The Competition Commission Enquiry

The Competition Commission Enquiry PRESENTATION BY THE ABSA GROUP 17th April 2007 Interchange

Main issues • Interchange fees in payment card schemes • The role of interchange fees • The benefit of interchange fees • Lower cardholder fees • Increased cardholder benefits and usage • Greater benefits for merchants • The level of interchange fees • How they have been determined in the past • Absa’s views on how they should be determined in the future

Payment cards are advantageous for consumers and merchants alike • Consumers have choice in respect of competing means of payment (cash, cheque, payment cards), some of which are more efficient than others • Payment cards add value to consumers • Debit cards reduce the need to carry cash – more secure and more convenient • Cheque cards can also be used off-line for internet and mail order payments • Credit cards facilitate purchases through access to credit and interest free periods • Payment cards add value to merchants • Increased sales • Reduced cash handling • Reduced security concerns (such as shrinkage and heists) • Payment guarantee (versus payment uncertainty with cheques) • Cost savings compared to offering in-store credit (no administrative costs or costs of maintaining a debtors book, benefits from economies of scale) • Both debit and credit cards have global acceptance through the main international schemes • South African consumers benefit when travelling outside South Africa • South African merchants benefit from tourists in South Africa

Transaction Volume Trends: Credit Cards, Debit Cards, Cheques Issued 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 - Apr-04 Apr-05 Apr-06 Jun-04 Jun-05 Jun-06 Oct-03 Aug-04 Oct-04 Aug-05 Oct-05 Aug-06 Oct-06 Feb-04 Feb-05 Feb-06 Dec-03 Dec-04 Dec-05 Dec-06 Cheques Issued Debit Card POS Credit Card POS The benefits of payment cards have led to steady growth Source: Absa

Cash remains the primary means of payment Total breakdown of Absa payment methods by volume Breakdown of payment methods at major food retailers by volume

The four-party model (Visa / MasterCard) Issuer Acquirer Interchange fee Merchant service charge Cardholder fees Cardholder Merchant Goods / services Four party schemes promote competition among issuers and among acquirers

The three party model (American Express / Diners International) System operator Merchant service charge Cardholder fees Cardholder Merchant Goods / services Cost allocation is also a feature of three party models

Cost allocation in two-sided markets • In all two-sided markets, there is the question of how the total costs should be allocated between the two sides to optimise the use of the system in question • In some two-sided markets, costs are recovered from one side only (classified directories / yellow pages, free newspapers) • In three party schemes such as American Express and Diners International, the system operator decides how to allocate costs and how to set prices on both sides of the market • Four party payment card schemes such as MasterCard and Visa have different providers (issuers and acquirers) on the two sides of the market • The operation of a four party payment card scheme has various costs • Card issuing costs including • Cost of credit, credit management and operations • Fraud and losses • Costs of acquiring • Costs of processing card transactions

The economic function of interchange fees • Interchange fees are the tool used in a four party scheme to allocate costs between issuing and acquiring in the most efficient manner for customers and merchants as a whole • Revenue from interchange fees allows issuers to reduce cardholder fees and increase the benefits of card use (e.g. interest-free period, payment guarantee). This increase in card usage increases merchant sales and reduces the use of cash (a less secure and more costly means of payment) • The optimal interchange fee balances the effects of cardholder fees and cardholder benefits on card usage against the effects of merchant service charges on merchant acceptance Absa believes that interchange fees are pivotal to ensuring consumer benefits

Elimination of interchange fees would be detrimental for consumers • If interchange fees were eliminated there would be a number of negative effects on consumers • Increased fees to cardholders (as seen in Australia) • Must be considered in context of introduction of National Credit Act • Reduced benefits of payment cards (e.g. interest free period) • Reduction in availability of credit cards to higher risk consumers, frequently lower income • Elimination of interchange fees could reduce merchant service charges, however • Whether this would be shared with customers is highly uncertain • Experience in Australia finds no reduction in retail prices • FEASibility found no evidence of a reduction in retail prices in South Africa following previous reduction in interchange fees

Elimination of interchange fees would be detrimental for merchants • Removing interchange fees would also be likely to lead to • Reduced use of payment cards (because of reduced benefits to cardholders which could include reductions in the interest free period) • Increased use of cash (a less secure and more costly means of payment) • Reduction in turnover for merchants • Reduction in card functionality such as the payment guarantee leading to increased fraud costs for merchants

Three party model not a feasible replacement for the four party model • Three party model in which banks act as both issuer and acquirer would be less efficient • Decreased acceptance of cards • Negative impact on smaller merchants • Negative impact on smaller banks • Higher cost from lower economies of scale and therefore decrease in cardholder benefits

Levels of payment card interchange fees • The current levels of payment card interchange fees were established following an Edgar Dunn study released in June 2003, based on data from 1999-2002 • Interchange on debit cards was reduced below the Edgar Dunn calculation (0.71%) in anticipation of increased usage *ABSA – SBSA Bi-lateral

Independent third party measurement of interchange • Absa’s suggested approach to interchange fees would be a determination through an independent and objective cost study • For example, Edgar Dunn is in the process of updating a study of debit and credit card costs for the purpose of calculating MasterCard interchange fees for credit and debit cards at point-of-sale • Absa is participating in this exercise following approval from the Competition Commission • The methodology used in this study can be used to provide an independent calculation of other interchange fees • Data submitted by the banks are reviewed by an independent auditor Absa supports the use of independent and objective cost studies

Summary of Absa’s views on interchange fees • The payment of interchange fees in relation to card transactions are a feature of most banking systems throughout the world and consistent with global practice • The current interchange arrangements in South Africa have received competition law sanction from the South African Competition Commission • Visa exemption • MasterCard advisory opinion • Interchange fees allow issuers to reduce cardholder fees and increase the benefits of card use bringing value for all participants • Increased use of cards increases merchant sales and reduces the use of cash, a less secure and more costly means of payment • Removal of interchange fees would have negative consequences for consumers • Higher cardholder fees and/or diminished cardholder benefits • No evidence that removal of interchange fees would lead to any significant reduction in retail prices • Absa’s suggested approach to interchange fees would be a determination through a third party objective cost study that can be reviewed regularly

Annexures • Off us ATM transactions (carriage fee model) • Payment card interchange fees versus ATM carriage fees • History of interchange fees for payment cards in South Africa • Methodology for independent cost studies

Off us ATM transactions (carriage fee model) Issuer Acquirer Carriage fee Off us withdrawal fee Cash Customer

Payment card interchange fees versus ATM carriage fees • At first glance, interchange fees in payment cards appear to be similar to carriage fees in ATM transactions. However • With ATMs, there is only one user – the customer • With payment cards system, there are two groups of users – merchants and cardholders • This leads to a fundamental difference • With ATMs, the carriage fee is a cost recovery mechanism • With payment cards, the interchange fee is there to allocate costs from one side to another in order to optimise the overall use of system • As a result, the removal of these fees has different impacts on ATMs and payment card systems respectively

History of interchange fees for payment cards in South Africa • Credit cards • First introduced with Barclaycard in the 1980s • Subsequently Standard Bank began to issue MasterCard in the late 1980s • Bi-lateral arrangement between Barclays and Standard Bank set the interchange rate between them at 1.99% • This rate changed following the Edgar Dunn study in 2003 • Debit cards • Absa was the first to issue debit cards in the 1990s • Followed by Standard Bank in the late 1990s • Bi-lateral arrangement between Absa and Standard Bank set interchange rate between them at 0.75% • This rate was revised following the Edgar Dunn study in 2003 • The study suggested a rate of 0.71% • However, debit card acceptance was a major issue • Debit cards were expected to have strong growth • Hence the rate was recalculated on the basis of expected volumes for two years’ time (with cost savings for the overall system from economies of scale and efficiency) • This led to a lower interchange rate of 0.55%

Methodology for independent cost studies • Third party sets out the methodology consistent with global best practice and decisions of competition authorities in various jurisdictions • Third party develops data questionnaires to accurate reflect the objectives of the study • These are continually reviewed to ensure that there are clear definitions for data needs and to prevent misinterpretations • Data definitions are provided to facilitate the process of data collection and data reporting • Visits and conference calls are used to review progress and data quality • Third party reviews and verifies data collected based on its experience, statistical methods and historical information • Third party uses weighted average cost information to calculate the interchange fee

The Competition Commission Enquiry