Aug 31, 2007 - It does not happen every day that a company like MasterCard has to publicly ... But on May 31st, MasterCard Europe announced that instead of ...
SEPA & debit-card interchange fees: one size fits none? * This version: August 31, 2007
Leo Van Hove It does not happen every day that a company like MasterCard has to publicly revert an important decision. But on May 31st, MasterCard Europe announced that instead of applying SEPA fallback interchange rates (see box) for its Maestro debit card from 1 January 2008, it had decided to delay their introduction until further notice. MasterCard cited continued lack of clarity from competition authorities and opposition from certain merchant organisations 1. The latter had been primarily upset by the level of the announced Maestro interchange fees (IFs), and feared that accepting debit cards would become more costly. Box - IFs, MIFs, MSCs: what's behind the acronyms? • Several payment card schemes, and in particular those operated by MasterCard and Visa, are organised according to a so-called four-party model. Under such a model, besides consumers and merchants, a clear distinction is made between issuing banks (the banks that offer cards to consumers) and acquirers (those who negotiate with merchants to accept cards). • Card companies claim that, compared to acquirers, issuing banks incur a higher portion of the multitude of costs involved in enabling card payments, and would have a difficult time in recouping their costs in full from cardholders. Hence, card companies argue, there is a need for an interbank transfer payment - called interchange fee (IF) - to correct these cost imbalances, and make sure that the issuing business is sufficiently attractive. The interchange fee is thus the amount that an acquirer pays to the issuer for each transaction made using a (debit or credit) card. To be clear, card companies themselves receive no portion of the interchange fee. • Issuers and acquirers are free to determine interchange fees on a bilateral basis. However, card schemes also set interchange fees centrally. These are called multilateral interchange fees (MIFs), and function as fallback rates that apply in the absence of bilateral arrangements, which is quite often the case. • The Merchant Service Charge (MSC), for its part, is the fee that an acquiring bank charges to merchants. This fee covers a charge for the acquiring service (which is a revenue stream for the acquirer) plus the IF (which the acquirer has to pass along to the issuer). Importantly, the (M)IF
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I am indebted to Annick Boyen, Simon Lelieveldt, Peter Mair, Marc Temmerman, Eric Tomlinson, and Francisco Tur-Hartmann, for comments and/or background information. 1 MasterCard Europe, MasterCard Europe extends timetable for introduction of Maestro SEPA fallback interchange rates, press release, May 31, 2007 . Visa Europe has yet to disclose its SEPA debit IFs.
-1Electronic copy available at: http://ssrn.com/abstract=1043861
typically represents a large part - reportedly between 65% and 80% 2 - of the MSC. • Crucially, today several national debit card schemes in the EU operate without an (explicit) IF 3. This is, for example, the case in Belgium, where the Bancontact/Mister Cash scheme relies not on a four-party, but a 3.5-party model. That is, cards are issued by individual banks, but the acquiring is done centrally. • In the Single Euro Payments Area (SEPA), there is no room anymore for purely national card schemes. As a result, several countries will witness the introduction of, c.q. an increase in IFs. Given the link between IFs and MSCs, this prospect has caused great concern amongst merchant organisations. • A crucial element in the debate is also that European institutions see a single, standardised IF structure as the logical corollary of SEPA's unified payments market (see main text).
This article discusses the level of the Maestro IFs only indirectly, in the sense that it does not try to determine whether the level is justified or not. Rather, the article focuses on the fact that the IFs are 'one size fits all', and this in two respects: there is a single IF for the whole eurozone, and for the full range of transaction sizes. In what follows, I argue in favour of a differentiated IF structure, on both accounts. Single payments area = single IF? In November 2006, the European Central Bank published a SEPA progress report dedicated exclusively to developments in the cards market, and entitled "The Eurosystem's view of a 'SEPA for Cards'". In this report, the ECB established nine provisions that a SEPA-compliant card scheme should comply with, one of which being: "to have a single interchange fee (if any) for the whole euro area within a given brand"4. In line with this objective set out by the ECB, MasterCard Europe in early December 2006 effectively announced a single interchange rate structure for its Maestro product, intended to become effective from 1 January 2008 5. While the press release did mention that "in some countries, domestic interchange rates [might] differ initially based on local arrangements", it stressed that "the rates [were] designed to promote – over time – convergence to a single interchange rate structure across the Euro Zone" 6. Also, when, in subsequent months, Belgian merchant organisations UNIZO and Fedis pressed MasterCard for a temporary lower IF - a call that eventually also received behind-the-scene support from a number of Belgian banks MasterCard refused to budge. 2
See Jones, P., The uncomfortable consequences of a universal multi-lateral interchange fee (MIF) for Europe, mimeo, PSE Consulting, March 2005 < http://www.psel.co.uk/pdf/articles/interchange/consequences_of_mif_mar05.pdf>. 3 See again Jones (supra) for an overview. 4 European Central Bank, The Eurosystem's view of a 'SEPA for cards', November 20, 2006, p. 13; emphasis added. 5 MasterCard Europe, MasterCard Europe announces Maestro SEPA interchange rates, press release, December 4, 2006 . 6 Ibidem.
-2Electronic copy available at: http://ssrn.com/abstract=1043861
My concern is that while a single IF structure may make sense in a truly unified European cards market where the service level is the same everywhere, we are clearly not there yet. Both the number of electronic payment terminals and the number of cards in circulation vary widely across eurozone countries. For example, at end-2005, the number of cards with a payment function ranged from 0.83 per capita in Ireland to 1.95 in the Netherlands 7. Likewise, the number of debit card transactions per capita varied from a mere 0.45 per year in Greece to an impressive 114.01 in Finland. Given that card companies argue that IFs function as balancing instruments that make it possible to stimulate card issuance (by redistributing revenues between acquirers and issuers; see box), such differences in infrastructure suggest that some countries need stronger, c.q. weaker stimuli than others. In other words, there seems to be a case for allowing IFs to differ from one country to another, at least in a transition period. Fortunately, both the ECB and MasterCard seem to have changed their stance in the meantime. In its fifth SEPA progress report, published last July, the ECB continues to emphasise that "a geographical differentiation of interchange fees (if any) within a given scheme is not compatible with the SEPA concept in the long term" 8. However, the ECB now signals - and to the best of my knowledge for the first time - that "such differentiations could be accepted during a transition period in order to facilitate change in national markets, given the differences in the underlying cost elements and market structures across the various euro area countries" 9. Note that according to an ECB official, the Eurosystem has not really changed its standpoint, and the progress report merely clarifies that the market may need some time to adapt to the new SEPA environment. Earlier, in the press release announcing the delay of the Maestro IFs, MasterCard Europe had already recognised that "domestic markets across the Euro zone are beginning from very different starting points in terms of market structure, level of competition, consumer and merchant expectations, and regulatory environments". And, crucially, in the same press release MasterCard also explicitly states that it would "consider the need to set country-specific and other Maestro interchange rates" 10. In short, at least on this account, MasterCard seems to have abandoned its 'one size fits all' approach in favour of a country-by-country approach. Hopefully, such an approach will ward off the following scenario that I was afraid might happen with a standardised IF structure. As explained, today debit card penetration (and usage) differs considerably between eurozone countries, and so do IFs and MSCs. The introduction of a single IF for the entire eurozone would probably have meant a 'regression towards the average' - or at least to 7
Source: European Central Bank, Blue Book, December 2006, Table 10.3, p. 63. European Central Bank, Single Euro Payments Area (SEPA): from concept to reality, fifth progress report, July 2007, p. 13. 9 Ibidem. 10 MasterCard Europe, MasterCard Europe extends timetable for introduction of Maestro SEPA fallback interchange rates, press release, May 31, 2007 ; emphasis added. 8
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some intermediate level - in order to soften the impact of the transition in both high- and low-fee countries 11. In other words, there was a risk that countries with a mature and efficient debit card scheme would see IFs (and MSCs) go up - and would thus in a way be 'punished' for their innovativeness 12. This is why I argue in favour of temporary exceptions, as this would allow countries with low IFs to (more or less) keep them, while at same time allowing higher IFs in countries that still need to stimulate card issuance 13. The ideal outcome would then be for the latter to fall over time - as the countries succeed in catching up - to the level of those in the more efficient countries, resulting ultimately in a common IF that would be lower than the 'average' of the current IFs (which might prove sticky once it is in place). Flat, percentage or mixed fees? As mentioned in the introduction, the proposed Maestro IF structure was also 'one size fits all' in a second respect: while it contained four transaction-type tiers (one for large merchants, one for secure e- and m-commerce, etc.), there was no differentiation in terms of transaction amounts. Concretely, the most relevant fee - for full chip & PIN transactions at the point-of-sale - was composed of a flat fee of EUR 0.05, plus an ad valorem component of 0.20%. In conversations with and presentations by MasterCard officials 14, I have essentially heard three justifications being advanced for the presence of the ad valorem part: fraud (which is proportionally higher for high ticket transactions), losses of payment default (same), and the 'War On Cash'. As an aside, where fraud is concerned, it can be noted that in a country like Belgium where all debit card transactions are on-line, fraud is (today) not much of an issue - which is another argument in favour of geographically differentiated IFs. It does not seem fair to make Belgian merchants pay for higher fraud elsewhere. However, here I would like to concentrate on the cash replacement argument. This argument was already explicitly mentioned in the press release announcing the Maestro IFs: "MasterCard's SEPA interchange rates have been set to encourage cash substitution with electronic forms of payment, due to the high cost of cash for consumers and merchants. The flat and ad valorem interchange rate structure addresses the economics of the full range of 11
See Jones (supra) for a quantitative analysis of the impact of a common MIF on issuer and acquirer revenues. There is an important caveat here: it is implicitly assumed that schemes with the lowest IFs and MSCs are the more efficient. Clearly, this relation is not always that straightforward. A case in point is the Netherlands. A study by McKinsey revealed that in 2005 the Dutch banks incurred a loss of no less than 101 million euro on their debit card business - which boils down to a loss of 8 eurocents per transaction (Source: McKinsey & Company, Payment services in the Netherlands: an analysis of revenues and costs for banks, final report, July 10, 2006). The implication is that Dutch banks rely heavily on cross-subsidisation. To be clear: my argument in favour of geographically differentiated IFs should not be seen as an argument in favour of maintaining different cross-subsidisation levels. On the contrary, in my view, the Dutch situation is not a healthy one, and I would argue in favour of reducing the cross-subsidisation (as I have done in earlier publications). However, following Enge and Øwre, one could argue that the negative consequences are limited if only the most efficient payment services are free/cross-subsidised; see Enge, A. and G. Øwre, A retrospective on the introduction of prices in the Norwegian payment system, Economic Bulletin, Norges Bank, Vol. 77, No. 4, December 2006, p. 170. A problem is also the real cost of cash is not sufficiently visible. 13 A caveat here is that Regulation 2560/2001 implies that an acquirer cannot charge a merchant a different MSC for domestic and cross-border transactions. 14 E.g. Etienne Goosse, general manager of corporate affairs, panel discussion, Febelfin Info session on SEPA, National Bank of Belgium, Brussels, March 1, 2007. 12
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transaction values and encourages cash substitution for low-value payment [sic] while recognizing the costs and risks of higher value payments" 15. The crux of the matter is that, unlike flat fees, percentage fees result in cross-subsidisation of lowvalue payments by higher-value payments. A combination of an ad-valorem component with a (low) flat fee therefore reduces merchants' interchange cost for low-value payments compared to a pure flat fee. This is illustrated in Figure 1, which - by means of a rough simulation - also tries to gauge the extent of the cross-subsidisation in the Maestro case. To that end, the Maestro IF mentioned above (EUR 0.05 + 0.20%) was calculated for all transaction values between EUR 0.01 and EUR 100; that is, for 10,000 payments in total (see blue line). In order to compute the equivalent pure flat fee (yellow line), the aggregate interchange revenue generated by the mixed fee was divided by the total number of payments. In other words, 'equivalent' is taken to mean here that, over the whole interval, both types of IFs generate the same revenue. The difference between the blue and yellow lines then gives the direction and size of the cross-subsidisation (see green and red areas). (The reader is kindly asked to ignore for now the brown line.) Figure 1 - Mixed vs. flat fee, and size of transfers 0.3
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Before discussing the results obtained, let me stress that the simulation is obviously very rough. There are several reasons for this - which are listed in a footnote 16 - but an important one is that 15
MasterCard Europe, MasterCard Europe announces Maestro SEPA interchange rates, press release, December 4, 2006 ; emphasis added. 16 For one, the outcome depends heavily on the choice of the lower and upper bounds of the interval. Setting the latter at EUR 50 instead of EUR 100, for example, shifts the cut-off between cross-subsidised and cross-subsidising transactions (a cut-off which, under our assumptions, always lies in the middle of the interval) to EUR 25. A transaction of EUR 50 then has to generate a transfer payment of 5 eurocents (or 33% of the total IF), compared to none at all in Figure 1. My choice of interval has been inspired by the fact that the average value of a debit card transaction
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costs have been assumed away because of a lack of data. My 'cross-subsidisation' results should therefore not be interpreted in terms of 'below cost' vs. 'above cost'. Perhaps 'transfers' is a more correct terminology. As can be seen in Figure 1, under the assumptions of our simulation, transactions above EUR 50 'subsidise' those below that level. Also, for the high ticket transactions, the extent of cross-subsidisation is quite large: the interchange cost of a EUR 100 transaction is EUR 0.25 under the mixed fee, compared to only EUR 0.15 under the flat fee. In other words, the subsidy amounts to 40% of the mixed interchange cost. Now that the mechanics of the mixed IF structure have been made clear, let me explain why I am not convinced that such a fee structure is the best option. At first sight, encouraging cash substitution can only be beneficial. After all, an increasing body of central bank studies shows that both the total and average social cost of cash is higher than that of debit cards 17. However, when trying to figure out whether society would benefit from the displacement of one payment instrument by another, one should reason primarily in terms of the marginal social cost - especially when comparing established payment instruments - and one should also take into account that, for several payment instruments, this marginal social cost varies as a function of the transaction amount. To be clear: the marginal social cost of a payment instrument is the cost, for society, of making one additional payment of a certain size. A study by the Dutch central bank shows that one additional debit card payment of EUR 1 would cost Dutch society 19 eurocents - a figure which rises only slightly in accordance with the amount to be paid 18. Crucially, if that same payment were to be made in cash, the additional cost to society would only be some 12 eurocents. However, because the cost of cash increases with the transaction amount, at a certain point debit cards do become more cost-efficient from the point of view of society. In the Netherlands, this switching point lies at EUR 11.63. A similar study for Belgium puts it at EUR 10.24 19. The message here is that for low-value payments, cash is still more economical than debit cards. Hence, society would not benefit from a displacement of cash by debit in this segment. The Dutch and Belgian studies also show that in both countries electronic purses, for their part, are more cost-efficient than cash, regardless of the amount of the transaction. In the Netherlands, one additional e-purse payment would cost society a mere 3 eurocents. Let me now, in order to drive home my point, bring together the building blocks of my argument. First, the figures on marginal social costs just cited provide an indication of the interval of in Belgium was almost exactly EUR 50 in 2005 (Source: own calculation based on European Central Bank, Blue Book, December 2006, p. 122-123). Secondly, the simulation implicitly assumes that transactions of all sizes occur equally frequently. A more realistic simulation would require data on the (expected) frequency distribution of debit card payments. Finally, economies of scale are not taken into account as the number of payments is identical under both fee structures. 17 Van Hove, L., Central banks and payment instruments: a serious case of schizophrenia, Communications & Strategies - International journal of digital economics, Nr. 66, 2nd Quarter 2007, p. 19-46. 18 De Nederlandsche Bank, The cost of payments, Quarterly Bulletin, March 2004, p. 57-64. 19 National Bank of Belgium, Costs, advantages and drawbacks of the various means of payment, Economic Review, June 2006, p. 41-47.
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transaction amounts for which a specific payment instrument is the most efficient from the point of view of society. Second, Figure 1 shows how the mixed IF structure stimulates low-value debit card payments. If one brings these two observations together, the inevitable conclusion is that this is not the best way forward from the point of view of society. Indeed, while the social cost of the payment system would fall as a result of a displacement of low-value cash payments by e-purse payments, increased usage of debit cards below the switching point of EUR 10-11 would actually increase it. It would also narrow the market for (cost-efficient) e-purses 20. Hence my fear that the mixed IF structure proposed by MasterCard might result in 'overreach'; that is, a situation in which a payment instrument is artificially pushed - I refer to the transfers in Figure 1 - into a segment of the market that is not its 'natural' segment. In this respect, it is interesting to also have a look at the brown line in Figure 1. The brown line represents the Merchant Service Charge (of 0.55%) that Belgian merchants face when they accept payments with the Proton e-purse. Worryingly, this MSC is lower than the mixed Maestro IF - which is not even a full MSC - for transaction values up to EUR 14.31. Provided that the Proton e-purse is not crosssubsidised 21, this would seem to indicate that, ceteris paribus 22, debit cards are less cost-effective than e-purses, even when making abstraction of the cross-subsidisation illustrated in Figure 1. A dedicated low-value solution This said, there is no denying that e-purses have not been much of a commercial success in Europe, and that they are no longer actively promoted in several of the countries where they still exist. There is also no denying that consumers like using their debit card for increasingly smaller payments 23. In addition, it is quite possible that technological advances - IP lines, standardised POS terminals, contactless technology, a (partial) switch to off-line, etc. - make it possible to lower the cash/debit social switching point 24. Also, the marginal social cost figures quoted above do not take into account any (dis)economies of scale caused, c.q. generated by the cash/card displacement process 25. 20
For the reader who would have difficulties to see how a MIF or its structure would push an instrument to the wrong segment, imagine the following scenarios: (1) Picture a merchant who currently already accepts debit cards but puts a floor on it; that is, below, say, EUR 10 she either surcharges or does not accept cards at all. With the new, artificially low MIF (and hence MSC) for low-value debit payments, such a merchant might be tempted to drop the surcharge or lower the floor; (2) A merchant who currently does not accept debit cards (because she sells mainly low-ticket items) might now become interested. 21 Reportedly, 2002 was the first year Belgian banks made a profit on Proton (Source: ECR, Electronic purse: last chance for GeldKarte, European Card Review, Vol. 10, Nr. 2, March/April 2003). 22 Note that abstraction is made of differences in merchant costs besides MSCs, differences in the way issuer costs are covered (i.e., with or without an explicit IF), etc. In fact, as above, a correct analysis would require comparing the marginal social cost of Maestro and Proton. However, the only piece of information available on Maestro was the proposed MIF. 23 A recent illustration is that the Dutch city of Schiedam has started installing parking meters that accept debit cards rather than the local Chipknip e-purse. According to a survey by the city of Amsterdam, this is what 80% of the motorists want (Source: "Pinnen bij parkeerautomaat maakt chipknip nutteloos", Algemeen Dagblad, August 4, 2007). 24 Note that the study by the Dutch central bank relies on data for 2002; the Belgian study relates to 2003. 25 Fixed costs are not included. In other words, the implicit assumption is that the infrastructure is already available.
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For an outsider like myself, it is difficult to gauge just how cost effective debit cards can be made for low-value payments; in other words, just how far the cash/debit switching point can be pushed to the left. However, in my view, the litmus test should be: can debit cards take on cash and e-purses in the low-value segment without subsidies coming from higher-value debit card payments (which might very well increase the overall social cost)? As hinted at in the introduction, I would therefore prefer to see a dedicated low-value solution - that is, a solution specifically designed (and priced) for this segment - rather than a 'one size fits all' card. If debit cards can indeed be made cost effective for low-value payments, then I would have no problem with the low-value solution being a debit card. It could even be the very same debit card as the one used for higher-value payments. In fact, consumers probably would prefer such a 'one size fits all' card. My point is that it need not be a 'one size fits all' solution from the point of view of merchants. What looks like the same card (and brand) to consumers could, in my view, very well conceal two separate pricing structures - and different risk management procedures? - on the merchant side: one for low-value payments (a percentage fee 26) and one for higher-value payments (a flat fee 27). In this way, the debit card would compete on it own merits in the low-value segment. To be clear, in my view, such a segment-by-segment approach does not equate with sector-by-sector approach, and it would obviously be beneficial if the low-value solution could piggyback on an existing, standardised infrastructure. In this way merchants with relatively few low-value payments could also be persuaded to accept it, resulting in higher coverage. According to Eric Tomlinson, MasterCard's SVP for Debit Product Management in Europe, MasterCard's Maestro PayPass solution fits in with just about everything I would like to see 28. For one, it is a single proposition for the customer, with Maestro PayPass and Maestro on the same card. There is also no need to reload the card. Secondly, Tomlinson stresses that unlike e-purse schemes, Maestro PayPass uses the existing EMV infrastructure so that there is no additional infrastructural cost. Also, PayPass is a chip-only product designed to operate off-line so that the 26
In this respect it is interesting to refer to the launch of contactless payment in London, planned for the fall. Today, UK merchants pay a fixed fee on conventional debit transactions - which, according to Card Technology, ranges from 10 pence or less per transaction for large retailers to 19 pence for small merchants. However, Visa Europe has recently confirmed that it will "set an initial (UK) interchange rate for contactless transactions at a level intended to incentivize adoption of Visa payWave". Visa declined to reveal the exact rate but, again according to Card Technology, it will likely be a percentage fee. Card Technology talks about 1% to 1.5%, which is fairly steep, but would nevertheless result in lower fees for merchants for low-value payments. Card Technology also mentions that UKP 10 is the maximum the banks and card organisations are targeting for contactless payment (Sources: Balaban, D., "UK merchants to pay lower fees to accept contactless", Card Technology news bulletin, May 9, 2007 ); Balaban, D., "Visa confirms new interchange rate for UK contactless launch", Card Technology news bulletin, May 11, 2007 ). 27 Interestingly, as I was writing this article, MasterCard withdrew plans to introduce (partial) ad valorem fees in the UK with the launch of its new Debit MasterCard. The fee MasterCard will charge retailers for transactions made with its new card has yet to be announced but, according to the British Retail Consortium, "it will not be linked to the value of the transaction" (Source: British Retail Consortium, End of card charge plan good news, press release, August 24, 2007 ). 28 Tomlinson, E., private e-mail, August 29, 2007.
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"marginal cost of an off-line transaction should be lower than cash to society down to the lowest level, even cheaper than purse". Finally, the flat part of the IF would be "low", so as to encourage low-value electronic payments. Obviously, it is impossible to check MasterCard's claims concerning low costs. Much will also depend on the exact level and structure of the IF, which is yet to be announced. And above all, if Maestro PayPass fits the low-value picture that well, why would there still be a need to stimulate low-value payments with the 'traditional' Maestro card? Finally, the flat part of the IF would be "low", so as to encourage low-value electronic payments. Obviously, it is impossible to check MasterCard's claims concerning low costs. And much will depend on the exact level and structure of the IF, which has yet to be announced. A call on the Commission In conclusion, when it comes to fees for SEPA debit cards, I would not only prefer a country-bycountry approach, but also a segment-by-segment approach. Importantly, the European Commission has an opportunity to have a say in this in the coming months. The Commission is expected to rule on MasterCard's interchange fees sometime this fall. Moreover, the exemption granted to Visa in 2002 ends on December 31, at which time the Commission will be free to reexamine the agreement. Let us hope that, in making these decisions, the Commission will not solely be guided by antitrust concerns in a specific market, but will also take into account the impact on other payment instruments, and ultimately on the social efficiency of our retail payment system. To put it pithily, not only the level of fees matters, their structure matters too.
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Leo Van Hove Associate Professor of Economics at the Vrije Universiteit Brussel (Free University of Brussels), where he teaches courses in monetary economics, advanced IT, and e-commerce. His current research interests are payment instruments and e-publishing. He has published extensively on these and other subjects in international journals (such as Journal of Money, Credit, and Banking; International Journal of Electronic Commerce; De Economist; Energy Economics; and European Journal of Operational Research). He maintains a comprehensive reference database on e-money as part of the ePSO website of the European Central Bank. Homepage: http://econ.vub.ac.be/cfec/leo.htm
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