Why is There a Chip in My Card?

By Matthew Cochrane Markets Fool.com

As American consumers familiarize themselves with their new credit cards, many still don't understand the benefits their new chip-embedded EMV card offers over the antiquated magnetic stripe cards we used for so long.

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Personally, I was probably happier than most to see the EMV card adoption begin. As an economic crimes detective, I get a front row seat to the impact of credit card fraud on the financial and economic system. In 2015, research issued by Barclays PLC revealed that the United States accounted for 47% of worldwide credit card fraud even though only 24% of the world's card volume is processed domestically. Virtually all experts agree that America's reluctance to adopt the EMV standard is the driver for our high rates of fraud.

Image source: Pixabay

The cost of this fraud on the American economic system is enormous. Simply replacing a victim's card can cost card-issuing banks over $12. This is to say nothing of the fraudulent transactions that must be written off by issuers. In 2014, that number reached a staggering $3.89 billion! In the end, though, we all pay for this: merchants, banks, and consumers.

Since questions still abound, I thought it would be worthwhile to review why the adoption of EMV cards is so important in the battle against credit card fraud.

What is EMV?

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EMV stands for Europay, MasterCard, and Visa. In the early 1990s these payment processor giants joined forces to create a universal standard for payment processing that would combine global compatibility with security. The security chip adds intelligence and security to every transaction by generating a unique code.

EMV is not really new technology; it has been used internationally for years. The United States traditionally employed a more stable and reliable telecom infrastructure than most of the rest of the world. Hence, many foreign countries were far more susceptible to fraud and saw the need to switch to the EMV standard much quicker than America. Of course, after foreign countries implemented the stronger EMV security, it wasn't long before fraud migrated to the United States.

While there are added security features to EMV cards, it is important to note that EMV is not a silver bullet that will end all fraud. What it will do is curb point-of-sale (POS) fraud that has become so prevalent in the US. When this EMV upgrade is complete, security experts believe e-commerce will become the new path of least resistance and card fraud will migrate in that direction.

Magnetic stripes on the back of cards are easily counterfeited

Before fully understanding the benefits of the newer EMV technology, it would probably be helpful to review how the older magnetic stripes on the back of our cards work. When a magnetic stripe is swiped at a point-of-sale terminal, key pieces of information are read including the card's number, the card holder's name, the expiration date of the card, a service code, and a CVV code.

What's important to note is that this is all fixed information. This makes counterfeiting the information inherently easy. So, when a crook obtains your credit card information (which can happen in a variety of different ways) there's nothing to stop them from creating a quality-looking counterfeit card with their name on the front. As a detective whose primary responsibility is investigating cases of credit card fraud, I have been shocked to discover how prevalent this type of credit card forgery has become!

Image source: Pixabay

After creating a counterfeit card, all a thief needs to do is walk into a retail location -- basically any store -- and confidently hand a merchant the forged card and pay for the selected merchandise. If they encounter a vigilant clerk who demands identification before the purchase is authorized, the fraudster can just hand them their own valid state-issued driver's license or identification card to show the clerk that the name on the front of the credit card does indeed match the identification the crook produced. Because, again, your real name is only embedded on the magnetic stripe on the back, invisible to a visual inspection, while the fraudster's name has been printed or embossed on the front of the counterfeit card for the world to see.

The EMV chip's dynamic and encrypted data prevents counterfeiting

Now compare how thesemagnetic stripes work with what the EMV chips do when they are inserted into the newer terminals. While most of the information the new cards transmit is the same, there is one key addition to the data being read: encrypted keys inside the chip create a dynamic code that is unique to each transaction.

If a card with an EMV chip is skimmed or a database with the card's information is breached, crooks cannot just produce a counterfeit with the static information on the magnetic stripe. Because the code generated by the chip is unique for each purchase, there is no way for fraudsters to reproduce the encrypted code.

No silver bullet, just another important tool

Banks and other card issuers long ago decided to consider the losses in these cases as just the cost of doing business. After a card issuer reimburses their card holder, it technically becomes the victim of fraud (though the consumer might still be the victim of identity theft). Card issuers rarely even pursue charges unless monetary losses begin to approach five digits.

The use of counterfeit credit cards made up 37% of all credit card fraud in the United States as recently as 2014. As EMV cards become more widely adopted and more merchants update their terminals, this percentage will drop. If the pattern holds from what happened in other countries once EMV chip-embedded cards were adopted, fraud will shift toward card-not-present transactions. The EMV system is no silver bullet to stop all fraud, but it is another tool in our tool box that we can use to curb fraudulent point-of-sale transactions.

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Matthew Cochrane owns shares of Mastercard. The Motley Fool owns shares of and recommends Mastercard and Visa. The Motley Fool has a disclosure policy.