Interchange Fees

Our position on the regulation of interchange fees is discussed in full below

What are interchange fees?
What does interchange pay for?
The Australian experience
The Retailer arguments
The European Commission arguments
Who benefits from cards?
Our recommendation

What are interchange fees?

Interchange fees are paid between banks when consumers make a payment using a credit or debit card.

They are a way of correcting the imbalance in costs incurred by each party in a four-party card payment, system such as MasterCard or Visa, in order to optimise the payments network to the benefit of all.

With 142 million credit and debit cards in issue in the UK compared to just over a million point-of-sale terminals, being part of a payment scheme is typically more expensive for card issuing banks than for banks providing services to retailers.

For every transaction, a small payment is made by the retailer’s bank (the merchant acquirer) to the consumer’s bank (the card issuer) to compensate the latter for their higher costs. The exact fee paid between banks depends on the type of card being used and the type of transaction being conducted.

Four-party card payment models have served the UK economy well, helping to promote a strong, innovative and competitive industry and encouraging as many merchants, consumers and banks as possible to participate

What does interchange pay for?

This can differ between card schemes, but in general covers:

The payment guarantee covering both fraud and credit losses (given that the retailer receives their monies from their bank long before the cardholder has to pay their bank)
Funding the interest-free period (the period between when a cardholder spends on their account and when they pay their credit card balance)
Security & fraud prevention (e.g. authorisations; hot card files etc.)
Processing costs
Innovation, such as chip & PIN

The Australian experience

In 2002 The Reserve Bank of Australia (RBA) decided to intervene to cap [Visa and MasterCard] interchange fees for banks operating in its domestic market. In 2008 the effects of this decision can clearly be seen in Australia’s card payments market. Consumers have seen:

Increased annual fees
The introduction or increase of other fees
Loyalty schemes are now less generous
Fewer innovations. Regulation has held back innovations like the roll-out of chip &PIN.
Market distortion. There has been a small distortion in market shares in favour of American Express and Diners Club (“three-party” models, where they act as both the merchant acquirer and the card issuer).
People paying by card don't pay less. Despite claims by retailers, there is no evidence that they have passed on savings (from a reduction in interchange fees) to consumers in the form of lower retail prices.

Although there are some differences between the UK and Australian markets (e.g. annual fees for cardholders are more prevalent in Australia) it is more than likely that similar impacts would arise here.

Australia also tends to have a less competitive market. It does not have mono-line credit card issuers such as MBNA, Capital One, Egg and Citibank who have brought sustained price competition to the UK market.

There is an argument that such issuers will be more susceptible to changes in interchange fees as they constitute a larger proportion of their cost covering income. One outcome in the UK, not seen in Australia, could be the consolidation of issuers through mergers and acquisitions, leading to reduced competition.

On 21 April 2008, the RBA issued a media release announcing its preliminary conclusions of the 2007/08 review of the payments system reforms, as undertaken by the Payments System Board. The RBA is now seeking submissions on these conclusions, before finalising the review later in the year.

The European Commission arguments

The Commission uses a number of arguments to justify its recent actions against MasterCard, most importantly claiming to be acting in consumers’ best interests. We believe that these arguments are flawed, or at least disputable:

Their argument	Our Response
“Our decisive action will … help to achieve better card payment services for a better price for consumers and businesses alike,” and, “If [card schemes’] operated without a multilateral interchange fee, merchants would pay lower prices for accepting cards and, as a consequence, their customers should also incur lower costs for shopping at a merchant.”	Untrue. This is not supported by evidence from Australia. There is no evidence that retail prices have fallen in response to regulation. At the same time the Reserve Bank of Australia has spelt out the additional cost to their consumers as a result of regulation: “Average fee revenue on bank-issued personal credit cards has risen from around $40 per account in 2002 to around $80 per account in 2006”. In effect, Australian banks have tried to mitigate the impact of the regulation by passing on the costs previously met by retailers to consumers.
“MasterCard interchange fees are among the highest in Europe, more than twice the level in Australia.”	Whilst this may be true now, the Commission fails to point out that Australian interchange fees were at comparable levels to Europe before regulation.
“In most Benelux and Nordic countries banks issue and acquire domestic debit cards at low cost, because domestic debit card schemes operate without interchange fees.”	Untrue. Such schemes either have interchange fees by another name, disguised fees, or these systems are cross-subsidised, or operate at a loss. In fact Commissioner McCreevy himself acknowledged this recently “It is inevitable that there will be a charge associated with using a payment network. That seems to be basic economic sense. Is there such a thing as a cost-free payment network? If there is then I can only suppose there must be some cross-subsidisation to cover the costs involved. After all, the costs have to be met from somewhere.”
“Multilateral interchange fee arrangements …. inflate the cost of card acceptance by retailers. Consumers foot the bill, as they risk paying twice for payment cards: once through annual fees to their bank and a second time through inflated retail prices paid not only by card users but also by customers paying cash.”	Misleading. It must not be assumed that this applies in all markets and that the Commission’s decision can be ‘read-across’. For example, in the UK, annual card fees are now very much the exception and thus most UK consumers don’t in fact pay twice in the way the Commission suggests.

The Retailer arguments

Retailers stand to gain most from regulation of interchange fees and use the following arguments to support their case.

Retailers say that “interchange fees are secretive and excessive”

Untrue. Interchange fees enable retailers to make a fair and equitable contribution to the costs of operating the system that they benefit from. They are based on regular cost studies commissioned by the card schemes. Fee levels are available on the schemes’ websites.

Is the retailer view based on the same rigorous analysis, or is it just an opinion with a vested interest?

If we take at face value the argument that interchange fees mean that UK retailers are incurring higher costs for accepting cards then they already have a right in law to surcharge for card payments (as we often see in travel agents). They could also choose to offer a discount for cash or not accept cards at all. In practice this is not happening on a widespread basis.

Retailers have often said that “high bank charges to retailers are leading to higher prices for consumers” and that they will pass on any savings on interchange fees to their customers

Untrue. This is not supported by evidence from Australia.

According to the Reserve Bank of Australia “in total, over the past year (2006) merchants’ costs of accepting credit cards are around $900m lower than they would otherwise have been”.

Visa report that “the evidence to date casts doubt on whether merchants have passed any, or any substantive, amount of savings on to consumers”.

MasterCard report that even “a cursory glance of the financial statements of many of Australia’s merchants would reveal a consistent growth in the profit margins irrespective of changes to that merchant’s cost base”.

Are UK retailers likely to be more philanthropic than their Australian counterparts?

Who benefits from cards?

Cardholders are protected from theft, loss and fraud and can make purchases over the counter, by phone, through the post or on the Internet. Cards are a flexible and convenient way to pay and also provide an easy way to pay when travelling abroad. Without interchange fees cardholders would have to bear the full costs of card issuing – and that could be more than they would be prepared to pay.

Retailers benefit from accepting payment cards in the following ways:

Increased sales to consumers with ready access to credit
Immediate and guaranteed payment
Savings for many compared to cash and cheques
Fraud protection
Facilitation of e-commerce
More sales channels (e.g. unmanned point-of-sale; self-service fuel pumps etc)
An ability to do business with any cardholder from anywhere in the world, 24 hours a day

Without interchange fees retailers would receive all these benefits whilst passing on all the costs to the consumer. At the same time fewer customers would be willing to pay the cost of having a plastic card so there would be fewer cards in circulation and less incentive for merchants to accept them.

Banks benefit by providing their customers – cardholders and merchants alike – with a popular, universal payment mechanism.

Our recommendation

The OFT is currently investigating interchange fees in the UK market. We understand the strict legalistic approach that the OFT will take when making any decision. However, it is our view that this approach risks significant and unpredictable results.

The UK Cards Association believes that the current interchange fee arrangements have served the UK well, resulting in one of the most competitive, advanced and efficient payment card markets in the world.

We would therefore prefer to see thinking that looks at the big picture: balancing the need for competition, innovation and efficiency in and between payment systems. Specifically, the OFT should consider:

1. Wider public policy objectives.

The OFT needs to be clear on the impact regulatory intervention will have on broader public policy objectives and whether these effects will be desirable for consumers, retailers and banks. For example, is regulation compatible with other policy objectives like the Single European Payments Area (SEPA) and the promotion of financial inclusion?

2. Economic impact.

Ideally the OFT should conduct a full impact assessment including reference to the Australian experience of regulating interchange fees and decisions in the USA not to regulate. In particular the OFT should be aware of the current review by the Reserve Bank of Australia of its 2002 interchange fee reforms and the ongoing MasterCard appeal.

3. Consumer benefit.

The OFT should be aware that the Australian experience shows consumers are unlikely to benefit. It has underlined the fact that expected or desired outcomes cannot be relied upon to happen. For example, Australian’s paying by card do not pay less, as retailers have not passed on their savings. The OFT must fully consider the broader interests of consumers, along with the effect on competition and innovation in the market.

4. Unintended consequences.

Regulation is a blunt instrument. The OFT should acknowledge that it is intervening in sensitive and complex market structures where its actions could have serious unintended consequences. Regulating cards alone could easily result in migration back to cash and cheques, to the detriment of the UK economy overall. We must avoid ‘regulating in the dark’.

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