Most consumers never think about the complex world of payment processing when they swipe bankcards at the POS. As long as transactions are approved, that's good enough for them. Most merchants are probably the same way. They don't want to be bothered with all that jazz about network routing and clearing functions; they just want to see that money end up in their bank accounts.
But ignorance of processing is not a luxury ISOs and merchant level salespeople (MLSs) can afford. As subject matter experts in the eyes of their merchants, not to mention prospective merchants, knowledge of how electronic transactions are processed is worth a little investment of time, especially for industry newbies.
The typical electronic transaction undergoes seven stages from the time a payment is initiated at the POS to the time the merchant's account gets credited for the purchase. The seven stages are: authorization, merchant balancing, capture, clearing, interchange, settlement and merchant payment/automated clearing house (ACH).
To understand the process, it is helpful to picture a transaction as a train traveling over various sets of tracks. In fact, you will often hear how a credit card transaction goes over the Visa Inc., MasterCard Worldwide, Discover Financial Services or American Express Co. "rails," alluding to that old-fashioned, proprietary transportation network known as the railroad.
When a payment card is swiped or otherwise presented at the POS, the terminal or e-commerce website collects cardholder data (such as the cardholder's name, card number, card brand, and transaction type, whether that be a PIN or signature debit transaction, for example.) When the train leaves the POS station, it is carrying that little packet of cardholder information.
The train travels down "rails" to a processor (which is often the acquirer) that reads that packet and reroutes the train down another set of tracks to the corresponding card brand. In the case of MasterCard and Visa, the card brand then forwards the train by yet another set of tracks to the bank that issued the card. (Discover and AmEx have typically issued their own cards.)
At the issuer, the contents of that packet are analyzed to verify the legitimacy of the transaction - that the cardholder name matches up with, for example, the PIN entered at the POS, that the card has not been reported lost or stolen, and that the cardholder's account has a sufficient balance to cover the cost of the transaction.
Once that information is confirmed, the issuer routes that train now carrying that transaction's authorization code back through the card brand, which returns that virtual locomotive back to the processor, which reroutes it back to the merchant's POS system, where the sale is finalized.
However, if back at the card issuer that packet contains information that doesn't jive, such as the cardholder name and PIN do not match or the account balance is insufficient to cover the transaction, then a denial message is sent and the transaction is declined at the POS.
Whether the transaction is approved or declined, it is here that the processor stores the transaction. Transactions are stored just in case a consumer disputes a charge, for example, in which case the chargeback process ensues.
That first authorization step comprises the "front-end" of processing. The function is performed in real time, which may last from a sub-second up to approximately five seconds, depending on the complexity of the transaction.
The remaining six steps make up what is commonly termed "back-end processing."
Merchant balancing is defined as the process of reconciling transactions, usually at the end of a 24-hour business cycle, by closing out a batch of transactions at a terminal and sending them off in encrypted format to the processor for back-end processing.
Capture means converting authorization codes into billable transaction records within a batch for the subsequent clearing and settlement of the transactions.
Clearing involves the processor performing risk management procedures on the transactions to flag potentially illegitimate ones, then submitting the "good" transactions via the respective card brands' rails for interchange processing.
This is where the card brands break up the transaction amounts into percentages (based on numerous rate categories for card types and other factors) to be routed to the appropriate card issuers, acquirers, processors, ISOs and merchants. This is also the stage where card brands sort transactions by bank identification number (BIN) and route the transactions to the appropriate issuers for posting to cardholders' accounts.
At this stage, the process of transferring funds for sales and credits between processors and issuers is accomplished.
In this final step, processors make deposits into merchants' accounts to reimburse merchants for sales completed way back in stage one. The deposits typically include the total amount of sales less the amount of credits/returns and the discount rate (interchange plus processing and other fees).
In some cases a merchant may use one provider for front-end processing and another for the back-end function.
The combined front-end and back-end processing of any payment is referred to as the payment's "life cycle."
The preceding explication of the payment process only scratches the surface of its complexity. However, it may come as a surprise that the five basic payment types - credit, debit and prepaid cards, as well as checks and ACH processing - do not add greatly to that complexity.
Credit and debit cards are usually processed over separate rails, but are very similar in how they are actually processed, according to Steve Mathison, a Vice President in Product Management at the industry's largest acquirer, First Data Corp.
"From a pure transaction processing and switching capability perspective, there's not a lot of difference," he said. "What happens on the Visa/MasterCard or the bank side, the biggest difference is, well, the bank giving the consumer a loan or are they drawing those funds directly out of a bank account."
Prepaid cards are processed basically the same way as credit and debit cards, but with a twist. "What's different is on the issuer's side - how they hold those funds," Mathison said.
"[Prepaid] is not a loan, and it's not withdrawing from a DDA [demand deposit account] - 'I've actually collected and I'm holding a liability that I owe to the consumer that the consumer redeems from time to time by going to a merchant.' So the style of how the issuer handles it is the biggest difference," he added.
Checks are processed similarly as the above card payments, Mathison added. After the data on the check (magnetic ink character recognition line information, the signature, etc.) is captured via a check reader at the POS, it becomes "just another electronic transaction," he said. The processor recognizes the transaction is a check and then usually routes it over the ACH network, Mathison noted.
The ACH, which began in the 1960s as a way for banks to facilitate recurring consumer credit payments (such as payroll and retirement benefits) and recurring consumer debits (payments of insurance premiums and utility bills, for example), has been expanded to include person-to-person money transfers and decoupled debit payments.
The main difference between a credit/debit/prepaid card payment and one that travels over the ACH is where the transactions are routed.
While a credit transaction would be routed through a card brand, an ACH payment is funneled through the U.S. Federal Reserve banking system, where money is transferred directly from one bank account to another, according to Mathison. Person-to-person payment via PayPal Inc. accounts is one example.
Among the top electronic funds transfer (EFT) networks over which debit cards run are First Data's Star Network, Discover's Pulse, Visa's Interlink, the NYCE Payments Network LLC and MasterCard's Maestro.
Among the top acquirer/processors that connect to those networks are First Data, Chase Paymentech Solutions LLC, Elavon Inc., Fifth Third Processing Solutions, Global Payments Inc. and Heartland Payment Systems Inc.
At processing's front end, the connection between the POS device, or online gateway, and the processor must be seamless. Greg Chapman, Chairman of gateway provider PaySentinel LLC, said that connection is like a "light socket plugged into a wall. The switch goes off and on."
To send transactions to the processor, data must be configured according to certain specifications. 1stTransaction Corp.'s TransactionX is POS software that runs on Microsoft Corp.'s Windows operating system for PCs. Rich O'Brien, founder and Chief Executive Officer at 1stTransaction, said each processor wants the card data formatted differently.
"The idea of taking data...and moving it into a format that's applicable to each of the different platforms, it takes a little bit of work to make sure everything works," he said. "And it has to be certified because it has to be repeatable."
For example, processors require transactions coming from restaurants to have different information from transactions coming from gas stations, O'Brien said; a transaction from a restaurant needs a separate data field for tips while a transaction from a gas station requires a field for the type of gasoline pumped.
Another example would be an airline ticket. Mathison said the front-end authorization of an airline ticket may include the card number, expiration date and limited track data; but, in the settlement phase, flight and ticket numbers are included in the data.
A core function at the processor level is analyzing the transactions received from POS devices for such things as transaction type and card brand and then routing them to the appropriate entities. The combination of hardware and software that analyzes that information and routes it over the right network is called the "switch."
David Bergert, Technology and Development Director at Dallas-based payment system manufacturer On-Line Strategies Inc., said a switch is either a "full tower computer or a highly available set of servers with specialized software optimized for online transaction processing."
Once a switch receives a transaction arranged in a certain processor's "message format," the switch's logic engine analyzes the different data fields in order to route it. "A lot of the switching algorithms are based on BIN-based routing," Bergert said. "They look at the first one to six digits of the card to determine what the card type is. If it's '5' it goes to MasterCard; if it's '4' it goes to Visa; if it's '6011' it goes to Discover; if it's '37' it goes to AmEx."
Like the processors, the card brands also have individual specifications for how they want card data formatted, Bergert added. So the switch does what is called "message translation" and sends along a "new" message to the card brands, he said.
Many factors play into how fast a transaction moves through a switch, including computer processing power and the physical age of the hardware, Bergert noted. But he also pointed to a transaction's "external duration" as also affecting processing speed.
For example, it may take a shorter or longer time for a transaction to get through the authorization stage, depending on how much fraud control the issuing bank applies to a transaction. It might take longer if the bank performs velocity controls (the frequency of transactions within a given time period that involves a particular card or a particular cardholder's name, for example) on a transaction to determine if it is valid.
"A lot of it depends on the amount of logic that the issuing bank determines it needs to do on each transaction that comes through," Bergert said.
Another factor is the size of the data packet itself. On-Line Strategies builds special switches to facilitate pharmaceutical payments.
Bergert said because such payments involve adjudication, the process for determining which purchases at mixed-use retailers are covered by health insurance plans, the card data includes insurance information, which makes the size of the "message" a hundred times larger than the size of an average 200 byte-size transaction.
Processing of such transactions can take up to five seconds, where a standard financial transaction takes a millisecond, he added.
Payment pros, like merchants and consumers, are guilty of taking for granted the payment infrastructure that allows modern commerce to occur.
It may be enough to know that the system works. But when you take the time to investigate how, you gain a deeper appreciation for the ingenuity that went into its construction. We have come a long way, indeed, when we think a transaction is slow if it takes all of five seconds to complete.
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