Cover Story: The Great Debit Network Reshuffle

MasterCard is up, and Visa’s Interlink is down—way down—as the U.S. debit industry realigns six months after the Durbin routing rules took effect. Other PIN-debit networks? It’s a mixed bag. But this card game is far from finished.

By Jim Daly

Think of countless Westerns where the bad guys storm in and tear up the saloon. In the eyes of many in the payments industry, U.S. Sen. Richard Durbin, chief sponsor of the now notorious Durbin Amendment to 2010’s Dodd-Frank Act, was the cowboy in the black hat who made a fine mess of the rollicking U.S. debit scene.

A year ago, Durbin’s interchange price controls began shredding about 50% of the revenue large debit card issuers, those with $10 billion or more in assets, earned on purchase transactions. And on April 1, Durbin’s transaction-routing provisions as interpreted by the Federal Reserve kicked in, provisions intended to give a merchant more choice over which network a debit card purchase would flow.

Durbin’s theory was that more network options would lead to lower card-acceptance costs as merchants chose the network with the lowest pricing.

MasterCard Inc. appears to be the winner, at least for now. The big loser is Visa Inc.’s Interlink network, which has lost more than half its volume.

‘A Pretty Big Winner’

The rules are having their largest effects on the side of the business where customers enter a PIN to complete a purchase. This side includes Interlink and MasterCard’s Maestro network, until now a minor player in U.S. debit, along with several former regional electronic funds transfer networks that have grown into national entities such as Star, NYCE, Pulse, and Accel/Exchange, and some smaller players.

Most of the networks are being guarded about revealing their transaction volumes, but the hints they are giving in public statements and filings, along with intelligence from industry sources, indicate a windfall for Maestro.

“The basic dynamic was that MasterCard shot up and Visa came plummeting down,” says Eric Grover, a former Visa executive who now heads Minden, Nev.-based consulting firm Intrepid Ventures. “All the other networks who thought this presented an opportunity to win either lost share, or are treading water.”

Adds Casey Merolla, a senior manager at Linthicum, Md.-based First Annapolis Consulting Inc. who follows the debit market: “We’ve seen Maestro as a pretty big winner here.”

In fact, Grover, based on his talks with industry insiders whom he won’t name, estimates Maestro’s volume is up 343% from a year ago.

On the other side of debit, where customers sign for a purchase, Visa remains a solid No. 1, with MasterCard remaining a distant second. Add signature and PIN purchases together and MasterCard has moved the needle only a little.

But don’t count anybody out yet. True, most issuers have cast their lot with a new PIN-debit network or two by now, but many merchants and merchant acquirers are still making routing decisions. And Visa has a multi-faceted comeback plan that could take months or even years to play out. That is, if the feds don’t intervene.

The plan includes the somewhat mysterious “PIN-Authenticated Visa Debit” program that enables the routing of Visa signature-debit purchases as PIN transactions. Visa has said little in public about PAVD, but industry executives say it’s an important factor as they assess their options in the changed market.

Before Durbin, network competition mostly meant enticing issuers to pump out cards bearing a particular network’s logo so that the network would get more revenue-generating transactions. Networks lured banks with financial incentives to put their logos on debit cards, and by raising interchange, a transaction fee paid by the merchant acquirer to the card issuer.

Acquirers typically pass the expense on to their merchant customers. So, in contrast to the layman’s expectation that business competition lowers prices, network competition in payment cards traditionally has raised them.

Networks, especially Visa and MasterCard, also give incentives to merchants to route transactions their way. But generally speaking issuers seem to have been the chief beneficiaries of network competition.

‘A Forced Dialog’

But now, Durbin forces networks and issuers to accommodate merchant routing choices. And all other things being equal, a merchant or acquirer acting on its behalf is likely to choose the lower-cost option.

“Durbin shifted the power to some degree from the issuer side to the acquirer side,” says consultant David Lott, senior vice president at Atlanta-based Speer & Associates.

Dan Kramer, senior vice president of marketing and merchant services at the Johnston, Iowa-based Shazam network, says Durbin also spurred something more intangible.

“It created a forced dialogue between retailer and processor,” he says.

Specifically, the Durbin Amendment bans networks and card issuers from entering into exclusive arrangements so that a debit purchase would be routed over only affiliated networks, such as Visa for signature transactions and Interlink for PIN-based sales.

The Fed, charged by Congress with writing rules to put flesh on the thin bones of the law, considered various options, including requiring that a card be able to access two unaffiliated signature networks and two unaffiliated PIN ones.

The Fed passed on that radical option and took what everyone agreed was the easiest one to implement: each card must enable a transaction to access at least one unaffiliated network. So a Visa-Interlink issuer, for example, would only need to add one more PIN-debit network to comply. The new network’s logo doesn’t even have to appear on the card as long as the issuer’s routing instructions enable the transaction to reach it if the merchant so chooses.

Exclusive Visa-Interlink combos have dominated U.S. debit card issuance in recent years. The Federal Reserve, in formulating its Durbin regulations, estimated the total U.S. PIN-debit purchase market at $555 billion in 2009. Visa has indicated that Interlink accounted for about a third of its U.S. debit volume, which works out to $291 billion for 2009. That would leave about $264 billion for everybody else.

Once the Fed’s rules came out, Visa executives began warning investors that Interlink was in for a hit.

And a hit it was. For the quarter ending June 30, Interlink volume fell 54% from year-earlier levels, Visa chief financial officer Byron H. Pollitt disclosed. Pollitt didn’t give actual dollar volumes, but this magazine sister publication Digital Transactions News estimated the quarter’s run-off at $52 billion.

‘All Over the Map’

Where’d it all go? Clearly a lot of it went MasterCard, which in the past couple of years has been reporting double-digit quarterly gains in total debit purchases on the strength of new issuers, such as SunTrust Banks, coming into its camp as well as debit’s enduring popularity with consumers.

MasterCard’s debit purchase volume totaled $111 billion in the second quarter, up 13% from a year earlier. How much of that gain came from Durbin isn’t known, but MasterCard president and chief executive Ajay Banga told analysts Aug. 1 that, “We feel really good about U.S. PIN debit in particular, even though we don’t yet know how these volumes will shake out.” He added that MasterCard has a “robust sales pipeline” in debit with “significant renewals” and new business.

MasterCard had some exclusive MasterCard-Maestro issuers so the Fed’s regulations hit it too, but not nearly as hard as the punch landed on the Visa-Interlink pairings. Some analysts believe Maestro may now have 20% or more of the U.S. debit market, possibly double its pre-Durbin share.

The other major contenders are gaining volume, but apparently not nearly as much as Maestro. Processors own the big ones—Star is owned by First Data Corp., NYCE by Fidelity National Information Services Inc. (FIS), and Accel/Exchange by Fiserv Inc., while Pulse is owned by Discover Financial Services, a network that also is a credit card issuer and merchant acquirer.

These owners all publicly report financials, but what they say about their EFT networks varies. The networks, along with MasterCard and Visa, all either refused or did not respond to Digital Transactions requests for comment for this story.

Discover reports Houston-based Pulse’s total transaction and dollar volumes—ATM transactions and point-of-sale purchases—and the percentage gains have been up in the teens lately. For the fiscal quarter ended May 31, Pulse posted $42 billion in volume, up 14% from $36.7 billion a year earlier. Digital Transactions estimates three-fourths of 2012’s volume, or $31.5 billion, was purchases.

First Data said in its second-quarter earnings call that its total debit issuer transactions increased 14% from a year earlier, 10% of which it attributed to Durbin’s routing and exclusivity rules. And First Annapolis Consulting says Accel/Exchange posted a 16% gained in PIN-debit purchase volume in the second quarter. FIS says NYCE’s revenues increased but didn’t provide details.

Below these large networks are a handful of other EFT networks, including Shazam, one of the last networks still owned by financial institutions and organized as a not-for-profit. Kramer won’t give numbers about Shazam’s post-Durbin experience, but says, “I can tell you as a network we have seen a gain in transaction traffic.”

This spotty reporting from the networks makes it hard to tell who among them has really won or lost so far under the routing rules, apart from MasterCard and Visa, respectively.

“I’m sure they’re all claiming they’re winners,” says Speer’s Lott. He adds: “I don’t think there was a tremendous amount of shift.”

Jim Hanisch, executive president of network operations and corporate development at Co-Op Financial Services, a Rancho Cucamonga, Calif.-based processor and network for credit unions, would agree with that assessment. The decisions by credit unions to add PIN-debit networks to their cards “were all over the map,” he says. “It wasn’t like there was a clear and definitive winner. There was a lot of reversion to regional loyalties.”

Yet the network battle for share ignited by Durbin is far from over and may continue indefinitely. One reason for that is that the April 1 deadline, while significant, did not mean that merchants had cast their final lots with any network.

“Merchants are still working things out, we’re also hearing,” says First Annapolis’s Merolla. “I’m not exactly sure what’s driving it, but things are more dynamic, and routing is moving week by week. There are just bigger fluctuations than we’ve seen in the past.”

The networks’ chief weapons are incentives, their interchange schedules, and whatever products and services they can dream up to differentiate themselves in a largely commodity business. In this new environment, Grover of Intrepid Ventures believes the smaller networks stand little chance against the likes of Visa and MasterCard.

“I think they’re toast,” he says. “They can’t compete with the nationals. It’s marketing, scale, footprint.”

Shazam’s Kramer would beg to differ, saying his network is offering competitive pricing and services, and is in discussions with issuers and merchants down to “my smallest retailer.”

“It’s easy for anybody to declare themselves the winner,” he says. “I’m not just going to quit on that, that somebody tells me they’ve won. That’s long from being determined.”

The most public side of the battle will be between Visa and MasterCard, which occasionally announce which new issuers are in their camp. They also report how much they’re paying out in incentives and rebates to issuers and merchants. Everything indicates an increasingly costly war to buy loyalty.

In the quarter ended June 30, MasterCard reported incentive costs of $661 million, up 24% from $534 million a year earlier. At Visa, incentive costs hit $614 million, a 37% increase from $448 million in fiscal 2011’s equivalent quarter. The other networks also pay incentives, but their costs are buried in the parent companies’ financials.

Most networks can be expected to engage in conventional warfare as the fight for share continues. The biggest unknown at this point is what Visa will do. Chief executive Joseph Saunders said at Visa’s latest earnings call that he expects Visa’s debit contraction to bottom out soon, but some of Interlink’s losses will be permanent.

Low-Cost Scenario

That doesn’t mean Visa is conceding anything. With its new Fixed Acquirer Network Fee (FANF), Visa promises to reward acquirers and merchants with lower variable pricing and lower overall acceptance costs if they commit certain volumes to Visa (“What’s This FANF Thing All About?” September).

There’s more. Saunders startled the industry a year ago when he said publicly that the VisaNet processing network, over which credit card and signature-debit transactions travel, also could handle PIN-debit transactions.

VisaNet apparently had that capability for quite some time, as does MasterCard. While many in the industry knew about the feature, few people gave it much thought and Visa never called attention to it until Durbin rattled the status quo. In the new environment, Saunders called the feature “an important competitive differentiator.”

The feature is now the core of Visa’s new PAVD program. Visa has said little about it publicly, and issuers and merchants are still learning about it.

Essentially, the feature enables a card with a Visa logo to capture a PIN-debit transaction even if the merchant doesn’t accept Interlink. Upon swiping the card, the POS terminal would prompt the customer to enter her PIN, whereupon the merchant would have the option to route the transaction to Visa, according to Merolla of First Annapolis.

Those routing decisions seemingly would rest heavily on the cost. Visa hasn’t publicly disclosed an interchange schedule for PAVD transactions, but Saunders in October 2011 indicated interchange rates for VisaNet PIN-debit transactions could be at or below Interlink’s.

Such a low-cost scenario for merchants may indeed be playing out. Hanisch of Co-Op Financial Services says some credit unions are reporting that some of their transactions are going the PAVD route, and that such volume negatively affects their interchange.

“We don’t know across the board what the interchange impact is … but the best we can tell, it’s less than it would be if it had gone through an alternative PIN-debit network,” he says.

It’s early in the game, but PAVD could prove to be a powerful weapon for Visa in the newly competitive landscape.

“It has pretty big implications,” says Merolla. “It’s blurring that line between a signature-debit transaction and a PIN-debit transaction.”

Ripple Effect

The government, however, could spoil Visa’s comeback party. In March, the Antitrust Division of the U.S. Department of Justice issued a Civil Investigative Demand (CID) to Visa for documents about PAVD and other components of its post-Durbin debit strategy.

The DoJ has made no comment about the investigation, but it could mark the beginning of a legal challenge if the department concludes that Visa is unfairly hindering competition.

Visa says it has met with the DoJ twice and is cooperating. The company also said it has cooperated with the DoJ on previous CIDs about different matters that ended with no court action.

Beyond Visa, small banks and credit unions voiced fears as the Fed wrote its regulations that market forces, aided by the routing provisions, eventually would lead to a convergence of regulated and unregulated interchange rates. Regulated issuers account for about two-thirds of the market and can legally receive no more than 21 cents plus 0.05% of the transaction, plus another cent for fraud control.

With the exception of small-ticket interchange, rates for so-called exempt issuers—those with fewer than $10 billion in assets—currently remain at or close to what they were pre-Durbin.

But perhaps not for long, and that could have a ripple effect in the payments industry, according to Kramer of Shazam, which provides processing and acquiring services to financial institutions in addition to EFT network services.

Exempt debit card issuers “fundamentally understand that they will see an interchange reduction,” says Kramer. “From our perspective, as they see reductions in those interchange revenues, they’re going to force processors like us, both on the core side and the EFT side, to lower their processing expenses.”

Of course, lower interchange revenues for issuers imply lower card-acceptance costs for merchants, which is what Durbin intended. Is that now the case across the board, and has the card game changed permanently?

The jury’s still out, though large merchants can be expected to assess their network and routing options to reduce their card-acceptance costs even more carefully than they did in the past. But some observers believe small merchants that care little about the nuances of payments will be the last ones to see any improvement in their bottom lines.

Some acquirers serving small merchants route transactions to the least-cost network, “but they’re not really passing on the savings to the small mom-and-pop,” says Speer’s Lott.

If anything, Durbin could inject some creativity into the payments industry as it struggles to maintain profitability in a newly regulated environment.

“In a way that’s a good thing because it forces innovation in the industry,” says Kramer. “We have not been substantively innovative in our industry in a long time, and that needs to change.”

Credit Unions Eye the  PIN-Debit Acceptance Market

Entering a market thrown into turmoil because of new Durbin Amendment regulations might seem a little dicey, but that isn’t stopping Co-Op Financial Services, an ATM network and processor for credit unions, from creating a specialty PIN-debit network.

In August, Rancho Cucamonga, Calif.-based Co-Op announced the formation of its Co-Op Network PIN POS service. The service rides on the rails of First Data Corp.’s Star electronic funds transfer network, enabling debit card holders of participating credit unions to access Star’s nearly two million U.S. merchant locations.

While the network’s backbone is Star’s, and Star sets the interchange rates, the branding is Co-Op’s, says Jim Hanisch, executive vice president of network operations and corporate development.

The new service will enable credit unions to sell point-of-sale acceptance of debit cards to business customers. “As a general statement, we do see business-related services as an area of growth,” says Hanisch.

And with the Durbin Amendment spurring a massive re-examination of PIN-debit card acceptance costs and strategies by financial institutions and merchants alike, Co-Op saw a new opportunity.

“We thought it made sense, especially given the Durbin situation,” says Hanisch. “Being a co-operative, the credit union is our focus. We thought it was time to have a POS program focused on our member credit unions.”

Hanisch says Co-Op chose Star as its partner because of the long-standing business relationship between the two firms, and because Star could offer competitive interchange rates.

Co-Op serves more than 3,000 credit unions with 30 million members, and links 30,000 ATMs.