Interac: Changing for the Future

Interac Association Tel: (416) 362-8550 Fax: (416) 869-5080 Suite 1905, Box 109 121 King Street West Toronto, Ontario M5H 3T9 October 1997 TABLE OF CONTENTS

OVERVIEW ...... 3

ORIGINS AND GOALS...... 4

ORGANIZATION...... 4

MEMBERSHIP ...... 5

CHANGES TO GOVERNANCE...... 7

CURRENT INTERAC SERVICES...... 8

FUTURE SERVICES – SHARED OR BILATERAL/MULTILATERAL...... 11

INTERAC NETWORK MODEL...... 12

INTERAC ASSOCIATION AND THE ELECTRONIC DEBIT PROCESS ...... 13

INDIRECT ACCESS...... 14

FEES...... 16

WHAT IS AHEAD? ...... 16

HARNESSING TECHNOLOGY TO IMPROVE SERVICES...... 17

CONCLUSION ...... 18

2 Overview

The payments system in Canada has been undergoing dramatic changes in recent years to meet new and growing consumer demands. These changes have led to significant developments in the Interac®1 payments network. This paper describes Interac Association’s current role in the payments system, examines the effects of changing consumer demands and technology, and of innovations, and highlights how Interac Association expects to evolve in the future.

What began in 1984 as the collaboration of a few deposit-taking institutions to link their automated banking machines (ABMs) is now an international success story. Interac Association members currently provide two core electronic payments services: Shared Cash Dispensing (SCD) and Interac Direct Payment (IDP). Shared Cash Dispensing currently links more than 18,800 ABMs. Introduced in 1992, Interac Direct Payment is now available at 225,000 retail locations from coast to coast.

In June 1996, the Competition Tribunal approved a Consent Order that was negotiated between some Interac Association members and the Bureau of Competition Policy. The Consent Order stipulated a new mandate for Interac Association. The new mandate included broadening the membership and changing the governance structure, which Interac Association has done by implementing new by-laws.

Interac Association’s mandate continues to include the provision of secure, convenient access to funds in chequing and savings accounts held by deposit-taking financial institutions. Through Shared Cash Dispensing, Interac Association also provides a means of obtaining cash advances on credit cards

1 Interac is a trade mark of Interac Inc.

3 Origins and Goals

Interac Association was founded in 1984 by five Canadian financial institutions: Royal Bank, CIBC, Scotiabank, TD Bank, and Caisses populaires et d’économie Desjardins. Their goal was the creation of a shared ABM network to give customers broader access to their money. By pooling resources and cooperating at this early stage, Interac Association members were able to build the infrastructure of a national electronic payments network. By 1986, Interac Association had grown to 10 members — Bank of Montreal, Canada Trust, Laurentian Bank, National Bank, and Credit Union Central of Canada had joined the original five.

Although it started as a cooperative venture of a few large institutions, as Interac Association grew, many of its new members were smaller institutions. Membership in Interac Association allowed members to offer services that were national in scope. A small financial institution with one branch could use the shared services to provide its cardholders with access to all ABMs and point of sale (POS) terminals connected to Interac services in Canada. Providing such a national infrastructure independently would be nearly impossible for a single firm. Smaller institutions were also able to participate in other innovations, such as Interac Direct Payment. Today there are 42 members of Interac Association. Organization

The following three organizations play a role in carrying out Interac Association’s mandate:

I. Interac Association is an unincorporated association. Its main purpose is to facilitate members’ transactions under a common set of rules and market the services Interac Direct Payment and Shared Cash Dispensing. II. Interac Inc. is a not-for-profit company that owns the Interac trade marks and oversees the licensing of the software used by the members of Interac Association. III. Acxsys Corporation owns the IMN software, the interface software that permits the exchange of financial transactions between members, and provides an exclusive licence for that software to Interac Inc.

4 Membership

Membership in Interac Association is open to any Canadian commercial entity. Since November 1996, membership has extended beyond deposit-taking financial institutions to other Canadian companies. These include non-deposit-taking financial institutions, such as retailers; communications companies; and firms that provide specialized network services.

There are two types of Interac Association members: direct connectors that connect to one another to use the Interac network, and indirect connectors that access the Interac network by connecting through a direct connector (see Figure 4).

The role members choose to play in Interac Association also varies. The Consent Order has made it increasingly easy to “unbundle” services into separate businesses or activities, thus enabling third parties to become important players. As a result, Interac Association members may now undertake four different service delivery roles, depending on the characteristics of their organization: issuer, acquirer, connection service provider, and settlement agent.

Issuers are members who are Canadian deposit-taking financial institutions. There are currently 35 issuer members. Among these members are deposit-taking institutions that are owned by other financial service providers, including Sun Life Trust, owned by Sun Life Assurance Company, and Trimark Trust, owned by Trimark Financial Corporation, a mutual fund management company.

Acquirers own or operate consumer access points such as ABMs and POS devices. These terminals are used to transfer to the issuer the cardholder’s instructions for a cash withdrawal or payment. Acquirers can be any organization that is capable of acquiring a transaction on the network service, such as a request for payment. Acquirers do not have to be issuers. As a result of the Consent Order, third party processors and retailers may now be acquirers.

5 Connection service providers are direct connectors that link to the network other Interac Association members that do not have a direct connection. While most large companies will choose to connect directly, smaller companies may choose to use the services of a connection service provider, thereby avoiding the cost and expertise required to build a sophisticated system to link them directly to the Interac network. The acquiring and connection service roles represent an intermediate market and provide the best example of how the Consent Order has had a significant impact on who participates in the payments system. Since November 1996, three new third party processors have joined Interac Association as direct connectors to serve as connection service providers while also functioning as acquirers. Interac Association expects to see a few more connection service providers entering the market in the near future.

Settlement agents are financial institutions that settle transactions between issuers and acquirers on the Canadian Payment Association (CPA) Automated Clearing Settlement System (ACSS). This final step in the process of a transaction is open only to certain deposit-taking institutions, known as direct clearers, that have sufficient volumes of transactions to settle on the ACSS. These institutions have a distinct relationship with the Bank of Canada that allows them to facilitate the final settlement of transactions at the end of the day.

A member can play one or all of these four roles, provided it meets the requirements of each category. A financial institution, for example, could be an issuer, an acquirer, a connection service provider, and a settlement agent. A third party processor or a retailer could be both an acquirer and a connection service provider. It is also anticipated that some members may specialize as connection service providers, whose sole business would be to offer connection services.

As of fall 1997, there are a number of membership applications in process, and the number of members is expected to keep growing.

6 Changes to Governance

The Consent Order has also affected the governance structure of Interac Association. Three seats have been added to the Board of Directors, for a total of 14. Members are appointed based on the following formula:

¾ At least two directors must be appointed by direct connectors to the network who are not financial institutions. ¾ Three directors must be appointed by indirect connectors to the network. ¾ The remaining nine positions are allotted to direct connectors on the basis of the volume of transactions they drive through the network.

The two Board positions reserved for direct connectors who are not financial institutions are expected to be filled by January 1998, the other Board seats have already been filled.

The Board is responsible for setting policy and relies on a professional staff to implement it and manage day-to-day operations. All the operating and security rules, technology enhancements and future directions for shared services are also the Board’s responsibility.

Members take an active role in the governance of Interac Association. Indeed, members actively participate in advisory groups on business, marketing, technical, and security issues. Interac Association is a member-directed organization in which a consensus among the increasingly diverse membership is sought before actions are taken. Members who are not represented on the Board or who do not participate in an advisory group provide input through regular consultations.

7 Current Interac Services

Shared Cash Dispensing is one of Interac Association’s two core services. This service gives customers access to cash through a wide network of ABMs across Canada. It is a shared service allowing the members of Interac Association to dispense money at their ABMs to any individual who has a banking card issued by any other member. In 1986, the year the Shared Cash Dispensing service was launched, consumers made 6.2 million shared transactions. In 1996, the Shared Cash Dispensing network processed 301.4 million transactions. Although use of this core service continues to grow, the rate of growth is somewhat slower than in earlier years. Figure 1 shows the annual growth in volume of Shared Cash Dispensing transactions from 1994 to 1997.

Shared Cash Dispensing Transactions

350

300

250 327.0 200 301.4 150

100 295.4 50 268.3 0 1994 1995 1996 1997

(in millions) Expected

Figure 1

8 Interac Direct Payment, the second of Interac Association’s core services, allows customers to debit their chequing or savings account directly at the POS. Canadians have embraced this relatively recent development in payments because it provides new convenience to consumers and retailers. This service is growing rapidly. Between 1993 and 1996, the number of debit transactions grew from approximately 71 million annually to 676 million annually, an increase of more than 900 per cent. Generally, other countries have not matched this pace in technological innovation: according to 1996 figures, on a per-capita basis Canadians used debit cards 24.9 times a year. The comparable figure for New Zealand is 56 times a year, for the U.K., 22.3 times a year, for the U.S., 4.3 times a year, and for Italy, 1.89 times a year. Today about 11 million Canadians use Interac Direct Payment at more than 225,000 retail outlets. Interac Association’s goal is to have all 18 million cardholders use the service at over 400,000 retail outlets. Figure 2 shows the annual growth in volume of Interac Direct Payment transactions from 1994 to 1997.

Interac Direct Paym ent Transactions

900 800 700 600 900.0 500 676.4 400 300 393.8 200 100 185.0 0 1994 1995 1996 1997

(in m illio n s) Expected

Figure 2

9 Research indicates that the use of Interac Direct Payment will continue to grow. A recent study conducted for Interac Association found that 60 per cent of the respondents between the ages of 18 and 24 said they are “very frequent” users, which means they choose to use Interac Direct Payment at least once a week. Furthermore, 37 per cent of the same respondents reported that Interac Direct Payment is the method of payment they use most.

Consumers cite the following reasons for embracing this core Interac service:

¾¾convenience ¾ ease of use ¾¾reliability ¾ safety

Many retailers have also expressed satisfaction with the use of the direct payment option, relative to that of cash, cheques, and credit cards, for the following reasons:

¾¾ease of use ¾¾reduced use of cheques, which are associated with processing costs and the risk of NSF payments ¾¾lower cash handling costs ¾¾reduced size of cash floats, which thereby reduce the risk of theft

Canadians benefit from a single service network. This is in contrast to the situation in the U.S. where consumers cannot rely on a single network offering service at retail establishments. It is clear that Canadian use of Interac Direct Payment now has its own momentum: the increasing consumer willingness to use Interac Direct Payment is fuelled by the increasing supply of Interac Direct Payment terminals in retail establishments. The increasing supply of terminals is fuelled by the public’s increasing expectations that Interac Direct Payment will be available everywhere. This cycle is especially evident in Quebec, where the service has the highest acceptance. In that province, over 75 per cent of stores offer Interac Direct Payment.

10 The extent of the success of Interac Direct Payment can be understood better when compared with the growth in credit card use in Canada. Figure 3 compares the annual growth in volume of Interac Direct Payment transactions with the annual growth in volume of MasterCard and VISA transactions combined. In five years, the volume of Interac Direct Payment transactions has reached the same level as that of MasterCard and VISA combined.

ID P versus VISA & M asterCard

1000

900 M/C IDP 800 M/C VISA M/C VISA 700 VISA 600

500 IDP

400

300 IDP 200

100

0 1995 1996 1997

Figure 3

Future Services – Shared or Bilateral/Multilateral

In addition to participating in the two current shared services, Interac Direct Payment and Shared Cash Dispensing, members can develop new shared services. Any new shared service must be approved by a simple majority of Interac Association’s directors. All Interac Association members would generally participate in any new shared service. At this time, Interac Association has no concrete plans to develop new shared services, but is examining secure debit card payment over the Internet, and issues such as bill presentment and shared deposits.

11 One of the advantages of membership in Interac Association is the opportunity to develop new services, even those that the entire membership may not be interested in. Two or more members can unite to offer new bilateral and multilateral financial services to consumers. Such cooperative efforts have the potential to significantly broaden the services provided to Canadians through Interac Association. Groups of members who believe there is a market for a new electronic financial service can come together under the Interac Association umbrella and provide these services under a new trade mark to their customers.

Interac Network Model

Compared with other possible network models, Interac Association’s structure is completely decentralized, relying on members’ systems to facilitate network transactions. Other than the Inter-Member Network (IMN) software, the physical components of the network are operated and owned or licensed by the members. These components include the POS terminals, ABMs, and cards. Figure 4 describes the Interac network model.

Interac Network Model

MEMBER 4 MEMBER 1

X.25 AC CO UNT SYSTEM AC CO UNT NETWORK SYSTEM AB M APPLICATION AB M IM N APPLICATION

MEMBER 2 MEMBER 3 ABM

AC CO UNT AC CO UNT ABM SYSTEM SYSTEM

AB M IDP IM N IM N APPLICATION APPLICATION

PO S ABM

CENTRAL NETWORK MONITORING FACILITY

Figure 4

12 In Figure 4, Members 1, 2, and 3 are direct connectors and Member 4 is an indirect connector. Direct connectors run a copy of the IMN software and communicate with each other using the X.25 network, a public packet-switching network. Member 4 depends on Member 3 to provide the network connection to communicate with Members 1 and 2. The Central Network Monitoring Facility is operated by a supplier on behalf of Interac Association for statistical and service-level purposes.

Interac Association and the Electronic Debit Process

Interac Association facilitates the transmission of information needed to complete a debit transaction. Figure 5 illustrates the electronic debit process of Shared Cash Dispensing and Interac Direct Payment transactions.

Electronic Debit Process

ISSUER 1

PIN PAD ACQUIRER A

ISSUER 2

DEBIT ACQUIRER CARD B

ISSUER 3

ABM

Figure 5

The electronic debit process begins when the customer decides to make a purchase or withdraw funds using a debit card. In the case of a withdrawal of funds from an ABM, the

13 customer inserts the debit card (a card from Issuer 2 for example) into Acquirer B’s ABM and requests a sum of money. The transaction goes from Acquirer B through the Interac network to Issuer 2, which verifies the customer’s Personal Identification Number (PIN) and determines if sufficient funds are available to fulfil the customer’s request. Issuer 2 provides a response through the Interac network to Acquirer B. If funds are available, then the customer receives the cash requested.

When a customer wishes to make a purchase using a debit card, the retailer rings up the sale and enters the amount into the POS terminal (represented by the PIN pad in Figure 5). The customer’s debit card, issued in this case by Issuer 3, is passed through the POS terminal and the customer enters his or her PIN using the PIN pad and selects the account which is to be debited (an account with Issuer 3). This debit request is passed along via Acquirer A through the Interac network to Issuer 3. If there are sufficient funds available in the customer’s account, Issuer 3 sends the message back to Acquirer A, and the customer is able to complete the purchase.

Indirect Access

Issuers can provide other firms with indirect access to Interac services -- that is, issuers can offer “co-branded” card services under the Interac logo. For example, an issuer might establish an agreement with an investment dealer that allows the latter’s customer to draw funds from an account held by the investment dealer. Both the investment dealer and the issuer are identified on the customer’s card. The service could be structured so that the investment dealer’s customer is, in effect, getting the service through the investment dealer. Such services are facilitated through what is known as sweep account arrangements. Figure 6 illustrates how an indirect access transaction is done.

14 Indirect Access to Interac Network

B A NK A ISSU ER PIN PAD B OF CARD A

contractual arrangement between Bank A and Non- bank DEBIT CARD A ACQUIRER B Bank A (any ca na dian company ) guarantees payment

ABM

ABM B NON-BANK

ACQUIRER NETWORK ISSUER (proprietary business ) (shared business) (proprietary business )

Figure 6

In Figure 6, the customer holds an account with a deposit-taking financial institution (Bank A, the issuer) and an investment account with a corporate entity, such as an investment dealer (the Non-bank). Bank A and the Non-bank enter into an agreement by which Bank A provides access to the account it holds, and at the close of each business day, “sweeps” any existing balances into the investment account held by the Non-bank.

The customer has access to funds in the investment account via Shared Cash Dispensing or Interac Direct Payment. This means the customer may use his or her debit card (Debit card A) at an ABM (Bank B’s ABM) to request a cash withdrawal from an account at Bank A. The request then travels from Bank B to Bank A, which provides authorization to Bank B. If sufficient funds are available, the customer receives the cash.

15 At the end of the day, Bank A sweeps any remaining funds from the account at Bank A into the account held at the Non-bank, or debits the account at the Non-bank to cover overdraft payments drawn on the Bank A account. Because of this daily sweep, the customer has effectively withdrawn funds from the investment account.

Fees

Transaction fees paid by members to Interac Association are calculated on a user-pay basis. Interac Association calculates the costs of operating the system, and determines the per-transaction fee, which is the same for all members, regardless of the volume of their transactions. These are the only fees paid to Interac Association. There are no service access or licence fees.

In Shared Cash Dispensing, an interchange fee is paid by the issuer to the acquirer for every completed transaction. The level of interchange fee is set by Interac Association but the fee is paid by the issuer to the acquirer for the use of the latter’s ABM. At this time there is no interchange fee in Interac Direct Payment.

While Interac Association sets the members’ transaction fee and the level of the interchange fee, members set their own fees to their customers. Card issuers set fees charged to their cardholders for the use of the Interac services. Acquirers set fees charged to the merchants that offer Interac Direct Payment. Acquirers are also at liberty to impose a fee for the use of their ABMs or POS terminals.

What Is Ahead?

Interac Association provides a common forum for the participants in payments systems to explore new ideas, pool resources and develop innovations. The future is bright. Interac Association will continue to adjust and grow as a result of expanding membership.

16 Interac Association’s key activities for the next few years will be the following:

¾¾Continue to focus on the two core services, Interac Direct Payment and Shared Cash Dispensing. ¾¾Harness technology to improve those services, including facilitating these services through chip technology. ¾¾Continue to provide a forum in which members can develop new shared services that build upon the strength of the current services. Members may initially develop bilateral or multilateral services, some of which may evolve into shared services.

Harnessing Technology to Improve Services

Interac Association is involved in the development of chip card technology in Canada. Chip card technology will allow issuers to enhance existing services and expand into new services. Another advantage of chip card technology is its capacity to provide additional service.

Canadian financial institutions, in cooperation with other stakeholder groups, have recently started to examine chip card technology as a means to provide innovative, secure, value-added services to their customers. One of these services is stored value on a chip card, which can to be used for low-value purchases. Consumer surveys indicate this is an area with considerable growth potential. In Canada, about 22 per cent of all cash transactions, measured by value, involve sums under $20. That means about $100 billion in cash changes hands annually in these small purchases. As a result, even if stored value cards displaced cash for only 10 per cent of these transactions, they would facilitate payment for $10 billion in annual purchases.

In the past year, a number of pilot projects have been launched to test stored value cards and consumer receptivity to them. These projects include Exact, piloted in Kingston, Ontario, in December 1996; Mondex, piloted in Guelph, Ontario, in February 1997; and VISA Cash, piloted in Barrie, Ontario, in September 1997.

17 While the stored value card is one exciting application, Interac Association is working in partnership with MasterCard International and VISA Canada on a cooperative venture known as the IMVCCP (Interac Association MasterCard VISA Chip Card Project) to develop a common set of technical specifications to move the credit and debit applications to chip card technology. The new specifications will allow for the coexistence of stored value, debit, and credit applications on the same chip card.

Network and terminal interoperability is another objective of the IMVCCP. The goal is to ensure that Canadian retail (e.g., POS) and banking (e.g., ABM) terminals can accommodate chip cards that are based on different technologies.

Interoperability and multiapplications are two important components that will provide consumers with increased convenience in purchasing goods and services, while making business as simple as possible for retailers.

Establishing standard specifications will help lay the groundwork for bringing chip cards into the marketplace. Interac Association members will decide independently if and when they want to move to chip technology, based on their individual business criteria.

Conclusion

Since its inception, Interac Association has played an important role in the financial lives of Canadians. As a result of its leadership in Shared Cash Dispensing and Interac Direct Payment, Canadians have come to take for granted the convenience and reliability of Interac services.

Interac Association welcomes new challenges and opportunities. But as it forges ahead, it is committed to maintain its high standards of service integrity and security. This combination of change and continuity provides a solid foundation for Interac Association and its members, and assures ever wider benefits for members and their customers.

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