Malcolm Edey: Card payments regulation - from Wallis to Murray
Speech by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank of
Australia, at the Cards & Payments Conference, Melbourne, 21 May 2015.
* * *
Thank you for the invitation to speak here today.
I have been asked to talk about the outlook for payments regulation. This is a subject that is
very much front of mind at present, given that the Murray Inquiry only recently presented its
findings in that area and the Reserve Bank Payments System Board (the PSB) is conducting
its own review following on from the Murray recommendations.
I'll say a bit more about that later, but I have to begin by saying that the PSB's review
process is still underway, and I am not going to pre-empt any conclusions that might come
from that. Instead, I want to address the topic in a more indirect way, by giving an overview
of the PSB's general approach to retail payments since it first entered the field. In doing so, I
hope to bring out some key principles that have been consistently applied and which remain
part of the ongoing policy framework.
The Reserve Bank's role as a regulator of retail payments systems was established following
the report of the Wallis Inquiry in 1997. Like Murray, the Wallis Inquiry was about more than
just payments. It was about the financial system as a whole, and Wallis took a holistic
approach to understanding the role of payments within the wider system.
I suggest there were four key observations that determined the overall shape of the Wallis
recommendations.
First, Wallis observed that the business model of traditional banking was fundamentally
changing. In simplified terms, banks could be thought of as suppliers of a portfolio of
products, the three main ones being deposits, loans and transaction services. In the earlier
highly regulated world, these were bound together in full-service banking institutions. Credit
was heavily rationed and potential borrowers needed to demonstrate loyalty to a bank in
order to qualify for loans. This environment tended to produce outcomes where net interest
margins were high, customers were immobile and banks cross-subsidised payment services
effectively as a utility.
This model broke down over time because of the combined effects of deregulation and
financial innovation. These forces enabled new players to compete separately for the most
profitable business lines. Examples were cash management trusts on the deposit side, which
enabled depositors to gain access to wholesale interest rates, and mortgage securitisers on
the lending side, which competed separately for lending business at lower margins. This was
the phenomenon of "unbundling". It meant that cross subsidies were competed away and the
different components of banking services had to be separately priced, including payments.
One of the manifestations of this, noted by Wallis, was the increased incidence of highly
unpopular transaction fees for bank accounts. But of course the implications were much
broader than that and are still being seen across the financial system today.
Second, Wallis noted the importance of technology and innovation. Today, at a conference
like this, it is impossible not to be struck by the pace of change in payments technology. Of
course, the specifics of that couldn't have been foreseen 18 years ago when Wallis
presented his report. What the report did foresee was the general tendency for the system to
innovate and the associated trends towards electronic and card-based payments, away from
traditional instruments like cash and cheques. Again, this is a process that is continuing
today.
Third, and related to the first two points, Wallis foresaw the growth of payment systems as a
business, in contrast to the utility-based model that I described earlier. If commercial realities
were leading to the unbundling of payments from other financial services, then it was to be
expected that this business would open up to innovative and specialist providers. It also
meant that existing players would need to put their own payments services on a more
commercial footing.
And lastly, Wallis looked at the regulatory implications of these developments. Payments
systems are networks which link service providers and their customers. That means that they
need to have ways of ensuring adequate coordination among network members who would
normally be competitors. This in turn raises a whole suite of questions as to whether
particular network arrangements are generating efficient outcomes: for example, is there
appropriate access to networks for new players, are network pricing arrangements efficient
and are there effective coordination mechanisms to promote network innovation?
Wallis concluded that there was a need for regulatory oversight of payment systems, and the
recommendations that flowed from that formed the basis for the arrangements we have
today.
To summarise the main elements, Wallis recommended that:
• the Reserve Bank be given powers as payments regulator;
• those powers should be vested in a separate board with a majority of independent
directors (the Payments System Board);
• the mandate of that board should be to promote efficiency, stability and competition
in payments systems; and
• as a starting point, the PSB should look at credit card schemes, with particular focus
on access arrangements, pricing and scheme rules.
Wallis also recommended that the PSB maintain a more general watching brief on the
efficiency of the system as a whole.
Looking back on the work of the PSB since that time, it has very much followed the original
Wallis outline and philosophy. Early work of the PSB focused on credit card systems, leading
to a package of reforms in 2003. This was followed by reforms to debit card systems in 2006
and to the ATM network in 2009.
In implementing the Wallis recommendations, the government's intention was that the policy
approach should be co-regulatory. The explanatory memorandum to the law which set up the
PSB's powers in 1998 stated that:
The philosophy of the Bill ... is co-regulatory. Industry will continue to operate by
self-regulation in so far as such regulation promotes an efficient, competitive and
stable payments system. Where the RBA considers it in the public interest to
intervene, the Bill empowers it to designate a payment system and develop
access regimes and standards in close consultation with industry and other
interested parties.1
The approach taken by the PSB since its inception has been consistent with that intent. The
PSB directly regulates only five payment systems (namely ATMs, eftpos, MasterCard and
Visa credit, and Visa Debit) and only in limited areas - that is, the level of interchange fees,
restrictions on merchants, transparency and access. In contrast to the more interventionist
approach of some other jurisdictions, the Australian framework leaves many aspects of the
payments system unregulated.
This philosophical approach has also very much guided the PSB's work on payments
innovation.
I have already mentioned the industry's enormous capacity to innovate. In talking about this
subject, however, it is important to distinguish between proprietary innovations, which are
carried out at the level of particular payment businesses, and network innovation, which
occurs at the level of the system as a whole. As you would expect, the industry is very good
at innovation in the proprietary space. Among the many examples of this are cardless ATM
withdrawals, new authentication techniques such as fingerprint, mobile banking and payment
apps and now digital wallets. These are areas where the incentives to innovate are clearly
effective.
But it is well recognised that efficient innovations can be more difficult to achieve at the level
of the system as a whole, because the available incentives do not necessarily support
coordinated action. Consistent with the Wallis vision, the PSB has been active in promoting
coordinated industry solutions where that was in the public interest. An early example was in
encouraging faster cheque clearing - an obvious improvement in system efficiency but one
that couldn't have been achieved without effective coordination.
On a larger scale, the PSB more recently undertook its Strategic Review of Innovation in the
Payments System, the results of which were published in 2012.2 That review was conducted
over a two year period and involved extensive consultations with both the payments industry
and with users of payments services. It found a number of areas where there was scope for
system improvements that could be achieved through coordinated action.
The key areas were:
• same-day settlement of direct entry transactions;
• faster payments and out-of-hours payments to be made generally available;
• capacity for richer information with payments; and
• an easy addressing solution for electronic payments.
The first one of these was delivered at the end of 2013 and essentially involved an
acceleration of existing direct entry processes. The remaining three form a more ambitious
agenda and are together being taken up as part of the industry's New Payments Platform
(the NPP project).
The NPP is a successful example of what can be done through collaboration between the
industry and its regulator. It is also a good example of the catalyst role for the PSB in
promoting system innovation that was envisaged by Wallis. While it is an industry-led project,
it is strongly supported by the PSB, and the Board continues to encourage commitment to
the project and to its timely completion.
The project was launched in early 2013 and is now well advanced. On current scheduling the
NPP will deliver a fast payments service with rich information and addressing capabilities in
the second half of 2017. It will be linked to a fast settlement service provided by the Reserve
Bank, which will allow transactions to be cleared and settled 24/7 in close to real time. All of
this will amount to a world-class payments infrastructure.
It will also be a platform for further innovation. One of the key decisions made at an early
stage of the project was to separate the basic clearing and settlement infrastructure from the
commercially based overlay services that would use it. The industry is committed to an initial
overlay that is intended to provide an attractive service and drive early volume growth. But it
is important to note that access to the overlay space has always been intended to be open
and competitive. Over time, this structure will allow new and specialist providers to make use
of the rich capabilities provided by the core infrastructure.
Before moving on to some more detailed regulatory matters, I will mention one more initiative
to have come out the 2012 Strategic Review, and that is the establishment of new industry
coordination and consultation arrangements. In line with a recommendation from the 2012
Review, a new industry coordination body, the Australian Payments Council, was launched
last year. The Council is a high-level body representing a diverse range of industry
participants including banks, payment schemes and other service providers. It will have the
capacity to give strategic direction to the industry as well as engaging in dialogue with the
PSB. At the same time, it is important that the policy process engages with users and not just
suppliers of payment services. To facilitate that, the Reserve Bank has also set up a
Payments User Consultation Group which began meeting late last year.
In summary then, the policy work of the PSB has been very much consistent with the
philosophy and objectives of the original Wallis reforms. A good deal of that work has been
what might be termed "co-regulatory" in nature, in the sense that it involved promoting
industry-led solutions rather than using formal regulatory powers.
But of course the PSB does have a regulatory mandate, and it has used its powers to
regulate a number of aspects of card payments where it judged that there was a public
interest case to do so. Probably the aspects of this regulation that have attracted the most
attention have been those related to interchange and surcharging, and I would like to make
some general comments about each of these.
First, interchange. The commercial function of interchange fees is a very interesting one.
They serve as a device for shifting the benefit-cost balance between issuers and acquirers in
a four-party scheme and therefore, indirectly, between cardholders and merchants. Payment
schemes argue that this can be an important competitive device that can promote innovation,
for example by being structured to encourage network growth or the take-up of new
products. Typically, interchange flows from the acquirer to the issuer, and hence the fee
structure tends to encourage issuance and use of a card, but may discourage acceptance by
merchants if the fee is too high. For mature schemes, however, the capacity of merchants to
refuse acceptance may be quite limited. As a result, it has been frequently observed that
competition between schemes can have the effect of pushing fees up rather than down, in
order to maximise incentives to issuers and cardholders.
The reason that this kind of outcome is possible is that there is a misalignment between the
incidence of these fees and the structure of decision-making power in a typical transaction. In
a nutshell, the cardholder chooses the payment instrument but the merchant pays the fee.
In designing its card payment reforms, both for credit and debit, the PSB concluded that
competition of this nature was distorting price signals in a way that inefficiently encouraged
the use of high cost cards and added to merchant costs. Hence, it judged that there was a
case for interchange fees to be capped by regulation. A number of other jurisdictions have
since taken a similar view.
The second aspect that I want to talk about is surcharging. The PSB has consistently taken
the view that merchants should not be prevented from surcharging for higher-cost payment
methods. Scheme rules that prohibited surcharging had the effect of reinforcing the distortive
effects of interchange fees by preventing costs from being passed on to cardholders. They
also reduced the flexibility of merchants in deciding how to respond to high-cost payment
instruments. The ability to surcharge improves merchants' bargaining position by allowing
them a greater range of responses, rather than just being faced with a binary decision to
accept or reject a particular card.
Efficient surcharging should of course reflect the underlying payment cost. The PSB's initial
reforms to credit and debit gave merchants the right to surcharge, while effectively relying on
competition to ensure that surcharging would not be excessive. This regulation was revised
in 2013 in response to concerns about practices that had developed since the initial reforms,
particularly about surcharging that appeared excessive or unrelated to costs. The amended
regulation still prevents schemes from imposing no-surcharge rules, but it allows them to limit
surcharging to the reasonable cost of acceptance. In doing so it strikes a balance, at least in
principle, between the rights of merchants and schemes. Merchants cannot be prevented
from recovering reasonable acceptance costs, but they can be prevented by scheme rules
from going beyond that. More on that in a moment.
The PSB's reforms to surcharging and interchange have formed part of a broader package
that also included rules relating to access and transparency. I don't have time to cover all of
that today. But taken together, the effects have been beneficial. The system has continued to
innovate, and merchants' card payment costs have fallen.3 It is also notable that these costs
are significantly lower in Australia than in a jurisdiction like the United States, where reforms
to card systems have been much more limited.4
The Murray Report last year broadly endorsed the PSB's reform approach while flagging a
number of areas for further consideration, particularly in relation to surcharging and
interchange. These have now been taken up as part of the PSB's card payments review.
The issue of surcharging remains contentious. Instances of apparently excessive
surcharging have persisted. While they acknowledge arguments for what might be called a
"no excessive surcharge" regime, the schemes have argued that the current formulation is
too complicated and difficult for them to enforce.
The card payments review is looking at several possible mechanisms for addressing this.
One option proposed by Murray is a tiered approach that would allow tougher surcharging
constraints to be placed on low-cost cards. A number of other options are available to
strengthen enforcement and disclosure practices, for example allowing schemes to cap
surcharges that are not percentage based at some low fixed amount.
On interchange fee regulation there are a number of issues to consider. These include the
overall level of the interchange cap, the complexity and proliferation of interchange
categories, the phenomenon of interchange "drift" with the three-year compliance cycle, and
the wide disparity between interchange rates for preferred merchants and those applying to
others.
While it broadly endorsed the PSB's regulatory approach to date, the Murray Report
recommended that consideration be given to tightening existing interchange regulations in
some significant respects. These included lowering the overall interchange cap, and
broadening its coverage to include other incentive payments that serve a similar function. It
argued that this would help to prevent circumvention and, in the case of companion card
arrangements, would improve competitive neutrality.
All of these things are now being carefully considered. As I said at the outset, the review
process is still underway and I won't pre-empt any possible conclusions. Reserve Bank staff
have already consulted extensively with interested parties, and I expect there will be more of
that to come in response to the submissions received. I take the opportunity to thank industry
participants for your constructive engagement, not just in this review but in the wider agenda
of promoting a more efficient and innovative payments industry.