LOOMING CHALLENGES TO ASEAN PAYMENTS

Recent International Payments Industry Developments and their Possible Impact on ASEAN Processors and Central Banks

Friday 25 April 2008

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Overview

International Payments Industry Developments

Discussion of Selected Payments Industry Developments

Implications for ASEAN Processors and Central Banks

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International Payments Industry Developments

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EDC conducted a survey of around 30 clients and senior staff globally on key payments industry events so far this decade

What are the major product developments or emerging products

What are the major technology developments or emerging technologies

Who are the most significant new entrants to the industry

Who are the most influential participants in the industry

Which industry events were the most significant

Which trends are the most significant

Responses were categorised by region (US/Canada, Europe, Middle East Africa, Australia / New Zealand and Asia)

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By region, there was a fair degree of commonality in responses, although some region specific issues were also mentioned

DebitEMV

PayPalRegulatorSEPA/PSD

DebitContactless

PayPalRegulators

Scheme IPOs

Bill PaymentInternet Banking

BPAYRegulators

RBA Reforms

PrepaidMobilePayPal

RegulatorsUnbanked

SegmentedContactless / NFC

CUP, PayPalRegulators, Schemes

various

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Amongst product developments this decade, the growth of Debit in its many forms is common across all regions

Debit growth generally has been strong

Debit schemes and Prepaid in Europe

Prepaid and unbanked in ME/A

Scheme debit and prepaid / gift cards in A/NZ

Prepaid, scheme and decoupled in the US, as well as debit rewards

Other products trends also had some commonality between regions

‘Faster Payments’ in Europe

Bill Payment in A/NZ

Internet and increasingly mobile banking / payments generally

PayPal, AliPay and the like

Card form factor and segment offerings in Asia

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Numerous technology developments and roll-outs have occurred, with chip related projects of greatest influence

Chip related technologies were generally considered the most influential

EMV in Europe, Asia, A/NZ

Contactless / NFC in Asia, US, Europe and Australia

Several other technology developments spanned more than one region

Internet related technologies, incl Web 2.0, were relatively common

The move to more open systems for devices and infrastructure

PCI compliance, together with Triple DES

Mobile, including links with scheme contactless

New fraud and decisioning software

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Amongst new entrants, there was one clear winner - PayPal

PayPal was ranked first or second for all regions

Despite strong alternatives in markets such as China

Increasingly under regulatory scrutiny – ACCC in Australia

Several other new entrants were mentioned across regions

CUP has high visibility globally

MS / Google were also perceived to be increasingly active

Other new entrants were market specific

BPAY in Australia

Bill Me Later in the US

Various P2P players – such as Revolution Money – in specific markets

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Regulators figured as the most influential market participant – is stark contrast to a decade earlier

Regulators vary by market, but a wide range were mentioned

Central Banks for policy, regulation

Competition Authorities for litigation, regulation

Most other parties mentioned often spanned regions

MasterCard / Visa globally (to a lesser degree Amex, Discover, JCB)

Processors (First Data, VocaLink, Equens, TSYS, Global

Global banks (RBS, Santander, Citi, HSBC, SCB)

Others were market specific

Major merchants (Wal-Mart, Target) and banks (Chase, Wells) in the US

Industry bodies in certain countries / regions

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There were a relatively small number of events that were noted, with most being common to all regions

Events mentioned by more than one region included:

SEPA / PSD

RBA Reforms

Interchange challenges generally

Visa / MasterCard IPOs

There were a small number of market specific events

Wal-Mart Litigation in the US

E-money license in Europe

Single currency proposal in Southern Africa

Contactless / NFC in Japan, Korea

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A wide range of trends were noted, with many being specific to particular regions

Generally, the continuing growth of debit (in its various forms) was noted

The continued growth of the internet and emergence of mobile as key channels were also common to all regions

Continued growth in fraud and greater focus on risk management

Accelerating growth in contactless / NFC

Consolidation of processors / issuers / acquirers, and greater globalisation

The emergence of new networks / schemes to compete with MasterCard / Visa

Greater focus on the un-banked, un-carded and under-served

Multi-application (smart) cards, and improved reward programs

The demise of co-brands, the slowing credit card issuing, the greater involvement of regulators and the failure of biometrics were also mentioned

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In this following sections we are covering five of these events that we believe may impact the payments landscape in ASEAN moving forward

1. Australian Payments Reforms

2. SEPA / PSD Initiative

3. Merchant Engagement

4. Globalisation & Concentration

5. Challengers to Cash

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1. Australian Payments Reforms

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The reform of the Australian payments system was a largely unexpected result of a broad ranging review into the financial system

Wallace Inquiry resulted in an increased focus on payments system regulation

Central Bank (RBA) and Competition Authority (ACCC) release in 2000 a joint study into payment systems, focussing on interchange, acceptance and access

RBA - via Payments System Board - introduced reforms on a per product basis:

Credit cards designated in 2003: opening access (SCCI), allowing surcharging, removing honour-all-cards rule and setting interchange based on defined costs (processing, fraud, funding and scheme costs)

Debit cards (domestic / PIN debit and scheme debit) designated in 2004 following an unsuccessful authorisation process: opening access (bilateral), allowing surcharging, setting interchange (processing costs only for scheme: negative for domestic) and removing honour all cards (2007)

ATM reforms agreed with industry for implementation in 2008: removing interchange, allowing direct charging, and enabling fee-free networks

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The impact of these reforms on card payments has been significant, with this most noticeable in reduced interchange / merchant fees

Impact to interchange has been most noticeable, with merchants benefiting

Credit card interchange rates fell from 95 basis points to 55 basis points (October 2003) and then to 50 basis points (October 2006)

Scheme debit card interchange initially reflected movements in credit card interchange, but then fell from 55 basis points to A$0.12 (April 2006)

PIN debit card interchange fell from bilaterally negotiated rates of around A$0.22 (-ve interchange: from issuer to acquirer) to A$0.05 (April 2006)

ATM interchange will be reduced from bilaterally negotiated rates of around A$1.00 (-ve interchange) to zero, with direct charging instead (early 2008)

Lesser impact on 3 party schemes, as well as other payment products

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However, there have been numerous other impacts, some of which have surprised industry observers

The market share of 3 party card schemes (Amex, Diners) has not benefited significantly relative to 4 party schemes (MasterCard, Visa)

This is despite the merchant service fees of 3 party schemes have fallen by around 10%, whilst 4 party schemes have fallen by around 40%

4 party acquirer margins net of interchange have fallen by about 30%

Over 20% of large, 15% of medium and 10% of small merchants surcharge

Some merchants have taken advantage of the removal of the honour-all-cards rule, although the rationale isn’t always aligned with the original goal

Debit has now surpassed credit by transaction number, possibly due to the winding back of credit card loyalty programs and greater surcharging

That being said, scheme debit is growing faster than PIN debit

The reforms in Australia have been closely followed and commented upon by regulators in other markets – with varying levels of support

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The RBA recently released the preliminary conclusions of a review into the reforms, which involved broad industry consultation

The RBA has indicated in its preliminary report:

No reason to remove access, surcharging and honour-all-cards reforms, with further changes possible to increase merchant choice and competitor access

Interchange needs further reform to improve competition and efficiency

Option 1 – Maintain status quo; no more cost studies; other minor changes

Option 2 – Continue reforms; lower credit card interchange to ~ 30bp; common cap of around 5 cents on all debit cards

Option 3 – Remove explicit interchange regulation; conditional upon greater competition between PIN debit and scheme cards, including creating a third scheme and supporting internet payments; further modification of honour-all-cards rule; greater transparency of scheme fees

The RBA is now seeking comments from industry by June 2008, and will make a decision by August 2009 for implementation in Q1 2010

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The ultimate impact of the reforms is not simply the change on rates, but the impact on all participants

Interchange Fees on a $100 Payment

??

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Outcomes and implications

Banks:

Market entry into Australia is now easier, but overall the market has consolidated, margins have narrowed and uncertainty remains

Some banks are now investing in their operations and expanding globally, whilst others are outsourcing and re-focussing on their core business

Processors

There has been relatively limited investment in infrastructure through the early part of the decade, but new low-cost players are emerging

Should the banks establish a national debit scheme, it is likely that the existing bilateral-based infrastructure will need to be replaced

Equally, it is likely that Australian-based processors will expand into nearby regions, seeking to leverage their investment in systems

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Outcomes and implications (cont…)

Regulators

Despite the extent of the reforms, consumer behaviour with respect to payment cards has changed little – and this is reflected in the limited change in market shares

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2. SEPA / PSD Initiative

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SEPA and the Payment Service Directive (PSD) aims to create a more competitive, single market for payments in Europe

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The scope of SEPA as driven by the European Payments Council, which was established by European banks in response to regulatory intervention

Three payment instruments covered are

credit transfers (2008+)

direct debits (2010+)

card payments (?)

Value-added services also being considered (e.g. e-invoicing, e-commerce)

Currently only applicable to payments in Euro currency

Cheques and Cash remain outside the remit of SEPA

Self-regulation by banks: European Payments Council (EPC) monitors migration and defines scheme rules / standards

Source: EPC

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SEPA is a catalyst to allow banks to enter new markets with new products, and in doing so realise economies and become more competitive globally

Enter new markets via new channels / models (e.g. direct banking) without being ‘local’

Develop and roll-out new, value-added products in a cheaper, centralised and faster manner

Realize economies of scale at pan-European / global level (product, processing)

Enable back-office rationalization / centralization, and encourage consolidation

But how many banks can qualify as pan-European player? ING, Citibank, Barclays, Deutsche

Source: World Payments Report

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For merchants, there will now be the opportunity to rationalise the typically complex web of acquiring arrangements across markets

AcquirerA

AcquirerB

AcquirerC

AcquirerD

AcquirerE

France

Italy

Belgium

Spain

Poland

Illustrative

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This also has significant benefits in terms of rationalisation of systems, consolidation of reporting, and better merchant cash management

SE

PA

SC

HE

ME

S

IllustrativeFrance

Italy

Belgium

Spain

Poland

Pan European

SEPAAcquirer

single terminal type acrossall countries

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SEPA is driving some important developments

Scale efficiencies through pan-European infrastructures

Simplified connectivity to a few SEPA schemes

Harmonisation / centralisation of IT / product platforms

New pan-European product propositions

Easier market entry

Consolidation of processing / ACH and acquiring

National card schemes / switches face serious challenges

Some new schemes emerging: EAPS, Third Scheme (?), PayFair, …

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But SEPA has not removed all barriers

Lack of progress on standardization

No pan-European scheme for debit cards in most countries – local schemes /switches still represent technical, economical and legal barrier to entry

Historic link in several continental European markets between ACH and cards processing

Recent regulatory developments increase reluctance of banks to invest in SEPA

European Commission ruling on MIF

Merchant complaint against European Payments Council

PSD implementation deadline November 2009

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The PSD legislation defines who can provide what payment services across the EU, as well as how they will be authorised and supervised

Credit institutions, e-money institutions and the new category of Payments Institutions (PI) can provide payment services in the EU

PIs can ‘passport’ their payment services across the EU without additional authorisation/requirements, with each market to authorise and monitor PIs

Activities that PIs are authorized to perform:

Issuing & acquiring

Operating a payment account

Execution of direct debits, credit transfers, standing orders, card payments

Same as above, but where the funds are covered by a line of credit

Money remittance

Payments using mobile phone (or similar device)

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The PSD legislation defines who can provide what payment services across the EU, as well as how they will be authorised and supervised (cont…)

PIs can also passport the provision of credit related to payment transactions (amount to be re-paid in full within 12 months)

Consumer protection (Titles III & IV): Transparency and minimum service requirements to be observed by all payment service providers in the EU

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Outcomes and implications

Banks

Market entry into Europe has improved as the business case can be leveraged across multiple countries

Foreign banks to get access to a harmonised payments market across Europe

Processors

European processors become more efficient and able to compete beyond Europe

Single connection into all banks provides access to large potential customer base

Potential for non-European entrants to also capture debit card volumes (vs. before only credit), providing necessary scale

Potential for third network

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Outcomes and implications (cont…)

Regulators

If successful, Europe will potentially have the power to lead global standards in many segments of the payments market

Opportunity to have similar regulatory initiatives on payments in e.g. South East Asia

Learning's for Asia

Clarity on business model is key

No pan-regional competition without global competition

Risk of commoditisation of payments

Standardisation can have several (often times conflicting) results

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3. Merchant Engagement

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Merchant are choosing to play an increasingly active role in the operation and development of payments systems globally

Merchant litigation and challenges to regulation have made headlines

Wal-Mart re. debit cards; Merchant class actions re interchange; AMPF appeal re debit card designation; Eurocommerce re EPC / SEPA

But merchants are also playing a more active and direct role in payments

Wal-Mart direct connect into VisaNet; Coles Group issuer direct acquiring; NTT DoCoMo investment in Sumitomo Mitsui; industry groups considering co-operative acquiring operations; numerous prepaid and loyalty cards

Merchants are increasingly demanding to be involved in decisions around infrastructure specification and new schemes / products / technologies

EMV rollout in numerous markets; contactless / NFC / mobile in Asia, Europe; Infrastructure design in Australia; role of schemes in Belgium

Of considerable interest has been merchant support for de-coupled debit

Initially in US; now Europe; interest high in other markets

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Debit in the US has experienced considerable growth in recent years, with further consumer substitution expected over the next two years

Debit growth originally came out of the regional ACH / ATM arrangements, with schemes soon playing ‘catch-up’

However ‘decoupled debit’ may well drive the next wave of debit growth

In-StoreIn-Store OnlineOnline Bill PaymentBill Payment

ChecksChecks

Credit CardsCredit Cards

Debit CardsDebit Cards

Expected Future Usage by Payment Type and Venue

Source: PaymentDynamics 2007 Preferred Payments StudyProprietary and Confidential. © 2007 Edgar, Dunn & Company / TransUnion LLC. All rights reserved.

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Decoupled Debit separates account-owning from card issuing, and has significant ramifications on transaction flow, funding, and settlement

Merchant FinancialInstitution

AcquirerProcessor

NetworkSwitch

IssuerProcessor

Authorizes transaction Settles funds between

bank and merchant Account

Merchant AcquirerProcessor

NetworkSwitch

Debit Service Provider

FinancialInstitution

Account

Authorizes transaction Conducts Risk Analysis

Funds Merchant

ACH file

Funds

Typically Day 1

Day 1

Days 2-4

Traditional Debit Card

Decoupled Debit Card

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There are a three major implementations of decoupled debit in the US market currently, which together have strong merchant support

Tempo (prev. DebitMan) – 2000

Enables FIs and retailers to deploy a decoupled debit card programs

HSBC has used Tempo to implement the ‘Optipay Card’ product

Retailers include Wal-Mart, CVS, Macy’s, Whole Foods, Barnes & Noble

PayPal – 2006

PayPal issues their own PayPal MasterCard Debit Card, which functions as a decoupled debit card and yet earns scheme interchange

Capital One – 2008

Began working on decoupled debit more than 3 years ago

Leverages their expertise in (1) credit card product development, (2) reward programs, and (3) customer information

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Merchant feedback to Capital One suggested that a gap existed in the available payment products a merchant could offer to their customers

Credit, debit, and gift cards are the card-based payment options for most merchant transactions

However, debit has been outside the control of the merchant, as it has remained aligned with the banking relationship of the consumer

Creating a decoupled debit product has allowed Capital One to address this gap for merchants

By adding the debit product, it allows the merchant and Capital One to expand the loyalty / rewards programs

Major merchant partners of Capital One likely to participate include:

Carnival Cruise Lines

TJ Maxx / Marshalls

Home Goods

Source: EDC analysis; Payment News May 28, 2007; Payment News October 30, 2007; “Decoupled Debit – Let’s Take a Closer Look” Mercator Advisory Group

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Decoupled debit has the potential to be a highly disruptive product to the payments system, but support from merchants and consumers is strong

Merchant like lower payment costs (no interchange), increased sales and greater customer loyalty, but start-up costs are high, adoption slow and risks to reputation

Consumers like rewards (richer, pooling) and competition (like selecting a credit card), but can be complex, suffer acceptance issues and results in processing delays (and dishonour fees)

Financial institutions may offset some costs to merchants, but could be disintermediated, lose customer loyalty, suffer revenues losses and dislike potential confusion over responsibilities

Processors benefit from greater revenue and stronger merchant (and sometimes cardholder) relationships – often at the expense of schemes – but the costs to establish the service are high and numerous risks (bad debt)

ACH rules have changed to require full merchant details per transaction – i.e. no aggregation

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4. Globalisation & Concentration

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During this decade there has been a significant increase in concentration across all aspects of the payments industry

Concentration is impacting all aspects of the payments value chain

Marginal issuers and acquirers are exiting the market as skills, investment and scale are increasingly the critical success factors for success

Processors are expanding their value chain role to defend margins whilst seeking opportunities that can leverage their existing assets

Specialist non-banks are dominating consolidating niches, such as ATM deployment, internet payments, device management and prepaid

Major schemes are expanding into white label clearing & settlement, acquirer processing and processing new forms of debit cards

As a result, the number of acquisitions, mergers and JVs is increasing

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As the opportunity for consolidation within a market reduces, leading value chain participants turn their attention to other markets

Increasingly, global firms are seeking exposure to all three regional markets – North American, Europe and Asia

Much of the growth is inorganic (acquisitions, joint ventures), with relatively few greenfield projects in new markets

Leaders Sector Key Markets

Citi, Barclays, ING, HSBC, GE, B. Santander Issuing Global

TSYS, First Data, FNIS, Equens, Metavante, Atos

Issuer Processing Europe, Asia

RBS, Chase, HSBC, regionals Acquiring Europe, Asia

First Data, Global, Paymentech, CUP Acquirer Processing Asia, Europe

MasterCard, Visa, CUP 4 party schemes Asia, Europe

PayPal, Discover / Diners, Amex, JCB, WU, ReD Other intl schemes Global

VocaLink, Equens, First Data, Euronet, TNS Networks Asia, Europe

Verifone, Hypercom, Ingenico Terminals Global

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However, the underlying infrastructure in many markets require significant investment to meet market needs

Many major networks globally are operating on transaction switching platforms that will cease to be supported in the next few years

Similarly, the transaction processing platforms are becoming more expensive to maintain, leading to an increased interest in outsourcing over replacing

The terminal fleets these networks support are increasingly unable to address scheme mandates, issuer initiatives and merchant requirements

The current credit crisis is making access to capital difficult for smaller, less experienced players (with banks preferring to deploy capital elsewhere)

Further, regulation, legislation and litigation often does not assist in ensuring investment occurs at the most appropriate time

All these factors conspire to position many (but not all) larger global players strongly in relation to further global growth

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Outcomes and implications

Despite having a fraction of the throughput of a larger, international competitors, it is possible for smaller processors to have lower unit costs

Further, smaller players with newer platforms can often be more flexible and responsive than larger competitors

Even with these benefits, a smaller player may benefit greatly from a joint venture or merger with a larger, foreign player, particularly where the other party delivers new product, technology and expertise (eg fraud) to the venture

Support for international and on-line payment capabilities are becoming more critical – products, networks and schemes that do not adapt are at a significant disadvantage

Finally, it is likely that a third network (or more) and new product schemes will emerge – perhaps regionally – to counter Visa and MasterCard

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5. Challengers to Cash

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The move from traditional to electronic payment systems can deliver significant benefits to an economy

This can reduce the social cost of a country’s payment system:

“…if a country moves from a wholly traditional / paper based payment system towards an electronic system, it may save 1% or more of its GDP annually…” (Humphrey et al, “What Does it Cost to Make a Payment?”, Review of Network Economics, Vol. 2, Issue 2, June 2003)

“An increase of just 10 percent in the existing share of card payments … would stimulate an increase of 0.5 percent in consumer spending.” (Global Insights for Visa International, ‘The Virtuous Circle: Electronic Payments and Economic Growth’, July 2003)

However, the development of a new payment system can consume significant capital over a long period of time – and not without risk of failure

And then there is seigniorage lost, tax gained and the true cost of cash

For many markets, the last remaining challenge is to replace cash (esp. coins)

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There are significant economic gains to be made from reducing cash payments

Size of transaction

$5 $20 $60 $100

Lowest Cost

Highest Cost

Cash

Direct Entry

Debit Card

Credit Card

Cheque

Direct Entry

Debit Card

Cash

Cheque

Credit Card

Direct Entry

Debit Card

Cheque

Credit Card

Cash

Direct Entry

Debit Card

Cheque

Credit Card

Cash

A potential annual resource saving in Australia of $2 billion could be achieved by shifting payments above $20 from cash to lower-cost electronic payment options

Source: Exploration of Future Electronic Payments Markets (Dept of Communications, Information Technology & the Arts

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There are six C’s that shape payment choice

Capability

What is the functional ability to actually undertake the payment?

Cost

What is the cost structure of the payment method and how is it spread across the parties?

Convenience

How easy is it to use the payment method for both consumers & merchants?

Coverage

How widely accepted is the payment method?

Confidence

Do customers believe that the payment will be successfully executed & completed

Confidentiality

How secure is the collection & use of personal information

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Barriers to electronic payment adoption

Supply-side Demand-side Regulation

Practice of existing stakeholders

Required investment & lack of

venture capital

Limited interoperability with

legacy systems

Lack of scale efficiencies

‘Prisoners dilemma’

Willingness to pay due to current conditions of

limited cost transparency

Lack of consumer & merchant education

Privacy & security concerns

Access to the electronic payment system

Information exchange with payments

Complex regulations may appear daunting to new

entrants

A large number of regulators

Focus on protecting the stability of the core payments system

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The major challenge in finding and electronic replacement to cash has been achieving sufficient utility at a reasonable unit cost

From the early 1990’s, numerous stored value card programs were launched (Mondex, Visa Cash, Proton, Digicash), but in most cases these failed because they were too complex, too expensive or too narrow in their application

In recent years, however, there appears to have emerged several contenders (individually or in combination) a a replacement to cash

Contactless cards – typically being scheme or transit based

NFC / mobile – increasingly complementing contactless

Certain prepaid debit cards

These products have typically leveraged to a significant extent existing infrastructure, and so have not involved as significant up-front investments

They are also relatively simply products that target lower value value transactions (coin replacement), rather than cannibalise debit and credit cards

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Iceland, however, has developed something very close to a cashless society based on standard scheme credit and debit cards

Iceland is small (pop 300,000) but highly developed and wealthy economy

There are around 2 cards per person – less than 3 per adult (18+) – with card spend per capita is around three times greater than the US and UK

Cash in circulation represents around 1% of GDP – between 15% and 40% of the levels of other development markets

Over 90% of non-cash payments by number are made with cards – and probably around 70% of all retail payments

So how has this occurred?

Fees are low and levied by all parties – with some cross-subsidisation

Single common infrastructure is used – floor limits & signature are used

Card products are modified to local needs – thus quick adopters

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Outcomes and implications

Successful cash replacement programs generally have the following characteristics

The product is kept relatively simple, but is localised

Utility is maximised through saturating transaction corridors

Existing infrastructure is leveraged and proven technologies used

Support is obtained cross industry, and only a single system operated

Whilst not all countries are targeting a cashless economy, several Nordic and Asian markets have made significant strides in recent years

That being said, it will probably only be small, relatively simple markets such as Iceland that have a chance of achieving this in the next decade or so

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Possible Impact on ASEAN Processors and Central Banks

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Conclusion

Products

Debit Scheme

Pre-paid debit

De-coupled debit

Faster payments

Technologies

EMV

Contactless / NFC

Open systems for devices / infrastructure

Mobile

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Conclusion

New Entrants

PayPal

CUP

Influential Players

Regulators

Schemes

Processers

Local Banks

Events

SEPA & PSD

RBA reforms

Interchange

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Conclusion

Trends

Debit

Mobile & internet channels

Fraud & risk management

Contactless / NFC

Consolidation & Globalisation

Shift from cash