The Federal Reserve Board faces a variety of issues should Congress approve the financial-reform bill and give the agency the task of setting debit card interchange rates. Among those is an apparent conflict of interest that might force the Fed to give up its role as one of the nation’s two automated clearinghouse operators, according to Stuart E. Weiner, former director of payments at the Kansas City Fed.
Many ACH-based payment offerings, including online bill payment and decoupled debit, compete with the traditional debit card networks and issuers, notes Weiner, who now works as an independent consultant and is a faculty member in Kansas State University’s finance department.
“The Fed will be setting prices for a competing industry,” he says. “It’s difficult to believe the Fed will remain an ACH operator once it begins setting debit card interchange rates. … That’s a byproduct that really hasn’t been thought through.”
Besides the Fed, ACH transactions also pass though the Electronic Payments Network, which also is an ACH operator. Officials at the Fed declined to comment on the legislation and how it might affect their activities.
Under the financial-reform bill, the Fed would be responsible for establishing “reasonable and proportional” debit card interchange rates, and that will be a “very difficult” task, Weiner says. The language is open-ended, so the Fed likely will not make major changes to the existing rate structures but instead will make incremental moves, he says.
“But the open-endedness will force the Fed to confront some very difficult issues and will force it to take a position on what costs should be considered,” Weiner says.
As the Fed weighs the costs issuers incur in the debit card programs as it determines debit card rates, fraud will be one of the factors. But fraud statistics are “severely lacking” in the U.S., and there is no independent source on fraud costs for the payments industry, Weiner says.
Moreover, the bigger expense involves processing debit card transactions, and it will be “very difficult to delineate the processing costs with all the other costs across the payment chain,” he says.
“Conceptually, this is going to create some very difficult questions–what in fact is a cost to the issuer? Weiner says. “That’s where the open-endedness will be problematic.”
The definition of “proportional” also is lacking in the legislation. Some observers have said that means the rates would be equal to the cost of processing a payment. But the Fed also might provide for some markup, and that could be where the “reasonable” aspect of the rate-setting comes in, Weiner says.
Another aspect of the legislation involves the exemption of smaller issuers, debit cards issued by governments and reloadable prepaid cards. Weiner agrees with former Visa Inc. executive Linda Perry that enabling merchants to identify whether a customer’s card is exempt, and therefore potentially imposes a higher interchange rate, will be difficult to accomplish (
Because the volume of transactions coming from exempt cards would be relatively small, it is possible merchants or their acquirers might just eat the added cost given the likelihood the Fed would reduce the rates on most other debit transactions. “That’s very much a possibility,” Weiner says. “It’s costly to set up a dual system–who is going to pay for it? Will the networks or acquirers be interested in setting up a dual system? I’m not sure how that all might fall out.”
Despite the likely reduction in interchange revenue resulting from the Fed’s rate review, Weiner believes debit card issuers will still have viable businesses. “Issuers will just need to figure out new ways to run their programs,” he says, citing the introduction of annual fees or restructured rewards programs as potential outcomes. “I would bet that that every major issuer today is already thinking about different scenarios at different interchange levels to see where that might change pricing.”
Not everyone agrees interchange will even remain once the Fed completes its review. Jeff Shinder, managing partner at Constantine Cannon, a New York-based law firm, suggests fraud should not be included as a cost in setting interchange rates but instead should be rolled in to an issuing institution’s overall cost of doing business. He believes in the end, signature-debit rates will at least drop, and PIN-debit, which is more secure, will emerge as the preferred form of debit payment as the business case for signature debit weakens.
And if that occurs, the Fed should take advantage of the situation and use its authority to help push the U.S. market to a chip-and PIN smart card system, just as most other parts of the industrialized world are doing, Shinder says. “The Fed may need to get involved to bring the process together to get there,” he says.
Shinder also believes an underlying goal of the debit-interchange portion of the financial-reform legislation is to eliminate the “perverse competition” inherent in the setting of interchange rates. Both Visa and MasterCard Worldwide compete by raising rates to attract issuers, which receive interchange from merchant banks each time their cards are used to initiate payments.
A fairer system would have issuers, merchants or both charging customers to have and use cards. That way, cash users would not incur the higher prices merchants charge for goods and services to offset their interchange costs, Shinder contends.
The House voted to approve the reform bill June 30. The Senate, where passage remains questionable, likely will take up the legislation later this month.
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