Updated: Jan 4
This is a developing article, and I'll continue to update it with new information.
There's quite a stir happening in the Senate. And the topic is Durbin. For anyone in Financial Services or FinTech, this is about the lucrative "digital gold" that is interchange.
Durbin v2 did not pass in its current form in the NDAA bill and will be pushed into 2023's bill. The positions are set, and I predict the rollout of FedNow will play a significant role in the shape of this legislation.
New prediction (10/13/22) - TBD November 2022
Durbin v2 is less likely to pass in its current form, but it has received congressional visibility that could aid payments innovation.
Durbin v2 did not receive approval on October 11 to be inserted into the National Defense act of 2022.
Issues on cybersecurity, Taiwan, and the Ukraine Security Assistance Initiative took precedence over the 900 amendments that were attempted to be squeezed into the NDAA bill.
Senators Durbin and Marshall will try again in November when they have one more chance to push it through. It looks like resistance to the bill has built up.
Original prediction (10/6/22) - FALSE
Durbin v2 is likely to pass, given we are going into a recession
Durbin v2, if passed, will:
Be "sold" as a way for consumers to get relief from inflation.
Severely hurt customers in the short term and put many Americans outside the credit system.
In the longer term, foster a lot of innovation and offer credit products that just don't exist today.
I have long held that Durbin v2 will never pass, the incentives aren't aligned, and the issuers and networks are too powerful to let it happen (and are also influential bi-partisan donors).
That said, I believe that momentum is building in government to target the high profitability of the networks. In the event of a recession, congress might have the consumer sentiment they need to make this happen, the same way Durbin v1 was passed.
Read more to see why I make this prediction.
What is interchange?
Interchange is a service fee set by the card networks (or card schemes). The card networks invest these earnings to build and maintain the global payment infrastructure.
Nearly all Visa transactions worldwide are processed through the company's directly operated VisaNet data centers in Ashburn, VA, Highlands Ranch, Colorado, London, England, and Singapore. These facilities are heavily secured against natural disasters, crime, and terrorism, can operate independently of each other and from external utilities if necessary, and can handle up to 30,000 simultaneous transactions and up to 100 billion computations every second.
So consider the global network infrastructure the "dedicated internet" that connects banks and merchants.
The networks also compensate card issuers (the bank whose logo is on your credit or debit card) to print, mail, and manage those card programs.
Here's an example of where those interchange fees go when you purchase a coffee cup, courtesy Ahmed Siddiqui, Author of the book Anatomy of the Swipe.
How did interchange become so lucrative?
Bank of America (BofA) founded Visa during the rollout of the BankAmericard credit card program. As a response to competitor Master Charge (now MasterCard) BofA began licensing this program to other financial institutions in 1966 and, by 1970, ultimately gave up control of the program to a consortium of banks. It was renamed Visa in 1976.
As a neutral party, visa sets the interchange rates. Here's an example of a rate table: Visa USA Interchange Reimbursement Fees. It's pretty complex, and Visa certainly works to ensure that merchants and issuers can implement programs (e.g., 3DS) to shift liability and reduce fraud.
A closer look a the interchange tables will show a correlation between the rate and fraud. A digital wallet transaction from a verified wallet will have a lower interchange than and card swipe at a POS terminal.
An online transaction at a merchant offering food delivery will have a lower interchange than a merchant offering gambling services.
By setting the rate, Visa had proven to be the arbiter of the ecosystem and has also benefitted from it, as shown before when the company surpassed JPMorgan's market cap after its IPO.
According to the Government Accountability Office (GAO), to attract issuers to the network, the networks have competed aggressively by adding new interchange categories. The GAO, in their report, found that these activities resulted in these findings:
Federal Reserve estimated that the value of interchange fees paid on Visa and MasterCard credit and debit cards increased substantially, from about $20 billion in 2002 to approximately $35 billion to 45 billion in 2007.
1991, Visa and MasterCard each had 4 standard domestic credit card interchange rate categories. Still, by 2009, Visa had 60, and MasterCard had 243 different rate categories that could be charged to card transactions, although not all of these rates would apply to all merchants.
While consumers benefitted from no-fee credit cards, merchant fees increased, and those costs were distributed to all consumers (those who used cards and those who did not).
Why was Durbin introduced?
Here's how the four-party system in debit works. Durbin would impose caps on the interchange fees that issuers would earn.
The Durbin amendment, implemented by Regulation II, was passed as part of the Dodd-Frank financial reform legislation in 2010. Many articles describe this federal law, and the Wikipedia page I linked is very well cited.
If you want to see the actual document, it is here: Microsoft Word - Final Text of Durbin Amendment (thomsonreuters.com)
In summary, it was how the government transferred billions of debit card revenue from banks to merchants (estimated to cost large banks $14BN annually at the time).
For your convenience, here are the main rules imposed by Durbin.
Interchange cap for banks with total assets above $10BN.
Applies to debit only, with a cap of 0.05% + 21 cents.
All debit cards issued in the United States carry the transactions of (i.e., participate in) at least two different debit networks.
This amendment was possible because it came during the Great Recession, a time of severe economic crisis where the government and consumers were highly motivated to reform banks.
Senator Durbin's (D-IL) thesis was that Durbin would force competition between banks. Big box retailers argued that it would reduce costs for consumers. That this regulation will allow smaller banks to compete with the big banks.
But this is what happened...
Debit rewards cards disappeared.
In 2009, I moved to the San Francisco Bay Area after living on the east coast for five years. As an immigrant, I did not have access to credit cards. The only issuer who would approve me for an account was American Express (probably why I still loyally use them).
As I was looking to optimize my funds, I tracked reward debit cards, which quickly disappeared from the market. As early as 2009, there was a lot of talk about "fraud in debit," which convinced me to use my Amex card more often to avoid losing my money in a fraudulent transaction and having to wait a long time to get it back.
To be honest, debit was doomed anyway because of the narrative around fraud as challenger banks such as PerkStreet failed in their business model despite being Durbin exempt.
Banks found other ways to get revenue.
Since Durbin reduced banks' interchange revenue by as much as 25%, they had to find a different way to recover these lost earnings. They imposed taxes on consumers by increasing fees across the board. Based on the report: The Impact of the Durbin Amendment on Banks, Merchants, and Consumers (upenn.edu), the findings were that:
The share of free basic checking accounts (accounts with a $0 monthly minimum for all customers, regardless of account balance) decreases from 60 percent to 20 percent.
Equivalently, average checking account fees increase from $4.34/month to $7.44/month.
Monthly minimums to avoid these fees increase by around 25 percent, and monthly fees on interest checking accounts also increase by nearly 13 percent.
These higher fees are disproportionately borne by low-income consumers whose account balances do not meet the monthly minimum required to waive these fees.
Consumer costs did not go down.
The UPenn found that some costs did go down immediately following Durbin's passing. Since gas retailers accounted for 15% of the total interchange savings, it was deemed a good place for the researchers to investigate price changes.
In regions of the country where debit usage was high (and there was a competition), the pass-through savings was highest. But outside these areas, there was little to no reduction in consumer costs in the six months following the Durbin amendment going into law.
The research paper found limited evidence for across-the-board consumer gains through significantly lower merchant prices in the gas industry. This merchant behavior was consistent with contemporaneous anecdotal evidence (Electronic Payments Coalition 2011, Wang et al. 2014) and industry reports documenting higher retail margins post-Durbin (Home Depot Earnings Call 2011).
According to research from the Federal Reserve of Richmond in 2015, "The Impact of the Durbin Amendment on Merchants: A Survey Study (richmondfed.org)," the cost savings were not passed down to consumers.
77.2% of merchants cited no price changes
21.6% of merchants increased prices
1.2% of merchants reduced prices
Since small merchants could not negotiate rates (you need to have at least $3BN in annual card sales to get a seat at the negotiating table), the networks would charge them the maximum allowable rates, giving very little room to pass-through savings to consumers.
What's in Durbin v2
Durbin v2 is the CCCA (Credit Card Competitiveness act of 2022).
It is a bipartisan bill from Senators Durbin (D-IL) and Marshall (R-KS) introduced in the Senate on July 28th, 2022, with a majority of 23-3 votes.
The bill would prohibit issuers with an AUM over $100BN from restricting card transactions to
a single credit card network
two or more networks operated by affiliated networks or persons
the two networks with the largest market share of credit cards issued
Additionally, credit card issuers are prohibited from imposing certain limitations on the routing of electronic credit transactions, such as through penalties for failure to meet a specified threshold of transactions on a particular payment card network.
So this would mean that if you purchased something with your Chase Sapphire Visa card, the new regulations would require that the merchant could route the transaction through a different secondary network if it were cheaper.
Even though no interchange cap was introduced in the bill, the idea is that mega-merchants could route card transactions on much cheaper networks causing interchange revenues to reduce.
The board must also provide for the designation of payment card networks that pose a security risk to the United States or are owned, operated, or sponsored by a foreign state.
Feasibility of the CCCA
The threat of the expansion or repeal of Durbin has been happening for many years. Due to strong consumer spending and price index, no administration has been particularly interested in pursuing this topic over other areas such as healthcare and counter-terrorism defense spending.
Implementing the CCCA will be expensive as big and small banks will have to do a lot of work to support multiple networks. In some cases, new networks will have to be formed or spun out in an unaffiliated form, and it can take many years to achieve compliance with the regulation.
All of this will be costly, and consumers will bear it.
The promise of reduced costs.
Right now, in 2022, after the pandemic and the resulting inflation and job numbers, consumer prices are high, and they are feeling the pain.
We've seen this trailer before, and it is clear that the government is most likely to capitalize on these events and build bipartisan momentum, even though it is doubtful, based on data from the last ten years, that costs will go down for consumers.
Given how merchants have been hurting, they will most likely keep any interchange savings from this rule.
Bipartisan Momentum is building.
Earlier this month, the Federal Reserve finalized a rule to expand Durbin. This rule would require online CNP (card not present) transactions to process on at least two unaffiliated networks. This was very unpopular with community banks, where the cost to process these transactions is more than double the interchange fee. Despite that, the RULE was finalized and will be implemented on July 1, 2023.
I'd expect debit cards to be declined by issuers for online payments especially for the smaller community banks that rely on them for their underserved populations.
This shows that momentum is building in congress to pass these sort of rules that are more "anti-bank" than "pro-consumer."
The CCCA is no different.
To speed up the movement of this bill before the mid-term elections in November, this bill has been attached to the NDAA: S.1605 - 117th Congress (2021-2022): National Defense Authorization Act for Fiscal Year 2022 | Congress.gov | Library of Congress.
The NDAA has passed every year since 1961.
The thesis is that interchange is a topic of "national security concern," so veterans and merchants servicing veterans should pay little or no interchange. Additionally, veterans should have options for other card networks in territories where they don't have a choice. For example, they are in a territory where the only network is China Union Pay. Given that a foreign state owns it, it is of national security concern to process that transaction.
This doesn't feel like a stretch - this is, and to me, it feels dubious.
But the fact that there is a lot of momentum for it in congress is reason enough to close attention to it as it goes for discussion on October 11th.
In the short term, consumers will find it harder to get a credit card.
It is most likely that an act of this nature will negatively impact consumers. It has been predicted that rewards cards (just like the debit rewards in 2010) will go away, and annual fees will promptly return.
Since costs will go up for issuers to implement these changes and potential interchange caps (not in the bill yet), there would be less money for investments in reducing the $11BN of fraud or infrastructure deployments, such as the recent move to contactless or NFC payments.
There are at least three Forbes articles this week spreading the doom and gloom of extending the Durbin amendment to include the CCCA and how it will imperil card security and innovation.
The risk is primarily tied to fraud and heightened cybersecurity concerns when transactions are routed over less sophisticated networks with higher operational overhead.
“By splitting transactions over two or more networks, the cardholder’s payment patterns will be obfuscated, making it more difficult for machine-learning algorithms to detect unusual spending patterns and, thus, flag potential fraud,” according to a new report from the International Center for Law & Economics (ICLE). “Second, to the extent that cardholder benefits are tied to a particular network —including, but not limited to, fraud-prevention tools such as card blocks — these may not be available to consumers if the merchant chooses not to route over that network.”
To offset these losses, issuers must increase income requirements and interest rates to issue and underwrite credit post-CCCA.
Therefore, we will find that underserved consumers cannot get credit and will be largely shut out of the market. As quoted in this article: Durbin Amendment ‘purest example’ of failed government policy | 2022-05-03 | CUNA News
CUNA members’ analysis finds extending debit card interchange regulations to credit card transactions will decrease revenue by over 50%, doubling the percentage of credit unions with net-negative margin credit card programs and particularly harming credit unions under $100 million in assets that disproportionately serve poorer and socio-economically disadvantaged populations.
In real terms, 73% of credit unions would have to raise credit card rates, 61% would have to implement or raise credit card program fees, and 15% would have to reduce or eliminate credit card programs altogether.
But it might spur a new wave of innovation in credit.
Durbin was supposed to help credit unions compete better with the big banks. They grew their total assets over time but didn't bring the innovation we needed to lower the barrier for the underserved market and provide them with more access to financial services.
Fueled by the interchange, Cash App and Chime offered innovative products.
What Durbin v1 did was to create companies like Cash App and give regional banks like Sutton a revenue opportunity across the United States that they could never achieve regionally.
Sutton Bank is located in Attica, Ashland, and Mansfield, Ohio. The population of these three cities is 67,594.
If Sutton Bank served every single customer (including kids) in Ohio, they could have 11.7 MM users.
As of September 2022, over 40 MM people use Cash App.
While this is the most prominent program on Sutton via Marqeta, there are 100s of other programs like this.
Noticing the capability of Neobanks in the US and how the winners can grow so fast, the big banks have adjusted their strategy when entering new regions.
Below is Jason Mikula's analysis of the deposits in the UK.
To get ahead of Starling and Monzo so quickly, JPMorgancChase has offered free checking, a straightforward and modern application experience, and 1% cash back on debit, which is unheard of in the UK. They are also offering 1.5% AER on savings.
Therefore Durbin v1, over the longer term, created successful Neobanks that competed directly with the big banks in an environment they couldn't before. And benefits like interchange give this platform that exists in the United States, but not in Europe or the UK.
You just have to look at the signup bonuses for the top 5 credit cards on NerdWallet to realize that the playing field for credit is unfair. No FinTech can raise enough venture capital funds or debt to compete with the big banks just on price. They must do much more concerning partnerships, integrations, and a unique embedded finance experience.
Even a large Tech company like Apple, with their Apple Card cannot match the types of rewards from Chase or Capital One.
I believe that if Durbin v2 were to force big banks to use secondary networks to process transactions or impose a cap on interchange, we would lower the barrister to entry for credit card embedded finance innovators.
The debate continues through Q4 2022.