Payment Cards and Interchange fee Hearings

1. Banking Enquiry Payment Cards and Interchange fee Hearings Banking Enquiry - Technical Team Team Presentation 17 April 2007

2. Introduction • Overview of South African payment card markets • Payment Card Models • Three party models • Four party models • Basis for the existence of the interchange fee • Functions of the interchange fee • Setting of the interchange fees in practice • Card scheme rules • The merchant service charge (MSC) • Main questions to be considered

3. Overview of the South African payment card market • Global card schemes issuing cards in South Africa: MasterCard, Visa, American Express and Diners Club • Branded credit and debit cards (PIN-based or signature-based), Charge cards, Buy-aid society cards, Petrol and Garage Cards, Gift Cards, Medical cards, ATM cards, Store cards, Cards issued under Joint-ventures, Affinity cards, Co-branded cards • MasterCard has nine principal member banks and one affiliate member bank in South Africa • Visa has 10 principal members and 2 associate members in South Africa • Of these only four banks are allowed to acquire credit and debit card transactions and one bank is allowed to acquire only debit cards. The rest are only issuers.

4. Overview of the South African market Between the big four banks (excluding ATM cards and Garage cards):

5. Payment Card Models • There are essentially two different models of Payment Card Systems in South Africa: • Three party or closed systems of which American Express and Diner’s Club are two examples • Four party or open systems of which Visa and MasterCard are two examples

6. Three party models

7. Four party models

8. Basis for the existence of interchange fees • Two distinct features characterise the payment card markets; the two-sidedness of the market and the joint provision of services (Rochet and Tirole, 2001). • Definition of two-sided markets by Rochet and Tirole (2005) where they defined it as: “A market is two-sided if the platform can affect the volume of transactions by charging more to one side of the market and reducing the price paid by the other by an equal amount; in other words, the price structure matters and platforms must design it so as to bring both sides on board.”

9. Basis for the existence of interchange fees • Two important characteristics of two-sided markets are: • Direct and Indirect Network externalities - Cardholders benefit from the fact that merchants accept cards, and merchants benefit from the fact that consumers use and carry cards. • The need to balance demand on the two sides - This balancing of demands needs to take cost, revenues, prices charged and benefits into account to maximize consumer welfare and network output. • “Joint demand and joint provision” of service - Cooperative enabling services are those that enable a service to be provided to both sides of a potential transaction or relationship. A demand for these services are said to be a joint demand or a two-sided demand.

10. Functions of interchange fee • Interchange is a flow of fees from one side of the four-party model to the other, usually from the acquiring bank to the issuing bank. • By redistributing revenue between the two sides, interchange fees provide a mechanism to allow pricing on the two sides to be adjusted so as to bring cardholder and merchant demand into balance. • There’s no robust relationship between prices charged on either side of the market and costs associated with providing the service on that side. Prices can be below marginal costs on either side and is seen as a norm rather than an exception in two-sided markets.

11. Setting of the interchange fee in practice • Each payment card scheme develops it’s own methodology for the setting of the interchange fee applicable to that particular scheme. Currently there are two different methodologies (besides regulation) for setting the interchange fee: • The setting of the interchange fee by the members of the scheme in the country; and • The setting of the interchange fees by the card scheme itself that will apply as a default to all the participating members in a country if bilateral negotiations fail. • In both cases there are two important elements involved the methodologies: the calculation of costs and the balancing of interests.

12. Setting of the interchange fees in practice (cont) • A third party, like Edgar-Dunn, can be used to assist in the collection and calculation of the costs associated with the provision of the service. These cost studies are used as an input in the setting of the interchange fee. • It is said that one role of cost studies is to identify what merchants are prepared to pay for accepting payment cards. These costs studies can differ for debit and credit cards. • The setting of the interchange as a balancing fee can either be performed on it’s own, without the consideration of a costs study, or in conjunction with a cost study that provide a proxy for the imbalance present in the system.

13. The interchange fee presently in South Africa • Currently in South Africa, the member banks of MasterCard and Visa decided on the setting and level of the interchange fee. They decided, through the ABCI, to initiate a cost study by Edgar-Dunn in 2003 to assist in the setting of the level of the interchange fee for credit card, debit cards (PIN-based) and cheque cards (embossed debit cards, hybrid cards or signature-based debit cards). • In November 2003 the South African banks reduced their interchange fees as follows: credit card rates were reduced from 1.99% to 1.71%, debit card rates were reduced from 0.73% to 0.55% and the hybrid card rate was induced at 1.09%. • These interchange fees are currently applicable to both MasterCard and Visa payment cards.

14. Interchange fees received by the issuing bank

15. Card Scheme Rules • The no-surcharge rule (NSR) means that merchants are not allowed to charge more than their standard price to customers paying with a payment card (they may however discount for cash). • The honour-all-cards rule forces merchants to accept all cards issued under the scheme regardless of type (debit or credit) or issuing bank. This guarantees issuers equality of access, non-discrimination and trust in the card to cardholders. • The honour-all-products rule (HAPR) is a dimension of the HACR and states that merchants are obliged to accept all debit and credit cards in the package of products covered under the acceptance contract for a particular scheme. They may not elect to accept only one product type.

16. The Merchant Service Charge (MSC) • Acquiring market in South Africa • Currently we have about 129 841 merchants who’s transactions are acquired by the big four banks in South Africa. • Typically the banks categorise merchants according to turnover size, and apply differential rates/MSC accordingly. Other factors include; the number of transactions and the average value of the transactions, as well as the risks associated with a specific merchant. • Range for credit card MSC: 7% - 1.8% • Range for debit card MSC: 6.5% - 0.6%

17. Main Questions • Is the balancing argument legitimate and does it entail dangers to consumer welfare? • How does one deal with the problem that there is an incentive for card schemes and issuers within card schemes to drive up interchange fees? • If interchange fees need to be set, who would be the best party to be responsible for this? What is the optimum form of regulation? • What are the proper requirements and eligibility criteria to become a member of the card schemes, either as an acquirer or an issuer?

18. Main Questions (cont) • Could direct charging (a vertical fee structure) on either side of the market achieve a socially optimum output? • Multiple acquiring and sorting at source? • What is the scope for non-bank acquiring in the payment card field?