Assessing the landscape of payments fraud

Chicago Fed Letter,  Jul 2008  by Jacob, Katy,  Summers, Bruce J

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The Federal Reserve Bank of Chicago will host its eighth payments conference on June 5-6, 2008. The conference will highlight threats to the security of the payments system and explore solutions to those challenges. This article previews issues that will be covered at the conference.

One of the key roles of the Federal Reserve is to promote the integrity and effi ciency of the U.S. payments system.1 This mission takes on many forms, and encompasses fi nancial services, supervisory activities, the Fed's public policy function, and economic research. The Federal Reserve System provides retail payments services on behalf of the U.S. Department of the Treasury and clearing and settlement services to depositories; helps set payments policy; provides consumer protections; and regulates the payments activities of banks around the country.2

A key component of maintaining the integrity of the payments system includes risk mitigation and fraud management. Since the very fi rst incidents of counterfeit currency, the payments industry has faced a variety of security-related challenges. Concerns related to payments security have escalated in recent years. As payments shift away from paper-based forms toward electronic instruments, consumers face an increasing array of payments options that entail different fraud risks. The Fed plays an active role in identifying new trends in payments fraud and developing effective ways of implementing responses to those trends.

Payments fraud: Past, present, and future

Fraud is a very real threat to the payments system's effi ciency, which is measured by the quality of its operational performance and cost.3 According to one recent survey, 71% of fi nancial institutions reported instances of payments fraud in 2007, and 37% of those fi rms reported fi nancial losses stemming from the fraudulent activity.4 Fraud degrades operational performance and increases cost-not only for the parties to the transaction(s) whose payments are disrupted but also for the payments system as a whole.

While older payment forms, such as checks, have always been vulnerable to fraud, newer electronic forms have opened up a more complex array of opportunities for fraud and data theft; these are related to the more open nature of twenty-fi rst-century electronic information and recordkeeping. Moreover, the number and type of players in the payments industry is growing, as nonbank companies, such as Wal-Mart, compete directly with fi nancial institutions by offering payments services. All of these changes have led to an increasingly complex security environment for payments providers, merchants, consumers, and the public sector. Various players must discern whether new payment types carry excessive fraud risk; who is liable when payments fraud occurs; how losses are allocated; what consumer protections should be in place; and how standards should be defi ned to lessen the incidence of fraud. While everyone might agree on the fundamental importance of reducing fraud in the payments system, there are differing philosophies about how to achieve this goal.

The role of the market

Payments practitioners have an immediate incentive to reduce fraud in order to remain profi table and to avoid reputational and regulatory risks associated with fraud losses. Industry participants recognize that security is hard to achieve and ensure. Security is expensive to produce; therefore, it can result in indirect but nonetheless real costs to consumers. For this reason, cooperation across the supply chain is not only desirable but also necessary to achieve effi cient outcomes for consumers. Institutions that are trying to manage payments fraud levels face constant change as they attempt to keep abreast of new technology and security needs. Regardless of the fast pace of change, participants in the payments system recognize the importance of effective fraud reduction strategies, since the banking and payments industries depend on reputation and trust for their success.

Many payments practitioners and some economists argue that the payments system performs quite well in responding to fraud risks; therefore, they favor a private market approach to fraud containment. This view of retail payments system fraud was represented by the diverse cross section of participants in a 2007 roundtable on the subject sponsored by the Federal Reserve Board's Payments System Policy Advisory Committee.5 The roundtable, which included representatives of banks, nonbank payments providers, payment card companies, and technologists, offered a variety of views but also reached a broad consensus on some important points. There was consensus that the current level of payments fraud is being effectively managed; however, organizations must constantly adapt to keep pace with criminal activity, technology-driven change, and innovation in the payments system.

Roundtable representatives concluded that it would be impossible to eliminate fraud completely. They noted that fraud prevention initiatives must balance costs and benefi ts and that payments practitioners have different incentives motivating their fraud resolution measures. While the roundtable representatives indicated that the dollar value of fraud relative to business revenue is declining, their business costs for fraud mitigation are both substantial and trending upward. An especially interesting consensus emerged: The instrument that is the principal source of fraud losses on a comparative basis is the traditional paper check, as opposed to more recent electronic payment innovations.6