The purpose of this article is to familiarize PSPs with the concepts of merchant services reserves. As mentioned in the previous article, handling of transactions that occur outside the normal processing cycle is an important consideration to bear in mind in the context of merchant funding (remittance). These transactions are refunds, ACH returns and chargebacks.
Chargebacks and ACH returns can come in within 60-day period from the time when the original transaction was processed. Consequently, the money for that transaction may already have been funded, and it is important to ensure that merchant will be able to cover the expenses resulting from these types of transactions.
The most common tool for dealing with refunds, chargebacks and ACH returns is withholding of the reserves.
Merchant services reserve concept
Generally, a merchant services reserve is a pool of money that is maintained to minimize the risk of financial fraud for PSPs (third party processors or payment facilitators). There are three reserves, which are commonly maintained, and can be dynamically adjusted every time a remittance process occurs.
The types of merchant services reserves and models for reserve formation are addressed in the sections below.
Types of reserves
Conceptually there are two reasons why reserves are maintained.
Firstly, reserves are intended to cover expenses resulting from transactions that reverse previously approved payments, and occur after the originally approved payments are already funded. Examples of those are chargebacks and ACH returns. Reserves for ACH returns and chargebacks are held because these transactions can come within 60-day period after the time of the original transaction processing.
Secondly, reserves are intended to cover expenses resulting from transactions that produce negative balance against an account (bank account) that doesn’t belong to the merchant, for example, credits and refunds. Reserves for refunds are often used by wholesale resellers, who use aggregation models (or by PSPs), as refunds for merchant’s products are withdrawn from the PSP’s account.
All merchant services reserves are always withheld by PSPs as deductions from merchant remittances. When a refund needs to be performed, the funds are taken out from the refund reserve. If the reserve is empty, no further refunds can be issues.
Merchant services reserve calculation models
Generally, a reserve can represent either a fixed amount or a percentage of processed transaction volume. These two approaches for merchant services reserve calculation are addressed below.
Reserve as a fixed amount
Under this approach a reserve represents a fixed amount of money. The approach is commonly applied to refund reserves. A certain fixed number (say, $5000) is established, providing the maximum reserve and the maximum possible amount of refunds.
Reserve as percentage
Under this approach a reserve is established as a percentage of the total volume of transactions approved. The option is more frequently used for ACH return and chargeback reserves.
A reserve percentage together with analysis time period (one or two months) is established. Every time a remittance is performed, depending on the time frame, transaction volumes processed during the last 30 or 60 days, are analyzed, respective established percentage is calculated, and the resulting amount becomes the reserve requirement. Reserve is refilled as a deduction from a remittance.
In some cases, if processing volumes increase, larger reserves may need to be withheld, while, if processing volumes decrease, some funds need to be returned back from the reserve. Sometimes, it is recommended to retain a minimum fixed amount in the reserve even if total reserve requirement is dynamically calculated. It is used as insurance against sharp decreases in processing volumes. That is why, beside percentage and time frame, chargeback and ACH reserves are often characterized by a fixed minimum reserve amount. For example, reserve amount may vary from $1000 to 5% of processed transaction volume. In such cases, if a merchant’s processing volume drops, the reserve amount cannot fall below the fixed threshold.
Reserve percentage 5%
Minimum reserve amount $500If volume of transactions processed during a month is $20000 then the reserve requirement will amount to $1000.
If volume of transactions processed during a month is $5000 then the reserve requirement will amount to $500 (and not $250 resulting from percentage calculation).
PSPs need to withhold refund, chargeback and ACH return reserves in order to protect themselves from losses induced by the respective types of transactions. Merchant services reserve amounts need to be carefully and flexibly calculated in order to provide the best solutions for both PSPs and merchants.