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«July 2012 THE WORLD BANK Acknowledgements The preparation of this paper was led by the Financial Inclusion Practice of the World Bank. Lead author is ...»

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Possible Actions Determine the existing gaps with regard to the legal and regulatory framework. This should be a cooperative effort between the central banks, other authorities, and market participants to ensure all views and different expertise are taken into account. Moreover, it should not be a one-time effort but rather a recurrent one to ensure that the legal and regulatory framework keeps pace with new developments.

In cases where most of the key provisions do not exist at the law level, consider developing an overarching law (i.e. a ―Payment Systems Law‖) that addresses as many such issues as possible.

The law should vest the central bank with adequate powers to regulate and oversee retail payments: This empowerment should be broad enough to allow the central bank to issue regulations and guidelines to rapidly react to specific situations without necessarily having to amend laws. Moreover, it should allow the central bank to propose new regulations and other types of measures in areas that are not directly under its jurisdiction.

The central bank should ensure that payment system operators and payment service providers develop a sound set of system rules and procedures, and that these be revised periodically for any required updating.

Guideline IV: Competitive market conditions should be fostered in the retail payments industry, with an appropriate balance between cooperation and competition.

Description The following key issues need to be analyzed in detail to determine whether any given market for retail payments operates under competitive conditions:64 Environmental, legal and legacy issues

The market for retail payments services is characterized by:

 Economies of scale in messaging, clearing, and settlement services due to the fixed costs of the infrastructure;

 Economies of scope in clearing and settlement as well as in messaging services due to technology flexibility; and,  Network externalities in messaging, clearing, and settlement services produced by complementarities of users and/or products and compatibility of products.

This discussion is based on the analysis presented in World Bank document ―Balancing Cooperation and Competition in Retail Payment Systems: Lesson from Latin America Case Studies‖, Washington, 2008(a).

These characteristics have resulted in natural monopoly features that cause a high concentration of payment platforms, sometimes due to vertical or horizontal integration in financial infrastructures.65 Whether this is a positive or negative result is unclear— there is not a definitive answer. Effective cooperation may exploit economies of scale and scope and network externalities in a cost-efficient way, and is likewise crucial for setting standards that will secure compatibility between the various products. However, centrally agreed upon common features can sometimes hamper product and/or service differentiation and innovation at the individual service provider level.

Retail payment markets are also influenced by a number of dynamics. Some of these are specific to the end users, some are specific to the platforms (networks), and some

depend on the intermediaries:

 Switching Costs—at the platform level (for platform participants), at the crossproduct level (among payment instruments) and within the same type of product.

Switching costs may prevent the adoption of better technologies and social optimization.

 Path Dependence as the legacy of previous technology developments, often determined by transient conditions, does typically influence later choices and outcomes, thus, restricting investment decisions that may negatively affect innovation and adoption of more efficient technologies.

 Tipping points as there is a tendency for one system to end up as the dominant one (payment card systems are an exception). Since the network externalities dictate higher utility for each participant by adding more participants, the participants‘ individual and group utility can be raised if everybody participates in one single network, and if there are no significant capacity limitations that can give rise to serious congestion effects.

 Multihoming and stickiness. In most cases, both sides in a payments market use several platforms, i.e. they multihome. Consumers have more than one type of payment instrument, and merchants accept several types of instruments. This multihoming also takes place within one type of instrument (e.g., credit cards).

Often, however, the consumers favor one card over another, i.e. their usage is sticky.

Public ownership of retail payments infrastructure is another factor that may impact competition. In response to coordination problems or due to legacy reasons, the central bank may be the owner and operator of one or more retail payments infrastructures. 66 Under certain circumstances, for example inadequate pricing or overly restrictive criteria See Bustos and Galetovic, U of Chile, 2003, Tapking and Yang, ECB, 2004 and Lai, Chande and O‘Connor, Bank of Canada, 2006.

The Global Payment Systems 2010 showed that 51 percent of check clearing houses and 40 percent of ACH‘s were operated by the respective national central bank. Also, around 20 percent of the payment card switches were either operated by the central bank or other governmental bodies.

for participation in the system, such public ownership of retail payments infrastructure may skew the pricing signals and market structure.

The legal and regulatory environment may also establish barriers to competition. For example, in some countries the legal framework directly prohibits non-banking entities from providing any type of retail payment services, even those not directly linked to a bank current account. In other cases, a similar effect is achieved through regulations that limit the provision of central bank account services to banks. In such situations, if a retail system settles its final positions in central bank money, then direct participation in that system by non-banks may not be feasible in practice.

Access to the relevant infrastructure and limitations to interoperability Gaining access to messaging, clearing, and settlement services is of capital importance for the ultimate success of new entrants in the market. In the absence of appropriate governance arrangements, participants with a dominant position in a payments infrastructure may establish strategic barriers to prevent new entrants to the system.67 These barriers could be explicit or implicit in terms of higher pricing terms and access requirements.68 Players with a dominant position in an infrastructure can alternatively block access to it for the customers of other issuers of the same payment instrument. This situation is known as lack of cross-platform interoperability, and is an important element that hinders greater competition and efficiency in the marketplace by impeding lowering of processing costs, duplication of infrastructure, and service providers focusing on competing through larger investments in infrastructure rather than by offering better products and services to their customers. While lack of cross-platform interoperability is usually associated with some payment card systems, it can also be observed for EFTbased products, for example co-existence of two or more ACHs for the same payment instruments that offer the same or very similar services to their respective participants.69 There is also the case of infrastructure-level interoperability, whereby the same infrastructure can be used to support multiple payment mechanisms. This is especially relevant for innovative payment products, since without some basic interoperability with more traditional payment instruments and systems their acceptance and/or usefulness for consumers might be very limited.70 Guideline V deals with governance issues for retail payment systems.

On the other hand, as earlier discussed, the operator of the payment infrastructure often establishes an access policy to ensure adherence to specific rules and also as a risk management measure to ensure overall safety and stability of the infrastructure being operated.

In the Global Payment Systems Survey 2010, only 57 percent of the central banks reported that the payment cards system in their country was fully interoperable for ATM transactions, and an even lower number of 45 percent for POS transactions.

For the Global Payment Systems Survey 2010, 61 percent of the innovative products/product groups reported were proprietary with no interoperability, and only 30 percent had some form of linkage with traditional retail payment instruments and systems.

However, in the case of innovative payment products, requiring cross-platform interoperability when the individual platforms are not that well developed could be onerous Pricing of payment systems infrastructure services Pricing and fee patterns for accessing the infrastructure supporting retail payments have an impact on the industry structure and competition. The pricing structure for accessing

a retail payments system is often a complex structure involving:

 Joining fees—often determined based on size of the participant, projected transaction volumes, membership type (e.g. direct or indirect), and other similar factors.;

 Membership fees—often collected periodically based on transaction volumes and other non-usage based parameters;

 Per-transaction fees—typically collected more frequently and directly linked to usage levels, with tiered pricing in many systems;

 Contributions to various funds like settlement guarantee funds, marketing funds and so forth; and,  Exception fees—linked to occurrence of certain events such as, for example, settlement delays, termination of membership, and other similar events.

This complex structure of fees is typically set to arrive at an equitable sharing of investment costs and proportional allocation of marginal costs, with an inbuilt revenue generation. The complexity of the fee structure can have a series of effects on network participation and development; it can, for example: even out average participation costs between small-volume and large-volume participants, and thus encourage more direct participation; enable the incumbents to misuse pricing structures to discourage new entrants; and support or discourage innovation in technology and services by affecting the pattern and rate of accumulation of system development funds.71 As previously discussed, public ownership of retail payments infrastructure may skew the pricing signals, and as a result affect market structure and competition. For example, the pricing structure may reflect a lack of urgency to recoup the investment costs and generate adequate returns. This could hamper both innovation and infrastructure modernization, as well as become unfair competition for other similar infrastructures owned by the private sector.

There are also positive effects to non-linear pricing schemes in network industries. See Rochet and others such as Chakavorti on (two-sided) network pricing. Also unpublished memos by McAndrews (Federal Reserve Bank of New York), Angelini (Banca d‘Italia), Green (Pennsylvania State University), O‘Connor (Bank of Canada).

However, it needs to be noted that even with public ownership the pricing structure can be set in a way that it does not impact competitiveness of private ventures.72 It should however be borne in mind that pricing models in payment services, as in many other industries, need not necessarily be cost-based pricing. Use of electronic payments

brings about a range of benefits to various stakeholders:

 Payee: benefits range from reduced operational expenses to increase in sales arising from customers not being limited by the cash in their person and in the case of credit cards even enhancing the payers ability to pay;

 Payers: more convenience;

 Issuers of payment instruments: lower operational expenses; and  Government: operational efficiencies through automated funds, accounting and records management systems and also increased financial intermediation.

Each of these stakeholders also experience a particular set of constraints and legacy inertia factors that impact adoption of electronic payments. This gives rise to various pricing models designed to build in incentives to increase adoption of electronic payments, some of which do not necessarily result in exact apportionment of costs incurred. One such model is that involving interchange fees in card payments. In any case, each of the entities involved in the electronic payments value chain needs to be better off with using the electronic payment instrument instead of cash. If this does not happen, the usage of the electronic payment instrument would not be sustainable.

Payment cards specific topics The pricing structure and specific program rules in card payments have for long been argued to be anti-competitive. These issues are discussed in detail below.

Interchange fees are arguably the most discussed of these aspects. Interchange fees are payments between issuers and acquirers. Their direction and amount is typically a function of the type of transaction, type of card being used, type of merchant accepting the card, channel through which the transaction is being conducted, whether the transaction is domestic or international, the authentication mechanism73 used, and in some cases the amount of transaction. Interchange fees are typically set by the payment network, and enforced uniformly for all similar type of transactions processed through that network. Interchange fees are, in general, meant to balance the interests of the parties involved in a transaction: merchants, acquirer, issuer, and cardholder, and to In the United States, for example, the Reserve Banks operating ACHs follow a pricing policy that requires them to ensure full recovery of all costs and inclusion of a private sector adjustment factor to reflect the cost structure of a private operator. This enables the three private sector ACHs to compete with the ACH services provided by the Reserve banks. For additional information see Oliver and Weiner 2009.

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