What's Ahead for Debit Card Acceptance

  The effects of the groundbreaking Visa/MasterCard settlements over offline debit card interchange are just beginning to be felt. How will signature- and PIN-based cards be affected, and will merchants dare to drop Visa and MasterCard debit cards?
  The debit world was rocked this spring with word that signature-based interchange would be cut and the announcement of plans by MasterCard International and Visa USA to eliminate their honor-all-cards rules beginning Jan. 1.
  Resulting from settlements in a seven-year-old antitrust lawsuit brought by merchants against the card associations, the two events have the potential to turn the financial models of key debit sectors upside down.
  Acquirers could prosper by keeping their discount rates the same and not passing on the sharply reduced interchange expenses-the amount of a bank card sale that the acquirer must pay the card issuer. While that's a scenario that most assuredly will not happen with the clout-heavy major retailers that brought the class-action suit, such as Wal-Mart Stores Inc., many smaller retailers and their allies fear that small merchants won't see lower prices.
  In response, some acquirers and independent sales organizations see an opportunity to poach the customers of competitors that try to widen their margins by not lowering their discount rates. Interchange is by far the largest component of the discount rates merchants are assessed for accepting card transactions (chart, page 12).
  Shared networks and processors, meanwhile, are facing a potential slowdown in the growth of online (personal identification number-based) debit volumes-and revenues-if offline (signature-based) debit transactions begin displacing charge volume on PIN-based debit cards (box, page 14).
  While the effect on specific segments remains cloudy, it is clear that the debit market will become more complex and competitive.
  "The big-picture issue is what will happen in January when it will be the merchant's option to say 'no' or 'yes' to taking specific cards," says Lloyd Constantine, managing partner of New York-based Constantine & Partners, the lead law firm for the merchants in the suit. "The industry then will no longer be regulated and there will be free choice."
  Starting next year, Visa and MasterCard credit card-accepting retailers will have the option to either accept or decline the associations' offline debit products, currently known as the Visa check card and MasterCard Debit. Before the settlements, the honor-all-cards rules forced merchants who accepted bank-issued credit cards to also take the signature-based debit cards.
  Many retailers were unhappy with that mandate because offline debit cards' interchange rates were similar to the rates of the associations' credit products. Debit carries little of credit's risk or costs as funds are debited directly from cardholders' demand-deposit accounts within a few days of a transaction.
  Under the settlements, the interchange rate on the Visa check card was lowered 29% on Aug. 1 to 0.88% of the sale plus 10 cents for most nonsupermarket, cardholder-present transactions, down from 1.25% of the sale plus 10 cents. Concurrently, MasterCard Debit's purchase interchange fell to 0.97% of the sale plus 10 cents, down from 1.4% of the sale plus 10 cents.
  The pricing, however, which is in effect until Dec. 31, could change next year because acquirers and retailers are scheduled to individually negotiate their offline debit interchange rates with Visa and MasterCard.
  "Each merchant will deal with their own economic situation, but until we see what Jan. 1 will bring, we don't know what retailers will do," says Gary M. Jewell, senior vice president, retail delivery, for Baltimore-based Carrollton Bank, a leading debit acquirer.
  Closing the Gap
  Yet, though it may be many months-or even years-before the full ramifications of the settlements are apparent, some analysts believe the PIN-based debit card sector may be one of the first to experience fallout. Before the settlements, offline debit interchange cost merchants about 63 cents on a typical non-supermarket $40 sale, compared with only about 34 cents for a similar transaction processed through online networks.
  But the electronic funds transfer networks have been raising their PIN-based, point-of-sale debit interchange rates. With lower offline debit interchange, and rising online fees, there now is even less incentive for retailers to steer transactions online.
  "By closing the PIN/signature gap, the (bank card) associations have invited inertia into the market and may have effectively slowed the growth of both PIN-pad development and PIN-based transactions," notes Ontario, Calif.-based CO-OP Network, the fourth-largest EFT network, in a report on the settlements.
  However, Paul Rasori, director of marketing for North America for Santa Clara, Calif.-based VeriFone Inc., a leading POS terminal vendor, notes that orders for VeriFone PIN pads have not declined since the announcements of the settlements. "People are moving forward with their plans," he says.
  And online debit acceptance still will be less costly to retailers than offline, and thus will remain a popular option, predicts Shalini Chowdhary, industry manger, smart cards and payments, for Frost & Sullivan, a San Jose, Calif.-based research firm.
  "Online debit activity still will go through the roof because it's cheaper, faster and safer," Chowdhary says. "Merchants still have to invest in PIN pads for online, but many of the larger retailers already have the pads installed."
  Retailers' Costs
  Recent figures from CCM sister publication ATM&Debit News show that the two forms of debit each have growth rates of about 21% ("PIN Debit: Not So Sharp," page 18).
  Perhaps the most important determinant of whether PIN and signature-based debit maintain their strong expansion momentum is the cost to retailers for taking the products. Wal-Mart, for instance, the world's largest retailer, could save millions of dollars annually in offline debit-acceptance expenses as a result of lower interchange rates.
  Reduced discount fees also will make offline debit a more attractive tool for merchants that receive recurring payments. Armen Khachadourian, Visa USA senior vice president for merchant sales and integrated solutions, says use of Visa credit and debit products for recurring payments, which includes cable television, insurance and telecommunications transactions, is growing 28% annually and the Visa check card already accounts for 50% of that rate ("A Boost for Recurring Payments?" August).
   But for the vast majority of the five million retailers who also were part of the class-action suit, the impact from the settlements may be more hollow than hearty.
   Acquirers could use the lower interchange to raise their margins instead of passing the savings along to their lower-volume customers. Competitive pressures, meanwhile, will force most retailers to continue to accept all payment cards, despite their new freedom to pick and choose, analysts say.
  Savings
  "Early indications are that there will be a mixed bag of pricing," says John Gould, director of consumer credit for TowerGroup, a Needham, Mass-based financial-industry research and consulting firm. "Some acquirers said they will pass most of the savings to the large merchants, but the poor mom-and-pops won't see anything. Others say they will pass the savings on to everyone. The bigger fish you are, the better deal you get."
  Many retailers are assured of lower debit rates because of processing contracts that tie discount fees to interchange. With "interchange pass-through" or "interchange-plus" pricing, for instance, a retailer may be charged the cost of interchange plus 2 cents a transaction by the acquirer.
  Yet, the exact fees that merchants are charged for debit transactions may remain a mystery to them because of bundled pricing, a system in which retailers receive a lumped bill that includes all acquirer expenses. Statements, for instance, may not only contain debit costs, but credit card fees and rates for such services as compiling and mailing statements.
  "Statements often resemble an electric bill," says John H. Hamby, senior vice president in the Merchant Services Center for Savings Bank of Manchester, a Manchester, Conn.-based acquirer and processor with more than 4,000 retail customers. "It is very complicated, and the disclosures to merchants are not crystal clear."
  And with Visa and MasterCard raising credit card interchange this year, bundled discount rates may further camouflage any actual savings from the cut in debit interchange, according to Jeffery C. McWey, executive vice president at Atlanta-based Global Payments Inc., a credit and debit processor and acquirer.
  "All of our customers are benefitting from the offline debit interchange decrease in varying degrees, depending on the size of the merchant," McWey says.
  'Non-Event'
  The prospect of reduced debit interchange, however, still may turn out to be inconsequential to the vast majority of the nation's retailers.
  "A large segment of merchants still don't understand what is going on," says Carrollton Bank's Jewell. "They won't see a big break in their fees and it will be a non-event for them."
  Indeed, a spokesperson for the National Federation of Independent Business, a Nashville, Tenn.-based trade organization representing 600,000 smaller merchants, says the group has not heard from any members about the Visa and MasterCard settlements.
  "We only get involved in issues that our members see as important, and this has not registered on their radar screens at all," the spokesperson says.
  Typical of these retailers is Be-Ez Sports & Cigars Inc., a Glenview, Ill.-based seller of collectibles and imported cigars. Owner Gene Zurawski says he has "never heard" of the antitrust suit or the settlements, and is not too interested in them.
  Be-Ez usually has between five and 10 weekly offline debit transactions. Yet because he is satisfied with his current discount rate, Zurawski says he is not concerned if his acquirer passes along the lower debit costs.
  Still, some ISOs believe other retailers will want to benefit from the settlements, and they plan to call on the customers of their rivals to see if the savings are being handed down.
  "Quite a few acquirers are finding this to be an opportunity to make more profit, and from a competitive point of view, we're going to go after their piece of the business," Savings Bank of Manchester's Hamby says. "When you try to hold back on (passing along interchange savings), you make yourself susceptible to your competitors."
  Heartland Payment Systems, a large ISO based in Princeton, N.J., also is passing along the entire savings from lower debit interchange to its customers, and is creating a marketing campaign to make merchants aware of it.
  In addition to developing brochures, Heartland, which has many restaurants in its portfolio, is sending out direct-mail pieces and placing articles in state and local restaurant-association newsletters.
  The acquirer has 62,000 merchant customers in 47 states that generate more than 30 million transactions a month.
  'Doesn't Feel Kosher'
  "This is a chance for the merchant to see how their acquirer is treating them," says Marty Uhle, Heartland president and chief operating officer. "In last 10 years there has been interchange increases and every acquirer has not missed an opportunity to pass those on to their customers. But I don't think they have the same opinion when interchange decreases, and that doesn't feel kosher."
  But interchange alone may not be enough to convince smaller merchants to go through the trouble of switching acquirers, or changing their card-acceptance policies. Sheri Kraft, owner of Alibi Books, Glenview, Ill., says she had not heard from her acquirer regarding lower debit interchange rates.
  But because she expects to be treated the same by most acquirers, Kraft says any savings will result from "the luck of the draw."
   "As a small business I can't control what acquirers do," she says. "I have no leverage. Before I look to switch (acquirers), my service levels will need to be affected."
  Kraft also intends to continue accepting signature-based cards, regardless of the interchange rates. "We're here to make things easier for the customer," she says. "Saying we won't take a card doesn't lead to more business."
  Yet, even retailers who switch acquirers to garner lower discount fees still may realize only a temporary savings. That is because the settlements call for "market forces" to set rates starting next year, and many industry participants expect interchange to rise at that time, especially for the lower-volume merchants who lack the clout of major retailers.
  "People already are wondering if interchange will sneak back up on us in six months," says Fred Joachim, vice president of third-party processing for Cincinnati-based Fifth Third Bank Processing Solutions. "A lot of us are waiting for the other shoe to drop."
  'Artificial Distinction'
  Indeed, Jim Hanisch, executive vice president of The CO-OP Network, says he expects both offline and online debit interchange to gradually rise as the popularity of both products continues to increase.
  "Signature debit, however, always will be higher because there always is the fraud risk that is not there with PIN," he says. "But the pricing will become closer than it is today."
  Some analysts even expect the price differentials to narrow to the point where Visa and MasterCard will eventually decide to blend the rates for PIN and signature-based debit. That will end the "artificial distinction" between online and offline cards, and those terms will only be used to describe methods of authentication, not unique products, TowerGroup's Gould predicts.
  Visa and MasterCard's settlements with the merchants have opened the door for wholesale changes in the debit landscape. New pricing policies and enhanced competition among acquirers will go a long way in determining if offline and online cards remain popular and potent, or suffer from the new economics of an evolving environment.