Startups Are Losers In Durbin Rejection

Welcome to PYMNTS.com’s VC Voices: a weekly column where we bring you commentary from the best of the best around the world of payments investment. Want to know what the biggest backers of our industry’s innovators and disrupters think? We give our VCs 500 words of unedited space to do with as they please, so you’ve come to the right place.

This week, we’re joined by Matt Witheiler, principal at Flybridge Capital Partners, who gives us his take on the court’s Durbin Amendment rejection and what it could mean for startups.

By Matt Witheiler, Principal, Flybridge Capital Partners

The payments world was abuzz this week when District Court Judge Richard Leon threw out the admittedly arbitrary $0.21 interchange fee cap set by the Federal Reserve in response to the 2011 Durbin Amendment. (For the record, he’s someone I’d like to meet given the humor he was able to weave into his opinion).

Finding that the cap included costs not intended by Congress to be covered by interchange, Judge Leon sent the Fed back to the drawing board with the intention to set fees even lower. It was a hard-fought battle two years in the making with obvious winners (every major retailer in the United States) and losers (banks and network operators) on both sides. But, there may be another, less obvious loser: startups.

The past five or so years have seen a number of startups enter the payments field. Models vary from frictionless checkout (Starbucks / mFoundry) to loyalty (LevelUp), but most are faced with the same challenge: finding a way to get merchants on board. After all, what good is an alternative payment mechanism in the hands of consumers if there are no venues in which to use it?

To overcome this chicken-and-egg problem, some players in the space attempted to build mass by clinging to a pain point common to all merchants: interchange. In an effort to increase merchant adoption, a number of these payment startups promised little to no interchange fees in return for using a particular payment mechanism. 

The merchant pitch was pretty simple: pay less than ~3 percent for credit card transactions and ~1.5 percent for debit card transactions without the startup, or pay nothing for transactions with the startup. 

Startups were OK eating this cost themselves with the assumption that what they lost from paying for interchange would be made up by monetizing other parts of a transaction (marketing to consumers, charging for loyalty products, etc). Merchants were excited to sign up with the hope that the fees they paid to networks would go to zero. Thus, the “interchange zero” model was born.

The model took its first hit back when the Fed initially set debit interchange to $0.21. This first drop represented a more than 50 percent price cut from what merchants previously paid on debit interchange ($0.44 on average). 

With Judge Leon’s ruling, the fees are set to plummet precipitously again (the latest thinking is ~$0.12). How does this impact startups who promise lower interchange rates to merchants? 

In theory, it should remove some of the merchant pain around interchange and make the value position of lower interchange weaker, decreasing merchant adoption of alternatives. The real impact to this end is unclear since debit only represents a portion of a merchant’s transactions, but at the very least, it has the potential to lessen the impetus to move to “interchange zero” startup alternatives.