Payment systems are evolving rapidly and are more complex than ever before 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. In this chapter, we concentrate on market interventions in retail payment markets with particular focus 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 prefunded, known as prepaid cards. Payment card usage has increased dramatically over the last two decades in most advanced economies. This increased usage has primarily resulted in the displacement cash and check transactions. In addition, the rapid growth of internet transactions has increased the attractiveness of card-based transactions.
We focus on three types of market interventions. First, we analyze 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, we summarize the impact on adoption and usage of payment cards when public authorities mandate caps on interchange fees—the fees paid by the payer’s financial institution to the payee’s financial institution. Third, we discuss the forced acceptance of all types of payment cards belonging to a single payment network, i.e. credit, debit, and prepaid, when merchants enter into contracts with acquirers. Such rules are often called honor-all-cards rules. While our 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 with electronic substitutes, and the profitability of payment providers demonstrate how vibrant and adaptive the payment card industry has been with limited involvement by public authorities. Other observers 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 United States, the ability to electronically exchange check images instead of original paper checks 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 the 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 checks. Today, some financial institutions are allowing customers to take pictures of their checks with their mobile phones that they receive and send images for deposit. Prior to the Act, check processors were reluctant to invest in new image technologies and abandon their paper check 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 check images instead of paper checks. 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 scale and scope economies 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 of 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—the fee paid by the payee’s bank to the payer’s bank—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 and 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. First, public authorities may intervene to improve the incentives to use more efficient payment instruments.9 Second, they may also intervene because fees are “too high.” Third, public authorities may enable adoption of payment standards that may be necessary for market participants to invest in new payment instruments and channels especially during times of rapid innovation and competing standards. Fourth, 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 which will have this specific mandate. However, if 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 improve the efficiency of retail payment systems broadly.
We conclude 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 nonbanks) 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.