How Do Payment Facilitators Use Reserves?

When it comes to managing risk, a lot of attention is paid to the front end of a merchant relationship, and rightfully so. Proper underwriting procedures go a long way toward characterizing the risk that a merchant represents, and payment facilitators (often called payfacs) can and should decline merchant applications when they deem the risk to be more than they intend to take on.

But risk management is an ongoing, critical part of a payment facilitator’s responsibility. Once a merchant is onboarded, practices like transaction monitoring to watch for suspicious behavior kick in, to reduce exposure to the risk of fraud.

When it comes to credit risk – the likelihood of financial exposure from merchants who are not operationally viable – payment facilitators sometimes use another tool, known as a reserve. This refers to the practice of holding back funds from the merchant to guard against the possibility of losses in the future.

One common example is a merchant that sells custom furniture. The merchant in this scenario might take payment up front with the order and then deliver the product when it’s completed. The customer could then initiate a chargeback to try and recoup the money they paid with the order. If that money cannot be recovered from the merchant, the payment facilitator would then be on the hook for the amount.

Reserves are one possible way to reduce this type of risk. The payment facilitator could direct a percentage of the merchant’s transactions to be held by the acquiring bank, which would then accumulate until a certain amount is reached.

Acquirers might require reserves for certain risky merchants, but usually their use is dictated by the payment facilitator. They can set reserves for a group of merchants, such as those within a particular category, or even merchant by merchant.

While this practice can be useful in certain situations, it can also be harmful to merchants, and it should be undertaken only with great care. For businesses that are already struggling financially, holding back funds can add to their difficulty. It’s most commonly used by payment facilitators working with higher-risk merchants.

This brings us back to the beginning – identifying and understanding the amount of risk upfront with proper underwriting procedures. Payfacs should be prepared to decline applications from merchants that they deem too great a credit risk.

They should also be prepared to work with their merchants more closely to address any unexpected setbacks – such as the impact of the pandemic on many small businesses over the past year. Vertical software providers in particular can use their detailed knowledge of their merchants’ businesses to understand the business climate and the potential challenges, and then help come up with solutions