Rewriting the Transaction Routing Rules

Rewriting the Transaction Routing Rules

The Durbin Amendment throws out exclusive debit network agreements and gives merchants more freedom to route debit transactions according to their wishes. Who will win and lose in the post-Durbin world?

BY JIM DALY

By the time you read this, the Federal Reserve Board will have released the first draft of its long-awaited rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act’s Durbin Amendment, surely the most controversial piece of legislation affecting the payment card industry in at least 20 years and perhaps ever.
The Amendment, named for chief sponsor Sen. Richard Durbin of Illinois and taking a mere seven of the law’s 848 pages, for the first time interjects the federal government into the interchange-setting process, though so far it’s limited only to debit cards.
The Amendment has other provisions, however, that affect merchants, card issuers, payment networks, and merchant acquirers. These are cause for joy or weeping, depending on where you stand. The law makes illegal so-called exclusive network arrangements in which a debit card gets a purchase transaction onto the toll roads only of affiliated networks.
Such arrangements might include, for example Visa Inc.’s network for signature-based transactions and the Visa-owned Interlink network for PIN-debit purchases, or MasterCard Inc.’s network for signature debit and Maestro for PIN-debit. Such exclusive arrangements ensure more data-processing revenues for the networks.
Further, Dodd-Frank bans networks and issuers from interfering with merchants’ transaction-routing choices. Many national retailers already use so-called least-cost routing procedures in which their point-of-sale payment systems identify, when a card is swiped, the least-expensive network choice available. An example of this is so-called PIN prompting, where a terminal is programmed to ask for a PIN as soon as the cardholder swipes his card. As debit cards add more network marks, this practice seems likely to grow.
Radical Outcome
Of course, no one knows exactly how things will shake out until the Fed releases its rules and the industry subjects them to real-world conditions. (The Fed released draft proposals just as Digital Transactions went to press in mid-December. Final rules for interchange are due by April 21, with affiliation and routing rules due by July 21.)
In contrast to the Durbin Amendment’s often vague language about how regulators should construct a “reasonable and proportional” debit- interchange regulation regime, the statute is fairly explicit about outlawing exclusive network affiliations and opening up transaction routing. The Fed doesn’t seem to have much room for far-reaching interpretations.
Regarding the future of exclusive network affiliations, Mike Kelly, general manager of bank processor Fiserv Inc.’s Accel/Exchange electronic funds transfer network says: “Our read is that is a no-no, a ban.”
Likewise, the law says the Fed must devise regulations “providing that an issuer or payment card network shall not … inhibit the ability of any person who accepts debit cards for payments to direct the routing of electronic debit transactions for processing over any payment card network that may process such transactions.”
Durbin, however, isn’t quite clear on what debit cards must offer going forward apart from that each card must offer an unaffiliated network option.
The law leaves open the possibility that the Fed could require a signature debit card to access both the Visa and MasterCard networks—and the Fed’s draft proposal indeed leaves that option open for comment. That’s a radical outcome some big merchants are shooting for, but many industry observers don’t believe the Fed ultimately will accept it.
The new regulations will come after settlements Visa and MasterCard struck in October with the U.S. Department of Justice, which after a two-year investigation challenged the networks’ restrictions on merchants’ ability to steer customers to the payment forms of their choice. The DoJ also targeted American Express Co., which refused to settle, so now the two are fighting it out in court.
Shopping for Networks
In a recent report, Boston-based research firm Aite Group LLC predicted who is likely to win and lose under the combo of the coming Fed regulations and the DoJ settlements (box, page 34).
The biggest winners: vendors of merchant-funded rewards programs that assemble for card issuers networks of merchants that give spending-based rewards to the issuers’ customers. These firms will step into a void created by issuers’ scaling back on traditional rewards programs funded by interchange, which won’t be flowing as freely any more.
Large merchants also are looking like winners, even if they don’t hit their home run of simultaneous access to both Visa and MasterCard for signature debit. They have the technological prowess and motivation to take full advantage of new networks and transaction-routing possibilities that could lower their card-acceptance costs.
In contrast, Aite rates small merchants’ prospects only as “mixed.” Their acceptance costs probably will decline when regulated interchange takes hold, and the demise of exclusive network affiliations and more transaction-routing freedom gives them further potential to reduce card expenses.
But their comparative lack of tech­nological savvy will prevent them from exploiting the new routing opportunities to the degree that their larger brethren can.
The Durbin Amendment, notes Aite Group research director Gwenn Bézard, sailed through Congress “in the name of helping small businesses. But I think at least in the short term it’s going to be bigger for large merchants.”
The surviving EFT networks, which grew into national players as regional ATM networks consolidated over the past 20 years and were sold by banks to for-profit companies, almost certainly will pick up new business as issuers shop for more PIN-based network marks to add to their debit cards.
“We’re very, very happy to accommodate some of that,” says Neil Marcous, president of the NYCE Payments Network, a unit of Jacksonville, Fla.-based processor Fidelity National Information Services Inc. (FIS).
Adds Richard S. “Rick” Jenkins, senior vice president and corporate counsel at Johnston, Iowa-based Shazam, the last big EFT network still owned by banks and run as a non-profit: “I think there is opportunity for issuers to take a look at the efficiencies of PIN-debit networks.”
The biggest losers: Visa, which dominates U.S. debit, and large debit card issuers that generate hefty interchange revenues from signature debit. Some 79% of Visa’s debit volume from its top 10 issuers comes through issuers with whom Visa has exclusive network arrangements, according to a November report from investment bank UBS (chart, page 32).
MasterCard’s prospects aren’t as clear as Visa’s. The No. 2 network might gain some former Interlink business even as its own exclusive affiliations end. Neither Visa nor MasterCard would comment for this story.
Large debit issuers, meanwhile, will see their interchange rates take a haircut—the law exempts from regulation the debit interchange of banks and credit unions with less than $10 billion in assets, or 99% of all financial institutions.
And if predictions prove true that merchants will migrate more signature volume to PIN debit, issuers might lose even more interchange revenue because PIN debit typically generates less interchange revenue than signature debit. All of this depends, of course, on spreads between signature and PIN-debit rates once the regulations kick in, and how merchants and issuers respond.
‘Messed up’
The Fed’s recently released 2010 Payments Study says total debit card payments grew at a compounded annual rate of 14.8% from 2006 to 2009. PIN debit’s compounded growth rate was 15.6% in the three-year period versus 14.3% for signature despite banks’ heavier promotion of signature because of the higher interchange. Signature debit, however, accounted for 62% of debit transactions in 2009 against 38% for PIN.
It’s a turbulent new world and likely to remain so for some time. Merchant acquirers, especially those serving small businesses, find themselves on the windward side of this building storm.
Few small businesses are even aware of what Dodd-Frank is bringing regarding card payments, notes Barry R. Sloane, chairman and chief executive of New York City-based Newtek Business Services Inc., which provides card processing for 15,000 small and mid-size merchants. “Our merchants are not talking about it at all,” he says.
Sloane thus anticipates a big, costly education effort and other expenses, including the printing of revised documentation for merchants reflecting more network choices.
“The whole thing is messed up,” he says. “You know what the cost is going to be to talk to all these people? They [regulators] don’t understand the cost of all this. We have to rewrite our agreements with each and every entity we process with.”
Sloane is not alone is asserting that “regulation” and “simple” often don’t mix. “The back office gets more complicated the more networks you have,” says Accel/Exchange’s Kelly.
One complication is that issuers will have to change the so-called BIN (bank identification number) files they supply to networks to reflect more routing choices. Networks distribute those files, which come with issuers’ transaction-routing messages, to merchant acquirers.
Large supermarket and retailing chains represented by the Merchants Payment Coalition lobbying group don’t seem to be too worried about such complications.
If they had their way, each dual-function debit card (MasterCard or Visa for signature transactions in addition to PIN-debit capability) “would offer at least two networks for each type of transaction,” according to a presentation the MPC gave the Fed in November. An MPC attorney did not respond to Digital Transactions’ requests for comment.
The MPC also is pushing for merchant control over routing. The Fed probably won’t grant the big merchants’ request for simultaneous access to Visa and MasterCard through one card, according to various sources. Most observers expect an outcome in which a debit card has one signature mark on the front and the marks of two or more PIN-debit networks on the back, with at least one unaffiliated with the signature network.
Under this scenario, a Visa check card could sport the logos of Interlink and the unaffiliated NYCE, for example. The dwindling breed of ATM-only debit cards may be required to add an unaffiliated EFT network mark too.
‘Feather in Our Cap’
What’s coming is actually a back-to-the future scenario. Two or more PIN-debit marks were common on debit cards before exclusive arrangements gained share.
In fact, the forced addition of unaffiliated networks on debit cards might even lead to network price competition in the direct data-processing fees networks charge to merchant acquirers with each transaction. Acquirers usually pass the full cost of such fees on to their merchant clients.
“On the face of it, people are going to end up choosing on price because that’s the lowest common denominator,” says Sloane.
In his recent report, UBS analyst Jason Kupferberg said, “A common (and we believe accurate) assessment of the increased number of PIN-debit routing options mandated by Durbin is that competition at the merchant level among PIN-debit networks (including Visa’s Interlink and MasterCard’s Maestro) will intensify, with overall network fees pressured downward as more merchants employ least-cost PIN transaction routing …”
As with network fees, acquirers also pass on to merchants the cost of interchange, which the networks set but is assessed to the acquirer and paid to the issuer. Interchange can account for at least two-thirds of a small merchant’s acceptance cost and even more for large ones.
With its regulations, the Durbin Amendment may have the effect of arresting a trend that started more than a decade ago, that of network competition having the perverse effect of driving up prices.
To attract issuers, networks have been raising interchange rates for years to gain fee-generating transaction volume from more cards with their marks. That was especially apparent in PIN debit as EFT networks upped interchange rates closer to the Visa/MasterCard signature rates. A Federal Reserve Bank of Kansas City researcher found that the average interchange expense for a $50 PIN-debit sale at a small retailer quadrupled between 1996 and 2007 (“The Narrowing Debit Card Interchange Gap,” September, 2009).
But with interchange spreads poised to narrow and network fees under pressure, EFT networks hope prospective issuer customers focus less on price and more on network uptime, efficiency, security, and differentiated products and services. PIN debit, which uses a so-called single-message authorization format for fast settlement, has fraud rates that are a fraction of signature debit’s, which uses a dual-message system with separate authorization and settlement messages.
Shazam, for example, is playing up its menu of security services under the Shazam Secure umbrella, including intrusion and firewall testing, assessments, and recommendations for members.
“That is a feather in our cap,” says Jenkins. “It is a very popular service.”
First Data Corp.’s Star Network “has created a dedicated team of people to analyze potential implications [of the Durbin Amendment] and ensure that we deliver innovative solutions for merchants and financial institutions that will enable them to drive success in the new payments landscape,” general manager Kevin Barry says by e-mail. He wouldn’t speculate about the Fed’s regulations ahead of their release.
‘Data-Security Concerns’
Meanwhile, vendors closely tied to the PIN-debit industry hope to gain as more transactions are routed EFT networks’ way. One company that expects to win once the regulations take effect later this year is Atlanta-based Acculynk Inc., the provider of the PaySecure product for Internet PIN-based debit card transactions.
“We’re going to get a very nice lift after that,” says Ashish Bahl, Acculynk’s chairman and chief executive. PaySecure features a floating online PIN pad that enables a debit cardholder to enter her PIN for authentication when buying online.
Acculynk stands to benefit because it has deals with eight EFT networks in addition to MasterCard to distribute PaySecure: Accel/Exchange, Alaska Option, Credit Union 24, Fifth Third Bancorp’s Jeanie, NetWorks, NYCE, Discover Financial Services’s Pulse, and Shazam. Five are live: Accel/Exchange, Credit Union 24, NYCE, Pulse and Shazam. As these and other networks recruit new POS debit issuers, Acculynk could rise with the tide.
“We’ve had people that have never called us calling,” says Bahl. “It’s a nice position to be in.”
Yet at least one bank, and probably many more, does not want to go network shopping. In an October meeting with Fed staff, executives from Kansas City, Mo.-based Commerce Bank N.A. voiced worries that Dodd-Frank’s proscriptions might force the Fed to set interchange at money-losing levels for issuers.
They also said the mandated addition of non-affiliated PIN-debit networks “will cause us to reissue our entire card base without the possibility of reimbursement [and] it will force us to do business with a network that we have avoided for business reasons,” according to a presentation the bank filed with the Fed. Commerce Bank, which did not respond to a Digital Transactions request for comment, is a Visa/Interlink issuer.
Further, the transaction-routing provision promotes the growth of the lowest-cost networks, according to Commerce Bank’s presentation, and “does not address data-security concerns that may have limited the success of these networks in the first place.”
Consumers’ Pain
The automated clearing house network, meanwhile, could be in line for higher prices as banks seek to compensate for lost interchange and debit card overdraft-fee revenues, the latter of which now require consumer opt-in under separate new regulations.
The low-cost ACH network is an important part of many alternative-payment providers’ operational systems, including giant PayPal Inc. Banks for years have expressed concerns about the “quasi-free ride” the alternatives have received on the ACH, according to Aite Group. With other revenue sources stressed, a transaction’s ride on the ACH may soon cost more.
“The ACH network stands as a prime candidate for pricing re-assessment,” Bézard’s report says.
Almost lost in all the debate are the Durbin Amendment’s possible effects on consumers. Aite Group’s report assesses consumers’ prospects as negative.
“Banks won’t stand still and let their revenue drop, but will likely raise the direct cost of banking for consumers,” the report says. “In the meantime, merchants are unlikely to pass the totality of the cost savings onto consumers.”
Accel/Exchange’s Kelly agrees that the coming changes could be painful for consumers. “The implication for the consumer is that if interchange goes away or goes down, all of a sudden those consumers are being assessed checking fees [and] that is going to cause consumers pain,” he says.
Currently, however, almost everyone in the debit business is feeling some aches and pains, even if their long-term prospects look bright. In business, uncertainty equals pain.