Payments: The Distribution Opportunity for Discover in Debit

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September 3, 2013

Payments: The Distribution Opportunity for Discover in Debit

  • We believe appeal unlikely to overturn the July Court finding that Congress intended the Durbin Amendment to impose dual routing (each debit transaction to be routable over at least two unaffiliated payment networks) and not dual branding (each debit card to be enabled for at least two such networks) as currently implemented.
  • In a dual routing, Visa and MasterCard will compete on many cards for merchant routing of debit transactions by lowering interchange; the only recourse for issuers will be to involve a third payment network, creating opportunity for Discover in signature debit.
    • Issuers need a third network so as to credibly threaten to disenfranchise (kick of the card face) a network that follows destructive interchange pricing; this is not possible if there are only two networks and both must be enabled for Durbin compliance.
  • Discover will thereby gain access to the primary distribution channel for signature-authenticated transactions; until now, these issuer banks have been locked up by Visa/MasterCardthrough network exclusivity arrangements until 2006 (when they were found by the Supreme Court to violate antitrust rules) and, since then, the legacy of these arrangements in the form of extortive interchange pricing as described in this note.
  • As a result, Discover can begin to close the wildly disproportionate gap between its merchant acceptance (~90% of that of Visa/MasterCard) and its share of signature-authenticated purchase volume (just over 3% versus 55% for Visa and 26% for MasterCard, see Exhibit). The resulting network effects will benefit the entire Discover card business.

Exhibit: 2012 Share of US Signature-Authenticated Purchase Volume (Debit and Credit Combined)


The share gap between Discover and Visa/MasterCard is wildly out of proportion to the merchant gap: Discover has just over a 3% share of signature-authenticated transactions versus a 55% share of Visa and 26% share for MasterCard (see Exhibit 1), despite the fact that Discover is accepted by approximately 90% of the US merchants who accept Visa.

Exhibit 1: 2012 Share of US Signature-Based Purchase Volume for General-Purpose Brands

Source: Nilson, Feb 2013

The share discrepancy is reflected in revenues. Unlike Visa which generated revenues of $3 billion in the June quarter, of which ~45% is domestic, Discover generates under $50 million from third-party issuers and this is substantially all related to the Pulse PIN debit network not the Discover brand. Even under an inclusive (i.e. including interchange) definition of payments revenue, the payments business at Discover generated $355 million in the June quarter or only 20% of firm-wide revenue after interest expense and credit provisions (see Exhibit 1).

Exhibit 1: Payments-Related Revenue at Discover

Source: Company Reports

Discover’s payments revenue meaningfully understates the value of its network, and arises for a single reason: Discover is effectively locked-out of the distribution channel for payment network services related to signature-authenticated transactions (which represent approximately two-thirds of debit volumes and substantially all credit volumes). This distribution channel comprises the US financial institutions which administer the credit and checking accounts to which consumers seek card-access at point-of-sale, and the lock-out of Discover occurs, as discussed below, because of the extortive interchange strategy followed by Visa and MasterCard.

Extortive Interchange: The Legacy of Visa/MasterCard Anti-Competitive Practices

Discover’s brand in the market for signature-authenticated credit and debit transactions is the “Discover” card (and, to a lesser extent, Diner’s Club). With Discover now accepted by over 9 million merchants, the “merchant gap” with Visa does not meaningfully affect utility for most cardholders; the gating factor for transaction volumes, for the Discover network as much as Visa and MasterCard networks, is getting cards into the hands of consumers.

Visa and MasterCard can rely on the marketing dollars, checking account infrastructures and, in the case of credit cards, balance sheets of the mass-ranks of US banks; Discover network services, on the other hand, have traditionally been “distributed” almost exclusively by a single client: the Discover issuing business. Indeed, until 2004, issuers of Visa- and MasterCard- branded cards were prohibited from issuing Discover-branded cards until the Supreme Court found that, in imposing this restriction, Visa and MasterCard were violating antitrust rules.

Since 2004, Discover has not been able to expand its distribution network because of the on-going competitive advantage to Visa and MasterCard of the legacy of earlier anticompetitive practice including, in particular, dominant market share (over 80% of all debit transactions and nearly 100% of signature debit transactions). In his judgment of July 31st this year, Judge Leon summarizes the relevant market dynamics:

“Due to their hefty market share, Visa and MasterCard exercise considerable market power over merchants with respect to debit card acceptance. Hundreds of millions of consumers use cards that operate on Visa’s and MasterCard’s debit networks. Merchants know that if they do not accept those cards and networks, they risk losing sales, and losing the sale would be costlier to the merchant than accepting debit and paying the high interchange fee.

At the same time, 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 and ability 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 short, Visa and MasterCard enjoy a virtuous circle initially set in motion by anticompetitive practice: with large numbers of their cards in consumers’ hands, they have the power to raise prices to merchants and use the funds, via interchange, to entice banks to issue yet more cards. This approach, which we refer to as the “extortive interchange” strategy defeats Discover which does not have the same interchange pricing power because, being less widely held by consumers, the Discover card can be refused by merchants without as significant a potential impact on sales as refusal to accept Visa or MasterCard.

The Early Impact of the Durbin Amendment

In October, 2011 the Federal Reserve Board (FRB) implemented the Durbin Amendment by capping debit interchange at 21 cents/transaction plus 0.05% of the transaction value plus a conditional 1 cent for fraud prevention. This ends the extortive interchange strategy for regulated issuers (those with $10 billion or more in assets) and to some extent shift the competitive focus to the features and pricing of the network as opposed to its ability to levy interchange.

Indeed, in January, Discover announced that it was re-entering the signature debit business and that Cadence Bank would be issuing signature-debit cards on the Discover network. Discover asserted the card offered a “competitive” interchange rate and that Cadence had been attracted by the advantages of the Discover network: lower transaction processing costs and fewer rules including, for example, no insistence that the network brand be on the front of the card competing with the issuer brand (see Exhibit 2).

Exhibit 2: The Discover-branded Cadence signature-debit card with Discover logo on Back of Card


The Challenge to Discover of Visa/MasterCard Subsidization of Regulated Markets

At first blush, the Discover-Cadence partnership is surprising because Cadence, with only $5 billion of assets, is not covered by the Durbin Amendment and so can benefit from the extortive interchange strategy of Visa and MasterCard. To be “competitive” with this, Discover must have set interchange on the Cadence card at higher levels than on most Discover cards. While this is feasible for a small portion of Discover cards, since it will not then meaningfully raise the average fees paid by merchants for accepting Discover cards, it is not scale-able: again, Discover does not have the market power with merchants to match the interchange charged by Visa and MasterCard.

This may explain why there do not appear to have been any follow-up deals to Cadence. But what of regulated issuers where Durbin ended the extortive interchange strategy of Visa and MasterCard in an effort to open the door for competing networks such as Discover? In practice, the door was not opened because Visa and MasterCard use the premium economics from unregulated segments to subsidize the economics in regulated segments.

To see how, it is important to remember that issuer economics depend on the net of interchange revenues paid via the payment network and network fees paid to the payment network. It follows that in unregulated segments (such as credit and small-issuer debit) extortive interchange allows Visa/MasterCard to set high network fees which can subsidize the lower network fees in segments where interchange is regulated (such as debit for large issuers). The lesson for regulators is the opportunity for subsidies means that carve-outs from regulation (such as small issuers for debit and credit generally) can defeat the regulatory objective.

Expect “New” Durbin to Impose Dual Routing for Debit

Ultimately, any regulatory solution must end extortive interchange by undermining the market power of Visa and MasterCard with merchants. This market power arises not only because, as Judge Leon points out, merchants cannot afford the risk of lost sales associated with refused a payment card but because, at least for signature-authenticated transactions, these cards do not offer the merchants a choice of network. If a consumer presents a Visa card, the transaction must be processed over the Visa network and if the consumer presents a MasterCard card, the transaction must be processed over the MasterCard network.

The intent of the Durbin Amendment was to intervene so as to provide merchants with a routing choice for debit transactions. Indeed, Senator Durbin was quite explicit that the objective was “to increase competition among debit networks by enabling 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[1]”.

In light of this stated intent, it is a testament to the lobbying power of Visa, MasterCard, and their client-banks that the Federal Reserve Board (FRB) chose to implement the Durbin Amendment by insisting that every debit card, rather than every debit transaction, be capable of routing over at least two unaffiliated networks: the two are quite different because a debit card carrying, for example, the MasterCard logo on the front for signature-debit transactions and the STAR network on the back for PIN-debit transactions complies with the FRRB’s implementation (since two unaffiliated debit networks are present on the card) but not with Congressional intent (since, for example, a signature debit transaction is enabled only for MasterCard).

As the District Court for the District of Columbia pointed out on July 31st, the FRB’s implementation of the Durbin Amendment “not only fails to carry out Congress’s intention; it effectively countermands it!” While the Fed is appealing the Court’s summary judgment against its interpretation of the Durbin Amendment, and the appeal process could take a year (although there is some chance the District Court may impose interim measures), we believe “dual routing” for signature debit will be the eventual outcome; dual routing is the requirement that every transaction be capable of routing over at least two unaffiliated networks. As discussed below, this creates an important opportunity for Discover in signature debit.

The Opportunity for Discover in Signature Debit

In a dual-routing environment, and absent side-deals, rational merchants will route over the network with the lowest all-in acceptance costs (i.e. including interchange as well as network fee). This is likely to put an end to the Visa/MasterCard extortive interchange strategy whether or not an issuer is covered by the Durbin interchange cap; again, extortive interchange is the strategy whereby Visa/MasterCard monetize market power with merchants through setting high interchange so as to win issuers business and lock out competing network services from the issuer distribution channel. It is threatened by dual routing since a merchant will tend to route to the lowest-cost network creating an incentive for networks to lower interchange to capture a greater share of a merchant’s routing.

As the extortive interchange strategy unravels for small debit issuers, Visa/MasterCard will lose the ability to subsidize the network fees of large issuers with the network fees of small issuers; this will create more of an opportunity for Discover to compete on the merits of its network rather than futilely trying to compete, via the interchange mechanism, on the basis of market power with merchants. Of course, dual routing in debit does not entirely level the playing field since no dual routing is contemplated for credit and since credit interchange remains unregulated. However, the credit card business is concentrated in the hands of the very largest issuers so that there are many debit issuers where credit network fees, if they exist at all, are not sizeable enough to generate a meaningful subsidy for debit.

  1. Statement of Senator Richard Durbin, July 15, 2010
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