MAG Insights

By Ruth Milligan, Head of Payments and Retail Finance at the British Retail Consortium

In July of 2013, the European Commission put forward a proposal for a legislative package to improve the competitiveness of the European payments market. This package consisted of two pieces of legislation: a revised Payments Services Directive (PSD II, which updates the 2007 PSD I) and a Regulation on interchange fees (Interchange Fee Regulation – IFR).[i][1]

This article will concentrate on the IFR, which proposes caps on the level of interchange fees, the removal of restrictive rules on cross-border acquiring and honor all cards, and changes to other payment card scheme practices that create barriers for new payment market entrants, and ultimately lead to higher costs for EU consumers.

Ruth Milligan, who previously served as Senior Advisor on Payments at for the European retailers’ organization EuroCommerce, explains the detail of the legislation and its long-term impact on the European payments market.

A qualified UK solicitor, Ruth began her career in London, in the UK Office of Fair Trading. In 2000 she moved to Brussels to work for a major UK solicitors firm, specializing in EU competition law. She obtained a postgraduate degree in this subject in 2003 and went on to specialize in European financial services policy and legislation. She joined EuroCommerce in early 2008 as Legal Adviser on payment systems. She is currently an expert member of several European level payment advisory groups. Ruth has also written extensively on financial services and competition issues in both specialist and general publications. Ruth recently became the Head of Payments and Retail Finance at the British Retail Consortium.

Interchange Fee Regulation

The Interchange Fee Regulation went through the EU legislative process fairly swiftly, although it was a hotly debated measure.  In early March 2015, the final version of the text was cleared by Members of the European Parliament in an overwhelming 621 to 26 vote. It was published in the EU’s Official Journal in May and came into force on 8 June 2015.[ii] However, the provisions do not apply immediately: the interchange fee caps are mandated from 6 months (December 2015) and the more technical requirements come in after 12 months (June 2016).

The Regulation sets caps on the interchange fees for all consumer card payments. Commercial cards are exempted – though merchants in some member states will be able to impose a surcharge. Three party schemes (Amex; Diners) are also exempt unless the scheme operates through an agent, in which case it is treated as 4-party network and the caps apply.

The rules in detail are:

• Cross-border payments: places caps on consumer debit interchange fees at 0.2% and on consumer credit at 0.3% of the transaction value
• Domestic payments:

       -    Places a cap on consumer credit IF at 0.3% (though member states can set a lower percentage)

       -    Places a cap on consumer debit at 0.2% with options for the member states to define lower percentage caps or to set a maximum fixed cap of 5 eurocents

• Honour all cards rule: is removed except for consumer transactions, which are capped. Merchants therefore will have much more freedom to choose (by brand) which cards to accept.
• Identification at the terminal: All new cards will have to visibly show what type of card they are (debit, credit, prepaid) and cards will have to be modified so that the same information can be seen at the terminal by the merchants (electronic identification).
• A merchant can select the default application/network he prefers (e.g. for cobranded cards) which can be overridden only by the consumer – it cannot be pre-configured in the card by the issuer.
• Allows cross-border acquiring: a merchant may centralize his acquiring in one member state in which case all interchange fees for consumer transactions are capped at the cross-border rates.
• Separates the card schemes from the processing entities: these entities must be separate in accounting, organization and decision-making. Schemes may no longer offer their services as a package with any one processing entity.
• Strong non–circumvention rules: any remuneration which goes to the issuer from the acquirer, scheme or through any intermediary will be deemed to be an interchange fee and subject to the caps.

Let us look at these provisions in some detail: how close has the EU come to getting this right? How will the reforms impact different payment system stakeholders? What impact, if any, will the reforms have on the development of the Single European Payments Area (SEPA)? And perhaps most importantly, how will reforms impact innovation in mobile and e-commerce?

The European payments market: some history

An important point to grasp in Europe is that payment systems evolved, and have largely operated at a national level. Domestic (national-based) banks developed systems, which functioned within one country only with different rules, standards and systems for electronic payments. National level card schemes – largely debit - were created which worked within their own country.

As the European Union developed and there was a need for payment systems to work across borders, the international schemes stepped in to link all the systems up. National schemes ‘co-branded’ with the international ones to include both domestic and global applications on the same card. Over the decades, many of the national debit schemes were taken over by the international schemes and ceased to operate; yet, in a number of the major member states, the national debit scheme is still very strong – Cartes Bancaire in France; PIN in the Netherlands, Girocard in Germany, for example. In all member states, however, Visa and MasterCard also operate at the domestic level.

This situation resulted in interchange fees differing according to whether the payment was ‘domestic’ or ‘cross-border’ and also, fees for the same payment type have been hugely higher in some member states than in others.

The impetus for the Single Euro Payment Area (SEPA) was to create one single market for electronic payments in the same way that the euro created a single cash market. THE PSD I in 2007 was the first legislative step to enable this. Yet, significant barriers remained and the Payments Package - the IFR and the PSD II - are intended to open up the payments market to competition, make one set of rules on fees and related practices for all payments across Europe, and set caps on those fees at fair and efficient levels. However, and this is crucial to understand, the national systems remain hugely important both economically and politically and still process the bulk of domestic debit payments in the countries where they exist[iii]. Therefore much of the argument concerning the IFR – and its final shape - has been determined by the need to find a balance between ‘cross-border’ (mainly MasterCard and Visa) fees and domestic fees where the national debit systems are still cheaper for merchants and consumers than the international brands.

Given this background, much of the argument over the text of the IFR was how to keep the efficiency of national debit while also setting maximum caps appropriate across Europe.

A second point to understand is that there are still many uncertainties as to exactly how the Regulation will operate in practice. Member states have yet to decide which option on debit card caps to implement. In addition, the practicalities of bringing the changes needed to implement the more technical rules are still being worked out, which we will discuss later on in this article.

The competition cases

EuroCommerce began action on the anti-competitive nature of interchange fees back in 1998. It took a number of years, but the Competition Directorate of the European Commission was finally convinced and began a competition case which resulted in a decision in 2007 against MasterCard: it found their fees to be anticompetitive under the terms of the EU Treaty. MasterCard fought this decision all the way up to the highest European-level court – but lost. Action was also taken against Visa and settlements were reached which did cap fees. However, this only addressed the problem at the EU level – only payments made from member state to member state were covered. The major issues remained – fees on domestic payments and anti-competitive practices that could not be addressed under competition law. EU level legislation, therefore, was absolutely needed and this is now what we have very successfully achieved.

The likely impact of the caps

As noted above, the member states now have to decide which of the options on debit to implement. Early indications show that each country is likely to choose the option that reflects the national status quo. For example, in the Netherlands, a national agreement already caps not just the interchange fee, but also the whole of the merchant service charge. Under the IFR, this may be maintained and probably will be. The fear therefore that setting EU-wide caps might result in increases in fees in some places seems to have been unfounded. In other countries, such as Portugal where fees have been very high, they may well opt for the maximum caps of 0.2% and 0.3%. Some member states, such as Spain already have national legislation, which - as it fits with the new EU Regulation - will remain.

Will there be savings and will these be passed on?

The European Commission estimates[2] the reforms ‘could lead to a reduction of about €6 billion annually in hidden fees for consumer cards.’ But from the outset, opponents of reforms (most volubly MasterCard) have been saying that consumer retail banking fees are likely to increase and so consumers will in fact suffer.

This, therefore, has been the most hotly contested question: will consumers in fact benefit from the IFR caps? My answer is yes, they must.  In Europe, levels of retail banking fees are largely determined by the level of competition among retail banks in any one country. In some member states, there is very little competition, in others more. The Commission has strongly argued that another piece of legislation, the Payment Account Directive, which makes it easier for consumers to switch bank accounts and compare prices, will improve the situation[iv].

However, the direct benefits to consumers from IF caps may take time to become visible. Some issuers are, it is clear, reacting to the Regulation by stopping gift and voucher schemes which hitherto had been given directly to card users (and funded from the interchange fee). Any direct pass-on of cost benefits for merchants - in terms of lower prices – is likely to be difficult to monitor and calculate.

In addition, in my view, the benefits to consumers will be determined by much more than the interchange fee caps in the IFR. Technology is radically changing the way payments can be made, which is leading to huge upheavals in the whole payments market, to new business models, new products and a shift in retail banking models. On top of this, in Europe we now have the PSD and the IFR. All these factors combined will open up the payments market to competition and lead to true long-term benefits to consumers.

The Payment Service Directive, the second of the two legislative changes in the EU will have a great effect. It allows non-bank providers (so-called third party providers or TPPs) to offer payment services by directly accessing consumer account information. For Internet payments, new players are expected to enter the market, some offering direct credit transfer payment products which will be much cheaper than traditional card payments. Other ‘disruptive’ payment models, such as peer-to-peer payments, are also making inroads into the market.

On top of this the worldwide Internet platforms are increasingly becoming involved in payments and although most of these models (ApplePay, Amazon, GooglePay) operate through existing card schemes channels, their impact on retail banks’ business models for payments is as yet unknown.

As to card acceptance, it is clear that electronic payments (whether by card or other models) are on the uptick – e-commerce is becoming ever more popular. This, in my view will be the determining factor. To take full advantage of this, however, retailers, consumers and regulators will have to be vigilant: there are significant potential pitfalls, as we shall see.

The Regulation in detail

The exemptions

There are a number of exemptions from the caps:

• Commercial cards: the definition is intended to limit this exemption to cards which are for true business use only;
• 3-party schemes (i.e. Amex, Diners) unless they operates under a license or through an agent, in which case it is treated as a 4-party scheme and caps apply. There is also a member state option, which enables full exemption of 3-party schemes to a market share of 3% for a limited period.
  
  

The rationale here is that these exemptions, coupled with the steering provisions in Article 11 and the near removal of the honour all cards rule, will enable merchants to steer consumers to the most efficient payment type. This should work. However, unfortunately, due to political considerations, merchants’ ability to surcharge may be restricted in some member states under the PSD II. Some national governments are opposed to surcharging per se as a consumer protection issue. This means that while merchants everywhere will be able to refuse non-capped cards only some will be able to surcharge them. This is an unsatisfactory position, which is confusing and arguably unfair for consumers.  For this theory to work well also, solutions will have to be found to the technical problems around application selection (article 8(6)) and electronic identification at the terminal (article 10(5) – see further below)

Circumvention

The inclusion of ‘any agreed remuneration, including net compensation (defined as ‘the total net amount of payments, rebates or incentives received by an issuing payment service provider from the payment card scheme, the acquirer or any other intermediary in relation to payment transactions or related activities’) with an equivalent object or effect of the interchange fee’ is intended to provide strong protection against circumvention of the cap levels.  The intent was to make the provision as broad as possible. However, the language of the clause reflects current fee models. It is not difficult to envisage fee models where much legal argument could be had about the ‘equivalent object or effect’ – for example a fee for decrypting a token. This is a major concern.

Article 8: Co-badging

This article prohibits any payment scheme rules that prevent an issuer from “co-badging” cards or devices with two or more different payment brands or applications. The U.S. has a somewhat similar law, but one that requires issuers to include at least two unaffiliated networks on a debit card. As explained above, Europe is very used to co-badging and this provision therefore is not as crucial, nor as controversial in the EU as it is in the States. The genesis of the provision was the possibility that a third, but European, card scheme could emerge and the fact that this would only be feasible if it were able to begin as a co-branded option. A number of card schemes have attempted to enter the market in the past 5 years but were unable to get a foothold, given their inability to offer as profitable interchange fees as the major brands. The co-badging provision now will retain the position where national and international schemes can operate on the same card and also offer the possibility that one or a combination of those schemes could expand onto the cross-border market to offer effective competition.

Article 10: HACR

The Regulation notes that ‘the Honour All Cards Rule (HACR) is a twofold obligation imposed by issuing payment services providers and payment card schemes on payees to, on the one hand, accept all the cards of the same brand ('Honour all Products' - element), irrespective of the different costs of these cards, and on the other hand irrespective of the individual issuing bank which has issued the card ('Honour all Issuers' –element).’  

It further states that, while the latter cross-issuer acceptance component is a “justifiable rule,” the tying of all products together – the Honour All Products element - adds cost to the entire system, and should not be tolerated.

There was a great deal of discussion about the extent of the removal of the honour all cards rule. The merchant sector argued that the rule should be removed all together. Yet, there was also political pressure to the effect that consumers should be able to be assured that their consumer cards would be accepted everywhere. In the end, the HACR is largely removed save that it remains for capped consumer cards of the same brand and of the same category (i.e. pre-paid, debit or credit).  As noted above the effectiveness of this rationale has been somewhat diminished by the member state option in the PSD II to completely ban or limit surcharging.

A further question arises as to form factor: is the merchant obliged to accept all capped consumer cards in whatever type of hardware the technology industry may devise – watches, jewelry etc? The Regulation defines a ‘card-based payment instrument’ as being technology agnostic [Art 2(20)] – yet how far does this go?

But more important, certainly in the next five to possibly ten years will be how rigorously the two provisions discussed below – on electronic identification and application selection - are implemented across the market and enforced by the member state authorities. The problem here, as often in payments is a ‘technical’ one, which has major political and economic ramifications and which no-one quite knows how to implement. However, the requirements will be mandatory from June 2016.

Electronic identification

Crucial to the effectiveness of the HACR provision is that merchants are able to choose which applications to accept, which to refuse, and which to surcharge - as different types of payment will carry different fees. Article 10(5) therefore provides that cards must be unequivocally ‘electronically identifiable’, to both merchant and consumer both by brand and as to whether it is a debit, credit, prepaid or commercial card (or indeed a combination). New cards will also have to be visibly identifiable. The rule throws up a number of problems:

• Current EMV chips do not necessarily contain this information. Indeed, the current EMV specifications do not make provision for it. Cards therefore may need to be modified.
• Current terminals cannot read the information or display it.
• Visible identification: which language should be used; or could it be a logo? How can stakeholders ensure that the same logos/words are used and understood across the different languages of 28 member states?

Application selection

This provision is perhaps even more problematic. It concerns cards (and mobile wallets), which contain more than one brand and/or category of payment application. The Regulation allows the merchant to configure his terminal to default to the application (or card network) he prefers and so ‘steer’ consumer to the cheapest payment method (most often the local debit scheme). The cardholder, of course, maintains the right to override this default – but the card issuer has no say in the matter. (Up to now, the ‘default’ application in co-branded cards has usually been set at issuance by the bank). The Regulation, however says nothing about how this should be done, but clearly terminals will have to be modified. There are numerous issues to be overcome:

• Application/Network selection is a merchant option, which many large merchants may not wish to make use of – preferring to accept all types of cards and optimize through-put at the till. There is therefore a debate as to whether all EU terminals should be upgraded to allow for application selection.
• What sort of display? Exactly how the options should be presented to the consumer is the subject of heated debate. There appear to be 2 options:

1. The card is inserted in the terminal and all possible payment types are shown with merchants' preferred option on top (presumably). The consumer then chooses;
2. The card is inserted and only the merchant’s preference is displayed with a ‘yes/no’ button. Only if the consumer presses ‘no’, will a second screen be shown with the other options available, which are supported by both terminal and card.

The argument is a business one: some schemes fear that if 2 above is used, their brands, even on co-branded cards, will suffer. Merchants fear that if 1 is used, consumers, being more familiar with the names of the international schemes will choose that option rather than the cheaper local option the merchant favors. Card schemes therefore have been pushing for blanket conversion across Europe to option 1. However, it is clearly, from the Regulation, it is the merchant who has the choice. Discussions within the industry have now concluded that no-one can ‘set’ a blanket rule. The outcome therefore may be that different solutions are adopted in different member states, which may not be the best solution for the consumer.

A further problem arises with contactless payments and certain sectors (motorways etc.) where the display of options is either not desirable or practical. Contactless and mobile payments will be new use cases to solve for in the evolving marketplace.

Future issues and the digital single market

Lastly, let’s look at the potential impact of the reforms on emerging payment technologies in e-commerce and mobile. The big issue so far not touched upon is the emergence of mobile technologies, based on card transactions, which may have other fees, security and data ownership concerns associated with them. The ‘technical issues’ above, of course, have huge implications in this. If merchants are still, realistically, obliged to accept certain types of payment brands no matter what the form factor or the technology, the door may be opened up for a quasi-re-emergence of the interchange problem in a different form.

Even more concerning, if a merchant ‘switches on’ the NFC facility in his terminals to accept contactless cards, he then, by default, accepts payments made through mobile wallets where he has no control over, or indeed knowledge of, possible data transference. Data - as to how often and what goods consumers buy - is crucial to any retail business and goes to the heart of competition.

In my view this is an issue where the retail sector must remain strong and assert control. Following SEPA, the emphasis of the European Regulators in the immediate future is on building a digital single market. On 6 May, the Commission launched a major new initiative setting out 16 initiatives to achieve a digital single market for Europe.[v] Payments as such do not figure large, but are, in my view, intrinsic – as is the issue of the emergence of digital commerce platforms, which may command extensive market power. Essential to that market power often is consumer data.

Consumers are beginning to expect access to online and mobile shopping at any hour from any place: this will hugely disrupt traditional retail models. Consumers are also being promised new payment functions which are ‘seamless’ – yet this must not be achieved at the expense of the transparency of the cost involved in payment, which is a lynchpin of the IFR.

How the retail sector reacts to these challenges will be crucial: it must embrace the changes while strongly asserting boundaries. Retail is the key player in these changes and therefore is in a very strong position to steer the coming changes in the right direction.