Regulating Retail Payment Systems: The Case of Payment Cards

Payment systems are evolving rapidly and becoming more complex in terms of global connectivity and the rules and regulations that govern them. They are a critical component of any financial system infrastructure – the “plumbing” – of any well-functioning economy. This chapter will focus on market interventions in retail payment markets with a particular emphasis on payment cards. Payment cards include cards that access transaction accounts (known as debit cards), cards that access lines of credit (known as credit cards) and cards that are pre-funded (known as prepaid cards). Payment card usage has increased dramatically over the last two decades in most advanced economies, which has primarily resulted in the displacement of cash and cheque transactions. In addition, the rapid growth of internet transactions has increased the attractiveness of card-based transactions.

The chapter will concentrate on three types of market interventions. First, they will analyse the impact of removing pricing restrictions placed on merchants that prevent them from setting different prices based on the payment instrument used to make purchases. Second, they will summarise the impact of public authorities mandating caps on interchange fees – the fees paid by the payer’s financial institution to the payee’s financial institution – on the adoption and usage of payment cards. Third, they will discuss the forced acceptance of all types of payment cards belonging to a single payment network (ie, credit, debit and prepaid) when merchants enter into contracts with acquirers. Such rules are often called honour-all-cards rules. While their focus is on payment cards, various pricing policies used to reach critical mass and steal market share from other payment instruments may also be valid for other types of payment instruments.

For many observers, the pace of innovation, the displacement of paper-based payments by electronic substitutes and the profitability of payment providers demonstrate how vibrant and adaptive the payment card industry has been with the limited involvement of public authorities. Others argue that payment  networks should be financial market utilities and regulated to limit the profits of network operators and payment providers. The economic justification for public intervention arises when there is market failure. For example, in the U.S., the ability to electronically exchange cheque images instead of original paper cheques on a wide scale in the clearing and settlement process was enabled by the Check Clearing for the 21st Century Act passed by Congress in 2003. Once this act was implemented, payment providers invested in new technologies and, for the most part, eliminated the exchange of original or substitute paper-based images, resulting in a more efficient electronic interbank processing of cheques. Lastly, some financial institutions have allowed customers to take pictures of their cheques with their mobile phones for receiving and sending images for deposit. Prior to the act, cheque processors were reluctant to invest in new image technologies and abandon their paper cheque sorters.

Many payment markets exhibit a combination of market failures. First, there may be coordination problems among the large number of participants, preventing large capital expenditures or the establishment of industry standards, inhibiting long-run growth and development such as the processing of electronic cheque images instead of paper cheques. Second, strong network effects exist in the provision of payment services because of the connectivity required between millions of payees, payers, financial institutions and payment network operators. Third, considerable economies of scale and scope in retail payment systems may lead to highly concentrated markets with few payment networks because of high barriers to entry for new payment networks. Economies of scale and scope along with network effects may result in few payment network operators raising potential concerns about significant pricing power. Fourth, “two-sided” network effects cause further interdependencies that affect the pricing structure of payment instruments, in particular the setting of interchange fees in payment card markets. Economic models of two-sided markets suggest that competition among network operators may result in fee structures that are less desirable than those set by a monopoly network. Fifth, consumer and merchant incentives to keep vital payment information secure and investments into fraud mitigation systems by payment providers and network operators may not be aligned to achieve the socially desirable level of prudent behavior by consumers and merchants to protect vital payment data, as well as sufficient investment in fraud detection and prompt resolution technologies by payment providers.

The motivation of public authorities to intervene in payment card markets varies by country. Public authorities may intervene to improve the incentives to use more efficient payment instruments.9 They may also intervene because fees are “too high,” or they may enable adoption of payment standards that could be  necessary for market participants to invest in new payment instruments and channels, especially during times of rapid innovation and competing standards. In addition, consumer protection and education about payment and credit products continue to be a concern and an area of active involvement by public authorities. Most notably, the Dodd–Frank Wall Street Reform and Consumer Protection Act (DFA) passed in 2010 mandates the creation of the Consumer Financial Protection Bureau to have this specific mandate. However, if the public involvement in payment markets is deemed necessary, public authorities must carefully weigh not only the immediate costs and benefits but also the impact on long-term investment in emerging technologies that would broadly improve the efficiency of retail payment systems.

It can be concluded that the justification to regulate fees is difficult at best given the lack of empirical evidence that conclusively shows the impact of fee regulation on consumers, merchants, financial institutions and investment in future innovations. Furthermore, the cost-based approach that is often used to regulate these fees ignores the economics of two-sided markets, arguing that cross-subsidies among payment system participants may be necessary – especially in mature payment card markets. However, public authorities should encourage the removal of merchant pricing restrictions such as the inability to charge different prices based on the instrument used to make payment. When consumers are faced with price incentives that more accurately reflect the underlying cost differences between payment instruments, they are likely to use the payment instrument that generates the greatest social benefits. Such a policy is likely to improve market efficiency, although there may be instances where merchants set surcharges that are greater than their cost of acceptance, potentially resulting in price signals that may cause consumers to use less efficient payment instruments. Finally, we would encourage greater competition among payment providers (banks and non-banks) to provide innovative payment solutions that may leverage non-card-based retail payment systems while maintaining the overall safety and integrity of the payment system.