irst of three parts

First it was the $800+ million judgment against Visa and MasterCard for hidden currency-conversion fees. Next came the announcement of the First Data Corp. acquisition of Concord EFS, Inc. Then it was the capitulation of Visa and MasterCard to Wal-Mart, Sears and the class action of virtually all U.S. merchants. This three-part series will examine these events and discuss their potential implications for the U.S. payment industry.

Lower Interchange Rates for Signature Debit

First, let's examine four likely ramifications of the settlement of the Wal-Mart suit. Lower offline (signature) debit interchange rates are set to go into effect on August 1, 2003. Visa has agreed to lower interchange for the Visa Check Card by 48 basis points, and MasterCard has agreed to establish a new interchange category for the Master Money Card that is 1/3 less than the MERIT III rate (a reduction of about 46.7 bps).

Sounds pretty straightforward, right? But, as usual, the devil is in the details.

1. Implementation Frustrations - Antiquated Back-End System Designs

Systems engineers are going to have to scramble to establish the new MasterCard interchange category and classify and rate all MasterMoney transactions properly to this new category. No separate debit category existed for MasterCard until a few weeks ago, and certainly these millions of offline debit transactions never have had to be classified and rated separately before.

The pathetic "card plan" systems architecture, together with the Billing Element Tables (BETs) designed in the 1970s but still in use in the 21st century, also are going to cause lots of grief. Yet another "card plan" is going to be forced into the database systems for every merchant, and yet another set of BET tables will have to be established for every merchant.

The bulk of our industry's back-end systems weren't designed to link to discount rates and transaction fees directly from inexpensive SAN-based databases. Instead, technology used today was designed back when the Y2K problem was a concern, and for the same reason - to save expensive direct-access storage space. Most of these system designs still form the merchant billing superstructure of the mainframe, "green-screen" systems of the ancient past.

2. Archaic Database Structures, Too

It's not just the software design. The databases must be fixed, too. Y2K problems were repaired several years ago, but the equally antiquated and inefficient "card plan" and "BET" table structures continue to provide pricing trees for back-end systems from Omaha to Columbus to Louisville to Cleveland to Toronto.

These systems look to see what BET was established for each merchant for each "card plan" and that BET defines the discount rate. To illustrate this approach, imagine having your weight and height coded as random four-digit numbers on your driver's license. For example, the number 1183 might represent 5-foot-10, and the number 3752 could represent 175 pounds.

Why would anybody use the code 1183 instead of just using 5-foot-10 or use 3752 instead of just using 175 pounds? If a police officer picked you up for a traffic violation, he would have to look into a thick manual (or a computer) to see the actual height and weight that should have been printed on the driver's license in the first place! Seems downright stupid, doesn't it?

The strange and inefficient thing about this type of system is that if you gained a pound, your BET would have to be reclassified to the BET for 176 pounds! With today's back-end BET structures in the payment industry, every merchant pricing change requires a change of BET tables unless the acquirer decides to change the actual BET value for all merchants assigned to that BET.

And therein lies the problem! With today's technology, changing rates for 5 million merchant numbers isn't easy. This difficulty will cause major fits in implementing this significant rate decrease. Many errors will be made because a lot of manual work will have to be done in a very short time frame.

With storage space so inexpensive these days, this database structure design has long since outlived its usefulness. However, it still dominates the back-end systems that cost millions of dollars each month to operate and maintain.

Look for more clunky patches or work-arounds to these antiquated back-end systems and databases to somehow allow for this new category to be established for 5 million merchants in world-record time. Maybe we can get a new generation of back-end systems before the next century!

3. Oops - Additional Margin Improvement

And then there is that pesky issue of unintended consequences - unintended by the merchants, that is. Sure, Wal-Mart and Sears have "cost plus" arrangements with their acquirers, and so do most of the big merchants. Visa and MasterCard settled the lawsuit and agreed to charge lower fees. The problem is that Visa and MasterCard's fees are paid by the acquiring banks, who often offload pricing to ISOs large and small. It is the acquirers who pay the interchange and establish merchant pricing - not Visa or MasterCard.

To date, the acquirers have not been asked about their intentions to pass these rate decreases directly to their merchants. And the settlement does not appear to require them to do so!

Some acquirers are saying informally that they do not intend to pass on all of this rate decrease to all of their merchants. Clearly, it was the intention of the class-action group of merchants led by Wal-Mart and Sears to have all of this rate reduction passed directly to the merchants. Visa and MasterCard probably intended for this to be the outcome as well.

But some acquirers are contemplating how much of this rate decrease they can keep for themselves and just how much they will pass on to their merchants. Surely some will say they can not get the rate decrease "programmed' into their antiquated systems by August 1.

Still others are currently surcharging (by as much as 50 or even 150 basis points) the already lower rate for Visa Check Cards as "non-qualifed" transactions. Will these acquirers continue to charge the merchant these extra fees for transactions that cost them even less? Are the merchants going to get the benefit of this rate decrease, or is this yet another way that the price-discounting sales organizations can "fix" their "margin compression" problem caused by their "teaser-rate" sales approach?

4. Current Visa Check Card Qualification Rules to Continue?

As of this writing, I can find nothing about any changed rules that will qualify a transaction as a Visa Check transaction come August 1. At this time, for example, if a Visa Check card is used at a restaurant, hotel or beauty salon, the tip-adjustment process disqualifies the transaction for the lower Visa Check interchange rate and causes the transaction to settle at a higher interchange level. Is this going to continue?

And what about transactions that must be key entered or that are not settled within 48 hours? Will these qualify at the new interchange levels? I can't find out.

Are all Visa Check Card transactions going to qualify for the lower rate or just those that meet the current qualification rules? If the rules are going to change, then there is a lot more systems-development work to be done for our front-end as well as back-end systems. If the rules aren't going to change, we all need to plan on thousands of extra phone calls explaining why all of the offline debit transactions don't always qualify for the new, lower rate that merchants learned about on TV and in newspapers.

In summary, the manner in which the lower interchange rates are going to be implemented on merchant statements beginning in August is going to be worth watching. My guess is that we will see a mother lode of billing errors. In addition, margin is going to improve significantly for many acquirers beginning August 1, and many, many merchants are going to be disappointed that they did not get the benefits that were contemplated by the settlement of this litigation.

First Data-Concord Merger

Second, let's discuss the First Data-Concord merger. The dearth of opposition to this merger speaks volumes about our industry. I am told that First Data's lobbyists have been busy for many weeks in Washington trying to convince the power brokers at and behind the Antitrust Division of the U.S. Department of Justice (DOJ) that there will be no negative anticompetitive impact on the payment industry as a result of this merger.

We all had better hope that the DOJ doesn't swallow this specious argument without forcing FDC to sell off NYCE and more.

If First Data is going to get away with forming this new monopoly for online (PIN-based) debit processing, all significant acquirers and ISOs are going to pay a heavy, heavy price. The class-action litigation discussed above accused Visa/MasterCard of using their power with credit to force high prices upon merchants for offline debit.

But the First Data-Concord merger creates a brand new monopoly that will allow the new FDC to leverage its online debit monopoly to acquire the credit card processing of merchants and eliminate all other competitors for large merchants with small and medium-size tickets.

What is shocking is that they may actually get away with it because the non-FDC factions of our industry are much weaker than the behemoth, and, worse, we are unorganized except for nifty social and highly effective educational and networking events.

We don't have to look back too far in our history to see what is about to happen in the future.

1. Is the McDonald's Contract the Precursor to FDC's Hegemony over Large Merchants? Remember awhile back when Concord announced that it had won the bidding war for the thousands of McDonald's hamburger restaurants? The coup de grace for the competitors in these bidding wars was Concord's willingness to set a lower interchange rate on STAR transactions in exchange for all of the payment business of McDonald's.

Funny thing: Only Concord had the ability to lower STAR interchange because it is the only competitor that owns the entire STAR network. It used its monopoly to win the contract for all of the payment processing of McDonald's. Get the picture?

The last time I checked, First Data was the only other significant acquirer that could pull off the same type of deal. It could lower interchange on its NYCE platform (which dominates the Northeast sector of the U.S., where STAR is not so strong).

With Concord and First Data combined, FDC will be the only player with the ability to link a lower price for PIN-debit interchange to get the acquiring business for credit and signature-debit transactions. Does this bother you?

It should most certainly bother anyone who thinks a level playing field with respect to interchange is important for the competitors in the payment industry. (See my previous articles on this subject in The Green Sheet - December 1, 1997, issue 97:12:01, and December 23, 2002, issue 02:12:02.) Of course, not all merchants can benefit much from a lower interchange rate on PIN debit, but is FDC going to own the business for all that can?

If the DOJ understood the long-term impact on merchants and acquirers of this new monopoly for FDC, it surely would force FDC to spin off NYCE (likely something FDC would do) and possibly STAR (which would kill the merger). Instead of addressing this issue, FDC is working hard to convince the regulators that its true competitor is cash and checks. Does anybody in this industry really think that FDC's payment competitor is cash and checks?

2. Visa Forced to Relinquish PIN-Debit Platform to FDC

The most crushing news for non-FDC players in the Wal-Mart settlement was Visa's agreement to not aggressively compete for the PIN-debit contracts of the big banks. STAR is likely to win this battle because Visa was forced to agree that Interlink would tie its hands behind its back by not offering signing bonuses for the new contracts.

That, of course, means that FDC is going to be the behemoth of PIN debit and will be using it to gain competitive advantages in ways that we cannot yet contemplate. For Interlink - the only viable potential competitor to FDC, in this writer's view - to be neutered in this way for the foreseeable future is a disaster for acquirers who will now be at the mercy of FDC's willingness to play nice.

The fox not only has snuck into the hen house, he is about to become the head rooster. How do you think it will feel to be a chicken in this new paradigm - aka, new monopoly. If you had been targeting conventional merchants with average tickets of less than $40 and annual volume of a million dollars or so, how are you going to compete when First Data can offer lower online debit interchange than you can offer? It might be time for us to call our U.S. representatives and senators.

In Parts 2 and 3 of this series, we will discuss our industry's problems with hidden fees and how the First Data-Concord merger will continue to mask the otherwise declining market share of First Data's merchant acquiring business.

To learn more about Heartland, visit www.hpsteammates.com or www.heartlandpaymentsystems.com, or e-mail Bob at Bob.Carr@e-hps.com.