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How Credit Card Processing Works

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It is the accessory that most everyone has but that few have taken the time to consider how it works.

While we could easily be talking about a smartphone, we’re actually talking about the credit card. If you’re over twenty (20) years of age, you probably have at least one credit card in your wallet.

And why not. The credit card is probably the single biggest financial innovation in consumer spending since GM rolled out auto financing in 1919.

These magical pieces of plastic drive the modern economy. Credit cards are behind everything from eCommerce transactions to international travel, and they rely upon a sophisticated a complex network of entities to operate.

This article will discuss the credit card system, its major players, and how it all works.

The Major Players Behind Credit Card Processing

First, we’ll start with the four major players in the credit card industry. We’ll explain each of their role and relationship to the consumer and the merchant (e.g., the place that you are buying goods or services from).

1. The Acquiring Bank

The acquiring bank, also known as the merchant bank, is where the merchant you are buying from keeps its money. The best examples of merchant banks include major names like Bank of America, Citi Bank, and Chase.

Sometimes the merchant bank processes payments for the vendor, but this is becoming a smaller part of its business. Nowadays, most vendors use a third-party like Paypal or Square for payment processing.

2. The Credit Card Processor

Speaking of credit card processors, they are very much an entity unto themselves. Major credit card processors include Authorize.net, Square, and Stripe.

While they can be a major bank, like we said above, third-party processors increasingly serve this niche. Whether it is due to fees or just the convenience of services that these processors offer, traditional merchant banks find this area of the credit card market a hard one to compete.

Those fees that we mentioned are how the credit card processor makes money – and it is also a make-it-or-break-it proposition for many merchants. After all, the higher the fee, the less revenue the merchant receives. What do merchants and consumers receive in return for this service fee?

Processors ensure everyone’s data is safe and that transactions adhere to something called the Payment Card Industry Data Security Standard or PCI DSS.

The PCI DSS is a set of comprehensive and universal data standards that processors maintain to protect all parties involved in the millions of credit card transactions that occur every day.

3. The Credit Card Networks

The next major player I’ll cover is the credit card networks. These are some of the most well-known names in the industry. The four major credit card networks are Visa, Mastercard, American Express, and Discover. Each one is different and offers different benefits to a merchant.

As you have probably noticed, when a merchant accepts a certain type of credit card, it’s usually noted on its signage or at the register. This tells you that the merchant is a member of that credit card network.

These credit card associations handle the transmission of data from the vendor to the merchant bank. It also sets interchange and assessment fees.

Interchange fees are transaction fees that the merchant pays whenever a customer pays with a credit card. Fees vary based on the type of card (e.g., debit, credit, rewards, etc.), the type of transaction (e.g., in person, over the phone, etc.), and the merchant’s transaction volume. There is also a risk component. Higher risk transactions are accompanied by higher interchange fees. These fees are paid to the issuing bank. I’ll cover the issuing bank in more detail below.

Assessment fees, on the other hand, are charged to help cover the operating costs of managing the credit card network. The credit card network receives these fees.

4. The Issuing Bank

The final major player in this process is the issuing bank. The issuing bank is also called the consumer bank. Its the bank that issued the credit card to the consumer.

If you have a credit card from Chase, then Chase is your issuing bank. The type of credit card branding – such as Visa or Mastercard – denotes your network.

The issuing bank’s job is to make sure you have the available credit and to release the credit you need to pay for what you’re buying. Because there are a variety of cards that a consumer bank can issue, the interchange fees for these different cards are variable, with rewards cards and other high-benefit instruments that typically cost more in interchange fees.

Our Ice Cream Cone Case Study

Let’s set the scene. You walk into your favorite ice cream parlor and order one ice cream cone. With sprinkles of course.

You present your credit card to pay to the cashier.

In the good old days circa 2015, the merchant siped your card in the reader. Today, most of us insert our chip cards into the reader.

Here’s when the magic happens. The payment processor collects your data, encrypts it, and sends it to the credit card network of which your card is a member (e.g., Visa or Mastercard).

Next, the credit card network takes your information, encrypts it again, and passes it on to the issuing bank attached to the card. At this point, your issuing bank determines if you have enough credit but the ice cream cone. If you have the credit, your purchase is approved. This all happens very quickly.

With your transaction approved, the funds are released from your credit line and transferred into the merchant account to complete the transaction.

But, the ice cream parlor can’t spend or use the funds until a holding period has cleared. Think of it as the same process which the bank uses to hold a deposited check. This verification period makes sure everything involved with the transaction is on the up-and-up.

As long as there are no issues, the funds are released to the ice cream parlor after a couple of days.

Now you can’t return an ice cream, but if you bought a new shirt and returned it, this entire process is unwound, and the funds are credited back to your account.