Networks: Prepaid Cards Navigate the Durbin Waters

Elizabeth Whalen

Durbin Amendment rules affecting prepaid card transaction routing take effect next month. Already, the regulations are raising thorny operational, legal, and strategic issues that could take months or more to resolve.

It’s not over yet. There is still one more provision from the Durbin Amendment in 2010’s Dodd-Frank Act that card-industry firms must comply with: adding a second network to general purpose reloadable (GPR) prepaid and gift cards. The provision, which has covered regular debit cards since April 2012, takes effect on April 1.

The implications of complying with the new regulations are not yet entirely clear, and may not be for months. The Federal Reserve Board, which wrote the rules implementing the Durbin Amendment, allotted prepaid card providers additional time to meet the routing rules so that issuers could draw down existing card inventories and modify their systems, says a Fed spokesperson.

The transaction-routing provision requires prepaid GPR and gift cards to offer merchants a choice between at least two unaffiliated debit networks, says Madeline K. Aufseeser, a senior analyst at Boston-based research and consulting firm Aite Group LLC. With most cards carrying either the Visa Inc. or MasterCard Inc. brand on the front for signature transactions, the challenge for issuers, she says, is establishing a second relationship to support a PIN-based debit network.

“They do not have to re-issue cards in order to do that. They do not have to advertise the two different networks that are associated on the card,” Aufseeser says. “It’s essentially a back-office routing initiative that has to be accounted for. It’s transparent to consumers as well.”

A Zero for Zero Liability?

The Durbin Amendment’s intent is to reduce merchants’ card-acceptance costs by requiring each debit or prepaid card to provide access to at least two unaffiliated networks and giving merchants control over transaction routing. Before Durbin, issuers mainly called the routing shots.

Retailers, all other things being equal, will now be able to send transactions to the networks with the lowest interchange rates. Since they receive interchange, issuers’ motives are just the opposite—to have transactions come to them from the networks with the highest interchange rates.

These Durbin-induced routing changes aren’t free, however, says Ben Jackson, a senior analyst with Maynard, Mass.-based Mercator Advisory Group Inc. New expenses may include network connectivity fees and back-end management.

“It’s the merchant who does the routing, so for some [GPR] cards that are in the market, the only thing that really needs to be done is to enable, for that BIN [bank identification number] range, the ability to run on more than one network behind the scenes,” he says. “But that still comes at a cost.”

And, even though the network routing change is transparent to consumers, it may still affect them, Jackson says. One spot where this seeming esoterica could bubble up to the surface involves the zero-liability policies of Visa Inc. and MasterCard Inc. for fraudulent debit transactions.

“It makes it hard to advertise zero liability because you don’t know which network the cardholder’s transaction just went over,” he says. “It’s up to the merchant which network that transaction went over. If you’re holding a Visa card, and the merchant processes a transaction over a PIN-debit network, and somehow that card is compromised, will the zero-liability guarantee be applied because it didn’t go over [Visa’s] network?”

Visa and MasterCard can’t take responsibility for what happens on other networks, Jackson notes. If they do advertise zero-liability protection and the merchant routes the transaction to another network—an action the consumer would not be aware of—that consumer could face liability, and the card brands ultimately might face unfair or deceptive-practices lawsuits. As a result, Visa and MasterCard might have an incentive to stop advertising zero-liability protection as a benefit of their cards, he says.

‘Upside Down’

Customer disclosures for people using open-loop gift cards also are likely to pose problems, says Tim Sloane, director of Mercator’s Prepaid Advisory Service. The margins on such cards are already extremely thin, he says, in part because of restrictions on monthly fees in the 2009 federal CARD Act. Adding a second network to the card and then communicating with the customer to inform him he now has a PIN adds more expense.

In addition, customers may become confused about how they can use these cards now that they have a PIN. If a point-of-sale terminal prompts a gift card holder for a PIN, he may call the support number on the back of the card for help completing the transaction, Sloane says.

Cardholders also may assume that having a PIN means they can get cash back at an ATM—even if gift card program managers have turned off that feature—and call in for support.

“All of these are costs that would turn the profitability of an open-loop prepaid card program upside down,” Sloane says. “Dual-network routing on an open-loop gift card challenges the financial model under which those open-loop gift card programs operate. We don’t even know what the impact is going to be yet because the gift card program managers are still wrestling with it.”

If users do try to access the gift card for cash and aren’t able to, they might consider filing deceptive-practices lawsuits, says Jackson. Therefore, program managers must inform consumers about using the cards. They must also now deal with two networks when getting approval for card design and disclosures, he adds.

Another potentially expensive issue facing open-loop gift card program managers is the number of remaining cards in stores that, as of April 1, will no longer be compliant.

“So they’ve got to figure out either how to bring those cards into compliance or they’ve got to pull them all off the shelves, destroy them and get new cards out,” says Jackson.

Various prepaid card managers and issuers contacted by Digital Transactions declined to comment on these issues.

‘A Cheaper Mechanism’

The Durbin Amendment’s impacts on PIN-debit networks also are still being worked out, says Daniel A. Kramer, senior vice president of marketing and merchant operations for the Johnston, Iowa-based Shazam Network. He expects the legislation’s true impacts will not become clear until after the April deadline.

One of the biggest impacts he expects is the commoditization of debit transactions.

“The retailer now has, at the point of sale, the choice to route the transaction to a cheaper mechanism for authorization. And he now has the capability to negotiate directly with the debit networks for more advantageous rates to send transactions to them,” Kramer says.

Those two choices will increase competition among networks for merchants, and networks in turn will likely offer retailers incentives. Those incentives may come in a variety of forms, he says, ranging from pricing reductions to offers to pay for connections to different acquirer-processors.

Kramer says he can’t predict which networks will benefit from the legislation, but he does expect that the total volume of transactions available will remain static. That means networks also will fight for issuer business, causing some volume to shift between networks.

“There’s a cost to that. You’re giving up margin in order to negotiate with some of the card issuers to put your brand on the card. It only further drives down the market price for processing,” he says.

‘National’ Networks

When it comes to prepaid cards, Kramer does not expect card fees will increase, but he does expect issuers will partner with more than the one additional brand the legislation requires to satisfy younger consumers’ preference for PIN-based transactions. He notes as an example that Shazam’s heaviest users typically are between ages 18 and 24, make PIN-debit purchases almost daily and rarely sign for those purchases.

“They’re used to using a PIN, so we want to make sure we’ve got the capability to do that, even if they’re buying a prepaid card,” Kramer says.

Therefore, he sees prepaid card issuers being willing to partner with multiple debit networks.

“That creates opportunity for everyone, not just for one or two networks. That’s fairly significant,” he says.

Aite’s Aufseeser expects that the larger debit networks will have an opportunity to increase transactions and will compete on price. Some of the smaller networks could also benefit, she says.

“But they need to be more banded together to be able to support national acceptance because that was also one of the [Fed’s] requirements. They have to be two unaffiliated national networks,” she says. “The rules were not specific on what ‘national’ is.”

Indeed, the prepaid card industry’s Durbin-influenced future lacks many specifics at the moment. But the industry in the past has displayed adaptability in the face of fast-changing conditions, so there is little reason to expect it won’t adapt again.

Durbin Gives AmEx And Discover Some Prepaid Aces

Not all open-loop prepaid cards are subject to the Durbin Amendment’s transaction-routing regulations, or its debit card interchange price controls that took effect in October 2011. Most notably, cards on the American Express Co. and Discover Financial Services networks are exempt.

That’s because AmEx and Discover largely function as “three-party” networks in which they issue the cards that use their networks. Durbin regulates only the “four-party” networks: Visa Inc. and MasterCard Inc.

AmEx and Discover are probably exploring their options, says Tim Sloane, director of the Debit Advisory Service at Mercator Advisory Group Inc.

“I would be surprised if they weren’t looking at channel partners and sales opportunities based on them having an advantage relative to the profitability of their product,” he says. “If I know I’m going to have more profitability in my product, I can start finding ways to edge out my competitors.”

AmEx seized the moment in October when it and Wal-Mart Stores Inc. introduced the Bluebird prepaid card, which AmEx advertises as a low-fee alternative to checking accounts and debit cards. Wal-Mart already was selling, and continues to sell, the Walmart MoneyCard managed by Green Dot Corp.

“It [Bluebird] looks like it’s a great consumer-value proposition,” says Eric Grover, principal at Intrepid Ventures, a consulting firm in Minden, Nev. “AmEx has an interesting advantage. They have higher interchange to begin with, and that’s enabled them to offer a product with essentially no customer-facing fees.”

Indeed, Durbin created openings for AmEx and Discover that are denied to banks and credit unions. The Federal Reserve’s final rule implementing the amendment sets a stringent debit card interchange cap for financial institutions with more than $10 billion in assets of about 23 cents per transaction. In preparing its rule, the Fed had estimated issuers’ interchange income on prepaid cards averaged 40 cents per transaction.

Reloadable prepaid cards issued by big financial institutions can be exempt from the debit interchange cap, but only if they don’t charge overdraft fees, do allow the first ATM transaction each month to be free, and do not allow underlying funds to be accessed by any means other than the card itself. AmEx and Discover don’t have to contend with those restrictions.

Bluebird, however, does not come with federal deposit insurance, while cards like the MoneyCard, which is issued by GE Capital Retail Bank, do. Lack of such consumer protection could be a strike against the card if consumers are concerned that American Express will fail, observers say.

AmEx’s merchant base is smaller than the Visa/MasterCard base, and that may be the bigger challenge for AmEx in serving Wal-Mart’s customers, according to Grover.

“If you think about the kind of consumer at Wal-Mart who’s going to be signing up for these cards, they are likely to be living in a downmarket area with weaker AmEx acceptance,” he says.

That creates brand dissonance between American Express’s traditional target market of affluent consumers and Bluebird’s target market, he says. It’s unclear to him how Bluebird will resolve that dissonance, but Grover notes that the card is clearly positioned as a replacement for a retail banking relationship, making it a product competitors will want to watch.

Indeed, Bluebird already is pecking at Green Dot. The company said Walmart MoneyCard activations fell 14% year over year in 2012’s fourth quarter and blamed Bluebird for much of the slippage.