Quick Thoughts – V/MA: It’s the Routing Rules that Matter

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On Friday, Visa rallied near 5% on oral arguments in front of an appeals court where judges appeared to support the Fed’s debit interchange cap of 21-24 cents/transaction in possible conflict with a district court ruling of end-July that the cap was too high and should be reset down to 12 cents/transaction or lower; MasterCard was flat. The Visa move on this news is surprising since a higher interchange cap does not advantage Visa over MasterCard in debit, does not directly improve Visa’s economics (since debit interchange is paid to bank issuers), and does not improve industry structure for the networks (and, in fact, increases the incentive for merchants to join the MCX consortium in promoting a lower-cost debit alternative to Visa and MasterCard).

The higher interchange may reduce the need for Visa to make incentive payments to large banks for issuing cards carrying its brand but the far more important matter for the relationship between networks and issuers is a second aspect of the district court ruling, on which the appeals court judges did not tip their hand, giving merchants greater choice as to how to settle or “route” debit transactions. Regardless, an appeals court decision is not expected until the Spring and, in any event, the case will likely be referred to the Supreme Court.

More broadly, there are structural risks in the US debit business which are more important to the Visa and MasterCard networks than the level of the interchange cap. These are around network routing rules (and in particular whether the appeals court upholds a district court ruling in favor of dual routing of signature debit) and merchant license fees (and in particular whether the Department of Justice allows the networks to tie debit to credit through these fees). The various scenarios are summarized in the table below and discussed in the attached note.

Our view is that the outperformance of MA over V since the district court ruling is unwarranted since there is no scenario in which MasterCard sustains debit share gains immediately following the district court ruling, and there is an important risk that US debit (accounting for 25% of global transactions at V and 16% at MA) becomes meaningfully less attractive to the networks if merchants are able to move towards least-cost routing by: (i) being offered dual routing on both signature and PIN debit transactions; and (ii) being able to make routing decisions on the basis of per-transaction fees rather than merchant licensing fees, and associated rebates, that tie debit and credit.

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