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November 11, 2016

How does credit card fraud detection system work?

How does credit card fraud detection system work?

— What is the objective of credit card fraud detection?

TL;DR: There are two objectives of credit card fraud detection. It helps merchants and banks reduce the number of payment fraud cases and helps merchants grow their revenues.

To run a sustainable business, merchants need to make a profit, which is what’s left after deducting the costs of doing business from a company's revenue. Therefore, a business’s tolerance for payment fraud is a function of, among other things, its gross margin (sell price - cost of goods sold). The lower the margin, the lower the tolerance for payment fraud.

In practice, when fraud occurs, the cardholder disputes the charge and the debit is usually cancelled, which means either the cardholder’s bank or the merchant absorbs the loss (see [1] for more details). Cumulatively, fraud represents a significant financial risk to the merchant and the issuing bank. To reduce fraud, chip and pin technology, 3DSecure, and fraud detection techniques are used.

But if chip and pin technology and 3DSecure exist, why is fraud detection used? There are two main reasons.

First, the total cost of chip and pin technology and 3DSecure is relatively high compared to the cost of fraud detection. e.g., while online merchants care about conversion, 3DSecure reduces it by several percents (> 5%). Hence, when they have the option, many online merchants decide to deactivate 3DSecure and manage the risk of payment fraud themselves.

Second, adding more security layers to the buying process greatly reduces checkout velocity and, in turn, convenience for the buyer. While convenience for buyers may look like a fuzzy concept at first, for companies like Amazon, which pioneered one-click checkout, it’s a marketing argument and a means to convert and grow revenues.

Conclusion. The objectives of credit card fraud detection are to reduce losses due to payment fraud for both merchants and issuing banks and increase revenue opportunities for merchants.



[1] How do banks afford to absorb costs associated with credit card fraud