The U.K. Office of Fair Trading launched a new investigation on Feb. 3, into the recently amended arrangements MasterCard uses for calculating interchange fees that apply to transactions made using its credit cards.
On Sept. 6, 2005, the OFT ruled that MasterCard's previous arrangement for calculating the fees violated competition laws (see ASR, 10/21/05). MasterCard is appealing this decision with the Competition Appeal Tribunal. The OFT said the outcome of its new investigation is likely to be strongly influenced by the outcome of the appeal.
A brief history
Interchange is an interbank transfer that occurs during the processing of a credit card transaction that involves the cardholder, the retailer selling the goods, the retailer's bank and the card issuer. The cardholder purchases the goods or services from a retailer. The retailer sends the transaction details to its bank, the merchant acquirer. The merchant acquirer forwards the transaction details to the bank that issued the credit card, the card issuer. The card issuer pays the merchant acquirer the retail price of the goods or services, less the interchange fee. The merchant acquirer pays the retailer the retail price, less a merchant service charge that includes the interchange fee. The issuer debits the retail price to the cardholder's account.
In March 2000, the Competition Act of 1998 went into effect. At the same time, MasterCard provided its interchange agreements to the OFT with a view to obtaining an exemption under the Competition Act. Under Chapter 1 of the Competition Act, agreements that have the object or effect of restricting or distorting competition in the U.K. are prohibited. Exemptions may be granted to a notified agreement if it can be shown that such an agreement will improve production or distribution, or promote technical or economic progress, and that customers obtain a fair share of the benefits, explained Paul Geertsema at Barclays Capital's research team. The agreement must be shown to be indispensable in obtaining these benefits.
MasterCard argued that interchange should be set at a level that compensates card issuers for administrative expenses, interest cost during the interest-free period and to cover fraud-related costs. The OFT found that MasterCard's initial interchange arrangement was used to recover "extraneous costs" - such as the costs of the interest-free periods provided by card issuers - for services that were not necessary for the operation of the MasterCard business as a mechanism for transmitting payments.
The OFT concluded that only the cost of services necessary for the operation of the MasterCard scheme as a viable payment transmission mechanism can be recovered legitimately through the interchange fee. Costs for the provision of other services are considered extraneous costs. Recovering extraneous costs under this structure resulted in merchant acquirers paying a higher interchange fee to card issuers. This fee was passed on to retailers by the merchant acquirers through higher merchant service charges and, ultimately, consumers, including those who do not use MasterCard cards through higher retail prices.
The OFT is investigating the new fallback interchange fees set and applied under the new arrangements because these fees may continue to be set with an aim to recover extraneous costs. The OFT said it had reasonable grounds for suspecting that the new arrangements continue to violate Chapter I of the Competition Act.
"MasterCard provides a service for which it should be compensated. However, the costs that are appropriate for it to recover are a matter for the OFT," said Janet Oram at Fitch Ratings.
She suspects that a decision won't be reached in the near term.
No credit given to interchange fees
Oram emphasized that this recent dispute does not aggravate its stance on existing credit card securitizations rated by Fitch. It gives no credit to interchange fees and expects credit card originators will implement alternative measures to support yield levels. According to Deutsche Bank, data from U.K. credit card ABS offering circulars suggest that interchange accounts for 0.5% to 2% of total portfolio yield. Any enforced reduction in interchange fees can be expected to impact portfolio yields.
Geertsema said a sudden reduction in interchange fees is likely to depress excess spreads in the short run. However, credit card originators in the long run will re-price their product offering so industry profitability returns to market equilibrium.
The OFT said the new investigation will be restricted to data gathering until the outcome of the appeal of its previous ruling is known.
"It is really no more than a continuation of the same issue," Geertsema said. "I think we may still be talking about this in six months time. However, I don't see this process dragging on forever [and] the outcome of the MasterCard appeal is likely to be decisive in terms of framing the eventual outcome."
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