EU payment legislation carries implications for card acquirers

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1 Exclusive insights from Masterard dvisors July 05 EU payment legislation carries implications for card acquirers uthors: Michael J. McEvoy, Phillip M. Miller The I fee regulation entered into force on June 8, 05. The caps on interchange will become effective on December 9, 05. Just as issuers will face changes from the EU payment legislation, card acquirers will need to consider operational and strategic implications from the Interchange Fee Regulation and the proposed second Payment Services Directive [PSD]. () The stated intent of the European ommission () in introducing this legislative package is to: ontribute to a further integrated and efficient European payments market. Level the playing field for payment service providers (including new players). Ensure a high level of consumer protection and payments security. Encourage lower prices for payments. Facilitate the emergence of common technical standards and interoperability. The final text of the Interchange Fee Regulation was published in the Official Journal of the European Union (OJEU) on May 9, 05. It entered into force on June 8, 05. Figure summarizes key elements of the adopted Interchange Fee Regulation from an acquiring perspective. come into force remains uncertain. fter it comes into force, Member States will have two years in which to transpose it into their respective national laws. The combined adopted legislative package is expected to give rise to significant changes (operational and strategic) in the card-acquiring and acceptance landscape in the European Economic rea (EE) in coming years. Given the impact that many expect the Interchange Fee Regulation to have on the card payments sector, we believe that card acquirers should be reassessing their approaches and strategy so that they are well positioned as the post-regulation business environment unfolds. While doing so, we suggest they consider the following key questions: 3 How will the industry likely evolve as the new regulatory environment takes hold? Will the traditional domestic focus of the card-acquiring business change? What are the main operational implications for card acquirers of the regulatory package? t the time of writing, the second Payment Services Directive has reached the stage of a political agreement during the trilogue negotiation meeting of May 5, 05, between the European Parliament, the ouncil of Ministers, and the European ommission to reconcile competing proposals. PSD will include a number of key provisions relating to surcharging, access to bank accounts for the purpose of initiating payments and strong authentication. The timing of when PSD will 4 What are the key strategic issues that acquirers should be considering for the postregulatory period? How will the industry likely evolve as the Q new regulatory environment takes hold? Merchant acquiring in Europe is characterized by the presence of both pan-european acquirers and domestically focused businesses. While the former are Exclusive insights from Masterard dvisors

2 entral acquiring is a term we use to describe the situation in which financial risk is assumed by an acquirer across several countries, in contrast to the more traditional model of an acquirer assuming financial risk in one country only. Figure : Key Features of the Interchange Fee Regulation That Will Impact cquirers Interchange Fee Regulation I Fees and usiness Rules Highlights Effective Date Interchange fees for consumer debit card transactions (rticle 3) Maximum permissible I levels of 0 bps, for intra-ee and domestic transactions; Member States may implement caps of 0.05 (or currency equivalent) for domestic transactions and may impose lower caps on domestic I. Member States may choose to combine it with I cap of up to 0bps, provided the overall I is no greater than 0bps December 9, 05 Interchange fees for consumer credit card transactions (rticle 4) Licensing (rticle 6) Separation of payment card scheme and processing entities (rticle 7) o-badging and choice of payment brand or payment application (rticle 8) Unblending (rticle 9) Member States may permit weighted average I of no more than 0bps within each payment card scheme Maximum permissible I levels: 30 bps, for intra-ee and domestic transactions; Member States may impose lower caps on domestic I Territorial restrictions within the EE on scheme licensing agreements with issuers and acquirers are to be prohibited Systems and processes must allow possibility for authorization and clearing messages to be separated onsumer choice of brand at POS in case of co-badged cards; merchants may install priority selection at the POS as long as customers can override Unless merchant opts out in writing, acquirers need to provide: Unblended MS for different categories and brands of payment cards Information on the amount of MS, IF and scheme fees applicable with respect to each category and brand of card payment December 9, 05 and permissible for up to 5 years thereafter December 9, 05 June 9, 06 entral acquiring, channel strategy and eommerce Some acquirers have already expanded their channel strategy to implement central acquiring and follow their merchants across borders, leveraging eommerce gateways. Eommerce, in particular, represents an area of potential growth and opportunity, despite its particular challenges (e.g., eommerce gateway, fraud management, foreign currency, languages, reporting). In meeting these challenges, solutions have been developed that enable eommerce across multiple geographies on a single platform with, for instance, multi-language and multicurrency support. cquirers that migrate toward central acquiring business models will need to implement capabilities that are also suited to the needs of eommerce merchants. While this may intensify competition among large central acquirers serving eommerce merchants today, it will also open up new potential opportunities for acquirers currently unable to cater to the online merchant. Source: Masterard dvisors and the text of the Regulation, as published in the Official Journal of the European Union, Volume 58, dated May 9, 05. relatively few in number, they have in recent years gained importance by attracting as clients large multinational merchants seeking operational gains through centralization. With such merchants seeking improvements to both operational efficiency and supply chain management through centralized operations, pan-european acquirers have tapped into this strategy by promoting central acquiring services. Given a number of elements in the regulatory package, many within the industry expect to see a continuation of the trend for transaction volumes to become more concentrated in a pan-european operating model: There will be no territorial restrictions on acquiring licenses from payment schemes within the EE a process that has already begun among specific scheme(s). Honour ll ards rule (rticle 0) Information to the payee on individual card-based payment transactions (rticle ) The Interchange (I) caps equate to a more uniform I rate environment. Honour ll Products element has been removed from the Honour ll ards rule Unless waived in advance by the merchant, detailed information is to be provided: Identifying reference to the payment transaction; The amount and currency credited; reakdown of charges applying to the transaction, including the MS and I December 9, 05 To become a central acquirer, acquirers may consider a number of potential paths, each of which would likely require significant upfront resources and investment: uild It Yourself. cquirers may decide to develop their own capabilities beyond the home country or outsource to other countries. Joint Venture. cquirers that are strong in one country and deploy superior technology may be best positioned to attract partners in other countries to form a regional or pan-european network that expands the options and services available to their merchant customers. M&. Some existing acquirers may decide to merge or be acquired, aiming for a broader footprint and potential for being more cost competitive. Likewise, some institutions with acquiring subsidiaries may decide that acquiring is not a core business and divest accordingly, having contemplated the competitive environment post-regulation.

3 Migrating to a central acquiring and centralised acceptance model. One of the major roles of an acquirer is to assume and manage financial risk primarily, the risk of merchant insolvency and, to a lesser degree, fraud risk. omplementary to the central acquiring model in which financial risk is assumed by the acquirer across several countries is the notion of centralized acceptance, which may be favored by large cross-border merchants seeking centralization. Together, central acquiring and acceptance may be considered to be the consolidation of: cquiring financial functions (risk analysis and management); and cquiring operations functions (IT, technology, customer service and reporting to consolidate acquiring in one location). Some industry observers anticipate faster migration to a central acquiring and acceptance model in the post-regulatory environment, driven largely by pan- European merchants. In a central acquiring and acceptance model, the merchant consolidates its card payment traffic through one acquirer. Merchant POS activity across multiple countries is routed to a central host, enabling transaction volumes to pass through a single acquirer (Figure ). central acquiring model has the greatest applicability to larger merchants operating physical stores in multiple countries, and these types of merchants are driving a growing demand for central acquiring services. Will the traditional domestic focus of the Q card-acquiring business change? Domestically focused acquiring institutions are often banks that have developed both issuing and acquiring businesses. These issuer-acquirer banks may be challenged post-regulation as pan-european acquirers may be able to leverage their scale to target the larger merchant customers of domestic acquirers. Such banks may also be more constrained by capital requirements and risk exposure limitations than are the emerging non-traditional types of competitors. Overall, we may identify three core options facing domestically focused acquirers as they contemplate their future in a post-regulatory environment: Retain a domestic focus. Engage in cross-border acquiring by developing a sales presence in other countries through partnership, organic growth, or outsourcing. 3 Migrate to a central acquiring model. Figure : Migrating to a entral cquiring and cceptance Model central acquiring model has the greatest applicability to larger merchants. Pan-European Merchant Locally cquired Type oncentrator cquirer Local Format Switch Type oncentrator cquirer Local Format Switch Type oncentrator cquirer Local Format Switch entral cquiring Model Standard Single Merchant Host/Gateway entral cquirer International Standard Format Switch Source: Masterard dvisors 3

4 If acquirers choose to remain domestically focused, they may anticipate loss of business from pan- European acquirers who may initially be inclined to focus on acquiring for larger merchants. s a result, acquirers choosing to remain domestic-only players may begin to focus more on relatively untapped sources of new business (e.g., government/public sector) and adding value-added services (e.g., recurring payments/ bill payment, terminal management), deepening their penetration and acquiring success in their home country. What are the main operational Q3 implications for card acquirers of the regulatory package? The Interchange Fee Regulation that has been adopted will have a number of operational implications for acquirers. s they begin to think through operational issues when planning for the period ahead, we suggest that acquirers include the following among their top-of-mind considerations: onsumer hoice of rand at POS. Under the new regulation, rules that prevent an issuer from co-badging two or more different brands of payment instruments on a card, telecommunication, digital, or IT device will be prohibited. t the point of sale, either the physical terminal or eommerce point of interaction, consumers using a co-badged card are to be given the choice of payment application or payment brand. While merchants have the option of prioritizing a particular brand or application at the POS, they must also permit the consumer to override this automatic priority selection in a non-discriminative and transparent manner. cquirers will need to ensure that POS terminals as well as eommerce websites are updated to remove automatic routing and to enable consumer choice at the point of interaction. Reporting Requirements/Pricing Transparency. cquirers will be required to offer, charge, and report to their merchant clients individually Figure 3: ompliance with Unblending, Enhanced Reporting Requirements urrent State Day-to-Day Impact Operational Implication SERVING MERHNTS THROUGH ONTRTS SED ON I++ LITTLE HNGE MY E REQUIRED IN ONTRTS WITH MERHNTS POTENTIL NEED FOR DDITIONL IT OST FOR REPORTING K-OFFIE TEHNIL HNGES MY E NEEDED TO SUPPORT REPORTING TO MERHNTS T THE LEVEL OF DETIL REQUIRED Y REGULTION Do not obtain merchant waiver SERVING MERHNTS SED ON ONTRTS THT INLUDE UNDLED PRIING/LIMITED REKDOWNS Obtain merchant waiver MJOR ONTRTUL HNGES POTENTIL MS NEGOTITIONS WITH MERHNTS POTENTIL NEED FOR DDITIONL IT OST FOR REPORTING SEEK MERHNT GREEMENT TO WIVER VI ONTRT DDENDUM NEED FOR REVISED ONTRT WITH MERHNTS ND NEED TO RESTRUTURE ND NEW ONTRTS WITH MERHNTS TO REFLET LEVEL OF MS DETIL REQUIRED Y REGULTION ND K-OFFIE TEHNIL HNGES ND MY E NEEDED TO SUPPORT REPORTING TO MERHNTS T THE LEVEL OF DETIL REQUIRED Y REGULTION NEED FOR DDENDUM TO URRENT ONTRTS WITH MERHNTS TO WIVE UNUNDLING Source: Masterard dvisors 4

5 ddressing country-specific technology issues There are several important country-specific technology issues that may need to be addressed following adoption of a regulatory package, including: Interconnectivity with the domestic debit schemes that exist in several EE countries. This will be a challenge for acquirers, necessitated by the practical implications of some of the regulatory requirements that have been adopted (e.g., consumer choice of brand at POS). With different protocols in place among such schemes and no one PI available today to enable these connections, the most optimal solution in the short term may be to use international schemes standards to create this interconnectivity. Differences in merchant POS technologies in use across different EE countries. Some acquirers will decide to follow their merchants as the merchant expands across borders and/or will decide to expand into new EE countries to acquire merchants located in those countries. In doing so, they will need to address the POS terminal and other payment technology needs of merchants. cquirers may rely on local outsourcing solutions for such technologies as they enter new EE countries. specified and detailed MSs for different categories and different brands of payment cards with different I levels. Individual merchants will be permitted to waive this unblending of MSs if they do so in writing to the acquirer. In addition, acquirers will have to provide transparency on the levels of interchange fees and scheme fees applicable with respect to each category and brand of payment cards. cquirers may need to implement separate item reporting MSs at the systems level to allow for the possibility of offering and reporting MSs in the manner described. Figure 3 summarizes the highlevel impacts and implications for acquirers of unblending and increased reporting detail. No Surcharging of ards Subject to I aps. Under the proposed PSD, merchants will not be permitted to surcharge cards that are subject to I caps. From the acquirer standpoint, there may be a need for technologies deployed at the point of sale to be updated to assist merchants in complying with this mandate and for ongoing monitoring. There may also be a need for acquirer-initiated campaigns to educate merchants on the difference in surcharging as it relates to the cards that are subject to caps and those that are not. The issues described above (and in the sidebar) are among the major operational considerations that acquirers will face in the post-regulatory environment. Related and potentially significant decisions may also need to be made that have operational implications, including, for example, where to become established in the future and what that decision entails in terms of organizational and legal structures a decision which may give rise to complex tax considerations and implications. What are the key strategic issues Q4 that acquirers should be considering for the post-regulatory period? onsidering both the newly adopted I regulation and emerging business trends within the industry, there are several opportunities and issues that acquirers should consider when formulating their strategy for the period ahead: ard acceptance expansion Value-added services for merchants Potential impact of third-party providers on the acquirer s business ard cceptance Opportunities. cquirers that are more domestically focused may expect increased competition post-regulation, given the long-standing trend toward central acquiring. In response, a first step may be to assess the available untapped opportunities for acceptance. cquirers would do well to conduct this type of strategic exercise as soon as is practical. The exercise may identify categories that are ripe for expansion, to generate replacement revenue for existing business at risk. Depending on the market, there may be acceptance gaps in sectors such as insurance, utilities, and government. cquirers should develop an understanding, for example, of how consumers and businesses make payments to government entities and where opportunities may surface for card payments. In some countries, acquirers may find support in a government mandate to encourage electronic payments in the public sector. Similarly, acquirers may find that insurance premium payments are ripe for card acceptance. potentially important enabler for expanded acceptance will be mobile technology, which may prove effective in penetrating relatively untapped markets such as insurance company agency sales. In addition, mobile POS acceptance can help to enable payments closer to an underlying event for example, mobile POS could be utilized to enable the purchase of travel-related insurance by the departing traveler at the airport. More broadly, opportunities may also be found among small and micro businesses (e.g., taxis, doctors, street vendors, small office/home office [SOHO] business operators). However, when exploring the micro and small business environment, it will be key to engage with them through appropriate distribution channels and partnerships (e.g., with industry associations). For micro businesses, in particular, it will also be important to offer an easy choice, in the form of streamlined operations and connectivity, at a transparent cost. rguably, retail banking channels provide the best growth opportunity for acceptance solutions as customers are known to the bank. The sale of low-cost devices via the retail banking channel/ counter also adds value to account offerings and would help to sustain the revenue stream on the retail banking side. 5

6 Figure 4: Identifying and Leveraging cceptance Gaps Identify acceptance gaps, develop plan 3 4 Track and monitor acceptance growth ddress resource needs ontinue to build, maintain strong merchant relationships Source: Masterard dvisors s opportunities are identified, a plan will need to be developed to prioritize and align them with available resources (Figure 4). lternatively, if there is insufficient potential domestically for new business to meet growth goals, the acquirer may also wish to consider the feasibility of following their merchants across borders, or central acquiring opportunities. Value-added Services for Merchants. Where appropriate, acquirers may work to improve the depth of their relationship with their merchant customers by providing superior, localized service (e.g., faster response to technical issues with POS terminals) and through the addition of valueadded services to strengthen merchant retention. These value-added services (see Figure 5 for examples) may help differentiate acquirers from their competitors while overcoming the perception among some merchants that card acceptance is a commodity business. In addition, valueadded services may serve to generate new and ongoing fee-based revenue, potentially providing incremental revenue as competition intensifies in the post-regulatory period. Some expect that the greatest impact of TPPs will be in handling eommerce payments on behalf of merchants, but their success will partially depend on consumer willingness to provide access to their current accounts, along with consumer acceptance of bank transfer fees. To counter the potential impact of TPPs on their business, acquirers should, at a minimum, work to deepen their relationship with merchants for instance, by improving service and offering value-added services to merchants as a means of competitive differentiation. In this regard, the trend toward channel convergence will be helpful to acquirers. If they embrace emerging technologies such as MPOS, acquirers can help bring an eommerce-like shopping experience to brick & mortar stores delighting customers and potentially bringing more sales to the merchant. Likewise, facilitating e-wallet payments will assist in the development of mobile payments and maintenance of transaction volumes. Increasingly, acquirers will need to provide supportive services for these types of technologies, regardless of whether they hold a domestic or international focus. Impact of Third-Party Payment Service Providers (TPPs). Under PSD, a new category of payment services providers, TPPs, will have right of access to bank accounts if the customer authorizes it, in order to check the availability of funds and/ or initiate a credit transfer or direct debt from the current account, as well as to provide account information services. cquirers should consider the potential impact of this new type of provider on their business model. ONLUSION ND NEXT STEPS With regulatory changes and highly impactful industry developments under way across the European Economic rea (EE), the payments sector is experiencing significant change. Merchant acquirers will face new challenges, but new opportunities will also emerge as the industry adjusts to a changing business and regulatory environment. 6

7 Merchant acquirers will face new challenges, but new opportunities will also emerge. Figure 5: Tailoring Value-added Services to the Merchant SHK MOILE TOP UP RIEF DESRIPTION LRGE SME PROFESSIONL Service to withdraw cash at the POS while making a payment for good/ service Service allowing customers to top up their mobile phone account at the POS using their card EST SUITED TO: PREPID TOP UP Service allowing customers to top up their prepaid card account at the POS using their card INSTLLMENT Service allowing customers to choose, at the POS, to pay for a purchase in installments ONTTLESS Quick and easy payment for goods or services M-POS SOLUTIONS POS devices working together with a smartphone or tablet device through luetooth or wireless connections DIRET MRKETING ONNETIVITY/ RODND Electronic customer retention solutions for terminals through customer loyalty discounts, gift card, prepay, and voucher redemption applications Offer of quick and secure connectivity services bundled with acquiring terminals and solutions PI DSS Offer of POS PI DSS certification for merchants or other providers accepting electronic payments Large: Tier, merchants. Small and Medium Sized Enterprises (SME): Tier, 3 merchants. Professional: Doctors, dentists, and other professionals. Source: Masterard dvisors. s discussed in this paper, we expect that merchant acquirers, particularly those with a domestic focus, will experience increased competitive pressures soon after the pending legislative package comes into force. The time to act is now and acquirers should start by undertaking a comprehensive, strategic reassessment of current approaches, and begin to develop a plan that will carry them through the post-regulatory environment. Merchant acquirers should consider partnering with trusted solution providers while developing their future strategies and seek to implement state-of-the-art responses that will be differentiators with customers. In fact, leveraging technology both to understand and address customer needs will be a key means to success in the new environment that will emerge. For custom analysis, please contact your Masterard representative or visit NOTES. Our views are based on the text of the Regulation, as published in the Official Journal of the European Union, Volume 58, dated May 9, 05.. See Section.3 of Pavement Services Directive and Interchange Fees Regulation: Frequently sked Questions. European ommission. July 4, 03. 7