PSD2, interchange fee and surcharging: lessons from history

Now that we have the second Payment Services Directive going live in a couple of jurisdictions, the news media are reporting on one of its prominent features: the retailers do not have the right to pass on payment fees to consumers for all cards that are subject to the EU regulation on multilateral interchange fees (MIFs).

As can be seen in the tweet below, the UK chose to extend this to 3 party schemes as well.

From today we're banning hidden charges for paying with your credit or debit card - a move that will help millions of people avoid rip-off fees when spending their hard-earned money. pic.twitter.com/EEk5jxdk7R

— Theresa May (@theresa_may) 13 januari 2018

As I expect quite some further discussions on this topic (and retailers circumventing the rules by introducing other types of charges to their customers) I figured it would be good to provide some background on the reasoning that is occuring in the area of MIF-regulations. A further look at history would even suggest that we need to take one step further back in order to rethink our analysis so far.

Some background on MIF-modelling (and subsequent regulation)
If we try to assess the arguments pro and con interchange fees, some important thinking in this area is done by Nobel prize winner Jean Tirole, who worked together with Rochet on competition in two-sided markets, such as payment-cards markets. At the heart of their studies is the question what the pricing structures are in two-sided markets and under which conditions and to which extend compensation payments between different sides of the market (interchange fees) are justified.

This work has been at the core of many regulatory strategies but it is subject to a lot of discussion. All market players, whether 3 or 4 party card schemes, issuing banks, acquirers, processors, retailers, consumers and regulators, heavily debate pro's and con's of interchange fees. And in doing so they must use the reasoning and models of Rochet and Tirol. In essence the model tries to determine which cost and interchange fee levels are relevant for competing products/platforms such as cards vs cash.

Do note however that already more than 10 years ago, Brookings Institution released a very good paper on interchange fees, concluding that it is impossible to prove one or the other side of the arguments on interchange fees, let alone determine which level of interchange fee is correct. I think their analysis still stands which means that in the end, interchange fee regulation is more about lobbying and power politics than actual econometric calculations.

Europe's reality under PSD2 and MIF regulation
What is happening under the current payments regulation in Europe, is that:
- a maximum cap is defined for the interchange fee of credit-card and debit-card transactions (reducing the cost to the retailer),
- retailers are forbidden to surcharge for payment costs, when the customer uses a card which has a capped interchange fee (reason being that they may not gain from reduced costs on the one hand while keeping surcharging intact on the other hand).

In essence this means that the EU has bought into the argument that multilaterial interchange fees were being set to high and require regulatory intervention (thus emulating the behaviour of other regulators such as the FED and Australian Reserve Bank). In doing so they accept and embrace academic models which mostly focus on the topic of optimal price regulation in a stationary market with alternative platorms/products.

Historic approach: where did the interchange fee come from in practice?
It strikes me that all the economists at play use an empirical description and mathematic approach to start their reflections on interchange fees. One very obvious element is missing in a lot of papers (except Baxter, who goes at length to discuss history): what were the market players thinking when they wanted to introduce these fees? What is the industry trade-off they are facing?

In Dutch payment history, the banks have been very keen not to disclose their cost/benefit considerations and finances. It was only in 2005 that they allowed McKinsey - as a notary - to have a full look at all internal costs and benefits, in order to draw up a report on costs/benefits based on a full insiders view. I have been personally committed to this effort and helped making it become a reality based on the belief that a lot of misconceptions can be eliminated by being open on ones business model.

However, while this report shows the situation in 2005, it doesn't tell us where the interbank fees came from. The archives of banks do however and to me it is stunning that very few academics in the interchange fee domain have tried to uncover these sources to calibrate their reasoning. Because if they would, they might be able to enrich their analytical approach.

Core question: can we avoid double charging for the retail customer ?
Reading through the old reports of collective groups of players in the Dutch payments domain, we can see an interesting game-theoretic approach to the multilateral fee discussion (which I will be disclosing more in detail in an upcoming publication on the history of Dutch retail  payments).

In essence, in the 1980s the emergence of new players, that were going to be piggy backing on an existing infrastructure without interbank compensation, fueled an existing debate on the distortion of the cost/benefits of banks. Banks with a lot of private consumers would usually bear many processing costs, while banks with corporate customers would reap the benefits. And the winner in the game would be new players, for example investment funds, that would hold pooled accounts for customers funds at a large bank, without having to pay anything for the incoming deposits that came from all the Dutch banks.

Setting an interchange fee in this context leads to:
- a more appropriate allocation and compensation of payment costs along the payments value chain: the entity that benefits from a payment will also bear part of the originating cost,
- the elimination of free-riders in the system,
- interbank understanding that consumers would not be levied fees for instruments where an interchange fee arrangement existed.

The explicit reasoning in a well documented cost/benefit study here in the Netherlands (never officially published as banks made sure to not disclose their thinking) was that it was of course also possible to not introduce an interchange fee system. The involved payment experts noted however that this would lead to bank fees on both the consumer and corporate side of the market. Absent coordination and agreement of reasonable interchange fees, the expectation was that those individual fees of banks to their respective customers would be higher than necessary.

In addition, the bankers expected the corporate side of the market to also add on surcharges and administrative charges to the consumer, which meant that effectively the consumer would then pay twice for payments processing costs: one time at the issuing bank and the other time at the retailer/corporation side, where the payments costs were incorporated into the price of services. Thus, for the Dutch society as a whole, this situation with mark ups on payment processing costs starting at the bank individual level, would undoubtedly be more costly, than the situation where the bank layer coordinates its cost/fee level and thereby avoids double charging of the customer.

The EU-choice revisited: higher payment costs as unintended side-effects of the MIF-regulation
It is clear that the EU perspective on interchange fees is:
- we don't trust the diverging interests of banks and competing card schemes in combination with competition to lead to an appropriate level of interchange fees, so we set an interchange level by ourselves,
- we also don't trust merchants and want to avoid them pocketing the benefits of lower interchange fees at the costs of consumers.

In practice we may now see in Europe that:
- issuing banks have shifted their income base and costs to consumers are increasing,
- acquiring banks will use other fee mechanisms to charge the retailer for the relevant payment costs in the card chain (as long as it exists as such, because a move to instant sepa credit transfers looks pretty enticing of course),
- retailers will use other fee mechanisms or labels (service charges) to charge the consumers for payments,
- consumers are paying higher fees to their issuing bank,
- consumers will effectively be paying twice for the relevant payment costs, in spite of the EU goal that they don't.

Where Europe has chose to intervene in interbanc dynamics, in order to achieve the best result for society, I am not sure if this will indeed work out as such. Yet, I must confess I am not an academic scholar in MIF-models and I get dizzy when reading all the equasions. However, I sense that some of the MIF-modelling doesn't match the actual game-theoretic constellation that occurs in practice.

Personally, I would rather place my trust in the diverging conflicts of interests between closely collaborating banks in an industry (leading to an interchange fee level that is scrutinised among quarreling bank experts) to keeping my payment costs appropriately low, than the good intentions of regulators that expand their interventions towards those mechanics themselves (thereby unleashing the possibility of double charging to me).

Ceci n'est pas une 'payment instrument': a reflection on fuel cards and the PSD2

In september this year, the FCA published its policy statement and approach document on the PSD2. I've been eagerly watching this document to find out what their final take would be on the understanding of the limited network exemption in relation to the specific nature of fuel cards. Because there is more than meets the eye here.

In essence, some fuel cards effectively function as a purchase button on a website. They don't initiate payment orders at all. They would thus fall outside of the PSD2-scope, as any other shopping-button on websites. Due to a twist of faith however, the bank supervisors seem to be keen to ignore this reality for fuel cards and bring those under the PSD2.

In this post I will highlight the flaws in this approach and conclude that the result is that if all regulators start re-writing the definitions themselves, we better label the PSD2 the Purchase Service Directive (see also the full  and more elaborate analysis on the subject here).

Background

In the original payment services directive article 3k provided for a proportional application of the PSD1. Instruments with a limited geographical reach and scope, such as store cards and fuel cards were not subject to its provisions. The exemption 3k) was thus called the limited network exemption.

3 (k) services based on instruments that can be used to acquiregoods or services only in the premises used by the issuer orunder a commercial agreement with the issuer either withina limited network of service providers or for a limited rangeof goods or services;

In its proposal for the new version of the PSD, the Commission claimed the existence of payments systems, waivered as “limited networks” with massive volumes, which imply greater risk and no legal protection for payment users as “feedback from the market”. However, this feedback was not really a result of the external impact analysis onthe economic impact of the PSD1. 

What could be seen though is that the interpretations of local supervisors ranged from strict to very lenient, which distorted the playing field in Europe. In addition, some observers noted that there was a strong desire by supervisors to have stricter rules for in particular the fuel cards market (see the mystery of unregulated massive payment volumes, as discussed in the Paysysreport of March 2014).

In the end, the net result was a very strict version of article 3k in the PSD2, to ensure that its future application would be for truly limited networks only. In addition, any organisation that uses this specific exemption has to notify the supervisor. But let's take a good look at the pre-amble and the exemption text.

The definitions

The pre-amble states that payment instruments covered by the limited network exclusion could include store cards and fuel cards, but it isn't conclusive. They could, but they could also not.

(14) Payment instruments covered by the limited network exclusion could include store cards, fuel cards, membership cards, public transport cards, parking ticketing, meal vouchers or vouchers for specific services, which are sometimes subject to a specific tax or labour legal framework designed to promote the use of such instruments to meet the objectives laid down in social legislation.

Where such a specific-purpose instrument develops into a general purpose instrument, the exclusion from the scope of this Directive should no longer apply. Instruments which can be used for purchases in stores of listed merchants should not be excluded from the scope of this Directive as such instruments are typically designed for a network of service providers which is continuously growing. The limited network exclusion should apply in combination with the obligation of potential payment service providers to notify activities falling within its scope.

Article 3k is actually more clear, certainly in comparison to the previous version. It now refers explicitly to services based on specific payment instruments. 

(k) services based on specific payment instruments that can be used only in a limitedway, that meet one of the following conditions:

• (i) instruments allowing the holder to acquire goods or services only in the premises of the issuer or within a limited network of service providers under direct commercial agreement with a professional issue;

• (ii) instruments which can be used only to acquire a very limited range of goods or services;

• (iii) instruments valid only in a single Member State provided at the request of an undertaking or a public sector entity and regulated by a national or regional public authority for specific social or tax purposes to acquire specific goods or services from suppliers having a commercial agreement with the issuer; 

The legal conclusion is thus: first you need to have something that is a payment instrument and then it may fall under a limited network exemption. 

The FCA's approach: let's not be clear about the payment adjective

The above may not be how the FCA are looking at it. Both in their consultation and further guidance they seem to that 3k is written as pertaining to all instruments, not just payment instruments. I pointed this out in a response to the consultation (see this separate blog) and asked for further clarification.

Yet, their feedback document, doesn't mention anything on this definition question at all, which is a bit disappointing given the timely and good job efforts that the FCA usually put in with all their consultation work. So the ambiquity stays: while the notification forms clearly outline that applications must clarify the nature of the involved payment services and payment instruments, all the guidance does is steer towards an understanding of the 3k article as pertaining to all instrument (as under PSD1). 

This still leaves us with the question: when would a fuel card qualify as a a payment instrument. Or is it just as exempt from the PSD as a purchase button in an Internet-webstore? 

Fuel card as a payment instrument or purchase device?

Let’s have a closer look at the workings of a fuel card and what it does in terms of business processes. Generally speaking, fuel cards are delivered by oil companies to corporate fleet owners, sometimes distributed via resellers or co-branding arrangements. They effectively are a tool that validates the legal competency of its holder, to take out goods/services from service delivery stations.

The company to which the cards are provided takes full responsibility for all services/goods delivered to the users of the cards and receives a monthly overview of all purchases done with the cards. It can set usage levels per card, ensuring that no more than a certain amount of goods and services are to be delivered to the cardholder. It can also set the range of goods to be delivered from narrow (fuel only) to wide (fuel and shop goods).

Every month, the fleet owning company receives an invoice with an overview of all purchases made and the rebate applied (mostly volume based). This specifies the purchases made in the network of the oil company itself as well as those in other networks and by other service providers. These other networks of service stations may also deliver goods/services to the card holder. What happens in practice is that prior to the actual delivery, the cardholders’ oil-company buys the whole service/goods package that the card-holder wishes to take out at the selected other networks with whom the oil-company has struck delivery and service agreements.

This results in a chain sale of goods/services from:

-              the service station dealer to its country organisation,

-              the service station country organisation to the oil company national organisation

-              the oil company in a country to the corporate client that distributed its cards to the employees.

While technically there may be many variations to this flow, it does serve to achieve an important effect in VAT-terms. It allows the involved oil companies and networks to reclaim the relevant VAT from local authorities and thus lower the end-fee to the corporate fleet-owners.

What's the difference between purchase and payment?

In the table below, I've summarized the functional difference between the use of a payment card or a purchase card at an oil station.

Using a purchase tool	Using a payment instrument
Used to instruct the retailer or service station to deliver goods/services	Used to instruct the bank to make a payment to a third party bank account
The amount to be paid is unknown. At the end of the month, rebates are applied and the reconstruction of what the actual equivalent price at this moment of sale would have been, is always a mathematic reconstruction.	The amount to be paid is clear.
Authentication of the card holder equals the right to receive goods/services up to a certain threshold	Authentication of the card holder equals the digital signature of the payment transfer
Positive response by oil company equals the formal sale of the services/goods from service station to oil company and the mandate to provide the services/goods to the card holder	Positive response equals the proper processing of the payment instruction
Holder of purchase instrument is not (by definition) authorised to give payment orders that relate to the billing account of the fleet owner	Holder of instrument is by design authorised to give payment orders from that account to the payees account
Holder only receives proof of purchase / delivery but not proof of payment	Holder receives proof of payment and possibly also proof of purchase
No cash-back possible	Cash back might be possible under the rules of the cards-account
Oil company may design its own purchase, control and billing procedures, use its own set of purchase tools and may set its own acceptance and risk parameters. Intercompany delivery agreements will apply.	Card is a payment instrument and payment transactions with it fall under legislation (PSD) and payment brand regulation, with bank specific acceptance and risk parameters
VAT-recovered and rebate applied to purchases by all cardholders of the fleet-owner	VAT-recovery not included
Aggregated invoice for goods and services delivered, sent to the corporate treasurer of the fleet owner, and paid for using the direct debit instrument	Periodic account statement for payments made or (as in the case of credit cards): aggregated invoice for total value of payments made, followed by direct debit.

While the bank card ticks all the boxes, the fuel cards as outlined above, do not qualify as payment instruments under the current Payment Service Directive. There is no request being made to place, withdraw or transfer funds, hence there is no payment transaction, no payment order and no payment instrument. Hence, article 3k is nowhere close to being relevant. 

What will happen to the fuel cards niche?
As the editors of the Paysys report outlined earlier in March 2014, there may exist a hidden regulatory agenda in Europe to capture fuel cards under the 3k article of the PSD2.

This seems to be exactly the discussion right now for the relevant stakeholders around this subject in Europe. While technically the legal argument is straightforward, leading to fuel cards being out of scope, some lawyers point to the spirit of the article or the statements of regulators (in whichever respect being made) to claim that fuel cards do fall under article 3k and require notification.

As in many situations, it's not the final legal analysis that is relevant but the legal uncertainty. Arguing the above case with a regulator may take too much time and is not the preferred option for risk-averse large issuers of fuel cards. So we may well see some players in the oil industry ending up not arguing their legal case and abiding with a flawed regulator view that takes fuel cards into the exemption scope of PSD2.

The wider implications: Payment Service Directive becomes Purchase Services Directive

If the fuel card case is not being challenged in courts, it sets an interesting precedent. Because in essence, there is no analytical difference between the fuel card and PIN mentioned above and the user-id / password combination that is in use by retail customers that are shopping at websites, using purchase buttons. Both tools are and should be out of scope for a payment service regulator. Just arguing that the instrument looks to much like a payment instrument is just not enough. Ceci n'est pas une pipe 'payment instrument'.

Forgetting the adjective 'payments' in article 3k means that the second Payments Services Directive may well turn into a full swing Purchase Services Directive. And by the looks of it, this is what the FCA may be doing in the fuel cards niche right now. This leaves the rest of the market wondering if their niches may follow at some point in time. 

Supervisors should however not cross that Rubicon and avoid transforming the PSD2 into a Purchase Services Directive. They should stick to the legal definition and if they don't like the consequence should not take justice in their own hands by forgetting adjectives that stand in the way of their (hidden) agenda's.  

Let commerce be commerce and payments be payments. 

Response to FCA consultation: please clarify what will happen to the payment in 'payment instrument' in article 3k?

This April, the FCA launched its consultation on the Implementation of the revisedPayment Services Directive(PSD2): draft Approach Documentand draft Handbook changes. When reading this I was in particular paying close attention to the discussion of the limited network exemption in article 3k.

Background: limited network exemption
The limited network exemption has its background in the fact that many retailer-based shopping or payment solutions exist, that have a function similar to that of a payment, albeit on a local scale or for a limited range of goods. In order not to be burdened with a huge supervisory obligation, the regulator has taken this class of activities out of the scope of the Payment Service Directive and rightly so.

There is a relevant difference between providing EU wide, reachable payment instruments and solutions that solve a specific niche retailer problem. But getting this right in all detail is tough and therefore the wording of article 3k is somewhat vague.

(k) services based on instruments that can be used to acquire
goods or services only in the premises used by the issuer or
under a commercial agreement with the issuer either within
a limited network of service providers or for a limited range
of goods or services;

This allows supervisors to apply the article in a sensible way, in line with the spirit of the regulation.

Changes in PSD2: from instruments to payment instruments
The Paysys report of March 2014, describes the following on the evolution of the article:

In its final report on the PSD II (11 March 201412) the ECON Committee accepted the Recital 12 with the statement of the Commission of the existence of “massive payment volumes and values” offering “hundreds or thousands of different products and services” which are wrongfully operating under the exception of the limited networks of the Payment Services Directive (2007/64/EC). In order to improve consumer protection, these huge payment schemes should no longer be waivered.

Therefore, the Commission proposed a narrowed definition of “limited network/limited range” (Article 3 k) and a very restrictive implementation. In general, the ECON Committee followed the proposal of the Commission by taking over uncritically its assumption of the existence of non-regulated “massive payment volumes” in the market.

In phrasing the new article however, something did happen that may have been legally quite relevant. The wording instruments changed into payment instruments. This means that instruments which do not qualify as payment instruments and are not used to deliver payment services under the PSD2, will not qualify.

(k) services based on specific payment instruments that can be used only in a limited
way, that meet one of the following conditions:

• (i) instruments allowing the holder to acquire goods or services only in the premises of the issuer or within a limited network of service providers under direct commercial agreement with a professional issue;
• (ii) instruments which can be used only to acquire a very limited range of goods or services;
• (iii) instruments valid only in a single Member State provided at the request of an undertaking or a public sector entity and regulated by a national or regional public authority for specific social or tax purposes to acquire specific goods or services from suppliers having a commercial agreement with the issuer; 

Effectively this takes out a lot of retailer instruments, which sometimes can be card-based, as they are not truly payment instruments but tools to add purchases into a shopping basket (which can be paid monthly via direct debit payment for example). It also means that petrol cards or fuel cards that are based on a similar mechanism - and may include a chain sale - will not fall under the exemption but can be considered out of scope.

Now, my personal guess is that while this legal consequence is clear, supervisors may want to ignore the relevant adjective 'payments' in order to keep their hold on near-payment mechanisms, even when they are not in scope of the PSD2 and do not fit under this definition. For that reason I was very interested to see what the FCA did with the difference between instruments and payment instruments.

What does the FCA propose to do with this?
It' turns out that in the consultation document the FCA sometimes pays lip service to the original definition, but mostly conveniently forgets the 'payment' part of 'payment instrument' in the definition of 3k. See for example their summary phrasing on page 19:

Limited network exclusion

2.18 Under the PSRs 2009, a business that offers a payment service may be excluded from regulation if its service is based on instruments that can be used only in a limited way to acquire goods or services in certain limited circumstances (often called the “limited network exclusion”) e.g. some gift or store cards.   

2.19 PSD2 aims to standardise the application of the limited network exclusion across the EU, and makes changes to the exclusion which mean it now applies less widely. One limb of the exclusion’s application is narrowed so that it relates to instruments used to acquire a “very” limited range of goods and services (rather than “limited range” set out previously in PSD). A new limb excludes certain instruments provided for social or tax purposes from regulation under the PSRs 2017. Our proposed amendments to Q40 and Q41 in PERG 15 give guidance on the scope of the amended exclusion. 

Then again, the formal notification form does state that the respondent should clarify if the notification tix all the boxes of the law:

Please explain how the product or service falls within the limited network exclusion specified, including details of the following where relevant:

• the payment instrument; 

• where and how the payment instrument can be used; 

• where the customers or users are based; 

• etc.....

Well, this proposed approach is pretty confusing, so therefore I sent in a reply to the consultation asking to clarify the FCA interpretation of article 3k. In doing so I also referred to the fuel card situation and the set up with chain sales.

Clarify the confusion: are you reading payment instruments as 'instruments' in 3k or not?

We are wondering why the FCA is properly using the delineation payment instruments in a lot of the texts on limited network exclusions, but when it comes down to the actual formulation of excluded activities in Perimeter Guidance, it chooses to forget the word "payments" and sticks to: payment services based on instruments used within a limited network of service providers or for a very limited range of goods or services (“limited network exclusion”). This would create an inconsistency in which the old understanding of limited network is moved towards the new PSD2-interpretations although the legal wording is substantially different.

Should we understand the changed wording to be merely an omission or a situation of intended regulatory scope creep, to include all kind of non payment instruments under the scope of the payments directive? 

When the final document comes in, we'll have a look at the response of the FCA, to see if things have become more clear.