High Tech Credit Cards and Fraud

Smartcard2 - Channel R The New York Times ran an article over the weekend about how even though “smart” credit cards are more advanced, there is almost no reason to expect them to be adopted here in the USA. That is an interesting story, which I will get to in a moment, but the article revealed an astonishing statistic that is worth the distraction.

Fraud losses for the credit card companies are currently running at just six cents per $100 charged. That is 0.06%. Put that into the context of the average fee paid by the merchant to the card company, around 1.8%. Or the 1% to 2% that we all expect to get back from our cards in the form of rewards.

0.06%, or as we finance types would call it, 6 basis points, is a very small number. In the context of a retail store it is the moral equivalent of zero. For most merchants it is an order of magnitude smaller than “shrinkage” i.e. theft of inventory.

I always assumed that the losses due to fraud were small. Visa and MasterCard have made it clear with their actions that they are not much concerned with it. Despite the buzz around ID theft, the card companies have been quietly reducing security to make card use easier and cheaper. In most places the customer now swipes it himself, meaning that the clerk no longer even sees the card. And merchants are no longer required to get signatures for smaller transactions.

The card companies also reduced the customer’s liability in cases of fraud and theft down to zero.

Obvious and relatively cheap, if not free, anti-fraud measures have not been implemented by the card companies. They could have required photos of cardholders on the cards, as a few banks once did. (Do any of them still do?) Or they could have required a PIN to use the card, which is, let’s face it, much more reliable than a signature. Or they could have simply allowed merchants to require customers to show ID.

Card companies have done none of these things and are unlikely ever to do them. Why would they? At 0.06%, the potential reward for any anti-fraud measure is tiny and unlikely to justify the cost. Indeed, I am wondering why they bother to do what little they do now. Why ever require a signature? I can charge thousands of dollars at Amazon without a signature. Why not Home Depot too? I am betting this will happen sooner or later. Probably sooner.

Europeans do not sign when they use a credit card. They punch in a PIN. Which brings me back to the topic of so-called smart cards. In Europe, credit cards have fancy looking chip in them which allows a portable device to validate a PIN on the spot, without accessing a central database.

That seems more advanced and even the Times article refers to the USA as being “far behind” Europe in this respect. But the only practical advantage of a chip is that it is harder for a criminal to forge one than it is for him to make his own magnetic strip. That is not much of a benefit, and it could not possibly justify the cost of upgrading the 13 million magnetic stripe readers in America.

Indeed, the Times leaves me wondering why smart cards were ever implemented in Europe. The story about high telecommunications costs in Europe in the 1980s, thus necessitating PIN validation on the spot, sounds plausible and clever, but it does not really work. There is plenty of space on a magnetic stripe to include an encoded PIN.

More likely, a confluence of two things inspired the adoption of what now looks like a pointless complication. First, I imagine that European card issuers saw putting chips in cards as a first step to something bigger. Once millions of chip readers were installed, future generations of even smarter cards would be able to do really great things. Those things never materialized.

The other reason is the more obvious one. Chips in cards are cool, and were particularly so in the 1980s. I think there was momentum behind smart cards in Europe because it seemed high-tech. And if it was something the Americans had not adopted yet, so much the better. As an executive with Target said when they introduced (an ill-fated) smart card in 2001, “What is most important to us is to keep our brand hip and hot and innovative.”

[Photo – Channel R]

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