Latest Interchange Regulation Shakes European Cards Markets
The European Commission shook the card issuing and acquiring industry in July when it released the much-anticipated proposed regulations on card interchange. The implications of the proposal are vast, both for issuers and for acquirers. Credit card issuers, in particular, will suffer average interchange revenue reductions of 60%. In acquiring, the proposed regulation accelerates cross-border competition, as well as imposes potentially significant operating obligations on acquirers.
Measuring the Impact
As shown in Figure 1, interchange levels today across Europe vary widely, as will the impact of the regulation. Most issuers are looking at rate reductions from c. 0.80% to 0.30%, though some markets (e.g., Germany, Central Europe) will see steeper reductions from 1.0% or higher, while still others, notably in France, will see no impact at all. Note that prepaid cards are also subject to the debit card cap of 0.20%, although commercial cards, as of now, are exempt.
Figure 1: Estimated Effective Interchange Rates by European Market
(selected European markets)
Source: Visa and MasterCard interchange rate disclosures. First Annapolis Consulting market observations and analysis.
When and How?
For the time being, the Commission’s regulations are technically still “proposed” and not enacted. However, most in the industry expect a relatively rapid enactment, possibly as early as Q1 or Q2 2014. Visa Europe has agreed to implement and support the Commission’s regulations, and will presumably implement the regulations in the scheme rates and rules early in 2014. MasterCard, on the other hand, continues to fight the Commission’s interventions on interchange in court, most recently appealing their defeat in the lower courts to the highest courts of appeals. A number of local legislatures and competition authorities have acted on interchange independent of the recent regulations (though informed by prior guidance from the Commission of the 0.20-0.30% interchange levels). Poland, for example, recently capped interchange at 0.50% (down from 1.20%-1.60%).
Issuers Must Rebuild Their P&L’s
Issuers are now scrambling to mitigate the impact of the regulation on credit card issuing P&Ls. While there is no ready-made roadmap among the numerous tactical response options, the responses listed below are the most widely discussed among our issuing clients.
1. Rationalize Product Portfolio, Slash Rewards Costs. Issuers’ product sets have tended to proliferate over time (Classic, Gold, co-brand, etc.), and issuers can often realize substantial cost reductions by carefully consolidating smaller and/or less profitable products and reducing associated rewards expenses.
2. Focus on Interest Revenue, Optimize Other Fees. Many European issuer strategies are focused on driving transaction volume and are averse to credit risk. Making money on transactors is now a difficult if not impossible ambition. Credit card issuers must refocus on interest revenue. This means improving risk decisions and management, expanding credit lines, and enhancing portfolio management. Installments are also an excellent method to expand balances while also potentially deriving fee revenue from merchants. Issuers must also ensure that other pricing levers, such as fees, are fully optimized (though hereto, regulations often restrict the option set).
3. Merchant-Funded Rewards. The Commission’s argument, put one way, says that merchants must not be forced to fund cardholder value propositions. Issuers can, however, still align with merchants to selectively fund card value propositions. We expect merchant-funded value propositions (arising from co-branded cards, coalition points schemes, or discounts and offers) to proliferate, although finding willing merchants will take issuers time and effort.
4. Data Commercialization. Banks are now more focused than ever on data commercialization, finding various ways in which a cardholder base can be creatively monetized. The most obvious commercialization tactic is to create a network which equips merchants to sell offers into cardholders. Offer networks come in many forms, though card-linked platforms such as those offered by Cardlytics, Cartera, or edo (among others) are now particularly relevant for issuers in Europe. Most European card issuers do little in the way of data commercialization today, and will therefore need to react quickly to develop strategies, select vendors and operating platforms, and to build a merchant network.
On a number of fronts, the regulation could force issuers to collaborate more with the merchant community, a somewhat ironic outcome and one which runs contrary to years of increased divergence between issuing and acquiring.
5. Migrate to Commercial Cards. Many European issuers have a healthy population of small businesses using consumer cards. These cardholders are now great candidates for migration to commercial cards; which will sustain significantly more lucrative rewards than consumer cards under the new regulations.
Acquirers Will Benefit on Net, but Domestic Market Shares are at Risk
Acquirers generally derive a financial benefit from interchange reductions. Larger, more sophisticated merchants demand and receive the pass-through, but small merchants generally do not (note that interchange plus pricing is not as common in Europe is it is in North America). Our experience in markets that have experienced an interchange reduction suggests that acquirers will retain as much as 40% of the reduction, although this margin tends to erode within three to five years as a result of competition.
However, acquirers must in parallel implement significant changes to how they bill merchants. The regulations require that interchange must be disclosed to the merchant, separate from commissions and fees. Acquirers must also “unblend” commission charges for different card types, charging distinct commissions for each type, unless the merchant, in writing, requests a blended rate. Most acquirers are not in a position to implement these measures easily, and will have to make significant upgrades to their billing systems in order to comply. It would not be surprising to see delays in the implementation of the regulations as a result.
Finally, and most interestingly, the regulations effectively hand cross-border acquirers a significant pricing advantage over domestic acquirers. Pure domestic transactions, meaning a transaction for which the merchant, issuer, and acquirer are all in the same market, are exempt from the regulations (at least in the first phase of the regulation) and presumably therefore remain at historical interchange levels. Transactions acquired by non-domestic acquirers (e.g., Dutch merchant, British acquirer) are subject to the interchange cap and can now be priced potentially significantly lower. This aspect of the regulation has incumbent acquirers exploring options to quickly obtain new scheme licenses and BINs domiciled in another market in order to defend their home markets.
Merchants are Clear Winners
Merchants are the big winners of the proposed interchange regulation. Proactive merchants will negotiate lower acquiring fees, will have greater transparency of underlying interchange costs and acquiring pricing, and will have a greater array of acquiring supply options. On the other hand, those select few merchants which partner for co-branded credit card programs must now reset their financial expectations and to refocus on the non-financial benefits of brand alignment.
Four-Party Model is Specifically Hindered by the Regulation
Under the regulations, the four-party model (issuer, scheme, acquirer, merchant) is specifically targeted, while other models are exempted. So, American Express’s GNS model, which relies on licensed, independent issuers, is now substantially at risk. On the other hand, the proprietary issuing business of American Express, relying on strong value propositions such as airline rewards, is now better positioned than ever to win market share. PayPal should also benefit, as its underlying account funding costs will decline with no corresponding obligation to reduce merchant prices.
Clearly, the implications of Europe’s new interchange regulations are profound. Parties across the markets must act decisively to address the threats and capitalize on the opportunities created.
For more information, please contact Joel Van Arsdale, Partner, specializing in Merchant Acquiring, firstname.lastname@example.org; or Erik Howell, Senior Manager, specializing in Credit Card Issuing, email@example.com.
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