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The Future of Debit Card Processing, What It Is and How It Works

In 2020, the Federal Reserve Bank of Atlanta conducted a Survey of Consumer Choice, which reported that:

  • Consumers made on average 68 payments per month
  • On average, consumers used their debit cards for 23 of those payments.
  • 85% of the consumers carried a debit card, with over 68% of those using that debit card each month, compared to 74% using cash and 63% a credit card.

There is also evidence that increasing debit card usage stems from linking Google Pay and Apple Pay in their digital wallets. The driving force behind much of this activity comes from reduced access to credit during the pandemic, more movement towards contactless payments, and the adoption of online payments linking their debit cards.

The pandemic accelerated many of these trends, and post-Covid, many of these behaviors will change permanently. The continued evolution of how we bank includes debit cards and the fees the different players can capture, such as Visa or PayPal.

Cash is dead, and the increased usage of debit cards is helping fuel this change; understanding the ecosystem will help us understand the potential investment opportunities.

In today’s post, we will learn:

  • What Is Debit Card Processing?
  • How Does Debit Card Processing Work?
  • What Are the Types of Debit Card Processing?
  • The Differences Between Debit Card vs. Credit Card Processing
  • The Fees for Processing Debit Cards
  • What is the Future of Debit Card Processing?

Okay, let’s dive in and learn more about debit card processing.

What is Debit Card Processing?

Debit cards and credit cards are similar, and many investors lump them together as if they are the same thing, but they are not. Even though both have 16-digit account numbers, PINs, and expiration dates, and both come from banks, credit unions, and fintechs, they are different in how those institutions profit from them.

Image courtesy of Quora

The card’s similarities end there; for example, credit cards allow us to use credit granted to us from our bank, such as JP Morgan, and then repay that credit and use it again. Debit cards are linked to our bank accounts, and payments directly deduct money from our checking account.

At the most basic level, debit card processing is a process that takes effect behind the scenes, even though the physical process appears on the surface the same. The consumer offers their card, then swipes, inserts, taps, following the instructions on the pin pad to complete the purchase. But in the background, how the processor handles the transaction is slightly different.

The difference stems from the debit card and credit card processing and the differences between the cards themselves.

When consumers use their credit card, it pulls from their credit account with their bank, while the debit card pulls from their account linked to the debit card and is now available in their account.

The biggest difference is where the funds come from to purchase the item, whether a credit or debit account. As we will see, each transaction carries different rates for the merchant and revenue generation for the processors and issuing banks.

How Does Debit Card Processing Work?

When a consumer swipes their debit card through a terminal, the point of sale (POS) system reads the information from the magnetic stripe on the back of the card. The terminal transmits the data to the debit card processing network.

Here is a breakdown of the process:

  • Consumer presents their debit card to pay for the transaction
  • The debit card is swiped, inserted, or tapped using the card terminal device
  • At this point, the point of sale system (POS such as Clover) reads the card information and transmits that card data to the processing network (Visa, Mastercard, Pulse, Interlink, and Star Network)
  • The processing network now verifies the data and determines the possibility of fraud (Visa and Mastercard)
  • The processing network then sends the payment data to the issuing bank (JP Morgan, PayPal)
  • JP Morgan or PayPal (issuing bank) confirms there are adequate funds to complete the transaction and sends approval back to the merchant

The whole above process takes a matter of moments, simply astounding considering the complexity of the process.

After the transaction is complete and the consumer completes their checkout, the debit card network continues to work to complete the authorization, clearing, and settling the transaction with the merchant.

The big difference is the treatment of the transactions by the processor and how they handle those transactions. Each type of transaction carries different rates for the merchants, leading to different revenue sources for those processors.

The Differences of Debit Card Vs. Credit Card Processing

There are four different types of debit card processing, and these types influence how the transaction interacts with the payment process and how that data transfers over the system.

Pin Debit Transactions

The most typical type of debit card transaction occurs when the consumer chooses “debit” on their paypad terminal, which next prompts them to enter their four-digit PIN to help confirm their identity.

When this type of verification occurs, the payment progresses along the process described earlier—also referred to as online debit card transactions because they connect to the bank accounts linked to the debit card.

And here’s the key, because they process over debit card networks, instead of standard payment rails, PIN transactions carry lower percentage fees and higher transaction fees for issuing banks and merchants, respectively.

For example, the typical fee is 0.05% + $0.21 per transaction, and to put that in context for the merchant and issuing bank. The $2 Coke we buy at the store generates $0.10 + $0.21, or $0.31 per Coke sold. That $0.31 is taken from the $2 that the merchant charges for the Coke and reduces their potential profit, while that $0.31 is part of the pie that the issuing bank splits up with the other participants in the payment network.

Signature Debit Card Transactions

A signature debit card transaction processes over the credit card network, so when a consumer chooses “credit” on their paypad, the payment processes over the credit card network. The consumer must sign for the transaction instead of entering a PIN.

The signature debit card transaction, also known as an offline credit card transaction, doesn’t connect to the attached account. And compared to PIN transactions, signature debit transactions carry higher percentage fees and lower transaction fees.

Contactless Debit Transactions

Contactless debit card transactions are similar to PIN debit transactions because they happen with a mobile device, contactless debit card, or smartwatch.

The only difference is that contactless occurs when the consumer holds their phone or contactless card over the NFC terminal to communicate the card data over the air instead of physically touching the device.

The consumer links their respective debit card to their Apple Pay or Google Pay wallet to their mobile phones. And once the card information transfers to the POS terminal, the transaction processes exactly like a PIN debit card.

Card Not Present Transactions

The last type is one of the fastest-growing types of payments; the card does not present transactions that are most common in e-commerce, card on file, or keyed in transactions.

As with signature debit transactions, cards do not present processes over the credit card networks, but because they carry a higher level of risk, they are more expensive for the merchants. That is because there is a lower level of verification, thus a higher risk of fraud.

That is one of the reasons why the take rate for e-commerce is higher than the in-person take rate, which leads to greater profitability and revenue rates for Shopify than Bank of America.

Quickly, the take rate is the percentage of the transaction Shopify gets to keep from the transaction, and the higher, the more revenue it generates.

Unfortunately, it is difficult to determine which method is better for the merchant versus the payment processor. That is because the Durbin Amendment limits the number of different transactions charged, depending on the size of the issuing card bank.

For example, JP Morgan charges a fixed rate set by the Amendment, where PayPal can charge a higher rate because they fall outside the Durbin Amendment. There is also the fact that both Visa and Mastercard determine the interchange rates charged along with the payment network, which drives revenues for payment processors.

But from the merchants’ point of view, they would prefer you use your bank debit card, as their fees are lower, leaving them with bigger profits.

The Fees for Processing Debit Cards

The differences in fees charged for the different processing systems stem from the amount of complexity involved. Credit card processing involves additional steps compared to debit cards.

For example, when you process a debit card, it moves along the payment rail through the processor to your issuing bank and returns directly to the merchant. It often goes over the debit network as if in a PIN debit transaction.

Interchange rates for Visa-branded debit cards

The credit card transaction or signature debit card goes the whole route through the processor, Visa/Mastercard, issuing bank, processor, and back to the merchant over the processor’s network.

Because of that extra step or two, higher fees occur because of the higher risk and complexity.

There is also the fact that a debit card transaction such as a PIN or contactless pay the merchant immediately because the money pulls directly from the consumer’s bank account.

Whereas the debit card processing as signature or card not present, the card processor pays the merchant a few days later and collects the funds later through their credit card agreement.

Because that payment flow is more complex for the credit card, it is more expensive, with credit card processing requiring that merchants pay surcharge fees to the merchant processor for their services.

Even though these processes occur over different payment rails, they all occur through the same POS at the merchant’s store, and different processors charge different fees to process those payments for the merchant.

The costs associated with debit card transactions vary based on several factors.

Easily, the largest fee charged in debit card transactions is the interchange fee or interchange rate. These are the fees that both debit or credit card networks charge for processing these transactions.

The interchange rate for any transaction depends on the size of the card-issuing bank, as referenced above in the discussion of the Durbin Amendment. The maximum for large banks is 0.05% + $0.21.

For banks smaller than the Durbin Amendment allows, the cards issued by those institutions carry far more complex interchange fees. The fees can vary depending on the size of the transaction, the merchant’s category code, and other factors.

While the maximum any regulated bank can charge is uniform, whether PIN vs. signature or card-present vs. not present, that is not the same story with unregulated banks such as PayPal, Revolut, or Square.

For example, with cards issued by PayPal, the PIN debit transactions carry lower percentage fees but higher transaction fees, while the signature, for example, is the opposite ratio.

That means for merchants, PIN debit transactions are cheaper for a large purchase, and signature transactions are cheaper with smaller purchases when a consumer uses their PayPal debit card to buy.

Along with the interchange rates are the fees that payment processors such as Fiserv or FIS charge to enable the transactions.

To say interchange fees are complex is an understatement, but in the simplest terms, we can think of it as a calculation as a percentage of the sale plus a fixed fee. Below is a chart from Mastercard outlining some of the differences, and we can see how some transactions and their differences are extreme.

Example of sales plus fixed-fee pricing, source: Mastercard

Processors charge different rates, depending on different categories, With the interchange-plus regarded as the most cost-effective model for merchants and tiered the most beneficial for processors and issuing banks:

  • Flat rate
  • Tiered
  • Interchange-plus

All in all, according to recent data from U.S. Federal Reserve, the average interchange fee per transaction was 31 cents for both regulated or unregulated cards. And the average take rate for credit card payments is 1.81%, versus the interchange for debit cards at 0.3%.

The Future of Debit Card Processing

Understanding the terms and the different interactions is necessary for understanding how the payment ecosystem works and how the different systems work, especially regarding debit card processing.

The first path to differences in debit card processing revolves around several innovations. The first is the focus on mobile wallets, which is already well underway.

Apple Pay and Google Pay are slowly becoming more of a force in debit card usage, with our phones able to process payments now. As more and more services become available on our phones, which we already use for almost everything, the more likely it is we will use it to make payments.

These network effects continue to drive more adoption of mobile wallets, with multiple states allowing the uploading of driver’s licenses, which only increases the adoption of carrying one wallet, with our payment options loaded onto the phone.

The other is through the digitization of cards, with the Marqeta leading the way. Marqeta, new to the market, is one of the leaders in digital cards and creating easier ways for businesses to accept digital payments either through a credit card or debit card.

Marqeta operates by using a powerful processing platform that is different from the legacy players in the space like Fiser, FIS, and Global Payments, with their systems. The Marqeta platform supports capabilities like virtual cards, instant card issuance, and just-in-time funding. When we use our Square debit card, Doordash, to order food or buy groceries from Instacart, we are using some of the capabilities of Marqeta.

Marqeta partners with banks and processors to enable issuing cards quickly, the creation of virtual or digital cards, and the management of those cards.

It allows the card issuers, banks, or fintechs to either debit cards or credit cards in whichever manner their customers wish, making payments easier for the consumer and removing friction.

The increasing adoption of digital or virtual cards is helping accelerate the shift in payments from card-present swiping to card-not-present transactions, which relates to more revenues for those processors and/or banks. Square’s most recent earnings statement saw a 34% increase in card-not-present volume, leading to greater profitability.

Combine those results with the increasing velocity in e-commerce, and the shift to card not present will only accelerate. The continued move towards digitization will allow that acceleration to continue.

The future of payments is being written every day, and companies like Marqeta are showing what is possible and how we can make payments more frictionless.

There is some legislation on the horizon that could shake up the payments sector, but it is a little to early to make any judgements on those.

Investor Takeaway

Debit cards are far from perfect, and many view them as old-school and dated, but they are one of the fastest-growing forms of payments for consumers and businesses. As cash continues to decline in relevance, it will only continue to grow in prominence.

Many investors focus on the credit card networks because the take rates the payment processors or issuing banks earn are higher, and frankly, it is flashier. But the growth of debit cards continues to accelerate, and many of the processors profit from these card transactions, and to ignore that aspect of the business is not smart, and you are all smart people.

Much of the increase in spending for consumers no longer takes place via the physical swipe, but as we observed, the type of card used and how the payment processes impact the revenue generation for the processor and issuer.

Whether debit or credit, the card processing system upsets how we pay for items and enables easier payments.

And with that, we will wrap up our discussion on debit card processing.

As always, thank you for taking the time to read today’s post, and I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave