Do you know what happens behind the scenes when you swipe your credit card or click Submit in an online shopping cart? What magic happens when you send a wire or ACH payment? Let’s get in the weeds a bit and uncover the mysteries of every-day electronic payments. We’ll start with credit and debit cards, then explore the inner workings of ACH, wire, and real-time payments, briefly discuss Venmo and PayPal type payments, then compare these payment methods to cryptocurrency payments, using the Bitcoin Lightning Network as an example.
Credit Card
Let’s start with one of the most popular payment methods in the world — credit cards. Before we dive in, you need to understand who the participants are in a credit card transaction: merchants, acquirers, card networks, and issuers. See image 1 below for a high-level process flow (discuss in detail later). This arrangement is called the Four Party Scheme (FPS) or Four Party Model (FPM).
Merchants accept credit cards in their physical stores or via their online shopping carts
Acquirers provide banking services to merchants. They allow merchants to receive funds from credit card transactions. They also provide technology solutions that enable merchants to connect to popular payment networks that process credit card transactions (steps 1, 2, 5, and 6 in image 1 below). Acquirers will often outsource the technology piece to a payment gateway like Stripe, Square, Adyen, Authorize.net, Braintree or Cybersource. These gateways handle all payment processing activities, allowing the acquirer to focus on the banking and risk management side.
Card Networks connect the many thousands of acquirers to the many thousands of banks around the world. Without card networks, each acquirer would have to set up a direct connection to every credit card issuing bank around the world. Card networks also establish payment transaction rules and stipulations that merchants, acquirers, and issuers must follow. These rules ensure a fair and safe marketplace for consumers and Four Party Scheme participants. The rules include data exchange protocols that allow the different systems to communicate and exchange information.
Note: Visa and Mastercard do not issue any credit cards to consumers! They only maintain the network connections and operating rules between acquirers and issuers. Only issuers can issue credit cards to consumers (look at the back of your credit card and you’ll see the name of your issuer/bank). AMEX and Discover, on the other hand, do issuer credit cards to consumers because they are both the card network and the issuing bank.Issuing Banks issue credit cards to consumers. They take all the credit risk of the cardholder not paying off their balance and the risk of fraudulent transactions. To pay for these risks and other operating expenses, issuing banks collect an interchange fee (avg of .3% for debit cards and ~1%-2.5% for credit cards in the U.S.) from the card networks. The card networks also collect a network fee (~.05%). All fees are charged to the merchant and deducted from the customer payments prior to depositing proceeds to the merchant’s bank account. (Acquirers may also charge the merchant additional operational and risk fees.) As noted above, Visa and Mastercard are not banks, therefore they do not issue credit cards. AMEX and Discover do have bank subsidiaries, therefore can and do issue credit cards directly to consumers.
How credit card transactions work in six steps (from image 1 above):
Customer/Cardholder swipes their card at a merchant terminal or submits an order on the retailer’s online shopping page. The card reader or web page component that accepts the card data is provided by the acquirer (or a payment gateway on behalf of the acquirer) to the merchant to incorporate into their sales systems.
Acquirer accepts and validates the transaction details then submits the transaction, in the appropriate data format, to the card network.
The card network validates the transaction, then submits it to the issuing bank for review and approval. (The acquirer and issuing bank may be domiciled in different countries.)
The issuer reviews the transaction details, validates fund availability on the cardholder’s account, checks for fraud, then returns an authorization or decline code to the card network.
The card network relays the issuer response to the acquirer
The acquirer relays the issuer response to the merchant. If the transaction is authorized, the merchant has the approval needed to provide the product/service to the customer and be confident that his bank account will receive the funds in the next 1–2 business days from the acquirer.
The above six steps complete in one to two seconds. Not shown in the above is the settlement piece. Once or more per day, the acquirer will send a settlement request to the card network to initiate actual movement of funds (aka “clearing”) from the issuer to the acquirer (merchant’s bank account). The card network coordinates and executes (via wire or ACH) the transfer of funds from the issuing bank account to the acquiring bank — thereby providing the merchant access to the funds. Merchants typically receive funds from credit card transactions in 1–2 business days from the date of the transaction.
To pay for the cost of operating the network and issuer fraud losses, card schemes charge merchants between 1% and 3% of the transaction amount.
Some interesting Visa credit card transaction stats for the July 1, 2020, to June 30, 2021 time period:
Visa processed $12 trillion in payment volume
There are ~15,200 acquirers and issuers connected to the Visa network
70 million+ merchants accept Visa globally
There are ~3.6 billion active Visa cards worldwide
Visa processed ~206 billion payments transactions
Debit Card
Debit cards operate similarly to credit cards except that the funds are withdrawn from the cardholder’s bank account and credited to the merchant’s bank account the same day as the transaction (usually within a few hours). For credit card transactions, the withdraw + credit isn’t completed until one to two business days after the transaction.
Additionally, debit card transactions often involve additional card networks called “debit networks”. Debit networks are similar to credit card networks in that they connect acquirers to issuing banks, but different in that they only process debit transactions; another difference is that acquirers often don’t connect directly to debit networks — for simplicity, they connect indirectly to debit networks via their existing credit card network connections. (Maintaining connections to payment networks is costly and resource intensive.)
In image 2 below, you see that debit networks sit between card networks and issuing banks, and exchange data with them via steps 3, 4, 5, and 6.
Interesting debit & credit card stats (2017 date unless noted otherwise):
Debit cards account for 67% of card payments
76% of consumers have at least one credit card
Only 10% of consumers make all their purchases with cash
There are 459 million credit cards in circulation
Market share (payment volume): Visa: 50%; Mastercard: 21%; AMEX: 20%; Discover: 4%; Other: 5%
ACH
Automated Clearing House (ACH) money transfers in the U.S. are bank account to bank account payments. This payment network is run by the National Automated Clearing House Association (NACHA). Unlike credit card transactions that happen in real-time at the point of sale, ACH transactions are batched up in a file and sent through the network several times throughout a business day. Recipients receive their money the same business day or by the next business day.
ACH process for a company paying an employee (image 3):
Banks accumulate multiple ACH transfer request throughout the day, then batch them up in a file and sent it to the U.S. Federal Reserve through the Automated Clearing House network.
The Federal Reserve retrieves the payment instructions from the ACH file, then transfers the funds from the employer’s bank to the employee’s bank. (The employee’s bank then credits the employee’s bank account to reflect the payment.)
The employee’s bank acknowledges to the Federal Reserve that the funds were received
The Federal Reserve sends an acknowledgment to the employer’s bank informing them that the transaction is complete
The employee logs into his online banking and sees the deposited paycheck amount
Wire Transfers
Wire transfers are similar to ACH transfers. In fact, ACH is a U.S. domestic wire transfer that only goes through the U.S. federal reserve. International wire transfers go through two ACH systems and thus take longer, about 2 business days, and cost more (up to $35 per transaction).
International wire transfers are executed without money transferring between the sending and receiving bank. The sending bank sends transfer instructions (not funds) to the receiving bank, then the receiving bank uses their own funds to deposit the payment into the receiver’s bank account. The two banks settle the balances later directly between themselves.
Process for sending an international wire transfer (refer to image 4 above):
The sender submits the wire transfer instructions to their bank
The sending bank sends payment instructions to the receiving bank via the global SWIFT global payment network
The SWIFT payment network forwards the message to the receiving bank
The receiving bank uses the instructions to credit the receiver’s individual bank account with the funds in their local currency.
The receiving bank sends an acknowledgement of the completed transaction to the SWIFT network.
The SWIFT network sends an acknowledgement of the completed transaction to the sending bank
The sending bank informs the sender that the transaction was successful.
The sending and receiving banks settle the funds between them via a separate transaction.
Real-time Payments
The newest entry in the bank account to bank account payments space is real-time payments (RTP)(aka instant payments). RTP schemes allow two parties to exchange funds in seconds with no recourse for refunds or charge-backs (similar to wire transfer). According to pymnts.com, global real-time payments volume has grown to $10.6 billion in 2020 and is estimated to grow at a 33% annual compound rate from 2021 to 2028.
There are many real-time payments networks around the world — all of which are not, yet, interoperable. For example, in the U.S. you have the RTP Network operated by The Clearing House (TCH) and the upcoming FedNow network operated by the U.S. Federal Reserve. U.K. real-time payments runs through the Faster Payments Service (FPS) network. Brazil operates the PIX instant payment platform. And in India you have the Unified Payment Interface (UPI).
Both consumers and businesses sending and receiving payments are driving the growth of RTP. Consumers like it because they can receive payments instantly (think gig workers, contractors, insurance settlements, and other payout) and send payments just as quickly (e.g. last-minute bill pay to avoid late fees, sending money to friends and family directly to their bank accounts without the use of a third-party app and at low costs). Businesses love it because it cost less to receive payments (less than 50 cents per transaction), the payments are instant (immediate reconciliation to their internal financial systems), final (no worries about charge-backs), and include enhanced data about the transaction to support fraud detection, risk management and internal reporting/cash flow management. Consumers and Businesses like RTP so much that some are willing to pay a premium for this product and, based on surveys, would move to a different bank to access RTP. RTP poses a long-term threat to domestic ACH and wire transfer, and to credit cards.
Downsides to RTP include:
Consumers can’t request forced refunds from card networks in case of disputes (charge-backs) like they can with credit card networks. [This is the one area that will never get addressed by RTP since payment finality is a core proposition of RTP; however, consumers will still be able to work directly with merchants to negotiate refunds, they may also continue reporting “bad” merchants to organizations like the Better Business Bureau and online review sites.]
Consumers will lose out on credit card points. [May get partially addressed by merchants offering lower prices to those who pay with RTP rather than credit cards.]
Payment finality exposes merchants and consumers to potentially greater fraud risk. [The risk is likely much lower than that of ACH and wire payments because payer must first authenticate themselves via their online bank account prior to sending the payment — this significantly reduces the likely of fraud.]
Real-time payments is not fully available globally. These networks are at early stages and still evolving — especially in the U.S. Banks are slow to adopt because they must make significant investments in infrastructure and personnel that may not payoff for many years due to the lower fee structure of real-time payments. Banks are quicker to adopt instant payments in countries where they’re mandated to buy local governments.
Image 5 below presents the real-time payment flow for the U.S. TCH and FedNow networks.
U.S. TCH and FedNow Real-time payments flow (image 5)
Sender initiates a real-time payment via their bank to send funds from their bank account to the receiver’s bank account.
Sender Bank sends an RTP message, in appropriate format, to either the TCH or FedNow (pending) network requesting a payment transfer.
TCH/FedNow sends a notice to Receiving Bank that Sending Bank wants to transfer funds to their customers bank account
Receiving Bank sends acknowledgement/approval message to TCH/RTP
TCH/Fednow transfers funds from Sending Bank to Receiving bank, then sends acknowledgement to Sending Bank that transfer was completed
TCH/Fednow sends acknowledgement to Receiving Bank that transfer was completed
Sending Bank sends acknowledgement to sender that money transfer is complete
Receiving Bank sends acknowledgement to receiver that money transfer is complete and that funds are available for them to use
All this happens in seconds!
Apple Pay, Google Pay, Venmo, PayPal, etc.
When you send a direct payment (not a credit card transaction) to a person or business using Apple Pay, Google Pay, Venmo, or PayPal, the recipient doesn’t actually receive the money in their bank account. The money sits in a sub-account that those apps maintain in the receiver’s name. If the receiver wants to spend that money outside of those apps, they have to withdraw the funds into their bank account (which can take up to two days, or cost money if they want it quickly). These apps are closed, proprietary payment systems managed by the app companies; however, these closed systems are convenient in that they make it easy to send/receive money to/from anyone using just their email address or app ID. This simplicity makes these apps the “go to” payment method for millions of people globally.
Bitcoin, Lightning Network, and crypto in general
With Bitcoin and other cryptocurrencies, the payment flows described in images 1 to 4 are greatly simplified. Cryptocurrencies allow you to send and receive payment to and from businesses and individuals quickly and without any third party in between (see image 5 below).
Also, crypto payment apps like Strike allow you to send money to anyone around the world in recipient’s local currency using your local currency as the starting payment instrument; the currency exchange is handled instantly by Strike via an instant transfer of Bitcoin from sender to receiver on the Bitcoin Lightning Network, followed by an immediate exchange of Bitcoin to the receiver’s local currency — all done in the background without the sender or receiver even noticing. All that’s required is for the recipient to have the Strike app on their phone or web browser.
Using the Lightning Network, you could exchange Bitcoin directly and instantly with the receiving party and bypass local currency conversion if both parties agree on a straight Bitcoin/crypto payment (image 6).
Let’s dig a little more into what happens when someone sends a Bitcoin payment to a friend using a payment app like Strike (similar process happens for payments via Coinbase Wallet, Trust Wallet, Metamask, and other crypto payment wallets/apps). Image 7 depicts the steps and participants in a Bitcoin payment flow.
Let’s walk through the crypto payment process (image 7):
The sender (Jane) uses Strike to enter receiver’s (Sarah) Bitcoin address and an amount to send
Using its copy of the Bitcoin blockchain (a Bitcoin node), Strike submits the transaction to the Bitcoin network (or via the Lightning Network that sits on top of the Bitcoin network if Sarah sends Jane a Lightning Network invoice)
The transaction is included in the Bitcoin blockchain, and Sarah’s Strike app observes the Bitcoin payment sent to the Sarah’s Bitcoin address
Sarah receives a notification from her Strike app informing her about the Bitcoin payment from Jane
Sarah can use the received Bitcoin to pay for goods and services or convert it to her local currency within the Strike app itself.
It’s possible for both Jane and Sarah to eliminate Strike or any other third party from this flow by running their own Bitcoin node (advanced topic).
Summary
In this article we reviewed payment flows for credit cards, debit cards, ACH, wire, Venmo/PayPal/Apple & Google Pay, and crypto payments. They each have their strengths and weaknesses. Credit cards are popular but are expensive for merchants to accept and not accessible to everyone. Debit card transactions are cheap for merchants but require both parties to have a bank account and rely on third parties to handle the payment. ACH and wire can be costly, slow and rely on third parties that may only operate on business days. Venmo, PayPal and similar apps do not deposit funds in a bank account and are closed, proprietary systems. Crypto payments are cheap, instant (using the right apps or blockchains), remove third parties, and operate 24x7, but are not widely adopted and are potentially risky for payment of goods and services due to potential price variability of the underlying cryptocurrency.
Despite their faults, these payment options give merchants and consumers a wide array of options to exchange value depending on their comfort with technology and preference for transaction speed, cost, convenience, or privacy.