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Credit and Debit Cards - How Do They Work?

We’ll attempt to demystify how credit card transactions work, and how the various entities involved make money from the transaction. Before we explore the credit card transaction flow, let's look at who’s involved.

Credit Card Associations

The credit card associations are brands that are well recognized by consumers and merchants. The major associations, ranked in order from high to low in terms of number of cards in the marketplace (2006 data) are:

  • VISA - 54% of cards in the marketplace, and 59% of overall purchase transaction volume
  • MasterCard - 36% of cards in the marketplace, and 27% of overall purchase transaction volume
  • Discover - 6% of cards in the marketplace, and 4% of overall purchase transaction volume
  • American Express - 4% of cards in the marketplace, and 10% of overall purchase transaction volume

It’s interesting to note that while Visa has the most transactions and overall charge volume, the average purchase transaction on an American Express card is almost twice as high as the average purchase transaction on a VISA card ($109.61 versus $59.28).

Card associations are responsible for creating and enforcing member governing rules, providing and managing authorization and settlement networks, monitoring fraud and enabling effective fraud controls, and mass marketing of the association brand.

These associations can be either closed loop networks or open loop networks. In an open loop card network, the association depends upon financial institutions for the card issuing role and the merchant acquiring role (more on this later). VISA and MasterCard are open loop associations, and their cards are branded by the issuing financial institution, who then markets the card to the consumer (CitiBank VISA, Chase Freedom MasterCard).

A bank might also offer open loop cards on behalf of affinity partners, such as airlines, colleges or universities, or professional sports teams.

In a closed loop card network, such as American Express or Discover, the association itself performs the functions of issuer and acquirer, although there are some cases where closed loop brands are being marketed by financial institutions on a revenue sharing basis (Bank of America is now offering American Express).

The card associations generate no revenue from interchange fees. They make their money by charging member financial institutions and credit unions annual membership fees, and they also get paid about a dime in assessment fees for every $100 that they process through their network.

Card Issuing Financial Institutions

Card issuing financial institutions market and provide branded credit and debit cards to consumers. There’s been a significant level of consolidation among issuers over the past 10 years, and today there are 6 top tier issuers:

  • Bank of America
  • Chase
  • Citigroup
  • Capital One
  • Wells Fargo
  • U.S. Bancorp

Card issuers make money from interchange fees when the consumer uses his/her card in a purchase transaction. However, the vast majority of the revenue that they earn (almost 70%) actually comes from the interest income resulting from the card holder carrying a month to month balance on their card account. They also generate income from late payment penalties and other fees assessed to the consumer.

Merchant Card Acquirers

Merchant card acquirers promote and sell card acceptance services to the merchant community. The top 5 acquirers control 85% of the market for VISA and MasterCard transactions:

  • Chase Paymentech
  • Bank of America
  • First Data
  • Nova
  • Fifth Third Bank

Card acquirers charge what is called a discount rate to merchants and billers, and this discount rate is their primary source of income. They often sell card acceptance hardware, and may also provide telecommunications services to the merchant at a marked up rate.

They utilize reseller organizations, called ISO’s (independent sales organizations) to sign merchants up for their services, and currently there are hundreds of ISO’s actively selling card services to merchants. The card acquirer collects fees from their ISO resellers, and in turn shares back some transaction revenue to the ISO when their merchants generate transactions.

Processors

The final link in the chain is the card processor, who provides transaction authorization services, account statement services, and invoicing services. There are four primary processors providing services today to 93% of the market. Processors only earn a fraction of a penny per transaction, so they must drive a lot of volume through their network to generate any meaningful revenue.

Interchange

Finally, there is interchange, which is the amount of money, set by the card associations, that is collected by the issuing bank from the acquiring bank for each transaction.

Interchange rates vary from vertical market to vertical market, and also vary within vertical markets due to variables like whether the card was physically present during the transaction or not.

A merchant will pay more for a credit card transaction initiated over the Internet than they will for a credit card transaction that was swiped via terminal at their brick and mortar retail store. This difference in interchange is related to the amount of risk associated with the transaction. Obviously, a “card not present” transaction carries more risk than a “card present” transaction carries.

Card associations have discounted interchange rates in markets where profit margins are thin in an attempt to generate new revenue streams. An example of this is in the grocery industry, where in previous years cards were often not accepted by grocers, but are accepted today due to interchange concessions made by the card associations.

Credit Card Transaction Flows

Now that we’ve defined all the terms and the various players, let’s outline the transaction flow for a credit card purchase:

  • Customer presents a card to the merchant for a purchase transaction.
  • Merchant swipes the card and the transaction is sent to their acquirer via the card processor.
  • The acquirer (or processor) captures the transaction information and sends it to the card association.
  • The association forwards the transaction to the card issuer (via the processor).
  • The issuer sends the approval or denial back to the association.
  • The association forwards the response back to the acquirer.
  • The acquirer forwards the response to the merchant.
  • Transaction complete!

Here is how the funds are settled:

  • Merchant deposits the transaction receipt with the acquirer.
  • Acquiring bank credits the merchant’s account and electronically submits the transaction to the association for settlement.
  • Association pays the merchant’s acquiring bank, debits the issuer’s bank account, and sends the transaction information to the issuer.
  • Issuer posts the transaction to the cardholder’s account, and sends the cardholder a monthly statement.

Assuming a $100 transaction by the card holding consumer, here is about how much revenue each participating entity makes:

  • Merchant revenue is $98.00 (assuming they have a 2% discount rate agreement with their acquirer).
  • Processor revenue is $0.01 from the acquiring bank.
  • Acquirer revenue is $0.08.
  • Association revenue is $0.10.
  • Processor revenue is $0.01 from the issuing bank.
  • Issuer revenue is $1.80 of interchange fee. The issuer gets the lions share of the revenue from the transaction for two reasons:
  1. They are the ones that are loaning the money to the consumer during the grace period between when the transaction occurs and when the consumer is obligated to pay the issuer.
  2. They are the ones that are assuming the payment risk in case the card holding consumer defaults on their obligation.

Debit Cards

There are a few noteworthy differences between a credit card and a debit card, and there are also a few different kinds of debit card transactions.

A signature debit transaction, which is the most common type of debit transaction, has the same transaction flow as does a credit card transaction. Note that the consumer does not need to physically sign the receipt in order for a transaction to be considered a signature debit transaction, and in fact most Internet-initiated debit card transactions are signature debit transactions. These transactions are typically around 40 basis points less expensive to the merchant than a credit card transaction, due to the decreased level of consumer credit risk.

A PIN debit transaction involves the card holding consumer to key in a 4 digit PIN on a physical key pad, which is a hardware device that encrypts the transaction and settles it via the ATM network, rather than via the credit card network. A PIN debit transaction will cost the merchant around $0.50 regardless of the amount of the transaction, which makes them a relatively expensive transaction (versus credit card) for very low dollar purchases and a relatively inexpensive transaction for high dollar purchases.

PIN-less debit transactions also use the ATM network for settlement. These transactions look the same to a consumer as a signature debit, but are 40 – 50 basis points cheaper to the merchant than a signature debit. PIN-less debit is only offered for bill payments in selected vertical markets, and the settlement time for the merchant can vary depending upon which ATM network is utilized.

Chargebacks

Chargebacks occur when the credit card holding consumer disputes a charge that appears on their monthly statement. These can be rather difficult for the merchant to fight, and most chargeback transactions end up being a cost of doing business for merchants that accept cards.

Aside from being responsible for all of the initial discount rate fees (remember the $2 that they had to pay in our example above on a $100 transaction), they are also assessed chargeback fees that are usually between $15 and $25 per occurrence . In addition, if a merchant has a history of excessive chargeback activity, their acquirer might ultimately decide to shut them down.