Visa/MasterCard: Expect Bank Disintermediation of Networks for US Debit
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
October 27, 2013
Visa/MasterCard: Expect Bank Disintermediation of Networks for US Debit
- With Durbin equalization of interchange, there is no business case for signature debit which we believe accounts for ~80% of Visa’s US debit volume; it has nearly 5x the fraud cost of PIN debit and no longer offers premium interchange to issuers. (In 2010, premium interchange of $12bn on signature debit comfortably exceeded fraud costs of $5bn across all US credit/debit products and split 2:1 between issuers and merchants/acquirers).
- With issuer and merchant preferences aligned around PIN debit, we expect signature debit to lose share over the next 5 years and not contribute meaningfully to payment volumes by 2019. The authentication shift will end duopoly debit dominance by Visa/MasterCard and reduce their annual volume growth in US debit (representing 53% and 46% US purchase volumes respectively) to 6-8%.
- While the networks have enabled their core processing infrastructures and acceptance brands for PIN debit, this growth estimate is subject to downward revision given the competitive threat from:
- Direct BIN routing from acquiring processor to issuing bank based on Bank Identification Numbers and using private bank infrastructures to by-pass the networks (since, in a PIN-authenticated environment, network-level fraud management is less necessary);
- Unaffiliated EFT networks such as PULSE, STAR, NYCE, and Jeanie owned by DFS, First Data, FIS, and VNTV respectively (whose share of the debit market increased to 21% in 2012 from 16% in 2010);
- ACH-enabled debit sponsored by online firms such as PayPal extending their brand to point-of-sale and merchants such as Target and the MCX consortium looking to protect and control transaction data and its use for promotional activity such as e-couponing.
- We see the February announcement of private processing by Chase as a first step towards direct BIN routing, and expect the bank to extend its reach beyond ON-US (i.e. CMS-acquired) transactions by establishing point-to-point connections with the three leading non-bank acquiring processors: First Data, Vantiv, and Elavon. These issuer/processor connections, combined with clearXchange (which links banks including Chase, BAC, and WFC for P2P payments), will allow clearXchange members to by-pass Visa/MasterCard for approximately 80% of debit volumes – see Exhibit.
With the Durbin equalization in October 2011 of debit interchange across signature and PIN authentication methods, there is no business case for signature debit. This is because signature authorization carries meaningfully higher fraud losses than PIN authorization (6.1 cents per $100 in total volume globally versus 1.1 cents) since it is easier to use a lost or stolen card when there is no PIN requirement.
Card fraud is a particular concern in the US which accounts for 47% of global fraud losses of over $11 billion on just 24% of total volume. A key reason for this skew is the use of signature-authentication in the US whereas overseas markets which are largely chip-and-PIN; relatively lower cash volumes (which are PIN protected); and higher online sales (which carry higher fraud risk because a card is not present) are other reasons.
Issuers bear approximately two-thirds of US fraud losses of $5.3 billion since, through the Visa/MasterCard charge-back rules, merchants and acquirers are responsible only for fraud losses on card-not-present (CNP) transactions. These fraud losses were tolerable to issuers when signature debit commanded premium interchange over PIN debit so that all-in fees were 1.6% of purchase volume for signature versus 0.7% for PIN and generated excess interchange of ~$12 billion on $1.5 trillion of debit volume. However, Durbin has now regulated this premium away (see Exhibit 1).
Exhibit 1: Equalization in US of Fee Rates on Signature and PIN Debit
Source: Nilson. Fees include acquiring fees, network fees, and interchange. V/MA debit includes prepaid along with PIN-debit on the affiliated EFT networks branded Interlink/Maestro respectively
The consequence is that issuer and merchant preferences are now aligned around PIN debit over signature debit, and we expect a debit share shift from signature to PIN authentication over the next 5 years so that by 2019 signature debit does not contribute meaningfully to aggregate purchase volumes. This shift, combined with likely growth in EMV-compliant payments (both contact chip-card payments and contactless phone-based “mobile” payment) will structurally change the competitive dynamics in the debit market and bring to an end the duopoly environment Visa and MasterCard have enjoyed for the signature product. These new competitive dynamics, which are discussed in the Appendix, include likely share gains by:
- Direct BIN routing from acquiring to issuing banks based on Bank Identification Numbers and using private bank infrastructures including those, such as clearXchange, developed to accommodate the interbank settlement of P2P transactions to by-pass Visa/MasterCard. The shift of PIN authentication facilitates BIN routing because there is less need for network-level fraud management services; the private processing arrangement announced by Chase this February was a first step.
- ACH-enabled debit sponsored by online payments companies such as PayPal and merchants such as Target and the MCX consortium. PIN debit is a natural choice for MCX, and given real-time authorization does not involve the settlement risk of ACH-enabled debit, but we understand that it will not be part of the initial roll-out.
Visa/MasterCard Debit Strategies
We view the promotion of Visa-branded and MasterCard-branded PIN debit as tacit acknowledgement by the networks of the threat to signature debit. Until the Durbin network routing rules went into effect, Visa reserved its Visa brand for signature-authenticated transactions (aside from cash advances on a credit card) so that PIN-authenticated transactions were routed by Visa through its Interlink-branded electronic funds transfer (EFT) network. Interlink competed in the PIN debit market with other EFT networks including Pulse (now owned by Discover), Star (now owned by First Data), NYCE (now owned by Fidelity National Information Services), Jeanie (now owned by Vantiv) and Maestro (owned by MasterCard).
Indeed, prior to Durbin, Interlink purchases were ~$100 billion representing one-third of Visa’s US debit volume, and many banks issued debit cards that were Visa-exclusive in the sense of being enabled only for Visa-branded signature debit and Interlink-branded PIN debit. The Durbin network routing rules prohibited this network exclusivity by requiring (at least as originally implemented by the Federal Reserve) that debit cards be enabled for at least two unaffiliated networks. In practice, this meant that Visa/Interlink only cards had to be re-issued to carry an unaffiliated EFT network; merchants then availed themselves of the routing choice by routing away from Interlink so that Visa lost share of debit to unaffiliated EFT networks. Specifically, Visa lost approximately half of Interlink volumes in the June quarter after the Durbin network rules went into effect on April 1st, 2012 and unaffiliated EFT networks saw their debit share increase to 21% in 2012 from 16% in 2010 (see Exhibit 2).
Exhibit 2: Share Shifts in Debit
After the Durbin routing rules went into effect, Visa introduced Visa-branded PIN debit which runs over the core VisaNet infrastructure rather than over Interlink and is sometimes referred to as PIN-authenticated Visa debit (PAVD). This product means that Visa can capture PIN debit volumes even if its Interlink EFT network is not represented on a debit card, and 12% growth in the June quarter for Visa’s US debit volumes suggest PAVD is recapturing some of the PIN debit volume lost by Interlink. MasterCard also has MasterCard-branded PIN debit running over its core processing infrastructure rather than Maestro, but this has been an on-going initiative of several years rather than solely a response to Durbin.
Debit Share Trends
Debit share trends in 2012 were profoundly affected by the Durbin Amendment first by the interchange cap which went into effect on October 1st, 2011 and second by dual-network routing rules which went into effect on April 1st, 2012. Visa’s debit growth declined from mid-teens to high single-digits after the debit interchange cap went into effect and then, because of loss of Interlink payments to unaffiliated EFT networks, went negative after the network routing rules took effect (see Exhibit 3).
Exhibit 3: Purchase Volume at Visa
Source: Company Reports
Having lapped the first quarter when Durbin’s network routing rules went into effect, Visa’s debit growth has recovered to mid-teens but we consider this unsustainable. Indeed, we believe that:
- Signature-authenticated debit, accounting for ~80% of Visa’s debit franchise in the US, will not attract meaningful volumes by 2019 because issuer and merchant preferences are now aligned around the lower fraud costs of PIN debit.
- Visa’s PAVD and its MasterCard equivalent will face a more challenging trade-off between volume and price than existed in the duopoly market environment of signature debit.
More specifically, we believe the 6-8% growth in Visa debit delivered after the interchange cap went into effect in October 2011 (but before implementation of the network routing rules in April 2012) is a more reasonable benchmark than last quarter’s growth of 12%, and this range is subject to downward revision as the competitive threat from ACH-enabled debit (sponsored by online players such as PayPal and merchants such as Target and MCX) and direct BIN routing by banks (which, in a PIN-authenticated environment, have less need for network-level fraud management services) becomes clearer. The change in competitive dynamics in the debit market as authentication shifts from signature to PIN is discussed in the Appendix below.
The Changing Competitive Dynamics in Debit as Authentication Shifts from Signature to PIN
The challenge to Visa/MasterCard in this debit shift (and particularly to Visa where debit accounts for 53% of purchase volume versus 46% at MasterCard – see Exhibit 3) is that they will no longer have the same ability to bundle-price network-level fraud management services (since PIN has lower fraud risk) and sustain duopoly pricing on network fees. Below, we summarize the competitive threats in debit:
Exhibit 3: V/MA 2012 Purchase Volumes
EFT networks: Visa and MasterCard have their own PIN debit networks branded as Interlink and Maestro respectively; in addition, both networks have enabled their core credit/signature-debit processing infrastructure for PIN-authenticated debit. In Visa’s case, this was a response to Durbin which led several issuers to disable Interlink on Visa-branded cards with the result that Visa could capture PIN-authenticated transactions on these cards only over its core infrastructure and not, as previously, over the Interlink network.
However, unlike in signature debit duopoly, PIN-authenticated Visa Debit (PAVD) and the MasterCard equivalent compete with EFT networks including Pulse owned by Discover, STAR owned by First Data, and NYCE owned by FIS. Furthermore, Durbin effectively insists that Visa- and MasterCard-branded debit cards be enabled for at least one of these EFT networks so that merchants have a debit routing choice across two unaffiliated networks. Without the incentive of signature-debit rewards, cardholders have been more receptive to merchant-steering towards PIN-debit and PIN-debit share rose meaningfully in 2012.
We expect share gains of PIN-debit share gains will accelerate as merchants gain more control over routing (by leveraging their ownership of in-store transaction data, for example) including, in particular, with the adoption of EMV technology. Specifically, Discover’s D-PAS application has been selected as a standard “gateway” (formally application identifier or AID) by the Secure Remote Payment Council (SPRc), which includes PULSE, STAR, and NYCE, and will give merchants the Durbin-compliant option to route debit transactions to these and other PIN-based networks. (For magnetic stripe cards, the network protocols, including rules for transaction routing and hence Durbin compliance, are held by the acquiring processor; in an EMV environment these protocols are embedded in the on-chip card applications).
ACH-enabled debit cards: Unlike a bank-issued product, an ACH-enabled debit card is “decoupled” from any particular bank in that the consumer can change the payment account by providing new bank checking information; access to the checking account is via the ACH network. The Target RED debit card is the best-known example of a decoupled debit card and now accounts for 6% of Target sales in the US versus 2% two years ago; PayPal transactions, to the extend funded by ACH rather than Visa/MasterCard products, provide a second example. More generally, merchant-sponsored ACH-enabled cards at physical point-of-sale accounted for $6.2 billion of volume in 2012, which is not meaningful in terms of total ACH volumes of $12.4 trillion and even total debit volumes of $2 trillion, but will likely grow rapidly once adopted by the MCX merchant consortium accounting for $1 trillion of total consumer spending and as PayPal gains adoption at physical point-of-sale through its joint-venture with Discover.
Proprietary Bank Solutions: PIN authentication increases the possibility of direct-routing of transactions from acquirer to issuer bank based on bank identification number (BIN). This BIN routing is more feasible for PIN transactions because of the lower fraud risk and hence lesser need to rely on Visa/MasterCard fraud detection algorithms before providing an authorization; this is true more for smaller issuers than larger issuers whose fraud algorithms are at least as sophisticated as those of Visa/MasterCard and, indeed, a source of competitive advantage. It is likely BIN routing will initially focus around ON-US transactions (such as those on Chase’s private processing platform) but this limits volumes: for example, if we assume Chase Merchant Services acquires the same share of debit volumes as it does of general-purpose card volumes excluding Amex and if we ignore the impact of regional concentration, ON-US transactions represent only 14% of its volumes (see Exhibit 3) and hence, given its 9% share of debit volumes, 1.4% of total debit volumes.
The equivalent ON-US share of total debit volumes for the other banks with large issuing and acquiring businesses are 2.4% for BAC and 0.6% for WFC; this means that total ON-US volumes for BAC, JPM, and WFC combined are less than 5% of the market. However, the acquiring business is relatively concentrated so that issuer could by-pass Visa/MasterCard for ~80% of its debit volumes by private routing with just the top 6 acquirers (see Exhibit 4). Since three of these (BAC, WFC, and JPM) participate in the clearXchange network for P2P payments no additional infrastructure is required and, indeed, all that is actually needed is for this network to be connected via one of its members to the three largest non-bank acquirers: FDC, VNTV, and Elavon. We believe Chase, at least, is exploring this option.
Exhibit 4: 2012 Volumes for Top Debit Issuers and Acquirers