How does payment processing work?

Get a clear overview of how payment processing works. This includes definitions and best practices when it comes to processes like chargebacks.

For customers and businesses, making and accepting payments has never been easier.

Payment cards can be tapped at the point of sale (POS) for in-person transactions, or 'pay now' buttons can be pressed for online payments.

Confirmation of transaction approval comes instantly. So complete transactions appear to take place immediately and effortlessly.

But there is more to the process than meets the eye...

Let's go through it step by step.

What is payment processing?

Payment processing refers to the mechanism that enables electronic financial transactions - i.e., credit and debit card payments and online payments - to take place.

It involves moving money from buyers’ bank accounts to sellers’ bank accounts. This process involves multiple intermediaries, such as payment gateways and payment processors.

To most people that use it, including most consumers and even businesses, payment processing seems simple and seamless.

However, it depends on complex technology from multiple parties that's constantly evolving.

What is a payment processor?

A payment processor is a third-party financial institution that facilitates transactions between buyers and sellers.

There are two distinct processors involved in the processing of electronic payment transactions, particularly in the context of credit and debit card payments - an issuer processor and an acquiring processor.

While both processors play crucial roles in payment processing, they operate on different ends of the transaction flow. The issuer processor focuses on cardholders and the acquiring processor works with merchants.

Payments processors act as an intermediary in authorizing and transferring funds, and are typically responsible for:

• Verifying the identity of the buyer and seller
• ‍Ensuring that the transaction is legitimate, i.e., checking it was made in the right location, fits past behavior, etc.
• ‍Protecting both parties' sensitive information, including credit card data

They may also charge fees for their services (see below, 'Payment processing fees'). But businesses have a choice of providers, which helps keep these fees competitive.

The term 'payment processor' can be confusing

The term 'payment processor' is often used interchangeably by business owners to describe POS system providers, merchant account providers, etc.

In this non-payment industry context, the term serves as useful shorthand for the broader suite of parties involved in payment processing services.

However, within the payments industry, using the term in this way is an oversimplification. It can lead to confusion because - as described above - there are two distinct processors.

The players and procedure of payment processing

The specific parties involved may vary depending on the payment method. This includes credit cards, debit cards, mobile payments, or bank transfers. The country or region where the transactions take place can also impact the process.

There are several different ways to explain payment processing.

One way is to describe the parties involved and their roles. Another way is to go through the process step by step. Below, we have used both methods.

First, we've outlined the parties involved, then we have given an example, which is also illustrated in a video.

But before this, let's outline the four-party model.

What is the four-party model of payments?

The four-party model (sometimes known as the four-party scheme) of payments refers to the four main players involved payment processing:

• Cardholder: The individual (or organization) that makes a purchase, i.e., the customer
• ‍Issuing bank (issuer): The cardholder's bank account
• ‍Acquiring bank (acquirer): The merchant's bank account
• ‍Merchant: The business (or organization) that accepts payment for goods or services through a payment card

The four-party model is one of the most widely adopted payment models for debit, credit, and online payments globally.

Is the four-party model actually the six-party model?

The core of the four-party payment model consists of four parties. But additional parties are frequently involved in the payment process.

So, to better understand payment processing, making it a six-party payment model is useful.

1. Cardholders

From one perspective, the primary agent in payment processing is the cardholder. Without them, the payment process wouldn't be necessary.

Debit, credit and digital payments statistics

In the US, spending on debit cards reached $2.729 trillion in 2021, up 18.3% from the year before. And in the UK, 60,019,000 credit cards and 106,880,000 debit cards were in circulation in the same year.

In many markets, the majority of consumers still use cards. For example, in Canada, 96.3% of people over the age of 15 own debit cards according to World Bank data. In Denmark, it's 98.9% for the same group.

And worldwide, two thirds of adults now use digital payments. This gives the digital payment industry an estimated value of 9.46 trillion USD in 2023. This is expected to grow to 14.78 trillion USD by 2027.

2. Issuing bank

An issuing bank (also referred to as the card issuer or issuer) is a financial institution that extends credit to a cardholder through bankcard accounts. It issues a payment card and bills to the cardholder for purchases against a bankcard account.

In order to make online purchases or make credit or debit card payments, a customer needs a bank account. And in order to readily access this account, they need to be issued a bank card.

In other words, an issuing bank is the cardholder's or customer's bank.

3. Payment processor

A payment gateway is a service that facilitates the authorization and processing of electronic transactions between cardholders, merchants, and financial institutions.

It is a service provided by the payment processor or a separate entity, with the primary role to securely transmit payment information from the cardholder to the merchant and then the acquiring bank (see below).

But it also performs various other related functions, too. This includes encrypting sensitive information like credit card numbers, verifying the customer's identity, and authorizing the payment transaction itself.

4. Acquiring bank

An acquiring bank is a Visa or Mastercard-affiliated bank or bank-processor alliance that processes transactions for businesses. It is always acquiring new merchants.

5. Merchants (& merchant accounts)

Merchants are businesses or organizations that sell products or services to the cardholder.

What is a merchant account?

A merchant account is an account set up through a credit processing company or a bank to both accept credit cards and process charge card orders. It is different from the merchant's bank account.

Without a merchant account, businesses cannot accept payments by any of the major credit card brands.

A merchant account is an account held with an acquiring financial institution (like Nuvei) or the merchant services department of a bank. It allows businesses to accept payments from customers through credit and debit cards.

When a customer makes a purchase using a card, the funds are transferred from the customer's account to the merchant account, and then ultimately to the business's bank account.

6. Card network

A card network (also known as card scheme or card brand), is a financial system that connects cardholders, card issuers, acquirers, and merchants.

The primary roles of a card scheme in payment processing include:

• Establishing rules and regulations
• Facilitating communication between parties
• Authorization of transactions
• Settlement of transactions
• Ensuring security and preventing fraud

Card schemes act as an intermediary between card issuers and acquirers. This enables the latter two parties to securely and efficiently exchange information and complete transactions.

Examples of card schemes

Some well-known card schemes are Visa, Mastercard, American Express, and Discover.

Payment processing example

Bob is a brick-and-mortar merchant. He sells an apple to a cardholder, Clara, for $1.

Here are the steps that take place for that $1 to move from Clara's bank account to Bob's merchant bank account.

1. Point of sale system is engaged

Clara taps her card on a terminal or POS system, which communicates with the issuing bank/processor as part of the process to obtain an authorization code.

The POS system then sends the transaction information to the acquiring bank/processor.

2. Acquirer bank/processor contacts issuing bank/processor

The acquiring processor then sends these details to the issuing processor via the credit card network (let's say Visa for this example). The acquirer then requests payment authorization for a $1 transaction from the issuing bank.

3. Issuing bank checks

The issuing bank checks several data points, including:

• If Clara has enough money
• If the card details, including card number, expiration date, and CVV/CVC code, are valid
• If Clara billing address matches the data provided by Bob

4. Issuing bank sends authorization code

Once the issuing bank confirms that everything is correct, it issues an authorization code. It sends this code back the same way it received the request - through the credit card network (Visa).

5. Authorization code received by merchant

Bob sees an approved message on his terminal or POS system. The issuing bank places a hold for $1 on Clara's account. For Bob to receive the money for this sale, he first needs to close the batch.

What is a batch?

As cardholders come in and buy apples, all authorizations are stored in a POS terminal in a batch. And to become a deposit in Bob's account, he needs to settle the batch.

6. Final clearing

When Bob settles the batch, each authorization travels back to the respective issuing banks for final clearing.

These authorizations travel via the same channels as before: first they go to the acquirer, and then via credit card networks via issuers.

7. Settlement

Finally, each issuing bank removes the hold and then withdraws actual funds from the cardholders' accounts. After this, the acquirer funds the merchant's account. Bob finally get his $1 transaction.

Payment processing fees

The exact fee or rate varies depends on the specific service being offered, payment types and the volume of transactions being processed.

1. Card processing fees

A merchant account has a variety of fees, some periodic, others charged on a per-item or percentage basis.

The majority of the per-item and percentage fees are passed through the merchant account provider to the credit card issuing bank.

This is done according to a schedule of rates called interchange fees (see below), which are set by Visa and Mastercard.

2. Interchange fees

Each credit card payment qualifies at a certain interchange rate. 'Interchange' refers to a matrix of discount rates and transaction fees defined by the card schemes, like Visa and Mastercard.

These fees are paid by the payment processor (e.g. Nuvei) to the cardholder's bank to compensate for accepting credit card payments.

Factors that influence these fees include:

• Type of card presented
• Business type
• How the transaction is performed

3. Chargeback fees

Essentially, a chargeback fee occurs when a cardholder disputes the sale with their card issuing bank.

This is not to be confused with a refund, which is simply a merchant cancelling and returning the credit of a transaction.

With chargebacks, the card issuing bank sends through a request to recover money for their cardholder. The merchant agrees to pay a chargeback fee (usually between $25-$50), for each chargeback that the bank deems valid.

Nuvei's global payment processing technology

Nuvei is a leading global payment technology provider that offers a comprehensive suite of payment solutions for businesses of all sizes.

Our platform supports over 450 local and alternative payment methods, enabling merchants to accept payments in more than 200 markets worldwide.

Conclusion

Payment processing enables electronic financial transactions, including debit and credit card payments and online transactions.

It involves transferring money between buyer and seller through intermediaries like payment gateways and processors.

As third-party financial institutions, payment processors facilitate transactions by verifying identities, ensuring legitimacy, and protecting sensitive information.

The four-party model of payments comprises the cardholder, issuing bank, acquiring bank, and merchant. Add to this card networks and acquirer/issuer processors, and you have a six-party model.

Businesses must apply for a merchant account through an acquiring financial institution or bank to accept debit and credit payments. Processing fees vary based on the service, payment method, and transaction volume.

Chargeback fees occur when cardholders dispute sales, and merchants pay a fee for each chargeback deemed valid by the issuing bank.

‍