Booklet: Retail Payment Systems Section: Payment Instruments, Clearing, and Settlement Subsection: Card-Based Electronic Payments

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A variety of electronic payments are available for retail use. Some are card-based, while others are electronic instructions for funds transfers. Usually, these payments link to an existing account relationship with a financial institution for both payee and payer.

Consumers may use credit, debit, or stored-value cards to initiate retail payments in face-to-face or remote transactions. The payee receives funds after the payment clears, but consumers actually pay before the transaction on a stored-value card, at the same time of the transaction for an on-line debit card, and after a transaction on a credit card. Both credit and signature-based debit card transactions are processed in batch mode at the POS, and settlement is delayed until the batches are processed at the end of the day. PIN-based debit card transactions, although processed in real time at the POS, typically settle at the end of the day using the ACH. Each of these types of card payments is described below.

Credit And Charge Cards
Financial institutions are important participants in various credit card systems. They issue and distribute cards, clear and settle the associated payments, and in some cases act as merchant acquirers. Credit cards can have revolving credit arrangements, and charge cards have a short-term, fixed-period, credit arrangement. Revolving credit arrangements allow customers to make a minimum payment in each billing cycle (e.g., two to three percent of their total balance) rather than requiring payment of the full balance. With charge cards, the consumer must fully pay the outstanding balance at the end of the one-month charge or billing period. This arrangement exposes the issuing institution to less credit risk than open-ended accounts.

This booklet groups credit or charge cards in three categories: general-purpose credit cards, co-branded/affinity cards, and private label (store) cards.

General-Purpose Credit Cards
General-purpose cards are cards that have the logo of one of the bankcard associations on the front. These cards have an associated account at a financial institution or other business with a credit line that limits the value of outstanding payments. They can be used at any location that accepts cards from the particular card association. General-purpose credit cards include bankcards and closed-loop cards. Bankcards require agreements and transaction processing arrangements among participants, while closed-loop cards may not.

Co-Branded/Affinity Credit Cards
Some merchants and organizations will form marketing arrangements with financial institutions that issue general-purpose cards with the merchant or organization name on the front of the card. These agreements are termed co-branded or affinity cards, and the card accounts may be part of the bankcard association networks.

Companies with which the cardholder has a relationship issue co-branded cards jointly with specific financial institutions. They typically offer consumers some kind of rewards program. Organizations such as sports teams, schools, or service organizations issue affinity cards jointly with a financial institution that offers compensation in return for marketing to the merchant’s customers or the organization’s members. The institution can base its compensation on the number of account applications, the number of accounts activated, account volume and income, or other defined benchmarks.

Private Label (Store) Credit Cards
In some cases, financial institutions might issue a card jointly with a merchant. These cards are private label or store cards. Consumers can only use them at the merchant whose name appears on the front of the card. These cards do not carry a bankcard association logo, and the merchant typically plays a limited role in the issuance of the card or managing the credit relationship.

Bankcard Associations
The two major bankcard associations, Visa and MasterCard, in conjunction with credit card issuing and acquiring financial institutions, account for the majority of credit and debit cards in use. Both associations began as bank service companies, owned by principal member financial institutions. They provided uniform operating policies, procedures, and controls for bankcard issuance, acquiring, and settlement activities. The associations own the credit card trademark, granting membership to financially sound institutions that apply. The associations only allow members to issue cards bearing the association logo. Members pay transaction and membership fees for use of the bankcard association logo and services.

Both associations have three types of membership: principal, associate (VISA)/affiliate (MasterCard), and participant (VISA)/agent (MasterCard). Each membership type conveys different privileges. Principal membership allows members to solicit cardholders and issue cards, solicit and sign merchants, and sponsor other financial institutions for membership in the association. Associate/affiliate and participant/agent members can perform all of the principal membership functions except sponsor other members.

The closed-loop credit card networks—American Express, Discover, and Diner’s Club—compete with the major bankcard associations to promote the use of their cards. However, in the case of the closed-loop credit card networks, the card issuer and merchant acquirer are the same financial institution.

Card-issuing institutions are financial institutions that have permission to issue bankcard association credit cards. Acquiring financial institutions and third parties have contracts with merchants that accept a bankcard association’s products. The financial institutions accept and process transactions from those merchants through the association’s network interchange payment system. The cost of technology infrastructure and level of transaction volume are high for bankcard-acquiring institutions. Most rely on third-party processors to perform the functions. Under the bankcard association bylaws, acquiring financial institutions are responsible for the actions of all contracted third-party processors, and therefore are expected to carefully monitor service provider compliance with the associations’ operating rules.

The bankcard associations set interchange fees, which are paid by the merchant acquirer to the issuing financial institution. The merchant acquirer typically passes this fee along with a “discount or acquirer fee” for processing services to its merchants. Bankcard issuing institutions generate their revenue from the interest charged on revolving balances, and interchange, late, over-limit, cash advance, and card fees. Merchant-acquiring institutions, which assist in clearing and settling credit card transactions, generate most of their revenue from the acquiring and other processing fees (e.g., chargeback processing and account maintenance) they charge to the merchant.

Figure 3: Credit Card Clearing and Settlement

Figure 3 illustrates the payment and information flows for a typical credit card transaction. In this example, the consumer pays a merchant with a credit card (step 1). The merchant electronically transmits the data, at the POS, through the bankcard association’s electronic network to the card issuer for authorization (steps 2 and 3). If approved, the merchant receives the authorization to capture funds, and the cardholder accepts liability by signing the credit voucher (steps 4, 5, and 6). The merchant receives payment, net of fees, by submitting captured credit card transactions to its financial institution in batches or at the end of the day (steps 7 and 8). The merchant acquirer forwards the sales draft data to the bankcard association, who in turn forwards the data to the card issuer (steps 9 and 10). The bankcard association determines each financial institution’s net debit position. The association’s settlement financial institution coordinates issuing and acquiring settlement positions. Members with net debit positions (generally issuers) send owed funds to the association’s settlement financial institution, which transmits owed funds to merchant acquirers. The settlement process takes place using a separate payment network such as Fedwire® (step 11). The card issuer will then present the transaction on the cardholder’s next monthly statement (step 12). The cardholder makes a payment for the charges incurred in accordance with the cardholder agreement.

Debit and Automated Teller Machine (ATM) Cards
Debit cards are associated with an existing transaction account at a financial institution. The card enables consumers to access the account for a variety of transactions. Debit cards are either on-line (e.g., PIN-based) or off-line (e.g. signature-based). On-line debit cards have been available for several decades and have seen tremendous growth since the early 1990’s. Off-line debit cards are a more recent innovation and consumers are increasingly using them at merchant locations that accept bankcards.

As a result of a legal settlement with Wal-Mart and other retailers, beginning in 2004, merchants will no longer be required to accept Visa and MasterCard off-line debit cards as a condition for accepting bankcard associations’ branded credit cards. This is a dramatic change from the longstanding “honor all cards” policy previously established by the bankcard associations used to enhance merchant acceptance of off-line debit. How this policy change will affect the popularity and profitability of off-line debit cards with merchants and cardholders is uncertain.

ATM Cards
Financial institutions issue ATM cards to consumers to provide on-line access to account information and to allow consumers to make withdrawals and deposits at ATMs. Consumers typically enter a PIN for authentication at an ATM, although other authentication methods such as biometric technology are available. Consumers may use an ATM deployed by other financial institutions or third parties but typically will pay fees to the ATM owner and their own financial institution. Many financial institutions now offer ATM cards that can also be used as debit cards for POS transactions at participating retailers.

EFT/POS NETWORKS
EFT/POS networks process, route, clear, and settle ATM and on-line POS debit card transactions by linking financial institution card issuers and merchant acquirers, consumers, merchants, and third-party service providers through telecommunication gateways. The networks’ primary roles include routing transactions through central switching gateways, acting as clearinghouses to settle network member “on-us” transactions, and forwarding “foreign” nonmember transactions for processing.

Most financial institution and nonbank ATM networks are connected to regional and national EFT/POS networks. Most regional networks are joint ventures owned and controlled by competing financial institutions. Ownership in regional networks can either be concentrated in several financial institutions or dispersed among 100 or more member financial institutions. A few regional networks function as cooperatives, while a single firm may own and operate one as a profit-making enterprise.

Visa and MasterCard own and operate the two national EFT/POS networks: Visa’s Plus and MasterCard’s Cirrus ATM networks and Visa’s Interlink and MasterCard’s Maestro POS networks. These national networks serve as a bridge between regional networks, and permit transaction information to be routed from one regional network to another.

Membership in regional and national EFT/POS networks facilitates universal access to financial institution card-based electronic services, providing participant financial institutions with an interchange system offering authorization, clearing, and settlement services. The fees financial institutions charge consumers for “foreign” ATM usage help defray the cost of membership services. Acquirers collect interchange fees from network members (issuers) to cover the cost of operations. With ATM transactions, the issuer pays the acquirer, in contrast to credit and debit card networks. EFT/POS networks clear both ATM and debit card (PIN-based) transactions.

Financial institutions rely on third-party service providers to conduct ATM and debit card payment processing. Third-party processors provide a range of retail payment-related services, including card issuing services, merchant services, account maintenance and authorization services, transaction routing and gateway services, off-line debit processing services, and clearing and settlement services. Although merchant acquiring financial institutions may use third parties to perform many acquiring activities, the acquiring financial institution is responsible for all third-party processor and merchant activity.
Independent sales organizations (ISO) provide third-party services to install and operate ATM and POS terminals for financial institutions and merchants. Representing merchants and community financial institutions, an ISO typically contracts with third-party processors for a variety of services including ATM and POS terminal driving, transaction processing, and cash restocking. Some EFT/POS networks require an ISO to be sponsored by a financial institution member of the network.

Figure 4: Credit Card Clearing and Settlement

Figure 4 describes a generic, on-line, PIN-based, debit card transaction. The consumer enters a PIN to authorize the transaction (step 1). The merchant’s financial institution requests authorization from the consumer’s financial institution through the EFT/POS network (steps 2 and 3). The consumer's financial institution, or in some cases the regional network, verifies funds and debits the consumer’s account (step 4). The EFT/POS network contacts the merchant and authorizes the purchase (step 5). For settlement, the regional EFT/POS networks determine the net debit and credit positions of the participating financial institutions and settle their positions using the ACH (step 6).

The acquiring financial institution typically does not credit the merchant's account with the entire amount of the transaction (similar to credit card clearing). Rather, the merchant receives the transaction amount, net of applicable fees and other expenses assessed by the acquiring financial institution and other intermediaries to the transaction (step 7). At the end of the business day, the issuing and acquiring financial institutions establish a net settlement of all the transfers between them using the ACH (step 8).

STORED VALUE CARDS
Financial institutions and nonfinancial businesses issue stored value cards. Either the consumer or the issuer funds the account for the card. Generally, the issuer does not pay interest on the card balances. When a consumer uses the card to make a purchase, the merchant deducts the amount of the purchase from the card. Once they exhaust the stored value in the card, customers may either replenish the value or acquire a new card. Transaction authorization can take place through an existing network, a chip stored on the card, or information coded on a magnetic strip. These cards are typically used for low-value purchases.

Stored value cards, mostly issued by nonfinancial businesses, have been successful in limited deployment environments such as mass transit systems and universities. In addition to cards, nonfinancial businesses have introduced a variety of other physical forms for carrying the customer account information. These physical devices are small and easily portable (e.g., key fobs, rings, etc.)

Some stored value cards may also be smart cards if they contain an integrated microchip. The integrated chip can store value and perform other functions, such as consumer authentication. The chip can be placed on a stored value card, a credit card, or a debit card. The chip might also contain consumer preferences and loyalty program information for marketing purposes.

Figure 5: Stored Value Card Clearing and Settlement

Stored value card transactions typically follow the pattern in figure 5. The consumer purchases a stored value card (steps 1 and 2). When the consumer pays for goods or services with a “smart” stored value card, electronic notations or tokens transfer from the card to the merchant's cash register (steps 3, 4, and 5). The merchant contacts the computer network of the financial institution that issued the stored value card and presents the tokens for payment (step 6). The network notifies the consumer's financial institution to pay the appropriate sum to the merchant's financial institution and net settlement occurs at the end of the business day (step 7). The financial institutions keep a percentage of the payment (the discount) as compensation for the services provided.

If the stored value card is not a smart card, the associated account funds are kept in a separate account. When a customer uses the stored value card, the merchant sends a message to the record-keeping entity to determine whether the balance is sufficient for the transaction. The third party or financial institution then processes the transaction.

This account arrangement may also be used for smart cards, and the accounts are debited when the merchant presents tokens for payment. Although financial institutions issue stored value cards and maintain account records, third parties may also be involved in maintaining individual account records.

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