Towards a Competitive Card Payments Marketplace Alan S. Frankel, - - PowerPoint PPT Presentation

Towards a Competitive Card Payments Marketplace

Alan S. Frankel, Ph.D.

afrankel@lexecon.com Reserve Bank of Australia • Melbourne Business School Payments System Review Conference 29 November 2007 Sydney, NSW, Australia

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Regulation Unwarranted?

• “The agreements that are in place

between card systems, merchants, and cardholders are consensual, not the product of force or fraud. It is hard to imagine how intervention in the form of price regulation could possibly improve matters.” – Tim Muris

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“Let me say up front that I am a firm believer in self-

• regulation. So is Visa…” – Visa’s Bruce Mansfield

The scheme acts as “price regulator,” “licensing authority,” and “competition authority” – Rochet & Tirole

If price regulation does not “improve matters,” then why should card schemes established by banks regulate bank fees?

Who Has Been Regulating?

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What is Going on Here?

• “Over the last two years, the PIN debit networks

have waged fierce interchange fee competition, spurred by steep increases in Interlink, Visa's PIN debit network.”

• “Being more attractive for issuers and

cardholders than merchants is the best route to maximizing network value.”

– From American Banker

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Inelastic Merchant Demand

• Created

collectively, not exogenous:

– Design of market. – Restrictions on merchants. – Restrictions on banks. Single-homing cardholder behaviour. Multi-homing merchants.

• Exploited

collectively:

– Interchange fee. – Price discrimination.

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Merchant Pays Its Own Bank Plus Other Scheme Members

Acquirer Fees Interchange Scheme Fees Scheme Fees

Interchange Fee = Overcharge to Merchants

Interchange Fees

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No Support for Interchange Fees From “Network Externalities”

• “This network externality becomes less and less important as the

network matures, when virtually all potential users have joined.” – Rochet

• “[N]etwork

externalities can decrease as a network grows and can reach zero at some point… [W]here national coverage of a joint venture is valuable, as in payment systems, attainment of such coverage may exhaust network economies.” – Evans & Schmalensee

• Australia is a “relatively mature” credit card market in which “the

importance of these [network] externalities may be difficult to quantify…” – Network Economics Consulting Group

• “Australia is a relatively mature market.” – Visa’s Rupert Keeley

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The “Usage Externality” Persists

• The “fundamental externality…

remains important: the choice of the payment instrument is ultimately a decision of the buyer, that impacts the net costs of the seller.”

– Jean-Charles Rochet

• Question: do the schemes use rules and interchange

fees to solve (internalize) the usage externality, or create and exploit it?

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Efficient Pricing When Merchant Costs Are Lower For Cards (No Other Transaction Costs - No Interchange Fee)

Merchant cash cost Merchant card cost Merchant Cost Cash Price Card Price

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Theoretically Efficient Interchange Fee If Cards Cost Less But Merchants Must Charge 1 Price

Merchant cash cost Merchant card cost Merchant Cost Cash Price Net Card Price (Accomplishes efficient discount for card use) Interchange Fee Rebated to Cardholder

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Efficient (Negative) Interchange Fee If Cards Cost Merchants More Than Cash

Merchant cash cost Merchant card cost Merchant Cost Cash Price Net Card Price (Accomplishes efficient surcharge for card use) "Negative" IF Collected From Cardholder, Paid To Merchant

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• “[W]hen

the optimal IF… is close to zero, the implementation costs that the network would have to incur for negotiating a non-zero IF and implementing the associated interbank payments could exceed the benefits generated by the internalization of usage externalities.” – Jean-Charles Rochet

• Also “implementation costs” to the merchant if the

network is not omniscient.

• Is optimal fee “close to zero?”

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But What if This Happens?

Merchant cash cost Merchant card cost Merchant Cost Price to Everyone With Interchange Fee Interchange Fee: Little Rebated to Cardholder Price to Everyone With No Interchange Fee

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Cardholders “Single-Home;” Schemes Divide Market

X

• Schemes face no direct competition

for merchant transactions.

• Merchant accepts all major card

brands, cannot shift transactions to scheme with lower interchange fee.

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Card Brands Carried: U.S. Cardholders

1 41.7% 2 36.8% 3 17.8% 4 3.7%

Source: Rysman (2007), Table V.

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“Must-Take” Cards

• “Most merchants…

cannot accept just

• ne major card because they are likely

to lose profitable incremental sales if they do not take the major payment cards.”

– Tim Muris

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Anti-Steering Rules

• No multiple network cards
• “Honour all cards”
• No surcharges
• Regulation of price promotions
• No discrimination
• No “suppression”
• No minimum purchase for card use

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Interoperable Card Can Enhance Inter-Network Competition

Dual- Scheme Card

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Example: Multi-Network Cards

Two networks can be accessed from single debit card at P.O.S. More “multi-homing” characteristics by cardholders. Technology has helped steer to PIN debit cards; 85-90% success in U.S. when merchants “PIN-prompt.” Front of card On Reverse

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Interoperable Card Could Enhance Inter-Network Competition

Multi- Scheme Card

But more “pipes” ≠ competitive merchant pricing with single homing.

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Can the Usage Externality Be Solved Competitively?

• Let each merchant decide whether to pay

an interchange fee, and how much.

– Have the amount appear as a direct credit to the cardholder.

• Eliminate mandatory interchange fees.
• Eliminate vertical restrictions.

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Par Settlement

• Is not: arbitrarily “regulating the price to zero.”
• Is:

– Declining to regulate prices. – Eliminating the collective overcharge. – Letting competition determine merchant fees. – Letting competition determine cardholder fees. – Letting each merchant steer customers. – Consistent with history and other successful card networks.

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Competitive Pricing, Competing Banks and Clearinghouses

Issuer fees, if any Merchant fees Scheme Fees Scheme Fees

Bank Card

But will competition be enough to keep issuers in multiple schemes?

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For-Profit Scheme Structure: Risks

Cardholder fees, if any Merchant fees “Stealthy” Interchange Fees Scheme Fees

• 1. Stealthy interchange fees

supplant interchange fees.

• 2. High scheme fees for

scheme’s own profits supplant interchange fees.

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Removal of Merchant Restraints is Not Enough

• Merchant steering is helpful, but not a

panacea.

• Interchange fees still fix bank prices;

– Don’t become competitive or beneficial just because they face some constraints from merchant steering.

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Designing Competitive Payments Markets

• Choices and competition at every stage:

– Issuing, Acquiring, Clearinghouse, Processing.

• No mandatory interchange fees.
• Merchant competition, not scheme restrictions,

determines POS payment terms and options.

• Network competition – consider:

– Separate clearinghouse from standard setting, rulemaking? – What is best competitive network structure for the future?

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Change in Merchant Fees After RBA Interchange Fee Intervention

• 0.60%
• 0.55%
• 0.50%
• 0.45%
• 0.40%
• 0.35%
• 0.30%
• 0.25%
• 0.20%
• 0.15%
• 0.10%
• 0.05%

0.00% 0.05%

Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07

Source: RBA Statistical Bulletin Series C-3

Visa/MC/Bankcard Interchange Fee American Express Diners Club

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American Express/Diners Club Share of Credit and Charge Transactions

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%

Jan- 02 Apr- 02 Jul- 02 Oct- 02 Jan- 03 Apr- 03 Jul- 03 Oct- 03 Jan- 04 Apr- 04 Jul- 04 Oct- 04 Jan- 05 Apr- 05 Jul- 05 Oct- 05 Jan- 06 Apr- 06 Jul- 06 Oct- 06 Jan- 07 Apr- 07 Jul- 07

Value Number

Source: RBA Statistical Bulletin Series C-2.

• Amex did not take over market.
• Differential surcharging constrains Amex, Diners.

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“Two-Sided” Visa/MasterCard Price in Australia Following RBA Reforms

• 0.45%
• 0.57%

0.16%

• 0.41%
• 0.70%
• 0.60%
• 0.50%
• 0.40%
• 0.30%
• 0.20%
• 0.10%

0.00% 0.10% 0.20%

Interchange Fee Visa, MC Merchant Service Charge

Higher Card Fees by Issuers

"Two-sided Price Level"

Source: RBA Statistical Bulletin C-3 and Chang, et al. (2005). (Note: uses midpoint of Chang, et al. estimates of increase in cardholder fees.)

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Will Merchants Keep MIF Reductions For Themselves?

• MasterCard: Merchants “pocket” the savings.

Not credible. Merchant sector is generally competitive.

• Rochet & Tirole:

– “Merchants are likely to pass through cost increases into the retail price.” – “Merchants are likely to pass the extra costs, if any, of card transactions through to consumers in general, that is to cardholders and cash payers altogether.”

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Conclusion

• Interchange fees exploit externalities.
• Scheme rules reduce merchant elasticity of

demand, intensify externalities and market power.

• Competitive payment markets:

– No mandatory interchange fees. – No competitive restrictions on merchants. – Competing clearinghouses.

• RBA Reforms: effective and should be extended.

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For a copy of my paper, see www.RBA.gov.au Alan S. Frankel, Ph.D. afrankel@lexecon.com