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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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For example, interchange fees for ATM transactions are typically paid by the issuer to the acquirer and is a fixed amount irrespective of the amount of withdrawal; interchange fees for transactions at merchants are paid by the acquirer to the issuer and is usually a percentage of the transaction amount; interchange fee for Internet transactions are higher than interchange for point of sale transactions; interchange fees for transactions authenticated using PIN are lower than transactions conducted without PIN, and so forth.

create the right incentives for the parties to maximize the volume and value of transactions processed through the payment network. The level of the interchange fee is very relevant because, among other aspects, it sets a floor for the fees charged by card acquirers to merchants (i.e. merchant service fee). If the merchants feel that the processing costs are too high, possibly because of the higher interchange fees, then the number of card acceptance points will not develop as fast as it would be desirable.

Conversely, if the interchange fees were too low, then the issuers would need to suitably adjust the fees charged and incentives provided to cardholders.

The so-called Honor All Cards (HAC) rule enforced by most payment networks typically requires the acquirers to ensure that their merchants accept all the cards affiliated with the payment network. The affiliation of a card to a payment network is typically visually represented by a logo of the payment network placed on the face or obverse of a card.

In some jurisdictions, a distinction is made between accepting all types of cards affiliated with a payment network and all cards of a particular type affiliated with the payment network, irrespective of the issuer. This rule very clearly enables greater utilization of the payment network by enabling introduction of new types of cards. However, there are drawbacks to this rule, which are discussed subsequently.

The No Surcharge Policy (NSP) is another of the contentious aspects. This rule typically enforced by payment networks requires the acquirer to ensure that the merchant does not surcharge, (i.e. add an additional fee) for payments made with a card.74 Merchants, merchant associations and lobbyists have long argued that the combination of interchange fees, the HAC rule and the NSR rule is anti-competitive. They argue that, taken together, this troika of rules forces the merchant to accept all payment instruments at par, and either absorb the extra costs or pass them on equally to all payers in the economy, amounting to a cross-subsidy for payers using payment cards.

This situation restricts competition amongst payment instruments and also places the merchants at a disadvantageous position.

The contentiousness of the HAC and NSP rules stems from the merchants‘ reluctance to accept certain types of cards, typically those that bear higher interchange fees, which is believed to directly reflect in a higher merchant service fee charged by the acquirer to the merchant. The HAC and NSP rules force the merchant to absorb the higher costs, as these rules require them to accept all cards and not disincentivize usage of specific cards by giving a discount for payment with another card or another form of payment.

Some researchers have also argued that the HAC and NSP rules result in obfuscating the price signals and help in promoting payment behaviors which benefit only issuers of In some jurisdiction, for example in the United States, merchants are however allowed by law to offer a discount for cash payments.

payment cards and card networks.75 They argue that the dismantling of HAC and NSP rules would therefore allow the merchants to provide the right pricing signals related to the processing costs of the payment instrument and thereby encourage a shift to more efficient payment instruments and lower interchange payment cards like debit cards.

It is however unclear whether the merchants would necessarily reflect the processing costs correctly in the surcharges. Card networks, issuers, and other entities argue that the merchants might not necessarily set the surcharges on a cost-recovery basis, and could in fact profit from surcharges. There is insufficient research to show how surcharges behave in the long-term. Also, given the large number of merchants, it could be difficult to enforce and monitor the surcharge levels.

The regulatory action thus far, has been widely divergent and has been guided by different public policy goals.76 Some of the actions have been focused exclusively on one of these three aspects, though in some recent cases all three aspects have been focused upon together (see Box 6).77 Box 8: Durbin Amendment – The Dodd-Frank Wall Street Reform § and Consumer Protection Act The Durbin amendment, as it is called, targeted all the three areas—HAC, NSP and interchange

fees rules —in the United States market. Some of the most relevant provisions are the following:

1. The Federal Reserve is to ensure that the interchange fees for debit cards be ―reasonable and proportional.‖

2. The debit cards and prepaid cards used for Government benefit programs and also debit cards issued by banks with assets lower than $10 billion are exempt from the interchange fee limitations.

3. The Act allows merchants to offer discounts for payments for specific cards, cash, or other forms of payments, provided there is no discrimination by issuer or brand.





4. The Act allows merchants to set a floor of below $10, under which credit cards acceptance can be denied.

5. The Act allows merchants to route transactions over a payment network of their choice, by requiring the payment networks to not impose specific routing requirement.

§ Note: Further details are available at the Federal Reserve Board‘s website: www.federalreserve.gov In countries with underdeveloped payment cards markets, the HAC and NSP rules could play a positive role and help in creating an enabling environment for faster introduction of payment cards.

Leinonen 2009.

For a snapshot of all the recent regulatory actions and a scan of the research on these topics, refer to Chakravorti 2009 and The World Bank 2008(a).

The Australian experience with reforms on HAC, NSP and interchange fees rules is also presented in Annex 4.

EFT products specific topics Interchange as an issue applies to EFT-based products as well. However, it has not been that controversial since the interchange fees involved are smaller, and also they do not involve external entities like merchants. However, interchange fees have been found to impact choice of the EFT-based products versus other products like cheques which do not have the same interchange structure.

Innovative products specific topics As mentioned earlier, most innovative products involve use of agents or a closed network of acceptance points. In many of these cases, exclusive arrangements are created for these tie-ups, thereby blocking an agent/acceptance point of one innovative product being able to accept another innovative product. In addition, given that many of the issuers of innovative payment products are not banking entities, they typically lack access to traditional clearing and settlement infrastructure. This could directly impact interoperability of innovative payment products with traditional payment products.

Possible Actions The World Bank study: ―Balancing Cooperation and Competition in Retail Payment Systems‖ recommended a number of guidelines (see Box 9). These have also been synthesized below.

Central banks and other authorities should determine their policy objectives with regard to competition in the market for retail payments, and make them transparent to stakeholders: Policy making is complex due to the institutional fragmentation of relevant policy makers as well as by the different—and sometimes overlapping—scope of their mandates. An ex ante and transparent determination of policy objectives clarifies different actors‘ roles and avoids mistrust in the development and operation of the infrastructure. This is especially important if the public sector is one of the infrastructure providers. Interventions should be closely related to the public policy objective(s) being pursued and upon evidence of perceived market failure. For example, in the presence of a sufficient number of service providers and lack of interoperability, efficiency might be a primary objective to be pursued. On the other hand, insufficient access to and excessive cost of payment services, coupled with an insufficient degree of innovation, might be a call for more competition, including networks and clearing arrangements.

Central banks should include the monitoring of aspects related to anti-competitive behavior as part of their oversight function: As earlier discussed, such practices include exclusive arrangements, unjustified denial of access to infrastructure, and unfair pricing mechanisms for infrastructure participants, among others. Although, the actual investigation and any regulatory actions on these aspects might be the responsibility of other specific authorities, including the same as part of a central bank‘s oversight activities would help in identifying such instances faster, and the central bank would be able to provide specialized feedback to such other authorities. Rules prohibiting certain anti-competitive behaviors could also be included as a condition in the licensing of payment system operators (i.e. license could be withdrawn in case of violation).

Central banks should also use their oversight function to balance other cooperation and competition issues: Identifying the socially optimal level of interchange fees and other interbank fees is a very difficult task, since competition at three different levels needs to be considered (across payment instruments, across platforms, across service providers of the same platform) and, also, the different nature of payment instruments (e.g., credit cards providing a payment and a credit service). In some cases, regulators may opt for a moral suasion approach to encourage stakeholders to evaluate their pricing policies and schemes in light of the public policy goal of achieving a socially optimal usage of payment instruments. In this regard, preparing and presenting detailed information on the direct and indirect savings and revenues associated with migration of customers from cash and cheques to electronic payment instruments can be an effective persuasive tool.

Institutional mechanisms to promote cooperation and information sharing are essential:

Sometimes authorities have already established cooperative arrangements but normally with a narrow scope that has to be broadened. In other cases these arrangements are inexistent and need to be established. In particular, it is essential to count with a good cooperative framework between the overseer and the anti-trust agencies that rule against uncompetitive behavior.

Box 9: Guidelines for Balancing Co-operation and Competition in Retail Payment Systems Guideline 1. Market complexities need to be recognized and analyzed in detail before any action is decided and implemented.

• Environmental, legal and legacy factors are important issues shaping the evolution of retail systems.

• Governance of the infrastructure has a significant impact on cooperation and competition.

Ensuring neutrality, objectivity and contestability normally requires a closer public scrutiny.

• Gaining access to messaging, clearing, and settlement services is of capital importance for the ultimate success of new entrants in the market. Players with a dominant position in one infrastructure may have the incentive to create barriers for access to new entrants. The authorities‘ analysis should go beyond traditional payment system providers (e.g., banks) and consider the role of new players (e.g., non-financial sector providers) and new instruments (e.g., mobile payments).

• Pricing of some retail payment systems are subject to network economies (e.g., two-sided markets) and traditional cost structures are not appropriate to analyze these markets as pricing structures matter. Interchange fees (e.g., cards markets) and interbank fees (e.g., ACH markets) are mechanisms to balance different interests in payment networks but can also be advantageously used by dominant infrastructure players. In order to determine a socially optimum level, competition at three different levels needs to be considered (across payment instruments, across platforms, across service providers of the same platform) and, also, the different nature of payment instruments (e.g., credit cards providing a payment and a credit service).

Guideline 2. Policy trade-offs are relevant in this domain. Therefore, policy priorities will have to be determined and the type of public intervention should depend on the main public objective(s) pursued.

• Public policy objectives in retail payments are multiple and none of them is in principle more important than the other. They include efficiency, safety, reliability, competition, access, and consumer protection. These objectives might need to be reconciled and prioritized, also taking into consideration the policy goals of other segments of the National Payments System (e.g. the need for a safe centralized system for the settlement of large value transactions).

• The justification for intervention depends upon the main public policy objective(s) pursued and upon evidence of perceived market failure. For example, in presence of a sufficient number of service providers and lack of interoperability, efficiency might well be the primary objective to be pursued. On the other hand, the insufficient access to and excessive cost of payment services, coupled with an insufficient degree of innovation, might be a call for more competition, including networks and clearing arrangements.

• An ex-ante and transparent determination of policy objectives clarifies different actors‘ roles and avoids mistrust in the development and operation of the infrastructure. This is especially important if the public sector is one of the infrastructure providers.

• Market transparency is key to promote competition and dispel mistrust among market players.

• Any policy solution should be considered in a dynamic rather than static context as these markets are constantly changing.



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