Review of Retail Payments Regulation – Issues Paper –
November 2019 2. Developments in Retail Payments

Box A: Interchange Fees and Surcharging: Key Concepts

Interchange fees

An interchange fee is a fee charged by the financial institution on one side of a payment transaction to the financial institution on the other side of the transaction. They are most commonly seen in card transactions, although can arise in other payment methods.

A typical card transaction (Figure 1) involves four parties – the cardholder, the cardholder's financial institution (the issuer), the merchant and the merchant's financial institution (the acquirer). For most card transactions, the interchange fee is paid by the acquirer to the issuer. Interchange fees can have important implications for the prevalence and acceptance of different cards as well as the relative costs faced by consumers and merchants. In contrast to normal markets for goods and services, competition in payment card networks can actually drive fees higher.

Financial institutions typically charge fees to their customers for payment services. Cardholders are charged by their financial institution in a variety of ways. This typically includes monthly account-keeping fees for debit cards and annual fees for credit cards plus interest on borrowings that are not repaid by a specified due date.

Merchants receiving payments are also typically charged by their financial institutions. The fees paid by merchants usually depend on the payment method. For card payments, merchants are usually charged a ‘merchant service fee’ for every card payment they accept. Some merchants are also charged a fee by their financial institution to rent a terminal to accept cards.

In contrast, interchange fees are paid between financial institutions and are present in many, but not all, card systems. Interchange fees are often not transparent; cardholders and merchants do not typically see them. But they have an impact on the fees that cardholders and merchants pay.

When a card payment is made, interchange fees are paid by the merchant's financial institution to the cardholder's financial institution. This has two effects. First, the merchant's financial institution will charge the merchant for the cost of providing it with the acceptance service plus the fee that it must pay to the card issuer (the interchange fee). The higher the interchange fee the merchant's financial institution must pay, the more the merchant will have to pay to accept a card payment. Second, since the card issuer is receiving a fee from the merchant's financial institution every time its card is used, it does not need to charge its customer – the cardholder – as much. The higher the interchange fee, therefore, the less the cardholder has to pay. In effect, the merchant is meeting some of the card issuer's costs which can then be used to subsidise the cardholder. Indeed, with rewards programs, the cardholder may actually be paid to use his/her card for transactions and competition tends to involve offering incentives for a consumer to hold and use a particular network's cards. A network that increases the interchange fee paid by the merchant's financial institution to the cardholder's financial institution enables the latter to pay more generous incentives, and can increase use of its cards.

However, the competitive response from other networks is typically to increase interchange rates.

That is, competition in well-established payment card networks can lead to the counterintuitive result of increasing the price of payment services to merchants (and thereby leading to higher retail prices for consumers). This phenomenon has been most clearly observed in the US credit card market, which has not been subject to any regulation. Prior to the Bank's reforms this had also occurred to an extent in the Australian credit card market, with average interchange rates in the MasterCard and Visa systems tending to rise.

When one compares the incentives for cardholders and merchants and for their financial institutions the implications of the interchange flows described above are clear. Other things equal – in particular assuming no regulatory intervention and no surcharging by merchants to offset the differences in their costs – cardholders will have a preference to use a card from a network where larger interchange payments flow to the card-issuing financial institution, while merchants will prefer to receive cards from a network with lower interchange fees (or fees flowing in the opposite direction). In circumstances where multiple card networks are widely accepted by merchants (as in Australia and many other developed countries), the consumer typically decides which means of payment is tendered and used in a transaction. Given this, financial institutions will have an incentive to issue cards from networks where interchange fees flow from the merchant's financial institution to the cardholder's financial institution, and competition may lead networks to increase the size of such fees. The generosity of cardholder rewards programs will rise, as will the cost of payments to merchants.

Interchange fees may be appropriate in some circumstances, particularly in the establishment of new systems where they may be necessary to rebalance costs between the sides of the market and ensure that both sides of a market have an incentive to participate. However, the major card schemes are mature systems, and regulators in many countries have reached the judgement that their cards are ‘must take’ methods of payments – that is, that merchants have little choice but to accept their cards. In practice, with interchange fees being used to incentivise issuers to issue cards from a particular scheme and cardholders to use that card, the tendency has been for competition between mature card schemes to drive up interchange fees and costs to merchants, with adverse effects on the efficiency of the payments system.

Since the early 2000s, the Bank has had in place weighted-average interchange fee benchmarks to constrain the potential for interchange fees to distort efficient payment choices and to underpin a fall in the overall resource cost of payments. Further reforms following the 2015–16 Review imposed maximum caps on interchange fees, as a way of addressing some large differences that had emerged between interchange fees that were being paid by small merchants and the lower ‘strategic’ rates applying to larger merchants

Surcharging

Merchants face a range of costs when they accept payments. In some cases, merchants might wish to charge a different price to a consumer depending on what type of payment method they use. A surcharge on a particular payment type or types helps the merchant send a signal to a customer that some payment methods are more or less costly for them. Card schemes in the 1990s in Australia had in place ‘no-surcharge’ rules that prevented merchants from doing this. The effect of this was that customers using low-cost payment methods were effectively cross-subsidising the payment choices of customers who elected to pay with high-cost cards.

The Bank's initial reforms required card schemes to remove these ‘no-surcharge’ rules, enabling merchants to pass on the cost of card transactions if they wished, resulting in improvements in price signals to cardholders. The right of merchants to surcharge for expensive payment methods is important for payments system efficiency and helps to hold down the cost of goods and services to consumers generally.

While most merchants tended to either not take up the option of surcharging, or applied surcharges at percentage rates that reflected their acceptance costs, some concerns emerged about possible cases of excessive surcharging by some merchants, and a tendency towards the ‘blending’ of surcharges for higher- and lower-cost schemes. In response, new powers were given to the ACCC in 2016 to investigate and take action against excessive surcharges, and this was supported by the Bank defining the concept of a ‘permitted cost of acceptance’ in its surcharging standard, in terms of the merchant's average cost of acceptance for each scheme. Merchants are provided with annual and monthly information by their financial institutions so that they are readily able to calculate their cost of acceptance.

The effects of reform in Australia

Card payments have continued to grow strongly in Australia since the initial implementation of the Bank's reforms in 2003 (Graph 3). Furthermore, data on merchant service fees indicate that interchange fee regulation and surcharging have led to overall lower costs for merchants in accepting card payments (Graph 4). Australia now has a relatively low-cost payments system by international standards, most notably compared with the United States (Graph 5).^[3]

Box B: Retail Payments Reforms in Other Jurisdictions

Since the 2015–16 Review, a range of developments in retail payments regulation have occurred in other jurisdictions. These included some new reforms as well as changes to existing regulations. Much of the regulatory focus has been on interchange fees and surcharging rules in card payment systems, although some countries have also begun to consider issues such as competition in acquiring and mobile wallets.

In the case of interchange fees and merchant service fees, tables compiled by the Federal Reserve Bank of Kansas City list 44 jurisdictions as having undertaken action or initiated investigations to date (Hayashi and Maniff 2019). Of these, 18 jurisdictions have taken regulatory action within the past four years.

Where countries have initiated retail payments regulation, this has mostly been to establish rules for interchange fees in credit and/or debit card systems. Some have taken an approach similar to the Bank's reforms that were introduced in the early 2000s and which aimed to promote competition and efficiency in the payments system. A number of jurisdictions have referenced the Australian reforms as influencing their approach.

The European Union (EU) brought a comprehensive package of regulatory reforms for retail payments into effect in December 2015, aiming to create a single EU market for card payments. Under these reforms, interchange fees have been capped at 0.3 per cent for credit card transactions and 0.2 per cent for debit cards. The EC argued that these caps were consistent with the ‘merchant indifference test’ and would promote competition by giving consumers greater choice of payment methods and service providers.^[4] Three-party schemes and commercial cards are exempted from the regulation, on the basis that they do not compete directly with retail payment instruments.^[5] A review by the European Commission (EC) of the impact and appropriateness of the interchange fee regulation is expected to conclude in mid-2020.

The EU interchange fee rules apply in all countries within the European Economic Area (EEA). However, member states are provided with some scope for national discretion. For example, the United Kingdom decided to apply a weighted-average fee cap of 0.2 per cent for domestic debit card transactions, rather than the 0.2 per cent per-transaction cap. The UK government considered that percentage-based caps would result in higher interchange fees for many UK merchants, since the majority of fees for debit card payments in the UK are capped at a fixed value amount.

A 2018 amendment to the EU interchange fee regulation requires the structural and legal separation of payment card schemes and processing entities. This is intended to enhance competition by reducing the disadvantage faced by independent payment processing entities. Following the new legislation, Visa Europe has split its scheme and processing entities into separate business units.

More recently, the EC has obtained legally binding commitments from Mastercard and Visa regarding inter-regional interchange fees. Under these commitments, the interchange fees on card-present transactions made in the EEA using consumer debit and credit cards issued outside the EEA will also be capped at 0.2 and 0.3 per cent of transaction value, respectively. Caps of 1.15 per cent for debit and 1.50 per cent for credit card payments will apply for online transactions. The commitments, which will come into effect in December 2019, were intended to avoid ‘anti-competitively increased prices for European retailers accepting payments from cards issued outside the EEA’, which ‘in turn lead to higher prices for consumer goods and services’.^[6]

In Canada, Mastercard and Visa voluntarily reduced their weighted-average interchange fees for all credit and debit cards in 2015 under the Code of Conduct for the Credit and Debit Card Industry in Canada. Following further discussions with the Department of Finance, the major card networks have committed to reduce the average annual interchange rates by an additional 10 basis points to 1.4 per cent on all cards. This will take effect in 2020 for a period of five years. American Express has separately also agreed to support the objectives of the Code of Conduct through bilateral rate agreements with third-party issuers and transparent merchant service fees.

In recent years, ‘no-surcharge’ and ‘honour-all-cards’ rules have also come under increased scrutiny by central banks and other authorities. The Federal Reserve Bank of Kansas City lists 37 jurisdictions as having taken action in relation to surcharges and discounts. Surcharging is permitted in some countries, including Canada and the United States, though it is generally subject to caps associated with consumer protection rights. In contrast, some jurisdictions have prohibited surcharging, either with a policy aim of increasing price certainty and comparability for consumers (such as in the EU and the UK) or to promote the use of card payments (as in India).

The EU banned surcharging on payment methods whose interchange fees are capped under regulation as part of the revised Payment Services Directive (PSD2), which came into force in 2018. According to the EC, regulated interchange fees are capped at a sufficiently low level that surcharging is no longer justified. The UK has extended the ban on surcharging to all non-commercial payment methods, including cards issued by three-party schemes, PayPal and digital wallets. This was intended to level the playing field between payment instruments and increase price transparency for consumers.

In contrast, Visa and Mastercard modified their no-surcharge rules in Canada following a class action settlement with Canadian merchants. Merchants are now allowed to levy surcharges under certain circumstances, although maximum surcharge caps and disclosure requirements apply.

In addition, some regulators have considered policy issues arising from mobile wallets. While, the PSD2 in Europe and the Canadian Code of Conduct have to date mainly focused on consumer privacy and data protection aspects of mobile wallets, the UK has begun to also consider competition issues. The UK Payment Systems Regulator (PSR) conducted an industry consultation to better understand the contactless mobile payments sector and examine the impact of Apple's restriction on access to the NFC chip in Apple devices, which impinges on the ability of other providers to install their own applications for contactless mobile payments. In 2018, the PSR concluded that there had not yet been any damage to innovation that required regulatory action, but said it intended to keep the mobile payment sector under observation.^[7] In September 2019, the EC initiated an informal investigation into Apple's NFC restriction, seeking information from market participants about any potential anti-competitive behaviour and abusive conduct. Competition issues involving Apple Pay have also arisen in Switzerland.

The PSR is also undertaking a review of card-acquiring services, and in particular whether the changes in interchange and scheme fees in the UK have flowed through to the payment costs faced by merchants. A report on the interim conclusions is expected to be published in Q1 2020.