The Durbin-Related Threat of Direct-Routing to Visa and Opportunity for FIS, ACIW, VNTV

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July 21, 2014

The Durbin-Related Threat of DirectRouting to Visa and Opportunity for FIS, ACIW, VNTV

Rewards cards could crater tomorrow … and [the volumes] move over to the debit or charge card side”, Phil Heasley, Chairman of Visa 1996-2003 and current CEO ACIW, June 2014

  • In 2015, we expect large issuers (with the top-5 controlling near-50% of US debit volumes) to begin direct-routing debit transactions (so that they pass directly from retailers to issuers rather than routing through a network) so as to avoid network fees, minimize data leakage, and find relief from the Durbin cap on debit interchange (which applies only for network-processed transactions). This will create a meaningful headwind for Visa which generates 20% of global revenue (and 27% of global purchase volume – see Exhibit 1 below) from US debit, and will benefit issuer-processors such as FIS and ACIW able to provide retailers with alternative access to DDA-accounts.
  • Through its core processing business and ownership of the NYCE PIN-debit network, we believe FIS can directly access ~70% of US DDA-accounts (with this breadth being a key reason for their appointment as network partner to the merchant payments consortium, MCX). ACIW claims DDA-access to “virtually every” bank in the US.
  • Durbin gives retailers the ability to direct-route debit transactions by providing that issuers and networks may not directly or indirectly “inhibit the ability of any person who accepts debit cards for payments to direct the routing of electronic debit transactions for processing over any card payment network that may process such transactions”. While there is a technical argument that cardholders who signature-verify a transaction are indicating a preference for the Visa network (so that it is the cardholder, rather than an issuer or network, that is restricting retailer routing), it is likely to be moot as the industry shifts to chip-and-PIN and as retailers allow more transactions without any verification at all so as to reduce checkout times.
  • Large issuers face a strategic imperative to move to direct debit routing since: (i) the Durbin interchange cap means that 40% of checking accounts are now unprofitable (and there is an average 5 cents loss on each signature-debit transaction vs. a 30 cents gain pre-Durbin and current 5 cents gain on PIN-debit); and (ii) Durbin-exempt competitors are taking share of checking accounts by using unregulated interchange to fund more price-competitive products, such as Serve from AXP and cashback checking from DFS. An important consequence of the shift to direct routing is that it will remove the regulatory advantage of credit cards (which are not covered by the Durbin interchange cap) over debit cards as a payment vehicle, and reverse the shift of spending from debit to “rewards” credit cards which has occurred since 2009. This, in turn, means that Visa’s exposure to direct debit-routing higher (by at least 20% when we work through the numbers) than current debit revenues suggest since some credit revenues will convert to debit and be direct-routed.
  • Direct-routing is a more serious threat to Visa than dual-routing (which the company managed through PIN-enabling its core infrastructure to create PIN-Authenticated Visa Debit or PAVD). The new routing flexibility of retailers has led to investment in alternative debit processing infrastructures including by the PIN-debit networks, by JPM in ChaseNet, by MCX and its network partner FIS, and by ACIW which launched its new “UP Base24-eps” direct-routing software in March. The challenge for Visa is that these competitors can pick-off debit share while leaving the Visa brand as a backstop rather than price-leader. This undermines the network-effect advantage that Visa has historically leveraged with ACIW, for example, commenting that “direct routing can create efficiency [with issuers paying 0.005 cents/transaction vs. at least 5 cents charged by Visa], but we still have the backstop of the ubiquitous systems”.
  • Indeed, we believe the threat of entirely disintermediating Visa in debit allowed JPM to secure Visa’s agreement direct-routing over ChaseNet of credit transactions (which are not subject to Durbin routing options) as well as debit.
  • Beyond saved network fees and Durbin relief, direct-routing of debit reduces the risk of data leakage (because fewer intermediaries touch the transaction) and so will tend to encourage information-sharing between retailers (who have in-store SKU-level data) and issuers (who have out-of-store basket-level data). We expect this pooling of payments information to lead to rapid innovation and improvement in the design of rewards programs particularly when combined with the integration of rewards-redemption into the payments stream that is enabled by mobile payments. These dynamics will favor large issuers who have the information-scale to better leverage payments data in rewards-design and will create an opportunity for issuer-processors, such as VNTV, able to provide marketing services and offer-platforms to smaller issuers looking to remain competitive.
  • A risk to VNTV is that its acquiring business is disintermediated by direct-routing of debit. In practice, we think it more likely that VNTV will be called upon by large retailers to integrate the processing of directly-routed transactions into back-end and marketing systems (just as it does for network-processed transactions), and by smaller retailers to provide connectivity to issuers (as an alternative to each retailer building its own dedicated direct-routing “rails”).

Exhibit 1: Mix of 2013 Purchase Volume at V and MA

Issuers and Networks May Not Restrict Retailers from Direct Routing

US debit accounts for 27% of Visa’s global purchase volume of $4.3tn (see Exhibit 1 above) and, we estimate, ~20% of revenue. Durbin puts this at risk to direct routing (where a transaction is routed directly from a retailer or its acquiring-processor to an issuer or its issuer-processor without passing through the central “hub” of existing “switched” debit networks) because of language that prohibits issuers or networks from restricting retailer choice among available debit processing infrastructures. In fact, Visa’s exposure to this Durbin language (which is separate from the debit interchange cap and the dual-routing provision preventing a network from monopolizing a debit card) is larger than the current revenue-contribution of US debit because direct routing will likely reverse the Durbin-related and interchange-driven shift of purchase volume from debit to credit that has led sales velocity[1] on US credit cards to increase to 3.3x from 2.3x in 2009 (see Exhibit 2). Specifically, given loans on Visa credit cards in the US amount to ~$340bn, a reversal would increase debit exposure by 20% from current levels.

Exhibit 2: Spend Shift from Debit to Credit Cards Mitigates Durbin Interchange Cap (effective October 2011)

New Debit Routing Choices are Undermining Visa’s Network-Effect Advantage

The specific Durbin language which is the focus of the note and the catalyst for direct-routing is that issuers and networks may not directly or indirectly “inhibit the ability of any person who accepts debit cards for payments to direct the routing of electronic debit transactions for processing over any card payment network that may process such transactions”. As with the (separate) dual-routing provisions of Durbin, it is not certain how the “no-restriction” language will be interpreted and implemented.

There is agreement that if the cardholder does not verify a transaction (i.e. does not provide a signature or enter a PIN-number as permitted by many retailers to speed checkout times for small transactions), the retailer has free hand over debit routing. Indeed, VNTV CEO Charles Drucker noted in May that “the rules are changing around all of the debit networks that allow, if a Visa or MasterCard card is swiped and the PIN isn’t entered … [the transaction] can run across the PIN debit networks and … there are more transactions we can work with merchants to route to different networks”. Transactions which are routed over a PIN debit network in the absence of cardholder verification are referred to as “PINless PIN” transactions.

However where there is signature verification, Visa may argue, as the Fed successfully did in March at Appeals Court over the dual-routing provisions, that the cardholder (as opposed to issuer or network) is indicating a preference for Visa-processing and that retailer over-ride of this preference goes beyond the Congressional intent of the Durbin rule. If this argument holds up, it may slow, but not prevent, debit share-loss for two reasons. First, retailers will derive two benefits from not insisting on cardholder verification (faster checkout and lower-cost routing) and we would therefore expect the share of transactions for which this is permitted to increase.

Second, the migration to EMV (in front of the deadline for liability-shift to retailers in October 2015) will create a share-shift from signature-authenticated to PIN-authenticated transactions (particularly given the focus on chip-and-PIN rather than chip-and-signature in the wake of the Target breach last November), and retailers have the flexibility to directly-route PIN-authenticated transactions because the dominant card brand is the issuer brand rather than the PIN-debit network brand[2]. We note that issuer incentives now align around PIN debit since, as a result of the Durbin cap on debit interchange which went into effect in October 2011, regulated issuers (i.e. those with more than $10bn in assets) presently lose 5 cents/transaction on signature debit (vs. pre-Durbin gains of ~30 cents) and make 5 cents/transaction on PIN debit (vs. pre-Durbin gains of 15 cents)

The longer-term challenge for Visa is that the new routing flexibility of retailers has spurred investment in alternative debit routing infrastructures. For example, the PIN-debit network Shazam has invested in dual-message processing[3], JPM is building out its ChaseNet brand, NACHA renewed proposals in March for same-day ACH settlement, ACIW is rolling out software that supports direct routing, and the merchant payments consortium MCX is developing direct-routing rails in partnership with FIS. Some of these initiatives will die on the vine. For example, the NACHA proposal is similar to an April 2012 that was voted down by large banks despite support from a plurality of banks through ICBA. The commercial reality is that large banks are in a stronger position than smaller competitors to offer same-day settlement through “on-us” transactions (where the payer and payee share the same bank) and through “on-we” transactions (where the payer’s bank and payee’s bank participate in a proprietary exchange[4]), and do not have a compelling business case to level the playing field by upgrading ACH capabilities for same-day settlement[5].

However, others will emerge as viable competitors including, in our view, ChaseNet, MCX/FIS, and ACIW. In particular, we believe MCX is a strategic imperative for the CMOs of member retailers including WMT and TGT and will lead to meaningfully above-consensus revenue growth for FIS as network partner; the specifics are included in December 8th note titled “FIS: The MCX Opportunity for PayNet”. In the past, Visa has nipped such competition in the bud through legal action (as in its successful 2002 complaint against First Data Net) to preserve the network effects associated with its brand.

Now, however, Durbin allows alternative infrastructures to pick off share leaving the Visa brand as a backstop rather than price-leader. As Daniel Frate of ACIW comments “[direct routing] can create efficiency but we still have the backstop of the ubiquitous systems”. We see ChaseNet as particularly illustrative of Visa’s vulnerability to loss of network effects and, indeed, believe the threat of disintermediating Visa entirely in debit allowed JPM to obtain permission for direct routing over ChaseNet of credit (which is not covered by Durbin routing rules so that Visa permission is required for alternative routing). In return, Chase agreed to use the Visa infrastructure and preserve the notion that transactions acquired on the Visa-brand are processed over the Visa infrastructure.

However, we assume that to the extent there is any variable (i.e. per-transaction) component to the Visa revenue on ChaseNet it is substantially below the average even for large issuers and is probably below 1 cent (versus an average across all issuers of 6-7 cents for debit and double that for credit). Furthermore, JPM can now build out its ChaseNet infrastructure for both debit and credit by signing up large retailers while using the Visa-branded infrastructure as a backstop; in other words, Chase is building a network without having to resolve the chicken-and-egg problem (i.e. cardholders will not use a network that is not accepted by merchants, and vice-versa) that presents a difficult challenge for network competitors that must compete with, rather than leverage the Visa acceptance brand, such as Dwolla and PayPal. Payment consultant Tom Noyes makes the point on Visa’s loss of network-effect advantage when he comments[6] that “[Visa has allowed] switching off of a core [infrastructure], and enabled cards to operate as Visa and non-Visa at the control of the acquirer.”

Direct Routing is a Greater Threat to Visa than Dual Routing

The initial impact of the Durbin dual-routing provisions, which went into effect in April 2012, was that Visa lost debit share as many issuers complied by dropping the Visa-owned Interlink PIN-debit network from Visa-branded cards. Visa responded by PIN-enabling the core infrastructure (previously used only for signature-authenticated debit) so that it was able to capture PIN-debit transactions (through so-called PIN-Authenticated Visa Debit or PAVD) on Visa-branded cards whether or not Interlink was represented. The result was that Visa stabilized its debit business after steep volume-declines in 2012 and is now maintaining share (see Exhibit 3).

Exhibit 3: Year-on-Year Change in Visa’s Debit Purchase Volume in the US

Direct routing, however, poses more of a threat since it allows issuers to avoid both network fees and reduce the risk of data leakage. Furthermore, directly-routed transactions will not be subject to the Durbin cap on debit interchange since the rule (and, indeed, the very definition of interchange) applies only to network-processed transactions. Direct-routing is therefore a strategic imperative for US banks since the debit interchange cap has rendered ~40% of US DDA-accounts unprofitable and given regulatory advantage to direct-routing competitors, such as AXP and DFS, who are gaining share of the debit/prepaid market through products – such as Serve/Bluebird from AXP and cashback checking from DFS – which take advantage of unregulated interchange to offer consumers better economics than Durbin-regulated banks can afford.

More specifically, we expect the large issuers (with the top-5 controlling near-50% of US debit and prepaid volumes – see Exhibit 4) to implement direct routing in 2015 at least for PIN-debit transactions (including PINless PIN where a cardholder provides no verification) and, like Chase, may negotiate with Visa for direct-routing of signature-authenticated debit as well. This will increase competitive pressure on smaller (but, to Visa, more profitable) issuers to follow suit particularly given that the shift to PIN reduces the fraud content of transactions (from an average of 5 cents to less than 1 cent) and hence reliance by smaller issuers on network-level fraud risk management provided by the Visa Debit Processing System or DPS; larger issuers are less reliant on DPS because they leverage the issuer-level fraud risk management in place for signature-authenticated credit card transactions.

Exhibit 4: Top-5 Debit Issuers Have Near-50% Share of US market for Debit/Prepaid Purchase Volume

Direct Routing will Create Structural Change in US Payments Favoring Issuer-Processors

Direct routing will catalyze bilateral (rather than network-intermediated and Durbin-regulated) negotiations between large issuers and retailers with transformational results. First, direct-routing arrangement are not subject to the Durbin cap on debit interchange and hence will remove the regulatory advantage of credit cards over debit cards as payments vehicles; this means issuers will no longer look to shift payments to credit cards (thereby incurring the risk and capital costs of large open-to-buys) but rather will encourage consumers to use debit cards when there are funds available in a DDA account with credit cards reserved for purchased dependent on a pre-approved credit line at point-of-sale. This dynamic is what lies behind the June comment[7] from ACIW CEO Phil Heasley that “rewards cards could crater tomorrow … and [the volumes] move over to debit or charge card side”.

Second, direct-routing reduces the risk of data leakage (because fewer intermediaries touch the transaction) and so will tend to encourage information-sharing between retailers (who have SKU-level data) and issuers (who have away-purchase data). We expect this pooling of payments information to lead to rapid innovation and improvement in the design of rewards programs particularly when combined with the seamless integration of rewards-redemption into the payments stream that is enabled by mobile payments. JPM CEO Jamie Dimon commented on the prospect of more constructive merchant relationships when ChaseNet was announced in February 2013: “It allows us to go to merchants and strike our own [deals]… If you go to merchants, what they always complained about was Visa’s got all these operating rules. Why can’t we just deal with you, and now we can”.

Winners in the structural shift in US payments towards direct-routing will be issuer-processors that can provide access to DDA-accounts without retailers needing to establish dedicated infrastructure for each and every issuer. FIS and ACIW are two of our favorite names. Through its core processing business and ownership of the NYCE PIN-debit network, we believe FIS can access 70% of the DDA-accounts in the US (with this breadth being a key reason for their appointment as network partner to the merchant payments consortium, MCX). ACIW claims DDA-access to “virtually every” bank in the US and that its “UP Base24-eps” software, launched in March, provides the technological capability for direct-routing[8] between client-banks and retailers regardless of how the funding account is tokenized – e.g. whether by a Visa PAN (as with a branded card transaction), check routing-number (as with a Target RED, and likely MCX, debit card transactions), or e-mail/mobile ‘phone number (as with a P2P transaction).

  • We acknowledge ACIW is the more speculative play as the new, token-neutral technology is in proof-of-concept and needs to be adopted by retailers. However, potential savings from earlier versions are substantial with CEO Phil Heasley commenting[9]: “For my largest customer, I charge 0.005 cents/transaction and do 1-2 billion transactions/month; that customer pays an average of 5 cents to Visa …. Every direct connection I make I can give that customer back 4.995 cents”. We also note that a contract-mix from licensed software (where revenue is recognized on go-live) to hosted SaaS (where revenue is recognized over contract-life, typically 5 years) will hold revenue growth over the next year or so to the low-end of ACIW’s guidance range of mid-to-high single digits.

The third of our favorite names is VNTV which has the potential for direct-routing because of its vertically-integrated business model across the acquirer- and issuer-processing businesses and because of the DDA-access provided by ownership of the Jeanie PIN-debit network. Firm-wide revenue (of $1.2bn in 2013) is presently split 70:30 between the merchant and acquiring businesses but we agree with CEO Charles Drucker that VNTV is a “likely [partner] choice for issuers that don’t own an acquirer”. A risk is that VNTV’s acquiring business is disintermediated by direct routing as highlighted by ACIW CEO Phil Heasley[10]: “There is no reason for a merchant acquirer to sit between a single-message [i.e. PIN debit] transaction; it can settle directly right back to the bank whereas in a credit card [transaction], by regulation[11], it has to be purchased by a merchant acquirer and then settled with the bank.” In practice, however, we view direct routing as an opportunity rather than threat for VNTV for both large and smaller retailers.

VNTV supports large retailers by integrating payments information into back-end systems (such as the General Ledger) and into marketing and rewards programs. These services are as relevant to directly-routed transactions as network-processed transactions and, indeed, would be undermined if they did not including the former. As a result, we expect VNTV to play a role in directly-routed transactions, as it does for network-processed transactions, even if it is not providing the “rails” to the issuer. A test case will be how VNTV interfaces with FIS with the implementation of MCX payments at WMT; in practice, we expect WMT to be more focused on saving network fees and entering into bilateral arrangements with issuers around marketing and rewards programs than complicating its back-end processes (by handling directly-routed transactions differently from network-switched transactions) for the sake of saving the 1/3 cent-per-transaction we believe it pays to VNTV for acquiring.

While large retailer may choose to build dedicated connections to large issuers (to reduce intermediary fees and the risk of data leakage), smaller retailers are more likely to rely on bilateral connections between their acquiring processor and issuers or their processors; this can be a more efficient approach because the top-4 acquirers have a near-60% market share (see Exhibit 5). VNTV’s has specialized knowledge of both sides of the market and the ability for on-us settlement across issuer and retailer clients.

Exhibit 5: Purchase Volume Share of Acquiring on US General-Purpose Card in 2013

  1. Sales velocity is the ratio of annual purchase volume on credit cards to outstanding loan balances and is a measure of the extent to which credit cards are being used as payment, rather than strictly borrowing, vehicles.
  2. No-one is arguing that cardholders are designating a network when they PIN-authenticate a transaction. Indeed, on Visa-branded debit cards, retailers are already choosing whether these transactions are routed over a PIN-debit network or over the core Visa infrastructure (which, as of April 2012, can process PIN-authenticated debit in a so-called PIN-Authenticated Visa Debit or PAVD transaction as well as signature-authenticated debit).
  3. In a dual-message system (DMS), instructions for authorization and clearance are carried in two separate messages while in a single-message system (SMS) they are carried in the same message. PIN-debit networks evolved with a SMS architecture but adding DMS capability may make it easier for retailers to transition from signature-authentication which evolved with a DMS architecture.
  4. Such as the clearXchange network, currently dedicated to P2P payments, owned by BAC, JPM, WFC, and COF
  5. While regulatory pressure may force the hand of the large banks, the Fed is taking a “collaborative” approach as opposed to, say, the UK where regulators have actively supported, and in some cases (e.g. standing orders) mandated, use of the same-day “faster payments system” or FPS over the three-day Bankers Automated Clearing Service or BACS.
  7. Minute 36-to-end for webcast at
  8. ACIW also claims the software provides real-time payments but we believe this is true only for the messaging not for settlement which would follow standard overnight practices for banks (although banks could choose to make cleared funds available to payees ahead of settlement with the payer bank); the only real-time, interbank settlement system is Fedwire.
  9. Minute 36 of webcast at
  10. Minute 48 on webcast at
  11. Visa insists that credit transactions are purchased by acquirers who underwrite their merchant-clients and, in particular, fund chargebacks (i.e. transactions that issuers seek to reverse because of fraud or faulty goods and services) to improve customer satisfaction and comply with Federal Reserve Regulation Z.
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