Networks: Once Again, with Feeling

By Jim Daly and John Stewart

A judge says the Federal Reserve Board failed to carry out Congress’s will for debit cards when it wrote its rules implementing the Durbin Amendment. Now what?

Most businesses dislike government regulations. But they really hate situations where a regulation gets upended, the result being confusion or even chaos.

That’s just the state of affairs debit card issuers, payment card networks, merchant acquirers, and debit-card-accepting merchants were facing late in the summer of 2013 in the wake of an astonishing federal court decision that overturned the Federal Reserve Board’s rule that implemented the Durbin Amendment, the part of 2010’s Dodd-Frank Act that regulates debit cards.

As of mid-August, the payments industry and legal observers were anxiously awaiting word about how the Fed would react to the July 31 decision by Judge Richard J. Leon of U.S. District Court in Washington, D.C., including whether the banking regulator would appeal or put in place an interim rule while it crafts a permanent rule that might pass muster with Judge Leon. At a mid-August hearing, a Fed attorney shed little light on what the Board’s next move might be.

In any case, there’s a good chance the interchange cap for large banks called for by the Durbin Amendment will be ratcheted down—great news for merchants, not so great for banks.

At the August hearing, Leon even raised the possibility that merchants might be reimbursed for the allegedly excess debit card interchange they’ve paid since October 2011 when the cap took effect, an amount that could total $3 billion or more.

A distinct possibility, too, is that each debit card will allow the merchant access to two signature-based debit networks, once a nearly unthinkable idea, in addition to the two unaffiliated PIN-debit networks most issuers chose under the Fed’s current rule to fulfill Durbin’s routing requirements.

That prospect has electronic funds transfer networks moaning because it throws a major new element of complexity into their plans for making the coming Europay-MasterCard-Visa (EMV) chip cards compliant with the Durbin Amendment, just when it looked like they might be on the cusp of solving that knotty issue.

‘A Massive Change’

“Whether people like or don’t like Durbin, everyone has adjusted to the current status quo,” says Tony Hayes, a debit expert and partner at Oliver Wyman, a Boston-based consultancy. “To have this thrown wide open again is going to create upheaval. It’s a massive change.”

Adds payments attorney Anita Boomstein, a partner at Hughes Hubbard & Reed LLP in New York: “The court wants to see action, and immediately wants to see a plan on what they [the Fed] are going do,” she says. “To me it’s a very strong signal that the court means business.”

Indeed, Leon’s 58-page decision finding for merchants and retail trade groups that challenged the Fed’s original rule is replete with one blunt assessment after another of how he saw the Fed veering away from the law’s intent.

Dodd-Frank assigned to the Fed the difficult task of crafting “reasonable and proportional” regulations for debit card interchange and devising transaction-routing requirements for networks and debit card issuers that would create more options for merchants. On the matter of interchange caps, for example, Leon charged the Fed with allowing too many extraneous costs in setting its cap.

“Accordingly, I find that the text and structure of the Durbin Amendment … are clear with regard to what costs the Board may consider in setting the interchange fee standard: Incremental [authorization, clearing, and settlement] costs of individual transactions incurred by issuers may be considered. That’s it!”

On the routing question, the opinion issued a sharp rebuke: “The Board’s final rule not only fails to carry out Congress’s intention; it effectively countermands it!”

Plaintiffs in the case are the National Retail Federation trade group; NACS, the convenience-store association; the Food Marketing Institute; Miller Oil Co.; Boscov’s Department Store LLC; and the National Restaurant Association. The Fed is the sole defendant.

“We’re very pleased to see the court light a fire under the Fed,” National Retail Federation senior vice president and general counsel Mallory Duncan said in a statement. “These [card-acceptance] fees have been driving up prices for merchants and their customers for years, and every day that it continues is one day too long.”

‘Consumer Harm’

The current interchange cap for card issuers with more than $10 billion in assets, who account for two-thirds of the debit market, is 21 cents plus 0.05% of the transaction, with another penny possible for issuers that take effective fraud-prevention measures.

While still representing a cut of about 50% from the interchange issuers received before the cap took effect, the lid is substantially above the 7-to-12-cent limit the Fed floated in the first draft of its Durbin rule. The Fed upped it after heavy bank and network lobbying by considering other costs it thought the law would permit.

Merchant acquirers technically pay interchange to card issuers, but acquirers invariably pass the expense on to their merchant clients. Issuers and networks over the past two years have blamed the interchange cap for crimping banks’ revenues, with banks responding by cutting free checking and debit card rewards and raising fees on consumer accounts.

Banks and networks also accused merchants of failing to pass on their reduced card-acceptance costs to consumers in the form of lower prices. All of those issues erupted again with Leon’s decision.

“This is an extraordinary decision that will have major repercussions for customers of both small and large financial institutions,” said Chris Matthews, a spokesperson for a coalition of financial-institution organizations. “The Fed’s rule was already causing consumer harm and now it looks like it will only get worse.”

The coalition includes Credit Union National Association; Independent Community Bankers of America; National Association of Federal Credit Unions; National Bankers Association; Midsize Bank Coalition of America; Consumer Bankers Association; The Clearing House Association; American Bankers Association; and The Financial Services Roundtable.

‘A Mind-Boggling Aspect’

On the technical side, implementing a lowered interchange cap is the easy part. It may not be so easy carrying out the revised transaction-routing provisions called for in Leon’s decision, which cast new light on what the Fed back in 2011 dubbed “Alternative B.”

Alternative B would have required each debit card to provide merchant access to at least two signature and two PIN-debit networks with each transaction. Instead, the Fed went with the simpler plan it called Alternative A, which said the existing signature network on the front of the card was OK if the card also provided access with each transaction to at least two unaffiliated PIN-debit networks.

Leon cited the statute and comments from Durbin Amendment author U.S. Sen. Richard Durbin, D-Ill., about what the law should do—which was to give merchants multiple choices for routing to potentially lower their acceptance costs. Such choices are limited by exclusive network and issuer agreements.

Leon signaled that Alternative A falls short. He noted in one instance that only a minority of U.S. merchants accept PIN-debit cards, which often leaves only the one signature network on a card available to the merchant for authentication.

“Congress adopted the network non-exclusivity and routing provisions to ensure that for multiple unaffiliated routing options were available for each debit card transaction, regardless of the method of authentication,” Leon wrote.

Implementing Alternative B could be a big job for merchant acquirers such as Princeton, N.J.-based Heartland Payment Systems Inc., which services more than 100,000 small and mid-sized merchants as well as a big portfolio of gas stations/convenience stores and other national merchants.

“I think that certainly the view that was very widespread in the acquiring industry two-plus years ago, when the Fed was considering this, was that the challenges associated with multiple signature debit bugs on one card was a mind-boggling aspect,” says Heartland vice chairman Robert H.B. Baldwin Jr.

Regarding Alternative A, Baldwin adds: “I think everybody was pretty much comfortable that that was sensible.”

In 2010, when Congress passed Dodd-Frank, many banks and credit unions had exclusive debit relationships with networks, especially with market leader Visa Inc. in which their cards accessed only the Visa network for signature authentication and the Visa-owned Interlink network for PIN authentication.

Durbin outlawed such exclusive network affiliations. In its commentary about its pending rule, the Fed said merchants favored Alternative B, but it acknowledged the operational issues for card issuers and others in the payment industry.

“Alternative A would minimize the compliance burden on institutions, particularly small issuers that might otherwise be adversely affected by a requirement to have multiple networks for each method of debit card authentication,” the draft commentary said. “Alternative A would also present less logistical burden on the payment system overall as it would require little if any re-programming of routing logic by issuers, networks, issuer processors, and acquirers.”

No ‘Separate Silo’?

But is Alternative B as onerous as it once seemed? Baldwin suggests perhaps not. As evidence, he cites Visa’s PIN-Authenticated Visa Debit (PAVD) program. Through the VisaNet network, PAVD enables Visa to process a PIN-debit transaction even if the card the customer presents doesn’t carry the Interlink logo.

PAVD is one part of Visa’s debit-recovery strategy in the post-Durbin environment, which saw Interlink lose more than half its volume during the quarter when the Fed’s routing rules took effect in April 2012.

“Until Visa told us that was a capability they had, none of us knew it existed,” says Baldwin. “That certainly gets you thinking: exactly how separate are these [authentication] systems and how hard would it be? Something we thought was a different silo wasn’t so much of a different silo.”

Visa declined comment about the court ruling. The company’s debit business is on the rebound, however. Visa reported that Interlink’s volume jumped 25% in the third fiscal quarter ended June 30 from Durbin-reduced year-earlier levels.

At the same time, a major rival of Interlink’s, the Pulse EFT network owned by Discover Financial Services, saw volume drop 3%, a decline Discover chief executive David Nelms suggested was the result of competitive pressure from Visa.

Leon himself suggested that payments companies shouldn’t automatically conclude that meeting the law’s routing mandates are as burdensome as many people believe.

“In fact, the Durbin Amendment does not specify how the Board should go about achieving the statute’s requirement,” he wrote. “It was possible for the Board to implement the law without requiring brand new networks be added to each card. As explained during the comment period on the [proposed rule], the Board could have guaranteed ‘multiple routing options for every transaction by barring the dominant networks’ anti-competitive rules to allow PIN-only networks to process signature transactions, and vice versa.’”

‘New Revenue Reality’

Payments executives, however, almost universally believe that reconciling chip cards with Durbin will be one big job.

All the major networks are pushing EMV to succeed fraud-prone magnetic-stripe cards. Yet mag-stripe cards work easily with Durbin’s routing requirements. In contrast, Visa and MasterCard Inc. own the core EMV technology. The EFT networks, led by the Secure Remote Payment Council (SRPc), are trying to forge an agreement about a common application identifier (AID) that would enable all chip debit cards to meet Durbin’s routing rules.

It looked like they were getting close to a solution in July when the SRPc suggested a compromise to Visa and MasterCard. The court decision adds yet another impetus to resolve the issue because of the potential requirement for cards to access more networks.

“From an EMV perspective I think it reinforces the need for an AID and a common application—that’s really the best way for all networks to provide the technology and the greatest flexibility,” says Terry Dooley, senior vice president and chief information officer for the Johnston, Iowa-based Shazam EFT network. “What makes it difficult today is utilizing intellectual property from specific business organizations.”

In a statement, the ATM Industry Association trade group highlighted the uncertainty roiling the debit world in the wake of the court ruling and various network deadlines that are shifting liability for fraudulent transactions to parties that don’t accommodate EMV.

“This decision could completely stall progress toward development of the debit solutions necessary for the vast U.S. EMV migration,” said David Tente, the ATMIA’s USA executive director. “With one liability shift passed and others looming in the near future, we’re already seeing that the court’s action has created a heightened level of confusion in the industry.”

The shrunken debit card interchange that issuers can expect might even affect the EMV conversion, suggests SRPc president Paul Tomasofsky.

“If [Judge Leon’s] way holds, then all debit portfolio managers will need to re-assess the way they make money and how they spend it since one part of how they make it will be drastically reduced,” Tomasofsky says by e-mail. “A major expense like EMV deployment will need to be carefully assessed in light of the new revenue reality. Perhaps, a true cost-benefit analysis of EMV will be conducted and more importantly looked at in relative terms to other risk-mitigation technologies.”

He adds: “A true common EMV solution governed in a fair and equitable way by all stakeholders is still the best way to fulfill that need.”

For now, however, it looks like one or more judges will be handing down their solutions to the multiple issues facing debit cards created by the intersection of law and technology.