{"id":1536,"date":"2011-07-23T09:52:22","date_gmt":"2011-07-23T13:52:22","guid":{"rendered":"http:\/\/journals.law.harvard.edu\/hblr\/?p=1536"},"modified":"2016-07-04T21:55:13","modified_gmt":"2016-07-05T01:55:13","slug":"debit-interchange-regulation-another-battle-or-the-end-of-the-war","status":"publish","type":"post","link":"https:\/\/journals.law.harvard.edu\/hblr\/debit-interchange-regulation-another-battle-or-the-end-of-the-war\/","title":{"rendered":"Debit Interchange Regulation: Another Battle or the End of the War?"},"content":{"rendered":"

Download PDF<\/a><\/p>\n

Stacie E. McGinn and Mark Chorazak*<\/a><\/p>\n

As one governor of the Board of Governors of the Federal Reserve System (the \u201cBoard\u201d or \u201cFederal Reserve\u201d) recently observed, \u201cthe financial crisis spawned or strengthened many reform agendas\u2014among them consumer protection, securities and commodities market regulation, and traditional bank regulation.\u201d[1]<\/a>\u00a0 The crisis also created opportunities unrelated to these reform agendas.\u00a0 At least one group\u2014merchants\u2014realized a legislative goal that had been unimaginable a year earlier:\u00a0 giving the Federal Reserve the authority to set debit interchange rates.<\/p>\n

Still reeling from the financial crisis and preoccupied with defending innumerable other measures in the Dodd-Frank Wall Street Reform and Consumer Protection Act (\u201cDodd-Frank\u201d),[2]<\/a> retail bankers big and small watched as an unprecedented government rate-setting amendment was approved in the U.S. Senate by a bipartisan vote of 64 to 33.[3]<\/a>\u00a0 Under the so-called Durbin Amendment, named for U.S. Senator Richard Durbin, an estimated $7.2 billion\u2014or roughly 45%\u2014of interchange revenue paid to banks for facilitating debit card transactions will be eliminated.<\/p>\n

This article explores the events that led to passage of the Durbin Amendment and describes the likely impact of this historic legislation on the banking industry, payments companies, merchants and consumers.\u00a0 Finally, we discuss whether the Durbin Amendment represents the final battle on debit interchange in the United States, or merely a skirmish in a long-running war.<\/p>\n

The Durbin Amendment was preceded by a long-running feud over interchange, with retailers on one side, and payment networks and the banking industry on the other<\/strong>.<\/p>\n

The seeds of the dispute were sown by payment processing arrangements and the success of debit cards with American consumers.<\/em><\/p>\n

Understanding the battle over interchange begins with understanding interchange itself.\u00a0 When a consumer uses a debit card to make a purchase, the merchant does not receive the full purchase amount, because a portion of the sale is deducted to compensate other parties to the transaction.\u00a0 In particular, the merchant\u2019s bank (the \u201cacquirer\u201d), the bank that issued the card (the \u201cissuer\u201d), and the card network that processes the transaction (the \u201cnetwork\u201d) all receive a portion of the transaction, with the largest portion paid to the card-issuing bank as an interchange fee.[4]<\/a>\u00a0 This multi-party relationship is shown in the simplified chart, below.[5]<\/a><\/p>\n

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The level and growth of debit interchange rates became increasingly controversial.\u00a0 Retailers felt their costs for accepting cards were too high and increasing.\u00a0 The total costs to merchants who accept debit cards did rise over time, in part because of the extraordinary success of the product.[6]<\/a>\u00a0 Consumers rapidly substituted debit cards for cash and checks.\u00a0 Debit share of U.S. Personal Consumption Expenditure (PCE), for example, grew 75% in five years\u2014it represented 9.7% of PCE in 2003 (for a total of $585 billion), and represented 17% of PCE in 2008 (for a total of $1.3 trillion).[7]<\/a>\u00a0 Payment networks report there were approximately 37.7 billion debit and prepaid card transactions in 2009, valued at over $1.45 trillion.[8]<\/a>\u00a0 At the same time, interchange revenue became increasingly important to card issuers of all sizes.\u00a0 Smaller issuers, such as community banks and credit unions, rely on interchange fees as a significant source of revenue for their card operations, and card operations were highly profitable activities for large banks, as well.<\/p>\n

Faced with escalating processing costs, merchants sought relief in the courthouse and in Congress.<\/em><\/p>\n

As interchange revenues climbed in the mid-nineties, payment networks began to face antitrust litigation over their practices.\u00a0 Beginning in 1996, various class action and Department of Justice lawsuits were filed against Visa U.S.A. Inc., MasterCard International and issuers, in some cases, claiming violations of federal antitrust laws.\u00a0 In the intervening decade, most of these claims were settled, and both Visa and MasterCard became publicly-owned institutions.[9]<\/a><\/p>\n

With judicial challenges proceeding slowly through the courts, merchants took their cause to Capitol Hill.\u00a0 Largely under the auspices of the Merchants Payments Coalition,[10]<\/a> and with the support of Senator Durbin, merchants made several unsuccessful attempts at legislation regulating interchange rates.\u00a0 In 2009, they were able to attach an interchange provision to a major piece of credit card legislation, the 2009 Credit Card Accountability, Responsibility, and Disclosure Act (the \u201cCARD Act\u201d).\u00a0 The provision directed the Government Accountability Office (\u201cGAO\u201d) to conduct a study of interchange.[11]<\/a>\u00a0 The resulting GAO study found no competitive concerns or the need for government rate-setting.[12]<\/a><\/p>\n

But 2010 ushered in the perfect storm for long time opponents of interchange regulation.\u00a0 Few in Congress understood the issues surrounding interchange, and industry leaders and members of Congress already were grappling with the complexities of other provisions of the 2,300 page bill that ultimately became Dodd-Frank.\u00a0 Senator Durbin\u2019s influence in the Senate was at an all-time high, and influence (and trust) of the banking industry was at an all-time low.\u00a0 From the midst of this chaos, retail bankers, big and small, watched as Senator Durbin\u2019s unprecedented government rate-setting amendment was approved in the Senate and ultimately became law.[13]<\/a><\/p>\n

The Durbin Amendment was designed to change fundamentally the economic underpinnings of debit payment processing and shift decision-making power as to transaction processing in favor of merchants.<\/strong><\/p>\n

In adopting final interchange regulations, Federal Reserve Governors and staff believed their hands were tied by a narrow statutory mandate.<\/em><\/strong><\/p>\n

Dodd-Frank required the Board to establish its interchange fee standards no later than April 21, 2011, with final rules effective on July 21, 2011.[14]<\/a>\u00a0 Prior to issuing its rule, Board staff held numerous meetings with debit card issuers, payment card networks, merchant acquirers, merchants, industry trade associations and consumer groups.\u00a0 Interested parties also provided written submissions.[15]<\/a>\u00a0 The Board also distributed three surveys to industry participants (an issuer survey, a network survey and a merchant acquirer survey) to assist the Board in developing its rules.[16]<\/a><\/p>\n

Section 1075 of Dodd-Frank and the Board\u2019s regulations fundamentally change the status quo in debit processing in three ways:\u00a0 introducing government regulation of interchange fees, prohibiting \u201cexclusive\u201d arrangements between an issuer and a network, and allowing merchants to \u201csteer\u201d a customer to use one type of card rather than another.\u00a0 Each is described below.<\/p>\n

Regulation of Interchange Fees.\u00a0 <\/em>Under Dodd-Frank, the amount of any interchange fee with respect to an electronic debit transaction received or charged by an issuer must be \u201creasonable and proportional to the cost incurred by the issuer with respect to the transaction.\u201d[17]<\/a>\u00a0 Dodd-Frank directs the Federal Reserve to prescribe regulations to establish standards for assessing whether the amount of any interchange transaction fee is \u201creasonable and proportional\u201d to this cost.[18]<\/a>\u00a0 Dodd-Frank permits the Board to allow in its regulation for an adjustment to the fee amount for costs incurred by the issuer in preventing fraud, provided the issuer complies with fraud-related standards established by the Board.[19]<\/a><\/p>\n

In setting new interchange rates, the Board\u2019s final rule caps the maximum debit interchange fee that an issuer may receive per transaction at the sum of 21 cents,[20]<\/a> plus 5 basis points (0.05% of the transaction amount) to account for fraud losses.\u00a0 The Board provides an additional allowance for fraud prevention equal to 1 cent per transaction, provided the issuer adopts fraud prevention procedures established under the regulation.[21]<\/a>\u00a0 While a significant improvement over the proposed rule, which capped interchange rates at 12 cents, the final rule will decrease interchange revenue by about 45% for covered issuers.[22]<\/a><\/p>\n

Certain entities and programs are exempt from the rate provisions of Dodd-Frank.\u00a0 Issuers that, together with all affiliates, have less than $10 billion in assets are exempt from the Board regulations, under the \u201csmall issuer\u201d exemption.[23]<\/a>\u00a0 In addition, prepaid cards used in connection with government-administered payment programs and certain general purpose prepaid cards are exempt.[24]<\/a><\/p>\n

During consideration of the final interchange regulations, the Board staff acknowledged they could not predict the impact of the statute on small banks or the effectiveness of the small-issuer exemption.\u00a0 Staff noted that while the major payment networks have indicated their intentions to adopt a \u201ctwo-tier\u201d pricing structure that accounts for small issuers, there is no certainty interchange rates for small banks will remain at current levels.[25]<\/a>\u00a0 Moreover, Board staff acknowledged they have no authority to require networks to maintain a two-tier structure.\u00a0 Governor Elizabeth Duke objected to the Board\u2019s final rules largely on the basis of the uncertainty surrounding the impact on small banks.<\/p>\n

The statute also provides that the Federal Reserve may regulate fees charged by payment networks, but only for the purpose of ensuring that the network fee is not used to circumvent the interchange fee provisions.\u00a0 To prevent circumvention or evasion of the limits on interchange fees, the rule prohibits an issuer from receiving net compensation from a debit card network, excluding interchange fees.\u00a0 In other words, the total amount of compensation provided by the network to the issuer, such as rebates, incentives or payments, may not exceed the total amount of fees paid by the issuer to the network.<\/em><\/p>\n

Elimination of \u201cExclusive\u201d Arrangements.\u00a0 <\/em>In addition to prescribing rules regarding restrictions on interchange fees, the Board also is required by Dodd-Frank to prescribe certain rules regarding transaction routing.\u00a0 The Board regulations must provide that neither an issuer nor a payment network may (i) restrict the number of payment card networks on which a transaction is processed to only one network, or (ii) inhibit a merchant who accepts debit cards from directing the routing of transaction processing over any payment card network that may process such transaction.[26]<\/a><\/p>\n

Board regulations provide that an issuer or payment card network may not restrict the number of payment card networks over which an electronic debit transaction may be carried to fewer than two unaffiliated networks.\u00a0 Under this approach, it is sufficient for an issuer to issue a debit card that can be processed over one signature-based network and one PIN-based network, or alternatively, two signature-based networks, provided that the networks are not affiliated.[27]<\/a>\u00a0 The final rule also adopts the statutory prohibition on routing restrictions.\u00a0 In practice, this means issuers will choose two or more unaffiliated payment card networks over which an electronic debit transaction may be carried, and merchants (not issuers or networks) will be able to direct the routing of the transaction from among the networks chosen by the issuer.<\/p>\n

Merchant Steering.\u00a0 <\/em>The statute provides that a network may not keep a merchant from offering a discount or other in-kind incentive for payment by the use of cash, checks, debit cards, or credit cards, provided the discount does not distinguish on the basis of issuer or payment card network (in the case of debit or credit cards).[28]<\/a>\u00a0 <\/em>In accordance with Dodd-Frank, the Board prohibits issuers and payment card networks from restricting the ability of a merchant to direct the routing of electronic debit transactions over any of the networks that an issuer has enabled on its card.<\/p>\n

Application of Interchange Fee Restrictions to ATM and \u201cclosed-loop\u201d networks. <\/em>\u00a0The rule defines \u201cpayment card networks\u201d to exclude three-party, or so-called closed-loop networks, such as American Express, and ATM networks.<\/p>\n

Effective dates.\u00a0 <\/em>While the statute provides that final rules should be effective July 21, 2011, the final rule takes a more practical approach.\u00a0 The Board rule ensures that the fraud prevention adjustment would apply at the same time as interchange fee provisions become effective, and provides additional time to account for technology challenges.\u00a0 Specifically,<\/p>\n