New moves in regulation of debit card payments

by Viral Shah.

The Reserve Bank of India has stepped in to regulate the pricing for debit card transactions. The rationale behind this regulatory change seems to be that lower transaction processing fees paid by merchants will lead to an increase in the adoption of retail electronic payments overall. Issuing banks will have to give up interchange revenue in the short run, but increased transactions will make up for lower fees in the long run. An unintended consequence could be that transaction processing gets adversely affected, and the current growth rate of retail electronic payments slows down. The RBI circular was released on June 28, 2012, and the industry is expected to comply from July 1, 2012.

Card payments background

Electronic payments are an outcome of the delicate combination of technology and incentives. A card scheme (Mastercard, Visa, etc.) brings four stakeholders together. Issuing banks issue payment cards to their customers, who become cardholders, whereas acquiring banks sign up merchants to accept card payments. The card scheme provides the interconnect between issuing and acquiring banks, so that a merchant can accept a payment from any cardholder. The diagram below shows the relationships between all participants in a payments transaction.




The service fee that merchants pays to the acquiring bank for processing transactions is called the merchant discount rate (MDR). The acquiring bank collects the MDR from the merchant and pays an interchange (I) fee to the issuing bank and a network fee (N) to the card scheme. The interchange is usually enabled by the card scheme, which guarantees revenue for the issuing bank. This incentivises the issuing bank to keep issuing more cards, and to spend on marketing and loyalty programs so that cardholders activate the cards and use card payments frequently. The MDR necessarily has to be higher than the interchange and includes the acquirer's processing fee (A), which is used to operate the card processing infrastructure. It is traditionally market determined, and is a contract between the acquiring bank and the merchant, based on the merchant's volumes, risk, chargebacks, infrastructure needs, etc.
We thus have the equation:

MDR (Merchant Discount Rate) = I (Interchange) + N (Network fee) + A (Acquirer's processing fee)

Debit card transaction volumes are growing much faster than credit card transactions, and if one extrapolates the trend from the RBI electronic payments data, it is expected that debit card transactions will have overtaken credit card transactions by volume.

Different methods of payments

Sr.	Payment Instrument	Cost	Who bears	Who earns	Volume (Million)	Value (Rs. Trillion)	Source
1.	Cheque	Rs.25-40	Bank		1,155	67	RBI 2010-11
2.	Cash (ATM)	Rs.18	Bank		3,500	10	Extrapolated from NPCI 2012 data
3.	ECS	Rs.2.50	Merchant / Biller	Issuing bank	273	2.5	RBI 2010-11
4.	NEFT	Rs.5	Customer	Issuing bank	132	9	RBI 2010-11
5.	Net Banking	Rs.7-10	Merchant / Biller	Issuing bank
6.	Credit cards	Rs.50 (average txn of Rs.3000)	Merchant / Biller	Issuing bank	265	0.75	RBI 2010-11
7.	Debit cards	Rs.25 (average txn of Rs.1500)	Merchant / Biller	Issuing bank	237	0.35	RBI 2010-11

We have a topsy-turvy world, where banks are willing to bear the cost of transactions for cheques and cash, but expect fees when transactions are processed electronically. Given that electronic payments often lead to customers keeping higher balances in their accounts, and savings on cheque processing and cash withdrawal, it would be rational for banks to incentivise electronic payments for customers and merchants alike.

Should credit card and debit card transactions have the same pricing?

Credit cards are really instruments for lending, whereas debit cards are instruments for making payments. The card transaction model evolved first in the case of credit cards, and was subsequently adopted for debit cards. In the case of credit cards, the interchange fee is used by the issuing bank to fund the cost of credit offered to the customer, and the risk of default, between the time of purchase and the time the customer pays the credit card bill. As a result, in case of a debit card transaction, one would expect (I) to be lower due to absence of credit, (A) to be similar since it is already market determined, and hence, (MDR) to be lower.

Large merchants are often able to negotiate a lower (MDR) with acquirers, even lower than (I), implying that (A) is negative. The acquiring bank offers this service to the merchant if the merchant maintains their current account with the acquirer. Clearly, this model is not scalable and does not work for the long tail of small merchants.

Should point-of-sale (POS) and e-commerce pricing be different?

Today, both credit and debit card transactions have the same MDR - roughly 1.6% for POS transactions, and 2% for e-commerce transactions. E-commerce transactions were once considered riskier with higher rates of fraud, and hence justified higher pricing. Now that two factor authentication is mandatory for internet and mobile transactions, there should be no difference in (I) and (A), and hence in (MDR) for POS vs. e-commerce transactions.

Why do regulators step in?

The card business is a two-sided platform, where the card issuing and merchant acquiring incentives are managed by card schemes. Consider the case of a new entrant in the card scheme business. The new entrant may want to lower prices to establish market share. However, if the entrant offers a lower (MDR) to merchants by lowering (I), issuers find the proposition unattractive. If the new entrant offers issuers a higher (I), merchants face a higher (MDR), and will be unwilling to accept the product. (A) is already market-decided and offers little opportunity for differentiated pricing. A new entrant can at best, charge a lower (N). These are the kinds of challenges faced by the Government backed National Payments Corporation of India (NPCI) in launching the domestic card scheme, RuPay. The issue of debit card transaction pricing was first highlighted in the public domain in the Report of the Task Force on Aadhaar-enabled unified payment infrastructure. Due to such high barriers to entry, card schemes are routinely examined by Governments, and regulators have stepped in to regulate debit interchange pricing. Regulators have typically capped (I), but in India, RBI has decided to cap (MDR). This is likely to have interesting consequences that are not easy to predict.

What will happen on July 1, 2012, when the new pricing kicks in?

On July 1, 2012, the MDR cannot exceed 0.75% for transactions up to Rs.2,000, and 1% for other tansactions. If existing contracts remain in place, then issuers are guaranteed to receive (I) (usually 1.1% or higher) and the card scheme is guaranteed to receve (N) (roughly 0.15%). In such a case, (A) becomes negative, and acquirers will lose money on every transaction they process. However, this announcement by RBI is likely to be considered a material adverse change, one expects contracts to be renegotiated. As per the data above, if debit card volumes are Rs.40,000 crore, MDR paid by merchants at 2% is roughly Rs.800 crore. The new regulation effectively means that the merchants are as a group better off by Rs.400 crore on a notional basis on July 1. The acquirers are likely to be inelastic on pricing, which means that it is issuers and card schemes that will have to largely absorb the notional loss - (I) and (N) will have to be reduced in the new regime. Much of this will be absorbed by five large issuers. Over time, as more transactions are processed electronically, banks will save on processing cheques and cash, and instead earn fees from processing electronic transactions.

Will the lower pricing due to regulation lead to higher acceptance of debit cards overall?

It is clear that merchants who were on the margin, are going to be more likely to accept card payments. It is even likely that merchants will now start demanding debit cards from customers instead of credit cards. At the same time, it is also worth noting that cards are largely accepted by merchants in metros and by e-commerce merchants. India has a network of only 600,000 POS devices and 100,000 ATMs, which is grossly inadequate for a country of our size. (A) is now likely to get fixed due to MDR being capped, and the acquiring business could start seeing stable revenues. This is also likely to lead to an interesting opportunity for the low cost merchant acquiring technologies similar to Square, a number of which are getting ready to launch in India. It could also create an opportunity for NPCI to differentiate itself from established competitors. Overall, the best case scenario is an increased demand for electronic payments with debit cards by merchants and consumers, savings for issuers due to reduced cash and cheque usage, greater acquiring revenues, and more banks entering the acquiring business (PSU Banks are notably absent in the acquiring business). At the very least, one hopes that the oil marketing companies will no longer charge a petrol surcharge fee of 2.5% when paying with a debit card.

What are the possible negative consequences of this regulation?

If (A) is set too low by the card schemes, the acquiring business will be affected. With no further bargaining power, acquirers may have to focus on cost cutting and holding back new investments. Issuing is unlikely to be affected much given the existing base of 300 Million debit cards, and that banks will continue to issue debit cards for ATM usage. One does expect cash-back schemes, loyalty programs, and various other cardholder incentives for debit products to effecively stop, and cardholder fees to increase. Even with ATM interoperability and pricing, RBI has continues to refine its policy (making interoperability mandatory at first, then free interoperable transactions, then restricting the number of free interoperable transactions to five, white labelled ATM policy, etc.). Similarly, this is likely to be the beginning and not the last word on the matter from the regulator. The policy should be stabilized quickly, since it is consumers who suffer during the experimentation phase.