What are Reserves, and How Do Payment Facilitators Use Them to Mitigate Risk?

Payment facilitators have a number of tools they can use to reduce their exposure to risk. To mitigate against credit risk, PFs will sometimes hold back funds from the submerchant – known as a reserve – to guard against possible future losses.

When are reserves typically used, and is now – as many businesses are experiencing financial hardship because of the coronavirus – a time to implement them?

One of the primary types of risk that PFs face is credit risk – the risk of financial exposure from working with submerchants that are not operationally viable.

For example, if a submerchant is selling a custom product, it might take payment for an order upfront. If it then goes out of business before delivering the order, the consumer could initiate a chargeback to get their money back. If the PF is unable to recover the funds from the submerchant, it is typically then responsible for the amount.

Using reserves is one way some PFs can reduce exposure to this type of risk. The PF might ask for a certain amount of money from the submerchant upfront or set aside a percentage of its transactions until a certain amount is reached. The reserve funds are held by the acquiring bank – not the payment facilitator.

Whether or not to maintain reserves is typically up to the payment facilitator. It can be done for a particular merchant category code (MCC) or group of them, on a portfolio basis, or submerchant by submerchant. There are times, on particularly risky accounts, when an acquiring bank may require a reserve.

However, while reserves can be a useful tool, they’re not considered a best practice for every payment facilitator. The practice is most often used by payment facilitators who are choosing to operate in higher-risk verticals.

Typically, PFs should instead be more focused on conducting proper underwriting to identify riskier submerchants at the outset. Under normal circumstances, they should be ready to decline a submerchant application or to terminate a client that they determine represents significant risk.

But what about now, during the COVID-19 outbreak? Consideration of credit risk is at the forefront for some payment facilitators, as many small businesses could be struggling to stay afloat.

While this may be true, using reserves during a time of economic turmoil time should not be taken lightly, according to Deana Rich, co-founder and co-CEO of Infinicept.

“Reserves in a time like this are tricky,” Rich said. “If you put a reserve on a flailing business, the reserve might be the straw that puts them under.”

Working directly with submerchants to find creative solutions is a better approach, and is now more important now than ever, she said. For example, submerchants could call their own suppliers to ask for changes in terms.

“Pay attention to those submerchants that are most at risk and work with them,” Rich said. “Don’t wait for the submerchant to come to you. Being proactive is more important than ever right now, as there are no safety nets.”