Surcharging and Honor-All-Cards Rules

Much of this discussion is taken from my paper titled “Externalities in Payment Card Networks: Theory and Evidence” presented at the Federal Reserve Bank of Kansas City’s 2009 Retail Payments Conference.

Generally, merchants charge the same price regardless of the type of payment instrument used to make purchases. In many jurisdictions, merchants are not allowed to add a surcharge for payment card transactions because of legal (some states in the U.S. do not allow surcharges) or contractual (card networks generally do not allow surcharges) restrictions. But, merchants may be permitted to offer discounts for noncard payments. Economic models of payment cards generally conclude that social welfare improves if merchants set prices based on payment instrument used.

There are examples of jurisdictions where no-surcharge restrictions have been lifted. To encourage better price signals, the Reserve Bank of Australia removed no-surcharge restrictions. While most Australian merchants do not impose surcharges for any type of payment card transaction today, the number of merchants who do is increasing. At the end of 2007, around 23 percent of very large merchants and around 10 percent of small and very small merchants imposed surcharges. In addition to allowing price differentiation across payment instruments, the RBA allowed merchants to price differentiate across networks. The average surcharge for MasterCard and Visa transactions is around 1 percent, and that for American Express and Diners Club transactions is around 2 percent (Reserve Bank of Australia, 2008).

Some economists have stressed that merchants may surcharge consumers more than their costs resulting in suboptimal card use. A potential regulatory response is to cap the surcharge. In responding to the 2007/08 review of reforms by the Reserve Bank of Australia, some market participants suggested that merchants might be imposing higher surcharges than their cost to accept payment cards. The RBA has considered setting a limit for the surcharge amount but has not gone ahead with implementing one.

In the United States, merchants are allowed to offer cash discounts but may not be allowed to surcharge credit card transactions. In the 1980s, many U.S. gas stations explicitly posted cash and credit card prices. Barron, Staten, and Umbeck (1992) report that gas station operators imposed these policies when their credit card processing costs were high but later abandoned these policies when acceptance costs decreased because of new technologies such as electronic terminals at the point of sale. Recently, some gas stations brought back price differentiation based on payment instrument type, citing the rapid rise in gas prices and declining profit margins.

In the Netherlands, Bolt, Jonker, and van Renselaar (2009) study the impact of debit card surcharges. They report that a significant number of merchants are setting different prices, depending on whether cash or a debit card is used. Debit card surcharges are widely assessed when purchases are below 10 euro. Bolt, Jonker, and van Renselaar find that merchants may surcharge up to four times their fee. In addition, when these surcharges are removed, they argue, consumers start using their debit cards for these small payments, suggesting that merchant price incentives do affect consumer payment choice. Interestingly, in an effort to promote a more efficient payment system, the Dutch central bank has supported a public campaign to encourage retailers to stop surcharging and for consumers to use their debit cards for small transactions.

There are instances when card payments were discounted vis-à-vis cash payments. During the conversion to the euro from national currencies, one German department store offered discounts for using cards because of the high initial demand for euro notes and coins to make change for cash purchases (Benoit, 2002). It should be noted, however, that the retailer was in violation of German retailing laws for doing this. In a more permanent move, the Illinois Tollway charges motorists who use cash to pay tolls twice as much as those who use toll tags (called I-PASS), which may be loaded automatically with credit and debit cards when the level of remaining funds falls below a certain level. In addition to reducing cash handling costs, the widespread implementation of toll tags decreased not only congestions at toll booths but also pollution from idling vehicles waiting to pay tolls. In both of these cases, the benefits of using cards outweighed the costs.

Another rule that restricts merchants is the honor-all-cards rule. A payment card network may require that merchants that accept one of its payment products to accept all of its products. In other words, if a merchant accepts a network’s credit card, it must accept debit and prepaid cards from issuers belonging to that network. Such a rule enables a card network to innovate by producing different products that when introduced will have a large base of merchants that accept them bypassing the chicken-and-egg problem. The introduction of payroll cards, a type of prepaid card, is an example of an innovation that leverages a card network’s existing infrastructure.

In the United States, around 5 million merchants sued MasterCard and Visa over the required acceptance of the network’s signature-based debit card when accepting the same network’s credit card. The case was settled out of court. MasterCard and Visa agreed to decouple merchants’ acceptance of their debit and credit products. While few merchants have declined one type of card and accepted another type, the decoupling of debit and credit card acceptance may have increased bargaining power for merchants in negotiating fees.

A subset of the honor-all-cards rule is the honor-all-issuers rule. If a merchant accepts a credit card from one issuer, it must also accept credit cards from another issuer within the same network. Such a policy levels the playing field between large and small issuers. Otherwise, small issuers may not be able to compete with the large issuers because of economies of scale and network effects.

Another type of honor-all-cards rule could cover the acceptance of different credit or debit cards from the same issuer. For example, an issuer may have a plain vanilla credit card and also have others that earn different types of rewards. While merchants may not care what types of rewards their customers receive from their banks, merchants may pay different fees based on the type of card used by their patrons from a single issuer. More recently, certain policymakers are considering allowing merchants to discriminate within a card classification, such as a credit card, based on differences in interchange fees.