What is a chargeback guarantee and should you want it?

The prevalence of fraud or rather the losses attributed to fraud have increased awareness of the issue and it has now become crystal clear that fraud prevention (FP) is a must for any online retailer – no matter if they own a three-man shop or an online giant. Fraudsters notoriously invent new scamming techniques and, consequently, FP solutions have to follow suit and adapt. As we debate over the latest developments in the FP space, we’re afraid some of them have essentially nothing to do with fraud and, hence, might be tipping in the wrong direction. So let’s open Pandora’s box and talk about what is a chargeback guarantee?!

Why would a chargeback guarantee cause us to raise an eyebrow? They are primarily intended to insulate merchants from fraudulent transactions involving the unauthorised use of a credit card. There’s a substantial level of risk tied to chargeback guarantees though. Why? When two partners want to do business together, they have to align their motivations. Issuing chargeback guarantees breaks this alignment. Merchants want to maximize accepted transactions and minimize chargebacks at the same time. A chargeback guarantee issuing solution will simply be looking to minimize chargebacks, precautionarily turning down transactions, even those initiated by legitimate customers (high false positive rate). Alarmingly, the LexisNexis study found that approximately 24% of declined transactions were in fact false positives. Moreover, the average cost of a false positive can be several times higher than the cost of a chargeback.

An FP firm offering chargeback guarantees can land one of three cases:

1. The chargebacks they are reimbursing are greater than the fees they are charging.
2. The chargebacks they are reimbursing are equal to the fees they are charging.
3. The fees they are charging are superior to the chargebacks they are reimbursing.

In each of these cases there are some worries for the merchant:

Instance 1 or 2: This is an unsustainable situation and the merchant should be weary of their fees increasing at some point knowing that the FP solution might have higher negotiation power the day of the fee increase.

Instance 3: In this case, it will become very evident that the FP solution is motivated to keep refusal rates at their maximum levels in order to maximize their revenues. It is estimated that US e-tailers lost $8.6 billion due to wrongfully declined transactions in 2016, which is $2 billion more than the $6.5 billion in fraud they could have stopped. This is, therefore, a motivational misalignment, which can be very expensive for the merchant.

Here’s my advice. The best way to align the motives of both the merchant and the fraud prevention tool is to set up a relationship in which both parties profit the more approved and good transactions there are. For this, we recommend looking at a mix of KPIs: the chargeback ratio, the denial rate and the manual review rate. Such an approach will help you make the most of your FP solution.

If you need the aforementioned peace of mind, simply get an elite fraud prevention system. I can assure you it will both mitigate the risk and keep fraud foiled. In fact, I believe that this is going to be more of an opportunity than a risk in the long term. Online merchants have been pushed to implement deep analytical tools into their infrastructure to counter payment fraud. Such tools, however, should also be creating value in their core business. Make sure that your fraud prevention provider is helping you leverage this opportunity to grow your business.

The article was published also by Lationews in Spanish and Portuguese.

The messaging presented here is based upon Bengt Holmström’s Nobel Prize-winning paper “Moral Hazard and Observability”. Read the paper or this article to learn more about the Principal-Agent theory.

If you liked this article and would like to prevent similar fraudulent activities connected to chargebacks from occurring in your business, Nethone's anti-fraud solution is perfect for you.