Horizontal Issues Relating to Networks in the Credit and Charge Card Industry
Remarks of
Christine A. Edwards
Executive Vice President, Secretary and General Counsel
DEAN WITTER, DISCOVER & CO.
Presented at the Federal Trade Commission's Hearings on
the Changing Nature of Competition in a
Global and Innovation-Driven Age
December 1, 1995
Washington, D.C.
1. Introduction
In my testimony today, I will address horizontal issues that are presented by the networks that operate in the credit and charge card industry (which for simplicity I will refer to as the charge card industry). Networks play a vital role in this industry, and in its formative years two nearly industry- wide joint ventures, operated by the Visa and MasterCard associations, were organized to build charge card networks. Those joint ventures, both of which include nearly every issuer of general purpose charge cards, have achieved a position of dominance and collective market power. The policy issues that I will pose this morning arise from the fact that changes in marketing and processing technology have created for the first time the opportunity for non-association, proprietary networks to provide the same kinds of services as the two associations, and to do so equally — if not more — efficiently. But at a time when there is a real question whether there is a need any longer for the associations, the associations are aggressively using exclusionary practices to impede competition from proprietary networks, and they are working to extend those advantages into new financial products and services, such as the electronic delivery of home banking services. These developments raise important policy issues, which can be summarized as follows:
How should antitrust enforcement respond when the two entrenched industry-wide charge card networks utilize their market power to impede the entry and growth of efficient, competing proprietary networks?
These policy issues should be of concern to you as antitrust enforcers because how they are resolved will determine the structure and competitiveness not only of the charge card industry but, as the bankcard associations utilize their market power to impede competitors in other emerging payment systems markets, other areas of electronic commerce as well. More broadly, similar issues will undoubtedly come up with increasing frequency in other industries, so the policy decisions that you make regarding these issues, whether affirmatively or by inaction, will have a significant impact elsewhere in the economy as well. For these reasons, I hope that you will consider these issues very seriously.
2. The Role of Networks in the Charge Card Industry
To explain the problem that our company faces, I would like to begin by briefly explaining the nature and role of networks in the charge card industry. Because charge cards are held by consumers across the country, and are used at millions of dispersed merchant locations, networks are required. A charge card network establishes and maintains contractual and processing arrangements that assure that merchants will accept the charge cards that are supported by the network, that merchants will be able to obtain authorization for transactions, that transaction settlement will occur periodically between merchants and card issuers, and that information about transactions will be provided to card issuers so that they can bill their cardholders. The charge cards that are supported by a network are typically identified by a shared logo, or “bug,” on the face of the cards.
a. The bankcard association networks. Although charge card networks can have a variety of structures, in the United States today there are two models. One is represented by the networks that are operated by the Visa and MasterCard bankcard associations. (Exhibit 1A.) The two bankcard associations were formed about 25 years ago. They are both extremely broad joint ventures, with virtually identical memberships that include almost every issuer of general-purpose charge cards in the United States. The Visa and MasterCard networks connect, directly or through intermediate processors, all of the associations' members who issue cards, with all of the merchants that they or other association members have signed up to accept those cards. (In my testimony this morning I will use the term “bankcard” to refer to the charge cards that are supported by the two association networks.) As Visa's spokesman explained earlier in these hearings, the associations are discouraged by their members from competing against one another for the benefit of consumers. Since almost all card issuers belong to both associations, their members gain no competitive advantage against other charge card issuers if either association engages in activity that makes its brand more desirable to consumers than the other's; moreover, innovations that result in differences in the operational requirements of the two associations can cause substantial additional expenses for their members. As a result, the associations engage in little meaningful competition with one another from which consumers benefit. One tangible reflection of this is the fact that banks that offer bankcard processing to merchants universally provide both Visa and MasterCard processing, and almost all, if not all of them, charge the same price for handling both cards. This phenomenon would undoubtedly raise eyebrows if it occurred with respect to the pricing of supposedly competing products with a combined share of more than 75% of any other market.
b. Proprietary networks. The other network model is the proprietary network. (Exhibit 1B.) This is a network that is operated by a single private firm, which enters into arrangements with merchants to accept the cards that the network supports and provides the link — again, directly or through intermediaries — between merchants and participating card issuers. There are currently three proprietary networks in the United States, and they are operated by my company, by American Express, and by the largest issuer of bankcards in the United States, Citicorp.
Unlike the bankcard associations, there is substantial incentive for a proprietary network to compete vigorously against other proprietary networks and against the association networks. This is true even in the case of a proprietary network operator who also belongs to one or both of the associations; even in that case, the ownership of the association networks and the proprietary network is very dissimilar, and competitive gains by one do not significantly inure to the benefit of the other. Thus, proprietary networks offer the potential for much more vigorous competition against the association networks than the association networks do against each other.
c. The NOVUS Network. The evolution of Dean Witter's network, which today we call the “NOVUS Network,” illustrates the operation of a proprietary network. In 1985, Sears, Roebuck, which at the time was Dean Witter's parent, decided to enter the general-purpose charge card market. The strategy that it chose to pursue was modeled on Citicorp's, which at the time participated not only in both the Visa and MasterCard networks, but also operated several proprietary networks of its own, including Diners Club and Carte Blanche. Our company decided that it would enter the charge card market by first launching a proprietary charge card, which we did by rolling out the Discover Card at the end of 1985. We faced enormous barriers to the entry of our new network, and many industry observers predicted confidently that we could not succeed. Among other obstacles, Discover Card had to deal with a classic chicken-and-egg problem: We sent eager, young salespeople out with the assignment of persuading hundreds of thousands of merchants to sign up to accept a credit card that not one consumer yet carried; and at the very same time we had to persuade millions of consumers to carry a credit card that merchants were just beginning to sign up to accept. It was a high-risk strategy, and it is very likely that without the substantial business credibility that Sears and Dean Witter had won over the years, merchants and consumers might both have rejected the new card.
As you know, we were in fact successful, and in the nearly ten years since its launch the Discover Card has come to be accepted by a large number of consumers and merchants. (An independent survey that was reported last month showed Discover Card tied for second place, out of 21 card competitors, with respect to overall cardholder satisfaction.) But while it is not my intention this morning to dwell on the past, it is important that you be aware that to achieve our success we had to overcome not only the fair competitive responses of those who were already in the market, but also a variety of efforts by the bankcard associations to prevent Discover Card from having a chance to compete in the market at all. These included, for example, what can fairly be called an elaborate “disinformation” campaign orchestrated by the Visa association, to try to persuade merchants to reject the Discover Card based on the false claim that Sears was going to use the Discover Card to spirit away the merchants' customers; and an association-led program to prevent our card from being processed over the authorization terminals that merchants used for bankcard transactions. While these actions slowed our progress, we nonetheless succeeded in making the Discover Card a viable competitor in the charge card market; and after an enormous investment and years of hard work, Discover Card eventually became profitable.
Then, about three years ago — after a trial court antitrust decision that gave us comfort that the law would afford us practical protection against the associations' collective interference in our competitive efforts — we embarked on a major project to enhance our proprietary network. We invested tens of millions of dollars in converting the network that we had built for the Discover Card into one that could be used not only for that card, but for other cards as well. The result was the NOVUS Network. If you look at a Discover Card today, you will see a little green NOVUS “bug” in the corner; you will see the same logo on the doors of merchants that accept the Discover Card. Now, any merchant who accepts the Discover Card is part of the NOVUS Network and will also accept any other charge cards with the NOVUS “bug.” In addition to Discover Card, Dean Witter now offers two cards on the network, called the “Private Issue” and “Bravo” cards, and other cards are in the works; and the system that we are building has the capability to support NOVUS-marked cards issued by other firms, as well.
3. The Competitive Future of the Charge Card Industry
a. The industry is at a crossroads. The antitrust policy issues presented by the bankcard networks are very timely right now, because we are at the beginning of a period of great change in the payment systems industry — change triggered primarily by significant technological advances, which are creating new players, new products and services, and new industry alignments. As a result of these changes, the role and dominance of the bankcard networks hang in the balance today, and there are two basic paths that the industry can take. To a large degree, which of them the industry will follow will depend on the extent to which antitrust policy responds to these changes.
The first path, which is the one that the bankcard associations clearly prefer, is one down which the associations continue their dominance in existing payment systems products, while at the same time they extend their economic power into new realms, including in particular the electronic delivery of banking services to the home.
The second path is markedly different. This is a path down which the collective power of the associations in the charge card market will be challenged by more aggressive and nimble proprietary networks, and in which we and others will compete vigorously and innovatively in emerging markets for new payment system services. From a competitive standpoint, it seems quite clear to me that this is a much more attractive path. But to go down that path, there must be a commitment on the part of antitrust enforcers to police vigorously bankcard association efforts to thwart the entry or growth of proprietary competitors.
b. The opportunity for invigorated competition. Advances in marketing and electronic technology since the bankcard networks were originally formed have fundamentally changed the role of the bankcard networks. As Visa testified, back in the 1970's the charge card industry was a dramatically different one that it is today. Banks had small, local franchises and did not do business outside their local markets; telemarketing and direct mail marketing were in their infancy; transactions were authorized by voice phone calls; the paper slips from charge card transactions were physically sorted and delivered to the card-issuing bank. Under those circumstances, there was probably no practical way for geographically fragmented financial institutions to offer national charge card services other than by pooling their resources and creating central clearinghouses to carry out this highly complex interchange of information and documents. The contrasts with today's charge card industry are striking. Today charge card issuers are able, though sophisticated advertising, direct mail marketing and inbound and outbound telemarketing, to reach customers all over the country. Authorization and transaction information is sent electronically with a swipe of the magnetic strip on the back of a card. The entire country is being wired together with increasingly efficient electronic connections. And firms with enormous resources, including General Motors and AT&T, have entered the charge card business, either directly or in joint ventures with existing issuers.
If the charge card industry were first coming into existence today, it is far from clear that there would be any need for networks operated by industry-wide joint ventures like Visa and MasterCard. A series of interlinked independent processors could probably perform the same services equally, if not more, efficiently, with issues such as common brand identity and marketing dealt with by jointly or individually owned entities with far more limited roles than the existing associations. One has only to think about the Internet to appreciate how an electronic network composed of independent computer locations, with no central clearinghouse, can be linked together with remarkable efficiency and pose a formidable competitive challenge to established network service providers. We are confident that if allowed to expand and achieve its full potential, a proprietary network like ours can be at least as efficient as the bankcard associations'.
c. The growing market shares of the bankcard networks. Despite this potential for reinvigorated competition and for a reduction in the role of the massive bankcard joint ventures, current developments in the charge card industry are in exactly the opposite direction. Market share data show that the proprietary networks are steadily losing ground to the bankcard networks, which already have an overwhelming majority of the market. In fact, based on the usual industry measure of transaction volume, in just the last three years the combined market share of the two bankcard networks has risen from 72% to almost 76%. (Exhibit 2.) And far from paring back their role as the need for their involvement has declined, the bankcard associations are working hard to extend their dominance in charge cards to new areas, such as debit cards, stored value cards, and the new and potentially huge market for electronic delivery of retail banking services to the home.
If these trends were simply the result of the free and unrestrained operation of the marketplace, I would not be testifying here this morning. But they are not. As I will illustrate shortly with a number of examples, the bankcard associations have repeatedly used their collective market power to disadvantage proprietary networks, for no reason other than to fend off challenges to the associations' power from new competition.
d. The restraining hand of the bankcard associations. The bankcard networks' objective is not a matter of speculation. A few years ago we obtained a videotape of one of the meetings that Visa held with its members in connection with the anti-Discover campaign that I referred to earlier. Behind closed doors, Visa's Vice President of Marketing, Fran Schall, was quite candid in summarizing Visa's goal with respect to proprietary networks like ours:
“[B]y working together, and by being pro-active rather than reactive, I think we can thwart the efforts not only of Sears but of other outside competitors. . . . If we are successful in responding to Sears, then other non-bank competitors who are likely sitting on the sidelines will likely think again when they try to follow Sears' lead. If we are not successful, then there are going to be many more Discovers that we are going to be hearing about in coming years.”
In her closed-door remarks Ms. Shall was referring specifically to Visa's early efforts to kill Discover Card by denying it access to merchants and their terminals, but the goal that she declared continues to guide the bankcard associations to this day. The bankcard associations have not succeeded in killing the Discover Card, of course, but they have benefited greatly from the fact that they have prevented Discover Card and the fledgling NOVUS Network from acting as a significant restraint on their market power. For example, by limiting the growth of our network and preventing us from becoming more significant competitors, the bankcard networks have protected their economic power to set interchange rates and thereby control the discounts that merchants pay for bankcard acceptance.
Because the associations recognize that proprietary alternatives like the NOVUS Network are a potential threat to their dominance, they have taken a variety of collective actions to impede the growth and development of the networks that already exist, and to deter the entry of additional networks that might otherwise form.
There can be no doubt that the bankcard associations have the power to carry out these objectives. They enjoy an enormous incumbency advantage. With some 6,000 members — the overwhelming bulk of the banking industry — pushing the association brands for years, the bankcard associations have achieved levels of acceptance among consumers and merchants that give them great market power. Dean Witter is very proud of the number of consumers who carry the Discover Card. But we know that because of the practically universal penetration of the bankcard brands among merchants, almost no Discover Cardholder does not also carry a Visa or MasterCard card. Discover Card may be the card that a consumer likes to use, but Visa or MasterCard is the card that she must carry. Likewise, although many merchants accept proprietary cards as well as Visa and MasterCard, if forced to choose almost every merchant would elect to continue accepting the bankcard brands — because they are carried by virtually every cardholder. This incumbency advantage gives the associations enormous power, and they have utilized that power in anticompetitive ways to ensure that competing proprietary networks cannot flourish. I will give a few examples.
i. Visa bylaw 2.10(e). Visa has adopted punitive rules to deter firms from issuing charge cards on proprietary networks. Today, Visa has a bylaw, 2.10(e), that automatically terminates the membership of any Visa issuer that begins to issue a card “deemed to be competitive” with Visa cards. Presumably MasterCard would follow the same approach in practice. There is no doubt that this rule is directly targeted at proprietary networks: Although cards supported by Dean Witter's proprietary network and by American Express's network are subject to the rule, Visa does not classify MasterCard cards as competitive with Visa cards and has not applied the rule to them. (The Diners Club and Carte Blanche proprietary cards issued by Visa's largest member, Citicorp, have also not been classified as competitive.)
The effect of this bylaw is clear. There is abundant evidence that issuing multiple brands of cards, including both association and proprietary cards, can be a particularly efficient strategy. Under the Visa bylaw, however, every card-issuing firm is required to make a choice. It can either issue a Visa card or it can issue a card on the NOVUS Network or any other proprietary network, but it cannot do both. The result is that proprietary networks have virtually no chance of attracting significant new issuers, and the growth of proprietary networks — and their potential to achieve maximum efficiencies — are severely impeded.
This impact was very deliberate. When Visa's board adopted the first version of this rule, the board asked Visa management to draw up a list of all the nonbank firms that had the capacity to introduce a competing network. The resulting list named more than 100 nonbank firms (including General Motors, Ford, Chrysler, Shell Oil, Amoco and AT&T). Visa's board then instructed Visa's management to monitor all of those firms, many of which were then Visa members, and to expel or exclude them from Visa if they actually began issuing proprietary cards. Many of those firms that were not then issuing cards have since entered the market — and not surprisingly in light of Visa's bylaw, not a single one of them has come in with a proprietary card program.
Incidentally, in light of bylaw 2.10(e), I was particularly struck when Visa's spokesman lamented the fact that the National Cooperative Research and Production Act is not available to a pre-existing joint venture like Visa. As I understand the NCRPA, any joint venture that restricts its parties from participating in activities outside the venture is specifically ineligible under the Act. So bylaw 2.10(e), as well as other Visa conduct, would disqualify Visa from the Act's protection even if it were being formed today.
ii. Restrictions on merchant processing. Another example relates to merchant processing. One of the important ways that Dean Witter has been able to build a merchant base for the NOVUS Network, particularly among smaller merchants, is by offering them cost-effective processing of their card transactions, which Dean Witter believes that it can do at least as efficiently as anyone in the industry. However, every merchant wants a processor who can handle not just Discover Card transactions, but also the much higher volume of Visa and MasterCard transactions. Recognizing this, Visa has adopted rules to prevent Dean Witter from efficiently offering bankcard transaction processing, and has saddled Dean Witter with constraints and costs that only apply to operators of proprietary networks. There is no apparent efficiency justification for these rules, but their effect is to make Dean Witter less efficient in providing transaction services to merchants, and thus less effective in recruiting merchants to join the NOVUS Network. Again, the result is that the growth of the proprietary network is impeded.
iii. Exclusionary standard setting. In its testimony, Visa provided another example of the bankcard association activities that concern us. Proprietary networks were not invited to participate in Visa's project with Microsoft to develop security standards for electronic commerce over the Internet. In light of the associations' overwhelming market dominance, the standards that they promulgate drive the market, and we must be in a position to comply with them; consequently, we view participation in discussions of this type as critically important to our ability to survive as a viable market competitor. Given our track record with the associations, you will understand why we are more than a little skeptical that Visa's intentions in developing these standards — and excluding proprietary network operators from the effort — are as benign as Visa portrayed them.
iv. The changing role of the associations. There is one additional emerging trend in the industry that causes us great concern — a fundamental change in the character of the bankcard associations, particularly Visa. Although this is too recent a development for us to know its full implications, it clearly has the potential to give the bankcard associations even greater power to entrench themselves and to limit our competitive opportunities.
The associations have traditionally characterized their role as that of a service provider to their members. They constantly emphasize that they do not directly compete in the charge card market; rather, they provide “back room” services which their members in turn use to provide charge card services to consumers and to merchants. Visa's spokesman repeated precisely this point in his testimony. This element of the associations' self-characterization is an important one, because they use it to justify the fact that they make rules and regulations, and establish technical standards, that govern many important aspects of how competition in this industry takes place.
However, recent developments show that the historic role of the associations is undergoing fundamental change. In August, Visa announced that it was entering a for-profit merchant processing joint venture with Total System Services Inc., to be called “Vital Processing Services.” According to published reports, this new venture, which will be operational by the end of the year, will sign up retail merchants for transaction processing services. This is a very significant turn of events. It means that Visa is changing from an organization that merely facilitates its members' ability to offer products into one that also directly competes in the marketplace, at the same level as those who do business with its network — in particular, all of the private firms, many of them owned by Visa member firms, that process charge card transactions.
I am sure that we will be hearing about more such developments in the near future. Press reports indicate that Visa and MasterCard have been exploring ventures in such far-flung fields from their traditional areas of operation as stored-value cards, bill payment, home banking, and — most recently — entertainment services on the Internet. These areas are entirely appropriate ones for individual firms to explore, including, when appropriate, in joint ventures with other firms. Is it desirable, however, for all-encompassing joint ventures like the bankcard associations — whatever the justification for their formation at the dawn of the charge card industry — to be entering these new areas? As a company that has seen the bankcard associations use their market power in the charge card market to impede our ability to compete, we are very troubled by the prospect of the associations' power, and of their ability to stifle competition, extended into new areas of financial services.
4. The Antitrust Policy Implications
a. Antitrust enforcement is needed to ensure that competition in this industry is not stifled. To summarize, the charge card industry today is an industry dominated by the networks operated by the two bankcard associations, which are huge, industry-wide joint ventures with virtually identical memberships. The association networks engage in little meaningful competition with one another for the benefit of consumers. However, recent changes in technology have made it possible for proprietary networks, whose economic incentives to compete with the bankcard associations are much stronger, to be far more efficient competitors than in the past, and companies like ours are prepared to make substantial investments in order to take on the association networks in the marketplace. The associations recognize this, and have chosen to employ their market power to prevent proprietary networks from achieving their full efficiency and undermining the dominance of the association networks. In fact, the associations are working busily to extend their power in new areas, where no one has ever shown an efficiency-based need for the involvement of these massive joint ventures.
In light of these facts, what should the response of antitrust enforcement be?
I believe that the goal of antitrust enforcement should be to serve consumers by fostering increased efficiency and innovation through unfettered competition. In this industry, that type of competition will occur only if antitrust enforcement actively polices the bankcard associations. This is not what the bankcard associations want, of course. As illustrated by Visa's testimony in October, it prefers a hands-off enforcement policy, under which the collective activities of the bankcard associations enjoy a heavy, if not conclusive presumption, of legality; they base this claim for favored treatment on their past role in creating the charge card market as we know it.
I do not think that the associations are entitled to the special treatment that they request. On the contrary, I believe that it is essential that antitrust enforcement monitor these massive joint ventures to ensure that the scope of their activities is limited to those that are really necessary to efficiency and that serve consumer welfare. Antitrust enforcement must address practices of the associations, like those that I have described this morning, whose primary purpose is to disadvantage proprietary networks. Equally important, antitrust policy should view skeptically and with concern the associations' expansion into new areas of activity.
The bankcard associations are antitrust anomalies. They are extraordinarily large joint ventures of competitors, cutting across virtually an entire industry. Antitrust policy has always strongly disfavored collective competitor activity of this magnitude, unless it is justified by compelling efficiencies.
There may have once been legitimate efficiency justifications for the scale and scope of the bankcard associations, although it is highly doubtful that the same case could be made today. But regardless of the circumstances of the charge card industry in its infancy, any new expansion of the activities of these joint ventures should receive exactly the same searching scrutiny as would the formation of a new joint venture to engage in those activities. When Visa's spokesman casually tells you that Visa is embarking on a list of activities in new payment systems markets — including activities in coordination with such competitively problematic companies in their own industry as Microsoft — alarms should go off here and at the Department of Justice.
In fact, I submit that it would be a prudent antitrust policy for the enforcement agencies to actively discourage the Visa and MasterCard associations from engaging in any new activities. If there are efficiencies that necessitate joint activity in order for a debit card market to develop, or for home banking to take off, or for health care claim processing to succeed, let appropriately scaled new joint ventures be formed. But do not allow the massive bankcard association joint ventures to quietly take the market power that they have achieved in the charge card industry and parlay it into similar power in entirely new areas, simply because in the past there was once a need for the associations. Thanks largely to the associations, only one significant proprietary network has entered the charge card market in the past 35 years. You should not permit them to use their power to deter new, innovative entrants from other markets, as well.
For similar reasons, I think that it is essential that the bankcard associations be prohibited from engaging directly in for-profit activity. Their central rule-making and standard-setting role, coupled with their market power, creates far too much risk of the associations' leveraging their not- for-profit activities into unfair competitive advantage in their related for-profit business activities.
b. The urgency of addressing these policy questions. The approach that antitrust enforcement takes to the bankcard associations and their networks will have a critical impact on the industry's competitive landscape. The executives whom I advise will make decisions about where they take the NOVUS Network based on their assessment of the legal ground rules under which they and, more importantly, the bankcard networks will be operating. The chances for business success will swing dramatically depending on whether or not the bankcard networks will be subjected to reasonably close antitrust scrutiny when they try to limit our growth and extend their current dominance. The same will be true for anyone else who considers a business challenge to the bankcard networks. As a consequence, this is an industry in which antitrust policy will influence real investment decisions, decisions that will determine the intensity of innovation competition and the future competitive structure of the United States charge card market.
The structure of the charge card market today is clearly far from optimal. I believe that the industry developments that I have described this morning have the potential to reshape it dramatically for the benefit of consumers. Antitrust enforcement should not prejudge the market outcome of the competitive confrontation of new and old market participants, but it should vigorously guard against collective efforts by powerful incumbents that prevent new entrants from proving their efficiency. What we ask is the opportunity to compete in this market unfettered by such constraints. Whether we will be able to is, in very real sense, in your hands.
Let me close by relating what I have said this morning to the specific questions that you posed in the agenda for this morning's session. Networks, particularly ones operated by joint ventures that encompass virtually an entire industry, as the bankcard associations do, very definitely can give rise to opportunities for strategic anticompetitive conduct. In particular, as I have discussed this morning, jointly owned networks can amass substantial market power and can use it to prevent the entry and growth of new competitors who want to offer more efficient network services by taking advantage of technological innovation. As for the criterion for assessing whether strategic conduct, and industry standard-setting, are procompetitive or anticompetitive, I believe that it continues to be the traditional, fact-specific one: Does the conduct in question increase the efficiency of the parties that engage in it, or is its primary purpose and effect to reduce the intensity of competition among themselves and from others? The bankcard association conduct that I have described this morning clearly fails this test. That is why it urgently deserves your attention.
Thank you for the opportunity to testify before you this morning.