Platform Payments 101

Your service connects buyers and sellers, and you want to learn more about payments. WePay's Platform Payments 101 is written to help you discover the realities of facilitating payments on your platform.

Chapter 5 Minimizing Chargeback Risk

For a payment facilitator, preventing losses is equivalent to preventing chargebacks. This may seem like a relatively simple goal: reduce chargebacks to an absolute minimum. Unfortunately, the means to achieving this goal is incredibly complex.

As discussed in Chapter 4, many scenarios can result in chargebacks. The process of preventing chargebacks is not as simple as detecting the use of stolen credit card numbers. Each type of fraudulent or risky behavior necessitates its own set of protections. This means that for a payment facilitator, loss prevention is an inherently complex process.

Detecting Merchant ID Fraud

In order to prevent fraudsters from impersonating actual merchants, a payment facilitator has to have a good system for verifying a user’s identity. To verify identity in real-time (an important feature for most major platforms), a facilitator must collect and analyze massive amounts of data. This often involves the use of third-party technologies to validate a user’s provided credentials. With so much overlapping data, identity verification is rarely a Boolean operation. Payment facilitators are more often faced with users that fall somewhere along a spectrum between verified and unverified.

Identity verification is rarely a Boolean operation. Payment facilitators are more often faced with users that fall somewhere along a spectrum between verified and unverified.

Once identity has been assigned a given probability, payment facilitators may still face problems with false positives (a valid merchant marked as fraudulent) and false negatives (a truly fraudulent merchant that is allowed to process transactions). PayPal has been widely criticized for their decisions to freeze accounts when they’ve assumed false positives.

Because of their exposure to chargebacks, if a payment facilitator makes a false negative and allows a fraudulent merchant to process transactions, they risk having to write off all of those transactions as losses. Even more distressingly, fraudulent behavior is rarely limited to one merchant. Fraudulent users often test a system’s weaknesses by working together in large, anonymous fraud rings across multiple accounts. If these fraudsters are successful, a payment facilitator will lose large amounts of money very quickly.

Unfortunately, any safeguards put in place to slow down fraudulent or risky activity will also get in the way of good merchants that want to receive their money as quickly as possible. There is a natural tradeoff between providing an enjoyable user experience and building protections against fraud. Traditional merchant accounts involve multi-page applications, credit checks, and waiting periods before a merchant is allowed to accept payments. Because they are required to maintain a good user experience, payment facilitators can rarely use those same protections.

Assessing Merchant Credit Risk

Though verifying identity is a challenge, it’s actually much harder to identify merchants who, while not exactly fraudulent, pose risk to the platform by the simple act of failing to deliver their products or services on time or as advertised to their customers. Unless you’re running credit checks, verifying a bank account balance, reviewing prior processing history, reviewing business policies, or auditing financials, you have very little insight into the credit risk of the business. Platforms can combat this by limiting the amount of funds an individual merchant can process or withdraw, but this obviously decreases the quality of the merchant’s experience.

In both cases (identity fraud and merchant credit risk), payment facilitators may require merchants to post collateral (“a reserve”) to ensure that they can cover any chargebacks they receive (this reduces the exposure of the payment facilitator).

The reserve requirement for a particular merchant is determined by the payment facilitator and its assessment of the merchant’s risk. Facilitators can also hold a percentage of a merchant’s payments or delay settlement for days, weeks, or months to minimize credit risk. Payment facilitators should establish reserve requirements proportional to their own risk level and develop procedures for updating and communicating those requirements to merchants whenever appropriate.

However, even the most sophisticated techniques in the world cannot abolish risk and fraud completely. Therefore, processors have to establish policies and procedures for recovering funds from merchants, referring them to internal or third-party collections, or pursuing legal recourse when necessary.

Managing Disputes

Not only should payment facilitators implement sufficient safeguards to prevent fraud and recognize suspicious activity, they must also implement processes to manage and resolve disputes between buyers and sellers.

As the merchant of record, payment facilitators receive chargeback notifications from acquirers and must reconcile the chargeback to its original transaction. In addition to recovering funds from merchants, payment facilitators are also responsible for notifying merchants and providing a means by which merchants can defend themselves against chargebacks.

There are hundreds of chargeback reason codes and they differ by each card network, so understanding the root cause of a chargeback may not be easy.

The documentation needed to successfully represent a chargeback depends on the chargeback reason code. There are hundreds of chargeback reason codes and they differ by each card network, so understanding the root cause of a chargeback may not be easy. Furthermore, the documentation required to fight a chargeback is often split between the merchant, who fulfills the order, and the payment facilitator, who authenticates and verifies the cardholder.

Some payment facilitators have productized the dispute-resolution process to preempt formal chargebacks. In this scenario, buyers dispute payments through the payment facilitator before filing a complaint with their issuing bank. The payment facilitator then attempts to resolve the dispute between the buyer and seller directly without involving the issuing bank or the acquirer. There is significant operational overhead associated with this method, but it can dramatically reduce chargebacks, especially in cases of “accidental” friendly-fraud (i.e. the cardholder authorized the payment but does not remember or recognize the charge when it appears on their statement).

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