From the July/August 2010 issue of ISO&Agent magazine.
Legislation surrounding U.S. debit-interchange rates is creating ripples of concern among ISOs and acquirers wondering how it eventually might affect their revenues and business models.
Though it is too early in the process to know exactly how various payments industry players might be affected, the so-called Durbin debit- interchange amendment included in the Dodd-Frank Act likely would reduce debit-interchange rates, most observers say.
At deadline, the House had approved the bill, but the Senate, where passage was uncertain, had yet to vote on the financial-reform legislation.
A reduction in interchange likely would trickle down to ISOs, acquirers and processors in the form of lower revenues. Other effects, including potentially lower debit-transaction volume, also could hurt ISOs' profits, observers say.
"ISOs are worried about losing a part of [the discount rate that includes interchange], and processors are concerned about higher costs to cope with new rules that are going to complicate business processes as a result of new laws," says Mary Bennett, director of government and industry relations at the Electronic Transactions Association. "This is a very complex topic, and it will be many months before we know its full effect."
The Federal Reserve Board would have nine months after the bill is passed to determine the new debit-interchange rates, and the new rules would become effective 12 months after the bill is signed into law.
If the Senate approves the bill, and the president signs it, the next several months likely would involve a comment period, when payments-industry players, including ISOs, acquirers and issuers, would be allowed to submit statements to the Fed before the agency issues its final rules some time next year.
"The debit-interchange amendment will most likely have far-reaching implications for ISOs and acquirers, and also for alternative-payment players" such as PayPal and merchant-funded payment networks, says Steve Mott, a principal at BetterBuyDesign, a Stamford, Conn.-based payment consultancy.
If interchange fees decline, ISOs likely would see a decline in the portion of the discount rate acquirers pay them, but it is too soon to forecast how steep the cuts would be or what effect it could have on the ISO business model, Mott says.
The central element of the debit-interchange amendment in the legislation would require the Fed to determine the "reasonable and proportional" cost of debit interchange. The law requires the Fed to take issuers' cost of covering fraud into consideration, but many factors surrounding the cost of processing debit transactions remain murky, clouding the outlook for ISOs affected by lower debit interchange.
Another provision would enable merchants to offer consumers discounts for paying with lower-cost forms of payment, such as cash versus debit, or debit versus credit. But the law specifies merchants cannot offer discounts that differentiate between card issuers or card networks.
Moreover, issuers would have to make debit cards operable on at least two different debit networks, enabling merchants to opt for the lower-cost network.
Another provision would allow merchants to refuse to accept credit card transactions under $10.
Several parties are excluded, and some observers say this could pose considerable challenges for merchants and processors.
Institutions with less than $10 billion in assets would not have to abide by the new debit-interchange rules, as would governments delivering benefits through debit cards and issuers of reloadable prepaid cards. The legislation does not specify how merchants would differentiate among these players at the point of sale, and considerable debate occurred about the potential complexity the excluded groups pose for merchants and processors.
"Presently, we don't know of any system that automatically sorts transactions at the point of sale by the size of the institution," Bennett says, noting merchants also lack an easy method of separating traditional debit cards from those associated with governments or agencies. "This law is going to cause a lot of headaches, and it may result in greater costs to ISOs and processors to sort out different types of transactions."
The legislation is the result of years of merchant pressure and lobbying to reduce the cost of interchange they pay on each sale, which they say amounts to tens of billions of dollars annually. Interchange compromises the largest portion of the discount rate, which includes processing and other fees.
Although credit card interchange was the primary focus of previous legislative efforts, it was debit interchange that finally caused lawmakers to move.
Retail-industry representatives consider the amendment a boon to merchants. The bill, "if properly implemented by the Federal Reserve," would "put an end to retailers being forced to accept 'Visa dollars' that are only worth 98 cents today and whatever Visa decides they're worth tomorrow," Mallory Duncan, National Retail Federation senior vice president and general counsel, said in a statement. Debit interchange costs merchants an estimated $20 billion annually, the federation says.
Debit card issuers fear new interchange rules could wipe out billions from their transaction-fee revenue. Although interchange rates vary widely, the average debit-interchange rate is estimated to be about 1% of the sale, compared with about 2% of the sale for credit cards.
But debit-transaction volume, which surpassed total credit volume in 2008, continues rising at a faster rate than credit card transactions.
Although it is difficult to estimate specific bottom-line effects so early in the process, some analysts speculate regulators could cut interchange from 25% to 75% of present levels.
The ETA lobbied against the debit-interchange amendment, sending a letter on behalf of its 500 members to the congressional conference committee that finalized the bill. The letter said ISOs' business models often depend on a portion of fees merchants pay acquirers. "If interchange fees are capped, they are in the undesirable position of experiencing the greatest reduction in income. Quite simply, this can translate into ISOs and other small businesses in the payments chain having to downsize, lay people off or possibly go out of business," the ETA said.
BRACING FOR LOSSES
Besides new pressure on their profit margins, ISOs may be hurt if overall card volume declines or if consumers are discouraged from using credit cards for under-$10 purchases, Bennett says. Debit card issuers may also add cardholder fees, which could lead to fewer overall cards in circulation, she suggests.
Though merchants generally applaud the arrival of debit-interchange regulations, at least one merchant-processor consultant is skeptical about the long-term benefits for merchants and processors.
"The term 'interchange' is used pretty loosely in the industry, and not only does it vary a lot, but there are a lot of other fees built into interchange that are not affected by legislation," says Robert Livingstone, president of IdealCost.com, a West Palm Beach, Fla.-based merchant-processor consulting firm. "Banks set interchange fees, but those are passed on to merchants through a complicated chain, which includes a general processing fee that's built into merchants' payment-acceptance costs. We assume the actual debit-interchange piece will be lower, but it doesn't mean overall costs will be substantially lower."
The Fed's new rules almost certainly would drive down signature-debit rates, says Mott. Visa in recent months has increased PIN-debit rates, in some instances to near parity with signature debit, a trend that is likely to draw regulators' scrutiny, he says.
Fraud costs associated with signature debit are about twice that of PIN-debit transactions, he says.
"There is no justification for a sustained increase in PIN-debit interchange rates. ... One would expect much of those increases to be rejected as not cost-based," Mott says.
William Shaw, a group vice president of First Citizens Bank, says PIN-debit transactions accounted for about 30% of the institution's debit mix in 2008, rising to about half today. First Citizens is both an issuer and an acquirer.
Because PIN debit is cheaper, the company breaks even on PIN debit, Shaw says. Signature- debit rates are as high as 1.35%, and the combined costs of marketing and supporting debit rewards programs consumes about 60% of signature-debit revenue, he says.
"We're going to see a big drop off in signature-debit programs when debit-interchange regulation comes through," Shaw predicts.
The Fed's task in setting "reasonable and proportional" debit-interchange costs could be complex, observers say.
The definition of "proportional" is lacking in the legislation. Some observers have said that means the rates would be equal to the cost of processing a payment. But the Fed also might provide for some markup, and that could be where the "reasonable" aspect of the rate-setting comes in, says Stuart E. Weiner, former director of payments at the Kansas City Fed who is now an independent consultant.
And merchants and industry observers are divided on how the new rules, particularly the handling exempt debit cards, might affect merchants and processors.
So far there are no obvious methods for merchants to separate exempted debit cards from mainstream cards at the point of sale, says Linda Perry, a former Visa Inc. executive who now operates as an independent consultant.
Perry doubts the Fed would force financial institutions to reissue cards, and though she believes identifying exempt cards using their BINs would be possible, it would be "extremely difficult based on the current BIN structure." Many smaller issuers that would meet the exemption threshold are agent banks and use the BINs of larger issuers, making it difficult for merchants to properly identify exempt issuers' transactions, Perry notes.
The card networks twice a year come up with new code requirements, so acquirers and merchant processors are used to making changes and budget for them. It has become a cost of doing business, usually $1 million to $3 million per year, depending on the processor's size, Perry says.
"From a practical perspective, acquirers don't charge to recode every time," Perry says. "It comes out of the profitability of the acquirer or [ISO]. But as some time passes, it eventually can come out of the merchants' pocket."
Merchants may be faced with diverse additional costs in accommodating the exempted debit cards. "Merchants may have to invest in new tools not yet on the horizon that would let them know which cards offer higher or lower transactions. And they may end up spending considerable time, especially smaller merchants, trying to find out which card is cheapest to accept, taking time away from sales and service," IdealCost.com's Livingstone contends.
But because the volume of transactions coming from exempt cards would be relatively small, it is possible merchants or their acquirers might just eat the added cost of processing the higher-rate cards, given the likelihood the Fed would reduce the rates on most other debit transactions. "That's very much a possibility, Weiner says. "It's costly to set up a dual system. Who's going to pay for it? Will the networks or acquirers be interested in setting up a dual system? I'm not sure how that all might fall out."
Although merchants have not yet assessed all the potential implications of debit-interchange regulation, most so far do not see complications. "This is the start of a new way of thinking for the financial community," says Jeff Lenard, a spokesperson for the Washington, D.C.-based National Association of Convenience Stores. "For the first time, there is going to be some consideration for the actual cost of interchange, and fair competition between debit networks. This may force banks to have to fight for customers with better deals."
Sonja Hubbard, CEO of E-Z Mart Food Stores Inc., a 300-unit convenience-store chain based in Texarkana, Texas, says she does not anticipate difficulties at the point of sale in handling debit cards from different-size issuers.
"The exemptions won't cause hassles," Hubbard says. "All cards will be treated the same way. While some will cost the retailer, and ultimately consumers, more, that won't make any difference as to how things happen at the point of sale."
A SILVER LINING?
As the Fed weighs the costs issuers incur, fraud will be one of the factors. Determining fraud's role in total interchange costs is tricky, but it could also create opportunities for terminal makers and third-party providers of fraud-prevention tools.
Fraud statistics are "severely lacking" in the United States, and there is no independent source on fraud costs for the payments industry. Moreover, the amendment specifies it would require issuers to "take effective steps to reduce and occurrence of, and costs from, fraud in relation to electronic debit transactions, including through the development and implementation of cost-effective fraud-prevention technology."
"If there is legislation that says, 'We the Fed technically can review issuers to make sure they are [using] all the fraud-preventing technologies'" available, "that might give a little more teeth to PCI overall," Darrin Peller, an analyst with Barclays Capital, told ISO&Agent sister publication AmericanBanker in an interview in late June.
Bob Carr, Heartland Payment Systems Inc.'s chairman and CEO, agrees that the proposed new debit rules could have positive implications for technology providers.
"The Federal Reserve might come up with security ideas above and beyond PCI" that are not necessarily requirements but guidelines for additional steps merchants can take to prevent fraud," Carr says.
Not everyone agrees interchange will even remain once the Fed completes its review. Jeff Shinder, managing partner at Constantine Cannon, a New York-based law firm, suggests fraud should not be included as a cost in setting interchange rates but instead should be rolled in to an issuing institution's overall cost of doing business. He believes in the end, signature-debit rates will drop altogether if not disappear, and PIN-debit, which is more secure, will emerge as the preferred form of debit payment as the business case for signature debit weakens.
And if that occurs, the Fed should take advantage of the situation and use its authority to help push the U.S. market to a chip-and PIN smart card system, just as most other parts of the industrialized world are doing, Shinder says. "The Fed may need to get involved to bring the process together to get there," he says.
Debit-interchange regulation also may help certain payments-industry players gain an advantage.
Emerging merchant-funded debit networks such as Bling Nation LLC may see increased market share as more banks opt to participate in such closed-loop debit networks, as traditional debit-interchange revenues begin to decline, Mott says.
"One of the big benefits Bling offers is fewer players in the transaction chain, compared with traditional debit networks where there is an ISO, a processor and an acquirer in the equation, along with the bank and the merchant," he says.
The industry also could see a scenario in which debit-interchange costs fall so low that players such as Bling Nation begin to feel competitive pressure to lower their merchant-processing rates further," Mott says.
PaymentsSource Editorial Director Jeffrey Green and AmericanBanker reporter Andrew Johnson contributed to this story.