Submission to the Financial System Inquiry -
8. Developments and Innovation in the Payments System
8.3.2.1 The Bank's reforms to card payment systems
The Bank's approach to regulatory reform of the card payments market has been holistic and has included a range of measures directed at improving the efficiency of the payments system, such as reforms to interchange payments and to various aspects of the rules of the card schemes that had placed restrictions on merchants and financial institutions.
Interchange reforms
Interchange fees are wholesale fees paid between a merchant's financial institution and a cardholder's financial institution when a cardholder undertakes a transaction (see ‘Box 8B: Interchange Fees’). The Bank's reforms in this area reflected concerns about the lack of transparency around these fees. The Bank also considered that the large gaps that existed between the fees charged in the eftpos, scheme debit[7] and credit card systems were not justified by costs and sent inefficient price signals to customers and merchants.
In April 2001, the PSB designated the Bankcard, MasterCard and Visa credit card schemes, enabling it to set standards for these schemes.[8] In August 2002, the PSB decided that from July 2003 the schemes would be subject to a standard which set an interchange fee benchmark for each scheme and increased transparency of these fees. The benchmark was based on the average costs of the issuers of each scheme. Since November 2006, there has been a common cost-based average interchange fee benchmark of 50 basis points for both MasterCard and Visa.
Reforms of the debit card systems began in 2004, with the PSB designating the Visa Debit system in February and the eftpos system in September. In July 2006, the PSB introduced interchange standards for each system and in 2013 a new standard took effect for the eftpos system to reflect structural changes to that system. The current standards set a common benchmark of 12 cents. The Debit MasterCard system has not been formally designated but MasterCard has given a voluntary undertaking to comply with the standards applying to Visa Debit.
The standards on interchange fees for the MasterCard and Visa systems set benchmarks for the average interchange fee that can be paid in those systems. In practice, the schemes have set a large number of different interchange fee rates for different types of transactions, with the weighted average interchange rate subject to the benchmark. The standards require that every three years, or at the time of any other reset of interchange fees, the average of the new interchange rates does not exceed the benchmark, with weights based on the transactions of the most recent financial year. In practice, reflecting the backward-looking compliance calculation, the setting of the international schemes' interchange fee schedules and the issuance strategies of financial institutions, the weighted-average interchange fees for the two schemes have tended to be a little above the benchmarks, albeit well below the average levels of before the reforms.
For the eftpos system, prior to the reforms interchange rates were around 20 cents per transaction, paid by the cardholder's bank to the merchant's financial institution – that is, in the opposite direction to the MasterCard and Visa schemes. With the creation of a scheme to govern the eftpos system and interchange regulation now in line with that applying to the MasterCard and Visa debit systems, eftpos interchange fees now typically flow to the issuer, the highest rate being 5 cents – well below the 12 cents cap.
Taken together, the interchange fee reforms have brought down the average interchange fees paid in the international systems and have reduced the gap between interchange fees in the credit card, scheme debit card and eftpos systems (Graph 8.5). The broader effects of the interchange reforms are discussed below.
Box 8B: Interchange Fees
A typical card transaction (Figure 8B.1) involves four parties – the cardholder, the cardholder's financial institution (the issuer), the merchant, and the merchant's financial institution (the acquirer). The Bank's reforms address interchange fees (typically paid by acquirers to issuers). These fees can have important implications for the prevalence and acceptance of different cards as well as the relative costs faced by consumers and merchants. In contrast to normal markets for goods and services, competition in payment card networks can actually drive fees higher.
Financial institutions typically charge fees to their customers for payment services. Cardholders are charged by their financial institution in a variety of ways. In the case of payments from a deposit account such as debit cards, financial institutions typically charge a monthly account-keeping fee and, sometimes, a fee per transaction (or for transactions above a certain number). In the case of payments using a credit card, financial institutions usually charge an annual fee rather than a per-transaction fee, and interest is charged on borrowings that are not repaid by a specified due date.
Merchants receiving payments are also typically charged by their financial institutions. The fees paid by merchants usually depend on the payment method. For credit and debit cards (the focus of the Bank's reforms) merchants are usually charged a ‘merchant service fee’ for every card payment they accept. Some merchants are also charged a fee by their financial institution to rent a terminal to accept cards.
In addition to cardholders and merchants paying fees to financial institutions, arrangements have evolved whereby there is payment of a fee between financial institutions on each card transaction. These fees are known as ‘interchange fees’. Interchange fees are often not obvious – cardholders and merchants do not typically see them. But they have an impact on the fees that cardholders and merchants pay.
Prior to the Bank's reforms, interchange fees in Australia worked differently in the international (MasterCard and Visa) credit and debit card schemes than in the domestic debit card system (eftpos).
In the MasterCard and Visa card schemes, interchange fees are paid by the merchant's financial institution to the cardholder's financial institution every time a payment is made using a MasterCard or Visa card. This has two effects. First, the merchant's financial institution will charge the merchant for the cost of providing it with the acceptance service plus the fee that it must pay to the card issuer (the interchange fee). The higher the interchange fee that the merchant's financial institution must pay, the more the merchant will have to pay to accept a card payment.
Second, since the card issuer is receiving a fee from the merchant's financial institution every time its card is used, it does not need to charge its customer – the cardholder – as much. The higher the interchange fee, therefore, the less the cardholder has to pay. In effect, the merchant is meeting some of the card issuer's costs which can then be used to subsidise the cardholder. Indeed, with rewards programs, the cardholder may actually be paid to use his/her card for transactions.
Where the market structure is such that there are two payment networks whose cards are accepted very widely (i.e. merchants accept cards from both networks), and where consumers may hold one network's card but not necessarily both, competition tends to involve offering incentives for a consumer to hold and use a particular network's cards (typically, loyalty or rewards programs). A network that increases the interchange fee paid by the merchant's bank to the cardholder's bank enables the cardholder's bank to pay more generous incentives, and can increase use of its cards. However, the competitive response from the other network is to increase the interchange rates applicable to its cards: as a result, unfettered competition in well-established payments card networks can lead to the perverse result of increasing the price of payment services to merchants (and thereby leading to higher retail prices for consumers). This phenomenon has been most clearly observed in the United States credit card market, which has not been subject to any regulation, with a 2009 United States Government Accountability Office Report documenting a significant increase in interchange fees over the previous two decades (United States Government Accountability Office 2009).
Until recently, in contrast to the fees charged in the international card schemes, in the eftpos system the cardholder's financial institution paid the merchant's financial institution a fee for each eftpos transaction. This also had two effects. First, it increased the cost to the cardholder's bank and, potentially, the fee paid by the cardholder to use eftpos. Second, since the merchant's financial institution received a fee from the card issuer, it did not need to charge the merchant as much – if the fee was high enough, the merchant could even receive a fee from its financial institution. In effect, in this case, the cardholder was meeting some of the costs of the merchant's financial institution.
When one compares the incentives for cardholders and merchants and for their financial institutions the implications of the different interchange flows described above are clear. Other things equal – in particular assuming no regulatory intervention and no surcharging by merchants to offset the differences in their costs – cardholders will have a preference to use a card from a network where interchange payments flow to the card-issuing financial institution, while merchants will prefer to receive cards from a network where interchange flows in the opposite direction. In circumstances where multiple card networks are widely accepted by merchants (as in Australia and many other developed countries), the consumer typically decides which means of payment is tendered and used in a transaction. Given this, financial institutions will have an incentive to issue cards from networks where interchange flows from the merchant's financial institution to the cardholder's institution, and competition may lead networks to increase the size of such fees. The generosity of cardholder rewards programs will rise as will the cost of payments to merchants.
Scheme rules
The PSB has also introduced regulation to address several scheme rules that it considered acted to hinder competitive forces. One such rule was the ‘no-surcharge’ rule, which prevented merchants from passing on the costs of accepting cards to consumers. Another was the ‘honour-all-cards’ rule, which required merchants that accepted one of a scheme's payment cards (e.g. credit cards) to also accept all that scheme's other products (e.g. their debit cards). The effect of these rules was to lessen the ability of market forces to place downward pressure on the cost of payments to merchants.
To address these concerns, the PSB introduced a standard that came into force in January 2003 which has the effect of enabling merchants, if they choose, to charge customers for Visa and MasterCard credit card transactions: American Express and Diners Club subsequently agreed voluntarily to comply with this standard. In January 2007, the PSB introduced an additional standard which extended the right of merchants to charge for the use of Visa Debit cards, and which also allows merchants to choose whether to accept Visa Debit cards independently of their choice to accept Visa Credit cards (and vice versa): MasterCard has undertaken voluntarily to also comply with this standard.
In 2012, the PSB decided to amend the standards relating to surcharging (the amendments took effect in March 2013). The decision reflected the PSB's concerns about surcharging practices that had developed over the period since no-surcharge rules were removed. In particular, the PSB was concerned about the increase in cases where charges appear to be well in excess of card acceptance costs or where surcharges are ‘blended’ across card schemes even though merchants' acceptance costs may be higher for some cards than others. The amended standards allow card scheme rules to limit charges to the reasonable cost of card acceptance, while continuing to ensure that merchants can fully recover their card acceptance costs. The Bank issued a guidance note to assist schemes, participants and merchants to determine the acceptance costs that might be considered reasonable.
Removal of the honour-all-cards rule has given merchants another tool to use in negotiations over merchant service fees. A merchant can, for example, decline to accept debit cards from MasterCard and Visa while continuing to accept their credit cards, and vice versa. To date, only one large merchant has carried through with action to decline acceptance of MasterCard and Visa debit cards, although the possibility of such action being taken has likely been used in negotiations in other cases.
Access
As noted above, the Wallis Report identified several areas of the payments system where there was scope for liberalisation of access. Following the Joint Study and subsequent work, the Bank identified some restrictions on participation imposed by the card schemes that unnecessarily inhibited competition and could not be justified as protecting the safety of the system. The PSB therefore