Five Takeaways from the Fed’s Latest Announcement on Regulation II
On Wednesday October 25th, the Federal Reserve Board of Governors affirmatively voted to release a proposal that would adjust all three portions of the debit card interchange cap.
In addition to the Fed’s proposal, the Board also voted to release the long-awaited 2021 report on Interchange Fee Revenue, Covered Issuer Costs, and Covered Issuer and Merchant Fraud Losses Related to Debit Card Transactions.
This blog breaks down elements of the Fed’s latest decision and provides an early look into the key takeaways from the Fed’s 2021 report.
Overview of the Fed’s Proposal
The Fed’s vote on Wednesday released a proposal which, if finalized without amendments, would adjust all three elements of the Fed’s current cap on debit card fees, which today applies to debit issuers with over $10 billion in assets. Introduced in 2012, the Fed cap was initially set at $0.21 per transaction, plus 0.05% of the transaction value, plus $0.01 as an adjustment for fraud prevention. The cap, directed by Congress to remain ‘reasonable and proportional’ to underlying issuer costs, has not changed since its implementation in 2011. While the transaction-weighted average issuer authorization, clearing, and settlement (ACS) cost has nearly halved since that time, falling from $0.077 in 2009 to $0.039 in 2021, this year marks the first formal review of the debit interchange cap by the Fed.
Table 1 provides a breakdown of the proposed new cap values. CMSPI estimates merchants would’ve saved $3 billion annually were the new cap introduced in 2021, which comes out to an average reduction of 11bps in the cost of regulated debit.
Table 1. Federal Reserve’s Proposed Debit Cap Components
In addition to the adjustments to the three elements of the cap, the Fed Board proposed codifying in Regulation II an approach for updating the three components of the cap every other year based on the latest data collected from networks and issuers reported by the board. This automatic review would implement a new cap based on the methodologies outlined in Table 1 consistent with data contained in the latest report on Interchange Fee Revenue, Covered Issuer Costs, and Covered Issuer and Merchant Fraud Losses Related to Debit Card Transactions. The automatic review mechanism would potentially kick-in as early as as July 1, 2025, meaning the proposed cap may only be in force for a few months before a second revision of the cap is implemented.
Other Possible Mechanisms for Adjusting the Per-Transaction Fee
While the Fed’s proposal suggests a base element cap of $0.144 per transaction, it also outlines an additional four scenarios under which the base cap could range from as high as $0.18 to as low as $0.11. These ranges are associated with different levels of regulated-issuer cost recovery, with the $0.18 cap associated with 99.5% of covered transactions recouping underlying relevant costs, and an $0.11 cap associated with 95% of covered transactions recouping underlying relevant costs. In Figure 1, we outline the various savings associated with each target for cost recovery.
Figure 1. Estimated Annual Savings and Average Effective Rate Reductions by Cost-Recovery Target(1)
Five key takeaways from the Fed’s 2021 report and proposal to revise the regulated rate
1. Exempt issuance is on the rise
Rising from 33% in 2011 to nearly 40% in 2021, issuance of cards by banks under the asset threshold (and therefore not subject to the fee cap) has seen a steady climb in its share of total debit spending (Figure 2). As of 2021, unregulated issuer interchange as a share of transaction value was 1.18%, a figure which is up six bps since the introduction of the cap and nearly 2.3 times the average regulated issuer interchange. Part of this increase in spending can be explained by the recent boom in partnerships between unregulated issuers and nascent fintechs with card programs. A recent review of fintech relationships with unregulated banks found that only one of 25 fintechs partnered with a regulated debit issuer.(2) This activity has been so rampant that some regulators are beginning to take notice given its potential impacts on the broader banking system.(3)
Figure 2. Share of Debit Spending Split by Regulated and Unregulated Cards
2. Single-message debit spending has declined and remained low on Card Not Present transactions
Across both regulated and unregulated issuers, single-message networks have lost share of overall spending. Single-message networks tend to be associated with PIN and PINless technologies, and, as a result of limited enablement, merchant availability to route via single-message networks has been limited.(4) These limitations are one factor that likely spurred the Fed’s October 2022 clarification of Regulation II which requires two networks to be made available for all types of debit transactions, including online transactions. As a result of the announcement, there’s been a significant shift in the availability of CNP enabled debit networks according to CMSPI estimates, and we anticipate the 2023 report to show meaningful growth in CNP single-message volume.
Looking at CNP volumes in particular, aggregate single-message volumes remain low (Figure 3). In fact, as of 2021, the ratio of dual-message to single-message volumes was 21:1 – meaning that for every dollar spent on single-message networks, there were $21 dollars spent on dual-message networks in a CNP environment.
Figure 3. CNP Single- and Dual-Message Volumes
3. Average CNP merchant fraud losses for dual-message networks have risen significantly
While CNP spending via dual-message networks has risen substantially, so too has the average CNP fraud loss incurred by merchants for dual-message transactions. While the average fraud liability for issuers across all transactions has risen from 4.65bps in 2011 to 5.83bps in 2021, the rise in CNP fraud losses has been disproportionately incurred by merchant and cardholders, according to the Fed’s data.
From 2011-2021, average CNP merchant fraud losses for dual-message transactions more than doubled from 3.3bps to over 8bps (Figure 4). In addition, in this period average CNP cardholder losses on dual-message rose from 0.12bps to over 1bp. In contrast to cardholder and merchant losses, issuer losses on dual-message only rose 75% from 1.3bps to 2.2bps from 2011-2021.
Not only do merchants tend to incur higher average fraud losses online, but they also incur higher average costs for processing online transactions than card-present transactions. This shows how important a balanced approach to optimized debit routing and transaction success strategies are for ecommerce merchants.
Figure 4. Average CNP Fraud Losses by Network Type
4. Exempt single-message interchange continues to remain between 65-70bps as competitive pressure keeps costs down
Despite the limited availability of competitive networks for CNP transactions, the average single-message interchange for exempt transactions has remained between 65-70bps from 2013-2021. Conversely, dual-message interchange has seen a steady climb from 1.38% to over 1.41% in that same period. As single-message transactions are typically routable, there is greater downward pressure on single-message transactions as compared to dual-message transactions, which don’t tend to have the same level of competition on each card. The downward pressure observed on exempt single-message transactions demonstrates the role of optimized debit routing to achieve and maintain below average exempt debit costs.
It’s also worth noting that the differential between single- and dual-message average interchange rates for exempt issuers has remained significant. In 2021, the average single-message exempt interchange was just 0.68%, less than half the 1.40% average interchange of exempt dual-message transactions.
Figure 5. Average Interchange Rate by Issuer and Network Type
5. Merchant incentives are rising along with network fees
In the period 2012-2021, there existed a consistent differential between single- and dual-message pricing on network fees. In 2021, the average network fee for single-message networks sat at just 10bps, and has hovered between 9-10bps throughout the entire period 2012-2021. Conversely, dual-message network fees have risen from 18bps to 20bps as of 2021. In addition, incentives paid by the networks to the merchants tend to be greater for single-message networks than for dual-message networks when measured as a share of the average network fee. For single-message networks, incentives measured an average 26.6% of cost-recoupment of the network fee for the period 2012-2021. For dual-message networks, this figure averaged just 17.5%. For merchants striking incentive deals, these benchmarks indicate that network incentive strategies are more aggressive than ever, and that achieving an above-average incentives requires a market-level, data-driven strategy.
Figure 6. Average Network Fees paid and Incentives received by Merchants, split by Network Type
The Fed’s report indicates that the debit market is more dynamic than ever, but there remain some unanswered questions. How did the Fed’s October clarification impact access to single-message networks online? How has online routing impacted average interchange rates? Will the shift in ATVs continue? The Fed’s answers to these questions may not be clear until the 2023 report. However, before then, the Fed has released a loose schedule of events for implementation of the revised cap.
Upon the Fed’s release of the proposal in the Federal Register, the public has 90 days to comment on the proposal. If the public comments received on the Fed’s Regulation II clarification in October 2022 are any indication, there are thousands of comments anticipated for this upcoming consultation period. After the consultation period, the Fed will consider the comments, and will likely release a final rule in 2024, but there are no official timelines for the release. Following the release of the final rule, the Fed has envisioned a proposed 60-day implementation period, after which issuers with over $10 billion in assets will be expected to comply with the revised rate.
How to Navigate the Changing Debit Landscape
Today is one of the most complex times in recent history when it comes to payments regulations and market activity. Between the Fed’s PINless clarification which took effect in July, the CFPB’s proposed rulemaking on consumer banking and account portability, the FTC’s crackdown on network tokenization routing impacts, and the DOJ’s investigations into the card networks, merchants are navigating one of the most rapidly-moving payments markets to-date. Adding in market trends, such as the breakneck pace of BIN issuance changes this year, it’s more important than ever for merchants to have data-driven insights about their own data to inform robust strategies that optimize for the present and strategize for the future.