From Cash to Bits: How Payments Work?
Have you ever wondered if you could live without cash?
If you’re in New York you get to the airport, take a taxi, Uber or underground and you can pay with a credit card, get to the hotel or Airbnb and pay again with a credit card. You go out on the street to buy a pretzel and a doughnut and again you pay with a credit card. Cash in some regions, especially in developed countries, is no longer the main source of payment. Today, a large part of transactions is carried out by credit card, debit card or other means of payment.
The first bank card was created in 1946 by John Biggins at Flatbush National Bank in Brooklyn, allowing the user to pay merchants within a two-block radius of the bank. Four years later, in 1950, the first “Diners Club” credit card was born, which had to be paid in full at the end of a 30-day period and could only be used at member restaurants.
In 1958, Bank of America created BankAmericard (now VISA) with the aim of creating a card that could be used at any merchant that could be used for these transactions. At that time, making a credit card transaction was extremely complicated, as it was a manual process, with the merchant telephoning the issuing bank, who in turn called the credit card company, and an employee manually verifying the customer’s details and available credit.
In 1959, American Express created the first embossed card which allowed the merchant to trace the information on the card for later payment and clarification. In 1970, the magnetic stripe with IBM technology was incorporated into the cards, which increased efficiency by certifying transactions. Despite being electronic transactions, a physical paper signature was still required to approve the transaction.
In 1982, Verifone released the first PoS card terminal. In the 1990s, the first wireless terminals appeared. In 2010, Square launched its portable terminal that could be connected to a smartphone to receive payments. Following this launch, companies such as iZettle and SumUp launched similar products.
Square’s development was revolutionary, due to the decrease in costs incurred by merchants for accepting card payments and facilitating the use of these devices. Before Square, banks were the only ones that could provide this service to merchants, who had to meet certain requirements such as having a business activity, being a bank account holder, being active with the tax authority -IRS, having a proof of address, among others. Some differences between Square terminals and bank terminals are as follows:
To understand the payment process, it is necessary to understand the main players and their role in the transactions:
User: Customer who makes the card purchase.
Merchant: Who makes the sale and receives the funds from the transaction.
Processor: Company that processes the transactions and acts as an intermediary between the merchant, the card scheme, banks, etc.
Card network: Financial institutions that assign the terms of the transactions (VISA, MC, Amex, Discover, Carnet).
Issuing bank: The bank to which the user’s card belongs.
Acquiring bank: The bank of the merchant to which the funds will be credited.
Interchange fee: Fees paid to the issuer for the transaction.
Gateway: The “digital gateway” that provides security for an online transaction.
Square and Paypal’s advances over traditional banking terminals have been made possible by technological innovations in the card payment process. The process can be described as follows:
- A purchase is made at the merchant with a credit, debit, or other digital card.
- The payment method information is registered at the bank or third-party terminal.
- The charge request is sent through the payment processor for authorization:
- The payment processor requests the payment via the card network (Visa, MC).
- The card network contacts the issuing bank to request approval of the transaction.
- The issuing bank checks the security information of the transaction (PIN, CVV, card date, funds, etc.).
- If approval is obtained, the approval is sent to the card network and in turn to the payment processor and the merchant.
- Subsequently, settlement takes place:
- The merchant sends a backlog of approved transactions to the payment processor.
- The payment processor contacts the card scheme, which in turn requests the disbursement of the transactions to the issuing banks.
- The issuing banks debit the user.
- The issuing bank transfers these sums to the merchant’s bank.
- The merchant’s bank deposits the corresponding amount to the merchant’s account.
- The authorisation of the transaction takes a few seconds.
- The transfer of balances used to take days, however, more recently it can be done at the close of the day.
In addition, the commissions to be considered throughout the process are as follows:
- Interchange fee: This usually represents 70% to 85% of the fee paid on each transaction. It is charged by the issuing bank, used to pay the card network (Visa, Mastercard, etc.) and to manage the costs of using the card (interest-free months, rewards, fraud, etc.). This fee varies depending on the type of card (credit, debit, corporate, etc.), type of transaction (online, point-of-sale, etc.) and is usually composed of 2 factors: a percentage fee on the transaction plus a flat fee e.g., 1.5% on the total amount transacted + $0.10. There are over 700 different interchange fees, and the ranges can go from a total of 1.4% to over 5%.
- Assessment and fees: These typically represent 10% to 15% of the total payment processing cost. This is usually a flat fee charged on the total sales processed by the merchant monthly and ranges from 0.12% to 0.14%. This fee is charged directly by the card networks (Visa, MC, Amex).
- Acquirer fees: These usually represent 5% to 20% of the total fees paid. These are paid to the acquiring bank for authorization, settlement, reporting and account management services. There are many items within the acquirer’s fees, some of them are: Terminal fees, minimum transaction fees, depository fees, gateway fees, authorization fees, settlement fees, processing fees, service fees, reporting fees, etc.
As with any process there are relevant elements to consider such as:
- Chargeback: The card issuing bank submits a chargeback request at the request of the user up to 4 months after the transaction has been submitted. The request must be answered by the business that submitted the transaction. If the chargeback proceeds the merchant must bear the cost of the transaction.
- Cancellations: Transactions can be cancelled if it is on the same day as the transaction.
- Returns: These must be made within the following days (variable from 15 to 30 depending on the bank) and the card with which the transaction was made must be presented.
Despite its apparent simplicity, processing a non-cash payment involves the work and coordination of many players. This process has been evolving slowly but steadily over the past decades and disruption is expected with the new technologies available. Some of the technologies that have promised to improve this process include:
- NFC: In 2007 Barclays adopted this technology in the UK for its cards and 7 years later there were over 147k terminals in use.
- P2P (Interbank Transactions): They work between individuals without the need for processors or intermediaries other than banks. Banks connect directly with each other at the request of users to make transfers.
- QR codes (Wechat, Walmart pay): These are payments that require a wallet, they work by connecting wallets with a payment method (debit, credit, giftcards, etc.) and are usually restricted by geography (you cannot use Wechat to send money outside China). Transactions are immediate and use banks’ interbank networks.
- Biometrics: Biometric payments ranging from easy recognition to fingerprints such as the Ingenico terminal (Move 2500B). They use the same infrastructure as other payment methods but have more integrated technology for approval.
- Sound payments: These are generated through an audio signature created on smartphones.
- Payments on the blockchain: They use a decentralized network (blockchain) to carry out transactions of Crypto assets, the most common for payments are Bitcoin, Litecoin, Dogecoin, among others. The main differentiator is that transactions can be completely anonymous, as they do not require any type of verification from users other than their private keys for the approval of the transaction.
Although making a purchase requires something as simple as holding a credit card up to a terminal, the process involved in making a successful payment is much more complex than it seems. Undoubtedly, this electronic payment process has become very relevant in the modern world where transactions are almost instantaneous, and merchants and shoppers are increasingly connected. It is very likely that we will continue to see evolutions that increase the efficiency and security of transactions as new technologies emerge that could replace those currently in use.
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Ricardo Latournerie. VC Investor at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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