Unintended Consequences of Regulation, Part “n”

I must admit, I lost count how many times we at Celent have written and talked about unintended consequences of regulation. This is the latest installment.

As most people know, PSD2 has introduced new card multilateral interchange fee (MIF) limits in Europe. Debit card transactions across Europe have been capped at 0.2% of transaction value, while for credit cards, the limit is 0.3%. This is often used as an example of regulators bearing down on the issuers, and in many cases, especially for credit cards, it is indeed a significant reduction of fees charged previously.

However, let's take a closer look at the UK. According to the UK Cards Association statistics, debit card transactions outnumber credit card transactions by 3.3 times (10.3 vs 3.1 billion in 2015), while the purchase value of debit card transactions was greater than that on credit cards by 2.4 times (£439 vs £181 billion in 2015). Furthermore, of nearly 100 milion debit cards issued in the UK, 97% carry Visa brand. In other words, Visa debit cards are the most popular payment cards in the UK.

Visa interchange rates have varied over the years, but immediately prior to March 2015, Visa interchange for consumer debit card chip & PIN transactions in the UK was flat 8p per transaction. In March 2015, those fees changed to 0.2% + 1p, but were capped at 50p. The extra penny could be charged, because the UK Payment System Regulator allowed an interim period where the cap of 0.2% could be applied at an aggregate rather than an individual transaction level. As the individual interchange fees were capped at 50p, that meant that in aggregate they didn't exceed the required 0.2% limit. However, we understand that as of September 1, 2016, Visa UK is removing both the extra 1p and the cap of 50p and setting debit interchange fees at 0.2% per transaction, as required by PSD2.

As the chart below demonstrates, transactions less than £35 become cheaper than 8p set prior to March 2015. At £41.34, which is the latest average debit card transaction value, the current charges are at 9p and new ones post September will be 8p, the same as before. However, transactions above that amount and up to £250 are already more expensive than 8p today and will remain so post September.


The real difference is for transactions above £250. The removal of 50p cap and charging at a straight 0.2% means that a £10,000 transaction (for example, when buying a used car) will now cost a merchant £20 in interchange versus the 8p the merchant paid before the regulation came into effect.


What about Brexit? Will these European regulations still apply in the future? The answer for domestic transactions is, yes. The interchange caps are now enshrined in the UK regulation and are independent of the UK's status in Europe. More broadly, the Payment Systems Regulator announced immediately following the referendum results that "current payments regulation deriving from the EU will remain applicable until any changes are made, which will be a matter for Government and Parliament." Perhaps a more interesting question is what would happen with transactions between the UK and Europe in the future. If the UK is no longer part of the EU, would the payment networks decide that such transactions should be treated as inter-regional rather than intra-regional? Only time will tell.

So, what are the merchants with larger than average debit card transaction portfolios going to do? In the short term, some might start surcharging to pass the costs on to the customer; longer term, others might start exploring other opportunities presented by PSD2, and consider becoming Payment Initiating Service Providers (PISP) to move customer funds directly from consumer bank account to theirs, shunning cards altogether. Almost inevitably, the most proactive ones will shop around to see which acquirers offer the best deals; remember, these are interchange fees, not the actual merchant charges, and it is up to the acquirers to decide how much they charge their merchants. However, once again, the consequences of a regulation are not quite as originally intended.

Much Ado About Nothing

Today the European Commission released its long awaited study into the cost of merchants accepting cash and card payments. A copy of the preliminary presentation can be found here. It’s long awaited for a number of reasons. Firstly, it is supposed to finally address the issue of comparing actual costs. Whilst there have been many studies in the past that looked at this, nearly all had a flaw. Those commissioned by one of the interested parties had such inherent biases that it rendered them almost unusable. For example, the anti-cards lobby conveniently chose to inhabit a magic kingdom where labour was free and cash magically appeared and disappeared from stores, free of charge!  Academic studies have typically been too academic – lots of interesting formulae, but not grounded in reality. The Commission set out, once and for all, to get a definitive answer. That’s the second reason why it is important. The Commission has taken what many believe as an “anti-card” stance, with a view that cards are unnecessarily expensive. At the same time, they are actively promoting electronic payments as paper/cash is costly and inefficient, but not taking into account some fundamental differences, such as cards are a commercial business, whilst cash is supplied in essence by the State (I know, I know – that sentence is a whole debate in itself!). The study then was supposed to create an unambiguous fact-base. The more cynical of us has wondered what happens if the study presents data that is contrary to the stance of the Commission, and that could contradict the last decade of activity from the Commission in this area! The programme has not been without it’s problems. A previous study commissioned a few years ago has never been released, and has been perceived as not reaching the answer the Commission wanted. This is primarily because the consultancy selected is highly regarded for their integrity and knowledge – by not sharing anything about the study, the market has reached it’s own conclusions. In the introduction to the document today though was a comment that it had “Unsatisfactory methodological recommendations.” Secondly, the request for a subsequent study was woefully underfunded. Unsurprisingly, the target number of merchants to study was not met by a considerable margin. This isn’t to criticize the firm that won the tender, more that the opportunity to do this right was never there. Alot of preamble – what did we learn? Not much. I wasn’t able to attend the presentation, so there is – literally – only the afore mentioned deck to study. For me the initial take-aways are:
  • The fact that no clear conclusions could be reached yet, and that the sample size achieved was only 50% of the initial target highlights, either just how hard this is to do and/or, actually it’s much closer than they thought. For example, if one payment type had substantially more costly than another it’d surely have been highlighted
  • The low response rate and the bias to large merchants is likely to leave the survey open to criticism
  • More detail is required to give comfort – for example, the cost seems to suggest some significant missing costs (such as CIT fees, bank cash handling fees, etc)
The net result is that we’ve not really any clearer, and we’re left wondering why they didn’t wait until they had reached some conclusions. Whilst we don’t have the commentary given during the presentation, the fact that the event and presentation didn’t even warrant its own press release suggests that not much was said. And so we’re left still in the dark, and probably, on balance, even less optimistic that we’ll get the answer that we all seek. Much ado about nothing!

Another Look at the European Card Regulation Proposals

We already talked on this blog site about the latest proposals by the European Commission to regulate the cards business – see Gareth’s and my posts on this topic. However, I wanted to come back to a couple of points, namely:
  1. the decision to cap debit and credit interchange to 0.2% and 0.3% of the transaction amount respectively;
  2. the requirement to separate schemes from processing companies.

The Commission expects that the caps will cut total EU debit card fees from ~EUR4.8bn to EUR2.5bn and credit card fees from EUR5.7bn to EUR3.5bn. How big of a deal is it though? The answer is that the impact will vary hugely market-by-market. For example, in Germany average credit card rates stand at 1.8%, and given the country’s aversion to debt, most cardholders are “transactors”, i.e. usually pay their balances in full, so interchange is the main source of income for the issuers. Compare that to the UK where Visa’s credit card interchange rate for EMV cards is 0.77%, and while the number of “revolvers” (i.e. people who borrow on credit cards) and their outstanding balances have been declining, the revolvers still represent over 60% of all cardholders, making the issuers less reliant on interchange income.

For debit it gets even more interesting. While average debit card charges are 1.6% in Poland, many other countries already have low and flat (i.e. fixed irrespective of the amount) fees for their domestic debit transactions. For example, Visa dominates the debit market in the UK and its interchange fee for a debit transaction currently stands at £0.08. Given that the average UK debit card transaction is just over £45, it already works out as an effective rate of 0.18%, i.e. cheaper than the proposed cap. From Durbin experience in the US, the proposed fee ceiling quickly became effectively the floor as well, i.e. most transactions were priced at cap. If this were to happen in Europe, the fees on debit cards in many markets might actually increase! Of course, the EC hasn’t ruled out the possibility that it might decide to ban interchange fees on debit cards altogether, but we expect this to remain a prospect in the distant future.

The EC proposals also include a recommendation that ‘card schemes and the entities that process transactions’ be organizationally separated. It will be interesting to see the actual interpretation of this recommendation. A similar requirement is one of the fundamental tenets of the SEPA cards framework: “a scheme should implement a separation of SEPA card schemes’ brand governance and management from the operations that have to be performed by service providers and infrastructures without any possibility for cross-subsidisation.” Visa’s and MasterCard’s position has always been that they meet these requirements by not mandating their processing services and having separate pricing for scheme and processing services.

However, some commentators believe that this time the Commission might want to go further and impose legal separation of the schemes, processing assets and potentially even issuing and acquiring side of the business, which would have far reaching consequences to most players, from Visa/ MasterCard to American Express to local debit schemes to even banks. Given the lack of clarity in how this might be implemented so far, we expect a lot of lobbying on all sides in the coming months and years until the outcome is settled.

The Latest Assaults on Card Fees

I said last year that I can’t really take a summer vacation – too many things seem to happen in payments while I am away. This year was no different with many interesting stories to catch up with from new chiefs at MCX and Visa Europe to PayPal trying out check-in payments in the UK to the latest announcements from Isis (I will try to review those in a separate blog.) However, two big news items really caught my eye, both to do with further assaults by regulators on card interchange fees. As Gareth already described in his blog, the European Commission confirmed its intentions to cap interchange fees across Europe to 0.2% for debit and 0.3% for credit. The enactment is expected to take one to three years for European Parliamentary approval and approval by a majority of EU member states. Caps will start applying to cross-border transactions two months after final approval and for domestic transactions after 24 months, so some of the caps could be introduced as early as late 2014. If and when this happens, it will have major repercussions to the industry – the banks will have to seriously question the viability of offering credit cards, are likely to be more open to experimenting with non card-based solutions (e.g. bank account), yet the merchants incentives to accept anything other than cards and card-based solutions would be seriously diminished, dampening the prospects of innovation and start-ups. If the EC announcement was expected, the news from the US was anything but. While the industry was still getting to grips with the aftermath of Durbin amendment, the District Court Judge Richard Leon threw out the $0.21 debit interchange fee cap set by the Federal Reserve and suggested that the Fed should review and lower the cap further. If the cap went down to $0.12 or even lower, the banks would stand to lose another $4bn or more in revenue. The Judge’s decision also appears to impose more routing requirements than the Fed’s ruling did, which even in the original implementation turned out to be a big stumbling block for EMV. What will this latest turn of events do for EMV prospects in the US? If there is one thing certain is that it will only create more uncertainty for the industry, making the original dates for the liability shift even more difficult to achieve.

Of Eggs and Omelets – Interchange Legislation Recipe for Disaster?

On Wednesday, July 24th, the European Commission will publish 2 widely anticipated documents. The first is the PSD II, updating the existing PSD (Payment Services Directive). The second is a new piece of proposed legislation around interchange. Interchange in Europe has long been an area of focus for the Commission, with over 30 significant investigations in the last 15 years at either country or European level. Many of these have been very public and, perhaps “personal”, with Visa and MasterCard receiving the majority of the attention. The interchange regulation therefore is  anticipated with some trepidation as the Commission is seeking to draw a line under the investigations once and for all. Last week, the FT ran article based on a leaked copy of a draft of the proposal. That draft contained a range of issues, but those that have grabbed the biggest share of attention are:
  • Domestic interchange rates for debit and credit to be capped at 0.2% and 0.3% respectively
  • Legal separation of schemes/networks and processors
A third, but now discounted element, was a belief that these rules also applied to 3-party schemes such as Amex. So what does this mean? Firstly, the devil will be in the detail. Those of us who’ve been round the block a few times will know that drafts usually get amended before publishing – the last draft of the New Legal Framework (the original name for the PSD) had over 200 amendments between draft and final version. Many of those changes were very minor, but when every word is poured over, those differences can be very important. Secondly, these are proposals for legislation. Based on the gestation time of the PSD, even with the political will to drive this through, this will take at least 5 years to come into force, and will not be exactly as published on Wednesday. If anything, this is probably the only thing that is certain in the whole process! Some potentially significant impacts A sweeping statement (because rates vary by country, category and negotiation), but my first back of the envelope estimate suggests that the majority of the credit card volume in Europe is currently at higher rates than the proposed cap. I also believe that there are significant numbers of debit cards subject to higher rates as well – the FT suggests that debit card interchange in Poland, for example, is 1.6%. When banks are already struggling with the economics of the card already, this may result in consumers paying more having a card, and potentially, using the card. At first glance, this may seem fair – the people who use it, pay for it. But what the proposal does not seem to allow for is the fact that it’s highly unlikely that the merchants will pass on those savings, plus there seems to be a suggestion that surcharging may be allowed. The customer could potentially lose out 3 times over. That in turn creates a “ripple” effect. Banks may not offer cards to everyone and/or customers may not use the cards. After all, these are choices both parties make. At the same time, the economics of cards may have changed sufficiently that existing national debit card schemes decide to call it a day, and the economics of cards today had already killed off any chance of a home-grown debit card scheme. What we may find is that there is a move away from cards, to other payment types. As debit cards are seen as a form of electronic cash, cash is a likely winner, almost certainly not what the regulator wanted. And in certain countries, such as France, by focusing the legislation on cards, not interchange more broadly, we’ll see further growth in payment types where there are greater levels of interchange, such as cheques. Additionally, card issuers may focus on corporates going forward. Not only do they currently have greater levels of interchange already, they are not subject to the legislative proposals, plus they have much lower levels of fraud than consumer cards. In short, more money and for less risk.   Whilst I understand that the regulator wants to improve transparency for consumers, and to provide them with a better deal, I feel that this legislation is more likely to make things worse, not better. Whilst, as the saying goes, you have to break some eggs to make an omelet, the regulator would seem more interested in the egg breaking rather than a successful recipe. A great chef doesn’t use a recipe, and is willing to experiment and take risks. I think this is shaping up more for a recipe for disaster.

Good Week for the Olympics (But Not For Everyone There)

London Olympics are in full swing, and so far it’s been a tremendous success. I thought the opening ceremony was absolutely breathtaking – it was creative, ambitious, beautiful and yet so different from everything else we’ve seen. After Beijing, most people said it would be difficult to surpass the sheer scale and grandeur of that opening ceremony. London organisers knew it and so they didn’t even try it, starting instead with peaceful images of rural England and running through the rich history of Britain, from industrial to digital revolution. There were plenty of worries before the Games that the infrastructure (e.g. transport system, security) would struggle to cope with the influx of athletes, spectators and officials. Many firms asked their employees to work from home (most of us at Celent already do anyway). However, the concerns so far proved to be overestimated and London has been running smoothly. The sport itself continues to thrill, offering a full scale of emotions from pride and joy for the medal winners to drama (e.g. competitors “ganging up” against Mark Cavendish, a favourite to win a cycling race) to shame (e.g. badminton players getting disqualified for deliberately losing matches). It’s also inspiring a new generation of future athletes – my own children (almost 5yrs and 2.5yrs) are wowed by almost everything they’ve seen on TV, from the equestrian events to diving, swimming and basketball. I also heard a kid on the radio saying that he would like to compete in the future Olympic cycling, “you know, the one with bikes, not the one where you sort out the rubbish into different bins”, he added helpfully 🙂 However, not everyone associated with the Olympics enjoyed the last week. The decision to make Visa the only accepted payments brand at the Olympics, continued to attract criticism. The Times, one of the largest newspapers wrote: “The sponsors, of course, are highly visible in the park and the one that emerges as early favourite for the gold medal in mean-spirited pettiness is the payments company Visa. Every commercial outlet and even every cash dispenser bears a sign saying it is “proud to accept only Visa”. They may be proud; everyone else will be annoyed.” That decision was really put to test when card payments failed at one of the events at a Wembley stadium and people could only pay cash (so much for the “cashless Olympics”!) It doesn’t necessarily mean that the failure had anything to do with the Visa network; in fact, Visa blamed “Wembley management”, but the incident clearly did not help the Visa’s brand. There were more bad news from Visa in Europe, when the EC commission had another go at Visa Europe and its credit card interchange fees. Encouraged by the court’s recent decision over MasterCard’s fees, the EC clearly feels the time is right to re-open its ongoing battle with Visa. At Celent we have long questioned the wisdom of regulators to keep pushing against the interchange fees in various markets. It looks like the lawyers and lobbyists at the schemes will continue to be busy.

Does EU Really Want to Ban Card Interchange?

Just as PayPal in the US was gearing up to challenge the established order of payment networks (see my previous blog), on the other side of the Atlantic, MasterCard (MA) received news that the European General Court upheld a decision by the European Commission (EC) that the scheme’s multilateral interchange fees (MIF) violate EU antitrust rules. MasterCard said it would appeal again, but if upheld, the decision could have profound consequences for card payments not just in Europe, but also globally. For those who haven’t followed this closely, back in 2007, the EC deemed MasterCard’s MIFs for intra-regional cross border transactions illegal, and ordered MA to withdraw these fees within 6 months. MasterCard appealed, and in the interim, reached an agreement with the EC which allowed it to establish cross border interchange rates, provided they do not exceed 0.3% for credit cards and 0.2% for debit card transactions on a weighted average basis. This week’s decision only applies to cross-border fees within Europe, which are “fall-back” rates when either bilateral agreements or multilateral domestic agreed rates do not apply. However, it’s been watched closely by all the interested parties, and already variuos domestic retailer bodies, such as the British Retail Consortium, are calling for the ban to extend to the domestic arrangements as well. Also, the court’s decision does not aply to Visa which has already cut its cross-border debit fees. The European Commission is now likely to turn its attention to Visa’s credit fees. In other words, while the decision’s immediate scope is limited, it sets a precedent and gives ammunition to the “anti-interchange brigade”. What makes this decision particularly dangerous is that it appears to be challenging the actual concept of interchange, rather than the level of fees or the approach by which they are calculated. As reported by Finextra, the court said that it “does not accept the arguments relating to the objective necessity of the MIF to the operation of the MasterCard payment system“. There is a big difference between arguing for a reduction in fees and banning them altogether. The ruling changes little in practice in the immediate term. MasterCard’s stock started the day of the decision at $426 and was trading at $416 just over 24 hours later, a 2.3% drop, which implies it was not unexpected news to the investors. Also, the story isn’t over – MasterCard already said they would appeal and I expect the pro-interchange lobbying efforts would only get bigger. The concept of interchange has been a cornerstone of four-party card schemes and many would say it’s worth fighting for.

“Should We Repel Durbin?”

That was the question someone asked me last week at an ATM, Debit and Prepaid Forum. I know – it was in Vegas, the person was joking and the question is really a rethorical one. And yet, it kind of rings true, because no one seems to be happy with the new regulation. Except, of course, the lobbyists, lawyers and other industry advisors. And perhaps some acquirers and ISOs. As expected, “Life after Durbin” discussions dominated the event. Of course, the large debit issuers are unhappy – the general consensus is that this will wipe out about $8bn in annual interchange revenue for the industry. The issuers are looking for ways to cut costs or to raise revenue. It was interesting to watch how nearly everyone had to update their slides, as Bank of America withdrew their planned $5 debit card fee about 24 hours before the official conference started. The bank itself explained that they “listened to the customer feedback and acted accordingly.” The smaller exempt issuers are not entirely unhappy. Credit unions announced a large new customer intake (“760k new accounts in the last 10 days, more than in the entire year previously”). However, they are worried that they will also feel competitive pressure on interchange or might be discriminated by the merchants and their acquirers. Also, it remains to be seen how profitable the new customers will be for them. Prepaid issuers seem to be unsure what to make of it. On one hand, some prepaid cards are exempt from regulation, however, the exemption conditions and small print gets very complex very quickly. Cue in the lawyers and corporate counsels to help navigate the regulatory maze. The network routing rules banning the exclusivity arrangements are seen as an opportunity by at least some of the networks, especially the smaller ones. However, the implementation – renegotiation of contracts, setting up of routing rules, etc – is not an insignificant undertaking for all involved. Cue in consultants and more lawyers. Perhaps most surprisingly, the merchants are not happy at all. The merchant panel, represented by senior executives from Walmart, 7-Eleven and McDonald’s was one of the most interesting sessions at the Forum. They all expressed disappointment in the final regulation. Walmart said that the regulation was a “disappointment, but a good start for future regulatory reforms, including credit.” It is true that for small ticket purchases, the costs of debit acceptance have gone up, as it’s now a flat fee, i.e. the cap was implemented also as a floor. When asked if and when consumers can expect to see lower prices, the merchants responded by saying that the “merchant market is very competitive, therefore any cost changes will be passed to consumers, both increases and decreases”. In other words, “expect prices not to change much or perhaps even go up.” Redbox, a US-based DVD rental firm, already followed through on this and raised its prices for DVD rentals from $1 to $1.20 quoting increases in their costs of debit processing. Smaller merchants are also unhappy because it might take time for any savings to trickle through to them. Unless their acquirers and processors charge them “interchange plus”, they may find it difficult to demand immediate reductions in their bundled fees. Those with lower volumes may also lack the necessary know-how or may simply prefer avoiding the hassle of putting pressure on their acquirers to lower their fees. It will take a better part of next year for the full effects of Durbin regulations to become clearer, but the early signs are that it won’t reach all of its intended outcomes. So, what’s next? P.S. As an aside, this year’s ATM, Debit and Prepaid Forum saw the best-ever attendance – over 1,100 participants – and had a very interesting agenda with great speakers. Congratulations and thank you to SourceMedia, the event organisers, and Tony Hayes, a conference chairman (and a partner at Oliver Wyman, Celent’s parent company) for all their efforts!

Durbin D-Day

Finally, the wait is over. Yesterday (June 29th), the Fed’s Board approved and announced the final version of Regulation II, known in the payments industry as the Durbin amendment, which sets out the rules for debit card transactions. Financial institutions feared the worst after the initial proposals annouced in December last year. Today, banks can breath a sigh of relief. In both of the major issues on the table – the interchange caps and the rules for network exclusivity – the Fed’s final rule is better than the proposed worst-case scenario. Visa’s stock closed the day at $86.57, up by $11.29 or 15%. For the interchange, the Fed settled on a cap of 21 cents on transactions that fall within the regulation’s scope. Furthermore, the banks can charge an additional 0.05% of each transaction’s value. Finally, another 1c could be added if the banks’ fraud-prevention systems were deemed adequate by the Fed. Given this, an issuer still needs a $100 transaction to break-even based on the issuer’s average transaction cost of $0.27, which was outlined in the Industry’s comment letter to the Fed during the consultation period. However, it is a significant improvement over the originally proposed cap of 0.12c per transaction. For network exclusivity, the Fed opted for Alternative A, i.e. the issuers will have to place two unaffiliated marks on every debit card, which is most likely to translate into one signature and one PIN network. Again, this is not as drastic a change as it would have been under Alternative B, which would have demanded two network choices for each method of payment (i.e. two signature and two PIN). Even though the final rules are not as harsh as the worst-case proposals, the financial industry is still worse-off and will have to adapt. The retailers should be declaring victory, however, instead, The National Retail Federation expressed “serious disappointment” and called the final rules “a major loss for American consumers.” The new rules will go into effect on 1 October, 2011. The cloud of uncertainty has been lifted and the industry can get on with final preparations and implementation. The numbers can be plugged into the scenario models built up by various institutions over the last year to finalise the expectations of impact, the relevant systems can be upgraded accordingly and the contract negotiations (e.g. around network affiliations) can proceed with certainty. Of course, as we all continue to study the final rules, more questions will emerge. And, as the dust settles, there will be unexpected outcomes and consequences of this momentous ruling. But this morning, the US financial institutions should reflect that it could have been a lot worse.

Replacing debit interchange with a new fee?

Over the weekend I read an open letter by Senator Durbin to JP Morgan Chase CEO Jamie Dimon regarding interchange fees. In the letter Senator Durbin sets outs his arguments for why the Senate was compelled to introduce debit interchange regulation, which overall makes a very interesting reading. One paragraph especially caught my eye (my Bold Italics highlighting): “Last year Congress decided that there should be reasonable regulatory constraints placed on Visa and MasterCard to ensure that they cannot use their market dominance to funnel excessive interchange fees to the nation’s biggest banks. A strong bipartisan majority supported my amendment, which said that if Visa and MasterCard are going to fix fee rates on behalf of banks with over $10 billion in assets, those rates must be reasonable and proportional to the cost of processing the transaction. It is important to make clear that if Chase wants to set and charge its own fees in a competitive market environment, the amendment does not regulate those fees. The only regulated fees are those fees that banks let card networks fix on their behalf.” This got me thinking… does this mean that the issuers are free to introduce a new fee, which they could charge the acquirers in lieu of interchange, lets say an “authorisation” fee? Of course, any issuer who goes first faces to be at a competitive disadvantage to others, at least initially. The industry players don’t have to collude to raise prices with various signalling techniques available to them and given the market clout of the largest issuers. I am sure there would be other challenges (e.g. technical, etc.), but is this completely out of the question? Why? What do you think?