How does digital payments work?

In this article, we will cover the basics of the credit card processing industry. We will review various components and how they are inter-connected and list some of the big-name companies at each component.

Let's start with a simple brick and mortar credit card processing where a person wants to purchase a coffee from this favorite cafe.

Before the advent of credit cards, let's leave e-commerce aside for now, which came after credit cards. A typical working person would work in a company and the company would pay salary to that person, who would deposit the wages in his bank account. And if he wanted money to purchase something, he would go to his bank teller and withdraw the funds required for the purchase. He would go to his cafe and buy the coffee with cash that he withdrew from this bank.

With improvements in technology, banks wanted to improve their customer experience. They started to issue debit cards, plastic versions of the cash, wherein a person can use the debit card in place of money to make a purchase. With this innovation, customers save a trip to the bank to withdraw money, and banks cut costs by not investing in more ATM's or hiring new bank teller staff. Instead of buying coffee in cash, a person goes to the cafe and gives his "debit" card for purchase.

Banks also wanted to give convenience wherein their customers could take "credit" - i.e., purchase something even when they don't have any money in their bank account. And banks wanted to have a plastic version of the "credit," and hence came the popular credit cards. Now a person, let's say, who is still waiting for this salary and has run out of his cash in his bank account can still buy coffee in his favorite cafe using a "credit card."

Now that we saw how a simple coffee purchase evolved, and all this is still a brick and mortar world with no fancy bitcoins, digital wallets, e-commerce, etc.Let's add various building blocks in credit card processing. To begin with, the bank that issued the credit card is called the "issuer bank."

Now in our coffee example, the owner of the cafe is called the "merchant."Like the person purchasing a coffee with a bank account in the issuer bank, our "merchant" friend needs to have his bank account where he can collect the actual cash. Bank, where the merchant will have his account, is called "acquiring bank." At times a merchant's "corporate account" can be in a different bank than the "acquiring bank."Then the acquiring bank will help facilitate the transfer of funds between the two merchant bank accounts.Other intermediaries in the "acquirer" bank ecosystem are predominantly centered around procuring new merchants. The "Independent Sales Organization"  (ISO), agencies that are authorized to resell acquirer solutions to merchants and "Payment Facilitators" (PayFac), agencies that can directly sign contracts on behalf of the acquirer.Now we have two bank accounts representing two sides of a transaction a seller (merchant) selling the coffee and a buyer buying the coffee.

There are so many "issuing banks" and so many "acquiring banks." The "Credit card network" is the magical glue that connects "issuers" with "acquirer."

There are two types of credit card networks, namely "open" network and"closed" network. In an "open" network, the credit card network acts only as a facilitator for the transactions and makes revenue by charging commission or service fees from merchants and issuing banks. VISA and MasterCard are very popular "open" credit card networks. On the other hand, in the "closed" credit card networks, a single entity will be both the issuing bank and the credit card network. American Express and Discover are popular "closed" credit card networks. For example, Bank of America can issue a VISA credit card that consumers can use on Visa Network. However, say it may not be able to give an American Express card.

Merchants usually don't connect directly to the credit card networks. Some intermediaries help ensure merchants can send the transactions to the credit card network and get their final amount deposited in the merchant account in the "acquiring" bank.Merchants first integrate with a "payment gateway." P.O.S(point of sale) device or mobile application are various payment gateways interfaces.

Similar to credit networks, there are two types of gateways, namely agnostic and dedicated."Agnostic gateway" provides a single interface for merchants to connect with multiple acquirers/processors and also offers value-added services such as fraud detection, fail over, and alternate payment methods.   In this case, the main advantage is that if a merchant decides to change the acquirer, the merchant doesn't have to make any changes on their end. Gateway will manage everything at the gateway. CyberSource and Authorize.Net are examples of "agnostic gateway."

On the other hand, in "dedicated gateways,"  the "acquirer" or "processor" owns the gateway. One of the advantages of a "dedicated gateway" is that it will help reduce the friction between gateways and acquirers/processors in any issue. Chase and First Data are examples of "dedicated gateway."

Now we have got merchants hooked up with "gateways," but gateways typically don't talk directly to the "credit networks."Gateways interface with "processors." Processors help in payment approval/authorization and settlement of funds and act as intermediaries between the merchants and the credit networks. TSYS and Firstday are examples of processors.

We have now covered various moving blocks in the payment ecosystem.Now let us review our end-end coffee purchase in the cafe.We will break the flow into two parts.

(a) Authentication and Authorization :

At the end of this stage, the buyer completes his transaction(i.e., Joe got his goods, but the cafe owner has not yet received his cash for the transaction).

(1) Joe goes to his favorite shop and orders a Latte. The cafe charges $5 for the coffee.

(2) Joe pulls up his credit card issued from his "issuing bank" and swipes at this P.O,S(point of sale) device at the merchant.

(3) The P.O.S data reaches the gateway, where the gateway transforms the information that the processor can understand.

(4)Processor further formats the data and sends it to the credit network for authorization.

(5) Credit network now parses the data, validates, and sends it to Joe's "issuing bank."

(6)Joe's issuing bank validates Joe’s account information and checks for available credit and sends validation responses back to the credit network.

(7) The credit network sends the authorization response back to the processor.

(8) The authorization response travels back to the gateway and reaches the merchant's P.O.S, and Joe gets his coffee purchase approved.

(b) Clearing and settlement:

At the end of this stage, both the buyer and merchant will have the transactions recorded in their account statements, and the merchant will have the "cash" in his account

.(1) Merchants usually at the close of business using "batching" send all authorized transactions to the "processor."

(2) the processor then formats the data and sends it to the "Credit network."

(3) credit network forwards the data to the respective "issuing bank."

(4)" issuing bank" deducts "interchange fees"  and then sends the money to the credit network

(5) Credit network collects the "assessment fees" and sends the remaining money to the processor/acquirer.

(6) The processor/acquirer charges the markup fees, and money finally gets deposited in the "acquirer" merchant bank account. If the merchant has a corporate bank account elsewhere, the acquirer transfers to the merchant's corporate bank account.

In future posts we will review similar transaction involving digital wallets and also break down various processing fee structure used by popular credit networks.