Recently, I've taken a position working in the payment space. As part of bring myself up to speed on payments, I've had to perform quite a bit of research.
To help others, I've decided to aggregate some of the best articles written about the payment space (see source). Below is my quick summary, which helped me remember all the stuff I had to read.
Payments 101
Payment Defined
To understand payments, it is important to have a standard definition. According to the Federal Reserve Bank of New York, payment is defined as “a transfer of value. ” But what does this transfer of value mean?
Celent, a division of Oliver Wyman expands upon this by stating that payment is a transfer of value between two parties using a value token or payment instrument. First, it is important to point out here that without another party, there can’t be a transfer of value (e.g., moving money from your pocket to your desk doesn't equate to a transfer of value). Second, the value token or payment instrument is important because it facilitates the transfer of value.
Payment Instruments
There are many payment instruments. In barter economies, the payment instrument is the good or service exchanged. For modern economies, money is generally the accepted payment instrument . However, other payment instrument exists such as check, credit cards, bank transfer, and stock transfer. Generally, these other payment instruments must be linked to money for the payment instrument to be “broadly useful.” Otherwise, the payment instrument will only be limited in usability and acceptance (e.g., Monoploy money is only good in the game of Monoploy for buying property and houses. You couldn't use the paper money to as a payment instrument for other goods or services outside the game.)
Credit Card as a Payment Instrument
The idea of a credit card “dates back to the early 1800s. While plastic wasn’t used then, merchant and financial intermediaries did extend credit on durable goods.” Thus, in the early days, the credit card was primarily a credit instrument rather than a payment instrument .
“In 1950, Diners Club launched the first general merchandise charge card. It was primarily used for travel and entertainment expenses for a more well-to-do customer.” This card did not have a revolving credit feature because all bills had to be paid by the end of the month. The first general credit card, the BankAmericard, was launched in the 1950s by Bank of America. “At the time, banking regulations limited the geographic reach of individual banks, so Bank of America found it difficult to compete with Diners’ nationwide access. To overcome this limitation, Bank of America licensed their card to other banks. Initially they were successful but soon became overwhelmed with the administrative task of processing all of the paper slips from member banks. In effort to address the growing needs, Bank of America decided to spin off the organization and it eventually became known as Visa. In light of Bank of America’s success with their card, a competing network of banks launched a third network in 1966 known today as MasterCard. American Express was launched in 1958 and Sears, Roebuck, and Co. launched the Discover Card in 1986.” (Braintree)
How Does a Credit Card Work?
To understand how a credit card facilitates the transfer of value (i.e., exchange of money) as a payment instrument, “it is important to first understand the participants and the models under which they operate.” There are two distinct models: open-loop and closed-loop. Visa and MasterCard operate in the open-loop model while American Express and Discover operate in the closed-model. (PaymentsRus)
Open-Loop Model Participants
There are at least five distinct parties involved in an open-loop model that work together to enable credit card. They are the following: Cardholder, Merchant, Card Issuing Bank, Acquirer (i.e., Acquiring Bank, Non-Bank Acquire, Acquire Processor), and the Card Network (i.e., Visa or Mastercard)
1. Cardholder: End-consumer (Party typically procuring a good or service from the merchant) who has been issued a credit card
2. Merchant: Provider (Second party typically selling or providing a good or service to the customer) who accepts credit cards
3. Card Issuing Bank: Financial institution that issued the credit card to the cardholder
4. Acquire: Financial institution that provided the merchant with the capability to accept the credit card and ensure the Merchant is paid
5. Card Network: Organization responsible for setting the payment scheme (e.g., rules that define the rights and obligations of all the involved parties, technical and operating standards, settlement framework, liabilities and dispute procedures, and other key, aspects of a payment transaction) and managing the physical payment network.
Typical Transaction
1. The Cardholder uses the card issuing bank’s credit card to pay for goods or services provided by the merchant
2. The Merchant submits the card transaction to Acquirer for processing
3. The Acquirer submits the information to the appropriate Card Network
4. The Card Network routes the transaction to the appropriate Card Issuing Bank for approval
5. The Card Issuing Bank either approves or denies the transaction based on various factors and passes the information back to the Card Network
6. The Card Network relays the information to the Acquirer
7. The Acquirer Bank relays the information to the Merchant and thus Cardholder
Above is the most basic example of a transaction using a credit card in a open-loop model. It should be noted that additional parties are often also involved. These parties may include a processor (i.e., acquire, acquire processor, payment gateway) or a reseller (i.e., Independent Sales Organization: ISO, Merchant Service Provider (MSP). Furthermore, it is also possible for the Acquirer and Card Issuing Bank to be the same for any given transaction. This type of transaction is called an “on-us” transaction, but still passes through the card network.
Closed-loop Model Participants
The fundamental difference in the closed-loop system is that the Card Issuing Bank and the Acquirer are effectively the same. With closed-loop systems, we will discard the term Card Network because there is no independent organization like Visa or MasterCard arbitrating between an Acquirer and a Card Issuing Bank. In this case, the simple term Bank will do and the primary Banks in the U.S. are American Express and Discover. The typical transaction process is similar to the open-loop except the Acquirer, Card Network, and Card Issuing Bank are the same party. Thus unlike Visa and Mastercard, American Express and Discover also issue credit cards and enable merchants to accept their cards.
Merchant Discount Rate/Merchant Service Charge
To accept a credit card as a payment instrument, Merchants must pay a Merchant Discount Rate/Merchant Service Charge (i.e., Discount Rate) to the Merchant Bank. This fee is typically calculated as a percentage of the transaction amount plus a small fixed fee. The fee varies anywhere from 1 – 5% + $0.10 - $0.50 . [This data is applicable only to the United States. Merchant Discount Rates may differ significantly in other countries.]
The money collect from the Merchant Discount Rate/Merchant Service Charge is then split among the Card Issuing Bank, Acquirer, and Card Network. According to Braintree, the Card Issuing Bank captures anywhere from 70 – 85% of the fee and the Acquirer (and its processor if it is outsource) and the Card Network split the remaining 30 - 15%. The first fee that is collected by the Card Issuing Bank is called interchange. To be precise, this interchange fee is not paid by the Merchant directly. Rather, the Card Network take a portion of the Merchant Discount Rate that is the Interchange and transfers it from the Acquirer to the Card Issuing Bank.
Interchange
The calculation of interchange is dependent upon various factors. Four main factors, according to Visa/MasterCard are: type of card (e.g., general, commercial, reward), merchant size (e.g., processing volume > $xx), processing mode (e.g., swipe, manual key in, card-not-present), and merchant category (e.g., retail, grocery, software).
Acquire
Now that we are a little more familiar with the terminology, it is really more appropriate to understand that there are actually two categories of Acquiresr: traditional banks (e.g., Fifth Third Merchant Services and Wells Fargo Merchant Services and non-banks (e.g., Chase
Paymentech, Heartland Merchant Services). While both are required to be licensed as a member of the Card Network, they differ in that the non-banks focus specifically on merchant acquiring business. Since I mentioned earlier that the Card Issuing Bank captures the majority of the revenue, banks have traditionally focused more of their effort on issuing cards rather than signing up merchants. Thus, according to the Aite Group, the non-bank acquires make up the majority of acquires.
Sources:
1. CREDIT CARDS: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges (Nov. 2009 by GAO) http://www.gao.gov/new.items/d1045.pdf
2. Taxonomy of Payments: Part I and Part II - (July 2010 by Zilvinas Bareisis: Celent, a division of Oliver Wyman)
3. Theory of Credit Card Networks: a survey of the literature (2001 by Sujit Chakravorti:FRB-Chicago)
http://ideas.repec.org/a/bpj/rneart/v2y2003i2n1.html
4. AN INTRODUCTION TO THE ECONOMICS OF PAYMENT CARD NETWORKS - [2003 by Robert M. Hunt:FRB-Philadephia] http://ideas.repec.org/a/bpj/rneart/v2y2003i2n3.html
5. Merchant Acquiring An Overview - (Feb. 2008 by Adil Moussa: Aite Group, LLC)
6. Where do credit card fees come from - (June 2008 by Bryan Johnson: Braintree)http://www.braintreepaymentsolutions.com/blog/where-do-credit-card-fees-come-from-cc
7. How payments work http://www.paymentsrus.com/additional-articles/credit-card
8. Various other sources:
http://www.virtualschool.edu/mon/ElectronicProperty/klamond/credit_card.htm
http://en.wikipedia.org/wiki/Payment
http://money.howstuffworks.com/personal-finance/debt-management/credit-card1.htm
http://en.wikipedia.org/wiki/Credit_card_number
http://en.wikipedia.org/wiki/Payment_card
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