Quick Thoughts: Benign Impact of Appeals Court Ruling on Visa/MasterCard
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July 1, 2016
Quick Thoughts: Benign Impact of Appeals Court Ruling on Visa/MasterCard
- Vacation by a federal appeals court of the November 2012 settlement between merchants and Visa/MasterCard will make no difference to card industry structure, and we see the price-break in the stocks of Visa and MasterCard (of ~3.5% and 4.5% respectively) as an over-reaction. That said, as described below, we remain concerned that industry structure is moving in a direction that will, over time, erode the pricing power of the networks particularly in debit.
- The appeals court had no objection to the monetary relief (of up to $7.25bn for merchants accepting Visa and MasterCard cards from Jan 2004 through Nov 2012) but took issue with the representation of a second class of merchants, those accepting network-branded cards after Nov 2012, awarded injunctive relief in the form of being allowed to impose surcharges on Visa and MasterCard cards. In practice, this relief has not been widely acted upon partly because many states, including New York, California, and Texas, prohibit surcharging as a matter of state law.
- The other reason the injunctive relief has had limited impact is because it provides that merchants can surcharge Visa only if they are surcharging other card brands such as American Express, and AXP independently imposes its own no-surcharge rules. Given most large retailers accept Amex cards, the more important legal case for industry structure is therefore the appeal of a District Court finding that AXP’s no-surcharge rules are unlawful; these rules remain in force pending the appeal which we expect to conclude later this year.
- Our benign view of Thursday’s appeal court ruling rests on the no-surcharge aspect of the settlement. If a retrial results in removal of default interchange or the honor-all-cards rules it would undermine Visa’s pricing power, but this is unlikely. The merchant case that default interchange represents horizontal price-fixing between issuing banks has been weakened by the IPOs of Visa and MasterCard (which were subsequent to the 2002 filing of the merchants’ original complaint) while the honor-all-cards rules, as currently implemented, are likely to withstand a rule-of-reason analysis (that their pro-competitive benefit outweighs possible anti-competitive impact) because of the potential consumer confusion arising from a merchant ability to accept Visa-branded cards issued by some banks but reject those issued by others.
- While we believe the market is over-discounting the adverse impact on Visa and MasterCard from the appeals court ruling on Thursday, we continue to be concerned about the ability of the networks to sustain long-run pricing power given the likelihood of merchant steering both in debit because of the routing flexibility granted to merchants by the Durbin Amendment (which is more potent in practice for PIN- than signature-authenticated transactions hence WMT’s complaint filed on May 10th in New York Supreme Court challenging Visa’s insistence that consumers be allowed to choose signature-authentication); and also in credit assuming the Amex ruling is upheld on appeal.
Visa and MasterCard sold off on Thursday (~3.5% and 4.5% respectively) as a federal appeals court vacated a 2012 settlement in a class action by merchants against the network alleging anti-competitive behavior around network default interchange rates, honor-all-cards rules, and surcharging restrictions.
The reasoning was that two sub-classes in the settlement were represented by the same counsel and that counsel had financial incentives (in the form of $545mm of legal fees) linked to the monetary relief provided to the first “Rule 23(b)(3)” class (those merchants accepting Visa or MasterCard cards from January 2004 through November 2012 who were awarded up to $7.25bn) provided they were also able to resolve the claims of the second “Rule 23(b)(2)” class (those merchants accepting Visa or MasterCard cards after November 2012 who were awarded injunctive relief in the form of being permitted to impose surcharges on these cards). Given legal fees were conditional merely on resolving the claims of the second class, and not on the form of relief provided, the federal court determined it could not assume the second class had been adequately represented. The case will now return to a lower Court albeit not under Judge John Gleeson, who approved the original settlement in December 2013 but has since stepped down from the bench; US District Judge Margo Brodie has scheduled a status conference for August 11th and may attempt to save the settlement or move for retrial. Either way, it is likely years before we have clarity.
The core conflict remains over the way in which the Visa rule-set supports what merchants allege is supra-competitive interchange representing the payment made on any network-branded transaction from the acquiring bank representing the card-accepting merchant to the card-issuing bank representing consumer. Acquiring banks typically recover interchange from merchants so that card-acceptance costs represent an important expense for many of them (more than Alaska Airlines spends on food and beverages, for example). The rule-set comprises three elements which are described below for Visa but operate identically for MasterCard:
- Default Interchange: An acquiring bank can bilaterally negotiate interchange with an issuing bank, either for all Visa cards or for certain classes of Visa card product, but Visa provides default interchange rates for transactions where no such bilateral arrangement exists (which, in practice, is the vast majority).
- Honor-all-Cards: Having made a decision to accept Visa-branded credit cards, a retailer cannot cherry-pick by, for example, accepting cards issued by Chase and refusing to accept similar cards issued by Bank of America; it is an all-or-nothing choice (although, subject to not discriminating between issuing banks, a retailer can elect to accept Visa debit cards independently of Visa credit cards and vice-versa).
- No-Surcharge Rules: Until November 2012, retailers were not permitted to impose surcharges on Visa cards.
Visa argues that these rules are pro-competitive because they create clarity for consumers and merchants alike: consumers presenting a Visa-branded card to a Visa-accepting merchant know that it will be valid for payment regardless of the issuer as does the merchant. Visa adds that default interchange is necessary to avoid a complex patchwork of bilateral arrangements that would require each Visa-accepting merchant to strike deals with every Visa-issuing bank, and vice-versa; and that the no-surcharge rules ensure Visa creates an even playing field versus other tenders and across issuers.
Merchants, on the other hand, argue that default interchange along with the honor-all-cards rules represents a form of horizontal price-fixing that supports supra-competitive fees, and that the no-surcharge rules prevent them from influencing consumer payments decisions and shifting spending to less expensive tender forms. The injunctive relief provided in the settlement to the b(2) class permitted surcharging but has been limited in effect because many states, including New York, California, and Texas, prohibit surcharging as a matter of state law and the settlement does not allow merchants to surcharge Visa cards if they do not also surcharge American Express cards and AXP, which was not a defendant, imposes its own no-surcharge rules (themselves found unlawful in a District Court decision of Feb 2015 that is now under appeal).
PINless PIN Debit and Threats to Visa Routing
A shorter-run threat to Visa than the appeals court vacation of the 2012 settlement is the attempt by large merchants, particularly WMT, to shift debit volumes to PIN- from signature-authentication. WMT has framed the issues around security arguing that PIN-authentication is more secure than signature-authentication and, indeed, it does reduce the risk of fraud on lost-and-stolen cards; however, this accounts for only ~10% of total fraud losses which are more driven by card counterfeiting (where a criminal obtains fraudulently obtains the information stored on a card and uses it to clone the card) which, in turn, is being addressed at the network level through EMV and tokenization.
However, the conflict is also a commercial dispute over the flexibility merchants have to route debit transactions for processing to alternative networks. Durbin allows merchants to route debit (but not credit) transactions over any available infrastructure and provides that debit cards must be enabled for routing over at least two unaffiliated networks. Banks have met this requirement by issuing cards that are enabled for a network handling signature-authenticated transactions (such as Visa) and an electronic funds transfer or “EFT” network handling PIN-authenticated transactions (such as STAR owned by DFS or NYCE owned by FIS). While the routing does not make a larger difference for bank issuers subject to the Durbin cap on debit interchange (of 5c/transaction plus 0.22% of volume), it does for exempt issuers (i.e. those with less than $10bn of assets) where the interchange on PIN-authenticated transactions can be half that on signature-authenticated transactions.
In theory, consumers have some input into how their transactions are routed when they select a card verification method (“CVM”) in response to a prompt from a POS terminal or cashier around whether the transaction is “debit or credit”. Of course, this query is oxymoronic since the transaction is unequivocally debit, but it is universally interpreted as asking whether a consumer wishes to provide a signature authentication (as in a credit transaction) or a PIN authentication (as in an ATM transaction). If the consumer opts for the former, then the transaction will route over the Visa network (on a Visa-branded card) since that it the only network represented on the card capable of handling signature-authenticated transactions; if the consumer opts for PIN authentication, the transaction can route over the Visa network (because of PIN-authenticated Visa debit or PAVD) or over the EFT network that Durbin, in effect, required to be represented on the card. Because the PAVD and EFT processing solutions are competing on the card-face, PIN-authenticated transactions have meaningfully lower acceptance costs to the merchant than signature-authenticated transactions where Visa has an effective monopoly on the card face.
Unsurprisingly, large merchants prefer that debit customers use PIN-authentication and are attempting to steer consumers in this direction through, for example, setting up POS terminals to make it the default choice. They are also introducing PINless PIN debit for small transaction (e.g. under $50) where no authentication at all is required from customers and, relieved of the need to ask for a PIN or signature verification from the consumer, merchants simply route the transaction over an EFT network. WMT is attempting to go further by refusing to accept signature-authentication from its debit customers, and it is this behavior – which Visa identified through noticing a drop-off in debit volumes from certain stores – that has led to additional conflict between WMT and V and ultimately the filing of a legal complaint by WMT on May 10th in New York Supreme Court.
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