We recently ran across a document from the Philadelphia Federal Reserve, entitled “The Merchant-Acquiring Side of the Payment Card Industry: Structure, Operations and Challenges“.  One of the biggest problems that business owners have in negotiating and understanding thier credit card processing contracts is that they don’t understand the economics of the credit card processor (also known as the merchant acquirer).  This is a 29 page document that is relatively easy to read.  If you really want to understand how payment processing works, we highly recommend it.  For those who don’t want to invest the time to read the whole thing, here is a short summary of the most important points:

* For bank-centered networks such as Visa and Mastercard, the Merchant Acquirer is defined as the member financial institution responsible for its merchant-customers’ transactions with the network.

* The work conducted by the merchant acquirer includes: 1. Signing up merchants to accept the cards, 2. providing the means to authorize valid card transactions at the client merchant locations, 3. Facilitating the clearing and settlement of the transactions through the payment network, and 4. Providing other services such as sending out statements to the merchant.

* In practice, the member banks typically outsource big portions of that work to third-party (non-banks).  Often those third parties (companies like First Data, TSYS, North America Bankcard, and Heartland Payment Systems) do so much of the work that they are referred to as the Merchant Acquirer, even though they don’t meet the technical definition.

* Of the above tasks, #2, #3 and #4 are all highly automated tasks best carried out by very large companies with massive scale.  #1, signing up and helping merchants accept cards is the most labor-intensive and and least scale-dependent.  That’s why, while there are only a few companies that maintain processing networks, there are thousands of small companies that sign other small companies up to accept credit cards.  Such companies are called ISOs (Independent Sales Organizations).

* When credit cards first came into existence in the 1960s the market was made up of local banks who conducted both the issuing and acquiring functions.  They issued cards to their personal banking customers and helped their business banking customers accept cards. Since then, the industry has consolidated, with most local banks getting out of the business.  Issuing credit cards has become dominated by a few large banks including Bank of America, Chase, Capital One and Washington Mutual.  Dealing with merchants who accept credit cards has become dominated by another group of large banks including 5th/3rd, USBancorp and Chase, as well as a few large non-banks such as First Data and Heartland Payment Systems.

* Merchant Acquirers have few ways to differentiate their services to their merchant customers and therefore rely mainly on price to attract new customers.

* Chargebacks (transactions that are disputed by the cardowner – usually because of fraud) are a very small percentage of total transaction volume.  Only about 0.015%- 0.025% of total credit and debit transaction volume is charged back.

* In 2006 there were 6.1 million merchants that accepted credit and debit cards.

* In every credit or debit card transaction there are three parties that get paid: 1. The network (Visa and Mastercard) gets to keep about 0.10%.  2. The card-issuing bank (like Capital One) gets about 2% passed on to them, depending on the kind of transaction.  The exact amount passed on to them depends on a complicated set of rules called Interchange. 3. The merchant acquirer gets to keep the rest (about 1.8% from the smallest businesses and about 0.06% from the largest businesses).

* Small and Medium merchants (those processing <$1M in credit card volume / year) make up only 20% of

credit and debit card transaction volume but contribute 67% of merchant acquirer revenue.  In other words, merchant acquirers make most of their money off small business owners because they have a much smaller markup on the transaction volume of large businesses since the large businesses are more powerful negotiators.

* The card-issuing banks, however, get to keep approximately the same percentage of a transaction occurring at a large merchant as they do from a transaction occurring at a small merchant.