U.S. shoppers made 72.7 billion non-prepaid debit card transactions in 2018, solidifying debit as a staple payment type.
Consumers only see a small part of what is involved in using this method, however. They insert or swipe their debit cards at stores’ point-of-sale (POS) devices — or key in details online — and maybe enter PINs, but the behind-the-scenes processes through which transactions are routed are kept invisible.
Network providers are very aware of those procedures, though, and have been actively seeking to claim larger shares of both the payment routing market and resultant revenues through associated fees. Merchants pay payment processing fees and banks pay for permission to issue cards stamped with providers’ brands, but the network over which payments are ultimately sent lies with individual merchants.
This is thanks to a 2010 federal law known as the Durbin Amendment, which requires that merchants be able to select from at least two unaffiliated networks through which they can route their transactions. It also allows them to choose how to direct customers to authenticate payments, such as with or without PINs.
This month’s Deep Dive delves into merchants’ debit routing choices and the factors that can sway them to select one network over another.
The Durbin Amendment
The debit card scene has evolved over the last three decades as consumer and business interest in increased and new policies gave merchants greater agency. Debit cards secured with PINs came into wide use in the 1990s, and regional card networks often processed such payments at the time.
Major worldwide credit card networks turned their attention to the debit market in the 2000s, however, and acquired PIN networks to gain footholds in the growing space. These larger operators sometimes made deals with card issuers, under which the latter would agree to only route payments over the former’s networks.
Global operators’ growing dominance over smaller competitors thus sparked concerns that the bigger networks’ exclusivity deals were quashing competition, sparking the need for protective legislation.
Such concerns drove the federal government to pass the Durbin Amendment as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, but this was not the first attempt to improve the debit card situation. Merchants had previously come together to file lawsuits, alleging major banks and card networks were acting as monopolies to maintain high charges for debit transactions. The amendment aimed to ease this strain by protecting merchants and consumers from paying high fees to banks and payment card networks.
Card networks told the banks with which they worked how high to set processing fees prior to the amendment, meaning the resulting fees could be sizable. Mastercard and Visa handled more than 80 percent of debit transactions in 2009 — the year before the amendment passed. Issuers took in $16 billion worth of interchange fees on 37.9 billion debit purchases that year, for example, and merchants paid $0.44 on average for each debit card payment they accepted, incurring costs of 1.2 percent of transactions’ values, on average.
The Durbin Amendment included a provision that allowed the Federal Reserve Board to restrict interchange fees to amounts deemed “reasonable and proportional” to issuers’ debit payment facilitation costs. This then prompted the Federal Reserve to decide in 2011 to restrict interchange fees on PIN debit cards to no more than $0.21 plus “5 basis points” of the payment’s value, dropping those fees by an average of 52 percent. The amendment also mandated that merchants be able to choose between two non-associated networks for routing payments — a measure supporting competition among networks.
The impact on consumers’ wallets has been limited because many financial institutions (FIs) increased charges for other banking services to offset fee revenue losses. The Durbin Amendment does have continued effects, however, such as requiring that merchants be offered debit transaction routing options.
PIN vs. PINless Processing
Merchants face key decisions when selecting how to route their payments, including whether to use PIN or PINless transactions. Each method uses different authentication measures and involves different risks and costs.
PIN debit transactions undergo several steps before they can be completed. Customers must authorize their transactions by entering the four-digit PINs associated with the cards, ensuring thieves cannot use stolen cards. POS systems that accept PIN-authenticated payments transmit card details to debit network operators that then assess transactions’ associated fraud risks. Operators send information about legitimate-appearing payments to cards’ issuing FIs, which confirm payers have enough funds to cover purchases and card details do not correspond to ones known to be lost or stolen. Consumers’ funds are then sent to PIN debit network operators, which extract interchange fees and pass the rest to merchants’ banks. The card network and issuers both take cuts after the funds arrive in merchants’ accounts.
Customers can easily type PINs into stores’ physical keypads, but this process does not translate smoothly to eCommerce checkouts. Online sellers could instead rely on 3D Secure 2.0 anti-fraud technology to verify purchases, with one-time PINs texted to customers who supply these codes during the checkout process to prove their legitimacy. This extra security step can be applied in such a way that it is only triggered if the transaction appears abnormal, and major credit card brands and merchants use it to protect themselves from liability. Responsibility for handling such chargebacks would instead fall to card issuers, should cardholders claim the purchases were fraudulent and demand repayment.
Not all merchants opt for 3D Secure, however, because of potential frictions. Some are concerned that consumers might be unwilling to wait for and enter codes, instead choosing to abandon their purchases. These merchants might want to consider PINless transactions, with purchases routed over electronic funds transfer (EFT) or card networks. The network then transmits the information to the issuing banks to initiate fund transfers from cardholders’ accounts and into merchants’.
Consumers making PINless transactions may be authenticated by providing their card verification value (CVV) codes, which are listed on their debit cards, as well as zip codes or other address-related details. These are then compared to the recorded addresses associated with their accounts. Many networks consider this to be less secure than requiring PINs, however.
Card networks therefore only permit PINless debit acceptance from merchants in sectors that are generally considered low risk and accept recurring payments from the same consumers — another factor than can reduce fraud. Each network’s definition of safe industries varies, but some examples might include utilities and mortgage companies.
PINless debit can also save businesses money as there are currently no policies allowing customers to file chargebacks on such purchases. This enables merchants of all sizes to better safeguard their budgets with irreversible payments. Networks charged lower transaction processing fees than major credit card companies in the pre-Durbin Amendment days, making PINless debit a major cost-saver, but the amendment restricted how much could be charged in processing fees, putting the two fee levels more in line — although PINless can still be slightly more affordable. Businesses can often save some money on each transaction, which adds up for those with slim profit margins that handle large quantities of payments.
Companies have many factors to consider when deciding how to route transactions, including security, convenient customer experiences and pricing. Merchants now call the shots in debit routing, though, meaning networks seeking to maintain strong footholds in the market must address these issues to win them over.