The optimal amount of fraud is non-zero

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Original Article: The optimal amount of fraud is non-zero

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I was recently interviewed by NPR’s Planet Money (podcast, transcript) regarding a particular form of credit card fraud. One comment which tragically ended on the cutting room floor: "the optimal amount of fraud is greater than zero."

This is counterintuitive and sounds like it is trying a bit too hard to be clever. You should believe it.

Crime rates are a policy choice

If you enjoy simulation games, you might be familiar with the mechanic where you click a button and some statistic in your civilization moves radically in response. In real life, cause and effect is more subtle, but this relationship exists, and there are (both historically and at this very moment) legal regimes which are radically different than your status quo, and which achieve(d) very different outcomes as a direct consequence of policy decisions.

A glib way to phrase this is that crime is a policy choice, both definitionally (you could simply agree something was not a crime anymore and bam, crime down) and, more interestingly, because crime responds directly to things which are within your control. Most of the world has taken most of the easy policy choices which have few tradeoffs available! But there are still arbitrarily severe options to control crime from where you are, from “increase the police budget” to “ban alcohol totally” to “implement an Orwellian dystopia.”

Fraud is a unique subset of crime which occurs, to a major degree, subject to the enforcement efforts of non-state actors. A commanding majority of all fraud which is stopped, detected, adjudicated, and even punished (!) gets those done to it by one or more private sector actors. And the private sector has, in this case, policy decisions to make, which, like the public sector’s decisions, balance the undesirability of fraud against the desirability of social goods such as an open society, easy access to services, and (not least!) making money.

Scoping down to payments fraud

To prevent this conversation from being painfully abstract, let’s scope it to one particular type of fraud against one particular type of actor: the bad guy steals a payment credential, like a credit card number, and uses it to extract valuable goods or services from a business. This is an extremely common fraud, costing the world something like $10 to $20 billion a year, and yet it is actually fairly constrained relative to all types of fraud.

This fraud is possible by design. The very best minds in government, the financial industry, the payments industry, and business have gotten together and decided that they want this fraud to be possible. That probably strikes you as an extraordinary claim, and yet it is true.

Before we get into the how, let’s get into the why.

Who pays for payments fraud?

Liability for payments fraud happens in a waterfall, established by a combination of regulation, contracts, and business practice. The specifics get complicated but, for ability to concretely visualize this, consider the case of consumer credit card users in the United States.

You might assume that, if a credit card is stolen/hacked and used by a bad actor to buy something, the cardholder would be liable. They will suffer the first loss, certainly, but society has decided by regulation (specifically, Regulation E) that that loss should flow to their financial institution...

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