UK Payment systems. How regulation of UK payment systems could enhance competition and innovation

Transcription

1 UK Payment systems How regulation of UK payment systems could enhance competition and innovation Part of the OFT's Programme of Work on Retail Banking July 2013 OFT1498

2 Crown copyright 2013 You may reuse this information (not including logos) free of charge in any format or medium, under the terms of the Open Government Licence. To view this licence, visit or write to the Information Policy Team, The National Archives, Kew, London TW9 4DU, or Any enquiries regarding this publication should be sent to us at: Marketing, Office of Fair Trading, Fleetbank House, 2-6 Salisbury Square, London EC4Y 8JX, or This publication is also available from our website at:

3 CONTENTS Chapter/Annexe Page 1 Executive summary 4 2 Introduction and background 13 3 UK payment systems 20 4 Rationale for regulation 29 5 Payment systems and competition in banking 33 6 Competition and innovation in payment systems 39 7 Regulation of payment card networks 49 8 Approach to regulation 60

4 1 EXECUTIVE SUMMARY 1.1 Payment systems are an essential part of modern banking. They enable a vast number of commercial and consumer transactions that allow the UK economy to function effectively. The UK has a range of secure and reliable payment systems that are effective in delivering many of the payment needs of consumers. 1.2 Despite this importance and the regulation of the security and reliability of these systems, the development of UK payment systems appears to have been slowed by the fact that, when acting as members, owners and users of payment systems, retail banks do not have significant incentives to generate competition and drive innovations. Consequently, consumers experience few innovations that drive service and improve the payment experience. 1.3 The Office of Fair Trading (OFT) supports, in principle, HM Treasury s (HMT's) approach to addressing concerns with this sector as set out in its recent consultation, Opening up UK payments, by seeking to create a new regulator of UK payment systems. 1.4 The OFT considers that this sector has a number of characteristics that mean competition may not always work well. These characteristics include high fixed costs and economies of scale in the infrastructure that enables electronic payment systems, as well as network effects, where the value of a payment system is dependent on the number of users it attracts. When combined, these characteristics give rise to a significant first-mover advantage in this sector, such that competition may not be an effective discipline on those that own or control the existing payment systems. 1.5 As noted in HMT s recent consultation, the OFT has carried out a short exercise, gathering evidence from stakeholders on competition and innovation in payment systems in the UK. This report summarises the OFT s views concerning how the proposed regulator could stimulate competition and innovations in payment systems. 1.6 The OFT has obtained only anecdotal evidence of a lack of competition and innovation in this sector, due to the limited nature of the work carried out to inform this report. While the OFT makes a number of 4 OFT1498

5 recommendations for additional regulation, over and above that set out by HMT, the OFT also notes that it has not carried out a detailed cost and benefit assessment of these recommendations. HMT may therefore wish to consider in detail the costs and benefits of the recommendations in this report. 1.7 Furthermore, the OFT notes that its views of this sector have evolved in recent years as the market has developed and the evidence available to the OFT has changed. Payment systems and competition in retail banking markets 1.8 Reliable access to payment systems is paramount for any bank or building society wishing to compete in providing personal current accounts or business current accounts. 1.9 There are two routes for smaller providers seeking access to payment systems. First, they can seek to join these systems directly, or second, they can request indirect, or agency access, from one of the larger providers (banks) in the market who themselves have direct access to payment systems. However, both of these routes are subject to the willingness of large banks to provide access to a potential rival. Given the high concentration in the retail banking markets, the OFT would not necessarily expect competition among these large providers to lead to competitive and efficient outcomes in the provision of access to payment systems. The OFT's concerns are the following: obtaining direct access to payment systems can involve time consuming regulatory processes and significant variations in security deposits there appears to be little choice or competition in practice for some providers seeking indirect access to payment systems, and some providers with indirect access have slower and more limited access to payment systems and the cost of this can be high The OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, HMT should ensure that legislation for the regulator provides objectives to minimise barriers to entry in retail banking markets and ensure that both existing and new 5 OFT1498

6 providers are able to compete on an equal basis for business and personal customers: To ensure that fair, reasonable and non-discriminatory direct access to existing payment systems is available to all banks and building societies. Barriers to accessing payment systems directly, such as the costs of access, the regulatory process, or the management of payments risk, should be minimised. To ensure that indirect or agency access to existing payment systems is offered on a fair, reasonable and non-discriminatory basis by a range of competing licensed banks, by compelling some member banks and building societies to make this service available to smaller competitors. The regulator should set minimum terms of access and conditions, including the service level, with the regulator also having powers to review pricing where this is not constrained effectively by competition. Redress mechanism 1.11 Through discussions with a number of stakeholders in this sector, it is clear there is a limited incentive for small banks to complain about the service they receive from larger banks in obtaining indirect or agency access to payment systems. This is due to the limited choice and competition available to small banks in practice, which, when combined with the importance of payment systems in banking, mean that small banks may be unlikely to challenge their providers, for fear of their agency agreement ceasing. Without such access, a bank would be unable to function The OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, HMT consider setting out in legislation for the regulator, a suitable redress mechanism to ensure that all providers of bank accounts are able to compete on a level playing field, and that those supplying indirect or agency access to smaller providers do so appropriately in practice as the regulator has determined The OFT also recommends that the regulator of payment systems be given powers to conduct own-initiative reviews, in the event that potential complainants may be reluctant to come forward. 6 OFT1498

7 1.14 Any such mechanism needs to enable complaints to be made by unlicensed organisations in relation to the service and or price of regulated organisations which are acting as service providers. Competition and innovation between payment systems 1.15 As the main members and owners of payment systems, large retail banks have a strong position and an ability to control the decisions made by the payment systems. This means that there are few incentives to develop competition between the various methods of payment. Such competition may be unlikely as large banks would not be expected to see a net benefit from moving payments between different systems that they own and control, with losses from one system being expected to offset gains on another The nature of payment systems, namely that users derive benefits from having a broad network of other users means that many of the innovations in payment systems infrastructure need to be undertaken collectively by all members of a system, or all systems. Therefore, investment by one bank in payment systems infrastructure may be expected to benefit other rival banks (non-rivalry). This may lead to under investment in payment systems, as banks may be less likely to invest in an innovation in infrastructure that benefits their rival banks in retail banking markets, compared to an alternative investment where they could gain some material advantage. Investment in payment services provided directly to consumers suffers less from this problem This incentive to under invest in payment systems infrastructure may lead to a failure of this sector to bring about innovations that are valuable to consumers and the economy in a timely manner The OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, HMT should ensure that the regulator of payment systems has sufficient powers to allow for the development of competition as set out below: First, to relax rules that determine the scope of payments that can be processed by recognised electronic payment systems to give at least some of these systems broader scope to process a wider variety of payments, so that more than one system is capable of processing certain payment types. 7 OFT1498

8 This would create the scope for choice and competition between payment systems which could drive innovation and efficiency in the underlying payment systems themselves. The OFT expects that competition between payment systems may lead, through a process of considering the value of the various attributes of the different payment systems, to the possibility of rationalisation of payment systems and potentially a reduction in the cost and an increase in the efficiency of this sector which could be passed on to retail banks and their customers. Second, to develop the infrastructure of the existing electronic payment systems to allow for broader access to the systems, giving new providers access to the underlying payment systems. For example, this might include either a pull-based payment system 1 for faster payments, or a request for push payment system. 2 The OFT notes that these innovations could facilitate the development of new payment businesses, in competition with traditional banks, offering services to customers that make the use of recognised payment systems easier and available in more environments, as well as between these new payment businesses and payment card networks. With access to payment systems on fair, reasonable and non-discriminatory terms, these new payment businesses would have clear incentives to develop competition in payments that large banks would not have an incentive to develop. In addition, this access may also generate valuable innovations for consumers and businesses. Third, generating competition in the ways described above may require changes to underlying payment systems' infrastructure to facilitate changes in the scope of, and access to, existing systems. 1 A pull-based payment system is one where, upon signing an agreement, customers give businesses permission to take money from their account without further authorisation and at certain times. Many subscriptions and similar transactions are pull-based systems. For example, Direct Debit, which operates through the Bacs settlement process. 2 A request for push system would involve retailers triggering consumers to make a payment to a retailer through sending information through a payment system. This may be in the form of a message or invoice, but would ensure the payment could be made to the correct retailer for the correct amount. 8 OFT1498

9 The OFT therefore recommends that HMT should consider whether the proposed legislation should extend the licensing regime to encompass the providers of infrastructure of the existing recognised payment systems. If accepted, this would ensure that the regulator has powers to compel changes across the payment systems sector as a whole. Regulation of payment cards 1.19 The OFT has a detailed knowledge of payment card markets in the UK as a result of its ongoing competition investigations in this area and the links between these and similar cases in the European Commission (EC). These investigations have highlighted concerns about competition in some payment card networks. Specifically, the 2007 EC decision found that MasterCard multilateral interchange fees (MIFs) infringed Article 101 of the Treaty of the Functioning of the European Union (TFEU) in that they restricted competition between acquiring banks and inflated the cost of card acceptance by retailers without leading to proven efficiencies under Article 101(3) TFEU The OFT is aware that the EC is considering a proposal for a regulation seeking to address a number of concerns in relation to payment card networks, including the level of interchange fees applicable to transactions made using MasterCard and Visa consumer payment cards The OFT notes that it is likely that HMT's proposed regulator could be established in advance of any European regulation in this area. The OFT also notes that there are inherent uncertainties around any legislative process and the content and scope of European regulation is not a settled matter. Consequently, HMT should continue to consider the appropriate way to regulate payment card networks in the UK. HMT should, however, have regard to the details of the EC's proposed regulation, once known, and seek to ensure, to the greatest extent possible, that its approach to regulating payment card networks will be compatible and consistent with that proposed by the EC. This would respect the primacy of EU law, avoid potential conflicts between the EU and UK regulatory regimes, and ensure that any transfer of responsibility or merging of regulatory regimes could be undertaken quickly and at a low cost to regulators and the industry. The OFT considers that there are a number of principles to which a regulatory 9 OFT1498

10 regime in the UK could adhere in order to be able, in theory, to address concerns in payment card networks. These are the following: regulation of payment card networks could seek to be neutral between the organisational form or structure of the network 3 regulation could seek to prevent the current practice of tying, where merchants are required to accept all cards, even though for some, they incur different fees to others in terms of transparency, the simplicity and predictability of charges are likely to be the most important aspects of regulation for endusers including merchants regulation could have a de minimis threshold to protect innovation and new entry among payment card schemes. As such, regulation could be focused on payment card networks which may have at least some degree of market power the merchant service charge may be an appropriate charge to regulate in terms of pricing where the regulator considers it important to be consistent between the regulation of three and four party networks, and where there are sound economic reasons for price interventions in four party networks but not in three party networks, it may be beneficial for a combination of multilateral interchange fees and scheme fees to be regulated. Where the acquiring market is sufficiently competitive, this could provide a competitive constraint on merchant service charges. Scope and powers of the proposed regulatory regime 1.22 Separate to the OFT s views about increasing competition and innovation in payment systems, the OFT has examined the practical elements of the proposed regulation and provides views on the following areas: creation of an organisation to enable industry-wide collaboration concurrent competition powers 3 See Paragraphs 7.25 to 7.30 for details. 10 OFT1498

11 price setting powers licensing, and a redress mechanism. Collaborative innovations 1.23 HMT has set out objectives for the regulator to promote innovation in payment systems. To help the regulator achieve this objective, the OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, the regulator of payment systems should ensure that there is an organisation with a suitable form and governance structure, and which is under the control of the regulator, to provide for the co-ordination of collaborative projects across the banking and payments sector and implementing initiatives sought by the regulator The OFT notes that the scope of such collaboration should be strictly limited to circumstances where the regulator is clear that such collaboration, rather than competitive market forces, would be the most efficient manner in which to deliver improvements in the sector and ensure such collaboration does not breach the provisions of the Competition Act Concurrent competition powers 1.25 The OFT notes that HMT intends to give the new regulator concurrent competition powers under the Competition Act 1998 and the Enterprise Act While the OFT considers that the new regulator may find these powers are used relatively rarely in practice, given the range of licensing powers envisaged, the OFT supports this extension of the concurrency regime. The OFT considers that these powers will bring a greater focus on stimulating effective competition within the objectives of the new regulator. Price setting powers 1.26 The OFT notes that HMT plans to provide the regulator with the ability to set prices in the market, (ex-ante price setting powers) rather than just the ability to consider whether prices set by licensed providers were appropriate after the event (ex post price setting powers). 11 OFT1498

12 1.27 The OFT considers that ex-ante price setting powers are likely to be necessary for the regulation of payment card networks to be considered efficient and pragmatic, given the competition concerns in this sector. For the remaining payment systems, the OFT has fewer concerns, and as a consequence, considers that the regulator may be able to achieve its objectives in relation to innovation and competition through the use of less interventionist ex-post price setting powers, with an extension of the planned regulation to cover infrastructure providers and an effective redress mechanism. However, the OFT has not considered this issue in detail. Licensing 1.28 The OFT agrees that the licensing powers set out by HMT in its consultation would be necessary in order to ensure the regulator has the power to compel the existing payment systems and their members to take specific action to ensure it meets its objectives. In addition, the OFT notes that such licensing powers, where expanded to cover providers of payment systems infrastructure, as the OFT recommends, have the scope to be used to compel change across the sector and allow for the development of competition and innovation in the sector. 12 OFT1498

13 2 INTRODUCTION AND BACKGROUND 2.1 The OFT is the UK s competition and consumer authority. Its mission is to make markets work well for consumers. OFT work on payment systems 2.2 The OFT has a strong interest in payment systems and in the past decade has published several reports on its work on payment systems and the retail banking sector. 2.3 This work has included a payment systems market study, published in 2003, and chairing the Payments Systems Task Force a body including banking industry, retail, consumer and business representatives as well as the Bank of England and HMT. The task force led to agreement on the introduction of the Faster Payments Scheme, the UK's first new payment system for 20 years. The Task Force also reached agreement over improvements to the way the cheque clearing scheme works, as well as governance changes to Bacs and LINK, and the creation of a new governance body, the Payments Council. 2.4 The OFT has ongoing investigations into the interchange fee arrangements for UK domestic point-of-sale transactions made using MasterCard/Maestro and Visa consumer payment cards. 2.5 The OFT is also part of the existing regulatory regime under Part 8 of the Payment Services Regulations Review of the Operations of the Payments Council 2.6 The Payment Systems Task Force recommended that the OFT should complete a review of the work of the Payments Council two years after its launch. The purpose of the review would be to assess its performance in relation to its three main objectives 4 and in facilitating progress in all payment systems within its remit. 4 The three main objectives of the Payments Council were: to lead the future development of co-operative payment services in the United Kingdom to ensure that the payment system was open and accountable, and to ensure the operational efficiency, effectiveness and integrity of payment services in the United Kingdom, through a focus on issues which cross schemes. 13 OFT1498

14 2.7 The OFT completed this review in The review 5 found that the Payments Council had been largely successful in meeting two of its three objectives greater strategic direction and greater openness and accountability. Key improvements included the speeding up of slow cheque clearers as well as the implementation of the Faster Payments Service. 2.8 However, the OFT found the Payment Council s progress had been disappointing in some areas. It was still too slow in driving improved payments for customers, with the Faster Payments Service only operating at 69 per cent capacity across member banks. The OFT recommended that it should be less dominated by banking interests by widening membership of the Council, perhaps to include payment processors and other bodies in order to gain a wider expertise and consider novel solutions to payment problems. This recommendation was not accepted. Programme of work on Retail Banking 2.9 In July 2012, the OFT launched a programme of work designed to achieve a more competitive and consumer focused retail banking sector. Specifically, the OFT wishes the retail banking sector to evolve to achieve the following results: a banking sector that is more customer-focused. Providers products are well-suited to their customers needs and are provided in a way that makes it easy for customers to make well-informed decisions about how and when they are used consumers are sufficiently engaged with their banking services to drive competition. Banks equip their customers to make better decisions about which products they use, and how they use them. This will stimulate banks to compete for customers' business on things that matter to them competition between banks (and from non-banks) that drives providers to operate more efficiently and to innovate. Effective competition between banks encourages them to perform more 5 Review of the Operations of the Payments Council (OFT1071), accessible at 14 OFT1498

15 efficiently, meaning that lower costs are passed on to consumers and businesses, potentially in innovative new ways consumers have a broad choice of provider. The sector is less concentrated, and 'challenger' banks and/or new technology provide scope for increased competition from outside the traditional banking model, and barriers to entry and expansion are lower. Credible new players are able to join the market and have reasonable prospects for attracting the scale of customer base needed to achieve the economies of scale required to operate effectively The programme of work is ongoing and involves several work-streams a review of the UK Personal Current Account market 6 published on 25 January a short exercise gathering evidence from a number of stakeholders in relation to competition and innovation in UK payment systems behavioural research into how consumers make decisions and engage with retail banking services, and a study of banking services provided to small and medium sized enterprises, launched in June Multilateral Interchange Fees in payment card schemes 2.11 The OFT has ongoing investigations under the Competition Act 1998 into the interchange fee arrangements for UK domestic point-of-sale transactions made using MasterCard/Maestro and Visa consumer payment cards. The OFT considers that high interchange fees may lead to high merchant service charges which ultimately may lead to higher prices for all consumers (whether paying by card or not) The EC has conducted parallel investigations into MasterCard and Visa s cross-border interchange fee arrangements. In 2007 the EC 6 This review followed the OFT s 2008 market study which reported that a combination of complexity and opacity made it extremely difficult for individual consumers to know how much their PCA could be costing them compared with other products. 7 See for details. 15 OFT1498

16 reached an infringement decision in relation to its investigation into MasterCard s cross-border interchange fee arrangements. This decision was upheld on appeal to the General Court and a further appeal by MasterCard is currently being considered by the European Court of Justice. The UK Government (with the OFT as lead) intervened in support of the EC at both appeal stages The OFT is awaiting the judgment of the European Court of Justice on the EC s MasterCard investigation before deciding next steps in its own investigations into Visa and MasterCard s domestic interchange fees. Action by the UK Government 2.14 In July 2011, the Treasury Select Committee (TSC) expressed concerns about the governance of payment systems, describing the Payments Council as industry-dominated and lacking effective public accountability One of the TSC s recommendations was that HMT should bring the Payments Council formally within the system of financial regulation In July 2012, HMT issued a consultation, Setting the strategy for UK payments 9, on options to improve UK payments strategy. The aim was to have: UK payments systems that operate for the benefit of end-users including consumers a UK payments industry that promotes and develops new and existing payment systems 8 In 2008 the EC launched a new investigation against Visa s cross-border interchange fee arrangements (further to its 2002 exemption decision), reaching a commitments decision on immediate debit cards in The EC s remaining investigation against Visa s credit card interchange fee arrangements may be resolved following an offer of commitments by Visa on 14 May Visa s commitments include a proposal to cut credit card interbank fees by between 40 to 60 per cent and to reform its cross-border acquiring rules in order to facilitate crossborder competition. The EC is seeking feedback on these proposals from interested parties through a market test before deciding whether to formally accept them. On 9 April 2013, the EC announced that it had opened new proceedings against MasterCard concerning, among other things, its rules on cross-border acquiring. See Chapter 7 for more information. 9 Setting the strategy for UK payments, HMT, July OFT1498

17 UK payments systems that facilitate competition by permitting open access to participants or potential participants on reasonable commercial terms, and UK payment systems that are stable, reliable and efficient The OFT responded to the consultation and detailed its concerns with both options, emphasising that it did not consider the case for regulation closed, and noting the industry s refusal to change governance procedures as OFT had requested. The OFT s view was that any governing body for the payments industry needs to have the ability to compel member organisations, individually and collectively, to take actions where there is a clear case that doing so would be in the interests of wider stakeholders in the UK's payment systems. Without an element of compulsion, there is a risk that innovation moves at the pace of the slowest member. There must be adequate representation of payment systems users on the governing body in order to ensure that payment systems meet the needs of their customers HMT concluded that the options considered would not adequately achieve the aims set out above, and that it would be preferable to bring retail payment systems under a new regime of economic regulation HMT launched a further consultation in March 2013, Opening up UK Payments, which set out its proposal for a new regulatory system, including how Government envisaged the new regulatory regime functioning, and sought stakeholders' views on the proposals. Action across the EU 2.20 In April 2011, the EC published the Single Market Act, highlighting the need for priority action on payment services and delivery services for goods ordered online. Concerns emanated from the findings that 35 per cent of internet users were not buying online because they had doubts over payment methods 10 and there remained barriers to market entry Eurostat Community Survey on ICT usage by Households and Individuals (2009) OFT1498

18 2.21 The EC s communication of 3 October 2012 elaborated further that it wished to address the issues of insufficient harmonisation across member states; ineffective competition in some areas of payment cards (cross-border multilateral interchange fees) and internet payments; and a lack of incentives for standardisation In order to make payment services in the EU more efficient, the EC intends to revise the Payment Services Directive and present a legislative proposal regulating multilateral interchange fees for card payments in OFT s analysis of payment systems 2.23 As part of the OFT s ongoing programme of work on retail banking, it has carried out a short exercise gathering evidence from a number of stakeholders concerning competition and innovation in payment systems in the UK. Specifically, the OFT has considered and presents views on the following: the size and significance of the UK payments sector competition and innovation in the payment systems sector, including how a new regulator may be able to stimulate competition and drive innovation access to payment systems whether access, either directly or indirectly to payment systems is reasonable, or whether there is scope for a regulator to improve this access, and the approach to regulation, including regulatory powers and other practical aspects of regulation that could be considered The remainder of this document considers these issues in turn. Chapter 3 provides some background on UK payment systems Chapter 4 examines the rationale for regulation of this sector Chapter 5 explores how competition in retail banking is affected by payment systems Chapter 6 assesses competition and innovation in payment systems Chapter 7 examines how payment card networks could be regulated, and 18 OFT1498

19 Chapter 8 explores regulatory powers and practical aspects of regulation. 19 OFT1498

20 3 UK PAYMENT SYSTEMS 3.1 In 2012, over 40 billion cash and non-cash payments took place in the UK with a total value of 9.5 trillion. 3.2 According to forecasts by the Payments Council, by 2021, the volumes of non-cash payments 12 will be approximately double that of cash transactions in the UK. 3.3 There has been significant growth in non-cash payments in recent years, coupled with a reduction in the volume of cash payments. Consequently, well-functioning payment systems are of increasing importance to the UK economy. Figure 3.1 Total cash and non-cash payment transaction volumes (millions) 30,000 25,000 20,000 15,000 10,000 5, Cash payments Non-cash payments Source: OFT analysis of 'UK Payment statistics 2012', Payments Council Types of payment system 3.4 This report refers to a number of specific terms relevant to this sector, which include the following: 12 Non-cash payments include various types of transactions: cheque transactions, plastic card payments as well as all automated payments such as direct debit, direct credit and faster payments. 20 OFT1498

21 Payment system - the system of rules, as determined collectively by member organisations that govern how a particular system of payments is administered, how payments are processed, and the criteria potential members need to meet to become members. Infrastructure - the network interconnections between members of a payment system that process the transactions and allow for communications to make the payment systems work in practice. For several payment systems in the UK, this infrastructure is provided by Vocalink Limited. Settlement (also known as clearing) - the process by which the payments initiated by members of payment systems are paid to other member organisations. As described below, the payment systems vary in terms of the method and the frequency with which the debts that occur from particular payments are settled between members. Payment card networks - these are methods of payment that require customers to hold a payment card from a particular network and retailers to accept the card from that network. The different types of payment card network and how payments are processed are discussed in Chapter 7. Recognised payment system - where HMT is satisfied that any deficiencies in the design of a payment system or disruption to its operation would be likely to: threaten the stability of, or confidence in, the UK financial system or have serious consequences for business or other interests throughout the UK. HMT may designate such a payment system as a recognised system, bringing it within the formal oversight of the Bank of England Further details of the current system of regulation of payment systems may be found in HMT's consultation document, Opening up UK payments, March OFT1498

22 Payment business - the OFT considers these to be businesses that may be able, with suitable access, to develop payment service products which use the (upstream) existing payment systems and develop a consumer or business interface providing access to payments in a range of sectors, and environments (downstream). This is discussed at the end of Chapter 3 and considers examples of possible products and businesses already involved in this area. Settlement/clearing payment systems 3.5 The payment systems that HMT proposes to bring under its proposed regulatory system are: Bacs - This is an automated payment system used extensively in the UK, typically for making bulk payments such as salaries. Payments are settled between member organisations on a rolling three day cycle C&CCC - this system provides the clearing of all cheques and credits in the UK. This involves the physical transfer of cheques and credits and the calculation of the net payments necessary between members, which are undertaken on a rolling two-day basis CHAPS - this system is administered by the Bank of England and provides for almost instantaneous payments to be made between accounts. It is normally used for large sums of money and customers typically have to pay for CHAPS transactions. Settlement between members is undertaken on a gross basis, that is settlement takes place for each transaction in real time Faster Payments System - this is a net settlement system, similar in concept to Bacs, however it allows near real time clearing of payments 24 hours a day, seven days a week. Settlement of payments between members takes place three times daily, and LINK - this network provides the interconnections underpinning the ATM or cash machine network in the UK. This allows fast connections between members to verify PIN details and ensure secure access to cash in the UK. 22 OFT1498

23 3.6 The OFT distinguishes for the purpose of this report between the system based on paper transactions which is the C&CCC, and the electronic payment systems that provide for electronic transfers of funds (the others above). Trends and use of clearing systems 3.7 Consumer preferences have changed substantially in the UK over the past decade. The move away from cash payments has resulted in growing numbers of non-cash transactions. The use of cheques has declined considerably as increasing numbers of customers have switched to non-paper based payments. However, there are still 2.7 million cheques cleared each day. 3.8 Before the introduction of Faster Payments in 2008 only Bacs and CHAPS offered clearing services of electronic payments. CHAPS was focused on clearing high value payments, while Bacs focused on more regular payments by consumers and businesses. Figure 3.2 Annual clearing volumes (millions of transactions) 7,000 6,000 5,000 4,000 3,000 2,000 1, Bacs Faster Payments C&CCC Source: OFT analysis of UK Payment Statistics, The graph above shows the overall trends in payments in recent years. As can be seen, there is a gradual reduction in the volume of cheques being used and increasing use of electronic payments. Bacs payments rose consistently before growth slowed. This slower growth may have been related to the newer faster payments system which has also seen growth consistently since OFT1498

24 3.10 In terms of the volume and value of payments in 2011 (and excluding payment card networks), 82 per cent of non-cash payments (by volume) were cleared through Bacs. Faster Payments accounted for 7.5 per cent of the volume of payments in the same year. In terms of the value of payments, while it processed less than one per cent of the payments (by volume), the CHAPS system cleared 92 per cent of the value of funds transmitted through clearing systems in the UK, due to the high value of transactions processed in the CHAPS system. Payment card networks 3.11 Payment cards are held and used extensively in the UK. There are over 80 million debit cards and over 50 million credit cards in issue in the UK. The number of consumer debit cards in circulation increased by 60 per cent between 2001 and 2011 and UK purchases on debit cards increased by around 300 per cent over the same time period. Debit cards accounted for 77 per cent of all UK purchases in 2011, totalling 7.3 billion transactions with a total value of 334 billion. The volume and value of credit (and charge card) transactions have also increased, albeit more slowly, over the last 10 years and accounted for 128bn in MasterCard and Visa together accounted for 96 per cent of UK card payments in There are currently no other debit card scheme operators in the UK and other payment card networks, including American Express and Diners Club International, have only a small share of credit card transactions. As a result, acceptance of MasterCard and Visa payment cards is sometimes considered essential by merchants Visa has significantly increased its share of debit card transactions since In 2011, Visa cards were used for 97 per cent of debit card transactions, by value, in the UK. 14 UK Payment statistics 2012', Payments Council, June OFT1498

25 Figure 3.3 Share of UK debit card transactions by value ( ) 100% 80% 60% 40% 20% MasterCard Visa 0% Source: OFT analysis of 'UK Payment statistics 2012' MasterCard has increased its share of credit and charge 15 card transactions from around 30 per cent of such transactions (by value) in 2002 to 59 per cent in Over the same time period, Visa s share of credit and charge card transactions halved to around 30 per cent. Figure 3.4 Share of UK credit and charge card transactions by value ( ) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Other Visa MasterCard Source: OFT analysis of 'UK Payment statistics 2012'. 15 Charge cards are similar to credit cards, but balances need to be repaid in full on a periodic basis, while credit cards allow for borrowing over a longer period of time. 25 OFT1498

26 Current and future developments in the payments sector 3.15 In recent years, there have been some developments in the payments sector. Some of these have involved the entry of new providers of payment services, while others are based on new technology or collaborative developments in the industry. Types of innovation are considered further in Chapter 6. Developments from new payment businesses 3.16 Some of these have included companies constructing new consumer interfaces which rely on the existing payment systems or payment card networks for underlying functionality. These have allowed endusers to make certain types of payments more easily or access payments in new ways. Some of these developments may be described as online or mobile wallets, (such as O2 Wallet or Paypal) where a customer transfers funds to their wallet account and uses this to pay other users. Other developments 3.17 The most significant recent developments in payment systems are the development of contactless cards and the industry work to develop mobile payments. Both are described below. Contactless cards 3.18 Contactless debit and credit cards began to be rolled out in the UK in late 2007 and are now accepted in a range of retail locations. Contactless cards can be used for transactions up to around 20. They are built on the existing payment card networks - mostly Visa and Mastercard At the end of 2011, 22.5 million contactless cards had been issued and approximately 80,000 terminals were capable of accepting contactless transactions. 16 However, only five per cent of consumers reported that they had and used a contactless card, a slight increase from the 3.8 per cent in 'UK Payment statistics 2012', Ibid. 17 'Contactless, Mobile, Online, and Prepaid in the UK', Datamonitor, July OFT1498

27 3.20 In addition to contactless cards, there are a number of mobile phones available which support contactless payments. Mobile payments 3.21 The Payments Council recently created a central database that will link mobile phone numbers to bank account details. Once active, this opens the possibility of making and receiving near-instantaneous payments using a mobile phone without needing to know the recipient s account details The database was made available to UK banks and building societies in December 2012 as a platform for them to build their own service Customers will be able to register for the service through their own banks, with no need to share their details with a third party. Banks can use their own branding, although it is expected that there will also be a central brand identity to reinforce customer confidence in the service. Using the database, any UK bank that is connected to LINK or Faster Payments can launch a mobile payment service for their customers that will make or receive payments. Payment businesses and possible products that could be developed 3.24 The OFT notes that there are a number of payment businesses in the UK that provide a range of services for consumers and businesses, including seeking to make payments easier and provide access to payments in different environments, including online and mobile transactions Chapter 6 of this report examines the possibility of increased access to the recognised payment systems and how this might generate competition. In effect, this would mean giving payment businesses greater access to some recognised payment systems, in order to allow them to develop and enhance their payment products for consumers and businesses. In particular, these payment businesses could use increased access to the recognised payment systems to generate competition with payments more normally made by payment cards. 27 OFT1498

28 3.26 One example of a payment business already offering easy access to payments for business is GoCardless. This offers a way for businesses to accept Direct Debit payments online, with GoCardless acting to process the payments on behalf of the relevant business, rather than the business having to seek payment directly. The underlying payments are made through the Direct Debit scheme and the Bacs payment system Another example of a payment business is Paypal. 19 Consumers and businesses can seek to use this payment business to both send and receive transactions, once relevant card and/or bank account details are provided. Essentially it acts as an online and mobile wallet, and has expanded to allow transactions in some physical shops. The transactions are processed via either a payment system or a payment card network, depending on the choice a consumer makes In the event that increased access were provided to the electronic payment systems, it may be possible, for example, to have Direct Debits operating on the faster payments system, with the increased speed of processing that this would have. For payment businesses, this may represent a profitable opportunity to expand the range of ways in which consumers can make faster payments to each other and businesses. 18 See for details. 19 See for details. 28 OFT1498

29 4 RATIONALE FOR REGULATION 4.1 This chapter considers the characteristics of the payment systems sector and whether, in principle, these characteristics support the case for creating a new regulator with oversight of this sector. Characteristics of payment systems 4.2 The OFT considers that the underlying infrastructure of the electronic payment systems have the following characteristics: large fixed costs which arise from establishing the interconnections between different members of a payment system and providing the necessary equipment to ensure that these connections perform as expected in the time expected significant economies of scale from using the infrastructure over an increasing number of transactions resulting in the cost per transaction falling network effects arise as the value of a payment system is determined by the extent of use, that is the number of organisations that are able to make and receive payments. The presence of network effects means that it is difficult for a potential new payment system to be created and grow, as for a new system to be considered valuable, it would need connections to a significant proportion of the existing banks and building societies. Unless the potential new system were able to offer something that the existing systems did not, it is not obvious that existing banks would wish to switch from the existing systems that collectively, they own and join such a new system. Therefore its value may be expected to remain low given the joint ownership structure of the payment systems and the infrastructure by the large banks, they have little incentive to switch away from the existing payment systems. 4.3 The OFT notes however that payment systems appear not to be a natural monopoly for the following reasons: 29 OFT1498

30 the underlying infrastructure is not shared across existing systems including Link, Bacs and Faster Payments, with separate infrastructure having been developed as new payment systems were created over time. Consequently, the existence of three sets of infrastructure shows that the fixed costs of the infrastructure may be unlikely to be prohibitive for other providers in the sector, and there are a small number of companies (including payment card providers and overseas payment system providers) that have similar infrastructures that could, at least in theory, provide the underlying infrastructure service to some existing payment systems without having to re-create the underlying interconnections in full. 4.4 While the level of fixed costs and economies of scale may seem to permit competition between rival payment systems in principle, the combination of network effects and the ownership structure of payment systems mean that in practice, competition has not developed. These two factors are considered in more detail below. Network effects 4.5 In order to be effective and valuable for businesses and consumers in allowing them to make and receive payments directly, each payment system needs to have significant scale to be able to be relied on to make payments to a variety of customers, therefore displaying network effects. Moreover, due to the differences in function between the payment systems, large banks need to be members of all of these systems to give consumers and businesses the range of payment types that they require. Smaller banks will need to be able to receive payments made through these systems, although they may choose not to join all systems directly and may access some payment systems through an agency relationship with a member bank. 4.6 There is no incentive to be the first bank to move to a new payment system in addition to existing systems or to replace an existing system, as such moves make more sense where other banks are already members of the new system. This means that, in addition to the more common challenges of attracting businesses to join a new payment system including the risk and costs involved, any potential 30 OFT1498

31 new payment system may struggle to be considered valuable to banks, consumers and businesses due to a lack of users. Ownership and control of payment systems 4.7 The joint owners and members of the recognised payment system companies and the infrastructure provider for Bacs, Faster Payments and Link (Vocalink Limited) are banks including the large retail banks in the UK. In addition, these banks are members of payment card networks, while the ownership of payment card networks varies This structure may afford these organisations, particularly the largest banks, an ability to control the decisions made by payment systems companies, infrastructure companies and payment card networks. and creates a number of incentives that may be adverse to competition: first, as owners of the infrastructure companies and payment system companies, as well as being the largest users of payment systems, there is little incentive for the large banks to switch away from the existing payment systems. This may arise as they have an incentive to continue using the extensive systems they control and have funded and to ensure they remain widely used. They may also incur additional costs from using alternative or additional payment systems. Consequently, in the absence of regulatory or government intervention, there may be little prospect of a new or rival payment system becoming established second, investment in the payment systems sector by one bank typically brings significant benefits to other member banks both directly and indirectly. Consequently, it is likely that, individually, banks would under-invest in the co-owned payment systems. This is compounded as banks are competitors in retail banking markets. As such, investment by one bank in the infrastructure of a payment system or the governance will also benefit rival banks, and 20 Visa Europe is owned by European banks. Out of its 21 directors on the board, 17 represent its different European members, five of whom are appointed by various UK organisations: WorldPay (UK), Barclays, Lloyds Banking Group, Royal Bank of Scotland and Nationwide Building Society. MasterCard was owned by its member banks up until 25 May 2006 when it became a publicly traded company and adopted a new corporate governance structure. According to the company s governance guidelines, there must be a majority of Independent Directors on its Board. American Express is a publicly traded company that is led by an independent Board of Directors. Diners Club s UK and Ireland franchise was owned by Citigroup until 2012 when it was transferred into the ownership of a private investor group. 31 OFT1498

32 third, there is, at least in theory, the potential for competition concerns involving restrictions to access, high prices and low service quality to arise where large banks have some control over the payment systems to which smaller competitors need to gain access, either directly or indirectly. Summary 4.9 The OFT considers that these characteristics, ownership structures and the lack of incentives for competition and investment create the conditions for a number of market failures with consumers failing to benefit from the discipline of competition on costs, innovation and service levels. Furthermore, the OFT's short review has indicated that competition concerns appear to arise in practice - as highlighted in the following two chapters. These concerns also indicate that there is scope for increased competition and innovation if a different approach to access and development of payment systems were taken In sectors such as this where there is at least some degree of market failure, there is a rationale for Government action to address the failure either through regulation or other intervention. 32 OFT1498

33 5 PAYMENT SYSTEMS AND COMPETITION IN BANKING 5.1 For any provider of payment services, access to payment systems is critical for ensuring its customers are able to make and receive a wide range of payments from their accounts. In this chapter, the OFT considers how access to and the operation of payment systems affects competition in the markets for business and personal banking. Access to payment systems and competition in banking markets 5.2 There are two ways in which retail banks can obtain access to the recognised payment systems in the UK. First, by seeking to join the relevant payment system as a direct member or second, by approaching another, typically larger direct member, to provide agency or indirect access to the payment system. Both of these processes are currently controlled in effect by the large retail banks that, either as members agree rules for the admission of new members, or individually offer indirect or agency access. 5.3 Such access arrangements may not necessarily be expected to operate efficiently in markets where concentration is high and competition between providers is limited. The OFT has previously found these characteristics to exist in both personal current accounts and the supply of banking services to SMEs. 5.4 The OFT s recent review of the personal current account market 21 found high concentration and limited competition. The four largest banks (HSBC, Barclays, RBS and Lloyds Banking Group) currently account for approximately 75 per cent of the personal current account market. Although there have been new entrants in recent years Metro Bank in 2010 and M&S Bank in 2012 the review found that neither is yet in a position to provide a significant challenge to the established providers. The OFT notes that the Independent Commission on Banking found that concentration among the four largest providers of business current accounts was higher, at 85 per cent in Consequently, it is possible that these levels of concentration may not be consistent with effective competition concerning access to payment systems. 21 Review of the personal current account market, 25 January OFT1498

34 5.5 The OFT notes that at present there are banks of very different sizes in the UK retail banking markets, and considers it important, to allow for the growth of competition in these markets, that regulation should preserve different ways of accessing payment systems that are suitable for such a range of differently sized banks. Direct access 5.6 To obtain direct access to a payment system, providers need to approach the payment system management and ensure they meet all the criteria for access, as determined by the members of the system. These can include credit ratings at or above a specific level, holding a settlement account at the Bank of England, as well as willingness to fund part of the system and to take on the settlement process and any risk that may arise from the default of members of the system Many of the recognised payment systems are controlled, in effect by large retail banks that, as members, are able to determine the entry criteria. This raises the possibility that these rules could, in theory, be established in a manner that favours incumbents and imposes higher burdens on smaller members and potential new members. This could be achieved through making direct access particularly time-consuming, cumbersome or unduly expensive for certain categories of members to meet. 5.8 The OFT has obtained evidence of some regulatory challenges in obtaining settlement accounts with the Bank of England albeit that the OFT has little evidence of concerns in practice relating to direct access to payment systems. However, the OFT understands that the security deposits sought from new members of payment card networks can vary significantly between some of the payment card networks for the same potential member, which may be an indication that some may be using these as barriers to smaller new entrants. 22 For example, the entry criteria for the Bacs payment system are the following: have a settlement account at the Bank of England; be based in the European economic area; meet agreed technical and operational requirements, including having an agreement in place with VocaLink (or another provider of approved clearing services), and having an approved trust service; be a bank or building society; have a minimum credit rating of (a) a prime short-term credit rating of A-3 or higher by S&P, F-3 or higher by Fitch and P-3 or higher by Moody's; and (b) an investment grade long-term credit rating of BBB- or higher by S&P, BBB- or higher by Fitch and Baa3 or higher by Moody's; sign a legal document in respect of membership, and of the settlement arrangements; and pay a share of Bacs costs. 34 OFT1498

35 Indirect access 5.9 To obtain indirect or agency access to payment systems, providers would need to approach a larger competitor to seek an agency or indirect access arrangement New entrants and small banks may prefer such access arrangements over direct membership either because they do not meet the criteria for direct membership, or because they do not wish to take on the settlement risk within the system or where they only process small volumes of payments within a particular system and that does not justify the cost of meeting the requirements of direct membership The OFT has heard concerns that small providers have experienced little competition and choice over the provision of agency access arrangements from larger banks. In some instances, small providers have been faced with only one or two potential agency providers. In addition, the OFT is also aware of concerns that some banks with agency access to payment systems experience a service that is substantially slower than direct members -with some interruptions and periods with no access - in return for a relatively high cost of processing transactions This means that some bank account providers with agency access may be unable to compete on an equivalent basis to their larger competitors over the service and speed of payments, placing them at a competitive disadvantage in an already concentrated market Furthermore, the indication that there is little competition and choice between providers of agency access means that competition may not act as a constraint on the price paid for access or the service offered A recent publication by the Financial Services Authority (FSA) noted concerns around the cost of indirect access to payment systems. While its review focused on regulatory barriers in the banking sector, it 23 The views and anecdotal evidence obtained in this report differs from the conclusion reached in the OFT's 2010 report into barriers to entry, expansion and exit in retail banking. While the level of competition in retail banking has not changed to a significant extent in this time, the OFT notes that the length of time between these studies and the anecdotal nature of concerns raised may demonstrate increased frustration with the current arrangements, however it is difficult to reach a detailed conclusion at this time. 35 OFT1498

36 uncovered some anecdotal evidence in the area of non-regulatory barriers to entry. It noted that the cost of agency banking: is particularly acute for new banks that require agency bank services (e.g. Bacs, CHAPS and Faster Payment Service). Industry participants reported the costs of agency banking are very high for some new entrants. These costs to a degree are set by industry standards governed by the Payments Council rather than the FSA The OFT considers it unlikely that small banks would seek to publicise any difficulties they may experience in this area. Given the critical role that payment systems play in both current and other bank accounts, enabling a wide range of payments to be made, and where choice and competition over the provision of agency access arrangements is limited, small banks may not wish to risk their existing agency relationship by making a complaint over the price or service they receive. This reluctance may be exacerbated by the lack of a current independent adjudication service. While complaints could be made to a number of government or regulatory bodies, it is not clear what action may be possible to remedy these concerns, other than ex-post investigation. The possibility of a redress mechanism is considered at the end of this Chapter. OFT recommendations to improve access and competition 5.16 Given the different size of UK banks, the OFT considers it important to ensure there are ways to access payment systems which accommodate banks of different size. Therefore, the OFT is of the view that the models of direct and indirect access should be preserved within the new regulatory system The OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, HMT should ensure that legislation for the regulator provides objectives to minimise barriers to entry in retail banking markets and ensure that both existing and new providers are able to compete on an equal basis for business and personal customers: To ensure that fair, reasonable and non-discriminatory direct access to existing payment systems is available to all banks and building societies. Barriers to accessing payment systems 24 A review of requirements for firms entering into or expanding in the banking sector, March OFT1498

37 directly, such as the costs of access, the regulatory process, or the management of payments risk, should be minimised. To ensure that indirect or agency access to existing payment systems is offered on a fair, reasonable and non-discriminatory basis by a range of competing licensed banks, by compelling some member banks and building societies to make this service available to smaller competitors. The regulator should set minimum terms of access and conditions, including the service level, with the regulator also having powers to review pricing where this is not constrained effectively by competition The OFT is aware that agency arrangements - where a large bank agrees to provide a smaller bank with access to payment systems indirectly with the large bank taking on the risk of failure of the smaller bank - create, at least in theory, the possibility for the smaller bank to act in a less cautious manner in considering the risk of payments not being honoured. The OFT notes that the regulator should ensure that providers of the service are able to guard against such risks in these arrangements The OFT makes these recommendations to ensure HMT is aware of the nature and scope of work for the proposed regulator to ensure that access to payment systems do not act as a barrier to competition in retail banking markets. These recommendations could be implemented by the regulator using the licensing powers as envisaged by HMT. Redress mechanism 5.20 Through discussions with a number of stakeholders in this sector, it is clear there is little incentive for small banks to complain about the service they receive from larger banks in obtaining indirect or agency access to payment systems The OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, HMT consider setting out in legislation for the regulator, a suitable redress mechanism to ensure that all providers of bank accounts are able to compete on a level playing field, and that those supplying indirect or agency access to smaller providers do so appropriately in practice as the regulator has determined. 37 OFT1498

38 5.22 The OFT also recommends that the regulator of payment systems be given powers to conduct own-initiative reviews, in the event that potential complainants may be reluctant to come forward Any such mechanism needs to enable complaints to be made by unlicensed organisations in relation to the service and or price of regulated organisations which are acting as service providers. 38 OFT1498

39 6 COMPETITION AND INNOVATION IN PAYMENT SYSTEMS 6.1 This chapter considers the potential for and ways in which a regulator could stimulate competition and innovation in payment systems. 6.2 Chapter 4 set out a number of characteristics of UK payment systems, which underpin the OFT s view that in the absence of regulatory or government intervention, it would not expect to see effective competition in this sector that could discipline pricing or drive improvements in payment services offered. 6.3 We set out below two further characteristics of payment services that affect the incentives for increased competition between payment systems and increased innovations for the benefit of consumers. Free-if-in-credit banking 6.4 The majority of personal current account customers and some business customers have accounts where there are no specific charges for each element of the product. In some cases, consumers and businesses may pay for a package of services or pay on a periodic basis for their account. Therefore, while banks face costs from consumers and businesses making payments through their accounts, in many cases, they do not charge consumers directly for individual transactions. 25 Moreover, despite banks facing the costs of providing cash, again consumers do not face direct costs for obtaining cash from the majority of ATMs in the UK. 6.5 In addition, due to the structure of payment card networks, most consumers are able to obtain and use payment cards, both credit and debit, without incurring either a surcharge on the transaction, or a 26 regular fee for holding a payment card. 6.6 As a result, most consumers and businesses do not receive price signals concerning the absolute and relative cost of making payments of different types. Moreover, the lack of choice between payment systems which arises as most consumers have little choice in some 25 One exception is the use of the CHAPS system, for which banks routinely charge customers a transaction fee. 26 While surcharging for the use of payment cards is not routinely carried out by retailers, some do use this practice. In addition, there are some types of payment card where consumers face fees for holding the card, however most consumers are able to obtain cards that do not have such fees. 39 OFT1498

40 circumstances of how to make particular types of payment, 27 (due to the lack of overlap between payment systems) means consumers do not routinely have to consider the cost, speed or security of different payment methods. 6.7 Free-if-in-credit banking, when coupled with an historic lack of consumer choice, means that the traditional prompts which drive consumer choice, including price, quality and service, are likely to be weak in the case of payment systems as they currently operate in the UK. That does not, however, mean that these prompts could not develop in future with greater consumer choice and competition in payment systems and services. The importance of security of supply 6.8 One of the features of recognised payment systems is the responsibility of direct members to ensure all payments are settled and to protect the integrity of the system against fraud. This gives both consumers and businesses confidence that the payments and transactions they make will be completed as expected. 6.9 Any substantial failure of a payment system would raise significant concerns among consumers and businesses in terms of confidence in the wider payments sector, as they are reliant on payments being made accurately and on time in order to pay for services, allow transactions to progress and avoid penalty charges. The failure of a payment system would also present a significant systemic risk across the economy In the event that the introduction of competition were to lead to entry from new payment systems, they would need to convince consumers, businesses and banks that they will offer a high quality and secure service in order to compete with the established payment systems. This may represent an additional burden on potential new payment systems. Increasing competition between payment systems 6.11 The OFT notes that, at present, competition in this sector is very limited for the following reasons: 27 Consumers may face choices between payment cards and clearing systems in some circumstances. 40 OFT1498

41 there is limited overlap in the activities of the payment systems there is limited competition between payment cards and payment systems there is limited access for payment businesses that wish to develop new ways of using payment systems, and further development to some payment systems would be needed to allow for effective competition These issues are examined below. Limited overlap in the activities of recognised payment systems 6.13 The recognised payment systems were designed to meet different customer needs and, due to the range of payments that business and consumers need to be able to make, are complementary in nature rather than competitive. There are few transactions where a choice of payment system is available. 28 Consequently, banks need to be members of, or have access to all these systems to process the range of payments that customers wish to make The OFT is aware that there are inherent similarities in the infrastructure of the electronic payment systems in that they all involve interconnections between banks to make and receive payments. This creates the possibility of the rules governing the payments made in these systems being amended, so that certain types of transaction could be made through more than one payment system. For example, the ability to make same day transfers between bank accounts using either faster payments or the Link infrastructure This could generate the scope for choice and competition over how to make certain types of payment. It may also lead to demand, either from banks and/or customers for the use of one payment system in preference to another, dependent on the speed, security and price of the system and its underlying infrastructure One exception is direct transfers, although even here, the size limits on faster payments means that the scope for overlap in practice is limited. 29 As noted above, while bank customers do not typically face direct costs of payments, banks do face these costs and may respond to this signal where choice is created. 41 OFT1498

42 6.16 It is also possible that this choice may lead to changes in the levels of use of particular payment systems and, the potential for rationalisation, if some systems have more favourable characteristics than others for a wide range of payment types. This may lead to a more efficient and possibly lower cost outcome for banks as well as customers. Limited competition between payment cards and recognised payment systems 6.17 The OFT has gathered views from a number of payment businesses that wish to develop value-added payment services for consumers. These would be based on recognised payment systems and designed to provide fast payments easily so as to compete with payment cards. To do this, payment businesses are keen to establish easier and broader access to the existing payment systems and to build new consumer interfaces with electronic payment systems so that consumers will be able to make payments more easily in an increasing range of ways, without using payment cards In addition, the OFT is aware of some developments in other countries, where credit and debit cards are used to a lesser extent and some payment systems are used more extensively in making a range of payments. Therefore, while the OFT does not discount the need to ensure the security of new payment services, these problems do not appear to be insurmountable The OFT also notes that some of the UK payment card networks are able to process their own transactions without reliance on a recognised payment system. As such, these payment card networks are in effect vertically integrated and self-sufficient payment systems in their own right. In theory therefore, there is scope for payment card networks to compete with other payment systems However, at present there are limited incentives for large banks to generate competition between payment systems and payment card networks. While payment systems may represent a cost to retail banks, the margins earned on credit and debit cards, through the fees and income earned, (as explained in Chapter 7) mean that large banks have little incentive to generate competition between payment systems and payment card networks, by promoting alternatives to 42 OFT1498

43 payment cards The OFT can see benefits from developing the electronic payment systems to provide an alternative to payment cards. A large part of these benefits could come through innovations that non-bank payment businesses could bring to the market in competition with banking services. In this regard, there is a strong case for treating payment systems similarly to essential facilities and allowing wide-ranging access to these not only from banks, but other payment businesses. If this were combined with developments to some of the functionality of the existing payment systems, for example a pull-based system for faster payments (similar to the direct debit system that operates using BACS), new entrants may be able to develop ways for consumers to have access to this for instant online and mobile payments. This could be one way in which to introduce competition between payment cards and payment systems. OFT recommendations 6.22 The OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, HMT should ensure that the regulator of payment systems has sufficient powers to allow for the development of competition as set out below: First, to relax rules that determine the scope of payments that can be processed by recognised electronic payment systems to give at least some of these systems broader scope to process a wider variety of payments, so that more than one system is capable of processing certain payment types. This would create the scope for choice and competition between payment systems which could drive innovation and efficiency in the underlying payment systems themselves. The OFT expects that competition between payment systems may lead, through a process of considering the value of the various attributes of the different payment systems, to the possibility of rationalisation of payment systems and potentially a reduction in the cost and an increase in the efficiency of this sector which could be passed on to retail banks and their customers. 43 OFT1498

44 Second, to develop the infrastructure of the existing electronic payment systems to allow for broader access to the systems, giving new providers access to the underlying payment systems. For example, this might include either a pull-based payment system 30 for faster payments, or a request for push payment system. 31 The OFT notes that these innovations could facilitate the development of new payment businesses, in competition with traditional banks, offering services to customers that make the use of recognised payment systems easier and available in more environments, as well as between these new payment businesses and payment card networks. With access to payment systems on fair, reasonable and non-discriminatory terms, these new payment businesses would have clear incentives to develop competition in payments that large banks would not have an incentive to develop. In addition, this access may also generate valuable innovations for consumers and businesses. Third, generating competition in the ways described above may require changes to underlying payment systems' infrastructure to facilitate changes in the scope of, and access to, existing systems. The OFT therefore recommends that HMT should consider whether the proposed legislation should extend the licensing regime to encompass the providers of infrastructure of the existing recognised payment systems. If accepted, this would ensure that the regulator has powers to compel changes across the payment systems sector as a whole. Non-bank access to clearing systems 6.23 The recommendations above could allow for access to payment systems for new payment businesses to build new consumer interfaces and allow greater competition. In addition, broadening 30 A pull-based payment system is one where, upon signing an agreement, customers give businesses permission to take money from their account without further authorisation and at certain times. Many subscriptions and similar transactions are pull-based systems. For example, Direct Debit, which operates through the Bacs settlement process. 31 A request for push system would involve retailers triggering consumers to make a payment to a retailer through sending information through a payment system. This may be in the form of a message or invoice, but would ensure the payment could be made to the correct retailer for the correct amount. 44 OFT1498

45 access to payment systems may have other benefits. For example, non-bank organisations that process large transactions or large volumes of transactions through the existing payment systems may wish to become direct members of payment systems. For example, large employers may wish to join the Bacs system if they pay staff salaries and other payments through Bacs. The OFT considers that a future regulator should consider the case for allowing non-bank businesses to join payment systems directly. Innovation in the payment systems sector 6.24 The OFT notes that innovative developments in payment systems could be expected through the following three routes: collaborative innovations and developments across the payment systems sector innovations which can be developed by banks and others through competitive market forces, and innovations that result in the establishment of a new payment system These are examined below. Collaborative innovations 6.26 Collaborative developments require co-operation, agreement and collective action by payment systems, members and infrastructure providers. This is due to the presence of network effects and the value for an industry from certain types of investment by retail banks. 32 However, the need for consent from all participants for certain developments means that innovation will often happen at the speed of the slowest member organisation. This means that consumers may not benefit from valuable innovations as early as possible Despite the slow decision-making process, the Payments Council National Payments Plan includes some plans concerning a new pull payments scheme and an online payments scheme that could be built on internet banking. Both of these developments, if implemented 32 Network effects are discussed in Chapter OFT1498

46 carefully and with appropriate access being granted, create the scope for increased competition in online and mobile transactions where many payments are made using payment cards. This proposal could redirect customers from online retailers to their respective online banking platforms and may enable them to initiate payments directly The OFT is aware that greater access to and development of some payment systems may allow new payment businesses to enter the market or to expand their activities, providing a competitive constraint on existing payment providers. This would only be possible through collaborative work to open up payment systems to allow for competition As part of the regulatory system, the OFT envisages the need for an organisation to help drive forward collaborative innovations in this market. However, it notes that the regulator may not have direct control, through its licensing process, over one potential organisation which could undertake this work, the Payments Council. Chapter 8 sets out OFT's recommendation on this matter. Innovations and developments from competitive market forces 6.30 While investment in payment systems and infrastructure may require collaboration, consumer-facing services designed to improve the customer interface with a payment system can be developed by banks and other payment businesses in competition. For example, while the Payments Council worked collaboratively on a project introducing payments via mobile telephone numbers, the introduction of these services is for banks to carry out themselves in competition with each other over the service they introduce In addition, with appropriate access to and suitable development of some payment systems, innovative new payment businesses could enter the market with new offerings expanding the ways consumers and businesses are able to pay each other in different markets and environments. Such developments, while underpinned by the existing payment systems, could be developed by competitive market forces incentivising new and existing providers to develop their product offering to better suit their users. For example, it may be possible to 34 A similar scheme has been put in place in the Netherlands where it may have contributed to improved competition. 46 OFT1498

47 provide a simple interface for consumers that allows secure access to the faster payments system linked to a number of retail websites. This may allow fast and secure payments to be made online, improving the customer experience and reducing the amount of time and effort involved in paying for goods online. Establishment of a new payment system 6.32 In addition to the possibility of treating the existing payment systems as essential facilities (with the regulator ensuring fair access), it is possible that some companies innovations may become sufficiently well used and far-reaching as to represent a new payment system. This may come about through finding a new area of payments not currently represented by the existing payment systems or potentially a new way of communicating payments between banks and other providers The OFT notes that while innovation on this scale is possible, it is likely to occur relatively rarely due to the characteristics of payment systems as set out in Chapter 4. In recent years, there has not been innovation on this scale; therefore, it is difficult to predict the nature of any future innovations in the development of new payment systems The last new payment system that was developed was the faster payments system, which resulted, in part, from pressure placed on the payments industry by Government and the OFT as chair of the payment systems taskforce. Summary 6.35 The OFT supports the new regulator of payment systems having powers to review the investment plans of members and payment systems that are licensed. This will allow the regulator to ensure that valuable collaborative developments in the sector are driven forward with pace to deliver benefits for consumers Together with the OFT s recommendations to develop competition, and its desire to see the infrastructure of payment systems regulated, these measures could allow for the growth of competition and 47 OFT1498

48 innovation in payment systems to the benefit of consumers and businesses. 48 OFT1498

49 7 REGULATION OF PAYMENT CARD NETWORKS Introduction 7.1 This chapter explains briefly the operation of payment card networks, the OFT s competition investigations into payment card networks, relevant developments across the EU and considers how, in practice, regulation could address concerns. Payment card networks 7.2 Payment card networks (PCNs) need demand from consumers to hold cards and to use them for purchases. In addition, they need demand from retailers (hereafter merchants) to be able to accept payments made by those cards. 7.3 PCNs are characterised by network effects. This means that keeping all other factors constant, the number of consumers who want a particular payment card will depend on the number of merchants who accept the card, and similarly, the value to merchants is dependent on the number of consumers who hold a particular card. 7.4 A key role for PCNs is the recruitment of cardholders and merchants. Scheme operators can either do this recruitment themselves or delegate the tasks to licensees. In essence, the difference between three-party networks and four-party networks is that the recruitment of cardholders and merchants is carried out directly by the scheme in three-party networks, whereas in four-party networks this is delegated to and carried out by member banks. In Figure 7.1 below the scheme in the three-party system unifies those entities contained in the dotted line. 49 OFT1498

50 Figure 7.1: Financial flows following the use of a payment card Note: The price referred to above represents the price of the item that the cardholder purchased from the merchant's business. 7.5 Figure 7.1 shows a simplified version of the financial flows in a payment card network. In a four-party system, following the purchase of a good, the issuer debits the cardholder s account and credits the acquirer s account. 35 The acquirer credits the merchant s account. The issuer and acquirer (both banks) pay fees to the scheme (such as MasterCard or Visa). The merchant pays a Merchant Service Charge (MSC) to the acquirer and the acquirer pays a Multilateral Interchange Fee (MIF) to the issuer. 7.6 In a three-party network, the scheme also performs the issuing and acquiring functions. It debits the cardholder s account and credits the merchant s account. The merchant is charged a Merchant Discount Rate (MDR). Competition investigations 7.7 This section sets out the competition investigations and legislative proposals relevant to payment card networks at EC and UK levels. This background is useful to demonstrate the need for HMT to take account of such investigations and legislation already planned in the 35 This description is illustrative. The timings of payments may differ from those set out here. For example in a credit card transaction the issuer may receive funds from the cardholder after it has paid the acquirer. 50 OFT1498

51 design of any regulation of payment card networks. Action by the European Commission 7.8 On 19 December 2007 the EC issued an infringement decision against MasterCard regarding its intra-eea cross-border multilateral interchange fees (MIF) arrangements. 36 MasterCard s appeal was dismissed by the General Court on 24 May 2012, and MasterCard then filed an appeal to the Court of Justice. The UK Government, with the OFT acting as lead department, intervened before the General Court and European Court of Justice in support of the EC's decision. The European Court of Justice hearing in this appeal was held on 4 July On 9 April 2013, the EC announced that it had opened new 37 proceedings against MasterCard. This investigation covers: interchange fees in relation to payments made by cardholders from non EEA countries 38 rules on cross-border acquiring, 39 and related business rules or practices which amplify the Commission s concerns (for example, the Honour All Cards Rule) On 14 May 2013, the EC announced that Visa Europe had offered commitments in relation to cross-border acquiring and to cap its crossborder MIF for credit card payments at 0.3 per cent. The EC announced its intention to market test these commitments. 36 The decision concerned the MIFs that applied to cross-border payment card transactions made using MasterCard and Maestro consumer credit and debit cards in the European Economic Area (EEA). The decision found that these MIFs infringed Article 101 TFEU as they restricted competition between acquiring banks and inflated the cost of card acceptance by retailers without leading to proven efficiencies under Article 101(3) TFEU. Some countries, not including the UK, also use the cross-border MIF rates as the default rates for domestic transactions. For more information, see: Such fees apply for example when a US tourist uses his MasterCard credit card to make a purchase at a merchant in the EEA. 39 Cross-border acquiring refers to the situation where the acquiring function for merchants is performed by a bank/acquirer based outside that merchant s Member State. 40 The Honour All Cards rule has two aspects to it. It requires merchants to accept all issuers of MasterCard cards. It also requires merchants to accept all MasterCard products (or none at all). 51 OFT1498

52 UK action 7.11 The OFT is investigating, under Chapter I of the Competition Act 1998 and Article 101 of the Treaty on the Functioning of the European Union, the interchange fee arrangements for UK domestic point-of-sale transactions made using MasterCard/Maestro and Visa consumer payment cards The OFT does not currently expect to issue Statements of Objections (if at all) prior to the handing down of the Court of Justice judgment in the matter of MasterCard's appeal against the European Commission's 2007 infringement decision. However, the OFT reserves the right to do so if it considers it appropriate. European legislative proposals 7.13 On 3 October 2012, the EC announced that it would present a legislative proposal for multilateral interchange fees on card payments in This followed a Green Paper issued by the EC on 11 January and a public consultation which closed in April The consultation sought views on the need for, among other things, action to reduce MIFs and, if so, what form such action should take The OFT's response to that consultation stated that the OFT considered that pan-european regulation which enshrined a methodology for calculating MIFs that is consistent with competition law might be a pragmatic route to legal certainty and consistency across Europe It is worth remembering that the 2007 EC decision found that MasterCard MIFs infringed Article 101 of the Treaty of the Functioning of the European Union (TFEU) in that they restricted competition between acquiring banks and inflated the cost of card acceptance by retailers without leading to proven efficiencies under Article 101(3) 41 For further details see the case page on the OFT website 42 Commission communication of 3 October 2012 to the European Parliament, the Council, the Economic and Social Committee and the Committee of the Regions entitled Single Market Act II (COM(2012)0573). 43 Towards an integrated European market for card, internet and mobile payments (hereafter 'the Green Paper'). See: 52 OFT1498

53 TFEU A methodology that meets the four cumulative criteria of Article 101(3) TFEU would not infringe competition law. The four cumulative criteria can be described as: efficiency gains (improving production or distribution, or promoting technical or economic progress) allowing consumers a fair share of the resulting benefits that the restrictions are indispensible to the attainment of those efficiencies, and that competition is not eliminated in respect of a substantial part of the product in question According to the EC's feedback statement on responses to the consultation, 45 competition authorities supported the need for action to lower MIFs, in particular for mature four-party schemes. Other public authorities were divided, with some favouring a ban or decrease in MIFs while others viewed competition rules as sufficient, and considered MIFs as necessary to incentivise the issue of payment cards The OFT notes that it is likely that HMT's proposed regulator could be established in advance of any European regulation in this area. The OFT also notes that there are inherent uncertainties around any legislative process and the content and scope of European regulation is not a settled matter. Consequently, HMT should continue to consider the appropriate way to regulate payment card networks in the UK. HMT should, however, have regard to the details of the EC's proposed regulation and seek to ensure, to the greatest extent possible, that its approach to regulating payment card networks will be compatible and consistent with that proposed by the EC. This would respect the primacy of EU law, avoid potential conflicts between the EU and UK regulatory regimes, and ensure that any transfer of responsibility or merging of regulatory regimes could be undertaken quickly and at a 44 See: 45 See: 53 OFT1498

54 low cost to regulators and the industry. Regulatory powers Price setting 7.20 Under HMT s proposed regulation, operators of payment systems and payment card networks and their members would be licensed by the regulator. It is proposed that licence holders will be required to adhere to principles on efficient and transparent pricing. This section considers the issues relevant for payment card networks The consultation envisages that prices will be set at the appropriate level to benefit current and future end-users of the payment system In considering the approach to the regulation of payment card networks, and in drafting guidance for their regulation, HMT could consider the following principles, together with the EC's proposed regulation, to ensure a consistent approach to regulation that would address concerns in relation to these networks: 47 the possibility of neutrality with respect to the organisational form 48 the possibility of a materiality threshold the possibility of the prevention of tying the practicalities of a transparency requirement, and the wider options available to cardholders Before discussing these areas in turn, it is useful to consider the price considerations of payment card networks. It was earlier noted that the core role of payment card networks is to bring together consumers and merchants by providing a payment technology that both groups are happy to use and to accept. Payment card networks operate in a two-sided market and face inter-dependent demands from their two types of end-user. Payment card schemes need to consider not only the total price faced by end-users (the sum of the prices faced by 46 In the context of payment card networks, we are interpreting end-users to be both cardholders and merchants. 47 These principles are provided solely with respect to payment card networks. 48 Alternatively the structure of the payment card scheme (while taking account of the effects of scheme rules or membership obligations that differ across the various networks). 54 OFT1498

55 cardholders and merchants) but also the balance of these prices between merchants and consumers. As a result, there are a number of different prices that could be regulated in payment card networks, depending on the desired outcomes from regulation and the approach taken Four-party and three-party schemes have different capabilities to influence these prices. In three-party networks, as shown in Figure 7.1 above, the scheme is also the issuer and acquirer and so can set the prices for end users (merchants pay and MDR while it is open for cardholders to pay to hold a particular system's card). In four-party networks however, the scheme is not responsible for setting prices to end-users; this responsibility lies with issuers (determining whether consumers pay to hold a particular card, or what incentives could be provided to consumers) and acquirers (determining the MSC). The scheme is able to influence the balance of prices through setting the balance of scheme fees between acquirer and issuer, and by setting default interchange fees and through the adoption of system rules. 49 Neutrality with respect to organisational form 7.25 Four-party and three-party networks, at least at the nascent stage, may have the aim of building their network through the optimal allocation of prices between the different groups of end-users (cardholders and merchants). However, as noted above, the available tools to achieve this are different for each type of network. In three party networks the scheme can set prices directly for cardholders and merchants. In four-party networks the scheme can influence cardholder and merchant prices through interchange fees, scheme fees and system rules The proposed regulator may wish to ensure that its regulatory approach is neutral to the organisational form or structure of a payment card network. From a competition perspective, it is the balance of end-user prices and the ability of end-users to impose constraints on the pricing of individual networks that is important for their interests (and therefore, given its proposed objectives, the interests of the proposed regulator). Different payment card networks 49 For example, a rule to prohibit merchants from surcharging cardholders would affect the balance of prices between merchants and cardholders. 55 OFT1498

56 with similar amounts of market power 50 are likely to have the ability to create similar levels of end-user detriment irrespective of whether the network is a three-party or a four-party type As such, neutrality as to organisational form/structure is compatible with the proposed regulator giving full consideration to the effects on consumers as one type of end user. These effects might differ markedly across four-party and three-party networks, or between networks of the same type. The proposed regulator might wish to consider whether scheme rules or membership obligations that are equivalent or counterparts across competing networks may nevertheless be having different effects on the respective end-users of those schemes, when viewed with a number of other factors including 51 the market power and conduct of the scheme operators. One example is discussed below in the section on the prevention of tying Having made these assessments, and if it is judged that a price-setting intervention is required, the regulator will need to consider at what level to intervene. The regulator will also need to consider whether intervention on the price set is required on both sides of the market, although the analysis below focuses on the price faced by merchants One approach to achieving neutrality across the different types of network would be to regulate MSCs and MDRs. Where price regulation encompasses four-party and three-party networks, this provides the simplest way of ensuring a neutral approach Alternatively, there may be a situation where there are sound economic reasons for price interventions in four-party networks but not for three-party networks. In such a situation it may be beneficial 50 In considering market power, the proposed regulator would need to take account of whether end-users consider the cards of a certain scheme to be must carry or must take products and whether those end-users are able to exercise any credible competitive constraint against increases in cardholder or merchant service charges (for example, by exiting the scheme, or declining to use/accept a card). This analysis of market power might also involve consideration of whether (and to what degree) each group of end-users is able to influence the opposite group of end-users to use/accept the payment mechanism that carries the lowest cost or the greatest benefit. For example, scheme rules might seek to constrain the ability of merchants to steer consumers towards using one brand or type of card over another. 51 It is well established that the same conduct by organisations with different degrees of market power may be considered to have different effects. For this reason, under competition law, a practice that would be anticompetitive and unlawful if performed by a dominant company may not be anti-competitive/unlawful if performed by a non-dominant company. In regulatory policy, Ofgem s 2011 guidance on the regulatory regime for gas storage facilities in Great Britain distinguishes between the conduct of market players depending on whether they hold significant market power. 56 OFT1498

57 for either MIFs, or a combination of MIFs and scheme fees, to be regulated, but for MSCs to be left unregulated. Where the acquiring market is sufficiently competitive, this would provide a competitive constraint on the remaining components of the MSC. Materiality threshold 7.31 The proposed regulator will need to consider the need for a materiality threshold for regulation which would exempt new and small payment card networks from the regulatory requirements It is unlikely that small payment card networks would successfully be able to implement a balance of prices that could harm end-users, as they could exercise a competitive constraint by choosing not to accept the service. Furthermore, there may be economic arguments that justify a balance of prices in a small network that do not apply in larger networks The consultation document proposes that HMT will have the power to amend the definition of payment systems to be covered by regulation, and to exclude payment systems falling within the definition from regulation. It will be important for the proposed regulator to liaise with HMT to establish clear criteria that strike an appropriate balance between avoiding barriers to entry and promoting the interests of endusers. Prevention of tying 7.34 The proposed regulator will need to take steps to ensure that endusers are able to choose freely between different products that are offered by the same organisation Both four-party and three-party networks can use an Honour All Cards Rule (HACR) that is designed to give cardholders a guarantee of acceptance. This might be unproblematic where a network issues only one type of payment card (or a number of different payment cards that are effectively identical to the merchant, including in terms of the cost of acceptance). However, the HACR might be a cause for concern 52 For example, indirect network externalities, which occur when the value of the network to one set of end-users increases with the number of the other set of end-users, may be stronger in smaller networks than in bigger networks. The efficient balance of pricing across end-users may be influenced by the strength of these externalities. 57 OFT1498

58 where a network is able to leverage its market power to introduce a new, more expensive payment card that merchants are, by the HACR, bound to accept alongside existing cheaper ones. The OFT notes that in the UK, over recent years, there has been a significant expansion in the holding and usage of premium MasterCard cards (predominantly branded as MasterCard World or MasterCard World Signia cards), for which MasterCard sets higher MIFs than it does for standard credit cards The proposed regulator might consider whether the Honour All Products aspect of the HACR as it currently operates in payment card networks is compatible with the principle of efficient pricing and whether it might need to take steps to prevent any tying of products with different prices that may be considered by end-users as a combined take-it-or-leave-it offering. Transparency 7.37 HMT envisages that the proposed regulator will need to produce guidance on how payment card networks will be able to demonstrate that they are complying with price transparency requirements. We note that for many end-users the key criteria for price transparency will include: the ability to identify easily, before a transaction is initiated, the costs that the transaction will incur 53 the simplicity of the pricing schedule, including easy comprehension of the charges and how they break down, including on any statement or invoice, and sufficient explanation of the reasons underlying any price increases In theory, these criteria could apply to both cardholders and merchants. In practice, given the price of a transaction to a cardholder 53 As part of this, the proposed regulator might wish to consider how readily identifiable (both visually and electronically) each type of payment card is to the merchant and whether the merchant is able to adequately understand the associated costs of accepting each card before a transaction is initiated. 54 This principle might be particularly relevant where (a) a payment card network has the ability to increase prices (e.g. increasing merchant service charges by setting MIFs at a higher rate) without the need for any renegotiation of contracts with end-users and (b) where experience indicates that end-users may face such price increases without any apparent additional benefits accruing to them. 58 OFT1498

59 is usually zero, these criteria are more likely to apply to merchants. Wider options available to cardholders 7.39 When making purchases, cardholders have a range of payment options. Often these payment options have costs which are not faced directly by the cardholder (as is the case with free cash withdrawals). The regulator will need to consider the extent to which it is appropriate and possible to take account of the price signals of other payment options when considering any price intervention in relation to payment card networks. 59 OFT1498

60 8 APPROACH TO REGULATION Introduction 8.1 In establishing a new regulator, it is important to consider the approach to regulation and the powers necessary to achieve the regulator's objectives and enable it to operate effectively. This chapter considers these matters in turn. Approach to regulation Utility regulation and payment systems 8.2 The liberalisation of some public markets in the UK began in earnest in the 1980s. When the public monopolies of utility markets such as telecoms, water and later energy were sold, the government was aware that due to the natural monopoly elements of these sectors, it would not be possible simply to introduce competition across the whole sector, and therefore, privatising the incumbent supplier could lead to poor outcomes for consumers from high prices and poor service levels. Consequently, in many cases, the incumbents were split, isolating the network infrastructure that resembled a natural monopoly and regulating that, while ultimately seeking to introduce competition for the provision of downstream or retail services. 8.3 The OFT agrees with the Government s overarching principle, that if a payments regulator is established it should seek to regulate this market in a similar fashion. The OFT considers that this model does not translate perfectly to payment systems, as, in contrast to the telecoms sector, the infrastructure in payment systems appears less of a natural monopoly and closer to a market where a number of characteristics lead to first mover advantages for infrastructure suppliers. This may be the case given the separate infrastructure for the Link, Bacs and Faster Payments system. However, the OFT does note that this separation may have arisen due to the sequential way these payment systems were designed and introduced over time. 8.4 The OFT considers that the characteristics of payment systems, including the nature of the infrastructure, means that, irrespective of whether this sector has the same characteristics as other regulated sectors, competition may not be expected to be fully effective in 60 OFT1498

61 constraining the actions of payment system members and providers of infrastructure. 8.5 Given the independent structure of payment system infrastructure providers, and the contractual relationship with payment systems that HMT is proposing to licence, the OFT has considered the extent to which the proposed regulation would be sufficient to exert control over the providers of infrastructure. The OFT considers that the regulator would have some control over infrastructure providers through licensing payment systems and their members, however, it would not appear to have the power to compel infrastructure providers to carry out actions it considers necessary. 8.6 Consequently, the OFT recommends that HMT should consider extending the licensing regime to encompass the providers of infrastructure of the existing payment systems. HMT may also wish to consider the relationship between the Bank of England and the proposed regulator, given the Bank of England provides the underlying infrastructure for payments in the CHAPS system, in addition to its role in the current regulatory structure. Ownership 8.7 HMT has proposed that the regulator would have the power to impose ownership changes on licensed organisations, in the event that the Competition Commission (or, from April 2014, a Competition and Markets Authority, Stage II investigation) should conclude that there are adverse effects on competition that lead to this remedy being appropriate. 8.8 In terms of practicality, given that payment systems and their infrastructure are separate legal entities, it would be possible to change the structure of ownership. 8.9 The OFT notes that while the infrastructure and payment system companies are owned by retail banks, these banks also have some element of control over such systems, by virtue of being large members of these systems. Furthermore, these banks are also the main users or customers of these systems. Consequently, while it is possible that changing the ownership structure of payment systems and the underlying infrastructure may remove some of the influence of 61 OFT1498

62 large banks, it is not clear that this change would remove all competition concerns that could arise in this area. This is because as the largest users of these systems, large retail banks would still expect to remain as the largest members of these systems and may be able to exert some control. Moreover, as the largest users, they could, at least in theory, be expected to have some degree of buyer power over these systems The OFT notes that there may be some arguments in favour of ownership change in the event that this were likely to help alleviate the slow pace of collaborative innovation. This might arise as ownership change may have the scope to change the incentives of organisations in this sector to collaborate with others in the sector to drive innovation In conclusion, the OFT agrees with HMT that there is not a clear cut case for seeking to impose changes in ownership at this time. Instead the benefits of having greater independent control of payment systems and infrastructure could be achieved through extending the proposed licensing to cover providers of infrastructure as well as members of payment systems. This would allow the regulator to ensure that infrastructure developments that are necessary to promote competition and innovation, as set out in Chapter 6, could be implemented directly with the infrastructure provider, rather than indirectly through the members of payment systems. Coordination body 8.12 The OFT notes that the regulator of payment systems may not have powers, directly, to control one possible organisation that could carry out the role of co-ordinating collaborations across the industry, the Payments Council. The OFT considers that it may be important for the regulator to ensure that the organisation that assists with such collaborative projects is under its control and governed as the regulator would wish Consequently, the OFT recommends that, in addition to its proposed regulatory objectives set out in its consultation, the regulator of payment systems should ensure that there is an organisation with a suitable form and governance structure, and which is under the control of the regulator, to provide for the co-ordination of 62 OFT1498

63 collaborative projects across the banking and payments sector and implementing initiatives sought by the regulator The OFT notes that the scope of such collaboration should be strictly limited to circumstances where the regulator is clear that such collaboration, rather than competitive market forces, would be the most efficient manner in which to deliver improvements in the sector and ensure such collaboration does not breach the provisions of the Competition Act Such an organisation could include representatives from the retail banking and payment systems sector, as well as specialist advisors for payment systems, and representatives of consumers, the regulator and government in proportions the regulator considers appropriate. Regulatory Powers Concurrency 8.16 The OFT notes that HMT intends to give the new regulator concurrent competition powers under the Competition Act 1998 and the Enterprise Act While the OFT considers that the new regulator may find these powers are used relatively rarely given the range of licensing powers envisaged, the OFT supports this extension of the concurrency regime. Price setting 8.17 The OFT notes that HMT plans to provide the regulator with the ability to set prices in the market, (ex-ante price setting powers) rather than just the ability to consider whether prices set by licensed providers were appropriate after the event (ex post price setting powers) The OFT considers that ex-ante price setting powers are likely to be necessary for the regulation of payment card networks to be considered efficient and pragmatic, given the competition concerns in this sector. For the remaining payment systems, the OFT has fewer concerns, and as a consequence, considers that the regulator may be able to achieve its objectives in relation to innovation and competition through the use of less interventionist ex-post price setting powers, with an extension of the planned regulation to cover infrastructure providers and an effective redress mechanism. The OFT has however, 63 OFT1498

64 not considered this issue in detail. Licensing 8.19 The OFT considers it necessary that the regulator has power to compel the existing payment systems, their members and providers of infrastructure to take specific action to ensure it meets its objectives. In addition, the OFT notes that the licensing powers, (where expanded to cover providers of payment systems infrastructure) have the scope to be used effectively to compel change and develop competition and innovation in the sector Licensing conditions for access in this sector already exist under part 8 of the Payment Services Regulations 2009, which were introduced to encourage non-banks to enter the payments market. However, as noted in Section 96 of these regulations, they do not apply to designated systems HMT will need to ensure that its new regulator's operations will be compatible with the operation of the existing regulations. It will also need to consider any potential conflicts arising from the regulator's powers to ensure open access to payment systems and the existing access provisions, where the OFT is at present the competent authority. 55 Designated system means a system which is declared by a designation order for the time being in force under regulation 4 of the Financial Markets and Insolvency (Settlement Finality) Regulations 1999(1) to be a designated system for the purposes of those Regulations. 64 OFT1498