Ninety percent of Americans have used a credit card, but far fewer understand the underlying systems enabling their payments. So let’s dive in to see what happens when you swipe your card!

Source: The Graduate, A Mike Nichols/Lawrence Turman Production

Suppose you purchase some carrots from the grocery store. You take out your credit card to complete the purchase, and see a logo with “Visa” on it. That’s the card association. You’d usually see one of the four major card associations: Visa, Mastercard, American Express, or Discover.

When the merchant swipes your card, it will most likely be on a First Data point-of-sale terminal (or a Square terminal, particularly if you’re in a hipster coffee shop). Swiping or inserting a card (or tapping a smartphone or smartwatch) at this terminal kicks off the transaction process. Many online systems use payment gateways, such as Stripe or Braintree, which provide a set of tools for interacting with the network, conducting analytics and detecting fraud. The gateway then hits the processor used by the acquiring bank (i.e., the bank of the grocery store). The processor is the main party responsible for conducting the transaction with the acquiring bank.

Once your request hits the processor, it is then forwarded to the card association (Visa, Mastercard, etc.), often interchangeably called the network since it has a relationship with several banks that issue credit cards to consumers. The bank of the cardholder (i.e., you, in this scenario) is the issuing bank, which finally receives the request, determines if you are who you say you are, checks if you have enough funds available for the purchase, and decides whether the transaction can be authorized. American Express and Discover are the issuing banks along with being networks, unlike Visa and Mastercard, which only serve as the network.

When the bank approves a transaction, it issues an authorization (or auth), which is then forwarded through the network back to the merchant, who finally lets you enjoy your carrots. The authorization indicates a confirmation that the customer has sufficient funds in their bank account to fulfill the transaction.

It’s worth pointing out the difference between the card being authorized for use and the funds actually being swept out of your account. The authorization leads your transaction to be in a pending state, i.e., the funds are reserved for the merchant. The merchant has to then issue a request for settlement (often interchangeably called a capture) for the funds to be swept to the merchant’s account, which is why at times you see transactions in a pending state for several days. This is usually initiated when a merchant ships the item. If the merchant doesn’t settle within a certain time frame specified by the network, then the authorization expires and the reserved funds are released (as with every complex system, there are caveats here too).

An interesting point to note here is that the settlement amount does not necessarily have to be the authorization amount. You essentially experience this every time you dine in a restaurant. The authorization amount is for the items ordered, but the settlement amount includes the tip.

So what happens to the merchant after they hand you your items?

The merchant sends to the processor a list of all the transactions that have not yet been settled. The processor then routes the transactions to the issuing bank. The issuing bank then debits the transaction sum to the acquiring bank, at which point it becomes available to the merchant.

The banks talk to each other via a system called Automated Clearing House (ACH). ACH is likely the system introducing joy in your life on a regular basis through payroll direct deposits. One could view ACH as the younger, more modern (relativity is in play here, of course) sibling of checks. Topic for a later blog post.

Being a relic of a batch-processing system that the network is modeled after, is there anything good coming from authorization and settlements being two separate activities?

Consider if the store charged you for nonfat Greek yogurt along with your organic carrots, but you didn’t actually buy nonfat Greek yogurt (why would you?). After you complain to the merchant enough about the charge, the merchant will void the transaction, which closes the auth if the merchant hasn’t issued a capture yet (if they have, they will need to issue a refund instead). This is possible primarily because auth and settlements are processed orthogonally; an auth authorizes the merchant for the transaction, while a settlement finalizes the transaction and actually removes the funds from your account and inserts the money to the grocer’s account.

On top of the complexity involved in transferring money, there are also convoluted fee structures. For every 100 dollars worth of carrots you buy from the store, the store usually only receives 97 or 98 dollars. Here’s where those minimum purchase amounts come in. Depending on the category of the merchant, the network charges an interchange fee, the cost of which is split between the issuing bank (which takes most of the cut), the card association, and the acquiring bank. An online provider usually pays more than 2% in interchange fees to the issuing bank. In restaurants and other businesses that require the card to be physically present, the fees are usually slightly lower (1.54% to the issuing bank and 10 cents to Visa, for example) because of lower fraud risk. There are several other fees that are slapped on the merchant, including AVS fees (Address Verification Service to validate billing address), chargeback fees (associated with a user disputing a transaction), and PCI-compliance fees (fees for being compliant with security standards outlined by the networks). While card regulations prevent many merchants from passing the interchange fees on to their customers, merchants often end up raising prices to cover the additional cost. The user eventually bears the brunt of merely using automated software.

So we know payment systems are unnecessarily complex and arguably unnecessarily expensive. Sounds like there should be some clear effort to improve them! But it turns out they are also controlled by just a few players. Visa and Mastercard alone control 70% of the market based on purchase volume. And lack of competition reduces the incentive for firms to improve the efficiency of their technological systems or price their services fairly.

Along with the inertia that hobbles financial systems, since most people aren’t aware of the intricacies of the system, they can’t improve it. Money systems are indeed the intangible voodoo magic of our day, sprinkled with incomprehensible jargon used to convince by confusion. These inadequacies provide an opportunity for companies like Affirm to come into being.

While Affirm’s primary vision is to solve the inadequacies in lending systems — lack of transparency, inability to underwrite consumers using a wide variety of data, and uninspiring design and user experiences — Affirm also tackles the payment challenge in an interesting way. When a customer purchases an item at checkout using Affirm’s point of sale product, the merchant ships the item to the customer without the customer having to enter any credit card details. We interact directly with the merchant and our bank partner to settle the transaction outside of the card network (although we are still reliant on the card network for repayments). This helps us create a closed-loop system when a user checks out.

Ultimately, the inertia and complexity of existing systems gives opportunity for a lot of interesting innovation that can be brought about by technology.

Are you inspired by the opportunities that arise from the many inefficiencies of today’s financial systems? We’re hiring!

Sources:

http://www.creditcards.com/credit-card-news/payment-method-statistics-1276.php

https://www.cardfellow.com/visa-interchange-fees/cps-restaurant/

https://www.cardfellow.com/visa-interchange-fees/purchasing-card-level-ii-data-rate/

https://wallethub.com/edu/market-share-by-credit-card-network/25531/

Thanks to my colleague Wenhui Yu for helping out with the systems diagram above!