What Happens When You Make a Credit Card Payment?
Last week, we gave a brief overview of the different payment systems in India. Over the next few weeks we will take a deeper dive into some of these payment systems. We start with this segment on Credit Card Payments.
You’ve heard all these amazing things about how a credit card will change your life — you will be able to get cash rewards, join Cred to get cashback points on your card bills, access the premium lounge at airports, and so many other benefits! So you decide you are going to get a credit card.
Say you already have a bank account with HDFC bank, and that is where you receive your monthly salary. You call up your relationship manager and tell him that you would very much like to be the owner of a credit card. At this point your relationship manager will raise a request internally to issue your card. The bank will verify that you are a credible customer (are financially capable of repaying them) based on your income, salary, spending habits and outstanding loans.
A credit card allows you to purchase now and pay later- by short term loans issued by your bank.
Once your bank has verified that you are a bonafide customer of sound financial standing, they will issue your credit card with a limit. This limit specifies the maximum amount of money that you can have outstanding on this credit card.
Any time you use your credit card to make a purchase, you are taking a temporary ‘loan’ from your bank. Your bank needs to protect itself against the possibility of default (you being unable to pay them back) — so they specify a limit that they are comfortable loaning to you. At the end of every billing period (usually every month), you settle your credit card bill, i.e. pay back the total amount of loan you’ve taken from your bank while using the credit card over this period.
The bank that issued your credit card — HDFC in our example — is known as the issuing bank (this will be important later). You also notice the logo of the card network, such as Visa, on your credit card.
A few days later you go down to your favorite sweet shop, G. Pulla Reddy sweets, to buy some jalebis. You meticulously pick out the hot, crisp and red ones from the freshly made jalebis, proceed to the counter and open your wallet to pay. An empty wallet stares back at you — unfortunately, you’re all out of cash! With a watering mouth and a broken heart, you turn to leave.
Suddenly, out of the corner of your eye, you catch a ray of light reflecting off of the POS (Point of Sale) machine on the counter. You remember your newly obtained credit card! Thanking Kuber and beaming, you reach again into your wallet and pull out your credit card. You present it to Mr. Reddy and he inserts the card into the POS device. He then enters the bill amount and turns it over to you. You enter your credit card PIN.
At this point a series of events takes place behind the scenes. These are broadly categorized into three steps — Authorization, Clearing and Settlement.
The merchant, i.e. the sweet shop has a bank, say ICICI, that helps it process its card payments. This bank is called the acquiring bank (it acquires payments for the merchant). When you enter your credit card PIN and press submit, the merchant’s POS device authenticates your card-pin combination using EMV technology. It then encrypts and sends the details of the transaction (such as your card information, purpose of payment and amount data) to the acquiring bank via a network connection. The acquiring bank appends additional data to this encrypted payment message and sends it on to Visa — the card network. The card network performs some checks on the payment related to fraud prevention and anti-money laundering. Once the payment passes these checks, it is forwarded to the issuing bank. The issuing bank (HDFC) ensures that you have the necessary balance on your limit to make this payment. If yes, it puts a hold on the specified funds in your account. The payment authorization is passed back to the merchant via the card network and acquiring bank. This constitutes a guarantee from the issuing bank to pay the merchant, but no money has been transferred just yet!
Great! The merchant is happy and presents you with the bill for your purchase. You also receive a message from your bank confirming that you have spent ₹100 at GPR Sweets. You go home happy to enjoy your jalebis!
However, the sweet shop has not been paid yet (doesn’t see the money in his bank account)! In reality, authorization for the payment is only the first step in the journey to acquire the money for the merchant. For this, the funds have to be cleared and settled.
The card network works in clearing cycles with a fixed period (usually a few hours). During this period the acquiring bank collects all the transactions that merchants with this bank have completed in an electronic file. At the end of the clearing period, it sends this file to the card network. The card network collates such files from all the banks that participate in its network, and calculates the net positions of each of the banks (e.g. if HDFC needs to pay 10 crores to ICICI and ICICI has to pay 2 crores to HDFC, then the net position is that HDFC needs to pay 8 crores to ICICI). It then sends these net positions to each of the banks in the network, instructing them to settle the balances. This collation and calculation of net positions is called clearing.
Finally, after the clearing cycle has ended and the net positions have been distributed to the participating banks, banks transfer the funds to each other as per the calculated positions. This is called settlement. Once the settlement is complete, the funds are made available to the happy merchant, i.e. the sweet shop!
Within the process of acquiring the payment that we have seen above, the acquiring bank, the card network and the issuing bank also deduct their own fees from this payment. Yes, only a part of the payment you have made will actually reach the merchant’s account! The image below shows how a typical ₹100 payment is divided between the various entities in the transaction.
The issuing bank charges a fee called the interchange fee for the trouble of managing the cardholder’s payment process, authorization and providing him with the credit for this transaction. Next, Visa — the card network — deducts its own fees called the network fee or the switching fee. When the payment (with deducted fees) reaches the acquiring bank, it in turn deducts its fees from the payment, called the acquiring fee. Collectively, the switching fee, the interchange fee and the acquiring fees add up to something called the Merchant Discount Rate (MDR). This is the total cost of the card payment for the merchant. This adds up to between 2–4% of the transaction for credit cards.
Payment Processors & Payment Gateways
You might have heard the term payment gateway. You may have even used it in conversation, hoping that the meaning of the term is implied. But you’re probably not quite sure what a payment gateway is, or what it does — just that it has something to do with online payments. Well, read on to find out! But before we go there, we will first look at another entity that is usually involved in payments processing, called a payment processor.
The model described above for credit card payments left out some details for the sake of simplicity. One of these is that the merchant does not directly connect to the acquiring bank — this is usually facilitated by another financial entity called the payment processor. A payment processor is responsible for processing the card, verifying the authenticity of the EMV chip and then encrypting the communication with the merchant’s bank. Additionally, it may provide the POS hardware at the merchant’s shop. This entity also receives a part of the transaction fee (including in the MDR).
Payment gateways on the other hand, are only used in online payments using cards. In this case, there is no physical card present. Instead, the customer enters his card information and the payment gateway handles the customer’s authentication, which may include many steps (such as verifying that the card information is correct and redirecting to the issuing bank for OTP authentication).
So in a way payment gateways are like a digital POS, analogous to the physical POS device at a brick-and-mortar store which authenticates your card information. Upon successful authentication, the gateway forwards the payment information to the payment processor that connects to the acquiring bank. Examples of payment gateway providers in India include PayU, Instamojo and Razorpay.
In this post, we have talked at length about credit cards. But there is also something to be said about their vanilla cousins, the debit cards.
In a lot of ways, the issuing and transaction processes for debit cards are very similar to credit cards. However, the fees involved in processing a debit card transaction are generally significantly lower — this is primarily because the interchange fee charged by the issuing bank is lower owing to lower risk for processing the payment. This is due to the fact that debit card transactions are directly debited from the customer’s account, and do not have a short term loan component like credit cards. Either you have the money for a transaction and your transaction is processed, or you do not and the transaction is rejected.
Fun fact: India sees about 3 debit card transactions for every 1 credit card transaction. Despite this, credit and debit transactions are nearly equal in value terms! [ref]
Next week, we are taking a deeper dive into UPI payments, arguably the most advanced payment system in the world right now.
DICE (Digital India Collective for Empowerment) is an industry body focused on the Indian Digital Payments ecosystem. DICE takes an India first approach to creating collaborative industry-regulator relationships in the thriving ecosystem. Follow us at @indiadice on Twitter.