Adverse Consequences for R&D and Innovation

One of the areas for which issuing institutions use interchange revenue is investment in R&D and innovation. Such investment is often channelled towards improving security of the card payments system by developing fraud prevention technologies and other security enhancing measures.

A 2013 report by the ECB on card fraud found that the total level of fraud using cards issued within Single Euro Payment Area (SEPA) and acquired worldwide amounted to €1.16 billion in 2011. According to the report, this corresponds to a decrease of 5.8 per cent since 2010, and fraud in relative terms (i.e. the fraud- related share in the value of transactions) fell from 0.040 per cent in 2010 to 0.036 per cent in 2011 — its lowest level since 2007.39 _{The diagram below shows the evolution of the total value of card fraud and the} volume of card fraud using cards issued within SEPA:

Note: POS = point of sale; CNP = card not present Source: ECB (2013) “Second report on card fraud”

One example of this improvement in security is the implementation of a chip in both credit and debit cards which increased security of the system as approval for payment is now done by requiring a security code.40 This is evident in the numbers in the chart above on the level of POS fraud.

The chart below shows the geographical distribution of the value of card fraud for these different transaction channels:

Figure 6.6: Geographical distribution of the value of card fraud by transactional channel from an issuing perspective (2011)

Source: ECB (2013) “Second report on card fraud”

40 _{In contrast, in Australia and the United States, some payments by credit cards are authorised by requiring a}

payments and the roll out of Near Field Communication (NFC) technology, also called mobile payments. Through the creation of the NFC Steering Group (NFC-SG), which consists of players from the card payment and other industries, several collaborations have been established. For instance card issuers and mobile network operators41 _{work together to design and develop new mobile payment methods.}

The fall in IFs revenues for issuing banks is expected to have a negative impact on innovation through three mechanisms. First, as issuers see their revenues fall, provided they do not manage to recoup them through other means, they would have fewer resources available to invest in R&D and innovation. The lower investment would mean that the development of new technologies for improved security and fraud prevention in the market would slowdown progress in the field. In summary:

Regulatory intervention  fall in IFs revenue for issuers  less funds available for investment in R&D and innovation  slowdown in the improvement of security and fraud prevention

Second, depending on the competitive position of four-party card issuers vis-à-vis three-party issuers, the incentives for banks to innovate in general terms may be reduced:

Regulatory intervention  alteration of balance in four-party credit card system  negative impact on ability to compete with three-party system  no level playing field in the market for card payments reduced incentives to innovate

This latter point was experienced in the Australian case. Four-party credit card schemes saw their ability to compete with three-party systems altered by the capped IFs and related reduction in IF revenue for issuers. This led to a decrease in the issuers’ incentives to innovate.

Third, as proven in the Spanish case, the regulatory intervention increased uncertainty for players in Spain, in particular with regards to future regulatory interventions. Such perceived uncertainty had a negative effect on the incentive and degree of innovation in the Spanish card payments industry.

Regulatory intervention  increased regulatory uncertainty for issuers  reduced incentives to innovate  decrease in innovation

As a result, the most direct consequence on consumers from a reduction in investment for innovation is that they may perceive that issuers are failing to improve security and protect consumers from fraud. This may lead consumers to associate card payments with higher risk, or non-decreasing risk, and thus choose not to switch to plastic cards. In this way, the displacement of cash with cards would be negatively impacted because increasing security of the system is seen as key to the adoption of cards as a payment method.

As described in Section 4 when analysing the Spanish experience, a greater use of cash is associated with boosting the shadow economy because cash payments are anonymous and are not as easily traceable as card payments, therefore making it easier to participate in the underground economy. In relation, regulating IFs would be expected to lead to the following causal mechanism:

Regulatory intervention  less investment in R&D and innovation  slowdown in the improvement of security and fraud prevention  lower perceived security associated with the card payments system  greater use of cash  boosting of underground economy

Consequently, cash as a form of payment is more conducive of tax evasion than plastic cards. Reducing the size of the underground economy is beneficial to society as it increases tax revenues, but also because it provides for a less distorted tax system as it reduces the burden on the “regular economy”.

Also, Schneider (2013) explains that “(c)ountries with high levels of electronic payment usage, such as the United Kingdom and the Nordic countries, have smaller shadow economies”. For this reason, increasing

41 _{Specific examples include collaborations between Barclaycard and O2 for the development of QuickTap, Vodafone}

author found that if the volume of electronic payments would increase by 10 per cent annually for at least four consecutive years, the shadow economy could be expected to shrink by five per cent.

In addition, one would expect a lower degree of security of card payments as perceived by consumers to adversely affect the e-commerce industry. As can be seen below, credit and debit cards are a popular means of online payment (though the distribution across Europe is non-uniform):

Figure 6.7: Online payment preferences across Europe

Source: Postnord (2014) “E-commerce in Europe”

If this means of payment is perceived as lacking the expected level of security, consumers may shift back to using cash. Such consumers would naturally no longer be able to engage in e-commerce, thus affecting its use and development.