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What are Merchant Services?
Back in the good old days, when life was much simpler, “merchant services” was limited to the following scenario:
John Doe walks in to Sam’s Supermarket and makes a purchase. Being that John and Sam were good pals, Sam had no problem extending “credit” to John. Sam would write down the amount of the purchase in his “little black book” and collect the balance at a later date.
Since this model was driven by Sam’s personal relationship with John, if John were to walk in to an unfamiliar store on the other side of town and request credit, he would probably find himself in the uncomfortable position of being shown the front door!
Wouldn’t it be great if there were some sort of system that would allow merchants to extend credit to their unfamiliar customers without exposing themselves to risk?
In 1946 the earliest form of “credit cards” (or bankcard) were introduced when Mr. John Biggins developed a system that did just that. It was known as the “Charg-It” system and it allowed customers to charge their local retail purchases. The merchant then deposited the charges at Biggins bank, and the bank reimbursed the merchant for the sale and collected payment from the customer.
Believe it or not, American Express (AMEX) is still based on this model to this very day, albeit on a very large scale with millions of merchants and millions of card holders. (Actually, until 2007 Discover also worked this way, but then switched over to the same model as Visa/MasterCard. We’ll get to that a bit later)
By 1959 many financial institutions had begun credit programs. Simultaneously, card issuers were offering the added services of “revolving credit.” This gave the cardholder the choice to either pay off their balance or maintain a balance and pay a finance charge.
But this system also had its disadvantages. As more and more banks started instituting their own credit programs, cardholders were presented with the dilemma of walking around with dozens of cards from multiple banks, and merchants were equally troubled with having to deal with many banking organizations. If only there were a way to get the banks to group together under one umbrella organization…
During the 1960s, the industry took this next giant step.
Many banks joined together and formed “Card Associations,” a new concept with the ability to exchange information of credit card transactions; otherwise known as INTERCHANGE. The associations established rules for authorization, clearing and settlement as well as the rates that banks were entitled to charge for each transaction. They also handled marketing, security, and legal aspects of running the organization.
The two most well known card associations were: National Bankamericard and Mastercharge which eventually became Visa and MasterCard.
A big distinction in the new system as opposed to the old way of doing things was that there are always 2 banks involved in the process – one on the side of the cardholder, and one on the side of the merchant, as well as the card associations (Visa/MC) which are not banks, but rather act as the “referee.” The bank representing the cardholder is known as the “issuing” bank, as they issue credit to their customer, and the bank representing the merchant is called an “acquirer,” as they acquire the money on behalf of the merchant. Just as the cardholder must have an account with the issuing bank, so to the merchant must have an account with the acquiring bank. This account is called a “merchant account” and is used strictly for the transfer of funds from their credit card sales through this account and on to their regular business checking account (this business account can be any account of their choosing). The card associations act as a “referee” since they handle marketing, security, and legal issues, but not the actual transfer or responsibility of funds.
But things were still far from perfect.
During the early 1970’s people were getting weary of the paper based system. The major problems were losses and huge overhead, not to mention that merchants had to wait as long as 2 weeks for their money. There was a tremendous need for automation and a more cost and time effective way to process transactions. So, both National Bankamericard and Mastercharge introduced electronic payment systems in two stages.
The “authorization” system was re-vamped in 1973. Authorization is the process of guaranteeing there is adequate credit available on the card and capturing that “authorized” amount to reduce the available credit. This was previously based on a floor limit and a phone call was placed to a call center for any amount over the floor limit. National BankAmericard (“NBI”) introduced Base I which was their electronic on–line authorization system. That same year MasterCharge introduced INAS for “on-line” authorizations.
In 1974, NBI introduced Base II for on-line electronic clearing and settlement while MasterCharge introduced INET. Also in 1974, Bank of America’s international licensee’s chartered an international company, IBANCO, to administer BankAmericard, Inc. outside the U.S. By the late 1970’s ICA too had members from as far as Africa and Australia. To reflect the commitment to international growth, ICA changed its name to MasterCard.
Although Visa and MasterCard are two distinct organizations, all banks today are members of both associations. It was not always this way, but in the 1970s they realized that it was to everyone’s benefit to work together.
By 1979, electronic processing was progressing. Dial-up terminals and magnetic strips on the back of credit cards were introduced thus enabling retailers to swipe the customer’s credit card through the electronic terminal. These terminals were able to access the issuing bank card holder information. This new technology gave authorizations and processed settlement agreements in a matter of 1—2 minutes. The reduction in paper was an added and much appreciated benefit.
Throughout its existence, Visa has been a leader in credit card innovation. Because of this they have emerged as the world’s leading credit card association with over 1 Billion cards being issued, and carrying over 50% of all credit card transactions conducted world wide.
In 2008, Discover switched joined the “interchange” model of doing business, and by now most acquiring banks are already offering all three services; Visa/MC/Discover.
The merchant must receive an approval from the card issuing bank authorizing the transaction in order to process the sale. The authorization process is designed to protect the merchant from the use of fraudulent cards, as well as prevent transactions being approved for cardholders who are over their credit limit or have not paid their bills.
Typically, the clerk at the point of sale swipes the credit card through a terminal to obtain the information stored on the magnetic stripe on the back of the card, then inputs the amount of the transaction. This information is then transmitted to the merchant bank or its processor, who captures the transaction and forwards the information to the card-issuing bank through the bankcard association network. The transaction will then be approved or declined depending on the status of the cardholder’s account, and this decision will be transmitted back through the bankcard association network to the point of sale terminal. Once the transaction is authorized, the clerk prints a sales draft that the customer signs.
THE TRANSACTION FLOW
STEP 1 The consumer purchases goods or services from the merchant
STEP 2 There are a variety of ways to transmit the information to the acquiring bank:
Standard terminal. The sales authorization request is submitted through a standard phone line connection to the acquiring bank.
IP terminal. The sales authorization request is submitted through an internet connection to the acquiring bank with a specially designed terminal.
Processing software. The sales authorization request is submitted through an internet connection to the acquiring bank using computer software (such as PC Charge) and a small magnetic stripe reader. No traditional terminal is needed.
Payment Processing Gateway. The sales authorization request is submitted through an automated internet website, which communicates with the acquiring bank.
STEP 3 The acquiring bank routes the transaction to a processor and then to the associations – either Visa, MasterCard or Discover.
STEP 4 The association system then routes the transaction to the issuing bank and requests an approval.
STEP 5 The issuing bank sends back the response. If the cardholder is approved the issuing bank assigns and transmits the authorization code back to the association.
STEP 6 The authorization code is sent from the card association to the acquiring bank.
STEP 7 The acquiring bank routes the approval code or response to the merchant terminal. Depending on the merchant or transaction type, the merchant terminal may print a receipt for the cardholder to sign, which obligates the cardholder to pay the amount approved.
STEP 8 The issuing bank bills the consumer .
STEP 9 The consumer pays the bill to Issuing bank.
SETTLEMENT OF FUNDS
The actual transfer of funds to the merchant is known as settlement. At the end of each day, the merchant will generally review the days sales, credits and voids. After verifying this, the merchant will close his batch on the point of sale terminal. This entails closing out the days sales and transmitting the information for deposit into their bank account. (On some terminals and gateways this might be programmed to happen automatically). The acquiring bank routes the transaction through the appropriate settlement system against the appropriate card-issuing bank.
The card-issuing bank then sends the money back through settlement system for the amount of the sales draft, less the appropriate “interchange fee,” to the acquiring bank’s account. The acquiring bank then deposits the amount, less the “discount fee” to the merchant’s bank account. Generally, within 24-72 hours, the merchants will have their money. Cutting-edge Merchant Service Providers such as Fidelity offer “next day funding.”
Important note: Even though a merchant has been funded, the transaction can always be reversed, such as when a customer initiates and wins a chargeback. Therefore, the funds released to a merchant can be theoretically almost considered by the acquiring banks as a “loan.” That’s one of the biggest reasons why the underwriting procedures for setting up a merchant account are so strict.
The settlement procedure varies on the front end depending on the program the merchant is on. For example, a restaurant may want to be able to track servers to easily settle tips at the end of the shift. A hotel or car rental agency may want to get a pre-approval before the customer checks in or uses the service. A bar may want to open a tab for its customers. At Fidelity Payment Services, we have many pre-built programs that any merchant can request based upon their type of business.
Each time a cardholder uses a credit card, the merchant is charged a percentage of each transaction, usually called a discount fee. This fee is charged to a merchant because the Issuing and Acquiring Banks assume all the risks on every transaction (late or no payment, fraud etc…), yet fund the merchant within 48 hours of the sale. The discount rate is largely comprised of the interchange and assessments. Interchange is determined by Visa, MasterCard and Discover. In order for the merchant to receive their funds, the acquiring bank must pay this fee to the issuing bank who is responsible for releasing the funds from the cardholders account. Interchange is the “wholesale cost price.”
All other cards such as American Express, Diners and JCB (Japan Credit Bureau) set their own discount rates.
The discount fee that a merchant is charged depends of several factors including:
- Type of Business
- Risk presented
- Retail or Internet
- Merchant Credit
- Card present or not
1. Merchant’s industry type: fast food, colleges, warehouses, gas stations, Internet merchants, catalog merchants, for instance
Each transaction must meet one or many factors to qualify for a specific category. Some factors determine if the transaction will be completed, while others determine the rate and transaction fee that will be assessed.
A handful of industries have been assigned a special rate category. In some cases, preferred rates were established to attract merchants to accept credit cards.
These include warehouse clubs and supermarkets. In other cases, categorization rules reflect the unique transaction flow for a particular industry, lodging or car rental, for example, which require authorization at check-in days before a transaction is settled.
As a result of new technologies, such as Mobil Speed passes, rates have been created for gas stations, fast food restaurants and convenience stores. Fast food and gas station transactions are normally completed without a signature and are considered more secure than MO/TO or Internet transactions, mainly due to the limit set on the amount of each transaction.
2. Type of card processed: traditional credit cards, corporate, rewards based, purchasing or check cards.
Commercial cards, the marketing departments of Visa and MasterCard have created an endless list of names for virtually the same product. Some examples: purchase, corporate, business, fleet as well as combinations like corporate purchase. The difference between the various commercial cards is defined by the reporting features available to the cardholder.
Commercial cards are designed to help companies maintain control of purchases while reducing the administrative costs associated with authorizing, tracking, paying and reconciling those purchases.
The interchange rate for commercial cards is different than the swiped rate for the average consumer card. in most cases, the interchange cost is higher than the consumers’ swiped rate.
Check cards, offline debit or signature-based debit: These transactions are routed through the Visa/MasterCard authorization and settlement system. Transactions are settled nightly and authorized by the cardholder’s signature. Due to the decreased risk factor, these transactions are at a lower rate structure. Keep in mind that the money is not loaned; it is money that is already in one’s checking account.
Check card transactions fall into a number of categories. Visa and MasterCard established check card rates that are priced significantly lower than all other consumer credit cards. These new categories provide yet another way for processors to create unique rate offerings.
3. How a card is processed: swiped or keyed-in, present or not present
Determining what a merchant will be charged is based on the method of card entry and what data is entered.
The first and most obvious factor is whether the card is physically present at the POS. Whenever a card is swiped through an electronic terminal or card reader, an indicator is transmitted to Visa or MasterCard, along with the rest of the data. It records the fact that the information was received directly from the card’s magnetic stripe. Without this indicator, the transaction is not eligible for any swiped interchange category.
The technology of reading magnetic stripe information has been incorporated into more and more products. Mag-stripe readers can be found in computer keyboards, as attachments to cell phones, or on PDAs to name a few.
Whereas it is relatively easy to capture the information from a magnetic stripe, it is entirely different to properly transmit the information to Visa and MasterCard in a way that will allow the transaction to qualify for a certain rate.
It is possible and, in fact, common for merchants to believe they are qualifying for the best swiped rates, when in fact their transactions are downgrading, which means higher transaction fees for them.
Merchants should be encouraged to test transactions and have their processor verify their qualification levels instead of assuming that a swipe will always qualify for a certain rate.
Key entered versus card not present: Visa and MasterCard both make a distinction between a card that was key entered due to a bad magnetic stripe as opposed to a transaction where the cardholder is not present, such as in MO/TO or Internet orders.
To avoid confusion, merchants should follow one simple rule to ensure that they qualify for either the key entered or the card not present rate: Whenever a card is not swiped, enter the information required for Address Verification Service (AVS) as well as an “order number” for every transaction. The order number can be any length.
Additionally, certain categories have strict qualifications, such as merchant category, merchant actions and transaction size. For most categories, the interchange cost is a combination of a percentage rate and a transaction fee.
What is downgrading?
Transactions are downgraded when they don’t meet interchange requirements, such as not capturing the correct card information at the POS, settling the transaction after a deadline has lapsed or key-entering rather than swiping a card. A downgraded transaction means higher cost for the merchant.
What is AVS?
In an effort to combat fraud that results from non-face-to-face transactions, Visa and MasterCard created the AVS, which attempts to verify the address and zip code of the credit card customer. Whenever a card is key-entered, the processing system should be set up to prompt the merchant to enter the billing ZIP code (for cardholder’s billing address) and the numerical portion of the address of the cardholder.
If this information matches the card issuing bank’s records, the system will qualify that transaction for an AVS rate category. (Visa also looks for an invoice number.)
Different rates for specific industries
In the case of categories such as lodging and car rental, data elements like arrival and checkout dates, folio numbers and length of rental are examples of the required information that is sent to Visa or MasterCard along with the credit card data. To qualify for these categories, merchants must use industry-specific software or terminal applications, which prompt for the extra information. They must also properly transmit it to Visa or MasterCard.
Transaction qualification is influenced by many factors. In many cases, the only way to truly know how merchants can minimize interchange costs is to critically examine their bankcard statements.
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