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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 . . .
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.
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.
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:
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.
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.
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]
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:
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]
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:
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]
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).
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.
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.
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.
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.)
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.
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]
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.
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]
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.
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.
TOTM In a recent piece for the Financial Times, Brendan Greeley argues that the misnamed Credit Card Competition Act would reduce inflation. In it, Greeley recycles numerous myths about the nature . . .
In a recent piece for the Financial Times, Brendan Greeley argues that the misnamed Credit Card Competition Act would reduce inflation. In it, Greeley recycles numerous myths about the nature of credit-card markets that have long been rebutted by serious economic research. Both theory and ample evidence from the United States and other countries shows that attempting artificially to force down interchange fees is bad for consumers—especially those with lower incomes and those who revolve their balances. Moreover, these interventions simply redistribute the costs of operating the payment-card system; they do not eliminate them. As a result, they won’t reduce inflation, as Greeley imagines.
Read the full piece here.
Popular Media Sen. Richard Durbin (D-Ill.) recently introduced legislation to regulate how credit-card transactions are routed that, if passed, would hinder competition between credit-card issuers, reduce benefits . . .
Sen. Richard Durbin (D-Ill.) recently introduced legislation to regulate how credit-card transactions are routed that, if passed, would hinder competition between credit-card issuers, reduce benefits for consumers, and impede fraud detection and prevention.
Popular Media Democratic lawmakers like Illinois Sen. Dick Durbin and the Justice Department’s Antitrust Division want to impose new rules for credit-card transactions that would reduce competition, harm consumers . . .
Democratic lawmakers like Illinois Sen. Dick Durbin and the Justice Department’s Antitrust Division want to impose new rules for credit-card transactions that would reduce competition, harm consumers and crush small banks.
TOTM Sen. Richard Durbin (D-Ill.) earlier this month introduced legislation that aims to manufacture competition in the routing of credit-card transactions. If enacted, the measure would require that . . .
Sen. Richard Durbin (D-Ill.) earlier this month introduced legislation that aims to manufacture competition in the routing of credit-card transactions. If enacted, the measure would require that merchants be able to choose from at least two networks when processing most credit-card transactions.
Written Testimonies & Filings Chairman Hickenlooper, Ranking Member Blackburn, and Members of the Committee: I am Todd Zywicki and it is a pleasure to appear before you today to . . .
Chairman Hickenlooper, Ranking Member Blackburn, and Members of the Committee:
I am Todd Zywicki and it is a pleasure to appear before you today to testify on the topic of “Protecting Consumers from Junk Fees.” I am George Mason University Foundation Professor at Antonin Scalia Law School and Research Fellow of the Law & Economics Center. From 2020-2021 I served as the Chair of the CFPB’s Taskforce on Consumer Financial Law and from 2003-2004 I served as the Director of the Office of Policy Planning at the Federal Trade Commission. I am also co-author of Consumer Credit and the American Economy (Oxford 2014) and have written and spoken extensively on issues of consumer protection generally and consumer financial protection specifically. I appear voluntarily today in my personal capacity and do not speak on behalf or represent any other party.
I share the frustration that many consumers hold today regarding the proliferation of seemingly ubiquitous add-on fees that we experience constantly, from surcharges for using our credit cards at a merchant, to hotel “resort fees,” and others. And earlier this year I experienced exactly this frustration when I checked into a hotel on vacation and was assessed a mandatory $30 a day “resort fee” that was only disclosed in fine print on the last screen of a multi-page checkout process at an Internet hotel booking website.
Buying a ticket to concert has in fact become a tedious process of searching for a concert or sports ticket and then having to spend 10 minutes clicking through multiple pages before you can discover the real price and decide whether to go to the show.
So I also say, “Enough.”
But it is also important to stress that not all of these fees are “junk” fees. Many of these multi-part pricing schemes are economically efficient, in that they better match consumers with the product terms and attributes they value. Others are appropriate as means to protect some consumers from being forced to subsidize others’ choices or the higher costs that some consumers impose relative to others. For example, requiring upper-income jet-setters to pay foreign currency transaction fees hardly seems unfair to those who don’t travel abroad and presumably nobody has an issue with requiring payment of “add on” fees for additional toppings on a pizza. Requiring every vacation resort to be all-inclusive would force those who don’t drink alcohol to subsidize those who do. While some use of multi-part pricing today is likely welfare-reducing, multi-part pricing has become more frequent is because paying for the services you actually use over the long run can be more fair and efficient for other consumers, even if foreign travelers, partiers, and those who pay late on their credit cards might disagree.
As Howard Beales and I wrote recently:
The term “junk fees” defies easy definition. But it is imperative to distinguish ‘junk fees’ that are designed to extract rents and consumer surplus from consumers from efficient behavior-based fees. Welfare-reducing “junk” fees are most likely to emerge only under a relatively narrow set of market conditions — particularly those markets with few repeat customers where consumers are less likely to learn of the hidden fees, where consumers are effectively locked-in and unable to avoid paying the fee when it is imposed, or where such fees may be atypical and thus consumers are not alert to them.
Presentations & Interviews ICLE Academic Affiliate Todd Zywicki joined Southwest Public Policy Institute President Patrick M. Brenner on SPPI’s SPPI-TV podcast to discuss interest rate caps and the role . . .
ICLE Academic Affiliate Todd Zywicki joined Southwest Public Policy Institute President Patrick M. Brenner on SPPI’s SPPI-TV podcast to discuss interest rate caps and the role of the Consumer Financial Protection Bureau (CFPB). Video of the full episode is embedded below.
Scholarship Abstract The notion of “junk” fees is a fine piece of rhetoric, but useless as an analytical tool. Many fees identified as junk impose costs . . .
The notion of “junk” fees is a fine piece of rhetoric, but useless as an analytical tool. Many fees identified as junk impose costs on consumers who generate those costs – rather than forcing others to subsidize their behavior. For example, credit card late fees deter late payments and their associated costs while only world travelers pay foreign currency transaction fees. There is no reason for ordinary consumers to subsidize either group. Because information is costly, consumers rationally focus on the elements of price that are most important in their own circumstances. Requirements to disclose everything everywhere will only interfere with this process. Both the structure of pricing, and the level of prices, should be determined by competition in the marketplace. As we observe, the result is detailed fee structures for some products and services, and bundled pricing for others. Attempts to regulate pricing structures by requiring itemized prices increased the costs of real estate settlements. Regulating components of credit card pricing structures led to increases in other fees and reductions in credit availability. Competition over pricing structures is far more likely to satisfy consumer preferences than an inevitably overbroad set of regulatory requirements
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 . . .
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.
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.
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.
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]
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.
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.
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:
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).
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:
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.
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).
