The inner workings of credit card networks

[UNITED STATES] Credit card transactions have become an integral part of our daily lives. Whether you're buying groceries, booking a flight, or shopping online, chances are you're using a credit card. But have you ever wondered what happens behind the scenes when you swipe, tap, or enter your card details? The answer lies in the complex world of credit card networks.

Credit card networks are the unsung heroes of the financial world, providing the essential infrastructure that allows customers to make purchases from merchants. These networks act as the intermediaries between various financial institutions, facilitating the flow of information and money.

As Investopedia explains, "If the bank accounts of a business and a customer are like individual countries, then a credit card network is like the international shipping company that goes between the two".

The Big Four: Major Credit Card Networks

In the United States, four major credit card networks dominate the market:

• Visa
• Mastercard
• American Express
• Discover

These companies are also known as payment card networks because they handle both credit and debit card transactions.

How Credit Card Networks Operate

To understand the intricate workings of credit card networks, let's break down the process of a typical credit card transaction.

The Journey of a Credit Card Transaction

Customer Initiates Payment: The process begins when a customer presents their credit card for payment, either by swiping, tapping, or entering card details online.

Merchant Submits Payment Information: The merchant enters the transaction details into their point-of-sale (POS) system, which then communicates with their chosen credit card processor.

Credit Card Processor Contacts Acquiring Bank: The processor forwards the transaction information to an acquiring bank, which holds a merchant account for temporary storage of credit card payments.

Acquiring Bank Contacts Credit Card Network: The payment information is routed to the appropriate credit card network (e.g., Visa, Mastercard).

Credit Card Network Contacts Issuing Bank: The network relays the information to the customer's bank (the issuing bank) to verify the transaction.

Issuing Bank Approves Transaction: If the customer has sufficient credit, the issuing bank approves the transaction and sends payment to the acquiring bank.

Funds Transfer: The acquiring bank holds the payment for the credit card processor, who then transfers it to the merchant's business account, minus any processing fees.

This complex dance of information and money transfer happens in mere seconds, allowing for seamless transactions between customers and merchants.

The Role of Merchant Accounts

All businesses that accept credit cards need a merchant account to handle these payments. This account serves as a safeguard against chargebacks, such as returned items or fraudulent transactions. Merchants can either apply for a merchant account directly from an acquiring bank or use a full-service payment processor that provides one, such as Square or PayPal.

Differences Between Credit Card Networks

While the four major credit card networks in the U.S. perform similar functions, there are some notable differences:

Visa, Mastercard, and Discover

According to Phillip Parker, founder of CardPaymentOptions.com, "Visa, Mastercard, and Discover are essentially one and the same at this point". These networks operate on an open-loop system, meaning their cards can be used at any merchant that accepts them.

American Express

American Express stands out due to its higher merchant fees. Parker notes, "It's a bittersweet pill for business owners because Amex cardholders are often affluent and big spenders, but their business comes at a higher price". This higher cost sometimes leads businesses to refuse American Express cards as a payment method.

The Cost of Convenience: Merchant Fees

The convenience of credit card transactions comes at a price, primarily borne by merchants. These fees, collectively known as the merchant discount rate (MDR), typically range from 1% to 3% of the transaction amount.

Components of the Merchant Discount Rate

Interchange Fees: Paid to the card-issuing bank, these form the largest portion of the MDR.

Assessment Fees: The credit card network's cut for bridging the gap between customer and merchant.

Payment Processing Fees: Charged by the payment processing company, these can vary based on different pricing models.

Parker advises, "As a business, there is more than one pricing schedule when it comes to how your processing fees can be assessed. Some schedules are transparent and fair, while others are intentionally veiled and expensive. Getting a basic understanding of these pricing models can save you a ton in fees".

Open vs. Closed Credit Card Networks

Credit card networks can operate on either an open or closed basis:

Open-Loop Cards

These are typical credit cards that can be used anywhere their network is accepted. Visa and Mastercard primarily operate open-loop networks.

Closed-Loop Cards

These are often store-specific credit cards that can only be used with the issuing merchant. Many nationwide retailers offer such cards.

American Express and Discover operate on a unique model. They function as both the credit card network and the issuer, cutting out the middleman and working directly between the customer and the merchant's payment processing system.

Credit Card Networks vs. Credit Card Issuers

It's important to distinguish between credit card networks and credit card issuers:

Credit Card Networks: Facilitate the flow of information and money between banks.

Credit Card Issuers: Provide credit cards to customers, maintain accounts, and handle customer-facing aspects like rewards programs and dispute resolution.

Companies like American Express and Discover perform both roles, handling both the network operations and customer accounts.

Global Market Share of Credit Card Networks

As of 2023, Visa leads the global market, handling 39% of all card transactions. UnionPay, popular in Asia, follows at 33%, with Mastercard at 25%.

The Future of Credit Card Networks

As digital payments continue to evolve, credit card networks are adapting to new technologies and changing consumer preferences. The rise of mobile payments, contactless transactions, and cryptocurrencies presents both challenges and opportunities for these networks.

Moreover, government regulators are increasingly scrutinizing credit card fees to ensure fairness for both consumers and businesses. This regulatory landscape may shape the future operations and fee structures of credit card networks.

Credit card networks play a crucial role in our modern financial ecosystem, enabling the seamless transactions we often take for granted. Understanding how these networks operate can help both consumers and businesses make informed decisions about credit card usage and acceptance.

As we move further into the digital age, the importance of credit card networks in facilitating global commerce cannot be overstated. Their ability to adapt to new technologies and regulatory changes will be key to their continued relevance in the ever-evolving world of financial transactions.