar to debit cards. In 2006, the Board determined that it was not necessary to regulate prepaid cards at the time, but noted its expectations regarding their treatment, including that interchange fees for transactions on these cards would be published and set broadly in conformity with the Standard on interchange fees in the Visa Debit system, and that merchants would not be prevented from surcharging transactions on these cards if they chose. The Board also noted that, consistent with the intent of the Standard on ‘honour-all-cards’ rules, were a prepaid card introduced with features substantially different from a scheme debit card, merchants should not be required to accept that card.

More recently, the Bank has received queries from a number of payments system participants about the meaning of ‘broadly in conformity with’, with some parties suggesting that the ambiguity in the wording might contribute to an uneven playing field. In addition, the factors that are present in the ‘drift’ of average credit and debit interchange rates apply equally to prepaid cards. Accordingly, in the Bank's view, a review that dealt with credit and debit card regulation should consider bringing prepaid cards into formal regulatory arrangements.

Arrangements for Competing Payment Options within a Single Device or Application

Issues concerning competing payment options on a single device have recently arisen in the case of dual-network debit cards. These are cards issued by banks and other financial institutions with point-of-sale debit functionality from two payment networks. The Board has indicated that it supports the longstanding practice of issuing dual-network debit cards in Australia, because they are convenient for cardholders and allow stronger competition between networks at the point of sale.

One concern that may arise with dual-network cards is that networks may seek to implement scheme rules that prevent a card-issuing institution from including payment functionality from another network on the issuer's card. Another question concerns the rights of merchants, cardholders, card issuers and networks in deciding which network will be used for a transaction. Until recently, debit card holders have typically chosen the network used, by pressing one of three buttons when they have inserted their cards into point-of-sale terminals, though, in principle, merchants also have had the ability to exercise choice in the routing of transactions.^[28] However, questions about choice of network may be raised more frequently as contactless authentication becomes more widely used, because contactless technology creates an element of automaticity in the routing of transactions. In particular, it removes the need (and the option) for holders of dual-network cards to choose the payment type and network at the point-of-sale terminal.

As discussed earlier, following concerns expressed by the Board, in August 2013 the three debit card networks (eftpos, MasterCard and Visa) reached voluntary agreements on principles relating to dual-network debit cards. The agreement aimed to maintain existing dual-network arrangements in the contactless environment and to safeguard the right of merchants to exercise their own transaction routing priorities.^[29] The agreements are consistent with some principles set out by the Board and to date the Bank's understanding is that the networks have worked constructively in relation to dual-network issues.

A related set of issues are posed by the emergence of wallet applications, which store payment card details and may be used to make payments online or with a mobile device capable of making contactless transactions via Near Field Communication (NFC) or a QR code. Wallets potentially raise new questions about access and within-application competition between payment options as well as cardholder and merchant control over transaction routing.

Accordingly, in light of the likely continued growth of arrangements where multiple competing payment options may be present in a single device or application, it may be useful to consider whether there are issues that arise that touch on the Board's mandate for competition and efficiency and where more formal ‘rules of the game’ might be appropriate.

Footnotes

The tendency towards a larger number of interchange categories is not, however, a purely Australian phenomenon nor a product of our regulatory system. In the United States, where there is no regulation of credit card interchange, the average number of credit card interchange fee categories for MasterCard and Visa increased from 4 in 1991 to 151 in 2009 (United States Government Accountability Office 2009). Currently MasterCard's US credit card interchange rates are generally lowest for strategic merchants such as Tier 1 supermarkets (1.15–1.25 per cent) and for utilities payments (65–75 cents) but can be as high as 3.25 per cent (plus 10 cents) in the case of premium cards for merchants that do not benefit from strategic rates. [25]

For eftpos, the gap is estimated to be much smaller. The interchange schedule for ePAL is much simpler, with all merchants eligible for an interchange rate of zero on transactions of less than $15, and then subject to a rate of between zero and five cents on larger transactions, depending on whether they qualify for a strategic rate. ePAL does not have ‘premium’ category cards and therefore does not have any such interchange rates. [26]

See footnote 10 which identifies that there are a number of European countries with high use of card payments but where debit systems have no or very low interchange rates. [27]

Woolworths, a retailer with its own payments processing capacity, between April 2010 and September 2012 chose to route all debit transactions on dual-network cards through the domestic eftpos network rather than the networks of MasterCard and Visa, citing the higher cost of the latter networks (Woolworths Limited 2010). A number of other retailers have asked their financial institutions to route transactions via a preferred network but have been unable to obtain this capacity. [28]

To date, cards with two contactless debit card applications (e.g. MasterCard and eftpos or Visa and eftpos) are not generally available, although eftpos is expected to commence a widespread rollout of its own contactless debit card this year. [29]