Payment systems - terms of reference

Objectives of the investigation and report

The main objective of the OFT investigation is to assess whether, and the extent to which, recent developments have affected the competition, efficiency and incentive issues relating to payment systems. Developments since March 2000 have included changes to self-governance, self-regulation initiatives, and the application of the Competition Act to cases involving payment systems.

In particular, the investigation will aim to:

• review and explain the underlying characteristics, ownership, operation and pricing of the credit card, ATM and clearing system networks
• assess how the recent developments have affected each payment system's incentive structure and, in particular, the incentive to provide non-discriminatory access (eg agency fees), cost-reflective wholesale charges (eg interbank payments), and innovate on cost and quality (eg clearing cycles)
• assess the impact of any changes to the incentive structure on downstream competition and end-users
• assess how developments at the European level are likely to affect the competitive pressure on UK systems
• assess how and why any retail practice (eg 'free for credit' charging, where personal consumers do not pay directly for making payments if their current account is in credit) may have contributed to any problems at the payment system level
• review the conclusions in the light of international comparisons of payment systems.

OFT's framework for assessing payment systems

'The lack of competition identified in the money transmission market are caused by the underlying economic characteristics of payment systems. Network effects mean that there is a natural limit to the extent to which competition is possible between payments systems. As a result, inefficiencies can persist for years, and payment systems can be run in the interests of those who control them rather than in the public interest.' [Cruickshank report, March 2000, p.ix]

Implications of network effects
While they all involve transferring funds from one end user to another end-user, UK payment systems are very diverse. But while they vary in terms of function, cost structure and the relationship between participants, they share in common the important characteristic of network effects. These arise when the value to a participant or final consumer of access to a network depends on the number of other users with access to the same network.

Network effects have important implications for the provision of payment systems. Their presence means that a degree of co-operation between banks or other participants is unavoidable for the payment system to function effectively. Moreover, they mean that competitive pressure payment systems face from alternative systems or the threat of new systems is limited. There are high barriers to switching customers (who tend to prefer larger networks) from one instrument to another, and the costs of duplicating and achieving the necessary critical mass for new system providers are usually prohibitive. The customers who would face barriers in this context are the banks and institutions who provide services to final consumers. To compete in retail banking, for example, a new entrant realistically must gain access to existing schemes and their infrastructure.

Serving consumers well
To serve consumers and other users well, competition in the retail provision of payment transfers must deliver downward pressure on prices and costs, and through innovation, improve the quality of the services provided. Clearly also important to the intensity of retail competition is the ability of institutions with new offerings to enter the market by accessing the system easily and fairly.

Retail competition, however, is dependent on the payment system and its ability to deliver efficient and transparent charges for access and use, and innovation and cost reductions. The incentives for delivering these are, in turn affected by the features of networks described above – co-operation and limited inter-system competition – and in particular, the incentives of the scheme's existing members. The specific arrangements of the governance of the scheme's network infrastructure may currently dampen incentives for payment systems to make changes that might improve this situation or facilitate greater retail competition.

In March 2000 Cruickshank concluded from his review of the markets and the above network features that the UK payment systems were failing in terms of delivering price transparency, good governance, non-discriminatory access and efficient wholesale pricing. While some failures may remain, since the time Cruickshank's conclusions were published, payment systems have undertaken various self-regulatory (and de-regulatory) actions.

In addition, under the Competition Act 1998, the OFT has issued a decision in relation to the LINK ATMs; and is considering the notification by MEPUK of its domestic rules.

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