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provided by Research Papers in Economics ESSAYS ON ISSUES THE FEDERAL RESERVE BANK DECEMBER 2005 OF CHICAGO NUMBER 221

Chicago Fed Letter

Debit card competition: Signature versus PIN by Victor Lubasi, senior analyst This article explores costs and benefits of two types of authorization methods— signature and PIN (personal identification number)—for merchants, consumers, and financial institutions. It also considers competition between signature- and PIN-based debit cards in the United States and looks at Canada’s predominant usage of PIN-based debit cards.

The U.S. payment system is transitioning Furthermore, cardholders perform twice from paper-based payments to electronic as many signature-based debit transac- alternatives, and debit cards are an im- tions as PIN-based debit transactions. portant part of this transition. In 2003, Cardholders in the United States per- led by the rapid growth of debit card formed 10.3 billion signature-based and payments, the volume of electronic pay- 5.3 billion PIN-based debit card trans- ments surpassed the volume of check actions in 2003. payments for the first time. Total debit The debit card debate essentially rests card transactions grew at a compounded on three issues: cost, fraud risk, and annual growth rate of approximately 20% competition between PIN-based and Most merchants state that from 8.3 billion in 2000 to 15.6 billion signature-based card transactions. In in 2003.1 Debit cards became the most PIN-based debit card trans- this Chicago Fed Letter, I consider these commonly used payment instrument actions are more secure and issues for the U.S. market. I also examine for in-store purchases and accounted debit card usage in Canada, which offers less costly than signature- for 31% of transactions performed at PIN-based debit cards exclusively. based debit card transactions. the point of sale (POS).2 Some industry observers attribute great- However, three times as many Debit cards allow consumers to debit er signature-based debit card usage in merchants accept signature- their bank accounts directly at the POS the United States to misaligned incen- to pay for an increasing variety of goods based debit cards than accept tives for cardholders and merchants. Ac- and services. For the most part, these PIN-based debit cards. cording to Jeffrey Shinder and Gordon transactions can be authorized in two Schnell, partners at Constantine and ways—by PIN (personal identification Partners, lead counsel in a 1997 mer- number) or signature. The payments chants’ lawsuit against signature-based industry in the United States continues debit card networks, growth in PIN-based to debate which authorization method is debit card usage was limited by bank superior in terms of both costs and securi- card networks’ Honor All Card (HAC) ty. The debate is driven by an interesting rules. HAC rules required merchants paradox in debit card usage. According that accepted Visa and MasterCard credit to Mallory Duncan, general counsel for cards to accept these networks’ signature- the National Retail Federation, PIN- based debit cards.4 As part of the 2003 based debit card transactions are more out-of-court settlement of the lawsuit, secure and less costly than signature- merchants could decline signature-based based debit card transactions.3 However, debit cards issued by either one of the three times as many merchants accept two largest payment card networks while signature-based debit card transactions as accepting its branded credit card. accept PIN-based debit card transactions. Furthermore, the current debit card (EFTPOS) networks, e.g., Star, Interlink, signature-based transactions, such as interchange fee structure may lead to NYCE, and Pulse. Data from signature- cash rebates, while fewer cardholders issuers offering greater incentives, e.g., based debit card transactions are transmit- receive PIN-based debit card rewards. usage awards, to cardholders to use ted in a similar manner via networks their signature-based debit cards, which operated by Visa USA and MasterCard Fraud risk are more expensive for merchants to International. PIN-based transactions are Naturally, consumers, merchants, and accept. In addition, some PIN-based generally settled faster—merchants re- financial institutions are concerned about debit card issuers impose per-transaction ceive good funds from their acquirers fraud risk when considering any new pay- fees, while most signature-based debit on the date of the transaction, whereas ment instrument. Most PIN-based debit card issuers do not. The debit card inter- settlement of signature-based transactions card fraud involves counterfeit cards change fee is the amount of a card sale takes approximately two days. However, created from account and PIN data cap- that the merchant’s financial institution the merchant is guaranteed delivery of tured surreptitiously from debit cards (acquirer) pays the card issuer, which good funds by the card issuer if certain when they are swiped (skimming) or the acquirer typically passes onto the authorization procedures are followed. cards used by unauthorized users. Sig- merchant. Merchants may prefer to nature-based debit card fraud is often accept PIN-based debit card transac- Costs to merchants and consumers committed using lost or stolen cards. tions because the interchange fee on Payment card fees are a leading cost to Some observers have suggested that them is generally lower than on signa- merchants. According to the National PIN-based debit card transactions are ture-based debit card transactions. Association of Convenience Stores, debit less vulnerable to fraud than signature- and credit card fees represent the fourth Other observers suggest that competi- based ones. However, debit card fraud largest expense for gas stations and con- tion between PIN-based and signature- losses are difficult to measure because venience stores after labor, rent, and based debit cards results in greater issuers are reluctant to disclose such in- utility costs.5 Debit card fees generally benefits for cardholders and merchants. formation. An unnamed executive re- increase with transaction values; however, Merchants may earn greater revenue sponsible for payment card security at a fees on PIN-based debit card transactions from debit card-based sales when con- large bank was recently quoted in a pay- are generally lower to start with, sumers authenticate using signatures ments industry publication as saying, they are capped. instead of PINs. The average value of a “If we say we’ve got it (fraud) covered, signature-based debit card transaction Interchange fees are a substantial com- that’s an open invitation to fraudsters to was higher ($42) than the average value ponent of debit card transaction fees. try to crack us. If we say it’s a problem, of a PIN-based debit card transaction Visa signature-based debit card inter- then the media wants to know why we ($38) in 2003. Some observers point to change fees ranged from $0.43 to $0.57 don’t have it covered.”9 merchants’ continued acceptance of on a $40 transaction in 2004. Mean- Furthermore, the comparison may be signature-based debit cards after the while, PIN-based debit card fees ranged biased because PIN-based and signature- HAC rule change as evidence that they from $0.11 to $0.38 on a similar trans- based transactions are not performed find value in accepting these transac- action.6 However, signature-based deb- in identical environments. PIN-based tions. Additionally, some consumers find it card transactions are sometimes less debit card transactions are primarily signature-based debit cards useful be- costly for merchants with small ticket performed at the POS. Signature-based cause they are able to make remote pur- sales (average transaction under $5.00). debit card transactions, similar to credit chases via the Internet, telephone, or According to Richard Lautch, treasurer card transactions, may be performed at mail, while PIN-based debit card pur- of the Starbucks Coffee Company, a the POS and remotely via the Internet, chases are generally made in person. signature-based debit card transaction telephone, or mail. Limiting the com- generates a merchant fee of $0.08 on Most debit cards support both PIN- and parison to POS transactions is not a a $3 purchase, while a PIN-based debit signature-based card transactions, but satisfactory solution, because PIN-based card transaction generates a fee of these transactions differ in a number of debit card transactions are accepted by $0.10 on the same purchase.7 ways. First, they differ in terms of how fewer merchants across a narrower range consumers authorize transactions at the Signature-based debit card transactions of retail outlets. For example, approxi- POS—requiring the customer to choose may be less costly for cardholders than mately half of all U.S. PIN-based debit “debit” and enter a PIN or “credit” and PIN-based transactions. Approximately card transactions are performed at one provide a signature. They also differ in 15% of all depository financial institu- type of merchant, supermarkets. Some terms of the infrastructure that carries tions’ customers with debit cards have ac- insight into fraud losses may be gained payment information and the timing of counts that are subject to per-transaction from surveys conducted by payments in- payment settlement. Data from PIN-based PIN-based debit fees.8 Only 1% of deposi- dustry groups. Based on results from the debit card transactions travel from the tory institutions charge signature-based 2001 and 2003 editions of the American merchant’s POS terminal to the card- debit card per-transaction fees. Further- Bankers Association’s ABA Deposit Account holder’s demand deposit account via more, approximately 10% of debit card- Fraud Survey Reports, PIN-based debit card electronic funds transfer point of sale holders receive rewards for performing fraud losses per transaction declined to 0.022% (or 0.86 cents per $40 transac- Debit cards in Canada Canada, PIN-based debit card fraud loss- tion), while signature-based losses per While the market in the United States es per transaction in 2003 were 0.038% transaction declined to 0.026% (or 1.02 offers an illustration of PIN-based and (or 1.52 cents per $40 transaction based cents per $40 transaction). Debit card signature-based debit card competition, on a daily average exchange rate pub- issuers earn approximately $0.34 on each in Canada, for example, debit cards are lished by the Federal Reserve Board). PIN-based $40 transaction and $0.57 on exclusively PIN-based. Limited signature- In comparison, in the United States, each signature-based $40 transaction, based debit card service (less than 1% signature-based debit card fraud losses making losses of 0.86 to 1.02 cents per of the total number of debit card trans- per transaction were 0.026% (or 1.02 transaction appear relatively minor. actions) is available for cross-border cents per $40 signature-based debit card retail payments between Canada and transaction).11 Competition the United States. Canada provides an According to Sarah Feldman, vice presi- Competition spurs innovation, which interesting case study of migration from dent of marketing at , PIN-based sometimes produces spillover effects check to debit card payments because debit card fraud rates may be greater in across payment networks. Until recently, incentives were aligned for financial Canada because there are more trans- only credit cards and signature-based institutions, merchants, and consumers. actions per capita performed and crim- debit cards could be used for remote re- In 2003, Canada recorded the highest inals have only one debit system to tail payments. However, spurred by the number of per capita debit card trans- attack.12 Alternatively, signature-based growth of Internet-based payments, the actions in the world, 82, compared with debit card fraud rates may be lower in Star, NYCE, and Pulse EFTPOS networks 63 per capita for U.S. residents. The deb- the United States because of superior launched PIN-based debit card payments it card interchange fee in Canada is set fraud monitoring systems. Visa USA and via the Internet and telephone. These at zero by Interac, the EFTPOS network, MasterCard International have devel- so-called PIN-less debit payments do not while consumers are assessed explicit per- oped advanced neural networks and require cardholders to provide a PIN transaction debit card and check fees. rule-based systems for early fraud de- when authorizing transactions. The pay- Some attribute the successful growth tection on their networks, which helped ments are limited to merchants in select- of the PIN-based debit card market in reduce Visa USA credit and debit card ed industries, e.g., insurance and utility Canada to less competition in the pay- fraud rates from 0.08% of total trans- companies, to allow them to receive ments industry there relative to the actions in 2001 to 0.05% in 2004. payments from established customers. United States. Canada has only one na- How do debit card transaction costs in Although signature-based debit cards have tional EFTPOS network and a highly con- Canada and the United States compare? long been accepted by online merchants, centrated banking structure, in which In both countries, debit card transaction payment fraud in electronic commerce the top eight banks control over 90% of fees are shared by merchants and card- transactions has discouraged some users total banking assets. The United States, holders. However, debit cardholders pay from shopping online. According to on the other hand, has more than ten James McCarthy, senior vice president debit card networks, and the top eight of eVisa merchant and member sales at banks control approximately 40% of Michael H. Moskow, President; Charles L. Evans, Visa USA, merchant losses from debit total banking assets. Senior Vice President and Director of Research; Douglas and credit card sales are approximately Evanoff, Vice President, financial studies; David Some industry observers argue that com- Marshall, Vice President, macroeconomic policy research; three times greater in the electronic Richard Porter, Senior Policy Advisor, payment parisons of debit card fraud rates and commerce channel than in face-to-face studies; Daniel Sullivan, Vice President, microeconomic transaction costs in the United States ver- policy research; William Testa, Vice President, regional transactions.10 Competition led to PIN- sus those in Canada are not meaningful programs and Economics Editor; Helen O’D. Koshy, based authentication systems spilling into Editor; Kathryn Moran, Associate Editor. because of differences in the structure of the signature-based debit card world and Chicago Fed Letter is published monthly by the their payments industries. Others counter enhancing electronic commerce. Visa Research Department of the Federal Reserve that consumers in the two markets are Bank of Chicago. The views expressed are the USA introduced a PIN-based service, authors’ and are not necessarily those of the similar in terms of characteristics that are known as Verified by Visa, for authen- Federal Reserve Bank of Chicago or the Federal critical to debit card adoption, such as per Reserve System. ticating signature-based debit and credit capita incomes, payment behavior, and © 2005 Federal Reserve Bank of Chicago card online purchases. The service en- payment fraud protections. Furthermore, Chicago Fed Letter articles may be reproduced in ables issuing banks to verify the identities whole or in part, provided the articles are not in both markets, financial institutions are of cardholders, in real time, prior to au- reproduced or distributed for commercial gain liable for more fraud losses per trans- and provided the source is appropriately credited. thorizing charges or debits. To partici- Prior written permission must be obtained for action than merchants and consumers. pate, cardholders need to register for a any other reproduction, distribution, republica- tion, or creation of derivative works of Chicago Fed password from their issuers. Participating So are consumers and merchants any bet- Letter articles. To request permission, please contact merchants install Visa password-verifica- ter off in Canada? On the basis of fraud Helen Koshy, senior editor, at 312-322-5830 or email [email protected]. Chicago Fed tion software and are not responsible for rates, the answer appears to be no. Based Letter and other Bank publications are available any fraudulent charges when the payment on results of the first comprehensive on the Bank’s website at www.chicagofed.org. is authorized through this service. fraud survey conducted by Interac, in ISSN 0895-0164 greater transaction fees than merchants PIN-based and signature-based debit cards 5 Peter Lucas, 2004, “Why gasoline retailers in Canada, while merchants pay more are less significant than often suggested. are fuming,” Credit Card Management, August, p. 20. transaction fees than cardholders in the Merchants appear to find value in both 6 United States. It is difficult to measure PIN-based and signature-based debit card Boland Hill Media LLC, 2004, “Visa’s new debit card rates help Interlink but could which allocation of debit payment fees transactions and continue to accept anger merchants,” Digital Transactions, is better for society. signature-based transactions, despite available at www.digitaltransactions.net/ the elimination of the HAC rules. newsstory.cfm?newsid=413, accessed on Nonetheless, debit cardholders in October 10, 2005; SourceMedia, Inc., 2004, Canada have benefited from the spill- The merits of PIN-based versus signature- ATM&Debit News, EFT Data Book, Vol. 4, over effects from competition. Approxi- based debit card transactions will con- No. 45, September 16. mately 13 million people from Canada tinue to be debated in the industry. 7 Richard Lautch, 2005, “Cash substitution take overnight trips to the United States Meanwhile, consumers and merchants at the POS,” presentation at the Federal per year, and most of them can not use in the United States will likely continue Reserve Bank of Chicago’s 2005 Payments their Interac PIN-based debit cards here. to benefit from having a choice between Conference, May 18–19, available at www.chicagofed.org/news_and_ Following the lead of MasterCard’s two distinct debit card payment options. conferences/conferences_and_events/ signature-based cross-border debit card files/2005_payments_lautch.pdf, accessed service in Canada, Interac launched a 1 For debit card transaction volumes and on October 10, 2005. PIN-based, cross-border debit card service values, see Geoffrey R. Gerdes, Jack K. 8 Federal Reserve Board, 2004, “Report to the with the NYCE EFTPOS network in Walton II, May X. Liu, and Darrel W. Parke, Congress on the disclosure of point-of-sale October 2004. Approximately 400,000 2005, “Trends in the use of payments in- debit fees,” submitted to the U.S. Senate struments in the United States,” Federal Interac PIN-based cross-border trans- Committee on Banking, Housing, and Reserve Bulletin, Federal Reserve Board, Urban Affairs, November. actions were performed in the United Spring, pp. 180–201; American Bankers 9 Steve Cocheo, 2004, “Debit’s downside,” States during the first six months of Association, 2004, ABA Deposit Account Fraud ABA Banking Journal, August 1, p. 34. service, and the volume is expected to Survey Report, Washington, DC, Novem- 10Linda Punch, 2004, “Relief for the charge- double this year.13 ber 22, available by subscription at www.aba.com/Surveys+and+Statistics/ back blues?,” Credit Card Management, July, SS_Depositfraud.htm, accessed on p. 30. Conclusion October 10, 2005. 11James Mennie, 2004, “Debit card fraud a Comparisons between PIN-based and 2 American Bankers Association and Dove growing crime,” Calgary Herald, July 24, signature-based debit card transactions Consulting, 2003, 2003/2004 Study of Con- p. D1; Interac, Interac direct payment statis- do not indicate that one is better than sumer Payment Preferences, Washington, DC, tics, website, available at www.interac.org/ the other. Each debit card payment meth- December, available by subscription at en_n3_31_idpstats.html, accessed on www.aba.com/Surveys+and+Statistics/ October 10, 2005. od offers unique benefits, as well as limi- SS_CPPS_03.htm, accessed on October 12 tations, to cardholders and merchants. SourceMedia, Inc., 2005, “Canada ap- 10, 2005. pears to have high PIN debit fraud loss- Signature-based debit card transactions 3 Richard Mitchell, 2005, “Bridging the debit es,” ATM&Debit News, February 3. are generally more costly for merchants gap,” Credit Card Management, February, p. 30. 13SourceMedia, Inc., 2005, “NYCE taps to accept but are accepted across a 4 Gordon Schnell and Jeffrey Shinder, 2004, into Canadian debit purchases in U.S.,” broader range of merchants. Differences “The great Canadian debit debate,” Credit ATM&Debit News, September 29. in payment fraud risk associated with Card Management, May, p. 16.