The Great Canadian Debit Debate

  Is the reason Canadians use debit cards more than their American counterparts the Visa/MasterCard rules in the U.S. that tied signature-based debit cards to credit card acceptance? In this commentary, two of the lawyers who led the merchant class-action lawsuit against the card associations say tying hurt U.S. debit.
  With its recently published report about debit in Canada, Dove Consulting has brought into focus one of the lingering questions remaining in the aftermath of the merchant lawsuit against Visa and MasterCard. That is, would personal identification number-based debit have been as successful in the United States as it has been in Canada if the associations had not used their "honor-all-cards" (HAC) rules to tie debit to credit card acceptance?
  While the Dove report does a good job of discussing some of the main differences between the two debit systems, it doesn't really confront this central question head-on. The report, therefore, is of limited utility in evaluating how the Canadian experience sheds light on the even more fundamental questions that remain post-lawsuit; namely, which debit products in the U.S. will prevail, and at what price?
  The Differences
  There is little disagreement as to how the Canadian and U.S. debit systems currently compare. In Canada, PIN debit accounts for roughly 100% of all debit transactions while in the United States it accounts for well less than half. In Canada, PIN debit is accepted at a significantly greater proportion and much broader array of merchants than it is in the U.S. In Canada, debit usage has far surpassed check usage while in the U.S. check usage, though slipping, still dominates. In Canada, debit transactions have zero interchange while in the U.S., both PIN and signature-based debit transactions have been subject to ever-increasing credit card-styled interchange rates. And in Canada, per-capita debit usage greatly exceeds debit usage in the U.S. (PIN and signature debit combined), despite the significant head start the U.S. had in debit.
  By virtually any measure, most will agree that debit, and particularly PIN debit, in Canada has been a much greater success than in the U.S. Where there is disagreement is how we got there.
  On the consumer side, there are no relevant differences in payment behavior that would explain the gulf. The populations are equally affluent. The use of plastic is equally prevalent. Consumers in both countries typically use credit for higher-ticket purchases and purchases for which they prefer or need to "pay later." And, they use debit principally as a "pay now" replacement for cash and checks.
  On the banking and merchant sides, the strategic incentives to implement and promote point-of-sale debit also have been the same. Banks in both countries looked to debit as a means to reduce the risk in the payments system, reduce the volume of checks and associated check-processing costs, leverage the success of automated teller machines, build and retain customer accounts, and increase revenues through larger account balances and the increased opportunity for cross-selling financial services. Likewise, merchants in both countries looked to debit, particularly PIN debit, as a cheaper, faster, safer, and more consumer-friendly alternative to cash and checks.
  So, why the great divergence in the debit paths taken in the U.S. and Canada? The Dove study points to five suggested reasons:
  * The highly concentrated nature of Canada's banking system (eight national banks account for more than 90% of all banking assets, and Interac is the only PIN debit network);
  * The Canadian government's purported regulation of Interac;
  * Differences in the network architecture employed by Interac and the U.S. debit networks;
  * The absence of signature debit in Canada; and
  * The difference in debit pricing (zero interchange in Canada).
  While these structural differences are, for the most part, real, Dove avoids any true discussion of why they are relevant to the significantly greater success of debit (and PIN debit in particular) in Canada. Or why they serve as impediments to replicating that success in the U.S.
  The closest Dove comes is in pointing to the absence of signature debit in Canada and the country's at-par pricing model for PIN debit. But even here, Dove shies away from exploring in any depth the root cause for these keystones of the Canadian system, or more importantly, for why they are not present in the U.S.
  For example, Dove does not mention that in the mid-1980s the Canadian banks unanimously and individually chose to exclusively focus on PIN debit because they viewed signature debit as inferior. Nor does Dove mention that the U.S. banks were also nodding in that direction until the associations began to aggressively push signature debit through the HAC tying rules.
  What's ultimately missing from Dove's analysis is any detailed study of the associations' HAC tying rules, the distinguishing factor that lies at the epicenter of the great Canadian debate. Visa and MasterCard did not use these rules in Canada to tie debit to credit. They did in the U.S. And, therein lies the real reason for the different directions each debit system has taken. Without understanding the full effect of the tying rules on the development of U.S. debit, it is impossible to evaluate where the market will likely be heading now that these rules have been banished.
  The U.S. Debit Story
  Visa and MasterCard created their signature-based debit products in the mid to late 1970s and immediately employed their HAC rules to require merchants that accepted their credit cards to also accept their debit cards. Despite this instantaneous, widespread merchant acceptance base, the tying rules had little effect on the development of U.S. debit in the early days. Few consumers were using debit and few banks were issuing debit cards.
  It was not until the mid to late 1980s that debit began to take off. But it was not Visa and MasterCard that lit the fire under debit. Rather, it was the regional electronic funds transfer networks that saw the opportunity and acted. They leveraged their burgeoning ATM programs to reach the point of sale and educated both consumers and banks on the great benefits associated with debit. During the 1980s and into the early 1990s PIN debit blossomed due to the promotional efforts of the regional networks. Throughout this period, PIN debit pricing remained at par (e.g., merchants paid no interchange) or, for several networks, even below par (e.g., merchants were paid for each PIN debit transaction they accepted).
  Finally awakening to the strategic importance of debit, Visa and MasterCard reexamined their own foundering debit programs and took action. The plan was simple. Make the banks an offer they could not refuse-credit card-styled interchange for debit. MasterCard at first resisted, recognizing the superiority of PIN debit, but was quickly turned around by the inexorable pull of high interchange.
  Some banks also stood up to the onslaught, Citicorp the most notable among them. But they too eventually fell, unable to resist the siren's call for interchange. The plan worked. And from the mid '90s on, signature debit reigned supreme, dominating the safer, cheaper, faster, and more efficient PIN debit product. The regional EFT networks were relegated to the sidelines, and their at-par pricing model went with them.
  How were the associations able to pull it off? Simple. The HAC tying rules. Here's how it worked.
  The HAC tying rules allowed the associations to avoid competing for merchant acceptance of their signature debit products. Any merchants that accepted Visa/MasterCard credit cards-and by the early '90s most merchants had to-were forced to accept the associations' debit cards, regardless of price or quality. So, the associations could charge merchants whatever they wanted for signature debit. And they did, setting interchange fees that were roughly the same as their credit interchange fees and up to 10 times (or more) higher than the fees the regional networks charged for PIN debit.
  An About-Face
  The vast pricing gap between signature and PIN debit completely distorted the incentives of banks in their debit issuance and promotion practices. After having initially favored PIN debit in the 1980s and early '90s, U.S. banks did an about-face and aggressively pushed signature debit.
  Not only did banks favor the riskier, more costly, slower, and less efficient signature debit product, they took active steps to suppress PIN debit altogether. They relegated PIN debit marks to the back of the card and did virtually nothing to promote its superior features. They imposed on their cardholders financial penalties for making PIN debit transactions.
  They adopted rewards programs-such as prize sweepstakes, air miles, and cash rebates-for which only signature debit transactions qualified and PIN debit was excluded or even vilified (e.g., Kansas City, Mo.-based Commerce Bank's "Skip the PIN, Sign and Win!"). And they sent their cardholders steering materials directing them to always sign for their debit purchases or press the "credit" button at the merchant terminal. Cincinnati-based Fifth Third Bancorp, the fourth-largest debit card issuer, went so far as to affix a "do not input your PIN" sticker on the face of many of its cards.
  The perverse incentives created by the HAC tying rules forced the regional networks to respond the only way they could to regain the attention of banks-raise their prices. The pressure to raise their interchange fees was exacerbated by Visa's use of its PIN-based Interlink POS network (and Visa Check II) as a lever to elevate PIN debit pricing. Over the past decade, PIN debit pricing has increased by well more than 2,000%!
  The combination of suppressed transaction flow and heavy price hikes significantly reduced the incentives of merchants to make the capital expenditures necessary to accept PIN debit. This further cemented signature debit's dominance in the U.S. The result of this HAC rule-driven spiral: higher prices, lower debit volumes, and the ascendancy of an inferior debit product.
  What Happens Now?
  None of this happened in Canada because the associations did not use HAC rules to tie debit to credit. The Canadian banks recognized the clear superiority of PIN over signature debit. And, they recognized that interchange was not necessary to support a business case for issuing and promoting debit. Dove's suggestion that PIN debit and at-par pricing prevailed in Canada because of industry concentration, government regulation, or network architecture is way off the mark. Market forces dictated the outcome in Canada. And they would have done the same in the U.S. had the market not been distorted by the HAC tying rules.
  So, where does U.S. debit go from here now that the merchants have succeeded in abolishing the tying rules? Two things seem likely. One, pricing for both PIN debit and signature debit will converge. And two, PIN debit will soon overtake, and eventually eliminate, signature debit.
  Pricing for signature debit has already dropped markedly. The settlements in the merchant lawsuit mandated temporary interchange reductions of roughly one-third. While the associations' published rates have crept up from there, the published rates do not account for the many private deals that the associations are no doubt negotiating with the larger merchants to ensure their continued acceptance of signature debit. Nor do these rates account for the new-found but largely untapped power that all merchants have, big and small, to just say no to signature debit.
  This merchant power will likely fuel over the next year or two a cat-and-mouse game between merchants and the associations that ultimately will determine whether interchange climbs to its pre-settlement levels and beyond, or tumbles in the opposite direction.
  With its recent decision to drop MasterCard debit, Wal-Mart Stores Inc. has delivered the opening salvo in this simmering tug-of-war. Other merchants may be similarly poised to follow, either through flat-out rejection of signature debit, or by using their vastly improved ability to steer their customers towards PIN debit. This dynamic will drive more and more merchants to accept PIN debit, and put increasing pressure on the associations to lower signature debit fees. As merchants flex their muscles with signature debit, they likely will start doing the same with PIN debit.
  This merchant power also will likely facilitate the inevitable disappearance of signature debit altogether. Once the pricing gap between PIN and signature debit sufficiently narrows, and PIN debit becomes commonplace at those merchants where consumers most like to use their debit cards, as it is in Canada, banks will have no motivation to favor the more costly, less efficient debit product. Then, signature debit won't be worth supporting at all.
  Conclusions
  As to the great Canadian debit debate, it was never really about which debit system is truly better. The high numbers for Canadian debit transactions readily answer that one. So do the low numbers for Canadian paper check transactions. By aligning the interests of banks, merchants, and consumers with a single preferred product, Canada has maximized the efficiency of its debit system redounding to the benefit of all participants.
  The U.S. system, in contrast, has been significantly hobbled because of the HAC tying rules which have misaligned the interests of banks, merchants, and consumers. The result has been less debit and more paper checks.
  Unfortunately, the Dove study avoids getting into any of this. By merely focusing on certain structural differences between the two debit systems, the Dove study fails to tackle what's really behind the tremendous success of PIN debit in Canada. This has allowed apologists for high interchange and signature debit to use the study to bolster their view that the U.S. debit system is just fine the way it is. Even worse, it has given them fodder to falsely suggest that the U.S. system is actually better for consumers because it is cheaper for them, $4.3 billion cheaper to be exact (Dove's calculation of per-transaction debit fees Canadian consumers paid last year).
  Consumer Costs
  This finding of supposed cost savings ignores the massive interchange overcharges that all U.S. consumers, not just debit consumers, have had to shoulder (and continue to do so) in the form of higher prices and reduced services. It ignores the consumer costs associated with the U.S. banking system's relative failure to displace paper checks with debit transactions. It ignores the PIN debit penalty fees that, up until recently, banks had been imposing with ever-greater abandon.
  It largely ignores the Canadian system of bundled pricing for bank-account services under which the majority of consumers do not pay per-transaction debit fees. And, it ignores the greater costs of fraud and dislocation to which many consumers have been subjected due to the prevalence of signature debit.
  But most of all, it highlights the failure of the Dove study to recognize the central teaching of the Canadian debit experience-that a low-price, PIN debit system is superior for all participants, and now that the HAC tying rules are gone, that system has a fighting chance of emerging in the U.S.
  Jeffrey Shinder and Gordon Schnell are partners at New York City-based Constantine & Partners, lead counsel in the merchants' class-action lawsuit challenging Visa and MasterCard's honor-all-cards tying rules. The card associations settled the suit last year by agreeing to repeal the tying rules, lower signature debit interchange and pay merchants approximately $3 billion. The views expressed herein are based on the positions taken by the merchants in their lawsuit and are not necessarily those of CCM. Messrs. Schnell and Shinder can be reached at gschnell cpny.com and jshinder cpny.com.