The Anatomy of a Payment

28 November 2008

In the payments industry, we commonly hear, “To stay competitive in today’s economic market, merchants need to offer a range of consumer payment options, dynamic currency processing and quick, secure real-time payments.” Credit and debit card processing is a complicated and highly coordinated technical process which is globally centralized and one of only two truly global payment systems that actually works so efficiently. The other, of course, is Swift bank wire transfers.

Take, for example, a Japanese consumer who completes a credit card transaction, at a Grand Canyon restaurant, via a wireless point-of-sale device. Within seconds, the transaction is authorized, the receipt is printed, the customer signs it and the next day, the merchant is paid.

Have you ever stopped to wonder how the credit card actually got charged? How the money for the transaction was transferred to the merchant and the transaction posted to the credit card account? And what’s involved in making all this work -- in seconds?

The payment system is incredible when broken down this way, and has both changed the way the world pays and how physical cash moves across global markets. The system has virtually eliminated travelers’ checks, and hardly anyone carries around more than a day’s worth of cash.

So, at a basic level, here's how it works.

There are two elements to every credit card transaction: a buyer and a seller -- or, simpler, a debit and a credit.

Fundamentally, card payments are just basic debits and credits, but the complex routing of intermediaries involved makes this the most reliable and secure source for global payments.

Cardholders are issued a credit card, with a specific credit limit, by their card Issuing Bank, which registers with Visa or MasterCard to distribute credit cards to their bank clients.

The Merchant, similarly, applies to accept credit card transactions at their store or Web site from a bank Acquirer, which registers with Visa and MasterCard to allow their merchants to accept credit card transactions for payment.

The common element between both Issuers and Acquirers are Visa and MasterCard (the Card Associations). They are the trusted "interchange brokers" in the card transaction process and balance the transaction funds for settlement between Issuing and Acquiring Banks. They also provide the accounting entries to the Issuer and Acquirer in order to balance the daily debits and credits for both Cardholders and Merchants.

Issuers typically contract with a third-party processor to manage their credit card programs, which includes issuing the plastics and managing the card-transaction exchanges/settlement to the Card Associations. Acquirers, similarly, work with a third-party processor to set up merchant accounts and manage the reconciliation of sales, refunds and chargeback transactions performed at their stores (online or retail). First Data is a well-known third-party processor for both Issuers and Acquirers.

When a credit card plastic is swiped through a point-of-sale terminal or cash register, the information contained on the magnetic stripe is read by the terminal and reformatted along with the transaction information to the Acquiring Bank.

Most point-of-sale terminals are connected via a landline to their Acquiring Bank (you can sometimes hear the terminal dialing the phone number, for instance). If it’s a wireless point-of-sale terminal, then a Wireless Application Protocol -- or WAP -- server, or similar, is used to route the payment to the Acquirer.

In the majority of cases, the point-of-sale terminals connect first to a switch at the Acquiring Bank, which then transmits the transaction to the third-party processor via a leased line circuit or Virtual Private Network.

The processor reformats the transaction and electronically submits it to either Visa or MasterCard for authorization by the card Issuing Bank or their representative third-party processor. Visa and MasterCard are able to identify who the Issuer is by the first six digits of the card number, called the Bank Identification Number, or BIN.

Every credit card product has a uniquely identified BIN associated with the card product type. When the Issuer is implementing a new card product, they will request the Card Associations to "point the BINs" for authorization and settlement services to their Issuing third-party processor. The Card Associations know from the BIN routing tables where to transmit or redirect the transaction received from the Acquirer’s third-party processor, to the Issuer’s third-party processor, for authorization.

Every authorization request, meanwhile, undergoes numerous checks -- including validating credit limit; number of transactions per day; average transaction amount; merchant location; Card Verification Code, or CVV; and card status -- before a six-digit authorization number is generated and the transaction considered “approved.”

Once the transaction is authorized, the original transaction request is reformatted with the authorization response -- which could also be a decline -- and sent back through interchange via the third-party processors, on to the Acquiring Bank’s switch, and then back to the originating Merchant’s point-of-sale terminal.

Every transaction has a unique Transaction Identification associated with it -- as well as a Merchant Identification -- so the transaction is directed back to the applicable Merchant point-of-sale terminal awaiting the response. The point-of-sale terminal does just that: It waits for the authorization response.

Usually, the entire transaction-authorization process happens -- end to end -- within a period of 10 seconds, no matter where the Merchant is located or where the Issuing Bank card authorizations are processed.

So, in my example above, the Merchant is located at the Grand Canyon and the Issuing Bank is in Tokyo. The transaction authorization travels 11,088 miles on a return trip across a multitude of secure electronic systems to provide a payment response within 10 seconds!

To break it down:

Visa cardholder --> Merchant point-of-sale terminal --> Acquiring Bank switch --> Acquirer third-party processor --> Visa interchange --> Issuer third-party processor (authorization) --> Visa interchange --> Acquirer third-party Processor --> Acquiring Bank switch --> Merchant point-of-sale terminal --> transaction approval or decline = 10 seconds.

Now, how does the merchant get paid?

At the end of the business day the merchant settles their point-of-sale terminal or cash register and totals their daily sales receivables. This also means performing a function within the point-of-sale terminal to total, and then submit, the approved credit card payments to their Acquiring Bank.

The Acquiring Bank receives all authorized transactions from the Merchant terminals and submits them to the third-party processor for clearing. The processor receives the data and formats clearing files for both Card Associations and submits settlement data to them on a daily basis.

The Card Associations perform a financial reconciliation, which calculates the total debits for each Issuing Bank -- by BIN -- and the total payments /credits for each Acquiring Bank/Merchant. The totals for each Issuer and Acquirer are then posted to the applicable bank's clearing accounts, with Visa and MasterCard, and reports identifying individual transactions for that day are provided to the third-party processor for their respective banks.

The Issuer receives a daily report identifying all transactions posted to cardholder accounts, and the Acquirer receives a report identifying which Merchants need to be paid for sales completed the day before.

The Acquiring Bank posts those sales to the Merchant’s bank account, minus commissions and fees. Cardholder debits are typically posted by the Issuer third-party processor, which also prints the monthly cardholder statements identifying the merchant transactions. Credit card limits and balances are adjusted once the transactions are posted by the third-party processor.

The fees charged by the Card Associations to the Issuers and Acquirers are known as interchange fees, and range between 1 percent and 2.2 percent of the card transaction amount, plus transaction fees.

The general rule is the Acquirer pays the Issuer the interchange fees required to process the sales transactions. The Card Associations "net settle" to both the Issuer and the Acquirer based on the fees associated with the transaction type, the card product type and the merchant transaction presentment (card present, card not present, A.T.M., etc.).

An e-commerce or Internet transaction replaces the point-of-sale terminal with a certified Payment Gateway Provider; but from here on, the process works fundamentally the same.

Internet merchants transmit credit card transactions to their Payment Gateway Provider, which formats the transaction for submission either to the Acquirer third-party processor or the Card Associations, directly. From that point on, the process is identical for authorization of transactions.

Settlement is processed by the Payment Gateway Provider at the end of each day, in the same manner as a point-of-sale terminal, in that files of approved online Merchant transactions are generated and sent to the Acquirer’s third-party processor for onward settlement by the Card Associations to the banks.

No matter what front-end system or device is used to acquire the card transaction, the back-end authorization and settlement process remains the same on a worldwide basis.

Ms. Wilson is the chief executive of First Atlantic Commerce Ltd., an international payments solutions provider. She has extensive experience in international, offshore and domestic card payments systems, as well as with Visa and MasterCard regional compliance regulations, e-commerce risk management and acquirer consulting.