Understanding merchant processing

For nearly a year now as quarterback of the Street SmartsSM column, I've discussed rebranding options that you, as a merchant level salesperson (MLS), can use to lead in with and tie merchant processing into the solution implementation on the back-end. But what exactly is merchant processing? This article discusses the in-depth particulars of merchant processing that, unfortunately, due to the low level of training provided in our industry, many MLSs might not fully understand.

The use of bankcards as a payment option dates back to at least the 1950s. A merchant account is an unsecured line of credit provided to a merchant by a registered independent sales organization (ISO) or merchant service provider (MSP), and a sponsor (acquiring) bank, that enable the merchant to accept credit cards from customers who received cards from issuing banks.

Interchange

During the processing of a credit card transaction, certain fees are charged, and interchange is one of them. Interchange varies depending on type of card used, and costs are listed for every type of card a merchant could run at the POS. You have interchange for credit cards, as well as signature debit cards run offline as credit cards and PIN debit cards that are run online and for which PINs are entered at the POS.

There might be from 100 to 200 categories of interchange, and categories determine pricing. The pricing is set strategically to where it is neither so high that merchants would not want to accept credit cards nor too low to where issuing banks (which receive the revenue from interchange) would opt out of assuming the upfront risks associated with issuing cards.

Discover Financial Services and American Express Co. control the issuing of their own bankcards and have, in prior years, been criticized by merchants for having higher costs than Visa- and Mastercard-branded cards. To address this issue, Discover created the Discover Acquiring program and AmEx created the Opt Blue program. Both provide merchants the opportunity to have lower pricing.

The players and how they get paid

Visa and Mastercard are publicly traded companies with their own card brands. They each manage a group of member banks, which includes issuing and acquiring (sponsoring) banks. Member banks pay Visa and Mastercard membership dues, which allows them to market their respective brands in the market.

Issuing banks issue credit cards with credit limits to consumers after they meet certain credit criteria. Issuing banks are paid the revenue from interchange.

Sponsor (acquiring) banks work with registered ISOs/MSPs to approve merchants for merchant accounts and process payments through front-end authorization networks, as well as settle transactions through back-end networks.

ISOs/MSPs market merchant accounts to the public and are paid by marking up interchange. They are also paid through related fees charged to merchants such as annual fees, statement fees and batch fees.

How the transaction process works

From start to finish, here is how a $50 credit card transaction is completed:

  • Sandra is approved for a Visa Rewards Card with a $5,000 line of credit from an issuing bank. While on the other side of town, Billy, owner of Billy's Meat Market, is approved for a merchant account by an ISO/MSP and receives a free terminal to process transactions.
  • Sandra purchases $50 worth of items at Billy's Meat Market using her Visa Rewards Card. When she swipes her card through the credit card terminal, the ISO/MSP sends the data to the acquiring bank, which sends it to Visa, which sends it to the issuing bank to verify that Sandra has a remaining credit limit large enough for the requested transaction.
  • Let's say Sandra's credit limit is sufficient, the issuing bank creates an authorization code and sends it to the acquiring bank, which sends the code to the ISO/MSP via the credit card terminal, prompting Billy to see an "approval" notification.
  • Billy prints out a receipt for Sandra to sign, then batches out all of his credit card transactions at night via the terminal. After the batch, the ISO/MSP deposits the $50 transaction into Billy's bank account within 48 hours, then bills him at the end of the month for interchange, the mark-up of interchange, and other fees such as the monthly statement fee, batch fee, etc. Sandra is sent a bill within 30 days by her issuing bank listing the transaction of $50 from Billy's Meat Market.

Understanding underwriting

When Billy runs Sandra's credit card for $50, he receives the full amount from the ISO/MSP within 48 hours, even though Sandra technically hasn't paid for the $50 transaction yet. Her credit card issuer won't send her a statement with the transaction listed for payment until up to 30 days from the transaction date. This means Billy is receiving an unsecured line of credit.

The risk of this transaction would come if Sandra were to initiate a chargeback of the $50 transaction, and if Billy were to lose the chargeback case, the $50 would have to be refunded to Sandra's credit card. Thus, she wouldn't have to pay her issuing bank for the transaction. But if the ISO/MSP proceeds to obtain the refund amount (plus a chargeback fee and retrieval fee) from Billy's Meat Market's bank account and there's no money in the account, the ISO/MSP that underwrote the merchant account is most likely on the hook for paying for the $50 instead.

This is why during the underwriting of a merchant account, the ISO/MSP is conducting an analysis on the industry that the merchant operates in, as well as the merchant's credit score and history of previous chargebacks, to determine if the merchant is likely to receive a high amount of chargebacks going forward, which could potentially put the ISO/MSP at risk.

Also, many sponsor banks don't want to be associated with certain merchant types that have a history of high chargebacks. This is why certain categories of merchants are considered low risk and some are considered high risk. Low-risk merchants would be those with a lower likelihood of chargebacks due to transactions taking place face-to-face (Billy's Meat Market, for example). Low-risk merchants are likely to receive faster approval with a lower amount of documentation needed for underwriting.

Higher-risk merchants are those who never see their customers during transactions (online merchants, for example) or merchants in industries where customers routinely challenge transactions. These include the high-risk merchant categories on many ISO/MSP "prohibited" lists. To be approved, merchants in these categories require higher levels of documentation during underwriting. Underwriting them will also take a bit longer, and they might even have to be placed offshore, as offshore providers, at times, can take on higher levels of risk than domestic providers can assume.