Credit risk in payments is sometimes mentioned, often forgotten about and occasionally deadly for payments companies managing delayed delivery merchants.
But let’s start at the beginning: what is credit risk in payments?
Credit risk in payments occurs when payments companies process transactions for merchants who deliver goods or services days, weeks, or even months after receiving payment.
During this gap, merchants hold a liability to their customers. Under normal circumstances, this works fine. But when a merchant fails with outstanding customer orders, the liability doesn’t disappear. Instead, it shifts to the payments company, turning merchant risk into your risk.
When it goes wrong
The dangers become clear when examining real-world failures. One high-profile example is the Pemberton Music Festival, a large Canadian music festival scheduled for summer 2017. Just two months prior to the event, the organisers filed for bankruptcy, citing financial difficulties. Roughly 18,000 tickets had been sold at that point. With the event cancelled and no refunds issued by the bankrupt organisers, attendees had to seek chargebacks. The festival’s ticketing platform, Ticketfly, was hit with C$7.9 million in chargebacks from card issuers refunding those fans. This catastrophic example highlights why payments companies must have robust risk mitigation strategies in place.
How do payments companies mitigate this risk?
Over many years, the industry has developed a set of strategies to ensure payments companies mitigate this risk as effectively as possible. While traditional approaches can provide some protection, they often create significant burdens for both the payments companies themselves (in terms of manual processes) and for the merchants, particularly those needing working capital to grow.
The first step is a thorough onboarding and underwriting process when the merchant first enters the system, before they start processing. Once the underwriting process is complete, payments companies assess each merchant against their risk appetite before allowing any transactions. However, medium and high-risk merchants typically require additional safeguards:
Collateral
One of the most basic methods is to take a large lump sum of collateral. This involves the payments company estimating any future losses and requiring the merchant to post a certain amount of money to offset these. As you can imagine, this can be quite difficult for a merchant as the money they post is no longer available as working capital. In the worst case scenario, if they are in financial trouble, this could mean the difference between survival and bankruptcy.
Rolling reserve
This method allows the payments company to hold back settlement of a percentage of funds on a rolling basis. This is a less blunt instrument than lump sum collateral, but it ties up valuable working capital that can be vital to the success of a merchant, and a lifeline in times of difficulty.
Delayed settlement
Allows the payments company to not settle to the merchant’s account until a number of days after the initial payment event has occurred. Similar to rolling reserve, this ties up vital funds that the merchant may need to access in the short term.
Insurance solutions
One of the newer ways the industry is looking to solve this problem is using insurance solutions as a means to offset merchant credit risk. How this generally works is that a payments company works with an insurance-as-a-service provider (such as Envisso) to perform thorough underwriting of their entire portfolio of delayed delivery merchants. This portfolio approach to underwriting means that the risk is spread across all merchants, and high-quality global insurers are willing to take this risk in a way that is economically viable for both the payments company and the merchant. It removes the need for a loss of working capital for merchants and speeds up the onboarding flow dramatically, giving merchants a much better experience.
So what is the ideal solution?
The ideal credit risk solution balances three factors: protection effectiveness, merchant cashflow impact, and operational efficiency.
Traditional methods (collateral, reserves, delayed settlement) protect payments companies but can restrict merchant working capital by 10-20% or more, potentially causing the very failures they’re meant to prevent.
Modern insurance solutions offer a compelling alternative:
- Portfolio-wide risk assessment instead of individual merchant penalties
- Instant coverage decisions during onboarding
- Full merchant cash flow preservation
- Dynamic scaling as volumes grow
Results speak for themselves: payments companies using insurance have reported 90% faster onboarding, while accepting merchants they previously would have rejected.
Your choice depends on your risk tolerance and growth goals. But in today’s competitive landscape, protecting your business while enhancing merchant experience is essential.
If you would like to learn more, reach out to our team.