RPR 1' 96 16: 53 FR BLRf<E CRSSELS 25TH FL 16 863 4257 TO 86139521123 P · 06 COh~P!"!iTlO!~ TN3~NAL TRUJ~HAl DE LA co:JCl:l:tt:·KE p R F 0 ~ f ~= 1 1996 ~ y 0 REGISTRt.• - REGISTrAIRE -on:AWA-,--ONT~ -r~-~- cr-95/02 THE COMPETITION TRIBUNAL 1N THE MATrER OF an Application by the Director of Investigation and Research under Sections 79 and 105 of the Competition Act, R.S.C. 1985, c. C~34;
AND IN THE MATrER. OF an abuse of dominant position in the supply of shared electronic netwotk services for consumer-initiated shared electronic financial services.
The Director of Investigation and Research Applicant -and-
Bank of Montreal The Bank of Nova Smtia Canada Trustco Mortpge Company
Canadian Imperial Bank of Commerce La Confederation des cat.es pouJab:es
et dteconomie Desjardins du Quebec Credit Union Central of Canada National Bank of Canada
Royal Bank of Canada The Toronto-Dominion Bank of Canada lntera.c Inc.
-and-
Telpay, a division of CTI~Comtel Inc. Retail Coundl of cauada Canadian Life and Health Insurance A.w>ciation Inc. Midland Walwyn Capital Inc. Richards&n Gnemhieds of Canada Limited MackeiWe Financial Corporation Trimark Investment Management Inc.
AFFIDAVIT OF JACK LFSLIE CARR
Respondents
Intervenors
RPR 1'96 16:53 FR BLRKE CRSSELS 25TH FL 16 863 4257 TO 86139521123 P.07 I, JACK LFSLIE CARR., of the City of North Yo:d:, in the Province of Ontario, make oath and say:
Introduction I. Since 1968 I have been a member of the Depa:rtment of Economics at the University of Toronto, fim as an Assistant Professor, subsequently as an Associate Professor and, as of 1978, Professor of Economics. I have also been Associate Chair of the Department of &onomics, Director of Graduate Studies and Acting Chair of the Department. I am a Research Associate of the Institute for Policy Analysis, at the University of Toronto. In addition to my teaching duties :in the Department of F.conomics, I have also taught in the Faculty of Law at the University of Toronto and I am currently a member of the Law and Economics group at the Faculty of Law, University of Toronto.
2. I have authored 9 books and monographs and 28 articles in refereed academic journals. My latest book (wruch I co-authored ) is titled, Ensuring Fai.lu.re: Fi.nancial System Stability and Deposit Insurance in Cmuultl.. My research has primarily been in the areas of monetary economics, money and banking, and law and economics. I have also conducted re.5eareb in industrial o:rganiz.ation.
3. In my 27 years of teacbi:og at the University of Toronto, I have taught courses in money and banking and monetary economics.
4. Now produced and shown to me and marked Exhibit "A'• to this, my affidavit. is a copy of my curriculum vitae.
S. In this affidavit, I will use capitals to denote concepts as defined in the Draft Consent Order (DCO).
APR 1'96 16:54 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 P.08 3 6. I have been asked to address the issue of whether penuitting Interac to continue to require that only Financial Institutions can become Issuers is anti-competitive. In my opinion, it is not anti-competitive and, indeed, results in I.nterac being operated in the most economically efficient manner.
Historical Evolution of the Payment System 7. Exchange in any economic system can be canied out either by baner or by the use of a medium of exchange, money. Money is more efficient at conducting exchange since it avoids the double coincides of wants and commodity indivisibilities. (For a description of the role of money as a medium of exchange and of the evolution of the payment system, see M. Goodfriend, "Money, Credit, Banking and Payment System Policy" in The U.S. Payment System: E./ficiency. Risk and the Role of the Federal Reserve, edited by David B. Humphrey, 1990, a copy of which is attached hereto as Exhibit "B").
8. Many different commodities have served as money. Precious metals such as gold and silver emerged as monies in the modem world. Gold and silver are dumble, divisible and easily recognizable at low cost. Coillability of gold and silver has further reduced veriflcati.on costs.
9. The exclusive use of commodity money in ma.king payments avoids the need for a clearing and settlement system since there is a simultaneous tn.nsfer or exchange of goods, services or secw:itWs, and a quantity of commodity money of CQual value.
10_ Real resources are used to transpOrt commodity money between its place of storage and the physical location of the transaction. Transportation costs c.an be reduced if warehouse receipts (i.e_, claims to commodity money) are excballged instead of commodity
APR 1'96 15:54 FR BLAKE CASSELS 25TH FL 15 863 4257 TO 86139521123 P.09 4 money. In addition, keeping commodity money in a central kx'at:i.on results in economies of scale in storage.
11. The use of warehouse receipts results in efficiencies over pure commodity money standards_ These efficiencies are purchased at a cost. This system of warehouse receipts, involves costs of monitoring and costs of enforcing promises to redeem warehouse receipts mto commodity money.
12. Warehouses who always honoured their pledge to redeem their receipts into gold at fixed exchange xates had their receipts become •as good as gold'. These warehouse receipts became genexally acceptable in ex.change. Warehouse receipts were one of the earliest forms of paper money.
13. Goodfriend summa.riud this evolution in the payment system: In fact, the evolution of the payment syst.em bas been, in large part, driven by efficiency gains from substituting credit (claims on particular institutions) for commodity money. The substitution of warehouse receipts for commodity money was only the first in a series of substitutions that have been found to be efficient .... To 1-eiterate, such substitution has been efficient because the oosts of enforeing restrictions on and monitoring institntions that i~ credit money have been less than the cost of using commodity money ditectly. In other words. the drive for ~r efficiency. which has dkjyrtM a continniu,g substitution of credit for commodity money in nWdn& payments. has brought with it l need 1o make mangement.s to Proteet the payment sysrem, (Marvin Goodfriend, 1990, p.252)
14. The payment system could be mn even more efficiently if part of the warehouse commodity money could be invested, leaving sufficient reserves of commodity money to honour requests for redemption for the warehouse receipts.
APR 1'% 15:54 FR ELAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 P.10 5 15. If the warehouse oWntains only fractional reserves, a given amount of commodity money base can support a larger issue of warehouse reoeiprs. This further 1economires on the use of commodity money. Fractional reserves allows the warehouse to loan out part of its commodity money, to eam interest and to reduce safekeeping f~ on commodity money (or even pay interest on commodity money balances).
16. When warehouses kept only fractional reserves of commodity money they became banks who issued their own paper money (warehouse receipts) which were 1redeemahle into gold at fixed xates of exchange.
17. Many govemments also entered the business of printing paper money which was redeemable into gold. When governments always honoured their pledge to :redeem their currency into gold at fixed rat.es of exchange, their currency also became 'a:; good as gold'.
18. When government paper money became generally accepted in exchange, the link between paper money and commodity mouey could be broken and a pure fiat money standard was established.
19. The warehouses, now baoks, further innovated and issued demand deposits along with bank notes. A cheque on a demand deposit, unlike a bank note, is a n double claim" since it is a claim on a specific depositor's account at a specific bank.
20. Cheques allowed individuals to make payments without the necessity of carrying currency. In addition~ cheques made payment by mail more reliable. For Cf"..rtain transactions, cheques were superior to notes.
21. The medium of exchange, money, is defined as paper money and batik~ (currency) and bank dq>osits. (The term bank is used here as a generic tenn for Financial
APR 1'96 16:55 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 P.11 6 Institutions). Liabilities of Financial Institutions constitute a substantial portion of the money supply in Canada.
22. Eventually, most governments eliminated the ability of banks to issue paper money. When the Bank of Qmada was set up in 1935 ~ the Bank was given the monopoly on the issuing of paper money.
23. The use of cheques drawn on demand deposits~ as a me.ans of paym.entf necessitated the creation of a cleari:og and settlement system. (It should be noted that, in principle, cheques could circulate by being endorsed, but be.cause of the lllgh information costs of collecting info.nnation on the drawer of the cheque, the least costly way of verifying the drawer-specific dimension of the cheque was to 'clear' the cheque as quickly as possible).
24. In the U.S., in the mid-1800 1 s, demand deposits :increased relative to bank notes, and this led to the first clearinghouse being established in the U.S. in 1853 (i.e., the New Yolk City Clearinghouse Association).
25. Prior to clearinghouses, cheques in the U.S. were cleared at many different locations on a bilateral basis. 1be clearinghouse provided a central place whme cheques would cltM. Net balances were settled in government currency or coin or in c.learlo.ghouse certificates. Clearinghouses reduced the ~ of clearing. Transportation costs were reduced by the use of a central location and the cost of transporting currency was reduced by the netting out of cle.ari.ng balances. Clearinghouses were an efficient way of clearing and settling cheques.
26. As clearinghouses developed in the U.S., they provided payment finality by agreeing to assess their members to cover the clearinghouse balance of a failed member.
27. Clearinghouses bad to accept risk, in order to improve the efficiency of the clearing and settlement process. To limit and contain this risk, they screened entry into the
APR 1'96 15:55 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 861395211:23 P.12 7 clearinghouse, regulated and monitored their members. Clearinghouses imposed m;n;mum capital requirements, interest rale restrictions, and reserve requirements. They coo.ducted frequent audit.s and colk.ct.ed information to ensure compliance with the rules and .regulations of the clearinghouse.
28. The ultimate power of tbe clearinghouse was the threat of expulsion for a member that failed to comply with the roles and regulations.
29. Control of members.hip was the essential way that clearinghouses controlled their risk exposure.
30. Non-clearing house members could clear their cheques through a member of the clearinghouse acting as their agent but the member agent was liable for all cheques its client cleared through the clea:ringhouse,
31. In Canada, undet an act passed in 1900, clearinghouses were established by and operated under the jurisdiction of the Canadian Bankers Association (CBA). The Canadiao Bankers Association was given the authority for clearing and settlement and the authority to establish rules and regulations (subject to approval of Treasury Board) for a clearing and settlement system.
32. Prior to 1980, only chartered banks could be members of the clearin& and settlement system. In the 1960's, there were ten clearinghouses (known as clearing centers) in the cities of Canada. The CBA ran the clearing system, and banb settled their daily clearing balances through their accounts at the Bank of Canada.
33. Banks were, and still are, regulated, inspected and supe:rvixd by various government agencies, such as the Bank of Canada~ which has the power to set reserve requirements and loan funds to the banks~ the Office of the Superintendent of Financial Institutions (OSFI,
APR 1'96 15:55 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 861395211~23 P.13 8 whose functions were fonnerly performed by the Office of the Inspector Genetal of Banks), which bas the power tD monitor and regularly examine banks, and the canadian Deposit Insurance CoipOration (CDIC), which has the power to tenn;nate deposit insurance for noncompliance with spe.cified standards. (It should be noted CDIC powers were upgraded in June, 1992). In Canada, these government insti1llti.ons assumed the various roles that the clearinghouse association historic.ally performed.
34. After 1945, the demand deposit business increased in non-bank Financial .Institutions (i.e., trust and loan companies, credit unions and cai~ populaires). These institutions cleared their cheques through chartered banks.
35. These non-bank Fillancial Institutions could have set up their own clearing and settlement system but decided against this option. It is my opinion that~ due to network economies, it would have been vecy costly for these non-bank Financial Institutions t.o run their own national clearing and settlement system.
Current Canadian Payment System 36. In 1980, the Canadian Payments Association (CPA) was created and given the mandate in s.5 of the Capadian Payment& Assoc:iation Act 'to e.stablish and operate a national clearings and seulements system' and 'to plan the evolution of the national payments system•.
37 . All cbal'tered banks and the Bank of Canada must be members of the CPA. Non-bank Financial Institutions (trust and loan compani~, credit unions and caisses populaires) may be members of the CPA.
38. The CPA has two classes of members: direct clearers, who must account for at l~ 0.5 percent of tbe national clearing volume, and indirect clearers, who clear through arrangements with a dired clearer.
APR 1'96 16:55 FR BLAKE CRSSELS 25TH FL 16 863 4257 TO 86139521123 P.14 9 39. The creation of the CPA allowed, for the first time, non-bank Fmanc.ial Institutions t.o be direct clea.ren in the natiooal payment system.
40. All direct clearers of the CPA have the right to hold deposits at the Bank of Canada, obtain loans and advances from the Bank of Csnada, and have access to a govemmentcontrolled deposit insurance scheme, (i.e. , a federal deposit insurance scheme for banks and trust and loan companies and provincial schemes for credit unions and caisses populaires).
41. It is current govemment policy to restrict membership in the CPA to Financial Institutions. Government ensures oompetition in the deposit-taking maiket by allowing 'relatively easy' entry to this market. For example, m Ontario alone, from 1968 to 1985, 62 new trust and loan companies (either fe.derally or provincially incorporat.ed) entered the market. (See Ca.tr, Mathewson, Quigley, Ensuring Fai.lure, Exhibit 4 to Professor Quigley's Affidavit at pages 56-57.)
42. As in all clearing and settlement netwoit:s, direct and indirect clearing members of the CPA impose risks on one another. Therefore, the identity and financial condition of CPA members is important.
43. Risk in the clearing and settlement system has evolved, as the Canadian payment system has evolved to include electronic payment items. Paper cheques can be :retu.med up to 1: 00 p_m. on the next business day after they are cleared. Electronic payment items can not be unwou.nd. Electronic payment items are irreversible.
44. The Affidavit of Bradley Crawford discusses the various types of risk .inherent in the clearing and settlement process. The rules and regulations of the CPA are designed to limit these risks.
P.15 RPR 1'96 16:56 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 10 45. Members of the CPA .incur a risk that other members will not be able to pay or settle what they owe in clearing balances (i.e., countetparty risk).
46. Each direct clearer in the CPA monitoIS the amount it is owed by other direct clearers_ Each direct clearer monit.ors the fmandal health of other members of the CPA so that it will know whether outSt.andllig clearing balances exceed the maximum allowed (i.e., detennined by its own internal risk analysis) for each financial institution. Knowledge of institutional f.toancial health is an important element in assessing and limiting counterparty risk.
47. Tbe Bank of Canada monitors the total system-wide exposure of each direct clearer to all other direct clearers, and oontrols the net indebtedness of eacll member to all other members by the imposition of net debit caps.
48. Direct clearers of the CPA also rely on regulatory institutions to limit counterparty risk. For ex.ample, capitalization rales imposed by legislation (e.g., Bank Act, Trust and Loan Company Act, etc.) and by the CDJC, monitoring and impections by OSFI, and asset quality rules imposed by the Bank of Caoada and by the Bank Act, Txust and Loan Company Act, etc. are all important counterparty risk assessment criteria.
49. In addition, direct c1earers of the CPA have deposits at the Bank of Canada and these deposits are used to settle baJances at tiie end of the day. As such, settlement occurs at the end of the day and this finality in settlement limits counterparty risk. The longer the time to settJement, the greater is the oount.elparty risk.
50. Direct clearers of the CPA pay or settle clearing balances at the end of the day. Members of the CPA maintain liquid ratios for regulatory and sound business practice reasons to minimize the risk of not being able to pay clearing balances as they arise.
APR 1'96 16:56 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 8613952112J P.16 11 51. If there are temporary liquidity problems, direct clearers of the CPA have the ability to OO!row at tbe prevailing Bank of Canada rate from the Bank or to boITOw in the overnight funds market from institutions with excess reserves. The line of credit from the Bank of Canada and the ability to bomw in the overnight funds market tends to minimize liquidity risk in the system.
52. Both the formal and infonnal rules of the CPA are designed to minimize risk and insure a safe, sound and efficient payment system. Professor Anvari in the 'The Canadian hyment System: An Evolving Structure' (in The U.S. Payment System: '@lei.ency. Risk and the Role of the Federal Re.serve, 1990, e.d. by David Humphrey, a copy of which is attached hereto as &bibit "C") 1 has stated that: Canada is reputed to enjoy one of the most efficient payment systems in the Western industrialized world. It is generally thought, particularly in the United States, that the deternrini.ng factor lea.ding to this efficiency is the existence of a small number of large banks with bxanches across the country. The large size of these banks fosters a high degree of automation; theit coast~ to coast branching lends itself to the development of nationwide networlcs; and theh' small number is conducive to a streamlined process of exchange and settlement (page 93).
Rnk in Payment System With Intenc Compelled to Have Non-ftuandal Imtitutlons as Card Issuing Members.
53. Professor Quigley has stated in his Affidavit that ~Interac is a system for the communication and clearing of financial messages in which a variety of services are currently provided and through which a broader :range of services could be provided~ (Paragraph 24}. 'Ibis description by Professor Quigley ignores the settlement risk to Interac members. Professor Quigl.ets description would aiguably apply to Acquirers in the Shared Services, but his description of the Association's activities ignores the risk element in participating as a Issuer.
APR 1'96 16=56 FR BL~ C~SSE~S 25TH FL 16 863 4257 TO 86139521123 P.17 12 54. Clearing baJanoes among J.nt.eiac members are cleared and settled through the Automated Cleariog Settlement System (ACSS) of the CPA.
55. By virtue of CPA legal framework, Shared Cash Dispensing (SCD) transactions are final. Moreover, for all Interac Direct Payment (IDP) transactions, the transfer of funds is also immediate. The cffe ct of both the SCD and IDP uansactions are to reserve the funds due to the Acquirer in a manner similar to a certified cheque. In an e1ectroni.c transfer system, such as that operated by Interac, payments are irreversible. Irreversible payments pose a greater settlement risk than reversible payments.
56. With the Inteivenors as Issuers in the SCD Service, there would be veey little netting of clearing balances since the Interven0ts have no AutolllaUd Banldng Machines (ABM) and are unlikely to have significant DUmbers of ABM in the foreseeable future. That being so~ if the Intervenors became Issuers in the SCD Service, the risks would all flow in one clitection, from the lntervenors to the current Acquirers in the SCD Service. Cash withdrawals would be from the cunent Acquirers' ABMs. The Intervenors, who would likely seek to be Issuers, have no ABMs, and are unlikely to incur the capital investment to become SCD Acquirers. Consequently, as Issuers in the SCD Service, the Intervenors can impose substantial settlement rl&k on the current .Acquirer members of the Service. On the other band, cUITellt SCD Acquirers would pose a zero or negligible .risk to the Intervenors.
57. With non-Fioancial Institutions as Issuers in the Interac Shared Services, risk in the payments system could increase sign:ifica.ntly.
58. Banks, ttust companies, credit unions and ~ populaires are in the same deposit-taking business and through their transactioos with one another can easily monitor the fmanci.al health t>f members of the deposit-taking community. It is much more difficult and costly for deposit-taking institutions to monitor: the fiDancial ~ility of rums whose core activity is not depositwtak:ing. Financial Institutions, will. find it costly to acquire information
APR 1'96 16:57 FR BLRKE CRSSELS 25TH FL 16 863 4257 TO 86139521123 13 and monitor the financial condition of the myriad of retailen, insw:ance companies, brokerage finns and mutual funds who desire Issuer status in Interac.
59. This higher cost of obtaining illformation and. monitoring the financial condition of non-Fina.new Institutions will inciease counterparty risk in the payment system. in which Int.eiae Members participate. Non-Finaucial Institutions do not have the same capitalization rules, inspection rules and asset quality roles as Financial Institutions. CDIC can not increase the capitalization requirements for i.nsuran~ companies a.od investment companies if the.it asset quality deteriol'3les. The different regulatory ftamewotk of non-Fmancial Institutions will increase c.ounterparty risk.
60. Non-Financial Institutions, unli1.re direct cleareis of tbe CPA, are neither requi.red DOI' able to maintain deposit accounts at the Bank of Canada. This again increases counterparty risks, since it is more difficult to settle cleaiing balances at the end of the day. Although other settlement arrangements could be made, these a.re riskier than the riskless procedures using the Bank of Canada as a '"bank of final settlement.' .
61. Non-Financial f.nstitutions m:e not subject to the same regulat.ory rules conceming liquid asset ratios as Financial Institutions are. Non-Financial Institutions do not have the ability to borrow from the Bank of C.anada, These instituti.ODal differences :result in increased liquidity risk with non-Financial Institutions participating in tho payment system.
62. Regulation of non-Financial Institutions is di:ff~nt from the regulation of Financial Institutions. Neither CDIC nor OSFI has the power to cause an :inv4'l'Stment fum to cease and desist from operating in order to limit risk exposure.
63. Life insurance companies are regulated with an emphasis on the long-term uature of their liabilities. life insuran~ customers do not have the same ability as the customers of financial Institutions t.o :redeem their claims and convert them into liquid fu:od.s. ReeuJators
- p .1 8
i:iPR 1'96 16:57 FR BLRKE rnSSELS 25TH FL 16 E;:53 4257 TO 86139521123 P.19 14 of life insurers are concerned about the ability of insurers to pay claims over tbe long-tenn and are not as concerned, as Financial Institntion regulators are> about short-tem liquidity.
64. Retailers are essentially unregulated institutions. 65. Mutual funds are essentially unregulated due to the fact that their liabilities are not :redeemable into money at fixed ra~ of exchange. JI a bank is badly managed, tlttte could be a run on the bank. If a mutual fund is badly managed, the value of the mutual fund shares will fall.
66. In summary, the stability of the payment system is vitally important for the health of the canadian economy. Money is used to finance almost all transactions in the economy and the liabilities of Financial Institutions constitute a substantial pordon of the money supply. As such, Financial lll8titntions, participating in the payment system> attract substantial regulation. Banks alone, are iegu1ated by the Bank of canada, the OSFI and CDIC, as are all Financial Institutions. Non-Financial Institutions do not bave the same stringent reguia.tion. As was noted above, some :non-Financial Institutions are essentially unregulated.
67. Non-Financial Imtitution Issuers in the Inteiac Shared Se!Vice will increase counterpa:rty and liquidity risks in the CPA.
68. It is troe that the risk to the CPA, with non-Fmancl.al Institutions as Issuers in the lnterac Shared Service, could be eliminated if the new Inteiac Association established a new settlement system outside the cur.rent Canadian payment system. It should be noted that such an action will eliminate the risk to the CPA but this action will not eliminate the rlsk to 1.ntm.c Members.
APR 1'96 16:57 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 P.20 15 69. Since a perfectly adequate Canadian settlement system already exists (ACSS), the establishment of a new settlement system will duplicate and waste rescJUICes. This clearly will pose added costs to the Members of Interac.
Economic Functiom of l:ntenlc 70. To appropriately assess Interac,s restrictions on Issuer sratns, it is neces&ny to examine the nature of the services for which the Members use Inteiac.
71. Historically, Financial Institution customers have accessed their demand deposit accounts either through a teller or through transferring fun& by cheque.
72. The develq>ment of the ABM allowed customers 24-hour access to their deposit accounts. ABMs are the electronic equivalent of tellers, except that they perform Financial Institution functions at greater speed and lower cost. These machines, operating as part of proprietary FI networks, allowed customers to obtain ~ withdla.wals from their accounts, transfer balances between accounts, pay bills from accou.nts, and obtain cash advances from credit cards.
73. Interac currently allows Financial Institutions t.o networlc to provide Shared Services, those being presently SCD and IDP. Customers of cunent Members, through card access, can obtain a cash withdrawal from a deposit account or direct payment at the point of sale. As well, and this is only a very small part of Intera.e s total transactions~ customers can obtain credit card cash advances.
74. The important point to note is that the SCD and lDP Services of Interac are essentially Financial Institution services that customers tradhionally accessed through tellers or writing cheques. lnteiac currently allows these two Shared Servic.es to be provided for all customers of Financial Institutions who are Members.
RPR 1'96 16=58 FR BLRKE CRSSELS 25TH FL 16 863 4257 TO 86139521123 P.21 16 75. In my opinion, one cannot credibly argue that it is anti-competitive to have tellers provide services Qnly for their own institution, or that it is anti-competitive to have a Financial Institution's own ABMs provide services Qnb for its Q'!£D customers. Similarly, one cannot credibly argue that it is necessary in the interests of competition that Financial lnstitntions be compelled to have a netwOJk of their own ABMs pedorm transaction services for non-Financial Institutions like insurance companies or investment companies. From a competition policy perspective, the wues of duty-to-deal should be the same for single firms as joint-ventures. Firms should only be required to share their assets or otherv.'ise facilitate potential competition when membership in or access to a joint venture is indispensable for competition.
76. If different rules were applied to joint ventures than single finns, then there would be an incentive for firms to form less efficient forms of organizations (with more market power). For example, mergers would increase in desirability relative to joint-ventures, since different criteria would be applied to the single merged film than to the joint venture.
77. Given the economic rationale for Interac, it is clear why Interac's Issuers have been Financial Institutions. Given t.he economic functions performed by Inteiac and the need to limit risk, there are good economic reasons why Interac should be allowed to restrict its Issuers to Financial Institutions.
Access to Payment System Throuch Sweep, ~Bala~ and Pass-'I'hroup Accounts 78. The DCO e1iminates lnterac rules against sweep, zero-balance and pass-through accounts. 79. The two experts hired by tbe Intervenors claim that sweep, zero-balance and pass-through accounts are neither pmctical nor cost-effective.
APR 1"36 16:58 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 P.22 17 80. The Affidavit of Kenneth Morrison attempts a the.ore.ti.cal calculation on the oost of using these accounts. Mr. Moni.son concludes that:
Virtually any sy&em can be forced to work from a teehnological perspective. However. the sweep, pass-through, and zero-balance account process adds c.osts to tra.osactions, will be .inefficient, could violate the privacy and
confidentiality right of consumers, negatively impact the ability of Alt.emative Entities to build and manage relationships with their customers and adds unnecessary confusion. (Page 3 8)
81. Professor Quigley argues that these: accounts creates a principal-agent problem which will be costly to resolve ..... . The fact that the Financial Institution and the non-F'mancial Institution are direct competitors to the customers for the supply of a wide raoge of fioanclal services will make it difficult and costly for them to write a contract which
will provide a satisfactory basis for this relationship. This is because the moral hazard (hidden action) and hidden information problems normally associated with the principal-agent relationships are compounded when the contractual parties are competitors. (pp. 18-19)
82. Both the Monison and Quigley arguments are theoretical. Theoretically, costs with tbese accounts could be so high as to make them an ineffective avenue for the Inrervenors. Theoretically, principal-agent problems and moral hazard problems could be so severe as to make such arrangements impossible to negotiate.
83. It should be noted that principal-agent and moral hazard problems abound in almost every financial contract. Further, sweep accounts, zenr-balance accounts and paM-through accounts have thrived in the U.S. banking system.
84. Interest payments on demand deposits were prohibit.ed in the U.S. in the Banking Acts of 1933 and 1935. Potential reasons for this prohibition may be as a :rewa.Id to large banks
RPR 1'96 15:59 FR BLAKE CASSELS 25\H FL 15 863 4257 TO 86139521123 P.23 18 for accepting a deposit insurmce scheme which they opposed and/or as a mea.ns of limiting moral ha7.atd in such a deposit-insurance scheme (i.e., high risk banks could not attract deposits by offering high rates on demand deposits).
SS. As long as int«est xates were low, the prohibition of interest rates on demand deposits was not economically very significant. However, to the 70;s and 80's with high and variable inflation rates and high and variable interest rates, the proln"bition of interest on demand deposits became a very binding economic constraint.
86. There was a major economic incentive to find a way around the prohibition of inrerest on demand deposit&. Investment fums set up a n.ew financial product. 'Ibis was the chequable money marlret mutual fund. The money market mutual fund paid market int.erest rates through the use of various sweep accounts, zero..~ accounts or pass-through accounts at participating deposit·taking financial institutions.
87. The Affidavit of :t.-lr. Liam CatD.lOdy documents the current successful use of sweep, zero-balance and pass-through accounts in the U.S.
88. There fa no reason to believe the U.S. experience is not relevant to Canada. The U.S. experience indicates that sweep accounts, zer<rbalance ~nts and.pass-through accounts are a practic.al, cost-effective way of giving non-Financial Institutions effective access to the payments system.
89. Non-F'mancial Institutions can participate as Issuers through subsidiaiy trust or banking fums. Some of the Interveno:rs currently own trust and bmikillg subsidiaries. For example, Mackenzie Financ.ial owns M.R.S. Trust Company t Sun Life Assuraoce owns Sun Life Trust, and .Manufactnren Life owns Manulife Bank.
APR 1'96 16:58 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 P.24 19 90. The significant entry of trust and loan companies, in the Ontario ma.tket in the 1960's and 1970's, indicate that such entry is relatively free of barriers.
91. The 1992 Federal Govemment :refo.nn of the fmancial system essentially allowed increased competition between the traditional four pillars of the financial systmt; banks, trust and loan companies, insurance companies and investment firms. These reforms preserved the distinctions between these in.~tu.ti.ons so as to allow prudential management of the different types of risks. The increased competition essentially took the form of allowing each pillar to set up subsidiaries to compete with the other pillars.
92. Liberalised cross-ownership rules and networking powers allowed financial institutions to move outside their core activity. Banks could set up subsidiary trust companies to perfo nn a trust and agency function. Banks could set up inswance subsidiaries and train insurance agents to sell insurance. (However, insurance could not be sold in ba.ok branches.)
93. It appears to be implicit Federal Government policy to allow competition through the subsidiary route. The advantage of this method of increasing competition is that it maintains a level playing field. All players in the insurance market will be regulated as insurance companies. All players in the deposit-taking market will be regulated as deposiHakers.
94. Canada bas a flexible regulatory syst.em. The Bank Act has a sunset provision which requires review every ten years. Financial services regulation was reformed in 1992 and it is due to be changed again in 1997. In response to financial innovation and changing technology, the Federal government has increased the frequency of changes in financial services regulation.
95. The Intervenors appear to want access to the deposit-taking business but do not want t.o be regulated as Financial Institutions. The Jnt.eIVenors appear to want a free ride on the
P.25 APR 1 , 96 16:59 FR BLAKE CASSELS 25TH FL 16 863 4257 TO 86139521123 20 regulatory system. They want to be in the deposit-mldng marlret but do not want to pay the price of deposit-taking regulation.
lnterac's Ability To Decide on Card Issuing Members 96. There are good economic reasons why oompetition policy does not, in general, force single firms or joint ventures to share their property with rivals.
97. lntetac has excluded non-Financial Institutions from being Issuers because they would bring increased risk. In addition, the essential economic function of lnterac is to provide what are essentially deposit-taking financial services. Non-Financial Institutions, as Issuers, offer little to enhance the value of the existing Intera.c network. Since none of the Intervenors have their own ABMs and none have a clearing/settlement business now, these non-Financial Institutions only impose costs to Interac and bring little in the way of benefits. (i.e. , increased netwolk economies)
98. It is not surprising that Interac Members want to use their property in the most efficient manner and as a consequence have excluded non-Financial Institutions from being Issuers.
99. The Inte:cvenors, however, may want to engage in free-riding. Free-riding can occur in many different ways. In the lnterac c:ontext, free-riding would occur if ce:rtam fums could gain from the innovations and investments of others v.1thout having incurred the costs or risk of developing the new technology.
100. David Evans and Richard Scbmalensee have argued in 'Economic Aspects of Payment Card Systems and AntitrUSt Policy Toward Joint Ventures' (Antitrust Law Journal, vol 63), a copy of which is attached hereto as Exhibit "D", that:
P.25 APR 1'96 16=5'3 FR BLAKE D::'.1SSELS 2SiH FL 16 863 4257 TO 8613'3521123 21 New industries present many serious free-ddini problems. Some firms bear the cost and risks of identifyin,g the demand for a new product and learoing about the costs and t.eclmology for providing the product. Other fmns wait to see whether the initial firms are successful before entering and then free ride
011 the lea.ming and innovation accomplished by the initial fums. (Page 878)
101. If free-rldi.Dg is not prevented~ and is even encouraged, by compelling innovative firms to share their in.vestments and technology with rivals, then innovators will not c.apture the full returns of their inoovation and, as a result, investment in new technologies will diminish.
102. It is etttaiDly the case th.at, because the Intervenon are non-Financial Institutions, they were precluded from joining lnt:erac, when it was founded. However, the Intervenors could have at any time invested in the new technology. It would appear tbat (except for retailers), the Intervenors bave not invested any funds in the new technology of ABM and POS necwolb. The Inierveaors have seen lnte.rac develop new technology. invest heavily in an ABM network, and succeed in this new venture and now want the Competition Tribunal to force Iate.rac to allow the Intervenors access to the new technology and networks through Issuer status.
103. Ii lntexac were compelled to accept the lntervenotS as Issuers, cmrent Members of Inte.rac would be compelled to accept clearing risks they otherwise would flnd uoa~le, and clearing ri&k.s for which they would not be compensated. By forcing current Members of lnterac to accept uncompensated risk, the Intervenors want to free ride on lntera.c.
104. In clearing house ammgemems, clearing partners were very carefully selected. Careful choice of clearing partners was a key to a succes.sful clearmghouse arrangement. In my opinion. the Members of Interac should bave the ability to decide from whom they will accept clearing risk To do so, Intuac needs the ability to select wbich Memben may be Issuen.
,-,,,~ P.27 CASSEL.S ~sTH FL 15 863 4257 TO 86139521123 APR 1' 96 16:59 FR BLHl".C; ' ' 22 l 05. There is another economic consequence of allowing fums to demand access to successful joint ven.tu:Ies. Such actions can in fact diminish competition. If fmns know they ean demand access to succesdul joint venmres, t.hey will never enter the rnaltet when the joint venture is started. They will want to see if the joint venture is successful. 'ff the joint venture is successful, then they will demand access. If the joint venture fails, the film does nothing. In either case it :refrains from entering the maticet at the time of tbe fonnation of the joint venture. In this way, int.el'system competition is reduced. Compelling ac(;eSS to the joint venture may have the effect of reducing the overall level of competition.
l 06. The only ecooomic case for compelling access to the joint venture of Intemc would be the situation where Interac was an 'essential facility'. By essential facility I mean a facility indispensable for competing finns to effectively pa:rticipat.e in the market for shared electronic financial services. Without being an Is.suer, the Interverors can fully function in their respective core lines of financial service busina%. The lntervenors can fully function as insurets, investment dealers or recailers without beinJ able to issue cards whieh access Interac Shared Services.
107. The Intervenon alYan had the ability to set up their own ABMs and to networic ~ machhles. Through their own ABM machines the int.ervellOl'S could have provided eled:roaic financial services. None of the Intervenors chose to do so.
108. The Intervenors can obtain~ to the payment system ti1tough the use of a subsidiary which would qualify as a F"umncial Institution.
l 09. The Inrervenors can obtain access to the payment system through the use of sweq>, zero-bala:llce and pass-through accounts.
P.28 5 25TH FL 16 863 4257 TO 86139521123 RPR 1'96 17:00 FR BLC\KE CASSEL 23 110. Given the number of alternative routes to offering card issuing or deposit account services available to the Interveoors, Issuer membership in Interac is not an 'essential facility' .
Conclusion 111. In my opinion, the DCO, which allows Interac to restrict Issuer status to Financial Institutions is J1Qt anti--competitive.
112. Historically, only FiDancial Institutions have been members of clearing and settlement systems. Historically, clearinghouses carefully selected and monitored their members.
113. If Intetac were compelled to accept the Int.ezvenors as Issuers, existing Interac Members would be subject to increased risk, and risk in the Canadian payment system would increase.
114. The government has maintained competition through relatively open entry into the financial ma.rlcets. Government policy has been tbat tinancial institutions providing the same service should be subject to the same regulation.
: J ': l ·,
'.J5'"' TO 86139521123 P.29 1'96 17:00 FR BLAKE CASSELS 251H FL 16 863 4~ • APR ~ ~ I
,,)• : I .. .. . .. 24 O• .. 115. Competition is DQt maintained by forcing lntelaq,to share its technology and ·.o!· innovations with non-Financial Institution Issuers. sudi. action is inefficient and can ultimately reduce the level of competition in the system~.
SWORN BEFORE ME at the City of Toronto, in the Municipality of Metropolitan Toronto, this lst day of April, 1996.
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