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A Thing

Is EMV a sound investment? The jury's still out

By Marc Abbey and Eric Wu

With the exception of the United States, every economic region has a migration plan for transitioning to the card Associations' chip-and-PIN technologies, known as EMV. The acronym stands for Europay/MasterCard Worldwide/Visa International and is the international standard for smart payment cards.

The United Kingdom leads all markets in the EMV transition and provides the most insight into how EMV will perform relative to the primary assumptions underlying the migration. EMV in the UK has been, in many senses, a technical triumph. However, early returns from the UK underscore a somewhat speculative system-wide business case.

Winners and losers

The benefits to the system and the benefits to individual participants are totally different matters. EMV migration includes intra-system transfers designed to distribute benefits and create an incentive for individual parties to take certain actions. Chief among these are interchange subsidies and liability shifts. These are redistributions and are not system benefits, per se (though we will argue later they can be part of the costs to the system).

Individual institutions will be winners and losers based on their tactics and whether they are net issuers or net acquirers. Some institutions will have very high returns on investment and rapid paybacks, and some will not.

Therefore, individual institutions may have strong business cases even if our thesis regarding the fragility of the system-wide business case turns out to be correct. The card Associations have proved adept at using intra-system transfers to effect a critical mass of support from stakeholders whose business cases are likely much better than the system-wide business case.

System-wide benefits

The primary system-wide benefit of EMV by far is the impact on the issuing side of fraud. EMV largely remediates fraud due to counterfeiting and lost or stolen cards - two rapidly growing sources of fraud in the UK and other markets. (EMV, however, does not totally eliminate skimming-related counterfeit risk: In May, Shell Oil Co. suspended chip-and-PIN payments at 600 gas stations across the UK after thieves siphoned over U.S. $1.8 million from customer accounts using counterfeit cards that employed data obtained through skimming.)

British payment association APACS reported a remarkable reduction in fraud for the year ended December 2005. Fraud due to counterfeiting and lost or stolen cards is nearly U.S. $110.5 million below 2004 levels. Measured off recent run rates, 2005 fraud of this type has declined as much as 31%, or U.S. $147.4 million. This is a remarkable validation of the primary intent of the technology.

Unfortunately, not all anticipated benefits from EMV have materialized. One anticipated benefit is reduced authorization traffic. EMV allows for authentication of the cardholders based on information resident on the chip plus the PIN at the POS. Thus, the business case included the assumption that issuers would authorize less than 100% of the transactions.

This reduction in authorizations would be an acquirer (and system) benefit because it would reduce acquirer operating expenses and a merchant benefit because it would speed POS transaction time, on average. But in the UK, issuers are authorizing 100% of transactions, so this benefit has not materialized. This issuer authorization strategy might be temporary; the UK is in the middle of a credit cycle and losses are elevated, but we will only know in time.

There is also, in concept, a product-development value benefit of EMV. Specifically, there are wide expectations that chip-and-PIN technology will facilitate product development not possible with mag-stripe technology. This is likely; however, in the UK market, EMV has been (probably wisely) implemented in a single-application environment initially. Though there are tantalizing experiments occurring regarding new applications in the loyalty and prepaid spaces, the product development value of EMV is far from concrete.

Leaking interchange reductions

One of the intra-system transfers to facilitate EMV migration was an interchange reduction for EMV transactions on the order of 10 basis points. This represents a transfer from the issuing to the acquiring side. British acquirers report they have retained 40% to 50% of this reduction, passing the rest through to merchants.

This pass-through breaks down according to merchant size: Large merchants tend to receive the interchange reductions and small merchants tend not to receive them. There is a ring of fairness and logic to this: In the UK market, the acquirers own the terminals small merchants use (and the acquirers have to invest in terminal upgrades), but large merchants foot the investment bill for upgrading their own integrated systems (although many received direct subsidies).

This leakage of the interchange reduction to merchants represents a reduction in value to the Visa/MasterCard membership. We estimate that the reduction represents leakage with a net present value, optimistically, of about U.S. $740 million to U.S. $1.1 billion. If, in the long term, acquirers compete away the interchange reduction, this leakage value will be even greater.

This leakage is in addition to the value of the direct investment necessary to implement EMV, which has been estimated widely in the British trade press at U.S. $1.8 billion to U.S. $2.8 billion.

The softer side of costs

In addition to these hard costs, there are soft costs. Most British acquirers believe that EMV has contributed to a shift from credit to debit in the UK, although the acquirers are divided on whether this shift is permanent or temporary.

The theory goes that consumers are less likely to know their credit PINs than their debit PINs. Therefore, as PINs have become required at the POS, consumers have been incrementally more likely to use debit than credit. Debit is, in fact, growing much faster than credit in the UK. Acquirers are divided on whether this phenomenon has trained consumers to use debit and, therefore, on whether it will persist.

The permanence of debit's ascendance is critically important to acquirers because their margins are three or four times higher on credit than debit. If EMV has triggered a substitution of debit for credit, on the margin, it will have effectively increased the cost of EMV geometrically.

Intangible factors

There are other important, intangible costs and benefits. EMV was a complex, extensive systems-development project with opportunity costs on some level for issuers and acquirers alike. Some believe these opportunity costs were actually massive; others dismiss this downside.

One potentially sizable benefit of EMV is the avoidance of regulation. It seems unlikely the public sector would have allowed fraud trends in the UK to continue unabated without intervention, which could have had significant negative cost and flexibility ramifications for issuers and acquirers. Likewise, we will never know if fraud due to counterfeit and lost or stolen cards would have increased from historical rates, but there is a credible argument that it would have accelerated.

EMV transactions are fundamentally more secure transactions, changing the nature of data security and the contingent liability the industry faces from data breaches. The self-service aspects of EMV are anticipated to improve merchant POS throughput largely because self-service makes certain processes at the POS parallel rather than sequential (though cynics argue self-service is not systematically related to EMV, per se, and can be implemented in a mag-stripe environment as well).

Certain types of merchants believe the value of improved transaction times at the POS is dramatic, although this is not a system benefit in the way we are using the term because it does not accrue to the Visa/MasterCard membership or generate a return on the investments members have made.

The payback

Concerning the hard costs and benefits of net fraud reduction, interchange leakage, and direct investment, EMV migration in the UK is looking like a payback period investment of 12 plus years, with correspondingly modest rates of return. Most other costs and benefits remain speculative and resistant to quantification.

Very few financial institutions routinely invest in projects with these types of characteristics. Discussions about EMV have tended to have an evangelical quality. As an increasing number of markets around the world develop hard results from EMV migrations, the actual business case for EMV will be more transparent and more subject to critical review, for good or ill.

Marc Abbey is a Partner and Eric Wu is an Analyst at Baltimore-based First Annapolis Consulting.

Article published in issue number 060702

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