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
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 2
Who Has Been Regulating? “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? 3
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 4
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. 5
Merchant Pays Its Own Bank Other Scheme Members Plus Interchange Scheme Fees Interchange Fees Acquirer Fees Scheme Fees Interchange Fee = Overcharge to Merchants 6
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 7
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? 8
Efficient Pricing When Merchant Costs Are Lower For Cards (No Other Transaction Costs - No Interchange Fee) Merchant Cost Cash Price Card Price 9 Merchant cash cost Merchant card cost
Theoretically Efficient Interchange Fee If Cards Cost Less But Merchants Must Charge 1 Price Merchant Cost Cash Price Interchange Fee (Accomplishes efficient Rebated to discount for card use) Cardholder Net Card Price Merchant cash cost Merchant card cost 10
Efficient (Negative) Interchange Fee If Cards Cost Merchants More Than Cash "Negative" IF Collected From Cardholder, Paid To (Accomplishes efficient Net Merchant surcharge for card use) Card Merchant Cost Price Cash Price 11 Merchant cash cost Merchant card cost
• “[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?” 12
But What if This Happens? Price to Interchange Fee: Everyone With Little Rebated to Interchange Fee Cardholder Merchant Cost Price to Everyone With No Interchange Fee Merchant cash cost Merchant card cost 13
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. 14
Card Brands Carried: U.S. Cardholders 3 4 17.8% 3.7% 1 2 41.7% 36.8% 15 Source: Rysman (2007), Table V.
“Must-Take” Cards • “Most merchants… cannot accept just one major card because they are likely to lose profitable incremental sales if they do not take the major payment cards.” – Tim Muris 16
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 17
Interoperable Card Can Enhance Inter-Network Competition Dual- Scheme Card 18
Example: Multi-Network Cards � Two networks can be accessed from single debit card at P.O.S. � More “multi-homing” Front of card characteristics by cardholders. � Technology has helped steer to PIN debit cards; 85-90% On Reverse success in U.S. when merchants “PIN-prompt.” 19
Interoperable Card Could Enhance Inter-Network Competition Multi- Scheme Card But more “pipes” ≠ competitive merchant pricing with single homing. 20
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. 21
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. 22
Competitive Pricing, Competing Banks and Clearinghouses Issuer fees, if any Bank Scheme Fees Card Scheme Fees Merchant fees But will competition be enough to keep issuers in multiple schemes? 23
For-Profit Scheme Structure: Risks Cardholder fees, if any “Stealthy” Interchange Fees Scheme Fees Merchant 1. Stealthy interchange fees fees supplant interchange fees. 2. High scheme fees for scheme’s own profits supplant interchange fees. 24
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. 25
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? 26
Change in Merchant Fees After RBA Interchange Fee Intervention 0.05% 0.00% -0.05% -0.10% Diners Club -0.15% -0.20% -0.25% American Express -0.30% -0.35% Interchange Fee -0.40% -0.45% -0.50% Visa/MC/Bankcard -0.55% -0.60% 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 27
American Express/Diners Club Share of Credit and Charge Transactions 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% • Amex did not take over market. Value 6.0% • Differential surcharging constrains Amex, Diners. Number 4.0% 2.0% 0.0% Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- Apr- Jul- 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 Source: RBA Statistical Bulletin Series C-2. 28
“Two-Sided” Visa/MasterCard Price in Australia Following RBA Reforms 0.20% 0.16% Higher Card 0.10% Fees by Issuers 0.00% -0.10% "Two-sided Price Level" -0.20% Visa, MC Interchange Merchant Fee Service -0.30% Charge -0.40% -0.41% -0.45% -0.50% -0.60% -0.57% -0.70% Source: RBA Statistical Bulletin C-3 and Chang, et al. (2005). (Note: uses midpoint of Chang, et al. estimates of increase in cardholder fees.) 29
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.” 30
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