Finality does not exist in payments

Patrick McKenzie (patio11)

Children have a culture all of their own, and one sacred ritual of it, in some times and places, is “no takesies-backsies.” Like much of the child law, it both rhymes and is enforced by social sanction dictated by custom immemorial. It means: transactions are absolutely final.

Many adults believe final transactions to exist. They mostly don’t, and it is a good thing, too. That might sound surprising.

Finality is a technosociolegal construct

What does a transaction being “final” mean? In the layman’s use of the term, it means that the transaction cannot be reversed.

As a payments professional, finality can be thought of more as a probability distribution given the technical/organizational infrastructure which was used to make a payment (the “rails”), the facts of the underlying transaction, the relationship of the parties, and the governing law(s) and regulatory regimes. We can confidently say things like “wire transfers are more final than credit card payments” but we generally don’t say “wire transfers are final.” If they were really final, the world would break.

An extreme example which proves the point: the cryptocurrency enthusiast community largely believes that code is law, “not your keys, not your coins”, etc. Many crypto enthusiasts would say that the Bitcoin protocol does not prohibit reversing transactions but provides a security guarantee which suggests that the likelihood of a reversal after an hour is infinitesimal.

And yet: someone sent $70 million worth of Bitcoin in 2016, and that transaction was partially voided, with the reversal being worth slightly more than $70 million due to Bitcoin volatility. This didn’t happen an hour later; it happened in 2022. How?

The answer is nowhere in the Bitcoin whitepaper or any codebase. A full recounting of it is outside the scope of this anecdote, but it rhymes with “If you and the United States federal government disagree whether a transaction is final, you are wrong.” That is true for notorious Bitcoin thefts, but also true for wire transfers, conveyances of real estate, credit card payments, and graverobbing. “Possession is nine-tenths of the law,” so the saying goes, but the state can conjure as many tenths as required if it is motivated to.

The overwhelming majority of transactions do not go to the state for adjudication. In fact, English lacks a non-mathematical phrase in common use to describe how much of an understatement that is. Billions of transactions happen every year; on the order of hundreds of thousands get explicitly adjudicated.

Non-state agreements for dispute resolution

If payment rails don’t provide finality, what do they provide in its stead? Predictability. They publish rules (don’t call them “laws”) and operate dispute resolution processes (definitely not “courts”) which provide for relatively efficient, relatively inexpensive, relatively fast decisions on transactions without needing to escalate past the payment rail to the state.

These rules have a property in common with formal law: they are not fully descriptive of the system that is envisioned by them. For example, in credit card disputes, almost all decisions which matter are made by an entry-level employee of the card issuer, and those decisions vary wildly across issuers even in circumstances which look very similar. As a simplified example, issuers who focus on “premium” card users frequently make a business decision to side with their customer more frequently than, say, mass-market banks do. (They would probably entirely automate “Chargeback sustained!” if the network rules allowed them to do so, but they don’t.)

A side effect of formal rules is that they give soft security guarantees to an ecosystem, and those security guarantees allow people within an ecosystem to transact in something approaching mutual understanding of the degree of finality on offer. Additionally, they let ecosystems compete for users and for individual transactions specifically on the basis of different rules for finality.

Take wire transfers (please!). We largely don’t think of Fedwire as being an agent in the same sense that American Express is an agent, but Fedwire factually does have a marketing department and, believe it or not, is in vicious competition with Amex for at least some transactions.

One important fact in the minds of both the buyer and seller is that Amex charges more as the transaction gets larger (and Fedwire, in relative terms, basically does not). But another is that Fedwire has a relatively strong presumption of finality, and American Express very explicitly does not.

Businesses who use American Express (and other credit card networks) to process payments often wonder why this is, particularly after they’ve been hit by a chargeback (industry jargon for “credit card payment reversal”) for the first time. The big strategic reason, unchanged in the decades we’ve had credit cards, is that card networks are a trusted overlay on economies with heavily heterogenous trust relationships.

Some credit card transactions are between a regular and the cafe they’ve gone to for 20 years, but some are between a business traveler and a hotel they’ll never set foot in again, and credit cards guarantee to users that the risk of these transactions is similar. They increase social trust between peers on the network by decreasing technical trust. This is akin to alchemy.

Younger generations might not appreciate this, but there was a very real question in the late 1990s (and across much of the world today) whether transactions could ever take place over the Internet without being able to look counterparties in the eye. “Aren’t hackers just going to take all money exposed to the Internet?” And low and behold, they did not, but a necessary precondition for answering that question was there being money exposed to the Internet. Credit card guarantees of reversibility substantially made that happen.

(I would be remiss if I didn’t give regulation some of the credit here. Again, the payment rails could say in their rules that transactions are final, but private industry is not the court of final appeal. This is, incredibly to me, still a live question for at least some financial institutions in the United States, who believe Zelle transfers are final because Zelle does not contemplate reversing transactions. Until the people with guns stop enforcing Regulation E, guidance to customer service representatives about finality is not actually controlling.)

Wait, are you telling me wires are reversible?

Of course wires are reversible. They were not designed by children, but by professionals who live in a society which has systemically important institutions, and in the event of malfeasance or mistakes society does not tolerate a bank failing or a state missing payroll simply because someone said “no takesies-backsies” fast enough.

Mistakes happen! By, conservatively, the hundreds of thousands daily across all payments systems, millions depending on your definition of mistake. Wire transfers, like almost all payment systems, explicitly contemplate them and have a sociolegal ritual to quickly reverse them.

The ritual is called “hold harmless” and comes from a soft guarantee about the wire transfer ecosystem, which is that transactions are largely between sophisticated counterparties acting in good faith, intermediated by institutions whose probity is almost sacrosanct. Importantly, wires are in expectation worth having a human in the loop for; that is very not true of most payments.

A “hold harmless” is a very, very brief conversation between two peers at different institutions which is then memorialized on paper. The peers are generally operations professionals, one at the receiving institution and one at the sending financial institution (and sometimes even at its customer, since many serious users of financial infrastructure have operations teams to interact with their providers). The conversation is often shockingly informal, on the level of “Yeah we goofed and sent you $1.2 billion to the wrong account. Mondays, am I right?”, and the operations professionals make a verbal agreement about disposition of the transaction in minutes (or less).

The agreement is then solemnized in a brief document which gives “hold harmless” its name. The ops professionals are both taking a risk in voiding a transaction, and the party asking to void it (the sender) offers the party with the capability to void it (the receiver) a contractual indemnification should the state later come to the opinion that the ops professionals acted improperly. You can get a flavor for the language NACHA’s model letter for ACH transactions; hold harmlesses for wires look a tiny bit different.

How common are hold harmlesses? It took the combined forces of several agencies of the federal government more than five years to reverse ~$4.5 billion in Bitcoin transaction; that probably accounts for a few days worth of hold harmlesses executed after breezy phone calls.

It is worth noting that this is substantially more complicated internationally. You can still absolutely reverse a wire between an arbitrary bank in Japan and the United States, in either direction, but the risk of unintentional finality goes up materially versus domestic wires, and while substantially all financial institutions in those two nations are de facto peers in a group of high trust counterparties that is decidedly not true of all financial institutions in all nations.

Why does this matter?

Obviously, if you (or more to the point, your business) interacts with the financial system, it is important to correctly model the sort of finality guarantees you get on transactions.

For financial professionals, we likely haven’t seen the final form of finality! There is still a rich design space there, and it appears underexplored over the last few decades. Some newer payment methods, including cryptocurrencies, are doing interesting tweaks (generally towards making payments substantially more final than credit cards), but you could imagine guarantees in the opposite direction working for some transactions among some groups of users. Another very interesting axis is whether finality guarantees should be much more explicit than they are currently, and whether one should be allowed to pay for different finality guarantees.

I have a fun example of this, but it will have to wait until a later issue. (Not even newsletters are final.)

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I write about the intersection of tech and finance, approximately biweekly. It's free.