Debit Dynamics

The Fed’s latest probe into debit card costs and revenues has merchants clamoring for lower regulated interchange.

Merchants have said it before, and they’re saying it again: It’s high time the Federal Reserve lowers its regulated debit card interchange rate.

The call by the Retail Industry Leaders Association came shortly after the Fed in March released its latest study of debit card revenues and expenses. The study, for the year 2017, says regulated debit card issuers’ authorization, clearing, and settlement (ACS) costs had declined 54% since 2009, the first year the Fed began collecting such data.

The ACS finding was just one factoid in a study that gives a fascinating look into the dynamics of the debit world, where regulated issuers’ cards tallied 43.2 billion, or 63%, of the 68.5 billion debit and prepaid card purchase transactions tracked by the Fed. Debit card transactions generated $20.7 billion in interchange paid by merchant acquirers to issuers in 2017, an expense passed on to merchants.

The Fed also found that PIN-debit interchange received by smaller, unregulated debit card issuers is trending down. And merchants are paying a greater share of network fees compared with debit card issuers.

Fraud, meanwhile, remains within tolerable limits, but who’s left holding the bag also is shifting.

“Merchants are bearing more of the cost,” says consultant and debit market researcher Patricia Hewitt of Savannah, Ga.-based PG Research & Advisory Services.

‘Long Past Time’

The Durbin Amendment to 2010’s Dodd-Frank Act required the Fed not only to implement its mandates on interchange and debit card transaction routing, but also to study the debit market every two years.

The Fed’s latest research is based on two separate surveys, an annual one for networks and a biennial one for regulated debit card issuers—those with $10 billion or more in assets. The Fed received responses from all 13 networks that processed debit transactions in 2016 and 2017. Some 115 regulated financial institutions responded to the issuer survey.

The ACS data provided fresh fodder for merchants in their unceasing quest to lower payment card acceptance costs. This quest includes the still-pending second settlement of a 14-year-old class-action suit over credit card interchange as well as individual lawsuits by some big merchants. Plus, grocery-store giant The Kroger Co. is boycotting Visa credit cards in some of its California stores (“Kroger Pokes Visa in the Eye Again,” April).

The new Fed study says average per-transaction ACS costs for regulated debit card issuers, excluding fraud losses, fell to 3.6 cents in 2017 from 4.2 cents in 2015, reflecting a cumulative decline of 54% since the Fed began collecting such data in 2009.

The regulated interchange rate is up to 21 cents plus 0.05% of the transaction amount. Issuers that take certain fraud-prevention steps are eligible for another penny in interchange. The Fed hasn’t changed the regulated rate since it took effect in October 2011.

“The Federal Reserve’s data confirms that it is long past time for the Federal Reserve to lower the base interchange rate of 21 cents to reflect the current reality in today’s payment ecosystem,” Austen Jensen, senior vice president of government affairs at Arlington, Va.-based RILA, said in a statement.

RILA represents 200 retailers, product manufacturers, and service providers with more than $1.5 trillion in annual sales. The organization noted that Dodd-Frank requires the regulated interchange rate to be “reasonable and proportional” to the issuer’s transaction cost. The statement claims the “580% markup” big banks receive in interchange is “neither ‘reasonable’ nor ‘proportionate’ to the cost of the transaction.”

A Fed spokesperson declined comment when asked by Digital Transactions if the central bank has any plans to change the regulated rate.

Cutting Deals

The fact that authorization and related costs are down isn’t surprising, says payment consultant Eric Grover, principal of Minden, Nev.-based consultancy Intrepid Ventures. He notes that with ever-greater computing and telecommunications power, the marginal cost of adding one more transaction to a card-processing system “is close to zero. The real vertical costs are getting cheaper.”

While ACS costs are down for the industry as a whole, expenses still vary widely among issuers. High-volume issuers—those with more than 100 million annual debit transactions—have the lowest average cost, at 3.3 cents. These issuers accounted for only 38 of the 115-issuer study group, but their cards generated 96.2% of debit transactions in 2017, according to the study.

Mid-volume issuers, with 1 million to 100 million transactions, have an average cost of 12.2 cents, while the small fry, with fewer than 1 million transactions, have the highest average cost, at 47.7 cents.

Still, low-volume issuers in 2017 saw their average ACS costs decline from about 50 cents in 2015, while mid-volume issuers’ costs rose very slightly. The difference probably is explained by the low-volume issuers, which outsource virtually their entire card-processing operations, enjoying greater scale economies passed on by their third-party processors, according to researcher Sarah Grotta, director of the debit and alternative products advisory service at Maynard, Mass.-based Mercator Advisory Group Inc.

But mid-size issuers may be using a combination of in-house systems and outsourced services, what Grotta calls “a mix of technology and not enough scale” that didn’t produce cost cuts.

The Fed says 76% of regulated issuers had average ACS costs, including their fraud losses, below the base interchange rate, and that ACS costs for 99.7% of regulated transactions were below the base rate.

With the Fed staying mum, it’s unknown if or when regulated interchange could be heading down. And it’s unclear whether big retailers, while they would appreciate a cut, really need it to improve their bottom lines. Grotta notes that most big merchants have cut deals with the card networks to give them lower rates than published ones.

“The largest merchants are paying rates that are much lower, anyway,” she says.

‘No Choice’

Regarding another sore point, RILA said big banks aren’t abiding by the Durbin Amendment’s requirements for transaction-routing competition in e-commerce purchases. The amendment says merchants must have a choice of at least two unaffiliated networks in a debit transaction. A RILA spokesperson could not be reached for further comment.

But others agree routing remains an issue, and not just in e-commerce. A partial explanation is the industry-specific accounting applications used by many merchants may come with predetermined payment choices. Robert Steen, chief executive of Bridge Community Bank in Mechanicsville, Iowa, points to the example of his son, a veterinarian, who uses a payment program that interfaces with his accounts-receivable system.

“He has … no choice [on] how to route that transaction, and that’s happening all over the place,” says Steen.

Other findings from the survey give mixed signals about merchants’ card-acceptance costs. For example, debit card transactions from so-called exempt issuers—those with assets under $10 billion and thus not subject to interchange regulation—are generating less interchange on single-message debit networks. Such networks, often called PIN-debit networks, produced a per-transaction average of 31 cents in interchange in late 2011 but only 25 cents in 2017—a reduction of 19%.

“The non-Mastercard-and-Visa networks are having to get very competitive with merchants so that they can retain that volume for their networks,” says Mercator’s Grotta. “Because of that, the smaller financial institutions are the ones that are seeing less interchange.”

Conversely, smaller merchants often let somebody else make the routing decision, which means many point-of-sale debit transactions that could be routed on cheaper PIN-debit rails instead go through as dual-message transactions. Dual-message debit frequently is referred to as signature debit because it traditionally has used the Visa and Mastercard systems, and it usually costs more than single-message debit.

“A lot of the merchants, particularly the smaller merchants, they just do what they’re told by the processor,” says Steen.

Feeling Pain

While regulated interchange hasn’t changed and unregulated PIN-debit interchange is trending down, the story is different with network fees. These fees totaled $7.03 billion in 2017. The average network fee per transaction was 10.3 cents in 2017, which has not changed substantially since 2011, according to the Fed. Merchant acquirers paid 63% of network fees while issuers paid the rest.

“In recent years, the percentage paid by acquirers has increased slightly while the percentage paid by issuers has correspondingly decreased,” the text of the report says.

Why the shift? While the Durbin Amendment gave merchants more of a say-so over transaction routing, issuers—with their ability to put this network’s or that network’s logo on their cards—still have more clout with networks than acquirers and merchants, according to some observers.

“Issuers have a greater ability than acquirers to deliver more payment share to the network,” says Grover.

In other words, issuers’ card numbers trump merchants’ transaction numbers, unless you’re talking about the top tier of merchants. And most merchants are reluctant to overrule a customer’s choice over which card to use.

“I don’t think merchants have demonstrated that they can shift volume away,” says consultant Hewitt. “Not until the networks feel pain” will there be “some downward pressure on fees,” she says.

Merchants also are bearing more of the cost of debit card fraud. The Fed report says losses to all parties—merchants, issuers, and cardholders—on regulated issuers’ cards were 11.2 basis points, or $11.20 per $10,000 in transaction value, up from 10.3 basis points in 2015. Merchants absorbed 53% of 2017’s losses compared with 39% in 2015.

The most plausible explanation for this lies in the U.S. conversion from magnetic-stripe cards to the EMV chip card standard. The key event was the payment networks’ October 2015 liability shift that required merchants to absorb the expense of counterfeit fraud if their POS systems could not read a credit or debit card’s EMV chip.

The introduction of EMV chip cards and POS terminals that could read them was not far along during the 2015 debit study. But the value of chip-based payments in 2017 comprised more than half the value of general-purpose card payments for the first time, the Fed said in a separate study. Thus, merchants that could only read a card’s mag stripe very likely were eating more fraud.

The overall increase in fraud probably reflects fraudsters moving to online channels now that EMV has made counterfeit fraud at the point of sale harder to commit, according to Grotta. Card-not-present transactions accounted for 18.9% of debit volume in 2017, but the CNP growth rate of 22.6% in the 2016-17 period was almost 10 times the 2.3% growth in card-present transactions, the Fed reported.

In any case, the larger share of network fees and fraud losses merchants are absorbing could serve as an impetus to finding a solution that lowers their costs, even if that solution isn’t obvious today. “The cost of payments continues to shift to the merchants’ shoulders,” says consultant Hewitt. “Some day that’s going to give.”