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Every processor must work under the sponsorship of a Financial Institution that is a principal member of the BankCard Associations. The stringent requirements for membership ensures that the Financial Institution has the financial ability to accept liability on behalf of its merchant base and is bound by all the rules and regulations governed by the member banks. The Financial Institution must then bind its processors under those same guidelines, and must also bind its processor to the applicable laws, regulations, and statutes that govern the banking industry in general. As the processing arm of the Financial Institution, we then accept all those same applicable rules and regulations. Along with those rules we also recognize the risks involved in processing transactions for the financial institution, the processing arm, and the merchant.
One of the most common misconceptions in the payment processing industry is to believe that opening a merchant account is no more than opening a checking account. The reality is that the "account" is in fact a provisional line of credit - the bank advances the merchant funds based on sales while acknowledging the possibility of chargebacks. Understanding this reality, we must underwrite the account taking into consideration many factors that will affect the performance of the account and to mitigate the risk. Pricing, though certainly important, should not be the first consideration. The type of account can influence pricing, but more importantly the considerations taken when underwriting the merchant account depends on many factors such as financial condition, length of time in business, previous processing history, product type and delivery of that product. These are but a few considerations taken in this process.
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When a merchant applies for a merchant account, and before it goes for final underwriting, we have a series of questions that we ask in order to understand the merchant's business from the initial marketing, to the fulfillment of product to customer service. These areas can have a serious impact on the pricing of the account, additional requirements of the account and ultimately on the performance of that account. Take, for instance, reviewing a merchant's desired "bill descriptor" (the name that appears on the cardholder's billing statement), if the marketing material and the website or advertising collaterals are not in sync, the cardholder may not recognize the billing name and that could result in a chargeback, a request for credit, and or a reason to be reported on any number of Fraud Reports maintained by the Associations. These all contribute to additional fees, fines and or a loss of the merchant account. The customer service level provided can also have a serious affect on the performance of the account and a negative affect on your bottom line. In too many cases inadequate customer service lines, improperly trained personnel or lack of monitoring have been the cause of accounts to be closed and its principals reported on the MATCH List. A merchant account is a privilege not a right. It is a prized commodity and must be viewed as such. Many of the negative actions taken on a merchant account can be avoided if the account is reviewed in depth before it goes live.
Our questionnaire and individual personal attention to our merchants before and after the account begins to process addresses those issues and many more to:
- Ensure that the merchant has an understanding of the basic rules and regulations required to maintain their account in good standing
- Assist in fraud prevention
- Mitigate possible reasons for a chargeback or request for credit
- Provide some guidelines for customer service
- Continuously review the account performance to make any adjustments necessary that can assist the merchant in maintaining maximum revenue.
Now that the account has been reviewed, and the merchant has adjusted their policies and procedures to the best of their ability, just how big is the fraud elephant we are trying to tame? We will supply many statistics to answer this question, but, although it is the common question, is it the right one? If a merchant looks at reducing fraud during order fulfillment as a primary goal, they will most likely be reducing their net profitability also. Zero fraud and or zero chargebacks is unattainable unless you close the store. To attain profit optimization, viewing order fulfillment as an end-to end process, the merchant must manage to all business metrics associated with order fulfillment. This is a classic cost vs. benefits analysis.
| Statistically, with sufficient data, a merchant can graph "adverse profit impact" vs. "accepted fraud rate". Considering the operation is structured to minimize fraud through review and order cancellation (if the order appears fraudulent), at a very low fraud rate a merchant would experience a high level of valid order rejection that would adversely impact profitability. Optimum profitability occurs when the marginal detriment of a lost valid sale matches the marginal benefit of eliminating a lost fraudulent sale. The amount of fraud acceptable at this point is directly related to the gross margin of the product line. The higher the gross margin, the higher the allowable fraud rate. This is intuitive since a higher margin provides more money to counteract the potential fraud losses. The analysis shows that it is better to err on the side of a higher fraud rate. An equal basis point shift in fraud rate to either side of the optimal profitability point will incur a greater loss in net profitability if the shift is to reduce the fraud rate at the expense of losing more valid sales. This is counter-intuitive since one would not expect a higher fraud rate to correspond to greater profitability. The bottom line, optimizing profit through proper order fulfillment is not always logical. It requires consideration of all elements in the product flow.
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How effective a merchant is in managing product flow depends, to a significant extant, on economies of scale. Larger merchants can afford more systems to automate the fraud screening process. Regardless of merchant size, online sales are growing at 20 percent each year. Order fulfillment that requires manual review to approve orders is very expensive. Most merchants can not afford to scale up their manual review process to meet the increasing sales. This implies that more effective automated screening is a necessity for all merchants. Today, the median ratio of fraud management expense to sales is 0.5 percent across all merchants, although some in high risk categories can spend significantly more. These costs include internal and external systems and services, management and development staff, and review staff. On average, the review staff expenses consume 48 percent of the budget with 28 percent for third party tools or services and 24 percent for internally developed tools and systems. Obviously, reducing the expense related to the review staff is critical and becomes more so as sales increase.
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All of these factors considered, within recent years the percent of online revenues lost to payment fraud has been relatively stable while the total losses have increased with sales (note graphs at left and below). Merchants are currently rejecting approximately 4 percent of their online orders, manually reviewing up to a third of all online orders and ultimately approving 85 percent of the orders reviewed. This is a very costly and inefficient process with serious restraints on scalability. |
| Partitioning the merchants into three tiers (<$5M, $5M-$25M, and >$25M) allows us to see the effects of economies of scale on the order fulfillment process. Interestingly, merchants in the middle tier have recently experienced the greatest increase in fraud loss rates. These merchants are struggling to automate the manual review processes created when they operated at lower sales volumes. Even more interestingly, while their fraud loss rates have increased, their valid order rejection has decreased and created a net increase in profitability.
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So, what are the tools available for the automated screening of fraud? Most likely, you are already familiar with the most prevalent ones. All of these tools are used to identify the probability of risk and or the probability of a chargeback associated with a transaction or to validate the identity of the purchaser. Results from these tools are interpreted by humans or rules systems (order decision/screening tools) to determine if a transaction should be accepted, rejected or reviewed. Currently, nearly two-thirds of merchants use 3 or more fraud detection tools, with four tools being the average. Larger merchants, on average, use six tools. |
| The most prevalent fraud detection tool is the Address Verification Service (AVS) and it is typical of the assets and liabilities resident in any single tool. Full AVS compares the first five (5) numeric address data elements and the zip code with information on file from the cardholder's issuing bank. It is currently available for US cardholders and to limited numbers in Canada and the UK. A recent study of 12.9 million credit card transactions where AVS was used, and the final status of the transaction was known, indicated that if a merchant were to reject orders based solely on AVS "no match" they would incorrectly reject 25 percent (false positives) of the good orders and fail to detect 61 percent of the fraudulent orders. This is a symptom of a dynamic society where people relocate frequently and many have more than one house.
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Next in popularity is the Card Verification Number (CVN) in its several variations: CVV2 for Visa, CVC2 for MasterCard, and CID for American Express and Discover. The CVN is predominately used in a card-not-present environment to verify the person placing the order has the card in their possession. However, these numbers can be obtained fraudulently just as credit card numbers are. Online merchants have increased the usage of CVN from 44 percent in 2003 to 66 percent in 2006.
The third most popular tool has a special advantage, even if it does not prevent the fraud, it will, in most cases, shift the liability back to the card issuing bank. This tool is the Card Association Payer Authentication Services: Verified by Visa and MasterCard SecureCode. This tool's usage has increased from 19 percent in 2003 to 29 percent in 2005. These services require the issuing bank to have implemented the program and the cardholder to register the card. This program, however, does not apply to all cards at this time.
The tests performed by these three tools, and the several other tools available, can be fed into an automated order decision/screening tool which will apply the merchant's business rules in the real-time evaluation of incoming orders. This tool can be designed to apply different criteria based on the product or service being purchased. This flexibility is crucial for minimizing the impact of the ever-changing fraud environment. Once the automated tool makes a decision, the order is accepted, rejected, or sent to manual review.
In 2005, manual review rates stabilized after steadily increasing for the previous four years. Across all merchants, the rate of review for online orders was 16 percent in 2000 as compared to 26 percent in 2005. Overall, 73 percent of merchants are engaging in manual order review with, in general, a reduction in the percentage reviewed as the sales volume of the merchant increases. This is primarily due to the increased automation available with larger budgets.
During manual review, additional information is collected primarily from various parties. Forty-four percent of orders reviewed require contacting the customer for additional information while 29 percent require contacting that customer's bank, and 18 percent require contacting a third party data source (such as credit bureaus). This process is slow, expensive, and inconvenient for the customer. Increasing revenue creates increasing cost from manual review, and merchants must move toward automated responses. While 63 percent of merchants review less than 20 orders per hour per reviewer, larger merchants have been able to improve on this by employing case management software.
In 2005, while merchants, in general, accepted 69 percent of the orders they manually reviewed, over 50 percent of all merchants accepted 90 percent or more. Overall, order rejection rates dropped from 5.9 percent in 2004 to 3.9 percent in 2005, more than a 33 percent reduction in rejection rates. And this trend coincided with an increase in valid order acceptance.
Now that the order has been accepted and fulfilled, the issue of which orders were actually fraudulent, and how to deal with them, takes precedence. Fraudulent orders are presented to the merchant either as chargebacks or as a direct request from the customer for credit. Chargebacks actually account for less than half of all fraud claims. Considering the fees associated with chargebacks, it is best to issue credit to the customer whenever appropriate. A merchant should always consider exceeding the customer's expectations in this area and retaining a loyal customer.
Effective re-presentment is required to optimize recovery from chargeback disputes. Overall, 43 percent of fraud-coded chargebacks are re-presented, with 28 percent of merchants contesting 90-100 percent of all chargebacks and a nearly equal amount not contesting any. On average, merchants win 39 percent of these disputes - translating to the recovery of 17 percent of all fraud-coded chargebacks. Larger merchants tend to have higher rates of recovery due to automated re-presentment systems.
From the moment the merchant applies for a merchant account to the moment they dispute their first chargeback, they are involved in a payments processing industry which grows more complex each year. Analyzing all the operational aspects that can impact the risk related to making a sale can be daunting. On the surface the merchant may not see the complexity required to circumvent fraudulent transactions while giving their good customers the service they deserve. And, unless the merchant is fairly large, they may not have the resources to handle all of these issues in-house. A strategic partner is necessary with expertise specializing in the risk management of financial transactions.
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©2009 Terminal Velocity Processing, Terminal Velocity International
all rights reserved
Terminal Velocity Processing, Inc is a registered ISO/MSP with Visa and MasterCard
through its Principal Bank Member, First Citizens Bank & Trust (FCB), Agoura Hills, CA (818) 735-9696
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