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June 28, 2022
How Do Payment Processors Work?
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How Do Payment Processors Work?

June 28, 2022

Most of us are very comfortable using familiar technology even though we might not know much about how it works. We drive cars without understanding how the engine works, we use computers without a thought for the complex coding involved, and we swipe or tap our credit and debit cards on a POS system without a second thought. We might be more cautious if the technology is new, but we stop worrying once we accept it as part of everyday life.

When it comes to electronic payments, this is equally true of most merchants for whom such payments are routine practice. In many ways, that’s as it should be because third-party payment processing is designed to take the complexity out of these transactions so retailers can get on with their business. As a user, you don’t need to know what goes on under the hood and shouldn’t need to worry about it.

Having said that, it is wise to understand how the interface between card and machine, or digits and virtual terminal, manages the transfer of funds. Although your payment processor will assume most of the responsibility in terms of security and compliance, it’s a mistake to assume that you are thereby relieved of all obligations. As far as your customer is concerned, you are the business they are dealing with.

In practice, these transactions may be largely in the hands of unseen parties and encrypted data transfers. Still, if something goes wrong, you or your employees will be the ones questioned by the customer. Knowing how the process works will enable you to offer a reasonable explanation to a disappointed customer.

Businesses with physical stores and those that operate online are almost totally dependent on the services of their payment processor to keep the cash flowing in. It is fast, efficient, and happens hundreds or even thousands of times a day in some environments. Let’s have a look at how it all works.

Payment Processing: The Basics

It has always been accepted that there are risks inherent in making and taking payments electronically by credit and debit cards. For one thing, cards can be stolen, counterfeited, or cloned. For another, the merchant may not receive the promised funds even in a legitimate transaction if the customer does not have sufficient funds to honour the payment. While this is a worry and inconvenience for consumers, it can have serious financial consequences for retailers who have accepted payment in good faith and find themselves subject to chargebacks and other liabilities.

These and other risks prompted the establishment of the payment processing industry. A payment processor enables the smooth and secure transfer of funds between the customer and the merchant, communicating with all parties involved, including the card companies and the banks. Providers of payment services supply the necessary procedural and technological protections to ensure that the chances of fraud, theft, and loss are, if not eliminated, then massively reduced.

What is a Payment Processor?

Essentially, they are mediators between the banks, card companies, and merchants. Once you have signed on with a processor, they will look after everything that occurs when your customer is ready to pay for goods or services. They are not financial institutions themselves and they have no power to release or withhold funds. Instead, they manage the lines of communication that enable the systems of verification, authentication, and authorization that ensure the secure, accurate processing of payments.

When you research providers, it's worth finding out which is the best POS your budget can afford. Your chosen payment provider will usually supply you with the POS equipment you need as part of your agreement with them. Some associated charges may include start-up, transaction, chargeback, termination fees, and lease payments for the equipment itself. Be sure to compare the costs of each service provider because they are not all standard.

To get started, the payment processor will supply the merchant with a credit card terminal. The terminal is connected to the merchant’s POS system and enables the acceptance of credit, debit, and contactless payments. Companies like Dello make it possible for merchants to also accept crypto payments on a POS terminal.

The Merchant Account

A merchant account is a bank account specifically designed to receive credit and debit card payments. This is not to be confused with the merchant’s regular bank account. You can set up a merchant account when you start your business. It can take a few days before it’s up and running. If you haven’t done this, it is relatively easy to do, and in fact, many payment service providers will offer to do this on your behalf.

Payment Processing: The Three Steps

Whichever payment services provider you use and whatever your POS equipment, the basic objectives are: to verify the validity of the card and the buyer’s identity; to ensure that the cardholder’s data is always protected; to confirm that sufficient funds are available for the purchase; and to transfer the funds to the retailer via their merchant account. We’ll consider the steps of an in-person purchase in more detail.

1. Authorization

Once the customer has decided what they wish to buy, they bring their purchase to the register. The merchant calculates how much is payable. The amount is entered into the terminal and the customer is invited to insert or tap their card. At this point, the cardholder’s issuing bank is contacted and asked to verify the account and authorize the transaction.

- The customer inserts their card into the terminal or taps it if it is contactless.

- The card details are encrypted by the terminal’s software and transmitted to the merchant’s bank, known as the acquiring bank.

- The acquiring bank transmits the card details to the credit card company which issued the card to the customer, such as Visa or MasterCard.

- The credit card company approves the transaction. It contacts the customer’s bank (the issuing bank) to ask it to authorize the payment.

- The issuing bank verifies the card number, the expiration date, the billing address, the 3-digit security code, and the payment amount.

All of this takes place within a few seconds through automated processes.

2. Authentication

Once the issuing bank has verified the card details listed above, it can authenticate the purchase and release the requested amount to the acquiring bank.

The procedure for authorized transactions is as follows:

- The transaction is approved by the issuing bank, which then informs the credit card company.

- The credit card company gives notice to the acquiring bank that authorization has been granted.

- The issuing bank then places a temporary hold on the customer’s account. This hold becomes a withdrawal once the transaction has cleared.

- The merchant’s POS system or card terminal prints out a receipt as confirmation of the transaction. The merchant gives a copy to the customer, keeping one for their records.

Should the authorization request be declined, this happens:

- Instead of giving an authorization code, the issuing bank will reject the transaction. 

- It sends a notification to the credit card company and the acquiring bank.

- The transaction is then voided.

- The POS system or terminal displays a message to this effect and prints a confirmation that the transaction has been voided. The merchant gives this to the customer as proof that no funds have been transferred.

Authorization can be declined for several reasons. For example, the issuing bank may not recognize all the card details, the customer may have insufficient funds in their account, or there may be a minor technical fault.

3. Settlement

It usually takes only seconds for the transaction to be authorized and all parties to be notified. The issuing bank will release funds from the customer’s account to the acquiring bank on behalf of the merchant.

However, this may not occur immediately. Sometimes transfers will be instant, but more commonly, it can take a day or longer for the funds to reach the merchant. If the customer checks their bank account, they will see the transaction listed as ‘pending’. This doesn’t mean the transfer can be stopped, simply that it is in process.

Similarly, it may seem as if the merchant has given goods without receiving payment into their account, but the pending status of the transfer doesn’t mean there is any problem, just the standard delay caused by the processing time.

- At the end of the day, the merchant closes the system. At this point, the POS or card terminal will send the day’s approved authorizations to the acquiring bank in a batch.

- The acquiring bank then transmits this batch to all the relevant card companies in the card network.

- All transactions are then settled, and the merchant receives payment.

- The issuing bank receives the authorized transactions from the card companies.

- The card companies then receive funds from the issuing bank.

- Funds are transmitted from the card companies to the acquiring bank.

- The acquiring bank places the funds into the merchant’s bank account

- The transaction changes from pending to complete in the customer’s account.

This is a lot more complicated than simply handing over cash. One of the main reasons for this complexity is the overriding concern for security.

Risks and costs

The potential for security breaches and theft in electronic payments is complex. Several parties are involved in the transfer of funds. All those parties are responsible for ensuring the transaction is legitimate, as a duty to their organizations and under regulatory and legislative provisions. The issuing bank also has a responsibility to the cardholder whose card someone may have used illegally.

As all the parties involved in the verification process are commercial entities, there are, inevitably, costs arising from their contribution. These costs make up the transaction fees payable by the merchant.

A fee applies to every transaction, calculated as a percentage of the total sum due from the customer. This amount covers the cost of the issuing bank’s verification and transfer of funds, approval from the credit card network and subsequent transfer of funds, and the execution by the payment processor of the transaction.

Each merchant’s agreement with their payment provider will contain terms providing either a fixed or variable percentage. The fee can vary depending on the type of business, the amount of data used in processing, and even the method of payment offered by the customer.

In some stores, you will have seen a list near the cash register of surcharges the retailer adds to a transaction for accepting certain cards that charge higher fees. The retailer is entitled, if they choose, to pass this cost on. Still, many prefer to absorb them in the interest of customer service.

One of the advantages of accepting crypto payments is that the processing fees are much lower. Dello’s fees are scalable and can go as low as 0.1%.

You don’t need to be an expert in the technology, or even the terminology, but if electronic payments are important to your business - and that’s pretty much a certainty - then understanding the basic operation of a POS system and the network of parties behind it will give you the confidence to trust it and answer any of the questions your customers may have.