Reform of Australia's Payments System 5. The Board's Assessment

This section sets out the Board's views on the major issues raised in the consultation process. First, it discusses the Board's assessment of the competitive forces acting on interchange fees, and in particular, why it is that close oversight of retail payments is warranted. Second, it discusses the main effects of the reforms. And third, it discusses the Board's proposed course of action in a number of areas. The options for interchange fees are discussed separately in the following section.

5.1 A central issue: the competitive forces acting on interchange fees

A central issue confronting the Review is the extent of the competitive forces acting on interchange fees. From the time of the Joint Study, the Board's view has been that the normal forces of competition have not acted effectively on interchange fees, and that the resulting configuration of fees was not conducive to the efficient evolution of the system. As noted above, during the consultation process a number of parties argued that, due to the Bank's reforms, the competitive environment is very different to that applying five years ago and that interchange regulation could now be removed. In contrast, others argued that because of the structure of the market, it was very difficult, if not impossible, to have confidence that competition could ever lead to an efficient configuration of interchange fees.

Following a careful consideration of this issue, the Board remains of the view that, in the absence of regulatory oversight, there is a significant risk that interchange fees in some systems will be set at levels that are too high from the point of view of the efficiency of the system. The main reason for this is that merchants find it difficult to exert sufficient downward pressure on interchange fees, largely as a result of the structure of incentives that they face. In essence, merchants face a co-ordination problem, and as a result are willing to pay more, in aggregate, for some payment methods than the aggregate benefit that they receive from accepting those methods. This difficulty is most apparent in the credit card system but, in principle, can arise in other payment systems as well.

While each merchant that accepts credit cards obviously judges the net benefit of doing so to be positive (otherwise it would not accept credit cards), the aggregate benefit to the merchant community of acceptance need not exceed the aggregate cost of acceptance. This is because part of the benefit that an individual merchant perceives from accepting cards is that of ‘stealing’ business from other merchants. But merchants cannot collectively steal business from themselves; one business's gain is another's loss. Further, the Board does not accept the idea that in the long run, credit card acceptance by merchants significantly increases the aggregate value of spending (although it is likely to bring forward some spending).

In a sense, merchants are in a game akin to the ‘prisoner's dilemma’: they would be better off if they could collectively agree on the terms of credit card acceptance, paying no more than their collective benefit, but instead they act individually and, as a result, can in aggregate potentially pay more for credit card acceptance than the benefit they receive.

Historically, merchants' ability to exert competitive pressure on interchange fees has been further diluted by scheme rules and a lack of transparency of interchange fees. In particular, the no-surcharge and honour-all-cards rules reduced the ability of merchants to put downward pressure on interchange fees by either threatening to impose a surcharge, or refusing acceptance of some cards with high interchange fees. The lack of transparency also made it difficult for merchants to know exactly what interchange fees were being paid on different transactions.

The Board's main concern about high interchange fees arises from the potential for these fees to distort payment patterns. In particular, a payment system with high interchange fees can effectively subsidise consumers to use that system, even if doing so generates a loss of welfare for society as a whole. In the Australian context, the cash, direct entry and cheque systems do not have interchange fees and there is no simple means by which such fees might be implemented in these systems. This puts these systems at a potential disadvantage.

Of more concern has been the structure of the EFTPOS debit card system, and in particular the existing governance and organisational structure of this system. The current arrangements have meant that, following the establishment of the system in the 1980s, it has been very difficult for industry participants to change the long-established interchange fees. Given that these fees were set up to be paid from the issuer to the acquirer (the reverse direction to almost all other interchange fees in the world), the EFTPOS system has been at a significant disadvantage to the credit card system. The result has been a set of price signals to consumers that have encouraged credit card use at the expense of debit card use.

It is important to note that the Board's concerns in this area have nothing to do with the level of credit card debt and do not reflect a view that ‘debit is better than credit’. Rather they reflect a judgement that the structure of interchange fees in the Australian payments system has distorted payment patterns in Australia.

While the Board recognises that there may be a case for interchange fees in some payment systems, it has not been presented with any convincing evidence to suggest that the various externalities that might justify these fees are sufficiently different in the debit and credit card systems to justify substantially different fees in these systems.

The Board's central conclusion here is that merchants, as a group, will pay more for credit card acceptance than the benefit they receive, introducing a distortion into the system. Historically, this distortion has been amplified by the various scheme rules that have restricted merchants' choices. The Bank's reforms have required that these restrictions be removed, but they have not completely overcome the source of the distortion. Given this assessment, the Board's deliberations in this area have focussed on two broad issues:

  1. whether more can be done to give merchants greater influence over the levels at which interchange fees are set by encouraging, or requiring, further changes to scheme rules or the structure of the system; and
  2. whether, in the long run, regulation of interchange fees will more effectively overcome the underlying distortion than other approaches.
    These issues are taken up further below.

5.2 The effects of the reforms

As part of the Review, the Board has considered the broad effects of the reforms and the various views expressed through the consultation process. The following discusses the Board's assessment of the main effects of the reforms.

5.2.1 Price signals and payment patterns

In the Board's judgement, the reforms have met a key objective of improving the price signals that consumers face when choosing between use of credit and debit cards. In particular, the relative prices that consumers face for credit and debit transactions more closely reflect relative costs than was the case prior to the reforms. While the Board recognises that efficiency does not necessarily require an exact alignment of costs and prices in the various systems, its assessment is that the relative prices that consumers now face are a substantial improvement compared to those that existed prior to the reforms.

An important part of the Review has been a re-examination of the costs of the various payment instruments. This work has confirmed that the resource costs of credit card transactions are higher than for EFTPOS transactions for both financial institutions and merchants. In terms of the payment functionality, the cost of an average-sized credit card transaction is around $0.46 higher than for an average-sized EFTPOS transaction.[1] The fraud costs associated with credit cards are higher than on EFTPOS transactions – due to signature authorisation and the ability to use credit cards in remote environments – and there are higher costs associated with maintaining an international scheme. Merchants also incur higher costs mainly because credit card transactions take longer to process at the point of sale than do EFTPOS transactions.

The changes in price signals that have occurred reflect both changes in interchange fees and the introduction of surcharging on credit card transactions. Lower interchange fees in the MasterCard and Visa credit card systems have resulted in a reduction in the value of reward points and higher annual fees, increasing the effective price of credit card transactions facing many consumers. For example, the effective price of a $100 transaction where the credit card balance is paid off by the due date has increased from around -$1.30 prior to the reforms (reflecting the value of the interest-free credit and reward points) to around -$1.10 currently.[2]

Surcharging has also led to a significant rise in the effective price of some credit card transactions. Since the beginning of 2003, when the no-surcharge rule was removed, the number of merchants surcharging has risen substantially (Graph 2). At the end of 2007, around 23 per cent of very large merchants imposed a surcharge; for small or very small merchants, the percentage was closer to 10 per cent.[3] Although the size of the surcharge varies across merchants, the average surcharge imposed is currently around 1 per cent for MasterCard and Visa transactions, and around 2 per cent for American Express and Diners Club transactions.[4] At these levels, the effective price of a MasterCard or Visa credit card transaction on which a surcharge is imposed and the balance is paid off in time is close to zero. For consumers who do not pay the balance by the due date, the effective price of a credit card transaction on which a surcharge is imposed is clearly positive.

For EFTPOS transactions, prior to the reforms most banks provided a certain number of fee-free transactions after which a charge of around $0.50 was levied. In contrast, most financial institutions now offer customers ‘all you can eat’ accounts, which offer unlimited fee-free transactions (usually electronic) for a fixed monthly account-keeping fee. While this change reflects a number of factors, the reduction in EFTPOS interchange fees from around $0.20 a transaction to $0.05 a transaction has made it more viable for institutions to offer accounts that do not have EFTPOS transaction fees.

While it is difficult to estimate precisely what effect these changes in price signals have had on payment patterns in Australia, the available evidence strongly supports the idea that relative prices matter to consumers' choice of payment instrument.

Confidential data from one card scheme indicate that when surcharges are imposed on a particular type of card, use of that card declines substantially. Where merchants have imposed a surcharge on one scheme only, or imposed a higher surcharge on one scheme than another, there have been large shifts in payment patterns away from the scheme with higher surcharges.

Similarly, data from the survey of individuals' payment patterns undertaken by the Bank as part of the Review indicate that those consumers that face a higher price for credit card transactions tend to use credit cards less than those that face a negative price. In particular, according to the survey results, credit card ‘transactors’ (who face a negative price) undertook around 22 per cent of their transactions on credit cards, while ‘revolvers’ (who face a positive price) undertook only around 12 per cent of their transactions on credit cards.[5] Conversely, revolvers are more likely to use a debit card for payments, while nearly 40 per cent of transactors did not use a debit card for any payments during the two-week survey period. The survey also indicated that credit and debit cards are used extensively for a wide range of transactions in the $25 to $200 range, suggesting significant substitution possibilities for some consumers.

Aggregate data also show a slowing in growth of the number of credit card transactions over the past few years, while growth in the number of debit card transactions has increased (Graph 3).

5.2.2 The effect on welfare

A number of submissions have argued that the reforms, particularly those to interchange fees, have reduced aggregate welfare, citing, among other things, the higher costs that credit card holders pay for credit cards. The Board does not accept this argument.

While the reforms have clearly affected different groups differently, the Board's assessment is that the effect on overall welfare has been positive. In assessing the aggregate benefits it is important to recognise that simply altering the size of the transfers between different participants in the payments system has only a limited direct effect on overall welfare, although it obviously affects the groups involved. The major benefits to the Australian economy accrue not through changing the size of these transfers, but through the improved allocative efficiency resulting from more appropriate price signals, and an increase in the contestability of markets.

While it is relatively straightforward to measure the change in the transfers between different groups, measuring the overall benefits is inherently difficult, partly because it cannot be known precisely what would have happened in the absence of the reforms. One approach is to use the principle of revealed preference, which suggests that if consumers use a particular payment instrument at a given price, they must receive a benefit at least equal to that price. Further, if the price increases then it can be inferred that those consumers that stop using the payment instrument receive a benefit less than the new price.

Using this principle, together with some assumptions about the change in the use of the various instruments, some indicative measures of welfare gain can be produced. If, for example, it is assumed that the number of credit card transactions was around 5 per cent lower over the past year than would have otherwise been the case (with these transactions migrating to the EFTPOS system), the welfare gain could be in the order of $100–$150 million per annum.

An alternative assumption might be that in the absence of the reforms, the EFTPOS system would have gradually withered, with transactions migrating to the international card schemes. Based on the cost data collected as part of this Review, this would have resulted in an increase in annual costs to the economy of around $300 million. To the extent that a number of EFTPOS users valued EFTPOS transactions more highly than scheme card transactions, the net benefit to society from the reforms would have been higher still.

The Board's overall assessment is that the welfare gains from the reforms are likely to have been substantial. Not only has the change in payment patterns relative to what would have occurred in the absence of the reforms resulted in lower costs, but there has also likely been an increase in welfare from consumers using a payment instrument from which they derive higher benefits. An estimate of the welfare gain of some hundreds of millions of dollars per annum would not be inconsistent with the available data.

5.2.3 Competitive position of the three-party schemes

One criticism of the credit card interchange fee regulations is that they have given a competitive advantage to American Express and Diners Club. While the Board has adopted a different approach to American Express and Diners Club than to the four-party schemes, this reflects differences in the structure of the schemes.[6] The Board does not accept the idea that the different approaches have given American Express and Diners Club a competitive advantage.

While neither American Express nor Diners Club has been designated under the Payment Systems (Regulation) Act, both agreed to voluntarily comply with the no-surcharge Standard. American Express also agreed to remove its no-steering provisions. These changes have had significant effects on the schemes. This is partly because they have higher merchant service fees than the four-party schemes which has meant that surcharges are more likely to be imposed, and where they are imposed, they tend to be relatively large. As noted earlier, survey data suggest that for those merchants that surcharge, the average surcharge for a transaction on a MasterCard or Visa card is around 1 per cent while for American Express and Diners Club cards it is around 2 per cent. Moreover, confidential evidence provided to the Bank by one card scheme indicates that where such differential surcharging has been applied it has had a marked effect on the use of the various cards.

Merchant service fees charged by both American Express and Diners Club have been under downward pressure as merchants have reviewed their acceptance of these cards given the increase in their relative costs compared to MasterCard and Visa cards. Since the reforms were introduced, average merchant service fees for American Express and Diners Club transactions have fallen from 2.44 per cent to 2.16 per cent (Graph 4). This decline is around half that of the four-party schemes and has occurred a little more slowly than the Bank originally expected. But at the same time, surcharging appears to be more prevalent for American Express and Diners Club than for MasterCard and Visa, suggesting that the three-party schemes have been prepared to preserve higher merchant fees at the expense of more surcharging.

The available evidence on market shares of the three-party schemes does not suggest that these schemes have enjoyed a competitive advantage. While the combined market share of American Express and Diners Club did increase by 2 percentage points in 2004, coinciding with the issuance of American Express cards by two major banks and an arrangement between Diners Club and another major bank, over the past two years their market share has been broadly stable and has actually declined a little recently. Over the three months to February 2008, the market share of the three-party schemes was only around 1 percentage point higher than over the same period five years earlier, prior to the reforms (Graph 5).

5.2.4 Competitive pressure on interchange fees

Evidence on the effect of the Bank's reforms on the competitive pressures on interchange fees is mixed. On the one hand, the modification of the honour-all-cards rule has resulted in a lowering of scheme debit interchange fees for some merchants, and the increased prevalence of surcharging has raised the prospect that future increases in interchange fees would be resisted by merchants. On the other hand, average interchange fees are still pushing up against the benchmarks, suggesting that upward pressure on these fees remains.

Increased competitive pressures flowing from the modification of the honour-all-cards rule have been evident mainly in the lowering of interchange fees on scheme debit products, at least for large merchants. Industry participants suggest that this outcome is partly attributable to the ability of these merchants to decline acceptance of scheme debit cards if the fees are too high. This ability reflects both the changes to the honour-all-cards rule and the existence of an alternative debit card system which the merchants can rely on if they decline to accept scheme debit.

In contrast, there is little evidence to suggest that surcharging has put direct downward pressure on interchange fees in the four-party schemes. However, in the Board's view, the increased willingness of merchants to surcharge suggests that, looking forward, the threat of surcharging could reduce the upward pressure on interchange fees. This would be consistent with the experience of the three-party schemes discussed above.

Notwithstanding these factors, the benchmarks set by the Board are binding and there is no suggestion that competitive pressure is leading to average interchange fees being set below the relevant benchmarks. Indeed, confidential data provided to the Bank suggest that average interchange fees are currently above the relevant benchmarks. Although large merchants have had some success in bargaining down interchange fees, these lower fees have tended to be offset by higher interchange fees for other categories of transactions, in particular interchange fees faced by smaller retailers. This experience suggests that despite some increased competitive pressures at the margin, the more important factor keeping interchange fees low is the regulatory caps.

5.2.5 Competition in acquiring

The reforms appear to have contributed to increased competition in acquiring. This is suggested by a significant decline in the margin between average merchant service fees and average interchange fees. The margin for the four-party credit cards has fallen from 0.45 per cent of the transaction value in the September quarter of 2003 to 0.29 per cent of the transaction value in the December quarter 2007. For EFTPOS, it has fallen from $0.18 per transaction in the September quarter of 2006 to $0.13 per transaction at the end of 2007 (Graphs 6 and 7).

In part this decline can be attributed to the increased focus that the Bank's reforms have brought to payments system issues, and the increased transparency that has resulted from the reform process. Merchants now understand more about the costs being incurred by acquirers and are in a better position to negotiate with acquirers. The access reforms may have also contributed to the lower margins (see Section 5.2.8 below).

5.2.6 Merchant pass-through of savings

One issue that has attracted considerable attention since the reforms were introduced is whether the cost savings that merchants have received from lower merchant service fees have been passed on to consumers in the form of lower prices for goods and services than would have otherwise been the case. The schemes argue that there has been no, or little, pass-through, while the merchants argue that the cost savings have been passed through. The Bank's estimate is that over the past year, these cost savings have amounted to around $1.1 billion.

No concrete evidence has been presented to the Board regarding the pass-through of these savings, although this is not surprising as the effect is difficult to isolate. The Bank had previously estimated that the cost savings would be likely to lead to the CPI being around 0.1 to 0.2 percentage points lower than would otherwise be the case over the longer term (all else constant). It is very difficult to detect this against a background where other costs are changing by much larger amounts and the CPI is increasing by around 2½ per cent per year on average.

Despite the difficulties of measurement, the Board's judgement remains that the bulk of these savings have been, or will eventually be, passed through into savings to consumers. This judgement is consistent with standard economic analysis which suggests that, ultimately, changes in business costs are reflected in the prices that businesses charge. A similar conclusion was reached by the House of Representatives Standing Committee on Economics, Finance and Public Administration when it considered the Bank's payments system reforms in 2006.[7]

5.2.7 Innovation

Another issue that has attracted considerable attention is the effect of the reforms on innovation in the payments system. In particular, some industry participants have argued that the introduction of chip and PIN on credit cards has been delayed in Australia because of the reduction in credit card interchange fees. The Board does not agree with this position.

Many industry participants have noted that, until recently, there has been only a weak business case for the introduction of chip and PIN on credit cards. This primarily reflects the fact that fraud rates in Australia have been very low. Data collated by APCA indicate that, over the year to June 2007, fraud on credit and charge cards amounted to around 39 cents per $1,000 transacted, around the same as in previous years. This is very low compared with overseas jurisdictions in which chip and PIN have been implemented, most notably the United Kingdom. Given this low rate of fraud, few industry participants have seen a strong case to incur the substantial expenditure required to implement these technologies.

In addition, in the Board's view it is unlikely that the level of interchange fees paid to issuers is an important determinant of investment in chip and PIN technology. Confidential information provided to the Bank in 2003 showed that around 80 per cent of the expenditure required to upgrade the Australian system to chip technology would be borne by acquirers. Raising interchange fees paid by acquirers would not seem to be consistent with encouraging those same acquirers to undertake significant additional capital expenditure. Furthermore, countries with higher interchange fees than Australia, most notably the United States, have not upgraded to chip and PIN.

No concrete evidence has been presented to the Board to suggest that innovation has been slowed by the reforms, although a number of general claims have been made. Some industry participants have argued that the reforms have actually promoted innovation, by making the market more contestable, although again few concrete examples have been provided.

The Board's general conclusion in this area is that the reforms have had little effect on the pace of innovation, either negatively or positively. The Board does, however, recognise that regulatory uncertainty and the regulatory environment can affect the pace of innovation, and this is discussed further in Section 6.

One related issue that the Board has drawn attention to on a number of occasions is the governance arrangements that apply to Australia's bilateral payment systems. As has been argued previously, the current arrangements are not always conducive to innovation, and the Board urges the industry to examine these structures as a matter of priority.

5.2.8 Access

The access reforms have made it easier for new participants to enter the payments system, although further progress is required. Two new acquirers and one new issuer have been authorised by APRA as Specialist Credit Card Institutions. In addition, there have been a number of cards issued under co-branding arrangements with established issuers; for example, rather than joining the schemes in their own right, a number of large retailers have chosen to partner with financial institutions to issue cards on their behalf.

The EFTPOS Access Regime has improved access at the margin for new entrants but the bilateral architecture of this system still makes access to this system difficult. Since its establishment in September 2006, there have been two applications for access under the APCA Access Code. In both these cases, however, access was ultimately negotiated outside the Code, suggesting that, while the provisions might not be used, the Access Code and Regime have provided a negotiating backstop for new entrants.

The experience of recent years has demonstrated that the ability to compete in one payment system is often conditional on being able to obtain access to another system. When a merchant is choosing an acquirer, it typically wants a firm that is able to acquire all its card transactions, requiring access to all the credit card and debit card systems. In the absence of more comprehensive access reform than has currently been undertaken, particularly to Australia's bilateral payment systems, access will remain relatively difficult, although substantially easier than was previously the case.

5.2.9 The use of cash

Over recent years, a criticism of the Bank's reforms is that they have not addressed what some see as a significant distortion in the payments system, namely the heavy use of cash. Some industry participants have gone further and argued that the reduction in interchange fees has promoted the use of cash, and that this has harmed the overall efficiency of the payments system. The Board's judgement is that the evidence does not support these views.

The Bank's research on payment patterns in Australia showed that cash is the most commonly used payment method, accounting for around 70 per cent of transactions by individuals.[8] It is used particularly extensively for small transactions, accounting for nearly all transactions under $10 and three-quarters of transactions between $11 and $25. Importantly, information on the cost of various payment instruments shows that for these low-value transactions, cash has a lower average cost than other payment methods.[9] This is partly explained by the fact that small cash payments have faster tender time than electronic payments, and that a single cash withdrawal can support multiple cash transactions in contrast to the electronic payment systems which require use of the electronic infrastructure each time a payment is made.

In addition, there are no restrictive practices in the provision of cash. Banks supply cash to individuals and merchants in a competitive market place and, while it is true that the costs of producing cash are not explicitly charged to the users of cash, the effect of this is more than offset by the interest forgone in holding cash. Indeed, in many cases, given the interest forgone and charges on foreign ATM withdrawals, cash represents a more expensive payment instrument for consumers than either debit or credit cards.

Despite this higher effective price, cash is used frequently, presumably reflecting the benefits that individuals derive from cash payments. Foremost amongst these are the quicker tender time and, to a lesser extent, the anonymity of cash payments. Perhaps at some point in the future an alternative low-cost payment instrument will emerge that can offer these same benefits. To date, however, the various schemes that have been proposed or trialled have not been able to gain sufficient merchant or cardholder acceptance. And, importantly, the costs have either been too high or the functionality too limited compared with cash.

The Board's assessment, therefore, is that there is no major distortion in the payments system that encourages or discourages the use of cash. For the low-value transactions for which cash is predominantly used, it is a low-cost, efficient payment instrument.

5.3 Major policy issues

This section discusses the Board's main conclusions about the various standards and access regimes introduced over recent years and, in particular, whether these standards and access regimes should be retained, and if so, whether they should be modified. It also discusses some further suggestions for reform.

5.3.1 Interchange fees

As noted above, the Board's judgement is that there are strong public policy grounds for continued close regulatory oversight of interchange fees in card payment systems. The nature of the incentives facing merchants means that there is a significant risk that, in the absence of such oversight, interchange fees will be set at levels that distort payment patterns. The likelihood of this outcome is increased by the current governance arrangements in the EFTPOS system which limit the capability of the EFTPOS system to be an effective competitor to the international card schemes.

The Board does not, however, view interchange fees as undesirable in all circumstances. While it remains unconvinced that interchange fees are needed in mature systems, it can see an argument for interchange fees in emerging systems or, potentially, in systems that are being upgraded. In the start-up phase, a payment system may find that it cannot attract consumers to use the system without subsidising use. An interchange fee may assist in establishing a payment network and realising the benefits to the economy. Once the system is established, however, there seems to be less reason to maintain the fees at their original level.

This assessment rules out the Board stepping back completely and unconditionally from the regulations introduced over recent years. The issue facing the Board, therefore, is how to best build on the progress that has been made in improving the competitive environment and in establishing less distortionary interchange fees. Looking forward, the Board has considered three broad options with respect to interchange fees. These are discussed in Section 6.

5.3.2 The no-surcharge Standard

The Board sees no case for allowing the schemes to reintroduce the no-surcharge rule. Given that the schemes have argued strongly against the no-surcharge Standard, it is the Board's expectation that if the Standard were removed the schemes would seek to re-establish the rule. The Board is, however, prepared to consider removing the Standard if the schemes provided an enforceable undertaking that they would alter their rules to allow surcharging.

In the Board's view, the benefit of the no-surcharge Standard has been substantial. It has improved price signals to consumers and, in time, might be expected to add to the downward pressure on interchange fees. The schemes' no-surcharge rules had long restricted merchants from passing on the costs of card acceptance to cardholders, and had reinforced the underlying distortion discussed in Section 5.1.

While the Board is proposing to retain the Standard, it has considered modifying the Standard to place a cap on the size of any surcharge imposed by merchants. This reflects concerns expressed through the consultation process that surcharging is being exploited by firms with market power. The Board's assessment, however, is that the case for such a cap is relatively weak, and it is not persuaded that the isolated examples of high surcharges are sufficient grounds to reimpose restrictions on merchant pricing for all merchants. The imposition of a cap would limit merchant flexibility and potentially remove a negotiating tool for merchants who might agree to limit the amount of their surcharge in exchange for a lower merchant service fee.

While surcharging might make more transparent any market power that already exists, it is a symptom not a cause: if a firm has market power, a limit on the surcharge is unlikely to affect the overall price charged by that firm. Furthermore, the evidence does not support the idea that surcharging is only used by firms with market power, with firms across a wide range of industries levying surcharges. By imposing a surcharge, some firms operating in very competitive markets are able to offer cardholders the choice of paying by credit card, without all their customers having to cover the higher costs of credit card acceptance. Finally, a confidential submission by one of the schemes provided the results of a survey that indicates that surcharges tend to be set with reference to merchant service fees.

5.3.3 The honour-all-cards Standard

The Board does not see a case to allow schemes to reinstate their earlier version of the honour-all-cards rule. The evidence to date suggests that the modification of the rule has, at the margin, been of benefit in exerting downward pressure on some interchange fees, and this benefit is expected to increase through time. As with the no-surcharge Standard, the Board is prepared to consider removing the Standard imposed on the Visa scheme if Visa provided an enforceable undertaking that it would alter its rules (MasterCard has already provided such an undertaking).

Since the introduction of the honour-all-cards Standard in 2007, there have been signs that some merchants have used their new freedom to negotiate lower interchange fees in the scheme debit systems. In particular, both schemes have introduced interchange fees for scheme debit transactions undertaken at large merchants significantly below the 12 cent cap.

This result is encouraging and in line with the Board's expectations at the time the Standard was introduced. It indicates that providing large merchants with more freedom on the conditions under which they take cards can result in more competitive pressure on the interchange fees applying to those merchants.

While the Board is proposing to maintain the Standard (and the associated Undertaking), it has considered modifications to address concerns raised during consultation about the treatment of scheme pre-paid cards. When the Board looked at pre-paid cards in 2006, it decided not to regulate interchange fees for these cards (which were, at the time, not in wide use) but did signal an expectation that interchange fees should be set broadly in conformity with those for scheme debit cards. Furthermore, it indicated that if a pre-paid card was introduced with features substantially different from a scheme debit card, merchants should not be required to accept that card.

Since then there has been an increase in the issuance of scheme pre-paid cards and the feedback through the consultation process is that the lack of an explicit reference to pre-paid cards in the Standard and Undertaking is causing confusion. Some industry participants have argued that the Standard and associated Undertaking should be modified to explicitly acknowledge that merchants are not required to accept pre-paid cards as a condition of accepting any other scheme card.

The forced acceptance of pre-paid cards is inconsistent with the general approach that the Board has taken. It has the potential to make it more difficult for other, non-scheme pre-paid cards to compete, and allows the schemes to tie the interchange fee to that applying to scheme debit. Given the potential for pre-paid cards to become a significant part of the payments system in the future, the Board sees a strong case for merchants being allowed to make independent acceptance decisions about this form of card. This could be achieved by the schemes voluntarily removing any rules that tie acceptance. In the event this did not occur, the Board would consider designation of the pre-paid schemes and regulation.

A further issue raised in the context of honour-all-cards rules is that one scheme has offered a discounted interchange fee to some merchants on the condition that they accept all the scheme's cards. Although not technically in breach of the honour-all-cards Standard or Undertaking, the requirement introduces a substantial penalty for a qualifying merchant who chooses not to accept all cards. In the Board's view, this is inconsistent with the spirit of the Standard and the principles that the Board discussed when it first introduced the honour-all-cards Standard.

Although the practice currently only applies to large merchants, it is possible that it could be extended more broadly, reintroducing a de facto honour-all-cards rule. For the same reasons that the Board viewed the original introduction of the honour-all-cards Standard to be in the public interest, it is of the view that this practice detracts from competition and efficiency by limiting merchant choice and, therefore, merchants' ability to impose downward pressure on interchange fees. The Board's preliminary conclusion is that the Standard and associated Undertaking by MasterCard should be modified to address this issue. Such a change would take place regardless of the final option chosen on interchange regulation.

Finally, the Board has considered whether a further modification of the rule to allow separate acceptance decisions for any product that has a separate interchange fee would promote competition and efficiency in the payments system. Its conclusion on this issue is discussed in the following section, given that the Board's proposed approach depends upon the direction taken with respect to interchange fee regulation.

5.3.4 Access Regimes

As noted in Section 3, a number of reforms to access have improved the ability of new entrants to compete in the card payment systems. The Board is proposing to retain all the existing access regimes.

Difficulties, however, remain particularly with payment systems built around bilateral technical links and business relationships. Even in the EFTPOS system where access reform has been helpful, access remains more difficult than is desirable.

The technology on which the bilateral payment systems are based is relatively old and is likely to need to be updated in the not too distant future. The Board is aware that there are alternative technologies available for exchanging payment messages, some of which do not require separate connections to all participants. Indeed, some of these new technologies only require entrants to establish a single technical connection in order to participate fully in a payment system. The Board has no specific views on the appropriate technology going forward and has no plans to impose an access regime or standards to implement a particular solution. It does, however, encourage the industry to consider seriously these new technologies and to assess which ones would provide the most open, transparent and cost-effective options for access by new entrants.

There is a minor issue related to the wording of the Visa Debit Access Regime that the Board will take the opportunity to modify at the same time as any changes related to the Review. This modification relates to the definition of a Specialist Credit Card Institution. The current definition includes an entity that proposes to engage in debit card issuing but does not otherwise conduct banking business. Such an entity could not exist because debit card issuing requires the taking of deposits. The change in the Access Regime will remove this anomaly but will have no practical effect.

5.3.5 Bypass rules

MasterCard and Visa have both advised the Bank that there are no rules in Australia that prohibit the bypass of the scheme processor. This is supported by the fact that two large merchants in Australia have bypass arrangements in place whereby they utilise their own switches to send credit card transactions directly to the issuer, rather than through an acquirer and the scheme switch.

The Board is not aware of anything in the scheme rules that would prevent an independent switch from providing a similar service to smaller merchants that do not have their own switch. Also, there seems no reason why an acquirer could not choose to send its transactions to the issuer through an independent switch. In both cases, competition would be enhanced.

Although there are apparently no restrictions on this activity, there would seem to be some benefit in the schemes making a clear statement on the criteria that alternative switches need to meet. Such a requirement would seem to impose little cost on the schemes and would increase the transparency of the relevant requirements.

5.3.6 Merchant choice of scheme

One issue that was raised a number of times at the Payments System Review Conference was whether merchants should be able to choose the network through which a transaction is processed. Under such an arrangement, rather than the cardholder pre-selecting the network by presenting, say, a Visa branded card, the merchant would choose whether the transaction was processed through the MasterCard or Visa network. In theory, this would exert pressure on interchange fees and scheme fees because the merchant would tend to select the cheaper network.

Such a change would be expected to have a very significant effect on the competitive dynamics in the payments system. Instead of competing for consumers partly on the basis of reward programs (or equivalently competing for issuers by offering the highest interchange fees), the schemes would have an incentive to compete for merchants on the basis of who could offer their payment services at the lowest cost. Such an outcome could well achieve an efficient level of interchange fees because the current market failure – arising from the difficulty that merchants have in refusing credit card acceptance because of business stealing incentives – could be largely overcome by the competition between schemes for merchant business.

Despite the potential advantages of such an arrangement, in practice it would require very significant structural modifications to the existing system. On the issuing side, it would be likely to require credit cards to be issued with both MasterCard and Visa brands. While multifunction cards already exist in Australia in the form of EFTPOS and credit cards, co-branded MasterCard/Visa cards do not exist anywhere around the world, and would require significant system changes. There would also need to be significant changes on the acquiring side, including possibly to terminals.

On balance, while the Board's view is that such changes could have a profound effect on competition, there is not a strong case to require a move in this direction through regulation. It would require costly adjustments in existing systems and may well have significant unintended consequences for the future development of card-based payment systems in Australia.

5.3.7 Transparency of fees

A number of industry participants have expressed a concern that, in an attempt to circumvent the interchange regulations, the payment schemes might raise scheme fees to acquirers (and hence the cost of credit card acceptance to merchants) as a way of generating revenue which could ultimately be rebated to issuers. Concerns about these fees have been heightened by the general lack of transparency to merchants about their magnitude and how they are set. These fees have a number of dimensions, but they are mainly ‘brand’ fees and fees for the processing of transactions. The main concerns relate to the former, given that it is difficult for acquirers to avoid brand fees. In contrast, if the processing fees were increased significantly, bypass arrangements might be expected to become more common (see above).

The Board can see considerable merit in greater transparency surrounding these fees. This is consistent with its approach in other areas, where transparency is seen as a way of strengthening competitive forces. At the same time, the Board recognises that there is a degree of commercial sensitivity about some of these fees, and has considered how best to increase transparency without forcing schemes to publish information which is legitimately confidential. The Board proposes, therefore, that at a minimum, information on average scheme fees paid by issuers and acquirers should be publicly available. There may also be a case for schemes to publish the average compulsory scheme fee paid by acquirers (that is, fees that cannot be avoided by on-us transactions or using a third-party processor).

In addition to transparency of scheme fees, the Board also sees merit in the schemes publishing their weighted-average interchange fee on a quarterly basis. Again this could be required through regulation if the schemes were not prepared to publish this information voluntarily.


Including the costs related to the credit and reward functionality of credit cards, the differential is around $1.33 on average, half of which is due to the cost of credit collections and write-offs with credit cards. These calculations are based on costs for the average transaction size for each payment method. Using a consistent transaction size of $50, which is around the median for credit card and EFTPOS payments, the average cost of the payment functionality of a credit card transaction is around $0.35 higher than for an EFTPOS transaction. See Schwartz C, J Fabo, O Bailey and L Carter (2008), ‘Payment Costs in Australia’, Payments System Review Conference, Reserve Bank of Australia and Melbourne Business School, Sydney, pp 88–138. [1]

These calculations abstract from changes in the general level of interest rates over time. The other component of these calculations, namely the length of the interest-free period, is directly controlled by issuers and on average has not changed significantly since 2003. [2]

East & Partners (2007), Australian Merchant Acquiring and Cards Markets: Special question placement report prepared for the Reserve Bank of Australia, December. [3]

East & Partners (2007). [4]

Emery D, T West and D Massey (2008), ‘Household Payment Patterns in Australia’, Payments System Review Conference, Reserve Bank of Australia and Melbourne Business School, Sydney, pp 139–176. [5]

For a discussion of why different approaches were adopted see: Reserve Bank of Australia (2002), Reform of Credit Card Schemes in Australia: IV Final Reforms and Regulation Impact Statement, August, p 2; and Reserve Bank of Australia (2005), Media Release No. 2005-02, ‘Payments System Reform’, 24 February. [6]

House of Representatives Standing Committee on Economics, Finance and Public Administration (2006), Review of the Reserve Bank of Australia and Payments System Board Annual Reports 2005, Canberra, June. [7]

Emery D, T West and D Massey (2008), ‘Household Payment Patterns in Australia’, Payments System Review Conference, Reserve Bank of Australia and Melbourne Business School, Sydney, pp 139–176. [8]

Schwartz C, J Fabo, O Bailey and L Carter (2008), ‘Payment Costs in Australia’, Payments System Review Conference, Reserve Bank of Australia and Melbourne Business School, Sydney, pp 88–138. [9]