Real Price of Risk and Who Covers the Bet

Retailers pay for an authorization code and yet might not receive payment. Effectively, retailers pay for the cost of risk likely chosen by the customer. That does not seem a good way to price risk, which is the critical component of price in electronic funds transfer.  It’s akin to a landlord determining the risk of fire damage for a rental unit without a fire extinguisher and then demanding a price for the risk with no competing bids allowed and only allowing purchase of authorized fire extinguishers from the landlord. 

In a mythical world where my proposed small value gross real time payment system (SVGRTP) reigns as the leading backbone of international retail payments, insurers of transactions will add a surcharge payable by the party increasing the risk of non-payment. For example the initiation of payment may follow the decision logic shown in diagram 17 

Diagram 17 Decision Tree for Initiation of Payment in a SVGRTP

Each of the processes may have a number of known steps and each step has a cost if not completed. For example the Device validates the device process may contain 3 steps, namely:

1. User validation application address is in the correct interrupt vector.
2. Check sum of user validation application computes correctly
3. User validation application validates cryptogram generated from secure area on device

The entity that provided the software for the device to the user may skip a few of the steps or the user may opt not to run the validation phase at all. The insurer of the transaction prices the risk surcharge accordingly and the consumer pays for the risk created by choice. Similarly the retailer may not wish to have the POP authorize the device, and pays a surcharge to the insurer for that choice. The transaction completes, the insurer receives the surcharges immediately, and the insurer pays unsatisfied parties and tries to recoup the cost from the party benefitting materially from a failed transaction.

There are lots of technical details I did not cover here such as does each transaction have two insurers, one for the consumer and one for the retailer, and what if a party to a  transaction claims to compete a validation and does not. I am not going to worry my pretty head about details, because that is not the point of this discussion. The point is that increase in quantifiable risk results from choice and each party to a transaction needs to pay for the choices they make affecting risk.

Next Blog: Does an independent insurer make sense for the retail payment industry?