1. Executive Summary 1

2. Background 6

3. Policy Issues and the Need for Government Action 9

4. Policy Options 21

5. Costs and Benefits 24

6. Consultation 37

7. Preferred Option 40

8. Implementation and Evaluation 44

References 45

This Regulation Impact Statement (RIS) is part of the Reserve Bank’s review of card payments regulation. It presents the Bank’s assessment of issues currently affecting the card payments market, options for reform and their costs and benefits.

In March 2015 the Bank published the Review of Cards Payments Regulation: Issues Paper (the Issues Paper) (RBA 2015a).

This Review has focused on a number of different elements of the payments card market in Australia, including: interchange fee levels and regulatory compliance methodologies; the treatment of bank-issued companion cards; transparency of card acceptance costs to merchants; and allowable card surcharges. While different in nature, these areas relate in one way or another to the Bank’s mandate for competition and efficiency in the payments system.

There are five related policy issues that the Bank has identified:

Whether there is scope for interchange fees to fall further, consistent with falls in overall resource costs and as was contemplated in the conclusions to the 2007/08 Review (RBA 2008). Interchange fees are wholesale fees set by four-party card schemes such as MasterCard, Visa and eftpos that involve payments from the merchant's bank to the cardholder's bank on every transaction. These fees affect the prices faced by cardholders and merchants in using and accepting payments. Most notably, interchange fees increase payment costs for merchants and are typically used to fund rewards programs for some cardholders. The rewards, funded by interchange fees, tend to distort price signals and skew consumer payment choices towards higher-resource-cost payment methods. While previous reforms have reduced interchange fees, there are signs they may still be inefficiently high. For instance, weighted-average interchange fees have tended to drift well above their benchmarks.

Widespread perceptions that card surcharges remain excessive in some industries. The Bank’s surcharging reforms removed the ‘no-surcharge’ rules that card schemes had in place, enabling merchants to surcharge card transactions and to provide price signals to cardholders. The ability to surcharge has been a valuable reform, but practices emerged in a limited number of industries where surcharges on some transactions appeared likely to be excessive. The Bank sought to address these cases with changes to its standards in 2013 that enabled schemes to limit surcharges to the reasonable cost of acceptance. However, scheme-led enforcement proved ineffective, with limited enforcement activities by certain schemes and by acquirers. Following the report of the Financial System Inquiry (FSI 2014), Parliament enacted legislation enabling the Australian Competition and Consumer Commission (ACCC) to take action against excessive surcharges, with provision for permitted surcharge levels to be defined by the Bank (Parliament of Australia 2016).

Perceptions that companion card arrangements may indicate that the current regulatory system is not fully competitively neutral. ‘Companion card’ models developed involving the four major banks and the three-party schemes in the mid 2000s. These featured the payment of an interchange-like fee as well as a range of other marketing and incentive fees, in many respects economically equivalent to the payment of interchange fees in four-party schemes that the Bank had regulated. Policy action may be needed to address concerns relating to competitive neutrality between unregulated companion card arrangements and regulated four-party schemes.

Some uncertainty in the regulatory treatment of prepaid cards. In many respects, prepaid cards are similar to debit cards. In 2006, the Payments System Board determined that it was not necessary to regulate prepaid cards at the time, but noted its expectations that interchange fees for transactions on these cards would be published and set broadly in conformity with the Standard on interchange fees in the Visa Debit system (RBA 2006). More recently, the Bank has become concerned that the Board’s expectations may not be sufficiently clear, giving rise to concerns about the potential for interchange fees to be used in a way that is detrimental to payments system efficiency and also that ambiguity could contribute to an uneven playing field between card schemes.

Regulation is needed to limit interchange fees because competitive forces in the payments card market do not have the usual effect of bringing costs down. Where merchants feel unable to decline particular cards (because consumers expect to be able to pay with that card and may take their business elsewhere if they cannot), card schemes tend to have strong incentives to raise interchange rates. Evidence from a range of countries suggests that competition between well-established payment card schemes can lead to the perverse result of increasing the price of payment services to merchants (and therefore to higher retail prices for consumers). The conclusion of the Reserve Bank in Australia, and by other regulators internationally, is that regulation is needed to contain the upward pressure on interchange fees. Previous attempts at self-regulatory responses to this issue have not proved feasible.

Act 2010 to give the ACCC enforcement power over surcharges which are above the ‘permitted surcharge’ defined by the Reserve Bank. Accordingly, the Bank is amending its existing standard to make it simpler and more enforceable.

In the Consultation Paper published in December 2015 the Bank proposed a number of options for regulatory reform across a series of issues. After wide consultation with stakeholders the Bank has refined and condensed these proposals into three main policy options:

Option 1: No change – business as usual.

Option 2: Mostly deregulatory – remove interchange fee regulation but introduce measures to increase the transparency of interchange fees to merchants, with real-time information, and strengthen their ability to surcharge and respond to higher interchange fee cards.

Option 3: Regulatory – modifying the regulatory regime, retaining the existing weighted-average interchange benchmark for credit cards but enforcing it more effectively with more frequently observed (quarterly) compliance, and supplementing it with maximum caps on interchange rates. Companion cards would be regulated in the same way as cards in the four-party schemes. The weighted-average benchmark for debit cards would be reduced, consistent with changes in average transaction values, and maximum caps would also apply to debit card rates. Prepaid cards would be brought formally into line with debit card interchange regulation. Permitted surcharge levels would be defined more narrowly to ensure more effective enforcement against excessive surcharging. Payments card acquirers would have to provide periodic statements with more detailed costs of acceptance to merchants.

income individuals are more likely to hold premium cards, people on lower incomes would be effectively subsidising those on higher incomes. Removing interchange fee regulation from the four-party schemes would be a way to address competitive neutrality concerns regarding companion cards issued by the major banks in concert with three-party schemes. As a result financial institutions might find it less attractive to issue companion credit cards. While merchants would have greater ability to surcharge, and some may do so at higher rates, instances of excessive surcharging are likely to be reduced by a stricter definition of payment costs and stronger enforcement by the ACCC. The removal of interchange fee regulation would likely remove some existing compliance costs from schemes and financial institutions. However, the provision of real-time payment costs information to merchants is likely to more than offset these costs savings.

Option 3 would be expected to reduce the existing dispersion in interchange fees across products. In particular, interchange fees for premium cards would fall substantially. This narrower fee range would benefit small merchants and others that do not qualify for strategic rates. While the weighted-average benchmark for credit cards would remain at current levels, the proposed quarterly compliance regime is likely to keep overall interchange fees much closer to the benchmark and materially lower than they currently are between resets. This may lead to some reduction in rewards for some holders of high-cost cards. The regulation of fees paid by three-party schemes to issuers of companion cards would improve competitive neutrality of interchange regulation. Consistent with this, other interchange-like marketing and incentive payments to issuers would also be covered by provisions in the interchange fee standards. As a result, financial institutions may find it less attractive to issue companion cards and the three-party schemes may redirect their marketing efforts to proprietary cards. Instances of excessive surcharging are likely to be reduced by a stricter definition of payment costs and stronger enforcement by the ACCC. Under this option, there are likely to be some compliance costs for schemes in meeting the interchange benchmark and attesting compliance with the standards. Similarly, payment card acquirers may face some compliance costs from having to provide periodic statements with more detailed costs of acceptance to merchants.

The Bank has consulted extensively about options for reform of payment cards regulation. In March 2015 the Bank published an Issues Paper and received more than 40 submissions from financial institutions, merchants, card schemes, consumer groups and individuals. Around 30 parties took up the invitation to have discussions with the Bank, with some major stakeholders having follow-up meetings. The Bank also convened a ‘payments roundtable’ on 23 June 2015, moderated by the Deputy Chair of the Payments System Board. Thirty-three organisations were represented at the Roundtable, including schemes, card issuers and acquirers, merchants, government and regulatory agencies, and ministerial staff. More recently, on 3 December 2015, the Bank published a Consultation Paper including draft standards for cards regulation. The Bank received substantive submissions to the Consultation Paper from over 40 stakeholders, with a number of parties providing both a public submission and additional confidential information. Following the Consultation Paper, Reserve Bank staff have held more than 50 meetings with interested parties to discuss their submissions.

issues highlighted and to promote efficiency in the card payments market. This is consistent with the FSI’s endorsement of the Bank’s overall approach to interchange regulation, and the Bank’s assessment that previous interchange reforms have contributed to a more efficient and competitive payments system.

The Reserve Bank will publish final standards soon after the Board makes a decision. The new interchange standards would be effective from mid 2017 for compliance with the new interchange benchmarks and the rules on net payments to issuers.

The implementation of the surcharging standard would be in two stages, depending on the size of the merchants. The definition of ‘permitted surcharge’ for large merchants takes effect in the third quarter of 2016. For all other merchants, the definition of ‘permitted surcharge’ takes effect in the third quarter of 2017.

The Reserve Bank’s review of card payments regulation formally started in February 2015 when the Payments System Board approved the publication of an Issues Paper (however, the Bank had identified in its March 2014 submission to the Financial System Inquiry (FSI) that there were a number of issues in the payments system that warranted review (RBA 2014)). Following the Board’s approval, in March 2015 the Bank published the Issues Paper identifying the policy problems. To further examine these issues, and discuss views on the need and direction of regulation, the Bank convened a ‘payments roundtable’ on 23 June 2015 with industry and government representatives. Taking into account the many submissions to the Issues Paper and the discussions at the roundtable, the Board authorised a Consultation Paper, published in December 2015. That paper was prepared to be consistent with the requirements of an early-stage RIS and outlined numerous options for regulatory reform to address the policy problems. After this extensive policy development and consultation process the Bank has refined its views and condensed its regulatory proposals into this RIS.

Growth in debit card spending has been the strongest contributor to recent overall growth in card spending in Australia, in part reflecting broader macroeconomic developments and the strong adoption of contactless card technology. Most debit cards in Australia are ‘dual-network’ cards and can be used in both the international (MasterCard and Visa) and domestic proprietary (eftpos) card networks. Contactless technology and online functionality are widely available for debit cards issued under the MasterCard and Visa networks. Additionally, eftpos has recently introduced contactless functionality, although it is still being rolled out. The prepaid card market also has a growing presence in Australia, with these cards taking a variety of forms. Prepaid cards are currently issued by a number of Australian financial institutions via the main card networks and generally have similar functionality to debit cards.

Domestic transactions on Australian-issued American Express, Diners Club, MasterCard and Visa chip cards now require a personal identification number (PIN) to authorise point-of-sale purchases. The main exception is contactless transactions, with no authorisation required for transactions under $100.

providers. Two major Australian retailers have payment switching arrangements which allow them to ‘self-acquire’ certain transactions. The three-party card schemes act as acquirers for cards issued under their respective networks.

In four-party schemes, such as Master Card and Visa, interchange fees are wholesale fees paid by the merchant’s financial institution (the acquirer) to the cardholder’s financial institution (the issuer) when a cardholder undertakes a transaction (Figure 1). 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 and some of these funds can then be used to subsidise the cardholder. Indeed, with rewards programs, the cardholders may actually be paid to use their card for transactions.

Interchange fees may be appropriate in some circumstances, particularly in the establishment of new systems where they may be necessary to rebalance costs between the sides of the market and ensure that both sides of a market have an incentive to participate. However, the major card schemes are mature systems in Australia, where both cardholding and merchant acceptance are extensive. In practice, with interchange fees being used to incentivise issuers to issue cards from a particular scheme and cardholders to use that card, the tendency has been for competition between mature card schemes to drive up interchange fees and costs to merchants, with adverse effects on the efficiency of the payments system.

Australia. The Bank’s reforms (announced in 2002 and coming into effect in 2003 and 2004) allowed merchants to apply surcharges to credit card transactions (whereas this was previously restricted by the international credit card schemes), introduced an interchange fee benchmark (currently set at a weighted average of 0.50 per cent) that brought down average interchange fees, and introduced an access regime to reduce barriers to entry into the credit card system for non-financial institutions. A modification of the access regime came into force in 2015, requiring the card systems to have transparent eligibility and assessment criteria and to report information about membership and applications to the Bank.

Reform of the debit card systems began in 2004, when the Bank designated the Visa Debit and the eftpos systems. (At that time the Debit MasterCard system had not been formally designated; in 2006 MasterCard provided a voluntary undertaking to comply with the standards applying to Visa Debit.) In 2006, the Bank released a package of reforms to Australia’s debit card system, including an interchange fee benchmark (currently set at a weighted average of 12 cents per transaction), standards to apply to Visa Debit interchange fees and Visa’s ‘honour-all-cards’ and ‘no-surcharge’ rules. In addition, from January 2007, merchants were no longer obliged to accept a scheme’s debit cards as a condition of accepting its credit cards and vice versa. Revised Standards came into effect in 2010 and again in 2013 that intended to place eftpos and the international debit schemes on a more consistent regulatory footing.

Interchange fees in card systems raise a number of interrelated policy issues. First, interchange fees tend to distort price signals and skew consumer payment choices, including towards higher-resource-cost payment methods. Second, interchange fees enable cross subsidies within the payments system, which are inefficient and likely to be regressive in practice.

In response to concerns associated with interchange fees, the Bank introduced regulation in the 2000s. These standards set caps of 0.50 per cent of transaction values for credit cards and 12 cents per transaction for debit cards, specified as a weighted average of interchange rates within a system. While these interchange caps have improved the efficiency of the payments system, there are signs that current interchange fees are still inefficiently high.

3.1.1 Distortion of price signals

Potential distortions from interchange fees arise because many merchants may feel that they have no choice but to accept the cards of a large scheme given the perceived or actual risk of losing sales. That is, these cards are regarded as a ‘must-take’ form of payment and merchants have little capacity to influence a significant component of their cost in the form of the interchange fee. With little capacity for many merchants to refuse acceptance, interchange fees can be focused largely on providing incentives to financial institutions to issue the cards of a particular scheme and to cardholders to use those cards (i.e. rewards programs). The higher the interchange fee paid to card issuers, the greater their incentive to issue the cards of a scheme and the larger the rewards that can be paid to cardholders to encourage the use of those cards (Graph 1).

Data from the Bank’s 2013 Survey of Consumers’ Use of Payment Methods (the Consumer Payments Use Study) show that around 36 per cent of respondents hold a rewards credit card, making up around 60 per cent of credit card holders (Ossolinski, Lam and Emery 2014). Similarly, around 12 per cent of all transactions at the point of sale were made using a rewards credit card, accounting for about 70 per cent of credit card transactions made at the point of sale.

These data also show that participation in a credit card rewards program has a material and positive effect on the probability of paying with a credit card. Raw payment frequencies show a substitution from cash and debit cards to credit cards if the cardholder participates in a rewards program (Graph 3 and Graph 4). For non-rewards card holders, cash is the most frequently used payment method for transaction values up to around $50, whereas for rewards card holders cash is preferred only up to around $30. Moreover, for non-rewards card holders, debit cards are used more frequently than credit cards for values up to around $90, whereas for rewards card holders, credit cards are used more frequently than debit cards for all transaction values. Accordingly, these data strongly suggest that rewards programs encourage the use of credit cards, a higher-cost payment method, at the expense of lower-cost payment methods, potentially creating inefficiency in the payments system.

3.1.2 Cross subsidies in the payments system

The incentives provided to cardholders also result in a significant degree of cross-subsidisation within the payments system. As mentioned, rewards programs provide incentives for customers to use higher-cost payment instruments. If merchants incorporate payment costs into the price of goods and services for all customers, users of these higher-cost payment methods are effectively receiving a subsidy from users of other payment instruments. To the extent that they encourage the use of higher-cost payment instruments, these subsidies detract from the efficiency of the payments system.

3.1.3 Benchmark compliance

The existing Standards on interchange fees for the MasterCard and Visa systems set benchmarks for the average interchange fee that can be paid in those systems. The Standards require that every three years, or at the time of any other reset of interchange fees, the weighted-average of the new schedule of interchange rates does not exceed the benchmark set by the Bank, with weights based on the transactions of the most recent financial year. In practice, compliance resets have occurred every three years on 1 November, with MasterCard and Visa voluntarily resetting their interchange schedules on 30 June of the following year and on a few other occasions.

Under the current three-yearly backward-looking approach, schemes are not required to reset their schedules in the event that their average interchange rates rise above the benchmark due to deliberate strategic decisions. In particular, the downside of infrequent and backward-looking compliance has been that it has allowed the international schemes’ actual weighted-average interchange fees to drift well above the benchmarks over time.

As a result, schemes’ weighted-average interchange fees – especially for credit cards – have almost always been above the benchmarks. This is likely to continue under the status quo.

3.1.4 Need for government action

Regulation is needed to limit interchange fees because they distort price signals and payment patterns, reducing the efficiency of the payments system. Further, in contrast to normal markets for goods and services, competition in payment card networks can actually drive fees higher. 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. The competitive response from the other network is to increase the interchange rates applicable to its cards.

In contrast to the fees charged in the international card schemes, in the eftpos system the cardholder’s financial institution used to pay the merchant’s financial institution a fee for each eftpos transaction. This 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 this case, the cardholder was in effect 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 direction of interchange flows 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 fees flow in the opposite direction. In circumstances where multiple card networks are widely accepted by merchants (as in Australia and many other developed countries), the consumer typically decides which means of payment is tendered and used in a transaction. Given this, financial institutions will have an incentive to issue cards from networks where interchange fees flow from the merchant’s financial institution to the cardholder’s 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.

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

In some areas there has been a decline in the visibility many merchants have about the cost of cards, in part due to the increased complexity and the wider range of interchange fee categories. Merchants are hindered in their ability to control their payment costs, given that they are typically unable to see the cost of different cards, are restricted by card scheme rules from choosing to accept only some types of debit or credit cards, and in practice are unable to differentially surcharge to reflect the difference in payment costs. As a result, cardholders may not face the correct price signals associated with their choices, which is likely to result in cross-subsidisation and less pressure to reduce the cost of payments.

3.2.1 Visibility of debit and credit cards

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

3.2.2 Widening range of interchange fees

There has been a significant increase in the range of credit card interchange fees since the introduction of merchant-based interchange categories in 2006 (by Visa) and 2007 (by MasterCard) (Graph 6).3

Interchange rates for ‘strategic’ and some other specific types of merchants have been lowered over this period, while the interchange fee rates that apply to the various types of premium cards have risen. Based on the hierarchy of interchange rates, the cost of the high interchange rates for consumer premium and commercial cards falls on small merchants and other merchants that do not benefit from special rates. The same credit card when presented to a merchant with a low strategic rate will carry an interchange fee of around 0.2 to 0.3 per cent, but could have a fee of around 1.8 to 2.0 per cent for a merchant that does not benefit from preferential arrangements.

Broadly similar developments have also occurred with respect to the debit interchange rates of MasterCard and Visa. The schemes have introduced low strategic or special rates for particular types of merchants as well as high rates for commercial cards. They have also introduced high rates for premium cards, though there has been relatively little issuance of such cards, with rewards programs being much less prevalent and less generous than for credit cards.

For both schemes, the hierarchy of interchange rates is such that strategic or preferred merchants receive low rates on all their transactions, so that only non-qualifying merchants are subject to the high commercial and premium rates.

3 The tendency towards a larger number of interchange categories is not, however, a purely Australian phenomenon nor a product of our regulatory system. In the United States, where there is no regulation of credit card interchange, the average number of credit card interchange fee categories for MasterCard and Visa increased from 4 in 1991 to 151 in 2009 (United States Government Accountability Office 2009).

There are two significant consequences of these developments in interchange schedules. First, there are now large differences in the average interchange rates paid on the transactions of strategic or qualifying merchants compared with other merchants. The Bank estimates that the average credit card interchange rate for non-preferred merchants (i.e. those not benefiting from strategic or other preferential rates) was around 55 basis points higher than the interchange rate applying to preferred merchants in the September quarter of 2015. For MasterCard and Visa debit cards, the average interchange rate paid by the non-preferred group of merchants is estimated to have been around 13 cents per transaction higher than the rate applying to the preferred group. These differences in interchange rates have a corresponding effect on the merchant service fees faced by the two groups which is in addition to the higher margin that acquiring banks would normally apply to small merchants relative to large merchants. For both debit and credit cards, the tendency has been for the differences in interchange fees applying to the two groups to have widened significantly since merchant specific rates were first introduced.

The second consequence of the complex interchange fee schedules is that the non-preferred merchants have little transparency over the cost of particular transactions. In the case of a

MasterCard or Visa credit card transaction, the interchange rate will be around 0.3 per cent on a standard card but will be up to 2.0 per cent if the transaction involves a premium card. In the case of a debit transaction, the interchange payment would be as low as 6 cents on a standard debit card transaction but will be up to 50 cents for an average-sized transaction on a premium or commercial card.4 Without visibility over the cost of the particular card used in the transaction, a merchant that wishes to surcharge, to reflect the much higher cost of some cards, is unable to do so.

The difference in interchange fees between preferred merchants and non-preferred merchants translates into much higher merchant service fees for non-preferred merchants. While the precise amounts are difficult to quantify, a simple approximation can be useful to provide context on the magnitudes involved. Based on data for average merchant service fees for the different schemes during 2015, a 1 basis point reduction in merchant service fees would have saved non-preferred merchants about $15 million. This could translate into material savings for merchants over time. For example, if merchant service fees for non-preferred merchants were to fall by just 5 basis points, over 10 years this would result in possible savings of $750 million. Naturally, greater reductions in merchant service fees would translate into larger savings for non-preferred merchants.

The increased complexity and dispersion of interchange fees, which reduce transparency to merchants, are not likely to be resolved without government regulatory action. Schemes are likely to continue to respond to competitive pressures by creating new interchange categories and to strategically differentiate between merchants according to their market power. This would continue to drive interchange fees higher, to the detriment of smaller merchants and consumers that do not use high-rewards cards.