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The Credit Card Competition Act’s Potential Effects on Airline Co-Branded Cards, Airlines, and Consumers

ICLE White Paper Executive Summary This study assesses the likely consequences of implementing the Credit Card Competition Act (CCCA), which proposes to require issuers of most Visa and . . .

Executive Summary

This study assesses the likely consequences of implementing the Credit Card Competition Act (CCCA), which proposes to require issuers of most Visa and Mastercard branded credit cards in the United States to include a second network on their cards, and to allow merchants to route transactions on a network other than the primary network branded on the card.

Proponents of the Credit Card Competition Act (CCCA) claim that it would “enhance credit card competition and choice in order to reduce excessive credit card fees.” In fact, by forcing most U.S. credit-card issuers to include a second network on all their cards, the CCCA would remove the choice of network from the issuer and cardholder, and place it in the hands of the merchant and the acquiring bank.

There is some uncertainty as to the legislation’s anticipated effects, as nothing quite like it has ever been implemented anywhere in the world. We can, however, make some inferences based on the known effects of prior regulations driven by similar motives, in the United States and in such jurisdictions as Europe and Australia.

The primary U.S. payment-card networks—Visa, Mastercard, American Express, and Discover—constantly vie with one another to attract customers, investing billions of dollars in innovations that improve the user experience and reduce fraud and theft.

At the same time, hundreds of banks and credit unions compete to offer a broad range of credit cards to American consumers, choosing the network for each card based on the fit between the network’s terms, the card’s purposes, and its intended market.

Credit cards offer numerous benefits, including access to credit (interest-free, if paid in full by the due date), fraud protection, and chargebacks. Many also offer purchase insurance, fee-free international transactions, and consumer rewards like loyalty points and cash back.

Many rewards cards are co-branded with partners such as airlines, hotels, and retailers. The relationship between partners and card issuers is highly synergistic, with issuers generating revenue—due to increased use and associated interchange fees—while partners receive payments for rewards, marketing, and other ancillary benefits (such as lounge access, in the case of airlines). For the top six U.S. airlines alone, these deals represent more than 5% of total revenue—and five times their net revenue.

Credit-card rewards, including cash back and travel points, have become an important part of many consumers’ budgeting decisions. Indeed, it is not uncommon for consumers to have two or three different rewards credit cards, enabling them to choose which to use at time of a purchase based, at least in part, on the rewards they receive from any particular card.

While the CCCA would likely reduce the interchange fees paid by acquiring banks to issuing banks, overall bank fees are unlikely to fall dramatically. Rather, banks would shift fees from interchange to other sources of revenue, including late fees and interest.

The reduction in interchange fees would almost certainly significantly reduce rewards and other benefits to cardholders, as happened when price controls were imposed on debit cards following the implementation of a provision of the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 known as the “Durbin amendment,” after sponsoring Sen. Richard Durbin (D-Ill.), who is also lead sponsor of the CCCA. The reduction in interchange fees, in turn, would make certain types of cards less viable. As such, the CCCA would reduce choice for consumers.

Exempted card issuers—especially those of the large three-party networks, American Express and Discover—would likely benefit from the CCCA, as they would still be able to offer rewards and the security of their networks would not be affected.

Merchants who partner with exempted three-party card issuers also would almost certainly benefit, at the expense of other merchants whose co-branded cards are issued by banks that are covered by the legislation. For example, Delta Airlines, which has a card co-branded with American Express, would benefit at the expense of all other airlines. Merchants that co-brand with a three-party card would not only benefit from higher merchant fees, but also from customers switching to receive higher levels of loyalty rewards. Moreover, those who currently spend the most on their co-branded cards would likely be most motivated to switch.

Given the relatively low margins of the U.S. airline industry and the significant proportion of revenue that loyalty rewards represent, the combination of reduced loyalty revenue and reduced customer revenue could be absolutely devastating for the industry (except, as noted, for Delta).

To make matters worse, the CCCA may also affect many airlines’ costs of capital. For example, a reduction in expected revenue from the sale of rewards could result in credit rating agencies downgrading the bonds that United and American Airlines’ rewards-program subsidiaries issued during the COVID-19 pandemic. That could trigger covenants requiring the parent companies to post additional capital, which would, in turn, increase the parents’ capital costs.

In general, the combination of reduced revenue and reduced loyalty-program memberships—leading to lower revenue from higher-value customers—would reduce airlines’ expected future profitability, which would increase capital costs. This may not pose a problem in periods when demand for air travel is high. In a downturn, however, it could result in a bankruptcy—previously avoided due to the airline’s ability to securitize its loyalty program.

One potential outcome is that bank issuers and airlines choose to cancel their co-branded agreements by mutual consent, so that the airlines could make similar arrangements solely with three-party card networks. While this would clearly be beneficial for those three-party networks, and could mitigate the harm to the airlines, it would be enormously costly, and the losers would be issuers, four-party networks, cardholders (especially those with lower credit scores who did not qualify for the three-party-network cards), and the U.S. economy as a whole.

It is also possible that issuers will do what they appear to have done in the EU: increase interest rates and late fees so that they can continue to offer some level of rewards. In that case, the CCCA would have brought about what some critics of credit-card rewards have previously falsely accused issuers of doing: using credit cards to transfer wealth from lower-income, lower-spending consumers who maintain a revolving balance to higher-income, higher-spending consumers who pay off their balances every month.

Either way, the CCCA effectively picks winners and losers. The winners will be three-party cards—especially American Express—and merchants that co-brand with those cards, such as Delta (and their customers), as well as big-box retailers. The losers will be Visa, Mastercard, the other airlines, the card issuers, and their customers. Overall, merchants are also likely to lose, as consumers spend less, which could translate into lower rates of economic growth. Unfortunately, the number and scale of those who lose is likely to be far greater than the number and scale of those who win.

I.        Introduction

Over the past 20 years, payment cards have become increasingly vital to the U.S. economy, largely replacing checks as the preferred means of making a whole range of payments. Underpinning this shift have been innovations in payments technologies that have made them quicker, more convenient, more secure, and less costly for both consumers and merchants.1F[1] These innovations have been driven by competition:

  • The primary U.S. payment-card networks—Visa, Mastercard, American Express and Discover—constantly vie with one another to attract and retain customers, investing billions of dollars in innovations that improve the user experience and reduce fraud.
  • At the same time, hundreds of banks and credit unions compete to offer a wide range of credit cards to American consumers. Those issuers choose the four-party network for each card, based on the fit between the network’s terms, the card’s purposes, and its intended market.
  • Meanwhile, the two major three-party networks—American Express and Discover—compete both with each another and with the large issuers and the four-party networks over which they operate.

A.      Counterparty, Default, and Collection Risk

Credit-card issuers guarantee payment to merchants, so long as those merchants comply with the terms and conditions set by the card network.[2] In so doing, credit cards provide a means of payment that has lower counterparty risk for the merchant than checks. At the same time, card issuers effectively assume the risk of default and collection.

Back in 2010, Sen. Richard Durbin (D-Ill.) himself recognized that operating credit cards is an expensive enterprise that entails counterparty, default, and collection risk, which is why credit cards were excluded from the original Durbin amendment. As he noted at the time:

About half of the transactions that take place now using plastic are with credit cards, and there is a fee charged—usually 1 or 2 percent of the actual amount that is charged to the credit card. It is understandable because the credit card company is creating this means of payment. It is also running the risk of default and collection, where someone does not pay off their credit card. So, the fee is understandable because there is risk associated with it.[3]

B.      Understanding Interchange Fees

For early card-payment systems, offering a means of payment and being exposed to counterparty, collection, and default risk were pretty much the core features of the product. This is because there were only two parties: the merchant and the consumer. The “card” (a metal plate) enabled merchants to maintain a record of credit provided to regular customers, who would then settle up at the end of the month.3F[4]

So, had Sen. Durbin been referring to the Charge Plate—or to its modern equivalent, which are merchant-issued charge cards—his characterization of the costs would have been largely correct. But nearly all modern payment networks are either three- or four-party systems that are fundamentally more complex.

1.        Three- and four-party cards

In the 1950s, Diners Club and then American Express both established “three-party” systems, which enabled consumers to use the same card at multiple merchants.4F[5] In a three-party system, the card issuer pays merchants directly, and bills and collects from cardholders directly.5F[6]

The following decade, several organizations developed “four-party” systems, which have four main parties: issuer, consumer, merchant, and acquirer. The issuer contracts with the consumer, providing the card, issuing bills, etc. The acquirer contracts with the merchant, making payment. The rules of the system are set by the network operator, which also facilitates settlement between the issuer and the acquirer, and monitors for fraud and other abuse.6F[7] Visa and Mastercard are the primary global four-party networks.

2.        Two-sided markets

One of the major challenges faced by both three- and four-party payment systems is to persuade both merchants and consumers of their value. If too few merchants accept a particular form of payment, consumers will have little reason to hold it and issuers will have little incentive to issue it. Likewise, if too few consumers hold a card, merchants will have little reason to accept it.

Conceptually, economists describe such scenarios as “two-sided markets”: consumers are on one side, merchants on the other, and the payment system acts as the platform that facilitates interactions between them.7F[8] While payment cards are a prominent example of a two-sided market, there are many others, including newspapers, shopping malls, social-networking sites, and search engines. Indeed, the rise of the internet has made two-sided markets practically ubiquitous.

All platform operators that facilitate two-sided markets face essentially the same challenge: how to create incentives for participation on each side of the market to maximize the joint net benefits of the platform to all participants—and to allocate costs accordingly.8F[9] Thus, the platform operator can be expected to set the respective prices charged to participants on each side of the market to achieve this maximand.9F[10] If the operator sets the price too high for some consumers, they will be unwilling to use the platform; similarly, if the operator sets the price too high for some merchants, they will not be willing to use the platform. As the U.S. Supreme Court put it:

To optimize sales, the network must find the balance of pricing that encourages the greatest number of matches between cardholders and merchants.[11]

3.        Transaction fees

This brings us to transaction fees, which are the primary mechanism that credit-card-network operators use to balance the market. In three-party systems (American Express and Discover), the card-network operator acts as both issuer and acquirer, and charges merchants a card-processing fee (typically a percentage of the transaction amount) directly. In four-party systems, the issuer charges the acquirer an “interchange fee” (set by  the networks) that is then incorporated into the fees those acquirers charge to merchants (called a “merchant-discount rate” in the United States). The schematics in Figure 3 show how these different systems operate.

The interchange fees charged on four-party cards vary by location, type of merchant, type and size of transaction, and type of card. An important factor determining the size of interchange fee charged to a particular card is the extent of benefits associated with the card—and, in particular, any rewards that accrue to the cardholder.

The various three- and four-party payment networks have been engaged in a decades-long process of dynamic competition, in which each has sought—and continues to seek—to discover how to maximize value to their networks of merchants and consumers. This has involved considerable investment in innovative products, including more effective ways to encourage participation, as well as the identification and prevention of fraud and theft.[12]

It has also involved experimentation with differing levels of transaction fees. The early three-party schemes charged a transaction fee of as much as 7%.15F[13] Competition and innovation (including, especially, innovation in measures to reduce delinquency, fraud, and theft) drove those rates down. For U.S. credit cards, interchange fees range from about 1.4% to 3.5%, while the average is approximately 2.2%.18F[14]

In general, economists have concluded that the “optimal” interchange fee is elusive, and that the closest proxy is to be found through unforced market competition. They have therefore cautioned against intervention without sufficient evidence of a significant market failure.25F[15]

C.      Regulation: In Whose Interests?

Despite these cautions, governments have intervened in the operation of payment systems in various ways. As we have documented previously, many of these regulations have slowed the shift toward more innovative, quicker, and more convenient payment systems, while also reducing other benefits and harming, in particular, poorer consumers and smaller merchants.2F[16]

Introduced in June 2023 by Sens. Richard Durbin (D-Ill.), Roger Marshall (R-Kan.), Peter Welch (D-Vt.), and J.D. Vance (R-Ohio), the Credit Card Competition Act of 2023[17] would continue this trend, to the detriment of consumers and businesses. As this paper documents, co-branded cards generate significant revenue for the merchants whose brand appears on the card. As Section II documents, this appears to be particularly true for airlines. While many other merchants also have valuable co-branded agreements, they generally represent a much lower proportion of total revenue. Hence, assessing the potential effect of the CCCA on airline co-branded credit cards—and on the airlines themselves—is particularly important.

As documented in Section IV, there are broadly two potential outcomes of the CCCA with respect of U.S. airlines:

  • Businesses could implement workarounds that minimize the law’s effects. These workarounds are not costless; among other things, they would entail rewriting hundreds of millions of contracts. Issuers, merchants, and consumers would bear those costs. There would also be a significant redistribution of revenue and profits away from the largest four-party card issuers and payment networks and toward the two major three-party networks—perhaps especially American Express. And there would be a smaller redistribution of revenue and profits away from the larger airlines that currently have co-branded cards with Visa and Mastercard (especially American, United, Southwest, Alaska, and JetBlue) toward Delta, which is the one major domestic airline that has a co-branded card with American Express.
  • If businesses are unable to implement adequate workarounds, the act’s effects could be much more severe. Most significantly, with the exception of Delta, the major airlines could potentially lose billions of dollars in revenue, mainly because of the reduction in revenue from co-branded cards, but also because some proportion of flyers would likely switch to Delta to take advantage of the more attractive benefits on Delta’s existing co-branded credit card. This, in turn, would affect airlines’ ability to operate some marginal routes, perhaps leading to a spiral of defections to Delta, which would become a huge beneficiary, as it would be relatively more profitable and attract additional fliers.

While the second outcome would clearly be worse, in both cases, Americans would have choices taken away, costs would increase, and economic growth would be adversely affected. Moreover, far from reducing merchants’ costs, most merchants would be adversely affected, as the costs of acquiring credit cards would not fall and could, indeed, rise (and, of course, merchants with co-branded loyalty-rewards cards would suffer substantial revenue losses). In short, there is basically no scenario in which the Credit Card Competition Act is actually good for competition, American consumers, or the U.S. economy as a whole.

D.     Overview of the Study

The study proceeds as follows:

  • Section II discusses the nature and economics of loyalty-rewards programs, with a particular focus on airline-rewards programs. It then explains co-branded credit cards and describes some of the major airline co-branded credit-card partnerships, including their likely revenue.
  • Section III provides a brief overview of the CCCA.
  • Section IV considers some of the primary examples of interchange-fee price controls and routing regulations that have been implemented in the United States and other jurisdictions.
  • Section V considers, in detail, the potential effects of the CCCA. It discusses various implementation scenarios and the likely effects of these scenarios on the rewards received by holders of airline co-branded cards, on the behavior of those cardholders, and on the airlines themselves.
  • Section VI offers some concluding remarks.

II.      Airline Loyalty-Rewards Programs and Co-Branded Credit Cards

Loyalty-rewards programs have existed for hundreds of years. The first documented program in the United States was established in 1793 by a merchant in Sudbury, New Hampshire, who gave away copper tokens to customers, which could be redeemed for goods.[18] Over time, programs became more sophisticated, with copper tokens replaced, first, by stamps and, later on, by plastic cards with magnetic stripes that encoded the owner’s account information (reward information being recorded on a central database that could be accessed using the card, enabling rewards to be deposited or used). These days, rewards are mostly held in online accounts and accessed via websites and mobile apps, although cards are often still distributed—albeit mainly symbolically.

While we are mainly concerned here with airlines loyalty-rewards programs, and specifically with the role of credit cards co-branded by those programs, it helps to have a more general appreciation of the nature and function of loyalty-rewards programs. Toward that end, this section begins with a basic explanation of the economics of loyalty-rewards programs. It then explores the nature and function of credit-card reward programs, before discussing airline/credit-card co-branded reward programs in more detail.

A.      The Economics of Loyalty-Rewards Programs

Loyalty-rewards programs function primarily as marketing tools to encourage customers to become and remain loyal to a particular merchant. Program participants typically receive points toward rewards each time they make a purchase associated with the program, creating incentives to buy goods and services from that merchant.

These incentives are enhanced by structuring the programs in tiers and making them time-limited, so that participants who purchase more goods or services in a particular period receive higher levels of rewards. Such features are prominent in airline-reward programs, which typically offer inducements to participants in the form of upgrades, waived baggage fees, and use of airport lounges, which become available upon spending a certain amount over the course of a year.[19]

Loyalty-reward programs that distribute specific goods or services in return for reward points, coupons, or stamps likely benefit from the ability to purchase goods or services at a bulk discount.[20]

Merchants may also use rewards redemptions as a means to practice price discrimination, offering specific goods and services to reward-program participants for reduced reward redemptions. For example, airlines typically offer seats for fewer reward points during off-peak periods. Such discounts reduce the marginal cost of the rewards program, enabling merchants to make use of otherwise-unfilled capacity or to sell bulk-purchased goods, while simultaneously providing additional benefits to loyal customers.

Card-based and digital (i.e., app-based or online) reward programs also collect data on the purchasing habits of program participants. As a result, program operators and partners can target marketing at specific participants and more effectively build longer-term customer relationships with them.

B.      Airline-Rewards Programs

American Airlines established the first airline loyalty-rewards program, AAdvantage, in 1981.[21] The other major carriers soon followed suit, realizing that such programs can be an effective means to offer incentives for loyalty. The standard loyalty-rewards program was boosted in 1982 when American Airlines introduced a “gold” tier for higher-value customers.[22] Again, other airlines followed suit, and most have since developed multiple tiers. The evidence shows that airline loyalty-reward schemes are highly effective ways to attract and retain high-value customers.[23]

The value of airline loyalty-reward programs was demonstrated in an unusual way during the COVID-19 pandemic. The collapse in demand for air travel caused more than 40 airlines around the world to file for bankruptcy.[24] Initially, some U.S. carriers issued bonds with very high coupons, as they hemorrhaged cash.[25] Then, in June 2020, United Airlines created a separate bankruptcy-remote entity for its rewards programs, and used it as collateral to issue $5 billion in bonds at a more favorable rate than the airline itself would have received.[26] American and Delta took the same approach.[27]

C.      Credit-Card Reward Programs

Credit-card rewards programs are similar in many elements of their basic operation to other reward programs. Card users receive rewards either in the form of cashback or points (or “miles”) that can be redeemed for various goods and services (the specific goods and services available vary, depending on nature of the rewards-program operator and any partners or affiliates).

Many card issuers offer credit cards that are co-branded with merchants, ranging from retailers to hotels. Among the most popular cards are those co-branded with airlines. Before delving into the particulars of airline co-branded cards, however, it is worth briefly considering the mechanics of co-branded cards in general.

Each co-branded card offering exists by way of an agreement between the card issuer and the co-brand entity. This agreement typically specifies the amount the card issuer will pay the co-brand entity for the purchase of loyalty-reward points, as well as marketing opportunities. These agreements enable issuers, in turn, to make further agreements with cardholders, offering them specific rewards in return for specific spending amounts.

By offering rewards, card issuers provide card holders with incentives to use their card. Meanwhile, the rewards themselves also create loyalty toward the co-brand entity. And the co-brand entity is typically able to adjust the redemption rate of loyalty rewards in order to encourage the use of rewards in ways that reduce the marginal cost of the rewards redemption to the co-brand entity. That, in turn, enables the co-brand entity to offer rewards to card issuers at a discount. In this way, rewards programs can generate significant profits for co-brand entities and issuers, while generating loyalty to the brand and the card for cardholders.

Credit-card-based reward programs can be a highly effective way both to increase the use of cards and to enhance customer loyalty. Survey data demonstrate the effectiveness of rewards programs as a means of encouraging loyalty. A 2015 survey by Technology Advice of U.S. shoppers found that more than 80% of respondents said they were more likely to shop at stores that offered loyalty programs.[28]

Credit-card issuers, in turn, fund the programs partly by charging annual fees to users and partly by charging interchange fees to merchants.

Merchants undoubtedly benefit from credit-card-reward programs both directly and indirectly. Direct benefits come from the ability to target marketing to reward-program members through discounts, additional rewards, and other inducements. As noted, card-based rewards programs enable merchants to customize marketing to specific individuals and groups based on information gathered through card use about their purchasing habits. This can result in a substantial increase in spending per-transaction (known as “ticket lift”).

Research by Mastercard, for example, found that international travelers to the United States who were offered incentives to shop at certain merchants spent four times as much on their cards as cardholders not redeeming such offers.[29] Indirect benefits come from increased use of credit cards in general, which leads to increased spending, due to reduced liquidity constraints, as well as reduced transaction costs and better transaction management.

Credit-card issuers also benefit from credit-card rewards programs, through additional card uptake and usage, as well as from fees charged to merchants and third-party reward-card operators for transaction-related information that better enables them to target marketing efforts.[30]

Arguably the greatest beneficiaries of reward programs, however, are consumers with reward credit cards. Such consumers benefit directly, both from the rewards themselves and from the various additional inducements offered by merchants and card issuers as part of marketing efforts. A survey by Ipsos conducted at the end of 2020 found that 60% of Americans consider credit-card rewards to be “very important” for them, while over half said the prospect of rewards influences their purchasing decisions.[31] Meanwhile, a more recent survey by WalletHub found that 80% of respondents said that inflation had made them more interested in credit-card rewards.[32]

Moreover, due to the better targeting of these inducements made possible by the use of individual transaction data, owners of rewards credit cards likely receive offers that are more relevant than poorly differentiated mass marketing and advertising. In the WalletHub survey, 58% of Americans said they go out of their way to spend at merchants who offer additional credit-card rewards.[33]

D.     Airline/Credit-Card Co-Branded Reward-Program Partnerships

Many merchants with loyalty-rewards programs partner with affiliated (non-competing) merchants to expand their program’s reach. Airlines notably partner with providers of related travel services, such as hotels and car-rental services, offering additional loyalty-rewards points in return for spending dollars at those partners. The partners in these programs purchase the loyalty-rewards points from the airlines, thereby generating additional revenue for the airline.

1.        The value of airline loyalty-reward programs

In 2022, loyalty-rewards programs represented 7.6% of total revenue for the top six U.S. domestic airlines (“loyalty income” column in Table 1). Given the airlines’ relatively thin profit margins (“net income” column in Table 1), this revenue is clearly important even in good times. Indeed, in 2019, the net cash income of the loyalty-rewards programs for the three largest U.S. airlines was $7.8 billion and the margin on those programs ranged from 39% to 53%.[34]

[35]

But loyalty-rewards income can be even more important during downturns. During the 2009-2010 recession, both American Airlines and Delta reported pre-selling $1 billion of loyalty rewards to their co-branded credit-card issuers (Citibank and American Express, respectively).[36] And during the COVID-19 pandemic, the airlines were essentially kept afloat by their loyalty-rewards programs, in general, and their co-branded cards, in particular.

In 2020, for example, American Airlines sold $3.65 billion of loyalty rewards, of which $2.9 billion came from sales to co-branded cards and other partners, resulting in adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) for the loyalty-rewards program of $2.1 billion.[37] It is noteworthy that those partner-rewards sales were only 25% lower in 2020 than in 2019, suggesting that co-branded cards were responsible for about 70% of the total.[38] Meanwhile, Delta, United, and American raised more than $10 billion by issuing debt backed by their loyalty programs, enabling them to avoid bankruptcy.[39]

2.        The value of credit-card co-branded partnerships

For airlines, the most significant loyalty-reward partnership is with credit-card issuers.[40] While the airlines do not usually break out the numbers specifically for co-branded cards, they are clear in their annual reports about the importance of their partnerships with credit-card issuers. Consider the following four examples:

  • American Airlines’ 2022 annual report noted that: “During 2022 and 2021, cash payments from co-branded credit card and other partners were $4.5 billion and $3.4 billion, respectively.”[41]
  • United Airlines’ 2022 annual report noted that: “Other operating revenue increased $664 million, or 31.8% [to 2.75 billion], in 2022 as compared to 2021, primarily due to an increase in mileage revenue from non-airline partners, including credit card spending recovery with our co-branded credit card partner….”[42]
  • Delta Airlines’ annual report noted that revenues from its loyalty program “are mainly driven by customer spend on American Express cards and new cardholder acquisitions.” Meanwhile, the company’s accounting of “miscellaneous income” was “primarily composed of lounge access, including access provided to certain American Express cardholders, and codeshare revenues.” In 2022, income from the loyalty program was $2.58 billion, while miscellaneous revenue was $894 million.[43] In total, the two revenue streams represented $3.47 billion.
  • In 2022, Southwest declared $3.03 billion in “passenger loyalty” related revenue.[44] As the company’s annual report explained: “Passenger loyalty – air transportation primarily consists of the revenue associated with award flights taken by loyalty program members upon redemption of loyalty points.” Southwest accounts for loyalty points on an accrual basis as a liability, which becomes “revenue” when they are spent. Southwest separately accounts for “other revenues” which “primarily consist of marketing royalties associated with the Company’s co-brand Chase® Visa credit card, but also include commissions and advertising associated with Southwest.com ®.”[45] It notes: “The Company recognized revenue related to the marketing, advertising, and other travel-related benefits of the revenue associated with various loyalty partner agreements including, but not limited to, the Agreement with Chase, within Other operating revenues. For the years ended December 31, 2022, 2021, and 2020 the Company recognized $2.1 billion, $1.4 billion, and $1.1 billion, respectively.”[46]

As these descriptions indicate, revenues to airlines from co-branded cards are a combination of loyalty rewards, which issuers purchase from the airlines and then allocate to cardholders in accordance with the terms of agreements between the issuers and cardholders; payments for marketing, which includes such items as sending promotional materials to the airlines’ lists of loyalty-rewards members; and payments for ancillary benefits, such as lounge access for some cardholders.

Previous estimates indicate that the proportion of “loyalty revenue” attributable to co-branded credit cards is in the 70% to 80% range.[47] At the lower end of that range (70%), the top six airline co-branded cards would have generated just over $10 billion in value in 2022. Plausibly, the number is somewhat higher. As such, revenue from co-branded cards would represent at least 5% of the operating revenue of the six largest airlines and five times those airlines’ net revenue.

Per the discussion above about the beneficiaries of co-branded reward programs, it seems reasonable to infer that airline co-branded reward cards are highly valued by consumers, airlines, the partners, and the card issuers.

III.    The Credit Card Competition Act

The Credit Card Competition Act of 2023 (CCCA) was introduced in the U.S. Senate on June 7, 2023, by Sens. Richard Durbin (D-Ill.), Roger Marshall (R-Kan.), Peter Welch (D-Vt.), and J.D. Vance (R-Ohio). If enacted, the bill would direct the Federal Reserve Board to promulgate regulations to prohibit banks with assets of $100 billion or more from issuing credit cards[48] that could be used with either (1) only one payment network, (2) only two affiliated payment networks,[49] or (3) only the two payment networks with the “largest market share.”[50] The bill also directs the Federal Reserve Board to promulgate rules prohibiting credit-card processors from limiting merchants’ ability to choose which network they use to route a payment.[51] Furthermore, it would effectively require interoperability of credit-card “tokens.”

While the bill does not explicitly name Visa or Mastercard, they are clearly its primary target. The legislation defines “largest market share” by number of cards issued, which is far larger for both Visa and Mastercard than for any three-party network (i.e., American Express and Discover), primarily because of the intense competition among banks to supply cards.[52] In addition, the Federal Reserve Board would be required to review market share every three years and, if the identities of two largest networks have changed, then the third requirement would no longer apply.[53] As if that weren’t clear enough, the legislation also states that “The regulations … shall not apply to a credit card issued in a 3-party payment system model.”[54]

A.      Prima Facie, Would the CCCA Achieve Its Aims?

In his summary of the act, Sen. Durbin claims:

[T]he giant banks that issue the overwhelming majority of Visa and Mastercard credit cards would have to choose a second competitive network to go on each card, and then a merchant would get to choose which of those networks to use to process a transaction. This competition and choice between networks would incentivize better service and lower cost; in fact, for more than a decade, federal law has required debit cards to carry at least two debit networks and this requirement of a choice of debit networks has fostered increased competition and innovation in the debit network market and has helped hold down fees.

That is, to say the least, an optimistic appraisal of the proposed legislation. While it is highly plausible that the CCCA would, if enacted, lead to a reduction in interchange fees, it appears highly unlikely that it offers incentives for better service. Indeed, the opposite is far more likely. The reason is asymmetric counterparty risk and, specifically, the lack of adequate incentives on the part of larger merchants and acquirers to choose networks that manage fraud risk. This is a problem that Todd Zywicki and I discuss at length in our recent paper on the regulation of routing in payment networks.[55] As we note there:

[E]ach party to a transaction has somewhat different incentives regarding the choice of network. In general, the card issuer and cardholder both have strong incentives to route payments over the main branded network associated with the card, thereby ensuring the use of all the security and anti-fraud protections available from an EMV card, including 3DS for online transactions and the ability for cardholders to place temporary holds on their cards. Some merchants also have incentives to route over the main branded network, especially smaller merchants selling higher-value goods online, given the potential for very expensive chargebacks from unauthorized transactions. However, many other merchants, especially larger high-volume merchants, would have incentives to use the lowest cost routing, especially those that are able to take advantage of the EMV chip and PIN for POS transactions, and those that have their own machine-learning-based fraud monitoring systems that enable them to reduce potential chargebacks on their own. Finally, acquirers generally have less incentive to avoid fraud and stronger incentives to route transactions over the least-cost route.

Since the CCCA would shift the choice of network from the issuer to the merchant and/or acquirer, and since those parties generally have weaker incentives to route transactions over more secure networks with better fraud detection, the likeliest effect is that the CCCA would reduce investments in fraud prevention. As we also noted in the paper on regulating routing, mandating “competition” over routing would cause data fragmentation, with some transactions being routed over the primary network while others are routed over the secondary network. The end result is that the networks’ fraud-detection algorithms would be less effective.[56] Thus, at least when it comes to fraud prevention, the CCCA would likely result in worse service, not better.

B.      The Effect of the CCCA on Airline Co-Branded Rewards Cards

As noted, for reasons explained in Section II, this paper is primarily interested in the effect of the CCCA on airline co-branded rewards cards. Subsequent sections draw on evidence regarding the effects of other interchange-fee regulations, both in the United States and around the world. As a prelude, here is what American Airlines said in its 2022 annual report about the legislation’s potential implications (referring to a near-identical bill that was introduced in the 117th Congress):

We may also be impacted by competition regulations affecting certain of our major commercial partners, including our co-branded credit card partners. For example, there has previously been bipartisan legislation proposed in Congress called the Credit Card Competition Act designed to increase credit card transaction routing options for merchants which, if enacted, could result in a reduction of the fees levied on credit card transactions. If this legislation were successful, it could fundamentally alter the profitability of our agreements with co-branded credit card partners and the benefits we provide to our consumers through the co-branded credit cards issued by these partners.[57]

IV.    Lessons from Other Interchange Regulations

Over the past four decades, jurisdictions across the world have imposed a range of regulations on payment cards.[58] The most common of these have been price controls on interchange fees. Because three-party card networks are closed loop, there is technically no “interchange” fee and, in many but not all cases, regulations have been interpreted as not applying to them.[59] Some jurisdictions have also imposed other regulations, of which the most relevant for the current analysis is the Durbin amendment’s routing requirements. This section discusses evidence of the effects of these two types of regulation in order to provide insights into what might be expected from the CCCA. (For additional details, see our recent literature review.[60])

A.      Price Controls

In every jurisdiction that has introduced price controls on interchange fees, issuing banks have responded by adjusting their offerings. In the case of credit cards, this has typically meant some combination of reduced card benefits (rewards, insurance, and so on); increased annual fees; and/or increased interest rates. In the case of debit cards, it has means reduced card benefits, increased bank-account fees, and overdraft charges. Some notable examples:

1.        Australia: Fewer rewards, higher annual fees, and companion cards

When the Reserve Bank of Australia (RBA) imposed price controls on credit-card interchange fees in 2003, it made clear that one of its objectives was to reduce the use of credit cards by making them less attractive as a payment solution for consumers.[61] The ploy appears to have worked, as annual fees for rewards credit cards rose, and the rate of rewards fell significantly:

  • Between 2002 (the year before the regulation came into effect) and 2004, the annual fee on a “standard” rewards credit card increased by 40% and the fee on a “gold” rewards card rose by 30%, from A$98 to A$128.61F[62]
  • Between 2003 and 2011, the estimated benefit of rewards fell by one third, from $0.81 to $0.54 per dollar spent.59F[63]

In addition, issuers introduced caps on the total number of rewards that could be earned in a given period.[64] This turns the conventional rewards-card model on its head: instead of creating incentives to use the rewards card more to achieve specific additional benefits, Australian credit-card issuers now provide incentives for rewards-card holders to switch cards when they reach the cap.

Shortly after Australia’s interchange-fee caps for four-party cards came into force in 2003, two banks introduced three-party credit cards with annual fees and rewards similar to those that previously existed on their four-party cards.72F[65] In addition, several issuers introduced packages of two similar premium rewards cards, one that operates on a four-party network and one that operates on a three-party network.73F[66] The reason these “companion cards” were created is that far fewer merchants accept three-party cards than four-party cards; with both cards, consumers could use the higher-earning three-party card where it is accepted and the lower-earning four-party card elsewhere.

Unsurprisingly, the market share of three-party cards, while still relatively small, increased considerably following the 2003 regulations. By volume of transactions, three-party cards increased from about 10% in 2002 to about 16% in 2013 (a 60% increase). By value of transactions, they increased their market share from about 15% in 2002 to more than 20% in 2013 (a 33% increase).

In October 2015, the RBA designated American Express Companion Cards a “payment system”74F[67] and subsequently announced that, as of July 1, 2017, the cards would be subject to the same interchange-fee caps as other designated cards.75F[68] Following the introduction of these caps, companion cards were discontinued and the market share by volume of three-party cards fell back to between 7% and 8% (but subsequently rose again slightly to about 8%).76F[69] By value, three-party cards’ market share of transactions also fell steeply after mid-2017, but is now back to about 20%.[70]

2.        Spain: Fewer rewards, higher interest rates, higher fees

In 2005, the Spanish government introduced gradually tightening price controls on interchange fees by “agreement” with the country’s banks. For credit cards, the controls started at 1.4% in 2006, falling to 0.79% in 2009-10. In response, local issuers reduced the rewards available from cards.57F[71] Meanwhile, from 2008 to 2010, issuers increased interest rates on credit cards from an average of 3% above the European Central Bank (ECB) base rate in 2005 to 4.6% above base.58F[72] As a result, income from interest payments was nearly 80% higher from 2006 to 2010 than in 2005, representing a total incremental increase in income from interest over the period of about €2.6 billion (although this could be an overstatement, since we are only comparing to revenue in 2005). At the same time, average annual fees on credit cards rose by 50%, from €22.94 to €34.39, generating incremental revenue over the period of €1.7 billion.

3.        EU: Fewer rewards, higher interest rates, and foreign transaction fees

In 2014, the European Union (EU) adopted the Interchange Fee Regulation (IFR), which imposed price controls on debit- and credit-card interchange fees at 0.2% and 0.3%, respectively, with the regulation taking effect Jan. 1, 2015. The IFR initially applied only to four-party cards (primarily to Visa and Mastercard, but also some domestic payment cards).

In response to the IFR, credit-card issuers significantly reduced rewards on credit cards, or terminated rewards cards altogether.[73] Several airlines have nonetheless continued to co-brand rewards cards. American Express cards were all initially excluded from the rules, so airlines that already had an Amex co-branded card (such as British Airways) were not affected. Following a decision by the European Court of Justice in 2018, however, the IFR was deemed to also apply to co-branded cards issued by three-party networks.

As in Australia, issuers in the EU increased annual fees on cards that already had fees.[74] The total revenue from annual fees fell, however, presumably because consumers switched to cards without fees (Table 2). Issuers nonetheless made up much of the revenue lost from the interchange price controls by increasing interest rates. As noted below, this enabled them to continue to offer rewards. As Table 2 shows, while revenue from interchange fees fell by nearly 50% between 2014 and 2018, issuer revenue related to credit cards fell by less than 5%.[75]

[76]

In addition, while rewards in the EU fell significantly across the board, some co-branded airline-rewards cards in the EU and the United Kingdom (which retained IFR caps on domestic transactions post-Brexit) earn at a rate that is nominally worth the equivalent of 1% to 1.5% of the amount spent on the card—that is, three to five times the interchange fee. For example, American Express (whose co-branded cards are now subject to the same fee caps as four-party cards) offers two British Airways co-branded cards in the UK, one that has an annual fee of £250 and earns 1.5 Avios per £1 on general spend, and 3 Avios per £1 spent on BA. The other card has no annual fee and earns 1 Avio per £1 spent. [77] Meanwhile, the value of each Avios is between 0.66 and 1.5p, depending on its use.[78]

There are several feasibly explanations for why the value of rewards exceeds the amount of interchange fees. First, issuers may be able to purchase airline-loyalty rewards at a significant discount. Because airlines know that they will be able to encourage holders to redeem them on flights that otherwise would not be full, the marginal cost is likely much lower than the nominal value. Second, other partner companies that redeem loyalty rewards may also be willing to do so at a discount, knowing that such redemptions both encourage loyalty to that partner and, in some cases, will only represent partial payment for goods and services, thereby acting effectively as a discount on larger purchases. Third, card issuers may be using other income—such as annual fees, interest, and late fees—to cover the shortfall. It is possible that all three explanations are true.

If card issuers in the EU are using additional revenue from higher-interest charges and late fees to cross-subsidize rewards cards—including airline co-branded rewards cards—then the IFR is effectively highly regressive. This is because late fees and interest charges are predominantly paid by individuals with lower credit scores and who spend less on their cards but keep a revolving balance, whereas rewards are earned primarily by people with higher credit scores who pay off their balance each month.

4.        US: Debit cards and the Durbin amendment

When the Federal Reserve adopted Regulation II, implementing the interchange-fee price controls required by the Durbin amendment to Dodd-Frank, some covered issuing banks initially responded by stating that they would introduce consumer fees for the use of debit cards.[79] That idea immediately met with backlash, so the banks instead increased monthly account fees and increased the minimum balance required for free checking, as documented by economists at the Federal Reserve.[80] Banks also essentially eliminated rewards for debit cards. Evidence suggests that the higher bank-account charges and higher minimum-balance requirement for free checking most likely led to a significant increase in the number of unbanked individuals. [81]

Meanwhile, the evidence also suggests that consumers received little, if anything, in return. A survey conducted by economists at the Federal Reserve Bank of Richmond two years after the implementation of Regulation II found that:

[T]he regulation has had limited and unequal impact on merchants’ debit acceptance costs. In the sample of 420 merchants across 26 sectors, two-thirds reported no change or did not know the change of debit costs post-regulation. One-fourth of the merchants, however, reported an increase of debit costs, especially for small-ticket transactions. Finally, less than 10 percent of merchants reported a decrease of debit costs. The impact varies substantially across different merchant sectors.

The survey results also show asymmetric merchant reactions to changing debit costs in terms of adjusting prices and debit restrictions. A sizable fraction of merchants are found to raise prices or debit restrictions as their costs of accepting debit cards increase. However, few merchants are found to reduce prices or debit restrictions as debit costs decrease.[82]

A subsequent study by economists Vladimir Mukharlyamov and Natasha Sarin investigated the Durbin amendment’s effects on consumers using a proprietary dataset of gasoline sales in different ZIP codes.[83] (Gas is a widely consumed commodity sold in a highly competitive market, and is thus arguably the product most likely to see interchange-fee savings passed through.) The researchers found that gas is, “cheaper in ZIP codes with a greater fraction of transactions paid with debit cards issued by large banks,” which suggests that at least some retailers passed on some savings. They note, however, that “the standard deviation of per-gallon gas prices ($0.252) is 168 times larger than the average per-gallon debit interchange savings ($0.0015). Relatedly, total Durbin savings for gas merchants amount to less than 0.07% of total sales. These points render the quantification of merchants’ pass-through with statistical significance.” In other words, whatever savings retailers passed on to consumers were tiny.

At the same time, using data from bank call reports and the Federal Deposit Insurance Corporation’s summary of deposits, Mukharlyamov and Sarin found that banks covered by the price controls “collectively lost $5.5 billion in annual revenue” from interchange fees. And using data from RateWatch, they found those banks “passed 42 percent of these losses through to their customers.”[84] Specifically:

We estimate that the share of free checking accounts fell from 61 percent to 28 percent as a result of Durbin. Average checking account fees rose from $3.07 per month to $5.92 per month. Monthly minimums to avoid these fees rose by 21 percent, and monthly fees on interest-bearing checking accounts also rose by nearly 14 percent. These higher fees are disproportionately borne by low-income consumers whose account balances do not meet the monthly minimum required for fee waiver.[85]

So, while the Durbin amendment served to dramatically reduce interchange fees on debit transactions, the main effect was to increase bank fees for poorer consumers, causing some of them to leave the banking system altogether and likely become reliant on more expensive forms of credit, such as payday loans.

B.      Routing Regulations

The only jurisdiction to have thus far implemented regulations mandating “competition” in network routing is the United States, which included such a mandate for debit cards in the Durbin amendment. Some other jurisdictions, most notably Australia, have contemplated such regulations. But in its most recent report on the matter, the RBA rejected mandatory “least cost routing.”[86] This subsection thus focuses on the effects of the Durbin amendment’s routing requirements.

1.        The Durbin amendment routing requirements

In addition to interchange-fee price controls on “covered” issuers—i.e., banks with assets of at least $10 billion—the Durbin amendment required the Federal Reserve Board to impose routing requirements on the debit transactions of all banks. Specifically, it mandated that these regulations should prohibit issuers and payment networks from imposing network-exclusivity arrangements.[87] In particular, all issuers must ensure that debit-card payments can be routed over at least two unaffiliated networks. It also required the Federal Reserve Board to prohibit issuers and payment networks from restricting merchants and acquirers’ ability to choose the network over which to route a payment.

[88]

As Figure 2 shows, for covered issuers, average interchange fees per-transaction fell to the regulated maximum for both dual-message (signature) transactions and single-message (PIN) transactions immediately following implementation of the Durbin amendment in October 2011. Meanwhile, discounting for inflation, average fees per-transaction for issuers that were exempted from the price controls fell by only about 10% for dual-message transactions, which were not subject to direct competition for routing. For single-message transactions, however, routing was subject increasingly to direct competition, and average fees per-transaction for exempt issuers fell by 30% over the course of eight years; by 2019, fees were only marginally higher than the regulated maximum for covered issuers.

Based on the experience of mandatory routing under the Durbin amendment, then, it seems highly likely that the CCCA would, if implemented, drive down the price of interchange, as proponents want. And issuers would respond as they did to the Durbin amendment, by finding other ways to recoup lost revenue. Consumers would again almost certainly endure the most of this shift through higher card fees, higher interest rates, and fewer benefits, including less generous rewards.

V.      How Would the CCCA Affect Co-Branded Credit Cards?

This section draws on the discussion in Section IV to infer the potential effects the CCCA would likely have on co-branded credit cards. It begins with a discussion of the effect on issuer revenue in general. It then looks at how issuers might address the loss of revenue through, e.g., increases in annual card fees, increases in interest rates and late payment fees, reduction in rewards, reduction in other benefits, and the introduction of “companion cards.” This is followed by a discussion of the potential effect on airlines.

A.      Effect on Issuer Revenue

As noted, the stated intention of the CCCA is to reduce merchants’ costs by lowering interchange-fee revenue. One proponent of the CCCA has claimed that it “could result in annual savings upward of $15 billion.”[89] But this claim is not supported by any evidence; indeed, so far as this author can tell, it seems to have been plucked out of thin air.

While it is likely that interchange-fee revenue will be reduced, it is difficult to know with any degree of precision by how much, or what other effects might occur. (As to the effect on merchant costs—that is quite another matter, as will be discussed later.) Much will depend on which networks issuers include as the secondary networks on their cards. This, in turn, will likely depend on complex negotiations among the issuers, the primary networks, and the various possible secondary networks. Factors that will affect the decision regarding which network is included as a secondary network on a card are likely to include:

  • The extent to which the secondary network is able to meet fraud and other security concerns of the issuer. For example, many of the alternative networks were designed to operate with ATMs, and are thus PIN-based single-message systems that do not offer dual-message transmission. Since at least some proportion of transactions on any credit card are likely to require dual-message transmission for the purposes of meeting such EMVCo standards as 3DS (in part, to limit the potential for card-not-present fraud), it is unclear how a single-message (PIN) network could be the secondary network.
  • Issues related to brand reputation of the two networks. This could affect, for example, the willingness of three-party networks to function as secondary networks, because those networks have positioned themselves as premium brands. Meanwhile, similar to the issuer concerns, Visa and Mastercard would be understandably reluctant to have a network with poor security and fraud detection as a secondary network on cards bearing their brands.
  • Relatedly, three-party networks might be reluctant to function as secondary networks if they expect that participation would result in a reduction in the rates they could charge merchants on their own closed-loop network.
  • Whether issuers wish to and are able to issue “companion cards” by partnering with three-party networks as the sole network, as Australian banks did for a while (see Subsection B below), which might also affect three-party cards’ incentives to function as secondary networks.
  • Which networks might be prohibited under Article D of the CCCA, which prohibits secondary networks that are either a national security risk or are “owned, operated, or sponsored by a foreign state entity.”[90] This would seem to eliminate China Union Pay, whose member banks are primarily state-owned. And potentially, it could be applied to any network, as “national security risk” is not well-defined.

These factors generally militate against single-message networks, three-party networks, and China Union Pay becoming secondary networks on credit cards. As such, many covered issuers might plausibly choose JCB Co. Ltd. (formerly Japan Credit Bureau) as their secondary network, assuming that JCB is not deemed to be a national security risk. JCB is a member of EMVCo and applies the same basic security standards as other EMVCo companies (Visa, Mastercard, American Express, Discover, and China Union Pay).[91] Unlike China Union Pay, however, JCB is a private enterprise, and so should not fall afoul of Article D of the CCCA. JCB has an agreement with Discover that enables JCB cardholders to use their cards in the United States by running them over the Discover network. By adding JCB as the secondary network, issuers would therefore effectively utilize Discover’s network, including the application of EMVCo rules, such as 3DS, which provides enhanced fraud protection for card-not-present transactions.[92]

Since the JCB secondary network would actually be run over the Discover network, the interchange rates that would be applied would presumably be Discover’s, which are similar on average to those of Visa and Mastercard, but appear to be slightly higher for standard cards and slightly lower for the higher-end rewards-type cards.[93] Assuming cards are programmed to apply interchange rates for somewhat equivalent products, the initial effect of the CCCA on interchange-fee revenue could, in theory, be modest.

That sounds like good news. Over the medium to longer term, however, this artificial “competition” between the networks on the card would almost inevitably lead to a gradual reduction in fees, as each network seeks to attract more users in each category. This is precisely what happened with PIN debit networks for banks and credit unions that were exempted from the Durbin amendment’s price controls on interchange fees. This would continue until each network could barely cover its costs in each category. In that case, the effect on interchange-fee revenue could be devastating.

The analogy here is not to the dynamic competition that drives innovation in conventional markets, guided by a process of price discovery that seeks to provide consumers with better goods and lower prices through the development of more efficient processes that consume fewer resources. The analogy here is, rather, the “tragedy of the commons,” or more precisely, the tragedy of open access. In effect, by forcing networks to compete on price alone—maximizing use, while minimizing expenditure on improvements—the result will be diminution in network quality, just as when anglers chase after fish stocks until they are economically exhausted (too depleted to be worth chasing).[94]

We can push the overfishing analogy further. Initially, fishers often do not notice that they are depleting the stock, but over time, they have to increase the amount of effort they put into fishing until the returns no longer justify the investment. A similar thing could happen with payment networks, with the effects initially being muted by decades of investment in security protocols and the collection of transaction data. But over time, the value of those investments and data will wither.

The solution to the open-access problem has been well-known to economists for more than half a century: establish clearly defined and readily enforceable property rights.[95] This has proved challenging in fisheries, but an increasing number of jurisdictions have developed successful approaches of various kinds.[96]

The irony is that the networks have expressly sought to avoid this tragedy by developing clear rules regarding who has access to the data transmitted from their cards, how it is transmitted, to whom, and under what conditions.

Interchange fees, as they exist today, are one of those rules: they are the default in open-network schemes and exist, at least in part, because of the high costs of negotiating and enforcing many bilateral agreements among banks.[97] They are set by payment-network operators, who are able to avoid the problems that would arise if individual issuing banks set their own fees. The latter might lead to fees being set at inefficiently high levels in order to maximize issuing-bank revenue, without regard to the impact on the value of the system as a whole.21F[98]

The CCCA would run roughshod over those rules.

B.      Response by Issuers to Compensate for Revenue Losses

Proponents of the CCCA seem to assume that issuers will simply accept the loss of revenue from interchange fees and do nothing to try to compensate. Based on the experience of both the Durbin amendment and of interchange regulations in other jurisdictions, this is an incorrect assumption.

In practice, it seems almost certain that card issuers would implement one or more of several measures to recover the lost revenue and/or reduce costs. Among other things, they might:

  • Increase annual card fees. In Australia, banks increased annual card fees by 30% to 40%. In Europe, they increased them by about 13%.[99] Such fees tend to be regressive, because they are charged at a fixed rate regardless of how much a cardholder spends. Thus, for lower-income cardholders who spend less, such a fee increase would be proportionately more onerous.
  • Remove insurance and other benefits. Many U.S. credit cards currently offer cardholders a range of benefits, often including purchase-protection insurance, car-rental insurance, travel insurance, and fee-free international transactions. These benefits were also common on cards issued in the EU prior to the introduction of the IFR, but were removed afterwards. As a result, most cards—including rewards cards—now have limited, if any, insurance and charge a transaction fee of between 2% and 3% for international transactions.
  • Increase late-payment fees (if not prohibited from so doing by other regulations) and interest rates. In the EU, issuers increased late-payment fees and interest rates following the introduction of the IFR. Between 2014 and 2016, interest rates on revolving balances rose from an average of 16.2% to 18.8%, while the European Central Bank base rate fell from 0.3% to 0.25%. This implies an increase in average real rates on credit cards of 2.75%. Likewise, in Spain, credit-card interest rates were increased at a substantially faster rate than increases in rates at the European Central Bank, with the result that revenue from interest rose by 80% during the period when IFRs were subject to national price controls on interchange fees, from 2006 to 2010.

The determination of which fees to increase and by how much will depend on issuers’ views regarding the willingness of cardholders to bear such fees. Likewise, the determination of which benefits to withdraw on which cards will be made—possibly simultaneously with the determination of any increase in annual fees (which could be used to cover such benefits in whole or in part)—on the basis of the effects such changes will have on demand for cards.

1.        Responses by issuers of co-branded rewards cards

As noted earlier, issuers typically cover the costs of rewards on co-branded cards through some combination of annual fees and interchange fees. Issuers also often pay for other items, ranging from lounge access for cardholders to marketing fees for promoting the card and related services, the costs of which also must be paid for by some combination of merchants and users.

Since the costs associated with co-branded rewards cards are typically higher than the costs of other non-rewards cards, the effects of the CCCA would likely be much more severe for such co-branded cards. As such, issuers of co-branded cards may seek to implement additional measures in order to recover revenue and ensure that they meet their obligations to cardholders and co-brand partners.

2.        Responses by issuers of airline-rewards co-branded cards

As noted, in the UK and some EU jurisdictions, issuers have continued to co-brand credit cards with airlines. Moreover, while rewards have been reduced significantly, and many other card benefits—such as insurance and fee-free foreign transactions—have largely been eliminated, the amount earned in rewards per euro or pound spent remains notionally higher than the interchange fee on the card. As also noted, there are several possible explanations for this, including that airlines may sell rewards at a discount, or that issuers were able to make up some of the losses on interchange fees by increasing interest rates, late fees, and foreign transaction fees. If the CCCA were enacted, we might see issuers adopt some combination of these approaches.[100]

In Australia, issuers put caps on the amounts of rewards that could be earned. As noted, this effectively inverts the purpose of such rewards, which are intended to engender loyalty, but if the amount that can be earned is capped or the earning rate declines after a certain spend, then users will have incentives at that point to switch to a different card. While this would reduce the loyalty element of the co-branded card (perversely encouraging disloyalty, in fact), U.S. issuers of multiple co-branded cards might be motivated to pursue this approach in order to drive short-term spending on each of their cards, especially if they have agreements to purchase a certain number or rewards at a discounted price.

C.      The Effect on Airlines and Their Response

The effect of the CCCA on airlines will depend very much on which networks become secondary networks, whether issuers are able to issue companion cards, and all the other factors discussed above. But in almost any imaginable scenario, the airlines that currently co-brand four-party credit cards will see a reduction in revenue. In many scenarios, that revenue reduction could be significant—in some cases it could be 5% to 10% of total revenue. While this would be partly offset by a reduction in liability associated with outstanding loyalty-rewards points, there is a timing mismatch effect: The revenue loss will occur in the short term, while the rewards-redemption effect occurs over a longer time horizon.

In addition, to the extent that airlines are unable either to offer companion cards or switch altogether to three-party cards—and thereby offer their loyal customers continued benefits at a similar level to those available on their current cards—there will almost certainly be some attrition of loyalty. In other words, some proportion of fliers who are currently loyal to American, United, Southwest, JetBlue, Alaska, and other smaller airlines with four-party co-branded credit cards will switch to Delta. Moreover, the evidence suggests that those most likely to switch will be those most adversely affected by the change—that is to say, those who tend to spend the most on their co-branded rewards card.

This likely includes many middle-class consumers who live far away from family members and currently value the rewards from their co-branded card highly. To the extent that those individuals are also among the most loyal to the airlines whose co-branded cards they use, this could have a seriously detrimental effect on the profit margins of the other airlines.

The CCCA may also affect many airlines’ costs of capital. For example, at least for United and American Airlines, a reduction in expected revenue from the sale of rewards could result in the downgrading of the bonds issued during the COVID-19 pandemic by the subsidiaries that now own the rewards programs. That could trigger covenants requiring the parent companies to post additional capital, which in turn would increase the parents’ capital costs. In general, the combination of reduced revenue and reduced membership of loyalty programs—leading to lower revenue from higher-value customers—would reduce airlines’ expected future profitability, which would increase capital costs. In times when demand for air travel is high, this may not pose a dramatic problem. It would, however, likely affect fleet investment, which would adversely affect the flying experience and might lead to the termination of some routes. And in a downturn, it could result in the bankruptcy that the airlines previously avoided, thanks to their ability to securitize their loyalty programs.

VI.    Conclusions

This study has focused relatively narrowly on the likely effects of the CCCA on co-branded reward credit cards and the knock-on effects on the co-brand partners, especially airlines. If enacted, however, the law’s effects would be far broader. For example, it would likely cause a reduction in investment in innovation by card issuers and networks for at least two reasons. First, by reducing prospective revenue, the CCCA would reduce network providers’ incentive and ability to invest in innovation. Second, by requiring networks to make tokens interoperable, the CCCA dramatically reduces the incentive to invest in improvements to the security, convenience, and other aspects of tokenized transactions.

Proponents of the Credit Card Competition Act (CCCA) claim that it would “enhance credit card competition and choice in order to reduce excessive credit card fees.” In fact, by forcing the majority of credit-card issuers in the United States to include a second network on all their cards, the CCCA would remove the choice of network from the issuer and cardholder and place it in the hands of the merchant and the acquiring bank.

Indeed, the name of the Credit Card Competition Act would appear to be unintentionally ironic, since one of its main effects would be to reduce competition between issuers, as margins would be reduced, and issuers would be less able to differentiate on the basis of such offerings as co-branded cards (airlines, hotels, retailers). As a result, there would be less pressure to compete on interest rates, which in turn would mean that—as happened in the EU and especially in Spain—issuers would likely increase interest rates in order to offset reduced interchange-fee revenue.

To the extent that issuers use this offsetting revenue from interest to enable them to continue to offer some level of rewards, the CCCA would have brought about what some critics of credit-card rewards have previously falsely accused issuers of doing: using credit cards to transfer wealth from lower-income, lower-spending consumers who maintain a revolving balance to higher-income, higher-spending consumers who pay off their balances every month.[101]

Even if issuers do continue to offer rewards, the evidence from Europe and Australia is that the CCCA would cause such rewards to be diminished significantly, harming consumers both directly and indirectly. The direct harms would come in the form of fewer rewards (except for those consumers who only use three-party cards). The indirect harms would come through the effects on businesses that currently rely heavily on revenue from co-branded cards that would be diminished by the CCCA.

As this study has demonstrated, airlines, in particular, could be adversely affected, leading to reduced fleet investment, termination of routes, and potentially to bankruptcy. There would also likely be a broader adverse effect, as consumers reduce their use of credit cards (including some who give them up), which would result in an overall reduction in consumption—harming both merchants and the broader economy.

Appendix: Routing in Payment Networks

When a cardholder submits a transaction for payment, information regarding that payment is sent over a proprietary network. This is called “routing.” There are, broadly, two types of payment network: single-message (PIN) networks that emerged from ATM networks, and dual-message (signature) networks that were developed by the credit-card networks (Visa, Mastercard, American Express, and Discover). In general, credit cards require dual-message networks, whereas debit transactions can run over either type of network. To understand why, it is worth briefly explaining the mechanics of the two systems.

  • Single-message (PIN) debit networks

Single-message networks rely on the PIN stored in the card to authenticate a transaction. As a result, the only message that is required is a notification to the issuing bank to debit the account of the cardholder in the amount they have authorized, and to credit that amount the account of the merchant—less the discount fee, which is paid to the acquiring bank. Because of the nature of the transaction, settlement can be effected over banks’ electronic-funds-transfer (EFT) networks that were initially built to settle transactions at shared ATMs, and then over networks of ATMs.[102]

  • Dual-message (signature) networks

As the name suggests, dual-message networks send two messages: the first is a request for authorization sent to the issuing bank, which confirms the authenticity of the card, checks whether the cardholder has sufficient credit available, and monitors for fraud. If authorized, the second message contains information confirming the amount to be credited to the merchant’s account during clearing and settlement.

For example, if you present your credit card at a sit-down restaurant, the check total would be authorized by the network and a “hold” or “pending transaction” amount would appear on your account. The opportunity to add a tip to the bill permits a second, later message that authorizes payment of the full amount of food, plus a tip to be credited to the merchant. Similar “holds” are also often used by online merchants in order to delay payment (sometimes by as much as several days), thereby reducing the likelihood of fraud and associated chargebacks.[103]

[1] See Developments in Noncash Payments for 2019 and 2020: Findings From the Federal Reserve Payments Study, Federal Reserve Board, (Dec. 2021), available at https://www.federalreserve.gov/publications/files/developments-in-noncash-payments-for-2019-and-2020-20211222.pdf, along with the various previous studies and associated data, https://www.federalreserve.gov/paymentsystems/frps_previous.htm.

[2] See, e.g., Mastercard Rules, Mastercard, https://www.mastercard.us/en-us/business/overview/support/rules.html (last accessed Nov. 16, 2023); Visa Rules and Policy, Visa, https://usa.visa.com/support/consumer/visa-rules.html (last accessed Nov. 16, 2023).

[3] 156 Cong. Rec. S3,571 (daily ed. May 12, 2010), available at https://www.congress.gov/111/crec/2010/05/12/CREC-2010-05-12-pt1-PgS3569-9.pdf.

[4] Claire Tsosie, The History of the Credit Card, NerdWallet.com (Mar. 15, 2021), https://www.nerdwallet.com/article/credit-cards/history-credit-card; see also Jeremy Norman, The Charga-Plate, Precursor of the Credit Card, Circa 1935 to 1950, HistoryofInformation.com, https://www.historyofinformation.com/detail.php?id=1710 (last accessed Nov. 16, 2023).

[5] See Todd J. Zywicki, The Economics of Payment Card Interchange Fees and the Limits of Regulation, International Center for Law & Economics (Jun. 2, 2010), available at http://laweconcenter.org/images/articles/zywicki_interchange.pdf. Several banks also attempted to establish three-party cards during the 1950s. Most of these were unsuccessful. The exception was Bank Americard, which subsequently became a four-party system and eventually rebranded as Visa.

[6] The issuer may arrange separate underwriting. More recently, the processing of three-party card transactions are sub-contracted to other payment processors, but the fundamental three-party legal arrangements remain the same.

[7] For a more detailed explanation of the operation of payment-card systems, see Zywicki, supra note 5, at 27-30.

[8] See Zywicki, supra note 5; see also Jean-Charles Rochet & Jean Tirole, Two-Sided Markets: A Progress Report, 37 Rand J. Econ. 645 (2006); As the U.S. Supreme Court wrote in Ohio v. American Express Co. (585 U.S. Slip Op, 2018, at 2): By providing these services to cardholders and merchants, credit-card companies bring these parties together, and therefore operate what economists call a “two-sided platform.” As the name implies, a two-sided platform offers different products or services to two different groups who both depend on the platform to intermediate between them.”… For credit cards, that interaction is a transaction…. The key feature of transaction platforms is that they cannot make a sale to one side of the platform without simultaneously making a sale to the other.

[9] Bruno Jullien, Alessandro Pavan, & Marc Rysman, Two-Sided Markets, Pricing, and Network Effects, in Handbook of Industrial Organization (Vol. 4), 485-592, (2021).

[10] Thomas Eisenmann, Geoffrey Parker, & Marshall W. Van Alstyne, Strategies for Two-Sided Markets, Harv. Bus. Rev. (Oct. 2006).

[11] Ohio v. American Express Co. (585 U.S. Slip Op, 2018), at 13.

[12] Zywicki, supra note 5, at 10.

[13] Tsosie, supra note 4.

[14] Visa USA Interchange Reimbursement Fees, Visa Public (Apr. 23, 2022), available at https://usa.visa.com/content/dam/VCOM/download/merchants/visa-usa-interchange-reimbursement-fees.pdf; Mastercard USA Interchange Rates, HELCIM, https://www.helcim.com/mastercard-usa-interchange-rates (last accessed Nov. 16, 2023).  

[15] Jean-Charles Rochet & Jean Tirole, An Economic Analysis of the Determination of Interchange Fees in Payment Card Systems, 2 Rev. Netw. Econ. 69-79 (Jan. 2003).

[16] See Todd J. Zywicki, The Economics of Payment Card Interchange Fees and the Limits of Regulation, International Center for Law & Economics (Jun. 2, 2010), available at http://laweconcenter.org/images/articles/zywicki_interchange.pdf; Todd J. Zywicki, Geoffrey A. Manne, & Julian Morris, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, International Center for Law & Economics (Apr. 25, 2017); Todd J. Zywicki, Geoffrey A. Manne, & Julian Morris, Price Controls on Payment Card Interchange Fees: The U.S. Experience, George Mason Law & Economics Research Paper No. 14-18, (Jun. 6, 2014).

[17] Credit Card Competition Act of 2023, S. 1838, 118th Cong. § 1 (2023).

[18] James J. Nagle, Trading Stamps: A Long History, The New York Times (Dec. 26, 1971), https://www.nytimes.com/1971/12/26/archives/trading-stamps-a-long-history-premiums-said-to-date-back-in-us-to.html

[19] Michael McCall & Clay Voorhees, The Drivers of Loyalty Program Success, 51 Cornell Hosp. Q. 35 (2010).

[20] This seems to have been an essential part of the business model of trading-stamp programs.

[21] Evert R. de Boera & Sveinn Vidar Gudmundsson, 30 Years of Frequent Flyer Programs, 24 J. Air Transp. Manag. 18-24 (2012).

[22] Id. at 19.

[23] Enny Kristiani, Ujang Sumarwan, Lilik Noor Yulianti, & Asep Saefuddin, Customer Loyalty and Profitability: Empirical Evidence of Frequent Flyer Program, 5 J. Mark. Stud. 62 (2013).

[24] Abigail Ng, Over 40 Airlines Have Failed So Far This Year — And More Are Set to Come, CNBC (Oct. 8, 2020), https://www.cnbc.com/2020/10/08/over-40-airlines-have-failed-in-2020-so-far-and-more-are-set-to-come.html.

[25] For example, on June 30, 2020, American Airlines issued $2.5 billion of bonds dated 2025 with a coupon of 11.75%. American Airlines Inc. Dl-Nts 2020(20/25) Reg. S, Markets Insider,  https://markets.businessinsider.com/bonds/american_airlines_incdl-nts_202020-25_regs-bond-2025-usu02413ae95.

[26] Tracy Rucinski, United Airlines Pledges Loyalty Program for $5 Billion Loan, Reuters (Jun 15, 2020), https://www.reuters.com/article/us-health-coronavirus-united-arlns-idUSKBN23M1PB

[27] So Yeon Chun & Evert de Boer, How Loyalty Programs Are Saving Airlines, Harvard Business Review (Apr. 2, 2021), https://hbr.org/2021/04/how-loyalty-programs-are-saving-airlines.

[28] Cameron Graham, Study: Why Customers Participate in Loyalty Programs, TechnologyAdvice.com (Jul. 23, 2014), http://technologyadvice.com/blog/marketing/why-customers-participate-loyalty-programs.

[29] Michelle Geraghty & Trisha Asgierson, Relationship Rewards: A Game Changer for Financial Institutions, Mastercard (2013), available at https://www.mastercard.us/content/dam/mccom/en-us/documents/relationship-rewards-whitepaper.pdf.

[30] See, e.g., Blake Ellis, The Banks’ Billion-Dollar Idea, CNN Money (Jul. 8, 2011), http://money.cnn.com/2011/07/06/pf/banks_sell_shopping_data/index.htm.

[31] Marie-Pierre Lemay & Negar Ballard, Majority Say Credit Card Rewards Are Very Important, and Drive Their Card Usage, Ipsos (Jan. 12, 2021), https://www.ipsos.com/en-us/majority-say-credit-card-rewards-are-very-important-and-drive-their-card-usage.

[32] John S Kiernan, 2023 Credit Card Rewards Survey, WalletHub (Jun. 13, 2023), https://wallethub.com/blog/credit-cards-rewards-survey/63067.

[33] Id.

[34] American Airlines, AAdvantage Investor Presentation March 2021, SEC Form 8-K (Mar. 8, 2021), https://americanairlines.gcs-web.com/node/38926/html, at 26.

[35] “Loyalty revenue” covers various terms used by the airlines in their 10K filings to refer to income related to the generation of loyalty, including co-branded reward cards.

[36] De Boera & Gudmundsson, supra note 21, at 22.

[37] American Airlines, supra note 35, at 37.

[38] Since most of American Airline’s primary loyalty-rewards partners are also travel-related, it seems reasonable to assume that the vast majority of partner income in 2020 was from co-branded cards.

[39] See, infra Section II.B.

[40] The first such card was an American Airlines co-branded card issued by Citibank (De Boera & Gudmundsson, supra note 21, at 19).

[41] American Airlines, 10K Filing (2022), at p. 68.

[42] United Airlines, 10K Filing (2022), at p. 41.

[43] Delta Airlines, 10K Filing (2022), at p. 37.

[44] Southwest Airlines, 10K Filing (2022), at p. 115

[45] Id at 119.

[46] Id.

[47] Jay Sorensen, Frequent Flier Credit Cards Generate More than $4 Billion for Major U.S. Airlines, Ideaworks (2008), available at https://www.ideaworkscompany.com/wp-content/uploads/2012/05/Analysis_USAirlineCC2008.pdf. See also above discussion of revenue from loyalty-rewards programs during the COVID-19 pandemic.

[48] Technically, it prohibits issuers from restricting “the number of payment card networks on which an electronic credit transaction may be processed.”

[49] See S. 1838, §2(a)(2)(A)(II): 2 or more such networks, if— (aa) each such network is owned, controlled, or otherwise operated by— (AA) affiliated persons; or (BB) networks affiliated with such issuer; or (bb) any such network is identified on the list established and updated under subparagraph (D). Subparagraph (D) empowers the Federal Reserve Board, in consultation with the secretary of the U.S. Treasury, to draw up a list of networks that pose a national security risk.

[50] See S. 1838, §2(a)(2)(A)(III): the 2 such networks that hold the 2 largest market shares with respect to the number of credit cards issued in the United States by licensed members of such networks (and enabled to be processed through such networks), as determined by the Board on the date on which the Board prescribes the regulations.

[51] S. 1838, §2(a)(2)(B).

[52] Poonkulali Thangavelu, Credit Card Market Share Statistics, Bankrate.com (Jul. 6, 2023), https://www.bankrate.com/finance/credit-cards/credit-card-market-share-statistics.

[53] S. 1838, §2(a)(2)(A)(III).

[54] S. 1838, §2(a)(2)(C).

[55] Julian Morris & Todd J. Zywicki, Regulating Routing in Payment Networks, International Center for Law & Economics, (Aug. 17, 2022), available at https://laweconcenter.org/wp-content/uploads/2022/08/Regulating-Routing-in-Payment-Networks-final.pdf.

[56] Id.

[57] American Airlines, 10-K Filing (2022), at 39.

[58] For a discussion of these, see Julian Morris, Todd J. Zywicki, & Geoffrey A. Manne, The Effects of Price Controls on Payment-Card Interchange Fees: A Review and Update, International Center For Law & Economics (Mar. 4, 2022).

[59] The multilateral “interchange fee” was developed to address circumstances where the credit-card-issuing bank was different from the merchant-acquiring bank; otherwise, it was considered an “on us” transaction. Since all three-party-card network transactions are “on us” by definition, there is no need for an interchange fee.

[60] Morris, Zywicki, & Manne, supra note 58.

[61] Reform of Credit Card Schemes in Australia: IV Final Reforms And Regulation Impact Statement, Reserve Bank Of Australia (Aug. 2002), at 13.

[62] Emily Perry & Christian Maruthiah, Banking Fees in Australia, Reserve Bank of Australia Bulletin, (Jun. 2018), available at https://www.rba.gov.au/publications/bulletin/2018/jun/pdf/banking-fees-in-australia.pdf, at 5.

[63] Iris Chan, Sophia Chong, & Stephen Mitchell, The Personal Credit Card Market in Australia: Pricing Over the Past Decade, Reserve Bank of Australia Bulletin, (Mar. 2012), available at https://www.rba.gov.au/publications/bulletin/2012/mar/pdf/bu-0312-7.pdf.

[64] See Robert Stillman, William Bishop, Kyla Malcolm, & Nicole Hildebrandt, Regulatory Intervention in the Payment Card Industry by the Reserve Bank of Australia: Analysis of the Evidence, CRA International (2008), at 16.

[65] Chan, et al., supra note 63.

[66] Companion Cards Increase Credit Card Rewards, Mozo, (Dec. 8, 2009).

[67] Designation Under the Payment Systems (Regulation) Act 1998, Designation No 1 of 2015, Reserve Bank of Australia, (Oct. 18, 2015), available at https://www.rba.gov.au/media-releases/2015/pdf/mr-15-19-designation-2015-01-american-express-companion-card.pdf.

[68] Standard No. 1 of 2016, The Setting of Interchange Fees in the Designated Credit Card Schemes and Net Payments to Issuers, Reserve Bank of Australia (May 26, 2016), amended version available at https://www.rba.gov.au/payments-and-infrastructure/review-of-card-payments-regulation/pdf/standard-no-1-of-2016-credit-card-interchange-2018-05-31.pdf.

[69] C1.3: Market Shares of Credit and Charge Card Schemes, Reserve Bank of Australia, (Sep. 2023), https://www.rba.gov.au/statistics/tables/xls/c01-3-hist.xlsx.

[70] Id.

[71] Juan Iranzo, Pascual Fernández, Gustavo Matías, & Manuel Delgado, The Effects of the Mandatory Decrease of Interchange Fees in Spain, Munich Personal Repec Archive, MPRA Paper No. 43097, (Oct. 2012), available at https://mpra.ub.uni-muenchen.de/43097/1/MPRA_%20paper_43097.pdf. at 34-37.

[72] Id. at 27. See also marginal lending-facility rates from the European Central Bank, https://sdw.ecb.europa.eu/browse.do?node=9691107.

[73] Interchange: Card Rewards Cull Takes Hold Across Europe, Loyalty Magazine (Dec. 11, 2015) https://www.loyaltymagazine.com/interchange-card-rewards-cull-takes-hold-across-europe.

[74] Interchange Fee Regulation Impact Assessment Study, Edgar Dunn & Co. (2020), at 22 (noting that, for their sample of cards with fees, annual fees rose by an average of 13% between 2014 and 2018).

[75] Table 2 does not explicitly account for inflation, but cumulative inflation from 2014 to 2018 was 1.75%. European Union Inflation Rate 1960-2023, Macrotrends (2023), https://www.macrotrends.net/countries/EUU/european-union/inflation-rate-cpi.

[76] Edgar Dunn, supra note 74, at 23.

[77] British Airways American Express® Premium Plus Card, American Express, https://www.americanexpress.com/en-gb/credit-cards/ba-premium-plus-credit-card/?linknav=en-gb-amex-cardshop-BritAirwaysAmexCC-details-learnmore-BritAirwaysPremiumPlusCC-rc (last accessed Nov. 16, 2023).

[78] Rob Burgess, What Is the Best Use of American Express Points?, Head for Points (Oct. 7, 2023), https://www.headforpoints.com/2023/10/07/what-is-the-best-use-of-american-express-points-4.

[79] See, e.g., Tara Siegel Bernard, In Retreat, Bank of America Cancels Debit Card Fee, The New York Times (Nov. 1, 2011), http://www.nytimes.com/2011/11/02/business/bank-of-america-drops-plan-for- debit-card-fee.html.

[80] Mark D. Manuszak & Krzysztof Wozniak, The Impact of Price Controls in Two-sided Markets: Evidence from US Debit Card Interchange Fee Regulation, Federal Reserve Board (Jul. 2017), https://doi.org/10.17016/FEDS.2017.074.

[81] Todd J. Zywicki, Geoffrey A. Manne, & Julian Morris, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, International Center for Law & Economics (Apr. 25, 2017), available at http://laweconcenter.org/images/articles/icle-durbin_update_2017_final.pdf; Morris, Zywicki, & Manne, supra note 58.

[82] Zhu Wang, Scarlett Schwartz, & Neil Mitchell, The Impact of the Durbin Amendment on Merchants: A Survey Study, 100(3) Economic Quarterly 183-208 (2014), at 189.

[83] Vladimir Mukharlyamov & Natasha Sarin, Price Regulation in Two-Sided Markets: Empirical Evidence from Debit Cards, Working Paper (2022), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3328579.

[84] Id. at 3.

[85] Id. at 3.

[86] Review of Retail Payments Regulation: Conclusions Paper, Reserve Bank of Australia (Oct. 2021), https://www.rba.gov.au/payments-and-infrastructure/review-of-retail-payments-regulation/conclusions-paper-202110/index.html.

[87] 15 U.S. Code §1693o–2(b).

[88] Regulation II (Debit Card Interchange Fees and Routing), Fed. Rsrv., https://www.federalreserve.gov/paymentsystems/regii-data-collections.htm; Consumer Price Index: All Items for the United States, Fed. Rsrv. Board of St. Louis, https://fred.stlouisfed.org/series/USACPIALLMINMEI (last accessed Aug. 10, 2022).

[89] Martha Southall, Credit Card Competition Act Could Result in Annual Savings Upward of $15 Billion, CMPSI (Jun. 7, 2023), https://cmspi.com/credit-card-competition-act-could-result-in-annual-savings-upward-of-15-billion. (CMPSI describes itself as “the go-to advisory firm for leading merchants across the globe, looking to supercharge their payments arrangements.”)

[90] S. 1838, §2(a)(2)(D)(II).

[91] Overview of EMVCo, EMVCo.com, https://www.emvco.com/about-us/overview-of-emvco (last accessed Nov. 16, 2023).

[92] For an explanation, see Morris & Zywicki, supra note 55.

[93] Anna G., Interchange Rates, CreditDonkey (Jun. 2, 2023), https://www.creditdonkey.com/interchange-rates.html. Note that these are only selections of all the available rates.

[94] H Scott Gordon, The Economic Theory of a Common-Property Resource: The Fishery, 62 J Political Econ 124 (1954).

[95] Anthony Scott, The Fishery: The Objectives of Sole Ownership, 63(2) J Political Econ Journal of Political Economy 116-124 (Apr. 1955).

[96] See, e.g., Christopher Costello, Introduction to the Symposium on Rights-Based Fisheries Management, 6(2) Rev Environ Econ Policy 212-216 (2012), and related articles.

[97] Eliana Garcés & Brent Lutes, Regulatory Intervention in Card Payment Systems: An Analysis of Regulatory Goals and Impact, working paper, (Sep. 21, 2018), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3346472, at 8. As Garces and Lutes note: Practically all open network schemes have set some default interchange fees that apply automatically when no bilateral agreement exists between banks. No widely adopted international scheme relies solely on bilateral negotiations for the interchange fee. This may be due to the excessive level of information complexity that a system of bilaterally negotiated fees would imply for merchants. To assess the cost of a card payment, the merchant would have to know not only the brand and type of the card used, but also the identity of the issuer. Additionally, given that most card systems impose an “honor all cards” rule on merchants, the absence of a common interchange fee may lead some issuing banks to impose high interchange fees for the cards that they issue and that the merchant is forced to accept. Although there are open network schemes that have operated without interchange fees, these are very rare and with limited regional scope.

[98] William F. Baxter, Bank Interchange of Transactional Paper: Legal and Economic Perspectives, 26 J. L. & Econ. 541 (1983), at 572-582.

[99] Edgar Dunn & Co., supra note 74 at 22.

[100] The CFPB is currently considering imposing price controls on late fees. If it were to do that, then issuers would likely compensate in other ways, such as through higher interest rates. Issuers would also likely deny credit cards to individuals with lower credit scores.

[101] Morris & Zywicki, supra note 55.

[102] Stan Sienkiewicz, The Evolution of EFT Networks from ATMs to New On-Line Debit Payment Products, Federal Reserve Bank of Philadelphia Discussion Paper (Apr. 2002), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=927473

[103] Mike Cannon, Credit Card Authorization Hold – How and When to Use, Chargeback Gurus (Dec. 26, 2021), https://www.chargebackgurus.com/blog/credit-card-authorization-holds.

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Financial Regulation & Corporate Governance

Peer-to-Peer and Real-Time Payments: A Primer

ICLE Issue Brief Executive Summary Electronic peer-to-peer (P2P) payments can serve as an effective alternative to other payment methods, such as cash and checks. Real-time payments (RTPs)—originally developed . . .

Executive Summary

Electronic peer-to-peer (P2P) payments can serve as an effective alternative to other payment methods, such as cash and checks. Real-time payments (RTPs)—originally developed to reduce settlement times and thereby lower float costs—have come into their own as means to facilitate interoperability between otherwise-closed P2P payments systems. That likely explains why 62 new RTP systems were created in the past decade, compared with a total of 22 in the prior four decades.

P2P payments and associated RTP rails are well-suited for payments where immediacy and finality are required, where the goods or services have already been delivered or are being supplied by a trusted provider, and where the payor is satisfied that the warranties provided by the payee are adequate and easily enforced. For such transactions, P2P payments are in many ways superior to cash, checks, or older EFT-based online debit transactions.

By contrast, P2P payments in general—including those made over RTP rails—are poorly suited to transactions where immediacy and/or finality are not required and where there are significant risks of nonperformance by the payee. This is because the speed and finality of P2P payments made over RTP rails makes it more difficult to detect, prevent, and rectify fraud, theft, and mistake. P2P-RTPs are thus particularly poorly suited to transactions where goods and services are delivered after payment has been sent and the payor does not have an established trust relationship with the merchant. In such circumstances, closed-loop or dual-message open-loop payment cards will typically be superior.

Organizations designing and implementing P2Ps and RTPs would do well to bear these lessons in mind and not pursue overly ambitious and impractical goals. Where those organizations are governmental entities—such as central banks—that have a remit to regulate payments, it is essential that they implement measures to mitigate potential conflicts of interest.

I.        Introduction

This is the first in a series of ICLE issue briefs that will investigate innovations in and the regulation of payments technologies, with a particular focus on their effects on financial inclusion. The aim of this paper is to offer an overview of two important and related payment systems: peer-to-peer (P2P) and real-time payments (RTPs).[1] Subsequent papers in the series will look at specific aspects of these systems in greater detail.

In traditional payment systems, funds sent from one account to another can take from hours to days to clear and settle. These delays have an opportunity cost: once funds have been debited from a sender’s account, they are not available for use until they are credited at the recipient’s account. In addition, delays in clearing and settlement can contribute to counterparty risk for recipients. At the same time, there are tradeoffs between the speed and finality of payments and counterparty risk for senders.

In principle, P2P and RTPs hold significant potential to increase financial inclusion and enhance economic efficiency. But to do so successfully, such tradeoffs must be acknowledged and factored into system designs. Relatedly, it is important for system designers and regulators to understand both the likely use cases for P2P and RTP systems and the uses to which they are poorly suited. For example, some P2P and RTP evangelists have argued that they will replace credit cards.[2] As explored below, this seems unlikely for two reasons: first, credit cards have more effective mechanisms to address counterparty risk for consumers and, second, in many cases, credit cards better enable consumers to address timing mismatches between income and consumption.

P2Ps and RTPs come in various guises. Some are purely private systems, including P2Ps offered by Venmo, Zelle, and PayPal, and RTPs operated by The Clearing House, Visa, Mastercard, and PayUK. Some RTPs (such as India’s Unified Payments Interface, or UPI) are public-private partnerships. Other RTPs—such as Brazil’s Pix and the forthcoming FedNow system in the United States—are run by central banks. These various systems have adopted different approaches to implementation. By considering the particular system designs and the consequences of those differences, this paper offers tentative best practices for P2P and RTP design. Future papers will explore these issues in greater detail.

In order to put P2Ps and RTPs into the broader context of payment systems as they have evolved, Section II describes the means by which payments are cleared and settled, starting with an account of the basic process, followed by descriptions of some of the primary payment-settlement systems, including automated clearing houses, faster-payment systems, P2Ps, and RTPs. Section III considers the benefits and drawbacks to P2Ps and RTPs. Finally, Section IV offers concluding remarks.

II.      Clearing and Settlement Systems

Bank accounts are essentially ledgers that record credits and debits. When funds move from account A to account B, a debit is recorded on account A and a credit recorded in account B. This is typically a four-stage process: authorization, verification, clearing, and settlement:

  • Authorization is the process by which the sender authorizes a payment from A to B.
  • Verification is the process by which the sender’s payment authorization is verified.
  • Clearing is the process by which the banks reconcile the ledgers of accounts A and B. If there are insufficient funds in A to facilitate the payment, the transaction will not clear. (In some definitions, clearing is taken to comprise, in addition, the two steps above.)[3]
  • Settlement is the process by which funds are transferred, either individually or in batches (often netted—see below), and the ledgers are updated.

Historically, this was primarily done through the use of checks and deposit slips. The signed check authorizes the transfer from the sender (debitor) account (A) and the deposit slip authorizes the receipt of funds by the creditor account (B). The bank—or banks, if the accounts are with different depository institutions—then verify the authenticity of the checks and deposit slips and clear the funds to be transferred. Finally, the bank(s) adjust the ledgers in each account, recording a debit in account A and a credit in account B.

Consider the simple case of a two-bank system with only one account holder in each bank. The owner of account A in bank X writes and signs a check to the owner of account B in bank Y authorizing the transfer of funds from A to B. In this case, X confirms the authenticity of the check signed by the owner of A and clears funds to be transferred to B. Meanwhile, settlement requires funds to be moved from X to Y, which entails the recording of a debit in X’s master ledger and a credit in Y’s master ledger. To avoid counterparty risk, while a debit will be recorded in A after clearing, a credit will only appear in B after settlement.

Now, consider the slightly more complicated case of multiple accountholders in each of the two banks. In this case, numerous accountholders in each bank write checks to account holders in the other bank. These checks are first cleared. Then, at the end of the day, the total amount of funds cleared between all accounts in X and Y would be calculated and any difference in the net amount would be settled by adjusting the ledgers of the two banks. As before, funds debited from senders’ accounts only appear as credits in recipients’ accounts following settlement.

In practice, there are many banks and many accountholders within each bank. On any day, some number of accountholders in each bank write checks to accountholders in other banks. It is therefore more efficient for clearing and settlement to occur on a multiparty basis. This led to the establishment of clearing houses, which are independent intermediaries that facilitate clearing and settlement. In 1863, the largest U.S. banks formed The Clearing House (TCH) for this purpose. The process is still essentially the same, however, with settlement occurring following the netting of amounts owed between each bank in the system.

A.      Automated Clearing and Settlement

Electronic payments enable more rapid funds transfer. The earliest such payments were “wires,” which began in the 19th century, with information about the sender and recipient being sent between individual banks over telegraph wires. In 1970, TCH established the Clearing House Interbank Payment Services (CHIPS) to clear and settle wire payments for eight of its largest members. Membership was subsequently expanded to banks across the United States and internationally.

During the 1950s and 1960s, banks introduced computers and gradually shifted from paper-based ledgers to electronic ledgers. As the cost of computers and telecommunications fell, it became increasingly efficient to send information relating to smaller-value payments electronically, which in turn facilitated automation of the entire payments system. In 1968, UK banks introduced the first automated electronic clearing house, called Bankers’ Automated Clearing System (BACS).[4] In 1972, a group of California banks established the first automated clearing-house (ACH) network in the United States to clear and settle accounts electronically.[5] Other regional networks and the Federal Reserve (FedACH) followed and, in 1974, these networks established the National Automated Clearing House Association (NACHA). Similar networks were developed in many other countries, typically supported by—and, in many cases, run by—central banks.

B.      Settlement Times

In the United States, settlement over NACHA and CHIPS originally took two to three days.[6] Settlement on payment systems in other jurisdictions, such as BACS in the United Kingdom, typically occurred on similar timeframes.[7] Over time, settlement times for payment systems have gradually been reduced. Most U.S. settlements now take only a day or less. Since 2010, FedACH has offered a same-day clearing/settlement service,[8] while NACHA has offered a similar same-day clearing/settlement service since 2016.[9] CHIPS settles at the end of the day over Fedwire.[10]

Separate from the ACH systems, real-time gross-settlement (RTGS) systems, such as Fedwire, are used for settling large-value payments between banks without netting. These typically settle immediately upon receipt, during hours of operation.[11] Because there is no netting, banks must either ensure they have sufficient reserves to send funds, or borrow funds to cover outgoing payments. Potential mismatches between outgoing and expected incoming funds can lead to cash hoarding, driving up demands for intraday borrowing, as occurred during the 2008 financial crisis.[12]

C.      Fast Payments, Faster Payments, and Real-Time Payments

So-called “fast payments” or “faster payments” systems are RTGS systems designed to clear and settle smaller sums quickly between accounts. In general, such systems have the following features: (1) payment messages transmit and clear sufficiently quickly that payor and payee can see changes in their respective account balances more-or-less instantly (practically speaking, that means under a minute); (2) payment is final and irrevocable.[13]

In 1973, Japan introduced Zengin, the first nationwide fast-payments system, and many others have followed suit in the ensuing half-century.[14] An early driver of fast payments’ introduction of was the desire to reduce float (see Section III Part B below). More recently, interoperability among P2P payment networks has become a major driver, leading to the introduction of systems that operate continuously. Such round-the-clock fast-payment systems are typically referred to as real-time payments (RTPs). (Various other labels, including “instant payments,” are also used.)

With improvements in the speed and capacity of data processing and transfer, settlement times have gradually fallen. Indeed, some RTPs, such as TCH’s RTP, settle instantly. This requires payment service providers (PSPs) to maintain a balance with the settlement provider sufficient to “pre-fund” any payment (similar to RTGS). Indeed, some proponents of RTPs argue that instantaneous settlement is a defining feature of such systems.[15] Other fast-payment systems, such as the UK’s Faster Payments Service (FPS), continue to operate on a deferred-settlement basis but are nevertheless referred to as RTPs because the other criteria are met. For the purposes of this primer, a payment system is considered an RTP if transactions using the system:

  • enable the payor and payee to see changes in their respective account balances instantly;
  • result in final and irrevocable transfers of funds from payor to payee; and
  • may be made 24 hours a day, seven days a week.

D.     Peer-to-Peer Payments

As noted, one of the drivers leading to the introduction of RTPs has been peer-to-peer (P2P) payments. Most P2P payments systems began as closed systems. While transfers within these P2P systems would often occur in real time, transfers into and out of the system—including to other P2P systems—could take days. RTPs offer a solution to this problem, enabling interoperability among different P2P systems, as well as interoperability between traditional bank accounts and P2P systems.

The first electronic peer-to-peer (P2P) payment system was M-Pesa,[16] a pilot of which was established in Kenya in 2005 by Safaricom, a cellphone-service provider, and subsequently rolled out nationwide in 2007. M-Pesa was inspired by the sharing of air-time credits by cellphone users in various sub-Saharan African countries.[17] Realizing that such air-time credit sharing was effectively acting as a form of money transmission and had the potential to enhance financial inclusion and associated economic development, the UK Department for International Development provided a challenge grant to Vodafone to support the development of more formal systems.[18] Initially, Vodafone worked with its Kenyan affiliate, Safaricom, to offer subscribers the ability to purchase M-Pesa funds at registered retailers in exchange for cash, thereby effectively turning their cell phones into mobile wallets. Users could send funds to others via SMS. Over time, M-Pesa expanded into other markets[19] and built numerous service offerings, including online payments[20] and savings and loans.[21] It now enables funding of accounts via online bank debits.[22]

Numerous companies subsequently built wallet applications for smartphones that enable users to link their bank accounts. This allows them to add funds by debiting those accounts and to deposit funds by sending credit to their accounts. Users of these wallets can send funds directly to other users of the same wallet. Examples include Venmo, Zelle, PayPal, Google Pay, Apple Pay Cash, Cash App, Paytm (India), WhatsAppPay (currently in India and Brazil), ViberPay (currently in Greece and Germany), and China’s AliPay and WeChatPay.

More recently, several bank associations and clearing houses have established RTP systems that facilitate interbank payments in real time, thereby in principle enabling interoperability between P2P systems. In some cases, interoperability has been baked in by design. For example, in 2016, the National Payments Corporation of India (NPCI) created the Unified Payments Interface (UPI), which is an RTP with an associated API that facilitates “push” credit payments and requests for payment for NPCI member banks.[23] As Figure I shows, around 400 banks are now part of UPI, which sees 8 billion monthly transactions with a total value of 14 trillion Rupees (about $170 billion).

SOURCE: NPCI[24]

TCH introduced an RTP system for member banks in 2017.[25] As Figure II shows, the RTP has experienced explosive growth over the past three years and many U.S. P2P services now operate over it, effectively turning those P2Ps into RTPs.

In the first quarter of 2023 alone, TCH’s RTP facilitated 50 million transactions with a total value of about $25 billion. While P2Ps operating over TCH’s RTP are not necessarily interoperable, Zelle users can send funds directly to a counterparty’s bank account over RTP, even if that counterparty does not have Zelle installed at the time the payment is sent (they will have to install Zelle to be able to receive the funds).

SOURCE: TCH[26]

Central banks have also established and are establishing RTPs. Notable examples include Brazil’s Pix,[27] which was launched in 2020; the U.S. Federal Reserve’s FedNow, which launched in July 2023;[28] and Bank of Canada’s Real Time Rail.[29]

At the time of writing, fast payments systems have been introduced in 72 countries,[30] with several of those jurisdictions having more than one such system. As can be seen in Figure III, the vast majority of fast payment systems were introduced in the past decade; most of those are RTPs.

SOURCE: Based on information from ACI Worldwide[31]

E.      Payment Cards

Payment-card networks emerged in the 1950s and have grown rapidly since, becoming the dominant means of retail payment in the United States and other OECD jurisdictions. Figure IV shows the dramatic increase in the  proportion of U.S. transactions made using payment cards over the past two decades, which rose from 32% in 2000 to 77% in 2021.

The earliest payment cards—Diners Club and American Express—were and are still largely closed-loop systems, operating separately from bank networks. In the late 1950s, banks began operating their own payment-card networks. Over time, these bank-card networks gradually became more expansive and independent, with Visa and Mastercard becoming the largest such networks in the world, although there remain many competitors, including JCB, China Union Pay, and numerous national schemes.

Today, payment card systems can be divided into three main types:

  • Closed-loop (three-party) credit cards
  • Open-loop (four-party) dual-message (“signature”) systems
  • Open-loop (four-party) single-message (“PIN”) systems

SOURCE: Federal Reserve Payment Study[32]

As the name suggests, closed-loop cards, such as American Express and Discover, operate largely outside the banking system. When a payor uses a closed-loop card to make a purchase, the card issuer decides whether the payment is legitimate (for example, by authenticating the payor and undertaking fraud checks) and whether the payor has sufficient credit; if it passes those checks, the issuer guarantees to pay the payee.

When a payor uses a card operating over an open-loop dual-message (“signature”) payment network, two messages are sent. The first is a request for authorization sent to the issuing bank, which confirms the authenticity of the card and checks whether the cardholder has sufficient credit remaining (for a credit transaction) or funds in their account (for a debit transaction). But the message is also parsed by the network, which is able to monitor for fraud. If authorized, the second message contains information confirming the actual amount of the transaction, which is then either added to the cardholders’ credit-card bill or debited from the cardholder’s account during clearing and settlement, as appropriate.

In this sense, the dual-message settlement process is analogous to a check, in that there is some delay in the posting and clearing of the transaction. The ability to put a “hold” on a dual-message card payment enables merchants to delay payment (sometimes by as much as several days), thereby reducing the likelihood of fraud and associated chargebacks.[33]

Single-message debit networks generally rely on the personal identification number (PIN) programmed on the card to authenticate a transaction. As a result, the only message that is required is a notification to the issuing bank to debit the account of the cardholder in the amount they have authorized, and to credit that amount to the account of the merchant—less the discount fee, which is paid to the acquiring bank. Because of the nature of the transaction, settlement can be effected over banks’ electronic-funds-transfer (EFT) networks, which were initially built to settle transactions at shared ATMs, and subsequently over networks of ATMs.[34] As with an ATM transaction, single-message debit transactions settle and funds are transferred more or less immediately from the consumer’s account.

One of the major advantages of card payments has always been that merchants are guaranteed payment (on the condition that they comply with the payment-card rules). The closed-loop systems and dual-message open-loop systems are not RTPs, however, because they do not settle instantly. As discussed below, this has certain advantages. Open-loop single-message systems, by contrast, can and increasingly do operate over RTPs for debit payments. For example, Visa Now and Mastercard Send enable debit-card holders to make real-time payments.[35]

III.    Benefits and Drawbacks of P2Ps and RTPs

P2Ps and RTPs have some significant advantages over other payment systems. In particular, they can reduce counterparty risk for recipients, decrease opportunity costs of funds, and facilitate more advanced bilateral messaging between payor and payee. But they also have some drawbacks. Most notably, they entail high counterparty risk for payors; have engendered new types of fraud and theft risk; and lack any built-in credit facility. This section discusses these benefits (parts A, B, and C) and drawbacks (parts D, E, and F).

A.      Reduced Counterparty Risk for Payees

Transfers sent using a system that nets payments, such as ACH or BACS, take some time to settle. As such, use of these payment systems creates a risk for recipients that payments will not arrive. This is particularly problematic for large-value transactions, such as home purchases, and for retail payments where the purchaser takes possession of the goods before the payment settles.

One way to reduce such payee counterparty risk is to use escrow (whereby funds are held on trust by a third party until the transaction is completed), banker’s drafts (also known as teller’s checks), or same-day wires. But these are all relatively costly solutions and hence only viable for larger-value transactions, such as the purchase of a car or a house. Wire transfers are clearly not suitable for transactions where the goods or services are of relatively low value, especially in cases where the purchaser will have left the premises before the wire has arrived, which would typically be the case for retail sales.

In comparison to wires, banker’s drafts, and escrow, credit and debit cards offer a lower-cost solution to counterparty risk. In both cases, payment is effectively guaranteed by the issuer (if the merchant complies with the card-network rules). In order to be able to accept credit or debit cards, however, the payee must establish a merchant account with an acquiring bank. While the costs and difficulty of establishing such an account has fallen with the introduction of modern payment-processing technologies, it can still be a barrier for merchants selling relatively small amounts of lower-valued items and is unlikely to make sense for individuals who make only occasional sales.

In contrast to these other payment methods, RTPs essentially eliminate counterparty risk for payees through the simple expedient of finality. This means that payees can see that funds have arrived nearly the moment that they are sent and know that the payment cannot be reversed. Meanwhile, when associated with a P2P system, RTPs can have very low setup costs, making them attractive for individuals and low-volume merchants.

B.      Reduced Opportunity Costs

RTPs also eliminate the opportunity cost associated with funds that take time to settle. Compared with some other forms of payment—such as checks or credit cards, which can take a day or more to settle—the instantaneous settlement available with RTPs can create significant benefits for payees.

The Federal Reserve estimates that approximately 12 billion checks were written in 2021, with a total value of $27.47 trillion.[36] Of those, approximately 800 million, with a value of $240 billion, were converted to ACH. This means that the remainder—i.e., 11.2 billion checks, with a combined value of $27.23 trillion—were processed through conventional clearing. It typically takes about two business days for a check to clear and settle, which means that U.S. businesses require an additional gross daily “collection float” of about $210 billion to cover this lag between payment and settlement.[37] In practice, the net collection float required is far lower, because most checks are paid from one business to another; at any point in time, many businesses will be both debtors and creditors. Nonetheless, the need for even a few billion dollars of collection float is a significant cost, either reducing the amount of cash available for other uses or requiring lines of credit and associated interest payments. Using RTPs in place of checks can eliminate this float and associated costs.

C.      Improved Bilateral Messaging

Another advantage of RTPs is improved documentation and bilateral communications. Some RTPs have introduced enhanced bilateral messaging between payer and payee.[38] Among other things, this enables senders to verify the identity of the account to which they are sending funds, which can reduce the incidence of mistakes. In addition, payees can send requests for payment to payors, which can simplify the payment process (but as noted below, can lead to fraud). In addition, messages can include human-readable documents such as invoices and receipts that can improve reconciliation by both parties.

D.     Increased Counterparty Risk for Payors

While counterparty risk for payees is low when using a RTP, the opposite is true for those who use RTPs to pay for goods and services—and for largely the same reason: the finality of payments made using an RTP means that, once a payment has been initiated, it cannot be stopped or reversed. This reduces counterparty risk for payees and increases it for payors. If the goods or services purchased using an RTP system are not supplied or do not meet the payor’s expectations, the payor cannot initiate a reversal or chargeback. (The payor could send a request-for-payment to the recipient, but the recipient is under no obligation to comply.)

E.      Fraud and Theft

Fraud and theft are perennial problems with payment systems of all kinds. Cash sales are particularly susceptible to “skimming,” whereby the till operator takes some of the cash tended (for example, by overcharging or by failing to ring up the correct amount in the register).[39] Cash is also susceptible to theft while in transit. To reduce such problems, merchants invest in such technologies as product bar codes, which prevent till operators from inputting incorrect prices (as well as improving inventory management) and security firms that use armored vehicles to transport cash.[40]

Non-cash payment methods are not subject to physical theft per se, but criminals have deployed all manner of schemes to use them to steal and defraud. Among other things, checks have been used to steal funds by impersonation of account holders; to defraud merchants by pretending to spend funds that are not available (“bouncing”); and to embezzle funds from companies. To address these problems, merchants introduced requirements like identity confirmation and caps on check amounts, while banks introduced card-based guarantees, and payor companies and banks introduced multi-signature requirements.[41]

Payment cards have suffered some similar problems. In response, issuing banks, merchants, card-payment networks, and other participants in the card-payments ecosystem have introduced rules and technologies designed to prevent fraud and theft. Early solutions included payment-authorization requirements; floor limits (above which authorization is required); and chargebacks (the ability to charge a transaction back to the merchant when an illegitimate transaction has not been authorized).[42] More recent innovations include machine-learning-based systems that monitor individual-payment patterns, with suspicious transactions subject to rejection or additional authorization requirements, as well as tokenized payments, which prevent the collection and transmission of personal account numbers (PANs).[43]

These rules and technologies have dramatically reduced fraud at the point of sale. But new technologies have created new opportunities for criminals to adapt old scams and develop new ones. The shift toward online transactions, for example, led to an explosion of card-not-present fraud.[44] As before, companies in the payment-network ecosystem have responded by developing systems that limit such fraud, such as the use of cookies, address verification, one-time passwords, velocity checks, multi-factor authentication, notification alerts, fraud scoring, and tokenization using token vaults.[45]

RTP systems are able to reduce some kinds of fraud and mistake. For example, the ability to check the identity of the recipient of the payee should, in principle, reduce the likelihood that a payment is sent to the wrong recipient. Raising the confidence of the payor, however, can also contribute to push-payment fraud. The lack of ability to reverse payments made over an RTP makes such systems particularly prone not only to push-payment fraud, but also to other kinds of frauds, as discussed in the subsections below.

1.        Authorized Push-Payment Fraud

One of the most common types of payment fraud is also one of the oldest. A fraudster pretends to offer goods or services (often apparently in the name of a real business) and asks for upfront payment, but never delivers the goods or services. Such cons can take many forms, but increasingly they use online communications (websites, emails, app-based systems) and take advantage of irrevocable electronic transfers of funds.

This is the essence of “authorized push payment” (APP) fraud, which involves a con artist sending a request for payment (RFP) from a fake business (usually with a name that is very similar to that of a real business). The victim, assuming the request is from a legitimate business, then authorizes payment. APP fraud has become particularly prevalent in the United Kingdom since the introduction of the country’s Faster Payment System (FPS) RTP.[46]

2.        Lightning Kidnappings, Data Breaches, and Malware Attacks

In some jurisdictions, the immediacy and finality of RTPs has been associated with an increase in other more disturbing crimes. Shortly after the introduction of Pix, Brazil saw a 40% rise in the phenomenon of “lightning kidnappings.” [47] Traditionally, such kidnappings involved victims being taken to an ATM and forced to take out money to secure their release. In the more recent iteration of the scheme, kidnappers simply demand that victims make a transfer to the kidnapper’s Pix account.

In response, Brazil’s central bank (BCB) capped the value of P2P Pix transactions made between the hours of 8 p.m. and 6 a.m. to R1,000 ($182, at the time).[48] Meanwhile, some Brazilians have taken matters into their own hands, responding to the threat of Pix kidnappings by purchasing secondary “Pix phones.”[49] Users load these mid-range Android phones with banking and Pix apps and leave them at home. Meanwhile, they delete all banking apps from their primary phone. While such an approach allows those who can afford a second phone to prevent criminals from stealing potentially large amounts of money, it is quite a costly solution.

Brazil’s Pix also appears to be particularly susceptible to cybersecurity risks. Over the past 18 months, there have been three significant cybersecurity violations relating to Pix accounts. The first three were data breaches that appear to have arisen as a result of inadequate cybersecurity protections at banks and fintech companies whose account holders had the Pix app installed.[50] One concern is that criminals may be seeking to use data gathered from these account breaches to create fake accounts in the names of real people, which they could then use to receive funds from the hostages they kidnap and/or engage in other criminal activities. They could then launder the money by using Pix to buy goods and, after depleting the account, destroy the phone used to create it.

The fourth breach, identified in late 2022, is by far the largest and potentially most serious, as it involved the use of a piece of malware nicknamed PixPirate, which targets Android versions of the Pix app itself and potentially affects all Pix customers using Android phones.[51] It would appear that PixPirate enables the theft of passwords used to access bank accounts, as well as the interception of SMS messages. In combination, these data could be used to defeat some types of two-factor authentication.

F.       Governance

In some respects, the problems of fraud and theft discussed above may be considered part of a wider problem of “governance” of P2P and RTP systems. While space precludes a detailed discussion of this issue here (it will be the subject of a forthcoming paper in this series), from an economic perspective, it is important for payment-network operators’ incentives to be aligned with those of users. Among other things, this means that the operator of a payment network should not also have monopoly powers to regulate all other payment networks and PSPs, since this creates a potential conflict of interest whereby the payment network that the regulator operates is privileged relative to other networks and PSPs, thereby undermining competition and harming users.

In practice, central banks often operate at least part of the payment-network infrastructure and have broad regulatory powers with respect to payment-network operations. In such circumstances, conflicts of interest cannot be entirely avoided, but can at least be mitigated by ensuring that there is separation between the division responsible for operating payments infrastructure and the division charged with regulation. As the BIS Committee on Payment and Settlement Systems has noted:

A central bank needs to be clear when it is acting as regulator and when as owner and/or operator. This can be facilitated by separating the functions into different organisational units, managed by different personnel.[52]

Such best practices are followed by central banks such as the U.S. Federal Reserve and the Reserve Bank of Australia.[53] By contrast, at the Central Bank of Brazil (BCB), the same unit that operates Pix also regulates other private PSPs.[54]

G.     No Automatic Credit

One of the key advantages of credit cards is that cardholders can pay for goods and services when they face temporary liquidity constraints—i.e., when they have insufficient funds immediately available to make a purchase. Most credit-cards issuers provide cardholders with interest-free credit from the time of a purchase until the bill is due, which typically ranges from 15 to 45 days, depending on when the purchase was made during the billing cycle. If the bill is settled in full by the due date, then no interest is payable. If the bill is not settled in full by the due date, then interest is payable on the outstanding amount.

Unlike payments made using credit cards, those made using a P2P-RTP do not inherently offer the payor the ability to spend more than they have in their account at the time of a purchase. Some P2P payments platforms have, however, developed credit facilities via buy-now-pay-later (BNPL) providers such as Afterpay (owned by Square), Affirm, Flexpay, Klarna, Sezzle, Splitit, and Zip.[55] BNPLs offer various ways to defer payment. For example, payors may be offered an option to defer the payment for a short period (such as four to eight weeks) at 0% interest, in which case the BNPL typically charges the retailer a transaction fee of between 2% and 8% (depending on the consumer’s credit score and the type of merchant).[56] Square charges the purchaser a standard rate of 6% plus a transaction fee of $0.30.[57] Alternatively, payors may be offered longer-term payment solutions, in which case, the merchant pays a transaction fee and the consumer pays the interest.[58]

Nonetheless, unlike credit cards, which automatically provide credit, BNPLs require the user to make an additional step when making a purchase, slowing the process down. And as noted, BNPLs can end up being more costly to the merchant and/or consumer than using a credit card.

IV.    Conclusions

P2Ps and RTPs clearly have both advantages and drawbacks compared to other payment systems. They are well-suited for payments where immediacy and finality are required, where the goods or services have already been delivered or are being supplied by a trusted provider, and where the payor is satisfied that the warranties provided by the payee are adequate and easily enforced. For such transactions, payments made using P2Ps and RTPs are in many ways superior to cash, checks, or older EFT-based online debit transactions.

By offering a means of sending credit in real time between banks operating on the same system, RTP rails have facilitated more widespread use of P2P payments. Indeed, it is likely this characteristic, as much as improved bandwidth and processing speeds for online transactions, that explains the dramatic increase in the number of RTP systems over the course of the past decade.

By contrast, P2Ps and RTPs are poorly suited to transactions where immediacy and/or finality are not required, either because the goods or services have not yet been delivered or because of concerns regarding the quality of those goods or services. This is because the finality of P2P and RTPs makes it more difficult for the systems to detect, prevent, and rectify fraud, theft, and mistake. P2Ps and RTPs are thus poorly suited to transactions where goods and services are delivered after payment has been sent and the payor does not have an established trust relationship with the merchant. That includes many online purchases.

In such circumstances, closed-loop or dual-message open-loop payment cards will typically be superior to P2Ps and RTPs. For example, cardholders may dispute charges and make chargebacks if products have not been received or are defective. Acquirers and/or issuers also may delay payment until fraud checks have been completed, reducing the likelihood of a fraudulent transaction and thereby protecting merchants from chargebacks and protecting cardholders from fraud.

P2Ps and RTPs are also less well-suited to paying for goods or services when the payor does not have adequate funds in their bank account. While BNPLs may offer a solution in such cases, in most cases, it will be quicker and in many cases, it will be less costly to use a credit card. Subsequent papers in this series will look in more detail at issues relating to adoption of P2Ps and RTPs, the problem of APP fraud, and governance of RTPs.

[1] P2P is sometimes used in a more restrictive sense to mean “person-to-person”; the broader meaning used here includes person-to-person, person-to-business, and business-to-business.

[2] Marcela Ayres, Brazil’s Central Bank Chief Predicts End of Credit Cards, Reuters (Aug. 12, 2022), https://www.reuters.com/world/americas/brazils-central-bank-chief-says-credit-card-will-cease-exist-soon-2022-08-12.

[3] For example, the European Central Bank defines clearing as “the process of transmitting, reconciling and, in some cases, confirming transfer orders prior to settlement, potentially including the netting of orders and the establishment of final positions for settlement.” See, All Glossary Entries, European Central Bank, https://www.ecb.europa.eu/services/glossary/html/glossa.en.html (last accessed Aug. 19, 2023).

[4] History of Bacs, Bacs Payment Schemes Ltd. (Feb. 23, 2015), available at https://www.bacs.co.uk/DocumentLibrary/History_of_Bacs.pdf.

[5] History of Nacha and the ACH Network, Nacha (Apr. 20, 2019), https://www.nacha.org/content/history-nacha-and-ach-network.

[6] Id.

[7] As recently as 2012, standard settlement over BACS was 3 days. See, Payment, Clearing and Settlement Systems in the United Kingdom (CPSS Red Book), Bank for International Settlement Committee on Payment and Market Infrastructure (2012), at 455, available at https://www.bis.org/cpmi/publ/d105_uk.pdf.

[8] Press Release, Federal Reserve Announces Posting Rules for New Same-Day Automated Clearing House Service, Federal Reserve (Jun. 21, 2010), https://www.federalreserve.gov/newsevents/pressreleases/other20100621a.htm.

[9] Same Day ACH, NACHA, https://www.nacha.org/content/same-day-ach (last accessed Aug. 19, 2023).

[10] CHIPS, Modern Treasury, https://www.moderntreasury.com/learn/chips (last accessed Aug. 19, 2023).

[11] Fedwire Funds Services, Federal Reserve (May 7, 2021), https://www.federalreserve.gov/paymentsystems/fedfunds_about.htm.

[12] Gara Alfonso et al., Interbank Payment Timing is Still Closely Coupled, Working Paper (Jun. 2022), available at https://www.dnb.nl/media/raafily1/presentation-session-vii.pdf.

[13] The Bank for International Settlements offers the following definition: “Fast payments can be defined by two key features: speed and continuous service availability. Based on these features, fast payments can be defined as payments in which the transmission of the payment message and the availability of final funds to the payee occur in real time or near-real time and on as near to a 24-hour and 7-day (24/7) basis as possible.” See, Fast Payments – Enhancing the Speed and Availability of Retail Payments, Bank for International Settlements (Nov. 2016), at 1, available at https://www.bis.org/cpmi/publ/d154.pdf; Meanwhile, the Federal Reserve notes that: “To be classified as a faster payment, the payment option must 1) enable both payer and payee to see the transaction reflected in their respective account balances immediately and 2) provide funds that the payee can use right after the payer initiates the payment. And because of this, the payment is, by its nature, also irrevocable, meaning it cannot be reversed by the payer or the payer’s financial institution (FI) after it is sent.” See, Fast, Faster, Instant Payments: What’s in a Name?, Federal Reserve, https://www.frbservices.org/financial-services/fednow/instant-payments-education/whats-in-a-name.html (last accessed Aug. 19, 2023).

[14] Alfonso, supra note 12, at 5.

[15] The Distinctions Between Faster Payments and Real-Time Payments, Payments Journal (Aug. 18, 2020), https://www.paymentsjournal.com/the-distinctions-between-faster-payments-and-real-time-payments.

[16] The name is an abbreviation of “Mobile Pesa”; Pesa means money in Swahili.

[17] Mobile Money: From Transferring Cash by SMS to a Digital Payments Ecosystem (2000–20) in Russell Southwood, Africa 2.0, Manchester University Press (2022).

[18] Nick Hughes & Susie Lonie, M-PESA: Mobile Money for the “Unbanked”, Innovations (Winter and Spring 2007), 63-81, available at https://www.gsma.com/mobilefordevelopment/wp-content/uploads/2012/06/innovationsarticleonmpesa_0_d_14.pdf.

[19] What is M-PESA?, Vodaphone, https://www.vodafone.com/about-vodafone/what-we-do/consumer-products-and-services/m-pesa (last accessed Aug. 19, 2023).

[20] M-Pesa for Business, https://m-pesaforbusiness.co.ke (last accessed Aug. 19, 2023).

[21] M-Pesa: Credit and Savings, Safaricom, https://www.safaricom.co.ke/personal/m-pesa/credit-and-savings (last accessed Aug. 19, 2023).

[22] M-Pesa, Safaricom, https://www.safaricom.co.ke/personal/m-pesa (last accessed Aug. 19, 2023).

[23] Unified Payments Interface (UPI) Overview, NPCI, https://www.npci.org.in/what-we-do/upi/product-overview (last accessed Aug. 19, 2023).

[24] Statistics of NPCI, NPCI, https://www.npci.org.in/statistics (last accessed Aug. 19, 2023).

[25] Frequently Asked Questions, The Clearing House, https://www.theclearinghouse.org/payment-systems/rtp/institution (last accessed Aug. 19, 2023).

[26] RTP Quarterly Payment Activity (1Q23), The Clearing House, https://www.theclearinghouse.org/payment-systems/rtp.

[27] Julian Morris, Is Pix Really the End of Credit Cards? Truth on the Market (Sep. 28, 2022), https://truthonthemarket.com/2022/09/28/is-pix-really-the-end-of-credit-cards.

[28] About the FedNow Service, Federal Reserve Board, https://www.frbservices.org/financial-services/fednow/about.html (last accessed Aug. 19, 2023).

[29] The Real-Time Rail: Canada’s Fastest Payment System, Payments Canada, https://payments.ca/systems-services/payment-systems/real-time-rail-payment-system (last accessed Aug. 19, 2023).

[30] Prime Time for Real-Time Global Payments Report, ACI Worldwide (2023), https://www.aciworldwide.com/real-time-payments-report.

[31] RTP Quarterly Payment Activity (1Q23), The Clearing House, https://www.theclearinghouse.org/payment-systems/rtp (last accessed Aug. 19, 2023).

[32] Federal Reserve Payments Study (FRPS), Federal Reserve Board (2023), https://www.federalreserve.gov/paymentsystems/fr-payments-study.htm.

[33] Tyler DeLarm, Credit Card Authorization Hold- How and When to Use, Chargeback Gurus (Dec. 26, 2021), https://www.chargebackgurus.com/blog/credit-card-authorization-holds.

[34] Stan Sienkiewicz, The Evolution of EFT Networks from ATMs to New On-Line Debit Payment Products, Fed. Rsrv. Bank of Phila (Apr. 2002), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=927473.

[35] Enable Individuals and Businesses to Move Money Globally, Visa, https://usa.visa.com/run-your-business/visa-direct/use-cases.html (last accessed Aug. 19, 2023); Send Money Quickly, Securely and Simply, Mastercard, https://www.mastercard.us/en-us/business/large-enterprise/grow-your-business/mastercard-send/mc-send-domestic-payments.html (last accessed Aug. 19, 2023).

[36] Federal Reserve Board, supra note 32.

[37] It should be noted that on the other side of the equation is “disbursement float,”—i.e., funds that have not yet left the payor’s account and are thus still available to the payor. The float is thus effectively a short-term loan made by the payee to the payor.

[38] For example, these features will be enabled for FedNow payments. See, The Real Value of Real-Time Payments, J.P. Morgan, https://www.jpmorgan.com/solutions/treasury-payments/insights/real-value-real-time-payments (last accessed Aug. 19, 2023).

[39] Skimming Fraud, Corporate Finance Institute (Jun. 8, 2020), https://corporatefinanceinstitute.com/resources/esg/skimming-fraud.

[40] Cash Larceny, Corporate Finance Institute (Jun. 7, 2020), https://corporatefinanceinstitute.com/resources/risk-management/cash-larceny.

[41] Check Fraud: A Guide to Avoiding Losses, U.S. Office of the Comptroller of the Currency (Feb. 1999), available at https://www.occ.gov/publications-and-resources/publications/banker-education/files/pub-check-fraud.pdf.

[42] David L Stearns, “Think of it as Money”: A History of the VISA Payment System, 1970–1984, PhD Thesis, University of Edinburgh (Aug. 2007), at 46 and 57-59, available at https://era.ed.ac.uk/bitstream/handle/1842/2672/Stearns%20DL%20thesis%2007.pdf.

[43] Julian Morris & Todd J. Zywicki, Regulating Routing in Payment Networks, International Center for Law & Economics (Aug. 17, 2022), available at https://laweconcenter.org/wp-content/uploads/2022/08/Regulating-Routing-in-Payment-Networks-final.pdf.

[44] Card Fraud Losses Dip to $28.58 Billion, Nilson Report (Dec. 2021), 5-7, available at https://nilsonreport.com/upload/content_promo/NilsonReport_Issue1209.pdf.

[45] Id.; see also, Card-Not-Present (CNP) Fraud Mitigation Techniques, U.S. Payments Forum (2020), available at https://www.uspaymentsforum.org/wp-content/uploads/2020/07/CNP-Fraud-Mitigation-Techniques-WP-FINAL-July-2020.pdf.

[46] Over £1.2 Billion Stolen Through Fraud In 2022, With Nearly 80 Per Cent of APP Fraud Cases Starting Online, UK Finance (May 11, 2023), https://www.ukfinance.org.uk/news-and-insight/press-release/over-ps12-billion-stolen-through-fraud-in-2022-nearly-80-cent-app.

[47] Bryan Harris, Brazil’s Criminals Turn to Flash Kidnapping as They Take Advantage of New Tech, Financial Times (Sep. 3, 2021), https://www.ft.com/content/225fd97c-ef82-4dfa-b09b-97b1671e1e00.

[48] Id.

[49] Alana Fernandes, Brasileiros Estão Apostando no Celular do PIX, Edital Concursos Brasil (May 21, 2022), https://editalconcursosbrasil.com.br/noticias/2022/05/brasileiros-estao-apostando-no-celular-do-pix-entenda-o-que-e-e-como-usar.

[50] The first, in late September 2021, resulted in the theft of information from nearly 400,000 Pix users due to a systems failure at state-owned Bank of the State of Sergipe (Banese). See Angelica Mari, Brazilian Data Protection Authority Investigates First PIX Data Leak, ZDNet (Oct. 6, 2021), https://www.zdnet.com/article/brazilian-data-protection-authority-investigates-first-pix-data-leak. See also Larissa Garcia & Alvaro Campos, New Leak Threatens Pix’s Credibility Central Bank Reports a Third Hacker Attack in Six Months, Now With 2,112 Keys Exposed, Valor International (Feb. 3, 2022). The second breach occurred in late January 2022 and involved the theft of data relating to approximately 160,000 Pix users from Acesso Pagamentos. See Gabriel Shinohara, Banco Central Comunica Vazamento de Dados de 160,1 Mil Chaves Pix da Acesso Pagamentos Segundo o BC, Não Houve Vazamento de Dados Sensíveis Como Senhas e Saldos, O Globo (Jan. 21, 2022), https://oglobo.globo.com/economia/banco-central-comunica-vazamento-de-dados-de-1601-mil-chaves-pix-da-acesso-pagamentos-25362574. The third breach, reported in February 2022 but relating to an incident in early December 2021, involved the theft of data from around 2,100 Pix users from LogBank. See Fernanda Capelli, Central Bank Confirms Another Leak of Pix Keys from Logbank, Programadores Brasil (Feb. 4, 2022), https://programadoresbrasil.com.br/en/2022/02/see-central-bank-confirms-yet-another-logbank-pix-key-leak.

[51] New Banking Trojan Targeting 100M Pix Payment Platform Accounts, Dark Reading (Feb 7, 2023), https://www.darkreading.com/risk/new-bank-trojan-targeting-100m-pix-payment-platform-accounts; PixPirate: A New Brazilian Banking Trojan, Cleafy (Feb. 3, 2023), https://www.cleafy.com/cleafy-labs/pixpirate-a-new-brazilian-banking-trojan.

[52] Central Bank Oversight of Payment and Settlement Systems, Bank for International Settlements Committee on Payment and Settlement Systems (May 2005), available at https://www.bis.org/cpmi/publ/d68.pdf.

[53] Policies: The Federal Reserve in the Payments System, Board of Governors of the Federal Reserve System (Jan. 2001), https://www.federalreserve.gov/paymentsystems/pfs_frpaysys.htm; Managing Potential Conflicts of Interest Arising from the Bank’s Commercial Activities, Reserve Bank of Australia (Feb. 2022), https://www.rba.gov.au/payments-andinfrastructure/payments-system-regulation/conflict-of-interest.html.

[54] Julian Morris, Central Banks and Real-Time Payments: Lessons from Brazil’s Pix, IInternational Center for Law & Economics (Jun. 1, 2022), at 13, available at https://laweconcenter.org/wp-content/uploads/2022/06/Lessons-from-Brazils-Pix.pdf.

[55] Erin Gregory, How Does Buy Now Pay Later (BNPL) Work for Businesses?, Tech Radar (Mar. 4, 2022), https://www.techradar.com/features/how-does-buy-now-pay-later-bnpl-work-for-businesses; Jaros?aw ?ci?lak, Top 10 Buy Now Pay Later Companies to Watch in 2022, Code & Pepper (Aug. 5, 2022), https://codeandpepper.com/buy-now-pay-later-2022.

[56] Id.

[57] Bring in More Business With Buy Now, Pay Later, Square, https://squareup.com/us/en/buy-now-pay-later (last accessed Aug. 19, 2023).

[58] Id.

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Financial Regulation & Corporate Governance

The Consequences of Caps on Cross-Border Payment Fees in Costa Rica

ICLE Issue Brief Executive Summary Under the auspices of Legislative Decree 9831, the Central Bank of Costa Rica (BCCR) has set maximum fees for acquiring and issuing banks . . .

Executive Summary

Under the auspices of Legislative Decree 9831, the Central Bank of Costa Rica (BCCR) has set maximum fees for acquiring and issuing banks in payment-card markets, with maximum acquisition fees (MDR) and interchange fees (IRF). Different fees were set for domestic transactions (i.e., those made using locally issued cards) and for cross-border transactions (i.e., those made using foreign-issued cards).

In November 2022, BCCR issued a proposal to retain the cross-border MDR cap at 2.5% and either to leave the cap on cross-border IRF unchanged at 2%, or to lower it to 1.25%. In the same document, BCCR proposed that the MDR for domestically issued cards would be capped at 2% and the IRF capped at 1.5%.

IRF for cross-border transactions typically are significantly higher than those for domestic transactions, primarily because cross-border transactions carry much higher risk of fraud. If BCCR caps cross-border interchange fees at the lower level it has proposed, foreign issuers are likely to respond by de-risking payment requests from acquirers in Costa Rica. This could take various forms, including rejecting payments from certain merchants, or simply increasing rejections rates across the board. Whatever approach, or mix of approaches, is taken, it is likely to cause problems both for merchants in Costa Rica and for their customers.

Prior to the COVID-19 pandemic, roughly 6.25% of Costa Rica’s gross domestic product (GDP) came from tourism, with a significant proportion of those tourist dollars spent using payment cards. Indeed, in 2021, even without a full resumption of pre-COVID rates of tourism, approximately 16% of credit-card payments in Costa Rica were cross-border. If tourists find that they are unable to make reservations at hotels in Costa Rica using their credit or debit cards because the payment is rejected by their issuer, they may well choose an alternative destination for their trip. Meanwhile, if tourists in Costa Rica are unable to pay for goods and services using their credit and debit cards, many will simply not make those payments. This could have a substantial negative effect on Costa Rica’s tourism and business-travel industries.

Introduction

Costa Rica Legislative Decree No. 9831—issued March 24, 2020—created a mandate to regulate acquisition fees (commonly known as the “merchant discount rate,” or MDR) and interchange reimbursement fees (IRF) charged by service providers on “the processing of transactions that use payment devices and the operation of the card system.”[1] The legislation’s stated objective was “to promote its efficiency and security, and guarantee the lowest possible cost for affiliates.”

Implementation was delegated to the Central Bank of Costa Rica (BCCR), which was tasked with responsibility to issue regulations and monitor compliance; ensure that the rule is “in the public interest”; and guarantee that fees charged to “affiliates” (i.e., merchants) are “the lowest possible … following international best practices.” Beginning Nov. 24, 2020, BCCR set the maximum IRF for domestic cards at 2.00% and the maximum MDR at 2.50%. These fell to 1.75% and 2.25%, respectively, in an updated regulation published in January 2022, and to 1.5% and 2% in February 2023.

In a study published in May 2022, we reviewed the available evidence regarding interchange fees and argued that it would be contrary to international best practices for Costa Rica to cap acquisition fees and interchange fees.[2] In particular, we raised specific concerns regarding the likely harmful effects of capping fees on cross-border transactions, owing to the higher risks and other costs associated with such transactions.

BCCR developed a technical study that considered the effects of different levels of caps on fees for both domestic and cross-border payment-card transactions and, in November 2022, issued a proposal to retain the cross-border MDR cap at 2.5% and either (1) leave the cap on cross-border IRF unchanged at 2%, or (2) lower the IRF cap for cross-border transactions to 1.25%.

If BCCR leaves the cross-border MDR cap unchanged but reduces the cross-border IRF cap to 1.25%, it might, in principle, appear to solve the immediate problem faced by acquiring banks. It would, however, create new problems for those banks, their customers, and the wider economy. It will also put Costa Rica in the unenviable position of being the only country in the world with a cross-border interchange fee that is below the domestic interchange fee.

This brief considers the international experience with cross-border payment-card transactions, with a focus on issues related to fraud, as well as the negative implications of imposing price caps. It begins with a brief discussion of the economics of interchange fees. Section II describes Costa Rica’s price controls on merchant acquisition and interchange fees. Section III discusses fraud and other costs associated with cross-border and card-not-present transactions. Section IV describes ways in which payment-card networks address issues related to fraud. And Section V assesses the likely implications for Costa Rica of price caps on cross-border interchange fees.

I.        The Economics of Interchange Fees

Payment systems are two-sided markets, with consumers on one side and merchants on the other; the payment network acts as a platform that facilitates interactions between the two sides.7F[3] For such a system to be successful, both merchants and consumers must perceive it as beneficial. If too few merchants accept a particular form of payment, consumers will have little reason to obtain it and issuers will have little incentive to issue it. Likewise, if too few consumers possess a form of payment, merchants will have little reason to accept it.

In any two-sided market, platform operators seek to encourage participation on each side of the market in ways that maximize the joint net benefits of the network to all participants—and to allocate system costs accordingly.8F[4] Among the means they employ to achieve this balance is by setting prices charged, respectively, to participants on each side of the market.9F[5] In the case of payments, if the platform operator sets the price too high for some consumers, they will be unwilling to use the platform; similarly, if the operator sets the price too high for some merchants, they will not be willing to use the platform.

In general, the costs of operating a platform will tend to fall on the party who is least sensitive to such costs (i.e., the party with the lower price elasticity). In the case of payment cards, that party is the merchant.13F[6] Merchants often pay, through transaction fees, not only all the costs of accessing the network, but also effectively subsidize participation by consumers—e.g., through cashback and other rewards programs, insurance, fraud protection, and other cardholder benefits that serve as incentives to card usage.

Merchants are willing to do this because they receive significant benefits from the use of payment cards, including: ticket lift (i.e., higher spending, due to the fact that consumers are not constrained by the cash in their pockets or, in the case of credit cards, the amount of cash currently in their bank accounts), guaranteed payment, reduced cash-management costs, and faster checkout times.

II.      Costa Rica’s Price Controls on Payment Card Fees

Article 14 of Legislative Decree 9831 requires the BCCR to undertake “ordinary reviews” of the price controls on MDR and IRF at least once annually. Its first such review, published in November 2021, set a timetable for maximum domestic-acquisition and interchange fees (see table below) and set maximum cross-border MDR at 2.5% and IRF at 2%.[7]

SOURCE: Banco Central de Costa Rica[8]

BCCR subsequently established a task force to develop proposals for setting payment-card fees. On Nov. 2, 2022, BCCR published the task force’s recommendations, which included, inter alia, the following:[9]

  • Use international comparisons of IRFs and MDRs “as the best technical tool currently available to the BCCR to ensure the lowest possible cost for affiliates, in accordance with Legislative Decree 9831.”
  • Maintain the differentiation of the ceilings on IRF and MDR between local and cross-border payment transactions, in accordance with Article 4 of Legislative Decree 9831, “as this leads to the proper functioning, efficiency and security of the Costa Rican payment system and the lowest cost for affiliates.”
  • For 2023, set maximum fees for local payment transactions at 1.50% for IRF and 2.00% for MDR. This is in line with the proposal made in 2021.
  • Maintain the cap of 2.50% on cross-border MDR, “since the information available in the international comparison does not allow modifications to be made to the limit established since 2020.”
  • Propose two alternative options regarding the maximum cross-border IRF:
    • Option 1: maintain the current maximum, e., 2.00%; or
    • Option 2: reduce the maximum to 1.25%.

The BCCR offers various putative justifications for these proposed caps. For example, it notes that Option 2 would result in a maximum cross-border IRF that is midway between “the minimum cross-border IRF established by Mastercard and Visa card brands for the United States and Canada, as well as Visa for Australia in the case of non-Asia Pacific issuers” (i.e., 1.00%) and the IRF “agreed by Mastercard and Visa card brands for card-not-present payments in the EEA” (i.e., 1.50%).

Such justifications, however, are fundamentally inconsistent with the economics of two-sided markets. The current and proposed price caps thus represent essentially arbitrary interventions. By focusing narrowly on the costs incurred by merchants through IRFs and MDRs, BCCR fails to account adequately for the offsetting benefits that accrue to consumers and merchants—and the costs to provide those benefits.

Legislative Decree 9831 does, however, permit BCCR to take into consideration “[a]ny other element that reasonably allows the Central Bank of Costa Rica to guarantee the efficiency and security of the card systems.”[10] As discussed below, one such element that should be considered by BCCR is the potential effect of regulating international IRFs on merchants in Costa Rica, especially those catering to tourists and business travelers, and the wider effects on the economy.

III.    Fraud Risks Associated with Cross-Border Payments

In comparison to domestic payments, cross-border payments entail significantly higher risks of fraud, as be seen by looking at the incidence of payments fraud in the European Union (EU). Data from the European Central Bank (ECB) show unambiguously that the rates of fraud on cross-border transactions—both between EU member states and from outside the EU—is much higher than fraud on domestic transactions. In its 2021 Report on Card Fraud, the ECB found that, between 2015 and 2019, cross-border transactions represented only 10% of transactions by value but 65% of all fraud by value, as can be seen in Figure I.[11] Thus, in value terms, cross-border fraud represents a risk more than six times greater than domestic fraud.

SOURCE: European Central Bank[12]

For most EU member states, the situation is even more dramatic, with cross-border fraud representing more than 90% of all card fraud, as can be seen in Table II.

SOURCE: European Central Bank[13]

Looking at the types of transaction involved in card fraud, the vast majority (83%) are card-not-present (CNP) fraud, as can be seen in Figure II.

SOURCE: European Central Bank[14]

While these data relate to payments fraud in the EU, they are likely indicative of broader international trends. As such, they suggest that cross-border fraud in general and CNP cross-border fraud in particular is a far more significant problem than domestic fraud of all kinds.

IV.    How Card Networks Address Payment-Card Fraud

Card networks have developed numerous processes and technologies to address payment-card fraud, including the following.

Zero liability protection for cardholders. Card networks’ standard terms and conditions include clauses requiring issuers to protect personal cardholders from unauthorized transactions (subject to certain conditions, such as that cardholders report such transactions promptly to the card issuer).[15] This protection is an important benefit to cardholders, who otherwise might be wary of using their cards, especially for online transactions or in foreign countries.

Liability protection for merchants. Just as cardholders are protected from liability for unauthorized transactions, so too are merchants. Issuers are, by default, liable for unauthorized transactions. This is an important benefit to merchants, who might otherwise be reluctant to accept card-based payments.

Chargebacks. The above liability protections apply only to unauthorized transactions. Where a cardholder has authorized a payment, they will be liable. Meanwhile, if a merchant has processed a payment without obtaining the necessary authorization, and where that payment has been disputed by the cardholder, the issuer may initiate a “chargeback”: effectively reversing the payment.

Authorization, verification, and fraud monitoring. To complement the system of liability protection and chargebacks, payment networks have developed increasingly sophisticated and effective systems for transaction authorization and fraud monitoring, including:

  • Tokenization—which underpins EMV (Europay, Mastercard, and Visa) chips, contactless cards, and smartphone-based payments—uses encrypted data to enable authorization without sharing personal account numbers;
  • Machine-learning-based transaction monitoring, which creates a dynamic model of each cardholder’s transactions and flags as potentially fraudulent those payments that do not fit the model; and
  • Contingent multifactor authentication, whereby transactions flagged as potentially fraudulent result in the cardholder being asked for secondary authentication.

These systems reduce the incidence of fraud and thereby reduce the liability of card issuers. For example, in 2015, payment networks changed the liability rules for U.S. merchants to encourage adoption of EMV cards. Estimates by Visa suggest that merchants that subsequently adopted EMV-compliant point-of-sale (POS) machines experienced an 87.5% reduction in fraud.[16] Nonetheless, as is clear from Section III, fraud remains a problem, especially for cross-border and CNP transactions.

The liability rules summarized above mean that the cost of fraud falls disproportionately on card issuers. In 2020, issuers bore nearly two-thirds of all card fraud losses worldwide.[17] The equitable and economically efficient solution is for issuers to charge higher fees for transactions that are more likely to be fraudulent.

In some cases, it may make sense to pass on some or all of these costs to consumers. In the case of cross-border transactions, some issuers do this by charging foreign-transaction fees on some cards.[18] Such fees can, however, discourage consumers from using their cards, so it may be preferable for merchants to pay higher fees instead. Thus, cards aimed at international travelers typically offer cardholders “no foreign-transaction fee” as a benefit. These cards instead charge a higher interchange fee for foreign transactions. Holders of such premium cards typically spend more, thereby benefiting the merchants (who pay slightly higher fees, if they are not on a blended rate).

V.      Possible Responses to Caps on Cross-Border Interchange Fees

As noted in Section II, the BCCR Task Force made two alternative proposals with respect to cross-border IRFs. The first would leave the current cap unchanged at 2.00%, while the second would reduce the cap to 1.25%.

Even the current cap is lower than the standard IRF charged for many credit cards that offer no foreign-transaction fee. Payments made using such cards in Costa Rica are thus effectively subsidized by merchants in other jurisdictions that do not impose such caps.

At the lower proposed rate, foreign issuers will receive a lower IRF than domestic-card issuers. Given the much higher fraud rate on cross-border payments, this is likely to cause significant problems, especially for premium cards that offer cardholders “no foreign-transaction fee” as well as other benefits, such as vehicle insurance, purchase-protection insurance, and rewards. The IRF revenue simply will not be sufficient to cover these benefits. As such, to reduce fraud, payments using such cards will be subject to greater scrutiny and many may well simply be rejected.

This is a problem not only for the cardholders, who will be frustrated when attempting to make purchases. It is also a problem for Costa Rica’s tourism and business-travel sectors. Consider what might happen when a prospective visitor attempts to book a room at a resort such as Tortuga Lodge, which takes bookings directly on its website and processes payments through its acquirer in Costa Rica.[19] The prospective visitor first tries their World Elite Mastercard and finds that it is rejected; they then try their Visa Infinite card and again find that the payment is rejected. Frustrated but undaunted, they instead decide to book rooms at Tortuga Lodge on Expedia.com, which uses a U.S. acquirer; this time, they have no problem making and paying for the booking, albeit at a higher price than was offered directly by the hotel. When they arrive in Costa Rica, however, they find that, once again, their cards are repeatedly rejected when they attempt to make purchases, whether it be at restaurants, tour agencies, or even an art gallery where they had hoped to buy a beautiful piece of local artwork.

The above scenario might already be happening, because the standard IRF for such transactions on the cards mentioned is higher than the current capped rate of 2.00%.[20] At the alternative lower proposed rate of 1.25%, rejections are a near certainty for at least some travelers. Worse, some prospective travelers who are looking for a more bespoke offering and want to book directly with the hotel are likely to abandon their plans to travel to Costa Rica at all and choose a different destination where they do not encounter such difficulties.

Ironically, prospective visitors who have standard debit or credit cards that charge foreign-transaction fees are much less likely to have their payments rejected.

Some other payment methods are not covered by the caps on MDRs and IRFs: specifically, wire transfers and other bank-to-bank transfers that do not involve the use of payment-card networks. Most likely, there will be a shift toward the use of such payment methods, as a result both of individuals paying directly through such transfers and an increase in payments from overseas agencies. In general, such alternative payment methods involve greater counterparty risk than payments made using cards due to their greater finality, which means it is more difficult to reverse a payment once made, and the lack of purchase insurance. To the extent that visitors to Costa Rica are limited to wire and bank transfers, as a result of their payment cards being declined, they are likely to reduce their spending.

These anecdotes and observations suggest a number of likely effects of the cap on interchange fees:

  • First, booking and payment for accommodation and other pre-bookable tourism activities will shift from Costa Rica-based agents and acquirers to U.S.-based agents and acquirers. This will reduce margins for Costa Rican hotels and other tourism businesses.
  • Second, higher–end tourists will likely spend less in Costa Rica because they will be less able to use their payment cards.
  • Third, there will likely be an overall reduction in high-spending tourists visiting Costa Rica, with a concomitant reduction in total spending.

In 2019, Costa Rica received about 3.1 million visitors who stayed for one night or more, spending about $4 billion, roughly 6.25% of the country’s GDP.[21] The tourism industry employed more than 170,000 people, about 5% of the country’s working-age population.[22] Tourist numbers fell dramatically in 2020 due to the COVID-19 pandemic, leading to a dramatic decline in income and employment. Visitor numbers began to rise again in 2021 and, while total numbers remained below their pre-COVID highs, the number of visitors from the United States (245,000) was not far off the number for 2019 (280,000). In March 2022. Costa Rica announced its national tourism plan for 2022-2027, in which it sought to increase the number of annual visitors to 3.8 million by 2027, targeting tourism revenue of $4.8 billion.[23]

In 2019, Costa Rican merchants processed around 19 million cross-border payment-card transactions, with a total value of around $2 billion—representing about half the total tourism revenue and 16% of the value of all card transactions.[24] After falling in 2020, the number of cross-border payment-card transactions rose in 2021 to nearly 23 million, with a total value of $2 billion, which is consistent with the return of higher-spending tourists from the United States.[25]

If BCCR chooses to cap interchange fees on cross-border transactions at 1.25%, it is likely to impede Costa Rica’s national tourism plan, both by discouraging tourism and, more importantly, by reducing revenue from higher-spending tourists.

VI.    Conclusion

Based on this assessment, there are significant costs associated with caps on cross-border MDRs and IFRs. As noted above, Legislative Decree 9831 permits BCCR to take into consideration such costs to the extent that they affect BCCR’s ability “to guarantee the efficiency and security of the card systems.”[26] As such it is incumbent on BCCR to consider the potential economic harm that is likely to arise if it were to lower the cap on cross-border IFR to 1.25%.

[1] Note, translations from the Spanish original are approximate.

[2] Julian Morris, Regulating Payment Card Fees: International Best Practice and Lessons for Costa Rica, International Center for Law & Economics (May 25, 2022), https://laweconcenter.org/resources/regulating-payment-card-fees-international-best-practices-and-lessons-for-costa-rica.

[3] Jean-Charles Rochet & Jean Tirole, Two-Sided Markets: A Progress Report, 37 Rand J. Econ. 645 (2006); See also Todd J. Zywicki, The Economics of Payment Card Interchange Fees and the Limits of Regulation, International Center for Law and Economics, ICLE Financial Regulatory Program White Paper Series (Jun. 2, 2010), available at http://laweconcenter.org/images/articles/zywicki_interchange.pdf.

[4] Bruno Jullien, Alessandro Pavan, & Marc Rysman, Two-Sided Markets, Pricing, and Network Effects, in Handbook of Industrial Organization (Vol. 4), 485-592 (2021).

[5] Thomas Eisenmann, Geoffrey Parker, & Marshall W. Van Alstyne, Strategies for Two-Sided Markets, Harv. Bus. Rev. (Oct. 2006).

[6] Id., at 33.

[7] Fijación Ordinaria de Comisiones Máximas del Sistema de Tarjetas de Pago 2021, Banco Central de Costa Rica, (Nov. 2021).

[8] Id. at 3.

[9] Alcance No 237 A La Gaceta No 212, Imprenta Nacional de Costa Rica (Nov. 7, 2022).

[10] Decreta: Comisiones Máximas Del Sistema De Tarjetas, No. 9831, Art. 15(j), Legislative Assembly of the Republic of Costa Rica, (“Cualquier otro elemento que razonablemente permita al Banco Central de Costa Rica garantizar la eficiencia y seguridad de los sistemas de tarjetas.”), http://www.pgrweb.go.cr/scij/Busqueda/Normativa/Normas/nrm_texto_completo.aspx?param1=NRTC&nValor1=1&nValor2=90791&nValor3=119755&strTipM=TC (last visited Apr. 12, 2023).

[11]Seventh Report on Card Fraud, European Central Bank 2022 (Feb. 1, 2022), https://www.ecb.europa.eu/pub/cardfraud/html/ecb.cardfraudreport202110~cac4c418e8.en.html#toc1.

[12] Id. SEPA refers to the Single Euro Payments Area.

[13] Id.

[14] Id. EA19 refers to the 19 EU member states that are members of the Euro zone.

[15] Zero Liability Protection, Mastercard (Oct. 17, 2014), https://www.mastercard.us/en-us/personal/get-support/zero-liability-terms-conditions.html; Zero Liability Policy, Visa, https://usa.visa.com/pay-with-visa/visa-chip-technology-consumers/zero-liability-policy.html (last visited Apr. 12, 2023).

[16] Visa EMV Chip Cards Help Reduce Counterfeit Fraud by 87 Percent, Visa (Sep. 3, 2019), https://usa.visa.com/visa-everywhere/blog/bdp/2019/09/03/visa-emv-chip-1567530138363.html.

[17] Card Issuers Accounted for 65.40% of Gross Losses to Fraud Worldwide in 2020, Nilson Report (Dec. 2021), Issue 1209, at 6.

[18] Jacqueline DeMarco & Poonkulali Thangavelu, A Guide to Foreign Transaction Fees, Bankrate.com (Feb. 24, 2023), https://www.bankrate.com/finance/credit-cards/a-guide-to-foreign-transaction-fees.

[19] Author’s personal communication with reservation specialist at Tortuga Lodge, April 2023.

[20] Mastercard 2022–2023 U.S. Region Interchange Programs and Rates, Effective April 22, 2022, Mastercard (2022), available at https://www.mastercard.us/content/dam/public/mastercardcom/na/us/en/documents/merchant-rates-2022-2023-apr22-2022.pdf; Visa USA Interchange Reimbursement Fees, Visa (Apr. 23, 2022), available at   https://usa.visa.com/content/dam/VCOM/download/merchants/visa-usa-interchange-reimbursement-fees.pdf.

[21] OECD Tourism Trends and Policies 2022: Costa Rica, Organisation for Economic Cooperation and Development (2022), https://www.oecd-ilibrary.org/sites/a99a4da2-en/index.html?itemId=/content/component/a99a4da2-en.

[22] Id.; see also, OECD Economic Surveys: Costa Rica 2023, Organisation for Economic Cooperation and Development (2023), https://www.oecd-ilibrary.org/sites/8e8171b0-en/1/2/2/index.html?itemId=/content/publication/8e8171b0-en&_csp_=0b8e1c4cf7b4fb558e396a4008a8398a&itemIGO=oecd&itemContentType=book.

[23] Plan Nacional de Turismo de Costa Rica 2022-2027, Aprobado en la sesión N° 6210 de la Junta Directiva del Instituto Costarricense de Turismo, Apartado 3.II, celebrada (Mar. 21, 2022),English summary: Costa Rica: National Tourism Development Plan 2022–2027, Tourism Analytics, https://tourismanalytics.com/news-articles/costa-rica-national-tourism-development-plan-2022-2027.

[24] Supra note 9, Table 9. Assumes an average Colones:USD exchange rate during 2019 of 0.0017.

[25] Id. The Colones:USD exchange rate averaged around 0.0016 during 2021.

[26] Decreta: Comisiones Máximas Del Sistema De Tarjetas, No. 9831, Art. 15(j), Legislative Assembly of the Republic of Costa Rica, (“Cualquier otro elemento que razonablemente permita al Banco Central de Costa Rica garantizar la eficiencia y seguridad de los sistemas de tarjetas.”), http://www.pgrweb.go.cr/scij/Busqueda/Normativa/Normas/nrm_texto_completo.aspx?param1=NRTC&nValor1=1&nValor2=90791&nValor3=119755&strTipM=TC (last visited Apr. 12, 2023).

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Financial Regulation & Corporate Governance

UK Payment System Regulator Market Reviews: Initial Concerns

ICLE Issue Brief Introduction The UK Payment System Regulator (PSR) is currently in the process of conducting two market reviews related to card payments. One of the two . . .

Introduction

The UK Payment System Regulator (PSR) is currently in the process of conducting two market reviews related to card payments. One of the two regards consumer cross-border interchange fees between the United Kingdom and the European Economic Area (EEA),[1] while the other relates to card scheme and processing fees.[2] This brief raises some initial concerns regarding the two reviews.

The most significant concern these market reviews raise is the implied “market” under investigation. By focusing narrowly on two very specific aspects of the overall payment system, the reviews almost by definition rule out a full analysis of the ecosystem. This is most unfortunate. Decades of research shows categorically that payment systems are highly complex multi-sided markets that have evolved over many decades—and continue to evolve—into a delicately balanced, technologically advanced ecosystem.

Payment systems and the thousands of banks that interoperate over them have invested tens of billions of dollars into their development. These investments, and associated innovations in technologies and the rules governing the systems, have been driven by a decades-long process of dynamic competition. That process has involved not only the main payment-system operators, but also many other businesses involved in payments processing. As a result, billions of consumers are now able to use payment cards and millions of merchants accept them. The system’s economic benefits unquestionably far outweigh the costs.

While it is always possible to conceive of models against which extant payment systems may appear “imperfect,” that does not necessarily mean there is any “market failure”; models are not reality. By considering only very narrow questions relating to specific aspects of the operations of payment systems, the PSR is likely to make inappropriate conclusions.

This brief begins with a description of some of the primary benefits that payment-card systems deliver. Section II offers a description of the economics of payment systems. Section III discusses some common misconceptions regarding payment systems, which have arisen due to misunderstanding the economics that underpins them and failing to appreciate the history and nature of the dynamic competition that explains the existing market structure. Section IV considers the market reviews in the context of the PSR’s overall remit. Section V draws some conclusions.

I. The Benefits of Payment-Card Systems

The PSR acknowledges that payment cards “are critical to the smooth running of the UK economy as they enable people to pay for their purchases and merchants to accept payments for goods and services.”[3] But it is worth spelling out why payment cards are so critical. In no small part, this comes down to the numerous inherent advantages that payment cards and their associated systems have over other types of payment, such as cash and checks. These include: [4]

  • They enable consumers to spend more than they have in their wallet at the time of the purchase, which in turn reduces the amount of cash that they need to withdraw from the bank.
  • Credit cards enable consumers to spend more than they have in their bank accounts at the time of the purchase. Because credit-card issuers typically charge no interest if the statement balance is paid by the due date (usually a month after issuance), cardholders are able to smooth their consumption patterns at much lower cost than if they were required to hold cash in their account or use an overdraft facility.
  • By increasing the ability of consumers to spend, payment cards benefit merchants, who sell more goods and services.
  • Merchants also benefit from reduced costs associated with handling cash, including the need for float and the risk of theft.

Payment cards have been essential to the development of e-commerce and were literally a lifeline during the COVID-19 pandemic, both for consumers and for businesses (especially smaller businesses), when millions of people were unable to leave their homes and primarily purchased essential goods through online merchants.

Figure I: Use of Cash in the UK Since COVID-19

SOURCE: PSR[5]

Despite these benefits, merchants have for decades complained about the prohibitive cost of processing card transactions. As explained below, these complaints reflect a misunderstanding of the nature and benefits of card-payment systems.

II.      The Economics of Payment Systems

A proper economic assessment of any payment system must account for the fact that both merchants and consumers must perceive benefits for such systems to be successful.  If too few merchants accept a particular form of payment, consumers will have little reason to possess it and issuers will have little incentive to issue it. Likewise, if too few consumers possess a form of payment, merchants will have little reason to accept it.

Conceptually, economists describe such situations as “two-sided markets”: consumers are on one side, merchants on the other, and the payment system acts as the platform facilitating interactions between them.7F[6] Other examples of two-sided markets include newspapers, shopping malls, social-networking sites, and search engines.

The challenge for any two-sided market platform is to attract and retain sufficient participants on one side of the market to persuade participants on the other side to adopt and stay on the platform, thereby making the system self-sustaining and maximising the joint net benefits of the platform to all participants.8F[7] To achieve this, platforms must allocate the costs and benefits of the system among the various parties, which is typically done by charging different fees to the different sets of participants on each side of the market in such a way as to create an equitable and efficient balancing.9F[8] Often this means that participants on one side will pay a larger share of the overall costs than participants on the other side.

Take newspapers, which as noted are a classic example of a two-sided market, with consumers on one side, advertisers on the other, and the newspaper acting as the platform in the middle. In essence, advertisers seek to target their adverts to specific consumers, while consumers are mainly interested in reading news, opinions, and other content. A newspaper thus provides content that appeals to consumers so that they read the paper. By attracting readers who might also view advertisements, the newspaper is able to sell advertisements, which help to cover the costs of producing and distributing the newspaper.

In the case of payment-card systems, the larger the number of holders of cards from a particular system (e.g., Visa, Mastercard, or American Express), the larger will be the number of merchants willing to accept cards on that system. Meanwhile, the larger the number of merchants that accept cards on a particular system, the larger will be the number of consumers who wish to hold cards on that system.

Maintaining such a system is challenging and expensive. In no small part, this is because payments are subject to counterparty risks—in particular, risks of default (non-payment), fraud, and theft. This problem so bedevilled early payment cards that many floundered within a few years.[9] The systems that succeeded did so because they figured out how to encourage adoption by both sides of the market and to limit counterparty risk. This entailed the introduction of effective security systems, setting appropriate liability rules, and charging fees that covered all the costs of operating the system. Perhaps most importantly, the systems that flourished were those that realised merchants had stronger incentives than consumers to bear the costs of the system, due to the significant benefits they receive, and introduced fee structures that reflected those incentives.

In three-party card systems, the merchants’ transaction fee is charged directly by the system operator. In four-party systems, merchants pay acquirers a “merchant service charge” (MSC), which includes the acquirer’s processing costs and the “interchange fee.” The default interchange fee is a charge made by the system operator that is paid to the issuer (in the form of a deduction from the amount sent by the issuer to the acquirer when settling the transaction).[10] In addition, the system operator charges fees to both acquirers and issuers, called “scheme” and “processing” fees, that cover the system costs. Figure II, which is taken from the PSR, provides a simplified schematic of the four-party card system. In practice, there are often other parties involved, including payment gateways and payment processors.[11]

Figure II: Simplified Schematic of Four-Party Card Payment System

SOURCE: PSR[12]

As discussed below, the various three- and four-party payment systems have been engaged in a decades-long process of dynamic competition in which each has sought—and continues to seek—to discover how to maximise value to their merchants and consumers. Card-payment systems also compete with other payment methods, including legacy methods such as cash and cheques, as well as the many methods that have emerged more recently, such as online transfers of various kinds. This has involved considerable investment in innovative products, including more effective ways to encourage participation, as well as the identification and prevention of fraud and theft.

Payment-card systems seek to optimise interchange fees to maximise the benefits of the system to participants on both sides of the market. Revenue from these fees thus covers a wide range of things, including: system operations, card issuance, customer service, fraud prevention and resolution, rewards, fraud-protection cover, and car-rental insurance (where these are offered). Moreover, these services are today often offered for free to cardholders (no annual fee) or even at a negative price, such as when rewards are provided. Finance charges on revolving balances also generate substantial revenue, much of which covers the costs of underwriting, servicing, and charge-offs on credit balances.

Similarly, many banks provide free current accounts to those who maintain positive balances (and in some cases even fee-free overdraft facilities up to a limit). The costs of such accounts are covered by other charges, including debit-card interchange fees.

III.    Misunderstanding the Economics of Payment Systems

While it may seem iniquitous for a platform to charge one side of the market more than the other, it is often efficient and ultimately socially beneficial.[13] In the case of payment systems, if the operator sets the price too high for some consumers, they will be unwilling to use the platform; similarly, if the operator sets the price too high for some merchants, they will not be willing to use the platform.

Since one side of the market is typically more price sensitive than the other side, joint net benefits are maximised when participants on the less price-sensitive side of the market incur a greater proportion of the system costs. This enables overall greater participation in the system, thereby achieving greater economies of scale. In the case of card-payment systems, the relatively large benefits merchants receive from accepting cards makes them less price sensitive than consumers, so it makes sense for them to pay a larger share of the transaction fees. This was true even when cards were a tiny fraction of payments and there were few, if any, competing cards for consumers to choose among. This demonstrates that it is not due to any perception among merchants that they lack choice.

The ineluctable benefits of such cross-market subsidies have, unfortunately, often been misconstrued as harmful by regulators, especially in markets where there are few competitors. In many cases, what seems to have happened is that the economies of scale entailed in the development and maintenance of certain systems has meant that only a small number of competing firms can operate efficiently. Regulators typically assume axiomatically, however, that the largest firms in markets with only a small number of competitors have a dominant position that has been created and is reinforced by those firms’ anticompetitive conduct. They thus automatically view all such conduct with suspicion.

Globally, there are many card-payment systems, although most of these operate only at a national level.[14] In the UK, as the PSR notes, two payment systems, Mastercard and Visa, represent the vast majority of consumer-debit and credit-card transactions.[15] But as the history shows, these large market shares were acquired through the development of technologies and rules that limited fraud and other counterparty risk, as well as by improving the efficiency and efficacy of payments, thereby creating enormous benefits to both consumers and merchants. While all markets are imperfect when compared to theoretical models of “perfect competition,” there is simply no evidence of “market failure” that might justify regulatory intervention.

It is also worth noting that, while card payments represent a large proportion of retail payments in the UK, they represent a relatively small fraction of all payments. Table 1 shows the value of payments made using various non-cash methods over the year from November 2021 to October 2022. This excludes higher-value payments settled directly over CHAPS, which accounted for more than £90 trillion in value.[16] As can be seen, the vast majority of payments were made over BACS and the Faster Payments systems, while cards (debit and credit) accounted for only about 11 per cent.

Table 1: Transaction Values of Selected UK Payments Systems, November 2021-October 2022

SOURCES: PayUK[17] and UK Finance[18]

A.      A Brief History of Payment-Card Systems

While merchant-specific charge cards had existed since the early 20th Century, the first multi-merchant payment-card systems in the United States were Diners Club and American Express. These were and in most cases are three-party cards; that is, they operate a closed ecosystem in which they have direct relationships with both merchants and cardholders (Amex now also acts as a third-party provider).[19]

Diners Club began in 1950 as a limited-purpose card that could be used at restaurants.[20] Starting with restaurants in New York City, the card gradually expanded to other cities and other hospitality services before becoming fully multipurpose. In 1953, Diners Club became the first international payment card, with acceptance in the UK, Canada, Cuba, and Mexico. International expansion continued gradually and, by 1967, Diners Club had a presence in 130 countries.

The American Express Card started as an alternative to Travellers’ Cheques, which were an already-popular payment product.[21] From an initial presence in the United States and Canada, American Express expanded its card issuance internationally in 1972.

While numerous banks experimented with their own credit cards, the first truly successful such card venture was BankAmericard, which began in 1958.[22] Initially a three-party card operated exclusively by Bank of America, in 1966, Bank of America began issuing licenses to other banks.[23] In 1970, National BankAmericard became a separate company owned by its member banks and, in 1976, it was rebranded as Visa.[24]

The precursors to Mastercard were regional associations of U.S. banks that had developed in response to restrictions on branch banking in 15 states, which meant that banks could only operate as individual units.[25] In 1966, several of these regional associations formed the Interbank Card Association (ICA), which established the authorisation, clearing, and settlement rules for all the banks in the ICA.[26] In 1969, ICA rebranded its cards as Interbank: the Master Charge card and, in 1979, the ICA became MasterCard.

The history of credit cards in the UK is similar. Finders Services was the first payment-card operator in the nation, launching its charge card here in 1951.[27] In 1962, Finders Services merged with Diners Club, becoming the UK’s first international payment card.[28] Amex followed in 1963.[29] Then, in 1966, Barclays became the first international licensee of BankAmericard, initially launching the Barclaycard as a charge card.[30] The following year, the Bank of England issued the first license to operate a credit card to Barclays and Barclaycard became the UK’s first credit card.[31] Barclaycard became a founding member of International BankAmericard Inc (IBANCO) when that was formed in 1974.[32] In 1977, IBANCO was rebranded Visa.[33] From 1981, Visa International was reorganised into five semi-autonomous international divisions, with their own boards and operational regulations, but subject to framework rules set at headquarters.[34]

The history of Mastercard in the UK is intertwined with Eurocard, which was founded in 1964 in Sweden and moved its corporate base to Belgium in 1965, from where it operated a pan-European not-for-profit association of card-issuing banks.[35] In 1968, Eurocard and the Interbank Card Association formed a strategic alliance. In 1971, Lloyds Bank, Midland Bank, National Westminster Bank, and (slightly later) Royal Bank of Scotland/Williams and Glyn formed a joint venture, the Joint Credit Card Company (JCCC), which launched the Access credit card in 1972.[36] In 1973, Access purchased a 15% share of Eurocard and, the following year, joined the Interbank Card Association.[37] In 1992, MasterCard merged with Europay International (which itself was a merger of Eurocard and Eurocheque).[38] In 1996, MasterCard purchased Access.[39]

B.      Dynamic Competition in Payment Systems

This brief history of the evolution of payment-card systems over the past 70 years shows how those systems gradually expanded. Underpinning that expansion was a process of dynamic competition, with payment networks continuously innovating ways to increase their security, scale, and efficiency. Among the major technological innovations have been:

  • The plastic card (previously, cards had used card stock).
  • Electronic systems for authentication, clearing, and settling transactions.
  • The magnetic stripe (magstripe) and associated data standards, which enabled more secure authentication.
  • The personal identification number (PIN), which was initially developed to enable the use of cards to withdraw cash directly from bank accounts using cash machines.
  • The EMV Chip—developed by a consortium of card networks that initially comprised Eurocard, MasterCard and Visa (EMVCo)—stores card information using public-key encryption technology and sends a one-time token to the POS machine. EMV chips are more difficult to “skim” than magstripes and, because the card number is not shared with the POS machine, dramatically reduce the potential for hackers to steal and use stored card information from merchants.
  • Contactless Tokens (cEMV), which are similar to the tokens produced by EMV Chips and enable similar protections for contactless transactions, whether using a card or a mobile phone.
  • Address verification (AVS), which is mainly used during card-not-present (CNP) transactions, such as telephone and online sales.
  • The card verification code (CVC/CVV), which is a three- or four-digit number unique to the card that is not held in merchant databases, and which is also primarily used during CNP transactions.
  • Two-factor authentication (2FA) entails the use of at least two independent proofs that the card user is legitimate, such as the CVV and a one-time password. 2FA is most commonly used for CNP transactions but is also sometimes used as a second line of defense for point-of-sale (POS) transactions identified as unusual.
  • Machine-learning-based systems that identify potentially fraudulent transactions by comparing transactions in real time with cardholders’ spending patterns, enabling issuers to block transactions.
  • 3D-Secure (3DS), which is an authentication system developed by EMVCo primarily for online transactions. It is a two-stage process: stage one involves using the information sent in the first (authorization) message to check against a cardholder’s profile; if the proposed payment fits the profile, it is permitted, and if not, then the cardholder is asked to complete 2FA on the transaction.[40]

We are now so used to making payments with cards that it is difficult to imagine just how important these innovations have been, let alone the scale of investment that went into them (and the many others, including those that were rejected or discarded). With that in mind, it is worth noting the dramatic impact of the introduction of one of the more recent innovations: contactless cEMV tokens. Over the past decade, these have facilitated a veritable revolution in contactless payments made using cards and cell phones. As Figure III shows, the number of contactless payments in the UK grew from almost nothing to more 1.2 billion by the end of 2021, representing about half of all card-payment-system transactions.

Figure III: Number of Contactless Payment Transactions, UK, 2015-2021 (Millions)

SOURCE: Statista[41]

Contactless payments dramatically reduce the time needed to complete a transaction at checkout, relative to cash or chip and PIN, with clear benefits for both merchants and consumers.[42] During the COVID pandemic, the ability to transact without touching a terminal or signing a payment-authorization slip also reduced the cost and difficulty of complying with rules intended to limit exposure through contact.[43] In addition, cEMV has gradually been integrated into public-transport systems, enabling riders on buses and trains in London, and increasingly across the UK, to use their payment card or mobile phone to tap in and out, eliminating the need for cash or additional transactions.[44]

There have also been many important innovations in incentive systems, the most notable being:

  • Merchant liability for non-authenticated fraudulent transactions above a certain minimum amount, which incentivises merchants to undertake authentication.
  • Prohibiting merchants who accept cards from a payment system from discriminating against that system by imposing surcharges on payments made using that system.
  • Guaranteeing zero liability for card users who have been subject to fraud on certain conditions (such as that the card user has notified the issuer that their card has been stolen).
  • Various forms of insurance, including purchase protection, return protection, extended warranty protection, cell-phone protection, price protection, rental-car liability protection, and travel insurance.
  • Rewards, including cashback and merchant-specific rewards (often on co-branded cards)

By offering these incentives, card issuers encourage adoption and use by cardholders. In addition, merchant-specific rewards encourage loyalty to that merchant. And, importantly, these incentives and technological innovations have been made possible by the system of fees, including most notably the interchange fee but also the scheme fees, processing fees, and acquiring fees.

Furthermore, there have been important business-model innovations over time that have improved the scale efficiency, responsiveness, and effectiveness of the systems. As noted, Visa and Mastercard initially deployed quite different ownership and management models. BankAmericard initially adopted a franchise model and then, from 1970, National BankAmericard/Visa operated as a joint-venture company, thereby overcoming conflicts of interest that arose from one bank acting as an issuer and an acquirer, while also setting the rules of the system for other issuers and acquirers.[45] By contrast, Mastercard and Eurocard both began as non-profit associations, which enabled them rapidly to scale, including by absorbing Access (which until then had operated as a profit-sharing joint venture), but this resulted in management challenges. The merger of Mastercard and Europay International in 1992 addressed some of those problems by creating a more streamlined structure and a more coherent global brand. Then, in 2006, MasterCard reorganised as a for-profit company and listed on the New York Stock Exchange through an initial public offering, enabling more centralised decision-making. In 2008, Visa also listed on the NYSE.

In short, the two largest global-payment systems emerged, survived, and thrived first and foremost by identifying and implementing superior solutions to the challenges of building and maintaining payment systems locally, nationally, regionally, and eventually, globally.

The large market share of these two firms operating at a global level is clearly not a consequence of some pre-existing market structure. On the contrary, the structure of the market for payments is a consequence of dynamic competition in technology, incentives, and business models.

C.      The Ongoing Process of Dynamic Competition

This dynamic competition continues, with innovative technologies and new global players emerging and deploying different business models. For example, PayPal offers users the ability to pay for services and goods purchased online and provides them with some of the same protections offered by credit cards, such as fraud monitoring and purchase protection.[46] PayPal operates a dual model in which users may fund payments either using their payment card or by making an ACH transfer to their PayPal account.[47] PayPal also offers users the ability to “buy-now-pay-later” (BNPL) at some merchants, with options either to make four bi-weekly payments with zero interest, or to spread the payment over a longer period (6, 12, 18, or 24 months), paying an interest rate that currently ranges from 0% to 29.99%, depending on the user’s credit score.[48]

In the past decade, several standalone BNPLs have entered the market, including Afterpay, Affirm, Flexpay, Klarna, Sezzle, Splitit, and Zip.[49] In 2021, merchant-payment-gateway provider Square purchased Afterpay, enabling the use of BNPL for in-store purchases in the United States.[50] In the UK, Square has partnered with BNPL provider ClearPay, enabling it to provide a similar offering.[51] Meanwhile, Stripe, another gateway provider, has partnered with several BNPL companies, enabling it to make similar offerings in several countries, including the UK.[52]

When offering zero-interest payment solutions to consumers, BNPLs typically charge the retailer a transaction fee of between 2% and 8%, depending on the consumer’s credit score and the type of merchant.[53] In the United States, Square/Afterpay charges the purchaser a standard rate of 6% plus a transaction fee of 30c.[54] By contrast, when offering longer-term payment solutions, the merchant pays a transaction fee and the consumer pays the interest.[55]

In addition to consumer-oriented BNPLs, there are business-to-business BNPLs. For example, in the UK, Funding Circle’s Flexipay (not to be confused with Flexpay or Payflex, a South African BNPL) offers loans of between £2,000 and £250,000, with the ability to spread payments over three months at an interest rate of 3% (as of the time of writing).[56]

Another example is real-time payments (RTP) systems, such as the UK’s Faster Payment System, which enable users to make near-instant peer-to-peer payments online and using mobile apps.[57] RTP systems typically do not replicate the fraud-protection and other counter-party risk offerings of traditional payment cards, nor do they enable consumers to defer payment, so they are likely less attractive than payment cards for making payments to merchants—especially when those merchants are unfamiliar and/or the size of the payment is large.[58] While the UK’s Confirmation of Payee system has somewhat reduced problems—such as, as the PSR notes,[59] automated push payment (APP) fraud—APP fraud remains very high, leading the PSR to propose that payment-service providers (PSPs) guarantee refunds for fraudulent payments in excess of £100.[60] Such a requirement would impose considerable additional costs on PSPs. By effectively transferring a considerable proportion of liability to those PSPs, it also would reduce payors’ incentives to undertake due diligence on payees. This, in turn, might lead PSPs to introduce more extensive screening of payments, which could well lead to overinclusive restrictions that harm smaller, less well-known but nonetheless legitimate payees.

At the same time, card issuers and payment systems continue to invest in improved methods for verifying the identity of persons making transactions, including most notably the development and deployment of a range of biometric technologies.[61] Meanwhile, many payment-card issuers are partnering with BNPL operators to provide alternative payment options for cardholders.[62]

IV.    The Market Reviews in the Context of the PSR’s Remit

Unfortunately, there is no evidence that the PSR intends to investigate the broader market for payments in the UK, of which payment cards represent only about 11%.[63] Instead, it has proposed to undertake two discrete reviews of very specific and narrow aspects of payments card systems’ operations, seemingly without any intention to consider the implications on the wider ecosystem. This seems doomed to draw inappropriate conclusions.

This section outlines the PSR’s remit and then discusses the two market reviews in the context of that remit, taking into consideration the foregoing discussion of the nature of payment systems and the dynamic competition that has driven their evolution.

A.      The PSR’s Remit

Section 49 of the Financial Services (Banking Reform) Act 2013 (FSBRA) states that “In discharging its general functions relating to payment systems the Payment Systems Regulator must, so far as is reasonably possible, act in a way which advances one or more of its payment systems objectives.”[64] It then lists three objectives: (a) the competition objective, (b) the innovation objective, and (c) the service-user objective, which are defined in the subsequent sections.[65]

Section 50 (1) of the FSBRA states that: “The competition objective is to promote effective competition in—(a) the market for payment systems, and (b) the markets for services provided by payment systems, in the interests of those who use, or are likely to use, services provided by payment systems.”

Section 50 (2) of the FSBRA states that: “The reference in subsection (1) to promoting effective competition includes, in particular, promoting effective competition— (a) between different operators of payment systems, (b) between different payment service providers, and (c) between different infrastructure providers.”

Section 50 (3) of the FSBRA states that:

The matters to which the Payment Systems Regulator may have regard in considering the effectiveness of competition in a market mentioned in subsection (1) include—

  • the needs of different persons who use, or may use, services provided by payment systems;

  • the ease with which persons who may wish to use those services can do so;

  • the ease with which persons who obtain those services can change the person from whom they obtain them;

  • the needs of different payment service providers or persons who wish to become payment service providers;

  • the ease with which payment service providers, or persons who wish to become payment service providers, can provide services using payment systems;

  • the ease with which payment service providers can change the payment system they use to provide their services;

  • the needs of different infrastructure providers or persons who wish to become infrastructure providers;

  • the ease with which infrastructure providers, or persons who wish to become infrastructure providers, can provide infrastructure for the purposes of operating payment systems;

  • the needs of different operators of payment systems;

  • the ease with which operators of payment systems can change the infrastructure used to operate the payment systems;

  • the level and structure of fees, charges or other costs associated with participation in payment systems;

  • the ease with which new entrants can enter the market;

  • how far competition is contributing to the development of efficient and effective infrastructure for the purposes of operating payment systems;

  • how far competition is encouraging innovation.

Section 51 (1) of the FSBRA states that: “The innovation objective is to promote the development of, and innovation in, payment systems in the interests of those who use, or are likely to use, services provided by payment systems, with a view to improving the quality, efficiency and economy of payment systems.” While Section 51 (2) states that: “The reference in subsection (1) to promoting the development of, and innovation in, payment systems includes, in particular, a reference to promoting the development of, and innovation in, infrastructure to be used for the purposes of operating payment systems.”

Section 52 of the FSBRA states that: “The service-user objective is to ensure that payment systems are operated and developed in a way that takes account of, and promotes, the interests of those who use, or are likely to use, services provided by payment systems.”

It is thus clear that, in principle, the PSR has a broad remit to investigate the functioning of payment systems. As such, it could undertake a broad review that considers the dynamic competition described earlier in this brief.

B.      The Market Reviews

Despite the PSR’s broad remit, it has chosen instead to undertake two very narrow market reviews. There is a grave danger that, in so doing, it will misconstrue the nature of the market for payments.

One is reminded of the rather wonderful 1986 “points of view” TV advertisement for The Guardian newspaper.[66] The ad began with a brief clip, from one angle, of a skinhead apparently running away from something. This was followed by a clip of the skinhead from another angle which shows him apparently trying to steal a besuited gentleman’s briefcase. Then, finally, we were shown an aerial view in which one can see that the skinhead is actually trying to save the other man from being crushed by a pallet of falling bricks. The point being that, if a policeman or other bystander had intervened to stop the skinhead on the presumption that he had committed or was about to commit a crime, based on seeing the situation only from the perspective of the first or second clips, the man in the suit might well have died or been grievously injured. As the advert notes at the end, “It’s only when you get the whole picture you can fully understand what’s going on.”

1.        Market review of UK-EEA cross-border interchange fees

In the case of the market review of UK-EEA consumer cross-border interchange fees, the PSR states:

We want to understand the rationale for and the impact of the rises in CNP IF levels for UK-EEA consumer debit and credit CNP transactions. We are concerned that the ability of Mastercard and Visa to increase these fees is an indication that there are market(s) which are not working well and may not support our statutory competition, innovation or service-user objectives.[67]

Here, the PSR seems to have assumed that an increase in prices is prima facie evidence of market failure. But a mere rise in prices does not provide such evidence. The fact is that, following the introduction of the IFR and prior to Brexit, the IFs were set by the EU, not by the market. Since then, domestic rates have been regulated at the same levels,[68] making it more likely that those IFs were (and, within the EEA, still are) not set at a level that reflects an optimal balance for the payments ecosystem.

Where prices for CNP IFs are set by market participants, they are generally higher than for card-present transactions. This is a straightforward consequence of the higher risks of fraud associated with CNP transactions.[69] Meanwhile, in markets where IFs for international transactions are set by market participants, those IFs include a premium to cover additional costs associated with operating the international system, as well as the higher counterparty risks (fraud and default) associated with such transactions. This leads to two conclusions:

  1. The appropriate prima facie assumption of the PSR, in response to the increase in IFRs for UK-EEA CNP transactions, should have been that it is a sign that the market is working well—e., the very opposite of the assumption that the PSR seems to have made.
  2. To investigate the appropriateness or otherwise of any IFR, it is necessary to understand fully the market in which it is being applied. In this case, the market is the entire global payments system, since UK-EEU transactions are but a tiny fraction of that system, which as discussed above has evolved over decades. At the very least, it entails a full analysis of both CNP and UK-EEA payments systems, not merely the narrow aspect of (and costs associated with) UK-EEA interchange fees.

2.        Market review of card scheme and processing fees.

In the case of the market review of cards’ scheme and processing fees, the PSR states:

We found that scheme and processing fees (which we referred to as ‘scheme fees’ in the market review) paid by acquirers increased significantly over the period 2014 to 2018 as shown in Figure 1.5 We also found that a substantial proportion of these increases are not explained by changes in the volume, value or mix of transactions.[70]

The PSR has decided emphatically to focus narrowly on how Mastercard and Visa set scheme and processing fees:

We will assess the factors that may influence and constrain how Mastercard and Visa set scheme and processing fees, and the impact of this. Such factors may include:

  • The extent of any barriers to entry or network effects involved in setting up and running card payment systems, which alone or in combination may mean that Mastercard and Visa face limited constraints when it comes to setting scheme and processing fees.

  • Whether Mastercard and Visa have a ‘must take’ status for merchants, which may mean that Mastercard and Visa face limited constraints from the ability of merchants (and their acquirers) to exercise choice about their acceptance when setting acquirer scheme and processing fees.[71]

Meanwhile, the PSR has already ruled out any consideration of the wider payments ecosystem, noting:

A number of comments in the consultation asked us to consider extending the market review to charges levied by other participants in the payments ecosystem (other card schemes, and other payment methods, including digital wallets). We agree that constraints from other participants and other payment methods could play an important role in Mastercard’s and Visa’s decisions about card scheme and processing fees. The scope of the market review we proposed in our draft ToR, however, would assess competitive constraints that may arise from other participants than Visa and Mastercard, to the extent this applies. We, therefore, do not think that it is necessary to extend the scope of the market review; and so, our market review will focus on card scheme and processing fees.[72]

This is troubling because, as discussed above, the payment systems in the UK and globally have evolved over many decades in such a way as to balance the two sides of the market: merchants on one side and consumers on the other. The fees charged by payment systems reflect this balance, not only within the card-payments ecosystem but also within the wider payments ecosystem of which card payments are only a relatively small part—about 11% in the UK.[73] Moreover, the scheme fees that appear to be a specific focus of the market review are only a small part of the total fees paid during a transaction. Visa offers the following example: when a consumer purchases a jumper for £30 at a small retailer using a Visa card, the MSC would be around £0.63, of which the scheme fee would be about £0.01.[74] So, the question is: why is the PSR focusing on a fee that makes up only 1.6% of the transaction fee and only 0.03% of the total transaction amount?

By seeking to investigate only a subset of card fees and not all the fees—which would necessitate also considering the effects of any adjustments to such fees on related offerings (such as rewards and cobranded cards, insurance, security upgrades, and new payment modes), let alone the wider payments ecosystem)—the PSR precludes a proper analysis of whether the market is operating efficiently.

In sum, intentionally or otherwise, the statements made by the PSR with respect to the terms of reference (ToR) for both market reviews look very much like the regulator has already decided its conclusions and is now looking for evidence to support its case, while expressly avoiding evidence that might point to other conclusions. They are classic examples of asking the wrong question and therefore getting the wrong answer.

V.      Conclusions

Payment systems have developed through a process of dynamic competition that has led to the emergence of extraordinarily complex and finely balanced ecosystems featuring an increasingly wide array of innovative technologies, incentives, and business models. As such, it is a little odd that the PSR should have chosen to undertake several discrete and very narrow reviews, rather than a more comprehensive review.

If the PSR were to undertake a more comprehensive review of payments, which would be more consistent with its remit under the FSBR, it might extend that to the wider payments ecosystem, of which card payments are only a relatively small part—approximately 11% in the UK, if larger payments made over CHAPS are excluded.

Despite stating—in the final ToR for the market review of card schemes and processing fees—that it does not intend to extend the market review, it left a window open by stating: “We expect our thinking to develop over the course of the market review, including the possibility that further issues or areas of analysis are added (if they relate to potential harm to competition, innovation or service users) or some issues are dropped.”[75] One can only hope that such thinking extends to a fuller examination of the payments ecosystem. If the PSR were to adopt such an approach, it might also drop the even more absurdly narrow market review of UK-EEA consumer cross-border interchange fees, a fuller (proper) review of which would entail looking not only at payments in the UK, but also internationally.

 

[1] Market Review of UK-EEA Consumer Cross-Border Interchange Fees, Payment System Regulator (Jun. 21, 2022), https://www.psr.org.uk/publications/market-reviews/mr22-2-1-market-review-of-uk-eea-consumer-cross-border-interchange-fees.

[2] Market Review of Card Scheme and Processing Fees, Payment System Regulator (Jun. 21, 2022), https://www.psr.org.uk/publications/market-reviews/mr22-1-1-market-review-of-card-scheme-and-processing-fees.

[3] Id.

[4] Todd J. Zywicki, The Economics of Credit Cards, 3 Chap. L. Rev. 79, 7 (2000), available at https://digitalcommons.chapman.edu/chapman-law-review/vol3/iss1/6.

[5] Snapshot of Payments in the UK Over Time, Payment Systems Regulator (Jan. 2, 2022), available at https://www.psr.org.uk/media/20ob5wee/payments-over-time.pdf.

 

[6] William F. Baxter, Bank Interchange of Transactional Paper: Legal and Economic Perspectives, 26 J. L. & Econ. 541 (1983); Jean-Charles Rochet & Jean Tirole, Two-Sided Markets: A Progress Report, 37 Rand J. Econ. 645 (2006); see also, Todd J. Zywicki, The Economics of Payment Card Interchange Fees and the Limits of Regulation, International Center for Law & Economics, ICLE Financial Regulatory Program White Paper Series (Jun. 2, 2010), available at http://laweconcenter.org/images/articles/zywicki_interchange.pdf.

[7] Bruno Jullien, Alessandro Pavan, & Marc Rysman, Two-Sided Markets, Pricing, and Network Effects, 4 Handbook of Indus. Org. 485-592 (2021).

[8] Thomas Eisenmann, Geoffrey Parker, & Marshall W. Van Alstyne, Strategies for Two-Sided Markets, Harv. Bus. Rev. (Oct. 2006), https://hbr.org/2006/10/strategies-for-two-sided-markets.

[9] David L. Stearns, Think of it as Money: A History of the VISA Payment System, 1970–1984, PhD Thesis, University of Edinburgh, at 42–43; Timothy Wolters, Carry Your Credit in Your Pocket: The Early History of the Credit Card at Bank of America and Chase Manhattan, 1 Enterprise & Society 315, (2000).

[10] In some cases, the interchange fee is established bilaterally by agreement between issuers and acquirers. The default interchange fee applies when such agreements are not in place.

[11] See, e.g., UK Payment Processing Companies & Merchant Account Providers, MerchantSavvy, https://www.merchantsavvy.co.uk/payment-processors (last visited Feb. 22, 2023).

[12] PSR, supra note 1, at 13.

[13] Zywicki, supra note 6.

[14] For example, 10 EU members had a domestic card scheme in 2018: Card Payments in Europe- Current Landscape and Future Prospects, European Central Bank (Apr. 2019), https://www.ecb.europa.eu/paym/intro/mip-online/2019/html/1904_card_payments_europe.en.html.

[15] PSR, supra note 2, at 7.

[16] Payment and Settlement Statistics, Bank of England (Feb. 16, 2023), https://www.bankofengland.co.uk/payment-and-settlement/payment-and-settlement-statistics.

[17] BACS Monthly Volumes and Values 1990-2022, Pay.uk (2023), https://newseventsinsights.wearepay.uk/media/iyral1oo/historical-monthly-payment-statistics-1990-to-dec-2022.xls.

[18] Card Spending, UK Finance (Feb. 16, 2023), https://www.ukfinance.org.uk/data-and-research/data/card-spending.

[19] Emily Sherman & Holly Johnson, Understanding Third-Party American Express Cards, credicards.com (Mar. 30, 2022), https://www.creditcards.com/card-advice/american-express-third-party-cards.

[20] Diners Club History, Diners Club International, https://www.dinersclub.com/about-us/history (last visited Feb. 22, 2023).

[21] Who We Are, American Express, https://about.americanexpress.com/our-company/who-we-are/who-we-are/default.aspx (last visited Feb. 22, 2023).

[22] Stearns, supra note 9.

[23] Id.

[24] Id.

[25] Dave Ahern, The Amazing Story of Mastercard: History and Making Money, eB (Nov. 10, 2021), https://einvestingforbeginners.com/the-history-of-mastercard-daah/#:~:text=of%20America%2C%20ironically.-,How%20Did%20Mastercard%20Start%3F,became%20known%20globally%20as%20Visa.

[26] Brand History, Mastercard, https://brand.mastercard.com/brandcenter/more-about-our-brands/brand-history.html (last visited Feb. 22, 2023).

[27] 1963: American Express Comes to Britain, BBC, http://news.bbc.co.uk/onthisday/hi/dates/stories/september/10/newsid_3031000/3031968.stm (last visited Feb. 22, 2023).

[28] Id.

[29] Id.

[30] Stearns, supra note 9, at 120.

[31] BBC, supra note 27.

[32] Stearns, supra note 9, at 120.

[33] Id. at 131.

[34] Id. at 180.

[35] Eurocard (Credit Card), Wikipedia, https://en.wikipedia.org/wiki/Eurocard_(credit_card) (last visited Feb. 22, 2023).

[36] History 1966-72, Access, https://www.accesscreditcard.info/history66-72.aspx (last visited Feb. 22, 2023).

[37] History 1973-77, Access, https://www.accesscreditcard.info/history73-77.aspx (last visited Feb. 22, 2023).

[38] Paul Doocey, MasterCard and Europay Merge to Form a Global Payments Company, BankTech (Jul. 16, 2002), https://www.banktech.com/payments/mastercard-and-europay-merge-to-form-a-global-payments-company/d/d-id/1288945.html.

[39] Sean Brierley, Mastercard and UK Banks Strike 40m Access Deal, MarketingWeek (Apr. 19, 1996), https://www.marketingweek.com/mastercard-and-uk-banks-strike-40m-access-deal.

[40] EMV 3-D Secure, EMVCo, https://www.emvco.com/emv-technologies/3-d-secure (last visited Feb. 22, 2023).

[41] Raynor de Best, Total Number of In-Store Debit or Credit Card Payments that Are Contactless, or Done with NFC, in the United Kingdom (UK) from January 2015 to October 2021, Statista (Jan. 11, 2023), https://www.statista.com/statistics/488054/number-of-contactless-cards-transactions-united-kingdom.

[42] David Bounie & Youssouf Camara, Card-Sales Response to Merchant Contactless Payment Acceptance, 119 J. of Banking & Fin. 105938 (Oct. 2020), available at https://www.sciencedirect.com/science/article/abs/pii/S0378426620302004; Emma Marie Fleck & Michael E. Ozlanski, Cash: Never Leave Home with It? 17 The CASE J. 182–201 (2021), available at https://www.emerald.com/insight/content/doi/10.1108/TCJ-06-2019-0055/full/html.

[43] Adrian Buckle, The Impact of Covid-19 on UK Card Payments In 2020, UK Finance (Jun. 16, 2021), https://www.ukfinance.org.uk/news-and-insight/blogs/impact-covid-19-uk-card-payments-2020.

[44] UK’s First Major Rollout of CEMV Outside of London Commences in Oxfordshire, VIX Technology (Nov. 14, 2016), https://vixtechnology.com/press-release/uks-first-major-rollout-of-cemv-outside-of-london-commences-in-oxfordshire; Dan Balaban, UK Transit Agency Plans London-Style Multimodal Contactless System with Fare Capping, Mobility Payments (Sep. 12, 2022), https://www.mobility-payments.com/2022/09/12/uk-agency-plans-london-style-multimodal-contactless-system-with-fare-capping.

[45] Stearns, supra note 9.

[46] Protection You Need, Peace of Mind You Deserve, PayPal, https://www.paypal.com/us/webapps/mpp/paypal-safety-and-security (last visited Feb. 22, 2023).

[47] Add Cards and Banks, PayPal, https://www.paypal.com/us/digital-wallet/ways-to-pay/add-payment-method (last visited Feb. 22, 2023).

[48] Buy Now, Pay Later with PayPal, PayPal, https://www.paypal.com/us/digital-wallet/ways-to-pay/buy-now-pay-later (last visited Feb. 22, 2023).

[49] Erin Gregory, How Does Buy Now Pay Later (BNPL) Work for Businesses?, Techradar (Mar. 4, 2022), https://www.techradar.com/features/how-does-buy-now-pay-later-bnpl-work-for-businesses; Jaros?aw ?ci?lak, Top 10 Buy Now Pay Later Companies to Watch in 2022, Code & Pepper (May 8, 2022), https://codeandpepper.com/buy-now-pay-later-2022.

[50] Square, Inc. Announces Plans to Acquire Afterpay, Strengthening and Enabling Further Integration Between Its Seller and Cash App Ecosystems, Square (Aug. 1, 2021), https://squareup.com/us/en/press/square-announces-plans-to-acquire-afterpay; Bring in More Business with Buy Now, Pay Later, Square, https://squareup.com/us/en/buy-now-pay-later (last visited Feb. 22, 2023).

[51] John Stewart, As Consumers Embrace BNPL, Square Brings It to the U.K. Across All Platforms, Digital Transactions (Aug. 23, 2022), https://www.digitaltransactions.net/as-consumers-embrace-bnpl-square-brings-it-to-the-u-k-across-all-platforms.

[52] Buy Now, Pay Later, Stripe, https://stripe.com/docs/payments/buy-now-pay-later (last visited Feb. 22, 2023).

[53] Id.

[54] Bring in More Business with Buy Now, Pay Later, Square, https://squareup.com/us/en/buy-now-pay-later (last visited Feb. 22, 2023).

[55] Id.

[56] Free Your Cash Flow with Flexipay, Funding Circle, https://www.fundingcircle.com/uk/payments/flexipay (last visited Feb. 22, 2023).

[57] £1 Million Faster Payments Now Possible, Pay.UK (Feb. 10, 2022), https://newseventsinsights.wearepay.uk/media-centre/press-releases/1-million-faster-payments-now-possible.

[58] Julian Morris, Is Pix Really the End of Credit Cards?, Truth on the Market (Sep. 28, 2022), https://truthonthemarket.com/2022/09/28/is-pix-really-the-end-of-credit-cards.

[59] PSR Finalizes Plans for Wider Implementation of Fraud Prevention Tool, Confirmation of Payee, Payment Systems Regulator, https://www.psr.org.uk/news-and-updates/latest-news/news/psr-finalises-plans-for-the-wider-implementation-of-fraud-prevention-tool-confirmation-of-payee/#:~:text=account%20to%20another.-,Confirmation%20of%20Payee,details%20provided%20by%20a%20payer (last visited Feb. 22, 2023).

[60] PSR Sets Out Proposals to Give Greater Protection Against APP Scams, Payment Systems Regulator (Nov. 25, 2022), https://www.psr.org.uk/news-and-updates/latest-news/news/psr-sets-out-proposals-to-give-greater-protection-against-app-scams.

[61] MasterCard Biometric Card Driving Cardholder Security and Convenience, MasterCard, https://www.mastercard.us/en-us/business/overview/safety-and-security/authentication-services/biometrics/biometrics-card.html (last visited Feb. 22, 2023); Fingerprint Authentication Moves from Phones to Payment, Visa, https://usa.visa.com/visa-everywhere/security/biometric-payment-card.html (last visited Feb. 22, 2023).

[62] Kimberly Palmer & Melissa Lambarena, Buy Now, Pay Later Already Comes Standard on Many Credit Cards, Nerdwallet (Dec. 9, 2022), https://www.nerdwallet.com/article/credit-cards/buy-now-pay-later-is-already-standard-on-some-credit-cards.

[63] Supra Section III.

[64] Financial Services (Banking Reform) Act 2013, c. 33, §49 (UK).

[65] Id.

[66] The Guardian, Cannes Lion Award-Winning “Three Little Pigs Advert”, YouTube (Feb. 29, 2012), https://www.youtube.com/watch?v=_SsccRkLLzU.

[67] PSR, supra note 1, at 7.

[68] The Interchange Fee (Amendment) (EU Exit) Regulations 2019, SI 2019/284, https://www.legislation.gov.uk/uksi/2019/284/contents.

[69] Board of Governors of the Federal Reserve System, Changes in U.S. Payments Fraud from 2012 to 2016, Federal Reserve (Oct. 2018), https://www.federalreserve.gov/publications/2018-payment-systems-fraud.htm.

[70] PSR, supra note 2, at 5.

[71] Id. at 10.

[72] Id. at 7.

[73] See Section III above.

[74] Paying with Visa: How Retailers and Consumers Benefit, Visa (Oct. 22, 2020), https://www.visa.co.uk/visa-everywhere/blog/bdp/2020/10/20/what-happens-when-1603211979840.html.

[75] PSR, supra note 1, at 11.

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Financial Regulation & Corporate Governance

Consumer Protection in the 21st Century

ICLE Issue Brief Executive Summary How do we know whether an apple we buy is safe to eat; whether the pound of butter on sale is really a . . .

Executive Summary

How do we know whether an apple we buy is safe to eat; whether the pound of butter on sale is really a pound (or really butter); whether our cell phone will blow up in our hands or send all of our data to the government; or whether a taxi driver will overcharge us (or worse)? Concerns such as these have driven the creation of consumer-protection laws. But with the emergence of new ways of sharing information and rating suppliers, do we still need such laws?

This brief describes the origin, development, and implications of government-mandated consumer-protection laws and contrasts these with emergent, bottom-up solutions of various kinds, especially those made possible by the internet. Section I offers a brief history of consumer-protection legislation and its effects. Section II discusses some traditional alternatives to such top-down controls, including contract law and reputation. Section III explains the growth of the regulatory state. Section IV describes some modern alternatives to regulation that have been made possible by the internet. Section V offers examples of how the regulatory state has reacted to these new alternatives. Section VI addresses some of the major criticisms of online information sharing. Finally, Section VII concludes.

I.              A Brief History of Consumer-Protection Legislation

Consumer-protection legislation is nothing new. The Babylonian code of Hammurabi, written in about 1760 BC, set prices for various goods and services, ranging from a medical operation to a ship’s rent.[1] It also set “prices” for various harms, including theft and injuries (for example, rule number 196 states: “If a man puts out the eye of another man, his eye shall be put out.”). Roman emperors introduced various regulations to standardize weights and measures,[2] which were replicated in various guises by medieval monarchs and local governments. Some of these laws established very specific requirements. Henry III’s Assisa panis et cervisia (“Assize of bread and ale”), promulgated throughout England in 1256, regulated the sale price of bread and ale of varying quantities.[3] Meanwhile, in Bavaria, the Rienheitsgebot of 1516 specified that only hops, barley, and water may be used to produce beer.

A.      Perverse Effects of Early Consumer-Protection Regulation

While notionally justified on the grounds that they protected consumers, these laws often had the opposite effect: protecting incumbents against competition, driving up prices, and impeding innovation.

Under the Assisa, the prices of standard loaves of “wastrel” bread were fixed at a farthing (a quarter penny) and half-penny, but local authorities would vary the size of the loaf based on the prevailing cost of inputs, particularly the price of wheat.[4] Thus, when wheat prices rose, the mandated size would fall, and vice versa. Most towns had only a small number of bakers, however, and they sometimes would conspire with local authorities to set quantities at levels that created supernormal profits, to the detriment of consumers.[5] But this was not ubiquitous; in some towns, the level was set infrequently, with the result that, when wheat prices peaked, the level would be too high and bakers would have no incentive to bake, leading to artificial shortages of bread.[6]

Until 1987, when the European Court of Justice ruled that it violated the principle of the free movement of goods,[7] the Reinheitsgebot had been amended only once in nearly 500 years.[8] Following the ECJ decision, imported beers not compliant with the Reinheitsgebot could be sold in Germany, but German producers are still largely bound by the law. In 1993, Germany amended the Reinheitsgebot, leading to the adoption of modern craft-beer techniques—but with few exceptions, those beers still cannot be called beer.[9] As a 2016 article notes, “until the arrival of craft beers, the most recent innovation in German brewing was the advent of the very successful Pilsner in the 19th century.”[10]

B.      Origins of the Regulatory State

During the 19th century, advances in science and industry dramatically improved the accuracy of measurement—leading to better, more reliable standards, as well as better means of detecting potentially harmful additives. At the same time, industrialization and urbanization resulted in a proliferation of mass-produced processed foods. Many of these contained “adulterants” of various kinds, which reduced the quality of the food and some of which were harmful.

Following a series of studies by Arthur Hill Hassall on instances of adulteration, published in The Lancet in the early 1850s,[11] Parliament launched a select committee on the issue in 1855. Between 1860 and 1875, Parliament passed a series of acts intended to address the problem of food adulteration,[12] culminating in the Sale of Food and Drugs Act of 1875. These acts established strict rules prohibiting the use of “injurious ingredients” in food and drugs, required local governments to appoint analysts to sample food and drugs for sale in their jurisdictions, and empowered those same governments to prosecute merchants for violating the act.[13]

The Safe Food and Drug Act was the first comprehensive legislation of its kind and arguably was a foundational moment in the establishment of the regulatory state. Other legislatures followed suit with similar laws, including the U.S. Pure Food and Drug Act of 1906.[14] And in Britain and elsewhere, the model of establishing strict rules and empowering agencies to enforce them became pervasive.

C.      Regulation Gets a Red Flag

While various consumer-protection laws typically have been enacted on the premise that they would protect consumers, like the Assisa and the Reinheitsgebot, they have often had the unintended effect of limiting supply and undermining incentives to innovate, harming the very consumers they are intended to benefit. One of the most blatant examples of this was Britain’s Locomotives Act 1865—better known as the “Red Flag Act.” The law limited the speed of self-propelled vehicles on public roads to 4 mph in the countryside and 2 mph in towns, and required that a person walk in front of each vehicle carrying a red flag.[15] Far from protecting consumers, the act had the effect of denying consumers access to a desirable technology. In the 1860s, the vehicles on the roads were heavy, steam-powered contraptions. By disincentivizing innovation, the law likely held up the development in the United Kingdom of better, faster, lighter, and less expensive automobiles that used alternative means of propulsion until 1896, when the speed limit was raised to 12 mph and the red-flag requirement rescinded.[16]

II.            Contract, Reputation, and Brands as Consumer Protection

Fortunately, these public laws were not the only sources of consumer protection. Indeed, actual protection mainly came from two other sources: private law and public reputation.

A key element of consumer protection has been the existence of warranties, enforceable against a manufacturer and/or vendor, that a product will do what it says it will do. Since Babylonian times, consumers have been protected by laws that impose liability on sellers for fraud.[17] These early laws were likely quite narrow in scope, but they were broadened over time.

First, there was a shift toward a more formal concept of contract formation being by agreement between private parties, rather than being primarily subject to rules set in code. Thus, in Roman Law, parties to certain kinds of contracts could include express warranties if the contract was made face-to-face.[18] During the early phases of the Industrial Revolution, English law adopted a somewhat broader notion of consensus ad idem (“agreement [by both parties] to the [same] thing”—often abbreviated to “a meeting of minds”) as the basis for private contract,[19] along with the principle of caveat emptor (“buyer beware”).[20] Meanwhile, courts in England and other common-law jurisdictions, including the United States, gradually imputed terms into contracts pertaining to the quality of products sold, such as requirements that the products be “of merchantable quality” and “fit for purpose.”[21] Companies also developed express warranties that went beyond those imputed by judges.[22]

This combination of express and implied warranties created strong incentives on the part of producers to ensure that the goods and services they sell conform with buyers’ expectations. Meanwhile, implied warranties notwithstanding, the general principle of caveat emptor creates strong incentives for consumers to ensure that a product is appropriate for the intended use and to obtain express warranties to that effect. As George Winder explains:

In this Australian case some young ex-service men had rented a threshing machine and undertaken contracts to thresh wheat. The machine had not worked satisfactorily and had finally broken down. Whereupon, the young men sued the owner for the loss they had sustained by reason of the defective machine. There was much sympathy for the young men, and most people in the little town thought they were bound to win their case. They told the Magistrate how in good faith they had rented this machine to do a job of threshing for which it had been built, but it had let them down. To their surprise, the Magistrate, although most sympathetic, pronounced the fatal words “Caveat emptor,” of which they had never heard, and gave the case to the defendant.

The good people who had listened to the case were inclined to agree that “the law was an ass” and to hope that they might never be subject to court action.

Eventually, it appeared that the law was right. The thresher had been used with a very powerful engine entirely unsuited for the job and this had caused the breakdown. This fact had not been known to the Magistrate but, by accepting the principle, “Caveat emptor,” he had reached the right verdict. The young men should have known that the thresher would not work with such an engine and should not have hired it. Having done so, they were not entitled to claim damages against the owner when the machine failed them.[23]

In addition to the obligations associated with express and implied warranties, companies have strong incentives to avoid harming their consumers to ensure repeat business and avoid reputational damage. A notable instance of this is Crosse and Blackwell, a prominent U.K. food processor that was identified in one of Hassell’s Lancet articles as purveying preserved fruits and vegetables adulterated with copper sulphate.[24] Thomas Blackwell declared during the parliamentary inquiry that, following the Lancet report, the company immediately eliminated adulterants from its foods.[25] The company also put in place a system of farm-to-factory quality control, sourcing ingredients directly from farmers.[26] By the mid-1860s, Crosse and Blackwell had become one of the largest food companies in the world and continues to be a significant brand today, suggesting that the firm’s actions had the desired reputational effect.

This example highlights the importance of brands as signifiers of quality to consumers. When purchasing products and services, consumers now typically face a choice between several different brands, each of which represents different bundles of characteristics. The existence of such competition means producers of goods and services have incentives to identify and meet the felt needs of different consumers, using their brand(s) to signal to specific groups of consumers. It also provides incentives to innovate so that those felt needs can be met more cost-effectively, thereby increasing the firm’s market share.

III.          Explaining the Growth of the Regulatory State

Despite firms’ incentives to ensure their products meet high standards to avoid liability and reputational damage, governments continued to expand the regulatory state throughout the 20th century. In addition to a plethora of product regulations, entire industries—from mining to finance—have been subject to regulation, and systems of occupational licensing were established for professions ranging from medicine and law to hairdressing.

Economists have long recognized the problems inherent in such top-down government controls. In a seminal 1959 study, Ronald Coase noted that the Federal Communications Commission was not the most efficient or effective allocator of radio spectrum.[27] Coase argued that it would be better to establish property rights in spectrum and allow market transactions to determine allocations. Yet now, more than 60 years later, although the FCC has improved the efficiency of spectrum allocation by auctioning licenses—arguably heeding Coase’s analysis, at least in part—it continues to act as the ultimate controller.[28]

A key reason for the persistence of such top-down regulations, despite ample evidence of their folly, is the power of interest groups that benefit directly or indirectly from them. In “The Theory of Economic Regulation,” George Stigler argued that, even when regulations are intended to promote the public interest, regulators tend to be captured by those being regulated. Regulation thereby serves as a barrier to entry, benefiting regulated firms and individuals but at great cost to society.[29] This insight is, however, hardly new. Back in 1776, Adam Smith noted that guilds were apt to promote their interests through mandates that limited competition.[30]

Aside from often benefiting the companies and individuals subject to them, regulations may also benefit more ideological interest groups, leading to a form of tacit collusion between regulated firms and those interest groups. Bruce Yandle explained this phenomenon in his essay on “bootleggers and Baptists,” noting that Baptist ministers call for prohibitions on the sale of alcohol on Sundays at least in part because they want people to go to their churches, so they will fill the collection plates; meanwhile, bootleggers benefit from restrictions on the sale of alcohol on Sunday because they get to be the only suppliers of alcohol on those days.[31]

Such tacit collusion is pervasive. For example, during the 1990s, environmental and consumer-advocacy groups in Europe raised concerns over—and called for bans on—genetically modified crops (GMOs), in spite of the many benefits those technologies bring to consumers and the environment (and a lack of evidence of harm).[32] Meanwhile, producers of so-called “organic” food benefited from the scare stories by emphasizing that their foods did not contain GMOs.[33]

IV.          Alternatives to the Regulatory State

While regulatory capture may explain the persistence of many top-down regulations in the face of overwhelming evidence of better alternatives, it also suggests that there may be a way out. Over the past two decades, innovative ways to enable consumers to make better-informed purchases have emerged that are generally superior to existing top-down regulations.

A.      Online Information Sharing

Before the advent of the internet, consumers interested in comparing the quality of various goods and services generally relied on information provided by expert reviewers working for specialist magazines, such as Good Housekeeping (which even established its own institute dedicated to evaluating products and offering product warranties) or nonprofit organizations such as Consumer Reports.[34]

Today, websites and apps offer various means for consumers to access information pertaining to the quality of goods and services on offer. Thumbtack—a marketplace for services ranging from appliance installation to wedding planners—undertakes background checks on all its providers and enables users to rate the quality of services.[35] Ebay enables buyers to rate sellers. Amazon enables buyers to rate both products and vendors. To varying degrees, these sites also enable buyers to provide more detailed feedback on the products and services they purchase, allowing consumers to better match their preferences with those whose tastes and views are more relevant to them.

There are many websites that enable either expert or user-shared evaluations of products and services, offer price comparisons, and enable users to purchase those goods, either directly or indirectly. These include TripAdvisor (mainly focused on accommodation and experiences); Yelp (various services); OpenTable (restaurants); Expedia and Booking.com (flights, cars, accommodation); and, of course, Google (practically everything).[36]

These online rating systems have proven so effective that a 2015 survey from the Pew Research Center found that 40% of U.S. adults said they always use them when making a purchase for the first time, while an additional 42% said they sometimes use them.[37] Among those aged 18-29, the proportions were higher: 54% said “always” and 43% “sometimes,” while only 3% said they never used such sites.

Social media (Facebook, Twitter, YouTube, Snapchat, Discord, LinkedIn, Instagram, TikTok, Reddit, Pinterest, etc.) also increasingly offers a means for both companies and consumers to share information about products. Social media also facilitates far more effective feedback loops than was previously possible, with consumers evaluating products and sharing ideas about product improvements. Sometimes this information is helpful primarily to other consumers—e.g., at least one site is devoted to “hacking” Ikea products.[38] But in other cases, companies use the information to address criticisms and incorporate new ideas into products.

B.      Product Enhancement

In some cases, websites and forums have helped shape an entire industry’s product development cycle. A case in point is the crucial role that online forums played in the early days of e-cigarette technology.[39] The first e-cigarette—Ruyan, invented by Beijing-based pharmacist Hon Lik—was generally considered to be a poor substitute for combustible cigarettes. In response, users started “hacking” the product by independently developing bigger, rechargeable batteries and better liquids, among other enhancements, and shared information about these potential improvements with other users of online forums. Manufacturers then incorporated the innovations shared on these sites to develop better commercial products.

Some users even collaborated in developing standards, such as the types of thread that connected different parts of the e-cigarette, which were then adopted by manufacturers.[40] These interoperability standards resulted in a plethora of products and enabled users to choose their preferred combinations of parts.[41]

Since e-cigarettes are estimated to be considerably less harmful than combustible cigarettes, these product improvements have generated enormous benefits to those millions of smokers who had been unable or unwilling to quit before switching to e-cigarettes.[42] Meanwhile, the e-cigarette revolution emboldened cigarette manufacturers to develop less-harmful alternatives to their own products, something that a half-century of regulation had failed to achieve.

C.      Sharing Apps

Other internet-based technologies, such as sharing apps, have gone even further in usurping the role of regulation. Ridesharing apps  such as  Uber and Lyft offer riders and drivers a way to coordinate with one another, provide price transparency, and enable riders and drivers to rate one another. When a driver picks up a rider, both parties know with whom they are dealing: the driver knows where the rider is going (and is guided to the destination by a GPS-based mapping system) and the rider typically knows how much the trip will cost. Payment is taken through the app, providing protection for both driver and rider. If, for example, a driver takes an inappropriate route, there are systems to dispute excessive charges. In addition, drivers whose ratings fall below a specified level are kicked off the system.

But ridesharing-app companies do not rely exclusively on customer ratings. They also vet every new driver, undertaking background checks via services such as Checkr.[43] Ridesharing services thus provide consumers with the confidence that they will be taken safely from their pick-up point to their intended drop-off at an agreed price. Moreover, trip wait times and costs are generally lower for rideshare services than for taxis.[44] In addition, the popularity of ridesharing services has put pressure on taxi companies to improve the quality, and lower the cost, of their own services, thereby demonstrating that competition is a far more effective driver of quality than regulation.[45]

A 2020 Brookings Institution study estimated the value of Uber’s benefits to travelers. Despite slightly higher average fares, they found that Uber generates annual net benefits of approximately $1 billion in the Bay Area alone—and, by extension, many billions of dollars nationwide—through a combination of higher service quality, more transparent fares, personalized pricing and services, and expanded taxi service into new markets in response to competition from Uber.[46] Meanwhile, using data from the New York City metropolitan area, Caitlin Gorback found that, three years after the introduction of ridesharing services in previously less-accessible locations, net restaurant formation increased by between 6% and 11%, while overall additional amenity value to residents increased house prices by about 3%.[47]

Like ridesharing apps, short-term rental apps and websites such as Airbnb, VRBO, and Flipkey allow users to coordinate short-term stays in rooms or whole properties, make payment, and rate one another. A study recently published in the American Economic Review found that, in 2014, Airbnb significantly increased the supply of accommodation, especially in areas of high demand during peak periods.[48] The authors estimated that, in that single year, Airbnb generated more than $400 million in additional economic benefits to society.[49]

V.            The Regulatory State Pushes Back

Despite the superiority of these decentralized information-sharing mechanisms for allowing consumers to make better-informed decisions, the regulatory state has, in many cases, attempted to continue to “protect” consumers. It has often been supported in these both by various activists and academics and by other regulated businesses.

For example, in the United States, the U.S. Food and Drug Administration (FDA) has hit back at e-cigarettes in a massive way. In 2009, it blocked the importation of e-cigarettes, claiming that they were illegal drug-delivery devices.[50] Two e-cigarette manufacturers sued the FDA and had the ban overturned.[51] Unfortunately, the plaintiffs in the case argued that, while the FDA did not have authority to regulate e-cigarettes as drug-delivery devices under the Food, Drugs, and Cosmetics Act, it did have authority to regulate them as tobacco products under the Tobacco Control Act, and the judge agreed. This offered the FDA a justification to introduce regulations in 2016 “deeming” e-cigarettes to be tobacco products.[52] Since then, the agency has effectively decimated the industry.[53] Combustible cigarettes, which are plausibly at least 20 times more harmful than e-cigarettes, nonetheless remain widely available.

The restrictions imposed by the FDA, as well as regulators in many other jurisdictions, were sought by a classic “bootlegger-Baptist” coalition: the “bootleggers” are cigarette and pharmaceutical manufacturers, who benefit from continued sales of their products, while the “Baptists” are so-called public-health groups, who claim that cigarette smokers should “quit or die” and that new products will result in a new generation of nicotine addicts.[54] The predictable result has been to reduce the availability and increase the cost of e-cigarettes in markets subject to such restrictions, to the detriment of those who would otherwise use these products as an alternative to more harmful smoking.

Ridesharing services have, unsurprisingly, been subject to persistent challenges from the taxi industry, and governments in many jurisdictions have responded by forcing individuals who wish to offer ridesharing services to obtain taxi licenses. In some places, such services have been banned altogether.

Given the total net benefits of app-based systems, these bans are clearly harmful. Licensing requirements are likely unnecessary from a safety perspective, since both parties are arguably better protected by the app-based system, which requires user and supplier to share pertinent information in advance and creates a record of the identity of each party.[55] Meanwhile, by imposing costs on those who offer ridesharing services, licensing reduces supply and raises prices, generating net costs. These costs make it uneconomic for many potential suppliers to offer such services.

For example, the New York City Taxi and Limousine Commission requires all operators of ridesharing services to obtain a T&LC license and associated insurance, which comes at an annual cost of some $3,000.[56] For people who might otherwise engage in ridesharing only a few hours a week (for example, at peak times or during a commute), it may not be worth the cost and hassle to obtain such a license. Likewise, those who offer ridesharing services in other parts of the metropolitan area (such as in New Jersey or Connecticut, or even in nearby cities in New York State) may pick up passengers who wish to go to New York City, but without a T&LC license, will be unable to offer return rides. Such licenses unarguably reduce competition and harm consumer welfare – and ought to be challenged as violations of antitrust.

A.      When Governments Care About Consumer Welfare

Ironically, despite the de facto or de jure monopoly status they often enjoy, taxi services have sought to use antitrust law against ridesharing services—e.g., claiming that transportation-network companies circumvent employment and other regulations to gain unfair competitive advantage.[57] Fortunately, the courts have thus far generally found against such hubristic claims. For example, in 2016, taxi companies in Philadelphia sued Uber alleging that, by avoiding costly regulatory compliance, the company had engaged in anticompetitive behavior in violation of the Sherman Act. The trial judge dismissed the complaint and the 3rd U.S. Circuit Court of Appeals affirmed that dismissal, noting that the company’s entry into the market for on-demand rides actually promoted competition and consumer welfare.[58] The U.S. Supreme Court refused to hear an appeal, although that has not stopped other groups from making similar claims.[59]

When it comes to harm from products containing nicotine, U.K. agencies have generally been more mindful of consumer welfare than the FDA. While the FDA was trying to ban e-cigarettes in the early 2010s, then-Cabinet Secretary Jeremy Heywood supported e-cigarettes as a less harmful alternative to smoking and commissioned studies from the Behavioral Insights Team into ways to encourage smokers to switch.[60] Meanwhile, Public Health England (the then-research arm of the National Health Service) commissioned a series of reports into the nature, effectiveness, and health risks associated with e-cigarettes, which concluded that e-cigarettes were “at least 95% safer” than combustible cigarettes.[61] The U.K. government has continued to support e-cigarettes as a less-harmful alternative to combustible cigarettes.[62]

VI.     Addressing Criticisms of Online Information Sharing

While the examples above highlight the benefits that can come from sharing information using online platforms, it is important to acknowledge that “the internet” is hardly an inviolable source of impartial, objective information. There is much nonsense and disinformation available online. Indeed, misinformation about technologies such as GMOs,[63] vaccines,[64] e-cigarettes,[65] and even bread[66] are spread virally on websites and social media. Meanwhile, many product “reviews” are posted by companies or their agents seeking to promote their own products.[67]

But the existence of biased and inaccurate information no reason to dismiss crowdsourced information. [68] Rather, it suggests a need for systems that enable consumers to separate the wheat from the chaff. The operators of platforms are aware of these problems and are evolving mechanisms to address them, such as prioritizing reviews by verified purchasers, reviewers of multiple products, and other means.[69]

In many respects, despite their imperfections, the information and assurances that consumers obtain through these internet-based systems is far superior to the information and quality checks required by government-imposed regulations. A 2016 survey by the Pew Research Center found that 46% of respondents felt that consumer reviews on websites and apps made them feel confident about their purchases, compared with 26% for “government regulation”; meanwhile, 41% said such reviews make companies accountable to their customers, against 30% for government regulation; and 41% said consumer reviews helped ensure the safety of products and services, against 33% for government regulation.[70] A 2021 survey by YouGov found that 54% of respondents in the United States trusted crowdsourced online reviews, suggesting that trust in such reviews has increased since 2016.[71] Meanwhile, 57% found such reviews “somewhat useful” and a further 21% found them “very useful.”

VII.        Conclusions

Returning to the questions asked in the opening paragraph, it is by now perhaps clear that there are no definitive answers. But it is surely instructive that, when it comes to making purchases, a considerably greater proportion of consumers value the information and assurances provided by online services than value government regulation. Indeed, it is not unreasonable to conclude that these services are increasingly usurping the role of government regulations as validators of information.

But companies who have been protected from competition by regulation have, unsurprisingly, sought protection from the purveyors of goods and services that threaten their markets. Most obviously, taxi companies and medallion owners have lobbied fiercely to require ridesharing services to comply with taxi regulations—or ban them altogether. Likewise, hotel operators have sought to impose restrictions on the operation of home-sharing services. And cigarette manufacturers and pharmaceutical companies have likely benefitted from regulations that impose very onerous restrictions on the supply of e-cigarettes, hindering competition and harming consumer welfare.

These efforts by vested interests should be resisted. One way to do so would be for government agencies charged with promoting competition and the free movement of goods to use their powers to counter the actions of other governments to impose anti-competitive regulation—as the European Commission did when French brewers challenged the Reinheitsgebot.

Competition and consumer-protection authorities should recognize the benefits that new technologies can offer in promoting both competition and consumer welfare. Instead of regulating those products, as some demand, they should be liberated to innovate better ways to enable consumers to access information, goods, and services.

This is not to advocate for the elimination of all government-imposed consumer-protection regulation, but rather to advocate for scaling back such regulation so that it focuses narrowly on well-recognized harms that are not adequately addressed by private alternatives—including those provided through internet-based services—and to ensure that when regulations are imposed, the benefits of such regulation unambiguously outweigh the costs they impose on society.

[1] The Code of Hammurabi Translated by L. W. King, Yale Law School (no date),  https://avalon.law.yale.edu/ancient/hamframe.asp.

[2] Philip Smither, Roman Weights and Measures, University of Kent (Dec. 13, 2017), https://blogs.kent.ac.uk/lucius-romans/2017/12/13/roman-weights-and-measures.

[3] James Davis, Baking for the Common Good: A Reassessment of the Assize of Bread in Medieval England, 3 Econ. Hist. Rev. 465 (August 2004). While the assize promulgated in 1256 (51 Henry III) is the best-known and longest lasting, it built upon earlier similar laws, including those proclaimed by Henry II (1154–89), Richard I (1189–99), and John (1199—1216) in England, and others imposed across Europe from 794 AD onwards.

[4] Id.

[5] Id. at 472.

[6] Id.

[7] Commission of the European Communities v Federal Republic of Germany, European Court of Justice (Mar. 12, 1987), Case 178/84, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A61984CJ0178.

[8] The amendment permitted the use of yeast, the presence of which had been unknown in 1516 (though other exceptions were made, including the grant, to one producer, to use wheat). Stephen R. Holle & Manfred Schaumberger, The Reinheitsgebot – One Country’s Interpretation of Quality Beer, 7 Brewing Techniques 1 (1999), https://www.morebeer.com/articles/Reinheitsgebot_Brewing_Germany_Purity_Law_Bavaria_1516_Malt_Barley_Water_Hops_Yeast.

[9] Kate Connolly, Medieval Beer Purity Law Has Germany’s Craft Brewers Over a Barrel, The Guardian (Apr. 18, 2016), https://www.theguardian.com/world/2016/apr/18/germany-reinheitsgebot-beer-purity-law-klosterbrauerei-neuzelle.

[10] Esme Nicholson, Germany’s Beer Purity Law Is 500 Years Old. Is It Past Its Sell-By Date?, National Public Radio (Apr. 29, 2016), https://www.npr.org/sections/thesalt/2016/04/29/475138367/germanys-beer-purity-law-is-500-years-old-is-it-past-its-sell-by-date.

[11] Arthur Hill Hassall, Food and Its Adulterations, The Lancet (1851-1854).

[12] Neil Coley, The Fight Against Food Adulteration, Education in Chemistry (Feb. 28, 2005), https://eic.rsc.org/feature/the-fight-against-food-adulteration/2020253.article.

[13] Sale of Food and Drugs Act 1875, c. 63, available at http://www.legislation.gov.uk/ukpga/1875/63/enacted.

[14] Pub. L. No. 59-384, available at https://govtrackus.s3.amazonaws.com/legislink/pdf/stat/34/STATUTE-34-Pg768.pdf.

[15] Locomotives Act 1865, UK Public General Acts 1865 c. 83

[16] Locomotives on Highways Act 1896, UK Public General Acts 1896 c. 36.

[17] Arvinder S. Loomba, A Chronicle of Global Evolution of Product Warranty, 55 J Jpn lnd Manage Assoc 311 (January 2005).

[18] Alan Watson, The Evolution of Law: The Roman System of Contracts, 2 LHR 1 (1984), at 9.

[19] Paradine v Jane (1647) Aleyn 26.

[20] Chandelor v Lopus (1603) 79 ER 3.

[21] These concepts were developed in case law and subsequently adopted as part of the Sale of Goods Act in the United Kingdom (Sale of Goods Act 1979, UK Public General Acts1979 c. 54 SCHEDULE 1, Section 14) and the Uniform Commercial Code in the United States (Uniform Commercial Code § 2-315. Implied Warranty: Fitness for Particular Purpose).

[22] Loomba, supra note 18.

[23] George Winder, Caveat Emptor, Foundation for Economic Education (Jan, 1, 1968), https://fee.org/articles/caveat-emptor.

[24] Hassall supra note 12, at 480.

[25] Peter Atkins, Vinegar and Sugar: The Early History of Factory-made Jams, Pickles and Sauces in Britain, in D.J. Oddy (Ed.) The Food Industries of Europe in the Nineteenth and Twentieth Centuries, Farnham, UK: Ashgate (2013). http://www.academia.edu/3550965/Vinegar_and_sugar_the_early_history_of_factory-made_jams_pickles_and_sauces_in_Britain.

[26] Id.

[27] Ronald H. Coase, The Federal Communications Commission, 2 J Law Econ 1 (1959); see also Thomas W. Hazlett, David Porter, & Vernon Smith, Radio Spectrum and the Disruptive Clarity of Ronald Coase, for the University of Chicago School of Law conference Markets, Firms, and Property Rights: A Celebration of the Research of Ronald Coase (Dec. 4-5, 2009), https://www.chapman.edu/esi/wp/porter-smith-hazlett-radiospectrum.pdf.

[28] See, e.g., Stepping In: The FCC ’s Authority to Preempt State Laws Under the Communications Act, Congressional Research Service (Sep. 20, 2021), https://crsreports.congress.gov/product/pdf/R/R46736.

[29] George J. Stigler, The Theory of Economic Regulation, 2 Bell J. Econ. & Mgmt. Sci 3 (1971).

[30] Adam Smith, The Wealth of Nations (1776), Book I, Chapter X. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. …  But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary. . . . A regulation which enables those of the same trade to tax themselves in order to provide for their poor, their sick, their widows, and orphans, by giving them a common interest to manage, renders such assemblies necessary. An incorporation not only renders them necessary, but makes the act of the majority binding upon the whole.”

[31] Bruce Yandle, Bootleggers and Baptists-The Education of a Regulatory Economist, 7 Regulation 12 (June 1983), https://object.cato.org/sites/cato.org/files/serials/files/regulation/1983/5/v7n3-3.pdf.

[32] GMOs can enable increased productivity using fewer agrochemicals, increasing output and lowering the cost of foods and reducing the amount of land required to grow crops. Meanwhile, there is no evidence that consumption of such crops poses harms of a different kind or scale to those presented by conventionally bred crops. For a review of the evidence, see National Academy of Sciences, Genetically Engineered Crops: Experiences and Prospects, National Academies Press (2016), available at https://www.nap.edu/catalog/23395/genetically-engineered-crops-experiences-and-prospects.

[33] Robert Paarlberg, A Dubious Success: The NGO Campaign Against GMOs, 5 GM Crops Food 223 (2014), https://www.ncbi.nlm.nih.gov/pmc/articles/PMC5033189.

[34] See, e.g., Good Housekeeping Institute, https://www.goodhousekeeping.com/institute; Consumer Reports, https://www.consumerreports.org.

[35] Smart Hiring on Thumbtack, Thumbtack, https://www.thumbtack.com/safety.

[36] This list is very far from exhaustive. For a range of other popular sites, see Nicole Martins Ferreira, You Should Try These Website and Apps to Compare Prices, Oberlo (Oct. 5, 2020), https://www.oberlo.com/blog/25-best-price-comparison-websites.

[37] Aaron Smith & Monica Anderson, Online Reviews, Pew Research Center (Dec. 19, 2016), http://www.pewinternet.org/2016/12/19/online-reviews.

[38] See, e.g., Ikea Hackers, https://ikeahackers.net.

[39] Forums included, e.g., ECF, https://www.e-cigarette-forum.com.

[40] Personal communication with Luc van Daele, one of the vapers who encouraged the use of these thread standards.

[41] See Julian Morris & Amir Ullah Khan, The Vapour Revolution: How Bottom-Up Innovation Is Saving Lives, Reason Foundation (August 2016), available at https://reason.org/wp-content/uploads/files/vapour_revolution_working_paper.pdf.

[42] Nicotine Vaping in England: 2022 Evidence Update Summary, UK Office for Health Improvement & Disparities (Sep. 29, 2022), https://www.gov.uk/government/publications/nicotine-vaping-in-england-2022-evidence-update/nicotine-vaping-in-england-2022-evidence-update-summary.

[43] Background Checks for the Gig Economy, Checkr, https://checkr.com/use-cases/gig-marketplace.

[44] See Lisa Rayle, Danielle Dai, Nelson Chan, Robert Cervero, & Susan Shaheen, Just a Better Taxi? A Survey-Based Comparison of Taxis, Transit, and Ridesourcing Services in San Francisco, 45 Transp Policy 168 (January 2016), finding that wait times were significantly lower for rideshare services; See Ed Perkins, How Much an Airport Uber, Taxi, or Rental Car Costs Around the Globe, Smarter Travel (Dec. 21, 2017), https://www.smartertravel.com/airport-uber-versus-taxi, offering a comparison of the costs of using Uber versus taxis at various airports and finding that Uber was significantly less expensive in most locations.

[45] Scott Wallsten, The Competitive Effects of the Sharing Economy: How Is Uber Changing Taxis?, Technology Policy Institute (June 2015), https://techpolicyinstitute.org/wp-content/uploads/2017/06/Wallsten_The-Competitive-Effects-of-Uber.pdf.

[46] Hyeonjun Hwang, Jia Yan & Clifford Winston, Measuring the Benefits of Ridesharing Services to Urban Travelers: The Case of The San Francisco Bay Area, Brookings Institution (Oct. 19, 2020, https://www.brookings.edu/research/measuring-the-benefits-of-ridesharing-services-to-urban-travelers.

[47] Caitlin Gorback, Your Uber has Arrived: Ridesharing and the Redistribution of Economic Activity, unpublished PhD thesis (April 2022), available at https://www.dropbox.com/s/12j62po4y3lwzj9/Gorback_draft_apr2021.pdf?dl=0.

[48] Chiara Farronato & Andrey Fradkin, The Welfare Effects of Peer Entry in the Accommodation Market: The Case of Airbnb, 112 Am Econ Rev 1782 (June 2022).

[49] Specifically, they found that it generated $305 million in consumer surplus and $112 million in producer surplus.

[50] Sottera, Inc. v. Food Drug Admin., 627 F.3d 891 (D.C. Cir. 2010); Smoking Everywhere, Inc., et al v. FDA, et al, No. 10-5032 (D.C. Cir. 2010).

[51] Id.

[52] 21 CFR Parts 1100, 1140, and 1143.

[53] Guy Bentley & Julian Morris, The FDA Has Decimated the E-Cigarette Market, Reason Foundation (Sep. 22, 2021), https://reason.org/commentary/the-fda-has-decimated-the-e-cigarette-market.

[54] Jonathan H. Adler, Roger E. Meiners, Andrew P. Morriss, & Bruce Yandle, Baptists, Bootleggers & Electronic Cigarettes, 33 JREG 313 (2016).

[55] Matthew Feeney, Is Ridesharing Safe?, Cato Institute Policy Analysis (Jan. 27, 2015), available at https://www.cato.org/sites/cato.org/files/pubs/pdf/pa767.pdf.

[56] Daniel Prendergast, 700 Uber Drivers Could Be Fired Under New Bill, New York Post (Jul. 12, 2015), https://nypost.com/2015/07/12/700-uber-drivers-to-be-fired-under-new-bill.

[57] Nick Passaro, Uber Has an Antitrust Litigation Problem, Not an Antitrust Problem, CPI Antitrust Chronicle (May 2018), available at https://www.competitionpolicyinternational.com/wp-content/uploads/2018/05/CPI-Passaro.pdf.

[58] Philadelphia Taxi Association Inc. v. Uber Technologies Inc., No. 17-1871 (3d Cir. 2018), https://law.justia.com/cases/federal/appellate-courts/ca3/17-1871/17-1871-2018-03-27.html.

[59] Mike Scarcella, Uber, Lyft Drivers Claim Price-Fixing in Lawsuit Against Companies, Reuters (Jun, 21, 2022), https://www.reuters.com/business/autos-transportation/uber-lyft-drivers-claim-price-fixing-lawsuit-against-companies-2022-06-21.

[60] How the Nudge Unit Threw Light on Lighting Up, Civil Service Blog (Aug. 11, 2015), https://civilservice.blog.gov.uk/2015/08/11/how-the-nudge-unit-threw-light-on-lighting-up; see also David Hencke, Lord Heywood of Whitehall Obituary, The Guardian (Nov. 4, 2018), https://www.theguardian.com/politics/2018/nov/04/lord-heywood-of-whitehall-obituary, (“Heywood had been a heavy smoker and no doubt understood at a personal level the importance of offering safer alternatives. Sadly, in spite of quitting in 2011, he died of lung cancer in 2018 at the age of 56.”).

[61] See, e.g., Anne McNeil et al., E-cigarettes: An Evidence Update, Public Health England (August 2015), available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/733022/Ecigarettes_an_evidence_update_A_report_commissioned_by_Public_Health_England_FINAL.pdf.

[62] E-Cigarettes and Vaping: Policy, Regulation and Guidance, UK Office for Health Improvement and Disparities (October 2022), https://www.gov.uk/government/collections/e-cigarettes-and-vaping-policy-regulation-and-guidance.

[63] Shahla Wunderlich & Kelsey A. Gatto, Consumer Perception of Genetically Modified Organisms and Sources of Information, 6 Adv Nutr. 842 (Nov. 10, 2015), https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4642419.

[64] Alexander Muacevic et al., The Anti-Vaccination Movement: A Regression in Modern Medicine, 10 Cureus e2919 (Jul. 3, 2018), https://www.ncbi.nlm.nih.gov/pmc/articles/PMC6122668.

[65] Linda Bauld, The Evidence Keeps Piling Up: E-Cigarettes Are Definitely Safer Than Smoking, The Guardian (Dec. 29, 2017), https://www.theguardian.com/science/sifting-the-evidence/2017/dec/29/e-cigarettes-vaping-safer-than-smoking.

[66] Michael Specter, Against the Grain: Should You Go Gluten-Free? The New Yorker (Oct. 27, 2014), https://www.newyorker.com/magazine/2014/11/03/grain.

[67] Yuanyuan Wu et al., Fake Online Review: Literature Review, Synthesis, and Direction for Future Research, 132 Decis. Support Syst. 113280 (May 2020.

[68] Counterintuitively, the presence of some inaccurate information may actually improve users’ ability to make good decisions, at least with regard to estimates of the size of effects, which is subject to cognitive biases. See Bertrand Jayles et al., How Social Information Can Improve Estimation Accuracy in Human Groups, 114 Proc. Nat. Acad. Sci. 12620 (Nov. 8, 2017), http://www.pnas.org/content/114/47/12620.

[69] Geoff Donaker, Hyunjin Kim, &Michael Luca, Designing Better Online Review Systems, Harv. Bus. Rev. (December 2019), https://hbr.org/2019/11/designing-better-online-review-systems.

[70] Aaron Smith & Monica Anderson, Online Shopping and E-Commerce: Online Reviews, Pew Research Center (Dec. 19, 2016), http://www.pewinternet.org/2016/12/19/online-reviews.

[71] Graeme Bruce, Most Consumers Trust Review Sites. Here’s What They Use Them for Most, YouGovAmerica (May 19, 2021), https://today.yougov.com/topics/technology/articles-reports/2021/05/19/most-consumers-trust-review-sites.

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Innovation & the New Economy

Regulación a las comisiones de tarjetas de pago

Scholarship [The attached was published by La Academia de Centroamérica, a private, nonprofit research center based in Costa Rica, as an adaptation of the ICLE issue . . .

[The attached was published by La Academia de Centroamérica, a private, nonprofit research center based in Costa Rica, as an adaptation of the ICLE issue brief “Regulating Payment-Card Fees: International Best Practices and Lessons for Costa Rica.” Translation by Juan Carlos Hidalgo.]

Resumen Ejecutivo

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Financial Regulation & Corporate Governance

Regulating Routing in Payment Networks

ICLE White Paper ICLE white paper looks at proposals from Congress and the Federal Reserve to mandate routing requirements on credit cards and other payment networks.

Introduction

Imagine you are at the grocery-store checkout line and it is to pay. You enter your credit card in the terminal, assuming that your payment will be routed over the network operated by the brand on your card (typically Visa or Mastercard). But you learn after the fact that the grocery store has chosen instead to route it over China Union Pay.

Most of us would be uncomfortable ceding to the merchant the authority to route transactions over the cheapest network, without considering our concerns about security, reliability, and other card features (including rewards). Yet that is already the case for many point-of-sale transactions made with debit cards—the result of a 2011 regulation implemented by the Federal Reserve. Consumers can, however, often still force the transaction to run over their preferred network by pushing the “credit” button.

But new rules under consideration by the Federal Reserve would extend merchants’ ability to determine how debit transactions are routed to online transactions, while also making it more difficult for consumers to control who gets to handle their personal data and process their transactions.[1] Perhaps more worryingly, a new bill (the “Credit Card Competition Act”) introduced by Sen. Richard Durbin (D-Ill.) would, in the name of “competition,” impose similar routing requirements on credit cards, while ignoring important differences in the competitive framework of debit and credit cards.[2]

Since they emerged more than 50 years ago, payment-card networks have come to play an increasingly important role in our lives, both directly and indirectly. Directly, they facilitate hundreds of billions of transactions every year, representing tens of trillions of dollars in value.[3] Indirectly, they have contributed to a near-complete shift from paper-based to electronic value exchange and accounting in the United States and many other countries. This has, in turn, resulted in enormous efficiency improvements and wider social benefits, such as the development of online commerce, greater ease of travel, and reduced tax avoidance.[4]

The shift from paper to electronic value exchange has been driven almost entirely by voluntary decisions made by businesses and consumers. Despite such clear evidence of market success, over the past three decades, governments have increasingly sought to correct alleged “market failures” in payment-card markets. The main tool governments have used is price controls on interchange-fee rates. More recently, however, several governments—including the United States, the European Union, and Australia—have sought to reduce rates further still by regulating the manner in which payments are “routed” (i.e., the way that messages pertaining to a transaction are sent between the merchant and the issuing bank). This has important implications for consumer protection, fraud prevention, and financial inclusion.

In previous studies, we have shown that regulation of interchange fees typically has slowed the shift to more innovative, quicker, more convenient payment systems, while also reducing other benefits and particularly harming poorer consumers and smaller merchants.[5]

Prohibitions on exclusivity in routing have similar effects as direct price controls. But imposed routing requirements will have additional effects that go beyond those of price controls and would result in various harms to consumers and the economy. This study seeks to delve deeper into the problem, focusing primarily on the justifications for and effects of regulations that affect the way in which transactions are routed. While “routing” may seem arcane, it is fundamental to the effectiveness of payment networks. Understanding the likely consequences of such regulation is thus important. That is the purpose of this paper.

We begin, in Section II, by describing the technological and economic elements of payment-card routing. Supporters of forced routing requirements contend that they will promote more efficient competition in consumers’ payment-card usage. But we show that this superficial argument ignores the basic economic realities of payment-card networks, as well as the fundamentally different nature of consumer competitive choice, both in debit-card markets (where routing requirements currently exist) and in credit-card markets (the intended target of Sen. Durbin’s proposed law). Section III reviews the evidence regarding the effects of regulating payment networks. We summarize the pernicious effects of price controls and then explain how the routing mandate created by the 2011 Federal Reserve regulation, known as Regulation II, has had similar effects. Section IV considers the proposed changes to Regulation II and the new Durbin proposal to regulate credit-card routing, with a particular focus on the likely harmful effects of the changes on the incidence of fraud and the knock-on effects on issuers, cardholders, and merchants. Section V concludes.

[1] Debit Card Interchange Fees and Routing, FR 26189 (2021), available at: https://www.govinfo.gov/content/pkg/FR-2021-05-13/pdf/2021-10013.pdf.

[2] Credit Card Competition Act of 2022, S. 4674, 117th Cong. § 2 (2022), available at: https://www.congress.gov/117/bills/s4674/BILLS-117s4674is.pdf.

[3]  Global Network Card Results in 2021, Nilson Report Issue 1224, https://nilsonreport.com/mention/1672/1link.

[4] See the appendix to this paper and references therein.

[5] See Todd J. Zywicki, The Economics of Payment Card Interchange Fees and the Limits of Regulation, ICLE Financial Regulatory Program White Paper Series (Jun. 2, 2010), available at http://laweconcenter.org/images/articles/zywicki_interchange.pdf; Todd J. Zywicki, Geoffrey A. Manne, and Julian Morris, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, International Center for Law and Economics (Apr. 25, 2017); Todd J. Zywicki, Geoffrey A. Manne, and Julian Morris, Price Controls on Payment Card Interchange Fees: The U.S. Experience, George Mason Law & Economics Research Paper No. 14-18, (Jun. 6, 2014).

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Financial Regulation & Corporate Governance

Central Banks and Real-Time Payments: Lessons from Brazil’s Pix

ICLE Issue Brief Introduction Real-time payments (RTP) are an increasingly popular means by which individuals can send credits from one account to another. Many banks have established internal . . .

Introduction

Real-time payments (RTP) are an increasingly popular means by which individuals can send credits from one account to another. Many banks have established internal RTP systems and, in some countries, these have been extended to other banks through private consortia such as The Clearing House in the United States. Such consortia enable someone with an account at Chase, for example, to send money to someone with an account at Wells Fargo, and vice versa, using their RTP apps.[1]

In other countries, central banks have inhibited the establishment of private RTP networks and have developed their own systems. One such example is Brazil, where the Banco Central do Brasil (“BCB”) has operated the Pix instant-payment system since 2020.

The Bank for International Settlements (BIS), the Basel-based organization that sets regulatory standards for central banks, recently published a paper examining Pix that was co-authored by two researchers from the BCB and three from the BIS.[2] This brief offers some initial thoughts on that BIS paper and on the Pix system more generally.

We begin with a discussion of the economics of payment networks, with an emphasis on the optimal distribution of costs and benefits. Section II addresses cost transparency and apportionment in payment systems run by central banks. Section III critiques several mistaken notions regarding the role of rewards in payment-card networks. Section IV illustrates the conflicts of interest that can arise when a governmental entity such as a central bank competes with the private sector. Section V discusses the inter-related problems of data breaches, inadequate know-your-customer procedures among some Pix-implementing entities, and the phenomenon of “lightning kidnappings.” Section VI compares the operational rules governing the BCB with international good governance. Section VII concludes with a discussion of the wider lessons for governments considering the implementation of RTP systems.

Read the full issue brief here.

[1] RTP Network Participating Financial Institutions, The Clearing House, https://www.theclearinghouse.org/payment-systems/rtp/rtp-participating-financial-institutions (last visited May 18, 2022).

[2] Angelo Duarte et al., Central Banks, the Monetary System and Public Payment Infrastructures: Lessons from Brazil’s Pix, BIS Bulletin no. 52 (Mar. 23, 2022), at 1.

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Financial Regulation & Corporate Governance

Regulating Payment-Card Fees: International Best Practices and Lessons for Costa Rica

ICLE Issue Brief Executive Summary In 2020, the Legislative Assembly of Costa Rica passed Legislative Decree 9831, which granted the Central Bank of Costa Rica (BCCR) authority to . . .

Executive Summary

In 2020, the Legislative Assembly of Costa Rica passed Legislative Decree 9831, which granted the Central Bank of Costa Rica (BCCR) authority to regulate payment-card fees. BCCR subsequently developed a regulation that set maximum fees for acquiring and issuing banks, which came into force Nov. 24, 2020. In BCCR’s November 2021 ordinary review of those price controls, the central bank set out a framework to limit further the fees charged on domestic cards and to introduce limits on fees charged on foreign cards.

This brief considers the international experience with interchange and acquisition fees, reviewing both theoretical and empirical evidence. It finds that international best practices require that payment networks be considered dynamic two-sided markets, and therefore, that assessments account for the effects of regulation on both sides of the market: merchants and consumers. In contrast, BCCR’s analysis focuses primarily on static costs that affect merchants, with little attention to the effects on consumers, let alone the dynamic effects. Consequently, BCCR’s proposed maximum interchange and acquisition fees would interfere with the efficient operation of the payment-card market in ways that are likely to harm consumers. Specifically, losses by issuing and acquiring banks are likely to be passed on to consumers in the form of higher banking and card fees, and less investment in improvements. Less wealthy consumers are likely to be hit hardest.

Based on the evidence available, international best practices entail:

  • As far as possible, allowing the market to determine interchange fees and acquisition fees;
  • Acknowledging that payment networks are two-sided markets in which one side (usually merchants) typically subsidizes the other side, thereby increasing system effectiveness;
  • Not benchmarking fees, especially against countries that have price controls in place; and
  • Not imposing price controls on fees on foreign cards.

Read the full issue brief here.

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Financial Regulation & Corporate Governance