“Bitcoin fixes this” is a popular refrain whenever a gun store or exotic dancer loses access to payment processing. But what causes “this” in the first place?
As long as people have been going online and paying to do things viewed as socially undesirable, there have been movements to use the payments system to prevent transactions associated with that activity from taking place.
More than 20 years ago, Rep. Jim Leach, a Republican congressman from Iowa, led a yearslong crusade to make it illegal for banks chartered in the United States to process payments for online casinos, even though the majority of those operations were legal in the countries where they were located.
More recently, the Obama administration’s Justice Department, from 2013 to 2017, ran Operation Choke Point, which targeted banks offering services to a vast array of businesses it deemed to present a high risk for fraud or money laundering. The list covered everything from the blatantly illegal, such as Ponzi schemes, to the simply disfavored, including tobacco sales, payday loan operations, “racist materials” and porn.
Choke Point was discontinued in 2017 amid accusations that it wrongly targeted legal businesses and the settlement of lawsuits brought against the Federal Deposit Insurance Corp. by businesses that were cut off from banking services.
While there may no longer be a concerted effort in the U.S. to block disfavored industries from accessing the payments system, many of the same legal businesses targeted by the feds in the past, and some that have only recently emerged, including firms in the cryptocurrency industry, still find it difficult to get access to payments services.
This article is part of CoinDesk’s Payments Week series.
In most cases, the problem isn’t attributable to law enforcement and bank regulators, as it was under Operation Choke Point. Rather, banks that serve as gatekeepers to the system simply don’t wish to do business with what they perceive as high-risk clients.
In general, companies in the payments industry label businesses as “high risk” if those businesses generate a large number of disputed transactions or if they operate a business that presents the possibility of damaging a bank’s reputation.
In some cases, intermediaries succumb to public pressure to remove merchants from their platforms. In 2018, PayPal (PYPL) announced it was blocking Infowars, the media company associated with conspiracy theorist and internet personality Alex Jones, from using its services, claiming that Jones “promoted hate.” The decision followed months of public pressure and came weeks after other major tech companies, including Facebook (FB) and Twitter (TWTR), had cut Jones off.
(As of last week, though, it remained possible to buy “Brain Force Plus” dietary supplements, “Alex Jones Was Right” T-shirts and a vast array of other items on the Infowars Store website, using any major credit card.)
The category of “high-risk” merchants is broader than one might assume, extending far beyond the realm of adult entertainment, gambling, drug paraphernalia and online psychics. Other businesses labeled as risky include large segments of the travel industry; furniture sellers; electronic retailers hosted by Amazon (AMZN), eBay (EBAY) or Google (GOOG); and magazine subscriptions.
To be clear, while it is difficult for many of those businesses to get payment services, that doesn’t mean it’s impossible. Most legal businesses operating in the United States can find a way to hook into the payments system, but they have to pay a steep risk premium to do so.
“It is more expensive,” said Maria Sparagis, founder of DirectPayNet, which helps companies labeled as “high-risk” find payment processing services. “And sometimes it can be highway robbery. It depends on who you're working with.”
Skittish gatekeepers and financial exclusion
For merchants who want to be able to accept credit cards for their goods and services, the key relationship they need to have is with an “acquirer,” which is typically a bank that can process payments on the major networks, including Visa (V), Mastercard (MA) and American Express (AXP).
While the payment systems themselves have rules that exclude some businesses, primarily outright illegal activities, most of the decisions about the kinds of business that can easily access the payments system are made at the bank level.
To simplify decision-making, banks usually divide prospective payments clients into categories, said Thomas A. Layman, president and CEO of Global Vision Group, a payments consultancy.
“Each merchant acquirer usually has a set of three,” he said. “Some are favored and they go right through. Others have to have more review. And then others, they just are prohibited.”
Because the decisions are made on a bank-by-bank basis, it can result in seemingly arbitrary distinctions between different kinds of businesses.
“A particular board of directors of a bank just does not want to be in adult entertainment, but they'll be happy to do gambling,” Layman said.
In some cases, bank management may decide to bar certain industries, like adult entertainment or gambling, because they don’t want their institution associated with those areas. In many cases, though, the decision about which industries to bar and which to accept is less about drawing moral distinctions between specific industries and more about simple risk management.
“To underwrite an account in a high-risk industry, you need an underwriter who understands that business in and out, and understands the risks, the implications, the fraud that can happen in this type of business on a transactional level, not just reputational risk,” Sparagis said.
“Say you're selling online prescriptions,” she continued. “It's legal to do that, but it's difficult for processors to accept these because there are licenses involved, there's a lot of research that the underwriter has to do to make sure that you're operating legally, that you're taking all the precautions that are necessary, that you’re keeping up with legislation.”
One thing that most of the businesses labeled as high-risk have in common is a higher rate of disputed charges and refund requests than typical merchants.
A person whose spouse finds a porn site subscription on the family credit card bill may well claim the card was stolen and demand the charges be reversed, a request card networks require banks to honor.
Merchants like travel companies, where the payment is made far in advance of the service being delivered, often receive payment from the acquiring bank before a customer cancels a trip and demands a refund.
In both cases, the acquiring bank needs to trust that the merchant will have enough cash on hand to make the bank whole after a purchaser’s money is returned.
Higher costs for “high-risk” merchants
In a typical payment processing arrangement, a merchant pays a fee to the processing bank for each transaction. The fee covers the “interchange fee” collected by the card issuer, as well as the acquiring bank’s own fees. The interchange fee usually adds up to 1.5% to 3.5% of the total transaction, depending on the network.
For low-risk transactions, acquiring banks typically compete on price, with processing fees well below 0.5% of the total transaction.
“It's sort of a race to the bottom when there's no risk involved,” said Michael Liquornik, president of Fin-Serv Advisors, a payments consulting firm. Mainstream payments processing is a business that operates best at scale, he said, and so most providers focus on building up a large base of merchants.
In the high-risk sector, however, the calculus changes. According to personal finance site NerdWallet, typical processing fees charged by acquiring banks can be five times as high as those for more traditional businesses.
For a high-risk startup trying to establish the kind of track record that would make a mainstream processor willing to take it on as a customer, the cost of entry can be even steeper.
Many turn to aggregators, which are companies that have relationships with acquiring banks and, for a price, assume some of the financial exposure related to high-risk businesses. That price can be 8%, 10% or even 12% of total transaction fees.
A typical startup’s strategy is to spend as little time as possible doing business with aggregators, building up enough of a reputation to persuade an acquiring bank to take it on.
But even with a history of steady business and a manageable rate of disputed charges, said Liquornik, some banks decide that the elevated processing fees just aren’t worth the trouble associated with high-risk clients.
“We would usually advise our clients to steer clear of a lot of these things. Whether it's financial, reputational or regulatory [risk], who needs this headache?” he said. “You have to remember, if you're providing a payment service, you typically have thousands, tens of thousands, hundreds of thousands, even millions of clients. How do you monitor the activity of all of those clients? It becomes almost impossible. The only way to approach it is to prohibit some edge cases.”
High-risk businesses that break through that reluctance and find an acquiring bank willing to work with them may face further hurdles. A common practice in the industry is to require them to establish a reserve account to protect the processor against unexpected claims in the event the merchant doesn’t have the funds to satisfy them.
A typical arrangement is a six-month “rolling reserve” of 10%. Under that arrangement, 10% of a merchants’ receipts are placed into an escrow account held by the processor. After the first six months of the relationship, the processor continues to withhold 10% of receipts, but pays out the first month’s reserve in order to maintain a balance of 10% of the previous six months’ receipts.
The difficulty of finding a payments processor leads some merchants into the legally dangerous practice of pretending to be a different sort of business altogether.
“Many merchants don't always tell you everything that they're selling,” said Layman of Global Vision Group. “There are a lot of websites out there that are really masking what I would call very high-risk merchants behind the scenes by appearing to be something else.”
Often that involves “miscoding” transactions by providing false information about the nature of a charge. In 2020, Visa and Mastercard imposed heavy fines on Wirecard, a now-insolvent German payments processor, for miscoding gambling transactions.
Misrepresenting the nature of a business in an application to a payment processor is an extremely risky move, said Adam Atlas, a New York-licensed crypto and payments lawyer.
“It is a crime in the U.S. to include false information in a bank account application, and the application for a payment processing account is tantamount to a bank account application,” he said. “There are a handful of criminal cases that I have seen where the prosecution has put its finger on factually incorrect information in the merchant account application as one of the bases on which to proceed with a criminal prosecution.”
The threat of prosecution doesn’t deter everyone, he said, and “willful blindness” on the part of some acquiring banks means that many legally dubious merchants are alive and well inside the payments system.
“If one were to audit every merchant account of every U.S. bank all the way down to the cardholder, the transaction and the settlement of funds, I would not be surprised if there were substantial volumes” of illegal activity, Atlas said.
The irony of crypto
Arguably, one of the few successful use cases for cryptocurrencies is as a means of payment for businesses, legal or otherwise, that have a hard time accessing mainstream payments processing at a reasonable price, or at all. Ironically, crypto businesses themselves struggle to gain acceptance by acquiring banks.
Much of the hesitation about providing payment services for crypto companies is a result of a lack of expertise among underwriters. If banks don’t understand the risks associated with a business, the thinking goes, they shouldn’t be processing payments for it.
According to Atlas, many banks also have doubts about crypto firms’ anti-money laundering screening processes and are afraid of “unknowingly assisting in money laundering.”
“Every crypto exchange, crypto liquidity provider or other crypto business that I see is having difficulty finding and maintaining banking and payment processing,” Atlas said.
“When a crypto exchange or crypto seller is looking to take payment by credit card or automated clearing house, they face a very difficult challenge of convincing the banks that control those services that they should be accepted as customers,” he said, though the reluctance is slowly fading.
“There was a time when absolutely anything to do with crypto was simply forbidden,” Atlas said. “I think we're past that era right now, and we're into an era where there are processing banks that welcome crypto businesses as clients, other acquiring banks that simply don't, but at least they understand what they're rejecting.”
Sparagis, of DirectPayNet, said there is still a fundamental lack of understanding within mainstream processors, of the crypto industry, making it a challenge to underwrite.
“Their staff is not necessarily up to date with everything that's happening in crypto,” she said. “I mean, we get a lot of leads. People who say, ‘Hey, I want to sell my NFTs (non-fungible tokens) and take a deposit with a credit card.’ Well, you've just lost like every payment processor in the world. … If they don't understand it, even if it's a valid business model, they're just going to say no.”
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