Interchange fees and customer surcharging

Recommendation 17

Improve interchange fee regulation by clarifying thresholds for when they apply, broadening the range of fees and payments they apply to, and lowering interchange fees.

Improve surcharging regulation by expanding its application and ensuring customers using lower-cost payment methods cannot be over-surcharged by allowing more prescriptive limits on surcharging.

Description

To improve the transparency and efficiency of interchange fee regulation,49 the PSB should consider:

  • Publishing thresholds for determining which system providers will be regulated.
  • Broadening interchange fee caps to include all amounts paid to customer service providers in payment systems,50 including service fees in companion card systems.51
  • Lowering interchange fees by reducing interchange fee caps, but also:
    • Replacing three-year weighted-average caps with hard caps, so every interchange fee falls below the interchange fee caps. This would also reduce differences in fees paid by small and large merchants.
    • Applying caps as the lesser of a fixed amount and a fixed percentage of transaction values, instead of only one of these components.52 This would also increase the use of electronic payments for smaller-value transactions and ensure fees reflect costs for larger-value transactions.53

The Inquiry considers that surcharging regulation should ensure merchants can surcharge to reflect their relative costs of accepting different payment methods.54 This could be better achieved by providing merchants with clearer surcharging limits, which could reduce over-surcharging and improve enforceability. To implement this, the PSB should consider allowing:

  • Low-cost system providers, such as systems subject to debit interchange fee caps, to prevent merchants from surcharging. This would prevent customers from being surcharged for using low-cost payment mechanisms that involve minimal acceptance costs for merchants, relative to other payment methods.
  • Medium-cost system providers, such as systems subject to credit interchange fee caps, to apply surcharge limits set by the PSB. This would make it easier to prevent over-surcharging, while still allowing merchants to reflect their relative costs of accepting different payment methods.
  • Higher-cost system providers to continue to apply reasonable cost-recovery rules. This would give merchants the flexibility to reflect the different costs of higher-cost payment methods.

The PSB should consider whether mechanisms are required to prevent merchants from only accepting payment methods they can surcharge. The PSB may also wish to consider other alternatives to improve the accuracy and efficiency of surcharging.

Objectives

  • Clarify regulation and enhance competitive neutrality between system providers.
  • Improve the efficiency and effectiveness of price signals, and reduce the potential for cross-subsidisation between customer groups and merchant groups.

The scenarios set out in Box 10 illustrate some of the practical outcomes these proposals could achieve, particularly in reducing costs and over-surcharging.

Box 10: Cameos on how the proposed reforms would improve outcomes

Alternative text:Cameo 1: Effects of proposals for interchange fee caps.Wei Ling and Brian often purchase tacos from their favourite Mexican food truck, which is operated by small business owner, Sarinda. When Wei Ling and Brian make card payments, their banks charge an interchange fee to Sarinda’s bank. Sarinda’s bank charges Sarinda a merchant service fee, in part to reflect the cost of the interchange fee. Interchange fees are capped by regulation. Current situation: Brian chooses to pay with his premium credit card because it provides frequent flyer points. His bank is able to offer these rewards because it charges high interchange fees, particularly for transactions involving small businesses like Sarinda’s. These high interchange fees result in high merchant service fees for Sarinda. Sarinda would like to pass on this cost to Brian with a surcharge. However, he is reluctant as Brian may switch to one of Sarinda’s competitors who does not surcharge. Instead, like his competitors, Sarinda recovers the cost through higher prices for all his customers. This penalises Wei Ling, who pays with a low-cost debit card with no reward points.Sarinda also sets a minimum spend of $10 for card purchases because his fees are proportionally higher for lower-value transactions, due to the way interchange fees are set. Wei Ling only wishes to purchase a snack, but must now also purchase a drink to meet the minimum spend.After proposed reforms: Sarinda benefits from lower interchange fee caps, which have led to lower merchant service fees. Sarinda also benefits from hard interchange fee caps, which have narrowed the difference in fees paid by small and large businesses. Like his competitors, Sarinda passes on these savings to his customers by lowering his prices to remain competitive.Both Wei Ling and Brian benefit from the lower prices. Wei Ling particularly benefits from no longer subsidising the reward points and other benefits for customers like Brian. However, Brian now receives fewer frequent flyer points for his purchase because the interchange fees for his credit card are lower. Wei Ling also benefits from Sarinda removing his $10 minimum spend for card purchases, which he is able to do because fees for low-value purchases have been reduced. Wei Ling is now able to purchase a snack with her debit card, without having to buy additional items. Cameo 2: Effects of proposals for surcharging standards.Wei Ling wishes to purchase a plane ticket online at short notice. Current situation: The airline imposes a $9 surcharge  for all debit card and credit card purchases. For most transactions, this exceeds the airline’s cost of accepting debit card and credit card payments. Wei Ling cannot avoid the excessive surcharge. After proposed reforms: Like all businesses, the airline benefits from lower interchange fees. However, it can no longer surcharge low-cost debit cards and must comply with set limits for medium-cost credit cards. Wei Ling chooses to pay with her debit card to avoid a surcharge. 

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Discussion

Following the Wallis Inquiry, Australia was one of the first countries to implement interchange fee caps. Interchange fee caps have since become more common and are currently applied in 38 jurisdictions.55

As outlined in the Interim Report, the Inquiry believes interchange fee caps improve the efficiency of the payments system.56 Without interchange fee caps, price signals for customers are less clear and outcomes are less efficient because customers can be encouraged to use higher-cost payment methods.

Figure 11: Retail payments system fees and charges shows the cycle of potential fees and charges involved in payment systems. For each transaction they accept, merchants (Box E) pay merchant service fees to merchant service providers (Box D), which in turn pay interchange fees to customer service providers (Box B). Customer service providers can then pass some of this revenue on to customers (Box A) in the form of reward points and other benefits.

Merchants can complete this cycle by surcharging their customers to recoup their transaction acceptance costs. However, this can be difficult when the system provider has high market penetration, as surcharging can cause the customer to switch to another merchant that does not surcharge.57 Merchants can either absorb the costs of high-reward payment methods (involving high interchange fees and therefore high merchant service fees) or pass them on to all customers in the form of higher prices. Interchange fee caps restrict this cycle by limiting how much revenue customer service providers can pass on to customers using higher-cost payment methods, in the form of reward points or other benefits.

Some submissions argue that, rather than reducing the prices merchants charge for their products, interchange fee caps increase merchant profit margins.58 They note that there is a lack of clear evidence showing caps have reduced product prices. Although caps are unlikely to result in immediate price reductions, the Inquiry agrees with the RBA that the competitive process should drive down prices over time and improve efficiency.59

Some jurisdictions, particularly the European Union, are now implementing lower interchange fee caps than Australia and applying caps more functionally to capture all amounts paid to customer service providers.60 The European Union is also considering allowing interchange fee–regulated system providers to impose more prescriptive surcharge rules on merchants.

Figure 11: Retail payments system fees and charges

The figure shows the five key parties/functions involved in retail payment systems: the customer, the customer service provider, the system provider, the merchant service provider and the merchant. When  a payment is made, the merchant pays a merchant service fee to the merchant service provider. The merchant service provider then pays an interchange fee to the customer service provider. The merchant service provider and the customer service provider may also pay /receive fees, charges and incentive payments to/from the system provider. In addition, the customer service provider may give reward points to the customer and the merchant may surcharge the customer. Interchange fee standards cap the  fees merchant service providers pay customer service providers.Surcharging standards allow merchants to pass on the reasonable cost of accepting payments to customers.In four-party systems, the customer service provider, system provider and merchant service provider are all separate entities. Examples  of four-party systems include the eftpos, MasterCard and Visa  systems.In companion card systems , the merchant service provider and the system provider are the same entity, while the customer service provider is a separate entity. An example of a companion card system is the Amex companion card system.In three-party systems, the customer service provider, the system provider and the merchant service provider are all the one entity. An example is the PayPal system.

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Problems the recommendation seeks to address

Interchange fee caps

Thresholds for interchange fee regulation. Currently, the rationale for limiting interchange fee regulation to selected system providers lacks transparency. Publishing thresholds for designating system providers for interchange fee standards would give system and service providers, particularly new entrants, certainty about how regulation is applied. This would support innovation by enabling providers to plan for future growth and development, and would also enhance competitive neutrality. Thresholds could be based on a combination of system providers’ annual transaction values and market shares.

Broadening interchange fee caps to include all payments made to customer service providers. Incentive payments used in most systems and service fees used in companion card systems can achieve the same outcome as interchange fees; however, they are not currently captured by interchange fee caps. Applying interchange fee caps on a broader functional basis would help prevent alternative payments from avoiding caps and provide competitive neutrality for four-party and companion card payments system providers.

Lowering interchange fee caps. Payments system efficiency could be increased by lowering interchange fee caps. The Inquiry acknowledges that lowering interchange fee caps would disrupt business models and involve transitional costs. Lower interchange fee flows may cause some service providers to reduce customer rewards. The Inquiry considers that these costs would be outweighed by lower product prices for all consumers, resulting from lower fees charged to merchants, and reduced cross-subsidisation.

Replacing three-year weighted-average caps with hard caps. The current approach of using three-year weighted-average caps enables system providers to meet the caps by charging high fees for transactions involving smaller merchants without market power, while setting low fees for merchants with market power and high transaction volumes.61 Introducing hard caps would help address this imbalance while also reducing total interchange fees.

Applying caps as the lesser of a fixed amount and a fixed percentage of transaction values. Applying fixed-percentage caps to debit systems, in addition to existing fixed-value caps, would ensure low fees for small value transactions. This would increase the rate of merchants accepting these transactions. Applying fixed-value caps to credit systems, in addition to fixed-percentage caps, would ensure the proportional cost of fees decreases as the value of transactions rises, better aligning fees with the costs of processing transactions. However, this could significantly affect some credit card system and service providers. If the PSB is inclined to implement this approach, it should phase in fixed-value caps to smooth transitional costs.

The Inquiry considered banning interchange fees altogether. This could improve efficiency by forcing customers and merchants to pay directly for the benefits they each receive. There are examples of payment systems operating without interchange fees in other countries.62 However, the Inquiry considers that banning interchange fees would have high transitional costs. Instead, the Inquiry recommends that the PSB consider reducing interchange fees in the short term, and then consider further lowering fees in the longer term, depending on market conditions.

Table 8: Summary of interchange fee cap options
Option Potential for inefficient cross-subsidies63 Competitive neutrality for system providers Simplicity and clarity of regulation Compliance costs
Recommended
Broaden application of caps Reduced Increased No change Transitional costs
Lower caps Reduced No change No change Transitional costs
Introduce hard caps Reduced No change Increased Transitional costs
Apply caps as lesser of fixed amount and fixed percentage Reduced Increased Decreased Transitional costs (larger for credit systems)
Alternative
Ban interchange fees altogether Significantly reduced No change Increased High transitional costs
Remove interchange fee caps Significantly increased Increased Significantly increased Decreased

Customer surcharging standards

Functional application of surcharging standards. Merchant surcharging standards do not currently apply to all system providers. This allows unregulated system providers to ban merchants from surcharging, even if they operate higher-cost systems. Applying surcharging standards to all system providers would address this concern and ensure consistency for merchants and customers.

Providing clearer surcharging limits. The Inquiry agrees with the RBA that surcharging can improve the efficiency of the payments system by providing accurate price signals to customers.64 In addition, some consumer groups, such as Choice, acknowledge that accurate surcharging can provide positive outcomes.65

However, the current reasonable cost surcharge rules are difficult for system providers to enforce, potentially complex for merchants to comply with and can cause frustration for consumers, as evidenced by the more than 5,000 submissions the Inquiry received on the matter.66 The rules are complex because each merchant needs to calculate its acceptance costs, which can involve subjective judgements about a number of factors.67 The rules are difficult to enforce because system providers have limited visibility of these calculations.

The Inquiry proposes that the PSB consider the following alternative arrangements to simplify compliance and improve the accuracy of surcharging:

  • Allow low-cost system providers to ban surcharges to encourage consumers to use low-cost payment methods. System providers could qualify as ‘low-cost’ if their interchange fees are below debit interchange fee caps. To ensure competitive neutrality, three-party systems could qualify if the costs they charge merchants are equivalent to those of other low-cost system providers.
  • Allow medium-cost system providers to enforce set surcharge limits to simplify surcharging for merchants and improve customer understanding. The PSB could set limits to approximate payment acceptance costs. System providers could qualify as ‘medium-cost’ if their interchange fees are below credit interchange fee caps. To ensure competitive neutrality, three-party systems could qualify if the costs they charge merchants are equivalent to those of other medium-cost system providers.
  • Allow higher-cost system providers to continue to enforce reasonable cost-recovery surcharging rules but require them to disclose this so their customers better understand why they may be surcharged. Although this retains the weaknesses of the current arrangements, it would be difficult to determine fixed surcharging limits for different higher-cost system providers. Maintaining the current arrangements would give merchants the flexibility to surcharge for the different acceptance costs of higher-cost payment systems.

These options could reduce over-surcharging by giving merchants clearer guidance on maximum surcharge limits. They would allow customers to avoid paying surcharges by using low-cost payment methods. The PSB should also consider whether mechanisms are required to prevent merchants from only accepting payment methods they can surcharge.

These new rules would be easier to comply with and enforce as merchants, system providers and customers would know the surcharge limits for low- and medium-cost payment methods.

These proposals would make surcharging arrangements more effective, but not perfectly accurate. The PSB would need to estimate set surcharge limits for medium-cost systems and equivalent acceptance costs for three-party systems. A transitional period would be needed to give merchants and service providers time to adapt to the new rules. The Inquiry supports the PSB considering these proposals in greater detail and implementing a solution that improves the effectiveness of surcharging.

Enforcing reasonable cost surcharge limits. The Inquiry considered imposing the current reasonable cost surcharging rules through Government regulation. However, regulators indicated this would involve considerable administration costs, as reasonable acceptance costs would need to be determined on a case-by-case basis. This option would also require strengthening regulators’ powers to seek documents to prove over-surcharging, and creating new penalties to discourage over-surcharging.

Conclusion

The proposals for interchange fee standards should improve clarity, enhance competitive neutrality, improve the efficiency of price signals and reduce cross-subsidisation. The proposals for surcharging standards should make surcharging standards simpler and more accurate, while encouraging system providers that are not subject to interchange fee standards to reduce their costs.


49 Interchange fee regulation is enforced through standards that cap interchange fees paid by merchant service providers to customer service providers (see Figure 11: Retail payments system fees and charges). The caps are currently applied on a three-year weighted-average basis. The caps are 12 cents per transaction for debit systems and 0.5 per cent of transaction values for credit systems.

50 That is, all amounts paid by merchant service providers and system providers to customer service providers.

51 These are individually negotiated fees between payments system operators and customer service providers rather than centrally established fees.

52 The proposal would add a fixed-percentage component to debit system caps (which already have a fixed-amount component) and a fixed-amount component to credit systems (which already have a fixed-percentage component).

53 This proposal would have a greater impact on credit systems than debit systems. If the PSB is inclined to implement this proposal for credit systems, it may wish to phase in fixed-value caps to smooth transitional costs.

54 Surcharging regulation is enforced through standards that currently prevent system providers from banning merchants from surcharging, while still allowing system providers to restrict merchants from surcharging above their reasonable cost of accepting different payment methods (see Figure 11: Retail payments system fees and charges).

55 Hayashi, F, Maniff, J 2014, Interchange fees and network rules: a shift from antitrust litigation to regulatory measures in various countries, Federal Reserve Bank of Kansas City, Kansas City, page 1.

56 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, page 2-28.

57 The Inquiry has received confidential feedback from merchants, including large merchants, that feel unable to surcharge customers due to the risk of losing customers.

58 For example, see Visa 2014, Second round submission to the Financial System Inquiry, page 14; MasterCard 2014, Second round submission to the Financial System Inquiry, page 6.

59 Reserve Bank of Australia 2014, Second round submission to the Financial System Inquiry, page 4.

60 European Commission 2013, New rules on Payment Services for the benefit of consumers and retailers, media release, 24 July, Brussels, viewed 18 November.

61 American Express 2014, Second round submission to the Financial System Inquiry, page 13.

62 For example, domestic debit card systems in Canada, New Zealand, Norway, Luxembourg, Finland and Denmark have set their interchange fees to zero. Hayashi, F, Cuddy, E 2014, Credit and Debit Card Fees in Various Countries, Federal Reserve Bank of Kansas City, Kansas City, page 5.

63 This includes cross-subsidies between customers using lower-cost and higher-cost payment methods, and between smaller and larger merchants.

64 Reserve Bank of Australia 2014, Second round submission to the Financial System Inquiry, page 6.

65 Choice 2014, Second round submission to the Financial System Inquiry, page 22.

66 These submissions were part of a campaign against surcharging, which encouraged submissions to the Inquiry. The organiser of the campaign provided a submission: Bartosch, K 2014, Second round submission to the Financial System Inquiry.

67 Reserve Bank of Australia (RBA) 2012, Guidance Note: Interpretation of the Surcharging Standards, RBA, viewed 3 November 2014.