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Why The Fed Should Use Durbin To Push EMV

o Aaron McPherson
28.04.2011 kl 23:25 | IDC Financial Insights Community

On April 27, 2011, I participated in a panel at the Visa Security Summit in Washington, DC on the possible impacts of debit card interchange reform legislation (otherwise known as "the Durbin Amendment") on payment system security, during which I advanced a seemingly radical proposal: that the Federal Reserve could, and should, use the Durbin Amendment as a vehicle to move the United States onto the EMV smart card standard. In this post, I will explain how I came to this conclusion. If you would like to see the original discussion, the archived copy of the webcast can be found here.

 

On April 27, 2011, I participated in a panel at the Visa Security Summit in Washington, DC on the possible impacts of debit card interchange reform legislation (otherwise known as "the Durbin Amendment") on payment system security, during which I advanced a seemingly radical proposal: that the Federal Reserve could, and should, use the Durbin Amendment as a vehicle to move the United States onto the EMV smart card standard. In this post, I will explain how I came to this conclusion. If you would like to see the original discussion, the archived copy of the webcast can be found here.

For further comment on Durbin, see my previous posts here.

The panel was asked to discuss a particular provision in the Durbin Amendment (Section 920(a)(5)) that allows debit card issuers to recover some of their fraud costs through higher interchange. In its draft rules, the Federal Reserve more or less threw up their hands, asking the community to tell it which of two options would work best:

1) A prescriptive rule, where the Federal Reserve picks a list of fraud-prevention technologies, and allows issuers to increase their interchange rate by some amount to cover the cost of implementing one or more of those technologies;

2) A non-prescriptive rule, where issuers document their actual costs of preventing fraud, and are allowed to increase their interchange rate by some amount to cover that cost.

Reading the law as written, it is clear that some variation of #2 was what Congress intended; however (as the Fed frankly states) this is poor policy, for it shifts the costs of fraud management onto the merchants, without ensuring that the merchants share in the benefits. Also, option 2 would be very expensive and difficult to administer, because each bank would have to document their fraud costs (which could be an epic project in itself), and bank examiners would have to decide which of the fraud costs to allow, and what the resulting interchange rate would be.

Hence the creation of option #1, which would be much simpler to administer, since the costs of implementing new technology could be easily tracked apart from existing fraud prevention costs. Although the merchants would still be paying for the banks to improve their fraud prevention systems, the Fed could choose technologies that would ensure that the merchants share in the benefits of lower overall fraud rates.

As I was preparing for the panel, it became obvious to me that this was the opportunity to finally get the United States onto smart cards. Smart cards, or "chip and PIN" as they are sometimes known, have been widely adopted all over the world as a safer alternative to traditional magnetic stripe cards. Not only are smart cards harder to counterfeit, but the encrypted key they bear is much harder to read than the data contained on a magstripe. With modern chips, it is possible to generate unique codes for each payment, ensuring that even if the encryption is cracked, the card data cannot be reused for another transaction.

However, smart cards have never been adopted in the United States, because the analytic fraud prevention systems are so good that fraud rates have remained below 0.001% of the transaction value, and any further reductions smart cards might offer would not offset the cost of manufacturing and issuing them. On the merchant side, the cost of upgrading terminals to accept the new cards would similarly be too high relative to the reduction in fraud costs.

Under the new law, the Fed has the power to change this equation. By allowing card issuers to recover some of the costs of issuing smart cards in the form of higher interchange, it could make it profitable for banks to issue smart cards. At the same time, card networks such as Visa and MasterCard could then impose a liability shift policy, similar to that deployed in other regions, where any merchant who chooses not to upgrade their terminal to read the chip bears all responsibility for any fraud that results. This would give merchants a strong financial incentive to upgrade their terminals, and within a short time, the entire payment card industry would have migrated to smart cards.

Surprisingly, I found no support for this position amongst my fellow panelists, who apparently feared that the Fed would make bad choices about which technologies to support. This might be understandable if smart card standards, in the form of EMV, were not already well established and in operation around the world. Even Richard Oliver, who wrote a blog in favor of setting a roadmap to EMV just over a month ago, and was on the panel following mine specifically to discuss EMV, would not (for what I hope are legal reasons) endorse my proposal.

Why hold back? If we have to have regulation, let us at least use it for positive ends. I call on the Fed to seize this opportunity, because I don't see a better one coming anytime soon. Will you join me?

Keywords: Industry Verticals  
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