A couple of weeks ago, I organized a conference in Washington, D.C. on the Durbin mess. Experts on payments from around the country gathered and had a long, lively conversation on the impact of Durbin so far but, most importantly, on what the heck is going to happen following Judge Leon’s thrashing of the Fed. Speakers included representatives from the retailers, networks, banks, entrepreneurs, venture capitalists, lawyers and a few economists like me.
I don’t think anyone on any side could describe it as anything other than a mess. The Fed is in a heap of trouble because Judge Leon told them they had screwed up massively and threw the Fed’s almost year-long rulemaking effort out the window. The banks are staring at another massive revenue hit from drastically lower interchange fees on debit transactions. The networks and just about everyone else is scratching their heads over what on Earth a world with four signature and PIN bugs on a debit card means and how to get there. Retailers—who you would think are sitting pretty—are facing potentially years of uncertainty over how much they are going to pay to accept debit cards. And entrepreneurs and venture capitalists who are looking a decoupled debit and other ACH-based alternatives don’t know whether they will be facing competition from debit cards priced at 24 cents, or a hair more than bubkus, a transaction.
I thought you might be interested in getting the collective wisdom, processed through me, of what the folks at the conference think the future may hold. Some caveats here: I’m ignoring some extreme positions that I don’t think are plausible. Generally anyone who said anything was certain I threw out. I’m also not endorsing any of the opinions here. But, hey, if you’re doing anything in the payments business, the outcome of the debit card litigation between the retailers and the Feds has absolutely massive consequences for your business decisions. So, better pay a lot of attention here.
Let me begin by introducing a term coined at the conference by one of the attendees- “The Full Leon.” If the originator of this would like to claim please do so!)
“The Full Leon” is what would happen if Judge Leon’s opinion gets affirmed in its entirety. That means the Fed has to go back to the drawing board on rate caps, but must hew closely to the language of the Durbin Amendment and include only the marginal costs of the debit transactions. That’s just for non-exempt banks. The Full Leon also means that the Fed must require issuers to include two bugs each for independent signature and PIN networks. That’s for exempt and non-exempt banks.
So, what are the odds of the Full Leon? Well to get the Full Leon a three-judge panel of D.C. Circuit Court of Appeals has to agree with all of Judge Leon’s decision. Then, the Fed—actually the Solicitor General—would likely appeal that decision to the U.S. Supreme Court. To get the Full Leon, the Supremes would have to decide not to take the case thereby letting the decision stand or, alternatively, hear the case and affirm Judge Leon’s decision.
The experts I’ve heard suggest that it’s probably not a slam dunk for either the retailers or the Feds. If you had to handicap this one, probably 50-50 wouldn’t be a bad start. Some wags suggest that the interchange fee cap part of Judge Leon’s decision has better odds of being affirmed than the routing part.
A Full Leon is, of course, a massive win for the retailers. And, man oh man, will it result in a world of hurt for the banks and networks.
Let’s start with the interchange fee caps. With a Full Leon the experts would say that it’s pretty much guaranteed that the debit caps will go down to at least the 7-to-12 cent range that the Fed initially proposed in December 2010. But, there’s a possibility, the experts say, it could go down even more. The problem is that the average incremental cost per transaction according to the Fed’s survey was about 4 cents. To get higher than that the Fed had to go to the median (7 cents) or the average incremental cost at which 80 percent of banks had lower costs (12 cents). Large banks likely had incremental costs much lower than 4 cents. The Fed may not have a lot of discretion on what it does. Judge Leon, once affirmed, could impose his interpretation on Durbin.
If I were doing scenario planning for a bank I would probably take 4 cents as the worst case, 7 cents as the most likely case and 12 cents as the best-case scenario. At 4 cents banks could kiss 83 percent of their debit interchange revenue goodbye.
If debit cards got to 4-to-7 cent interchange fees, my guess is that would have a lot of knock-on effects for other payment methods. Here I’m not going to handicap it. Retailers are going to flock to debit cards if they cost about one-tenth of credit cards on average (and of even a smaller fraction for higher value transactions), and banks are going to have a lot of incentives to flee debit cards for credit cards.
With that sort of wedge, something’s gotta give. And of course at those interchange fee rates it’s hard to see what the advantage of decoupled debit is.
Then, there’s the routing requirement. Now, the experts seemed to agree that the Full Leon 2 x 2 routing requirements aren’t impossible. Although there was some disagreement, several experts thought this required a massive retooling of the payments infrastructure with a lot of the heavy lifting done by the acquirers working with the retailers and networks. And this would take about a year or more to actually put into place.
I don’t think anyone has really gotten their heads wrapped around what this means. At first blush, this looks like it could whack exempt banks. With this much choice for merchants—and of course this was the whole point—it puts a lot of pressure on networks to lower interchange fees for exempt banks. Merchants are going to be making routing decisions based on the average cost of the brand. With exempt banks counting for about a third of debit-card transactions, the easiest way to get fees down is to ratchet the exempt bank fees down.
So when is all this going to get resolved? There was actually a fair amount of agreement on that. Short answer for the time-challenged: NOT ANYTIME SOON. Here are the scenarios.
Scenario 1. The D.C. Circuit overturns Judge Leon and upholds the Fed. This is the No Leon result. Chances are the Supreme Court won’t be interested if the retailers ask for a rehearing. Case done. Getting a decision from the DC Circuit and then a decision by the Supreme Court not to take the case could take perhaps a year or possibly more after the case is heard in January 2014. So, figure late 2014, early 2015. But maybe sooner, maybe later.
Scenario 2. The D.C. Circuit affirms Judge Leon, in whole or in part. Chances are the Supreme Court will be interested in a case brought by the Solicitor General of the United States that involves a challenge to the power of the Fed. Here’s where the timing gets interesting and almost unknowable. So, the Supremes take that in 2015, hear the case in 2015-2016 and reach a decision at the end their 2015-2016 term. If they reject Judge Leon in whole, then we’re done probably by the summer of 2016. If they affirm Judge Leon then it goes back to Leon for directions to the Fed and then to Fed which probably has to do another rule making. So, maybe we’re done in 2017. Or, they reverse Judge Leon and give him directions for how to try the case. He then has to try the case. Geez, what happens after that is unpredictable.
Unfortunately, a lot of the timing is unpredictable. In fact, one of the experts wouldn’t even guarantee that the end of all this would happen by 2020. You might think that’s crazy but the American legal system doesn’t operate on Internet time. Seven years isn’t impossible for complicated cases.
Now, cutting to the chase, what this means is that the Full Leon probably couldn’t happen until 2017 at the earliest and maybe more like next decade. That means that the payments industry is going to be facing considerable uncertainty over the debit card business for four, or perhaps many more, years. That has a lot of implications.
Some of the questions raised at the conference were: (1) Will retailers really invest in EMV without knowing how all the routing stuff is going to sort itself out? (2) Should VCs and entrepreneurs, invest in low-cost payment methods, like decoupled debit-based products, when the business case for these products might have the rug pulled out from under them in a few years. (3) Should banks and networks invest anymore in debit? And that’s just the start.
So, the decade started with a bang for the debit card business—the Durbin Amendment in July 2010. It sounds like it could end with either a bang or a whimper. In the meantime, there’s definitely going to be a whole lot of shakin’ going on.
David S. Evans
David S. Evans, is the Chairman of the Global Economics Group in the firm’s Boston office, and has broad experience in the economics of antitrust, intellectual property, and financial regulation. Dr. Evans has an international practice and has worked on matters in the United States, the European Union, China, Brazil, Australia, and other jurisdictions. He has provided economic advice on a wide range of industries but has special expertise in financial services, internet-based, media, and information-technology based businesses. He is one of the world’s leading authorities on platform-based (“two-sided market”) businesses.
Dr. Evans currently teaches economics and antitrust at the University of Chicago Law School where he is a Lecturer and at the University College London where he is a Visiting Professor. He is the Founder and Publisher of Competition Policy International and is on the editorial boards of Concurrences and The Review of Network Economics. He has authored or edited 8 books and more than 100 articles and book chapters.
Dr. Evans was a Managing Director of LECG (2004-2011) where he was the head of its global antitrust practice and Vice Chairman of LECG Europe. Previously he was Senior Vice President at NERA (1989-2004) where he was also a member of the management committee and board of directors. He received his Ph.D. in Economics from the University of Chicago in 1983 and subsequently taught at the Department of Economics and the Law School at Fordham University in New York.