Executive Overview The Joint Study into Debit and Credit Card Schemes in Australia (A Study of Interchange Fees and Access) discusses many aspects of the 4-party credit card systems operating in Australia and around the world. It claims that these systems have several socially undesirable attributes. In particular, the Joint Study asserts that 4-party card systems: • are more socially costly than debit cards; • have unnecessarily high interchange fees; • result in a subsidy being paid to non-revolving users of credit cards from consumers using other payment methods; and • have unnecessarily restrictive membership rules for their issuers and acquirers. These conclusions fail to acknowledge, however, that: • interchange fees help promote network membership and usage; • proving the existence of a cross subsidy requires looking at the indirect as well as the direct costs and benefits (e.g. transaction costs and foregone benefits) faced by all parties; and that • as evidenced by the large fall in the cost of credit since their introduction, open credit card systems actually bring competition to the market, both between payment systems and within each open credit card system. The Joint Study acknowledges that, due to the presence of network externalities in credit card net- works, interchange fees serve a useful balancing role, ensuring that growth occurs both on the issuing and on the acquiring side of credit card systems. The question is then whether these fees are too high. One way to assess this is to look at whether the network is ‘‘unbalanced’’. There is, in this respect, nothing in the Joint Study to suggest that current fees are ‘‘unbalancing’’ or in any other way distorting the development of credit card networks. However, the Joint Study argues that credit card networks in Australia are mature and that, as a result, the ‘‘balancing role’’ justification for setting the interchange fee to encourage network growth is not relevant. The evidence presented in this paper shows that credit card networks in Australia are in fact not mature. Rather, they are still experiencing strong growth. No less importantly, this paper demonstrates that even if the networks were mature, the need for an interchange fee would persist. Moreover, the efficient level of that fee might be higher, not lower, than in a network at an initial stage of development. The Joint Study puts forward two alternative approaches to the setting of interchange fees. Both are cost-based approaches. However, an interchange fee level based solely on costs will only ever be efficient by pure chance – and it is shown here that the approaches the Joint Study proposes are far more likely to hinder than to promote efficiency. The exclusion of closed credit card networks (e.g. American Express and Diners Club) from the scope of the Joint Study is also a matter for serious concern. Any moves to regulate interchange for open card systems such as VISA would provide a significant competitive advantage for closed credit card networks such as American Express. Indeed, there is a strong argument that if the interchange fees set by the open systems are regulated, then there is a clear need for final price regulation of closed systems. Furthermore, any move to regulate the setting of interchange fees would have serious international ramifications, placing Australia at odds with global practice. T.1 Overall, this paper shows that efficient determination of the interchange fee involves a myriad of factors. Mechanical approaches, of the kind favoured by regulators and advanced by the Joint Study, cannot capture this complexity, and hence entail efficiency losses. In contrast, the current arrange- ments, in which these fees are determined by the members in the course of negotiation, will benefit from an understanding of commercial realities that regulators lack. The Joint Study also argues that two other aspects of 4-party card networks should be changed. In particular, it proposes: • abandonment of the no-surcharge rule; and • relaxation of the rules regulating membership of the open card systems. The proposal to abandon the no-surcharge rule is a consequence of the Joint Study’s conclusion that current arrangements provide a cross-subsidy to non-revolving credit card users from consumers using other methods of payment. However, the Joint Study’s analysis is mistaken as a matter of economics. Rather, it is shown here that the no-surcharge rule both promotes efficiency in the opera- tion of credit card systems and protects consumers. The costs to the Australian community of remov- ing the no-surcharge rule are conservatively estimated as being in excess of $4 billion. Nor are the Joint Study’s conclusions with respect to membership rules any better based. Well-estab- lished and widely accepted economic principles highlight the need for entry criteria of exactly the type used by VISA. There are serious risks associated with any dilution of prudential standards for those seeking entry into open card networks. Members, be they card issuers or merchant acquirers, are required to bear very substantial liabilities towards consumers, merchants, system members and the system as a whole. The current arrangements rely on the RBA to ensure that members have the capacity to discharge the obligations this entails. Weakening the membership criteria could jeopardise the financial soundness of the systems in Australia and overseas. In addition to their impact on financial soundness, changes to the access rules would damage the functioning of the systems, including by raising the costs involved in decision-making and reducing the effectiveness of governance arrangements. There is consequently no basis for thinking that such changes would be in the public interest and hence consistent with any of the current legislative instru- ments. The issues raised by the Joint Study are of great importance. They are important to the institutions directly involved and to the Australian community. Currently, the Australian payments system is strong, secure, dynamic and technologically sophisticated. It has evolved in a way that has allowed the economic development of credit card systems that are sought after by consumers and merchants. Regulatory intervention in a successful, privately run and competitive joint venture would set an undesirable precedent. It may well have destabilising effects on the Australian Payments System, isolating it from global best practice. It should only be envisaged if compelling grounds for interven- tion can be advanced. The Joint Study seems to favour regulation, but the arguments it puts simply do not resist scrutiny. Rather, experience and analysis of open credit card systems suggest that regulation is likely to do more harm than good. The RBA and the ACCC should carefully reconsider the views they have put. T.1 Table of Contents 1. SUMMARY.......................................................................................................1 2. NETWORK ECONOMICS:AN OVERVIEW OF BASIC PRINCIPLES................................... 3 3. THE STARTING PROPOSITIONS............................................................................7 3.1 CARD PAYMENT SYSTEMS SUBJECT TO NETWORK EXTERNALITIES ..................................................... 7 3.2 INTERCHANGE IS NECESSARY ........................................................................................... 8 3.3 HONOUR ALL CARDS RULE IS NECESSARY .............................................................................. 8 3.4 IMPLICATIONS OF THE STARTING PROPOSITIONS ........................................................................ 9 4. ARE INTERCHANGE FEES TOO HIGH?................................................................. 10 4.1 NETWORK MATURITY ...................................................................................................12 4.1.1 Does the evidence suggest maturity?..................................................................12 4.1.2 Resource cost interchange fees in a mature network ..............................................14 4.1.3 Summary of theory and evidence on maturity ........................................................15 4.2 WILL WELF ARE INCREASE IF THE INTERCHANGE FEE FALLS? .........................................................15 4.3 RELEVANCE OF ‘OVER-USAGE ’ FOR INTERCHANGE FEES ..............................................................18 4.4 HARMFUL EFFECTS OF PROPOSALS ...................................................................................19 4.4.1 Joint Study alternative 1 ...................................................................................20 4.4.2 Joint Study alternative 2 ...................................................................................21 4.4.3 Comparison to 3-party credit card systems ...........................................................22 4.5 RESOURCE COST INFERENCES ........................................................................................23 4.5.1 The Study’s resource cost benchmark .................................................................23 4.5.2 Gap between interchange fees and resource costs exaggerated ...............................24 4.6 SUMMARY OF INTERCHANGE ISSUES ...................................................................................25 5. DOES THE ‘NO-SURCHARGE’ RULE DISTORT COMPETITION?................................... 26 5.1 THE CAR-PARK ANALOGY ...............................................................................................26