Acquiring: Capped Off

Karen Epper Hoffman

It’s been 18 months since the Durbin Amendment’s debit card interchange cap took effect. Who is benefitting the most from the first government intervention into card-acceptance pricing?

A year-and-a-half after the Durbin Amendment’s debit card interchange cap took effect, the radical legislation that created the cap remains no less controversial than it was when Sen. Richard Durbin, D-Ill., introduced it about three years ago. Whether by design or not, the Durbin Amendment pitted merchants against big banks and card networks.

Sewn into 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act, the amendment set interchange price controls—as established by the Federal Reserve Board—for 131 financial institutions with more than $10 billion in assets. Beginning Oct. 1, 2011, the Fed fixed those institutions’ debit interchange at 21 cents plus 0.05% of the transaction, plus another 1 cent if the issuer employed effective fraud-control measures. That comes out to roughly 23 cents on the typical debit card transaction.

The cap effectively cut average per-transaction interchange revenue by about 50% on two-thirds of the nation’s debit cards. The loss of interchange revenue will cost banks $8.4 billion annually, according to Card Hub’s 2012 Impact Study. In March, the Fed declined to review its Durbin regulation.

In addition, the Durbin Amendment also changed network-exclusivity and transaction-routing rules. Instead of debit card issuers choosing which network handles the transaction, it’s now basically the merchant’s call. This rule took effect on April 1, 2012, with similar routing rules for prepaid cards taking effect this month (“Prepaid Cards Navigate the Durbin Waters,” March).

There’s little doubt, according to industry observers, that the amendment has favored large merchants, who arguably benefit from lower interchange costs and greater choice. But whether the new rules have done much for other players in the debit transaction food chain—particularly consumers—is a more difficult question to answer. In a bank card transaction, the merchant acquirer pays interchange to the card issuer at rates set by the card network.

Mallory Duncan, senior vice president and general counsel for the Washington, D.C.-based National Retail Federation, believes the effects of Durbin are “a mixed story. For three out of four merchants, this lowers the costs for them and their customers.”

In the case of the one-quarter of merchants he believes the regulation didn’t help, Duncan says, “It was not the law, but the Fed’s interpretation of the law.” He says that had the Fed gone with the transaction cap of 7-to-12-cents that it first proposed, “it would have been unalloyed good news for all customers and merchants.” In its final rule, after heavy bank lobbying, the Fed raised the cap to 21 cents plus 0.05% of the sale.

But did the cap help anyone aside from the merchants?

“[The Durbin Amendment] has reduced debit interchange rates, which has helped the merchant. But there’s no evidence of any consumer benefit,” says veteran acquiring industry researcher C. Marc Abbey, managing partner at First Annapolis Consulting, Linthicum, Md.

Duncan disagrees. As evidence, he points to the comparatively slim net profit margins of the retail industry, which were 2% before Durbin took effect and remain at about the same percentage.

“If [merchants] were not returning the profit to the customers, those margins would have gone up,” Duncan says. He adds that it’s still good for the retail industry, which is effectively able to sell more goods by lowering prices, benefiting the consumer.

But Trish Wexler, a spokeswoman for the Electronic Payments Coalition, an organization of banks and card networks that lobbied against the Durbin Amendment, is still adamant that the legislation is “really bad policy. Government price controls ultimately harm consumers in the end,” she says.

“When the government is picking winners and losers … it’s never an even shift. And the side that’s losing will pass all their losses into their costs. So in the end, it’s the consumer that ends up getting hit.”

Big banks raised checking account fees and cut debit card rewards for consumers in order to compensate for debit card interchange shortfalls, according to Durbin Amendment opponents.

But others say there is a silver lining around the Durbin clouds. While the amendment has had “a fairly major impact on card processing … it has worked to reduce costs in a fairly significant way. It has worked for larger merchants,” says Robert H.B. Baldwin Jr., vice chairman of Heartland Payment Systems Inc., a large merchant acquirer based in Princeton, N.J.

“Even smaller merchants have gotten a range of benefits, some greater routing choice [for example],” he continues. “We have seen merchants taking advantage of that.”

Sharing the Wealth

For independent sales organizations and acquirers, there’s undoubtedly been at least a short-term boon to their bottom line. Since they are the ones that directly pay interchange, acquirers almost always pass the expense on to the merchant, who in turn passes it to the consumer. When interchange rates fall, as they did under Durbin, however, acquirers are not obligated to pass their reduced expenses on to merchants, and some indeed have not. While experiences vary based on the company, acquirers’ net spreads have generally improved by more than 10%, according to Abbey.

Consultant Eric Grover, principal with Minden, Nev.-based Intrepid Ventures and a staunch advocate of the pre-Durbin status quo, also says many acquirers and ISOs pocketed the benefits, at least initially. The big merchant processors Global Payments Inc. and First Data Corp. both reported some margin lift post-Durbin. They and other processors “reaped a one-time windfall,” Grover says.

But most acquirers are now using “interchange-plus” pricing models that delineate interchange and the processor’s own charges. Under such plans, merchants fairly quickly pay either more or less when Visa Inc. and MasterCard Inc. adjust interchange pricing, which can account for 75% or more of total card-acceptance costs. In the intensely competitive world of merchant acquiring, most experts expect the Durbin margin lift will be temporary.

A few acquirers, notably Heartland, “have taken a righteous stance” and explicitly played up their merchant-friendly policies of immediately passing on their reduced debit interchange expenses to merchants, says Grover. Heartland in 2011 launched its “Durbin Dollars” program to explicitly point out how much merchants could save under the Durbin Amendment by processing through Heartland.

“We charge based on whatever the interchange is and what we have negotiated,” Baldwin says. “When interchange went down, it was an  entirely natural approach [for us] to pass that along to merchants. That’s just how we run our business.”

Heartland has passed back more than $400 million in debit interchange savings to small and mid-sized merchants alone, Baldwin says. While he would not disclose how much new business this aggressive approach has gathered for the processor, Heartland’s new margin installed, a measure of sales-force productivity that tracks merchant profitability, was up 20% last October, due at least in part to the Durbin Dollars campaign.

“There’s no question we have won over merchants and also kept merchants that might have left by attrition,” says Baldwin. And that, in turn, has had an impact on Heartland’s margins, which started to see a bump as early as October 2011. “It’s not hard to surmise where it came from,” he adds.

Ultimately, Baldwin expects that more acquirers will follow suit, given the competitive pressures in the market.

“There’s a certain pressure on the base,” Baldwin says. “Over time, we expect pricing to come down modestly for [small and medium-sized] merchants.”

Jeff Fortney, vice president for ISO channel management at processor Clearent LLC in Clayton, Mo., believes that about half of ISOs and acquirers are still pocketing their Durbin savings. But there’s danger in that tactic since merchants may become aware that they could get a better deal with a different processor.

“The trouble is that more and more ISOs keep using a lazy strategy,” Fortney says. “That technique has cost ISOs some parts of their portfolio.”

Who’s Getting Squeezed

Commentators on the Durbin Amendment also say that it disserves small and mid-sized merchants—those that lack clout to strike the best deals with acquirers, and especially those that deal in low-value debit transactions. Acceptance costs for small sales have actually gone up because Visa and MasterCard set interchange rates for them at the Fed’s cap.

“The big loser here was the small-ticket merchants because they ended up being charged for every transaction at the caps,” says Baldwin. “It basically hurts this category.”

Duncan of the NRF blames the small-ticket merchants’ plight on what he calls the Fed’s misguided interpretation of the “reasonable and proportional” wording in the Durbin Amendment for what interchange should be in light of issuers’ costs for authorizing and settling transactions.

“[Small merchants’] costs stayed the same or went up,” Duncan says. “This is clearly not what Congress intended.”

Gray Taylor, consultant for NACS (the National Association of Convenience Stores) and executive director of the standards board for the convenience-store industry, says c-stores have seen their effective interchange rate increase by 5% under the debit cap.

“They’re seeing diminishing returns as more consumers are moving to plastic,” Taylor says, adding that he has seen a 15-basis-point drop. “It’s very expensive and this isn’t just our problem. It’s hurt [quick-serve restaurants] too.”

The year-old network-exclusivity and transaction-routing rules also have had an effect on the dynamics of debit processing. The regulations—which outlaw issuers and networks from having exclusive arrangements in which the signature and PIN-debit networks offered by a card are affiliated—affect only so-called “four-party” cards, Visa- and MasterCard-branded cards issued by banks and credit unions. “Three-party” network cards, issued by American Express or Discover, are exempt.

Under the regulation, the Fed now requires that a bank card be able to access at least one PIN-debit network unaffiliated with the signature network. The card doesn’t even have to display the new logo, it simply must make access to that network possible for the merchant. Unlike the price controls, this part of the Fed’s rule affects all debit card issuers, not just those with $10 billion or more in assets.

In the year since the routing rules took effect, it is Visa’s PIN-debit network, Interlink, which has taken the biggest hit. Due to the many issuer contracts that required exclusive use of the Visa and Interlink networks, Interlink previously accounted for, by some estimates, as much as 60% of the PIN-debit market. But by the end of 2012, Interlink had lost half of its volume. In an effort to rebuild its debit business, Visa last year launched its PIN-Authenticated Visa Debit (PAVD) program, which enables merchants to route PIN-debit transactions on Visa debit cards regardless of whether or not the issuer is an Interlink member.

Fumiko Hayashi, senior economist with the Federal Reserve Bank of Kansas City and the author of two recent reports on the Durbin Amendment, says the “first intended outcome [of the exclusivity regulation] is to encourage competition among networks for merchants.” She believes the reduction in market share for Interlink signals that the regulation has been effective, at least for PIN-debit transactions.

The main beneficiary of Interlink’s downsizing, observers say, has been MasterCard’s Maestro network, until last year a debit also-ran that may have picked up more than half of its rival’s lost volume (“The Great Debit Network Reshuffle,” October 2012).

“With these market changes, many issuers observed volatile routing patterns for much of 2012,” First Annapolis noted in a recent report. “While routing has by most accounts stabilized, issuers are still observing significant monthly swings in the routing preferences of specific merchants. In 2013, the network-routing environment will remain dynamic and unpredictable. Acquirers and merchants vary widely in the sophistication of their routing capabilities, ranging from a simple ranking of network preferences to more granular transaction-level decisioning.”

As Grover of Intrepid Ventures sees it, “Network competition has been affected and will continue to be affected.”

While he believes Visa will continue to work on “clawing back share with merchants,” the company could face more woes due to a U.S. Department of Justice probe, launched last year, to investigate Visa’s Fixed Acquirer Network Fee (FANF)—a new pricing mechanism that some insist penalizes merchants that route debit transactions to other networks. (Visa deferred to the EPC for comment for this story.)

“Networks are finding their economics subject to a new kind of pressure that has not existed before,” Grover says.

As migration from magnetic-stripe payment cards to Europay-Visa-MasterCard (EMV) chip cards comes to the fore, he adds, network competition will get even more heated and potentially more complex.

Another wrinkle in the exclusivity regulation: Since it affects all debit card issuers, it could be have an adverse impact on smaller financial institutions, according to the EPC’s Wexler.

“No one bothered to ask credit unions or community banks if this would work,” she says.

Wexler says recent research by the Credit Union National Association (CUNA) concluded that while exempt from the interchange pricing caps, credit unions are still “seeing their revenues on interchange go down” due to the non-exclusivity rules that favor merchants.

The Durbin Amendment clearly raised many questions and issues, some anticipated and some not. It may take years to know the answers.