The payments industry is one of the most complex and interesting out there to me. A lot happen behind the scenes whenever we send out a rent payment through a checking account or buy a coffee with a swipe of our credit card. As consumers, we don’t know much about such complexities. Plenty of innovation over the years has gone into providing optionality as well as a smooth experience to consumers while helping out merchants and financial institutions achieve their business goals. It can be daunting and difficult to start learning about an industry as complex as payments, especially when there are numerous abstract concepts and jargon. But if you are really interested, I’d recommend these three books. They touch upon the general concepts, operational details of each payment method and more importantly, these books are written for laypeople like you and myself
This book is focused more on credit and debit cards. You’ll learn about key concepts such as interchange, settlement, authorization, chargebacks, Know-Your-Customers (KYC), the parties involved in a card transaction and so on. You’ll learn about how money moves in a card transaction and how a merchant gets paid ultimately. The author did a great job explaining abstract concepts in an easy-to-understand manner. In fact, I gave this book to our intern who had had zero knowledge on payments as a crash course to our industry. He loved it. Hence, I think you too can learn a lot about card payments from this book. Check out my review here.
Launched earlier this month, The Field Guide to Global Payments covers more payment methods than just cards and it touches up on other countries than just the US. Because of the number of topics that it tries to cover, in my opinion, I don’t think it has the same depth as the other two books. Nonetheless, there are very interesting facts, stats and concepts covered that will trigger more research and investigation.
One of the earliest noted uses of the term “credit card” dates all the way back to 1887. In his utopian novel Looking Backward, Edward Bellamy described the concept of using a card for purchases; he used the term “credit card” eleven times in the novel. In 1946 the first bank card, Charg-It, was introduced by Brooklyn- based banker John Biggins. A user’s bill was forwarded to Flatbush National Bank, and the bank settled the amount with the merchant directly and collected the funds from the user’s bank account. Only a small number of merchants were supported by the program – those in a specific two-square-block radius – and the card could only be used by those who banked with FNB.
On the checkout page, the shopper fills in their payment details. Typically these are the PAN (payment account number, the sixteen digits on their card), the expiry of their card, the CVV (the three or four-digit security code), and their billing address. Pro tip: if you don’t send the AVS data (billing address information) in the authorization, you may get an interchange downgrade, which means, in short, that the transaction will cost you more as a merchant.
Taking on PCI compliance is a large decision – there are more than 1,800 pages of documentation and more than three hundred security controls, alongside yearly audits. There are four levels of PCI, which each have their own requirements that apply to different use cases. Partnering with a gateway, PSP, or standalone vendor to outsource PCI scope is the decision many merchants make because of this.
Merchants do, however, have a lot of agency in improving decline rates. Overall, in-store (POS) transactions tend to have very low decline rates, while ecommerce transactions can have 5 to 10 percent decline rates. Note that the prevalence of declines goes up for recurring transactions, like a subscription payment, or for cross-border transactions. High-risk merchants, like gambling or escort services (what many dating apps are considered by the card networks!), have even lower benchmark auth rates.
Visa’s excessive chargeback program is called the VDMP – Visa Dispute Monitoring Program. They divide the previous month’s chargebacks by that month’s total Visa transactions. If a merchant has 100 chargebacks and a chargeback ratio of at least 0.9 percent they are added to the program to be monitored. Mastercard has the ECP – Excessive Chargeback Program. The ECP divides the number of chargebacks in a single month by the total number of transactions in the previous month over Mastercard. Their threshold for entering the program is one hundred chargebacks and a ratio above 1.5 percent. In the event that a merchant hits these thresholds, they are notified by their acquirer who may also help them to get fraud levels below the threshold.
Signature debit cards get their name from the fact that a customer must sign the receipt during an in-store payment, and a merchant must subsequently authenticate that the signature on the receipt matches the signature on the back of the card. Signature debit transactions clear funds from the cardholder’s checking account same-day and are usually processed over Visa or MasterCard’s networks. PIN debit cards, however, are authenticated when the cardholder enters their PIN number on a point-of-sale device. Though the funds are also pulled from the cardholder’s checking account, they don’t always clear the same day. These transactions are also eligible for cashback. When you buy groceries and ask for $20 cash back, that transaction will be processed as a PIN debit transaction. There are many more PIN debit networks than the signature networks.
This book provides an overview of payments systems in the US with great details. First, it talks about payments and payments systems in the US in general. Then, it discusses each core system in details, ranging from the history of the system to what happens behind the curtain and what it is like today. The systems discussed in this book include checking, cards, ACH, wire transfer and cash. Then, it also provides the perspective of consumers as well as the banks before closing out with thoughts on payments innovation. It’s quite a long book, but if you are nerdy about payments, I’d recommend it.
In a net settlement system, the net obligations of participating intermediaries are calculated by the payment system on a periodic basis—most typically daily. At the end of the day, a participating intermediary is given a net settlement total and instructed either (a) to fund a settlement account with that amount, should it be in a net debit position, or (b) that there are funds available to draw on in its settlement account, should it be in a net credit position. Checking, card payments systems, and the ACH are all net settlement systems in the United States.
In a gross settlement system, each transaction settles as it is processed. With the Fedwire system, for example, a transaction is effected when the sending bank’s account at a Federal Reserve Bank is debited and the receiving bank’s account at a Federal Reserve Bank system is credited. No end-of-day settlement process is necessary in a gross settlement system.
Signature debit card interchange is lower than credit card interchange, and PIN debit interchange is even lower for unregulated debit card issuers. Larger debit card issuers (with over $10 billion in assets) receive regulated interchange rates that do not distinguish between signature or PIN debit usage.
Debit card authorization is more challenging than credit card authorization, as the bank must check against an ever-changing account balance. In the early days of debit, banks would authorize transactions (or have a processor authorize them) against a “shadow file” that could be hours or even days out of date. Now, however, most large banks handle authorizations dynamically against the “real” balance in the checking account.
Some payments networks are heavily resourced (i.e. have lots of money), enabling network-level investment in product definition, brand, risk management, and exception processing requirements. Visa, Mastercard, American Express and PayPal are all examples of what we call “thick model” networks. Other networks are thinly resourced, and manage only minimal interoperability issues, leaving functions such as product definition and brand to intermediaries. Check clearing houses, the ACH, and PIN debit networks are all examples of this “thin model.”
Closed loop networks, such as American Express, have card issuance policies similar to some provisions of the open-loop card network rules, so as to ensure interoperability for merchants and other users of the payments system. Merchant agreements, for similar reasons, are much like those of open-loop card networks. But a closed loop network is free to change such policies and agreements without the involved processes used by open-loop networks.
Closed loop systems have the advantage of simplicity. As one entity sets all of the rules and has a direct relationship with the end parties, it can act more quickly and more flexibly than the distributed open loop systems, which must propagate change throughout the system’s intermediary layers. The disadvantage of closed loop systems is that they are more difficult to grow than open loop systems; the payments system must sign up each end party individually.