A holiday gift to e-retailers, with a promise of more to come

At first blush, it was a stunning announcement: the Federal Reserve proposing to slash debit card interchange fees by about 75%. That proposal, released last week, is a big deal for online retailers, for it is retailers that pay the debit interchange fee that flows back to banks that issue debit cards. Payment networks like Visa and MasterCard, or PIN-debit networks Star and Interlink, serve as the conduit for those fees, but they don’t make money directly from interchange. The banks do.

Why would the Fed propose to reduce U.S. banks’ debit interchange revenue by roughly $10 billion (of which approximately $500 million comes from online retailers)? It’s not so surprising when you take a longer view—and that longer view also suggests more major changes in payments in the offing. But let’s start by looking at the backdrop to the debit proposal and then talk about what other industry-shaking changes may be coming.

To understand the Fed’s proposal, which will take effect next July if not modified, you have to look at how regulators around the world have viewed credit and debit cards historically. As plastic took off as a means of consumer payment in the 1970s and 1980s, economists and regulators welcomed the development. They saw replacing cash as improving the efficiency of payments. And they knew that merchants that handle lots of cash don’t typically report all their receipts to taxing authorities (ever wonder why taxi drivers don’t like to take credit cards?); they saw electronic payments as a way to boost government tax revenue.

Because they liked electronic payments, they wanted to provide incentives for banks to issue cards and promote their use to consumers. That led them to take a benign view to the rules and pricing schemes of the major card networks, notably Visa and MasterCard, which grew into global networks. It was hardly a secret that big banks controlled Visa and MasterCard, and thus no surprise that those networks tailored their rules and prices to make card-issuing a very profitable business for the banks.

But by the late 1990s the card networks were well-established. Regulators no longer saw the need to incent banks to build out those networks or to tempt consumers to try paying with plastic. Meanwhile, consolidation of the retail industry led to the emergence of mammoth merchants like Wal-Mart that had the clout to go toe to toe with the biggest banks and to make the argument at the highest levels of government that the fees they were paying for accepting debit and credit cards were too high. As a result, regulators have looked closely in the past decade at the actual costs of processing card transactions and on the whole concluded that the fees set by networks like Visa and MasterCard—and largely paid by retailers—were  out of line with actual costs. That’s resulted in a series of decisions in Europe and particularly in Australia that have forced the networks to lower their interchange fees, reducing merchants’ costs considerably.

Here in the U.S., the Fed was watching. In fact, Fed staffers summarized these developments in a report on interchange issued in May 2009. And while U.S. regulators did not lower fees as they had in Australia and Europe, merchants and the U.S. Justice Department pursued lawsuits against the pricing policies and other rules of Visa and MasterCard. Those suits led to settlements in recent years that chipped away at rules that hamstrung merchants and, in the case of a 2003 settlement of a suit led by Wal-Mart, resulted in lower debit card interchange fees.

So when Congress last year instructed the Fed to set interchange fees that were reasonably related to banks’ actual costs in processing debit card transactions, the handwriting was on the wall: The Fed was going to lower those fees. 75% may seem drastic. But the 12-cent cap the Fed proposed is in line with the fees European and Australian regulators have imposed on debit card transactions in their jurisdictions, points out longtime payments industry consultant Steve Mott.

The Fed could still amend its proposal before it issues a final ruling in April, but if it doesn’t, the rules that take effect in July 2011 could save online retailers $500 million by Internet Retailer’s estimate.

And that’s just the start, Mott says. Regulators elsewhere have also been forcing down credit card interchange fees. While those fees aren’t likely to go to 12 cents per transaction—after all banks actually take a risk when they lend money to card cardholders, whereas they have little risk when consumers access their own funds with debit cards—Mott believes credit card interchange will be cut in half in the next several years. That could mean another $500 million in savings for online retailers, by Internet Retailer’s estimate.

Nor is that the end of the changes that could be coming. Mott has been spending a fair amount of time with Federal Reserve staffers of late, providing them with some of the data they used in their interchange analysis and advocating for his merchant clients. He says the Fed has some other important issues on its mind. A big one is card fraud.

The Fed is not amused that al-Qaeda web sites direct aspiring terrorists to hacker sites where they can obtain stolen credit card numbers they can then use to buy the materials needed to make explosive devices. There are millions of stolen card numbers available online because the U.S. still uses an old technology for storing card data on pieces of plastic, the magnetic stripe.

Most of the world has moved to cards that store data in small computer chips, so that those cards transmit to payment terminals only encrypted data, not actual card numbers as in the magnetic stripe system still used in the U.S. By hacking into retailer networks in the U.S., primarily networks breached through bricks-and-mortar stores and not e-commerce sites, criminals have stolen tens of millions of card numbers that they use to make fraudulent purchases, or sell online. Not only does that result in billions of dollars in annual fraud losses to merchants and banks, it’s now facilitating terrorist activities as well.