Merchants Zero in on Payments

 

By John Stewart and Jim Daly

 

Having beaten the banks on debit card pricing, they’re now staking out positions on mobile payments and chip cards. This could be the start of the decade of the merchant in the business of consumer payments.

 

 

 

Who controls consumer payments? Lately, banks, card networks, wireless operators, and software developers have spent a lot of valuable time squabbling over this question. But now one party stands out as having staked a pretty convincing claim: merchants.

 

To be sure, retail companies have always occupied a strategic position when it came to processing consumer payments. After all, it’s the cashier—not the banker or network manager—who stands in front of the customer and accepts her payment.

 

But even as these transactions grew increasingly electronic, merchants kept largely to the sidelines when it came to controlling or even influencing payments. “Merchants were taken for granted, by and large,” says Mark Horwedel, chief executive of the Merchant Advisory Group, an Irving, Texas-based organization that brings retailers together with bankers and others to hash out payments issues.

 

Though a thriving business for banks, payments was, after all, incidental to selling shoes or groceries or gasoline. So, except for occasional eruptions over acceptance costs, merchants largely left pricing and technology questions up to the banks.

 

‘Common Ground’

 

No more. Consumer payments these days are very much big business for merchants, and for the first time in history they hold at least some of the keys that will decide which payment media their customers will use and how they will use them.

 

And for the first time, they have thrashed the banks and the networks in an all-out interchange fight. Moving at the moment when banks’ reputation among the public was at a low ebb, well-organized, well-rehearsed retailer lobbyists convinced Congress to write debit card interchange caps for banks over $10 billion in assets into a federal law, the Durbin Amendment to the 2010 Dodd-Frank Act, that also hands significant transaction-routing power to merchants. Never before had the banks lost such a crucial battle to retailers.

 

This victory was decisive because, among other things, it came just as the payments industry has been trying to figure out how to deploy mobile payments and chip cards. These are both highly sophisticated technologies that promise big benefits in convenience, security, and marketing capabilities. But they come with complex questions that no one has entirely figured out yet. Now merchants’ clout in payments must be added to that list of complexities, whether the banks like it or not.

 

To get a sense of how merchants’ linchpin role in payments has come into focus, listen to retail representatives these days when they speak at trade shows and other public events. There’s a newfound confidence in confronting banks and networks, and not just over interchange. Big merchants are making it clear what they want when it comes to technologies like mobile and smart cards, and it doesn’t line up with what big banks are starting to offer.

 

“Merchants have been emboldened by the smell of victory,” says Horwedel. “This storm that was created over debit [interchange] may subside, but merchants aren’t going away.”

 

Ironically, Horwedel until earlier this year was a Capitol Hill lobbyist for Wal-Mart Stores Inc., but now finds himself working to forge cross-industry agreements on standards for integrating mobile and EMV, the reigning global chip card standard. The MAG, he says, “is the one area to develop some common ground so we’re not at everyone’s throats on the Hill.”

 

But merchants’ rising profile in payments has already led to sharp disagreements over these new technologies and how they should be deployed. Here’s a review of what merchants have gained from Durbin, and how they now view the questions surrounding EMV and mobile payments in its various guises, chiefly near-field communication (NFC), the two-way, short range technology that lets handsets make contactless payments and receive a variety of payment and non-payment messages.

 

Price War

 

Merchants may have won a famous victory, but you couldn’t tell by the mournful cries coming from many of them on June 29 when the Federal Reserve Board, as directed by the Durbin Amendment, released its interchange caps for issuers with $10 billion or more in assets (“The Great Game Changer,” September).

 

Indeed, the Durbin victory’s biggest benefit for merchants may well turn out to be enhanced clout in the payments business, not so much reduced acceptance costs or routing power. Still, that victory was so stunning—coming after decades of failed tries to overcome the banking industry’s massive lobbying prowess—that its reverberations will be felt on a wide range of issues at the point of sale.

 

As of Oct. 1, the regulated price is now 21 cents plus 0.05% with another penny possible for fraud control, versus the 44 cents the transactions averaged until now. Thus, debit card issuers with more than $10 billion in assets, which account for the majority of debit transactions, are bracing for a cut in interchange revenue of about 45%.

 

That’s considerably higher than most merchants had hoped for, and quite a bit more than the Fed had allowed for in its original proposal, released in December. Big chains are still crying foul. Some, which sell a lot of low-ticket goods, expect to see little or no savings.

 

“We’re very disappointed. The way Durbin turned out, merchants with high tickets are really going to benefit, but those guys don’t have as much debit volume,” says Richard Peck, senior director of corporate finance for Dallas-based 7-Eleven Inc., which was so committed to Durbin it took thousands of petitions signed by customers to Capitol Hill to sway lawmakers.

 

In fact, the regulated rate means stores like 7-Eleven could end up with higher costs on transactions under $3, which aren’t uncommon inside its stores. A $3 ticket on a big-bank debit card will now carry at least 21 cents in interchange, compared to the 18.5 cents, or 17 cents plus 0.50%, 7-Eleven had been paying on signature debit, Peck says. The new regs make no distinction between signature and PIN debit.

 

On the other hand, soaring gasoline prices will deliver some relief. “Fuel sales have higher average tickets, so we’ll see some benefit,” says Peck, who adds the savings will be muted by the extent to which customers pay at the pump with credit cards. Some 40% of 7-Eleven’s more than 8,800 North American locations sell gas.

 

If big merchants are disgruntled, small ones may not even have fully digested the implications of Durbin’s price controls.

 

These controls are certain to trigger a price war that could add to the already considerable number of calls mid-sized and small merchants take from big acquirers all the way on down to the tiniest independent sales organizations peddling merchant-processing services.

 

‘A Political Tack’

 

Princeton, N.J.-based Heartland Payment Systems Inc., for instance, is rolling out its “Durbin Dollars” marketing campaign by letting merchants know how much they’ll save in debit card processing charges by sticking with Heartland. Heartland’s salespeople will be taking that same message to competitors’ merchants.

 

Heartland uses a so-called “interchange-plus” pricing model that clearly delineates how much the merchant pays in interchange and Heartland’s own processing charges. More common are tiered and other plans that mix interchange and processor charges, with interchange harder to discern. Industry experts believe many acquirers and ISOs will attempt to pad margins by not passing on the full Durbin savings.

 

Heartland president Robert H.B. Baldwin Jr. expects the average merchant in Heartland’s small and mid-sized portfolio will save more than $1,000 a year, and he believes the Durbin Amendment could force acquirers to come clean about their pricing.

 

“If the merchant sees no change in their rate, then obviously the acquirer has not” passed on the reduced expenses, he says.

 

While Durbin could indeed represent a windfall for merchants, many payments executives regret that the price reductions are coming as a result of Congressional intervention rather than market forces. Networks set the price of interchange, which technically is paid to card issuers by acquirers, but ultimately merchants bear the expense.

 

Networks try to balance the interests of issuers, acquirers, merchants, and consumers in setting interchange, but network competition has the perverse effect of encouraging higher prices to attract issuers. All else being equal, issuers will put on their cards the brands of networks with the highest interchange rates.

 

Over the years, with the numbers of credit (at least until the Great Recession) and debit cards growing steadily and consumers expecting to be able to use those cards everywhere, it became almost impossible for most merchants to refuse to accept them, Baldwin notes. That tilted the balance of interchange power toward issuers. Now, thanks to Congress, that balance has shifted back toward merchants.

 

“I’m philosophically opposed to government intervention, there are a lot of inefficiencies that are going to be introduced,” he says. “That said, I don’t think that the preexisting interchange rates represented the outcome of a good, competitive process. Merchants didn’t have a true market tack to take, so they took a political tack and succeeded.”

 

Adds payments consultant Janet Langenderfer, former senior director of credit cards at Amtrak, the national passenger-rail service: “No one likes the government to control prices. What happened was there was not enough competition at that level.”

 

As with chains like 7-Eleven, small-ticket merchants already are bracing for newly introduced inefficiencies, especially if the 20-something-cent price ceiling turns into a floor for debit cards from smaller issuers and exempt prepaid cards. For them, debit interchange could rise to claim a painfully high percentage of sales.

 

‘Cautiously Optimistic’

 

Consider the Utah Transit Authority, the mass-transit provider in Salt Lake City and nearby locales. The UTA, currently the only transit system in the U.S. that accepts contactless bank cards for payments, is considering switching from flat fares to distance-based fares. But under a distance-based system, the shorter the ride, the higher the proportionate interchange expense.

 

“Our average ticket price is a little over $2.25,” says Craig Roberts, the UTA’s manager of technology development. “If you charge me 21 cents every time I collect a fare, that’s not a very good deal for us. That’s going to give us some heartburn.”

 

Roberts cautions, however, that it’s very early in the Durbin era and difficult to predict outcomes with any certainty.

 

Merchants, however, can expect their costs for accepting general-purpose reloadable (GPR) prepaid cards to rise. Provided that the cards meet several conditions set by the Fed, they are exempt from interchange price controls no matter the size of the issuer. Visa Inc.’s new interchange schedule gives banks clear incentives to start issuing more GPR prepaid cards (“Visa Gives a Push to Prepaid Cards,” page 6).

 

And while big merchants welcome the demise of exclusive network affiliations and their new transaction-routing freedoms with debit, that aspect of the Durbin Amendment means little with small merchants, according to some observers.

 

“I think a lot of the network routing goes over the head of most merchants,” says Langenderfer, who heads Vision Partners & Associates LLC in Silver Spring, Md.

 

Here is how an executive with a regional convenience-store chain in the Northeast put it in an e-mail:

 

“We retailers currently can do nothing (at least nothing I am aware of) to take advantage of our ‘new freedoms.’ I do not believe that any technology exists right now that can identify card types. We are still at the mercy of our credit card networks, and nothing gets done for us until someone pays for requested changes. Right now I am perfectly free to fly to the moon. Can I do that under current conditions? Same situation with what we’d like to do with card types.”

 

Heartland’s Baldwin calls that assessment “a little too skeptical,” adding the merchant may have more capabilities than he indicates.

 

But he does note that Durbin’s routing rules mostly apply to PIN debit, rendering them meaningless to most small merchants, since they don’t have PIN pads. Nor, with signature debit now priced the same as PIN debit on regulated cards, can they make a case to deploy PIN pads. “They have to look at the economic proposition of installing a PIN pad—it’s just not there,” Baldwin says.

 

Still, the new routing provisions, which are effective with issuers in the spring, have heartened merchants that formerly believed they had no opportunity for least-cost routing. “It doesn’t go into effect until April, so it’s an unknown at this point,” says 7-Eleven’s Peck. “We’re cautiously optimistic.”

 

‘Breakthrough Time’

 

Merchants may have felt their Durbin victory was muted somewhat by the Fed, but that hasn’t stopped them from growing increasingly vocal about chip cards.

 

The Europay-MasterCard-Visa (EMV) global standard for this plastic, which replaces conventional mag stripes with bits of silicon capable of far more security and computing power, has been around since the late ‘90s. But now, with most first-world countries—including Canada—having mandated the standard, U.S. networks and banks are getting serious about deploying it.

 

Most of the deliberation about EMV envisions combining the standard with mobile payments, incorporating NFC. With smart phones booming, payments strategists see consumers using NFC-equipped handsets to make payments in volumes far beyond what mere contactless chip cards were capable of.

 

In August, Visa announced a major push to bring EMV chip technology to the U.S. via contact, contactless, and mobile devices. Visa’s three-part plan includes its Technology Innovation Program, which offers a waiver on a merchant having to validate its compliance with the Payment Card Industry data-security standard, or PCI, provided that 75% of its Visa transactions originate on an EMV terminal also capable of reading transactions from NFC mobile devices beginning in October 2012. Visa introduced TIP earlier for overseas merchants.

 

While some observers criticized Visa for seemingly trying to impose its vision of EMV and mobile payments on merchants (“Is Visa’s EMV-NFC Push All About … Visa?” September), others hail the network for doing something to finally bring chip technology to the U.S., the last bastion of the fraud-prone magnetic stripe.

 

“It’s a breakthrough time,” says Heartland chief executive Robert O. Carr. “We want to be a leader in supporting it.”

 

Still, big chains have their own ideas about how chip cards should evolve, and these ideas aren’t always in concert with the ideas of the big banks. Early this year, for example, JPMorgan Chase & Co. and Wells Fargo & Co. launched EMV programs for customers who travel frequently abroad, where mag-stripe cards are increasingly hard to use, particularly in self-serve machines.

 

But, instead of rolling out the typical chip-and-PIN cards common in other countries that have adopted EMV, Chase went with chip-and-signature, a protocol permitted under the standard. Wells went with both but encouraged the signature flavor of EMV. The banks argued signature is a more familiar authentication technique for their customers.

 

And Visa is de-emphasizing the PIN in its EMV initiative, instead focusing on so-called dynamic authentication with one-time transaction identifiers.

 

Wal-Mart, which is enthusiastic about the security benefits of EMV and has equipped all of its U.S. stores to accept EMV cards, lashed out at the banks for pushing signatures over PINs. “Don’t waste our time,” thundered Jamie J. Henry, senior director of payment services, at a chip-card conference in May in Chicago. “It’s chip-and-PIN or nothing.”

 

Chargebacks on signature debit transactions run significantly higher than on PIN debit payments at Wal-Mart, Henry said in arguing for the added security of PINs. The signature, he said, proves nothing about the identity of the user. “It’s just a little squiggly mark. What good does it do me?” he asked.

 

Rich Steckroth, director of business development at Sheetz Inc., a 400-store regional c-store chain based in Altoona, Pa., agrees. “With signature, you’re still looking at questions of verification,” he notes. “With PIN, you eliminate the question marks.”

 

Steckroth is optimistic about EMV but would like to see more details. “Visa made an announcement but as yet there’s not spec behind it,” he says.

 

Meanwhile, at least some big-box merchants are ready for a more robust rollout. At the chip-card conference, Henry also criticized the banks for confining EMV, at least for now, to travelers. “We believe it needs to move beyond international travelers,” he said.

 

Merchants love to complain about the costs and hassles of PCI compliance, so Visa’s program may strike a chord in inducing merchants to upgrade their point-of-sale technology for EMV and mobile payments. Heartland’s Carr says the PCI waiver “is a great move for merchants. We’re going to try and implement it as rapidly as we can.”

 

Visa’s program also requires acquirers and their sub-processors to be able to support chip transactions by April 2013, and includes a liability shift in 2015 from issuer to merchant acquirer if a chip card transaction proves fraudulent and the acquirer’s merchant has not installed chip-reading terminals.

 

“If we get something that says this is what the standard is going to be and there’s going to a change in the way chargebacks are done, I think people are going to embrace it,” says Langenderfer of Vision Partners. That’s how Sheetz’s Steckroth sees it. “If I’m responsible for the fraud, then I’m all about chip-and-PIN,” he says.

 

Langenderfer says she can’t talk about specific payment projects from her days at Amtrak, but she echoes what other technology and payments executives at large merchants have been saying—that the laying of the groundwork has been going on quietly in back-office computing centers to handle EMV when the day comes. Also, manufacturers are now making POS terminals capable of accommodating EMV technology.

 

“[Merchants] have been hearing for the last five years that something along the lines of EMV is coming; they have been planning for the investment but waiting to find out what the technology is for the front end,” she says. “Many companies like Amtrak have been investing in the back end.”

 

Zero Bank Promotion

 

As Visa acknowledges, EMV comes in both contact and contactless forms, with the contactless variety especially adaptable for mobile payments. While some big banks began promoting contactless cards in 2005, the technology never caught on with merchants. It didn’t save them on acceptance costs (no interchange break), and was no faster than a swiped transaction once the card networks did away with signature requirements on tickets under $25.

 

Still, contactless went farther in the U.S. than anywhere else, with about 144,000 locations equipped with readers. That lays the groundwork for NFC, experts argue, as soon as handset manufacturers start putting the chips in their mobile phones in commercial quantities. “For us, moving to NFC is really a no-brainer,” says Steckroth. That’s because Sheetz put readers in its stores and at its pumps years ago. “We’re kind of excited about the movement to mobile payments.”

 

Apparently, the chain’s customers are excited, too. Steckroth says he hears from them “every day” about mobile payments. “There’s some version of pent-up demand,” he says. That’s what Google Inc., Visa, and a carrier-led consortium called Isis are counting on. All are planning launches of NFC payments products that crucially depend on widespread merchant buy-in.

 

Still, while much of the talk centers on what merchants need to do regarding contactless and mobile payments, the UTA’s Roberts says card issuers need to do more.

 

“So far, we have not seen much interest on the part of the issuers to promote the contactless payment product, the use of the product,” he says. “We always assumed the bank card industry would be promoting contactless payment, but we haven’t seen that yet.”

 

That lack of industry support is one reason why the UTA hasn’t done a big marketing push for acceptance of contactless bank cards on its trains and buses, according to Roberts. Such cards today account for only between 1% and 2% of fare payments.

 

Things could change, however. “Providing merchants to set up contactless payment also encourages mobile,” he says.