What is a payment processor? (And how does it work?)

Payment processors are essential for credit and debit card payments in eCommerce.

Understanding the role of a payment processor can help you better navigate the technical complexities of the payment process more generally.

Let's take a look closer at what payment processors are, how they work, and what role they play in communicating between the main financial institutions involved in the payment process.

What is a payment processor?

A payment processor offers the technology to manage credit and debit card transactions, as well as other popular payment methods such as ACH bank transfers.

It acts as a third-party facilitator between the customer and merchant banks, as well as card networks like Visa and Mastercard.

The payment processor authorizes credit card transactions and ensures merchants get paid on time. It does so by facilitating the transfer and settlement of funds.

Some payment processing providers also provide payment terminal equipment for card acceptance, security solutions, implementation of PCI compliance, customer support, and other value-added services.

Issuer processor vs acquirer processor

There are two types of payment processors - an issuer processor and an acquirer processor.

An issuer processor works for the bank that provides the customer's credit or debit card, handling things like approving or declining transactions and managing their bank account.

An acquirer processor, on the other hand, works for the merchant's bank, helping businesses accept card payments by processing transactions and ensuring the merchant gets paid.

A payment service provider may also offer both processing services under one roof.

Do businesses need payment processors?

Payment processing services are critical in the overall payment process.

A processor enables the transmission of payment data (captured by a merchant's point-of-sale system or payment gateway) to the networks and financial institutions for authorization, clearing, and settlement.

Businesses must have some form of payment processor if they want to accept card, digital, mobile, ACH bank transfers or other popular payment methods. This applies to both eCommerce and in-person transactions.

For example, a business wishing to accept ACH bank transfers requires a payment processor because it facilitates the secure and efficient movement of funds between banks. It also ensures compliance with regulations and proper transaction routing.

What is a payment gateway?

A payment gateway is a technology that securely captures and transmits online payment information from a customer to the payment processor.

There are various types of payment gateways to suit different business needs.

Hosted payment gateways redirect customers to a third-party page (like PayPal) to complete transactions.

• Self-hosted payment gateways allow businesses to capture payment details on their website and then transmit the data to the gateway provider.
• API-integrated gateways provide seamless, on-site payment experiences by integrating directly with a business's website or app.
• Local bank integration gateways that connect directly to specific banks, but are usually only used for niche or local markets.

A business can choose a separate payment gateway provider to their processor.

How does a payment processor typically work?

Online and in-store payments typically involve at least two financial institutions, including:

• The issuing bank (the customer’s bank)
• The acquiring bank (the merchant’s bank)

Payment processors facilitate the connection and communication between these two financial institutions.

There are two distinct parts to the processing system - front-end processing and back-end processing.

• Front-end processors handle the authorization of transactions, including communication with card networks and issuing banks to approve or decline payments. This role is more aligned with the acquirer processor, as it ensures the merchant can accept the payment.
• Back-end processors focus on settlement and clearing, ensuring funds are moved correctly between the issuing bank (via the issuer processor) and the acquiring bank. While this involves both the issuer and acquirer processors, it primarily facilitates the financial movement after the initial authorization.

So, while there's overlap, front-end processors are closer to acquirer processors, and back-end processors support both issuer and acquirer roles in settlement.

The following steps typically take place from when a customer initiates a payment to when the transaction is completed.

1. Transaction is initiated

Electronic payment processing appears to happen in an instant for customers. But using a card reader device at the point of sale (POS), or pressing 'pay' on an online checkout page, is the initiation of a transaction.

Cardholders are passing on their payment information (typically card details and name) and submitting a request.

2. Verification & encryption

The physical (or online) terminal passes the payment information onto the payment gateway, which verifies and then encrypts the payment information.

Verification and encryption ensure sensitive payment information is protected from fraud and unauthorized access during transactions.

3. Enter the payment processor

Next, the payment gateway passes on the information to the payment processor. The payment processor transfers the information to the card network, e.g. Visa or Mastercard.

4. Authorization/disapproval

The card network authorizes or declines the transaction, and then informs the payment processor via the card network.

6. Confirmation

Once the merchant and the customer have been notified of the outcome of the payment authorization, it appears that the transaction flow has now completed. However, there is still one last stage.

7. Settlement

Settlement refers to the final transfer of funds between accounts.

Once transactions have been authorized, the payment processor instructs the issuing bank to settle with the merchant account. This sometimes happens immediately, other times within a few business days.

What is a merchant account?

A merchant account is a specialized bank account that allows businesses to accept credit and debit card payments from customers. It is what establishes a business relationship between a merchant and the acquirer.

A company does not necessarily need to have a merchant account. It can use an aggregated account which is shared between multiple merchants. In this case, the company will need to contract with a third-party payment processor or payment aggregator.

What's the difference between a business account and a merchant account?

Whilst merchant accounts and business accounts can be provided by the same banks, they are not the same thing. A business account is used for everyday banking activities like expenditures and financial tracking. However, a merchant account is used to accept payments, with funds deposited from customers paying with debit and credit cards.

Types of payment processor set-up

Payment processors typically operate under two main setups: direct processors and third-party processors. Many merchants do not choose a specific payment processor. Instead, they open a merchant account and use the payment processor that comes with it.

Direct processors work closely with banks to provide businesses with dedicated merchant accounts. In contrast, third-party processors like PayPal or Square, aggregate multiple merchants under a single account.

Payment processors can also specialize in handling different payment methods to suit the needs of various businesses, for example, a debit and credit card processor may not offer to process crypto payments.

Third-party payment processors

Third-party payment processors like Nuvei, PayPal, Stripe, or Square are providers that do not necessarily require a separate merchant account to accept card and mobile payments.

They are usually quick and simple to set up, and better suited to small businesses.

They work by having issuing banks deposit funds into aggregate accounts, which are shared between different merchants. Many companies share this aggregate account - sometimes thousands, which can speak to the account's reliability.

Once the funds have been deposited, the processor deducts its processing fees and transfers the remaining funds to each business’ bank account.

However, this transfer can take a few business days, which is longer than it takes for merchant accounts.

How to choose a third-party payment processor

There are a number of important factors to consider when choosing a third-party payment processor ranging from the diversity of payment methods to compatibility with your business operations.

1. Payment methods

Many companies need to be able to accept different payment methods, including credit or debit cards, digital wallets, and bank transfers. So, they need a third-party payment processor that can support these.

2. Payment security

When choosing a third-party payment processor, the company should make sure the processor is PCI-PDI compliant and has fraud prevention baked in. It should also use encryption and other security measures that are necessary to protect the customer’s payment details.

3. Compatibility

The third-party payment processor must also be compatible with the other eCommerce software the company uses, such as payment gateways.

4. Costs

The cost of payment processors varies according which specific provider provides which type of payment processor.

Payment processing fee structures associated with merchant accounts are relatively fixed. They typically include start-up fees, transaction fees, chargeback fees, and credit card processing equipment lease charges.

Different third-party payment processor providers have different fee structures. They can include an initial start-up fee, a monthly membership fee, and a flat-rate processing fee or a percentage of the transaction value. And there may sometimes be hidden costs, such as chargeback termination fees.

5. Reviews

Companies should check reviews and testimonials before choosing a third-party payment processor. These will hopefully give insight into all of the above points as well as costs, customer service, etc.

What's the difference between a payment gateway and a payment processor

The main difference between a payment getaway and a payment processor is that the former ensures the safe transfer of customer information into the payment chain, while the latter is responsible for the actual funds transfer.

A payment gateway is primarily used for online transactions to securely capture and transmit payment data. For in-store payments, a payment processor works with a point-of-sale (POS) terminal to handle card transactions directly, without requiring an online gateway.

Is PayPal a payment processor or a payment gateway?

PayPal is both a payment gateway and a payment processor, depending on how it is used. Its versatility allows it to act in both capacities for businesses and consumers.

Conclusion

Payment processors are essential technology that securely manage card transaction processes between merchants and their cardholders. They enable payments both in brick-and-mortar stores and e-commerce platforms.

They support multiple electronic payment methods, such as cards, mobile or online payment, acting as intermediaries to facilitate secure authorizations and settlements while bridging acquirers, issuers, and card networks.

In addition to core processing, payment processors often provide value-added services such as equipment provision, PCI compliance support, fraud prevention tools, and customer assistance.

Small merchants typically rely on their merchant bank's default payment processor, whereas businesses without a merchant account must work with third-party processors to accept card or mobile payments. Larger companies handling high transaction volumes often seek tailored solutions that align with their specific needs and scale.

It’s important to note the distinction between payment processors and payment gateways: payment processors manage the transfer of funds, while payment gateways focus on securing transaction data.

Whether you wish to accept cutting-edge payment options, optimize new revenue streams or just get the most out of your existing stack. Speak to Nuvei to find the best payment solution for your business.