Think combating fraud is not of paramount concern to online merchants? The topic was front and center at the Merchant Risk Council’s annual conference held in early March. Online merchants gathered there were eager to get a deeper level of understanding of how better to combat fraud — fraudulent chargebacks chief among their worries.
For purposes of this article, we define fraud in the context of a fraudulent chargeback, which occurs when a credit card transaction is refuted by the cardholder. Chargebacks can be classified into three major categories, the first two of which are fraud-related: “True” or “third-party” fraud are most often seen with stolen credit cards. “Friendly” fraud occurs when the actual cardholder makes the transaction and then decides to refute the transaction after the fact. While there are times the chargeback is absolutely valid, there are, in fact, many occasions when the cardholder is intentionally defrauding the merchant in question.
Finally, chargebacks often occur not as a result of deliberate intent to defraud, but because merchant-specific business processes (e.g., murky terms and conditions or poor customer service) drive that result. While the goal to eliminate chargebacks of all three varieties is a laudable one, best practices to manage and control them are heavily influenced by three core variables that affect online merchants: margins, average customer lifetime value (ACLV) and the phenomenon known as “false positives.”
Tangible vs. Non-Tangible
Merchants range from low-margin retailers selling tangible goods to online music publishers, where the cost to serve every new customer is not much more than the incremental bandwidth. This concept of margin has significant impact on the way merchants should manage their fraud rate and chargebacks. Lower-margin tangible goods merchants have every incentive to minimize their fraudulent chargebacks because they lose not just the value of the transaction but the good itself.
For a merchant selling flat-panel TVs online, this can be an expensive proposition. For non-tangible goods merchants, the cost of the chargeback is the bandwidth cost (think cents) plus any internal costs of fighting or processing the chargeback itself, which typically runs in the US$10-to-$15 range per transaction.
ACLV also has a distinct impact on how merchants should think about the impact of fraud and online commerce. It is not the $10.99 one-time transaction that merchants should care about, but rather the potential lifetime value of that customer that can total in the hundreds of dollars. This is most explicitly seen in recurring billing environments in the form of subscriptions, whether to an on-demand customer relationship management system like Salesforce.com or to the world’s largest multiplayer online game, “World of Warcraft.” The reason ACLV is so relevant has much to do with the concept of false positives.
Implications of False Positives
A false positive refers to a valid transaction that gets incorrectly refused by a merchant despite the use of fraud screening tools. For low-margin merchants, there is far less of an incentive to minimize false positives because of their aforementioned costs. However, high-margin merchants have a more complex proposition to ponder. Take, for example, a high-margin merchant selling a service for $10.99 a month with an average customer life of 18 months. Its ACLV is therefore a little under $200, which means any false positive transaction actually costs the company that amount of money. If the transaction does result in a chargeback, then the cost of processing and fighting that chargeback can total about $15. The economics of this trade-off are quite stark. This isn’t to say that high-margin merchants should just ignore fraud.
Obviously, merchants need to ensure their chargeback rates are in compliance with the standards set forth by the different card associations. For Visa, this limit is typically 1 percent; for MasterCard, the rate can be as low as 0.5 percent. In addition to the obvious economic costs of managing fraud and chargebacks, there is also a distinct social cost. In online environments where there is a critical social element to the industry (e.g., gaming or dating), the cost to having fraudsters ruin the experience for other subscribers is just as critical as the direct economic costs of the fraudulent transaction itself.
A merchant’s position relative to these three criteria will determine what best practices it should employ to combat fraud. A high-margin merchant selling intangible goods will want to minimize the number of false-positives and keep its customer acquisition pipeline as wide open as it possibly can. This will allow it to capture the benefits of ACLV, especially in a recurring billing environment, while continuing to minimize true fraud and its social impact.
On the other end, low-margin, tangible goods merchants will want to reduce as much fraud as possible, even at the expense of having a few false positives, since the replacement costs to them are far greater than the costs of processing chargebacks.
No matter where an online merchant may be in this spectrum, understanding the implications of margins, ACLV and false positives is a critical requirement to managing its fraud situation and boosting its bottom line.
Gene Hoffman Jr. is chairman and CEO of Vindicia, a provider of payment management services for online merchants.