E-Commerce: How Online Merchants Can Make Durbin Pay off

 

René M. Pelegero

 

The dominance of credit cards for online purchases means Durbin’s debit-interchange cuts won’t benefit e-commerce merchants as much as brick-and-mortar retailers. But, with some strategic thinking, online sellers can wring maximum savings out of the new regulations.

 

By the time this article went to print, it was not known if the Federal Reserve Bank would meet the July 21 deadline to issue its final regulations on debit card interchange. The Fed, which is implementing the provisions of the Durbin Amendment to the 2010 Dodd-Frank Act, is challenged due to the inherent complexity of the proposed regulations and the lobbying efforts of the financial-services industry to delay them.

 

While that delay effort was finally defeated in Congress last month, it had been in progress for months, adding to the uncertainty surrounding Durbin.

 

Even if the delay effort had succeeded, the impact of this legislation on the different segments of the economy would have remained a topic of debate. Will merchants pass the financial benefit to consumers? Will Durbin cause the failure of financial institutions? Will consumers care?

 

A Silent Fed

 

In the e-commerce space, one of the most vibrant sectors of the U.S. economy, the one question frequently asked is, How much benefit will Durbin bring? The answer seems to be … very little. Why? Mainly, because U.S. consumers seem to prefer credit cards over debit cards to shop online. This is due to the perception that credit cards are more secure than debit cards. Approximately three out of every four online purchases paid with bank cards are done with credit, rather than with debit, cards.

 

Additionally, the number of online payments made with bank card transactions is decreasing as a percentage of total transaction volume because online merchants have introduced alternative payment methods such as PayPal, Secure Vault Payments, BilltoMobile, and many others. These alternatives can account for as much as 10% of the total payment volume. When all these variables are factored in, the estimated share of online purchases made with debit cards is around 20% of the total transaction volume.

 

In any environment, a 70% reduction of fees (footnote 1) on 20% of the transaction volume would be a good thing indeed. However, markets are dynamic. Financial institutions will not remain idle. Large credit card issuers (which command a 90% market share of all online transactions) can be expected to launch marketing campaigns to drive consumers to use more credit over debit when shopping online. They will use positive incentives, like additional rewards, or send negative messages, emphasizing the perceived safety of credit over debit.

 

Debit issuers are also planning measures to recover lost revenue from debit interchange. These measures can be expected to draw consumers away from debit cards. The press has reported that some financial institutions will cut reward programs and charge fees to consumers for using their debit cards. A New York Times article in March, for example, stated that “JPMorgan Chase isn’t the first bank to back off debit reward programs: PNC Bank and U.S. Bancorp also have rolled back some perks.”

 

Financial institutions are also considering establishing transaction caps, as reported by the American Banker in February. The New York Times also reported that in addition to JPMorgan Chase, Citigroup Inc. and Bank of America Corp. are considering transaction-size limits of $50 to $100.

 

The practical result from these caps is that merchants may not be able to accept debit cards when the transaction amount exceeds the cap because they lack the facilities to accept “split tenders” and because Visa/MasterCard regulations prohibit such splitting of transactions.

 

Another possible play by financial institutions is to migrate debit cards users to reloadable prepaid cards, which are not subject to the new interchange caps. Financial institutions themselves could sell prepaid cards, as has been suggested by several industry analysts, or consumers may acquire prepaid cards from other sources and use them to shop online as a way to avoid fees and caps.

 

Undoubtedly, the future of online payments after Durbin remains uncertain. Many parts of the regulations that can have a major impact on online merchants are still to be officially disclosed. As an illustration, it is not yet known whether the card-not-present (CNP) effective surcharge will be removed from debit transactions. (footnote 2)

 

In a joint letter sent by Amazon, Apple, Dell, Digital River, Expedia, Google, Net­flix, Orbitz, Zappos, and others, e-commerce merchants asked the Fed to eliminate the “pricing discrimination for CNP transactions” stating that the cost of authorizing, clearing, and settling the transaction—the basis for establishing the “reasonable and proportional” cost on which the interchange caps are based—is the same whether the card was present or not at the time of the transaction.

 

As of this writing, the Fed remains silent on whether the new debit card fees will indeed be the same regardless of transaction type. An interesting side issue from this decision is that if the CNP surcharge is eliminated for debit cards, how can it be justified for credit cards?

 

Competitive Balance

 

Usually, whenever a new piece of legislation is introduced there are some unintended consequences, and Durbin is no exception. The first Durbin-related unintended consequence is the potential for limiting innovation in the payments space. Isis, the recently formed joint venture of telephone carriers, is scaling down its ambitious plans to offer an alternative payments mechanism because—so the pundits claim—there is just not enough money to be made from transaction fees.

 

Another unintended consequence is the impact on the PIN-based EFT networks such as Star, NYCE, Pulse, etc. These networks, either using alternative authentication methods (Star and NYCE), or using floating PIN pads (Pulse), are finally stepping up to the challenges of supporting e-commerce transactions and could deliver merchants a 33% to 50% reduction in debit card fees when compared with signature debit transactions. With Durbin in effect leveling the fees for all debit cards, why would merchants go through the bother of supporting a new payment method?

 

So, on the cusp of fundamental changes in the economics of debit payments, what can online merchants do to take maximum advantage of these developments?

 

Unlike brick-and-mortar merchants, online merchants cannot fall back on checks or cash. They need to think about the problem strategically. Online merchants must depart from the premise that the long-term battle is how to get consumers to use debit over credit when buying online.

 

They must address consumers’ concerns regarding the safety of their bank-account information. And they must find a way to drive consumer behavior toward debit—acknowledged to be a very hard thing to do. In the short term, however, they can develop tactics to take advantage of all the avenues available to them to reduce transaction expenses.

 

Online merchants ought to segment their customer base and think of ways to incent their best (and lowest-risk) customers to use lower-cost forms of payment.

 

Online merchants should actively leverage the provisions of the recent Visa/MasterCard settlement with the U.S. Department of Justice, which allows steering of customers to lower-cost forms of payment using incentives such as free shipping. Many merchants are already offering free shipping for competitive reasons, so they could very well offer it to selected customers in exchange for bank-account information allowing conversion of expensive credit card transactions into very low-cost ACH transactions.

 

Additionally, online merchants should also implement support for split tenders, where one purchase can be charged to multiple cards to deal with the expected transaction caps.

 

All retailers should also pay close attention to the “multihoming” provisions of Durbin. One of the wild cards with the upcoming regulation is what effect the interchange caps will have on network fees and assessments and whether these will replace revenue issuers lose from interchange.

 

Routing transactions through the EFT/PIN-based networks could offer a competitive balance to the traditional signature-based networks. Since EFT networks probably have the best chance to change consumer behavior and encourage use of debit over credit, this is an alternative that provides multiple benefits.

 

Opening Skirmish

 

Longer term, retailers should invest in accepting alternative payment methods and supporting the development of new payment ideas.

 

Even though they cannot easily take cash or checks, online merchants have an advantage over brick-and-mortar operations because the Internet and mobile devices offer alternative paths to access consumers’ funding sources. This can, in turn, deliver lower payment costs. Thus, online merchants are better-positioned to take advantage of innovations in the payments space.

 

In summary, brick-and-mortar merchants can gain mightily from Durbin, but these benefits are not expected to flow to online merchants to the same degree. Online merchants, however, can still derive benefit from these changes, but they need to think strategically and develop tactics to get consumers to use their bank accounts for online shopping, rather than credit lines.

 

The changes introduced by Durbin are just the opening skirmish in a much larger and longer battle for control of the consumer and for the cost of payments.

 

 

 

René M. Pelegero is president and managing director of Retail Payments Global Consulting (RPGC) Group LLC, Woodinville, Wash. Reach him at renep@rpgc.com.

 

 

 

1. The American Bankers Association estimates that the proposed interchange cap of 12 cents will generate 70% to 85% less revenue to financial institutions as compared with current levels.

 

 

 

2. This is the 50 to 65 basis points of additional interchange that the card schemes have effectively established on top of the interchange charged to brick-and-mortar merchants.