Comment by tzs

Suppose I sell things on my website, and you visit it and buy something. You pay with a credit card. Maybe I accept credit cards directly and you pay that way, or maybe I accept PayPal and you pay me that way, and pay PayPal with a credit card.

Now suppose it turns out I have misrepresented the items I sell. When your item arrives, you find that my site was pretty much fraud. You try to contact me to demand a refund...but no one answers the phone or responds to email. That's because I took all the money from you and the rest of the people I deceived and moved far away, to someplace safe from extradition to the US and that won't enforce US civil judgments.

So you call up your credit card company, tell them what happened, and they quickly refund your money. As do the credit card companies of all the other people I took advantage of.

Where does the credit card company get the money for all those refunds? They aren't going to get it from me. They certainly have no interest in eating those losses themselves.

What they do is require a business that accepts credit cards to have an account at a "merchant bank". When someone pays that business by credit card, the credit card company does not pay the business directly. They pay the merchant bank, which pays the business.

In order to be allowed to do this, the merchant bank has to enter into a contract with the credit card company that says that the merchant bank will pay the credit card company for all refunds and chargebacks. The merchant bank will try to get the refund money from the business, but if they fail they have to make up the difference.

The way merchant banks do this is they hold back some of the money they receive from the credit card company for the business, to build up a buffer to cover refunds and chargebacks. As the business establishes a track record and the merchant bank becomes more confident in its estimates of the refund/chargeback risk for the business, they will adjust the amount they hold in reserve.

I don't know exactly how it works when a buyer uses a credit card to pay PayPal, but somewhere between the credit card company and the seller there is an entity taking the role of the merchant bank and guaranteeing that the credit card company won't be left holding the bag if the seller can't cover refunds/chargebacks.

I suspect that the entity is PayPal itself, and most of the incidents you hear about of them holding some seller's money is them increasing the reserve because there was some change in his selling pattern that suggested the current reserve was no longer in line with their estimates of his refund/chargeback risk.

I think people don't switch to alternatives because the alternatives, at least the ones that provide strong consumer protection, almost all have the same or similar mechanisms to try to make sure that if the seller is bad it is the seller who pays.

They could switch to alternatives that do pay the seller directly with no mechanism for a refund other than asking the seller, such as most cryptocurrencies, but then they would probably lose a lot of buyers unless they were very well established businesses with outstanding reputations. (But if that were the case, then they probably could accept credit cards without their merchant bank requiring a large reserve).