First Quarter 2006 - PDF document

First Quarter 2006 for granted. You and others like you carry millions of cards and use them billionsof times annually. But unless a transaction goes awry, you rarely think aboutthe terminal flashes a result? How does that swipe translate into a line on your billor four-digitnumber printed on the back of the card, the cardÕs expiration date, or arcane infor-mation such as your motherÕs maiden name?From the merchantÕs perspective, how is that same card swipe turned into cashthe representative from the payment card company so interested in the merchantÕsconverted into cash for the merchants. The discussion begins with an explanation of thesimplest type of card transactionÑone using a private-label card (one that is acceptedby only one merchant)Ñbut the focus is primarily on the Visa and MasterCard net-countries, although details may differ, especially for cards other than Visa andacquirer and the payment card processor. The largest of these often perform bothfunctions. Together, merchant acquirers and processors serve as the communicationsPayment Card Processors: RAMON P. DThe author is the SunTrust Professor of Finance at the University of Tennessee and a visit-ing scholar at the Federal Reserve Bank of Atlanta. He thanks Jerry Dwyer, Dick Fraher, ScottFrame, Will Roberds, and Lynn Woosley for useful comments and discussions. He is gratefulto Timothy Miller and Mario Beltran of NOVA Information Systems for explaining importantinstitutional details and to Lee Cohen and Victoria L. Messman for research assistance. FEDERAL RESERVE BANK OF ATLANTA First Quarter 2006 every card issuer deals with at least one payment processor, and every merchant thataccepts cards has a relationship with a merchant acquirer. Without them, the pay-ment system as we know it would not exist. According to Gerdes et al. (2005), U.S.(2005a), in 2004 consumers in the United Statesheld 795.5 million MasterCard and Visathe fourth-largest expense for gas stations and convenience stores after labor, rent,that the industry employs about 50,000 people.Despite the size of the industry, fewdifferences among card transactions from the perspective of the merchant acquirer. associations and the merchant acquirers. Unbeknownst to the cardholder, card-basedminor from the cardholderÕs perspective. This situation exists because Regulation Zand card association rules limit an innocent cardholderÕs liability to at most $50 inFEDERAL RESERVE BANK OF ATLANTA Unbeknownst to the cardholder, card-basedtransactions actually travel through theBlack BoxÑa highly evolved group of First Quarter 2006 one processing entity are involved. For universal cards such as Visa and MasterCard,Payment Cards: The Industry and Transactions ProcessingThe industry.perform various tasks, and because many of them have formed alliances, the linesand, in the case of credit cards, extends credit to the consumer. (See the sidebaron page 32 for information about different types to-consumer. The merchant acquirer signs up merchants to accept payment cards forend processing). Later, they handle the information and payment flows needed toFEDERAL RESERVE BANK OF ATLANTA Table The Ten Largest U.S. Merchant Acquirers in 2004, Excluding Partnerships and AlliancesRanking (transactions)Ranking (dollar volume)1.First Data1.Chase Merchant Services2.BA Merchant Services2.BA Merchant Services3.Chase Merchant Services3.First Data4.Paymentech4.Paymentech5.Fifth Third Bank5.Nova Information Systems6.Global Payments6.Fifth Third Bank7.Nova Information Systems7.Global Payments8.Wells Fargo8.Wells Fargo9.Alliance Data Systems9.First National Merchant Solutions10.Heartland Payment Systems10.Heartland Payment SystemsMerchant acquirers holding at least 1 percent of U.S. market share in 2004 (by dollar volume), including partnerships and alliances1.First Data (including Chase Merchant Services, Paymentech, Wells Fargo, SunTrust, and PNC)2.BA Merchant Services3.Nova Information Systems (including KeyCorp)4.Fifth Third Bank5.Global Payments6.First National Merchant Solutions7.Heartland Payment Systems8.TransFirstSource: The Nilson Report First Quarter 2006 issuer and merchant acquirer are the same entity.The transactions process has two major parts. The first is authorization, and thesettlement is the process of sending transactions through the Visa or MasterCard net-sumer presents his card to the merchant for a purchase. Usually, this authorizationdone in Òcard not presentÓ situations (for example, online).Merchants usually obtainauthorization electronically, either by having the consumer swipe the card through aterminal at the point of sale or by entering the card information manually. However,the merchantÕs identification number, the card information, and the transactionamount to the card processor. The processorÕs system reads the information andFEDERAL RESERVE BANK OF ATLANTA Types of Payment CardsSears and MacyÕs. General-purpose cards, bycontrast, are accepted by a wide variety ofmerchants. Visa and MasterCard are the mostdrawal from the userÕs savings or checkingand funds are deducted from the userÕs accountimmediately. In offline mode, the card is swipedholderÕs signature. In this case, the customerÕscards even come with overdraft protection. In contrast, credit cards and charge cardsallow the purchaser a longer period of timebefore he must deliver funds to cover the pur-the cardholder to pay the balance in full eachmonth unless special arrangements have beencards is by the type of issuer. Financial institu-cards or credit cards. Visa and MasterCard are theance from month to month while some travel First Quarter 2006 To recover these funds, the MAS sends information about the merchantÕs trans-actions to Interchange, which is part of the Visa or MasterCard network. Interchangeand the issuing bank. Interchange determines the interchange fee and Visa/MasterCardassessments (to cover the cost of the issuing bankÕs services and the networkÕs costs)and sends the information to the card-issuing bank. In turn, the issuing bank remitsto the MAS. Finally, the issuing bank bills the cardholder and collects the balance.the merchantÕs customers.product or service, cardholders have as much as three months to claim a charge-The presumption is initially in favor of the customer, and theamount of the chargeback is deducted from the merchantÕs account pending theresult of a review. If the dispute is resolved in the merchantÕs favorback. In this case, according to the card networkÕs rules, the merchant acquirer isliable and must make restitution to the customer.the merchant acquirer. In essence, the merchant acquirer has insured the issuingbank against an adverse result. The risk of a merchant acquirerÕs contingent liabilityis similar to that of a bankÕs guarantee of a debtorÕs liabilities or an insurance contract.as a warranty, neither the buyer nor the seller can cancel the transaction after theexchange. In contrast, because of Visa/MasterCard chargeback provisions, creditgood or service. This lack of finality is a key determinant of a merchant acquirerÕs riskof delayed delivery. FEDERAL RESERVE BANK OF ATLANTA First Quarter 2006 making it easier to detect suspicious behavior. Second, customers would have beenin the store or overheard conversations and complaints. Finally, either the merchantfailed. Either way, the merchant acquirer would have been better off. Instead,Because the fraudulent merchant could not pay, the merchant acquirer was forced toClearly, a merchant acquirer must consider the credit standing of the merchants itfrom that of a more familiar bank loan. A merchant acquirerÕs contingent liability isences. For example, for a bank loan, the bank delivers funds to a borrower. A meracquirer, though, advances no funds. Instead, it indemnifies a third partyÑthe cardFEDERAL RESERVE BANK OF ATLANTA Three-Party Networksto the four-party diagram in Figure 2. Theare the same entity; in four-party networks, theyare separate. In four-party networks, banks thatare members of Visa and MasterCard issue thethree- and four-party networks is unimportant Parties Involved in a Card Program: A Three-Party Network Express Cardholder Merchant Serviceproviders First Quarter 2006 to substantiate. Timeshare services have high chargeback rates because customersFEDERAL RESERVE BANK OF ATLANTA Delayed Delivery in the ExtremeindustryÕs current financial problems com-trip by air. In some cases, the cardholder buyscan the potential losses be?One merchant acquirer, National Citytickets, then travelers who purchased theirrefunds under Visaand MasterCard rules, andexposure to United Airlines alone. National CityCorporation (2004a) says that it processed overfive times that amountÑabout $5 billion worthmonths ending June 30, 2004. National City Cor-poration (2004b) reports that as of December 31,reducedto Of course, the odds are small that Nationalwithin the allotted time limits. Although this isnumber of travelers who file chargebacks. Finally,is unlikely because, even as a general creditor, thelosses from the bankrupt carrier. If National CityNational City Corporation (2004a) puts thequarter, for a total of about $150 million in theeach quarter, for a total of about $4 million. Thethis size are not trivial, and Òunlikely,Ó of course,1.In November 2005, Congress extended this provision through November 2006. Airlines must honor these tickets First Quarter 2006 usually a function of the delivery delay and, less frequently, the chargeback ratio.Transaction-related risks.mously. This low level of risk is still truemanually keying the card number, thechance for error drops to near zero. True,ing is at least one step toward insuringlegitimacy: A thief must have stolen the card itself and not just the card number. Thisconsideration goes far toward eliminating theft losses from, say, a dishonest waiterwho copies the card number while clearing a dinerÕs tab.For a growing number of transactions, however, the cardholder and the card aretransactionsÑand, more recently, Internet transactionsÑhave presented specialjust the card number. For example, card associations have long encoded a verificationnumber into the magnetic stripe on the back of the card. Visa calls this code the CardVerification Value (CVV or CVV1); MasterCardÕs term is the Card Validation Codehe can steal a card number. Because these procedures are only partially effective,and answers. Card users might be asked to verify their motherÕs maiden name, forFEDERAL RESERVE BANK OF ATLANTA These procedures are only partially effective,so merchant acquirers charge higher fees forcard-not-present transactions to compensate First Quarter 2006 Hundreds of millions of cardholders make billions of transactions worth trillions ofdollars each year. Yet few cardholders understand how payment networks operate.Most treat them as a Black Box.the roles of the merchant acquirer and card processor. After outlining the regulationsintroduced by general-purpose cards, such as Visa and MasterCard, and introduces akey participant in the payment card market, the merchant acquirer. The description offor these transactions services. Finally, the article discusses some ways that merchantFEDERAL RESERVE BANK OF ATLANTA Journal of Financial Trans-12(December):21Ð23Chang, Howard H. 2004. Payment card industry primer.Payment Card Economics Review 2(Winter): 29Ð46..Cline Groupfor Specialized Publications, September.Gerdes, Geoffrey R., Jack K. Walton II, May X. Liu, andDarrel W. Parke. 2005. Trends in the use of paymentKahn, Charles M., and William Roberds. 2005. CreditWorking Paper 2005-19, August.Lucas, Peter. 2004. Why gasoline retailers are fuming.Credit Card ManagementMcCartney, Scott. 2004. Bill to protect flyers fromshutdowns has a surprising beneficiary.Wall Streetof the Securities Exchange Act of 1934Ñfor theÑÑÑ. 2004b. Annual report.. 2005a. Visa & MastercardÑU.S.2004. No. 828, February.ÑÑÑ. 2005b. Top U.S. acquirers. No. 831, April.Quinn, Stephen F., and William Roberds. 2003. Areon-line currencies virtual banknotes? Federal ReserveRochet, Jean-Charles, and Jean Tirole. 2002. Cooper-