Chip & PIN, liability shift and the game of chicken (part II)

[continued from part I]

In a WSJ article, a representative from MasterCard describes the plan for incentivizing EMV adoption:

When the liability shift happens, what will change is that if there is an incidence of card fraud, whichever party has the lesser technology will bear the liability. […] So if a merchant is still using the old system, they can still run a transaction with a swipe and a signature. But they will be liable for any fraudulent transactions if the customer has a chip card. And the same goes the other way – if the merchant has a new terminal, but the bank hasn’t issued a chip and PIN card to the customer, the bank would be liable.

This is an interesting approach. It leaves the card-holder out of the equation– no pesky consumer protection agencies to worry about. Instead banks and merchants square-off against each other in a race to adopt EMV before the other party does, lest they be left holding the bag for losses.

While MasterCard representative quoted in the article disclaims any attempt to move liability around, there is no question that the proposed scheme amounts to disrupting the current equilibrium temporarily. The way dispute resolution for charge-backs is handled today, typically the merchant gets the benefit of the doubt for card-present transactions– in other words in-store payments when there is a signed receipt proving that the merchant performed due diligence to confirm the transaction. Conversely for card-not-present transactions, benefit of the doubt goes to the issuer and the merchant eats the fraud loss, which explains many of the misguided schemes such as Verified-by-Visa desperately trying to make a dent in the incidence of such fraud. For now CNP is unlikely to play much of a role in EMV adoption. From a technology stance, all of the elements are in place to enable NFC payments over the web using mobile devices/tablets. Yet business/regulatory hurdles remain before such systems can be deployed broadly.

With the new incentive structure proposed by the card networks, merchants may find themselves on the losing side of an unauthorized transaction dispute even for card-present transactions, if they are dealing with chip & PIN cards. (One amusing consequence may be that such customers become persona non grata; merchants may decline to accept cards with chip & PIN, although such discrimination would almost certainly run afoul of network regulations.) In theory this gives merchants incentives to upgrade their POS and payment processing systems, in order to maintain the status quo vis-à-vis issuers. Dangling before issuers on the other side is the lure of a temporary reprieve from card-present fraud. Any bank that issues chip & PIN cards may enjoy an advantage against merchants if the merchant still processed the transaction the old-fashioned way.

The problem is all such gains are temporary. In equilibrium, after both issuers upgraded all of their customers to carrying chip & PIN cards and all merchants terminals process payments via EMV protocols, the exact same liability regime from today is restored.

This leads to a bizarre state of affairs. In game theoretical terms, either merchants or issuers can benefit in the short run by adopting EMV first, before the other actor does. (This assumes that savings from fraud exceeds the capital investments required for upgrading, whether that means the cost of buying new POS hardware or reissuing new cards to existing customers.) Such benefits need not correspond to an actual decrease in fraud as experience by consumers. After all chip & PIN cards still have magnetic stripes, so they can be cloned for fraudulent transactions at merchants still relying on swipe technology. The operative question for the merchant/issuer is not whether fraud exists but who is picking up the tab. From that perspective, preemptive EMV adoption pays-off, leaving the “other” side on the hook. But once both sides have upgraded, that advantages vanishes.

Put another way, the card networks have almost set up a text-book experiment in behavioral economics. Crash upgrade to chip & PIN pays off unilaterally for each player as long as the other one has not upgraded but such benefits disappear once the opponent also upgrades. What is the rational choice in this situation? Racing to upgrade is no doubt the outcome the card networks are hoping for. In the short-term, merchants could pass on the capital investment to consumers in the form of higher prices. (It would be particularly amusing, and a certain measure of poetic justice, if a special surcharge applied to chip & PIN card payments only. But card networks would likely crack down on such blatant attempts to single-out EMV mandate for higher prices.) Curiously there is another equilibrium point: status quo. Both sides can delaying upgrades, betting that no one else is deploying EMV, and consequently there is no additional liability incurred from the redistribution mandate. Another wild-card here is how international transactions are treated. Even if US banks move slowly on issuing EMV cards, merchants can still be exposed to a significant downside from transactions involving cards from other countries. Card fraud is very much a global business. To the extent chip & PIN frustrates certain types of fraud in Europe, it has also served to redirect the criminals’ attention to the US market where it is easier to  monetize stolen EMV cards using traditional magnetic stripes. Cracking down on that by shifting liability to US merchants alone could be enough to tip the scales. Time will tell.


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