Scoping out Durbin’s Impact

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Scoping out Durbin’s Impact

Would a telecom network qualify as a payment network if it is providing the primary transaction authorization and settlement infrastructure?

The Fed’s proposed Durbin rules portend a thorough-going reshaping of the electronic-payments business. Time to start figuring out who’ll win and who’ll lose, says Patricia Hewitt.

Patricia Hewitt is director of debit advisory services at Mercator Advisory Group, Maynard, Mass. Reach her at phewitt@mercator advisorygroup.com.

On Thursday, Dec. 16, 2010, the beginning of a material reshaping of the electronic payments industry took place as the Federal Reserve Board relied on the letter of the law to interpret the Durbin Amendment and write the draft rules for a new Section 920 of the Electronic Funds Transfer Act. A thorough consideration of the implications of this draft is not possible in this limited space, but I can touch on a few of the primary strategic implications, based on my most recent analysis of the Durbin Amendment draft rules.
In a nutshell, a majority of debit card issuers are going to be operating their programs on a revenue model that has been slashed by 75% or even more. But put aside the extreme fee reduction for the moment. Given the fact that both signature and PIN debit transactions will be indistinguishable to issuers, and the sharp difference in their fraud rates as revealed by the Fed’s data analysis, the industry may be experiencing the beginning of a migration to a PIN-only debit market.
This extreme interchange-revenue cut will also most certainly give issuers pause to consider their internal economics. That may result in a strong shift to outsourcing more processing and portfolio servicing as issuers search for a means of maintaining their product equilibrium and competitive position in the market. It is very unlikely that there will be a wholesale flight out of the debit card issuing market. But the industry will reform itself around co-op processing, outsourcing, and cost-shifting strategies for the near future, and around payment type and form innovation once the market stabilizes.
The other main reform of the Durbin Amendment has to do with network relationships, specifically issuer-network participation and merchant-routing rules. Put aside for the time being the fact that, under the proposed Fed rules, there would be no economic differentiation between a signature and PIN network. Consider that the industry is being asked to comment on two alternative proposals. One proposal defines the rule to require issuers to offer routing on two unaffiliated debit networks regardless of authorization method. The other proposal requires two unaffiliated debit works for each authorization method (i.e., signature vs. PIN).
At a minimum, then, all debit card issuers that are in exclusive, single-brand relationships will be changing one of their affiliations, since this component of the amendment has no exemptions. Further, since interchange fees will be flattened, networks will have to compete on value. Those networks that have made investments in infrastructure to support more flexible programs (including such things as rewards from managed merchant-funded discount networks), as well as better reporting, fraud control, and operating efficiencies, should be able to quickly take a more leveraged position. Ultimately, however, there will be great pressure on networks to control their non-interchange fee structures.
Scale will become even more important in this new market landscape, which may drive additional merger-and-acquisition activity among issuers, networks, and acquirers. However, scale and operational efficiencies are not sustainable growth strategies. Long-term growth will have to come from a combination of more deeply penetrated electronic payments and innovative payment schemes. It is perhaps in the area of payments innovation that the market will get most interesting. The current draft rules are calling for a wide range of commentary around three-party and alternative networks.
The definition of what constitutes a payment network is perhaps one of the most critical, difficult tasks the Fed has in front of it. From a regulatory viewpoint, this will be the first time that such a definition has been attempted, and the outcome of that effort will do nothing less than shape the electronic-payments industry in the foreseeable future. For example, in its written proposal, the Fed appears inclined to include any mobile device that is used to access funds in an account, regardless of network affiliation—including no network affiliation. Therefore, would a telecom network qualify as a payment network if it is providing the primary transaction authorization and settlement infrastructure?
The alternative-payment network market in the U.S. may find itself in an oddly inverted position once the rules that impact them are defined. If it turns out they are regulated networks, then some of them will collapse under the weight of a much higher operational cost structure and lack of scale. Larger organizations will have to compete squarely on value alongside their legacy cousins and will have less revenue to draw on, severely impacting their revenue-share models. If they are not regulated, their stronger revenue-sharing models should find a bigger welcome mat laid out for them among issuers. But merchants may shy away in favor of very low-cost debit transactions, especially if the industry can crack open the online debit market.
And, of course, until the Fed defines exactly what a regulated payment network is, there’s no telling which alternative solutions will be impacted other than to say that it appears the Fed has excluded “pure” automated clearing house transactions from the definition of a debit card. This exclusion would seem to protect electronic-check or electronic-banking payment schemes such as Secure Vault Payments, Noca, and Moneta, but does not protect payment schemes whose sole use of the ACH is to settle transactions, like PayPal and Bling Nation.
The Fed left many questions unanswered in its quest to provide the industry with initial guidance on these and other Durbin-related topics before the end of last year. It has signaled that the industry should expect the interchange-fee rules to be written by the statute’s April 21 deadline, but perhaps not much else. Clearly, the Durbin Amendment is going to be a journey on a road that’s going to take some time to be paved.