The Role and Regulation of Interchange Fees in European Payments Cards The Role and Regulation of Interchange Fees in European Payments Cards Wilko Bolt De Nederlandsche Bank PYMNTS.com, Hotel Silken Berlaymont Brussels, 15 June, 2011 The views expressed are those of the author and do not represent the views of De Nederlandsche Bank nor the ESCB.

Introductory Remarks  Payment economics is complicated because of the interactions of a set of interdependent bilateral relationships  The ongoing shift from cash and paper towards electronics potentially confers large economic benefits. But card payments in particular have remained expensive for merchants  Divergence of social and private incentives  SEPA: integration and harmonization of European retail payment markets. Focus on “electronics”. How to achieve goals?

Key Questions  What is the optimal structure of payment fees between consumers, merchants, and financial institutions? Is the market sufficiently transparent to generate the right price signals and incentives?  Will competition among payment providers, networks, or instruments improve consumer and merchant welfare and social welfare generally?  What guidelines should policymakers follow when regulating payment services?

 Society will be best off when it relies on the most efficient payment system  In a two-sided market, a transfer (e.g an interchange fee) between end-users may be socially optimal to balance demands on both sides of the market. Different payment instruments may require different transfer schemes  However, (wrong) incentives on one network may affect usage of another, e.g. cash, check, or payment cards (example: in Holland, ‘cheap’ debit cards were surcharged favoring ‘expensive’ cash use) Pricing and Usage Externalities

 Question: Why can’t most merchants refuse costly payment instruments?  Answer: Customers will go to competitors (however, depends on consumer demand and merchant competition)  Merchants may accept payment instruments to steal business from competitors but aggregate sales may stay constant  Merchants may be willing to pay higher fees than socially optimal (weak “merchant resistance”) Merchant Competition

Ability to Surcharge  Merchant surcharges may alleviate “two-sided” tensions. Interchange fee may become neutral  Card acceptance becomes virtually costless, yet one does not observe complete acceptance in countries that allow surcharges  To what extent can card fees be passed on? Merchants also benefit from cards, so should they not absorb some of these costs? Complex issue of optimality. Competitiveness plays a role for economic welfare as well  In some cases, merchants may set higher prices than their costs, e.g. Dutch debit cards (merchants charged 4 times their cost)

Network and Issuer Competition  Platform or network competition does not necessarily improve the price structure although the total price may decrease  Competition may result in low or negative consumer fees if issuers compete too vigorously on the consumer side  Intense issuer competition may tilt pricing against merchants  There exists a fine line between cooperation and competition in payment markets

Interchange and Credit  Credit provides another source of extraction for payment providers. Debit and credit cards offer different credit options: overdraft vs credit line  But who pays for credit? High finance charges may affect willingness-to-pay (fixed fees) thus influencing merchant fees allowing different interchange fees for debit and credit cards  When debit competes with credit, default risk and funding cost may also affect debit card merchant fees. Competition and complementarities may drive debit cards out of the market as banks may have incentives to increase credit card acceptance  There may be a tradeoff between extending credit to less creditworthy consumers and the merchant fee

Cost-Based Approach and Innovation  Due to externalities payment prices cannot be purely cost- based (elasticities, benefit distribution)  Cost-based approach may limit incentives to innovate  Networks and issuers may require years to recoup investments in new products  May not introduce new products but upgrade existing rails

Conclusion  Payment card economics is complicated because of the interactions of set of interdependent bilateral relationships  No consensus among economists and policymakers on what constitutes an efficient fee structure for card-based payments  Too much regulation could frustrate dynamic efficiency and innovation. Unintended consequences of regulation  Initial conditions and market specifics matter, no one size fits all. Theory alone is not enough. We also need to look at the facts!