Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Can Smart Cards Reduce Payments Fraud and Identity Theft?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Can Smart Cards Reduce Payments Fraud and Identity Theft?

Article excerpt

In the United States, when a consumer presents a payment to a merchant, the merchant typically makes a request for authorization before accepting the payment. Personal information, such as an account number, address, or telephone number, is often enough to initiate a payment. A serious weakness of this system is that criminals who obtain the correct personal information can impersonate an honest consumer and commit payments fraud.

A key to improving security - and reducing payments fraud - * might be payment smart cards. Payment smart cards have an embedded computer chip that encrypts messages to aid authorization. If properly configured, payment smart cards could provide direct benefits to consumers, merchants, banks, and others. These groups would be less vulnerable to the effects of fraud and the cost of fraud prevention would fall. Smart cards could also provide indirect benefits to society by allowing a more efficient payments system. Smart cards have already been adopted in other countries, allowing a more secure payments process and a more efficient payments system.

This article explores why smart cards have the potential to provide strong payment authorization and thus put a substantial dent into the problems of payments fraud and identity theft. But adopting smart cards in the United States faces some significant challenges. First, the industry must adopt payment smart cards and their new security standards. Second, card issuers and others in the payments industry must agree on the specific forms of security protocols used in smart cards. In both steps the industry must overcome market incentives that can impede the adoption of payment smart cards or limit the strength of their security.

Section I reviews the costs of payments fraud and describes how payments fraud is related to identity theft. It then illustrates how card payments in the United States are currendy authorized. Section II explains how smart cards work and how they can improve payment authorization. It also describes weaknesses that can remain even with the use of smart cards. The next two sections discuss the economic challenges that smart cards face in the United States. Section III examines the incentives for adopting payment smart cards and for upgrading payment security standards. Section IV examines the market processes that determine the security standard used in payment smart cards. The final section offers some concluding thoughts.


Payment fraud is costly to all payment participants and has indirect costs that affect all members of society. Identity theft often leads to payment fraud, which is made possible because the authorization process fails to identify a fraudulent transaction. Before looking closely at how payment smart cards can improve the security of payment authorization, it is useful to consider several basic questions. What are the costs of payments fraud and how are they distributed? How is payments fraud related to identity theft? And, what is the purpose of payment authorization and how does it work?

The costs of payments fraud

The exact costs of payments fraud are difficult to pin down because the data on costs are not consistently reliable. Still, a review of selected data helps show the magnitude of the problem and who pays the costs. Clearly, the costs are spread across many members of society.

Losses from payments fraud are shouldered by banks, merchants, and consumers. Bank losses total about $2.89 billion per year (Table 1 , panel A). ' The largest share of bank losses are on credit cards, followed by losses on checks, debit cards, and ACH payments. Fraud losses for retail merchants total about $1 5.6 billion per year, with most losses due to bad checks.2 Reflecting the growing importance of Internet retailing, merchant losses from credit card fraud at websites are now larger than those at brick-and-mortar locations. …

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