The robust debit card is strengthening its grip on the evolving U.S. payments sector.
  In an environment with declining signature-based (so-called "offline") interchange, increasing personal identification number-based ("online") rates, and a newfound ability by merchants to eliminate offline debit acceptance if they do not receive satisfactory interchange, point-of-sale transaction volumes for both products are skyrocketing. Growth rates on both sides of the debit divide generally have been in the 20-plus percent range in recent years (chart, page 36), compared with the single digits for credit.
  And with issuers and the bank card associations still heavily marketing the signature-based Visa check card and debit MasterCard products, and retailers annually deploying hundreds of thousands of new PIN pads to support online debit transactions, widespread expansion of debit is likely to continue throughout the decade. Signature debit transactions in the Visa system already have exceeded credit transactions, though credit card dollar volume is still higher.
  This expanding interest in debit by consumers, financial institutions and merchants is occurring just a year after pundits were analyzing which credit card-accepting retailers would stop taking signature debit products following the settlements in the spring of 2003 of a seven-year-old, class-action antitrust lawsuit brought by merchants against Visa USA and MasterCard International. Those settlements eliminated Visa and MasterCard's "honor-all-cards" rules forcing merchants to accept offline debit cards if they accepted credit cards. The settlements also led to the lowering of signature-based interchange-the amount of a card sale that the merchant acquirer must pay the issuer, which acquirers typically pass on to their merchant customers ("The Retailers' Home Run," July, 2003).
  In a show of force, Wal-Mart Stores Inc. last year briefly stopped accepting debit MasterCard, a signature-based card that accounted for only about 1% of its sales. Wal-Mart resumed taking debit MasterCard after reaching an accord with MasterCard that observers believed offered more favorable pricing to the world's largest retailer.
  Not only have nearly all retailers continued taking signature-based cards, but more also are supporting the online products, even though steadily rising PIN-based interchange is softening the incentive to install PIN pads among merchants interested in lowering their debit acceptance costs.
  With both signature and PIN debit becoming more solidly entrenched in the payments landscape, there is more uncertainty over how the cards will evolve in the face of steady pricing adjustments. Though offline debit interchange rates still are substantially higher than online debit fees, the gap is narrowing, as the Visa example in the chart on this page shows. And if the fees eventually were to reach the same level, the products then could subsequently merge into a single entity, some analysts say.
  While such a development is not likely to occur until at least the next decade, PIN debit cards are positioned to become the dominant debit product, says Gordon Schnell, a partner in New York-based Constantine & Partners, the lead firm for the retailers in the lawsuit against Visa and MasterCard.
  "There still is a minority of merchants in the U.S. who are PIN-capable, but when they become the majority, there may be no need for signature-based debit," he says. "It is very possible that offline debit will become obsolete and could disappear within the next five to 10 years if more merchants continue to install PIN pads."
  'PIN Will Win'
  Schnell and others point to the proliferation of PIN debit-instead of signature debit-in Canada and elsewhere as an indication of its value ("The Great Canadian Debit Debate," May, 2004). Merchants and bankers generally consider PIN debit transactions more secure than signature transactions because they are authorized and settled in "real-time" in a single message. Signature-based transactions, which have a delayed clearing process, carry more fraud risk.
  "PIN will win over time because it is the superior debit product with no party in a transaction taking on risk," says Bipin Shah, president and chief executive of Genpass Inc., a Fort Washington, Pa.-based payments processor. "The advantage of signature debit is that it is accepted worldwide without a PIN pad because of the Visa and MasterCard marks. But it operates in a 'bounced-check' environment in which consumers could take money out of their accounts after a transaction and before the charges are presented. As PIN-based fees continue to rise, more signature-based issuers will start promoting online debit."
  There currently is little economic advantage for card issuers to favor PIN over signature cards. Even though Visa and MasterCard cut signature-based interchange rates by about one-third in August 2003 as part of the lawsuit settlements, and the organizations have since made further changes that give more price breaks to high-volume merchants, the fees still are substantially greater than PIN debit's.
  Visa, for instance, says that come April it will reduce check card interchange while raising the rates for its Interlink PIN-based point-of-sale product. A typical non-supermarket $40 check card purchase is expected to generate between 37.8 cents and 56.2 cents in interchange ("Merchants Skeptical About Visa's Narrowing POS Debit Interchange Spreads," December, 2004). Interlink issuers, meanwhile, would receive just 26 cents to 45 cents in online interchange for the same $40 transaction.
  Regional electronic funds transfer networks also are increasing their interchange rates to remain competitive with each other and to make network-branded online cards more appealing to issuers. First Data Corp.'s Star, for instance, the largest EFT network, has a top interchange fee of 45 cents per transaction, up from 34 cents in 2003. Montvale, N.J.-based NYCE, the third-largest network, has a top rate of 65 cents, an increase from 40 cents in 2003. And Houston-based Pulse, the fourth-largest network, has a flat 18-cent interchange fee, up from 15 cents in 2002.
  "Signature-based debit cards only are being issued because of American bankers' greed," says a veteran EFT executive who insisted on anonymity. "An issuer can receive about $1.50 in interchange from a $100 signature-based transaction compared to less than half of that from a PIN transaction. And PIN also is overpriced. Why should the issuer get interchange for online POS when they don't receive such revenues in the ATM world?"
  Indeed, John Hamby, senior vice president and manager of the Merchant Services Center for New Haven, Conn.-based NewAlliance Bank, says that with PIN debit volumes increasing-leading to greater processing economies of scale-merchant fees should be dropping. Debit fees are artificially high so that many banks can compensate for the lower growth rates they are seeing in their credit card programs, he says.
  "The credit card's relative expansion pales to that of the debit card and eventually there will be several times more debit activity," Hamby says. "Debit soon will be the leading card product and credit will fall back in terms of prominence."
  CCM sister publication ATM&Debit News estimates U.S. acquirers had deployed 5.28 million PIN-reading payment terminals by March 2004, a 24% increase from 4.26 million in March 2003. An estimated 6.6 billion PIN-based POS transactions were initiated last year, up from 5.3 billion in 2003 and 4.3 billion in 2002.
  Debra Janssen, president of First Data Debit Services, a unit of Greenwood Village, Colo.-based First Data Corp., projects that PIN-based volumes will continue to escalate as bill-payment transactions and the acceptance of online cards at such sites as quick-service restaurants and medical offices becomes commonplace.
  The expansion of PIN debit, however, is unlikely to cause the eventual demise of signature debit and other payment products, she notes.
  "We don't ever really retire any of the payment methods," Janssen says. "Many people in the industry were waiting for a significant decline in check use as debit became more popular. But there still are a lot of checks being written." There were 36.7 billion check transactions in 2003, compared with 41.9 billion in 2000, according to a recent Federal Reserve study.
  Fade Away?
  Yet, because the U.S. is the only country in which financial institutions issue both signature and PIN-based debit cards, it is likely that offline debit eventually will fade away as America gets in step with the rest of the world, says James Hanisch, executive vice president for Co-op Network, the fifth-largest EFT network.
  Hanisch predicts the online and offline products will merge in three to seven years. "Eventually what we know as signature and PIN POS will converge to a single PIN-based product, but the timing will depend on how quickly the technology to support PIN is implemented by retailers," he says. "The cost to the merchant for deploying online systems will decline and that will create an incentive to get more PIN pads into the marketplace."
  Co-op processed 28 million PIN-based transactions in September 2004, up 40% from a year earlier. Hanisch attributes the increase to consumers being able to use PIN debit cards at new locations and becoming more educated about the product. The network's signature-based debit processing volume increased 21% in the same period, to 25 million monthly transactions.
  But even with a stronger PIN debit foundation, several factors still are preventing online cards from becoming ubiquitous in the U.S., says John Gould, director of consumer lending and bank cards for TowerGroup, a Needham, Mass.-based financial-industry research and consulting firm that MasterCard acquired in 2004.
  Gould notes that PIN debit still cannot be used for telephone orders, mail orders or Internet transactions, and that many consumers still are resistant to using PINs in any environment.
  Most financial institutions, meanwhile, still are giving marketing priority to their signature-based products even as the offline and online interchange gap narrows. Cleveland-based KeyBank, which has issued 1.9 million debit MasterCards, provides offline rewards and charges some customers-depending on their account and balances-a 25-cent fee for initiating PIN-based POS transactions, says David Sanderson, vice president and debit card manager.
  The bank offers a signature-based card that provides consumers with between 0.25% and 1% in rebates on purchases. Cardholders also can earn airline miles with specific debit products. Sanderson says the institution's online and offline card activity each increased about 20% in the last year.
  KeyBank this year plans to expand its debit activities by testing a card that uses radio frequency identification technology to transmit transaction data to the merchant terminal. Such a system is designed to cut transaction times by eliminating the need for consumers to swipe cards at the POS device.
  "It is important that we create an environment that is increasingly convenient for the customer to use debit cards, and to also provide more incentive for merchants to accept the products," Sanderson says.
  Indeed, it is crucial for retailers to see value in the cards because they will play a major role in determining how debit will evolve, observers say. And Mallory Duncan, senior vice president and general counsel for the Washington, D.C.-based National Retail Federation, a plaintiff in the merchant lawsuit, predicts that they eventually will view PIN as the more-important debit product.
  "Offline card acceptance continues to be an unbearably expensive process and one that merchants are increasingly disfavoring," he says. "More retailers are realizing that PIN transactions are faster, safer for consumers and cheaper for the banks to process."
  A Changing Mix
  Still, Duncan says signature debit likely will always exist because it works efficiently with niche products, such as gift cards.
  "Payment mechanisms tend not to disappear completely," Duncan says. "The balance of transactions is just going to change."
  Thomas Nitopi, chief executive officer of NXGEN, a Transaction Company, a Whitefish, Mont.-based independent sales organization, agrees that more large retailers are starting to emphasize PIN debit because of the lower rates. Indeed, such merchants as Belk's, Circuit City, Dick's Sporting Goods, Hancock Fabrics and Kenneth Cole recently began accepting Star-branded debit cards.
  Nipoti notes, however, that many small and mid-size retailers may be reluctant to invest in PIN pads and related equipment, or train their sales staff to accept the cards, if acceptance costs keep rising toward signature-based levels. "There is no great security problem at the point of sale to cause merchants to perceive PIN as having much greater value," he says.
  Nitopi says he expects Visa and MasterCard, which own the PIN-based Interlink and Maestro POS networks, respectively, to continue to more heavily promote their signature-based products as long as those cards generate more revenue for issuers.
  Yet, the payment organizations also are stepping up their support of PIN-based debit. Visa in November enhanced the chargeback rights and dispute resolution protections for Interlink. Cardholders who are dissatisfied with the delivery or quality of their Interlink purchases now can dispute the charges with their issuers if the merchant is unwilling or unable to provide goods ordered. The option only is available for Interlink transactions that are processed through the VisaNet network.
  "Cardholder-merchant disputes are becoming more prevalent as PIN-based debit starts to expand from the very large multilane retailers-who tend to take care of consumers-into other types of retail environments, such as auto-body shops," says Stacey Pinkerd, Visa USA senior vice president. "It is important that consumers who use PIN have strong rights."
  Pinkerd says it also is "logical" that PIN-based pricing should more closely resemble signature-based rates as online cards become more of a mass-market product, and thus are more valuable to merchants. PIN debit interchange originally was set low to spur retailers to support the product and invest in terminals and software, he notes.
  "Pricing to a large degree is a reflection of value," Pinkerd says. "PIN was a very niche product, but now it is moving beyond that. Supermarkets once were responsible for about 75% of the online debit volume, and now they account for about 50%."
  Despite the higher interchange, Pinkerd expects more retailers to support online debit because of customer demand. And he agrees that PIN and signature debit always will co-exist because some environments are not conducive to PIN transactions.
  Yet, while the products may operate independently, some payment organizations are starting to meld the brands in their marketing. MasterCard, for instance, last year began emphasizing the MasterCard logo in its promotions instead of the debit MasterCard, Maestro POS debit and Cirrus ATM marks, says Richard G. Lyons Jr., MasterCard International senior vice president for global debit product management and development.
  MasterCard's strategy stems in part from its consumer research that revealed that most cardholders weren't paying attention to specific products, but were more interested in using cards that enabled them to quickly complete transactions, he says.
  "The emphasis will be on getting consumers to look for the MasterCard mark regardless of how they want to pay, instead of promoting three debit brands," Lyons says.
  Lyons will not say if MasterCard intends to follow Visa's lead and raise its Maestro interchange. He says fee alterations were made to PIN in early 2004 to keep it as a "competitive alternative" for issuers and retailers.
  He adds, however, that it still is unclear if higher online interchange will deter many additional merchants from installing PIN pads. A large number of retailers, he says, did not accept online cards even when fees were lower.
  "Most consumers just want to get through the checkout lines quickly and don't care if the card is PIN or signature," Lyons says. "And merchants want to have the fastest tender time available so customer service can be enhanced. There are many elements of a transaction beyond just economics."
  Nevertheless, some analysts say that PIN-based interchange will rise steadily to provide greater income to issuers, regardless of the impact on merchants.
  "Retailers are virtually unrepresented in the decision-making process for interchange," says Tom Dailey, a Chicago-based payments consultant and former Discover Financial Services senior vice president who headed up the company's merchant network. "Online transactions are more efficient and the risk is less, but the prices still are going up. It is a bit of a perverse relationship."
  Dailey predicts that it will take between five and 10 years of online pricing increases before PIN-based interchange starts to resemble the signature-based rates. And that the largest merchants with the greatest clout will continue to strike deals in which they are paying lower fees than the vast majority of retailers.
  "Most merchants are too small to have leverage when it comes to setting pricing," Dailey adds. "And their debit volume either is too low for them to care about fees, or they are ignorant about pricing issues. Most mom-and-pop retailers are completely unsavvy about their fees. Hardly any of them know the effective discount rate."
  While card-acceptance costs may not mean much to smaller merchants, debit revenues and expenses are major factors to card issuers and larger retailers, and will be the catalysts in determining how the signature and PIN-based debit products ultimately will unfold.

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