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  1. Analysis
July 12, 2011

Fed forges the way ahead

The Feds latest meeting has resulted in an interim final rule on interchange fees in the US. Finding it impossible to please everyone, the result is a "lighter touch" rule. But it is not enough for the retail sector, writes Louise Naughton.

By Verdict Staff

The Fed’s latest meeting has resulted in an interim final rule on interchange fees in the US. Finding it impossible to please everyone, the result is a “lighter touch” rule. But it is not enough for the retail sector, writes Louise Naughton.


Box showing US interchange feesThe atmosphere was tense as the Federal Reserve Board met with the aim of finding a way forward on interchange.

Amid mounting pressure from opponents to debit reform (and despite missing its 21 April deadline), the Fed has managed to issue a final rule establishing standards for debit card interchange fees. Not only that, it has also set out standards for network exclusivity arrangements and routing restrictions. These standards, Regulation II (Debit Card Interchange Fees and Routing), sits under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Under the final rule, the maximum permissible interchange fee that an issuer can charge for a debit transaction is $0.21 and 5 basis points multiplied by the value of the transaction. The cap is three times the amount first proposed, but still a huge drop from the current 44 cent average. The provision will become effective from the 1 October 2011.

An interim final rule that allows for an upward adjustment of no more than $0.01 to an issuer’s debit card interchange fee has also been approved, on the condition that the issuer “develops and implements policies and procedures reasonably designed to achieve fraud-prevention standards as set out by the Fed”.

An issuer eligible for the fraud prevention adjustment could receive an interchange fee of up to approximately $0.24 for the average debit card transaction – valued at $38.

Comments on the interim final rule are due by 30 September and the Board has expressed its commitment to re-evaluate the adjustment in light of feedback received.

The Fed’s final ruling also prohibits all issuers and networks from restricting the number of networks over which electronic debit transactions may be processed to less than two unaffiliated networks. This ruling will come into effect for card issuers on 1 April 2012 and payment card networks on 1 October 2011. Issuers of certain health-related and other benefit cards and general-use prepaid cards have a delayed effective date of 1 April 2013, or later in certain circumstances.

Issuers and networks are also prohibited from inhibiting a merchant’s ability to direct the routing of a debit transaction over any network that the issuer has enabled to process them.


Could be worse

Issuers that, together with their affiliates, have assets of less than $10bn are exempt from the debit card interchange fee standards. In order to assist payment card networks to separate those banks that are covered and exempt, the Fed plans to publish by mid-July, and annually thereafter, lists of institutions that are above and below the small issuer exemption asset threshold.

The Fed’s final ruling, voted in four to one, is nowhere near as catastrophic for the payments industry as was first envisaged.

“Congress has directed the Board to accomplish a very difficult task,” Fed chairman Ben Bernanke said at the 29 June meeting. “I believe the final rule gives careful consideration to the statutory language, the cost data available to us and the complexities of the debit interchange payment system.”

In December 2010, the Fed proposed it would cut fees merchants pay to accept debit card payments by an average of 73%, to a range of $0.07 to £0.12 per transaction. Despite the significant, and to some unexpected, jump to cap interchange at $0.21, many anticipated this is exactly where the cap would be pitched and believed it was the Fed’s meeting in December that was anomalous, being as it was more legislative and narrow than June’s ruling.

David S Evans, founder of management consultancy firm Market Platform Dynamics, says the Fed was much more confident in its December meeting and this was evident to all in its final outcome.

“The Fed’s final ruling was a more complete and thoughtful take on proceedings,” agrees Tom Durkin, former senior economist on the Federal Reserve Board. “It is unusual for the Fed to move so far from its original proposal. The ambiguity in the interchange discussion coupled with the benefit of feedback from the payments industry and merchants may go some way to explaining this u-turn.”

The Fed heard what the impact of the debit-interchange reform would mean for smaller banks and consumers in the US alike “loud and clear”, and the final ruling shows the organisation understands the responsibility it has to minimise such an impact on these groups, says Tom Brown, a partner at US law firm O’Melveny & Myers and a member of the Financial Services Practice.

It is argued that the case put forward by small banks in the US forced the Fed into considering a “lighter touch”.

First Data is in the process of reviewing and analysing the Fed’s final ruling, yet it claims it has already made the necessary changes to comply with the new regulations.

“Over the last year we have invested in new programmes and technology on behalf of our financial institutions and merchant customers in the US to comply with the changes resulting from the [Durbin Amendment] regulations,” says Ed Labry, president of First Data North America.

“These include reinvesting in the STAR Network; routing programmes to negotiate effectively with other payment networks; and near-field communications (NFC) technology for use at the point-of-sale for the future of payments acceptance.”

The final ruling of the Durbin Amendment seems to have appeased even its fiercest of opponents, at least for the time being.


Last chance denied

TCF National Bank announced its intention to file a lawsuit challenging the Durbin Amendment in November 2010, claiming it to be an “unconstitutional infringement of its right to recoup the costs of providing debit services”.

However, the Eighth Circuit Court of Appeals ruled to deny TCF’s motion for a preliminary injunction against the implementation of the Durbin Amendment on the very same day of the Fed’s final ruling. This was made on the grounds that TCF had not shown the rules were dictating a maximum price for a good or service set below the cost of production, the heart of what is known as a confiscatory-rate claim.

This rejection effectively killed off the banking industry’s last chance to prevent the regulations from going into effect.

In light of the ruling TCF decided to request the US District Court in South Dakota dismisses its case without prejudice, believing it time to “move on”.

“While we continue to believe that the Durbin Amendment is unconstitutional because it requires below-cost pricing and exempts 99% of all US banks, we believe our lawsuit has served its purpose in demonstrating the unfairness of the Durbin Amendment and that it is time for us to move on,” said William A Cooper, chairman and CEO of TCF.

“The Federal Reserve Board’s final rule is an improvement from its initial proposal and recognises many of the points we made in our case.”

Merchants are clearly unhappy about the Fed’s decision to up the interchange cap from initial proposals, says O’Melveny & Myers’ Brown. He argues it will be easy for the merchant community to file a case against the Fed on the grounds that the correct administration procedures were not followed.

“No matter what the Fed did, a lawsuit would have followed,” says Brown. “Merchants are now the most likely plaintiff.”


Retailers still want more

The National Retail Federation (NRF) was immediate in its response to the Fed’s final ruling. It expressed “serious disappointment” and called the decision a major loss for American consumers.

“We are extremely disappointed that the Fed chose to be influenced by special interests and ignored the will of Congress and American consumers. While the rate will provide modest relief, it does not go far enough,” says Matthew Shay, NRF’s president and CEO.

“While we are disappointed that the Fed did not follow through to the full extent of the swipe fee reform, we take some comfort in knowing we were able to shine a light on these deceptive practices and bring some relief to merchants and their customers. Even though this rule is specific to debit cards, we are hopeful that it leads to more transparency and relief from credit card swipe fees as well.”

While the new regulations are seen to be a step forward, the NRF claims debit card transactions should be honoured at, or close to, face value as debit cards function as plastic cheques which draw from the same bank account.

According to the NRF, debit and credit card transaction fees together amount to about $50bn a year and drive up prices by an estimated $427 a year for the average household. Under the new rules, it is anticipated retailers will now be able to offer modest discounts to customers who pay with debit cards.

“The Fed very clearly did not follow through on the intent of the law,” says Mallory Duncan, NRF’s SVP and general counsel.

“This rule is unacceptable to Main Street merchants and consumers who were counting on the Fed to issue a reasonable and proportional rule. Unfortunately, this rule does not meet those qualifications.”


Some happy customers

Not everyone is feeling quite so down and out, however. Shares of eBay jumped 4.4% to $32.22 in the wake of the Fed’s final debit-interchange ruling, which is expected to benefit its wholly owned alternative payment service PayPal.

“The effect on the online retail community will be somewhat mitigated by the Fed’s decision to exclude alternative payment providers, such as PayPal, from the new rules,” says PayPal in a statement.

“For this reason, we do not believe PayPal’s broader payment service will be subject to the cap on debit card interchange fees.”

Scott Thompson, president of PayPal, revealed on 29 June that PayPal now has more than 100m active accounts. In light of this announcement, Thompson has boldly predicted digital currency will be accepted everywhere by 2015, which will effectively kill off the physical wallet.

The Fed’s final debit-interchange rule was bound to upset both the banking and the merchant industries. It has been holding off in its decision in a bid to create a ‘workable’ solution for both parties, but it is arguably beyond the remit of the Fed to bring together two such opposing, and sometimes warring, industries on the topic of the price of payments.

In comparison to the Fed’s original proposal, the $0.21 interchange cap could be seen to be more banking friendly, but retailers would do well to look at the bigger picture and realise the victory that has been won by halving the current fee average.

For now though, merchants feel let down by the Fed and will not take this ruling lying down. The US debit-interchange war is far from over.

Table showing Visa PIN-debit interchange fees

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