The Merchant-Acquiring Side of the Payment Card Industry: Structure, Operations, and Challenges - Ann Kjos - October 2007 Editors Note: On January 19, 2007, the Payment Cards Center of the Federal Reserve Bank of Philadelphia sponsored a workshop led by Marc Abbey, managing partner at First Annapolis Consulting, to discuss the merchant-acquiring side of the payment cards industry. Abbey described the often overlooked acquiring industry as a dynamic growth business that is an integral part of the payment cards industry. He outlined several factors that have affected the evolution of the industry and described the current state of industry dynamics in terms of growth, competition, and business economics. In addition, Abbey discussed two recent developments: the emergence of data security standards and the new public structure of payment networks, which have drawn the focus of lawmakers, policymakers, and consumers to the merchant-acquiring business.
Pay By Touch is both a Merchant Acquirer, and a Processor for over 150,000 businesses, and currently recruiting experienced Independent Sales Organizations, so I thought I'd cover some of the background from the report: (As always, click any picture to enlarge)
Background on the Business of Merchant Acquiring
A: Definition of a Merchant Acquirer
The merchant-acquiring function may best be understood in the context of card use in a typical retail purchase transaction. As the diagram (chart 1) below illustrates, there are several stages in the transaction flow involving cardholders and their banks on the one side, merchants and their banks on the other, and a payment network in the middle that coordinates the flow of information and money underlying the transaction. There are many relationships within the payment card industry. The merchant services industry is shaped by the relationships between merchants and acquirers.
The various activities associated with merchant services (highlighted in Chart 1, and described later) can generally be thought of as the merchant-acquiring function. But who is the merchant acquirer?
For bank-centered payment networks such as Visa and MasterCard, the merchant acquirer is defined as the member financial institution responsible for its merchant-customers’ transactions with the network (the merchant-acquiring bank in Chart 1). In practice, member financial institutions often contract with third parties to perform any number of the functions associated with merchant-acquiring services.
In some cases, the extensive scope of merchant-acquiring services provided by these specialized third-party firms has led these companies to be commonly identified as merchant acquirers. Irrespective of name, it is important to note that it is the network member financial institution that is ultimately responsible for the underlying transactions with its direct or indirect merchant-customers.
In addition to Visa and MasterCard, other network structures involve other acquiring models. Most significant among these are American Express and Discover. Unlike Visa and MasterCard, these two card networks are not based on a bank-member structure but, rather, operate as independent entities. As such, they maintain the contract relationship with cardholders as “issuers” and similar direct relationships with the merchant that accepts their cards as “acquirers.” In a sense, the generally independent functions of issuers, acquirers, and networks that exist in the Visa/MasterCard models are collapsed into one entity in the cases of Discover and American Express.
Although Discover, American Express, and other networks play significant roles in the broader payment cards industry, the merchant-acquiring business is more generally associated with Visa and MasterCard transactions2 (commonly known as bankcard transactions), and this part of the payment cards business is the focus of this paper.
B. Merchant-Acquiring Services
In Chart 1 and in the earlier discussion about participants in the payment cards transaction flow, the general term merchant services was used to describe the activities undertaken by merchant acquirers. In essence, these activities may be seen as the services rendered by the acquirer to enable merchants to accept their customers’ payment cards at the point of sale. In support of the transaction flow, merchant acquirers generally perform four key functions: (1) signing up and underwriting merchants to accept network-branded cards, (2) providing the means to authorize valid card transactions at client merchant locations (3) facilitating the clearing and settlement of the transactions through the payment network, and (4) providing other relevant information services, such as sending out statements.
Signing up and Underwriting Merchants: Signing up merchants to accept card-based payments is a key marketing function of a merchant acquirer. This starts with soliciting merchants to accept the network-branded payment cards. The next step is the underwriting process, which ensures that the merchant meets the network requirements for financial stability and other conditions. This is an important step, since the merchant acquirer is ultimately responsible for its customers’ transactions with the network.
Very often, the merchant acquirer or its agent may also assist the merchant in obtaining necessary point-of-sale equipment and provide other relevant services. These and other functions are documented in a contract, called the merchant agreement.
Authorization and Capture: Operationally, a critical function of the acquirer is facilitating the authorization for purchase transactions. From a merchant’s perspective, authorization means that, barring future disputes, payment is guaranteed for authorized purchases. When a payment card is swiped at the merchant’s terminal, a request for authorization, along with the cardholder’s information and the transaction amount, is transmitted to the merchant acquirer. The merchant acquirer then forwards the request through the network, which, in turn, queries the cardholder’s issuing bank. The cardholder’s bank either approves or rejects the transaction based on credit or funds availability.If the transaction is approved, the issuing bank confirms the transaction with an authorization code, and the amount of the authorization is set aside from the available credit or available funds in the cardholder’s account. The authorization code is sent through the network from the issuing bank to the merchant-acquiring bank and then on to the merchant’s terminal. The authorization process does not result in an actual collection of funds at that time, but rather, it confirms that the issuing bank authorizes the transaction and agrees to a future settlement with the acquiring bank and its merchant customer.
Once the transaction is authorized, the sales process at the merchant location proceeds. The next step involves capturing the sales transaction information, which is separate from the authorization data. Typically, merchants capture their daily transaction details and either group all of the transactions together for transmission to the acquirer at the end of the day or, in the case of large merchants, process the transaction on a real-time basis. In either case, the transaction is confirmed with the cardholder, typically with a paper receipt.
Clearing and Settlement: The process of collecting the funds from the issuing bank and reimbursing the merchant is known as clearing and settlement. This process begins once the merchant submits transaction information, generally at the end of the day, to its merchant acquirer.
The acquirer then transmits the transaction data to the appropriate payment network, which, in turn, directs the transaction to the respective card-issuing banks. The issuing banks charge their customers’ card account and remit funds through the network to the acquiring bank, less the issuing banks’ fees. The process is completed when the acquiring bank credits its merchant customer’s account, net of fees paid to the issuer, the payment network, and the acquirer. Typically, merchant accounts are funded between 24 and 72 hours after the purchase transaction.
Statements and Information Services: Compiling and reporting on its merchant customers’ transaction data are an important service provided by acquirers. The extent to which this is done and the degree of integration into merchants’ accounting systems vary and can be a source of competitive advantage for acquiring entities. In recent years, the fee structures of networks and issuing banks have become increasingly complex, and most major acquirers now also offer a range of analytical services to assist merchants in better understanding and managing their payment card costs.
C. Industry Participants Within Merchant Acquiring
As will be described in more detail later, the bankcard industry has gone through significant structural change since its inception in the 1960s. At that time, both issuing and acquiring functions were generally conducted by a single bank servicing its cardholders and merchant customers located in a common geographic market. Over time, the industry has seen substantial change as the business of banking and retailing expanded well beyond local geographies. Driven in large part by these market factors and concurrent advances in technology, the payment cards industry today is dominated by large scale, specialized entities. Consequently, the issuing and acquiring functions historically conducted within a singe bank are now more generally seen in separate institutions, and various nonbank partners play important supporting roles, especially on the acquiring side.
In today’s market, various combinations of business structures are used to carry out the functions of merchant acquiring. At one end are acquiring banks, such as Fifth Third, that provide most of the relevant merchant services directly to their merchant-customers. In other cases, banks and large nonbank acquirers have formed jointly owned firms.
One notable example is Paymentech, a joint venture between JPMorganChase and First Data Corporation. Under this arrangement, JPMorganChase serves as the banking sponsor into the payment networks. Heartland Payment Systems is an example of a third model. Under contract with a sponsoring financial institution, this publicly traded company provides virtually all market services for its merchant-customers, including access to the Visa and MasterCard networks.
Supporting all of these models are a number of specialized service and transaction processing companies that provide everything from sales and merchant servicing, including training and technical assistance, to purchase transaction processing, terminal support, encryption servicing, and statement processing. While many of these service providers are common to the payment cards industry, one third-party entity is unique to the acquiring industry. These are the independent sales organizations (ISOs), which specialize in signing up new merchants for payment card acceptance and managing merchant relationships. Pay By Touch currently has dozens of Independent Sales Organizations and is recruiting more and more every day.
Note that despite the sometimes complex chain of service providers, they are always linked by contracts to the network member bank and subject to network-defined registration requirements designed to ensure safe and sound practices.
For the complete report from The Federal Reserve Bank of Philadelphia, click here.
The various activities associated with merchant services (highlighted in Chart 1, and described later) can generally be thought of as the merchant-acquiring function. But who is the merchant acquirer?For bank-centered payment networks such as Visa and MasterCard, the merchant acquirer is defined as the member financial institution responsible for its merchant-customers’ transactions with the network (the merchant-acquiring bank in Chart 1). In practice, member financial institutions often contract with third parties to perform any number of the functions associated with merchant-acquiring services.
In some cases, the extensive scope of merchant-acquiring services provided by these specialized third-party firms has led these companies to be commonly identified as merchant acquirers. Irrespective of name, it is important to note that it is the network member financial institution that is ultimately responsible for the underlying transactions with its direct or indirect merchant-customers.
In addition to Visa and MasterCard, other network structures involve other acquiring models. Most significant among these are American Express and Discover. Unlike Visa and MasterCard, these two card networks are not based on a bank-member structure but, rather, operate as independent entities. As such, they maintain the contract relationship with cardholders as “issuers” and similar direct relationships with the merchant that accepts their cards as “acquirers.” In a sense, the generally independent functions of issuers, acquirers, and networks that exist in the Visa/MasterCard models are collapsed into one entity in the cases of Discover and American Express.
Although Discover, American Express, and other networks play significant roles in the broader payment cards industry, the merchant-acquiring business is more generally associated with Visa and MasterCard transactions2 (commonly known as bankcard transactions), and this part of the payment cards business is the focus of this paper.
B. Merchant-Acquiring Services
In Chart 1 and in the earlier discussion about participants in the payment cards transaction flow, the general term merchant services was used to describe the activities undertaken by merchant acquirers. In essence, these activities may be seen as the services rendered by the acquirer to enable merchants to accept their customers’ payment cards at the point of sale. In support of the transaction flow, merchant acquirers generally perform four key functions: (1) signing up and underwriting merchants to accept network-branded cards, (2) providing the means to authorize valid card transactions at client merchant locations (3) facilitating the clearing and settlement of the transactions through the payment network, and (4) providing other relevant information services, such as sending out statements.
Signing up and Underwriting Merchants: Signing up merchants to accept card-based payments is a key marketing function of a merchant acquirer. This starts with soliciting merchants to accept the network-branded payment cards. The next step is the underwriting process, which ensures that the merchant meets the network requirements for financial stability and other conditions. This is an important step, since the merchant acquirer is ultimately responsible for its customers’ transactions with the network.
Very often, the merchant acquirer or its agent may also assist the merchant in obtaining necessary point-of-sale equipment and provide other relevant services. These and other functions are documented in a contract, called the merchant agreement.
Authorization and Capture: Operationally, a critical function of the acquirer is facilitating the authorization for purchase transactions. From a merchant’s perspective, authorization means that, barring future disputes, payment is guaranteed for authorized purchases. When a payment card is swiped at the merchant’s terminal, a request for authorization, along with the cardholder’s information and the transaction amount, is transmitted to the merchant acquirer. The merchant acquirer then forwards the request through the network, which, in turn, queries the cardholder’s issuing bank. The cardholder’s bank either approves or rejects the transaction based on credit or funds availability.If the transaction is approved, the issuing bank confirms the transaction with an authorization code, and the amount of the authorization is set aside from the available credit or available funds in the cardholder’s account. The authorization code is sent through the network from the issuing bank to the merchant-acquiring bank and then on to the merchant’s terminal. The authorization process does not result in an actual collection of funds at that time, but rather, it confirms that the issuing bank authorizes the transaction and agrees to a future settlement with the acquiring bank and its merchant customer.
Once the transaction is authorized, the sales process at the merchant location proceeds. The next step involves capturing the sales transaction information, which is separate from the authorization data. Typically, merchants capture their daily transaction details and either group all of the transactions together for transmission to the acquirer at the end of the day or, in the case of large merchants, process the transaction on a real-time basis. In either case, the transaction is confirmed with the cardholder, typically with a paper receipt.
Clearing and Settlement: The process of collecting the funds from the issuing bank and reimbursing the merchant is known as clearing and settlement. This process begins once the merchant submits transaction information, generally at the end of the day, to its merchant acquirer.The acquirer then transmits the transaction data to the appropriate payment network, which, in turn, directs the transaction to the respective card-issuing banks. The issuing banks charge their customers’ card account and remit funds through the network to the acquiring bank, less the issuing banks’ fees. The process is completed when the acquiring bank credits its merchant customer’s account, net of fees paid to the issuer, the payment network, and the acquirer. Typically, merchant accounts are funded between 24 and 72 hours after the purchase transaction.
Statements and Information Services: Compiling and reporting on its merchant customers’ transaction data are an important service provided by acquirers. The extent to which this is done and the degree of integration into merchants’ accounting systems vary and can be a source of competitive advantage for acquiring entities. In recent years, the fee structures of networks and issuing banks have become increasingly complex, and most major acquirers now also offer a range of analytical services to assist merchants in better understanding and managing their payment card costs.
C. Industry Participants Within Merchant Acquiring
As will be described in more detail later, the bankcard industry has gone through significant structural change since its inception in the 1960s. At that time, both issuing and acquiring functions were generally conducted by a single bank servicing its cardholders and merchant customers located in a common geographic market. Over time, the industry has seen substantial change as the business of banking and retailing expanded well beyond local geographies. Driven in large part by these market factors and concurrent advances in technology, the payment cards industry today is dominated by large scale, specialized entities. Consequently, the issuing and acquiring functions historically conducted within a singe bank are now more generally seen in separate institutions, and various nonbank partners play important supporting roles, especially on the acquiring side.
In today’s market, various combinations of business structures are used to carry out the functions of merchant acquiring. At one end are acquiring banks, such as Fifth Third, that provide most of the relevant merchant services directly to their merchant-customers. In other cases, banks and large nonbank acquirers have formed jointly owned firms.
One notable example is Paymentech, a joint venture between JPMorganChase and First Data Corporation. Under this arrangement, JPMorganChase serves as the banking sponsor into the payment networks. Heartland Payment Systems is an example of a third model. Under contract with a sponsoring financial institution, this publicly traded company provides virtually all market services for its merchant-customers, including access to the Visa and MasterCard networks.
Supporting all of these models are a number of specialized service and transaction processing companies that provide everything from sales and merchant servicing, including training and technical assistance, to purchase transaction processing, terminal support, encryption servicing, and statement processing. While many of these service providers are common to the payment cards industry, one third-party entity is unique to the acquiring industry. These are the independent sales organizations (ISOs), which specialize in signing up new merchants for payment card acceptance and managing merchant relationships. Pay By Touch currently has dozens of Independent Sales Organizations and is recruiting more and more every day.
Note that despite the sometimes complex chain of service providers, they are always linked by contracts to the network member bank and subject to network-defined registration requirements designed to ensure safe and sound practices.
For the complete report from The Federal Reserve Bank of Philadelphia, click here.
