What Happens When You Make a Credit Card Payment?

A Peek Behind the Scenes

Abhav Kedia
Jul 29, 2020 · 8 min read

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.

Getting Started

[credit: Sheeba Sheikh]

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.

The Transaction

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.

Authorization

[credit: Sheeba Sheikh]

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.

Clearing

Settlement

Charges

Credit Card Fees Example [credit: Sheeba Sheikh]

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

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.

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 Time…

Stay tuned!

About DICE

DICE India

India First Approach to Digital Payments Industry

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