Acquiring: The New Pricing Puzzle

 

By Lauri Giesen

 

The Durbin Amendment will disrupt merchant acquirers’ long-standing pricing strategies, at least temporarily. How long will the profit-padding opportunities created by Durbin last?

 

 

 

When retailers and their trade associations rallied in support of the Durbin Amendment to the Dodd-Frank Act last year, most believed they would see a big savings in the fees they pay for debit card acceptance if the amendment became law.

 

But now that the amendment is indeed law and the Federal Reserve in implementing it has come up with a debit card interchange rate that is about 45% below the former average for big banks, it appears that not all retailers are going to see lower card-acceptance costs—at least not right away.

 

“This is a huge victory for the big-box retailers who will see an immediate savings. But it will have very little impact on the small to mid-size retailers,” says Marc Gardner, chief executive of North American Bancard, a big independent sales organization based in Troy, Mich.

 

The reason is that the new interchange cap set by the Fed is actually paid by merchant acquirers, not merchants themselves. Acquirers and the ISOs they sponsor may pass on their savings to merchants—or they may not.

 

“There is no mandate in the regulation that says how acquirers have to pass the savings on to the merchants,” says David Fish, senior analyst with Maynard, Mass.-based Mercator Advisory Group Inc. “Some ISOs will pass on every penny of the savings to the merchants while others will use it as a means to increase their profit margins. Eventually, most ISOs will pass on some of their savings, but they might not pass on all of it.”

 

For now, there seems to be a bit of confusion as to what ISOs will do. “We’re seeing a little bit of everything in terms of pricing in the market today,” says Steve Cadden, president and chief operating officer of Dallas-based TransFirst, a big merchant processor. “Some ISOs are guessing at what the effect of Durbin will be in their card mix and taking an aggressive stance by lowering prices to retailers right away while others are holding off to see what happens.”

 

‘Another Disappointment’

 

Part of the difficulty in deciding whether and how to pass on the savings relates to the range of pricing models used to set discount rates, which incorporate interchange and processors’ own expenses and profits. Those acquirers and ISOs that use “interchange-plus” models—where the exact interchange rate for each specific transaction is shown plus a processing and handling fee—will pass on the lower interchange cost right away.

 

But retailers, typically smaller ones, that are charged “bundled” or “tiered” rates may not see quick savings. With bundled fees, retailers pay one rate for all transactions, regardless of whether the transaction is credit or debit, card-present or card-not-present, etc. With tiered rates, acquirers sort transactions into several broad categories and charge a set rate for each category, though debit and credit transactions still often are in the same category.

 

With the latter two types of fee structures, it is often difficult to isolate the impact of lower debit card interchange. Complicating the matter is that the Fed’s cap of 21 cents plus 0.05% of the sale, with another penny under consideration for fraud control, only applies to transactions on cards issued by financial institutions with more than $10 billion in assets.

 

Visa Inc. and MasterCard Inc., which set interchange rates, are retaining most of their pre-Durbin rates for smaller issuers. Acquirers dealing with bundled or tiered rates would have to figure out what percentage of transactions is likely to come from the big banks if they plan to give some relief to retailers. Based on anecdotal reports, big issuers probably generate about two-thirds of all debit transactions.

 

“With tiered pricing, you could cut a few basis points on some tiers, but it is technically difficult to do. Most ISOs are looking instead at adding to the value they bring to the retailers,” says Henry Helgeson, co-chief executive of Merchant Warehouse, a Boston-based ISO.

 

Indeed, merchants with tiered and bundled rates may not see any savings for some time.

 

“The larger retailers with interchange-plus rates are likely to see significant reductions in fees,” says Adil Moussa, senior analyst with Aite Group LLC, Boston. “But it is highly unlikely that the acquirers will pass on any savings to those smaller retailers with bundled rates. This will be just another disappointment for retailers.”

 

And if there are changes, it could take a while.

 

“I don’t expect to see many changes in pricing for at least the next six months,” says Scott Calliham, a principal with First Annapolis Consulting Inc., Linthicum, Md. “I think it will take at least that long for ISOs to get a feel on how this will affect them.”

 

‘Competitive Pressure’

 

Not only do acquirers have to examine what percentage of debit transactions are from big vs. small banks, but they will also have to wait and see if there is a shift from debit to credit card use as many banks drop debit rewards programs or start charging for debit card use.

 

Bank of America Corp. ignited controversy in late September when it said it would charge a $5 monthly fee to some checking-account holders when they use their debit cards for purchases. If moves like that drive down debit usage, that could affect how much savings acquirers pass on to merchants.

 

And some ISOs may resist passing on any savings unless they are forced to by customers threatening to take their business elsewhere.

 

“Our research shows that most ISOs will not be passing on any savings right away,” says Moussa. Instead, he expects many ISOs will increase their profit margins. “Christmas has come early for the ISOs. They are the big winners in this.”

 

Even if it takes several years, however, there could be savings coming down the pike for many retailers. For one thing, some experts believe that interchange-plus will become more common in the next year or two, especially for mid-size and the larger of the small retailers that currently have bundled or tiered fees. That alone should lower card-acceptance costs for many merchants.

 

Also, even if ISOs don’t switch more customers to interchange-plus rates, competitive pressure coming from those ISOs that do charge interchange-plus could push the others to lower the bundled and tiered pricing a few basis points on all transactions or create new lower-priced tiers for debit transactions.

 

“It is possible that some ISOs, once they know what their savings are going to be, will simply knock off five basis points or so on every transaction. They may keep some of the savings from Durbin themselves but then pass on part of the savings through lower bundled fees,” says First Annapolis’ Calliham.

 

Additionally, Calliham says some ISOs could create new tiers just for debit transactions and include both signature and PIN-based debit at a price level lower than that for credit card transactions. The Fed’s cap makes no distinction between signature and PIN debit.

 

Key to what happens is how competitive the market gets as a few aggressive ISOs and big acquirers begin to offer lower prices, mainly through interchange-plus models. “Short term, I think most ISOs will see a lift in their margins, but long-term the margins will decline due to competitive pressure,” says Greg Cohen, president of Schaumburg, Ill.-based acquirer Moneris Solutions USA.

 

‘Huge Opportunity’

 

Still, many merchant processors aren’t exclusively committed to any specific pricing model. They offer all of them, depending on the merchant. North American Bancard, for example, typically offers interchange-plus to its bigger retail customers and bundled prices to smaller ones.

 

And while Gardner does not expect that model to change, he does expect the ratio of interchange-plus vs. bundled pricing to shift as more mid-size retailers move over to interchange-plus.

 

Gardner notes that the savings under Durbin would not be that significant to a retailer that does $10,000 or less in card business per month, so it may not be worth changing its pricing plan or hunting for a less-expensive ISO.

 

But for merchants in the $30,000-to-$50,000-monthly range, the savings could be big enough for them to pressure their acquirers to move them to interchange-plus. Gardner expects just that to happen over time with a number of his mid-size retailers.

 

And merchants in that range are the customers most ISOs are trying hardest to retain, in part because their margins are higher than price-sensitive national retailers. “There is a huge opportunity in the medium-size retailer market. ISOs looking to stimulate growth all want customers in that size range,” Gardner says.

 

Another acquirer that has a mix of interchange-plus, tiered, and bundled pricing plans is TransFirst. For now, TransFirst is taking a “wait-and-see” approach.

 

“We’re not sure how much of a change we will see. We have every type of mix of pricing plans and it is hard to tell how this will shake out,” Cadden says.

 

Until TransFirst can see if changes are justified to its tiered and bundled rates, the company will offer rebates to those retailers that appear to be paying higher fees than they should under the new Fed interchange rule.

 

While Cadden believes there will be a greater movement by retailers toward interchange-plus in the next few years, he adds that the trend actually began three or four years ago and would have continued regardless of any legislation.

 

“The trend toward interchange-plus was happening before Durbin,” Cadden says. “Much of it was sales rep-driven. Most of the new sales reps in the industry do not really understand interchange and it was hard for them to come up with bundled and tiered plans that took interchange shifts into consideration. It was easier for them to simply take Visa and MasterCard’s interchange list and add a few basis points to every transaction and pass it on.”

 

Too Complicated?

 

But even if more retailers move to interchange-plus, there likely will be some that stay with their old plans.

 

“The conversion to interchange-plus will happen with the more sophisticated merchants, and Durbin will accelerate that trend, but there will always be some retailers that it won’t make sense for,” says Helgeson.

 

Currently, the majority of Merchant Warehouse’s volume is interchange-plus, yet the majority of merchants are on a three-tier pricing model, Helgeson says.

 

“There are 6 million home-based businesses that accept credit cards in the U.S., but the margins on their accounts are not enough to sustain an interchange-plus model,” he says.

 

Another acquirer waiting to see the outcome of Durbin is Moneris Solutions. But Cohen says Moneris may eventually lower rates or switch to different models if there is pressure from retailers. Like many acquirers, Moneris has multiple pricing plans.

 

“We will increase our efforts on retention and adjust rates when approached. We are prepared to lower rates if we start to see significant merchant churn,” Cohen says.

 

For those ISOs that primarily rely on interchange-plus, passing on the lower rates is simple. New York-based Kredit Karte, for example, has used interchange-plus for the vast majority of its customers, according to Mark Stoss, CEO.

 

The remaining retailers are online merchants that came to Kredit Karte through a Web host reseller that initially insisted on a two-tier pricing model. And even those retailers are now being moved over to interchange-plus as well.

 

But while Stoss and others argue that interchange-plus is the only way to go, many payment experts say there will always be a merchant segment that wants tiered or bundled pricing.

 

Aite’s Moussa argues that many retailers find interchange-plus too complicated. “Interchange-plus requires a greater understanding of payments and a lot of paperwork. Instead of getting a three-page monthly bill for bundled pricing, a retailer might get 16 pages detailing each transaction and they have to spend time to make sense of it all,” he says.

 

Calliham of First Annapolis agrees. “Interchange-plus appeals to retailers that are more educated on payment-pricing issues. There can be a real savings with interchange-plus, but there is a segment of the smaller merchants that find it too complicated to figure out. They just want one rate to pay,” he says.

 

And TransFirst’s Cadden adds that it’s often not only small retailers that want bundled prices. “A lot of merchants of all sizes don’t want to dig too deep into pricing and have to understand it. They just want a fair price and not have to spend a lot of time analyzing and worrying about what they are paying on every single transaction,” he says.

 

But Kredit Karte’s Stoss disagrees with the idea that interchange-plus is too difficult for even small retailers to understand.

 

“Half of our job is educating merchants. Once you show them what they are paying under tiered pricing vs. interchange-plus, they catch on quickly. They are intelligent and can see that tiered pricing gives bigger profits to the ISOs. If you want to retain your retailers, you explain how interchange-plus works and show them how much money they can save,” he says.

 

Race to the Bottom

 

The Durbin Amendment clearly could juice competition in the merchant-acquiring business. A few processors—most notably Princeton, N.J.-based Heartland Payment Systems Inc.—have made numerous announcements stating that they will pass on all of the savings of Durbin through their interchange-plus pricing.

 

The publicity generated from such announcements could push processors big and small to move toward an interchange-plus pricing model, or at least cut their tiered or bundled rates.

 

“If Heartland has a successful fourth quarter in terms of enticing new customers, that could put pressure on those ISOs that are not offering interchange-plus to move in that direction,” says Helgeson of Merchant Warehouse.

 

And that could affect the payments industry in more ways than just pricing.

 

“This could create an environment where the whole industry is devalued if everyone cuts their prices and races to bottom pricing,” says Mercator’s Fish.

 

Regardless, it appears there will be a shift toward interchange-plus pricing. Still uncertain is how long and deep the shift will be.

 

 

 

An Instant Read on Durbin

 

Merchant acquirer Heartland Payment Systems Inc., which serves 250,000 merchants, put out a press release on Oct. 4 detailing its experiences with regulated debit interchange from Oct. 1-3, the first three days that the Durbin Amendment was in effect. Heartland uses the interchange-plus pricing model, and its “Durbin Dollars” marketing campaign promises that merchants will immediately share in the savings from regulated interchange.

 

Highlights of the release:

 

– $1.78 million in debit interchange savings passed to merchants.

 

– Restaurants received $671,652 of the savings.

 

– The average Heartland merchant will save more than $1,000 in the first year of regulated prices.

 

– 65% of Heartland’s signature debit sales volume comes from regulated cards—those from issuers with more than $10 billion in assets.

 

– The average unregulated (exempt) debit interchange fee is 44 cents versus 23 cents for transactions with regulated cards.

 

– The average effective signature debit interchange rate for exempt cards is 1.55% of the sale versus 0.80% for regulated signature debit cards.

 

– Changes by Visa and MasterCard in their debit interchange rates for small tickets are actually raising costs for some merchants. Heartland’s quick-service restaurants are now paying on average an effective rate of 2.15% versus 2.08% pre-Durbin.