You may recall in an earlier article, we noted that the Federal Reserve began seeking comments on proposed changes to Regulation II of the Durbin Amendment in May. At that time, the Fed said that it felt the changes would be non-substantial and would not include more compliance obligations.
Currently, the Fed bars issuers from restricting the number of unaffiliated networks for debit card transactions to fewer than two, including one signature network and one PIN network. The new proposal would make issuers responsible for ensuring that all transactions with U.S. merchants can be routed across two unaffiliated networks.
SRM took some time to sort through the comments posted on the Fed’s website and various government sites to summarize the key points – not just from financial institutions but also merchants so we could evaluate both sides of the conversation.
It was clear that issuers and merchants were concerned about the various financial and operational implications of any changes to Reg II.
Here are the highlights:
Issuer Concerns
Issuer Compliance: One of the most significant areas of concern is how the proposal would significantly change the compliance obligation by replacing the word “enable” with “ensuring.” This means that issuers must ensure their unaffiliated networks can support all transaction types across all U.S. merchants, but there is still uncertainty around how far this goes. What if a merchant does not accept the alternative network? What if a merchant intentionally limits the routing options of its transactions due to valid business purposes? What if a mobile wallet only has one routing option? Issuers and networks clearly stated the compliance burden of this is significant and not feasible from an operations perspective. Visa warned that issuers could be held accountable for the actions of third parties such as merchants, merchant acquirers, merchant processors, and networks.
Unintended Consequences: Associations and networks noted that, while there are PIN solutions merchants could use in the card-not-present (CNP) environment, merchants have mostly chosen not to adopt them for economic reasons. Instead, they’re seeking support for riskier PIN-less transactions. There is uncertainty about whether issuers will be forced to accept certain transaction types to be compliant, such as high dollar amount transactions from less dependable merchants. Issuers selectively evaluate such transactions per their risk tolerances.
Innovation Impacts: The Fed recommended definitional changes, including exchanging the words “means of access” for “form factor,” but it provided no definition. It is unclear if new forms of authentication and innovation could fall under the “means of access” definition and would be blocked unless two networks could support the service. This could put a significant damper on industry innovation and reduce competition.
Smaller Issuer Exception/Fintech: The Clearing House Association and others expressed concern that larger fintechs have leveraged unregulated issuers in a way that has created an unfair interchange advantage. They are advocating for closing this loophole.
Diverted Resources: There are concerns that these clarifications would impact smaller issuers, specifically regarding financials, fraud, and back-office challenges. These issues would divert resources from other projects and enhancements, thus negatively impacting consumers.
Timing Concerns: Issuers, especially smaller financial institutions, said they would need time to enable changes, citing technology contingencies and back-office challenges. Some issuers want at least three to four years to comply.
Merchant Concerns
Change Needed: When Durbin was enacted, CNP transactions made up less than 10% of all transactions (though exponential growth had occurred and was projected to increase). Now that CNP transactions are 20% of the mix, merchants believe they only have one network available due to issuer configurations. Merchants argue that clarifications should be implemented before the holiday season of 2021.
Routing/Share Incentives: The Federal Trade Commission said financial incentives from networks like Visa and Mastercard created a pattern of issuer behavior that includes turning off competitive features like PIN-less. The FTC wants those incentives to be disallowed. As such arrangements often take the form of quantity discounts, it would be difficult to argue that networks should be prohibited from engaging in such financial arrangements.
Means of Access/Authentication: Merchants raised concerns that networks could use authentication methods to limit access. They asked that issuers be barred from turning off authentication methods for the alternative network if the primary network has them turned on, and the merchant wants to accept them, even if the unaffiliated network lacks the controls, sophistication, or capabilities of the primary network.
Regulated Interchange: While they believe issuers costs have gone down by nearly 50%, merchants noted that interchange stayed the same. While the Fed’s data refutes the latter claim, the merchant community encourages the Fed to review regulated interchange.
What to Expect Next?
This continues to be a top priority for issuers and merchants. We noted that the Federal Trade Commission and Justice Department weighed in on behalf of merchants and in support of the Fed’s recommendations. While the Fed has not said when it plans to act, the consensus is that the industry will hear something by mid-2022.
Reg II’s clarification outcome could have significant impacts for financial institutions with very troubling elements. With all the comments and the stated intent of not increasing issuers’ compliance obligations, we hope the outcome could be less problematic with more clarifications.
Many believe, at a minimum, the Fed is likely to bar issuers from opting out of PIN-less or CNP transactions with their unaffiliated networks. That said, issuers should actively engage their government relations areas and prioritize this issue at the local and national levels while working with their associations. Be sure to monitor this closely and highlight this item during strategic planning for the year ahead. And take inventory of existing relationships and evaluate this potential change’s technological, operational, and financial implications for your institution.
Keith Ash, Senior Vice President at SRM, has 25 years of payments expertise across issuer, network, and process roles. Keith can be reached via email at kash@srmcorp.com.
