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Who’s Paying for Your Rewards Points?

posted by Adam Levitin

The relationship between consumers and credit cards gets a lot of attention. But merchants also have relationships with credit cards, and the dynamics of this relationship have significant effects on consumers’ use of credit cards as well as on the competitive landscape in the credit card industry. A lot of my academic work has related to this (I apologize for the self-promoting links), and this post is meant to provide a short summary of some of the issues that arise in this relationship. There are a lot of twists that I cannot convey in this blog posting, but I am happy to carry on a conversation in the comments and refer readers to my articles on the topic for more detail (the most recent papers are at the bottom of the linked webpage).

Merchants pay banks a fee on every credit card transaction. The fee is referred to varying as the "merchant discount fee" or the "interchange fee." Because of these fees, credit card transactions are much more expensive for merchants than transactions on most other consumer payment systems: cash, checks, ACH, PIN debit (but not signature debit). There is also significant cost variation among credit cards. Some cards, such as rewards and corporate cards can cost merchants twice as much as others. These fees (tens of billions of dollars) are vital to credit card networks’ profitability and have led merchants to attempt all sorts of strategies to minimize their payment costs.

The largest component of the fee merchants pay goes to finance credit card rewards programs, which in turn generate more credit card transactions. Although merchants finance the rewards programs, they derive little or no benefit from them. Rather than generating additional sales, rewards programs merely induce consumers to shift transactions from less expensive payment systems to more expensive rewards credit cards. So why, then, do all consumers pay the same price for purchases, regardless of the means of payment?

The answer lies in merchants contracts with bank members of the card networks. These contracts incorporate, by reference the networks’ operating rules. Incredibly, the complete network rules are not available for merchants to view (merchants are agreeing to terms that they don’t know!), but their contours are well known, and are substantially similar for all four major networks.

The key rules require merchants to accept all credit cards of particular brands (MC/Visa/Amex/Discover) for all transactions and on the same terms and forbid merchants from surcharging for credit cards. (Federal law gives merchants the right to discount, which is mathematically equivalent, but economically very different.) In short, credit card network rules (a/k/a merchant restraint rules) prohibit merchants from accepting certain credit cards selectively and from pricing according to cost of payment. Merchants find credit card acceptance an all-or-none proposition, and in order to accept the card transactions they want, they are forced to take the more expensive cards on the same terms.

Credit card network rules prevent merchants from signaling to consumers the costs of different payment methods. Accordingly, consumers never internalize the costs of their choice of payment system. Instead, they decide which payment system to use based on a comparison of benefits, not benefits net of cost. And credit cards, with rewards programs, rank higher in consumer preferences than they would if consumers had to internalize their costs. Credit card network rules thus encourage more credit card transactions at higher price than would occur in a perfectly efficient market. By encouraging overconsumption of credit cards as a transacting instrument, card network rules also foster higher levels of consumer debt. In short, some obscure credit card network rules are a factor contributing to more defaults and bankruptcy filings, decreased purchasing power, and inflation.

Credit card network rules also permit card issuers to externalize the costs of rewards programs (and credit cards in general) to merchants. Empirical evidence shows that merchants pass on a large part of this externality to to consumers who do not use reward cards or credit cards at all. The result is a highly regressive cross-subsidy of credit card users by non-card users. In its most egregious form, this means that food stamp recipients are subsidizing first class upgrades for platinum card users!. Essentially, the credit card industry has created a tremendous sub rosa subsidy for itself.

Lastly, credit card network rules distort competition within the credit card industry and among payment systems in general. Credit card network rules take away the cost efficiency advantage of other payment systems (a significant barrier to entry) and allow credit cards to compete on the basis of bundled rewards programs rather than on price. This helps maintain higher profit levels for the entire credit card industry.

How can this be? Surely there couldn't be a market failure on this scale. Impossible. Well, consider this: Even defenders of the four credit card networks (yes, there are only four quasi-competing networks in the entire market), are forced to rely on argument that credit cards are sui generis and have economics of "second best" efficiencies.

What is to be done? Congress has also held some hearings, but is unlikely to act, and the Fed claims (incorrectly, I believe) that it has no authority in the matter. But there’s some hope. Merchants have filed a number of antitrust suits against the card networks. (In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation (MDL 1720)). Former FTC Chairman Timothy Muris has referred to this litigation as the "largest private antitrust litigation in U.S. history." It's hard to calculate the potential damages, but a figure over a hundred billion is not unrealistic (remember, treble damages in antitrust!). Arguably, at stake is the continued existence of MasterCard and Visa. The litigation spurred the MasterCard IPO and Visa's pending IPO.

What would happen if merchants win in court? Would we suddenly be faced with surcharges for using credit cards or find that we couldn’t count on our cards being honored? Highly unlikely. Merchants would not need to surcharge because the threat of doing so (would you pay 4% more for using an Amex card?) would result in lower fees and less variation among cards. Rewards programs would be scaled back, which is a good thing—card users would have to pay their own way. Basically, credit cards would become what they should be—commodity products unbundled from the bells and whistles of rewards. And the result for consumers? Lower prices, less debt, and, hopefully, more innovative payment products.


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Adam, it is great to see you presenting your ideas in a blog format which will hopefully allow us more frequent access to your insight on topical subjects as they pop up. I totally agree with your analysis. The pressures you describe will force the payment brands to (finally) create innovative new features designed to please merchants. This will lead to differentiated interchange strategies, which is very good for everyone.

Thanks for posting this. As a merchant I agree 100% with your thoughts in this article and I am crossing my fingers that the class action suits will prevail. Anything that reduces the costs of credit card transactions will be plus for consumers and merchants alike.

I wish I could remember where I read recently about the way in which the housing bubble and the related run-up of available mortgage financing tended to inflate spending, injecting artificial consumer borrowing based primarily on the easy availability of credit out of proportion to the ability to actually service the debt taken on.

Just as consumers were encouraged by advertising to access their home equity as a species of credit card, thereby encouraging consumer spending, so also might it be said that rewards programs encourage consumer spending that might otherwise not occur.

What happens when home equity loans are less available, and rewards programs are appropriately priced? I certainly don't have a clue.

lmclark--I think there's a difference between being encouraged by mere advertising and being encouraged by altered economic incentives. Of course, teaser rates on home equity loans (like ARMs) are similar to credit card teaser rates and rewards programs teasers (if you look at the fine print of many rewards programs, they aren't worth a lot, but consumers still perceive the programs as valuable).

I'm glad to hear from Aneace, who has a fine blog of his own (I can't do hyperlinks in these comments, alas), and a very interesting product that could make credit cards more of a value-added proposition for merchants.

Adam -- fair point. I re-read your post and appreciate the distinction.

Adam, very well stated. I can't wait to read your response on the debit reward programs that are coming out.

Doug, I don't follow debit cards as closely as I do credit, but my sense is this. There are two types of debit cards (often physically the same card): PIN-debit and signature-debit. For PIN debit transactions, you enter a PIN number; for signature debit, you usually sign your name (often after pushing a "credit" button--misleading, huh?), but contactless RFID debit transactions are also signature to my knowledge. PIN debit networks piggyback on ATM networks; signature debit piggybacks on credit card infrastructure (that's why you press "credit" I assume). PIN debit is less expensive for merchants than signature debit, although all debit fees are creeping up. Signature debit costs about as much as a credit card transaction. (PIN debit has lower fraud rates (but the fraud rates are extremely low for both in absolute terms)).

My guess is that most, if not all debit rewards programs are on signature debit cards. Debit rewards programs are less generous than credit ones, but their function is similar--to encourage consumers to use signature debit cards to transact. Signature debit rewards are being used to compete against PIN debit; the question is whether any gain they make against PIN debit is offset by transactions they steer away from an issuer's credit card. All things being equal, a bank probably prefers a credit transaction to a debit one because of the possibility of interest, but with debit overdraft fees, it might be more of a wash, especially for non-revolving customers. Merchants really don't want to steer customers from credit to signature debit; there's just no benefit. As the Wal-Mart case shows, what merchants want is PIN debit. Not surprisingly, PIN-pads are becoming more common.

Incidentally, Capital One has a very interesting new debit product that is not bundled with a DDA (checking) account. You can get the Capital One debit and link it to any bank account. Your payment provider no longer has to be your bank. Cool, no?

merchants need to price credit card usage in to their cost of doing business. Credit cards are a great way of paying for consumer purchases if used responsibly. I make over $1500 a year in taking advantage of rewards programs, 0% intro rate arbitrage with large purchases (finance five-figure home improvements, keep the cash in high-yield savings until a few months before the 0% rate ends, etc) and since I am non-revolving on the rewards cards I do not pay a dime of interest. Just about anyone these days can get a credit card (maybe not with rewards) and use it as cash - just takes discipline to not spend what you cannot pay back at the end of the month.

Cash and checks are insecure, inefficient, outmoded and dangerous. Whenever someone presents large amounts of cash I think criminal/ drug dealers. Cash has higher overhead in the form of additional security against theft, both internal and external, checks are even more trouble for the merchant (NSF, etc)

"Merchant discount fee" -- as someone who works for a merchant group, that cracks us up every time. As we like to say... what discount? Merchants certainly don't see one. As far as Newspeak goes, it's impressive.

Anyway, Adam, great post. I don't find much to disagree with here, at all. If you don't mind, I'll mention the site for Merchants Payments Coalition, whom I work for: UnfairCreditCardFees.com -- for anyone else reading this who wants to know more about the interchange fee, it's a pretty comprehensive website.


Thanks for posting on this topic, which obviously interests a lot of people. Merchants are free to discount cash transaction (though it's not easy), as required by the TILA and allowed by Card Association rules. It seems to be becoming more common, especially for gas stations, and even the NYT did a story on it this week. At least in California, V/MC seem to have relaxed their language requirements a little in the face of state regulatory pressure. Of course, PIN-steering has become ubiquitous at large merchants, and there is an increasing proliferation of non-Card Association payment method (though their foothold is questionable, outside of paypal). I think savvy merchants have made some real progress in managing interchange costs, and more is on the horizon, as frequent reads of Aneace's blog show.

Really great posting and thanks for giving such a nice information about credit cards and how to earn reward points for your card. Its really amazing.

What seems to make people think that forcing lower merchant transaction fees will in turn benefit the consumer? People who use rewards credit cards often are doing so to reap the rewards; without that incentive many people will simply use their card less. I do understand how the companies essentially coerced merchants into accepting all cards and footing the bill for accepting them (As there used to be a time where a consumer might run into paying a fee or paying more for using credit.), but I just think that was natural progression of technology and consumer spending.

Look, I'm all for helping little merchants fight the big guys and make profits but a lot of them aren't as helpless as this article makes them out to be. Think about this: How often have you gone to a merchant and seen a sign written and posted that says 'Minimum Purchase of 10 dollars for Credit Card'. Is that legal? Their forcing the consumer to give up their right to earn rewards or pay with their choice of payment or simply spend more money. I've seen signs ranging from 5 dollars to 35 dollars essentially demanding that a credit card user purchase more goods. I don't fault some merchants for doing this, after all they need to offset the fees. But there is a reason why gas stations no longer charge different prices for cash or credit. It is illegal to do and it doesn't sit well with most consumers to the point that you see signs at gas stations stating 'Same Price Cash or Credit!'.

As a credit card user I shouldn't have to tolerate this kind of backdoor way of merchants charging me for a fee their required to pay. Transactions take technology and equipment to run and process and if they want my business then they'll pay the small price to do so. If I go to a store to buy 5 dollars worth of merchandise and the cashier tells me that I need to buy 5 dollars more in order to charge it; it makes financial sense to the merchant, but not to me at all. I can take my business elsewhere because if I can go to one store and charge a one dollar soda and that business accepts the fee to handle the transaction then I'll avoid the stores that set illegal minimum purchase requirements.

JM--First, merchant fees support rewards programs. As long as credit cards compete on the basis of bundled rewards, they won't be competing based on price. And that hurts revolving consumers.

Second, merchants raise their prices on everyone because of the costs imposed by credit card users. And unless you're using the highest end card (like a Visa Signature Plus card, which very few people qualify for), you're subsidizing some other folks, at least at certain merchants. I''m not real big on subsidizing anyone well-heeled enough to be offered a Signature Plus card.

Third, you also note that without the incentive of rewards, people with simply use their cards less. That's exactly the point. Rewards encourage more credit card use than should otherwise occur, and more transacting use leads to more debt-build up with a host of concomitant social problems.

It is not illegal to charge different prices for cash or credit. In fact, federal law (the Cash Discount Act) creates a right to provide discounts for cash (surcharges for credit, the mathematic equivalent are not so protected).

Minimum purchase amounts do not violate any law. They do, however, violate merchants' contracts with their acquirer banks, which require them to abide by credit card network rules, which include no-minimum amount provisions. It might well be that these rules are themselves illegal, in violation of antitrust law.

As you note, you can shift your spending to merchants whose policies you like. That's the market working. But if the market really works, why do card networks need to force merchants to accept cards on losing or break-even transactions? If there were a natural progression of technology and consumer spending, we would probably not be using credit cards in their current form. We'd generally use PIN-debit cards or credit cards with much better security technology (for a look at a first step in this direction, see the new Revolution Card network's products).

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