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1 Chargebacks: Another Payment Card Acceptance Cost for Merchants Fumiko Hayashi, Zach Markiewicz, and Richard J. Sullivan January 216 RWP
2 Chargebacks: Another Payment Card Acceptance Cost for Merchants Fumiko Hayashi, Zach Markiewicz, and Richard J. Sullivan Federal Reserve Bank of Kansas City January 216 Abstract Although chargebacks are perceived as one of the major cost components for merchants to accept card payments, little research has been conducted on them. To fill that gap, this paper describes the current chargeback landscape by generating detailed statistics on chargebacks for signature-based transactions. Our data are from merchant processors, which, altogether, processed more than 2 percent of all signature-based transactions in the United States. For Visa and MasterCard transactions, chargebacks merchants receive are, on average, 1.6 basis points (bps) of sales number and 6.5 bps of sales value. About 7 to 8 percent of chargebacks are resolved as merchant liability. The most common chargeback reason is fraud, which accounts for about 5 percent of the total chargebacks. The merchant fraud loss rate is.7 bps and 2.6 bps. For American Express and Discover transactions, the total and fraud chargeback rates are somewhat lower. For all of the four networks, the total and fraud chargeback rates are significantly higher for card-not-present transactions than for card-present transactions. They also vary by merchant category. Our fraud results are generally consistent with other available fraud statistics. JEL Classification: E42, L81 Keywords: Chargebacks, Fraud, Payment cards Fumiko Hayashi is a senior economist, Zach Markiewicz is a lead risk specialist, and Richard J. Sullivan is a senior economist at the Payments System Research department of the Federal Reserve Bank of Kansas City. Their addresses are and The authors thank merchant processors who participated in this study, the Merchant Advisory Group for soliciting those processors, and Josh Hanson for excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System. 1
3 1. Introduction When consumers make purchases with a credit, debit, or prepaid card at merchants, the merchants typically receive funds of those payment card transactions a few days after the transaction date. However, even after merchants received the funds, those funds are not necessarily guaranteed for the merchants due to chargebacks. Chargebacks are full reversal of transactions by card issuers. When a card issuer initiates a chargeback to the merchant, the merchant processor, which is an entity that provides payment card processing services for the merchant, returns the funds to the issuer from the merchant s account. The funds may again be deposited to the merchant account if the merchant successfully reclaims the funds by disputing the chargeback. When a cardholder disputes a transaction on his payment card statement, either his card issuer or the merchant at whom the transaction was made typically incurs the loss. The issuer initiates a chargeback to the merchant if the issuer believes the merchant is financially liable for the cardholder s dispute according to rules set out by the card network, such as Visa, MasterCard, American Express, and Discover. Merchants respond to chargebacks by either accepting the chargebacks or disputing the chargebacks and reclaiming the transaction funds. Ultimately, if the issuer and the merchant are in disagreement, the card network determines which party is financially liable. There are many reasons for, and reason codes associated with, chargebacks. When an issuer files a chargeback, it needs to include a chargeback reason code. One of the most common reasons for chargebacks is a fraudulent use of a payment card account. Fraud reason codes are associated with chargebacks of transactions that were reported as being unauthorized by 2
4 cardholders. Other common reasons include processing errors, problems related to authorization or cancelation, product quality, and non-receipt of goods and services. Chargebacks are perceived as one of the major cost components for merchants to accept card payments; nevertheless, little research has been conducted on them. 1 Unlike interchange or merchant discount fees, which are presumably the largest cost for U.S. merchants to accept payment cards, the number and value of chargebacks merchants have received and the number and value of losses merchants have incurred as a result of chargebacks have not been well documented. 2 To fill that gap, this paper describes the current chargeback landscape by generating detailed statistics on chargebacks. The detailed chargeback statistics are useful not only for merchants but also for policymakers. Chargeback rates (i.e., the number or value of chargebacks relative to the number or value of sales transactions) by merchant category allow merchants to compare their own chargeback rates against the category s averages. Chargeback rates by transaction channel, such as card-present, e-commerce, or mail/telephone orders, may also help merchants to predict their chargeback rates as their businesses shift from one channel to another. Chargeback rates by reason code category enable merchants to review and refine their payment card processing practices. Detailed fraud chargeback statistics would be especially helpful for policymakers as they consider security of the payments system. For example, fraud chargeback rates inform fraud loss distribution between issuers and merchants, which affects issuers and merchants incentives to invest in the payments security. As the United States migrates to a 1 The Government Accountability Office (GAO) cited chargebacks accepted by a card network as a percentage of sales on that network s cards ranged from.1 percent to.2 percent from December 26 through June 29, according to a large issuer (GAO 29). 2 Merchants pay a merchant discount fee for each card transaction. One of the components of the merchant discount fee is an interchange fee, which is set by the card network and received by the card issuer. Merchant discount fees for American Express transactions do not include interchange fees. See Hayashi (212) for details about those fees. 3
5 chip-card technology standard (referred to as EMV), which is more secure than the currently used magnetic-stripe card technology, detailed fraud chargeback statistics also enable policymakers to examine the effect of the EMV migration on the fraud losses. 3 To generate chargeback statistics, we collected chargeback and sales data from merchant processors. Both chargeback and sales data are for one year period from October 1, 213 to September 3, 214. The data focus on signature-based general-purpose card transactions (i.e., general-purpose credit and signature debit or prepaid card transactions). PIN debit card transactions are excluded. The processors participating in this study, altogether, processed more than 2 percent of signature-based purchase transactions in terms of value (the total value of signature-based purchase transactions in 214 was estimated to be $4,55 billion, of which $3,243 billion were Visa and MasterCard transactions, and $814 billion were American Express and Discover transactions). 4 Our results suggest that the total chargeback rate is 1.6 basis points (bps, or.16 percent) and 6.5 bps for Visa and MasterCard transactions combined. Merchant losses account for about 7 to 8 percent of those chargebacks, implying 2 to 3 percent of chargebacks were resolved as issuers liability. The most common chargeback reason is fraud, which accounts for about 5 percent of the total chargebacks. Both the total and fraud chargeback rates vary by transaction channels and by merchant category. For card-not-present (CNP) transactions, the total and fraud chargeback rates are significantly higher than those for card-present (CP) transactions. The travel industry tends to have higher total and fraud chargeback rates, even for CP transactions. The statistics are somewhat different for American 3 EMV stands for Europay, MasterCard, and Visa, the three card networks which originally created the standard. 4 The total value of American Express and Discover purchase transactions is from the Nilson Report, Issue 157. The total value of Visa and MasterCard signature-based purchase transactions is the authors estimation using the purchase transactions reported in the Nilson Report, Issues 134 and 157, and in the Federal Reserve Board of Governors (214). 4
6 Express and Discover transactions combined, especially regarding their total and fraud chargeback rates, which are lower than those for Visa and MasterCard combined. However, due to the sample difference of our data for Visa and MasterCard and for American Express and Discover, we cannot confirm whether the total and fraud chargeback rates are truly lower for American Express and Discover transactions combined. The rest of this paper is organized as follows: Section 2 describes chargeback lifecycle and reason codes. Section 3 explains our data. Section 4 provides the results and discusses how our fraud results are compared with other available fraud statistics and what our results implications are. Section 5 concludes. 2. Chargeback process Cardholders can dispute their payment card transactions for various reasons. Not all transactions disputed by cardholders result in a chargeback, and not all chargebacks filed by issuers result in merchant losses. To better understand for what reasons cardholders can dispute their transactions and how the liability of cardholders disputed transactions is distributed between issuers and merchants, this section explains chargeback reason codes and describes the chargeback lifecycle. 2.1 Chargeback reason codes There are no common chargeback reason codes in the industry; instead, each card network defines its own reason codes. Thus, a reason code of one network does not necessarily match with a reason code of another network. Each network s reason codes, however, can be divided into seven basic categories: (1) fraud; (2) non-receipt goods and services; (3) product quality; (4) cancellation; (5) non-receipt information; (6) processing errors; and (7) authorization. 5
7 Fraud related reason codes are associated with chargebacks of transactions that were reported as being unauthorized by cardholders. Some card networks fraud reason codes identify sources of fraud (e.g., counterfeit), transaction environment (e.g., CP vs. CNP), and whether multiple fraudulent transactions were made at a given merchant. Non-receipt of goods or services reason codes are associated with chargebacks of transactions for which cardholders reported not receiving the merchandise or services they purchased. Product quality related reason codes are for situation where cardholders received goods and services but they are defective or not as described in the sales literature. Cancellation related reason codes are used mainly for two cases. The first case is when a cardholder was charged a recurring payment (such as a utility bill automatically charged to the card every month) even though the cardholder had cancelled the contract or automatic payment arrangement using the card. The second case is when a cardholder has not received refunds for returned goods or cancelled services. A chargeback using a non-receipt information reason code occurs when a cardholder does not recognize a transaction on his payment card statement. The cardholder must first request a copy of the sales receipt from the merchant through the issuer (this process is called retrieval). If the cardholder is not satisfied with the receipt, which may be because of an illegible account number or transaction amount, he contacts the issuer to initiate a chargeback. Chargebacks initiated by card issuers with processing error and authorization issue reason codes do not involve cardholder disputes. Processing error related reason codes include duplicate processing, incorrect transaction amount, credit posted as debit, paid with other payment methods, charged in the wrong currency, and late presentment (i.e., merchants did not deposit sales receipt within the time frame specified by network rules). Some of the authorization issue 6
8 related reason codes are declined authorization or no authorization: the issuer received a transaction for which authorization was declined or not (properly) obtained. Other authorization issue related reason codes include transactions completed with an expired card, with an account number which does not match with any existing account, or with an account number included in the lost or stolen account file. 2.2 Chargeback lifecycle Figure 1 illustrates the lifecycle of chargebacks which are generated due to cardholders disputes and are reversible by merchants. 5 Five distinct parties are involved in the chargeback process: cardholder, card issuer, card network, merchant acquirer, and merchant. Typically, either card issuer or merchant incurs the financial liability of a cardholder s disputed transaction, and cardholders are rarely liable due to consumer protection laws and the zero liability rules of card networks. 6 Card networks rules determine whether the issuer can initiate a chargeback for a cardholder s disputed transaction. For example, issuers cannot initiate chargebacks for fraudulent transactions made in the CP environment with a counterfeit card as long as merchants received transaction approval by the card issuers, obtained signature by the card users and properly authenticated their cards. Issuers can initiate chargebacks for CNP fraud more easily because it is more difficult for merchants to authenticate cardholders and their payment devices when transactions are made remotely. 7 In the figure, boxes represent a party s action or decision and ovals represent financial liability outcomes. Steps 1 through 7 of the chargeback lifecycle are common across card 5 Card networks do not allow merchants to dispute chargebacks with certain reason codes. 6 Regulations Z limits consumer liability for credit card transactions and Regulation E limits consumer liability for debit and some prepaid card transactions. 7 When 3D Secure, such as Verified-by-Visa and MasterCard Secure Code, is used to authenticate cardholders for online transactions, issuers are generally liable for fraudulent online transactions. 7
9 networks, while Step 8 and beyond vary slightly by card network especially regarding who files for arbitration with the card network when the issuer and merchant cannot resolve the case. Panel A of Figure 1 shows Steps 1 through 7. After a cardholder disputes a transaction and contacts his card issuer with disputed information (step 1), the issuer reviews eligibility of the transaction for a chargeback. If eligible, the issuer initiates a chargeback to the merchant through the card network and the merchant acquirer; otherwise, the issuer incurs the financial loss of the transaction (step 2). The card network screens the chargeback for technical criteria compliance and forwards it to the acquirer if it is appropriate (step 3). The acquirer reviews the chargeback and re-presents the chargeback to the network if it has adequate proof to do so; otherwise, it forwards the chargeback to the merchant (step 4). The merchant decides whether to accept the chargeback and incur the financial loss or dispute the cardholder s claim and represent the chargeback to the acquirer (step 5). The acquirer forwards the re-presented item to the card network after reviewing the item (step 6). The card network screens the re-presentment for technical criteria compliance and forwards it to the issuer if it is appropriate (step 7). 8
10 Figure 1: Chargeback lifecycle Panel A: Steps 1 through 7 Step 1 Cardholder Disputes a transaction (green arrow) Step 2 Issuer Reviews the transaction and decides whether to initiate a chargeback (green arrow) or incur the loss (red arrow) Issuer loss Step 3 Network Screens the chargeback; if appropriate, forwards it to acquirer (green arrow) and if inappropriate, rejects it (red arrow) Issuer loss Step 4 Acquirer Decides whether to re-present the chargeback (red arrow) or forward the chargeback to merchant (green arrow) Go to Step 7 Step 5 Merchant Decides whether to accept (red arrow) or re-present the chargeback (green arrow) Merchant loss Step 6 Acquirer Decides whether to forward the re-presentment (green arrow) or advice not to re-present the chargeback (red arrow) Merchant loss Step 7 Network Screens the re-presentment; if appropriate, forwards it to issuer (green arrow) and if inappropriate, rejects it (red arrow) Merchant loss Issuer (Continues to Step 8 in Panels B and C) 9
11 Panels B and C show Steps 8 and after for MasterCard and for Visa, respectively. For a MasterCard transaction, after receiving the re-presentment, the issuer decides whether to accept it and incur the financial loss or issue a second chargeback to the merchant, which is sent through the network and the acquirer (step 8 in Panel B). The merchant decides whether to accept the second chargeback and incur the financial loss or file for arbitration with the network (step 9 in Panel B). In arbitration, the network decides which party the issuer or the merchant is financially responsible for the disputed transaction (step 1 in Panel B). For a Visa transaction, after receiving the re-presentment, the issuer decides whether to accept it or send a prearbitration notice to the merchant via the network and the acquirer (step 8 in Panel C). The merchant decides whether to accept the pre-arbitration and incur the financial loss or reject the pre-arbitration (step 9 in Panel C). After receiving the merchant s rejection of pre-arbitration, the issuer decides whether to file for arbitration with the network (step 1 in Panel C). The network decides which party has financial liability for the disputed transaction (step 11 in Panel C). Panel B: Steps 8 through 1 for MasterCard Step 8 Issuer Decides whether to accept the re-presentment (red arrow) or issue a second chargeback (green arrow) Issuer loss Step 9 Merchant Decides whether to accept the second chargeback (red arrow) or file for arbitration (green) Merchant loss Step 1 Network Decides which party is responsible for the disputed transaction (red or green arrow) Merchant loss Issuer loss 1
12 Panel C: Steps 8 through 11 for Visa Step 8 Issuer Decides whether to accept the re-presentment (red arrow) or send the merchant pre-arbitration (green arrow) Issuer loss Step 9 Merchant Decides whether to accept (red arrow) or reject the prearbitration (green arrow) Merchant loss Step 1 Issuer Decides whether to file for arbitration (green arrow) or not (red arrow) Issuer loss Step 11 Network Decides which party is responsible for the disputed transaction (red or green arrow) Merchant loss Issuer loss 3. Data We collected chargeback and sales data from several merchant processors, and their merchant clients are from a wide variety of merchant categories. Both chargeback and sales data are for a one-year period from October 1, 213 to September 3, 214. To measure chargeback rates accurately, it is ideal to keep track of chargebacks for sales transactions made in a certain period of time (say, the calendar year 214). However, since some chargebacks take more than a year to resolve, we, instead, collected data on chargebacks received by the processors and sales made by their merchants for the same one-year period. As for the one-year period, from the beginning of the fourth quarter 213 to the end of the third quarter 214 was chosen, instead of 11
13 the calendar year 214, to avoid potentially biased chargeback statistics due to the holiday shopping season. 8 The data focus on general-purpose signature-based card transactions (i.e., credit and signature debit or prepaid card transactions) and PIN debit card transactions are excluded from this study for a few reasons. First, PIN debit networks typically do not have a chargeback process; rather funds of transactions are reversed as adjustments. Second, adjustments are quite rare. 9 Third, merchants are allowed to directly return transaction funds to their customers with cash and thus processors and networks cannot observe some of the reversed PIN debit transaction funds. To examine the number and value of chargebacks merchants receive and the number and value of losses merchants incur from chargebacks relative to sales transactions, we asked merchant processors to provide the number and value of chargebacks received on behalf of their merchant customers. We also asked for the number and value of chargebacks which were subsequently disputed by the processor or the merchants, and of which how many/much of them the card issuers initiate second chargebacks (or pre-arbitration). To generate detailed chargeback statistics, we asked for the number and value of chargebacks by card network, by transaction channel, by reason code category, and by merchant category. For Visa and MasterCard transactions, merchant acquirers or their outsourced processors process chargebacks for their merchant customers of all size. In contrast, for 8 Since retail sales during the holiday shopping season typically account for 2 percent of retail sales during the entire year, the treatment of holiday shopping sales and their chargebacks is important. Our chargeback and sales data exclude chargebacks and sales during the holiday shopping season in 214 but include those in 213. If we use the calendar year 214 as for the one year period, many chargebacks for transactions made during the holiday shopping season in 214 would not be in the chargeback data, but those in 213 would. In contrast, sales transactions made during the holiday shopping season in 214 would be in the sales data, but those in 213 would not. This may cause underestimation of chargeback rates because holiday retail sales in 214 increased by 4.5 percent from that in According to the authors interviews with industry experts. 12
14 American Express and Discover chargebacks, merchant processors process for their mid- and small-size merchants since large merchants often work directly with the card networks. To avoid potential bias of chargeback rates created from small versus large merchants, we generate chargeback statistics for four-party schemes (Visa and MasterCard) and three-party schemes (American Express and Discover) separately. 1 In our data, the number and value of chargebacks by card network are separated into three transaction channels card-present (CP), e-commerce, and other card-not-present (CNP) such as telephone and mail orders. Many countries have reported higher fraud rates for CNP transactions (which include e-commerce and telephone/mail orders) than for CP transactions. Some countries, such as France and the United Kingdom, divide CNP fraud statistics into e- Commerce and other CNP. 11 The numbers and values of chargebacks in our data are also divided into seven reason code categories fraud, non-receipt goods and services, product quality, cancellation, nonreceipt information, processing errors, and authorization issues. 12 We asked merchant processors to provide the detailed numbers and values of chargebacks not only for all merchants they process but also by merchant category. Five major categories are selected. The first includes department, big box, and apparel stores; the second includes grocery, food, and drug stores; the third is petroleum (i.e., gas stations); the fourth 1 Visa and MasterCard are called four-party schemes, because four types of entities cardholders, card issuers, merchants, and merchant acquirers play major roles besides the card network. American Express and Discover are called three-party schemes because originally three entities cardholders, merchants, and the card network which acts as the card issuer and the merchant acquirer were the major players. American Express and Discover now have third-party issuers and merchant acquirers. 11 See Financial Fraud Action UK (214) and Observatory for Payment Card Security (214). 12 See Appendix A for reason codes for each of the seven reason code categories. 13
15 includes restaurants, drinking places, and caterers, and the fifth is the travel industry including airline, car rentals and hotels. 13 To calculate chargeback rates and merchant loss rates, detailed sales data are essential. We asked for the number and value of sales transactions divided by card network, by transaction channel, and by merchant category. Several merchant processors furnished the detailed chargeback and sales data. To encourage participation and detailed responses, processors were assured anonymity. The processors who participated in this study, altogether, processed more than 2 percent of signature-based purchase transactions. Although our data include not a small percentage of signature-based transactions, they may not be representative of all signature-based transactions. Although the processors who participated in our study, as a whole, have a wide variety of merchant clients, most of them have a client base that is skewed to some degree toward specific transaction channels (such as CP, e- Commerce, and other CNP), merchant categories and sizes. We cannot assess the representativeness of our data, since there are few publicly available statistics regarding how the signature-based transactions are distributed across channels, merchant categories and sizes. 4. Results Almost all statistics vary across processors, and thus we calculate the weighted average using the number or value of sales transactions and the number or value of chargebacks each of the processors merchants made or received. This section provides various statistics related to total chargebacks, which include all chargebacks regardless of reason codes, for all merchants and by merchant category. It then presents statistics related to fraud chargebacks, discusses 13 See Appendix B for merchant category codes for each of the five merchant categories. 14
16 whether our fraud results are comparable to other available fraud statistics, and provides the implications of our fraud results. 4.1 Total chargebacks for all merchants Chart 1 presents the weighted average chargeback rates and merchant loss rates for all merchants, regardless of their merchant category and transaction channels. For four-party schemes signature-based transactions (i.e., Visa s and MasterCard s signature-based transactions combined), the weighted average chargeback rates the number or value of chargebacks merchants receive from card issuers relative to the number or value of sales transactions they make are 1.63 basis points (bps, or.163 percent) and 6.45 bps in value. The weighted average merchant loss rates the number or value of losses merchants incur from chargebacks relative to the number or value of sales transactions they make are 1.3 bps and 4.55 bps, suggesting not all chargebacks resulted in merchant losses. The weighted average merchant loss to chargeback ratios are about 8 percent and 7 percent, implying 2 to 3 percent of chargebacks were resolved as being the issuers liability. Chart 1: Total chargeback rates and merchant loss rates bps Four-party schemes Chargebacks Merchant losses Three-party schemes 15
17 For three-party schemes transactions (i.e., American Express s and Discover s signaturebased transactions combined), the weighted average chargeback rates are.93 bps and 3.29 bps and the weighted average merchant loss rates are.8 bps and 2.58 bps. The weighted average merchant loss to chargeback ratios are about 9 percent in number and 8 percent. It is important to note that whether or not the three-party schemes have lower chargeback rates than the four-party schemes cannot be confirmed from our data because of the sample difference. As mentioned above, in our data, the three-party schemes transactions were made at small- to mid-size merchants only, while those of the four-party schemes were made at merchants of all sizes (i.e., transactions made at large merchants are also included). 14 It is possible that large merchants tend to receive more chargebacks than their smaller counterparts, if large merchants have relatively more sales through e-commerce or telephone/mail orders. If this is the case, our results would underestimate the actual chargeback and merchant loss rates for three-party schemes. However, there is another possibility. Large merchants might tend to receive less chargebacks than smaller merchants if large merchants are more sophisticated to prevent fraudulent transactions or transactions that attract chargebacks. In this case, actual chargeback and merchant loss rates for the three-party schemes would be even lower than our results. The higher chargeback rate than that in Chart 1 indicates the average value per chargeback is higher than the average value per sales transaction. Indeed, the average value per chargeback is $222 for four-party schemes and $322 for three-party schemes, while the average value per sales transaction is $56 for four-party schemes and $91 for three-party 14 Because our data do not include information on merchant size, we cannot assess how severe the difference of merchant size in our data for four-party schemes and for three-party schemes. 16
18 schemes (Chart 2). The average value per transaction from which a merchant incurs a loss is slightly lower than the average value per chargeback, suggesting merchants are more likely to dispute chargebacks with higher value (and accept chargebacks with lower value). 15 Chart 2: Average value per transaction $35 $3 $25 $322 $294 $2 $15 $222 $197 $1 $5 $ $56 Four-party schemes $91 Three-party schemes Chargebacks Merchant losses Sales Chargebacks and merchant losses are distributed across three channels CP, e- Commerce, and other CNP. Chart 3 shows those distributions for four-party schemes (Panel A) and three-party schemes (Panel B). For four-party schemes, the share of e-commerce is about the same as that of CP, but it is smaller by 15 to 2 percentage points than that of CP, suggesting the average transaction value per e-commerce chargeback is smaller than that per CP chargeback. 16 For three-party schemes, the CP share is stable around 6 percent, and the rest is almost evenly distributed between e-commerce and CNP other. 15 A small value chargeback may not justify a merchant s cost of researching the transaction and submitting evidence to dispute the chargeback. 16 In fact, the average transaction value per e-commerce chargeback is $168, which is significantly smaller than the average value per CP chargeback of $268, for four-party schemes. See Chart C1 in Appendix C for more details. 17
19 Chart 3: Channel shares A: Four-party schemes 1% 8% 6% 4% 2% % Chargebacks Merchant losses Chargebacks Merchant losses CP Other CNP e-commerce B: Three-party schemes 1% 8% 6% 4% 2% % Chargebacks Merchant losses Chargebacks Merchant losses CP Other CNP e-commerce We use a subset of our data to calculate chargeback and merchant loss rates for CP versus CNP. This is because some processors were unable to distribute their sales data by channel, and processors who reported sales data by channel did not have sufficiently large sales transactions made in other CNP environment (e.g., mail and telephone orders). Chargeback and merchant loss rates in the CNP environment are higher than those in the CP environment. The differences are remarkable for four-party schemes (Chart 4, Panel A). In 18
20 the CP environment, the chargeback rate is less than 1 basis point and about 3 bps in value. In contrast, in the CNP environment, the chargeback rate is about 3 bps and 38 bps. The differences are much smaller for three-party schemes (Chart 4, Panel B). Nevertheless, these results suggest merchants are much more likely to receive chargebacks and incur losses from CNP sales than from CP sales. Chart 4: Chargeback and merchant loss rates for CP vs. CNP bps A: Four-party schemes CP CNP Chargebacks Merchant losses bps B: Three-party schemes CP CNP Chargebacks Merchant losses 19
21 Chargebacks and merchant losses are also distributed across seven reason code categories. Chart 5 shows the reason code distribution in chargebacks and. The seven reason code categories do not add up to all chargebacks for three-party schemes, possibly because those schemes have chargeback reason codes that do not fall under the seven categories we defined. Fraud is the most common reason for chargebacks: About 4 to 5 percent of chargebacks were due to fraud. The second most common reason for three-party schemes is no-receipt information, while it is the least common reason for four-party schemes. Some of the chargebacks categorized as no-receipt information may include fraudulent transactions, especially for three-party schemes. Three-party scheme networks use a no-receipt information reason code if a retrieved sales draft did not include enough information for the cardholder to recognize the transaction. In contrast, four-party scheme networks recently discontinued at least one reason code in the no-receipt information category, so that issuers use a reason code that adequately describes the cardholders original disputes. The other five reason code categories are more or less evenly distributed. Chart 5: Reason code shares Chargebacks % Four-party schemes Three-party schemes Fraud No receipt goods Quality Cancel No receipt information Processing error 2
22 These reason code shares slightly change for different channels. 17 If limiting to the CP environment, the shares of processing error and authorization reason code categories become larger; the share of no-receipt information becomes larger for three-party schemes but smaller for four-party schemes; and the shares of the other four reason codes become smaller. In the CNP environment, the opposite is true. How much merchants incur losses relative to the chargebacks varies by reason code category. Chart 6 shows the merchant loss to chargeback ratio by reason code category. Noreceipt information reason code category has the highest ratio close to 1 percent for both four-party and three-party schemes. 18 Fraud reason category has the second highest ratio, suggesting 8 to 9 percent of fraud chargebacks were merchants liability. reason category has the third highest ratio for three-party schemes, while it has one of the lowest ratios for four-party schemes. Cancel reason category has among the lowest ratios for both schemes. Chart 6: Merchant loss to chargeback ratio by reason code category A: Four-party schemes % Fraud No receipt goods Quality Cancel No receipt information Processing error 17 See Chart C3 in Appendix C. 18 For three-party scheme transactions, the high merchant loss to chargeback ratio of the no-receipt information reason code category has a significant effect on the merchant losses because of the large share of this reason code category in chargebacks. In contrast, for four-party scheme transactions, this high ratio has little impact on the merchant losses. 21
23 B: Three-party schemes % Fraud No receipt goods Quality Cancel No receipt information Processing error Chart 7 splits merchant loss rates into the seven reason code categories. Except for fraud and no-receipt information categories, merchant loss rates are surprisingly similar across categories for four-party schemes, while they have some variation for three-party schemes. For four-party schemes, merchants rarely incur losses from no-receipt information reason category, but for three-party schemes, this category causes merchants to lose.16 bps in sales transactions and.8 bps in sales value. For both types of schemes, merchants lose the most from fraud reason category, which will be examined more details later in this section. 22
24 Chart 7: Merchant loss rates divided into reason code categories A: Four-party schemes bps Fraud.8 No receipt goods Quality Cancel No receipt information Processing error B: Three-party schemes bps Fraud No receipt goods.16.8 Quality Cancel No receipt information Processing error Total chargebacks by merchant category Our data include detailed numbers and values of chargebacks for each of the five major merchant categories. Those categories are department (also includes big box and apparel stores), grocery (also includes food and drug stores), petroleum, restaurant (also includes drinking places and caterers), and travel (including airlines, car rentals, and hotels). These five merchant 23
25 categories altogether received less than 5 percent of all chargebacks, but they generated more than 5 percent of all sales, suggesting they are relatively less likely to receive chargebacks than other merchant categories. In this subsection, some of the statistics are calculated from a subset of our data because some processors were unable to provide sales data by merchant category. Chart 8 presents chargeback and merchant loss rates for each of the five merchant categories. For four-party schemes, the travel category has the highest chargeback and merchant loss rates, followed by the department category. These two categories have higher rates than the average chargeback and merchant loss rates of overall merchants shown in Chart 1. The grocery category has the lowest merchant loss rates and the restaurant and petroleum categories have the second lowest. For three-party schemes, no categories have higher rates than the average chargeback and merchant loss rates of overall merchants. The department category has the highest chargeback and merchant loss rates in terms of value, followed by the restaurant category. The travel category has the highest chargeback rate in terms of the number; however, it is less than 2 bps, which is a sharp contrast to almost 13 bps of the travel category for four-party schemes. This is because one of the two three-party schemes rarely requests chargebacks to the travel industry. 24
26 Chart 8: Chargeback and merchant loss rates by merchant category bps A: Four-party schemes in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Chargebacks Merchant losses bps 5 B: Three-party schemes in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Chargebacks Merchant losses Are the higher chargeback or merchant loss rates of the department and travel categories explained by a greater CNP share in those categories? Chart 9 shows channel shares of chargebacks in the department, grocery, restaurant, and travel categories: The petroleum category is excluded from the chart because almost all chargebacks are CP chargebacks. The department category has a relatively greater CNP share in chargebacks, which may at least partly explain the category s higher chargeback rate. In contrast, the travel category has a very small 25
27 CNP share, and thus, the category s higher chargeback rate for four-party schemes may be contributed by other factors. 19 The results suggest even within the same channel, chargeback and merchant loss rates vary by merchant category. Chart 9: Channel shares of chargebacks for four merchant categories A: Four-party schemes 1% 8% 6% 4% 2% % in # in $ in # in $ in # in $ in # in $ Department Grocery Restaurant Travel CP Other CNP e-commerce B: Three-party schemes 1% 8% % 4% 2% % in # in $ in # in $ in # in $ in # in $ Department Grocery Restaurant Travel CP Other CNP e-commerce Chart 1 compares chargeback and merchant loss rates across merchant categories in the CP and CNP environment, separately. All panels provide evidence that even within the same CP, 19 A very small CNP share of chargebacks in the travel category might be unique to some processors who participated in our study. 26
28 or CNP environment, chargeback and merchant loss rates vary across merchant categories. For four-party schemes, the travel category has significantly higher chargeback rates than the other four categories in the CP environment. The department category s chargeback and merchant loss rates are comparable to those of the petroleum category. In the CNP environment, although all four relevant categories have chargeback rates at least 1 times higher than those in the CP environment, the restaurant and travel categories have remarkably high chargeback rates their CNP merchant loss rates are around 3 bps, implying they incur losses from chargebacks for 3 percent of their CNP sales value. 2 For three-party schemes, the chargeback rate variation across merchant categories is rather modest in the CP environment, but in the CNP environment, the restaurant category has much higher chargeback rates than the other three categories (around 2 bps vs. less than 1 bps). Chart 1: Chargeback and merchant loss rates by merchant category for CP and CNP bps A: Four-party schemes, CP in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Chargebacks Merchant losses 2 These significantly high chargeback and merchant loss rates may be unique to some processors who participated in our study and may not represent the overall restaurant category or the overall travel category. Subsection 4.4 provides further discussion. 27
29 bps B: Four-party schemes, CNP in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Chargebacks Merchant losses bps 5 C: Three-party schemes, CP in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Chargebacks Merchant losses 28
30 bps D: Three-party schemes, CNP in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel* Chargebacks Merchant losses *: CNP sales transactions in the travel category for three-party schemes may not be sufficient (less than 1, transactions), and thus the rate may not be stable. To some extent, the distribution of reason code categories varies by merchant category (Chart 11). However, merchants generally incur most losses from fraud. For four-party schemes, authorization is also a common reason for all the five merchant categories, and processing error is a common reason for the restaurant and travel merchant categories. For three-party schemes chargebacks, no-receipt information reason is a common for the department, petroleum, and restaurant merchant categories. Other statistics, such as the merchant loss to chargeback ratio by merchant category, are shown in Appendix C. 29
31 Chart 11: Reason code shares of chargebacks by merchant category % A: Four-party schemes B: Three-party schemes in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Fraud No receipt goods Quality Cancel No receipt information Processing error % in # in $ in # in $ in # in $ in # in $ in # in $ Department Grocery Petroleum Restaurant Travel Fraud No receipt goods Quality Cancel No receipt information Processing error 4.3 Fraud chargebacks This subsection examines detailed statistics on fraud chargebacks for three reasons. First, fraud chargebacks are the most common reason for chargebacks. Second, as explained earlier, policymakers are particularly interested in fraud chargebacks and merchant fraud losses because they are key pieces of information to consider policy for the payments security and assess the 3
32 improvement of payments security. Third, unlike total chargebacks and merchant losses from them, we can compare fraud chargebacks and merchant fraud losses obtained from our data with other available fraud statistics. Chart 12 shows the weighted average fraud chargeback and merchant loss rates for all merchants, regardless of merchant categories and transaction channels. For four-party schemes, the (weighted average) fraud chargeback rate is.87 bps and 3.22 bps, and the merchant loss rate is.73 bps and 2.63 bps. For three-party schemes, the fraud chargeback rate is.38 bps and.99 bps, and the merchant loss rate is.35 bps and.88 bps. It is important to remember that our three-party schemes data only include transactions made at small- to mid-size merchants, while our fourparty schemes data include transactions made at merchants of all size. Thus, the lower rates for three-party schemes might be due to the sample difference. 21 Chart 12: Fraud chargeback rates and merchant loss rates bps Four-party schemes Three-party schemes Chargebacks Merchant losses 21 The lower rates may also be due to the use of no-receipt information reason codes for three-party scheme chargebacks. 31
33 The average values of a fraud chargeback and of a merchant losse are greater than $2, which are more than three and two times greater than the average value of a sales transaction for four-party schemes and for three-party schemes, respectively (Chart 13). Compared with the average values of a total chargeback and of a total merchant loss shown in Chart 2, the average values of a fraud chargeback and of a fraud merchant loss are much smaller for three-party schemes (about $23 vs. about $3) but are about the same for four-party schemes. Chart 13: Average value per fraud chargeback, fraud merchant loss, and sales transaction $3 $25 $2 $15 $29 $22 $239 $227 $1 $5 $ $56 Four-party schemes $91 Three-party schemes Chargeback Merchant loss Sales Chart 14 describes the distribution of fraud chargebacks and merchant losses across transaction channels. For four-party schemes, e-commerce has the greatest share (around 5 percent), but CP has the greatest share (slightly smaller than 5 percent). For three-party schemes, CP has the greatest share in both number and value, although the CP share is slightly smaller than. 32
34 Chart 14: Channel shares of fraud chargebacks and merchant losses 1% A: Four-party schemes 8% 6% 4% % % Chargebacks Merchant losses Chargebacks Merchant losses CP Other CNP e-commerce B: Three-party schemes 1% 8% % % 2% % Chargebacks Merchant losses Chargebacks Merchant losses CP Other CNP e-commerce The average value per fraud chargeback or fraud merchant loss transaction varies by channel (Chart 15). For four-party schemes, the average value is almost comparable between the CP and other CNP channels (around $25), but it is significantly lower for e-commerce (around $165). For three-party schemes, the average value is significantly higher for other CNP (about $33) than for e-commerce or CP (lower than $24). 33
35 Chart 15: Average value per fraud chargeback and merchant loss transaction by channel $4 $35 $3 $25 $2 $15 $1 $5 $ A: Four-party schemes $266 $261 $245 $236 $169 $163 CP CNP other e-commerce Chargeback Merchant loss $4 $35 $3 $25 $2 $15 $1 $5 $ B: Three-party schemes $336 $329 $237 $216 $214 $22 CP CNP other e-commerce Chargeback Merchant loss Chart 16 presents fraud chargeback and merchant loss rates for CP versus CNP. As explained above, we use a subset of our data to calculate these statistics due to some processors missing sales data by channel. Clearly, the fraud chargeback and merchant loss rates are significantly higher for CNP than for CP. For example, the four-party schemes fraud chargeback and merchant loss rates are.3 bps or lower and 1.2 bps or lower in the CP environment, while they are 12 bps or higher and 14 bps or higher in the CNP 34
36 environment. Again, due to the sample difference, we cannot confirm the three-party schemes lower fraud chargeback and merchant loss rates for both CP and CNP than those of four-party schemes. Chart 16: Fraud chargeback and merchant loss rates for CP vs. CNP bps A: Four-party schemes CP CNP Chargebacks Merchant losses B: Three-party schemes bps CP CNP Chargebacks Merchant losses Fraud chargeback and merchant loss rates also vary across different merchant categories (Chart 17). In a given merchant category, those rates vary between the CP and CNP 35
The Economics of Retail Payments Security
The Economics of Retail Payments Security Fumiko Hayashi, Tyler Moore, and Richard J. Sullivan June 2015 Abstract Economics provides a useful framework for understanding both drivers of and barriers to