Payment instruments are not ordinary products. Hence, the market for payment instruments is not an ordinary market. For one thing, the demand for payment instruments is a derived demand: consumers don’t want to buy payment instruments, they want to buy other goods and services and are required to use payment instruments to do so. One of the most obvious implications stemming from this observation is that there is a low price elasticity: the consumer demand for goods and services does not depend greatly on the cost of the payment instruments. Another observation is that (I’ve no idea if this is a real economic concept or not) there is a low “satisfaction elasticity”: if the payment service does a great job, the consumer barely notices. A final observation is that there are very high network externalities, well-recognized by all players in the payment space, because of the nature of the consumer and merchant acceptance (ie, the good old chicken and egg issue). Meanwhile on the supply side, the barriers to entry are significant. It is simply not the case that anyone can start offering new payment instruments, as distinct from payments processing services. Regulators take both consumer protection and financial stability quite seriously. This is not to say that regulators do not recognize that it might be an overall benefit to have more competition in the payment space. In Europe this recognition translated first into the Electronic Money Directive (EMD) and then the Payments Services Directive (PSD) as part of the SEPA drive.
With this background, lets think about the competition between cash and electronic payment instruments. Leo’s point is that there is an odd competition between private and public players on the supply side. Both commercial banks and the central banks are active in the market: the banks issue payment cards, the central banks issue cash. We all understand the basic dynamics for the commercial banks on the supply side. In Europe banks lose a great deal of money on cash and cheque handling, roughly break even on debit cards (a McKinsey study in the Netherlands found that Dutch banks lose 8 Euro cents per transaction) and make money on credit card transactions. Overall there is a heavy cross-subsidisation of cash. Setting to one side the issue of whether some form of electronic payment system might be a public good and should actually be provided by the central banks (one might, for example, envisage the European Central Bank issuing a European debit card that worked the same way as the Capital One non-account linked debit card), Leo focuses on the apparent tension between a central bank’s duty to ensure efficient payments systems and its operational activities in providing the least efficient payment system of all.
We’ve agreed that the market for payment instruments is very different from other markets. So different, in fact, that “market” is probably an inappropriate description. This issue is a basic structural problem: central banks are charged with improving the efficiency of the payment system while being responsible for the most inefficient mechanism. Inefficient here means, just to be clear, “has highest social cost”. Note that the social cost of a payment instrument is the total of the resources that society as a whole consumes in using the service (the sum of the private costs to all stakeholders less transfer payments). The social costs of payments systems have only recently been studied to any degree of accuracy by, for example, the Dutch and Belgian central banks (who found the social cost to be .65% and .74% of GDP respectively). In both of these countries, cash accounts for three quarters of the total social cost. In other words, each family in the Netherlands pays about 300 Euros per annum to use cash. Cash is not free.
In attempting to lower these social costs, the e-purse was (more than a decade ago) seen as being a reasonable way forward. There is some justification to this argument on economic grounds because e-purse transactions (taken by me to mean offline, pre-authorised or pre-paid transactions) have a very low marginal cost. The figures that Leo brings to bear show the marginal social cost of an e-purse payment in the Netherlands is only 3 Euro cents, whereas the marginal social cost of a cash payment is 11 Euro cents. The low marginal costs of e-purse transactions mean that society as a whole would clearly be better off by substituting cash payments with e-purse payments. Yet as we all know, this argument founders on the high cost of introducing a new e- purse scheme, primarily on the acquiring side. As has been discussed before, for electronic payments to make a real dent in cash payments they need to have at least an order of magnitude more acceptance points and this investment is very difficult to reconcile with the private interests of banks or merchants in the short term. While it’s not the subject of this discussion, this is of course one of the reasons why the mobile phone is such a significant device in the evolution of retail payments. It is not because the phone can be used on the issuing side to deliver new payment instruments (or mobile versions of existing payment instruments) but because it can be used on the acquiring side to accept electronic payments.
But back to the tension. Central banks derive their revenue from the seigniorage on notes and coins. Hence a reduction in the notes and coins means a reduction in central bank income. If you take a look at the UK, where the note issuing department of the Bank of England is undoubtedly the most profitable nationalised industry in history, under legislation going back to 1844 the entire profit of the note issue is given over to the Treasury (cash is indeed a “stealth tax“). Interestingly, in the eurozone things are be a little different. The European Central Bank (ECB) keeps 8% of the seigniorage loot for itself and divides the rest up between eurozone members according to (of course) a complicated Euro-formula which, incidentally, is unrelated to usage and instead based on total population and GDP.
Leo sets out these basic facts and figures with admirable clarity before moving on to discuss the specific policy issues that are on the horizon. The core of the argument around cash is that all of us end up footing the bill, even those of us who choose more efficient payment mechanisms. Hence in economic terms, a shift to cost-based pricing is desirable. This does not mean pricing at cost. What it does mean is that policy makers should recognise that price is an important element of communication. If consumers see the relative costs, they can make more efficient choices. The problem in the case of cash is obvious: any attempt to price it properly results in public uproar and political interference. This happened in Belgium a couple of years when one of the banks decided to start charging 6 Euro cents for some cash withdrawals whereupon there was immediate public outcry and the Minister for Consumer Affairs threatened to bring in legislation to regulate the pricing of cash withdrawals. To my mind this demonstrates clearly how politicians do not know how to serve consumer interests properly, but that’s just my opinion. Studies in other European markets show that unlike other retail point of sale payments, the price elasticity associated with cash withdrawals is quite high, so cost-based pricing of ATM withdrawals would significantly reduce cash payments and boost debit card use. One of the surveys referenced suggests that in Europe as a whole the market share of cash would fall from 96% to 81% under such a pricing structure and debit cards would jump from 4% to 19% of retail payments by volume.
Now, actually, some central banks have already made it clear that they would be happy to see seignorage income fall in return for a more efficient payment system which is better for the economy as a whole. The Norwegian Central Bank, to pick one example, has consistently promoted the principle that the party that chooses the payment service should pay for it in a cost-based structure with the natural result that cash and cheque usage suffers. The ECB itself has pointed in the same direction. Gertrude Tumpel-Gugerell, the member of the Executive Board of the ECB responsible for payments systems and market infrastructure (Ms. SEPA), has said
I would expect banks to apply pricing methods that better reflect the efficiency of the respective instrument. Consumers may choose inefficient payment instruments, but they should pay the true price of the instruments and bank should not subsidise inefficient payment instruments by making efficient instruments more expensive.
The dynamics of a potential transition away from cash will undoubtedly shape the roadmap. The average cost of a cash transaction increases substantially as the number of transactions drops so in a country that has high non-cash usage, the cost of cash escalates. The most cashless country in Europe is Iceland and the average social cost of a cash transaction in Iceland is 3.1 Euros, more than five times more than the average social cost of a cash transaction in Belgium. Therefore, as the usage of cash falls, the cost of cash will increase, hastening its demise.
The recommendations from this fascinating review of the situation in Europe are straightforward. Policy makers should foster cost-based pricing and create a legal environment that makes it possible for banks to use it. Meanwhile, of course, any government that introduced charges on cash would be committing electoral suicide and the impossibility of explaining economic concepts such as social cost and net welfare to the general public are insurmountable. Where next?
These opinions are my own (I think) and presented solely in my capacity as an interested member of the general public [posted with ecto]