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How does the credit card industry work

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From the information presented in the preceding sections, we can start to piece together what is occurring during a credit card transaction. We know that merchants have a relationship with either an acquiring bank or independent sales organization, through which they have their credit card transactions processed. The section on industry terminology shows us some of the fees involved in this process. Merchants must pay the acquiring bank or ISO a discount fee based on the total amount of the sale. Likewise, the acquiring bank or ISO must pay the card issuer an interchange fee when they process the sales draft from the merchant.

I talk about piecing information together because that is what I needed to do to generate an overall view of a "normal" credit card transaction. There was no one source that I found which presented the whole picture of how things work. In fact, most of the material I read treated the interaction between an acquiring bank and card-issuing bank as a black box. The descriptions only cover the starting point where the acquiring bank gets an authorization or sales draft from the merchant, and the final point when the acquiring bank sends an approval or authorization code back to the merchant.

I was able to find bits and pieces that led me to create the picture I present below. The CyberCash site provides a step-by-step walk-through of a secure payment which shows the acquiring bank contacting the card-issuing bank for authorization. A conversation I had with a representative from Card Establishment Services, Rosemary Cox, brought out the fact that a hold is placed on the cardholder's account when an authorization is done, for the amount the authorization was requested. This hold guarantees that enough credit will remain when the actual sales draft is processed. Several sites, including this Merchant FAQ. mentioned that acquiring banks and ISOs provide the merchant with a merchant ID and a separate terminal ID for each point of sale device they will use. Each of these pieces of information led me to the overview shown below.

Here is one caveat I must tell you before I present my overview of the credit card process. I am sure there are holes in the picture I present, since it has been cobbled together from the bits and pieces I was able to find during my research. This overview shows what I believe happens during a "normal" credit card transaction. I discuss how authorization of a retail sale through a point of sale unit proceeds. Many variations exist on this process. Not every merchant processes their credit card sales electronically. For example, if you look at the First Union merchant services. you will see that they offer both paper and electronic processing of credit card transactions.

Steps involved in a normal credit card transaction:
  1. Merchant calculates the amount of purchase and asks buyer for payment
  2. Buyer presents merchant with a credit card.
  3. Merchant runs credit card through the point of sale unit. The amount of the sale is either hand-entered or transmitted by the cash register.
  4. Merchant transmits the credit card data and sales amount with a request for authorization of the sale to their acquiring bank.
    • Point of sale units are usually set to request authorization at the time of sale, and then actually capture the sales draft at a later time. This is pointed out in RFC 1898. and was also observed personally during my short period of retail work.
  5. The acquiring bank that processes the transaction, routes the authorization request to the card-issuing bank. The credit card number identifies type of card, issuing bank, and the cardholder's account.
  6. If the cardholder has enough credit in their account to cover the sale, the issuing bank authorizes the transaction and generates an authorization code. This code is sent back to the acquiring bank.
    • The issuing bank puts a hold on the cardholder's account for the amount of the sale. Note that the cardholder's account has not been actually charged yet.
  7. The acquiring bank processing the transaction, and then sends the approval or denial code to the merchant's point of sale unit. Each point of sale device has a separate terminal ID for credit card processors to be able to route data back to that particular unit.
  8. A sale draft, or slip, is printed out by the point of sale unit or cash register. The merchant asks the buyer to sign the sale draft, which obligates them to reimburse the card-issuing bank for the amount of the sale.
  9. At a later time, probably that night when the store is closing up, the merchant reviews all the authorizations stored in the point of sale unit against the signed sales drafts. When all the credit card authorizations have been verified to match the actual sales drafts, the merchant will capture, or transmit, the data on each authorized credit card transaction to the acquiring bank for deposit. This is in lieu of depositing the actual signed paper drafts the with the bank.
  10. The acquiring bank performs what is called an interchange for each sales draft, with the appropriate card-issuing bank. The card-issuing bank transfers the amount of the sales draft, minus an interchange fee to the acquiring bank [Baughn, 88].
  11. The acquiring bank then deposits the amount of the all the sales drafts submitted by the merchant, less a discount fee, into the merchant's bank account.

The overview presented above is far from complete. It does not cover the role of the financial networks, nor of the bankcard associations. Also, it is geared towards Visa and MasterCard transactions. There is no card-issuing bank with American Express and Discover. These shortcomings aside, the sequence of events outlined above provides a good overview of the credit card payment process. It will also give you something to look back at as I discuss methods for performing online credit card transactions. You will find that the CyberCash and SET online payment schemes try to match the process I outline above.

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