Q&A: The Risks and Benefits of Frictionless Underwriting

The advent of frictionless underwriting turned the payments world on its head.

The ability to onboard merchants quickly with a minimum of fuss has enabled small merchants to accept payments more easily, clearing the way for many more to enter the market.

But the practice does have its downside. Lowering barriers to entry into the payments system lowers them for everyone, not just the good guys.

With that in mind, PaymentFacilitator.com is beginning a series on the perils and the benefits of frictionless underwriting. We start with a conversation between editor Kim Graber and co-publishers Todd Ablowitz, president of Double Diamond Group, and Deana Rich, president of Rich Consulting, about what frictionless underwriting really means.

KG: Is there an official, agreed-upon definition of frictionless underwriting?

TA: No. It means different things to everybody.

KG: What’s your definition?

TA: My definition is avoiding the paper and avoiding the unnecessary 150-question application. Most frictionless onboarding includes a merchant application that has 15 to 30 questions and some automated database checks for KYC and other required checks, to ensure that a merchant is not a bad actor. That’s followed by a human process if something looks out of line to the automated system.

KG: How fast is frictionless underwriting?

TA: When done right, it should be close to instantaneous. They take the merchant and the owner data and bounce it against automated databases that exist. There are many of them. A good system can execute on that in seconds.

DR: We need to make sure we’re clarifying that a proper frictionless system also has low approval limits in the beginning.

So, where Todd is saying that if you check against enough databases you should be able to get an instantaneous approval, that’s a true statement. But if the merchant is applying for $200,000 a month worth of processing, that will not be enough. If they’re applying for a small amount, it may be enough.

Also, with frictionless underwriting, you need to increase the risk monitoring in response. With less rigor on underwriting comes more rigor on monitoring.

KG: So, if low limits and increased monitoring are sufficient in some cases, why do you ever do full underwriting?

DR: You’re always doing full underwriting, you’re just doing it differently. Because you can’t not do KYC. You just have to do more in-depth underwriting when the processing amount increases.

KG: What do you mean by “in-depth”?

DR: One example is website review. With frictionless underwriting, you might be ok with the merchant monitoring service provider review of a web site. The more in-depth review of that web site would be an actual person looking at it for appropriateness.

If a merchant is saying they want $200,000 a month in processing and the web site has two pages, while it might pass merchant monitoring service provider lookups or scrapes, it’s not going to pass the sniff test of, “Will these two pages be really able to generate $200,000 a month?”

TA: Another way to think about it is that, with frictionless underwriting, you’re not necessarily doing everything that you would do normally, but you’re doing all the required checks, with possibly not as much rigor on the optional ones.

So, the example there is, you may not do a credit check with frictionless underwriting. You’re always worried about KYC, you’re worried about acceptable use – meaning not having counterfeit goods sold – or you’re worried about illegal content or things like that.

But you’re not necessarily as worried about the creditworthiness of the merchant in certain low-risk industries. You’re going to do an automated screen, but maybe not have a human looking over it as well.

DR: Agreed.

KG: What gave rise to frictionless underwriting in the first place? What’s the need that it met?

TA: First of all, Square started it, and they brought very small merchants into the fold that really weren’t even candidates.

The business need is, how do you just spend a lot less money to onboard someone? And a lot less time? And have almost the same result? That was the idea.

And now when you look at it, there’s all sorts of overkill process with bringing on small merchants. For large merchants, there isn’t the same urgency. It takes time to onboard them anyway.

KG: What sort of risk does frictionless underwriting open up?

DR: With frictionless, you run the risk of more bad actors getting a merchant account.  So, when you use frictionless underwriting, you do need to be more diligent in your transaction monitoring.  As they begin to process, you need to make sure that what they told you they’re doing is what they’re really doing. With frictionless, you often don’t do any human sniff tests on it, which means people really looking at it to make sure everything is as it says it is, as opposed to just enough to get by a computer system.

So, once they begin to process, you then add the human element that is always necessary in understanding your merchants.

TA: At the end of the day, you have to make sure the merchants don’t run away with your money. And to do that, you’re going to need to put certain controls in place to make sure that, while you trusted them when you did a frictionless evaluation of their business, you verify that they’re not running a bunch of white plastic cards through the terminal in the back room.

KG: Or might one example be if someone signs up for a merchant account to sell something legitimate, but they instead use it to sell something illegal, like drugs? The transaction monitoring is looking for consistency with what you said you were doing?

DR: That’s right. And that’s why, at some point, a person’s review is necessary. If I said I’m selling widgets for $75 a widget, and I sell something illegal for $75, and no other research is done, it will look as though it’s consistent with what I applied for. So, at some point there has to be testing, as you otherwise would have done if you didn’t use the frictionless approach.

KG: What happens to the payment facilitator, then, if someone in the chain finds out that transaction laundering or something else illegal is happening?

DR: If they’re doing something illegal – transaction laundering, for example – the payment facilitator is on the hook. They are responsible to make sure that their submerchants sell legal goods and they are selling the legal goods they’ve applied to sell.

And if they don’t, the very least that will happen is they will have to shut that merchant down. But they also could receive fines from Visa and Mastercard for enabling the selling of those illegal goods. There are programs against that. And the fines can be pretty hefty – tens of thousands up to hundreds of thousands of dollars.

Depending on how big the offense is, the CFPB or FTC could get involved. The DOJ sometimes gets involved. The more consumers that are harmed, the more likely it is that relevant government agencies will come in as well.