How does the payments ecosystem work?

Answer by Faisal Khan:

This is a pretty wide open question. Will try to answer as much as I can. I've included more visual versus text, as visuals can very easily get the point across, in a few minutes. Should you wish to explore further, I have provided some relevant links for further reading.

First of all, the definition. When discussing payment systems, it is so easy to have different understanding of what a payment system is.

WHAT IS A PAYMENT SYSTEM?

a payment system consists of a set of instruments, banking
procedures and, typically, interbank funds transfer systems that
ensure the circulation of money

Glossary definition from the Committee on Payment and Settlement Systems (BIS – Bank of International Settlements). See glossary at: http://www.bis.org/publ/cpss00b.pdf (March 2003)

In its basic form a payment ecosystem has this very important singular relationship, without which a payment cannot be made:

The whole concept of a "payment" is to exchange money between two parties, so hence the Payer and Payee concept.

*Barring Bitcoin, regulated money (which is what 99.999+% of us use) requires a bank. It is not necessarily that a bank is required to move money, but a Bank is at the core, for example in Cash-to-Cash transaction, whilst a bank is not involved, a Bank was the source of the cash and could very well be the destination of cash as well (if) and when it gets deposited.

The definition of a Payment System can be visualized as follows:

The Payment Instrument section above can be expanded as:

Central to all this is the Bank, and how the bank interacts with various entities would be explained below. First, you have to understand with whom a commercial bank can interact with:

The above essentially represents the eco-system in which a commercial (non-investment bank) is operating in. The ovals in purple, represents the various verticals a bank can choose to associate themselves with and work in/with.

A slightly wider view of the same would be:

Credit: Above visuals are extracted from the presentation "An Introduction of Payment Systems" by Dyah N.K. Makhijani, Bank Indonesia. Source: http://www.bi.go.id/NR/rdonlyres…

As far as Banks are concerned, there are many types of banks, below is a pictorial representation of the different types of banks:

PAYMENT SYSTEMS LAYER (REGULATORY)

In most cases, a payment's ecosystem has a hierarchy of how the central bank is, then commercial banks, the payments layers and companies that work with the payments layer (as one of the examples, here is how a payments system hierarchy looks like for startups in a particular model that I was trying to demonstrate):

The concept shown in the above diagram in a rudimentary form was to show that in most cases, Startups work with a Payment Service Provider who work with Banks, who are regulated by the Central Banks.

THE FINANCIAL SWITCH ECOSYSTEM

The Switch in the Payment's Ecosystem is extremely important, it is what allows for a lot of the connectivity and transactions routing/communication to go through.

Below is an example what the transaction set of a unified switch would look like. Not every transaction set shown below has to be on the switch, this is just a unified example, it all depends from switch to switch and operators/usage of that switch.

BANK TO BANK (SETTLEMENT OF FUNDS)

One thing that confuses people a lot is how is the bank to bank settlement done?

I wrote a detailed answer on this which can be read here: Faisal Khan's answer to Online Payment Gateways and Processing: How does the settlement of payments work in banks?

WIRE TRANSFERS – HOW DO THEY WORK?

From a wire transfer point of view, what exactly happens when a Wire Transfer is made, please read this answer: Faisal Khan's answer to What exactly happens when a wire transfer is made?

WHAT HAPPENS WHEN YOU CHARGE YOUR CARD?

From a merchant's POV, the payments ecosystem processing looks something like this:

In a process flow, it would look something like this:

Since everyone has a slightly different way of representing flows, here are a few more:

and another one:

Nomenclature aside, the key players/components are the same:

Role of an Acquirer: the acquirer (Chase, First Data, etc) solicits, underwrites and owns the merchant account. They provide technology and hardware, which enables the merchant to process the transaction.

Role of the Issuer: The issuer is the bank (Capital One, CIBC, RBC, etc) that provides the cardholder with their credit card. They bare the responsibility of approving the cardholder and billing and collecting the owed funds from cardholder.

Credit Card Associations: Associations (Visa, MaterCard, AMEX, et) are commonly referred to as the credit card and debit card companies. The role of the associations is to govern the policies pertaining to their bank cards, monitor processing activity, and oversee the clearing and settlement of transactions. Currently VISA is the most popular association with approximately 65% transaction volume.

ISOs (Independent Sales Organizations): ISOs (Payfirma, Square, etc) are organizations that partner with acquirers to open merchant accounts, handle support, manage payment processing, and build added-value technology on behalf of acquirers. ISOs do this in exchange for a percentage of the transaction volume.

Merchant: The merchant is a business owner who submits a request to an ISO/acquirer for the ability to accept credit. Merchants are approved under the qualifications set by the associations and the policy of the underwriters.

Cardholder: Cardholders (consumers) are customers of a bank that request a credit card. The cardholder will be approved by the issuer based on credit worthiness.

Source: Payment Processing 101

Here is a graph of how transfer fees in a credit card transaction works:

A simple visual, to give you an example of some of the vendors involved:

Juxtapose this to mobile payments, and it is inherently no different. Below visual shows the various types of payment systems.

Here is another infographic on the mobile-payment ecosystem:

On the processing side, you might want to read this answers:

One other link I would like to recommend to understand how consumers make choices as far as payment instrument of choice is concerned: The 2009 Survey of Consumer Payment Choice

To better understand the various payment systems – these two infographics are worth reading and are must-read/must-have.

Evolution of Payments Market Map (2011)

Mobile Payments and Banking Market Map (2012)

Both these PDFs can be downloaded for free from: Downloads: Market Maps

You may also want to have a look at BIS (Bank of International Settlements), they have an excellent repository of reports (PDFs) on various payment systems around the world. Source: Payment and settlement systems in selected countries

There is just so much information out there. Inbox me if you require more information.

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