Visa and MasterCard Confront China’s Stacked Deck

New Standards Give UnionPay Big Advantage Over Foreign Bank Card Companies

Visa and MasterCard executives eager to expand in China were thrilled recently when Premier Li Keqiang seemed to suggest that a door would open to them for bank card yuan business in the country.

But they had read Li wrong: The premier's statement in late October did not signal an opening to overseas bank card firms. Instead, it signaled tougher times.

Despite a World Trade Organization directive putting China on notice to open its bank card market by August 2015, the central government has no immediate plans for letting Visa or any other company substantially challenge UnionPay, the state-controlled firm that has exclusive permission from the People's Bank of China (PBOC)the nation's central bankto clear all domestic interbank payments.

As it stands, foreign bank card firms can't do business in China without working through the UnionPay network and paying its network access fees. They were also required to stamp all bank cards issued to its clients in China with the UnionPay logo, an agreement that fell apart in 2010 as their relationship with UnionPay went south.

On November 3, UnionPay's grip tightened with a central bank announcement that "new financial integrated cards issued by all banks must conform to the PBOC 3.0 standards."

These standards govern the electronic language through which a bank card transmits an account holder's data at a checkout counter or at an ATM. They are used by only UnionPay and are incompatible with the so-called EMV standards adopted years ago by MasterCard and Visa. EMV stands for the former Europay (which MasterCard bought in 2002), MasterCard, and Visa.

Even if Beijing were to open for bank card clearing services, the latest rule forces every company except UnionPay to adjust its business practices before being allowed to operate in China. For example, retail point-of-sale (POS) terminals for band-card swiping as well as ATM operations will have to conform to the new standards.

The changeover won't come cheap: A UnionPay technician said changing just one machine to meet the new standards could cost several hundred yuan.

The decision to make PBOC 3.0 standards a national requirement followed Li's October 29 statement about opening the market for clearing payments, suggesting domestic and foreign companies would be allowed to compete. At the time, Visa and MasterCard executives apparently didn't know that the central bank's rule essentially barring their EMV systems would soon follow.

Homegrown Standard

With the central bank's decision, China may find it possible to overcome the sting of a legal slap from the WTO in 2012. China was found guilty of breaching the trade group's rules by letting UnionPay monopolize bank card clearing services. The WTO ordered China to open its market by August 2015.

The WTO issued the ruling following a period of cooperation between UnionPay and foreign bank card companies that eventually turned sour. UnionPay officially ended efforts to integrate services with Visa and MasterCard in 2010, after the Chinese company refused to let Western counterparts use its company logo.

Li Xiaofeng, a central bank official, said any company that issues bank cards denominated in yuan should be required to follow China's standards for the industry. But while following the standards, Li said, foreign and domestic players should be free to compete by offering distinct operations and services.

"Opening up the clearing service market does not mean we have to give up self-developed, proprietary standards or cater to foreign bank card companies by using their standards," he said. "All foreign and domestic card organizations will be treated the same [in China]. There will be no separate standards for foreign companies."

Critics of the standards have accused the government of using the standards as technical barriers designed to protect UnionPay's market position. Some warned that China could get another slap from the WTO.

"When various interests have different interests, the government needs to find a balance," said a source at MasterCard. "Otherwise the WTO will find [China] has been violating its trade rules again."

But a technical department official at the central bank said that "every country has its own clearing system, and China should have its own. It does not have to follow the standards of Visa and MasterCard."

The standards set technical parameters for chip-equipped, so-called "smart cards," which in China are replacing older bank cards with magnetic strips. Each card type lets a user move money to and from bank accounts at a store checkout counter or an ATM.

Like many other countries, China has been pushing to replace cards that store an account holder's personal information in a magnetic strip. Smart cards are considered safer than magnetic strip cards and can be equipped with more functions, such as the ability to use near-field communication technology to move money.

A central bank official working in the bank's payment division said the new smart card standards are designed to protect account holder data while also meeting China's sovereignty requirements.

China's smart cards and EMV cards are incompatible because they use different encryption methods, said Chen Zhong, who directs the financial digitalization research center at Peking University. The government sees smart cards as a worthy alternative to EMVs because they're better at protecting data, and homegrown standards enable the government to have more initiative, he said.

The central bank started setting standards for smart cards in 1997. They were adjusted several times before the bank created the PBOC 3.0 system for UnionPay.

Chinese banks have been issuing smart cards since 2011. ATMs and POS machines across the country are being upgraded as well.

Today, according to UnionPay, about 1 billion smart cards have been issued in China and 95 percent of the country's ATMs accept them. The central bank wants smart cards to replace all magnetic strip cards by the end of 2014.

Search for Balance

MasterCard officials have no problem with the Chinese government's interest in developing standards of its own. What's not fair, they say, is that the government's standards exactly match those used by UnionPay, thus giving their Chinese competitor a clear advantage.

A source at MasterCard who asked not to be named said industry standards in every country should treat all companies with bona fide businesses with impartiality.

But UnionPay officials feel they've been treated unfairly outside China. In 2010, for example, Visa ordered all merchants using its POS machines outside China to stop routing transactions through the UnionPay network. UnionPay quickly retaliated by ending an agreement that put its logo on cards alongside Visa and MasterCard logos.

As a result, today all Visa and MasterCard cards issued in China must be cleared in U.S. dollars rather than yuan. Technically, that should make these cards more expensive for merchants than UnionPay cards, and thus discourage the use of Visa and MasterCard. In practice, however, many Chinese banks that issue overseas cards work around this requirement by automatically converting dollar-denominated payments into yuan, thus sparing merchants the extra charges.

Nevertheless, Visa and MasterCard have been losing clients in China, according to a source at a non-Chinese bank card company who asked not to be named. When a card bearing the UnionPay logo alongside a Visa or MasterCard symbol expires, the holder often switches to UnionPay, he said. "In response, the strategy we're taking is to make the cards valid for as long as possible," he said.

UnionPay says it's now doing business in more than 140 countries and regions worldwide. In 30 of these countries, UnionPay cards have been issued. The company reported a total transaction turnover for all countries outside China of 620 billion yuan last year. It is also upgrading its business practices overseas by, for example, installing POS machines that use smart cards.

Meanwhile, non-Chinese bank card companies are hitting bumps while trying to expand their international reach into China. According to a central bank official, non-Chinese bank card companies seeking to do business in China are being required to base their clearing systems inside China's borders as a prerequisite for providing clearing services for bankcard payments in China.

A Visa official who asked not to be named said the company is considering at least two options for meeting this domestic-base requirement. Under one proposal, servers would be located in China. Under another, a separate department to manage bank cards issued in the country would be established and clearing services would be outsourced to server operators in China.

Central bank officials are also looking at ways to overcome technical barriers. Under one proposal, ATMs and POS machines would be equipped with software compatible with EMV and Chinese standards, a bank official said, adding that "all parties" have been looking for a way to make this work.

"Ideally there should be one unified standard," said a Visa technician who asked to remain anonymous. "It should be convenient for UnionPay to go out and international card associations to come in. Otherwise, everyone has to pay high costs for adaptations."

A Chinese bank official said he thinks eventually non-Chinese bank card companies will yield to Chinese requirements simply because they want business in the huge Chinese market.

"As Chinese consumer power rises, foreign institutions handling bank card payments will feel the pressure to adapt their technologies, and foreign bank card companies will help them because they want a huge number of Chinese card holders," said the banker, who asked to remain anonymous.

Once this happens, China's standards would become the norm for transactions worldwide. Turning China's standard into the international standard is "a national strategy" of the government, he said.

But some non-Chinese bank card companies discouraged by the recent policy developments said they have no immediate plans to pursue yuan business in China, as long as they are required to follow rules designed to put them at a competitive disadvantage.

"I don't know when we can start a yuan bank card business," said a source at a non-Chinese bank card company who asked not to be named. "There is no timetable."

Some in the industry have taken a modest view of China's efforts to set the pace for the world's bank card transactions. They cite the fact that digital chip technologies are constantly improving and said foreign card companies do not have the incentives to keep upgrading them.