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How does payment processing work?

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How does payment processing work?

Updated:
May 15, 2024
by
How does payment processing work?

1. Transaction initiation

When a customer decides to make a payment using a credit or debit card, either in-person, in an online store, or through a mobile device, the transaction begins. The customer's payment information (like credit card number and expiration date) is collected via a point of sale (POS) system, an online payment gateway, or another payment interface.

2. Data transmission

The payment processor receives the transaction data from the merchant. This information is encrypted to ensure security and is then sent to the payment processor. The processor's primary task here is to ensure that the data moves securely from the merchant to the relevant parties, such as the card network (Visa, MasterCard, etc.).

3. Authorization request

The payment processor forwards the transaction details to the card association (Visa, MasterCard, etc.), which then routes it to the issuing bank (the customer’s bank that issued the card) for authorization. The issuing bank checks several things, including:

  • Whether the card number is valid.
  • Whether the card has sufficient funds or credit available.
  • Whether the card is not reported lost or stolen.

4. Authorization response

The issuing bank then approves or declines the transaction based on the verifications and sends this response back through the card network to the payment processor. The processor, in turn, sends this authentication response back to the merchant.

5. Completing the transaction

If the transaction is authorized, the merchant completes the sale. For an online transaction, this might mean sending an order confirmation to the customer. In a physical store, it often results in printing a receipt.

6. Settlement

After the transaction is authorized and completed, the actual movement of funds is processed during settlement. At the end of the business day, the merchant sends all the authorized transactions in a batch to their payment processor. The processor then forwards these batches to the card networks, which settle the transactions with the issuing banks.

7. Funding

After settlement, the funds are transferred from the issuing bank to the merchant's bank, also known as the acquiring bank. The payment processor plays a role in ensuring that these funds are deposited into the merchant’s account, typically within a few days.

8. Fees assessment

During these transactions, payment processors assess fees that are typically a percentage of the transaction amount, sometimes combined with a flat fee. These fees can include interchange fees, which are paid to the card-issuing banks, and additional monthly fees that cover the processor's merchant services.

9. Security and compliance

Throughout this process, payment processors must adhere to strict security standards, such as the Payment Card Industry Data Security Standard (PCI DSS) or “PCI compliance”, to protect sensitive data and prevent fraud. They may also offer services like fraud detection, tokenization, and encryption to further secure transactions and enhance trust.

An upcoming addition to payment processing compliance is the U.S. open banking rule that was proposed in October 2023 and is set to be finalized in 2024—Dodd-Frank Section 1033. The forthcoming rule will guarantee consumers’ right to access and share their financial data.

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