Review of Retail Payments Regulation – Conclusions Paper
October 2021 Interchange fees

4.1 Issues for the Review

A key issue for the Review was whether the levels of the card scheme interchange benchmarks and caps remained appropriate, particularly in light of:

• recommendations by the Black Economy Taskforce (2017) and the Productivity Commission (2018) that interchange fees should be reduced or even eliminated, on the grounds that there is little justification for such fees in mature card systems such as Australia.
• the continuing decline in the average value of card transactions, particularly for debit cards. The average value of debit card transactions is now around $48, down from $56 in 2016 when the Board lowered the weighted-average benchmark for debit and prepaid transactions from 12 cents to 8 cents. This trend is largely attributable to a migration of lower-value payments from cash to debit cards, amid the widespread adoption of contactless ‘tap-and-go’ technology, which has accelerated during the COVID-19 pandemic.
• the increased tendency for schemes to set debit interchange fees for non-routable transactions at smaller (or non-strategic) merchants at the cents-based debit interchange cap of 15 cents (Table 1). The Bank's regulatory framework, which is based around weighted-average benchmarks, provides schemes with flexibility in setting their interchange schedules, including to incentivise behaviours that support innovation and benefit the payments system. However, in the case of debit cards, the schemes have increasingly been using this flexibility to set low rates on some categories of transactions that are at risk of being routed to another scheme, while – to maintain interchange revenues for their issuers – increasing rates on other transactions that are less at risk of being routed. The result has been increasingly complex interchange fee schedules, which offer lower rates for routable transactions at larger ‘strategic’ merchants, accompanied by rates at the cap for many non-routable transactions (for example, device-not-present and tokenised device-present transactions) at smaller merchants.

The Board has been concerned that the growing practice of setting some interchange rates at the 15-cent cap has resulted in unreasonably high costs for some low-value transactions at smaller merchants. For example, a 15-cent interchange fee on a $15 transaction is equivalent to 1 per cent of the total value of the transaction. This is up to 15 times the interchange cost of the same transaction for larger strategic merchants. It is also significantly higher than the cost would be if the ad-valorem cap on debit transactions of 0.2 per cent applied, and higher than the interchange fee incurred if a credit card had been used (which is capped at 0.8 per cent).

A second issue was whether the interchange regulations should be expanded to include transactions on foreign-issued cards, which attract interchange fees that are significantly higher than those on domestic cards. There are currently no restrictions on the interchange fees levied on these transactions, and schemes are not required to publish inter-regional interchange fee schedules. In the 2015-16 Review, the Bank decided not to bring transactions on foreign-issued cards into the regulatory framework, but indicated that it would continue to watch developments in this area. In 2019, the European Commission (EC) announced that it had accepted legally binding commitments from Mastercard and Visa to: reduce their inter-regional interchange fees to caps set by the EC; refrain from circumventing the caps; and publish inter-regional interchange fees.^[17] With transactions on foreign-issued cards increasing as a share of card payments at Australian merchants over the past decade, the Review was a timely opportunity to consider whether a similar approach should be adopted in Australia.

A final issue was the regulatory status of three-party schemes, which are currently not subject to the interchange standards and can potentially incentivise greater issuance through higher cardholder rewards, funded by higher merchant fees. The question for the Review was whether the Bank should regulate the merchant service fees charged by these schemes.

4.2 Options presented in consultation

4.2.1 Debit interchange caps

To address the high cost of some low-value debit (and prepaid) transactions that are subject to interchange rates at the 15-cent cap, the Board considered three broad policy options:^[18]

Option 1: Retain the current debit interchange caps

This option involved no change to the status quo, where schemes can set fees on debit interchange categories up to the current cap of 15 cents per transaction (or up to 0.20 per cent for interchange fees specified in percentage terms).

Option 2: Reduce the cap on debit interchange fees set in cents-based terms

This option involved reducing the cents-based cap for debit (and prepaid) cards. The specific proposal was to lower the cap to 10 cents for transactions on DNDCs (and all prepaid cards) and 6 cents for transactions on SNDCs (with the different cap for DNDCs and SNDCs consistent with the reform options considered for ‘Dual-network debit card issuance’). The 6-cent cap would apply equally to SNDCs issued by the international schemes and to the remaining stock of proprietary, eftpos-only cards. There would be no change to the ad-valorem cap of 0.20 per cent for interchange fees specified in percentage terms.

Option 3: Require any debit interchange fees to be set in ad-valorem terms

Under this option, the cents-based cap for debit (and prepaid) transactions would be eliminated, and the ad-valorem cap of 0.20 per cent would apply to all debit and prepaid interchange categories.^[19] The weighted-average benchmark would be set in ad-valorem terms. With an average debit card transaction value of around $50 in 2020, a weighted-average benchmark of around 0.16 per cent would be equivalent to the current cents-based benchmark of 8 cents.

4.2.2 Foreign-issued cards

To address the high interchange fees on transactions on foreign-issued cards, the Board considered three possible responses:

Option 1: No regulation of foreign-issued cards

This option would retain the status quo, where foreign-issued cards are outside the scope of the interchange standards.

Option 2: Extend interchange regulation to foreign-issued cards

Under this option, there would be caps on interchange fees on transactions on foreign-issued cards. The interchange standards would be amended to make transactions on foreign cards subject to the same caps as apply to transactions on domestic cards, though they would not be included in the calculations for the observance of the weighted-average benchmarks. The schemes would be required to publish interchange rates for transactions on foreign cards on their websites.

Option 3: Publication of interchange fees on foreign-issued cards, but no regulation regarding fee levels

Under this option, the interchange standards would be amended to require schemes to publish the interchange fees on foreign cards on their websites. However, the fees on foreign cards would not be subject to the interchange caps or benchmarks.

4.3 Stakeholder views

There was little support among card schemes and banks for a further lowering of the interchange benchmarks, with some arguing that the new interchange standards have only been in effect for a few years so it was too early to consider making any further changes. Many stakeholders noted that Australian interchange fees are already low by international standards. Many industry stakeholders argued also that interchange revenue is essential to support continued investment in innovation, security and the provision of services by card issuers. There were some concerns about a reduction in the cap on debit interchange fees that are set in cents-based terms, with stakeholders expecting that this would lead to a corresponding fall in weighted-average interchange rates and limit the schemes' ability to use their interchange schedules to incentivise innovation and the adoption of certain functionality. In response to concerns raised about some smaller merchants paying high cents-based fees on low-value debit card transactions, some stakeholders provided feedback that only a very small share of transactions fall into this category, and argued that it would therefore not be appropriate to further reduce the interchange caps on all debit card transactions.

Several stakeholders noted that the proposed changes would affect individual issuers differently, depending on their transaction mix. It was suggested that smaller issuers would be disproportionately disadvantaged by any further interchange reductions as they have fewer other sources of revenue to offset this; indeed, some issuers claimed that they were making a loss on many transactions due to the low interchange fees paid by strategic merchants. Relatedly, two issuers proposed a floor on interchange fees to reduce the difference between interchange paid by large and small merchants and provide certainty of income to card issuers. Finally, a few industry stakeholders argued that the right of merchants to surcharge provided sufficient competitive pressure on payment costs that restrictions on interchange were not necessary at all.

In contrast, some merchant and consumer groups argued for a further lowering of the benchmarks to place downward pressure on card acceptance costs. Some stakeholders argued also that the cents-based cap on debit transactions has allowed schemes to set unreasonably high interchange rates (in percentage terms) on some low-value transactions. In addition, there were concerns that the wide range of interchange fees has disproportionately benefited larger merchants by enabling them to negotiate discounted rates, with schemes raising some ‘standard’ interchange rates paid by smaller merchants to maintain a high overall level of interchange fees for issuers.

There were mixed views on whether to extend interchange regulation to transactions on foreign-issued cards. Those in favour generally cited the relatively higher costs of these transactions. Arguments against extending interchange regulation to foreign-issued cards included: the continued limited use of such cards in Australia; the international schemes having rules that prevent circumvention of domestic interchange caps by issuance of foreign cards; the unfair advantage it would confer on unregulated international schemes; and uncertainty about the eventual impact of the EC's recent move to reduce interchange on foreign-issued cards. The international schemes also highlighted that cross-border transactions have unique risks and complexities (including higher fraud rates) that increase issuer costs and justify higher interchange rates. In contrast, stakeholders were generally supportive of the proposal to require schemes to publish interchange fees for foreign-issued cards on their websites.

Similarly, stakeholder views were mixed on the issue of whether regulation should be extended to three-party schemes. Most stakeholders who argued in favour of extending the regulation pointed to the principle of competitive neutrality between three- and four-party schemes. In contrast, arguments against applying interchange regulation to the three-party schemes included that: competitive pressures have seen merchant fees fall at least as much as those on four-party schemes since interchange regulation was introduced; three-party schemes have not increased their overall market share over the past two decades; and merchants can surcharge three-party cards or choose not to accept them as they are generally seen as optional for both merchants and customers. There was also little indication of what form regulation of three-party schemes might take.

4.4 The Board's assessment and conclusions

4.4.1 No change in some areas

The current interchange settings have been in effect for only 4 years and appear to be working well in most respects. While the Board does not rule out lowering the weighted-average interchange benchmarks (8 cents for debit transactions and 0.50 per cent for credit transactions) or the cap on individual credit card interchange fees (0.80 per cent) at some point in the future, it has assessed that such reform is not required at present.

The Review did not change the Board's long-held view that there is no strong justification for significant interchange fee payments in mature card systems. There could be some benefits associated with lower interchange fees including, among other things: a reduction in payment costs in the economy; downward pressure on retail prices of goods and services for consumers; and lower barriers to entry for potential new methods of payment.

However, a range of factors indicate that there is not a strong public policy case for lowering the benchmarks at present. There has been a significant decline in merchants' average cost of accepting card payments over the past two decades (see Graph 1 above), to levels that are relatively low by international standards. Developments in the payments mix in recent years also suggest that the current settings are contributing to positive outcomes, with a significant shift to debit cards from credit card payments (which have both higher private and total resource costs).^[20] Further, the Board noted that Australian interchange rates for both debit and credit transactions are already low compared with most other economies (Graph 3).^[21] One exception is the lower cap on credit card interchange fees in Europe (0.30 per cent, versus a weighted-average benchmark of 0.50 per cent and a cap of 0.80 per cent in Australia); however, the Board feels it is too early to assess the European experience and draw implications for settings in Australia. Finally, while some stakeholders favoured lowering the benchmarks to further drive down the cost of card payments to merchants, most did not support further reductions.

The Board noted that there would also be risks associated with further reductions in the weighted-average benchmarks. Lower interchange on debit transactions could make it harder for new debit issuers to enter the market and could disproportionately disadvantage smaller issuers, which may have fewer other sources of revenue to offset any interchange reduction. There is also a risk that a further reduction in the debit benchmark could incentivise issuers to promote greater issuance and use of (higher-cost) credit cards. In relation to the credit card benchmark, a further reduction could provide an advantage to both the three-party card schemes and other three-party systems such as BNPL arrangements; this is because these arrangements are not subject to the Bank's interchange regulations, which allows them to fund more benefits for consumers through higher merchant fees. The benefits from lower interchange rates on credit card transactions might therefore be offset by a longer-term shift towards more costly three-party systems.

The Board did not see a strong case for expanding the scope of the regulations to capture three-party schemes at present. The evidence does not suggest that three-party card schemes have benefited at the expense of the four-party schemes under the current regulatory settings. The market shares of three-party credit card schemes have declined markedly over the past few years (Graph 4). This was largely driven by the closure of the major banks' companion card programs following reforms introduced in the Bank's 2015–16 Review of Card Payments Regulation, which resulted in the American Express companion card system being regulated in a similar way to the traditional four-party schemes. The average cost of acceptance of three-party card payments has also declined since the previous review (see Graph 1 above). These changes to merchant service fees charged by three-party schemes reflect the indirect competitive pressure flowing from interchange regulation on four-party schemes (including companion cards), as well as the continuing effectiveness of the ban on schemes imposing no-surcharge and no-steering rules.

4.4.2 Debit interchange caps

The current debit caps provide the schemes with considerable flexibility to set a range of rates on different types of transactions to incentivise certain issuer and acquirer behaviours that benefit the entire network (for example, the adoption of new security features such as tokenisation). However, in practice, the three debit schemes appear to have used the ability to set some interchange rates at the 15 cents or 0.20 per cent caps not only for the purpose of incentivising innovation or other actions that improve the payments system, but also for the purpose of holding up overall interchange revenues for their issuers by taking advantage of transactions that are not at risk of being routed to another scheme. The Board was concerned that these actions are particularly disadvantageous for smaller merchants that do not benefit from strategic rates and that they can result in unreasonably high payment costs for some low-value debit transactions. While merchants have the option of recovering higher payment costs by surcharging debit transactions, in practice this may not be feasible due to the risk of customers abandoning the transaction and the potential difficulty of imposing differential surcharges based on transaction value. Routine surcharging of debit transactions would also not be a desirable outcome, given that debit cards are now the most prevalent payment method for retail goods and services, and are increasingly replacing cash for low-value transactions. The Board's assessment was that the high cost of some low-value debit transactions, particularly for smaller merchants, would likely persist under the current regulatory settings.

However, the Board was wary of making significant changes to the interchange framework, for example by requiring schemes to set all debit interchange fees on an ad-valorem basis as suggested by some stakeholders. The Board noted that a key rationale for the original cents-based benchmark and cap was that most of the costs of processing debit card transactions were unrelated to transaction value. For example, the messaging cost of a $1 payment is no different to that of a $100 payment, and debit transactions are not subject to many of the ad-valorem costs associated with credit cards; they do not provide interest-free periods and typically do not offer rewards programs. While the Board generally expects there will be some correlation between payment cost and transaction size, the original rationale for the cents-based nature of the benchmark remains relevant.

Instead, the Board favoured a reduction in the cap on debit card interchange fees that are set in cents-based terms, which will reduce the possibility of very high effective interchange rates on low-value transactions, without significantly changing the overall interchange framework. More generally, this will result in less cross-subsidisation and price discrimination between large merchants that benefit from strategic rates and smaller merchants. The lower cap will also increase the net benefits of LCR for large merchants that are eligible for strategic rates, by reducing the penalty associated with losing these strategic rates if they adopt LCR.

One concern about a lower cap raised by schemes and some issuers was that decreasing the permissible range of interchange fees would reduce the scope for using differential fees to incentivise behaviour that benefits the system as whole. However, the Board's view was that a lower cents-based cap would still provide considerable scope for differential pricing. Further, the range of fees that could be set in ad-valorem terms would be unaffected, with no change to the cap of 0.20 per cent on fees set in ad-valorem terms.

Stakeholders also suggested that lowering the cents-based cap would reduce the total interchange revenues flowing to issuers, with concerns that smaller issuers would be disproportionally affected, as they are more dependent on interchange revenues. The Board noted that a reduction in the cap would affect each scheme (and its issuers) differently, depending on the current structure of its interchange schedule and average transaction sizes. However, as the weighted-average benchmark for interchange fees on debit transactions would not change, card schemes would be free to adjust their interchange schedules to seek to maintain issuers' interchange revenue, including by making greater use of ad-valorem fees set at the 0.20 per cent cap. To address concerns by stakeholders about the disproportionate impact on smaller issuers of having a lower cap for SNDCs, the Board favoured a modified version of the proposal for lower caps presented in the Consultation Paper, whereby the 15-cent cap on debit interchange fees set in cents-based terms would be reduced to 10 cents for transactions on both SNDCs and DNDCs. (As discussed in the ‘Dual-network debit cards and least-cost routing’ section, the potential for schemes to incentivise SNDC issuance through interchange would instead by addressed by introducing a ‘sub-benchmark’ for SNDCs, such that the weighted-average interchange fee on SNDCs from a given scheme must be no more than 8 cents).

4.4.3 Foreign-issued cards

While the share of total card payments in Australia made using (more expensive) foreign-issued cards has grown over the past decade, it remains low at 3 per cent in 2019, prior to a significant fall in 2020 due to the reduction in international travel during the pandemic. The impact of foreign-issued cards on system-wide payment costs, therefore, is not significant. There has also been no evidence of issuers attempting to circumvent the Australian interchange regime through offshore card issuance (which has been noted previously as a potential concern). In view of these factors, the Board assessed that applying the interchange caps to foreign card interchange fees is not warranted at present.

Nevertheless, given the higher cost of foreign card transactions, the Board considers it desirable to increase the transparency of the interchange fees that apply to foreign-issued cards. Accordingly, schemes will be required to publish these fees on their websites. Greater transparency across schemes of the cost of accepting payments on foreign cards should bring greater competitive pressure on these fees.

4.4.4 Conclusions