Subcommittee on Financial Institutions

Hearing on Competition and Innovation in the Credit Card Industry
at the Consumer and Network Level

10:00 a.m., Thursday, May 25, 2000 - Dirksen 538

Prepared Testimony of Mr. Phillip Purcell
Chairman & CEO
Morgan Stanley Dean Witter

Mr. Chairman, Chairman Gramm and Members of the Subcommittee. My name is Phil Purcell and I'm Chairman and Chief Executive Officer of Morgan Stanley Dean Witter & Co. Morgan Stanley Dean Witter is a global financial services company serving both consumers and businesses. Our three core businesses are securities/investment banking, asset management and credit services. Our primary credit services business is Discover Financial Services, which issues the Discover credit card.

Let me say at the outset that I have great respect for this institution, for this Subcommittee, and for its Chairman, Senator Bennett. I felt it was important, therefore, that I appear personally in this proceeding. I am sure that the other networks have this same respectful attitude, and I look forward to hearing comments from Mr. Golub of American Express and from the chief executives of the two dominant networks, Visa and MasterCard.

I am going to be talking this morning about a number of very troublesome rules and practices in this industry that are harmful to cardholders, merchants and competition generally. These anticompetitive rules and practices have been enacted by Visa and are enforced against other smaller networks. In virtually every case, Visa and MasterCard have enacted these rules and practices in tandem - with Visa leading the way and MasterCard soon following. In effect, therefore, the two dominant associations, which together control over 80% of the network market and which have virtually identical memberships, have often acted as one. To keep things simple today, when I talk about all of these anticompetitive and anti-consumer actions undertaken by the associations, I am going to refer only to the ringleader, Visa.

I wish there were more time available today to hear from other consumer groups, retail merchants, state and local government officials and others who, like us, have been harmed by Visa's anticompetitive practices over the years. I'm concerned that the hearing not appear to be merely a fight among networks since healthy competition in the credit card markets is a critical issue for consumers and merchants as well. What is ultimately at stake is competitive pricing, innovation and consumer choice.

I am confident that Frank Torres will, very ably, discuss the impact of network competition on consumers. I'd like to take just a moment to speak about our other network partners - the retail merchants who are often left out of the discussion. Strong competition in the network business is vital for America's retail merchants. Since our inception in 1985, Discover has been the low-cost competitor in terms of merchant fees. Over the past couple of years, the associations have implemented several significant rate increases for merchants. In addition, merchants who deal with these two associations face an array of confusing price structures and penalty fees, including a penalty that the merchant has to pay whenever the magnetic strip on the card isn't readable. That's like saying to a customer, "You're going to have to pay us more if the product we've sold you doesn't work." Sadly, with the two associations together representing over 80% market share of U.S. card volume, most merchants find it virtually impossible to stop accepting these brands. The fact is that merchants have very few options today. Public policy that encourages new entry -- or, put differently, that discourages the two dominant associations from creating barriers to new entry -- is a critical way to ensure new network competition and choice for consumers and merchants.

By way of background, there are several distinct types of competition in the card industry - involving network services, issuing and acquiring. Competition at the network level is very concentrated, with only four principal competitors - Visa, MasterCard, Discover and American Express. Visa and MasterCard are structured as membership associations and are, by far, the dominant competitors, accounting for 80% of the network market. While Visa purports to open its network to any bank in the United States, we know from our own history that it is quick to make an exception whenever someone attempts to compete aggressively against it. Discover and American Express, by contrast, are privately owned by MSDW and American Express. Because of Visa's anticompetitive rules that I will discuss this morning, both Discover and American Express have been barred from pursuing the procompetitive strategy of growing their networks by having Visa member banks issue cards on those networks. Today, Discover accounts for only about 5% of the network market, while American Express accounts for only about 15%.

While the issuing and acquiring businesses are far less concentrated than the network business, Visa's anticompetitive rules have harmed competition at those levels as well. Competition at the issuing level occurs among the thousands of banks who issue cards on the various networks. Because of Visa's rules, however, banks are forced to issue cards either on the association networks or on the proprietary networks - even though many banks would prefer to do both. Competition at the acquiring level occurs among firms that acquire transactions from merchants. As I will describe, Visa's rules have hampered competition at that level as well by imposing artificial restraints on certain acquirers, including Discover, that have no purpose other than to protect the selfish interests of the association.

Discover is the only new credit card network to enter the market in over a generation. When we started the business in 1985, we had a very ambitious and very pro-consumer strategy. It called for building a large-scale card issuing business featuring multiple brands of low-priced and innovative card products, including Discover, Visa and MasterCard. It also called for the creation of a highly efficient, state-of-the art credit card network on which Discover (and eventually other firms' proprietary cards) could be issued. In keeping with our aggressive pricing philosophy, we always intended our network to be the low-price leader, charging less for each transaction than Visa, MasterCard or American Express, and thereby making it extremely attractive to merchants. Today, for example, Discover charges merchants about 30% less than Visa and MasterCard - with a typical merchant discount fee of only about 1.6%, compared to Visa/MasterCard's typical fee of about 2.1%.

When we embarked on our strategy, there were no restrictive Visa rules that stood in our way. To the contrary, the largest Visa/MasterCard issuer in the country, Citibank, was already pursuing the same multiple card approach - offering its customers a mix of cards including Visa, MasterCard, Diners Club and Choice. We were confident that we could provide a totally new and competitive product that would be appealing to consumers and merchants. Not only were we intent on charging lower prices to consumers, cardholders and merchants, we also had the benefit at the time of our affiliation with Sears Roebuck, a pioneer in the credit card business with its Sears charge card. Our only issue was whether to start first with Discover or Visa/MasterCard. For strategic reasons, we decided that our first step should be to get the Discover business up and running. That was in 1985.

The Discover card - with its innovative features such as Cashback Bonus® and no annual fee -- proved to be very popular with cardholders. And the Discover network - with its lower merchant fees - also was very well received. Nonetheless, our efforts to compete in the industry have been seriously undermined from the beginning by a series of anticompetitive practices engineered by Visa. As soon as we began the Discover business, Visa started engaging in blatantly anticompetitive and anti-consumer actions that had no purpose other than to torpedo our business plans and eliminate us from the market. Visa's improper interference with our business has hurt consumers and merchants by reducing price competition and discouraging new entrants.

Let me be specific. As soon as Discover entered the market, Visa began doing whatever it could to eliminate Discover and other competitors. In fact, Visa did not even try to hide its anticompetitive and anti-consumer agenda. I would like to show you a videotape that we managed to obtain showing a Visa executive talking to member banks shortly after Discover's entry. What you are about to see is not the consumer-friendly Visa that its lawyers and publicists try so hard to portray. Instead, this is the real Visa that Discover, American Express and retailers have had to deal with since 1985:

[Play tape] "[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."

Just so everyone is clear, when the Visa executive talks about the members "working together," she is talking about banks that in the aggregate control over 80% of the credit card business in this country through their memberships in Visa and MasterCard. Without question, the two associations possess huge market power - and, as the videotape so clearly depicts, Visa's game plan from the beginning has been to openly use that power to eliminate existing competitors and to ensure that no new competition emerges.

What has happened since Visa's competitive "call to arms" to its members? Very simply, it has behaved exactly like the Visa executive described. Time and again, whenever we have posed any kind of challenge, Visa enacted new punitive rules tailored to interfere with our business plans and restrict our ability to compete. Not surprisingly, as other firms have gotten the message that there is a heavy price to pay for competing against Visa, not a single firm has "followed our lead" by attempting to enter the network market.

Over the years, Visa has acted in a deliberate and discriminatory way to limit competition and interfere with our business. These actions have ranged from passing discriminatory bylaws and operating regulations, to preventing us from acquiring credit card portfolios in order to build our business. While Visa's lawyers and publicists always claim that its rules have some supposed procompetitive purpose, that obviously is not true. The fact that the very rules that are enforced so vigorously against Discover and American Express are not enforced against MasterCard or Citibank underscores this point. Moreover, the real Visa, not the benign image painted by its lawyers, operates on a cloak of secrecy. Its rules are highly secretive, its decision making processes are not transparent, and even its board membership lists are protected. I encourage you to try to obtain a list of Visa International's current board members.

Visa's Anticompetitive Rulemaking

Let me describe some of these rules and practices that have been enacted to specifically interfere with our business but have had a profound chilling effect on competition generally.

1. Exclusion from merchant terminals.

The first example occurred almost immediately after Discover entered the market. In our effort to build a critical mass of merchants throughout the United States who would accept Discover card, we were immediately confronted with an organized effort by Visa to prevent us from signing merchants. Visa persuaded its members to deny Discover access to transaction processing terminals at merchant locations. We responded by developing our own state-of-the-art terminals that we offered to merchants, telling the merchants that they were welcome to use our terminals to process their Visa and MasterCard transactions, as well as Discover transactions. Visa then adopted a rule effectively barring merchants from processing Visa transactions over terminals that we provided. Only by threatening litigation did we manage to get Visa to partially back off from that particular anticompetitive rule, but their actions continued to increase costs, stifle efficiencies and create disruption for Discover and for merchants.

2. Exclusion from association membership.

By 1988, it had become clear that, despite intense efforts to drive Discover out of business, we were in the market to stay. It was at that point in time that we decided to move forward on the next phase of our business plan - which was to begin issuing multiple cards, like Citibank was doing. In late 1988, we submitted an application for Visa membership that met all of the existing membership requirements. Nonetheless, we received a letter back from Visa stating that our application had been rejected by the Visa Board of Directors because we intended to continue operating our Discover network.. At that same Board meeting, the Board voted unanimously to adopt a new rule, called Bylaw 2.06, which stated that Visa would not accept for membership any firm that its Board deemed to be "competitive." Only our firm and American Express were specifically targeted as "competitive." Neither MasterCard nor Citibank were mentioned, even though both of them also owned competing brands.

When we learned of Visa's exclusionary action, we had little doubt that we were being punished for starting a competing card business. Our suspicions were confirmed a few years later when, during a court case, a prominent bank representative on the Visa Board testified about why he had voted to exclude us from Visa. He said: "Discover was a very effective price competitor, and had been very successful and [he] did not want to encourage that kind of price competition within Visa." At least that gentleman gets high marks for honesty.

But the bottom line is that, through its enactment of Bylaw 2.06, Visa wielded its immense power to exclude us from doing business on the two largest networks in the market - not because there was any legitimate business reason to keep us out, but rather because we had proven to be an effective price competitor. That was certainly a sad time for American consumers and merchants.

I'd like to show you a chart that sets forth key pillars of our initial - and still preferred -- business strategy, so you can get a better idea of just how pervasive these anticompetitive rules have been. As you can see, the first key pillar was to offer Visa and MasterCard cards to our customers, along with our own proprietary card - just like Citibank was doing. But then Bylaw 2.06 was enacted and that ability was taken away from us.

A second key pillar of our business plan was to build a large-scale and highly competitive merchant acquiring business. This is the business of contracting with merchants to get them to accept particular card brands and then processing the point-of-sale transactions made with those card brands at merchant locations. As any merchant will tell you, it is extremely important that this business be competitive, particularly given the hundreds of billions of dollars worth of card transactions done every year in the United States. Our initial plan, which was implemented even before we sought a Visa membership, was to establish "agency" relationships with certain Visa members, which allowed us to serve as their "agents" in signing up merchants for Visa cards. These relationships permitted us to go to merchants with a full complement of card brands - which in turn provided a significant boost in our ability to convince merchants to accept Discover Card. But as soon as Visa learned of our strategy, it enacted a rule called Operating 10.6.9, which prohibited us from acting as agent for Visa members in acquiring merchant transactions.

And, of course, once Visa enacted Bylaw 2.06, that rule deprived us not only of the ability to issue Visa cards, but also to acquire their transactions directly as a member. Thus, we have been stripped of another important component of our business strategy.

In order to understand just how damaging this rule is to our ability to compete effectively, you need to understand that our key competitors in the acquiring business are able to contract with merchants to accept all card brands and to acquire transactions for those brands.

Thus, today, we have no ability to acquire Visa and MasterCard transactions either directly or as an agent, even though that was a key element of the business strategy that led us to enter the market in the first place.

3. Foreclosure of access to Visa/MasterCard members.

A third pillar of our business plan was more long term. We recognized that if we were able to build a nationwide network of merchants, we would have the ability to use that network as a platform not only for the issuance of Discover, but also for the issuance of other proprietary cards. The network business is very much a business of scale economies, with heavy infrastructure expenses and little marginal expense for each transaction. Thus, the larger our scale, the greater our ability to compete on the network side.

One obvious way to increase our network scale is to have other firms issue their own cards on the Discover network. The firms most likely to have an interest in that opportunity, of course, are the firms already in the business of issuing Visa and MasterCard. If Discover were permitted to offer those firms the opportunity to issue cards on the Discover network, and perhaps even to take a stake in the network, there would be a number of important competitive advantages. For consumers, it would mean new card choices. For merchants, it would mean more of their transactions would be done on the network that charges them the lowest merchant fees.

But Discover cannot pursue this strategy either. Visa has enacted yet another rule, Bylaw 2.10(e), that prohibits its members from issuing cards on any network deemed "competitive." As with Bylaw 2.06, the targeted list of "competitors" includes MSDW and American Express, but not MasterCard or Citibank. Thus, through the discriminatory enforcement of yet another anticompetitive rule, we have been deprived of a third key component of our overall business plan.

4. Global interference.

There is yet another important pillar of our business plan that has been undermined by the associations. The credit card business today is global, and the business opportunities in Europe and Asia for a low-priced competitor like MSDW are tremendous. We would have liked to pursue a multiple card issuing strategy throughout the world - offering a worldwide Discover brand on our own network, as well as Visa and MasterCard. This would have allowed us to build additional scale and thus be an even stronger competitor in the United States. But, once again, Visa has thwarted our plans.

Given our experience in the United States with the Discover network, we have determined that it is not economically sensible to attempt to expand that network outside of the United States. Despite our investment of several billion dollars, Visa has managed to restrict the size and success of our domestic network to the point where today it accounts for barely five percent of the U.S. market. MSDW simply cannot afford to make comparable network investments overseas, only to be confronted with the same kinds of anticompetitive obstacles that have limited our success and prospects in the United States. Accordingly, there will be no Discover global network.

But the improper interference by Visa in our global plans goes even further. As you may have read, MSDW recently entered into an agreement with Bank One to acquire its card issuing businesses in the United Kingdom and Canada. Because Bank One's business involved the issuance of Visa cards, one condition of the contract was that we be approved for Visa membership in those two countries. Even though Discover does not operate in either of those countries, we were informed that MSDW was not welcome in Visa in the United Kingdom or Canada - and, in fact, was not welcome anywhere in the world. Visa cited yet another rule, International Bylaw 2.12, which prohibits firms that are deemed "competitive" internationally from applying to Visa. But Discover does not compete with Visa internationally. Our only significant international business is the issuance of a Europay/MasterCard in the United Kingdom, and hundreds of banks that do the same thing are welcomed into Visa. Nonetheless, Visa refused to admit us into membership, overturning our contract with Bank One. Clearly, we continue to be punished - and punished severely - for starting and continuing to operate a competing network in the United States.

In Canada, our situation is even worse. Not only has Visa refused to admit us into membership, so too has MasterCard. In that country, therefore, we have been completely excluded from the market.

To underscore the point that Visa's executives have not changed their anticompetitive stripes since the videotape I played earlier, when the head of our U.K. credit card operation recently attended a dinner in London, he found himself sitting next to a senior executive of Visa International. When the subject of our proprietary card business came up, the Visa executive turned to our man and said, "Give it up - fold your network and come join the good guys."

As you can see, many of our original pro-competitive and pro-consumer strategies have been blocked by Visa - leaving us with business options that are far narrower than what we had when we entered the business and far narrower than options available to Visa members today. As you know, we continue to issue the Discover Card on our own network. That network accounts for only about five percent of the market in the United States and thus is a distant fourth in size. It has never been able to achieve anywhere close to the scale that we had hoped or that we need in order to achieve long term success. While our issuing business is profitable, our network and acquiring businesses are not and never have been. To date, we have had to live with the fact that our overall credit card business is smaller, less profitable and less competitive than it would have been, but for Visa's anticompetitive actions.

MSDW's Efforts To Eliminate The Anticompetitive Rules

Over the years, we have tried our best to address the associations' anticompetitive practices through the legal system. In the early 1990's, when we were prepared to start issuing Visa cards at low prices and on a nationwide scale, we sued Visa over its exclusionary Bylaw 2.06. We obtained a unanimous jury verdict that the Bylaw violated the antitrust laws, and that verdict was then upheld by the United States District Court Judge Dee Benson in Salt Lake City. But thereafter an appellate panel in Denver reversed the verdict on narrow theoretical legal grounds that make no sense in the real world. I have never understood that decision, which - in my view - cannot be reconciled with evidence like the videotape and the Bank Board member's testimony that show so clearly that Visa's purpose in enacting the Bylaw was to insulate its members from competition.

We also have urged the Department of Justice to address these problems. As the Department knows, in Europe the government antitrust enforcers have taken aggressive action to block several of Visa's anticompetitive rules, thereby benefiting consumers, merchants and competition generally. In this country, however, while the Department did file an antitrust case against Visa that is set to go to trial in New York in about two weeks, the relief that the Department appears to be seeking falls woefully short of what is needed. The case does not even mention Bylaw 2.06, for example, even though that Bylaw - especially given the discriminatory manner in which it is applied -- is at the heart of the anticompetitive problems in the industry, and even though the grounds for challenging the Bylaw today are different and even more compelling than they were during our private litigation in the early 1990's. Nor does the Department seem troubled by the obviously pretextual nature of Visa's defense of the Bylaw. While Visa pretends that the Bylaw is intended to preserve competition among card networks, its discriminatory enforcement of the Bylaw - enforcing it against MSDW, but not against the similarly-situated MasterCard and Citibank - demonstrates unequivocally that Visa's real purpose is to punish those firms that have chosen to compete aggressively against it.

While the Department case does challenge Bylaw 2.10(e), which prevents Visa members from issuing cards on other networks, the relief that the Department intends to seek in that regard would not benefit a small network like ours that needs the ability to offer additional consideration, including perhaps an ownership stake, in order to attract large issuers to its network. In fact, if the Department is successful in obtaining the relief it now seeks with respect to Bylaw 2.10(e), it will have created a situation where Discover is the only network that will not be able to build volume by attracting substantial third-party issuers. In addition, other than America Express, Discover will be the only card issuer not able to issue multiple association and proprietary brands. Thus, if the Department is successful, the position of our network relative to the competition would be weakened still further.

To make matters worse, the Department appears content to let Visa accomplish by contract what 2.10(e) accomplished by rule. Faced with the possibility that 2.10(e) may be declared illegal, Visa is now offering special incentives to some of its largest issuers in order to induce them to sign contracts committing up to 90% of their overall card transaction volume to the Visa network for the next five years. The Department is aware of this development, yet has taken no steps to stop it. As a result, even if Bylaw 2.10(e) is eliminated, Visa still will have managed to lock up the transaction volume of its largest issuers - creating the same anticompetitive effects as the Bylaw itself.

The Solution

Having now described for you the serious nature of the competitive problems in this market, let me now tell you the solution - which is simple, straightforward and easy to implement. Eliminate all anticompetitive rules. Open up competition among the card networks so that market forces, not the conspiratorial acts of two dominant competitors, determine market success. Issuers should be permitted to issue cards on whatever networks they choose. Merchant acquirers should have the same freedom. If this were to happen, there would be a surge of new competition among issuers - in terms of prices, innovation and service. There would also be significant new competition at the merchant level, because for the first time the networks would vie on a level playing field for merchant business. In addition, and of critical importance, open competition would create an environment in which firms would be incentivized to start new networks (like Discover did in the years before these anticompetitive rules emerged). Just look at other areas of financial services, where literally hundreds of networks - often referred to as ECN's -- are forming and where competition has been invigorated as a result. There is no doubt in my mind that incentives for new network creation can be regained in this industry as well - so long as the two dominant networks are stopped from imposing punitive rules that harm consumers and merchants by penalizing firms, like MSDW, that dare to start competing networks.

In closing, I am the person principally responsible for the decision to start the Discover business in 1985. I made that decision at a time when open competition existed in this industry and when I believed that our firm could carry out the ambitious pro-competitive and pro-consumer strategy that I have described today. In a world of open competition, I would make that same decision again. So would other firms. But if I had known in 1985 that Visa -- with its dominant market position - would be permitted to enact and enforce such anticompetitive rules, there would have been no Discover network. And so long as those rules remain on the books, there will never be another new network again.

This Subcommittee should be aware that our network competitors have suggested to us over the years that we would be far better off converting our volume to them and giving up on our efforts to operate a competing proprietary network. For the past 15 years, I have resisted those suggestions. I have been convinced that, over time, in this free enterprise system, the serious anticompetitive abuses that Visa has committed would be corrected. But these abuses have saddled this industry for a long time, and now is the time to correct them. Anyone who understands the industry knows that time is growing short. If Visa is allowed to continue abusing its power, no new networks will be started and existing networks will have little choice but to consider alternative business strategies. And that would be a shame. Because a far better result, and the result that I strongly prefer, is to re-create an environment (like we had in 1985) in which networks are open and fair - which, in turn, would provide powerful economic incentives for existing networks to remain in business and for new networks to emerge. This is the vision of the industry that truly serves the interests of consumers, merchants, and anyone else in this country interested in healthy and vibrant competition.

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