competition amongst the schemes has seen fees increase from under 1. 3 per cent in 1994 to 1. 65 per cent today – a perverse outcome to anyone with an economics background who expects competition to lower prices. i might add that this is three times the average level of interchange fees in australia following the reserve bank's reforms in 2003. graph 1 of course the increase in us interchange fees has to be paid for by somebody. and, in the first instance, that somebody is the merchant, since interchange fees are built into the merchant service fee ( what the merchant's bank charges it for processing credit card transactions ). not surprisingly, average merchant service fees have increased broadly in line with the increase in interchange fees since the mid 1990s. the end result is that merchants have to bear the extra costs of the competition between the credit card schemes. but, of course, the story does not stop here. ultimately, higher merchant costs flow through into higher prices for the customers of those merchants. this is a cost borne by all consumers whether they use a credit card or not. competition between debit card schemes there is a similar story in the competition between two types of debit card systems in the united states. in one system, operated mainly as regional networks, transactions are authorised by pin ( the pin - based systems ), while in the other, operated by visa and mastercard, transactions are authorised by signature ( the scheme - based systems ). the interchange fee paid by the merchant's bank to issuing banks is much higher in the schemebased systems than the pin - based systems ( graph 2 ). as a result, issuing banks have been switching to the scheme - based systems and their share of the market has increased from 45 per cent to 60 per cent over the past decade ( graph 2 ). the pin - based schemes have retaliated to some extent, and their interchange fees have more than doubled over the decade, although they are still well below the scheme - based systems'interchange fees. once again, interchange fees have encouraged the growth of the relatively expensive payments system at the expense of the lower - cost system, and forced the lower - cost scheme to raise the price that is charged to merchants. graph 2 there is an interesting additional twist to this story, and it concerns the question of why the merchants of america allowed this to happen? why didn't they resist more strongly the inroads into their profits caused by the expansion of the expensive system? partly, of

i j macfarlane : gresham ’ s law of payments talk by mr i j macfarlane, governor of the reserve bank of australia, to the aibf industry forum 2005, sydney, 23 march 2005. * * * i suppose i should start by explaining why i have chosen this title for my talk today. gresham's law is usually stated simply as'the bad currency drives out the good'and it refers to a time when all transactions used coins. if you had to buy one pound's worth of merchandise and you had two coins – one which you knew contained one pound's worth of gold and another where some of the gold had been shaved off – you would pass the second coin and keep the first one. in that way, most of the transactions would take place using the inferior transaction medium and the superior one would play a minor role. note that this can occur only if both the inferior and superior transaction medium were accepted at the same price, or in modern parlance, the price signals were not getting through to the users. having introduced this quaint historical economic law, i would now like to put it aside for a moment and move on to the main subject of my talk today, which is the regulation of the retail payments system. as you are probably aware, the payments system board of the reserve bank, of which i am the chairman, is charged by an act of parliament with responsibility for the efficiency, competition and safety of the payments system. this is quite a daunting task, and has involved us in an enormous amount of research and consultation on payments system issues, some controversy with payments system providers and, to a lesser extent, with some payments system users. most of us at the reserve bank come from a background in economics and hence have a predisposition in favour of free markets and a sceptical attitude towards intervention in those markets unless there is a clearly defined economic rationale for it. after much analysis and discussion, we came to the view some time ago that there was, in fact, an overwhelming case for regulation of some parts of this market, and that competition, such as it was, would not lead to an optimal outcome in terms of the public benefit. in my remarks this afternoon i would like to set out why this is so and, in the process, i hope it will become clear why i introduced this talk by referring to sir thomas gresham and his famous law. there are five basic ways of making