Capital One’s acquisition of Discover closed on May 18th, and with the integration of the two firms now underway, it is a good time to pause and consider the deal’s implications for competition in the payments industry. Pre-merger, Capital One and Discover were the 2nd and 4th largest credit card issuers, by cards in circulation, and the 4th and 6th largest, by outstandings and purchase volume. On the network side, Discover owned the Discover network, which had achieved virtual parity in the United States, along with the PULSE debit network and the Diner’s Club global franchise. This deal, thus, involves a horizontal acquisition in credit card issuance, and a vertical acquisition with horizontal effects in the network space, given Capital One’s significant participation in both Visa and Mastercard.
On the issuing side, this deal could trigger more consolidations in that market if competing banks feel pressure to match Capital One’s scale and/or specialization in certain segments. But even more important are the potential implications on the highly concentrated credit card network market. Capital One has now acquired one of the four major credit card networks, and, remarkably, was permitted to do so notwithstanding its long history as a leading member bank in Visa and Mastercard. Discover is the only network to have entered this market since the 1980s, and it is now owned by a bank that has long been tethered, and loyal, to the interchange-driven Visa and Mastercard network model. This outcome eliminates the only network that has competed for merchants on price in this century, and it is hard to conceive of Capital One using the Discover network to offer a competitive alternative to interchange.
So this begs two difficult questions. Why was this merger permitted? And how will it impact competition? The first question might be harder to answer than the second. As to why this deal was cleared, one potential explanation could be resources – the payments expertise at the DOJ is currently dedicated to prosecuting the monopolization case against Visa, and the digital wallet portion of the Section 2 lawsuit against Apple. The Antitrust Division may not have the bandwith to take on another payments case at this time. It may have simply decided to put its enforcement eggs into different baskets.
An alternative, less satisfying explanation, might be that the DOJ ultimately concluded that it could not sustain a Section 7 challenge to this merger. Under this reasoning, the Antitrust Division may have concluded that this merger likely will not “substantially lessen competition” because, among other things, Discover was not a serious competitive constraint on Visa and Mastercard prior to the merger. That conclusion ignores the continuing reality that, even if Discover had embraced pricing models similar to Visa and Mastercard in recent years, it was the only network that competed for merchant preference by offering lower prices. Merchants that enjoy lower Discover acceptance costs should expect less Discover volume as Capital One shifts Discover cards to higher interchange Visa and Mastercard cards, or higher prices for Discover, or both. They can also expect higher interchange for PULSE transactions as Capital One takes advantage of the three-party network exception to the Durbin Amendment to raise PIN-debit interchange rates to merchants. At the end of the day, merchants can expect to see higher interchange rates, in credit and in debit, and those outcomes will plainly represent a “substantial lessening of competition” when they materialize.
The most intriguing subtext to this merger is its relationship to the Visa and Mastercard network model. That model, which relies on collectively set fixed interchange backed by the Honor All Cards rules, faces threats in court, with an antitrust trial scheduled in October, and in Washington, where the Credit Card Competition Act enjoys bipartisan support. Consider Capital One CEO Rich Fairbanks’ explanation concerning why he bought Discover — that owning a network was critically important to him. What Mr. Fairbanks did not say, but likely meant, was that he needs a network hedge in the event the Visa and Mastercard interchange model collapses under the weight of accumulating legal and regulatory pressures. The big banks (including Capital One) remain loyal to Visa and Mastercard because of interchange. No other model would deliver them comparable revenues from merchants. If that goes away, or is materially revised, the banks will start competing for merchants. In that world, Mr. Fairbanks acquisition of Discover will look far sighted. Unfortunately, until that world emerges, we are left with more of the same, minimal network competition and higher prices for merchants.
For more of Jeff’s insights on the Capital One/Discover merger, check out the latest episode of The Hub and Spoke Podcast featuring fellow SCL Founding Partner Matthew Cantor.
