Hey fintech friends,
On Monday, Capital One announced it will acquire Discover in a $35 billion deal that will form the largest card company in the US by loan receivables– by some estimates, accounting for a combined ~20% share of the card market.
On its surface, this deal makes sense for Cap One because of:
Market positioning- Discover enables Cap One to move down-market at a time when consumer credit card debt is at a 23-year high and Discover’s near-prime customer portfolio is delivering a more attractive net interest margin (of 10.98% vs. Cap One’s NIM of 6.73%).
Interchange ✨synergies- Cap One called out in yesterday’s earnings call that they plan to migrate $175 billion of card volume to Discover’s network by 2027. Processing transactions on their own card network would allow Cap One to recapture anywhere between 10bps - 50bps in network assessment fees on every transaction, driving an anticipated $1.2 billion in “network synergies” for Cap One.
$1.2 billion in savings on network fees is cute, but it’s nothing compared to what Cap One can make if Congress passes the Credit Card Competition Act this year. “Durbin 2.0”, if adopted, will give merchants the option to route payments from Visa- and Mastercard-branded credit cards to unaffiliated networks that might offer more favorable interchange rates. Altogether, Durbin 2.0 would enable unaffiliated networks to compete for >$15 billion in network assessment fees that are predominantly routed to Visa & Mastercard today.
Let’s dive into how Durbin 2.0 would overhaul the economics of credit card processing, and what the proposed regulation means for card networks, issuers, and fintechs.
Durbin 1.0: How debit networks became interchangeable
Card networks compete for payment volume by passing a cut of the interchange generated on transactions to financial institutions (as an incentive to issue cards on their network) and merchants (as an incentive to route transactions to their network). Intensified competition for payment volumes has pushed Visa and Mastercard to ramp up client incentives in recent years, and it’s eating directly into their bottom lines:
Source: Visa’s 2023 Annual Report
Flagship points out that Visa and Mastercard’s client incentives as a share of payment volumes rose 12% and 8% last quarter, respectively, while both networks’ net revenues as a share of GDV only increased 1%.
Last August, Visa and Mastercard announced that they’ll be increasing interchange fees to fund fraud mitigation initiatives– and, presumably, to cover the growing cost of client incentives too:
Merchants don’t love eating these higher interchange fees, but didn’t have much say in the matter until the 2010 Durbin Amendment to the Dodd-Frank Act forced banks issuing debit cards on “signature” networks (Visa, Mastercard) to add at least two unaffiliated “PIN” networks that merchants could alternatively route transactions to. The Durbin Amendment fueled competition among regional debit card networks and prompted payment processors like FIS and Fiserv to acquire a number of these smaller PIN schemes (e.g. Accel, STAR, NYCE, Jeanie…). In 2005 Discover launched its own debit network, PULSE, which today supports 20% of Card-Not-Present debit transactions in the US.
Durbin 1.0 only applied to debit card issuers; on the credit card side, merchants are still stuck paying the interchange set by whichever one of the 4 major networks a credit card was issued on (Visa has made a point of conducting in-person audits on small merchants surcharging customers to recoup these fees, which… woof).
Source: Upgraded Points
Durbin 2.0: Credit schemes can also network to get work
The Credit Card Competition Act introduced in Congress last June seeks to change this by extending Durbin regulations on debit card payments to the credit card space. Notably, “Durbin 2.0” will require banks with >$100 billion in assets (i.e. the top 30 US issuers) to add a secondary “unaffiliated” network to credit cards, giving merchants the option to route transactions to a potentially lower-cost network than Visa or Mastercard.
Whereas there is relatively high competition for transactions among debit PIN networks, only two networks can feasibly compete for secondary credit card routing: American Express and (you can probably see where this is going…) Discover.
AmEx and Discover, as issuing banks that operate their own card networks, wouldn’t be required to add secondary networks under Durbin 2.0. Instead, the other top 30 US issuers will need to onboard either one as a secondary network, effectively bringing tens of millions of cards onto AmEx and Discover overnight (and by “bringing on” I mean, like, physically re-issuing every card in circulation with "AmEx" or "Discover" printed on the back).
Source: CardRates.com
The credit card market is already concentrated to a handful of banks, with the top 10 issuers accounting for 82.4% of credit card volumes as of 2022. On the merchant side, AmEx and Discover would need to coax sellers to route payments to their secondary networks by pushing their own client incentives over Visa and Mastercard’s.
The payoff for AmEx and Discover Cap One? In the US, credit cards account for +157 billion transactions and ~$5.5 trillion in payment volumes yearly. Roughly assuming that credit card networks make $0.10/txn, we’re looking at the opportunity to compete with Visa+Mastercard for upwards of $15 billion in network assessment fees.
Impacts
Cap One’s acquisition of Discover not only allows the bank to recapture “synergies” on its own card processing costs– it also positions them to compete with Visa, Mastercard, and AmEx for scheme fees in a post-CCCA world. The CCCA will undoubtedly drive down interchange fees for merchants, with mixed impacts on stakeholders more broadly:
Consumers could see fewer rewards and free perks from the top 30 credit card issuers. As we saw with Durbin– which was found to have directly lowered banks’ interchange revenues by a combined $15 billion annually– banks passed on the losses by rolling back card-related rewards, as well as ancillary perks like fee-free accounts. One study found that post-Durbin, customer access to free checking accounts went from 61% of accounts to 28%, that average fees on bank accounts doubled from $3.07 a month to $5.92, and that minimum balances shot up to $1,400 a month (70% of low-income households couldn’t afford to meet this threshold).
Merchants will recognize savings on interchange, but won’t necessarily pass these on to customers. The Federal Reserve Bank of Richmond found that only 1.2% of merchants actually lowered their prices after Durbin passed– implying that most merchants ended up pocketing the interchange savings, with major retailers like Walmart and Amazon being the biggest winners. Smaller merchants may actually lose revenue, since card perks are shown to influence consumers to spend more day-to-day.
Top 30 credit card issuers will see lower interchange revenues while bearing the costs of onboarding unaffiliated credit networks and re-issuing cards to millions of customers. On top of this, they’ll likely face greater fraud risks in working with multiple card networks that may not all come with the same levels of technological sophistication, data visibility, or loss protections.
Issuers with <$100B assets: Rejoice! Smaller issuers will have the opportunity to better compete for consumer volumes by offering better rewards than top 30 counterparts. This also makes smaller issuers more appealing to co-branding partners, and in BIN issuance partnerships with non-bank partners and fintechs.
