Are Merchant-Controlled Debit Networks the Next Big Thing?

In Germany, half of all debit transactions are processed via a merchant-controlled debit scheme. Could such a scenario unfold in the U.S.?

Debit cards have become the fastest-growing consumer payment method worldwide. But in countries like the U.S. -- where interchange fees are relatively high and where recent litigation has not really changed the rules of the game -- merchants are likely to pay greater attention to the prospects of a merchant-controlled debit network. For years, merchants in Germany have run their own debit card infrastructure by piggybacking on the low-cost Automated Clearinghouse (ACH) network, which does not carry interchange fees. Fifty percent of all debit transactions in Germany are handled by such a scheme. Although U.S. merchants are far from achieving what their German counterparts have, it is not outrageous to contemplate their catching up in this area.

In the U.S. today, some retailers and independent companies are actively trying to leverage the ACH network to offer a low-cost debit card infrastructure to the merchants with fees below those of the already low-cost regional EFT networks. Since the rising competition between the EFT networks and Visa and MasterCard's rival PIN debit networks is likely to keep pushing the interchange rates up in the coming years, it is reasonable to expect merchants' appetite to control their debit destiny to grow.

Debitman Card Inc., a privately held company headquartered in Chico, Calif., is spearheading the most visible effort to develop such a merchant-controlled debit network in the U.S. Launched in 2001 as an alternative to bank-owned debit card networks, Debitman is a national debit card POS network that allows merchants to become issuers of PIN debit cards. The network relies on a partnership with merchant processors (e.g., Fifth Third Bank) to debit cardholders' checking accounts using the ACH network.

With Debitman, merchants can choose to become either issuers/acquirers or solely acquirers. To become an acquirer, merchants do not have to install any software or hardware -- they simply have to ask their processor to connect to Debitman. To become issuers, merchants need to install proprietary hardware and software in their stores to issue the cards or deliver cards by mail. Not surprisingly, the value proposition for merchants differs depending on whether they are just acquirers or both issuers and acquirers. As acquirers, they save on card acceptance costs when their customers use a Debitman card at their POS. As issuers, they may not only save on payment costs when the card is used at their store, but they may also earn interchange fees when the card is used at other merchants.

To avoid putting another card into consumers' wallets -- and to motivate consumers to use the card and merchants to promote it -- Debitman is piggybacking on the millions of loyalty cards already issued by retailers. When they become issuers with Debitman, merchants are encouraged to embed the payment function into existing loyalty cards, thereby allowing consumers to start paying with their reward cards. Merchants may also pass the acceptance cost savings onto the customer in the form of additional rewards (e.g., free cash back), thus encouraging greater use. To issue cards, merchants need to either mail a card or use a card-issuing station on their premises. Debitman has developed proprietary software to be loaded into the card-issuing station. Once this is set up, the merchant can immediately place cards in customers' hands by requesting an ID and Social Security number. Debitman authorizes the card issuance by checking the information provided by the customer against a proprietary database. If necessary, Debitman can also tap into third-party databases, including eFunds' SCAN and First Data Corps' PPS. The only capital investment required by the retailer is the card issuing station, which ranges in cost from U.S.$600 - U.S.$1,700.

The card has a PIN but does not have the cardholder name printed on it; the card can be used only with a PIN number. In case of fraud, Debitman is liable for the loss. The merchant is liable for losses in on-us transactions only.

Debitman has already signed up several merchants on the acquiring side, totaling 25,000 locations. Acquirer merchants include Burger King, McDonald's, KFC, Wendy's, Taco Bell, Best Buy, Bed Bath & Beyond and Shell. The merchants that have joined as both issuers and acquirers include Duane Reade, Walgreens and Holiday Quality Foods.

The key challenges Debitman faces include:

Issuing process. To issue cards on the spot, merchants have to train employees, market the card to consumers, and dedicate some floor-space to the card-issuing station. Although a drugstore (e.g., Duane Reade) may place the machine in the photo station, many merchants have neither the room nor the employees needed to operate it (e.g., quick service restaurants, or QSRs). Such operational hurdles may impede merchants' ability to join as issuers.

Pricing. Debitman's value proposition is strongest when merchants are issuers. When merchants are solely acquirers, the benefits are much less attractive. In fact, Debitman interchange fees are in a number of instances higher than those charged by big rival networks like Star Systems, as well as smaller ones, like PULSE or Shazam. The Debitman interchange fee is comparatively high in the critical segment of QSRs, for instance.

No subsidization. Debitman refuses to have smaller merchants subsidize large ones, a rule of business that prevails with other networks. Although small merchants will appreciate it, the reality is that Debit-man is unlikely to be of immediate appeal to large merchants (e.g., Wal-Mart), which enjoy bottom rates from the debit networks. Indeed, the rock-bottom on-us fee charged by Debitman, US$0.06, is roughly what Wal-Mart already gets from the bank-backed debit networks, such as Star Systems.

Loyalty. Debitman's plan to piggyback on the loyalty cards that merchants have already put into their customers' hands is astute. But some merchants might not be happy with the prospect of their customers using their cards at rival retailers.

ACH interchange fee. If banks decide to slap an interchange fee on ACH transactions, Debitman's cost structure might be fatally jeopardized.

To succeed, Debitman will have to overcome these challenges, the main one being enlisting large retailers as issuers to build up transaction volumes. Fortunately for Debitman, rising competition between Visa Interlink, MasterCard and the regional networks is very likely to keep pushing the PIN debit interchange rates up, thus creating a favorable environment for the venture. To be sure, chances for a merchant-controlled debit network to gain momentum in the U.S. have never been so high.

Gwenn Bezard is a senior analyst in the banking group at Celent Communications, a financial services research and advisory company headquartered in Boston, Mass.