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prior consent of the Reserve Bank of Australia.

ISBN 0-9752213-1-0 (PRINT)

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R E S E R V E B A N K O F A U S T R A L I A

Executive Summary

1. Background to Reforms

1.1 Introduction

1.2 Debit Card Payment Systems

Like the EFTPOS system, the Visa Debit system allows cardholders to make payments by

electronically debiting an account at an authorised deposit-taking institution. Unlike the EFTPOS

system, however, transactions are processed and authorised through the Visa system (in the same

way as are credit card transactions). Australian Visa Debit cards can be used wherever Visa

credit cards can be used and, indeed, cannot be visually distinguished from Visa credit cards. If a

merchant accepts Visa credit cards, Visa’s ‘honour all cards’ rule requires the merchant to accept

Visa Debit cards as well.

In addition to the different infrastructure, the Visa Debit system differs from the EFTPOS

system in other ways. One is that the cardholder usually authorises the transaction by signing a

receipt at the point of sale rather than by entering a PIN. A second is that the card can be used

to pay for goods and services in situations where the cardholder and merchant are not in the

same location; examples include payments over the internet or telephone. A third is that the

cardholder is not able to obtain ‘cash out’ at merchants. A fourth is that the card can be used

internationally. And fi nally, Visa Debit transactions attract the same protections as other Visa

transactions, with so-called ‘chargebacks’ for customers whose cards are used fraudulently or

where goods and services are not delivered as promised.

Visa Debit cards are issued as multi-function cards that can be used to make transactions

through both the Visa Debit and EFTPOS systems. At an electronic terminal in Australia the

cardholder can press either the ‘credit’ button, or the ‘cheque’ or ‘savings’ button. Pressing

the ‘credit’ button results in the transaction being processed through the Visa network, while

pressing the ‘cheque’ or ‘savings’ button results in the transaction being processed through the

EFTPOS network. Regardless of which button is selected, the transaction is a debit transaction

on the same account.

The fi rst Visa Debit cards were introduced in 1982 by building societies and credit unions.

The introduction of these cards was partly in response to regulations that prevented non-bank

fi nancial institutions from issuing credit cards. While these controls have since been abolished,

credit unions and building societies remain signifi cant issuers of Visa Debit cards.

Institutions offering Visa Debit cards have typically not charged per-transaction fees for

Visa Debit transactions.

1.3 The Payments System

As mentioned above, the two Australian debit card systems operate within the wider context

of the Australian payments system. Graph 1 shows the trends in use of the most signifi cant

non-cash payment systems over recent years.

Over this period, the use of electronic payment methods has grown particularly strongly

at the expense of more traditional, paper-based cheques. While all the electronic methods have

been growing strongly, there have been changing patterns of use within this category. Until

the late 1990s, debit cards were used more frequently than credit cards. However, the mid

to late 1990s saw very rapid growth

in credit card use and the number

of credit card transactions has

exceeded the number of debit card

transactions each year since 2000.

This change coincided with the

introduction and heavy promotion

of credit card reward schemes which

served to lower the effective price of

credit card use to the cardholder, but

not to the community as a whole.

In most situations, cardholders

have a variety of payment options

from which to choose. A number of

factors infl uence this choice including convenience, security and ubiquity of acceptance. It is

generally more convenient, for example, to use card-based payments than cheques at the point

of sale due to the shorter transaction time for card-based payments. Similarly, cash is generally

the fastest payment method for small transactions, and so is commonly favoured for quick, lowvalue

purchases in locations with high turnover.

Another important factor infl uencing the choice of payment instrument is price. The

reduced use of cheques, for example, has coincided with higher charges for writing cheques.

Similarly, the shift away from bank branches to ATMs for cash withdrawals has been infl uenced

by the higher charges for branch withdrawals. These price effects are evident in other countries

as well. For example, in the United States, scheme-based debit cards, such as Visa Debit and

MasterCard Money, gained market share at the expense of PIN-based debit cards because they

offered a very similar service at a lower price to the cardholder.2

The effective price is also frequently mentioned as a factor infl uencing choice in surveys

of cardholders. For example, a survey of New Zealand consumers found that 56 per cent of

credit card users listed the interest-free period as a reason to use credit cards while 46 per cent

listed other price-related factors such as reward programs and lower transaction costs. Similarly,

61 per cent listed high transaction costs as a reason for not using EFTPOS.3 A survey commissioned

by the Australian Merchant Payments Forum also found that price was important for Australian

consumers.4 Nearly half of credit card users cited loyalty points or other price-related factors

as the reason they used a credit card instead of other payment instruments. Of those consumers

that were aware of the price they were paying for a particular transaction, the overwhelming

majority chose to use a payment instrument that had zero per-transaction fees. Indeed, much

of the recent competition between fi nancial institutions has focussed on the price charged for

use of transaction accounts. This clearly suggests that these fi nancial institutions believe that

consumers will be attracted to their institution based on the price they charge for transactions.

2 L Nyberg and G Guiborg (2003), D Humphrey, M Kim and B Vale (2001).

3 Liu, C, C Matthews and D Tripe (2004).

4 A report on the survey results can be found on the Reserve Bank website at http://www.rba.gov.au/PaymentsSystem/PaymentsPolicy/

Reforms/Eftpos/SubmissionsOnEFTPOSInterchangeFees/ampf_09112004_2.pdf.

Graph 1

0

10

20

30

40

50

0

10

20

30

40

50

Non-cash Payments per Capita

BPAY

Direct debit

Direct credit

Debit card

Credit card

Cheque

No No

1996 1998 2000 2002 2004

Sources: ABS; APCA; RBA

Both the Australian and international evidence strongly supports the view that price is an

important factor infl uencing payment choices.

Payment systems sometimes require the payment of fees between the institutions in the system.

These fees – known as interchange fees – are an important factor infl uencing the prices that

cardholders and merchants face for using the system.

Where interchange fees exist around the world they typically fl ow from the merchant’s

fi nancial institution to the cardholder’s fi nancial institution. The EFTPOS system in Australia

is an exception. In this case, the fee fl ows in the reverse direction: that is, from the cardholder’s

fi nancial institution to the merchant’s fi nancial institution. The fee is fl at and averages around

20 cents per transaction. Most of the interchange fees for the major banks are clustered around

this average, while smaller fi nancial institutions typically pay interchange fees some 5 to 10 cents

higher. The interchange fees are identical in both directions (that is, they are the same when Bank

Y’s customer uses a card at Bank Z’s merchant and when Bank Z’s customer uses a card at Bank

Y’s merchant).

Most interchange fees in the EFTPOS system were negotiated when initial network

connections were formed and have varied little since that time.

In the Visa Debit and credit card systems, interchange fees fl ow in the opposite direction;

that is, from the merchant’s fi nancial institution to the cardholder’s fi nancial institution.

Unlike in the EFTPOS system, the fee is a percentage of the amount spent, and is the same as

the fee in the Visa credit card system. This fee currently averages around 0.55 per cent across all

transactions, 0.4 of a percentage point lower, on average, than it was prior to the Bank’s reforms

to the credit card systems.

As an illustration of the

various fees, Graph 2 shows the

interchange fees that would typically

apply on a payment of $100 in

different payment systems.

A consequence of these

interchange fees is that they increase

the net costs of the institution

paying the fees, and reduce the net

costs of the institution receiving

them. As such, institutions receiving

interchange fees may be able to

charge customers a price lower

than the underlying cost to them of

providing the payment service. And institutions paying interchange fees may need to charge their

customers a price above that suggested by the underlying costs of providing the service. In this

way, interchange fees can alter the usually direct link between costs and prices on both sides of

a payment system.

Graph 2

-0.4

-0.2

0.0

0.2

0.4

-0.4

-0.2

0.0

0.2

0.4

Interchange on a $100 Transaction

$ $

Credit cards Visa Debit

EFTPOS Cheques

Source: RBA

1.4 The Reserve Bank’s Payments System Powers

The Reserve Bank has various powers to address questions of effi ciency, competition and the

These powers are exercised by the Payments System Board of the Reserve Bank. According

to the Reserve Bank Act 1959:

The Payment Systems (Regulation) Act 1998 gives the Reserve Bank the authority

to ‘designate’ a payment system if it considers that doing so is in the public interest. Having

designated a system, the Bank may then set an access regime, determine standards, give

enforceable directions and arbitrate on disputes (where the parties agree to arbitration). In

introducing the legislation, the Government made it clear that the development of an access

regime or the setting of standards should be undertaken, as far as possible, in conjunction and

consultation with the private sector.

1.5 The Public Interest Test

In applying the public interest test, the Bank has considered how best to assess effi ciency

and competition in the Australian payments system. After considering a number of theoretical

approaches, it is the Bank’s opinion that this assessment is best done by using a number of

practical benchmarks.

In particular, an effi cient and competitive payment system is one in which:

• the relative prices charged by fi nancial institutions to consumers who use payment

instruments refl ect the relative costs of providing those instruments (except where the

private benefi ts or costs do not match the society-wide benefi ts or costs) as well as

demand conditions;

• merchants are free to set prices for customers that promote the competitiveness of their

business;

• prices of payment services are transparent;

• any restrictions on entry of institutions to a payment system are the minimum necessary

for the safe operation of the system; and

• competition within each payment system and between payment systems is open and

effective.

In assessing the current system against these benchmarks, the Bank considered whether

it was necessary to defi ne strictly the market in which particular payment systems, including

debit cards, operate. The Bank determined that market defi nition, of the kind customarily

undertaken under the Trade Practices Act 1974, would not assist its analysis and was not

necessary before forming an opinion about competition and effi ciency in Australia’s debit card

payment systems.

The Bank recognises that payment instruments are substitutable in many circumstances,

but also recognises that in other circumstances the same payment instruments may not be good

substitutes for one another (for example, where a consumer does not have cash funds available

in his or her account and wishes to purchase on credit).

The Bank also considered whether it was necessary to obtain formal estimates of the

extent of substitutability between different payment instruments. It concluded that it was not

necessary to do so given the strong evidence that credit and debit cards are highly substitutable

for many people. In many cases, a single card offers both credit and debit facilities, with the

cardholder simply pressing ‘credit’ or ‘savings/cheque’ at the point of sale to use one system or

the other. For cardholders with funds in their account, a key factor infl uencing which method

they choose is the relative price of the two methods. In particular, the Bank noted that fi nancial

institutions often promote the use of credit cards over both EFTPOS and ATM withdrawals on

the basis that using a credit card saves the cardholder transaction fees. The Bank also noted that

obtaining reliable estimates of elasticities using existing techniques and data is very diffi cult.

Overall the Bank’s opinion is that the above benchmarks provide a suffi cient basis for judging

the effi ciency and competitiveness of the current system.

In this context, the Bank noted a number of aspects of the overall Australian payments

system that fall short of these benchmarks.

The fi rst is that the relative prices of various payment instruments are not closely aligned with

the relative costs of providing those payment instruments. In effect, users of the payment system

with the lowest cost often face the highest price.

For many people, the effective price for using the EFTPOS system is higher than that for

using the credit card system. This is despite the EFTPOS system having the lower resource costs.

Given the strong substitution possibilities between these systems, the effect of this is likely to be

that the EFTPOS system is underused.

Similarly, users of the EFTPOS system face either the same or a higher price than users of

the Visa Debit system, despite the Visa Debit system having higher costs.

To a signifi cant extent these divergences between relative prices and costs are the result

of the different interchange fee arrangements in the EFTPOS, Visa Debit and credit card systems.

Moreover, these interchange fees are not subject to the normal forces of competition that operate

in most other markets.

It is also important to recognise that interchange fees affect not only the prices that

cardholders face, but also the charges faced by merchants for accepting various payment

instruments. Under current arrangements, credit cards are much more expensive for merchants

to accept than EFTPOS payments. Moreover, merchants are charged the same fee for accepting

Visa Debit cards as they are for accepting credit cards, despite the fact that the user of a Visa

Debit card is not offered any free credit by the fi nancial institution that issued the card.

In effect, the distorted price signals to the cardholder, which have encouraged the use

of the more expensive payment options, have come at the expense of higher merchant costs. In

turn, these higher costs fl ow through into higher prices for goods and services.

Accordingly, the Bank’s opinion is that bringing the relative prices and costs for these

payment systems into closer alignment would promote the effi ciency of the overall system.

Encouraging more effi cient payment choices by cardholders should reduce merchants’ overall

costs, and thus put downward pressure on the overall level of prices for goods and services.

In forming its views, the Bank has taken a medium-term perspective and considered not

only the individual payment systems in isolation, but also the payments system as a whole. In

particular, it has considered how the system is likely to evolve if the existing incentives facing

fi nancial institutions remain unchanged. Given the often strong competition on the issuing side,

the Bank’s assessment is that a continuation of current arrangements could see, over time, fi nancial

institutions encourage customers wishing to use a debit card to use the Visa Debit system (or

similar scheme-based systems with similar interchange fees) rather than the EFTPOS system.

One effect of such a change would be an increase in merchants’ overall payments costs,

given that merchant costs for accepting Visa Debit are signifi cantly higher than for accepting

EFTPOS. This, in turn, would put upward pressure on the general prices of goods and services.

In forming its views, the Bank has recognised that a payment system in which all payments

were made with the lowest cost payment instrument would, in all probability, not be effi cient.

In many cases, payment systems with higher resource costs deliver greater benefi ts to their users

than low-cost systems. From an effi ciency perspective what is important is that the price signals

are correct, that cardholders are free to use the payment systems that best suit their needs, and

that merchants are free to accept those payment systems that deliver them value. If the high-cost

system is underpriced, then the system will be overused with cardholders using payment services

whose cost of provision to society exceeds the benefi t they obtain.

The second aspect of current arrangements that falls short of the benchmarks is that merchants

are not able to freely choose which payment instruments they accept. In particular, under current

arrangements a merchant who accepts Visa credit cards must also accept Visa Debit cards.

Moreover, merchants are charged the same fee on both cards despite the fact that on a Visa

Debit card there is no provision of interest-free credit.

The Bank is concerned that this restriction inhibits normal competitive forces and

increases the overall costs to merchants of accepting Visa Debit. As noted above, these higher

costs fl ow through into the general level of prices of goods and services.

The third aspect where current arrangements fall short of the above benchmarks is that of entry

into the EFTPOS system.

In most markets, competition and effi ciency are enhanced by having low barriers to

entry. A concern for the Bank has been the potential for entry barriers in the EFTPOS system,

particularly on the acquiring side, to effectively limit competition. Currently, direct entry to the

system by an acquirer can require negotiations with around ten institutions on both technical

matters and pricing. The failure to reach agreement with any one of these institutions – which

are typically competitors – means that the potential entrant could have considerable diffi culty in

offering a marketable or competitive acquiring service. Even if an incumbent agrees to a direct

connection, it can take considerable time before it agrees to schedule the necessary testing for

establishment of the link. The alternative entry route is through a gateway, although here the

costs can be quite high.

The diffi culty of entry can limit effective competition on the acquiring side and can

impair effi ciency by making it diffi cult for new lower-cost entrants to enter the system and offer

acquiring services to merchants at a lower price.

1.6 History of Reform in the Card Payment Systems

Soon after the Payments System Board was established, it undertook an extensive study of

debit and credit card schemes in Australia. The fi ndings of this study, which was conducted

jointly with the Australian Competition and Consumer Commission (ACCC), were published in

A central theme of the Joint Study was that in a number of areas the price signals faced

by consumers of payment services did not refl ect the underlying costs of providing those services.

The Study concluded (page v) that the ‘structure of incentives has encouraged the growth of

not use credit cards.’

Given the conclusion that the effi ciency of the payment system would be improved if

consumers faced prices for payment services that more closely refl ected underlying costs, and

restrictions on effective competition were removed, the Bank set about encouraging industry

efforts at reform.

The initial roadmap envisioned parallel work on the major card payment systems in

Australia with the introduction of fi nal reforms in all systems at roughly similar times. As it

eventuated, progress in some payment systems has been more protracted than in others. Given

the complicated nature of the task, the diffi culty of achieving industry coordination, and the

extensive legal proceedings, the process has run over a number of years and reform across

individual payment systems has become decoupled.

In the area of credit cards, the reforms have addressed:

• the setting of interchange fees;

• the so-called ‘no surcharge’ rule that prevented merchants from passing on the cost of

accepting credit cards; and

• restrictions in the schemes’ membership requirements that were stronger than those

needed to protect the integrity of the schemes.

After an extensive period of consultation, the Bank established two standards. The fi rst

of these came into effect on 1 January 2003 and made it possible for merchants accepting

MasterCard and Visa cards to pass on the cost of acceptance to customers that use the cards.

The Bank also obtained undertakings from American Express and Diners Club to eliminate

prohibitions on such charges (Bankcard had no such prohibitions). The second standard came

into force in October 2003. This standard requires that the weighted-average interchange fee in

each of the Bankcard, MasterCard and Visa schemes not exceed a cost-based benchmark based

on its issuers’ eligible costs. This standard has seen the average interchange fee in these schemes

fall from around 0.95 per cent to around 0.55 per cent. This fall has been passed through to

merchants in the form of lower merchant service fees, and is estimated to have saved merchants

around $500 million in 2004.

The Bank also established an access regime which came into force in February 2004.

Under the regime, potential entrants could seek authorisation by the Australian Prudential

Regulation Authority (APRA) as specialist credit card issuers and/or acquirers. Card schemes

are now not permitted to discriminate against potential entrants on the basis of whether they

are a specialised credit card institution or a traditional authorised deposit-taking institution, or

on the basis of whether the potential entrant will be an issuer of credit cards only, an acquirer of

credit card transactions only, or both.

At the time the credit card reform process was proceeding, the Bank hoped that a voluntary

industry process would deliver changes to the debit card system on a timetable roughly similar

to that of credit cards. To assist in this process, the Bank convened a series of meetings of

industry participants, beginning in early 2002, to explore the options for reform.

Industry views on reform were quite diverse and strongly held; for this reason, the

Bank encouraged the industry to seek public input into the reform process. In July 2002, an

industry group released a paper outlining three basic options for reform: retention of current

arrangements (with small modifi cations); adoption of collectively determined interchange fees

calculated on a cost-based approach; and the elimination of interchange fees either through their

abolition or by setting them to zero.5

Following publication of the paper, the group met with interested parties to discuss

the options. Signifi cant differences in commercial interests remained both within the industry

group and among other interested parties. Despite the lack of unanimity, in February 2003, a

group of banks, building societies and credit unions submitted an application to the ACCC for

authorisation of a proposal to reduce interchange fees to zero.6 The ACCC initially proposed

to deny the application due to concerns about access arrangements. In response, at the request

of the applicants for authorisation, the Australian Payments Clearing Association (APCA)

committed to develop an access regime and the Bank indicated that, were these efforts to fail,

it would consider designating the EFTPOS system to achieve access reform. In light of this, the

ACCC authorised the application in December 2003.7

Following the authorisation, a group of retailers successfully appealed to the Australian

Competition Tribunal (ACT), with the Tribunal overturning the ACCC’s decision on

25 May 2004. The Bank has carefully considered the evidence before, and the fi ndings of, the

ACT. The Bank’s views in response are set out in Section 2.3 below.

Following the ACT’s decision, the Bank invited submissions from interested parties

on whether it would be in the public interest for it to designate the EFTPOS system. In all

23 submissions were received, with arguments being presented both for and against designation.

Parties making submissions were invited to discuss them with the Bank. After reviewing these

submissions, together with submissions previously made to the ACCC and the ACT and the

decisions by those bodies, the Board concluded that designation was in the public interest. In

September 2004, the Bank designated the EFTPOS system.

On the issue of access, APCA is still drafting a regime. As the draft currently stands,

prospective entrants will be offered greater certainty as to the cost of connection and the time

such connection will take. While the proposed arrangements offer an improvement on those

currently in place, the Bank has recently written to APCA raising some concerns with the

proposal. These concerns relate to whether the regime provides suffi cient certainty on the cost

and timing of entry and whether volume requirements are necessary for new entrants. If these

5 EFTPOS Industry Working Group (2002).

6 ANZ Banking Group and others (2003).

7 Australian Competition and Consumer Commission (2003).

concerns are not addressed satisfactorily, and in a timely manner, the Bank will consider issuing

a draft access regime for public comment.

Initially, the Bank also pursued voluntary reform of the Visa Debit system with Visa and the

institutions that issue the cards. Much of the discussion took place between Visa and the

Bank, with Visa making a number of submissions on voluntary reforms it was prepared to

implement and arguments in defence of its current arrangements. Although some progress was

made, discussions were complicated by the fact that issuing institutions could not discuss what

would amount to the collective setting of interchange fees and the process was not transparent.

Furthermore, there remained a number of areas where the Bank and Visa could not reach

agreement.

The Payments System Board ultimately reached the conclusion that designation of the

Visa Debit system was in the public interest. This decision was infl uenced in part by the fact that

designation would allow for a transparent and inclusive consultation on possible reforms – a

situation that had been diffi cult to achieve previously. In February 2004, the Payments System

Board designated the Visa Debit system.

2. Interchange Fees

Interchange fees have important implications for both the effi ciency and competitiveness of

the payments system. They have a signifi cant infl uence on the pricing of payment services to

merchants and consumers and thus, in turn, on the use and acceptance of those services. Despite

this important role, interchange fees are, in the Bank’s assessment, typically not subject to the

same type of competitive forces that operate on other prices and fees.

The Bank is of the view that a change in current interchange arrangements in the EFTPOS

and Visa Debit systems would help promote the overall effi ciency of the payments system. It sees

little justifi cation for the current arrangements, which have contributed to the relative prices

charged by fi nancial institutions for various payment methods not refl ecting the relative costs of

providing those methods of payment. Much of the Bank’s reasoning and the supporting evidence

this section of the Consultation Document presents the Bank’s analysis of the public interest

with respect to the reform of interchange fees. It then discusses various options for reform and

presents proposed standards for interchange fees in the EFTPOS and Visa Debit systems.

2.1 Potential Justifi cations for Interchange Fees

The existence of interchange fees is not, in itself, inimical to the effi ciency of the payments

system. Indeed, in some cases, such fees may promote effi ciency. There are a number of reasons

why this may be so.

In theoretical models it can be shown that a carefully chosen interchange fee can promote social

welfare by promoting optimal use of a particular payment system. These models typically focus

on credit card networks but are also broadly applicable to other card networks, including debit

cards. Payment systems typically have two joint providers (the issuer and acquirer) and two

joint users (the cardholder and the merchant). Without any one of these parties it is typically not

possible to complete a transaction – for example, a debit card transaction cannot be completed

without the participation of both the cardholder’s bank and the merchant’s bank. Because there

are two joint providers, it is possible to redistribute costs through the use of interchange fees,

thereby changing the prices charged to users and, potentially, improving welfare. This is especially

so where the actions of one participant in the payment system affect others and where this effect

is not taken into account when individuals make decisions. Thus, in the case of centrally set or

multilateral interchange fees, the argument has been advanced that fees can be set in order to

maximise the benefi t to society as a whole.

While these theoretical models provide some insights, they rely on knowing the benefi ts

received by all users of the payment system. Typically, the nature of these benefi ts is simply

assumed to follow convenient functional forms for mathematical neatness. In addition, the

Table 1: Costs and Benefi ts – An Example

Gross Costs Fees Fees Net

benefi t incurred paid received benefi t

(1) (2) (3) (4) (1)-(2)-(3)+(4)

Merchant $5 — $4 — $1

Consumer $5 — $4 — $1

Acquirer — $2 $2 $4 $0

Issuer — $6 — $2+$4 $0

current theoretical literature typically focuses on a single non-cash payment system rather than

multiple systems as exist in the real world.

As part of its deliberations, the Bank considered the practicalities of applying these models

to the setting of interchange fees in Australia. It concluded that the simplifying assumptions

used in the models, together with the signifi cant shortcomings in the available data, made it

impractical to use these models in this way. The Bank is not aware of any payment system

around the world where these models have been used to set interchange fees.8

A more practical argument for the existence of interchange fees is that they can be needed to

make a payment system viable.

Because payment systems generally require the cooperation of at least two institutions,

both institutions need to be able to profi tably provide the services at a price that their customers

are willing to pay. In effect, this means that customers must be willing to pay at least their

fi nancial institution’s costs in providing the service.

Problems arise, however, if either the acquiring institution or the issuing institution

cannot recover all their costs directly from customers. If the benefi t to the merchant is less than

the acquirer’s costs, the merchant will not be willing to pay a price for the service that will cover

the acquirer’s cost and the acquirer will not be willing to participate in the network. Similarly, if

the benefi t to the cardholder is less than the issuer’s costs, the issuer will not be willing to offer

the service.

When costs exceed benefi ts on one side of the transaction but not the other, interchange

fees can be a means of establishing the system. These fees redistribute the revenue fl ows to allow

both issuers and acquirers to offer the required services at a profi t and therefore bring the system

into existence.

The following example, which is summarised in Table 1, provides an illustration. Suppose

that the cost of providing the system is $8 ($6 borne by the issuer and $2 borne by the acquirer)

and the benefi t of the system is $10 ($5 to merchants and $5 to cardholders). Total benefi ts

are greater than total costs so the system would increase society’s welfare (ignoring possible

interactions with other systems). Without interchange fees, however, the system will not exist.

8 There have been arguments that the particular rules used by card payment schemes are ‘close’ to the social optimum. However,

these arguments have always been advanced in the context of theoretical models that make very particular assumptions and, thus,

render the conclusions fragile.

The issuer will need to charge at least $6 to cardholders and the acquirer will need to charge at

least $2 to merchants. But the benefi t to cardholders is $5 and they will therefore not be willing

to pay $6, so issuers will not be able to recover their costs.

The system can be established, however, if an interchange fee of $2 is paid from the

merchant’s bank to the cardholder’s bank. In this case, the merchant will pay $4 to its bank and

have a net benefi t of $1 and the cardholder will pay $4 to his or her bank and have a net benefi t

of $1.

In this example there is a range of interchange fees consistent with the operation of

the system. In particular, any interchange fee between $1 and $3 will result in the payment

system being used. More generally, depending on the relative sizes of the costs and benefi ts,

the interchange fee needed for a system to operate could be paid to issuers by acquirers, or by

acquirers to issuers. Importantly, there is a wide range of circumstances in which no interchange

fee is necessary to ensure a payment system is viable.

This general justifi cation for interchange fees is sometimes referred to as the ‘balancing

argument’. The principle is that, when the costs and revenues on each side of the system are out

of ‘balance’ there needs to be a payment to balance the system and make it viable. This argument

is typically applied to credit card systems given that the costs to issuers are generally signifi cantly

higher than the costs to acquirers, and it is argued that cardholders would not be prepared to

pay enough to meet these costs. It is not normally especially relevant for debit card systems. In

these systems, the costs of provision are typically more balanced between the two sides of the

market and both acquirers and issuers can recover their costs from cardholders and merchants,

reducing the need to rebalance the costs and revenues.9

The Joint Study investigated whether interchange fees in the EFTPOS system could be

justifi ed on the basis of the ‘balancing argument’. It found that weighted-average acquirer costs

of processing an EFTPOS transaction were 26 cents and weighted-average issuer costs were

15 cents. On the basis of these data and further analysis, the Joint Study (page 68) came to the

conclusion that ‘Application of formal interchange methodologies does not provide a convincing

case for a debit card interchange fee, in either direction.’

To obtain more recent data, the Bank conducted a second survey of costs in the EFTPOS

system in 2004. This survey covered issuers and acquirers accounting for 90 per cent of the

transactions in the system. It found that on the acquiring side, the average cost for fi nancial

institutions was around 20 cents, compared with 26 cents in the previous study. This decline

is accounted for by a fall in average telecommunication costs and one acquirer reporting

signifi cantly lower costs than in the Joint Study.

As with the Joint Study, the EFTPOS cost data supplied to the Bank on the issuing side

are less comprehensive than on the acquiring side.

Overall, the recent data confi rm the Bank’s earlier conclusion that an interchange fee

is not essential for the operation of the EFTPOS system. This conclusion is further supported

by the observation that the Visa Debit system in Australia operates with an interchange fee

9 A signifi cant reason for this is that debit cards do not typically provide an interest-free period.

paid in the other direction and that in Canada and the Netherlands debit card systems operate

successfully without any fee at all.

A third argument for interchange fees, and one related to the balancing argument, is that, while a

fee may not be required in the medium term, it may be required during the establishment phase.

If cardholders and merchants do not take into account the positive network benefi ts of having

a widely used card scheme, they may underestimate the potential benefi ts they would receive.

Issuers and acquirers, in turn, may have substantial start-up costs and require a critical mass of

cardholder and merchant participation to generate suffi cient revenue to cover their costs. There

is, thus, a ‘chicken and egg’ dilemma: cardholders and merchants have no incentive to join until

the network is large enough, while fi nancial institutions have no incentive to participate unless

they can cover their costs. The more these institutions seek to cover their costs by charging their

customers, the less likely are cardholders and merchants to participate. Absent interchange fees

there may be no way to get the system running.

Provided at least one of the participants perceives benefi ts in excess of costs during the

start-up phase, there is scope to encourage other participants through a transfer mechanism.

Thus, in the case of the EFTPOS system, it has been argued that one reason for the particular

fl ow of fees is that acquirer and merchant costs at the beginning of the system were particularly

high and, in order to establish the system, there needed to be payments to them to ensure that

they were willing to participate.

It is important to note that, once start-up expenditure is incurred and recovered, this

justifi cation for the payment of interchange fees is no longer relevant. Given this, it is diffi cult to

apply this rationale for an interchange fee to the current situation. Both EFTPOS and Visa Debit

networks are well established, having been introduced around 20 years ago. As such, consumers

and merchants can readily assess the benefi ts they obtain from the network already in place and

there are no signifi cant establishment costs remaining to be recovered.

A variation on this argument is that there are periodic technology upgrades needed to

maintain the system and that the cost of these upgrades justifi es a continuation of the current

structure of interchange fees. While terminals and processing equipment are currently being

upgraded to use an improved encryption standard, the system costs involved do not appear

comparable (in inflation-adjusted terms) to the costs incurred in the building of the EFTPOS

system. In any case, the Bank’s view is that they do not justify the payment of an ongoing

interchange fee. Similar upgrades for debit and credit card systems have taken, or are taking,

place in a number of countries. Some have used short-term levies on participants to fund

incentives for investment in programs to introduce chip cards and terminals. These targeted

levies and payments are independent of ongoing interchange fee arrangements. They are less

likely to have longer-term detrimental effects on price signals and incentives and may be an

appropriate way to promote the upgrading of relevant systems.

A final argument for the existence of interchange fees – one made by the merchants – is that these

fees are a payment made by issuers to acquirers (and merchants) for banking services rendered by

the merchant. In the case of debit cards it is argued that the particular banking service merchants

provide is access to a deposit account, either to purchase a good or service, or to obtain cash. In

particular, this argument has focussed on the provision of cash out by merchants.

The Bank, however, gives little weight to this argument, particularly as it considers

only one side of a payment system. In reality, both merchants and cardholders benefit from the

payment system and receive services jointly provided by both issuers and acquirers. The ‘user pays’ argument,

as advanced above, ignores the costs incurred by issuers in providing a service

to merchants – namely a convenient way for their customers to purchase goods and services. A

true ‘user pays’ system might include payments from acquirers (and merchants) to issuers for the

services they provide, in addition to payments flowing the other way. It might also consider any

savings to merchants from lower cash-handling costs.

The fact that some merchants provide cash out facilities does not, in the Bank’s view,

provide a justification for the current level of interchange fees paid to acquirers. Around 85 per cent

of EFTPOS transactions do not involve any cash out at all. The EFTPOS transactions that do

involve cash out in conjunction with a purchase provide considerable benefit to merchants, who

provide the service voluntarily, because they see it as in their interest to do so. In addition to the

associated sale of goods and services, merchants potentially save cash handling costs. Finally,

less than two per cent of EFTPOS transactions are pure cash out. It is hard to see that they can

provide a basis for an interchange fee paid on the other 98 per cent of EFTPOS transactions.

2.2 Competition and Interchange Fees

The Bank’s view is that current interchange fees in the EFTPOS and Visa Debit systems cannot

be justifi ed on any of the four rationales discussed above. It is possible, however, to make the

alternative argument that, if interchange fees are subject to competitive forces, it can be presumed

that their level is effi cient. Indeed, this is the basis on which it is generally argued that there is

no need to regulate most prices in a market economy. In normal competitive markets, prices are

driven towards costs, promoting effi cient outcomes.

The critical element in this argument is that prices are determined in a normal competitive

market. The Bank has substantial concerns that this requirement is not met in practice for

interchange fees.

When interchange fees are set multilaterally, as is the case with credit cards and Visa

Debit, all issuers in the scheme pay the same interchange fees and this is refl ected in merchant

service fees. Merchants cannot force interchange fees lower by the threat of moving from one

fi nancial institution to another for supply of the scheme’s services. As a result, the normal

competitive forces do not exist.

When the fees are bilaterally set, as is the case in the EFTPOS system, the dynamics of

competition are different, but again, normal competitive forces tend to be weak. In general,

neither acquirers nor issuers are willing, or able, to initiate a process of competition over

these fees.

The main reason for little competition emanating from the issuing side is that in any

negotiation with an acquirer, an issuer cannot credibly threaten to end the current agreement

if a lower interchange fee is not agreed to. Ending the agreement would mean that the issuer’s

cardholders were not able to use their cards at merchants serviced by the acquirer. For even

the largest issuers, this would be seen as unacceptable as it would effectively mean that they

could not offer a full-service transaction account. Indeed, during the genesis of the EFTPOS

system, issuers did not offer universal merchant acceptance but were quickly driven to make

arrangements with other banks to offer that service.

Similarly, an acquirer attempting to expand its business would have diffi culty doing

so if it were to offer, or agree to, a lower interchange fee. If the acquirer were receiving less

revenue from interchange payments than its competitors, it would be unlikely to be able to offer

merchants as competitive pricing as other acquirers. It would certainly not be able to do so

profi tably. Accepting a lower fee can hurt, not improve, the competitive position of acquirers.

One qualifi cation to this arises from the possibility of large merchants bypassing their

acquirers and connecting directly to issuers. Under such an arrangement, both issuer and merchant

can be better off by sharing any margin earned by the merchant’s existing acquirer. However,

the gains to be achieved from this source are limited. Once the merchant has established a direct

connection with issuers, there is unlikely to be any further signifi cant competitive pressure on

interchange fees. To date, only one large merchant has been able to undertake such negotiations

and smaller merchants are typically not in a position to do so.

The rigidity of interchange fees in the EFTPOS and Visa Debit payment systems since

the 1980s supports the assessment that neither have been the subject to normal competitive

pressures. In both the credit and debit card systems, interchange fees have barely moved over the

past decade despite signifi cant changes in costs and the maturing of the systems.

2.3 The Detriment from Current Interchange Fees

The Bank’s view is that the arguments in support of the current interchange fee are relatively

weak. There is no evidence to indicate that a consideration of network effi ciency was undertaken

when the fees were initially set and normal competitive forces are weak or non-existent.

Furthermore, there are identifi able distortions that these fees cause in the pricing and marketing

of various payment instruments.

As noted in Section 1, many users of credit cards typically face either a zero or negative

effective price for each transaction. In contrast, users of the EFTPOS system face either a zero

or positive price for each transaction, while users of the Visa Debit system typically face a zero

per-transaction price.

These relative prices do not refl ect the underlying relative resource costs of the various

payment methods. While it is diffi cult to obtain precise dollar estimates of these costs, it is

possible to form clear views about the relative costs of the various methods.

The diffi culty in estimating absolute costs arises from the lack of data on the resource

costs borne by the merchant and consumer in handling the various payment methods. In

comparison with the costs of fi nancial institutions – about which a reasonable amount is known

– relatively little is known about these costs. They are, however, unlikely to differ signifi cantly

between credit and debit cards. If anything, merchant resource costs may be slightly lower for

EFTPOS given the shorter time it typically takes to complete an EFTPOS transaction compared

with a credit card transaction.

According to the Joint Study, the combined issuer and acquirer cost of processing an

EFTPOS transaction averaged 41 cents in 1999. The more recent cost study referred to above

suggests a number a few cents lower. In contrast, the resource costs involved in credit card

payments are signifi cantly higher. Data presented in the Joint Study suggested that if the cost of

the interest-free period and credit losses are excluded, the average cost was around $1.75. While

some of these costs are fi xed costs, associated with the initial issuing of the cards, the variable

costs are still signifi cantly higher than for the EFTPOS system.

The higher costs involved with credit cards have been confi rmed by more recent data

collected by the Bank as part of the credit card standard. According to these data, issuers’

authorisation, processing and fraud costs amount to an average of around 30 cents per

transaction. On top of this needs to be added the issuers’ other costs, as well as the acquirers’

costs. Given these data and industry consultations, the Bank is confi dent that the credit card

system is a higher-cost system than the EFTPOS system.

While the Bank has not collected cost data explicitly for the Visa Debit system, many of

the resource costs for Visa Debit would be expected to be the same as for Visa credit given that

the two systems use the same technology and infrastructure. Notwithstanding this, Visa Debit

might be expected to have lower average costs given that the card is used as part of an existing

deposit account, rather than a stand-alone account.

The higher costs for credit and Visa Debit cards refl ect a number of factors. One is

that payments made using four-party credit card and scheme-based debit cards are processed

through the relevant proprietary infrastructure set up by the individual credit card systems to

ensure worldwide acceptance of their cards. The global nature of this infrastructure means that

there are additional expenses, relative to the domestically based EFTPOS system.

A second is that the costs of fraud and fraud control are considerably higher for credit

card and Visa Debit transactions, due to the fact that they are signature based and can be used

in situations where the merchant cannot check the signature. EFTPOS transactions, on the other

hand, have low fraud costs due to the EFTPOS system being PIN based.

Data published in the Joint Study indicated that fraud losses amount to around

0.07 per cent of the amount spent on signature-based cards. Subsequent data provided to the

Reserve Bank by independent experts appointed by Bankcard, MasterCard and Visa in the course

of implementing the interchange standard for credit cards show that, once explicit account is

taken of both fraud losses and the costs of preventing fraud, the fi gure for total fraud-related

costs is around double this. By way of contrast, the Joint Study reported that fraud costs in the

EFTPOS system were averaged around 1 cent per transaction. More recent data from APCA

suggest that fraud in the EFTPOS debit card system may be even lower than this.

Another reason for the cost differential is that the credit card system offers some

additional fl exibility and protections to cardholders. For example, credit cards can be used at

some merchants that do not have an electronic connection to their acquirer and cardholders

are protected in situations in which the merchant does not deliver goods and/or services as

promised. While these additional features are of benefi t to cardholders, they are associated with

additional costs. Finally, as mentioned above, there are some additional costs associated with

a credit card due to the fact that these cards are usually issued as a stand-alone product, rather

than as part of an existing deposit account.

An important reason for the higher-cost credit card system being offered to consumers at lower

per-transaction prices is the existence of interchange fees.

Interchange fees affect merchants’ costs of accepting the various cards, the prices that

cardholders face for using different cards, and the incentives and promotional activities of the

banks that issue them. The price effects are well illustrated by the recent changes to interchange

fees following the Bank’s reforms of the credit card schemes. These reforms have seen the

average interchange fee across the Bankcard, MasterCard and Visa schemes fall by around 0.4

of a percentage point to around 0.55 per cent. Data collected by the Reserve Bank show that this

fall in interchange fees was almost fully and immediately passed through into lower merchant

service fees.10 There have also been changes on the issuing side. Most major banks have reduced

the attractiveness of their reward schemes, effectively increasing the per-transaction price of

credit cards. There have also been increases in the fi xed costs of holding a credit card with

annual fees and fees for being a member of a reward scheme rising.

The recent experience in the United States, where both PIN-based systems and

signature-based debit card systems operated by MasterCard and Visa exist, provides further

evidence. Fees fl ow from acquirers to issuers in both systems. In the PIN systems the fees are

fl at and are relatively small, while in the scheme-based debit systems they are value based and

relatively high. This has had two effects. The fi rst is that the arrangements have enabled banks to

offer rewards to customers using scheme-based debit cards, effectively making the price for using

these cards negative. The second is that an increasing number of banks are charging customers

who make PIN-based transactions, effectively encouraging them to use the system that provides

the issuing banks with higher fees; these fees range from US$0.25 to US$1 per transaction.11 No

issuers charge transaction fees for scheme-based debit transactions.

The interchange fee differential has also had a signifi cant infl uence on banks’ choice of

which product to issue. Prior to 1994 most regional PIN-based networks in the United States

had either a zero interchange fee or a fee paid by issuers to acquirers.12 However, they were

losing market share to the scheme-based debit systems and many changed their interchange fees

to increase payments to issuers (although they were not as high as for the scheme-based debit

systems) to compete for issuance. Notwithstanding this, between 1993 and 2003 scheme-based

debit cards increased their share of the number of debit card transactions in the United States

from 39 per cent to 60 per cent as issuing banks were persuaded to issue scheme-based cards

rather than PIN debit cards.13 In effect, the expensive system has been driving out the cheaper

one, even though the two systems provided essentially the same payment service.

10 Reserve Bank of Australia Bulletin, July 2004.

11 Dove Consulting (2002).

12 Fisher F, (2000).

13 Nilson Report, Issue 809, p6.

The same dynamic, although less dramatic, can be seen in Australia. Institutions that

issue Visa Debit cards actively encourage their customers to use Visa Debit instead of EFTPOS.

In some cases they also charge a fee for use of the EFTPOS system, whereas no fee is charged if

the same transaction is made through the Visa Debit system.

In contrast to the US, Visa Debit has not substantially increased its market share in

Australia over recent years. In consultation, some institutions have indicated to the Bank that

one factor that has inhibited the growth of Visa Debit is the uncertainty over the regulatory

environment. The Bank is concerned that, when that uncertainty is resolved, unless appropriate

measures are put in place, the Visa Debit system will grow at the expense of the EFTPOS system,

not because of its intrinsic strength as a product, but as a result of the higher interchange fees.

The fact that cardholders often face negative prices for credit card transactions, but zero or

positive prices for EFTPOS transactions, has encouraged the use of the credit card and, to a

lesser extent, the Visa Debit system at the expense of the EFTPOS system.

If two goods or services provide very similar functions, but one is priced much lower

than the other, it will tend to increase its market share. The effect of interchange fees on prices

and on consumer choices is most clearly demonstrated by the experience of PIN-debit and

scheme-based debit in the US mentioned above. It is also evident in the very rapid growth of

credit card usage in the late 1990s in Australia.

Interchange fees also affect merchants’ costs through infl uencing the merchant service

fees they are charged. Unless merchants pass their merchant service fees onto consumers through

explicit charges, these fees must be incorporated into the prices that merchants charge for goods

and services.

The evidence reported above indicates that the cost to merchants of accepting credit

and Visa Debit cards is considerably higher than of accepting EFTPOS. In the fi rst instance,

lower credit card and Visa Debit interchange fees would reduce merchants’ costs, while lower

EFTPOS interchange fees would increase merchants’ costs. However, over time, to the extent

that cardholders shift from credit and Visa Debit to EFTPOS in response to the shift in relative

prices, merchants’ overall costs would fall as a larger share of transactions are made using the

payment method with lower merchant service fees.

Interchange fees affect the prices consumers pay, and therefore the incentive to use the various

payment systems. Moreover, these fees are not subject to normal competitive pressure nor have

they been set with the effi ciency of the payments system in mind. Partly as a result of the fees,

current price signals to users of card payment systems are out of line with the relative costs to

society of providing these systems.

These factors lead directly to the Bank’s view that current price signals are not promoting

the effi ciency of the overall payments system.

In reaching this view, the Bank considered the possibility that a change in interchange fees

would not lead to a change in pricing of EFTPOS and Visa Debit transactions. Some submissions

questioned whether competitive forces in retail banking were suffi ciently strong to lead to a

change in pricing, and noted that banks had not committed to any particular pricing restructure

should EFTPOS interchange fees change. Notwithstanding these submissions, the Bank’s view

is that competition in Australian retail banking is suffi ciently strong that a material change in

banks’ costs will, in time, fi nd its way into a change in pricing or the extent to which various

payment methods are promoted by fi nancial institutions. Such a conclusion is consistent with

recent changes in the credit card market and the general trend towards cost-based pricing.

The Bank also took account of the fact that a number of fi nancial institutions currently

offer EFTPOS transactions without charge as part of a bundled transaction account. In the

Bank’s view such arrangements are likely to come under pressure over time should the current

interchange fees continue. Currently, fi nancial institutions need to pay around 20 cents in an

interchange fee for every EFTPOS transaction, but receive around 40 cents if the transaction

is made with a Visa Debit card.14 This difference in fees (if not compensated by charges to

cardholders) is likely to create, over time, a strong incentive for institutions to migrate cardholders

from the EFTPOS system to a scheme-based debit system.

The Bank also considered the possibility that a reduction in current interchange fees in the

EFTPOS system would lead to reduced merchant acceptance of EFTPOS and, thus, increased use

of other payment instruments, most notably credit cards. It gave little weight to this possibility

however, given the strong incentives that merchants have to accept a wide range of payment

instruments, and the fact that merchant service fees for EFTPOS would, for most transactions,

likely remain below those on credit cards.

In reaching its opinion, the Bank also considered (as noted in Section 1) whether it

was necessary to undertake further empirical work to determine the extent of substitutability

between various forms of payment. It reviewed available evidence on reactions of Australian

consumers to changes in the prices of payment and other fi nancial services. It also reviewed

evidence on the effects of interchange fees on prices and consumer behaviour in the United States

and studies on reactions of consumers to price changes in other countries.15 The Bank also

considered the practicalities of obtaining reliable estimates of substitution possibilities using

empirical techniques. In considering this issue the Bank noted that no such results had been

published in Australia, that estimates elsewhere were very limited, and that obtaining reliable

estimates was inherently diffi cult. The Bank also assessed the value of existing survey evidence

and considered whether further survey work was required for it to form its views about effi ciency

and competition. It concluded that the existing evidence was suffi ciently strong and that further

survey work would have limited value.

Overall, the Bank considers that the various card-based payment systems are close

substitutes for one another in a wide range of circumstances. Often the systems are operated by

the one card, and where different cards are used they are sometimes visually indistinguishable

from one another. Given this, the Bank’s view is that the benchmarks discussed in Section 1 are

14 Assuming an average transaction size of $80.

15 See for instance Schneider I, (2004); Anon (2004); Green J, (2005) and references cited in footnote 2.

an appropriate basis upon which to assess the effi ciency and competitiveness of the payments

system.

Finally, the Bank considered the fi ndings of the ACT which included the following:

The Bank’s assessment of the evidence available to it has lead it to reach different views

to those of the ACT on a number of important issues.

First, as noted above, the Bank is confi dent that, given the competitiveness of retail banking

in Australia, lower interchange fees in the EFTPOS system would lead to more attractive EFTPOS

pricing for cardholders or more favourable promotion of EFTPOS by fi nancial institutions.

Second, as noted above, the Bank is confi dent that, over time, cardholders would respond

to changes in prices and the promotion of payment instruments by fi nancial institutions. If

current arrangements were to be maintained there is a strong possibility of a migration of debit

card users from the EFTPOS system to scheme-based debit systems through a combination of

more attractive pricing and positive marketing of scheme-based debit by fi nancial institutions.

Third, the Bank’s view is that a switch to EFTPOS from credit cards is warranted on

allocative effi ciency grounds. The EFTPOS system is a lower-cost system than the credit card

system, yet for many cardholders, EFTPOS is more expensive to use. As noted above, while the

Bank recognises the differences between credit and debit cards, it views the two types of cards

as highly substitutable in many circumstances.

Fourth, the Bank does not agree with the conclusion that consumers will suffer a

detriment from higher prices as merchants pass on higher EFTPOS costs. As noted above, in

assessing the likely effect on merchants’ costs of any standards, the Bank considered how the use

of various payment instruments is likely to evolve over time, not just the current situation. If the

existing arrangements were to continue, the likely migration away from EFTPOS to Visa Debit

16 Australian Competition Tribunal (2004).

by debit card users would put upward pressure on overall merchants’ costs. A change to existing

arrangements would lessen this possibility. Further, to the extent that revised arrangements lead

to increased use of debit cards at the expense of credit cards, merchants’ overall payments costs

are likely to fall, not rise.

The Bank also considered the ACT’s concerns that the data in the Joint Study may be out

of date. In particular, the Bank undertook an additional survey of costs of EFTPOS acquirers and

issuers to assess the extent to which costs had changed since the Joint Study. These updated data,

combined with the data obtained as part of the credit card standards, and other information

available to the Bank, gave the Board confi dence that the broad conclusions of the Joint Study

remained valid.

2.4 Consultation

The Bank has received numerous submissions on EFTPOS and Visa Debit over the past year.

These submissions stem from the Bank’s letters of December 2003 to participants in the EFTPOS

and Visa Debit systems; the decision to designate the Visa Debit system in February 2004; the

invitation to comment on possible designation of the EFTPOS system in June 2004; and the

decision to designate it in September 2004. Moreover, as early as September 2001, the issuers of

Visa Debit had submitted a discussion paper to the Reserve Bank that covered many of the issues

under consideration. In each case, those making submissions have been offered the opportunity

to discuss their submissions with Bank staff.

The views put in submissions and consultations fall broadly into two categories: those

that argue that it is not in the public interest to set a standard for interchange fees for the

EFTPOS and Visa Debit systems and those that argue that doing so is in the public interest. In

the latter category two main approaches have been suggested. The fi rst is to regulate interchange

fees for both EFTPOS and Visa Debit consistently with those of credit cards. The second is to

use a methodology consistent with that of credit cards for Visa Debit, but to set interchange fees

in the EFTPOS system to zero.

Throughout the process, submissions have generally focused on the level of interchange

fees in a particular system with few submissions considering the interactions between systems.

The Bank has made requests of a number of participants that they consider the likely effect

of interchange fees across payment systems in their submissions. To date there have been few

responses on this issue.

The views of the merchants on EFTPOS interchange fees are clear – they see no need to change

the current system.17 They argue that the system is ‘fi nancially safe for use by participants’ and

‘effi cient’ and that there should, therefore, be no standard imposed on EFTPOS interchange

fees. The merchants see the current interchange fl ow as appropriate because they argue that

merchants provide services to issuers and their cardholders. In addition, the merchants argue

17 Australian Merchant Payments Forum, 15 October 2004; Coles Myer, 15 October 2004.

that the current interchange fee fi nances the development and maintenance of the system and

without it, investment in the system would fall, ultimately impairing the effi ciency of the system.

They have also argued that any change in interchange fees will not result in a change in prices to

cardholders and that, even if prices did change, consumers will not respond.

A number of submissions argue that interchange fees in the EFTPOS system should be set

to zero.18 In some cases, the submissions see a conceptual case for a small interchange fee paid to

issuers (the reverse of the current situation), but on pragmatic grounds argue for a zero fee. Most

submissions proposing a zero interchange fee argue that the fee should be set to zero, rather than

abolished, allowing the possibility that the fee could be changed in the future.

One of the suggested advantages of a uniform zero interchange fee is that it would help

put small institutions on a level playing fi eld with larger issuers. The smaller institutions argue

that, because of their negotiating position, they have to pay higher interchange fees than large

institutions, and that this higher cost puts them at a competitive disadvantage.

While not arguing for zero interchange fees, APCA has made an argument for standardised

interchange fees on the grounds that an effective access regime requires standardisation of an

important condition of access, namely, the interchange fee.

A number of submissions argue that all interchange fees should be set on a consistent

basis using the methodology used for credit cards.19 Such an approach would see all interchange

fees set by reference to issuers’ eligible costs, and would result in a change in the direction of

interchange fees in the EFTPOS system.

This view was advanced by smaller institutions in particular. They see this approach as

delivering relatively low interchange fees (to issuers) in the EFTPOS system, somewhat higher

fees in the Visa Debit system and the highest fees in the credit card systems. This outcome refl ects

both the cost categories included in the Bank’s standard on interchange fees in the credit card

systems and the level of those costs in the various systems.

Finally, most submissions support the APCA process for EFTPOS access reform.

Nevertheless, four submissions on the subject of designation argued that the Reserve Bank

should take over the reform of access. A number of organisations feel marginalised by the

current process and argue that, because of vested interests, it will not deliver the best possible

outcome.

Although the Joint Study focussed on interchange fees in the EFTPOS system, it noted

that while a Visa Debit transaction accesses the same account as an EFTPOS transaction, it

attracts the same interchange fee as a credit card transaction. This is despite Visa Debit not

18 See submissions by Bank of Queensland Limited, 15 October 2004; Commonwealth Bank of Australia, 15 October 2004;

MoneySwitch Ltd, 15 October 2004; St George Bank Limited, 15 October 2004.

19 See submissions by Australian Settlements Limited, 9 July 2004; CreditLink Services Ltd, 16 July 2004; Credit Union Services

Corporation (Australia) Limited, 9 July 2004; National Australia Bank Limited, 9 July 2004; and Westpac Banking Corporation,

9 July 2004.

offering cardholders the possibility of interest-free credit. The Joint Study concluded that there

was no case for the current interchange arrangements, although it did not suggest how the issue

should be addressed.

After the release of the Joint Study, the Bank wrote to Visa International to emphasise the

Bank’s concerns about the interchange arrangements for Visa Debit. After a response from Visa

noting that it had no power to intervene in the practices of its members, the Bank wrote to the

issuers of Visa Debit to ask them to put more appropriate arrangements in place for Visa Debit

interchange fees. The Bank noted that there were practical and technical issues to be addressed

and that the issuers would need to work with Visa International to address these issues. Through

2002 and 2003, Visa and the Visa Debit issuers worked towards identifying an acceptable means

of determining an interchange fee.

The Bank discussed its concerns regarding Visa Debit with industry participants at the

end of January 2004 and again in the context of discussions following the designation of the

EFTPOS system in September 2004. In these discussions there was widespread, although not

universal, acceptance that it was inappropriate to include interest costs in the calculation of

any cost-based interchange fees in the Visa Debit system, given that there was no possibility of

interest-free credit.

Notwithstanding this general view, Visa argued in its submission of January 2004 that

the interchange fee for Visa Debit should be close to, if not identical to, the interchange fee for

Visa credit. The general basis of this argument is that Visa Debit cards were more similar to

credit cards than to EFTPOS cards and, thus, should have similar interchange fees. Visa also

argued that this similarity meant that any signifi cant divergence in interchange fees for Visa

Debit and credit cards would encourage issuers to switch towards credit cards and thus, when

the competitive responses of issuers were considered, that a signifi cant differential in interchange

fees could not be sustained in the marketplace.

Echoing Visa’s arguments, smaller issuers have claimed that if interchange fees in the Visa

Debit system are reduced too far, they would consider encouraging their cardholders to move

to credit cards rather than EFTPOS. They also argue that reducing the Visa Debit interchange

fee will harm the competitive position of small fi nancial institutions since they are the main

issuers of Visa Debit. The building societies claim that if the interchange fee drops much below

the credit card interchange fee, it would negatively affect their profi tability and their ability to

compete with larger institutions.

The merchants’ position on Visa Debit is that there should be no difference in the

interchange fees between Visa Debit and EFTPOS. However, their view on whether it is

appropriate to set a standard for interchange has varied over time. Earlier submissions argued

for setting an interchange standard that would ensure the interchange fee for Visa Debit is

identical to that for EFTPOS transactions, which would in turn remain bilaterally determined

and paid by issuers to acquirers. The submissions were not clear on how this would be achieved,

given that the Visa Debit interchange fee is currently determined multilaterally. In arguing their

case, the merchants claimed that differences in interchange fees between the two debit systems

were encouraging the growth of scheme-based debit over the EFTPOS system. In their most

recent submissions the merchants were silent on whether there should be a standard for Visa

Debit interchange.

MasterCard argues that the Bank should consider the effect of reform on potential new

entrants. It argues that the set-up costs for new issuers are such that they might be unwilling to

issue a new debit card if interchange fees were too low. As a result, MasterCard is concerned

that interchange fees for scheme-based debit cards that are lower than the current credit card

interchange fees would limit the ability of potential competitors to Visa Debit to enter the

market.

Many of the arguments raised in consultation have been addressed above. Others are

addressed in more detail in the discussion of the Bank’s preferred response.

2.5 Possible Regulatory Responses

In assessing possible regulatory responses the Bank has thought it important to consider the

EFTPOS and Visa Debit systems together, particularly given the similarities in the two systems.

Four broad options have been considered with the Bank also considering combinations of these

options. The four options are:

This would leave interchange fees in the debit card systems unchanged.

This would involve setting interchange fees to zero, except where a fee was required according

to the ‘balancing’ or other arguments discussed above.

This would see the credit card standard applied to Visa Debit and EFTPOS. As a result,

issuers of Visa Debit and EFTPOS cards would receive an interchange fee that covered their

authorisation and processing costs as well as their fraud and fraud mitigation costs. There

would be no payment to cover the costs of the interest-free period, as this is not a relevant

consideration for debit cards.

This would involve setting interchange fees for both EFTPOS and Visa Debit closer to zero

but would keep the direction of fees unchanged.

2.6 Discussion of Options

On the basis of the discussion above, the Bank’s opinion is that no change is not an appropriate

option. The Bank is of the view that a narrowing of the current differentials in interchange fees

in the EFTPOS and Visa Debit systems would have important effects on price signals and the

behaviour of cardholders and institutions that would promote the effi ciency of the payments

system.

In contrast, the merchants have argued that altering interchange fees in the EFTPOS

system will not have the effect that the Bank expects as it is unlikely to lead to changes in the

prices of EFTPOS payment services and, even if it does, consumers are unlikely to respond.

For the reasons discussed above, the Bank does not fi nd this argument convincing. Given

that retail banking is relatively competitive, changes in banks’ costs of providing payment services

are likely to lead to either a change in the price of those services or a change in the intensity

with which they are marketed. Moreover, if the current regulatory uncertainty was removed and

interchange fees were to remain at current levels, an incentive would exist for issuers to migrate

debit card users from the EFTPOS system to scheme-based debit systems.

The merchants also argued the changes to credit card interchange fees have been effective

in changing the prices charged for the use of the credit card system and that further reform is

unnecessary. While the Bank recognises that the earlier reforms have served to increase the

effective price of credit card transactions, credit cards remain a signifi cantly cheaper payment

option than EFTPOS for many people. A change in the interchange fees in the EFTPOS system

would represent a further step in promoting a better alignment of prices and costs.

The Bank also gives little weight to the merchants’ argument that a reduction in

interchange fees would cause investment in the system to fall reducing its overall effi ciency. All

participants in the EFTPOS system – merchants and acquirers included – have an interest in, and

directly benefi t from its effi ciency, security and fraud resistance. While the Bank recognises that

a change in interchange fees could alter how investment to promote those objectives is paid for,

the international experience shows that the investment needed to maintain and upgrade such

systems takes place with a variety of interchange fees. The available evidence does not support

the proposition that such investment depends on the payment of current levels of interchange

fees by issuers to acquirers.

The second option – setting interchange fees to zero except where justifi ed by the

balancing or other arguments – has considerable appeal. Given the discussion in Section 2.1, the

implementation of this option would likely see a zero interchange fee in the EFTPOS system and

possibly a zero fee in the Visa Debit system. A signifi cant advantage of this approach is that it

is consistent across the two debit card systems. It could effectively remove interchange fees as a

direct infl uence on pricing of debit card payment services, leaving pricing to be determined by

costs and market considerations.

Despite the appeal of this option the Bank has some reservations about its implementation

at this time. A number of submissions to the Bank noted that, given the current credit card

interchange fees, setting a low (or zero) interchange fee in the Visa Debit system could induce

Visa Debit issuers to promote credit cards rather than EFTPOS cards. There have also been

suggestions in some submissions that setting interchange fees to zero goes beyond the powers of

the Bank, given that it could be viewed as the setting of a price.

The third option – using the credit card standard for all payment systems – also has

some appeal on the grounds of consistency. However, it too faces a number of diffi culties. First,

it would involve reversing the direction of interchange fees in the EFTPOS system. This would

change long-standing business arrangements, and may cause substantial disruption to some

institutions. Second, this approach would entrench the credit card interchange standard to a

degree that the Bank does not believe is justifi ed. At the time the standard was introduced it was

described as providing the basis for a transition to a lower level of interchange fees, not as a

standard to apply for all time and to be applied to other systems. Given this, the Bank does not

see it as desirable to apply the credit card standard to the debit card systems.

The Bank’s preferred approach is the fourth option mentioned above – namely determine

standards that would move the EFTPOS and Visa Debit interchange fees closer together, but

maintain their current directions. In its deliberations, the Bank considered a number of ways in

which this could be done, including determining standards that would move both interchange

fees or, alternatively, determining standards that would move just one of the interchange fees.

Given the arguments discussed above the Bank does not see a strong justifi cation for the current

level of interchange fees in either system and so its preferred option is to propose standards that

would adjust fees in both systems.

This option is consistent with an evolutionary, rather than revolutionary, approach

to reform. It would reduce the infl uence of interchange fees on the pricing and promotion

of payment services, while at the same time avoid signifi cant disruption to existing business

arrangements.

The proposed standards are detailed below. It is proposed that the maximum interchange

fee in the EFTPOS system be based on acquirers’ eligible costs, with the eligible costs being

restricted to processing and switching costs. In the Visa Debit system, it is proposed that the

benchmark would be based on the processing and authorisation costs in the credit card standard.

It is proposed that both fees be fl at fees.

Based on the Bank’s current information these standards, if implemented, are likely to

result in a maximum interchange fee (being paid to acquirers) of around 5 cents in the EFTPOS

system and a maximum fee (being paid to issuers) of around 15 cents in the Visa Debit system.

On a transaction of $80, this would see the differential in interchange fees fall from around

60 cents to a maximum of around 20 cents.

The Bank has considered the implementation and compliance costs associated with these

proposed standards, should they be introduced. It is of the view that these costs would not be

signifi cant or unreasonable, given the improvements in effi ciency these reforms are expected to

generate. The Bank also considered whether there was a strong possibility that the changes in

relative prices expected to fl ow from the proposed reforms could encourage the use of means

of payment that would lead to a less effi cient payments system. Its view was that there were no

grounds for expecting this to be the case.

The Bank recognises that, if the standards are implemented, different interchange standards

would apply in the credit card, Visa Debit and EFTPOS payment systems. In particular, in each

of these systems different costs will be included in the eligible costs. To a signifi cant extent this

outcome refl ects the combination of the starting points in the three systems being so far apart,

and the Bank’s preference for a gradualist, rather than revolutionary approach. Historically,

interchange fees have been set in quite different ways and at different times and on different

bases. This has signifi cantly complicated the reform process. Using the same methodology for all

three standards, at this point in time, could involve very large, and potentially disruptive changes

to at least one of these systems.

This gradualist reform process has meant that the Bank has taken a pragmatic approach

to developing standards, including the selection of eligible costs. Nevertheless, in the Bank’s

opinion the proposed debit card standards and the existing credit card standards are important

steps in reducing the distortions in the payments system caused by interchange fees that are

either unnecessary or too high.

Notwithstanding the pragmatic approach to date, the Bank sees considerable merit in

moving to a consistent methodology over time. From this perspective, option (ii) above has

considerable appeal. At the time that the credit card standards were fi nalised, the Bank indicated

that it would review the eligible costs included in the standard in 2007. It is the Bank’s intention

to examine the arrangements for both debit and credit card systems as part of this review, with

a view to considering whether the arrangements in the different payment systems should be put

on a more consistent basis.

2.7 Draft Standards for Interchange Fees

The draft standards are presented below. The Bank proposes to publish guidance notes to

accompany any fi nal standards determined following the consultation process. It will do so at

the time it releases its fi nal standards. It welcomes industry input into the content and form of

guidance notes during the consultation period.

The proposed EFTPOS interchange standard constrains the setting of interchange fees in the

system on the basis of acquirers’ eligible costs, in much the same way as the interchange standard

in the credit card schemes uses issuers’ eligible costs.

If this standard were implemented, interchange fees would continue to be set on a

bilateral basis but any interchange fees paid to an acquirer would be subject to a cap determined

by industry-wide costs. An issuer and an acquirer could agree to lower interchange fees or to

none at all.

To reduce the industry’s compliance costs, the ‘nominated EFTPOS acquirers’, whose

costs will be used as an input to the standard, are those who account for 90 per cent of

transactions acquired in the EFTPOS system. The Reserve Bank collects the data that will

be used to identify those institutions. Around 5 institutions are expected to be required to

provide data.

To provide effi ciency incentives, the standard uses the eligible costs of the three ‘nominated

EFTPOS acquirers’ with the lowest eligible costs.

Because there is no central administrator of the EFTPOS system, the Reserve Bank or its

agent will calculate the benchmark cap and the Bank will publish it on its website.

Standard No. 3

The Setting of Interchange Fees in the EFTPOS Payment System

Objective

Application

2. This Standard applies to the payment system operated within Australia known as the

EFTPOS system, which was designated as a payment system on 9 September 2004

and referred to below as the EFTPOS system.

3. In this Standard:

an ‘acquirer’ is a participant in the EFTPOS system that provides services to a

merchant to allow that merchant to accept a debit card;

‘cash out’ means the provision of cash to a cardholder by a merchant, as a result of a

debit card transaction at the merchant;

‘debit card’ means a card issued by a participant in the EFTPOS system that allows the

cardholder to make payments to merchants for goods and services or obtain cash out

using the EFTPOS system by accessing a deposit account held at the participant;

‘debit card transaction’ or ‘transaction’ means a transaction in Australia between a

debit cardholder and a merchant involving the purchase of goods and services and/or

the provision of cash out using a debit card;

‘fi nancial year’ is the 12-month period ending 30 June;

an ‘issuer’ is a participant in the EFTPOS system that issues debit cards to its

customers;

‘merchant’ means a merchant in Australia that accepts a debit card for payment of

goods and services and/or that provides cash out;

a ‘merchant principal’ is a participant in the EFTPOS system that is a merchant that

sends transactions directly to issuers rather than through an acquirer and takes on

the responsibilities usually undertaken by an acquirer;

‘nominated EFTPOS acquirers’ are those acquirers and merchant principals

determined by the Reserve Bank, selected in order of their share of the number of

transactions, who comprise the minimum number of such acquirers or merchant

principals required to account for at least 90 per cent of the number of transactions

acquired in the EFTPOS system in the ‘reference year’;

‘reference year’ is the fi nancial year prior to the relevant year;

‘relevant year’ is the fi nancial year in which the benchmark is calculated;

terms defi ned in the Payment Systems (Regulation) Act 1998 have the same meaning

in this Standard.

4. This Standard refers to wholesale fees, known as ‘interchange’ fees, which are payable

between an issuer and an acquirer or merchant principal, directly or indirectly, in

relation to a debit card transaction in the EFTPOS system.

5. Each participant in the EFTPOS system must do all things necessary on its part to

ensure compliance with this Standard.

6. If any part of this Standard is invalid, the Standard is ineffective only to the extent of

such part without invalidating the remaining parts of this Standard.

7. This Standard is to be interpreted:

• in accordance with its objective; and

• by looking beyond form to substance.

8. This Standard comes into force on [1 July 2006].

Interchange Fees

9. Issuers and acquirers or merchant principals in the EFTPOS system may agree to pay

an interchange fee between themselves. If such a fee is paid by an issuer, the total fee

for each transaction must not exceed the benchmark published by the Reserve Bank

in accordance with paragraph 15.

Methodology

10. The benchmark for the EFTPOS system is calculated by the Reserve Bank as

follows:

a. for each of the nominated EFTPOS acquirers, the aggregate value of eligible costs

in the reference year is to be divided by the number of debit card transactions

in the reference year. This ratio is to be expressed as a number of cents per

transaction;

b. the benchmark is to be calculated by the Reserve Bank as the aggregate value

of eligible costs in the reference year of the three nominated EFTPOS acquirers

with the lowest ratios as calculated in 10a, divided by the number of transactions

undertaken by the same three nominated EFTPOS acquirers in the reference year.

The result is to be expressed as a number of cents per transaction, rounded to the

nearest cent.

11. Eligible costs are those directly related to processing and switching EFTPOS

transactions incurred by an acquirer or merchant principal when performing the

business responsibilities usually undertaken by an acquirer.

12. Data on eligible costs must be drawn from accounting records of the nominated

EFTPOS acquirers, prepared in accordance with generally accepted accounting

principles and Australian accounting standards.

13. Data on eligible costs must be provided by each nominated EFTPOS acquirer to the

Reserve Bank of Australia, or its agent, by [15 August] in the relevant year.

14. The Reserve Bank, or its agent, will review the data to determine if the costs included

are eligible costs and the Reserve Bank will use the eligible costs to calculate the

benchmark in accordance with paragraph 10.

15. The Reserve Bank will publish the benchmark for the EFTPOS system by

[15 September] in the relevant year.

16. Interchange fees in the EFTPOS system must conform with the benchmark from

[31 October] in the relevant year.

Initial and subsequent benchmarks

17. For the initial benchmark the relevant year is the fi nancial year [2006/07].

18. The benchmark is to be recalculated in the fi nancial year [2009/10] and every three

years thereafter.

Transparency

19. Acquirers and merchant principals in the EFTPOS system must report to the Reserve

Bank the weighted average interchange fee they received and the range of interchange

fees received in the previous fi nancial year by [30 September] each year. The

weights to be used in this calculation are shares of transaction value to which each

interchange fee applies. In the fi rst year, this requirement applies to the [8] months

ending [June 2007].

20. The Reserve Bank will publish the industry weighted average of interchange fees on

its website.

The proposed Visa Debit interchange standard constrains the interchange fee for Visa Debit card

transactions on the basis of eligible costs. The fee is to remain multilaterally determined.

In drafting the standard, the Bank has been mindful of the administrative costs

imposed by regulation. Partly refl ecting this, the draft standard is based on the processing and

authorisation costs used in the credit card interchange standards. Institutions do not need to

calculate additional cost data for the purposes of this standard.

Unlike the credit card standard, however, the proposed eligible costs are not exclusively

based on the costs of the current issuers. This refl ects two considerations.

First, if the standard were based on the costs of current issuers alone, the result could

be quite a high interchange fee given that most existing issuers are quite small. Should larger

issuers seek to issue Visa Debit cards in the future, they could be signifi cantly overcompensated

for their costs.

Second, the Bank took account of the possibility that MasterCard may at some stage in the

future consider introducing a scheme-based debit card in Australia. Given the strong competition

on the issuing side, the Bank sees merit in having the same interchange fee arrangements apply in

both schemes. In order to achieve this, the Bank proposes that the standard uses the costs of all

issuers collected as part of the credit card standard, not just issuers of Visa credit cards.

The proposed interchange fee is fl at, rather than a percentage based fee. The usual

justifi cation for a percentage fee is that relevant costs are predominately related to the size of

the transaction. In the case of Visa Debit, the processing and authorisation costs are unrelated

to the size of the transaction. Accordingly, and in line with the EFTPOS system and debit card

systems in a number of countries, the Bank is proposing a fl at fee expressed as a number of cents

per transaction.

Standard No. 4

The Setting of Interchange Fees in the Visa Debit Payment

System

Objective

Application

2. This Standard applies to the payment system operated within Australia known as

Visa Debit, which was designated as a payment system on 18 February 2004.

3. In this Standard:

an ‘acquirer’ is a participant in the Visa Debit system that provides services to a

merchant to allow that merchant to accept a Visa Debit card;

‘credit card transaction’ has the meaning it has in Standard No. 1;

‘Visa Debit card’ means a card issued by a participant in the Visa Debit payment

system, under the rules of the Scheme, that allows the cardholder to make payments

to merchants for goods and services by accessing a deposit account held at the

participant;

‘Visa Debit card transaction’ means a transaction in Australia between a debit

cardholder and a merchant involving the purchase of goods and services using a Visa

Debit card;

‘fi nancial year’ is the 12-month period ending 30 June;

an ‘issuer’ is a participant in the Visa Debit system that issues Visa Debit cards to its

customers;

‘merchant’ means a merchant in Australia that accepts a Visa Debit card for payment

of goods and services;

‘reference year’ is the fi nancial year prior to the relevant year;

‘relevant year’ is the fi nancial year in which the benchmark must be calculated;

terms defi ned in the Payment Systems (Regulation) Act 1998 have the same meaning

in this Standard.

4. This Standard refers to wholesale fees, known as ‘interchange’ fees, which are payable

between an issuer and an acquirer, directly or indirectly, in relation to a Visa Debit

card transaction.

5. Each participant in the Visa Debit system must do all things necessary on its part to

ensure compliance with this Standard.

6. If any part of this Standard is invalid, the Standard is ineffective only to the extent of

such part without invalidating the remaining parts of this Standard.

7. This Standard is to be interpreted:

• in accordance with its objective; and

• by looking beyond form to substance.

8. This Standard comes into force on [1 July 2006].

Interchange Fees

9. The weighted average of interchange fees in the Visa Debit system in Australia must

not exceed the benchmark calculated in accordance with paragraphs 10 and 11

below. The weights to be used in this calculation are shares of transaction values to

which each interchange fee rate applies.

Methodology

10. The benchmark is to be calculated by the Reserve Bank using data for the reference

year supplied by the credit card schemes designated by the Bank and to whom

Standard No. 1 applies.

11. The benchmark is to be calculated as follows:

a. A cost base is to be calculated for each designated credit card scheme. It is

determined by dividing the costs of processing and authorisation described in

paragraphs 11(i) and 11(iii) of Standard No. 1 in the reference year by the total

value of credit card transactions in the reference year.

b. A weighted average of the cost bases in the designated credit card schemes will

be calculated. The weights to be used are the shares of the value of credit card

transactions in each designated credit card scheme in the value of total credit card

transactions in the three designated credit card schemes in the reference year.

c. This weighted average will be multiplied by the average value of a Visa Debit card

transaction in the reference year to yield a benchmark expressed as a number of

cents per transaction.

12. The Reserve Bank will calculate the benchmark by [15 September] of the relevant

year and publish it on its website.

13. Interchange fees in the Visa Debit system must conform with the benchmark from

[31 October] in the relevant year.

Initial and subsequent benchmarks

14. For the initial benchmark the relevant fi nancial year is [2006/07].

15. The benchmark is to be recalculated in the fi nancial year [2009/10] and every three

years thereafter.

Transparency

16. The administrator of the Visa Debit system must publish the interchange fees applying

to Visa Debit transactions on its website.

17. The administrator of the Visa Debit system must certify in writing to the Reserve

Bank by 30 September each year, that interchange fees in the Visa Debit system

complied with this Standard over the previous fi nancial year. In the fi rst year, this

requirement applies to the [8] months ending [June 2007].

3. The ‘Honour All Cards’ Rule

Merchants that accept Visa credit cards are also required to accept Visa Debit cards under Visa’s

so-called ‘honour all cards’ rule. MasterCard has a similar rule but, at this time, does not issue

a debit product in Australia. This rule has received heightened scrutiny in recent years and, in

addition to the Bank’s investigations, has been the subject of legal proceedings in the United

States and an investigation by the European Union.

This section considers the ‘honour all cards’ rule in the Visa Debit system. The analysis

could apply equally to similar products issued by other card schemes which applied such rules

in Australia.

3.1 The Rationale for an ‘Honour All Cards’ Rule

There are two relevant aspects to the ‘honour all cards’ rule.

The fi rst is that the rule requires merchants to accept Visa cards regardless of which bank

or fi nancial institution issued the card. This might be best thought of as an honour all issuers

rule.

The second is that the rule requires merchants to accept all products issued under the

Visa brand. This might be best thought of as an honour all products rule.

The main rationale provided to the Bank by Visa for the honour all cards rule largely

relates to the honour all issuers aspect of the rule. Indeed, because Visa initially issued only

credit cards, the ‘honour all cards’ rule related to issuers and there was no honour all products

dimension. Over the years, however, Visa has expanded the types of products it offers under

its brand. In particular, it now offers credit cards, debit cards and pre-paid cards (in overseas

markets). Consequently, over time, the rule has gained an honour all products aspect in addition

to the original honour all issuers dimension.

There is a general acceptance that the honour all issuers aspect of the rule is in the public

interest. By insisting that merchants must accept Visa-branded cards regardless of the issuer,

Visa is maximising the network value to cardholders and issuers. If merchants were allowed to

selectively refuse cards issued by particular institutions, the value of the Visa brand and card

system could be reduced. Selective refusal could generate a need for bilateral negotiation between

issuers and acquirers and, potentially, merchants. This would raise the costs of participating in

the system and generally impair effi ciency. Cardholders could also be directly disadvantaged by

not knowing whether cards issued by their fi nancial institution would be accepted at any given

merchant.

Visa has made two related arguments as to why the honour all products rule is also in the public

interest.

First, it argues that the rule provides a cost effective way to offer multiple card products.

For example, there is little additional cost to Visa of ensuring merchant acceptance of Visa Debit

cards because it is a condition of merchants accepting Visa credit cards. Additionally, because

the two products only differ in the nature of the customer account they access, there is no need

for acquirer systems or the Visa network to be structured to accommodate any differences.

Second, Visa argues that the ‘honour all cards’ rule encourages the development of new

products. That is, with a ready-made acceptance network, it is easier for issuers to experiment

with new products. Visa argues that such experimentation is in the public interest.

3.2 Concerns with the ‘Honour All Cards’ Rule

The Bank’s concerns with the ‘honour all cards’ rule are focused on its honour all products

aspect. The Bank accepts that the honour all issuers aspect of the rule provides effi ciency gains

and enhances the value of the Visa credit card network in a way that benefi ts the public. In

contrast, the Bank does not view the extension of the ‘honour all cards’ rule across product

types to be in the public interest. By ‘tying’ acceptance of one card product to another, normal

competitive forces are diminished.

In consultation, merchants have repeatedly told the Bank that they would rather not

accept the Visa Debit card on its current terms, yet they are forced to accept it as a condition of

accepting Visa credit cards. A consequence of the forced acceptance is that competitive forces

cannot bear upon the price of, or acceptance of, the product. In particular, merchants pay the

same fees for Visa Debit as they do for Visa credit cards. This is despite Visa Debit not offering

interest-free credit.

There is also the clear practical concern that competition between payment systems is

being distorted by the rule. In most respects Visa Debit and EFTPOS are competing payment

systems. In particular, for domestic point-of-sale transactions, which represent the largest

segment of card-based transactions, they are effectively interchangeable – all that is required is

the press of a different button at the terminal. Visa Debit, however, has a competitive advantage

over EFTPOS because merchants are forced to accept the card when they make the decision to

accept Visa credit cards and must pay a higher price to do so than with EFTPOS. Moreover, the

higher interchange fee is used to encourage issuers to issue and promote Visa Debit in preference

to EFTPOS. This raises concerns that, over time, the effi ciency of the payments system will be

impaired through the operation of the ‘honour all cards’ rule as it currently stands.

These concerns are reinforced by the experience of the United States. As discussed in

Section 2, the combination of higher interchange fees and the ‘honour all cards’ rule has enabled

Visa Debit and the similar MasterCard product to signifi cantly increase their market shares in

the US at the expense of alternative debit products. A signifi cant spur to this was the higher

revenue issuing banks could earn by issuing scheme-based debit cards over other debit cards.

These arguments were central to recently concluded litigation between US retailers, led

by Wal-Mart, and the credit card companies. In this case, a number of US retailers sued Visa

and MasterCard under US anti-trust laws to force Visa and MasterCard to remove the tying

provisions between their debit and credit card products. The litigation was settled when Visa

and MasterCard agreed to: pay $US 3 billion to the retailers; reduce their debit card interchange

fees; and untie the two products. Debit cards issued in the United States by Visa and MasterCard

are now separately identifi ed and subject to separate acceptance decisions by US merchants.

Finally, as discussed above, available cost data suggest that the Visa Debit system requires

more resources to process a transaction than the EFTPOS system. These cost differences are

not currently refl ected in prices to consumers. The Bank’s proposed regulation of interchange

fees is aimed at reducing this discrepancy. Nonetheless, even with reduced interchange fees, the

‘honour all cards’ rule means that merchants will be unable to respond freely. Effi ciency of the

overall Australian payments system is likely to be enhanced if cardholders and merchants are

in a position to freely evaluate the benefi ts provided by Visa Debit against the costs and make

acceptance decisions based upon that evaluation. The honour all products rule signifi cantly

restricts this possibility.

3.3 Consultation and Summary of Submissions

The Bank invited submissions from interested parties at the end of January 2004 on whether it

was in the public interest to designate the Visa Debit system. These submissions are available on

the Bank’s website. The Bank has also been engaged in ongoing discussions with Visa and Visa

Debit issuers over the product.

As discussed above, Visa argues that there are a number of reasons why the ‘honour all

cards’ rule is in the public interest. In addition, Visa’s consultant, NECG, has detailed what it

sees as the benefi ts for effi ciency and competition of the ‘honour all cards’ rule. According to its

analysis, the rule reduces consumer transaction costs and enhances effi ciency by increasing the

ability of a scheme to offer a wide choice of card products.

The issuers of Visa Debit and Visa also argue that the rule should be retained because

Visa Debit is mainly issued by small fi nancial institutions as a way of competing with the credit

card issuance of the large banks. These smaller institutions would be disproportionately affected

if merchants decided not to accept Visa Debit cards. They also argue that removing the rule

would allow the large acquirers who do not issue Visa Debit to refuse to acquire Visa Debit

transactions – thereby unfairly limiting competition.

MasterCard argues that retention of the rule is essential if it is to introduce a product to

compete with Visa Debit on equal terms.

A number of industry participants suggested that the distinction between a debit product

and a credit product will be increasingly diffi cult to make. For example, they raised the question

of how a Visa card attached to a mortgage account should be classifi ed. Also, it was argued,

consumers may be confused if there are multiple variants of the Visa product available and

signifi cant expenditure would be required to educate consumers and merchants about the

differences.

Some of those arguing for retention of the honour all products rule concede that, if

something must be done, the no-surcharge rule could be formally removed, giving merchants the

ability to charge a different amount for accepting Visa Debit than for accepting Visa credit cards.

This possibility is raised because the no-surcharge rule has not been formally removed for the

Visa Debit system – previous Bank standards applied only to the credit card systems, although

de facto they also applied to Visa Debit as it is currently not possible to distinguish credit and

debit cards. If Visa Debit cards were to become separately identifi able, as is canvassed in this

document, the Bank proposes that the no-surcharge rule in the Visa Debit system be formally

removed for the same reasons as applied in the case of credit cards. A number of submissions

argue that most of the benefi ts of untying could be obtained by such an action without some of

the perceived costs of a full untying.

The merchants, on the other hand, argue that the honour all products rule should be

removed. They argue that Visa Debit offers them no benefi ts over and above those they receive

from EFTPOS, yet it costs them considerably more. Given this, they would like the freedom to

decline acceptance, and/or negotiate over the terms of acceptance. They point to examples from

the UK and the recent Wal-Mart settlement in the United States to support the view that there

is no detriment from abolition of the rule and, in particular, that consumers are not confused.

Finally, the merchants argue that a pre-requisite for the abolition of the ‘honour all cards’ rule to

have any effect is the separate identifi cation of Visa Debit cards, both at the merchant/customer

level and the issuer/acquirer level. There was little opposition amongst fi nancial institutions to

the proposal for separate identifi cation on its own.

3.4 Possible Regulatory Responses

Through consultation three distinct options have emerged. First, there is the option of doing

nothing. Second, some Visa Debit issuers have suggested that the honour all cards rule be

retained but that separate product identifi cation be required, thereby, allowing for differential

charging by merchants. Third, there is the option of removing the honour all products aspect

from the ‘honour all cards’ rule and making associated changes to ensure the effectiveness of

this change.

Regardless of the option chosen, the Bank proposes to require that the no-surcharge

rule be removed. This proposed change is essentially a housekeeping matter to ensure that Visa

Debit cards are treated identically in this respect to other card payment products in Australia. A

comprehensive discussion of the no-surcharge rule can be found in the consultation document

on the credit card standards issued in December 2001.

3.5 The Bank’s Preferred Option

In the Bank’s view, current arrangements whereby it is not possible to treat Visa Debit cards and

Visa credit cards differently are not in the public interest. In its opinion, the effi ciency of the

system would be promoted by Visa Debit competing against other debit and card products on

its merits – something that it currently does not do. Thus, the Bank believes that no change is

not in the public interest.

The fi rst option for change is to mandate separate identifi cation of Visa Debit and credit

cards. This change would offer the possibility that a merchant could impose different charges on

Visa Debit cards and Visa credit cards. If Visa Debit interchange fees are lowered in line with the

draft Standard 4 outlined in the previous section, Visa Debit is likely to be cheaper for merchants

to accept than Visa credit cards and this may be refl ected in any charges levied by the merchant.

Similarly, merchants may elect to impose a charge on Visa Debit transactions but not EFTPOS

transactions.

The option would require Visa issuers to develop visually distinctive Visa Debit cards

so that merchants would be in a position to identify the cards at the point of sale and impose

different charges if they chose to do so.

The benefi ts of this option are, however, limited. It is unlikely that many merchants would

take advantage of the ability to differentially charge for Visa Debit cards. Many merchants

do not currently charge for accepting credit cards and fewer impose differential charges; as

such, it is unlikely that many would differentially charge for Visa Debit cards. Consequently, in

the Bank’s view the implementation of this option would, at best, have little effect on market

dynamics. And, to the extent that there are benefi ts, they are unlikely to outweigh the costs

involved. As such, the Bank does not favour this option.

The second option for change is to require separate identifi cation and modify the ‘honour

all cards’ rule such that a merchant’s decision to accept Visa credit cards did not automatically

require him or her to accept Visa Debit cards (and vice versa).

By separating the acceptance agreements, Visa Debit would be required to compete with

other payment systems on its own merits. If merchants do not see value in accepting the card

at the price charged by their fi nancial institution they will be free to decline acceptance. This

would move the payments system closer to the benchmarks discussed in Section 1, enhancing

the effi ciency of the overall system.

Visa argues that there are higher costs involved in maintaining a separate brand for

debit cards. Visa also argues that there may be increased customer confusion if Visa Debit

cards were distinguished from Visa credit cards. In evaluating these arguments, the Bank noted

that separate electronic identifi cation of Visa Debit cards is, as a practical matter, required if

differential interchange fees, as discussed in the previous section, are to be implemented. It

views physical identifi cation of the cards to be a natural complement to this change. Separate

identifi cation is also necessary if merchants are to be able to exercise their ability to accept just

Visa credit or Visa Debit cards. Furthermore, recent advertising by Visa promoting the Visa

Debit card suggests that Visa perceives some benefi t from separate promotion of the product

even absent regulatory changes. Ultimately, there has been little objection to the proposal to

have separate product identifi cation. On balance, while this approach would involve greater

costs to implement than the previous option, it has larger potential benefi ts.

As noted above, concerns have been raised that, because Visa Debit is predominantly

issued by small fi nancial institutions, any restrictions on Visa Debit would harm their competitive

position. While the Bank recognises this argument, it does not believe that limiting competition

to protect the current issuers is in the long-term interests of the Australian payments system.

There is the signifi cant prospect that any regulatory authorisation of the ‘honour all cards’ rule

would contribute to rapid growth in issuance of scheme-based debit cards by larger fi nancial

institutions at the expense of EFTPOS. Furthermore, any action by large acquirers to refuse Visa

Debit acquiring services to their merchants, as has been suggested might happen, would seem to

be likely to raise further regulatory attention. More importantly, it is unlikely to be a profi table

strategy for acquirers to follow.

On the basis of this discussion, the Bank’s preferred approach is to require the

modifi cation of the ‘honour all cards’ rule to remove its honour all products aspect and make

associated changes to support this.

3.6 Draft Standard on Visa Debit Identifi cation and Acceptance

Restrictions

This standard deals with two matters. The fi rst is the abolition of the no-surcharge rule for Visa

Debit transactions. Although the rule was removed for Visa credit transactions on 1 January 2003,

there is still scope for it to apply to Visa Debit transactions. Paragraphs 8 and 9 of the Standard

address this using language consistent with that in the standard for credit cards.

The second is the ‘honour all cards’ rule that requires merchants to accept Visa Debit

cards if they accept Visa credit cards. Paragraph 10 would disallow this rule while paragraph 11

would provide for separate identifi cation of Visa Debit cards.

Standard No. 5

The ‘honour all cards’ rules in the Visa Debit and Visa credit card

systems and the ‘no surcharge’ rule in the Visa Debit system

Objective

Application

2. This Standard applies to the payment system operated within Australia known as

Visa Debit, which was designated as a payment system on 18 February 2004 and to

the Visa credit card system operated within Australia known as the Visa system or

the Visa network card system which was designated as a payment system on 11 April

2001.

3. In this Standard:

an ‘acquirer’ is a participant in the Visa Debit system that provides services to a

merchant to allow that merchant to accept a Visa Debit card;

‘credit card’ has the meaning it has in Standard No. 1;

‘credit transaction’ means a transaction in Australia between a credit cardholder and

a merchant involving the purchase of goods or services using a credit card;

‘fi nancial year’ is the 12-month period ending 30 June;

‘Visa Debit card’ means a card issued by a participant in the Visa Debit payment

system, under the rules of the Scheme, that allows the cardholder to make payments

to merchants for goods and services by accessing a deposit account held at the

participant;

‘Visa Debit card transaction’ means a transaction in Australia between a Visa Debit

cardholder and a merchant involving the purchase of goods and services using a Visa

Debit card;

an ‘issuer’ is a participant in the Visa Debit system that issues Visa Debit cards to its

customers;

‘merchant’ means a merchant in Australia that accepts a Visa Debit card for payment

of goods and services;

‘rules of the Scheme’ means the constitution, rules, by-laws, procedures and

instruments of the Visa Debit system and the Visa credit card system as applied in

Australia, and any other arrangement relating to the scheme by which participants

consider themselves bound;

terms defi ned in the Payment Systems (Regulation) Act 1998 have the same meaning

in this Standard.

4. Each participant in the Visa Debit system and the Visa credit card system must do all

things necessary on its part to ensure compliance with this Standard.

5. If any part of this Standard is invalid, the Standard is ineffective only to the extent of

such part without invalidating the remaining parts of this Standard.

6. This Standard is to be interpreted:

• in accordance with its objective; and

• by looking beyond form to substance.

7. This Standard comes into force on [1 July 2006.]

Merchant pricing

8. Neither the rules of the Scheme nor any participant in the Visa Debit system shall

prohibit a merchant from charging a Visa Debit cardholder any fee or surcharge for

a Visa Debit card transaction.

9. Notwithstanding paragraph 8, an acquirer and a merchant may agree that the amount

of any such fee or surcharge charged to a Visa Debit cardholder will be limited to the

fees incurred by the merchant in respect of a Visa Debit card transaction.

Honouring cards

10. Neither the rules of the Scheme nor a participant in the Visa Debit system or Visa

credit card system may require a merchant to accept Visa Debit cards as a condition

of the merchant also accepting Visa credit cards. Likewise, neither the rules of the

Scheme nor a participant in the Visa Debit system or Visa credit card system may

require a merchant to accept Visa credit cards as a condition of the merchant also

accepting Visa Debit cards.

Transparency

11. Visa Debit cards must be identifi able as such, both visually and electronically.

12. The administrator of the Visa Debit system and Visa credit card system must certify

in writing to the Reserve Bank by 30 September each year that the Visa Debit system

and Visa credit card system and participants in those systems complied with this

Standard in the previous fi nancial year.

Glossary of Acronyms

ACCC Australian Competition and Consumer Commission

ACT Australian Competition Tribunal

APCA Australian Payments Clearing Association

APRA Australian Prudential Regulation Authority

ATM Automatic Teller Machine

EFTPOS Electronic Funds Transfer at Point of Sale

NECG Network Economics Consulting Group

PIN Personal Identifi cation Number

Reference Material

Anon, ‘Issuers Ponder the Debit Rewards Payoff’, Credit Card Management, 17 (1), 2004

December 2003

Australian Settlements Limited, Letter, 9 July 2004

Bank of Queensland Limited, ‘Submission to RBA on EFTPOS Reforms’, 15 October 2004

Commonwealth Bank of Australia, ‘Reform of Card Payment Systems in Australia’, 15 October

2004

Credit Union Services Corporation (Australia) Limited, Letter, 9 July 2004

Dove Consulting, ‘Debit Issuer Survey: Cardholder Fees & Industry Outlook’, August 2002

Fisher F, Expert Report In Re: Visa Check/MasterMoney Antitrust Litigation, United States

District Court Eastern District of New York, 2000

Green J, ‘Debit Rewards Gain Traction’, Credit Card Management, 17 (12), 2005

Humphrey D, M Kim and B Vale, ‘Realising the Gains from Electronic Payments: Costs, Pricing

and Payment Choice’, Journal of Money Credit and Banking, 33, 2001

MoneySwitch Ltd, ‘EFTPOS Interchange Fees’, 15 October 2004

Nilson Report, Issue 809, April 2004

Nyberg L and G Guiborg, ‘Card Payments in Sweden’, Economic Review, 2, Sveriges Riksbank,

2003

Reserve Bank of Australia, Payments System Board Annual Reports, Sydney, 1999-2004

Reserve Bank of Australia, ‘Merchant Service Fees for Credit Cards’, Bulletin, Sydney,

July 2004

Reserve Bank of Australia, ‘Reasons for the Decision to Designate the EFTPOS Payment System’,

Media Release, 14 October 2004

October 2000

St George Bank Limited, ‘Re: Designation of Visa Debit, Designation of EFTPOS’, 15 October

2004

Westpac Banking Corporation, Letter, 9 July 2004