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 selfregulation. 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.
Æ Single-homing cardholder behaviour.
Æ Multi-homing merchants.
• Exploited collectively:
– Interchange fee.
– Price discrimination.
5
Merchant Pays Its Own Bank
Plus Other Scheme Members
In
te
s
Fee
e
g
n
cha
r
s
e
t
In
Fee
r
ire
s
qu
c
ee
A
F
me
e
h
Sc
rc
ha
ng
e
e
m
e
h
Sc
es
e
F
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
Merchant Cost
Efficient Pricing When Merchant Costs Are Lower For Cards
(No Other Transaction Costs - No Interchange Fee)
Cash
Price
Card
Price
Merchant cash cost
Merchant card cost
9
Merchant Cost
Theoretically Efficient Interchange Fee
If Cards Cost Less But Merchants Must Charge 1 Price
(Accomplishes efficient
discount for card use)
Merchant cash cost
Interchange Fee
Rebated to
Cardholder
Cash
Price
Net
Card
Price
Merchant card cost
10
Merchant Cost
Efficient (Negative) Interchange Fee
If Cards Cost Merchants More Than Cash
(Accomplishes efficient
surcharge for card use)
"Negative" IF Collected
From Cardholder, Paid To
Merchant
Net
Card
Price
Cash
Price
Merchant cash cost
Merchant card cost
11
• “[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?
Interchange Fee:
Little Rebated to
Cardholder
Merchant Cost
Price to
Everyone With
Interchange Fee
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
17.8%
2
36.8%
Source: Rysman (2007), Table V.
4
3.7%
1
41.7%
15
“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
DualScheme
Card
18
Example: Multi-Network Cards
ƒ Two networks can be
accessed from single debit
card at P.O.S.
Front of card
On Reverse
ƒ More “multi-homing”
characteristics by
cardholders.
ƒ Technology has helped steer
to PIN debit cards; 85-90%
success in U.S. when
merchants “PIN-prompt.”
19
Interoperable Card Could Enhance
Inter-Network Competition
MultiScheme
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
Bank
Card
Issuer fees,
if any
Scheme Fees
Fees
e
m
Sche
t
an
h
rc
Me ees
f
But will competition be enough to
keep issuers in multiple schemes?
23
For-Profit Scheme Structure: Risks
Cardholder
fees, if any
“St
Interc ealthy”
hang
e Fee
s
Fees
e
m
Sche
t
an
h
rc
Me ees
f
1. Stealthy interchange 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%
-0.15%
Diners Club
-0.20%
-0.25%
American Express
-0.30%
-0.35%
-0.40%
Interchange Fee
-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%
6.0%
4.0%
Value
• Amex did not take over market.
Number
• Differential surcharging constrains Amex, Diners.
2.0%
0.0%
Jan- Apr02
02
Jul- Oct- Jan- Apr02
02
03
03
Jul- Oct- Jan- Apr03
03
04
04
Source: RBA Statistical Bulletin Series C-2.
Jul- Oct- Jan- Apr04
04
05
05
Jul- Oct- Jan- Apr05
05
06
06
Jul06
Oct- Jan- Apr06
07
07
Jul07
28
“Two-Sided” Visa/MasterCard Price in Australia
Following RBA Reforms
0.20%
0.16%
0.10%
Higher Card
Fees by
Issuers
0.00%
-0.10%
-0.20%
-0.30%
Interchange
Fee
Visa, MC
Merchant
Service
Charge
"Two-sided
Price Level"
-0.40%
-0.50%
-0.60%
-0.41%
-0.45%
-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.
ÎNot 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
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.
31
For a copy of my paper, see
www.RBA.gov.au
Alan S. Frankel, Ph.D.
afrankel@lexecon.com
32