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The RBA must put a price on innovation

As giants like Apple and Google and China Union Pay, along with literally thousands of would-be disruptors, try to upend the global payments system, it may seem slightly anachronistic the Reserve Bank of Australia still has its focus on interchange fees – an agenda kicked off well over a decade ago when Apple still just made computers and Google was barely a verb.

Yet as the RBA's Review of Card Payments Regulation under the auspices of its Payments System Board (PSB) ticks over another milestone with industry responses to its March 2015 issues paper, it's important to recognise some debates are ageless.

"Set (fees) too low and there will not be enough incentive for new competitors to enter the market."
Andrew Cornell, Managing Editor

And the key one is who pays for innovation?

This will be the underlying question the RBA will have to answer. Interchange fees, the fees paid by payment processors to payment device issuers (which may be cards or phones), will be front and centre.

Set too low and many in the industry argue there will not be enough incentive for new competitors to enter the market or to reward innovation. Set too high and the RBA believes the incumbents will become fat and lazy and fail to seize the opportunity of new, more efficient, networks such as the proposed real time New Payments Platform.

We all want innovation – consumers because it should make our lives easier, policy makers because it drives productivity in the economy, merchants because it lowers costs and boosts sales and the financial services industry because it delivers profits.

So who should pay? Well economic theory tells us those who benefit. But decades of work on payments networks, around the globe, reminds us payments systems are incredibly complex. There needs to be a return for those who innovate – just as Copyright pays a dividend to those who innovate in the arts – but what should it be? Should Copyright be for 100 years, as many owners of Copyright content (typically not the creators of it) maintain? Or much less to promote greater use of the content and appreciation of its artistic value?

This was the fundamental challenge the RBA confronted when the reform of Australian payments campaign kicked off in 2003. The bank argued the issuers of payment cards received too much revenue while those who processed transactions didn't earn enough and lacked market power. The merchants meanwhile – and hence their customers – paid fees which were both too high and not specific enough to drive efficiency.

The reforms certainly cut interchange and transferred nearly a billion dollars annually from banks to merchants. Consumers should have benefited from lower prices and this is likely the case although that is almost impossible to measure given the dispersed affect.

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However, the reforms also saw a surge in surcharging, particularly in industries with market power where coincidentally the major players all moved in lock step. Typically these surcharges sought to recover the full cost of bank fees rather than the net cost of fees less the benefit to the merchant of direct electronic payment – benefits like lower cash handling costs, faster crediting, higher average spend.

The RBA itself has identified certain industries as very enthusiastic surchargers including taxis, airlines and hotels.

In its March issues paper, the PSB noted its reforms “had improved access, increased transparency and had led to more appropriate price signals to consumers”.

It further noted it had been prepared to step back from more formal regulation of interchange but the industry had not been able to get its act together. Or words to that affect.

“Aspects of the interchange fee system and merchant surcharging practices have raised concerns, some of which were noted in the Board's 2013 Annual Report and the Bank's two submissions to the Financial System Inquiry (FSI),” the PSB said in March.

“There have been some significant changes to the regulation of card payments in other jurisdictions.”

The FSI did indeed make piecemeal reference to payments, in some cases driven by concerted public campaigns, particularly one against surcharging.

Yet, while this latest review will discuss the rapid and even drastic revolution taking place in payments, and address a range of particular industry concerns around fee setting, it will still hinge on who should pay for innovation?

The PSB says as much: “Interchange arrangements in the card systems will also affect the nature of new payment arrangements that are adopted by the payments industry.”

“In particular, a more efficient and lower-cost new payment system might be hampered in its development to the extent that it had to match existing interchange payments to card issuing institutions to ensure the participation of banks in the new system.”

This is the hard core of the debate and there is no easy answer. Apple Pay, the highest profile new player in payments, has taken off in the US but barely anywhere else. One theory is because interchange rates in the US are high enough – more than double Australia - that banks can offer Apple a clip of the deal, encouraging Apple to take a greater role in shifting payments on to bank systems and networks such as Visa and MasterCard through the use of Apple Pay.

A particularly thorough piece of work by Deutsche Bank in the US, “Solving for Frictionless Mobile Payments: Networks in the driver's seat”, analysed how profoundly the payments landscape is changing.

Deutsche argued the “emerging payments growth will be in-app, eCommerce, international expansion, loyalty, and digital marketing”. The report looks at “the evolving emerging payments landscape and the strategies of notable public and private players including Google, Samsung, Facebook, PayPal, Amazon, Square, Stripe and MCX (Merchant Commerce Exchange)”.

However, “the recent Apple Pay launch, along with the marketing blitz by the networks/banks, has led to increased awareness, but adoption and acceptance of mobile payments remains slow,” Deutsche said.

”We believe that the key consumer value proposition, namely targeted offers and loyalty programs, will get an increasing amount of intention.”

But what pays for these programs? Ultimately it is interchange, primarily. Moreover, where schemes such as Visa and MasterCard are developing new security systems for mobile payments, such as tokens, to make merchants and consumers more comfortable, Deutsche doesn't believe it will drive interchange lower.

This is the challenge the PSB faces in its regulatory quest and there are no easy targets. Even where formal “interchange” doesn't exist, such as with American Express, there is a complex interchange of fees and charges between Amex, the Amex network, banks, merchants and others.

Cutting fees in these systems looks attractive up front – it's an easy sell to say $A1 billion a year has been taken off financial institutions. But if in the long term that stifles innovation because it's not attractive to invest and develop, customers and the economy may pay more in the future.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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