Ebook Taming the Beast: An Assessment of the Fraud Risk Implications of the Electronification of the U. S. Payments System
The U.S. payments system is glacially, but inexorably, metamorphasizing from a paper to an electronic state. We may be seeing, finally, the beginning of what was predicted in 1974, when the National Automated Clearing House Association was born: that is, the demise of the paper check. It is clear, however, that the U.S. payments system remains tied to paper. In 2000, the last year for which reliable data are available, the Federal Reserve estimates that Americans wrote 50 billion checks with a value of $48 trillion, 60% of all cashless transactions conducted in the United States. However, that represents a significant reduction from 1979, when checks totaled 85% of the volume of cashless payments. During the same period, electronic options have trended up, at a steep rate. Debit card use has increased from 1.1 million transactions valued at $33. billion in 1994 to 8.3 million transactions valued at $348 billion in 2000. ACH debits have grown from 886 million transactions in 19946 to 5.6 billion transactions valued at $5.7 trillion in 2000.
The parties to the payments system, consumers, retailers, payments processors, and financial institutions have different, and often competing, interests in the system’s evolution. Consumers want convenience and security. NACHA, the Federal Reserve system, regional ATM networks, Small Value Payments Company (SVPCo), the Electronic Check Clearing House Organization (ECCHO) and other groups, including the Banking Industry Technology Secretariat (BITS), are seeking ways to streamline the payments system, cut costs and to reduce risk and float. Of course, each wants to accomplish these in ways that benefit its own interests. For example, NACHA hopes to drive more volume through the automated clearinghouses while SVPCo sees the ATM/POS networks as providing the best way to electronify payments at the point of sale. ECCHO sees Electronic Check Presentment (ECP) as a means of squeezing expense out of the payments system without adding to fraud risk. Traditional retailers want to reduce their check-related expenses and card-related interchange charges. At the same time, the burgeoning online retail market requires new approaches to payments.
Paper-based check fraud cost banks nearly $700 million dollars in 1999, the last period for which reliable data are available. During the same period, commercial banks were successful in averting fraud attempts totaling $1.5 billion Check fraud losses are increasing 15% annually. However, anecdotal data suggest that the losses are well in excess of $1 billion per year to banks, with another $10 billion lost by retailers and other companies. To mitigate the effect of these losses, virtually every large bank (assets >$50 billion) and most medium-sized banks (assets $20-50 billion) have installed software that identifies suspicious transactions for further analysis.
The purpose of this paper, then, is to examine the impact these new "electronified" check transactions, which have been designed to increase the efficiency of the payment system, will have on check fraud losses. In particular, the paper will focus on projects involving the conversion of paper checks to ACH, ECP (Electronic Check Presentment) or electronic debits. In some cases, risks will increase. In others, risks will decrease. In others, risks will remain the same. In some, liabilities will shift and, in others, liabilities will remain unchanged.
The electronification of payments is not a new concept. Recurring consumer credits processed through automated clearinghouses (ACH) are widespread, particularly for federal payments to Social Security beneficiaries and direct deposits of salary. For instance, during 1998, 2.7 billion ACH credits totaling $7.8 trillion were processed in the United States. Similarly, recurring ACH consumer debits are a common, popular way to pay insurance premiums and make loan payments. Traditionally, these ACH payments have been between parties with well-founded relationships who use the ACH network because it is fast, reliable, inexpensive and, until now, virtually free of fraud. However, the industry initiatives to convert paper checks to electronic debits, and pay for goods and services over the Internet with funds from a checking account, will, I submit, increase the combined fraud losses of merchants and financial institutions and will redistribute fraud losses away from financial institutions to merchants. There are three reasons for this increase. First, the new environment creates new opportunities for criminals with no offsetting expectation of losses from other sources to decrease. Second, the parties to the transactions do not have an established relationship and the transaction may be the only encounter between the payer and the payee. Finally, the liability for forged maker’s signatures will be transferred, for the most part, from the financial institutions to the merchants. Hence, a primary objective should be for the financial services and retail industries to take steps to manage these risks.
Three specific risk areas that will benefit from electronification are losses arising from insufficient funds, closed accounts and stop payments. This is not an insignificant benefit. In 1999, insufficient funds losses accounted for 26% of the $679 million estimated to have been lost by the commercial banking industry. Closed account losses were 10% of the total and stop payments were 2%. By converting the transaction to electronics, the time it takes for a depositor to be notified that a check he or she accepted is no good is dramatically decreased. This time reduction limits the number of times someone can write worthless checks and directly translates into reduced losses both for financial institutions and merchants. Merchants will be the major beneficiaries from this reduction.
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