Back to the Drawing Board on Debit Rates: Sorting Out Winners and Losers

With merchants prevailing in their long-running legal battle to overturn debit rate caps set by the Federal Reserve, the largest debit card issuers could wind up the biggest losers, while Capital One Financial Corp. emerges as the big winner.

U.S. District Court for the District of North Dakota Judge Daniel M. Traynor late Wednesday delivered a huge blow to debit-issuer revenues with a ruling that the debit card interchange rates set by the Fed must reflect debit issuers’ actual cost per transaction. The Fed gained the power to set debit rate caps under the Durbin Amendment to the Dodd-Frank Act, enacted 15 years ago.

Prior to Traynor’s ruling, the Fed set debit caps using a so-called “blended” formula that takes into account myriad costs issuers incur with a debit card transaction, including fraud prevention and fraud loss recovery. Tying debit rate caps more closely to actual per-transaction costs could severely crimp issuers’ profits, some payments industry executives say.

“This ruling is going to have a seismic impact and radically reduce profits for large debit issuers, because their cost per transaction is pretty close to zero,” says Eric Grover, principal at Intrepid Ventures. “If the ruling sticks, tens of billions of dollars in interchange revenue will evaporate.”

Grover supports Traynor’s ruling despite opposing the Durbin Amendment because the Fed did not faithfully implement the law’s “purposefully punitive debit-interchange price caps,” he says. “Congress, not the Fed, is the policymaker,” Grover adds. “The Fed’s job was to implement Congress’s intent as expressed in the text of the statute.”

Under rate caps imposed by the Fed in 2011, Mastercard and Visa issuing banks with at least $10 billion in assets can charge up to 21 cents per debit card transaction, plus a penny for fraud prevention and 0.05% of the transaction for fraud-loss recovery. While the Fed’s rate cap cut the interchange revenues of big issuers by about 50%, merchant groups have long argued the caps do not reflect the actual per-transaction cost to debit card issuers, which is 3 to 4 cents and can be even less for the largest issuers.

“The judge basically told the Fed that debit rates need to be calculated in a more straightforward way,” says Stephanie Martz, chief administrative officer and general counsel for the National Retail Federation. “Judge Traynor did a very good job of establishing that the Fed included a lot of costs in setting the caps that violate the Durbin Amendment.”

While the Fed opted to review the rates caps in 2023 and asked for industry input, that move was essentially a non-starter with merchants. They felt the central banks’ decision was motivated by a decline in other costs associated with debit transactions, rather than a decline in interchange.

“That proposal didn’t correct the original mistake, which was looking at the entire cost structure of debit acceptance, not just the actual cost per transaction,” says Doug Kantor, an executive committee member at the Merchants Payment Council and general counsel for the National Association of Convenience Stores.  “[Traynor’s] ruling also supersedes the Fed’s 2023 proposal.”

While large debit issuers are expected to see their revenues severely crimped as a result of Traynor’s ruling, Capital One is a potential beneficiary thanks to its acquisition of Discover Financial Services earlier this year. Discover, which issues both credit and debit cards, is exempt from the provisions of the Durbin Amendment as a third-party network that competes with the Visa and Mastercard networks. 

“Discover issues debit cards, and there are very few of them in circulation, but Capital One now issues them, which gives Discover an enormous advantage [under Durbin,]” Grover says. “Capital One can use the higher revenues it can earn under the terms of the ruling to fund incentives that can attract cardholders that banks affected by Traynor’s rulings can’t.”

Traynor also issued a hold on his decision, pending any appeals, to prevent any market chaos that could result from immediately dispensing with the Fed’s rate caps and creating an unregulated market in which debit issuers could set interchange rates as they see fit.

“With the hold in place, the current rules regulating debit interchange remain while the appeals process plays out,” Kantor says. “Without the hold, the debit ecosystem would jump into the unknown of no regulation.”

Traynor’s ruling may well be appealed, but the odds of success are poor, even if the appeal reaches the United States Supreme Court, some observers say. “The Fed has exceeded its authority by taking [on] too much discretion in its interpretation of the Durbin Amendment,” Grover says. “If the ruling is appealed to the Supreme Court, it would probably agree with Traynor’s ruling.”