Documentation

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0 :e: 1 1996 ~ ·~ I v I ·----· REGISTKAR - R -fG -I -STRAIRf CT-9 /02 --· -· ----:;:;;..-OTTAWA, ONT. #7d THE COMPETITION TRI

IN THE MATTER 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, as

amended;

AND IN THE MATTER OF an abuse of dominant position in the supply of shared electronic network services for consumer-initiated shared electronic financial services.

BETWEEN: THE DIRECTOR OF INVESTIGATION AND RESEARCH Director - and -BANK OF MONTREAL, THE BANK OF NOVA SCOTIA, CANADA TRUSTCO MORTGAGE COMPANY, CANADIAN IMPERIAL BANK OF COMMERCE, LA CONFEDERATION DES CAISSES POPULAIRES ET D'ECONOMIE DESJARDINS DU QUEBEC, CREDIT UNION CENTRAL OF CANADA, NATIONAL BANK OF CANADA, ROYAL BANK OF CANADA, THE TORONTO-DOMINION BANK and INTERAC INC.

Respondents - and -TELPAY, A Division of CTl-Comtel Inc. RETAIL COUNCIL OF CANADA CANADIAN LIFE AND HEAL TH INSURANCE ASSOCIATION MIDLAND WALWYN CAPITAL INC., RICHARDSON GREENSHIELDS OF CANADA LIMITED, MACKENZIE FINANCIAL CORPORATION and TRIMARK INVESTMENT MANAGEMENT INC.

lntervenors

AFFIDAVIT OF DR. ROGER WARE

AFFIDAVIT OF DR. ROGER WARE I, ROGER WARE, of the City of Kingston in the Province of Ontario, MAKE OATH AND SAY AS FOLLOWS:

1 . I have been retained by the Director of Investigation and Research to provide an economic assessment of certain issues raised in the affidavits filed on behalf of the lntervenors by Professor Quigley and Mr. Morrison in relation to the Application of the Director in this matter. My report setting out that assessment is attached as Exhibit "A" to this Affidavit.

2. I am an Associate Professor in the Department of Economics at Queen's University. I base my report on expertise built up over fifteen years as a professor of economics at the University of Toronto and Queen's University, teaching and researching in the area of Industrial Organization. I have published many research papers, and developed special expertise, in the areas of market structure and barriers to entry. Specifically, I have studied the electronic payments industry for two years while giving advice to the Director in regard to the investigation of the lnterac Association. My Curriculum Vitae is attached as Exhibit "B" to this Affidavit.

- 2 -3. The lntervenors make two fundamental claims. They assert that the restoration of competition in the relevant markets requires that they must be allowed to directly issue cards to their customers that can access funds through the lnterac network. They also claim that entry to the network by entities that would participate as acquirers only is not economically viable or that it will be prevented by stragegic activity of the Respondents.

4. My conclusions are that the arguments of the lntervenors on both these issues are invalid and that the provisions of the Draft Consent Order that relate to these issues, taken in conjunction with the whole of the DCO, will be adequate to restore competition.

SWORN BEFORE ME, in the City of Hull, in the Province of Quebec, Dr. Roger Ware this 31st day of March, 1 996

133 831 A Commissio er for taking oaths in and for tlie Province of Quebec for the Judicial District of Hull

REPORT BY DR. ROGER WARE INTRODUCTION 1 . The object of this report is to provide an economic assessment of the arguments advanced by Professor Quigley and Mr. Morrison, in support of the lntervenors' position that the Draft Consent Order (DCO) in this matter is not adequate to restore competition. Their position rests on two essential points:

(i) indirect card issuing arrangements for non-financial institutions ("non-Fis") will not enable them to provide effective or competitive access to shared electronic financial services for their customers; and

(ii) participation in lnterac as an acquirer-only is not economically viable, or will be prevented by strategic conduct on the part of the current members of lnterac.

2. The conclusion of my report is that the concerns of the lntervenors are unwarranted. The case presented by the lntervenors and their experts does not hold up under sound economic analysis. Secondly, the facts on which they base their arguments do not establish the points they seek to make.

This is E,x 1 .h. .. JL;, 11 it ... to the affidavit of fil~:. .. '.?o.0e.c .. ~ sworn before me this 3 \ s+- day oL.~('C..~ _....,...-.o.-dll·non•••••• ..

- 2 -II THE ANALYTICAL FRAMEWORK OF COMPETITION IN A SHARED ELECTRONIC FUNDS NETWORK

3. This section sets out the analytical framework of competition in a shared electronic funds network. The purpose is to evaluate the claims made by the intervenors and their experts, Mr. Morrison and Professor Quigley.

4. The economic model that I will use to address these issues is that of a network of demand complements, developed by Professor Steven Salop. 1 I apply the model to competition in a shared electronic funds network, where issuance and acquisition are complementary activities. Every transaction, either at an ABM or at a point of sale terminal, involves a card issuing institution and an acquiring institution. The acquiring institution can be any member of the network that deploys terminals. Because one unit of each of these activities is required for every transaction, issuance and acquisition are, in economic terminology, perfect complements.

5. In a shared electronic funds network, members compete for card issuing services by offering cards. Other things being equal, the cards of competing issuers are substitutes, from the cardholder's perspective. Members also compete

1 Salop, S.C. "Evaluating Network Pricing Self-Regulation" in Electronic Services Networks, edited by Guerin-Calvert, M.E. and Wildman, S.S., Praeger, New York (1991 ).

- 3 ­to deploy terminals and acquire transactions. Other things being equal, a terminal of any member is a substitute for a terminal of any other member in acquiring. Members may compete in both activities or in only one. Competition among members, whether for issuing or acquiring, is referred to as intranetwork competition. The overall structure of the network is that of a group of substitutes in issuing (card issuing services) which are perfect complements to a group of substitutes in acquiring (terminals).

6. The description of this framework is completed by considering the prices for these services. Consider first pricing for SCD. The per transaction price for issuing services is the "foreign fee", charged to cardholders by their issuing institution. The per transaction price for acquiring is a surcharge at the terminal, charged to the card holder. Either fee could take the form of a rebate. This fee structure is equally applicable to IDP transactions, but for IDP services, the acquirer may also charge the merchant a per transaction fee.

7. Another fee, the interchange fee, is set by the network and it is a payment between issuer and acquirer per transaction. An issuer's revenue per transaction consists of the foreign fee less the interchange fee. An acquirer's revenue per transaction consists of the interchange fee plus any surcharge. In the IDP service, the acquirer' s revenue may also include any fee charged to the merchant. There is an important relationship between these fees or prices. If competition is effective

- 4 ­in both card issuance and acquisition, then the interchange fee is redundant. That is, in a fully competitive network, if the network establishes a $1.00 change in the interchange fee, competitive forces will operate to produce equal and offsetting changes in the fees for issuance and acquiring. As a result , it makes no difference to any of the parties, issuers, acquirers or cardholders, at what level the interchange fee is set. 2 8. The predictions of a model in which the final product is made up of two complementary inputs are quite standard. The first key prediction is that if there is competition in the supply of both inputs, the market for the final product operates efficiently. The second key point is that if a party exercises market power over one input, it cannot improve its economic position by seeking to monopolize the other input. It would extract the maximum economic surplus from the exercise of market power over one input and could not benefit if it extends its market power into the other input.

9. The following example illustrates this second point. There are two complementary inputs: glass jars and jar lids. Assume a consumer will not pay more than $2.00 for the combination of a glass jar and lid. Seller A has a monopoly in the supply of glass jars and can produce jars at the marginal cost of

2 The redundancy result is developed in Salop, S.C. "Deregulating self-regulated ATM networks", Economics of Innovation and New Technology, 1, 85-96 (1990).

- 5 -50 cents. Lids are supplied in a competitive market at a price equal to a marginal cost of 20 cents. Seller A maximizes its profit by setting the price of jars at $1.80, thereby earning a profit of $1.30. Now suppose seller A seeks to monopolize the market for lids. Because it can never charge more than $2.00 for the entire package, it could not earn a higher profit by selling both lids and jars. That is, because its total cost of producing the package is 70 cents (20 cents for lids and 50 cents for jars) its profit is still $1.30. As this example shows, in a model of demand complements, a firm which exercises market power in the supply of one input cannot increase its profits by seeking to extend its market power into the supply of the other, where the other input is supplied competitively. 3 10. In the remainder of this affidavit, I will apply this model and its predictions to analyze the two concerns raised by the intervenors; the efficacy of indirect card issuance and the economic viability of acquiring transactions. In terms of my model, these two concerns can be broadly characterized as an inadequate level of competition in the supply of the two complementary inputs, card issuance and acquiring. As I will argue, these concerns are unwarranted. In my opinion, the DCO will promote effective competition in card issuance and card acquiring and, consistent with the model, will lead to a competitive supply of shared electronic financial services.

3 See Herbert Hovenkamp, Federal Antitrust Policy (St. Paul, Minn., West Publishing, 1994) at 371.

- 6 -Ill COMPETITION IN CARD ISSUING SERVICES 11 . The first concern of the intervenors, expressed in the affidavits of Mr. Morrison and Professor Quigley, is that indirect access for non-Fis is not a viable or efficient substitute for direct card issuance.

12. In response, I will first describe a simple mechanism by which an arrangement between an Fl and a non-Fl could provide effective indirect card issuance for the non-Fl. Secondly, whether or not such indirect issuance is efficient and profitable, I suggest that there are other alternatives to direct card issuing status in lnterac, for these non-Fis and their customers.

13. Finally, I point out that several arguments by the lntervenors' experts against the efficient operation of "sweep, pass-through and zero balance accounts" are in fact misleading and erroneous. In my opinion, the affidavits of these experts systematically overstate the alleged costs of such arrangements, and understate their efficiency advantages.

14. A simple arrangement to issue co-branded cards might operate as follows. Customers of the non-Fl sign a cardholder agreement with the Fl of a conventional form, acknowledging liability for their transactions. The Fl issues cards to these customers, which will bear the name of the non-Fl. The non-Fl maintains funds

- 7 ­with the Fl in an amount sufficient to cover daily transactions by these cardholders. Each day the non-Fl provides information to the Fl to establish withdrawal limits for each of the cardholders. As cardholders make debit transactions, the messages come in to the Fl, which authorizes the transactions and guarantees payment, reducing the cardholders' withdrawal limits accordingly. At the end of the day, the non-Fis account at the Fl is debited by the total amount of the transactions of the cardholders. A record of transactions is sent electronically to the non-Fl, which adjusts its customers' balances accordingly. am informed that arrangements similar to this were operated for a period by an lnterac member, Royal Trust, until lnterac prohibited such arrangements.

15. I emphasize that the market will select the most efficient arrangement to facilitate the indirect issuance of cards. There is no reason why it should be precisely as I describe in the above paragraph. There may be numerous arrangements of a "co-branding" nature that could facilitate indirect access for non-Fis and their customers, as the American experience demonstrates.

16. An example might be the kinds of arrangements described by Mr. Carmody that have developed in the United States between brokerage firms and card issuing "banks". Experience shows that certain depository institutions have responded to the demand by non-Fis for access for their customers to shared networks, by supplying an off line debit card. The affidavit of Mr. Carmody documents

- 8 ­extensively the operation of such off line debit cards. 17. While the regulatory and financial environment of the U.S. might be different from Canada's, the widespread adoption of such indirect access arrangements supports my view of their economic efficiency. In addition, the U.S. experience has demonstrated that banks will enter and compete to provide these indirect issuance services, and that some banks have specialized in providing such services to non-Fis and have exploited economies of scale to drive down costs. 4 As a result of competition in the market among Fis providing this service, fees charged to non-Fis have come down in exactly the way that the economics of entry and competition would predict.

18. Another alternative is available through the use of credit card networks. I am informed and believe that Canadian Tire, through an affiliate, and GE Capital Ltd., are members of the MasterCard Association and are entitled to issue MasterCard products in their own right. The liabilities arising out of transactions by cardholders of these entities are cleared and settled directly through the mechanism maintained for this purpose by the MasterCard Association. MasterCard membership, with the right to issue MasterCard products, may not be a perfect substitute for direct issuing status in lnterac, with the attendant need to

4 See the affidavit of Mr. Carmody (para 70).

- 9 ­clear and settle through the CPA. Nevertheless, it is my view that it could be a functional alternative for the intervenors, having regard, inter alia, to the fact that MasterCards are accepted at a much greater number of retailers than are lnterac debit cards.

19. Still another alternative to direct card issuance exists for non-Fis. These institutions can form subsidiary financial institutions which do meet the requirements of the DCO pertaining to card issuing. It is not in dispute that lnterac cards may be issued by such subsidiary Fis. By taking advantage of the removal of the lnterac ban on arrangements involving "sweep, pass through or zero balance accounts", a non-Fl will be able to allow its customers to use a card issued by its Fl subsidiary and indirectly access their funds held with the non-Fl.

20. The conclusion of the above discussion is that substitutes exist for direct card issuance by non-Fis. It is my opinion that any lessening of competition, measured in terms of lost economic surplus, which could ensue from the restriction against direct issuance by non-Fis is, at most, very small.

The fee structure of contracts between Fis and non Fis for indirect card issuance 21. Mr. Morrison's affidavit contains a schedule of hypothetical costs that might be associated with indirect card issuing arrangements. The U.S. experience with

- 10 ­competing suppliers of card issuing services to non-Fis suggests that Mr. Morrison's figures are exaggerated and that the forces of entry and competition will, over time, bring down the cost of indirect card issuance services. There is every reason to believe that indirect card issuance would provide adequate service to non-Fis at an efficient and competitive cost.

Transactions Costs and Efficient Institutional Arrangements in Card Issuance 22. Professor Quigley argues in his affidavit (paras 36-38) that indirect card issuance utilizing sweep, pass through or zero balance accounts will impose higher transactions costs on non-Fis and place them at a competitive disadvantage. The point is echoed in Mr. Morrison's affidavit (para 40).

23. Both experts suggest that additional, unnecessary costs will be generated by requiring the routing of messages from the acquirer, through the issuing Fl, to the entity which obtains indirect lnterac access for its customers. Such a position may well be applicable to a goods market (e.g. the shipping of grain) where shipping, loading and unloading entail significant economic costs. But the transmission of messages in an established electronic network involves virtually no additional costs, even when routed through a number of connected entities. If there were such costs, the fact that there are indirectly connected Fis that could connect directly, suggests that the costs are not significant.

- 11 -24. Both Professor Quigley and particularly Mr. Morrison emphasize the transactions costs of having the cardholder open and maintain two accounts, one at the non-Fl and one at the card issuing Fl. This point rests on assumptions about the characteristics of the accounts involved. Their description tends to maximize the costs and complexities of such accounts. It is not realistic to assume that sophisticated institutions would not develop the most efficient arrangements at the least cost. The evidence of Mr. Carmody indicates that this is the reality in U.S. arrangements of this sort.

25. In my opinion, the evidence of Professor Quigley and Mr. Morrison systematically overstates the transactions costs associated with indirect issuance. They exaggerate the transactions costs of sending electronic messages through additional entities, but neglect the essence of transactions cost analysis, which is to locate activities in those institutional arrangements best suited to provide them. Transactions cost analysis, properly applied, would suggest that reliance on specialist issuing institutions may well be less costly than having unspecialized non-Fis issue cards themselves.

Hold up problems and principal agent issues 26. Mr. Morrison (paras 69-70) and Professor Quigley (paras 45-49) argue that requiring non-Fis to enter into arrangements with Fis for indirect card issuance

- 12 ­introduces the potential for inefficiencies of the type which economists term "hold up" and "principal agent" problems. The argument is essentially that in an asymmetric bargaining relationship, inefficiencies may be introduced into the contractual outcome. For example, Professor Quigley postulates that economic inefficiency will result if an Fl can use superior information in negotiating with a non-Fl for an indirect issuance arrangement.

27. The simple answer is that if markets are competitive, almost all principal agent issues disappear. Continuing with Professor Ouigley's example, if there is a competitive supply of card issuance services by Fis to non-Fis, the type of inefficient contract he postulates would not be feasible. In my view, because the DCO will remove the barriers to entry, a competitive supply of such services to non-Fis is likely to emerge.

28. A different argument, propounded by Mr. Morrison (paras 69-71), is that even if there is competition among card issuing Fis, the non-Fl may be liable to exploitation because it is "locked in" by virtue of its investment in the cardholder agreements and its outstanding stock of cards. Economists would describe this as a "hold up" problem. Standard theory holds that the problem cannot arise if each party is able to enforce the contract between them, and therefore avoid exploitative renegotiation strategies by the other party. And in reality, if there is competitive supply of card issuance services to non-Fis, each party would

- 13 ­recognize this risk, and the non-Fl would be able to negotiate an agreement of sufficient duration, and on sufficiently competitive terms, to mitigate the risk of a "hold up". As we are dealing with substantial corporate entities, I regard the hold up hypothesis as implausible and Mr. Carmody' s evidence tends to corroborate this assessment.

IV COMPETITION IN ACQUIRING SERVICES 29. The terms of the DCO include two important changes which effect the acquiring business. First, full acquiring status is open to non issuing, non-Fis. Second, surcharging at terminals is permitted. The lntervenors' experts argue that entry by entities acting as acquirers-only is not economically viable, and that if it is, strategic conduct by the members of lnterac will prevent it.

30. The broad question at issue is whether sufficient economic incentives will exist, in the environment generated by the DCO, to induce entry by firms in the sole business of acquiring. In my opinion, scope for profitable entry will exist, on the following grounds.

Revenue issues

- 14 -31. Under the DCO, in SCD transactions, acquirer revenue accrues from interchange fees (75 cents) plus any surcharges. Mr. Morrison claims that at the average volume of ABM transactions per month, revenue is insufficient to allow profitable new entry. In fact, the important point to note is that an acquirer will not deploy terminals at locations likely to yield only "average revenues" but will seek locations with above average revenue opportunities. At locations where demand is high, but volume low, an acquirer would be able to sustain a positive level of surcharging in long run equilibrium. In the United States, where surcharging has recently been permitted in many States, the result has been an increase in the profitability of the acquiring business, and a more efficient allocation of ABMs. 5 32. In IDP transactions, surcharging by an acquirer is also allowed under the DCO, and may be expected to occur in some locations. Acquirer revenue in IDP is enhanced by a merchant fee, paid from the merchant to the acquirer: my understanding is that values range currently between 0 - 17 cents per transaction. While it is difficult without more information to know the absolute viability of per terminal entry by new acquirers, it is clear that retailers, as well as other entities, have at least some incentive to become acquirers either directly, through a

5 "This (surcharging) means the acquiring part of the EFT business can be a very good and profitable business to be in" according to the president of the Pulse network, quoted in Bank Network News, Vol. 14, No. 8, September 13, 1995. The same article cites a level of ABM transactions similar to that used by Mr. Morrison as being profitable with surcharges. The affidavit of Scott Engle, para 28 (a) also provides supporting evidence.

- 15 ­consortium or through a third party. In my opinion, they will do so, when it is to their economic and competitive advantage.

Cost Issues: Economies of Scale and Scope 33. Both Professor Quigley (para 59} and Mr. Morrison (implicitly in para 106} argue that economies of scope between the businesses of acquiring and issuing will render entry by specialized acquirers uneconomic. Economies of scope occur where a firm can produce two different products more cheaply than could two specialized firms producing the same products.