Multilateral Interchange Fees Capping a Good Idea?

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1 International In-house Counsel Journal Vol. 7, No. 28, Summer 2014, 1 Multilateral Interchange Fees Capping a Good Idea? SANCHO GUIBERT Assistant General Consel, EMEA Cards, Citibank, Spain Summary: Multilateral interchange fees: something which shoppers, banks and merchants have to deal with on every purchase made through credit and/or debit cards Background: anti-trust issues; war drums Legislative intervention on the multilateral interchange fees capping, aimed to protect consumers? The EU proposal for a regulation on interchange fees Conclusion The alternative approach Consumers and shoppers in general, are increasingly using credit and debit cards to make payments for goods and services, leveraging the significant technical developments and breakthroughs in the field of payment services and payment instruments. By way of example, one of the most prominent worldwide payment networks Visa is involved in 240 million plus transactions on a daily basis. In spite of the high level of use of credit and debit cards by shoppers in their day to day purchases at merchants, an infinitesimal part of them is really aware of the costs, expenses and related fees that are allocated among the different players involved in the payment services industry, namely, merchants, issuing banks, acquiring banks and the relevant four party scheme payment network, like Visa or Master Card, as opposed to the three party payment schemes (i.e. American Express or Diners Club) which may alternatively be involved in the credit or debit card payment transaction, as it is explained in some further detail below. On the contrary, merchants are quite aware of the transactional costs related payments made through credit or debit cards, as they do not receive the full purchase amount because a certain portion of the sale is deducted and distributed among the merchant s financial institution which provides the point of sale terminal that reads the cards (the acquiring bank), the banking entity that provides the card to the shopper (the issuing bank), and finally the payment network that processes the purchase transaction (usually the so-called four-party schemes such as Visa or MasterCard). The acquiring institutions provide the means for merchants to accept cards by forwarding the request for authorization of the transaction through the payment network to the cardholder s issuing bank. The issuing bank authorizes the transaction by verifying that the account is valid and that the cardholder has sufficient balance or credit lines for the purchase, and for merchants this authorization process occurs automatically through the electronic point of sale terminals. Then, the acquiring institutions clear and settle card purchases by providing payment from the issuing institution to the merchant s account, except for the interchange fees and their own service fees. It should be noted that acquiring banks assume the credit risk of merchants and, for example, if a given merchant defaults the promise of goods and becomes bankrupt, then the acquiring bank is International In-house Counsel Journal ISSN print/issn online

2 2 Sancho Guibert responsible for settling claims with the payment network and issuers whose cardholders are waiting for goods or services. As a result, the majority of the costs mentioned above are part of the so-called multilateral interchange fees, which are charged to the merchants by the issuing banks of the credit card and by the acquiring banks, and its basic flow could be described as follows: a given cardholder makes a purchase of, say, 100 Euros the merchant submits the full purchase order through the point of sales provided by the acquiring bank, but the issuing bank keeps 1.70 Euros the acquiring bank keeps 0.50 Euros (commonly named merchant service charge), and therefore the merchant is paid Euros as a result of a discount fee of 2.20 Euros deducted from the purchase price. It should be noted that other transactions involve the three-party schemes which simultaneously act as both issuing and acquiring entity, and therefore merchants negotiate directly with these entities the merchant discount fees that will be assessed on their transactions. These schemes do not have an interchange fee explicitly agreed between the financial institutions, and there are only fees paid by the cardholder (like annual fees) and merchant service charges paid by the retailer. However, despite the fact that three-party schemes do not have explicit interchange fees, they charge proportionately higher fees to merchants than to cardholders. As some years ago it was not very unusual to see a big number of merchants that were very reluctant to accept credit or debit cards as payment instruments, nowadays this means of payment has become increasingly popular and therefore the costs for merchants have been constantly rising. And it is especially significant to consider the evolution attached to payment instruments, as another evolution is currently underway, from plastics and terminals to multi-touch point devices. This remarkable use of cards is highly beneficial for different players due to a number of factors: for cardholders, it is a convenient and highly accepted payment solution which may imply personal benefits such as discounts, rewards, privileges and insurance protection, as well as a reduced level of cash and, most importantly, instant access to funds and credit; for merchants, it is a guaranteed payment which provides increased sales and reduced collection efforts, it is free of costs of handling cash, provides for data integration delivering processing efficiency and controls, and an increased turnover through indirect access to credit; for markets, it is a crucial element in developing cross-border commerce for international companies as it allows international commerce, reduces the dependency on cash and increases the turnover through credit; and for regulators, as it gives transparency, control and traceability of fund flows and also provides for an integrated payment network with wellestablished and mature rules. Background: anti-trust issues; war drums During the past decade, interchange fees have been subject to antitrust investigations and litigation procedures around the world, from Australia and New Zealand to the US and the UE, as many regulators and enforcement agencies have questioned its pricing,

3 Multilateral Interchange Fees Capping 3 alleging that these fees (also popularly called swipe fees in the US) are actually higher than reasonable levels due to technology improvements and development. From a legal perspective in this field, the key question on this subject is whether or not a centrally set interchange fee restricts competition either as an agreement between payment networks or as an abuse of a dominant position. In 2005 in the US, a class-action suit was filed by several merchants against Visa, MasterCard and other banking institutions, due to price fixing and other antitrust practices. This process was settled in December 2013 by reducing interchange fees for merchants and forcing the defendants to pay 7.25 billion US Dollars. In 2002 the European Union s ( EU ) Commission exempted Visa Europe from article 81 of the EC treaty concerning anti-competitive arrangements, but this ended in December After investigations and enquiries about antitrust practices, on 28 February 2014, the EU Commission notified Visa Europe of its decision accepting Visa Europe s proposed commitments concerning multilateral interchange fees, including capping intra Visa Europe consumer credit interchange fees within the European Economic Area at an annual weighted average of 0.30%. The decision obliged its members to modify their procedures and to update their systems. Likewise, on December 2007, the EU Commission issued a decision prohibiting MasterCard s interchange fees for its credit and debit cards for cross-border payment card transactions, as in violation of the aforementioned article 81 of the EC treaty. Both Visa and MasterCard decisions were based on considering whether the interchange fees were the result of an agreement between networks or a concerted price that restricts competition. Visa and MasterCard defended their positions in the sense that interchange fees are a way of balancing the conflicting interests of merchants and cardholders by distributing the costs of the system between the two user groups in a way that corresponds with the marginal benefit that each user derives from the system, and thus maximizing the overall use of the system. On Visa, the EU Commission considered the interchange fees pricing to be an appreciable restriction of competition by limiting the freedom of banks individually to decide their own pricing policies, which distorted the conditions of competition in the Visa issuing and acquiring markets. Therefore the Commission found that the Visa rules could be regarded either as decisions of an association of payment networks or as agreements between these networks. In the case of the MasterCard decision, decisions on the level and structure of interchange fees were found to be decisions of an association of payment networks or undertakings within the meaning of article 81 of the EU treaty. However, it is not denied by competition authorities that such agreements could bring benefits, which might make them compatible with competition law, but in most competition cases, card schemes and financial institutions have not been able to prove these benefits. Legislative intervention on the multilateral interchange fees capping, aimed to protect consumers? Legislative actions: The negative consequences of legislative intervention in this field are becoming more and more obvious. Notably, as seen in widely divergent legal frameworks including the ones of Australia and Spain. In Australia, the legislative intervention which took place in year 2003 had the clear target to reduce interchange fees in order to reduce merchant fees, but the naked truth is that merchants however did not present any empirical evidence of these benefits being passed-through to customers in

4 4 Sancho Guibert reduced prices for goods and services. On the contrary, cardholder fees were increased significantly and rewards propositions decreased significantly. In Spain, in 2005, an agreement was reached between merchant associations and cards schemes with the purpose of reducing interchange fees; the final results were, like in Australia, a redistribution of wealth from cardholders to merchants, and evident decrease in the pace of the cash-displacement despite bankarisation. Further, there is no evidence to show that consumers have benefitted from the drops in interchange fees rates and this agreement has altered the dynamics in the market, affecting competition and innovation. In this country, the government was not even satisfied with this interference with the markets and the economic players, and it has approved a law (based on urgent and extraordinary need reasons, as set out in the preamble) which is ahead of schedule in respect of the proposed EU Regulation on interchange fees. It has already set up 1 September 2014 as the date upon which debit and credit card interchange fees shall be capped at, respectively, 0.2% and 0.3% per transaction, in line with the said proposed EU Regulation. But the legislative intervention has been especially intense within the EU area, as the EU legislative powers believe that interchange fees are harmful to consumers who tend to be unaware of the fees paid by merchants. The EU proposal for a regulation on interchange fees In the EU, competition authorities and regulators had been looking at interchange fees for some time. The European Commission adopted several decisions under EU antitrust rules, including the Commission s MasterCard Decision of December 2007 (according to which, multilateral interchange fees must be set at a level that allows merchants to receive some of the benefits of the alleged efficiencies of the card system) and a number of national competition proceedings were conducted, including in Poland, Hungary, Italy, Latvia, the UK, Germany and France. The European Commission was of the view that the European cards market remained fragmented and interchange fees varied widely, often at a higher level than the one accepted by the EU Commission for Visa and MasterCard cross border transactions. Due to its nature, the EU thought that competition enforcement could not address the imbalances and obstacles for a level playing field to emerge in a comprehensive and timely way. The EU also thought that the different stakeholders in the process launched by the same Commission, were of the opinion that the multilateral interchange fees needed further legal clarity in light of the competition cases launched at European and national levels as commented on above, and that cross border acquiring needs to remove certain obstacles for a genuine single market for interchange fees, as interchange fees differ substantially from one country to another. So, the EU conducted an impact assessment on this issue and concluded that the most beneficial approach was a combination of a series of measures to, on one hand, enhance effective market functioning including the limitation of the so-called Honor-all Cards- Rule which obliges merchants to accept all cards within the same brand if they accepted one category of cards in this brand and allowing merchants to determine the choice of card brand at the point of sale for all cards and card-based transactions based on fourparty scheme models and, on the other hand, capping the level of interchange fees for cross-border and domestic transactions with consumer debit and credit cards.

5 Multilateral Interchange Fees Capping 5 The proposed caps of 0.2% and 0.3% for, respectively, debit and credit cards, was based on the merchant indifference test which identifies the fee level a merchant would be willing to pay if he were to compare the cost of the customer s use of a payment card with those of non-card (cash) payments (taking into account the fee for service paid to acquiring banks, i.e. the merchant service charge). The EU also took into account the levels proposed by the payment networks in the competition proceedings mentioned above, which were accepted by the competition authorities as not requiring further action. It should be noted that the EU considered imposing a ban on interchange fees for debit cards. Surprisingly, commercial cards will also be within the scope of the proposed regulation, when this type of card was initially in the so-called non-regulated area together with the cards issued by the three-party schemes, even though these schemes tend to be more expensive and therefore are less accepted amongst merchants. Who wins? Obviously, the answer to this question depends on the angle through which the subject is considered. For the EU legislators, retailers would benefit from lower fees, resulting in savings, a portion of which would be passed to consumers. Consumers already pay through the incorporation of interchange fees in the retail prices (via the merchant service charges), and banks are less likely to pass on the benefits of the interchange fees to their account holders than merchants to their clients, given the lower level of competition in the banking sector and the current lack of consumer mobility in the field of retail banking. Hence, the pass-through by merchants should be greater in any case than the pass-through by banks, albeit the impact may however vary from one retail sector to another, the size of the merchant, its use of payment instruments, and the basket of purchases. It will always be difficult to associate the variation of a specific economic factor to that of a specific price for a product or service in a given retail shop. The EU also holds that capping interchange fees would be expected to have a positive influence on card acceptance, which can, on the basis of scale effects, also positively influence card issuing. The EU considers that there is no automatic linkage between decrease of interchange fees and increase of annual fees. The lack of market integration in this field results in higher prices and less choice for consumers and retailers, and more limited opportunities to take advantage of the European internal market. A level playing field for interchange fees will facilitate market entry and increased competition which would result in benefits for consumers and retailers. For the banks and payment service providers in general, the unanimous approach is that interchange fees capping would lead to higher cardholder fees, and that retailers would not pass on benefits to consumers. For retailers, merchant and consumer organizations the view is that multilateral interchange fees would result in inverse competition; favoring the most expensive means of payment raises barriers to market entry, whilst creating a risk of spill-over effect from cards to mobile and internet payments. This group also expressed concerns that reduced fees could lead to higher card fees and other consumer charges. Lastly, the payment networks, and in spite of the competition cases, were not initially proactive in adjusting their practices to reduce interchange fees until they assumed the interchange fee capping commitment to the EU at an annual weighted average of 0.30% for credit card based transactions.

6 6 Sancho Guibert Conclusion The consequences of the legislative intervention in a field which was absolutely efficient and booming from all different angles are not entirely positive for various reasons. First of all, there is a significant transactional volume which is shifting back to a prehistorical means of payment : cash. This means that there are higher costs of handling cash and cheques, reduced traceability of funds flows, and reduced safety, to the detriment of recently developed security procedures such as chip and pin. This involution also means a decrease in transportability of funds, less reliability and speed for payment transactions and a decrease in appetite for financial institutions to invest in developing payment systems. On top of this, there are much less benefits for cardholders (who in the end are consumers and shoppers on which worldwide consumption is largely based via retailers, manufacturers and financial institutions). Hence, there would be a reduced palette of credit products for cardholders, including lower credit lines to compensate lower revenues; an increase in cardholder fees and a correlative decrease in reward schemes and loyalty programs; the issuing entities would be more focused on credit solutions rather than in payment service solutions; there would be a shift towards three-party schemes with lower acceptance levels among merchants, and most painfully, there would be an unfair redistribution of wealth from cardholders (consumers in the end) to merchants and retailers. This legislative (more exactly said, political) interference in a seasoned, innovative and booming market such as credit and debit card payment instruments, is shamelessly designed to gain voting benefits for supposedly helping the consumers, but it shall bring reduced levels of investment and innovation, new barriers for entrance of small players in this industry (and hence lower competition) and a dramatic separation from global dynamics. It is highly uncertain that one pan-eu rate can correctly reflect the difference in levels of penetration and market maturity at national level, as within the EU there are countries in which cards penetration and usage is very high and interchange is relatively low, or countries in which penetration is very high, and interchange fees are low but actual usage is equally low; this is due to cultural differences and personal habits in credit or debit cards use. It may be a better idea that interchange fees capping should be a decision to be taken by sovereign governments in cooperation with competent authorities to look at the market for payments and decide whether an intervention is needed. Last, but not least, the EU proposed regulation on interchange fees is introducing an unfair treatment for payment service providers as it excludes from its scope the threeparty schemes who albeit they do not use interchange fees as they act as acquirer and issuer, they negotiate higher fees for cardholders and charge higher amounts to merchants. The fact is that the financial sector will lose 2,000 million Euros as a direct result of the interchange fees capping and, despite the EU estimates that retailers will save 5,994 million Euros, this figures may be perceived as a subsidy to retailers at the expense of consumers and shoppers who will be paying exactly the same prices. The alternative approach If the cap on interchange fees is finally approved and it is understood that it may bring greater transparency and a certain level of harmonization in the payment sector, it also may bring some unintended or unforeseen consequences, such as the cancellation of card reward programs, increase of card fees, no direct benefits to consumers like the decrease

7 Multilateral Interchange Fees Capping 7 of the prices, and therefore an alternative approach would be worth of being considered in order to introduce: 1) a progressive approach that allows for adjustments, would also benefit national payment schemes which have not been subject yet to the caps agreed upon under the anti-trust settlements; 2) a weighted average as opposed to an absolute cap, as agreed in the anti-trust context and currently monitored by the payment networks under the supervision of independent trustees and the EU Commission allowing greater consumer choice; 3) a minimum harmonization in the regulation, to allow for the adoption of caps at national level that better reflects the development and penetration of cards in each country; and 4) commercial cards should be kept outside of the scope of the regulation as the market for this instrument is intrinsically different (i.e. purchases are mainly done with pre-selected merchants through negotiated contracts, estimate of 70-80% of spend, and are mainly used to arrange travel and allowances for business versus consumer retail purchases). All in all, taking into consideration the great significance of the cards based payment industry, the emerging payment devices and systems and the massive use and utilization by consumers, we face (by paraphrasing Adam Smith) another chapter of government laws and regulations that are at best a necessary evil which encroach upon the obvious and simple system of natural liberty. *** Sancho Guibert has been with Citibank for more than 15 years as Legal Counsel: corporate and investment bank, private bank and currently at the consumer bank unit where acted as Secretary of the Board of Directors of Citibank España until March Now is Assistant General Counsel for Citi EMEA Cards. Wide additional compliance experience. His earlier experience includes 2 years working at at Baker & McKenzie as an associate in the commercial law department, 1 year at Mayer, Brown & Platt, New York office, Latin American Practice Group, 9 months at Uría Menéndez in the New York Office, and a Summer internship in the Legal Department at Banco Santander, New York Branch. Citigroup, Inc., a global financial services company, provides consumers, corporations, governments, and institutions with a range of financial products and services, including consumer banking, credit cards, corporate and investment banking, securities brokerage, and wealth management. Citigroup Inc. has approximately 200 million customer accounts and operates in approximately 140 countries. The company was founded in 1812 and is based in New York, New York.