Credit Card Processing

Table of Contents

1. How does credit card processing actually work?
2. How does clearing and settlement work?
3. What are best practices for credit card processing?
4. What merchants need to know about card processing
5. What is a credit card processing service?

At a glance, processing a credit card payment seems like it couldn't be more straightforward. The card goes in the slot, the terminal does some behind-the-scenes communication with the credit card mothership, the customer scribbles a rough approximation of their signature on the screen, and presto—a transaction has occurred.

For the layperson, this explanation may be sufficient, but merchants need a better understanding of the technical details of credit card processing in order to protect themselves from fraud and chargebacks. What do merchants need to know about how credit card processing works, and how can this inform the best practices for handling transactions?

The simplicity of credit card processing on the consumer end is highly dependent on choices the merchant makes: Which payment processor to use, what protocols to observe, and how to configure the payment terminal to balance ease-of-use versus security.

Creating a streamlined, friction-free experience for the customer can come at the cost of increasing the risk of fraud. This is especially true in card-not-present environments, where merchants cannot rely on physical security features like EMV chips. Almost every security measure a merchant puts in place comes with some downside, whether that's the occasional rejection of a legitimate transaction or some additional action you're requiring of all your customers.

The choices merchants make about things like how to handle various authorization messages, or when to re-run a declined transaction, can have a big impact on the outcome of disputes that involve these transactions.

In order to make the best and most informed decisions about credit card processing, let’s take a closer look at all of the steps involved in it.

How does credit card processing actually work?

Many steps are involved between the initiation of a transaction and the moment when the buyer’s funds actually land in the merchant’s bank account.

Processing begins when the customer provides their payment card credentials to the merchant. In a card-present setting, this means inserting the card into a chip reader or swiping it. For card-not-present merchants, the credentials must be submitted electronically. The merchant may receive this information directly (when taking an order over the phone, for example) or it may be sent to a secure payment gateway.

The following details are typically required for authorization:

• The full account number
• The expiration date
• The transaction amount
• The cardholder’s billing address
• The Card Verification Value (CVV) code 

The terminal or gateway then sends this information to the merchant’s payment processor, which passes it on to the credit card network in charge of the customer’s card brand. The card network, in turn, contacts the cardholder’s issuing bank to request payment authorization.

The issuing bank will authenticate the transaction by verifying that the account number is valid, that the billing address and CVV match, and that the customer has sufficient funds or credit in their account. Based on these factors, they will then provide an “approve” or “decline” response by sending an authorization code back through the same channels. In addition to indicating whether the transaction has been approved or declined, the authorization code can also provide more specific information, such as the reason for the decline or instructions for the merchant to call the bank or maintain possession of the card if possible.

If the merchant receives a code indicating that the transaction has been approved, they can go ahead and finalize the purchase. The issuer will place a hold on the cardholder’s account for the purchase amount pending settlement, and the merchant can then request a customer signature and provide a receipt.

How does clearing and settlement work?

As every merchant knows, a completed transaction doesn’t mean the money is in their account yet—clearing and settlement have to happen before the funds are actually there, although some banks provide an immediate credit to the account at this point in the process to speed things up.

Merchants add completed transactions to batches that are submitted to their payment processor, usually once at the end of each business day. Once again, the processor will hand these off to the card networks, which will forward each transaction to the issuing bank to which it belongs.

The issuers submit the funds for these transactions back to the card networks on their way to the merchant's account. This is the clearing phase, which should take no more than one to two business days. Dynamic currency conversion, if necessary, will also take place during this phase.

The card network sends the funds to the acquiring bank. Then the appropriate fees are divvied up between the issuing bank, card network, and payment processor. Once the remaining funds are in the merchant account, settlement is complete.

What are best practices for credit card processing?

One of the most important things a merchant can do to keep their payment processing smooth, secure, and affordable is to choose a good payment processor.

This is one of the biggest reasons why it’s so important to keep your chargeback rate down: if you’re classified as a “high risk” merchant due to excessive chargebacks, you may be blackballed by mainstream payment processors and forced to deal with the ones that accept high-risk merchants. These processors charge significantly higher fees and their quality of service may not be up to the same standard.

Worse yet, if a merchant finds themselves on the MATCH list, which they usually will if their merchant account is terminated due to excessive chargebacks, it takes years of good behavior to get their name removed from it. Many merchants who find themselves on the MATCH list have enough additional problems and costs as a result that they don't last that long. With chargebacks, as with many things, prevention is the best medicine.

Merchants who keep their chargeback rates low, on the other hand, will often have their pick of the best payment processors.

The ideal payment processor should offer a fast, reliable network; an affordable and transparent pricing structure, and attentive, 24/7 customer support.

For their own part, merchants should process transactions in a way that eliminates the possibility of fraud and chargebacks as much as can reasonably be achieved.

Merchants should always require address verification and CVV matching and should never force a transaction that received a “decline” response by attempting to resubmit it until it goes through, except in the case of specific issues as indicated by the authorization code, such as a network error. Many chargeback reason codes are specifically tied to authorization issues, and merchants rarely have good standing to fight a chargeback filed on these grounds.

In card-present environments, merchants should also obtain signed receipts whenever possible. Most importantly, merchants should never use the magnetic stripe on a card with an EMV chip. For one thing, this can expose merchants to fraud committed using cloned cards with fake EMV chips. For another, the merchant will be automatically held responsible for any chargebacks resulting from transactions processed this way. Keeping up to date with best practices in payment processing can help you avoid liability and fight fraudulent chargebacks.

What merchants need to know about card processing

Credit card processing may look simple on the surface, but it really is a complex multi-step affair that involves many parties beyond just the merchant and customer.

Choosing a reputable and reliable payment processor and following the guidelines and best practices for transaction procedures can save you money and protect you from fraud, chargebacks, and customer friction.

Just remember that a strong chargeback defense strategy is essential if you want to be able to choose from among the best payment processors—let your chargeback ratio get too high, and you could end up stuck paying exorbitant fees to a high-risk processor.

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