27 March 2009

The Zone of Essential Risk

Bruce and I recently had a bit of email conversation about his eBay Fraud blog entry.

I emailed him saying that this incident is the fraud pattern for which escrow agents were invented; Investopedia defines an escrow agent as:

An entity that has fiduciary responsibilities in the transfer of property from one party to another. Typically associated with selling or buying a home or other property, the escrow agent will secure the property and examine documents to make sure that the terms of the sale are met on each end, serving both the buyer and seller in the transaction.
Bruce pointed out in his return email that while the fraud pattern was a good match for escrow, the transaction size wasn't: since the item exchanged in the eBay transaction he highlighted was sold for only $500, the price of an escrow agent would have been hard to justify. He's right.

We ran into each other at the IAPP Summit and discussed the situation a little more, and I've concluded on the basis of our little chat that there's actually no good solution to the problem in Bruce's example; it falls into what I'm going to call a "zone of essential risk".

The figure at the head of this post illustrates the problem. If you conduct infrequent transactions which are also small, you'll never lose much money and it's not worth it to try to protect yourself - you'll sometimes get scammed, but you'll have no trouble affording the losses.

If you conduct large transactions, regardless of frequency, each transaction is big enough that it makes sense to insure the transactions or pay an escrow agent. You'll have occasional experiences of fraud, but you'll be reimbursed by the insurer or the transactions will be reversed by the escrow agent and you don't lose anything.

If you conduct small or medium-sized transactions frequently, you can amortize fraud losses using the gains from your other transactions. This is how casinos work; they sometimes lose a hand, but they make it up in the volume.

But if you conduct medium-sized transactions rarely, you're in trouble. The transactions are big enough so that you care about losses, you don't have enough transaction volume to amortize those losses, and the cost of insurance or escrow is high enough compared to the value of your transactions that it doesn't make economic sense to protect yourself.

As far as I can see, there are only three ways out of this box: make your transactions smaller, make your transactions bigger, or make your transactions more frequent. If you've got a better idea, I'd love to hear it. But unless you do, I'd advise you not to order your risk medium-rare.



Blogger Nicholas Weaver said...

One other option: Reduce the cost of escrow, where what the escrow service does is twofold:

One, conduct a lot of transactions so IT gets the amoritzation advantage, even though individual transactions don't.

Two, plays real hardball when defrauded (even when this costs more money) to set the precident that this low-cost escrow service plays hardball.

March 30, 2009 7:37 AM  
Blogger Radovan Semancik said...

A solution that comes to my mind is outside your box. That "eBay problem" seems to be a variation of prisoner's dilema. You are only considering the impact of defecting player on the cooperating player. It is obvious that without an escrow there is no way how to decided which player have defected, therefore the only visible outcome is only C/C or D/D.

The solution might be to defect as well (which is not desirable) or to make sure that the other player cannot afford to defect. Can a well-balanced reputation system help? In C/C case both players gain reputation, in D/D case both lose. Then make sure that you enter into a transaction only with a user that for whom the loss of reputation in D/D case would be equally or more harmful than to you (relatively speaking). Might that work?

March 30, 2009 3:59 PM  
Blogger Unknown said...

It seems to me this is where a true middleman (not eBay, more like Amazon) adds the most value; typically, this is because the buyer and seller populations are asymmetric: usually with many potential buyers per seller. The middleman takes on some or all of the risk of the transaction, and manages that risk through diligence processes, through amortizing their risk over many transactions, and through standardization.

The middleman can be a transactor, or it can just be a reviewer like a credit-rating agency or standards body (Underwriters Laboratory, for instance).

(Unfortunately, as we've learned to our regret, these informational middlemen can weaken the entire system, hence the mortgage crisis. So really what happened was not a net reduction in risk so much as a systematization of risk across the whole market. But still, the intent was to reduce overall risk in the system.

March 30, 2009 7:57 PM  
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