The proverbial invisible hand of the market, acting through competitive pressures, will yield far more effective results than heavy-handed price regulation in the payments services market
If you enjoy coffee like me, there are chances you bought it at the nearest Starbucks outlet using the Starbucks app. Clubbing loyalty with payments, the app is a beautiful hook for the customer to stay engaged with the brand. The “gamified” experience it offers the consumer by challenging her to get more stars the more she buys at the stores, and the rewards at the end of each incremental iteration, go a long way in driving sales. It’s a killer app. Since it is a “closed-loop” payment instrument, Starbucks saves on merchant discount charges that it would otherwise pay its partner banks, the more its customers transact using the app.
Now, how does the Starbucks experience relate to central bankers and card schemes?
Consider the alternative. You walk into the store, use your pin and chip card issued by your bank on say, MasterCard rails, to buy your favourite coffee. Now as card economics currently stand, Starbucks pays its “acquiring bank” a merchant discount rate (MDR). This MDR is partly a function of the fee (called interchange fee) the acquiring bank pays the card-issuing bank. These transaction charges are baked into the business model of cards and there are reasonable arguments, including in academic literature, that show that these charges are efficient and facilitate both the consumer and the vendor in terms of bringing the latter sales.
As payment ecosystems are two-sided markets, the interchange fee (and its corollary, the merchant discount fee (MDF)) are essential in facilitating transactions through the cards ecosystem. The issuing bank incurs customer-specific investments in the rewards-programmes that motivates the user to transact. These transaction charges are compensation for the issuing bank for those investments. Since the consumer has a multitude of payment options, absent these specific investments, she may not transact using cards. That, in substance, is the rationale for their persistence.
But central bankers in several nations have historically taken a different view of these fees and sought to regulate them directly; mostly through capping the MDF/interchange fee. Empirical studies suggest such direct regulation may have demonstrably hurt merchants and consumers, the very constituency central bankers sought to protect through the regulation.
For example, the United States Federal Reserve imposed price caps on debit interchange fees to achieve the objectives of the Dodd-Frank Act (the so-called Durbin Amendment). In capping these charges, the Fed hoped to protect the consumer from retail inflation through surcharge and the like. However, surveys carried out by Richmond Fed indicate that these price caps had no impact on many merchants and may have actually increased their costs in case of small value transactions.
Furthermore, the Congressional Research Service found that consumers experienced either higher charges or lower payment services, in part flowing from the effects of Durbin Amendment.
The effects remain similar even if central banks choose to cap the MDR, as the Reserve Bank of India (RBI) has historically done. As the Watal Committee report on digital payments pointed out, the MDR caps are an important constraining factor in India’s low density point-of-sale (PoS) ecosystem. The MDR caps essentially make acquiring merchants a non-viable proposition for acquiring banks, thus depressing the number of card transactions. Interestingly, the Watal panel argued for regulating interchange fees and leaving the MDR to the free play of market forces. But as the US experience shows, even if the RBI were to implement that regime, the effects on consumers would likely remain the same.
The conclusion is clear: central banks should not regulate prices in the payment services sector. Instead, they should facilitate innovation and competition to supply an upper bound for potentially high interchange fees and let markets work. Such innovation is most likely going to emerge from the merchant ecosystem.
Starbucks is not an isolated example. Uber recently introduced Uber Cash that consumers can use to pay across the Uber ecosystem including food-delivery, ride-sharing and such. It can also emerge from new payment service providers with different pricing models.
Further, competition need not be a preserve of bulge bracket merchants. Subject to permissive regulations, mid- and small-sized retailers can issue common closed-loop tokens redeemable across their respective outlets to mitigate the cost of payments. The proverbial invisible hand of the market, acting through competitive pressures, will yield far more effective results than heavy-handed price regulation in the payments services market. That’s the lesson central bankers can learn from the Starbucks app. For the price of a cup of coffee.(The author is a payments / fintech policy consultant. Views are personal)