The Shift from Signature Debit and Prospect for a Bank-Owned PIN Debit Network

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The debit business in the US is unsustainable. Durbin-regulated banks are losing money on signature debit as the swipe fee has fallen to 24 cents/transaction (from a pre-Durbin 59 cents) vs. Fed estimates for fraud and processing costs at 30 cents. While the swipe fee on PIN debit has fallen less (to 23 cents from 34 cents), it still does not offer much margin (5 cents/transaction vs 29 cents and 16 cents on pre-Durbin signature and PIN debit respectively) despite lower fraud and processing costs of 18 cents/transaction.

Beyond the immediate revenue impact of the Durbin interchange cap (which took effect in October 2011 and led to a 40% decline in debit to $12bn in 2012), banks face an enduring threat in their core checking account franchises as competitors take strategic advantage of unregulated interchange.

  • Credit card issuers are using the rewards funded by unregulated interchange to shift spending by creditworthy customers to credit cards from debit cards so that the spend velocity on credit cards (i.e. ratio of spending-to-loan balance) has increased to 3.3x from 2.3x in 2009; this hurts banks with sub-scale credit franchises (so all but BAC, JPM, C, and COF), and likely explains WFC’s decision last year to increase focus on credit cards as a payment vehicle.
  • Three-party networks, such as AXP and DFS, are not covered by Durbin and are using unregulated interchange to build prepaid card franchises with low-balance customers (under the Serve and Cashback Checking brands respectively) further eroding bank swipe revenue. While banks have attempted to respond, they either have to: (i) hobble prepaid cards (by limiting non-card access to funds including, in particular, online bill pay as in the case of Chase Liquid) to avoid the Durbin interchange cap; or (ii) offer a full-featured prepaid product, including online bill pay, and charge consumers to offset regulated interchange (as in the case of BAC’s SafeBalance product where consumers pay $5/month + ATM-usage fees vs. no charges for most customers of AXP’s Serve product).

Bank debit economics improve with a shift to PIN but this is happening slowly (except for some banks such as USB) in part because only one-third of merchants have PIN pads and in part because many consumers are habituated to signature-authentication. As merchants refresh POS hardware for EMV compliance (to avoid liability for fraud on EMV cards beginning October 2015), merchant penetration of PIN pads will increase and we expect the shift to PIN debit, now ~37% of debit volumes, to accelerate. The shift will increase pricing pressure on network fees, currently running at 5-7 cents/transaction for debit, by opening the network business to more competition:

  • First, there are the electronic funds transfer (EFT) networks – such as STAR owned by First Data, PULSE owned by DFS, NYCE owned by FIS, and JEANIE owned by VNTV – which compete with Visa and MasterCard in PIN, but not signature, debit.
  • Second, PIN debit reduces the value to banks of network-level fraud tools (because PIN debit has ~one-sixth the fraud content of signature) and so opens the possibility for direct routing between acquiring processors and issuing banks based on the bank identification number (BIN).

In the past, Visa has blocked direct BIN routing by insisting that transactions initiated on Visa-branded cards settle over the Visa processing infrastructure (including, in 2002, filing an ultimately successful legal complaint against First Data Net as it implemented the approach). However, the announcement in February 2013 of ChaseNet was a watershed event because Chase is not required to process all transactions initiated on Chase-Visa cards over the Visa network. Visa argues that ChaseNet-enabled cards will use the Chase acceptance brand, not the Visa brand, but the distinction is moot since all Chase-issued Visa cards carry both brands. Regardless, as acquiring processor for ChaseNet merchant clients, Chase will have the option to route transactions on cards carrying the Visa brand to the Visa infrastructure or to the ChaseNet infrastructure.

  • We refer to the ability of an acquiring processor to route a transaction initiated on a network-branded card to the network or to a proprietary infrastructure as mutability (as distinct from dual-routing where the routing choice is specified at point-of-sale not at the option of the acquiring processor). The economic significance is that mutability gives the acquiring processor a business-case for building out an infrastructure that can provide lower-cost settlement “rails” than the branded networks, and so will put downward pressure on network fees.

As the shift to PIN occurs, we expect other banks with acquirer processing businesses – such as BAC, USB, and WFC – to demand mutability from the networks and to build-out their own proprietary infrastructures. These fledgling networks will extend from initial ON-US settlement (where the issuing bank and acquirer processor are the same so that transactions are settled between the cardholder and merchant account entirely on internal systems) to: (i) direct BIN routing as the bank, in its issuer capacity, makes bilateral settlement arrangements with other acquiring processors; and (ii) ON-WE settlement as the bank, in its acquiring capacity, makes bilateral settlement arrangements with other issuers.

Over time, the resulting quilt of bilateral arrangements among banks (for ON-WE settlement) and between banks and acquiring processors (for direct BIN routing) will evolve into a bank-owned and switched PIN debit network. This precedent for this evolution is the EFTPOS system in Australia where a switch is being introduced (with the support of FIS) to facilitate the coordination of network upgrades such as EMV. Of course, as this occurs in the US, we will have come full circle: the now-independent ATM networks, which were the progenitors of today’s EFT networks, originally evolved as extensions of individual banks’ proprietary ATM infrastructures to allow interoperability of ATM cards issued by one bank at ATM terminals maintained by another.

Please see our published research for the full note and tables.

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