This is part of an ongoing series.  For earlier installments, see The Five Actor Model, Credit Cards, Part One, and Credit Cards, Part Two.

In this article, we will dive into debit cards: what they are, how they work, the two different models, and legal issues. Here is the version of the Five-Actor Model I have adapted for debit cards:

Five Actor Model for Cards

Existing readers may notice that the diagram is the same as the one for credit cards.  This is by design; from the beginning, debit cards were designed to mimic credit cards in all respects.  That makes debit cards the first real step toward enterprise payments, in that they were the first new payment instrument to mimic an existing one.  Enterprise payments is one of the organizing principles of this series, and it is the idea that all payment methods share a common structure, as shown in the Five Actor Model.  This fact allows us to convert one payment instruction into another. An “enterprise payment hub” is a specialized piece of software that does this conversion.

Debit cards are the first payment method that made use of this principle, by imitating ATM cards and credit cards.

Online vs. Offline Debit Cards

There are actually two types of debit cards, although now most debit cards enable both types.  Online, or PIN debit, was the first to come out, and it was a conversion of the ATM card to enable point-of-sale purchases.  Since ATMs interact with a core banking system in real time to check funds availability, they have been termed “online.” The PIN part also comes from the ATM card history; even today, Personal Identification Numbers, or PINs, must usually be entered when an ATM card is used in its debit mode.

The second type is offline, or signature, debit.  Signature debit cards mimic credit cards, and they operate over the same network.  Since banks authenticated credit cards at the time using a signature, they came to be known as signature debit cards, or check cards.  The “offline” refers to the fact that banks do not settle credit cards in real time, but in overnight batches, when processing costs are lowest.

Before Online Processing

In the early days, if a merchant wanted to check funds availability, they would have to call up the bank and get approval for a charge.  Most of the time, however, they would just make a copy of the card using a mechanical device (also known as a “knuckle buster” – see Figure 1) and submit all the signed receipts in a batch to their bank’s overnight deposit drop box.

Offline Card Transaction Generation

Pictured right: he mechanical predecessor to the credit card terminal. You placed the card on the light metal insert, and then a three-layer charge slip, with mimeo graphic ink, would be placed on top.  You then brought the roller (left) over the charge slip, creating an impression of the embossed numbers on the card on all the layers.  Finally, the cardholder would sign the slip, and the merchant would give one copy to the cardholder, send one to the bank, and keep the third for their records.

The bank would then enter all the receipts and send them to the card network, which would clear and settle them.  In this way, the process originally occurred offline.  Today, banks authorize almost all cards, of any type, in real time using an online process, so the “offline” term is no longer accurate.  However, you will find that in payments, terminology lasts forever.

Why It Matters

The difference between PIN and signature debit cards might seem a matter of details, but it is actually extremely important, because the pricing is completely different.  PIN debit cards were for a long time much cheaper for merchants to accept than signature debit cards, because they had to be to get merchants (primarily grocery stores) to accept them.  Remember, PIN debit cards weren’t compatible with existing credit card systems; merchants had to invest in completely new hardware to provide a PIN pad and a telephone connection to the debit network.

Signature debit cards were indistinguishable from credit cards, and therefore had the same pricing.  It was not long before merchants realized this fact, and also that there was no way for them to distinguish between signature debit and credit.  However, the risk involved in signature debit was much less, because there was no extension of credit (except for the very brief period between presentation and settlement), and no risk of default.  Since banks called signature debit cards “check cards” when they marketed them to consumers, merchants reasoned that they should be priced the same as checks.

Cash and Checks vs. Cards

One of the main reasons checks are still so common is that they settle at “par,” which is to say a $100 check deposit actually shows up as $100 in your bank account.  Of course, checks aren’t really free; in fact, they cost more to process than cards.  Since the rise of free checking, however, most consumers don’t see a charge for depositing or writing a check.  Businesses do, but usually it is included in the monthly fee they pay to their commercial bank.

The average merchant in the late 90’s and early 2000’s took a combination of cash, checks and cards.   Cash and checks were worth what they said they were, while cards were worth less.  Merchants could see how card discount fees were eroding their profit margins, and retail has notably thin profit margins to begin with.  As more and more consumers started using debit cards instead of checks, the cost of the discount fees became a larger and larger part of the expense line, leading to accusations of price gouging.

The banks exacerbated this problem by extending cash back rewards to debit cards.  While a boon to consumers, merchants hated paying for cash back that could be spent anywhere, not just with them.  Yet they were powerless to block debit cards, because of a credit card network policy called “honor all cards.”

Honor All Cards: Necessary Feature or Constraint on Trade?

The original idea of an acceptance mark was integral to the value proposition of the Visa and Mastercard interbank networks.  Instead of a separate terminal and integration to each bank’s credit card business, merchants only had to do one for each network.  This enabled credit cards to grow beyond businesspeople and travel-oriented businesses.  Any merchant who displayed the Visa acceptance mark had to accept all Visa cards, otherwise the system wouldn’t work.

Merchants felt that Visa and Mastercard had abused this rule when they enforced it for signature debit cards, because debit and credit cards are not the same, and there PIN debit cards had a much lower discount fee.  They wanted to be able to refuse the new “check cards,” until Visa and Mastercard lowered their pricing.  For their part, the networks and their allies argued that debit cards would not have been feasible without the existing acceptance network, and that while PIN debit looked attractive pricewise, they had to offer lower pricing because they did not have nationwide acceptance.  Merchants had to be persuaded to install PIN pads, and at the time, this was still uncommon.

For a good explanation of the network view of “honor all cards,” see Playing with Plastic by David S. Evans and Richard Schmalensee.

Merchants Sue Visa and Mastercard Over Honor All Cards

In 1996, a group of merchants filed a class action suit, In re: Visa Check/ MasterMoney Antitrust Litigation, asserting that the “honor all cards” rule, by forcing them to accept signature debit cards along with credit cards, was an illegal “tying” of one product to another. The largest merchant in the class was Walmart, so this is sometimes referred to as the “Walmart Suit.”  In 2003, on the eve of trial, Visa and Mastercard settled out of court, agreeing to pay $3.05 billion and apply “honor all cards” separately to credit and debit cards.  This marked the first time that Visa and Mastercard made major changes in response to antitrust concerns.

Part of the settlement required that banks print the word “Debit” on debit cards. The networks also agreed to lower signature debit interchange by about a third.  The merchants learned in time that a one-time payment, while nice, ultimately did not make much difference. Visa and Mastercard started to segment pricing by merchant category and size, ultimately making back from smaller merchants what they lost from the settlement.  As a result, merchants were soon back in court, in litigation that persists to this day.

The Durbin Amendment

In 2010, riding a wave of anti-bank sentiment after the collapse of the mortgage industry, ushering in the “Great Recession,” Congress passed the Dodd-Frank Act, which imposed new regulations on the banking industry.  Inserted at the last minute at the instigation of Senator Richard Durbin (D-Illinois), the so-called “Durbin Amendment” (Section 1075 of the Act) gave merchants much of what they had been seeking in court.

The law gave the Federal Reserve the power to regulate debit card interchange, and instructed it to use processing costs as the basis.  The result was Regulation II, which ended up capping interchange at about 24 cents.  Banks could charge an additional cent to cover the costs of implementing fraud technology.  It also gave merchants the right to prefer PIN debit over signature debit, something was possible because of signature debit being predominantly online at that point.  This was transparent to the consumer, although it did lead to a confusing process at the point of sale.

Since signature debit still operated using the same systems as credit cards, a consumer who wished to use it would have to select “credit” on the POS terminal when swiping (or inserting) their card.  If they picked “debit,” the terminal would request a PIN and route the transaction over the PIN debit networks.

The Networks Prove Resilient

Of course, this settled nothing; the banks, furious at the way they had been outmaneuvered by the merchants, immediately started lobbying for a repeal of the provisions.  The networks responded by signing volume agreements with merchant acquirers providing an incentive for merchants to route transactions over their networks, with the result that the PIN debit network market share began to decline.  The Federal Reserve has come under attack for failing to reduce the rate in accordance with falling processing costs at issuing banks.  The $10 billion threshold has created market distortions by itself, in particular opening up opportunities for challenger banks that take advantage of the exemption to issue debit cards without any branches or checking capability, funding their operations solely on the unregulated interchange.  I will get into this more in the article on prepaid cards, coming up next.

Conclusions

In conclusion, debit cards are important to our study of payment systems because:

  1. They were the first payments product designed to emulate an existing payments product (ATMs and/or credit cards), leading the way to enterprise payments
  2. Their cost structure made them very similar to yet another payment product, checks, with an entirely different pricing structure, which caused a lot of friction with merchants
  3. They led to a major settlement and legislation that signaled a fundamental change in the way payment cards were perceived by governments around the world. Payment cards would now be viewed as utilities, subject to regulation like any other utility.

There is much more to say about debit cards, and I hope to come back to it in the future.  However, I will leave it here for now, as we must move on to our third type of payment card: prepaid cards.  Prepaid cards overlap in interesting ways with debit cards, and indeed some of the changes in the debit card market enabled new types of prepaid cards.