Square’s withholding practice is an alarm for all payment facilitators

Square issued a corporate blog post Tuesday explaining why it has begun holding onto a portion of some sellers’ payments, demonstrating how liquidity shortages challenge the recovery for both businesses and the companies that process their payments.

A Change.org petition demanding Square halt a “reserve” practice had about 1,500 signatures at noon Eastern Time on Tuesday, contending the payment company was holding as much as 30% of the payment volume for some businesses for about four months with inadequate information.

This practice, according to the petitioners, is causing a disruption in cash flow at a time in which many small businesses are struggling with liquidity due to coronavirus shutdowns. Media coverage of the Change.org petition accelerated Tuesday, along with anecdotal tales of merchants claiming they had funds withheld while facing economic hardship.

Square’s reserve policy, which it explained in a corporate statement on Tuesday, is designed to manage chargebacks, which grew 25% year-over-year in April across the entire payment industry, according to Chargebacks911, which forecasts further increases due to economic losses, fraud and supply chain disruptions.

As the economic crisis spreads among merchants, the AI technology that feeds the data backing Square’s risk engine gains more information about the nature of each business. It’s technology that’s become part of the payment facilitator model, according to payment consultant Richard Crone, referring to the fintech business category that offers digital onboarding, payment acceptance and merchant credit.

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The merchant credit portion of the business relies on payment flows for decisioning, giving the payment facilitator insight into the merchant that changes over time. Square offers loans to merchants through its Square Capital service, which uses a bank to fund the loans. Square also recently received an industrial bank license to lend to businesses directly a service that may not launch until 2021. PayPal also offers capital to merchants with future payment flows covering the repayment, and Stripe has made moves toward a similar service. PayPal said it has not changed its risk mitigation, and Stripe did not return requests for comment.

“Settlement risk is a problem for all payment processors, but it’s magnified for payment facilitators since they act as the merchant of record,” Crone said. “The AI has been refined to a point where the [payment facilitator] knows the merchant’s business better than the merchant does.”

Square’s public statement said the majority of its sellers do not fit the high-risk model to trigger withholding, but “when the macroeconomic environment shifts, certain industries may become 'riskier' than before (meaning the likelihood of chargebacks may increase), and changes in consumer behavior may affect even businesses that typically pose a lower risk, as we’ve seen with COVID.”

Most payment companies have to contend with chargeback spikes amid the crisis. PayPal, for example, in May introduced a service that allows merchants to respond to disputes about PayPal transactions through Chargehound, an Oakland, Calif.-based fintech.

Mastercard has postponed a plan to shorten chargeback dispute windows and will give banks and merchants 90 days of fraud monitoring services from Ethoca.

Square faces a chargeback risk given the remote and on-site nature of many of its sellers. Square’s core merchant base includes locally owned shops or sole proprietors, who cannot move their businesses fully online.

In its Tuesday statement, Square said that in late 2019 it tested what it calls “rolling reserve” to onboard businesses selling CBD products, a category Square contends is at a greater risk for chargebacks. Square says a percentage of a seller’s processing volume is set aside and released on a rolling basis. The funds are only used if the seller cannot cover disputes, refunds our outstanding fees.

The Square FAQ for reserves lists factors such as lack of processing history, high-risk services, high rate of payment disputes and inconsistent processing activity such as sudden changes in transaction sizes or payment frequency.