Offline Debit Gets Scorched

  Lower interchange, new freedom for merchants to choose card brands, and other changes have caused the old world of debit cards to go up in flames. What will the new world look like?
  It is a capricious period in the debit card sector. Until recently, financial institutions could depend on solid revenue streams from escalating card activity, and be confident that the base of retailers accepting the increasingly popular payment products would continue to expand.
  But last spring's settlements of a seven-year-old, class-action antitrust lawsuit brought by merchants against Visa USA and MasterCard International-which received final approval by U.S. District Judge John Gleeson in December-are making attempts to forecast future debit-related volumes, income and costs increasingly problematic.
  Card issuers, who still were deciphering the effects from the approximately one-third decline in signature-based (offline) debit interchange rates that resulted from the settlements, now are dealing with additional fee adjustments by the bank card associations. And with the elimination of Visa's and MasterCard's "honor-all-cards" rules as part of the agreements, merchants now have leverage to drop offline debit acceptance if they do not receive satisfactory rates.
  Major shared electronic funds transfer networks, meanwhile, have been raising interchange rates-the amount of a card sale that the merchant acquirer must pay the card issuer, which acquirers typically pass on to their merchant customers-for personal identification number-based (online) debit transactions. The higher online fees might help issuers recoup some debit revenue in the face of declining offline interchange, but they also could give retailers added incentive to promote signature-based cards if Visa and MasterCard come up with marketing dollars.
  "The free market is taking over and we can't predict what any merchant will do," says Lloyd Constantine, managing partner of New York-based Constantine & Partners, the lead law firm for the merchants in the suit. "The market dynamics will keep on changing. We will not get a sense of what's going on until the middle of 2004."
  But the announcement in December by Wal-Mart Stores Inc. that it would stop accepting offline debit MasterCard transactions beginning in February is perhaps a preview of how more retailers will exercise their new ability to only accept specific card products (box, page 22). Indeed, a spokesperson for Sears, Roebuck and Co. says that signature-based debit rates "are substantially too high" and that Sears is "evaluating all of our options in respect to that."
  Negotiating Tactics?
  While Wal-Mart's move may simply be a negotiating tactic to get MasterCard to further cut its debit interchange rates, it demonstrates the power high-volume merchants wield to obtain the most favorable pricing. Indeed, some analysts suspect that Visa already has cut a deal with Wal-Mart in which the retailer is paying lower than listed rates to accept the Visa check card signature-based debit product. (Neither Visa nor Wal-Mart will confirm that.) And they note that Wal-Mart also may be sending a message to the other major card companies-such American Express Co. and Discover Financial Services-on the need to keep pricing low.
  "Wal-Mart is known for squeezing its suppliers, and MasterCard and Visa are nothing more than suppliers of payment tools to them," says John Gould, director of consumer lending and bank cards for TowerGroup, a Needham, Mass.-based financial-industry research and consulting firm. "MasterCard signature debit accounts for less than 1% of Wal-Mart's volume, so the risk to Wal-Mart for not taking the card is low."
  A spokesperson for Wal-Mart, which led the retailer lawsuit, says MasterCard's signature-based debit fees "are simply too high for an inefficient, less-secure product, which is why we chose to eliminate this payment option rather than pass these costs on to our customers."
  The spokesperson would not say if Wal-Mart is continuing discussions with MasterCard, but noted that "we can resume MasterCard signature debit or any other newly developed signature product at any time."
  Fred P. Gore, MasterCard International senior vice president of North America Acceptance, said in a written response to CCM questions that "we must manage the MasterCard system in a way that balances the needs of all participants in the system-the financial institutions that issue cards, merchants and consumers."
  MasterCard, he adds, has not been notified that other retailers will follow Wal-Mart's actions, and "if consumers were not permitted to sign for purchases, merchants might very well lose sales or see consumers use a more expensive form of payment, such as check or credit."
  Both card associations, meanwhile, are making additional alterations to their "listed" signature-based debit rates that took effect following the settlements. MasterCard says merchant acquirers, beginning April 2, will pay a retail interchange rate for non-supermarket transactions of 1.23% of the sale, compared to its current 0.97% of the sale plus 10 cents. The new rate translates into higher interchange for purchases of more than $38. MasterCard's current supermarket rate of a flat 29 cents per transaction will decrease to 26 cents.
  Gore says the rates were aimed at enabling MasterCard issuers to remain competitive while offering merchants and acquirers pricing stability.
  Visa's new rates, which were scheduled to take effect Jan. 31, are part of a four-tier system and are based on merchants' Visa check card volume between June 2002 and May 2003. It rewards high-volume retailers that maintain low chargeback and fraud rates.
  The Threshold I rate for merchants with at least 35 million transactions is 0.7% of the sale plus 15 cents, equating to 43 cents on a $40 purchase. The Threshold II rate for retailers with at least 18 million transactions is 0.83% plus 15 cents, or 48.2 cents on a $40 purchase; and the Threshold III rate for merchants with at least 6 million transactions is 0.95% plus 15 cents, or 53 cents on a $40 purchase. Visa retailers also must keep chargebacks within 0.018% of sales volume, and fraud within 0.022%. Supermarket rates are the same for each threshold and are capped at 35 cents per transaction.
  Retailers failing to meet the threshold requirements pay 1.05% plus 15 cents, or 57 cents on a $40 purchase. Visa's former rates were similar to the new MasterCard rates.
  MasterCard is analyzing the new Visa pricing and "will assess whether we need to make further changes to our 2004 rates to assure that we maintain a competitive structure, with rates that benefit both issuers and merchants," Gore says.
  'Stacked Against Me'
  It is the largest merchants, however, who are positioned to receive maximum benefits from the settlements. Most small and mid-size retailers lack the market power to obtain the best rates, or to guarantee that their acquirers will pass along interchange savings in the form of lower discount rates. Many of the retailers also must accept offline debit cards-regardless of the rates-to remain competitive, analysts and merchants say.
  Darren Lee, owner of Copy U.S.A., a New York City print and copy shop, doubts he is benefiting from the settlements, and says it will be "a hassle" to change acquirers just to pay a slightly lower discount rate of which interchange is far by the largest single component. Lee says he would only contemplate switching if there were continual equipment problems.
  And with less than 5% of Copy U.S.A.'s transactions initiated with signature-based debit cards, Lee says "the situation is stacked against me. I don't even know what my exact discount rates are. I know they are high, but a small merchant like myself has no real power."
  Some independent sales organizations, however, say smaller retailers can be enticed to switch acquirers by making them aware of their new options. Heartland Payment Systems Inc., an ISO based in Princeton, N.J., even created a marketing campaign emphasizing that it was passing along its reduced interchange expenses to retailers.
  Heartland mailed more than 50,000 postcards to potential merchant customers that asked, "Did You Get Your Rebate?" The ISO also distributed other direct-mail pieces and brochures.
  Heartland's signings of new merchants for September, October and November were 25% higher than for any other month in its history, says Marty Uhle, president and chief operating officer. The firm has more than 62,000 merchant customers in 47 states that generate more than 30 million transactions a month.
  "We haven't seen a widespread move by ISOs to pass along the reduced interchange rates," Uhle says. "Many acquirers have kept the decrease to increase their own margins. So we're knocking on every door that we can find to say that we'll give you the benefits."
  Though the declining interchange rates are giving retailers greater incentive to accept offline cards, growing consumer attraction to debit also is making the PIN-based card a more important product. A recent consumer survey conducted by Boston-based Dove Consulting on payment preferences at the point of sale found that debit cards accounted for 31% of in-store payments, up from 26% in 2001 and 21% in 1999.
  Among debit card users, 45% of respondents said they preferred to enter a PIN, and 38% favored signature-based transactions. The remaining 17% had no preference
  'Enormous Potential'
  Checks, meanwhile, accounted for 15% of payments, a decline from 18% in both 2001 and 1999, while cash comprised 32% of payments, compared to 33% in 2001 and 39% in 1999. Credit cards accounted for 21% of payments in both 2003 and 2001, and 22% in 1999. There were 2,008 respondents to the nationwide mailed survey.
  Hoffman Estates, Ill.-based Sears is among the merchants leveraging this increasing customer interest in PIN-based debit. Sears plans to begin rolling out online debit to its 870 U.S. stores in 2004, the spokesperson says. Many customers prefer to initiate PIN-based transactions because they are more secure and convenient than signatures, the spokesperson notes.
  Sears already accepts PIN-based debit at 400 stores in Canada, and at a handful of locations in Puerto Rico.
  Visa and MasterCard, meanwhile, are eyeing additional markets for debit card acceptance. Elizabeth Buse, Visa USA executive vice president, says the San Francisco-based association is especially interested in quick-service restaurants and automatic bill payments.
  "There is enormous potential for debit growth as more than 60% of transactions from a demand-deposit account still are from cash and check," she says.
  Both associations say the recurring payments sector is ripe for debit acceptance. A 2003 MasterCard survey found that 26% of all U.S. households already link at least one automatic payment to a debit card, a 30% increase since 2000 ("New Markets for 2004," January).
  Forty-eight percent of the users also said they would consider using debit cards for additional recurring payments, and 62% noted that they are less likely to change their financial-institution relationship if recurring payments are linked to their debit card. The study included 727 in-person interviews in 25 geographic markets.
  "The debit card is becoming more popular for recurring payments as it is a more secure payment vehicle in the minds of consumers, and also is associated with rewards programs," says Richard G. Lyons Jr., senior vice president, Deposit Access Group, North America, for MasterCard International.
  Updates
  Visa, meanwhile, has launched an account-update service for its automated payment system aimed at preventing transaction rejections because of outdated account information. It enables new expiration dates for Visa check cards to be automatically entered into the system when the older cards expire. Buse says the debit cards' liability protection for cardholders if fraud occurs is another key consumer attraction.
  MasterCard also is working to expand use of its debit MasterCard BusinessCard. The Purchase, N.Y.-based association reports that more than 55 financial institutions are issuing the product, a 21% increase from 2002. MasterCard already has run television commercials that target the more than 30 million small businesses in the U.S., especially the nearly 90% that report using cash and checks to pay for business expenses.
  Lyons says the cards are an important vehicle for enabling small-business owners to keep personal and business expenses separate. They are most often used to purchase business supplies, support travel and entertainment, and buy equipment and inventory.
  Though such newer debit markets are helping to boost signature-based volumes, the interchange generated by the added activity is not yet sufficient to replace the interchange revenues lost from recent rate declines. Most institutions, however, are hesitant to implement card fees as a means of recouping debit income, analysts say.
  "It is unlikely that banks will go overboard and charge for the use of a card that is saving them money," says Mallory Duncan, senior vice president and general counsel for the Washington, D.C.-based National Retail Federation, a plaintiff in the lawsuit. "The last thing they want to do is force their customers to write more checks."
  Indeed, Ferndale, Mich.-based Credit Union One, a debit MasterCard issuer, is experiencing monthly revenue declines of between $35,000 and $50,000 as a result of lower interchange rates, says Armando Cavazos, president and chief executive officer. But the institution hopes to compensate for the losses by operating more efficiently and offering new products.
  "We do not see adding card fees now," he says. "It would be challenging from a consumer standpoint to say 'here is a great convenience, and now we'll charge you this great fee for it.'"
  It also would be difficult to compete in a market in which most other institutions are issuing fee-free cards to customers, Cavazos notes. And it still is less expensive to support card payments than check transactions, he says.
  'A Challenge'
  "Debit cards provide convenience to our customers, and they are more efficient for us internally," he says. "But we have to make a lot of loans to get that $500,000 back on the bottom line, so it is a challenge for us."
  The 100,000-member institution anticipated the reduction in interchange in its recent budgeting, Cavazos says. Credit Union One now is considering upgrading its technologies for greater efficiencies, partnering with third parties to operate loan programs, and offering such new products and services as insurance and mutual funds.
  Baltimore-based Carrollton Bank, meanwhile, is reporting a 30% decline in its signature-based income despite steady volumes. Gary Jewell, senior vice president of Carrollton's retail delivery group, agrees that competition makes it difficult for institutions to add debit fees, especially as many consumers still prefer offline debit because they don't have to remember a PIN to initiate transactions.
  "People will use debit cards more and more, and they will be increasingly sensitive to the costs attached to the product," says John H. Hamby, senior vice president and manager of the Merchant Services Center for Savings Bank of Manchester, a Manchester, Conn.-based acquirer. "There may be a tendency for some issuers to charge customers to use the card. But we all operate in a free-enterprise system, and when we make such changes, we run the risk of people switching their allegiance."
  One alternative to the implementation of offline card fees is an increase in promotion of PIN-based debit transactions, which carry steadily increasing interchange rates, analysts say. Indeed, the three leading shared electronic funds transfer networks-Maitland, Fla.-based Star, Montvale, N.J.-based NYCE and Houston-based Pulse-all announced higher rates in the last year.
  PINs Still Popular
  Network executives say the rate increases were needed to adequately compensate their card-issuing financial-institution members. They forecast that retailers still would be interested in accepting online cards because of the product's enhanced security and quicker transaction speeds. And while reduced, the spread between online and offline debit acceptance costs still generally favors online.
  "We have no indication that merchants are less willing or desirous of taking PIN-based debit," says Dennis Lynch, president and chief executive officer of NYCE Corp. "In fact, we expect more merchants to install terminal software that prompts consumers to punch in their PIN at the point of sale."
  NYCE in July increased its interchange rates between 12% and 14%, depending on the merchant category, in an effort to stay competitive with other networks and make NYCE cards more appealing to issuers, Lynch says.
  "We see both PIN and signature-based debit as our competition," he notes. "So it is important that we take steps to insure the NYCE system is reliable and speedy, and that the PIN is seen as the best way to do business."
  Pulse in October hiked its interchange to 18 cents from 15 cents for all transactions. Stan Paur, Pulse president, says the move was justified because PIN-based debit was undervalued, just as signature debit was overvalued.
  "There previously was a lack of attention paid to the costs associated with the transactions," Paur says. "We also exist in a competitive market, and while merchants are impacted by our higher fees, we had to do what was right for the issuers. And our volumes have remained steady."
  Star slightly raised its percentage-based fees across the network's three, volume-based merchant categories, but left unchanged its flat 12.5-cent transaction fee for quick-service restaurants. The pricing was scheduled to take effect Feb. 1.
  Barbara Span, Star vice president, says it is important to have a competitive rate for issuers while also balancing the needs of retailers, processors and consumers. Giving card issuers greater incentive to promote online debit is especially important as approximately 80% of Star members issue offline cards that also have PIN-based debit capabilities.
  And network research reveals that 55% of debit card holders conduct both PIN and signature-based transactions. The specific product used for each transaction depends on such factors as the retailer and the ticket price, Span says. Also, there still is ample opportunity for volume growth, as 49% of active debit users still write checks at the point of sale, she notes.
  Yet, while greater consumer interest in debit is expected to result in solid transaction increases over the next few years, the playing field might have a much different look. Not only may more retailers follow Wal-Mart's example and alter their card acceptance policies, but newer issuers-perhaps even AmEx and Discover-could enter the debit sector.
  They caution, however, against hasty responses to the latest developments. "The market is in flux, and having an immediate reaction to the recent changes may not be the most effective course of action," Span says.
  The network landscape also may change further because of Greenwood Village, Colo.-based First Data Corp.'s decision to sell its 64% controlling interest in NYCE, the second-largest PIN-based network. First Data agreed to divest itself of NYCE as part of a settlement with the U.S. Department of Justice over the processor's planned acquisition of Memphis, Tenn.-based Concord EFS Inc., a leading transaction processor and owner of Star, the nation's largest EFT network.
  "We will be at least as strong in the future as we are now, and hopefully will combine with an entity that will give us even greater power to compete in the market," Lynch says.
  It is such enhanced competition, along with the market's evolving pricing and merchants' new freedom in choosing the payment vehicles they will accept, that promises to make the debit sector anything but dull.