Game of Loans: Impact of Credit Tie on Competitive Dynamics in US Debit
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
January 10, 2014
Game of Loans: Impact of Credit Tie on Competitive Dynamics in US Debit
- The relative outperformance of MA versus V since end-July, when a Federal District Court ruled in favor of dual-routing for signature debit, is hard to explain. It is likely predicated on a share shift in signature debit from V to MA if the ruling is upheld on appeal (with the share shift that occurred in PIN debit immediately after the original network exclusivity rules of the Durbin Amendment were implemented in April perhaps acting as precedent).
- In practice, if dual routing in signature debit becomes a reality, Visa is likely to gain share from MasterCard in one scenario and unlikely to lose share in another. Specifically, Visa will gain share if there is no regulatory challenge to FANF because it will offer FANF rebates to merchants in return for debit volume. This approach, combined with Pin-Authenticated Visa Debit (“PAVD”), has already allowed Visa to reverse most of the share losses in PIN debit to MasterCard and the regional EFT networks which occurred in the immediate aftermath of Durbin implementation.
- While MasterCard is a tougher competitor in signature debit than the regional EFT networks in PIN debit (because it has a credit franchise and so the market power to impose its own FANF-like merchant-licensing fee called the Annual License and Registration Fee or “ALR”), it does not have the same pricing power as Visa because its credit franchise is half the size. This gives Visa a structural advantage in a dual-routing debit environment for signature debit.
- If the current regulatory investigation of FANF goes against Visa (on the grounds the fee represents an illegal tie of the credit to the debit franchise), it will lose structural advantage from credit, but will not be disadvantaged. More likely than a debit share shift is price competition with networks bidding down merchant fees (both interchange and switch) to marginal cost to win the merchant routing decision. With V more exposed than MA to US debit (representing 27% of global purchase volume versus 16% at MA), some valuation discount makes sense. However, both V and MA will be de-rated.
- Of course, the Appeals Court may not uphold the District Court ruling for dual-routing of signature debit in which case MA likely gives back the outperformance since end-July. If, in addition, regulatory challenge to license fees undermines the advantage V enjoys in PIN debit over MA and regional EFT networks, Visa will protect share by cutting PIN debit interchange (to win merchant routing) and raising signature debit interchange (to compensate issuers); in other words, Visa will leverage market power in signature debit into PIN debit.
Overview: Competitive Dynamics in Different Debit Scenarios
Dual routing, where merchants can choose between two or more unaffiliated networks to settle a given transaction, fundamentally alters the competitive dynamic in the debit business. In a single-routing environment, where merchants are restricted to a single network, competition among networks is focused on obtaining from the issuer the designation as exclusive network. In his July ruling, Judge Leon described this succinctly and accurately: “Visa, MasterCard, and other debit networks vie for issuers to issue cards that run on their respective networks. They can entice issuers by emphasizing their relative market power to set interchange and other fees. Networks thus have an incentive to continuously raise merchants’ interchange fees – which again flow from merchants to issuers – as a way to attract issuers to the network”.
In a dual routing environment, however, this does not work because a merchant can route away from high-cost networks (whether that cost is driven by interchange or switch fees). Indeed, since Judge Leon’s ruling in favor of dual routing for signature debit, the market pricing of Visa and MasterCard presumes that MasterCard will benefit if the ruling is upheld on appeal because Visa will be less able to use its relative market power (Visa is more than twice the size of MasterCard in the US) to maintain a disproportionate share of debit. The thesis is that Visa’s success in attracting the large issuers to its network will count for less as merchants will simply choose to route transactions to MasterCard regardless of issuer preferences.
This is not what will happen, however, and we expect the market premium of MasterCard to Visa to unwind and likely reverse. The reason is that the Court ruling does nothing to erode Visa’s market power but will rather change the way in which this market power is expressed. The precedent is PIN debit where dual routing is already the norm (at least on Visa-branded cards) and where Visa has used its market power to gain the alignment of merchants by levying a license fee (called the Fixed Acquirer Network Fee or FANF) for accepting Visa-branded products and then offering rebates for debit volumes. As a result, Visa is now gaining share of PIN debit from MasterCard and the regional EFT networks even though, on a per-transaction basis, Visa’s PIN debit network is more expensive.
Visa will deploy the same strategy for signature debit as it has in PIN debit if the Appeals Court sustains Judge Leon’s ruling in favor of dual routing for both types of debit. Of course, MasterCard is a tougher competitor to Visa in signature debit than the regional EFT networks in PIN debit because MasterCard has a credit franchise and so the market power to levy its own license fee. Indeed, MasterCard already has such as license fee, called the Annual License and Registration Fee or “ALR”, but for the time being it is meaningfully less than FANF. In a dual-routing environment, MasterCard will likely raise ALR so as to be able to offer rebates for debit volume that are more competitive with the FANF rebates provided by Visa. However, MasterCard is structurally disadvantaged in this competitive dynamic because its credit franchise is half the size of Visa’s in the US and so it does not enjoy the same license-fee pricing power. As a result, Visa is more likely to gain debit share from MasterCard than vice-versa.
The root issue is that Visa has market power because of its credit franchise and, through FANF, is leveraging this in the debit business. The Justice Department is investigating this tieing of the credit and debit businesses and Visa’s market power in debit will be eroded if there are regulatory constraints on FANF. If this occurs along with dual-routing of signature debit, then Visa will not have a pricing advantage over MasterCard in debit but neither will it have a disadvantage. There is no reason to believe there will be meaningful share shifts but rather that the networks will compete for the merchant routing decision by reducing interchange and network fees to marginal cost. In other words, the network economics of the debit business will degrade and Visa may trade at valuation discount to MasterCard because of its greater relative exposure to the US debit business. However, this will be in the context where both Visa and MasterCard are derated.
A final scenario is that there are regulatory constraints on FANF but the Appeals Court does not mandate dual-routing of signature debit. In this case, Visa will revise its strategy in PIN debit and compete for the merchant routing decision by cutting PIN debit interchange since rebating FANF will no longer be as effective. To compensate issuers for lower PIN debit interchange, Visa will raise signature debit interchange since, without dual routing, merchants will have not ability to avoid the higher costs. The net effect is that Visa will continue to gain share from regional EFT networks but by leveraging market power in signature debit rather than market power in credit.
Relative Valuation of Visa and MasterCard
The premium valuation at which MasterCard trades to Visa (with a next-twelve-month price-earnings multiple of over 28x versus ~25x for Visa – see Exhibit 1) is based on a misunderstanding of competitive dynamics in the US debit business and will reverse, in the current regulatory environment, whether or not the Courts insist on dual-routing of signature debit. Specifically, we do not agree with the thesis that dual-routing of signature debit will lead to a share shift from Visa to MasterCard in the same way that, at least initially, the implementation in April 2012 of the network exclusivity provisions of the Durbin Amendment led to share shift of PIN debit from the Visa-owned Interlink network to competing networks including the MasterCard-owned Maestro network.
Exhibit 1: NTM Forward Price/Earnings for Visa and MasterCard
Traditionally, Visa has had the premium valuation on the basis that its scale (with over twice the volumes of MasterCard in the US – see Exhibit 2) allowed it to outbid MasterCard for issuer business by offering incentive for exclusive mandates. Indeed, the top-5 bankcard issuers are essentially Visa-only (see Exhibit 3 which shows debit purchase volumes to illustrate) if we allow for the fact that following the announcement of the Chase private processing deal last February Chase, which had been a dual-issuer, will migrate MasterCard volumes to Visa. The economics are that Visa can pay issuers for exclusive mandates
Exhibit 2: US Card Purchase Volumes
Notes: Visa/MasterCard debit volumes include PIN and prepaid; EFT figures are for regional networks only (i.e. excluding Interlink and Maestro) from Nilson issue 1028
Exhibit 3: Alignment of Top Issuers to V or MA Based on Debit/Prepaid Purchase Volume in US
Note: JPM volumes will migrate to V based on February announcement
When a Federal District Court ruled in favor of dual-routing for signature debit at the end of July, investors awarded MasterCard a premium valuation on the apparent grounds that, with merchants able to choose whether to route over Visa or MasterCard, debit share would likely equalize versus the current state where Visa has a 70% share of combined volumes in the US (see Exhibit 4). The District Court ruling is under Appeal and there is a chance it will be reversed. However, the market (properly in our view) appears to be pricing in the likelihood that it will be upheld. Citing remarks of the eponymous Senator Durbin (see Exhibit 4), the District Court ruling suggested that, in its interpretation of the Durbin Amendment, the Federal Reserve Board: “not only fails to carry out Congress’s intention; it effectively countermands it!”
Exhibit 4: Remarks of Senator Durbin on Network Exclusivity Provisions of Legislation
This paragraph [concerning network exclusivity] is intended to enable each and every electronic debit transaction – no matter whether that transaction is authorized by signature, PIN, or otherwise – to be run over at least two unaffiliated networks, and the [Federal Reserve] Board’s regulations should ensure that networks or issuers do not try to evade the intent of this amendment by having cards that may run on only two unaffiliated networks where one of these networks is limited and cannot be used for many types of transaction.”
Impact of Network Exclusivity Provisions of Durbin
The network exclusivity provisions of the Durbin Amendment are well-known but merit a brief summary since Visa’s response provides a clue as to how competitive dynamics will unfold and why a premium valuation for MasterCard is questionable. The Durbin Amendment was intended to blunt the network dominance of Visa and MasterCard in debit by making it possible for merchants to have a choice over which network a debit transaction could be routed and by creating a more level playing field for regional electronic-funds-transfer (EFT) networks such as STAR owned by First Data, PULSE owned by Discover, NYCE owned by FIS, and ACCEL owned by FISV.
The Fed interpreted the legislation to mean that each debit card needed to be enabled for unaffiliated networks rather than each debit transaction. The difference is important because there are two methods of authenticating debit transactions (by signature or by PIN) and networks have traditionally been dedicated to one of these authentication methods but not both. The Fed’s interpretation meant that issuers could comply with Durbin by enabling a debit card for Visa or MasterCard for signature-authenticated transactions and an unaffiliated network for PIN-authenticated transactions. While compliant, these cards did not provide merchants with a routing choice since the consumer typically makes the decision whether to use a debit card in signature or PIN authentication mode and each card had only one network represented for each authentication mode.
The practical impact of Durbin, as it was implemented by the Fed in April 2012, was that Visa lost share in the PIN debit market; indeed, its Interlink PIN debit network lost ~$50 billion of purchase volume, representing about 50% of its business, in the following quarter. The reason is that Visa had provided incentives to issuers to designate it as an exclusive network-provider. These issuers then enabled their debit cards for Visa in signature-authentication mode and the Visa-owned Interlink network in PIN-authentication mode. Since Visa and Interlink are affiliated networks, this configuration was non-compliant with Durbin, even under the Fed interpretation, and issuers responded by leaving Visa in place for signature authentication and replacing Interlink with the MasterCard-owned Maestro debit network or a regional EFT network for PIN authentication. This replacement alternative was preferred over supplementing Interlink with Maestro or an EFT network because the competing networks offered issuers incentives to be an exclusive provider of authorization and settlement for PIN-authenticated transactions.
Visa’s Response to Durbin in PIN Debit
Visa’s response was to take a calculated regulatory risk, and has been wildly successful. Visa departed from the practice that networks are typically dedicated to either signature-authentication or PIN-authentication and insisted that processors and issuers accept PIN-authenticated transactions over the VisaNet network that previously had been used only for signature-authenticated transactions (except in the special case of cash-advances on credit cards). The effect of this was that Visa could settle PIN-authenticated transactions so long as a card carried the Visa brand for signature-authenticated transactions whether or not it was enabled for Interlink.
Visa called the product PIN-Authenticated Visa Debit (“PAVD”) and it provides an illustration of how Visa will compete in a dual-routing environment since, on all debit cards enabled for Visa for signature-authenticated transactions, PAVD competes network-against-network with the unaffiliated EFT network required by Durbin. In other words, because of PAVD, merchants do in fact have a routing choice for PIN-authenticated transactions on debit cards carrying the Visa brand for signature-authentication. A reasonable expectation is that this network-against-network competition would result in competitive bidding between networks for the merchant routing decision by lowering merchant acceptance costs. In practice, this has not happened and PAVD charges merchants meaningfully higher interchange (see Exhibit 5) for unregulated issuers. (For regulated issuers, which account for approximately half of all debit transactions, debit interchange is capped at 21-24 cents/transaction)
Exhibit 5: Debit Interchange to Issuers not Covered by Durbin
Source: Debit Advisor, April 2012
The reason is that, as a scale player (with over double the purchase volumes of MasterCard in the US – see Exhibit 6), Visa chooses not to compete on price. Rather, at the same time as launching PAVD, Visa introduced a license fee for merchants (technically acquirers but typically passed on to merchants) referred to as the Fixed Acquirer Network Fee (“FANF”) based, among, other things on the size of the merchant by dollar volume and number of locations. Visa then offers rebates on FANF for merchants that direct PIN debit volume to PAVD rather than a competing network. The effect of the rebates is that merchants have an incentive to route transactions to PAVD even though the per-transaction acceptance cost is higher.
Exhibit 6: Visa and MasterCard Volumes by Geography and Type
Implications for Dual-Routing in Signature Debit
The implication for signature debit is clear. If the Appeals Court upholds the District Court ruling and insists on dual-routing for signature debit (so that debit cards must be enabled for both Visa and MasterCard when in signature-authentication mode unless a credible third network emerges), share will shift to the network which has the greatest market power with merchants and hence the most ability to levy a license fee against which rebates-for-debit-volume can be granted.
This network is Visa, not MasterCard, because it has twice the credit volumes and hence more pricing power with merchants. In short, dual-routing of signature debit will not result in MasterCard siphoning debit volumes from Visa-aligned issuers but in Visa siphoning debit volumes from MasterCard-aligned issuers because Visa has the bigger merchant “billy club” in the form of a licensing fee and associated rebate opportunities. Indeed, the difference in credit market power between Visa and MasterCard is behind the divergence in their debit strategies. MasterCard CEO Ajay Banga acknowledges: “we are not playing the game the way they are”. MasterCard is pursuing a single-routing strategy in both PIN and signature debit:
- PIN Debit: MA gained significant PIN-debit volumes in the two quarters after the network exclusivity provisions of Durbin were implemented in April 2012 (see Exhibit 7) as many Visa-aligned issuers for signature-debit chose to comply by replacing the Visa-owned Interlink PIN debit network with the MasterCard-owned Maestro PIN debit network. Visa is now recapturing share through the PAVD/FANF strategy even though per-transaction acceptance costs for PAVD are meaningfully higher than for Maestro. (MasterCard has commented that PAVD is impacting the regional EFT networks more than Maestro and that is almost surely true since, lacking credit franchises, regional EFT networks do not have the ability to levy FANF-like license fees while MasterCard does, and is, through its Annual Licensing and Registration Fee or ALR. However, we do not interpret the comment to mean that Maestro is unaffected by PAVD and, given Visa’s ability to charge higher licensing fees and so offer greater rebates for debit volume, believe it almost surely is).
- Signature Debit: In signature debit, MasterCard has the high interchange characteristic of a single-routing strategy and has not created dual-routing for merchants in PIN debit by enabling its core network dedicated to signature-authenticated transactions for PIN-debit (beyond cash advances on credit cards); there is no PIN-Authenticated MasterCard Debit or PAMD acting as an equivalent to PAVD. In part, this is because MasterCard has traditionally been less aggressive than Visa in PIN debit so that the replacement of Maestro as a PIN debit network on MasterCard-branded debit cards had a less adverse impact on debit volumes than the replacement of Interlink as a PIN debit network on Visa-branded debit cards.
In contrast, Visa is pursuing a dual-routing strategy in PIN debit and preparing for dual-routing in signature debit. PAVD creates dual-routing for PIN-debit on Visa-branded debit cards and Visa competes aggressively to win the merchant routing decision through setting FANF at a high level to enable meaningful rebates for debit volume. Visa rationalizes FANF to merchants by arguing that it is lowering per-transaction costs and, indeed, it has lowered signature debit interchange which is now meaningfully below that on MasterCard-branded transactions; this appears to be setting up for dual routing in signature debit. In addition, substituting FANF for interchange in merchant pricing favors Visa’s economics, to the extent not shared with issuers in the form of incentive payments, FANF is for Visa’s account whereas interchange is for the account of issuers.
Exhibit 7: US Debit Purchase Volumes for Visa and MasterCard
Source: Company Reports
Possible MasterCard Responses to Dual-Routing in Signature Debit
It is not clear how MasterCard can competitively respond to Visa in a dual-routing environment; there are three possible (and not mutually exclusive) options none of which are attractive:
- Reduce signature-debit interchange to parity with Visa or less. This will be the least that is necessary to avoid loss of the merchant routing decision to Visa but it will put an end to share gains MasterCard has made among smaller issuers by offering premium signature-debit economics and there is a risk that some issuers may convert portfolios to Visa.
- Raise the ALR merchant licensing fee and then match Visa rebates for debit volume. This is a game MasterCard cannot win because of its smaller credit franchise; furthermore, it increases regulatory risk by making the tie between the credit and debit franchises more transparent.
- Become more aggressive in PIN debit by implementing PAMD. If implemented today, MasterCard could win volume from the regional EFT networks on MasterCard-branded debit cards but, in an environment of dual-routing for signature debit, these cards will also carry the Visa brand and so be enabled for PAVD where Visa has the advantage because of its pricing power on FANF.
Ultimately, in a dual-routing environment, the key success factor for debit is market power in credit so that MasterCard’s best shot is to close the share gap in credit. This is a clear focus of the company but, as pointed out by Ajay Banga: “it is a slow fix, it does not happen overnight”.