That seems rather weakly-founded to me. If a network paired its “honor all cards” rule with a rule that interchange fees would be the same for all cards then merchants could accept all of them without being ripped off by some of them (the difference in interchange fees may be 1% or even more of the transaction value– that’s a lot to a merchant– it may be in the same league as his own margin on the sale!) Of course, that’s not how “honor all cards/no-surcharges” works. The “assurance” to the cardholder is that she can sign up for the most remunerative card-issuer rewards program without worrying that the merchant clobbered with the cost of those “rewards” will balk. That’s not critical to the functioning of the network, it’s only critical to the supracompetitive margins of card issuers.

As for the potential for merchants to “damage the reputation of the network” by choosing to accept lower- (interchange/ merchant) fee cards and decline higher-fee cards, we have empirical reason to believe this is (a) not damaging at all, and (b) pro-competitive. Right now merchants decide whether to accept Visa, MasterCard, American-Express, and various other cards. Merchants often refuse American Express cards because the fees are much higher than for most (though not all) Visa or MC cards (network rules forbid surcharging).

Does this “damage” American Express’ reputation? No. Cardholders understand the economic tradeoffs well and adjust the mix of cards they carry to meet their desires for “rewards” and their desires to use cards with some merchants who don’t want to price those rewards into their goods and services.

AmEx stays in business because merchants and cardholders agree that it provides the right mix of benefits to all parties for some transactions (it helps that AmEx rewards transfer some surplus from businesses to cardholders effectively (if not legally) tax-free through “expense reimbursements” paying inflated prices which in turn support “rewards”).

Merchants who don’t see a benefit from AmEx don’t accept those cards. AmEx and the others (Visa, MC, etc.) *compete* for merchants; all of them offer co-op advertising deals and special fee arrangements to merchants with clout (either cachet or volume).

If the big networks like Visa and MC were forced to expose their member card-issuers to competition over “interchange” fees, then on the experience of AmEx competing with the other networks, I would expect such competition to result in a more efficient market overall. Immediately after a reform of the rules, cardholders trained in the “honor all cards/no-surcharges” era might be briefly discomfited by some merchants rejecting or surcharging some (greedy) cards, but that would be a minor transition problem– such customers would call their issuers (or perhaps other issuers) and get lower-fee cards to carry. The lower-fee cards might come with fewer “rewards” but obviously, consumers in the aggregate could not lose by that.[1]

Merchants could choose how many sales, if any, to forego by refusing or surcharging some cards. They might waive surcharges for good customers, or on high-margin sales, or “just this once, but next time bring a different card.” It doesn’t matter– competition would sort that out fairly quickly. Banks could compete to offer more widely-accepted (read: cheaper) cards as well as cards with fancier loyalty programs. I am quite confident of that, because Visa/MC do that now, competing with AmEx! (Remember those old Visa ads? “Bring your Visa card, because the Olympics don’t take American Express.” That could turn into “bring your XYZ Bank Visa card, because department stores don’t take Citibank.”)

[1] Certainly the distribution of “rewards” benefits and burdens among cardholders would shift.

I think its also important to note here that the increase interchange fees occurred at least in part because of an increase in payment card system competition for issuers as the issuers developed methods to increase cardholder loyalty. With increased cardholder loyalty came greater sensitivity to interchange fee differences from issuers (because they could now shift customers from one card to another while losing fewer sales) and more intense competition from payment systems and higher interchange fees. Complaints about the particular margins on which this competition took place sound much more like complaints about the competitive process than they do like traditional antitrust concerns.

I’m persuaded by the former view that the honor-all-cards rule is critical to the functioning of the payment system because it ensures the cardholder that her card will be accepted at all merchants participating in the network. If one allows merchants to decide on their own which of the cards within the network they would select, the potential for those individual merchant decisions to damage the reputation of the network would be substantial.

The second point is that, while one must recognize that pro-competitive function of the honor all cards rule in payment systems in the overall balancing, it does necessarily follow that (as you suggest in your comment) the interchange fees are at optimal levels. I agree with you there. But I do not think it changes the analysis in my post that regulators do not have a useful baseline for determining optimal fees. In the absence of clear efficiency gains and the risk of significant efficiency and consumer welfare losses, I believe the “first do no harm” principle is a wise guide to policy whether or not we have any evidence that current fees are “optimal” in the blackboard economic sense.