Interchange fees, a balancing act

An empirical examination of a possible regulatory benchmark

Michal Kalina1 Duisenberg School of Finance

April, 2015

Thesis, LLM Finance & Law

Supervisor: prof. dr. Maarten Pieter Schinkel

1 Author can be contacted through: michal@savnar.nl

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Interchange fees, a balancing act

An empirical examination of a possible regulatory benchmark

Michal Kalina1 (20120064)

Duisenberg School of Finance, LLM Finance & Law Programme

Master thesis, 20 April 2015

Abstract

In this paper I show the notional development of the level of the interchange fee for

debit card payments in the Netherlands, based on an alternative method to the tourist-

test. The alternative has a few a priori attractive features, such as a closer resemblance

to a debit card favouring market, whereas most of the literature does not distinguish

between debit and credit cards or focusses on the latter. Countries in Europe with high

card usage per capita and low interchange fee levels, are typically debit card markets.

However, using cost data for 2002 and 2009 I show that the method is likely to exhibit

market disturbing effects by reversing the market structure through a negative and

much larger interchange fee than in reality. In the long run, calibrated to actual

institutional settings, the method would create the wrong incentives, stimulating the

use of the more expensive payment instrument and discouraging the more efficient. The

results indicate that application of this alternative method would be ill-advised for

countries such as the Netherlands, with rising costs for cash and declining costs for

debit card; thus, regulators should be looking for other benchmarks.

1 I would like to express my gratitude to a few people without whose support or doings, this thesis would not have

been accomplished: Joe McCahery for directing a superb programme in Finance & Law; Maarten Pieter Schinkel

for sharing his insights on the subject and support to set the scope; Søren Korsgaard for elaborating on his model,

enabling me to properly calibrate it; Nicole Jonker for showing me the adjustments in cost item classifications in

the 2009 data set compared to the 2002; Frank Leerssen at Rabobank for his support and flexibility to combine

my work and study; and foremost my wife, Caroline Spoor-Kalina, for the best support I could wish for throughout

the course, this thesis and beyond.

The views expressed in this study are my own, as are any remaining errors.

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Table of Contents

1 INTRODUCTION .............................................................................................................................................. 8

1.1 Background and motivation ............................................................................................................. 8

1.2 Research question ............................................................................................................................. 11

1.3 Academic contribution..................................................................................................................... 12

1.4 Thesis structure .................................................................................................................................. 13

2 PAYMENTS MARKETS, INTERCHANGE FEES AND REGULATION .......................................... 14

2.1 Basics and terminology ................................................................................................................... 14

2.2 Social costs of payments.................................................................................................................. 15

2.3 Challenges in payment markets ................................................................................................... 15

2.4 The concept of interchange fees .................................................................................................. 17

2.5 Justifications for interchange fees ............................................................................................... 18

2.6 Some landmarks in interchange fee litigation ........................................................................ 20

2.7 A note on SEPA and PSD .................................................................................................................. 23

3 REVIEW OF LITERATURE ........................................................................................................................ 26

3.1 Preliminary ........................................................................................................................................... 26

3.2 Models of interchange fees and policy implications ............................................................ 27

4 ANALYTICAL FRAMEWORK ................................................................................................................... 37

4.1 Interchange Fee model .................................................................................................................... 37

4.2 Costs model .......................................................................................................................................... 41

5 DATA ................................................................................................................................................................ 45

5.1 Data collection 2002 ......................................................................................................................... 45

5.2 Data collection 2009 ......................................................................................................................... 46

5.3 Data .......................................................................................................................................................... 47

6 ESTIMATION ................................................................................................................................................. 49

6.1 Payments developments in the Netherlands 2002 - 2009 ................................................ 49

6.2 Calibration ............................................................................................................................................ 53

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6.3 Obtained results ................................................................................................................................. 56

6.4 Robustness ............................................................................................................................................ 57

7 CONCLUSIONS .............................................................................................................................................. 60

7.1 Discussion of the results ................................................................................................................. 60

7.2 Limitations of the study ................................................................................................................... 61

7.3 Afterword .............................................................................................................................................. 61

8 REFERENCES ................................................................................................................................................ 62

8.1 Bibliography ......................................................................................................................................... 62

8.2 (Pre-) Legislation, Cases and Miscellaneous Links ............................................................... 66

9 APPENDICES ................................................................................................................................................. 69

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LIST OF ACRONYMS AND ABBREVIATIONS

ABC Activity Based Costing

ACH Automated Clearing House, see CSM.

ACM Autoriteit Consument & Markt. Founded in April 2013, merger of Dutch

Telecom regulator (OPTA), Dutch competition authority (NMa) and Dutch

Consumer Rights supervisor.

AFM Autoriteit Financiële Markten. Dutch supervisor of financial markets

conduct.

AML Anti-Money Laundering

ATM Automated (or automatic) Teller Machine.

BBAN Basic Bank Account Number.

BGC BankGiroCentrale. Former interbank payments processor (CSM) in the

Netherlands.

CSM Clearing and Settlement Mechanism. In the context of this paper, CSM can

be deemed synonym for ACH. More info: e.g. Kokkola (2010).

CUP China Union Pay, a four-party scheme card brand based in Shanghai.

DNB De Nederlandse Bank, Dutch central bank.

EC European Commission.

ECB European Central Bank.

ECJ European Court of Justice.

EEA European Economic Area: all Member States of the EU plus Iceland,

Norway and Liechtenstein.

EIM Economisch Instituut voor het Midden- en Kleinbedrijf (~Economic

Institution for the SME sector). Now part of Panteia.

EP European Parliament.

EPC European Payments Council. More info:

http://www.europeanpaymentscouncil.eu/

FD Financieel Dagblad, Dutch leading daily financial newspaper.

HACR Honour All Cards Rule. A business rule set by a scheme prohibiting the

merchant who accepts a particular card brand to distinguish between

issuers (general implementation of the rule in Europe, differs from the US).

IBAN International Bank Account Number.

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IF Interchange Fee.

JCB A three-party scheme credit card company based in Tokyo.

MIF Multilateral Interchange Fee.

MinFin Either the Dutch Minister of Finance or the Ministry of Finance.

MOB Maatschappelijk Overleg Betalingsverkeer (~Societal Consultation on

Payments), by order of MinFin in 2002. Chaired by DNB. More info:

http://www.dnb.nl/binaries/Oprichting%20MOB_tcm46-274623.pdf

NBC Nationale BetalingsCircuit. See Box 3.

NFC Near Field Communication or Near Field Communication technology.

NMa Nederlandse Mededingingsautoriteit. Dutch competition authority. Now

part of ACM.

NVB Nederlandse Vereniging van Banken (Dutch Banking Association)

NYSE New York Stock Exchange

OFT Office of Fair Trading. UK’s consumer protection and competition

authority.

OJEC Official Journal of the European Communities.

PIN Personal Identification Number. Also the brand and scheme of the former

Dutch domestic debit card. Became part of Dutch vocabulary: to pin is to

make a debit card payment or ATM cash withdrawal.

POS Point Of Sale.

PSD Payment Service Directive (Directive 2007/64/EC). See References.

PSP Payment Service Provider, term introduced in PSD

RTGS Real Time Gross Settlement (system)

SCT SEPA Credit Transfer (scheme)

SDD SEPA Direct Debit (scheme)

SEPA Single Euro Payments Area. The jurisdictional scope of the SEPA Schemes

currently consists of the 28 EU Member States plus Iceland, Norway,

Liechtenstein, Switzerland, Monaco and San Marino. Note that this is a

larger area than the Euro-countries. More info:

http://www.europeanpaymentscouncil.eu/index.cfm/knowledge-

bank/epc-documents/epc-list-of-sepa-scheme-countries/

SME Small and Medium-sized Enterprise

SO Statement of Objections

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St.BEB Stichting Bevorderen Efficient Betalen (Foundation to Promote Efficient

Payments). Founded in Nov. 2005 to manage EUR 10 million donated by

the banks as agreed in the Convenant Betalingsverkeer. More info:

http://www.efficientbetalen.nl/

SWIFT Society for Worldwide Interbank Financial Telecommunication. A member-

owned cooperative, predominantly owned by banks.

TFEU Treaty on the Functioning of the European Union (2012).

TPP Third Party PSPs, term introduced in PSD2

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1 INTRODUCTION

“The most important financial innovation that I have seen the past 20 years is the automatic teller machine,

that really helps people and prevents visits to the bank and it is a real convenience. How many other

innovations can you tell me of that have been as important to the individual as the automatic teller machine,

which is more of a mechanical innovation than a financial one?”

Paul Volcker, former FED Chairman1

1.1 Background and motivation2

The history of the payments industry is the history of banks and money. And it is full of

“mechanical innovations”, some of which successful like the ATM, while many others were

not or only briefly so. For example, after almost 20 years the Dutch banks have

decommissioned the Chipknip, a domestic e-wallet type payment product3, per the beginning

of this year. An empirical cost study in 2002 showed that a payment made by Chipknip had

already then by far the lowest variable social costs compared to cash, debit card or credit

card4. For the longest time most consumers had one in their wallet and the system had

worked without an interchange fee, yet as a payment product it never became a real success5.

One may wonder why. Clearly, the absence of an interchange fee is no guarantee for a

successful payment instrument. Nor is the presence of one. This paper is however not a post-

mortem on the product.

The worldwide success of payment cards is undisputed and it provides a fruitful ground to

academics for study. And for regulators to intervene, so it seems. For long, offering payment

services has been the exclusive domain of banks and their legal monopoly on providing

current accounts or creating money remains until today. Being mostly private institutions

entrusted with the facilitation of a public good6, banks are obligated to comply with a sizeable

and increasing set of rules and regulations. On the one hand, this may ensure the security and

1 Speech at the occasion of addressing ideas for reforming financial services at Wall Street Journal Future of

Finance Initiative in the UK, December 2009. [1], 21 August 2014. 2 Several terms and concepts introduced in this paragraph will be properly explained later on in this paper. 3 e-wallets currently on the market are more advanced and can typically contain several virtual payment ‘cards’.

The Chipknip was designed as an alternative to coins and low-denominated banknotes. 4 3 eurocents, compared to 11, 19 and 80 eurocents for a cash, a debit card and a credit card transaction

respectively. Source: (DNB) Brits & Winder (2005), table 4.3, p.26. 5 The officially first Chipknip transaction was done by Wim Duisenberg, then president of DNB on October 26,

1995. It reached its peak in 2010 with 178 million transactions that year; by comparison, there were 2,154 million

debit card transactions (source: Currence Annual Report 2011, p.8). The decommissioning was announced by the

banks and the brand owner Currence in March 2013, to take effect as of 1 January 2015. 6 See also e.g. Freixas & Rochet (2008) par. 1.1.

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safety of the entire payment system. For example, banks are expected to take appropriate

measures to fight illegal activities such as fraud, money laundering, terrorism financing or tax

evasion, or prevent payments to entities (e.g. persons, institutions and countries) that have

been sanctioned1. On the other hand the regulatory burden amounts to a significant cost level

and since the efficiency of the payment system is also of fundamental concern to society, it

constitutes another justification for public intervention. A frequently taken route by

governments to increase efficiency, is to create or let market participants create (regulated)

monopolies that can then capture the economies of scale that so typically characterise

payments processing volumes2. Another way to increase efficiency is to increase competition,

or so the contemporary paradigm dictates. In the payments industry however this can lead

to different or even opposite results3. To illustrate this point from theory: Matutes and Padilla

(1994)4 model a case of three competing banks who choose membership to some ATM

network and find that if equilibrium exists, it will not be efficient as there will be either three

incompatible ATM networks (so the cardholder can only withdraw cash at ATMs from his

own bank) or two banks sharing their ATM network and leave the third bank out. To illustrate

the point from practise: it is generally posited that the US banking sector and the US payments

industry is competitive, and more competitive than for example (most countries in) Europe.

Yet the interchange fees for credit cards are significantly higher in the US (around 50%) than

in Europe, the UK or Australia and that was even before regulatory action brought it further

down in the latter three regions5. One explanation offered for this phenomenon is known as

reverse competition and can be summarized as follows: card schemes compete with each

1 Economic and political sanctions on territories and/or specific persons therein; current examples include Russia,

the Crimean part of the Ukraine, Iran, Cuba (although these are now in the process of being (partially) lifted),

Zimbabwe, North Korea, and others. There are multiple sanction lists, most importantly the US OFAC list, the

EU-sanctions list and lists maintained by designated agencies (e.g. Interpol). Many banks have recently found

themselves facing criminal charges and huge penalties for not taking appropriate measures and/or failing to report

suspicious transactions. For example: JP Morgan Chase $1.7 billion penalty regarding Madoff’s Ponzi scheme;

HSBC for facilitating transactions to and from Cuba, Libya, Iran (and others) and for drug cartels in Mexico and

Colombia ($1.9 billion), similarly BNP Paribas ($8.9 billion); UBS ($780 million) and Credit Suisse ($2.6 billion)

for facilitating tax evasion; Commerzbank for “unsafe and unsound practises” violating US sanctions and AML

laws ($1.7 billion). [2], [3], [4], [5], 12 March 2015. 2 Beijnen and Bolt (2009), in Bolt (2013) p.75, estimate economies of scale for card payments about 0.25–0.30,

based on cost data of 8 European processors spanning 15 years. This means that a 100% increase in payment cards

volume leads to just a 25–30% increase in total costs. 3 Opposite to conventional economic wisdom. Economic history seems apt in bringing forward counter-intuitive

results. For example Gresham’s Law (“bad money drives out good money”) or Akerlof’s lemon (“poor quality

second-hand cars drive out good quality second-hand cars”). Some scholars regard government intervention as a

cause of counter-intuitive results, e.g. Fisher Black on systemic risk: “… It means that they [the government] want

you to pay more taxes for more regulations, which are likely to create systemic risk by interfering with private

contracting…” (in Danielsson, 2013, p.35). 4 Taken from Freixas & Rochet (2008) p.87. 5 See Hayashi (2004), p.3, chart 1, also to be found in Weiner & Wright (2005), p.299, chart 2.

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other by offering ever higher interchange fees to banks that issue their cards. These IFs

constitute revenues to these bank and this results in higher fees for card payments for

merchants who pass these costs on to consumers, either directly or indirectly1. The European

Commission (EC) uses this argument in their assessment of the economic effects of

interchange fees2. A second effect of reverse competition is that the increased interchange fee

(IF) level then may serve as a protection for incumbents from market entry of new card

schemes as these will at least have to match the existing IF level to get a foothold.

Similarly, the increasing regulatory burden can also work as a barrier to market entry as a

large part thereof are sunk costs. In this sense it may perhaps seem ironic that the EC has

recently proposed more regulation to increase competition and foster innovation on the

payments market. I’m referring in particular to the ‘Payments Legislative Package’3,

consisting of an Interchange Fee Regulation (IFR) and a revised Payments Services Directive

(PSD). Years of legal combat and emotional debate have preceded the IFR4, in courts and in

political and academic circles5. The IFR has largely been voted for on 10 March 20156 in the

Plenary of the European Parliament7. Once official, a maximum IF will apply for debit cards

of 0.2% and for credit cards of 0.3% for cross-border consumer transactions as of 2 months

after the IFR enters into force (art. 3) and equally for all consumer transactions as of 2 years

1 By applying a surcharge on the card payment or by slightly increasing overall prices of the goods sold. 2 See for example SDW(2013) 288 final, the EC’s Impact Assessment accompanying the proposals for PSD2 and

IFR (see footnote 3 below). Europe Economics, a London based consultancy firm, in a report commissioned by

MasterCard finds this assessment to be “plainly wrong” (Europe Economics, 2014, p.11). 3 Presented by the EC on 24 July 2013. Core pieces are COM(2013) 547 final, hereafter PSD2 (Payment Services

Directive 2); and COM(2013) 550 final, hereafter IFR (Interchange Fee Regulation). The EC currently expects

adoption in May 2015. 4 Parts of the PSD2 are also still under heavy debate, see §2.7. 5 As another example of possible adverse outcomes: several banks have voiced that the EC’s choice to let the

cardholder choose the payment card brand at the moment of the transaction when more than one brand is accepted

at the POS (IFR art. 8(18)), will lead to higher costs for the users and strengthen the MasterCard/VISA duopoly

in Europe. The argument is that the cardholder will choose the brand that’s on top of mind which is most likely

one of the two international brands and not some cheaper yet less known local brand; thus, this will start an ever

intensifying advertising campaign, a race ultimately to be won by the two deep-pocketed companies. See for

example [12], 9 April 2015. The hypothesis bears similarity to the reverse competition argument, formal economic

literature however points in the opposite direction, see e.g. Rochet & Tirole (2002). For more on consumer

payment behaviour, see e.g. HBD (2002), Jonker (2007), Bolt, Jonker and Renselaar (2008), Jonker, Kosse and

Hernandez (2012), Kosse and Vermeulen (2014) and Bagnall et. al. (2014). 6 Proposed amendments to articles have been taken into account in this paper as far as possible and relevant until

31 January 2015. As the exact final wording of the entire text is not yet officially published, I use the text as

published in 2013 (COM(2013) 547 and 550), unless otherwise indicated. 7 Similar developments take place all over the world. For example Rochet & Wright (2009, p.4-5) report “...more

than 50 lawsuits concerning interchange fees filed by merchants and merchant associations against card networks

in the US, while in about 20 countries public authorities have taken regulatory actions related to interchange fees

and investigations are proceeding in many more”. Hayashi (2013) gives an updated overview and accounts for

over 30 countries where regulatory actions have been taken.

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after the IFR enters into force (art. 4). These caps have been calculated by MasterCard1 using

a test called the (merchant) avoided-cost test, popularised as the ‘tourist-test’, derived from

Rochet and Tirole (2008). The EC finds it a “reasonable benchmark for assessing a MIF level

that generates benefits to merchants and final consumers”2. To calculate the figures

MasterCard used three empirical cost studies of the central banks of Belgium, Sweden and

the Netherlands (DNB). The latter study was published by Brits and Winder (2005) and

contains data pertaining to the year 20023. MasterCard implemented the caps on their cross-

border MIFs with the EC’s consent as of July 2009 (see also §2.7).

Jonker and Plooij (2013)4 have analysed the tourist-test using the Brits and Winder data and

a second dataset pertaining to 2009 and report in an understatement that their results

indicate the test can have “unintended consequences”: in a country like the Netherlands

where social costs of cash are increasing and the social costs of debit card payments are

decreasing, the IF level may actually more than double from 0.2% to 0.5% of an average debit

card transaction size and still pass the test (in other words: the test would qualify the IF level

as ‘not excessive’). If this rise were to be passed on to merchants completely, they would

experience a surge in their costs by 233%. Moreover, where an IF is intended to cover (part

of) the internal costs of the issuing bank, the calculated tourist-test IF level would be higher

than the issuing and acquiring costs of the banks combined. The researchers therefore

recommend competition authorities to look for a different benchmark.

1.2 Research question

The objective of this study is to examine an alternative model to the tourist-test and analyse

how that model, if applied, would affect the IF level for debit card payments in the

Netherlands over time, using cost data for 2002 and 2009, i.e. the same data sources that the

DNB researchers used for their empirical test of the tourist-test. This alternative model has

some preferable features, in particular a closer resemblance to a debit card favouring country

such as the Netherlands, whereas the Rochet and Tirole’ model does not distinguish between

debit and credit cards. The main question to be answered is:

Does the method present a viable alternative to the tourist-test benchmark?

1 Schwimann (2009). 2 Press release by the EC, Commissioner Kroes, 1 April 2009, memo 09/143. 3 The Belgian and Swedish studies concern the years 2003 and 2002 respectively. 4 Also published by Bolt, Jonker & Plooij (2013).

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PM: I make a distinction between the formal model and its operational counterpart which I

casually refer to as ‘method’.

1.3 Academic contribution

After Baxter (1983) his contribution, the topic of interchange fees faded from academic view

and policy circles. By the end of the 1990s the topic started to attract academic attention, in

parallel with law suits and regulatory investigations in a number of countries in the world.

Rochet and Tirole (2000) published a seminal paper and since then economic literature on

the topic surged, together with the building of knowledge on the functioning of two-sided

markets. The more formal economic literature in the first decade of this century generally

yields two broad conclusions: 1) IFs are foremost a balancing device, as opposed to a collusive

device, their level depends on much more (if at all) than the costs of producing the payment

alone; 2) there is no apparent need for a regulator to intervene. These findings are of

particular importance considering that regulators and courts usually employ a test based on

issuers’ costs in their assessment of possibly excessive merchant fees. Some more recent

academic contributions however do point to market failures that might need mending by

regulation. Confrontation with empirical data was for long very rare. As far as I am aware,

Brits and Winder (2005) were one of the very first to publish empirical cost data (see also

section 5). Their study concerned the Dutch POS1 payment market in 2002. Similar studies

by other central banks in European countries followed, often adopting their conceptual cost

model. Schmiedel, Kostova and Ruttenberg (2012) present the aggregated results of thirteen

of these empirical studies, most of which with data on 2009. So far, only for the Netherlands,

Sweden and Norway detailed cost studies on two or more years are available2 (year 2009

data on the Netherlands and Sweden were part of the study by Schmiedel c.s.). This offers a

first opportunity to study the development in social costs of card payments. Jonker and Plooij

(2013) use two datasets on the Netherlands in their examination of an application of the

tourist-test. To my knowledge Korsgaard (2014) is the first to construct a formal model that

resembles more that of a debit card favouring market, whereas other papers focus either on

credit cards or on the payment activity, rather than the particular instrument. He also reviews

his model in the light of empirical data for Denmark3 and finds a ground for regulation (as is

1 Point Of Sale. 2 See Jonker (2013) p.9. 3 Most of the data Korsgaard uses is published in Danmark Nationalbank (2011, 2012) which were the basis of

the Danish part of the cost study by Schmiedel c.s.

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already the case in Denmark). My study is the first to calibrate that model to two different

years and to analyse the predicted notional IF levels over time. By using the same datasets

and data sources as in the empirical test of the tourist-test for the Netherlands, the

predictions of the two models can be compared.

1.4 Thesis structure

The remainder of this paper is structured as follows. Section 2 offers an introduction to the

retail (card) payments industry, introduces basic terms and concepts and touches upon

regulatory developments. Section 3 reviews the literature on interchange fees with a focus

on formal models that allow for a welfare analysis. Section 4 presents the analytical

framework to examine the notional interchange fee levels in the Netherlands, consisting of a

formal model for optimal interchange fees and a cost model that captures the concept of

social costs in payments. Section 5 outline how the data for the two years, 2002 and 2009,

have been collected and presents the most important data. Section 6 then shows how I

calibrate the model with the empirical data, presents the results and extends some

robustness checks. Section 7 discusses the results and offers some recommendations for

future research and policy. Finally, section 8 contains the references.

Reading notes

For illustrative purposes, I sometimes make references to news articles, position papers etc.

that can be found on the internet. I refer to them, mostly in footnotes, with a simple [#], which

is short for: “see References, link [#number]”, for example link ‘[9]’. The references link is

followed by a date indicating when I last accessed it.

Occasionally I place short stories, also meant as illustrative background information, in boxes.

They can be skipped without loss of thread of this study.

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2 PAYMENTS MARKETS, INTERCHANGE FEES AND REGULATION

This section provides a brief introduction to the retail (card) payments industry and a context

for putting the findings of my research into perspective.

2.1 Basics and terminology

In retail payments there are usually four parties involved: the payer and the payee who

transact with each other, and their respective banks. In their roles of economic agents, the

payer is normally referred to as the “buyer” (of goods) and the payee is the “seller”: the

payee/seller sells goods or services to the payer/buyer and in return the payer offers cash,

writes a cheque, uses his debit or credit card, initiates a credit transfer, mandates the payee

to initiate a direct debit, or uses some other payment instrument1. In the context of (wire)

transfers, the payee is normally referred to as the “beneficiary” (of the funds) and his bank is

the “beneficiary’s bank”. In the context of payment cards, the seller is usually referred to as

the “merchant” and his bank as the “acquirer” or “acquiring bank”; the buyer is then referred

to as the “cardholder” and his bank as the “issuer” or “(card) issuing bank”.

A debit card is issued by the issuing bank to the cardholder and provides him electronic

access to his current account2, either through internet/online banking, to withdraw cash

from an ATM or to initiate a transfer of funds at a POS terminal. A credit card on the other

hand is not directly linked to a current account and in three-party models (see §2.3), the

credit card company is an entirely different firm than the bank where the cardholder holds

his current account.

Retail payments between banks on behalf of their customers, millions per day, are usually

not executed individually but sent to clearing institutions or Clearing and Settlement

Mechanisms (CSMs) who sort, match and net all of the incoming and outgoing payment

instructions and then calculate the net amount to be paid or received per bank participating

in the mechanism. Information on these calculated net amounts is then sent to the settlement

institution, usually the local central bank, who settles the claims. This means that the central

bank, where all domestic banks hold an account, transfers funds between these accounts

corresponding to each bank’s claim, provided there is sufficient liquidity or collateral. The

banks are only liable for these net amounts but the banks receive details of all underlying

1 I use the term “payment instrument” in a general meaning as a way to initiate a transfer of funds. Whether a

paper cheque, a plastic card with a magnet stripe or chip, a chip with NFC inside a mobile phone or an app on a

smartphone, the exact technology or carrier is not of particular relevance in the context of this paper. 2 Synonyms for “current account” are “payment account” and “checking account” (typically US custom).

15

transfers from the CSM, enabling them to credit each customer’s account accordingly. The

settlement is usually a daily process at the end of the business day, but frequently the

participants choose to settle several times a day1.

2.2 Social costs of payments

From the point of view of society, payments are costly: estimations of the costs of retail

payments for the European Union (EU) are roughly 1% of GDP, i.e. € 130 billion. Banks and

interbank infrastructures (e.g. CSMs) incur 50% of these social costs, retailers about 46%,

central banks about 3% and the remaining 1% is incurred by cash-in-transit companies (e.g.

conveyance of banknotes)2. Social costs refer to the costs of the resources employed to

‘produce’ the payment services, that is: the sum of all internal costs by all the agents involved

to execute a payment transaction. Private costs are all the costs a single agent faces and/or

incurs to produce a payment transaction and include by definition internal and external costs.

External costs are the charges (e.g. fees) the agent pays to other agents in the value chain.

Since the external costs to one agent in the chain are revenues to others, these external costs

cancel out in the calculation of total social costs. Equivalently, social costs can be defined as

the sum of all parties their net costs (total costs – revenues)3.

2.3 Challenges in payment markets

Payment markets exhibit interesting dynamics, in part resulting from multiple potential

market failures. I will indicate a few, in no particular order. Banks are in competition with

each other and increasingly with non-banks. Yet a payment transaction cannot take place

without some basic form of cooperation between the bank (or party) acting on behalf of the

payer and the bank (or party) acting on behalf of the payee, at the very least on some standard

of exchange4. The element of cooperation may conflict with the element of competition. An

1 Next to this there are systems to settle individual, typically high-value transactions in real-time, so-called RTGS

systems, for example TARGET2 used by e.g. central banks in Europe. The CSMs in the payment cards business

are usually different from the CSMs used for wire transfers. Indeed, within the payments business these are rather

separate domains. Typically cards settlement is a daily cycle (end to end) whereas wire transfers often take a few

working days. For example an SCT, see §2.7, is regulated to take no more than 2 business days, that is: the

crediting of the beneficiary’s account must happen at the latest at the business day following the business day on

which the bank received and accepted the payer’s payment instruction (as of 1 January 2012 (PSD, art. 69); until

2012 this was max. 4 business days and before the introduction of the PSD, this could be even longer). 2 Schmiedel, Kostova and Ruttenberg (2012), p.6. Numbers refer to the year 2009. This excludes social costs

incurred by households, which would add on average another 0.2% if those were to be included (id. p.7). 3 See e.g. Schmiedel c.s. (2012), Brits & Winder (2005) or Jonker (2013). Section 4 will give more details. 4 This is the case even when the economic transaction is settled in cash (with fiat money): if a merchant sells goods

and accepts some ‘pieces of paper’ in exchange but later finds out other economic agents such as the banks do

not, then he is likely to end up with a real loss. On a larger scale, the economy might then revert to barter trading.

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industry practise is to separate (as a first step) the set of standards, e.g. the ‘scheme’ and

scheme rules, from the product, i.e. the payment instrument. The latter is the object of

competition, whereas the former defines the space where cooperation is, under certain

conditions, allowed; in the case of payment cards the space has been gradually narrowed

down by courts and regulators where for example certain scheme rules have proven to

hamper competition, see section 3. For a standard to be set effectively requires the

cooperation of a significant part of the market to gain critical mass, which may pose

coordination problems. Similarly, for a card scheme to be successful requires attracting a

sufficient number of merchants as well as consumers (cardholders). Three-party schemes,

for example American Express, Diners Club, JCB and Discover, who issue their cards directly

to cardholders and directly acquire merchants, can set a price structure and price level that

appeals to both sides of the market. Four-party schemes on the other hand, such as

MasterCard, VISA and CUP, do not deal with both sides of the market simultaneously and are

therefore unable to directly balance the costs and benefits to both. This may be a role for

interchange fees. But without the right price structure there may be no payment card product

in the first place. Typical of payment card markets and two-sided markets in general, is the

asymmetrical distribution of costs and benefits, resulting in a (heavily) skewed price

structure: one side of the market bears a significantly larger part of the total costs than the

other. More on these points follows in the next paragraphs and section.

Strong economies of scale may lead to monopolistic platforms with the most efficient cost of

production possible but equally to a risk of abuse of the dominant position and/or a price

setting below socially optimal, thus leading to an underprovisioning of payment cards and

furthermore a lack of incentives to continue to improve efficiency through innovation. The

presence of switching costs to bank customers may reduce banks’ incentives to make their

(ATM) networks interoperable. The same mechanism applies to banks themselves: the

presence of switching costs may reduce interbank networks (e.g. CSMs) to become

With cash, the payment instrument and the standard of exchange coincide. With electronic money there is a

difference: some technological standard for data exchange and the acceptance of these data as a change in debt

obligation (through entry in the bank’s books), that is: liability or ‘money’. This is indeed somewhat ambiguous

because ‘money’ has no clear and unambiguous real-world definition, despite being such a fundamental economic

concept. Recall the definitions of monetary aggregates M0, M1, M2 etc., see e.g. Danielsson (2013) p.36. See

also §2.5.

17

interoperable1, which could ultimately make a transfer of funds between two banks

connected to two different networks, impossible2.

As a last example, I revisit the role of banks as guardians of a safe and secure payment system.

For this they need to share payments information and sometimes information on the

transacting parties, the beneficiary and payer. This sharing of information can conflict with

consumer data protection and privacy rights. These conflicts can occur on national level but

are exacerbated on international level as countries, e.g. the US and the EU, or Member States

within the EU, not always agree or align their positions3.

2.4 The concept of interchange fees

The concept, the mechanics so to say, of interchange fees is straightforward. Following the

setting of payment cards in a stylized setup, picture a consumer (the cardholder) using his

payment card to pay for some goods at a merchant’ store. The cardholder received this card

from his issuer; in case of a debit card this is usually his own bank, in case of a credit card this

can be his own bank, a company affiliated with his or some other bank or a totally unrelated

firm (e.g. American Express and other three-party schemes). This relationship is mirrored at

the other side of the trade: the merchant can accept this payment card as a legitimate way of

receiving payments ever since he has a contract with his acquirer4. When the cardholder

swipes, or nowadays ‘dips’ his card at the POS terminal5, he initiates an authorisation request.

In case of a debit card this request is sent to his bank and if there is enough money on the

account, the transaction will be authorised. In case of a credit card, the request is sent to the

acquirer who authorises the transaction6. The authorisation is observed by the merchant who

1 See also Box 3. 2 Matutes and Padilla (1994) in Freixas and Rochet (2008); for more on the economic effects of switching costs

in general see for example Klemperer (1987). 3 Recall for example the conflict between the EU and the US in the summer of 2006 on the latter’ Terrorist Finance

Tracking Program where they, based on their International Emergency Economic Powers Act of 1978, gathered

information on financial transactions from SWIFT, the world’s largest financial communications network,

following the events of September 11, 2001. The EU forced SWIFT to process intra-EU financial messages within

the EU, removing their backup systems from US territory. 4 The merchant also need a contract with at least a telecommunications network provider for data exchange

between the terminal and a switching centre. 5 For the example it is irrelevant whether it is a POS transaction in the physical world or an online transaction, the

IF works exactly the same way. 6 In practise, there is obviously more to this. For example, the card has to be validated first, checked for not

reported stolen, missing or other fraudulent options and the authorisation request is first sent to a switching centre,

perhaps rerouted to another before it arrives at the issuer. The request can also be handled offline by the terminal.

See e.g. Kokkola (2010) for more on these mechanisms. Notice the difference in risk and liability between a debit

and credit card transaction. Credit card companies will sometimes contractually shift the risk of e.g. eventual non-

payment to the merchant.

18

then can rest assured he will receive a transfer of funds to his bank account in an amount

equal to the selling price of the goods. An IF is simply an amount of money, a fraction of the

value of this funds transfer, that usually goes the opposite direction: from the acquirer to the

issuer1. It is calculated per card-transaction, either some percentage of the value of the

transaction or a fixed fee per transaction.

The IF can be determined either bilaterally between the issuer and acquirer in an arm’s-

length agreement or multilaterally by the scheme. The multilateral interchange fee (MIF)

then applies as a default fee, a fallback in the absence of a bilateral agreement. From a

practical point of view, the MIF accomplishes that the transaction between the merchant and

cardholder can proceed, without the issuer and acquirer ever having made agreements with

each other. The efficiency gain is obvious: with more than 8,000 credit institutions (banks) in

Europe alone, one would need over 32 million bilateral agreements to accommodate all

possible card payment transactions. Disturbing to regulators is that a MIF, in case of VISA and

MasterCard before they were listed (and even thereafter) used to be set by an association of

banks. Parallels with a cartel are apparent. In case of a (pure) three-party model there is no

(explicit) IF as the scheme typically combines and includes the issuing and acquiring

functions.

2.5 Justifications for interchange fees

Whereas the concept of IFs is straightforward, it is the interpretation and justification that

meets scepticism and critique. For a part this is understandable as payment markets are an

instance of two-sided markets and the body of economic knowledge on their functioning is

still evolving. In the earlier literature, economic scholars have gone sometimes to a

considerable extent to emphasise that two-sided markets are nothing exotic but an often

observed and old phenomenon, for example Evans (2003), Rochet and Tirole (2000, 2002,

2005) and Wright (2004a). This has lead others to the remark that therefore no new antitrust

policy should be necessary, at least when dealing with predatory pricing, see e.g. Motta, 2004,

p.452. The main message from these early contributions is that in a two-sided market, it is

perfectly normal and just that one side of the market pays (substantially) more than the other

(instead of each their own ‘fair share’). Consequently, there is no economically justified

reason for a regulator to intervene.

1 The only country I know of where the opposite used to be the case is Australia for eftpos-transactions, a PIN

based debit card scheme (Weiner & Wright, 2005, p. 293 fn.5). However, in 2012 the IF direction was reversed.

19

It should be noted that IFs are not a feature exclusive to payment cards: other retail payment

instruments like cheques, direct debits and typical local instruments like the Dutch

Acceptgiro also carry IFs1. An ATM cash withdrawal by a customer of a different bank than

the one owning the ATM is sometimes mentioned in the literature as another example of an

IF, as it involves a fee from the customer’s bank to the ATM-owning bank. This is however not

a good example as there are only three agents involved: the two banks and a customer of one

of them, but a merchant is missing. In a ‘true’ two-sided market, an issuer (or: bank of the

payer) supplies a service to an acquirer (or: bank of the payee) who supplies a service to the

merchant (payee), but the issuer also supplies a service to the cardholder (payer) to enable

his payment transaction with the merchant. The more merchants accept the payment

instrument (cheques, debit card, credit card, direct debit,…) the higher the benefits of using

it to the payer/cardholder and vice versa. One could therefore reframe the question on the

justification of the IF as: does the issuer get compensation from the acquirer for part of his

internal cost? Or do the issuer and acquirer essentially cooperate to redistribute some of the

benefit the payment instrument usage has to the merchant from the merchant to the

cardholder, in order to induce the latter to use it through a lower fee? This interdependency

and ‘general’ feature adds merit to the argument that IFs are primarily a device to balance a

two-sided market when there is not a single platform to do that implicitly, as for example

with a three-party scheme2.

What complicates matters is that once a line of thought has been chosen, e.g. by a regulator

or the market participants themselves, the line tends to persist. Domestic direct debit

schemes in France, Italy and the Netherlands for example carry an IF but these are strictly

cost based and, as for the Netherlands, set collectively by the Dutch banks based on the per

transaction processing costs of the most efficient debtor bank (issuer). This practise was

1 During the ‘free banking periode’ in the 19th century, commercial banks could issue their own banknotes and

central banks were typically established to organise their orderly issuance. A central bank issues its own liabilities

for use as ‘central bank money’. Commercial banks too began increasingly to issue liabilities, i.e. ‘commercial

bank money’. A layered structure then emerged, whereby private individuals held their deposits in commercial

banks, and these in turn held theirs in accounts at the central bank. Individuals’ confidence in commercial bank

money lay in the ability of commercial banks to convert their liabilities into liabilities of other banks or central

bank money when requested by their customers. The central banks were in particular responsible for ensuring that

central bank money and commercial bank money could coexist and be ‘interchangeable at par’ (Kokkola, 2010,

p.152). 2 See e.g. Rochet and Tirole, 2003, p.73-76, where they argue that for four-party models, the IF is the only

balancing device available.

20

authorised by the NMa1. For SEPA Direct Debits (SDDs), (M)IFs are prohibited as per

November 2012 for cross-border SDDs and as per February 2017 for domestic SDDs2.

This leads to the question if/when an IF is competitively neutral or socially optimal and

consequently, if there is reason for a regulator to intervene. These questions are addressed

in the review of literature section.

2.6 Some landmarks in interchange fee litigation

Evans and Schmalensee (2005) report the case of National Bancard Corporation (NaBanco)

vs. VISA3, filed in 1979 and decided in 1986. NaBanco claimed the MIF that VISA’s member

banks set, was a per se violation of the Sherman Act. This claim was rejected by the court with

reference to the potential efficiency benefits for a two-sided market. In 1983, William F.

Baxter, then professor of Law at Stanford who had worked on the case, published a paper that

was the first to explain the rationale for interchange fees. After the court’s ruling however “...

interchange fees faded from view in academic and policy circles and was a topic of interest

mainly to industry insiders” (Evans and Schmalensee, 2005, p.75). That changed with the

proliferation of payment cards in the Western world (see charts 1 and 2a below for an

illustration) accompanied with lawsuits and complaints to regulators by retailers who were

confronted with an increase in their costs of receiving payments as a result of the usage

increase.

[charts 1 and 2a about here.]

The high profile case in the US of Wal-Mart, Sears Roebuck, Safeway and a long list of other

merchants versus VISA and MasterCard marks the increase in litigation. The case started in

October 1996 and took seven years of legal combat before it was settled in 20034. In Europe

a similar case was filed in 1997 by EuroCommerce, an association of large European retailers

1 Exemption granted in 2002 for 5 years and since then prolonged. Exemption is based on art. 17 Dutch

Competition law (Mededingingswet) “…promoting technical or economic progress…”, compare art. 101(3)

TFEU. 2 Per Regulation EU 260/2012, with the exception of so-called R-transactions, i.e. returned or rejected DDs. These

IFs too must be “strictly cost based” (art. 8). 3 As do Rochet and Tirole (2000, p.2 fn.9). 4 The case turned into a class-action lawsuit and was finally settled on June 4, 2003 for “the largest antitrust

settlement in history” ($2 billion for VISA and $1 billion for MasterCard). Later that month, the district court

approved the notice of settlement. Eighteen merchants, of around five million in the class, objected to the

settlement; the district court however approved it in January 2004 after a fairness hearing. E.g. [7], 7 Sept. 2014.

21

and national commerce federations, however not before court but with the EC. The difference

in approach between these two quests for relief is noteworthy. An important explanatory

factor is the difference in the implementation of VISA’s and MasterCard’s Honour All Cards

rule (HACR). In the US the two schemes required merchants who accept their credit card to

also accept their (signature-based) debit card, whereas in the EU the merchant is not allowed

to distinguish between issuers of a card brand, that is: the merchant has to accept e.g. all debit

cards but is allowed to refuse the scheme’s credit card. Wal-Mart c.s. argued that the tie-in of

both types of cards, together with other scheme rules was an attempt to monopolize the debit

card market in violation of section 1 of the Sherman Act (anti-cartel rule) and as a

consequence the plaintiffs had been charged excessive interchange fees during October 1992

and June 2003. The courts affirmed this notion. This tie-in of both types of cards has never

been present in the EU1. After the EC’s investigation into VISA’s MIFs and VISA’s offer in 2002

to cap them at the level of relevant costs, VISA’s intra-EEA cross border MIFs were exempted

based on Art. 81(3) of the EC Treaty until the end of 20072. EuroCommerce and First Data, a

cards transactions processor and acquirer, appealed against the exemption. Both eventually

dropped the case but First Data did not do so until VISA had withdrawn another one of their

scheme rules: No Acquiring Without Issuing3. Meanwhile, MasterCard had received a

Statement of Objections (SO) from the EC in October 2003 for the way it sets its MIFs,

basically suggesting MasterCard is acting as a cartel. MasterCard was listed on the NYSE in

May 2006, which led to speculations that this change in its legal structure may have been to

avoid the antitrust allegations, or at least in part; see Schinkel (2010) for an entertaining

account. It nevertheless received a supplementary SO from the EC in June 20064, followed by

its infringement decision in December 20075. MasterCard sought annulment of this decision

but the General Court upheld it in May 2012, including the surprising assessment that

1 See also Weiner & Wright (2005) p.300. 2 OJEC L318, 22.11.2002. VISA will apply flat-rate intra-EEA MIFs before the end of 2002 whose weighted

average will not exceed EUR 0.28 (par. 18) and similarly for credit cards an ad valorem fee of 0.7% before the

end of 2007 (par. 19); exemption granted until 31 December 2007 (par. 109). In short, Art. 81(3) states that certain

restrictions on intra -EU competition may be allowed if the agreement / decision / practice “…contributes to

improving the production or distribution of goods or to promoting technical or economic progress...” provided

certain criteria have been met. Art. 81 of the EC Treaty of 1957 has been renumbered as Art. 101 in TFEU. 3 See e.g. Bos (2007, p.114-115) for more on this case. 4 MEMO/06/260, 30 June 2006. [9], 3 April 2015. 5 Case COMP/34.579, December 19, 2007: the EC views MasterCard’s multilateral intra-EEA IF for cross-border

payment card transactions made with MasterCard (credit card) and Maestro (MasterCard’ debit card brand) a

violation of Art. 81 and the MIFs should therefore be withdrawn within 6 months.

22

MasterCard “… had continued to be an institutionalised form of coordination of the conduct of

the banks…”1. MasterCard’s appeal to the ECJ was rejected in September 20142.

After the expiration of VISA’s exemption and just before the IPO on the NYSE in March 2008

as of when VISA Inc. separated with VISA Europe with the latter continuing to be a

membership organisation, VISA Europe was informed of the EC’s opening of antitrust

proceedings, for which it received an SO in April 2009. Another year later both parties had

come to an agreement: following MasterCard who had introduced caps on its weighted

average cross-border MIFs for debit (0.2%) and credit (0.3%) card transaction in July 2009,

VISA Europe would likewise cap its intra-EEA cross border MIFs for debit cards at a weighted

average of 0.2%; moreover the same cap was agreed to apply to domestic VISA debit card

transactions in nine Member States3. The agreement was made legally binding in December

that year. In May 2013, VISA agreed to adopt the same cap of 0.3% MIF for both its cross-

border intra-EEA and domestic credit card transactions.

As already noted in §1.1, the IFR will take this another step further and apply caps to all four-

party payment card transactions, both cross-border intra-EEA transactions and domestic

transactions, both debit card (0.2%) and credit card (0.3%) transactions, regardless how the

IF is set (multilaterally, bilaterally or otherwise). An exemption is made for pure three-party

schemes, schemes that directly contract both the cardholder and merchant. This may raise

speculations as to whether the four-party schemes will add another chapter to market

oversight games (Schinkel, 2010) and perhaps turn into three-party schemes. As evidenced

from a working document, the EC seems aware of this risk of regulatory circumvention4.

Impact IFR

Had the scope been only cross-border intra-EEA transactions, or only MIFs (as a fallback fee),

then the impact of the IFR on issuing bank’s revenues would not have been that large. Merely

to illustrate this point: most economies are still locally oriented; to take an ‘extreme’: the

1 Case T-111/08, 24 May 2012, par. 259. 2 Case 382/12P, Sept.11, 2014. Note that the decisions relate to MIFs, not bilaterally agreed IFs or IFs set

collectively at national level. 3 See [8], 11 April 2015, for an overview of the EC’s work on MIFs, including links to relevant documents. 4 Commission Services, Working Party on Financial Services, Proposal for a Regulation on interchanges fees for

card based payment transactions, Inclusion of three party card schemes under the scope of Chapter II,

WORKING DOCUMENT #27, MIF, 17 October 2014. This document was shared with payment industry insiders

(such as the author) and may not be available outside the stakeholder group.

23

economy of the Netherlands has a relatively large international orientation, ranking for

example no. #1 in 2014 in the Global Connectedness Index of logistics company DHL1. Still,

only 2.7% of all debit card transactions are cross-border2. The number can reasonably be

taken as an upper limit indication when generalizing to other European economies. However,

with the domestic transactions in scope, the impact of IFR will be much larger. How large

exactly will depend on the actual IF levels in each country, see for an estimation the EC’s

Impact Assessment3. As for the Netherlands, the actual market IF levels are substantially

below the proposed caps, in 2009 between 1 and 2 eurocents per debit card transaction, i.e.

0.04% of an average debit card transaction4. The Dutch government therefore would like the

EC to choose an even lower cap on debit card IFs5.

2.7 A note on SEPA and PSD

The EU and the Member States started a huge endeavour with the integration of the internal

market, including money to transact. First cash (banknotes and coins), then the instruments

to transfer money electronically. However, throughout the years each country had developed

and grown accustomed to their own payment instruments so this proved to be quite a

challenge. The European banking industry created the European Payments Council (EPC) in

2002 to help realise SEPA, a Single Euro Payments Area6. Through its efforts and under its

coordination, the two most commonly used instruments in the EU for electronic payments,

the credit transfer and the direct debit, were redefined in standardising schemes7. Soon

thereafter a scheme for payment cards, the most common alternative to cash, followed. To

dismantle legal barriers between the countries and create a ‘level playing field’, the Payment

Services Directive (PSD) was introduced, taking effect on November 1st, 20098. As already

1 Measured in cross-border traffic of goods, capital, information and people. The Netherlands also ranked #1 in

the previous edition of the Index in 2012. Source: FD (Financieel Dagblad), 5 November 2014. 2 Around 70 million cross-border transactions versus 2.6 billion POS debit transactions in total. Cross-border

includes Dutch cardholders paying abroad and foreigners paying in the Netherlands. Taking credit card

transactions into account, the number is 5.5% (152.6 million cross-border POS transactions versus 2.8 billion in

total). Looking at other retail payments instruments, credit transfers and direct debits, then the numbers are 2.1%

and 0.0% (too low to measure). Source: DNB retail payments statistics 2014. 3 SDW(2013) 288 final, figure 6, p. 21. 4 Average transaction amount with a debit card in 2009 was EUR 39.07. Calculated with an IF of 1.5 eurocents. 5 Fiche 1: Verordening interbancaire vergoedingen, Kamerstuk 22 112, nr. 1705, 4 October 2013 6 The jurisdictional scope of the SEPA Schemes currently consists of the 28 EU Member States plus Iceland,

Norway, Liechtenstein, Switzerland, Monaco and San Marino. Note that this is more than the countries carrying

the Euro as their currency. 7 The SCT (SEPA Credit Transfer) and the SDD (SEPA Direct Debit) were implemented as of 2008 and 2009

respectively. 8 The PSD however does not apply to Switzerland and Monaco. Previously, the jurisdictional ‘misalignment’

between the PSD and SEPA was much larger.

24

noted, the PSD is currently being revised. The proposed changes have caused an intense and

still ongoing debate and lobbying over certain topics. Two are at the heart of the controversy:

1) the introduction into its scope of two new payment services, so-called payment initiation

services and account information services, and the legal provisions regarding the parties

offering these services; and 2) the prohibition of surcharging together with caps on IFs (the

IFR).

Just to briefly illustrate one of the several issues regarding the first controversial topic before

continuing with the second, which is the focalpoint of this paper. The parties offering the

newly introduced services1 will be allowed to gain access to account information of the

consumer and initiate a payment on his behalf using his personal credentials, the same as the

consumer himself uses to log in to his internet/online banking environment. The banks

consider this a major security risk as it may be impossible for them to unambiguously

distinguish the consumer, i.e. their own customer, from a potentially fraudulent party

disguised as the consumer. A contract or agreement between the TPP and the bank will

however not be required2. The concern has even created ‘unnatural allies’ where banks find

regulators3 and consumer’ interest organisations at their side and this has struck a chord

with the EP and several Member States4 but so far not visibly with the EC.

Given the significant reduction in the general IF level across Europe and the expected

consequential reduction in merchant fees, the EC finds surcharging no longer justified for the

regulated payment cards and will therefore prohibit surcharging (PSD2, art. 55(4)). The PSD

left its regulation at the discretion of Member States and this resulted in half the countries

(thirteen) prohibiting it while the other half allowed it5.

1 Called TPPs, Third Party Providers or Third Party PSPs. PSPs are Payment Service Providers, a term introduced

in the PSD for banks and non-banks (“payment institutions”) authorised to provide payment services. 2 ING filed suit against AFAS, a provider of bookkeeping tools for small businesses and individuals, claiming

AFAS seduces ING’ customers to share their personal credentials in breach of ING general terms and conditions.

AFAS used inter alia the upcoming PSD2 in their defence. The court agrees with ING (30 July 2014). [6], 18

August 2014. 3 E.g. BaFin, the German Federal Financial Supervisory Authority; [13], 18 April 2015. 4 For example, France, Denmark and the Netherlands have officially notified the EC of their strong objections

against the provisions requiring the sharing of personal credentials. Austria has even filed a waiver, stating that it

will under no circumstances transpose these provisions into national law. 5 Situation at the time of the PSD2 proposal, July 2013. A few countries have changed their policies since.

Countries that currently allow surcharging include the Netherlands, Denmark and the UK, where regulation

abolished the no-surcharge rule in 1991 (Vickers, 2005, p.233 fn.10). In Denmark, only for international debit and

credit cards surcharging is allowed, but not the domestic Dankort (so-called ‘split model’, see Danmark

Nationalbank, 2012, p.121). For the Netherlands see section 6.

25

Next to these provisions (and a few others), the IFR sets forth in art. 10 the HACR, basically

reconfirming the European interpretation of the HACR (§2.6). It will also enforce a legal and

organisational separation between the scheme and the processing infrastructure.

26

3 REVIEW OF LITERATURE

The cost-based approach, derived from conventional economic wisdom on monopolistic and

oligopolistic ‘one-sided’ market behaviour and benchmark perfect (Cournot and Bertrand)

competition, does not fit a two-sided market. Market authorities and courts using

benchmarks based on issuer’ cost to assess possible excessiveness of merchant charges and

interchange fees, have therefore been strongly and unanimously advised by economists to

readjust their logic. I have borrowed from Wright to summarise in Box 1 some incorrect

applications of ‘one-sided logic’ to two-sided markets. See Wright (2004a) for a discussion of

each fallacy and an entertaining illustration using quotes from investigations into credit card

schemes by three different market authorities.

3.1 Preliminary

At that time however, the economic knowledge on two-sided markets was still rapidly

developing. As Evans and Schmalensee put it in their survey of the economic literature on

interchange fees and their possible regulation in 2005: “Economists have only scratched the

surface of the theoretical and empirical work that will be needed to understand pricing in two-

sided markets in general and the determination of interchange fees in particular” (id. p.104).

The most important conclusions from the survey can be summarised as follows. Next to the

factors that determine socially optimal prices for customer groups in multisided industries,

inter alia a) price elasticities of demand, b) indirect network effects between the customer

groups, and c) marginal costs for providing goods to each group, socially optimal prices in the

payment card industry also depend on other characteristics, including d) the use of fixed and

variable fees, e) competitive conditions among merchants, issuers, and acquirers, and finally

f) the nature of competition from cash, cheques, and three party payment schemes. Thus, the

socially optimal interchange fee is not, in general, equal to any interchange fee based on cost

BOX 1. Eight fallacies - lessons to forget in two-sided markets.

1. An efficient price structure should be set to reflect relative costs (user-pays).

2. A high price-cost margin indicates market power.

3. A price below marginal cost indicates predation.

4. An increase in competition necessarily results in a more efficient structure of prices.

5. An increase in competition necessarily results in a more balanced price structure.

6. In mature markets (or networks), price structures that do not reflect costs are no longer justified.

7. Where one side of a two-sided market receives services below marginal cost, it must be receiving a

cross-subsidy from users on the other side.

8. Regulating prices set by a platform in a two-sided market is competitively neutral.

27

considerations alone and such a solely cost based interchange fee is unlikely to improve social

welfare (id. p.102).

In my selection I have mainly focussed on contributions with formal models that allow for a

welfare analysis, either total surplus or user surplus1. I describe these models in non-

technical terms.

3.2 Models of interchange fees and policy implications

In Baxter’s (1983) model, cardholders use and merchants accept a card payment if the per-

transaction price charged to each of them is less than the per-transaction benefit they derive

from it. Each of their marginal valuation of the payment transaction depends on the other

party accepting, respectively using the card (otherwise the valuation is zero). Cardholders

are assumed to be more price sensitive than merchants and so their costs, that is the price

they pay for the transaction to the issuer, need to be lowered to reach equilibrium. For this, a

transfer – the IF – needs to be made from the acquirers to the issuers who both are assumed

to behave (perfectly) competitively. Therefore the IF does not affect the overall price level (it

could be at any level), only the price structure. In absence of bargaining power, the price the

issuers charge the cardholders is not based on their marginal costs, nor is the price the

acquirers charge the merchants based on their marginal costs (which is what ‘one-sided logic’

would suggest); instead, in equilibrium aggregate joint demand for card payment services of

merchants and cardholders equals the total combined issuers and acquirers costs of

providing them. In this perfectly competitive world, an assumption Baxter acknowledges may

not hold in reality, without e.g. fixed costs or membership fees, the equilibrium is efficient

(the model is not equipped for a welfare analysis). Baxter concludes his article stating that

the characteristics of the payments market, i.e. joint costs and interdependent demand, are

not well understood and the controversy that troubled the US banking industry for more than

five decades around ‘clearance at par’ of cheques2 is likely to repeat in the context of debit

and credit cards (id. p.586). Those words proved prophetic. In light of this anticipated

controversy, Baxter warns that governmental intervention should be resisted. See Box 2 for

a sidestep to Baxter’s account of payment instruments and substitutes.

1 Total welfare, or total surplus, is the sum of consumer surplus and producer surplus. In the context of payment

markets, the producer is (are) the banks and other providers in the chain and the consumer is (are) both the

payer/cardholder and the payee/merchant, both are “users” of the card. Consumer surplus, or consumer welfare,

thus involves simultaneously both users. 2 Baxter uses the US spelling: checks.

28

Schmalensee (2001) allows for imperfect competition among issuers and among acquirers.

He focuses on credit cards and on a four-party, cooperative (not-for-profit) scheme that sets

a MIF. Assuming the scheme is facing a multiplicative demand function and conducting a

welfare analysis, first with a monopolistic issuer and a monopolistic acquirer which he next

generalizes to oligopolistic competition, Schmalensee arrives at similar conclusions as

Baxter: privately optimal IF is also socially optimal and the IF depends on demand conditions,

costs, competition among issuers and acquirers and on externalities between merchants and

cardholders. He sees no cause for a regulator to step in.

BOX 2. On payment means and substitutes.

Baxter’s historical account of US four-party payment systems covering roughly 200 years narrates the

growing popularity of cheques (initially: drafts) and currency (initially: bank notes) as markets developed

from very local to increasingly larger geographies, while inferior country bank notes were driving sounder

city bank notes out of circulation and transporting bank notes was increasingly costly and risky. This

explains the heavy usage of cheques for which later the credit card became the prime substitute. By

contrast, cheques have never gained comparable popularity in other countries such as Sweden, Spain,

Denmark, and the Netherlands (revisit chart 1). Baxter speculates that the ‘clearance at par’ of cheques,

before Federal regulation put an end to this heterogeneous practise by imposing an ‘IF’ of zero, was a result

of a shift in relative demands of purchasers (~cardholders) and merchants for cheque services and a shift

in relative costs in providing them. It is also interesting to note that Baxter treats cheques and credit cards

as main substitutes (thus cheques’ costs are the most appropriate benchmark for credit cards’ costs,

including IFs) whereas in Europe, economists and the EC focus more on cash versus debit cards. Though

these may perhaps be better comparable substitutes , the comparison is not without difficulties as cash

usage is very difficult to measure reliably, comes with “interchange fees at par” and nowadays involves a

monopolist supplier (i.e. the central bank, see §2.5).

Note 1: Although Baxter occasionally mentions debit cards simultaneously with credit cards, the focus of

his article is largely on the latter. Indeed, the debit card is a “poor man’s card” as “…any cardholder entitled

to use a credit card, will always use it rather than a debit card” (p.585), because of the float benefits

attached to the credit card. For this reason, and because of a lower risk of default, Baxter predicts that debit

card transactions will be substantially cheaper than credit card transactions and with different IFs. This

prediction is confirmed in Weiner & Wright (2005) who report credit card IFs typically between 1% to 2%

of transaction value and debit card IFs typically between 0% and 1% for a number of regions and countries

(id. tables 1 – 3).

Note 2: Payments practitioners frequently use a rule of thumb categorisation of payment instruments from

a payer’s point of view: Pay Before, Pay Now and Pay Later. Cheques and credit cards are examples of Pay

Later instruments, while cash and debit cards are Pay Now instruments. Prepaid cards like a gift card or

special purpose card, are often considered Pay Before instruments as it involves a transfer of funds (from

the cardholder’s account to the card or to the administrator of the card) while the goods or service will be

delivered somewhere in the future. Because the card usually cannot be used everywhere and for all

purposes, like cash, consumers tend to view their funds have ‘changed currency’. Examples are the Dutch

Public Transport card (OV-chipkaart) and, according to most of its (former) users, the Chipknip.

29

Rochet and Tirole (2000, published in 2002) introduce in this seminal paper a formal

framework upon which most of the later scholarly contributions build. Like Baxter, they take

into account the (direct) benefits of using and accepting a card payment. However, they also

model merchants and cardholders as strategic players: merchants use the acceptance of

cards to generate higher sales revenue by winning consumers (cardholders) from

competitors and consumers may decide to visit stores based on stores’ card acceptance

policy. Thus merchant resistance to increases in IF is likely to be lower than in Baxter’s model.

Their framework also allows for consumers to hold cards of more than one scheme1, making

merchants’ opportunity costs of card acceptance endogenous. Acknowledging that the

schemes compete for cardholders, merchant resistance to increases in IF may in this respect

be higher than in Baxter’s model. Furthermore, acquirers are assumed to behave

competitively while issuers may enjoy some market power2. Cardholders are assumed to

have a fixed volume of transactions3, which (technically) implies that there is no difference

between an annual fixed fee or a variable per-transaction fee, at least not from the issuer-

cardholder relationship perspective4. Cardholders are modelled to have structural

preferences for using cash or cards. The model makes no specific distinction between debit

and credit cards as it focusses on the payment activity rather than the instrument. Merchants

face no fixed costs for accepting payments. Given this model setup where by assumption all

profits fall at the issuing side of the market, Rochet and Tirole show by applying a total

welfare analysis that the socially optimal IF, which is the one where the total cost of the

marginal transaction equals its total benefit, coincides with the privately set IF (as set by the

scheme, i.e. the issuers) if that IF exceeds the level at which merchants accept the card. This

requires a low cardholder fee. Or the privately set IF exceeds the socially optimal IF, in which

case consumer fees are set too low leading to an overconsumption (overusage) of cards5. No

cost-based regulatory intervention can prevent this. Both equilibria apply under the no-

surcharge rule, a scheme rule that prohibits the merchant to price-discriminate between

payment means (e.g. demand an extra fee from the customer for a card payment). Lifting this

rule creates however ambiguous welfare effects6.

1 This is sometimes also referred to as multi-homing (vs. single-homing). 2 As Rochet and Tirole note on p.5 fn.13, this is closer to reality. As an indication thereof, they refer to the voting

rights of the banks in the US in VISA and MasterCard (before their respective IPOs) which are more sensitive to

issuing than to acquiring volume, suggesting some bargaining power is on that side. 3 In their model this is normalized to one transaction for each customer. 4 For their main model, cardholders are assumed to be charged a fixed annual fee. 5 This situation can be found in countries where regulation prevents banks from charging customers for the use of

cheques, thus leading to an overprovisioning of cheques (Rochet & Tirole, 2000, p.17 fn.23). 6 Rochet & Tirole, 2000, p. 18-20.

30

The main result, including its corollary that there is no equilibrium where a privately set IF

is lower than the socially optimal IF, critically depends on an assumed merchants

homogeneity. Relaxing this assumption can lead to an underprovisioning of cards, depending

on how well informed the cardholder ex ante is of a merchant’s card acceptance.

Interestingly, the way cardholders are charged for card usage does matter as it influences

merchant resistance: if the cardholder would be charged a perfect fixed and variable fee, with

marginal cost pricing for the variable fee, then this would reduce merchant resistance if (and

only if) the IF exceeds the issuer cost. Indeed, the main mechanism at work in this model is

merchant resistance to accept cards. A higher resistance is likely to bring an equilibrium

where private and socially optimal IF coincide; a lower resistance is likely to create an

overconsumption of cards with a higher than socially optimal IF. The question whether the

IF is ‘too high’ is left an empirical one.

Gans and King (2001b, published in 2003) show in a general way that if merchants can

costlessly surcharge, then interchange fees will have no real effects irrespective of the level

of competition at either the banks or the merchants.

Following closely Rochet and Tirole’s main model, Wright (2004b) relaxes the assumption

of identical merchants and introduces heterogeneity on both sides of the market, applying a

standard Hotelling model of competition (of ‘linear cities’). This accounts for the fact that in

some sectors accepting card payments may be more beneficial to merchants than in others.

Cardholders are assumed to pay a per-transaction fee as do merchants and neither pays a

fixed fee or faces fixed costs. Cardholders are supposed to be fully informed about merchant’s

card acceptance policy before they frequent the store, which maximises the merchant’s

incentive to accept cards. Cardholders discover their preference for a cash or card payment

at the moment of purchase of the good1. The results show that the privately set IF may or may

not be equal to the socially optimal IF and either one can be higher than the other. Thus there

may be too many or too few card transactions from a socially optimal point of view. No cost-

based regulation would be able to restore balance in case of a troublesome diversion as it

depends on differences in price elasticities on both sides of the market, competition (among

issuers, among acquirers, among merchants and among schemes) as well as costs. Again, this

leaves the question of a possible excessive IF an empirical one.

1 This makes merchants’ card acceptance decisions independent rather than strategic complements as in Rochet

& Tirole (2000)

31

By this time the literature had rapidly build into several directions focussing on specific

topics such as platform competition1, multiple card membership (multi-homing) and usage,

market two-sidedness and the influence of merchants and cardholders entering into a

Coasean negotiation as to set their own fee directly. Rochet and Tirole (2005) integrate in

particular the findings on multiple membership and multiple usage (in the broader context

of two-sided markets, not only card payments industry) and reinterpret some of the

previously obtained results. In summary: 1) pricing in two-sided market obeys standard

Lerner principles2 with a reinterpretation of marginal costs as ‘opportunity costs’3; 2) a

market is two-sided if the price structure matters (and much less so the price level),

measured by the ability to affect the volume of transactions; however, in the absence of

membership externalities, the market can turn one-sided in the presence of asymmetric

information between the card-users (merchants and cardholders) if the transaction between

them involves a bilaterally negotiated price or monopoly price. A market turns two-sided

when there are transaction costs to the bilateral price negotiation or constraints on this kind

of price-setting (like an imposed no-surcharge rule) or when there are membership fixed fees

(fixed costs).

This latter finding is one found in McAndrews and Wang (2008) who develop a formal

model different from the ones described above in that they 1) ignore benefits consumers

derive from using a payment instrument (the instrument imposes a frictional cost to the

purchase of a good), 2) assume a contestable market for merchants, which simplifies the

welfare analysis, and 3) take merchants and consumers as non-strategic players (as Baxter).

They do take both fixed and variable costs into account. Starting with cash as a benchmark,

they analyse the choices of merchants and consumers when offered a payment instrument

such as a card that comes at a higher fixed cost but offers lower variable costs. Consistent

with empirical studies (id.), they find that large merchants adopt payment cards faster than

smaller merchants and will set a price that is lower than cash customers would experience at

only-cash accepting merchants; smaller merchants on the other hand may accept card

payments or not and those who do, set a price higher than the competing only-cash accepting

1 See in particular Rochet & Tirole (2002) and Guthrie & Wright (2007). 2 The price charged to a side of the market is inversely related to that side’s elasticity of demand. 3 Marginal cost c is in the context of a two-sided market with a platform replaced by (c-vj), i.e. platform cost c per

transaction minus vj, the ‘other’ side j’s willingness to pay to interact with ‘this’ side. See for an accessible account

Tirole’s lecture in accepting the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2014;

[10], 18 January 2015.

32

merchants; finally, the small merchants will not accept cards. The paper adds the insight that

if a merchant serves both cash-preferring and card-preferring consumers, the first group is

facing a lower selling price than they would if the store only accepted cash. This insight

contradicts the findings and intuitions that price coherence1, or the inability to surcharge,

leads to higher selling prices.

In another milestone contribution, Rochet and Tirole (2008) respond to Vickers’ (2005)

“must take card” argument. The then head of UK’s Office of Fair Trading2, Vickers posed that

in the UK retail business it had become a market practise to accept at least the two major

credit card brands (VISA and MasterCard) and non-compliance with this market standard

could jeopardise the retailer’s business as he would risk losing customers to competing

retailers who do. It should be noted that the use of credit cards (and cheques) is very high in

the UK compared to other countries in Europe. See also chart 1 and as a further exhibit:

“Indeed, the United Kingdom has accounted for more than 75 percent of credit card spending in

western Europe in recent years. By contrast, France and Germany each account for less than 1.5

percent” (Vickers, 2005, p.232). Rochet and Tirole operationalise and validate the argument

under different models of merchant competition building on earlier frameworks, in

particular the ones described above. The possibility that a merchant might accept a card

payment even though this would increase his net operating cost3, was already identified in

their earlier paper (2000). The reason for the merchant’s decision lies however not in

competition, i.e. to win over a customer over a competitor: the property holds even when the

merchant is a local monopolist. It lies in the merchant’s improved quality of service by

offering the customer extra payment means, which translate into slightly higher retail prices4.

The paper presents an alternative to the benchmark for excessive IF-setting used by

regulators, which is based on issuer’ costs5. Their alternative is based on the merchant’s

1 A term coined by Frankel (1998) and later adopted by others, which he defines as: “the phenomenon in which

the price paid by a consumer for a product does not vary with modest differences in the costs imposed on the

merchant by the customer’s choice of brands or payment methods” (p.314). 2 The OFT was at that time involved in a several-year-long investigation into MasterCard’s MIFs. 3 The property that has become known as merchant internalization states that merchants accept cards if, and only

if, the merchant fee 𝑝𝑀 is equal to or less than the sum of the merchant benefit of accepting a card payment 𝑏𝑀

plus the average net cardholder benefit per card payment 𝑣𝐶(𝑝𝐶): 𝑝𝑀 ≤ 𝑏𝑀 + 𝑣𝐶(𝑝𝐶) This can lead to merchants

accepting card payments even when it increases their net operating costs: 𝑝𝑀 ≥ 𝑏𝑀 Rochet & Tirole show that

this property holds under three important models of competition: perfect competition, Hotelling-Lerner-Salop

differentiated products competition and monopolistic competition. 4 This result is also derived in Bedre-Defolie and Calvano (2009). 5 See e.g. the EC COMP/34.579 in 2007 (as mentioned in par. 1.1), the Reserve Bank of Australia in 2003 (Wright

2004a) and the US Federal Reserve by the Durbin Amendment (section 1075, adding section 920 to the Electronic

Funds Transfer Act) to the Dodd-Frank Act as of July 2011.

33

avoided-cost: would he have an incentive to refuse a card payment if an incidental customer,

like a tourist, wants to pay and is also able to pay in cash? (hence the nickname the “tourist-

test”). Since accepting this card transaction would trigger a fee to his acquirer1 - a significant

portion thereof constitutes the IF - the test looks for the merchant’s point of indifference

between the two means of payment. The merchant fee passes the avoided-cost test if, and

only if, the card payment does not increase his net operating cost compared to accepting a

payment in cash. If it does not pass the test, then this should be interpreted as an indication

of an excessive IF. Rochet and Tirole show that the test yields unbiased results if the objective

is short-term total user surplus2, provided that issuers’ margin is constant. However, the IF

that would be optimal from a social point of view lies higher in that case and the same holds

in the case of variable issuers’ margin. The test yields false positives if the objective is total

welfare. Zenger (2011) shows the avoided-cost test and the model of Rochet and Tirole

(2000) under perfect surcharging yield the same outcomes.

Discussion of the avoided-cost test

Before moving on to the last piece of review of literature in this section, I briefly discuss the

test and its implications in some more depth. The avoided-cost test seems reasonable at first

sight but on second thought appears problematic. The test makes no distinction between a

debit and credit card transaction, while the proposed benchmark is cash. As noted before,

from a payer’s point of view, cash and debit cards are more or less substitutable payment

instruments, but credit cards and cash are much less of substitutes3. More importantly, as the

test looks for the merchant’s point of indifference between the means of payment, it thus

removes incentives to choose the most efficient one from a social point of view4. If the aim of

1 The fee paid by the merchant to the acquirer is usually called the Merchant Service Charge in the credit card

business (MasterCard and others). Rochet & Tirole have consistently used the term “merchant discount”,

indicating that the merchant does not receive the full amount, i.e. the sales price for the goods sold, from the

cardholder (through the issuer and acquirer) but that the acquirer subtracts (“discounts”) a fee from this amount.

From the merchant’ point of view however, he does not get a “discount” in the meaning of common language. To

avoid confusion, I use the more neutral term “merchant fee” throughout this paper. The practise to actually subtract

a fee from the full amount was abolished by the PSD, as of then the merchant can still be charged such a fee but

it has to be invoiced and paid separately. 2 As indicated before, in a two-sided payment market, the ‘one-sided’ consumer surplus includes both the

cardholder’s and merchants’ surplus. I will use the term “total user surplus” from this point onwards, as do Rochet

and Tirole. The term “consumer surplus” is then reserved for the card and cash using consumers (their surplus),

i.e. ex. merchant surplus. In their (2008) model, all consumers hold cards, so there is no distinction between a

consumer paying in cash and a consumer paying with a card in the context of welfare analysis. The “short term”

reflects a situation without market entry. 3 A similar remark is made by Rochet & Wright (2009) who define the avoided-cost test with respect to “store

credit” (credit supplied directly by the merchant to the consumer) instead of cash. 4 A point Rochet and Tirole are aware of (id. p.8).

34

a regulator is to correct a market that is failing in producing economic efficient outcomes,

then adopting this test will at best result in maintaining the status quo if the benchmark, cash,

is the correct one. But empirical studies show that cash payments are relatively expensive to

‘produce’ compared to electronic payments, debit card payments in particular, and the price

to use cash does often not reflect the full (social) costs; see Schmiedel c.s. (2012), Brits and

Winder (2005), Leinonen (2011) and Humphrey, Willesson, Lindblom and Bergendahl

(2003). Indeed, putting the avoided-cost test to an empirical test, Bolt, Jonker and Plooij

(2013) show that it creates the wrong incentives when a country’ social costs of cash

payments are rising and those of debit card payments are declining; as is the case for e.g. the

Netherlands1. These findings are particularly relevant since the EC accepted the tourist-test

as a “reasonable benchmark for assessing a MIF level that generates benefits to merchants and

final consumers”2 and the caps proposed in the IFR are the result of MasterCard’s calculations

using the test and three empirical cost studies3 which MasterCard implemented with the EC’s

consent as of July 2009.

A final remark in this sidestep concerns the welfare objective. Most economists, and I agree,

argue that competition authorities should adopt a total welfare standard instead of a

consumer welfare standard. See e.g. Motta (2004, par. 1.3) and Rochet & Tirole (2003, p.77).

Whether courts and regulators favour one over the other is difficult to say, wording such as

in art. 101(3) TFEU4 merely seem to induce its explicit inclusion in court’s rulings, not

prioritising consumer welfare over total welfare. However, as evidenced by the adoption of

the avoided-cost test and the quoted memo, in the case of the IFR the EC seems to adopt a

strict consumer welfare standard5. Such a standard is unlikely to solve a market failure, more

likely the opposite (see also Rochet and Wright, 2009). In particular, capping the IFs may

initially lead to lower prices but in the longer run are likely to deprive the ‘producers’ of

1 Bolt cs. calculate that the tourist-test may allow the IF level to increase from 0.2% to 0.5% of the transaction

amount of an average debit card payment. In case of a full pass-through this would increase the notional merchant

fee by 233%. For other debit card favouring countries similar results should be expected, see also Leinonen (2011)

and Danmark Nationalbank (2011). 2 Press release by the EC, Commissioner Kroes, 1 April 2009, memo 09/143. 3 These concern the cost studies of the central banks of Belgium, Sweden and the Netherlands. The latter is the

study published by Brits and Winder (2005), with data from 2002. The Belgian and Swedish study contain data

from 2003 and 2002 respectively. See also Bolt c.s. (2013). 4 Certain restrictions on intra-EU competition may be allowed if the agreement / decision / practice “… contributes

to improving the production or distribution of goods or to promoting technical or economic progress, while

allowing consumers a fair share of the resulting benefit...” [underline font added]. 5 Another indication can be found in the EC’s Impact Assessment: “Rochet and Tirole (2002) find that the

privately set interchange fee either is socially optimal (but only total welfare has been analysed)…” (p.102)

[underline font added]. Also Rochet and Wright (2009) have noticed and seem to disapprove: “Thus, if regulators

only care about (short-run) consumer surplus, our theory can provide a rationalization for placing a cap on

interchange fees.” (id. p.6).

35

incentives to innovate. Note that the issuer and acquirer function can be fulfilled by others

than banks and the incentives concern both incumbents and potential new entrants, so this

may negatively affect banks, other PSPs, merchants as well as consumers. Thus, at the very

least the consumer welfare objective should be framed in dynamic terms. Evans (2011)

analyses the relationship of IF levels and innovation and argues that drastic reductions of IFs

may invert the skewness of the price structure on the two sides of the market, resulting in a

reduction in the overall level of innovation in the industry and a discouragement of new

entrants1. Circumstantial evidence of this point can be found in Australia for eftpos-

transactions, a PIN based debit card scheme and as far as I am aware, the only country where

IFs used to go from the issuer to the acquirer. In 2012 however, the IF direction reversed “…to

encourage investment in innovation and enhanced functionality for eftpos, so that it can

continue to compete effectively in a fast changing payments landscape”2.

Whereas Rochet and Tirole confirm some validity of Vickers’ “must take card” argument but

conclude that this need not be harmful to social welfare as there is no systematic bias in the

price structure, Wright (2012) now arrives at the opposite conclusion. Using basically the

same model as Rochet and Tirole (2000, 2008) and Wright (2004b), he finds that a profit

maximizing card scheme sets a MIF or price structure that will lead to an overprovisioning

(overconsumption) of cards with merchants paying too high a fee. This possibility is present

in the earlier work and arises from the fact that a monopolist scheme only focuses on

marginal users and not on average users, thus ignoring the effect of IFs on the surplus of the

average merchant or consumer. As long as this happens on both sides of the market, there is

no particular bias either way. But with the property of merchants internalizing the consumer

benefits (meaning they offer their customers an improved quality of service with extra

payment means) for which the extra costs are uniformly included in the prices of the goods

sold (and in the absence of surcharging, i.e. price coherence), this introduces a systematic

bias in favour of cardholders. Therefore, Wright advises a regulatory intervention, not based

on any antitrust considerations since the bias is not the result of any shortcomings in

competitive market behaviour, including the argument that an IF puts a floor in what

competing acquirers can charge merchants. Such an intervention is to be dealt with

cautiously, he warns: the main mechanism at work in the model is merchant internalization

1 As Evans (2011) summarises it: “getting innovation right is likely to be far more important than getting

prices right” (p.2). 2 [11], 5 September 2014.

36

but to which extent this holds in a particular case, is an unanswered empirical question. As

to the proper level of IF, he stresses that economists have reached near unanimity against a

fee based on issuer’ costs and instead proposes a direct cap on merchant fees (which should

include three-party schemes) or to apply the merchant’ avoided-cost test. This I already

discussed.

As far as I know, Korsgaard (2014) is the first to discuss interchange fees in a setting that

resembles more that of a debit card payments market. As I use this model, more details are

given in the next section. Using basically the same model as Rochet and Tirole (2000, 2008)

and Wright (2004b, 2012), he shows that the level of the IF only influences merchant

acceptance of cards (the higher the former, the lower the latter) and banks will set an IF that

exceeds or equals the socially optimal IF. Two critical assumptions underlie this result: 1) all

consumers already possess a payment card and do not incur fees per transaction (cash nor

card), 2) merchants nor banks face fixed costs. In essence, the two-sided market then turns

one-sided; this echoes a finding earlier stated, see Rochet and Tirole (2005). As the only

condition under which the banks set an IF equal to the socially optimal IF, is when merchants

are assumed to be homogeneous (else the banks set an IF that is higher), Korsgaard advocates

a cost-based regulation. His model features consumers, merchants and banks; the latter in

their capacity of producers of payment services1. Issuing and acquiring banks are not

distinguished individually, which is motivated by the assumption that acquiring banks are

assumed to behave perfectly competitively and so the merchant fee consists only of the IF

plus the acquiring bank’s marginal cost of producing the card payment2. Banks are assumed

to maximise their joint profit, which depends on the fraction of consumers, respectively

merchants using and accepting cards. Both consumers and merchants are heterogeneous and

they may face fixed costs for accepting payments.

A striking result of this model is that the socially optimal IF can turn out to depend solely on

costs. More precise, if merchant fixed costs are assumed to be zero, consumers face no

adoption costs and in the absence of surcharging, then the socially optimal IF equals the

difference in bank’s marginal costs of producing card payments and cash payments. Under

surcharging however, the welfare outcomes are ambiguous and the optimal IF no longer

depends on costs alone (same is true when fixed costs are introduced).

1 From a modelling perspective this is akin to a proprietary platform, i.e. a three-party scheme. 2 The merchant fee and the IF are therefore assumed to have an one-to-one relationship.

37

4 ANALYTICAL FRAMEWORK

This section describes the analytical framework I use to answer the research question. It

consists of two models, the first is the formal model for socially optimal interchange fee

estimation as developed by Korsgaard (2014). I intend to keep the outline, based on the

original paper, as short as possible for a good understanding and leave out the propositions

and extensions not relevant for my purposes, including the analysis on surcharging. For this

I offer three reasons: 1) as indicated before, in this model surcharging complicates the

analytics and may yield multiple (discontinued) equilibria or no equilibria at all. 2) In an

application of his model, calibrated to Danish cost data, Korsgaard finds welfare to be higher

when surcharging is not applied1. 3) Surcharging is allowed in the Netherlands for at least

since the year 2000, yet it has never grown into a general market practise, rather a

disappearing one2.

The second model I use is the concept of social and private costs and the operational content

as added by Brits and Winder (2005); again the outline, based on their study and Jonker

(2013), will be kept concise. Their framework was also used for the cost data in 2009 and

followed in the other twelve central bank studies (Schmiedel c.s., 2012), as well as in the

empirical examination of the avoided-cost test for the Netherlands (Bolt, Jonker and Plooij,

2013; Jonker and Plooij, 2013).

4.1 Interchange Fee model

The model features three types of agents: consumers (buyers “B”), merchants (sellers “S”)

and banks. Merchants compete according to a standard ‘linear cities’ Hotelling model of

competition3 with a unit length continuum of pairs of merchants. Each merchant of a pair,

located at the opposite ends of a line segment of unit length, enjoys the same benefits 𝑏𝑆 from

accepting cards and competes for consumers who are uniformly distributed across the line

segment. Merchants produce a good at cost γ and set a price so as to maximize profits,

assuming price coherence (no surcharging). If a merchant chooses to accept cards, he may

face fixed costs K (adoption costs) and if a consumer pays by card, he additionally incurs a

merchant fee m (usage costs). All merchants accept cash. Merchant pairs differ in their

1 This finding is consistent with an empirical study on surcharging in the Netherlands where Bolt, Jonker and

Renselaar (2008) find that if the merchants who do surcharge would discontinue this practise, social cost savings

of more than EUR 100 million could be realised. See also §6.1. 2 Supra. The decrease was bolstered by an long-running public campaign that started in 2007 to stimulate the use

of debit cards. The campaign proved effective (Jonker, Plooij and Verburg, 2015). 3 As in e.g. Wright, 2004b, 2012, Rochet & Tirole 2000, 2008.

38

benefits derived from card payments (net savings from a card instead of a cash payment),

which are drawn on an interval [𝑏𝑆,𝑚𝑖𝑛, 𝑏𝑆,𝑚𝑎𝑥] from a cumulative distribution function G(𝑏𝑆).

Similarly, consumers differ in their benefits 𝑏𝐵 from card payments (preference for a card

instead of a cash payment), which are drawn on an interval [𝑏𝐵,𝑚𝑖𝑛, 𝑏𝐵,𝑚𝑎𝑥] from a cumulative

distribution function H(𝑏𝐵). I assume the benefits to be uniformly distributed within each

function1. All consumers possess a payment card at no adoption costs nor usage costs2.

Consumers incur a distance cost t per unit of distance from a merchant store, although this

may also be interpreted in the traditional sense to reflect product differentiation. Banks

produce payment services, card and cash payments, and set the merchant fee collectively so

as to maximize joint profits. Since issuing and acquiring banks are not modelled separately,

the merchant fee is assumed to consist of an IF for the issuing bank plus the acquiring bank’s

marginal cost of producing the card payment. Banks have variable costs of producing

payment services of 𝑐𝐶 and of 𝑐𝐷, which are proportional to the fraction of card payments,

respectively cash payments in the economy; additionally banks may face fixed cost F. Banks

revenue is the merchant fee m times the fraction of card payments in the economy 𝜇(𝑚). In

the model the social costs of payments are for simplicity assumed to equal banks’ private

costs. The banking sector profit function for maximization is then:

Π = 𝜇(𝑚)(𝑚 − 𝑐𝐶) − (1 − 𝜇(𝑚))𝑐𝐷 (1)

where 𝜇(𝑚) ≡ (1 − 𝐻(𝑏𝐵∗ ))(1 − 𝐺(𝑏𝑆

∗)) (2)

with 𝑏𝐵∗ denoting the threshold above which consumers use cards, and similarly 𝑏𝑆

∗ denotes

the threshold above which merchants accept cards. Banks are assumed to be obligated to

provide cash. Their rationality constraint, for the moment ignoring fixed costs F , is then that

they must be no worse off by providing cards:

𝜇(𝑚)(𝑚 − 𝑐𝐶) − 𝑐𝐷(1 − 𝜇(𝑚)) ≥ −𝑐𝐷 (3)

1 The original paper assumes, as in the reference literature, each cumulative distribution function to have a certain

density, a monotone hazard rate and to be twice continuously differentiable. The assumption of uniform

distributions is used in the calibration. The monotone (increasing) hazard rate assumption guarantees concavity

of the objective functions, see Prékopa (1973) in Rochet & Tirole (2008). 2 Korsgaard treats consumer adoption costs as an extension to the basic model.

39

The cost component F will be dealt with later on. The reason to proceed in this manner is

mainly to closely follow the setup of the original model for comparison purposes and to be

able to show the (theoretical) existence of a purely cost-based socially optimal IF, which is

when the market turns one-sided; it is this fixed cost component that makes the market in

this model two-sided, just as when merchants or consumers are assumed to face fixed costs

(i.e. adoption costs1). A social planner would aim to maximize the total benefits from card

payments minus the cost of producing the payments. Thus, his objective function is:

𝑊 = (1 − 𝐺(𝑏𝑆∗)) ∫

𝑏𝐵,𝑚𝑎𝑥

𝑏𝐵∗

𝑏𝐵 𝑑𝐻(𝑏𝐵 ) + (1 − 𝐻(𝑏𝑆∗)) ∫

𝑏𝑆,𝑚𝑎𝑥

𝑏𝑆∗

𝑏𝑆 𝑑𝐺(𝑏𝑆 )

−𝜇(𝑚)𝑐𝐶 − (1 − 𝜇(𝑚))𝑐𝐷 − (1 − 𝐺(𝑚))𝐾 (4)

In what follows are basically the outcomes of the assumptions and construction described

above. First the merchant threshold: a pair of merchants accepts cards if the condition below

is satisfied:

𝑏𝑆 ≥ 𝑏𝑆∗ = 𝑚 − 𝐸[𝑏𝐵 𝑏𝐵 ≥ 𝑏𝐵

∗ ] + 3𝑡(1−√1−

2𝐾

𝑡)

1−𝐻(𝑏𝐵∗ )

(5)

If merchant face no adoption costs (i.e. fixed costs) K = 0, this condition simplifies into:

𝑏𝑆 ≥ 𝑚 − 𝐸[𝑏𝐵 𝑏𝐵 ≥ 𝑏𝐵∗ ] (6)

This is the same merchant card acceptance condition Rochet and Tirole (2008) arrive at and

which they show holds under three distinct models of competition: perfect competition,

Hotelling-Lerner-Salop product differentiated competition (as here) and local monopoly.

Wright (2012) refers to this condition as “full merchant internalization”, meaning consumers

are fully informed about merchant’ card acceptance policy and take that into account when

deciding what store to visit. If this was not the case, or only partially so, a merchant would

not (or only partially) be able to attract extra customers from card acceptance.

The next three propositions can be shown to hold2:

1 In derivations, when computing for interior solutions, a unique equilibrium can then no longer be guaranteed. 2 For proof of propositions and lemmas see the appendix of Korsgaard (2014).

40

1) When, as assumed, consumers do not face adoption costs, card usage is decreasing in

merchant fees.

2) When merchant fixed cost K = 0, the socially optimal merchant fee equals the difference

in banks’ marginal cost of producing card and cash payments, that is:

𝑚 = 𝑐𝐶 − 𝑐𝐷 (7)

3) Banks set merchant fees equal to or higher than the fees set by the social planner. The

two equal when merchants are relatively homogeneous across pairs (all enjoy the same

𝑏𝑆), in which case there is an interval of socially optimal merchant fees.

The outcome in proposition 2 is remarkable, it shows the optimal merchant fee can be purely

cost-based, though still not based on issuer’ costs. Intuitively, the social planner sets a

merchant fee to reflect the difference in marginal costs between the two payment

instruments and induce merchants to use the cheapest from a social cost perspective. It can

easily be verified that the banks rationality constraint, equation (3), holds under proposition

2.

When merchants do face fixed costs, K ≠ 0, the socially optimal merchant fee is no longer

purely cost-based and turns into:

𝑚 = 𝑐𝐶 − 𝑐𝐷 + ( 𝐾−3𝑡 (1−√1−

2𝐾

𝑡)

1−𝐻(0)) (8)

As can be shown, the term between round brackets is always negative.

Reintroducing the assumption that the banks may face fixed costs, F ≠ 0, this modifies their

rationality constraint:

𝜇(𝑚)(𝑚 − 𝑐𝐶) − 𝑐𝐷(1 − 𝑚𝜇(𝑚)) − 𝐹 ≥ −𝑐𝐷 (9)

This constraint is no longer satisfied at the socially optimal merchant fee as bank’ profits

would fall below profits in a cash-only economy, which is −𝑐𝐷, and now decreases with an

amount equal to F. Hence, a social planner would need to correct for that by imposing a

(constrained) optimal merchant fee equalling the difference in marginal costs of card and

41

cash payment (that part remains unchanged) plus the average fixed cost of card payments

given that optimal fee. This way, banks may recover their average fixed costs.

𝑚 = 𝑐𝐶 − 𝑐𝐷 +𝐹

𝜇(𝑚) (10)

In section 6, I will calibrate this model according to data from the Netherlands for the years

2002 and 2009, largely the same data as was used to test the avoided-cost test for the

Netherlands1.

4.2 Costs model

Social costs of payment services, in this study debit cards and cash, refer to the costs for

society as a whole of the resources sacrificed to produce the payment services. What matters

however to merchants, consumers and banks (including the central bank) are their private

costs and revenues. Following the conventions in the empirical cost studies, I adopt the next

definitions (all summed over the parties involved):

External costs are transfers (fees, commissions, etc.) to other agents in the payments

value chain2.

Internal costs are then all other costs, roughly the costs of value added payment services.

In the cost calculations, transfers to parties other than the three mentioned are

considered internal cost components, proxied by the actual price paid for that

component3. For example, merchants pay for their use of telephone land lines or secure

(mobile) internet connections and these transfers to telecom network providers are

considered internal costs to merchants; or fees merchants pay to cash-in-transit

companies who deliver the surplus of cash (banknotes and coins) safely to cash centres;

bank pay fees to CSMs to process card and wire payments, etc.

Total costs are the sum of internal costs and external costs.

Revenues are the transfers received from other parties in the payments value chain.

Revenues for banks come in different forms, from merchants, consumers and other

banks. Clear examples are periodical fees (e.g. payment/banking packages) and per-

transaction fees (either fixed per e.g. debit card transaction or related to the transaction

1 “Largely” as obviously the model parameters differ but the data sources are the same. 2 Seigniorage is an implicit transfer of the public to the central bank as holding cash means incurring opportunity

interest costs. These are included in the costs calculations, see Brits & Winder (2005) for details. 3 This introduces a slight bias in the estimate of the social cost of the particular component.

42

amount as with e.g. a credit card transaction or per deposited sealbag or ATM

withdrawal). There are also less clearly visible sources of revenue, for example taking

float, value-dating1, paying no interest on payment accounts2 and all sorts of margins (e.g.

in currency conversions). If merchants surcharge, these would count as revenues.

Total net costs equal total costs minus revenues.

Social costs (SC)3 are then the sum of internal costs of all parties in the payments value

chain.

Consumers are assumed not to incur any internal costs associated with making a payment

but do face external costs (typically bank fees).

Fixed and variable costs

Next to social and private costs, external and internal costs, costs can also be divided into

fixed and variable costs. Obviously, agents make decisions based on such divisions (and more

refined categorisations), but in the context of this study it is also relevant as it enables an

assessment of the cost efficiency of payment instruments. Variable costs have a relation with

the execution of the payment transaction, whereas fixed costs do not (within a certain time

span)4. A further division of variable costs is whether they are linked to the transaction value

(“sales-linked”) or to the transaction occurring regardless of the value (“transaction-linked”).

This may also depend of course on existing market practises and the pricing models of the

providers and need not per se reflect the product’s underlying cost structure or associated

risks. For example, for a merchant the charges he faces for a credit card transaction usually

depend on the transaction value, whereas for debit card transactions the market practises

differ: in some countries a fixed fee per transaction is custom5, while in others it is some

percentage of the amount (i.e. sales-linked). Costs for cash on the other hand show to have a

high correlation with the transaction value. The main reason is that larger cash payments

entail increased time consumption for cash handling by retailers (e.g. staff costs to sort and

count banknotes, fees to cash-in-transit companies, etc.) and banks. Intuitively, one can

1 Value-dating and taking float have been abolished or made virtually impossible as per PSD, November 2009.

They are therefore accounted for in the cost estimations for 2002 and 2009. 2 This is often the most important source for banks to recover their costs on retail payment services. See for

example McKinsey&Company (2006). Since these costs/revenues are independent of any specific payment

instrument, they are considered out of scope in this study (as in the reference studies). 3 Only variables that will be used later on get denoted. For the full set and interrelations, see Brits & Winder

(2005). I adopted the notational form from Jonker (2013) in this paragraph. 4 See next section. 5 For example the Netherlands, Sweden and Belgium, the three countries whose cost studies formed the input for

MasterCard to calculate the IF levels that also have been adopted as caps in the IFR (Jonker and Plooij, 2013,

p.57).

43

expect cash to be the most efficient payment instrument for lower transaction values, while

a card is so for higher values (see below).

The (total) social costs SC of a payment instrument j can thus be defined as the sum of its fixed

Fj, variable transaction-linked Vj,tr and variable sales-linked Vj,s costs.

SCj = Fj + Vj,tr + Vj,s (11)

Each of these components is a sum of the corresponding internal costs of merchants, banks

and consumers respectively. The total variable transaction-linked costs of a payment

instrument Vj,tr can also be defined as 𝛼𝑗, the average transaction-linked variable costs per

transaction made with that payment instrument times 𝑁𝑗 , the total number of transactions

done with that instrument: 𝑉𝑗,𝑡𝑟 = 𝛼𝑗𝑁𝑗.

Similarly, the total variable sales-linked costs of a payment instrument Vj,s can be defined as

𝛽𝑗, the average sales-linked variable costs per Euro sales amount paid for with that payment

instrument times 𝑆𝑗, the total sales amount paid for with the instrument: 𝑉𝑗,𝑠 = 𝛽𝑗𝑆𝑗 .

Cost comparison criteria

In order to compare the social costs of each payment instrument, one would need to account

for the differences in the number of transactions and the amounts involved (value). The

charts below indicate how these have evolved during the years 1996 – 2004 in the

Netherlands in relative terms.

[charts 2b and 2c about here.]

Chart 2a (§2.6) shows that the Dutch clearly prefer the debit card over other non-cash

instruments, but chart 2b puts this into perspective and reveals the predominance of cash.

The progression of the debit card replacing cash is however unmistakable, in particular for

transaction amounts (chart 2c).

Thus, three criteria to compare social costs of payment instruments qualify:

Criterion 1: social cost per transaction: SCj

𝑁𝑗=

Fj

𝑁𝑗+ 𝛼𝑗 +

𝛽𝑗Sj

𝑁𝑗

with Sj/Nj representing the average value of a transaction with payment instrument j (scaling

according to number of transactions);

44

Criterion 2: social cost per euro sales amount: SCj

𝑆𝑗=

Fj

𝑆𝑗+

𝛼𝑗Nj

𝑆𝑗+ 𝛽𝑗

with SCj/Sj and Fj/Sj representing the total costs, resp. fixed costs of each euro in sales, and

Nj/Sj the number of transactions needed to generate EUR 1 in sales (scaling according to value

of transactions);

Criterion 3: the cost of one additional transaction of predetermined size s: 𝛼𝑗 + 𝛽𝑗𝑠

Criterion 3 focuses on the variable costs of a transaction, consisting of two components, one

that depends on the occurrence of a payment transaction being executed and a component

that depends on the transaction value. This criterion is most appropriate for discussions on

the efficiency of the individual payment instruments and enables a calculation of a break-

even transaction amount, i.e. a transaction value at which the costs of the two payment

instruments are equal. Using this criterion, Brits & Winder (2005, p.27) compute the break-

even point for cash and debit card for the Netherlands in 2002 at EUR 11.63, meaning for

lower transaction amounts cash is the most cost efficient way to pay from a social cost

perspective while for higher amounts, the debit card is cheaper. Bolt, Jonker and Renselaar

(2008, p.9) report the break-even point to have dropped below EUR 5 in 2006 and by 2009

it had further decreased to EUR 3.06 (Jonker, 2013, p.30).

45

5 DATA

For this study I gleaned data from several sources. Starting point is the Brits & Winder (2005)

study with estimates on social costs of cash and debit card payments in 2002. Their

methodology was followed in the study on social costs of cash and debit card payments in

2009, published by Jonker (2013). In both cases DNB conducted the studies, using a survey

by EIM to collect cost data on the retail sector. The studies used additional data from other

sources, as mentioned below. Unless otherwise indicated, I have revisited all of the original

sources of these data.

5.1 Data collection 20021

The paper published by Brits and Winder, both at that time employees of DNB, was based on

a cost survey conducted by an ad-hoc working group made up of representatives of the

banking community (including DNB and ACH Interpay, see box 3), and merchants’ and

consumers’ interest organisations, chaired by DNB. The banking community supplied their

data on costs, fees and metrics2 directly to DNB, while information about the costs for the

retail trade, hotel and catering, gas stations, street trade and vending machines was reported

to DNB through a survey by research institute EIM. The costs for the remaining retail

subsectors, a largely heterogeneous group including the entertainment sector, museums,

public transport and small service providers was approximated by DNB using the survey

outcome. The core of EIM’s survey is a telephone questionnaire among a large representative

sample of retailing SMEs and a written questionnaire among the (very) large retail

companies. Finally, a time registration was carried out on location to estimate the front-office

time (payment time) per transaction per payment instrument.

DNB supplied the figures on cash usage and Currence3 the figures on debit card usage.

Additional information about the private costs for retailers for 2002 was based on

information on acquiring fees for debit card payments by HBD (2002) and NMa (2006). In

2002 the debit card system worked without IFs. The average merchant fee for a debit card

transaction was 4 - 6 eurocents (NMa, 2006, p.144).

1 This paragraph borrows from Brits & Winder (2005) and Jonker & Plooij (2013). More detailed information on

the data collection 2002 can be found in the annex of Brits and Winder. 2 Parties for whom offering payment services is part of their core business, usually use an ABC cost allocation

method. 3 The scheme owner of the Dutch domestic debit card and brand PIN.

46

5.2 Data collection 20091

The data collection for 2009 was slightly different in setup but followed the same

methodology to ensure comparability of the results throughout the years. The costs, revenues

and profitability of the Dutch retail payments market (covering all retail payment

instruments and payment accounts) was estimated by McKinsey&Company (2006) in a study

commissioned by DNB and NVB, the Dutch association of banks, in consultation with the

banking community and merchants’ and consumers’ interest organisations and in

participation with the five largest Dutch banks. Jonker (2013), also an employee of DNB,

published a study on the social costs of POS payments in the Netherlands 2002 – 2012, using

the Brits & Winder study for 2002 as described in the previous paragraph. For 2009, for the

costs data of debit card payments, she used the McKinsey study and a second, confidential

one on costs of cash services of banks from 2007 and extrapolated the results to 2009, taking

into account changes in the cost drivers for cash, changes in the payment habits of consumers,

changes in the organisational structure of banks, changes in short-term interest rate,

increases in labour costs as well as inflation. The retail sector’ costs were again collected by

EIM in a largely similar setup and with the same scope as for the 2002 data, and extrapolated

by Jonker to cover the whole retail sector. Information about the total number and the value

of POS payments in 2009 was estimated by DNB as part of the ECB cost study. As a result of a

change in institutional setting in the Netherlands during 2004, whereby Currence2 was

founded and the former single acquirer and ACH Interpay transferred all acquiring contracts

with the merchants to the respective banks, the banks introduced interchange fees.

Information on the average IF level and about banks’ acquiring fees was taken from NMa

(2010). The IFs were based on bilateral agreements and averaged between 1 and 2 eurocents

(NMA, 2010, p.21) per debit card transaction3. The average acquiring fee had decreased to 4

eurocents per debit card transaction in 2009 (NMA, 2010, p.20).

Between 2002 and 2009 the classification of cost items was adjusted at some points in

accordance with practises in the retail sector4. For debit card payments these changes

1 This paragraph borrows from Jonker (2013) and Jonker & Plooij (2013). More detailed information on the data

collection 2009 can be found in the annex of Jonker (2013). 2 Started operations as of 1 January 2005 3 This is lower than the cap proposed by the EC: 0.04% of an average debit card transaction, versus 0.2% cap. 4 In short: the time horizon to distinguish fixed from variable costs had changed from 3 to 5 years in 2002 to 7

years in 2009. With respect to cash payments, the classification of “own money transport” was changed from

variable sales-related costs to fixed costs. The back-office costs for cash payments were changed from fixed costs

into a mix of fixed, variable transaction-linked and variable sales-related costs. In 2009, the cost of payments

47

resulted in a shift of EUR 25 million from variable transaction-linked costs to fixed costs. For

cash payments there was a net shift of EUR 125 million from fixed costs to EUR 40 million

transaction-linked and EUR 85 million transaction-sales-linked costs. In section 6 where I

test the results of my calibrated model in a sensitivity analysis, I will examine the impact of

these changes on the estimated notional level of optimal IF. However, such changes keep

occurring in practise and, though interesting from an academic perspective perhaps, a

theoretical optimal IF should reflect the actual social costs in cost allocations as used by the

market participants and not an allocation the market deemed appropriate in the past1.

5.3 Data

The paper of Jonker (2013) contains most of the data I need to calculate the estimations of

the parameters. There are some significant advantages of using the data as reported in that

paper. One is that the methodology for both years was the same, as well as the institute to

collect the data on the retail sector with largely unchanged surveys. Second is that the study

reports the social costs for cash and debit cards for both years per agent, including the

classification into variable and fixed costs using the cost model as described, which saves the

trouble of calculating the social costs per instrument per central bank, banks and retailers

from private costs and revenues (which are much harder to come by). Third is that the

reported social costs for the retailers are a consistent aggregation of the data as collected by

EIM, which have been used by (Bolt), Jonker and Plooij to estimate the interchange fees for

both years according to the tourist-test. But whereas the tourist-test focusses on the private

costs of retailers, the model of Korsgaard focusses on the total net costs of banks.

The total social costs for cash and debit card payments in the Netherlands declined from EUR

2,642 million in 2002 to EUR 2,405 million in 2009; the social costs for cash fell by EUR 334

million to EUR 1,788 million in 2009 while the social costs for debit cards increased with EUR

97 million to EUR 617 million (during which timeframe the total number of debit card

transactions almost doubled; an economy of scale of roughly 0.20). Table I, reused for ease of

reference from Jonker (2013), shows the social costs borne by the central bank, the banks

and retailers for cash and debit card payments for the years 2002 and 2009; this table

contains a large part of the numbers needed to estimate the model parameters. Table II,

related equipment was completely (cash) or largely (debit card) classified as fixed costs, whereas in 2002 the

division fixed to variable was 50:50. 1 In the study of Jonker & Plooij (2013) the estimated tourist-test IF increased from 0.2% in 2002 to 0.5% in 2009.

Using the 2002 cost classifications, the authors calculate it would have increased even further to 0.7%.

48

reused from Jonker & Plooij (2013) shows the breakdown of the costs for retailers

(merchants) into several cost items and classifications (fixed, variable transaction-linked and

variable sales-linked) for the year 2009. A similar table for 2002 can be found in the annex of

Brits and Winder, table A.2 (not reproduced here).

[Tables I and II about here.]

For the sake of completeness: average merchant fees are 7 eurocents per transaction in 2001

(DNB, 2002, p. IX), 4 – 6 eurocents in 2005, 2006 (NMa, 2006, p.144) and below 4 eurocents

in 2009 (NMA, 2010, p.20).

49

6 ESTIMATION

Using the cost data from table I in the previous section, and several other sources which I will

specify, this section shows how I estimate the parameters of the model and calculate the

socially optimal IF for the years 2002 and 2009 according to the model. I will also analyse the

robustness of the outcomes by performing some sensitivity analyses. But first I briefly outline

some stylized facts on POS payments and a few changes in the institutional setting in the

Netherlands during the relevant timeframe, as far as relevant for this study. The outline

suggests that the results found in this paper will not easily generalize to other countries.

6.1 Payments developments in the Netherlands 2002 - 2009

The Dutch sometimes take pride in the efficiency and security of their payment system, see

e.g. DNB (2002) and McKinsey&Company (2006). The next examples are meant to add some

substance to the efficiency claim and illustrate market practises that have bearing on POS

payments.

Efficiency

As a first exhibit the average price for a payment account. In most countries, the Netherlands

included, a payment account comes as a package deal to consumers, comprising an account,

a debit card, access to internet/online banking and a number (or limitless amount) of debit

card transactions, ATM cash withdrawals, credit transfers, standing orders and direct debits.

Chart 3 displays the average annual prices of a payment account for consumers in the EU in

20091. The average prices in the Netherlands were the lowest with EUR 41.17, the highest

amounted to EUR 243.64.

[Chart 3 about here]

This has not been always the case. For long, consumers had been raised with the idea that

payments are and should be free2. This was substantiated by the vision and business model

of the government-owned Postbank that promoted home-banking and had the image of

1 Source: factsheet accompanying another piece of EU payments regulation, the Payment Account Directive

(Directive 2014/92/EU), published OJEC 28 August 2014. Member States must transpose the provisions into

national law and regulations by 18 September 2016. 2 See for example the stated opinion of the consumer’ interest group as represented in the ad-hoc working group

(§5.1): “De Consumentenbond is van mening dat het basispakket van het betalingsverkeer gratis zou moeten zijn

en toegankelijk voor iedereen” [basic payments package should be free for all], DNB (2002, “bijlage III”).

50

providing free payment services1, even after it was privatized (see also box 3). And so,

consumers were not charged for their current account or payment instrument usage; at least,

not visibly because value-dating, taking float and low or no interest on payment accounts

(opportunity costs) were common2. That started to change somewhere around the turn of

the millennium and banks introduced fixed, often annual, fees for consumers. Note that this

is the main and crucial assumption underlying the formal model for optimal interchange fees:

consumers do not pay per-transaction fees. Initially, the fees were labelled “card fees”,

suggesting that debit cards are more expensive than cash (Jonker, 2007), a view supported

by the fact that merchants were allowed to surcharge and some indeed did (Jonker, 2013)3.

The fees have been relabelled to something akin to “payment package fees” and have been

slowly increased over the years, while banks stopped paying interest on payment accounts4.

Credit cards are usually not included and available at extra (fixed and variable) charges.

As a second exhibit supporting the efficiency claim: Schmiedel c.s. (2012), see §2.2, estimate

the social costs of retail payments around 1% of GDP for the EU, based on thirteen empirical

cost studies by as many European central banks5. The authors included in their study the

most frequently used retail payment instruments, that is: cash, cheques, debit cards, credit

cards, direct debits and credit transfers. The social costs of cash and debit cards in the

Netherlands is 0.42% of GDP6, extrapolating this to all retail payments combined yields an

indicative 0.61% of GDP7, which is the lowest of the sample of thirteen8 and likely to be one

of the lowest in the EU9. In 2002 the social costs of cash and debit cards were 0.57% of GDP

(revisit table I). They declined from EUR 2,642 million in 2002 to EUR 2,405 million in 2009.

These net cost savings of EUR 237 million were the result of cost savings in the retail sector

1 E.g. DNB (2002), p.II 2 Those did not cover bank’s cost though. The market perception that it did (and more than that) was a direct

reason for the banks to commission the McKinsey (2006) study. That showed banks were losing EUR 779 million

on cash services and additionally EUR 101 million on debit card transactions. All payment instruments, including

accounts, proved loss making, totalling EUR 2.664 million in losses. Revenue came from account balances, EUR

2.641 million, resulting in an economic profit of EUR -128 million. One exception: the only profitable payment

instrument was the credit card (EUR 69 million profit). 3 I have not been able to pinpoint the exact year when surcharging was abolished. Indirect evidence I found was

a study by ITM Research in 2000 commissioned by the EC to investigate the effects of the abolishment. 4 This practise remains until today for the three largest banks who dominate the market and provides ground for

competition to challengers. 5 These are the central banks of Denmark, Estonia, Finland, Greece, Hungary, Ireland, Italy, Latvia, Netherlands,

Portugal, Romania, Spain and Sweden. 6 Jonker, 2013, table 4, p.26, reproduced as Table I in section 5. 7 Cash and debit card account for 68.4% in market share, see Schmiedel c.s., 2012, table 4, p. 23. Since no domestic

payments instruments have been excluded, a simple extrapolation to 100% yields the 0.61%. 8 Second lowest reported 0.68%; Schmiedel c.s., 2012, table 7, note 2), p.27 and table 11, p.35. 9 Schmiedel c.s., 2012, table 13, p.40.

51

of EUR 264 that offset the small cost increases at banks and the central bank (Jonker, 2013).

For merchants, the operating costs of a cash payment in 2002 were lower than that of a debit

card payment but 2009 the situation had reversed, with lower overall costs for POS payments

for merchants1. Contrary to consumers, merchants never experienced ‘free’ payments and

paid fixed and variable fees for basically all payment instruments to receive funds and make

funds transfers. The fees merchants pay for debit card payments are fixed per-transaction

fees, which is both unusual by international standards (Börestam and Schmiedel, 2011,

Annex I, p.39) and low compared to other countries (EC Sector inquiry2); furthermore, they

have been decreasing over the years: on average 7 eurocents per transaction in 2001 (DNB,

2002, p. IX), 4 – 6 eurocents in 2005, 2006 (NMa, 2006, p.144) and below 4 eurocents in 2009

(NMA, 2010, p.20). Following this decline, the number of retailers that accept the debit card

increased and the number of retailers that surcharged their customers for using a debit card

decreased, with a corresponding decline in revenues from surcharging from EUR 8 million in

2002 to EUR 3 million in 2009 (Jonker and Plooij, 2013, p.63). This stimulated card usage.

Surcharging

In 2007, surcharging was a heterogeneous practise among merchants, with significant

differences among retail sectors (Bolt, Jonker and Renselaar, 2008). On average, 20% of debit

card accepting retailers do surcharge. Many retailers who do, surcharge only debit card

payments below a certain threshold, mostly EUR 10 – 15, in line with the break-even amount

of EUR 11.63 below which cash is cheaper from a social cost perspective, as Brits and Winder

calculated. About 90% of the merchants charged between 10 and 25 eurocents. The charge

initially served as an effective steering device towards the more efficient payment

instrument. But a mentioned in §4.2, the break-even point dropped to EUR 3.06 in 2009,

mainly due to technological progress and increasing payment volumes; cost savings that

were foremost benefitting the merchants themselves. The practise of surcharging however

hardly changed and this lead the researchers to conclude that the practise now hampered the

use of the more efficient debit card and therefore social cost saving of EUR 100 million could

be realised in the long run if the surcharging practise on debit cards would be discontinued.

In 2011 only 2% of the merchants still surcharged debit cards (Jonker, 2013, p.28).

1 Jonker & Plooij (2013), table 2, p.63, reproduced as Table II in section 5. 2 SEC(2007)_106, p.104: MSC debit cards weighed averages 1.0% - 1.5% in 2001 in the EU. Average debit card

transaction value was EUR 47.25 in 2002; i.e. 7 versus 47 eurocents (if taking MSC of 1.0%).

52

Institutional changes

See box 3 for a very brief overview of the Dutch interbank infrastructure developments. In

the context of this study, the changes that occurred in 2004 and 2005 are relevant. Before

2004, Interpay was the only acquirer of debit cards in the Netherlands and also the single

CSM. Following an advice of the ‘commissie Wellink’1, Interpay transferred all acquiring

contracts with the merchants to the respective banks by the end of 2005 and the banks

introduced interchange fees on debit cards, based on bilateral agreements. The merchants

loudly voiced their concern this would lead to higher merchant fees. In a good Dutch tradition

(poldermodel), the issue was resolved with a Convenant Betalingsverkeer where the banks

agreed with merchant’ interest groups not to raise merchant fees for 5 years, offer a 1

eurocent discount on each debit card transaction and donate EUR 10 million to a foundation2

that would promote efficient payments (among others end the practise of surcharging and

induce consumer payment behaviour changes). The transfer of contracts was finalised by the

end of 2005. In the same year, ownership of the domestic debit card brand PIN was

transferred to Currence3 that as of then acted as the scheme owner. PIN debit cards have

usually been co-branded with MasterCard’s Maestro4 to enable debit card transactions

1 NMa, 2006, p.131 2 Stichting Bevorderen Efficient Betalen. The campaign was effective (Jonker, Plooij and Verburg, 2015). 3 Started operations as of 1 January 2005. 4 At the moment one bank, a challenger of the ‘big three’, issues debit cards with both Maestro and VISA’s VPAY.

BOX 3. Dutch market infrastructures.

During last century there were two, largely separate, payment systems: the Postgiro and the

BankGiroCentrale (BGC). The first one can be traced back to the national savings bank, Rijkspostspaarbank

(founded in 1881) and the Postcheque- & Girodienst (founded in 1918), both government-owned until

privatized as Postbank in 1986. The Postbank merged into ING Group in 2009. The BGC was founded in

1967 by a number of merchant- and general banks, including (predecessors of) Rabobank and ABN AMRO

Bank. While the Postgiro was basically one system, the BGC worked as a CSM for the founding banks. In the

mid-seventies, DNB took an active role in stimulating the parties to increase inter-operability and efficiency,

a process that was intensified during the eighties under the then DNB president, Wim Duisenberg, until its

completion more than 20 years later in 1997 (1). In that timeframe several efficient payment products were

introduced: among others the national debit card PIN and the Dutch direct debit. The BGC merged in 1994,

together with BeaNet and Eurocard into Interpay which merged into Equens in 2006. The remaining Dutch

banks are still shareholders of Equens, together with the former shareholders of Interpay’ merging partner,

the German Transaktionsinstitut für Zahlungsverkehrsdienstleistungen AG. With the replacement of all

BBANs with IBANs as per August 1st, 2014 (2), the last noticeable difference between the two payment

systems finally disappeared: giro account numbers were typically 7 digits long whereas bank payment

account numbers were 9 digits. The NL IBAN is fixed to 18 characters.

Note (1): knows as the NBC, “Nationale BetalingsCircuit”; this was not one central system but an

arrangement of agreements, standards and procedures.

Note (2): As a consequence of Regulations (EU) 260/2012 (‘SEPA Regulation’), and (EU) 248/2014.

53

abroad, so until 2011 when PIN (the brand and the domestic infrastructure) was

decommissioned, not every debit transaction carried IFs.

6.2 Calibration1

The key parameters to estimate the (unconstrained) socially optimal IF are 𝑐𝐶 and 𝑐𝐷. Other

parameters are merchant’s cost price of the good γ, merchant’ fixed cost of card acceptance

K, consumer distance cost t, consumer net benefits of cards 𝑏𝐵 and merchant net benefits of

cards 𝑏𝑆. Additionally, for the constrained socially optimal IF we need banks fixed cost for

card payment services F. Below, I show step by step how I estimate the model parameters,

utilising the numbers in table I (unless otherwise indicated). To keep this paragraph brief, I

only exhibit the estimations on the 2009 parameters, the 2002 can be found in the same

fashion. All estimations are summarised in table III.

If one thinks of the model as describing a single transaction, then the transaction value may

be thought of as consisting of two parts2: the cost price of the good γ and a profit margin,

approxied by t. In other words, we will be normalizing for transaction value. The total sales

value of cash and debit card transactions was 58.1+76.1=134.2 billion. The total number of

cash and debit card transactions was 4,579+1,946=6,525 million. So the average transaction

size in 2009 is EUR 20.57. Choosing a markup of around 10.5% yields γ = EUR 18.41 and t =

EUR 2.16. The choice of the markup is arbitrary and I will test the model for sensitivity to this

choice later; the main reason for this exact markup is to be able to compare the outcome with

the outcome of Korsgaard, so I use the same markup. Besides that, a profit margin of 10%

does not seem too wild. In the model, K corresponds to the total fixed cost, but the model

describes a situation in which there is a unit mass of transactions. The logical counterpart

would then be to scale the merchant fixed costs to the total value of cash and card payments.

Merchant’s fixed cost of card payments is EUR 99 million and aggregate sales amount is EUR

134.2 billion which yields for an average transaction size of EUR 20.57: (99/134,200)*20.57

= K = 0.0152.

The parameters 𝑐𝐶 and 𝑐𝐷 reflect the banks’ marginal costs of card and cash payments. The

banks’ economic production function is not observable, so the correct proxy would be the

average variable costs for if we may assume constant marginal costs. Brits and Winder (2005)

assume linearity of the merchant‘s private variable cost function, which implies that unit

1 Unless otherwise indicated, the numbers used can be found in tables I and II. 2 See also Wright (2004b) p.19.

54

variable costs are equal to marginal costs. Apparently, MasterCard also used this assumption

when calculating the caps (Bolt, Jonker and Plooij, 2013, p.13). I extend this assumption to

banks’ variable cost function1. Accordingly, the banks variable average costs for debit cards

can be calculated as their total variable cost of debit cards divided by the total value of debit

card transactions and then multiplied by the average transaction value. Similarly, the banks

variable average internal costs for cash can be calculated as their total variable cost of cash

divided by the total value of cash transaction and then multiplied by the average transaction

value. Since the banks in the model represent the ‘producer’ of payments, the variable costs

of the central bank need to be included (only for cash as the central bank has no part in the

production of debit card transactions).

This yields an average variable social cost of cash 𝑐𝐷 of: 20.57*(445+41)/58,100 = 0.172 and

an average variable social cost of debit cards 𝑐𝐶 of: 20.57*83/76,100 = 0.022.

A little bit more involved are the estimations concerning the distributions of benefits.

Merchant benefits 𝑏𝑆 can be interpreted as the marginal savings from a card payment as

compared to a cash payment. This is where criterion 3 proves convenient: 𝛼𝑗 + 𝛽𝑗𝑠. Jonker

(2013), table 5, reproduced as table IV in the appendix, shows these functions for both years

and both cash and debit cards. For 2009, the function for cash is [0.1376 + 0.0089s] and for

debit card [0.1643 + 0.00013s]. Inserting the average transaction value into both and taking

the difference, yields 0.1537. This is then taken as the midpoint 𝑏𝑆,𝑚𝑖𝑑 of a uniform

distribution2: let 𝑏𝑆,𝑚𝑖𝑛 = 0.1537 − 𝑥 and 𝑏𝑆,𝑚𝑎𝑥 = 0.1537 + 𝑥.

Similarly, the distribution for 𝑏𝐵 can be estimated. This presents however a small challenge

as the consumer costs of payments were not included in any of the studies on the

Netherlands. I worked around this by looking at the Danish cost study, where estimates of

household costs of payments at POS were included and assuming the Danish households are

representative for the Dutch in this respect. The total net cost of cash for households in 2009

is DKK 1,523.5 million3, this is 0.081% of Danish GDP in 2009. Jonker (2013) uses a Dutch

GDP 2009 of approximately EUR 572.62 billion, a number I ‘reengineered’ from table I.

Applying the same percentage, the total net cost of cash for Dutch households in 2009 would

1 To support the assumption from an empirical view, Schmiedel c.s. (2012, p.29), shows diagrams in chart 2 that

depict the relationship between average unit social costs and the number of payments per capita for each retail

payment instrument; the lines are downwards sloping at a decreasing rate, which is consistent with constant

marginal costs. 2 As already mentioned, the assumption of uniformly distributed benefits is convenient for calculations but should

be empirically tested whether it is reasonable. A priori, the assumption seems no more nor less reasonable than

others. Unfortunately, I have no data to execute such a test. 3 Danmark Nationalbank (2011), table 6.

55

then amount to EUR 463.8 million. Dividing this number by the total value of cash sales, EUR

58.1 billion, yields a consumer net cost of cash per Euro sales of 0.0080. Similarly, the total

net cost of debit card for households in 2009 is DKK 718.2 million, this is 0.045% of Danish

GDP in 2009 which translates to EUR 257.7 million for the Dutch households. Dividing this

number by the total value of debit card sales, EUR 76.1 billion, yields a consumer net cost of

debit card per Euro sales of 0.0034. Subtracting the two numbers and multiplying by the

average transaction value indicates consumer enjoy benefits of 0.09 by paying by debit card

for an average transaction size. Setting this as the midpoint 𝑏𝐵,𝑚𝑖𝑑 gives 𝑏𝐵,𝑚𝑖𝑛 = 0.09 − 𝑦 and

𝑏𝐵,𝑚𝑎𝑥 = 0.09 + 𝑦. The estimation of the midpoint for 2002 can be found using the same steps

but as the Danish study only concerns the year 2009, I estimated the corresponding numbers

for 2002 using Dutch GDP of 2002 and I used a small correction to account for fees paid by

the Dutch households to banks; that is, the portion of the total cost of cash for Danish

households, great DKK 1,523.5 million that were fees to banks in 2009 (DKK 153.1 million),

I subtracted to account for Dutch households not paying any such fees in 2002.

The values of 𝑦 and 𝑥 have now to be set so that the fraction of merchants accepting debit

cards and the fraction of consumers preferring to pay by debit card match the empirical data.

According to Korsgaard, almost all of the merchants in Denmark accept the domestic debit

card Dankort: 95% in 2009. For the Netherlands, EIM (2007, p.24) reports 93% of retailers

accepting the debit card in 2006 and 63% in 1998. Since the scope of EIM is a subset of all

retailers, which might be slightly biased towards the more debit card favouring retailers, see

section 5 on the data collection. The number we are looking for here is the percentage of all

merchant stores, locations and venues where debit cards are accepted, regardless how many

debit card transactions actually take place there. Jonker and Lammertsma (2010) use this

metric and report an average percentage of businesses accepting debit cards of 70% in 2007.

I therefore choose more conservative estimates of 75% for 2009 and 60% for 2002, taking

into consideration the successful long-running public campaign that started in 2007 and

other initiatives by St.BEB. In 2009, the total portion of card payments by value is: 76.1/134.2

= 56.7%, so the fraction of consumers preferring to pay by debit card is assumed to be

0.567/0.75 = 75.6%. Now 𝑦 can be found first by solving the following equation for 𝑦:

1 − 𝐻(0) =𝑏𝐵,𝑚𝑎𝑥

𝑏𝐵,𝑚𝑎𝑥−𝑏𝐵,𝑚𝑖𝑛 =

𝑏𝐵,𝑚𝑖𝑑 +𝑦

𝑏𝐵,𝑚𝑎𝑥−𝑏𝐵,𝑚𝑖𝑛 = 0.756 (12)

The merchant threshold is:

56

𝑏𝑆 ≥ 𝑏𝑆∗ = 𝑚 − 𝐸[𝑏𝐵 𝑏𝐵 ≥ 0] +

3𝑡 (1−√1−2𝐾

𝑡)

1−𝐻(0) (13)

where for 2002, 𝑚 = 0 and for 2009 can be set at 𝑚 = 0.04.

This can be calculated using the found parameters estimates and 𝑥 is set so as to solve

1 − 𝐻(𝑏𝑆∗) =

𝑏𝑆,𝑚𝑎𝑥 −𝑏𝑆∗

𝑏𝐵,𝑚𝑎𝑥−𝑏𝐵,𝑚𝑖𝑛 =

𝑏𝑆,𝑚𝑖𝑑 +𝑥− 𝑏𝑆∗

2𝑥= 0.75 (14)

which for 2009 yield 𝑦 = 0.185 and 𝑥 = 0.386 and for 2002 𝑦 = 0.043 and 𝑥 = 0.042.

6.3 Obtained results

The estimated parameters of interest are summarised below in table III.

[table III about here]

The merchant card acceptance threshold 𝑏𝑆∗, equation (13), evaluates to −0.039 which

implies that a merchant would accept debit card payments even if it increased costs relative

to receiving payment in cash by 0.039 for an average transaction amount, i.e. 0.19%,

indicating merchant internalization. For 2002 the merchant threshold is positive but close to

zero (0.007), indicating an on average slightly higher merchant resistance to accepting debit

cards in that year compared to 2009.

The value of y in 2009 is less than x, indicating less heterogeneity in consumer benefits than

in merchant benefits (in the estimation for Denmark, the opposite appears to be case). No

corner solutions have been obtained in the numerical estimates: 𝑏𝑆,𝑚𝑖𝑛 is less than the

merchant threshold.

Recall the formula for the unconstrained optimal merchant fee 𝑚 = 𝑐𝐶 − 𝑐𝐷 it evaluates

for 2009 to −0.150 or −0.73% and

for 2002 to −0.106 or −0.76%.

By comparison, the optimal merchant fee as derived by Korsgaard for Denmark is −0.47%

(which results in an estimated optimal interchange fee of −0.50% as acquiring costs need to

be included and these are 0.03% for Denmark; we could try to approximate the acquiring cost

for the Dutch banking sector for both years, using the average acquiring fees for the two years

as mentioned in §5.3 (times number of debit card transactions) to come to comparable

estimates of the optimal IF but this would be a mix up as these are external costs to merchants

57

and revenues to banks, which are not good proxies for average variable internal costs for the

acquiring banks. Thereofore I leave this small exercise aside).

What would be the optimal interchange fee as set by the banks? The model provides an

approximation that can only be obtained if one assumes uniformly distributed benefits for

both merchants and consumer, still ignoring merchant fixed costs. The equation reads:

𝑚 =1

2 (𝑐𝐶 − 𝑐𝐷 + 𝑏𝑆,𝑚𝑎𝑥 +

1

2𝑏𝐵,𝑚𝑎𝑥 ) (15)

and evaluates to 1.21% for Danmark. It is easy to calculate now the corresponding estimates

for the Netherlands. Similarly expressed in relative terms (relative to the average transaction

value of the respective years), for 2009 that would yield 1.29% and for 2002, −0.07%.

The formula assumes fixed cost for merchants and banks to zero. As said before, the merchant

fixed cost will drive the optimal interchange a fraction further down. I relax both assumptions

consequentially and take fixed costs for both merchants and banks into account. First

employing equation (8) and then equation (10), we obtain the constrained socially optimal

merchant fees

for 2009 of −0.072 or −0.35% and

for 2002 of 0.063 or 0.45%.

6.4 Robustness

I take the two indicators of socially optimal merchant fees according to the model, the

unconstrained optimal fee and the constrained optimal fee, for both the two years to see how

they hold in a few sensitivity analyses.

The first is an analysis of changes to the markup. As table V shows, the model outcomes hardly

respond to the changes. This indicates the model is robust for changes in the arbitrarily

chosen markup of 10.5%. Only the constrained optimal merchant fee is shown in the table as

the unconstrained optimal merchant fee is independent of the markup.

[Table V about here]

58

The next is an analysis of changes in the average value of a transaction. Table VI shows the

constrained and unconstrained socially optimal merchant fees for 2009 and 2002 in absolute

values (EUR) and in percentages for different transaction size.

[Table VI about here]

The unconstrained socially optimal merchant fee is negative for both years for all transaction

sizes. Consequently, the absolute values are also negative. It means that according to this

model, translated back to a four-party model, the issuers pay the merchants a fee per

transaction, instead of receiving one. The reason a social planner would choose to do so is

because cash is relative expensive and banks are effectively subsidising cash. As cash became

even more expensive in 2009, one would expect a higher (i.e more negative) merchant fee,

but this is counterbalanced by the change in fraction of card payments relative to cash

payments measured in value. The socially optimal merchant fee remains fairly unchanged

compared to 2002. And herein lies the weakness of the and model: the costs are assumed to

vary with the fraction of card, respectively cash payments in the economy which seems like

an oversimplification of reality. Furthermore, the estimation method normalizes over the

value of the transactions, thereby neglecting the proper scaling criteria as presented earlier.

As table IV shows, the banks had an average social cost per transaction of EUR 0.17 for debit

cards and of EUR 0.19 for cash. To demand issuing banks to pay EUR 0.15 for each debit card

transaction seems quite out of place, the notion that issuing banks need compensation for

(part of) their internal costs is denied in this setup.

Even more interesting is taking into account banks’ fixed cost. The socially optimal merchant

fee is then adjusted so the banks get compensated to cover for their average fixed cost,

expressed in terms of the fraction of card payments in the economy. In the numerical

example, this is again averaged over the value of card payments. The result is that the optimal

fee, the constrained optimal fee, is negative in 2009 but positive in 2002, as banks had a

relatively larger fixed part of card costs. The result would be that the interchange fee would

actually stimulate the more expensive payment instrument, cash, while discouraging cards.

Note that all the calculated optimal merchant fees (which by modelling assumption include

interchange fees) are much lower in reality than estimated here. With “lower” I mean closer

to zero. A two-sided market is virtually never symmetric so a price level below zero may be

59

expected to lead to different price structure, with the risk of creating a market failure instead

of solving one.

A final exercise in this paragraph is to examine what impact the reclassification of certain cost

items had on the optimal fees. This remains a short exercise as the impact turns out to be

none. The reason is simple, all the changes in classifications concerned the retail sector and

none of those costs have impact on the optimal merchant fee, constrained nor unconstrained.

This is because the model presumes the banks to be the producer of card payments and

merchants are ‘users’. Their costs are no input to the banks’ production function.

60

7 CONCLUSIONS

7.1 Discussion of the results

Whereas most of the literature focusses either on the payment activity rather than the

instrument, or on credit cards, it seemed refreshing to have a model closer to a debit card

favouring market. In particular as those experience lower interchange fees. Secondly, none

of the models in the literature accounted for the fact that consumers do not experience per-

transaction costs as is so often assumed; or a fixed fee for consumers is assumed but then the

total volume of transactions is assumed fixed which renders the difference immaterial. But

the model employed in this study turns out to create the wrong incentives in the long run,

working with the constrained optimal merchant fee. Because in derivations the developer

tried to avoid dealing with corner solutions, at the point of addressing fixed costs of banks

the model showed to contain a superior solution from a welfare perspective compared to the

one used. I will present it here: the social planner would still impose the unconstrained

optimal fee and banks would then be reimbursed their fixed costs as that would not result in

a loss of welfare from lower than optimal card usage. As it happens, the Danish debit card

model actually works in a fashion very similar to this (the system actually does work with an

IF, only implicitly1). Such a model would run against the current institutional setting in the

Netherlands and would reverse large parts of the changes that occurred about a decade ago2.

While the unconstrained optimal merchant fee is a striking result from an economic and

intellectual perspective, the choice to ignore merchant fixed costs or banks fixed costs that

create the simple yet elegant and striking result, seems arbitrary and unsupported from an

empirical perspective.

From an estimation point of view, the model showed to be too coarse to cater for relatively

very small interchange fees like in the Netherlands. Korsgaard views IFs of -0.47% or 0.23%

“still a very low figure compared to actual interchange fees” (p.21), but from a Dutch

perspective these are big numbers. Recall that the Convenant Betalingsverkeer includes a

(real) merchant discount of EUR 0.01 and that agreement has been prolonged twice,

1 See Börestam & Schmiedel (2011), p.11 or Danmark Nationalbank (2011). 2 Whether the Danish model is ‘future proof’ remains to be seen, as the PSDII will demand a separation of

processing and scheme ownership, where Denmark operates a monopoly acquirer, as was the case in the

Netherlands before 2005. Perhaps the Danish will find a way to avoid a negative impact on what otherwise appears

to be a very efficient debit card infrastructure. The point I’m making is more that those enforced changes, have

already passed the Netherlands so also from that perspective a reversal seems unlikely and undesirable.

61

currently until 2018. The assumption of a profit-maximizing banking sector that is the (sole)

producer of payment services, appeared reasonable at first glance. But as it turns out, the

model neglects several costs that are important from a social perspective, in particular the

costs of retailers. In defence of the model, it has to be stated that all benefits have been

modelled and estimated as cost savings. This ignores other benefits merchants and

cardholders attach to card usage.

As in Rochet and Tirole (2000, 2008) and Wright (2004b, 2012), the model produces the

merchant internalization property. But to what extend this is actually present did not show

from the empirical data as I conveniently assumed uniformly distributed benefits. As Jonker

(2011) demonstrates, merchants are sensitive to the cost of accepting card payments,

especially fixed costs. But the competition the merchant faces also influences merchants’ card

acceptance and surcharging decisions. As competition increases, card acceptance is likely to

increase. It would be interesting if this fact would be combined in a model where consumer

do not pay per-transaction fees and study the outcomes.

7.2 Limitations of the study

Next to the limitations I have already indicated above, one I would like to point out in

particular. The concept of social costs is valuable from a cost-to-society perspective. If the

costs would be reduced social welfare would increase as the production resources become

available to other ends. But this view ignores the payment system itself generates social

benefits as well. See my brief accounts on ‘money’. Efficient payment systems are vital to real

markets and financial markets. New products like e-wallets, mobile payments, iDEAL, can

actually create new demand. The difficulty is that the benefits are difficult to measure. But

what is easy is not necessarily what is right.

7.3 Afterword

“All solutions have costs and there is no reason to suppose that government regulation is called for simply

because the problem is not well handled by the market or the firm.”

Ronald Coase, The problem of social costs, p.18

62

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Guthrie, G., and Wright, J., 2007, Competing Payment Schemes, Journal of Industrial

Economics, Vol.55, No.1, pp. 37-67

Hayashi, F., 2004, A Puzzle of Card Payment Pricing: Why Are Merchants Still Accepting Card

Payments?, (Federal Reserve Bank of Kansas City). Available at:

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Hayashi, F., 2013, Public Authority Involvement in Payment Card Markets: Various Countries

(Federal Reserve Bank of Kansas City). Available at:

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HBD, 2002, Afrekenen in winkels 2002, Meningen, feiten en mogelijkheden tot verandering,

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Humphrey, D., Willesson, M., Lindblom, T. and Bergendahl, G., 2003, What does it cost to

make a payment?, Review of Network Economics, Vol.2 Issue 2, pp. 159–174

ITM Research, 2000, The abolition of the No-discrimination Rule, ITM Research for

Competition DG, Amsterdam

Jonker, N., 2007, Payment instruments as perceived by consumers: Results from a

household survey, De Economist, 155 No.3, pp. 271-303

Jonker, N., 2011, Card acceptance and surcharging: the role of costs and competition, DNB

Working Paper, No. 300

Jonker, N. , Kosse, A., and Hernandez, L., 2012, Cash Usage in the Netherlands: Where, When

and Whenever One Wants?, DNB Occasional Studies, Vol.10, No.2

Jonker, N. and Lammertsma, A., 2010, From cash to electronic payments: a survey of the

developments, in: Statistics Netherlands (ed.), The Digital Economy 2009, The

Hague/Heerlen, pp. 203-210

Jonker, N. and Plooij, M., 2013, Tourist-test interchange fees for card payments: down or

out?, Journal of Financial Market Infrastructures, Vol. 1, No.4, pp. 51–72

Jonker, N., Plooij, M., Verburg, J., 2015, Does a public campaign influence debit card usage?

Evidence from the Netherlands, DNB Working Paper, No. 0

65

Klemperer, P., 1987, Entry deterrence in markets with consumer switching costs, The

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Kokkola, T. (ed.), 2010. The Payment System. Payments, securities and derivatives, and the

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Korsgaard, S., 2014, Paying for Payments, Free Payments and Optimal Interchange Fees, ECB

Working Paper Series No. 1682

Kosse, A., and Vermeulen, R., 2014, Migrants’ choice of remittance channel, do general

payment habits play a role?, ECB Working Paper Series No. 1683

Leinonen, H., 2011, Debit card interchange fees generally lead to cash-promoting cross-

subsidisation, Bank of Finland Research Discussion papers, no. 3(2011)

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de opbrengsten en kosten voor het bankwezen (DNB). Available at:

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Motta, M., 2004. Competition Policy: Theory and Practice (Cambridge University Press, New

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NMa, 2006, Monitor Financiële Sector 2006, NMa

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Rochet, J-C. and Tirole, J., 2000, Cooperation Among Competitors: Some Economics of Credit

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Economics, Vol.33 No.4, pp. 549–570

Rochet, J-C. and Tirole, J., 2002, Platform Competition in Two-sided Markets, Working Paper

December 13, 2002; published in 2003 in: Journal of the European Economic Association,

Vol.1 No.4, pp. 990–1029

Rochet, J-C. and Tirole, J., 2003, An Economic Analysis of the Determination of Interchange

Fees in Payment Card Systems, Review of Network Economics, Vol.2, Issue 2

Rochet, J-C. and Tirole, J., 2005, Two-sided Markets: A Progress Report, Working Paper

November 29, 2005; published in 2006 in: Rand Journal of Economics, Vol.37 No.3, pp.

645–667

66

Rochet, J-C. and Tirole, J., 2008, Must-take cards: merchant discounts and avoided costs,

Working Paper November 7, 2008; published in 2011 in: Journal of the European

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Rochet, J.-C. and Wright, J., 2009, Credit card interchange fees (ECB Working Paper Series,

no. 1138 / December 2009)

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recent developments, Journal of Payments Strategy & Systems, vol. 3, no. 3 (April), pp.

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Interchange Fee, Proceedings of a conference on “Interchange Fees in Credit and Debit

Card Industries” (Federal Reserve Bank of Kansas-City, May 4-6, 2005) pp. 231–247.

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Weiner, S., E. and Wright, J., 2005, Interchange Fees in Various Countries: Developments and

Determinants, Review of Network Economics, Vol.4, Issue 4

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Vol.3, Issue 1, pp. 44-64

Wright, J., 2004b, The Determinants of Optimal Interchange Fees in Payment Systems,

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Zenger, H., 2011, Perfect surcharging and the tourist test interchange fee, Journal of Banking

and Finance, Vol.35, No.10, pp. 2544–2546

8.2 (Pre-) Legislation, Cases and Miscellaneous Links

COM(2013) 547 final, 2013/0264 (COD): Proposal for a DIRECTIVE OF THE EUROPEAN

PARLIAMENT AND OF THE COUNCIL on payment services in the internal market and

67

amending Directives 2002/65/EC, 2013/36/EU and 2009/110/EC and repealing

Directive 2007/64/EC, 24-7-2013. Available at:

http://ec.europa.eu/internal_market/payments/framework/index_en.htm

COM(2013) 550 final, 2013/0265 (COD): Proposal for a REGULATION OF THE EUROPEAN

PARLIAMENT AND OF THE COUNCIL on interchange fees for card-based payment

transactions, 24-7-2013

COMMISSION DECISION of 24 July, 2002 relating to a proceeding under Article 81 of the EC

Treaty and Article 53 of the EEA Agreement (Case No COMP/29.373 - Visa International -

Multilateral Interchange Fee) OJEC L318 22.11.2002

Decision d-g NMa July 24, 2002, case 82/50, GIP-Overeenkomst: Dutch only.

DIRECTIVE 2007/64/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 13

November 2007, on payment services in the internal market amending Directives

97/7/EC, 2002/65/EC, 2005/60/EC and 2006/48/EC and repealing Directive 97/5/EC

DIRECTIVE 2014/92/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 23

July 2014 on the comparability of fees related to payment accounts, payment account

switching and access to payment accounts with basic features

MEMO/09/143 of April 1st, 2009, Antitrust: Commissioner Kroes notes MasterCard's

decision to cut cross-border Multilateral Interchange Fees (MIFs) and to repeal recent

scheme fee increases – frequently asked questions

Regulation (EU) No 260/2012 of the European Parliament and of the Council of 14 March

2012 , establishing technical and business requirements for credit transfers and direct

debits in Euro and amending Regulation (EC) No 924/2009

SEC(2007) 106 COMMISSION STAFF WORKING DOCUMENT, Report on the retail banking

sector inquiry, Communication from the Commission – Sector Inquiry under Art 17 of

Regulation 1/2003 on retail banking (Final Report) [COM(2007) 33 final], 31-1-2007

SDW(2013) 288 final: COMMISSION STAFF WORKING DOCUMENT, IMPACT ASSESSMENT,

Accompanying the document [{COM(2013) 547 final}, {COM(2013) 550 final},

{SDW(2013) 289 final}], Volumes 1 and 2 (of 2), 24-7-2013

Links

[1] Paul Volcker: http://nypost.com/2009/12/13/the-only-thing-useful-banks-have-

invented-in-20-years-is-the-atm/

[2] Penalty JP Morgan Chase:

http://www.justice.gov/usao/nys/pressreleases/January14/JPMCDPAPR.php

68

[3] Penalty HSBC: http://www.justice.gov/opa/pr/hsbc-holdings-plc-and-hsbc-bank-usa-

na-admit-anti-money-laundering-and-sanctions-violations

[4] Penalty Commerzbank:

http://www.federalreserve.gov/newsevents/press/enforcement/20150312b.htm

[5] Penalty BNP Paribas: http://www.dfs.ny.gov/about/press2014/pr1406301.htm

[6] ING vs. AFAS:

http://uitspraken.rechtspraak.nl/inziendocument?id=ECLI:NL:RBMNE:2014:3250

[7] Wal-Mart c.s. vs. MasterCard and VISA: http://caselaw.findlaw.com/us-2nd-

circuit/1181291.html

[8] Short overview of the EC’s work on MIFs with more links: https://www.gov.uk/cma-

cases/investigation-into-interchange-fees-mastercard-visa-mifs

[9] EC sent supplementary SO to MasterCard, MEMO/06/260:

http://europa.eu/rapid/press-release_MEMO-06-260_en.htm?locale=fr

[10] Jean Tirole’s lecture in accepting the Sveriges Riksbank Prize in Economic Sciences in

Memory of Alfred Nobel 2014: https://www.youtube.com/watch?v=YQdF23RfX5w

[11] Reversal of IF direction in Australia: http://www.eftposaustralia.com.au/for-

merchants/faq

[12] Position paper of Groupement des Cartes Bancaires CB in response to IFR and PSD2

proposals: http://www.cartes-

bancaires.com/IMG/pdf/CB_Position_paper_on_MIF_Regulation_and_PSD_2_-

_December_2013.pdf

[13] BaFin expert article on PSD II:

http://www.bafin.de/SharedDocs/Veroeffentlichungen/EN/Fachartikel/2014/fa_bj_

1406_zahlungsdiensterichtlinie_II_en.html

[14] Factsheet accompanying DIRECTIVE 2014/92/EU:

http://ec.europa.eu/consumers/financial_services/bank_accounts/index_en.htm

[15]

69

9 APPENDICES

Chart 1: Non-cash payment shares in selected countries

The chart shows the share of the most frequently used non-cash payment instruments, measured in number of

transactions, in selected countries at three points in time: in the mid-nineties, at the end of the nineties and around

2003 (except Australia and Mexico where data of only two points in time are available).

Source: Weiner & Wright (2005, p.295)

Notes:

- Mexico debit card figures include ATM transactions.

- Weiner & Wright do not further indicate what payment instruments could fall in the category ‘Other’ (it is

not cash).

70

Chart 2a: Non-cash POS payment shares in the Netherlands

The chart shows the share of the most frequently used non-cash POS payment instruments, measured in number

of transactions, in the Netherlands during the years 1996-2004.

In absolute numbers, the debit card use increased with approx. 20% annually, from 371 million in 1996 to 1,247

million in 2004. In share however it lost some to the e-purse (brand: Chipknip). The usage of cheques peaked in

1991 (not disclosed in the chart) but gradually declined in the years after. In 1999 the Dutch banks decided to

stop issuing them during 2001 and on 1 January 2002 cheques were taken off the market. The decommissioning

of cheques and the introduction of the e-purse were part of the trend to stimulate the use of more efficient payment

instruments.

Source: Brits & Winder (2005), table 2.1.

Note: source reports absolute numbers, converted to shares by author.

71

Chart 2b: POS payment shares in the Netherlands

The chart shows the share of the most frequently used POS payment instruments, measured in number of

transactions, in the Netherlands during the years 1996-2004. In other words, this chart depicts the same as chart

2a with the estimated annual number of cash transactions.

Source: Brits & Winder (2005), tables 2.1 and 2.2

Note 1: source reports absolute numbers, converted to shares by author.

Note 2: The number of cash transactions in an economy is difficult to measure reliably. DNB has estimated the

number for the year 2002 on 7,000 million transactions and a value of EUR 120 billion (id. p.11, 12). Using the

yearly number of cash withdrawals by consumers (id. table 2.2), assuming the average value of a cash withdrawal

had not changed significantly in the time period, I have estimated the number of cash transactions for the other

years.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1996 1997 1998 1999 2000 2001 2002 2003 2004

debit card credit card e-purse cheques cash

72

Chart 2c: POS payment value shares in the Netherlands

The chart shows the share of the most frequently used POS payment instruments, measured in value of the

transactions in Euros in the Netherlands during the years 1996-2004. In other words, this chart depicts the same

as chart 2b now in terms of (sales) value of the transactions.

Source: Brits & Winder (2005), tables 2.1 and 2.2

Note 1: source reports absolute numbers, converted to shares by author.

Note 2: Bolt, Jonker and Renselaar (2008) offer a very similar chart depicting the value shares of the same POS

payment instruments (p.8, figure 1). They use a different method to estimate the yearly value shares, which gives

more accurate estimates. For consistency and comparability of the charts, I choose to use the Brits & Winder

data. The general message in this chart and their figure 1 is the same but more conspicuous in figure 1: in terms

of value share the debit card is gradually taking over from cash in this chart but in figure 1, the debit card has

already surpassed cash as of 2004.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1996 1997 1998 1999 2000 2001 2002 2003 2004

debit card credit card e-purse cheques cash

73

Table I: Social costs of cash and debit card payments, 2002 - 2009

The table shows the social costs borne by the central bank, the banking sector and the retailers for cash and debit

card payments for the years 2002 and 2009. All numbers are reported in EUR millions, unless otherwise indicated.

Source: Jonker (2013), table 4.

(a) The increase of the average value of cash payments can be explained by the fact that consumers tend to buy

more purchases at one point-of-sale instead of visiting multiple points-of-sale. Consequently, they make less

payments with an on average higher transaction value. In addition, inflation exercised upward pressure on the

average value of a cash transaction.

(b) Variable costs to retailers are split into costs that vary with the number of payments made, the so called

variable transaction-linked costs and costs that vary with the sales generated with the payment instrument, the

so called variable sales-linked costs. No such a breakdown could be made for banks’costs.

.

74

Table II: Merchants’ costs for cash and debit card payments, 2009

The table shows retailers’ main cost components and the allocation to fixed, variable transaction-linked and

variable sales-linked costs for cash and debit card payments for the year 2009. All numbers are percentages.

Source: Jonker and Plooij (2013), table 1.

75

Chart 3: Average price of a payment account per EU country, 2009, in EUR

A study carried out for the EC compared the prices for payment accounts for consumers in the 27 Member States

and found significant variations in prices, measured in absolute terms (PPP adjusted) across Member States.

Source: Factsheet 1, Directive on payment accounts [14], last accessed on 17 April 2015

76

Table III: Model parameter estimates, 2002 and 2009

The table show the parameter estimates to the model, as described in §4.1 and as computed in §6.2 (for

Netherlands 2009 only; the 2002 estimates for the Netherlands have been calculated following the same procedure

as described in §6.2; the estimates for Denmark have been calculated by Korsgaard and added here for

comparison. Units for Denmark are in DKK, for Netherlands in EUR.

parameter

Estimate

Denmark 2009

Estimate

Netherlands 2009

Estimate

Netherlands 2002

γ 230 18.41 12.49

t 27 2.16 1.47

K 0.326 0.0152 0.0085

𝑐𝐶 0.321 0.022 0.017

𝑐𝐷 1.527 0.172 0.123

𝑏𝑆,𝑚𝑖n -2.533 0.2320 -0.0262

𝑏𝑆,𝑚ax 3.698 0.5393 0.0576

𝑏𝐵,𝑚𝑖n -3.823 0.0901 -0.0261

𝑏𝐵,𝑚ax 7.421 0.2791 0.0590

Source: Author

77

Table IV: Cost measures for cash and debit card payments, 2002 - 2009

The table shows the breakup of social costs per transaction and per EUR sales for the banks, merchants (retailers)

and the central bank. Additionally, the table shows variable costs per average transaction. These are exactly the

three cost comparison criteria.

Source: Jonker (2013), table 5.

78

Table V: Sensitivity analysis to changes in distance cost t, 2002 - 2009

The table shows how the constrained socially optimal merchant fee changes with different values for distance cost

t, i.e. the markup, which is in the method the profit margin (in percentages). Only the constrained is shown as the

unconstrained does not depend on the variable t. As is shown, the outcome is largely insensitive to the changes,

although the markup cannot be 0%.

Parameter t

Optimal m

2009

Optimal m

2002

Base (10.5%) -0.35% 0.45%

0.5% -0.37% 0.43%

5% -0.35% 0.45%

10% -0.35% 0.45%

20% -0.35% 0.45%

Source: Author

Table VI: Sensitivity analysis, changes in average transaction value, 2002 - 2009

The table shows how the unconstrained and the constrained socially optimal merchant fee respond to changes in

average transaction values for each year in question (2002 and 2009). The unconstrained does not change in

relative terms, but yields different absolute values (merchant fees in EUR). The BASE line mentions the average

transaction values as from empirical data for that year, for 2009: EUR 20.57 and for 2002: EUR 13.95 and the

corresponding (un)constrained optimal merchant fees.

2009 2002

Unconstrained

Optimal fee

Constrained

Optimal fee

Unconstrained

optimal fee

Constrained

optimal fee

% EUR % EUR % EUR % EUR

BASE -0.73% -0.15 -0.35% -0.07 -0.76% -0.11 0.45% 0.06

1.00 -0.73% -0.01 11.33% 0.11 -0.76% -0.01 18.77% 0.19

3.00 -0.73% -0.02 3.15% 0.09 -0.76% -0.02 5.62% 0.17

5.00 -0.73% -0.04 1.51% 0.08 -0.76% -0.04 2.98% 0.15

10.00 -0.73% -0.07 0.28% 0.03 -0.76% -0.08 1.01% 0.10

15.00 -0.73% -0.11 -0.13% -0.02 -0.76% -0.11 0.35% 0.05

20.00 -0.73% -0.15 -0.33% -0.07 -0.76% -0.15 0.02% 0.00

25.00 -0.73% -0.18 -0.46% -0.12 -0.76% -0.19 -0.17% -0.04

30.00 -0.73% -0.22 -0.54% -0.16 -0.76% -0.23 -0.31% -0.09

50.00 -0.73% -0.37 -0.70% -0.35 -0.76% -0.38 -0.57% -0.29

Source: Author