Payment Card Routing Is All Politics

The real winners from the Fed’s latest debit card routing rule aren’t the merchants. And they certainly aren’t the banks. Guess who?

In the last decade, the flow of funds across debit card networks has curiously become a concern of Congress and the Federal Reserve.  It all began with the Durbin Amendment to the Dodd–Frank Wall Street Reform and Consumer Protection Act, which was implemented by Regulation II.

Reg II regulates the interchange income that large banks (defined as having $10 billion or more in assets) can receive and requires that every debit card issued, regardless of the issuer’s size, include at least two networks available for merchants to route transactions. These networks are required to be unaffiliated with each other, meaning they cannot have mutual ownership.

Issuers responded to the regulation when it was implemented in 2011 by having a global network, Mastercard or Visa, paired with an EFT debit network such as Accel, NYCE, Pulse, Star, or Shazam. Because payments executed across EFT debit networks are often much less expensive for merchants to accept, particularly for small businesses with lower transaction volume, Sen. Richard Durbin, the creator of this rule, could rightly claim his support for Main Street merchants.

Merchants who understood the complexity and nuances of global versus EFT debit routing cheered, as they just received a potential decrease in their processing costs. The EFT debit networks could celebrate as well, as they had just been handed a guaranteed place in the payments industry as long as debit cards exist as a payment vehicle.

A New Transaction Type

Since the implementation of Reg II, however, the world has changed. A significant percentage of consumer buying has moved to remote, card-not-present (CNP) channels. The Federal Reserve estimates that in 2019, CNP activity controlled 23% of debit volume. That has only increased in recent years, spurred by the Covid pandemic.

The EFT debit networks and acquirer processors initially were not ready for this shift. The lower fees these networks charge means they have less funding to invest in new solutions, including a transaction that works for a remote purchase.

The EFT debit networks’ legacy technology relies on consumers entering a PIN through a POS device. PIN entry is immensely effective at decreasing fraud losses for in-person purchases, but it doesn’t support e-commerce. There isn’t an effective method to enter a PIN through your computer or mobile device.

While the PIN can be dropped as a transaction requirement, the EFT debit networks needed to develop a new transaction type.

A PIN transaction operates using a single message, meaning that the authorization and clearing communication is accomplished simultaneously. But what e-commerce and other remote transactions need is a dual-message function. This allows a merchant to first authorize a transaction when the purchase is made, then clear the funds in a separate activity when goods are shipped, which, with a CNP purchase, could be days later.

The EFT debit networks began to recognize the rise in CNP activity. They developed two-message transaction solutions, and dropped the PIN requirement, to be competitive with their larger, global competitors.

But another interesting trend was occurring. More of the EFT debit networks were being snapped up by the global core processors. Fiserv, for example, purchased First Data, which owned the Star network. Fiserv also owns the Accel network. Earlier, another big processor, FIS, had purchased Metavante, which brought along the NYCE network.

The core processors began to require their banking customers to accept the dual-message PINless product offered by their EFT debit networks as a requirement of their vendor relationship.   This was particularly hard for smaller financial institutions to resist, since they lack the bargaining power to push back.

In contrast, large banks and credit unions scrutinized Reg II. They determined that, because two unaffiliated networks were available on their cards, they were compliant—regardless of the ability of merchants to access both options for CNP activity.

This approach didn’t do much for large financial institutions’ interchange income because that is capped at the regulated level. It did, however, preserve the volume going through the global networks.

So the current environment finds that many, but not all, small institutions offer an unaffiliated debit network that works in a CNP environment, at the instance of their core provider. But many of the largest financial institutions, which have the most debit customers, do not.

The Fed Acts

This state of debit routing caused the Senator from Illinois to write a letter in July 2020 to Jerome Powell, chairman of the Federal Reserve, calling out that the lack of an unaffiliated debit network on some debit cards that work in CNP channels violates the regulation.

It’s the Fed’s job to enforce Regulation II, so Durbin stated that routing choice had been “periodically undermined by the dominant networks’ efforts to circumvent and limit routing choice,” and asked the Fed to do something about it.

The Fed responded in May 2021 with a Notice of Proposed Rule Making, and invited public comment. The notice included information showing that very few CNP transactions were processed through the unaffiliated debit networks.

The Fed acknowledged that, when Reg II was implemented, PINless options weren’t available. But now that the unaffiliated debit networks had caught up to their global competitors, it was time for all issuers to ensure that merchants had a choice of networks for CNP transactions.

Thousands of merchants and issuers responded with comments.  Issuers’ primary arguments against the proposed changes to the regulation can be summarized as the following:

1. 1. Small financial institutions with less than $10 billion in assets that did not already offer PINless transactions would struggle with a loss of revenue due to reduced interchange they would receive from the EFT debit networks;
   2. Financial institutions would incur elevated fraud levels with a greater number of CNP transactions routed through the EFT debit networks as these transactions are
      less secure;
   3. The Notice unfairly burdened financial institutions as the parties solely responsible for ensuring routing choice, when in fact merchants and their acquiring processors have a role to play to acquire these transactions.

What the Fed Said

The Fed considered the responses it received, and in October published the “Final Amendments to Regulation II to Clarify the Prohibition on Network Exclusivity.” The Fed concluded that Reg II requires all financial institutions to offer a PINless option.

It also apologized (sort of) for implying that issuers are solely responsible for creating the environment for merchants to accept unaffiliated debit networks, and, without evidence, denied banks’ and credit unions’ concerns about fraud. And it downplayed the impact to smaller financial institutions, saying most are already compliant.

When the final rule was published, Fed Governor Michelle W. Bowman had this rather foreboding statement:

“During the public comment process, community banks raised substantial concerns with the proposal. Although the Board has attempted to identify the likely effects of the proposed rule based on available information, I believe that significant questions remain about how the rule will affect banks, and particularly community banks, with respect to both fraud and the cost of compliance. Given this continued uncertainty, I do not support the final rule.”

Winners And Losers

The result of the final rule is that the Fed has created winners and losers in this battle over debit routing.

Main Street merchants could see a decline in interchange costs for CNP debit card purchases, which are fewer than one-quarter of all debit card traffic and an even smaller portion of total transactions. Of course, their processors need to be able to recognize the unaffiliated debit network and pass along the savings.

Big merchants won’t see a measurable cost difference because their rates are negotiated. But they get to declare victory over the global networks, which, they believe, have far too much power.

Global networks, namely Mastercard and Visa (oddly, Reg II doesn’t apply to most of American Express’s or Discover’s business), will lose some transaction activity from merchants of all sizes.

Unaffiliated debit networks get a victory lap. Through their efforts to enforce Regulation II for CNP transactions, the transaction losses the global networks experience are their gains.

Big financial institutions that have not already adopted a PINless network have a little project on their hands to update the networks on their cards and adjust their fraud monitoring. They will see little monetary loss as interchange is already regulated.

Small financial Institutions that have not already adopted a PINless network are the most impacted party. Like their large bank brethren, they will need to fund projects to make the necessary adjustments to their card portfolio. Since today they are receiving the higher global network interchange rate, they will incur a drop in non-interest fee income. This comes at a particularly painful time for community banks that are struggling under other hefty regulatory requirements and tough competition from fintechs.

It’s Not Over Yet

The construct of Reg II gave the Fed no option. It could not arrive at a conclusion other than what it articulated in the Final Rule. While some may feel that merchants were getting a bad deal, this ruling merely shifts the burden to banks, hurting community banks the most.

Indeed, the latest clarification does not improve the payments industry. It doesn’t make the payment networks more secure. It doesn’t make the market for card processing more competitive than it already is. Nor does it offer merchants true parity for CNP transactions. That would mean that the EFT debit networks would have to develop functionality similar to that of Mastercard and Visa, including global network reach. It certainly has done nothing to help consumers.

So what has this Final Rule achieved? It has secured a platform for politicians to appear as defenders of small business and to vilify banks and the global networks. In fact, this positioning has worked so well for Sen. Durbin, he has now turned
his sights on politicizing credit card processing.

—Sarah Grotta is head of payments at LSBX