Card Networks: ELI5

Diners Club was the first open loop (meaning used across many merchants) card network.  Cards were issued by restaurants to accept monthly billing from select loyal clients. Within the first year, they had reached 10,000 card members who wanted the convenience to buy now, but pay later.

The largest card networks today are Visa and Mastercard, with a cool $10.4T and $4.8T of 2021 payments volume respectively.

What is a card network?

Card networks reduce payments friction to almost zero (except in Web3), and create a set of incentives for all stakeholders in their network.

  • Users get convenience and security, often at no direct cost
  • Merchants get higher conversion rates at decreasing risk
  • Banks earn revenue on both sides of the transaction

There are four major card networks: Visa, Mastercard, AMEX and Discover. Each performs the following key functions:

  • Enforce network rules
  • Maintain network security
  • Determine eligibility for network membership (Issuers + Acquirers)

Some card networks, such as AMEX, are also issuers that directly provide customers with payment cards. Others, like Visa and Mastercard, partner with banks and financial institutions to issue cards on their behalf.

What parties are required to make a transaction?

  • Cardholder: 70% of Americans 18+ have at least one credit card.
  • Merchant: The business that is accepting card payments.
  • Issuing bank: The financial institution that issues the credit or debit card to a cardholder.
  • Acquiring bank: The financial institution that “sponsors” the merchant and  payment processor, thereby enabling them to accept card payments
  • Card network (the communication system): As the bridge between the issuing and acquiring bank, the card network ensures that transaction information and approvals are delivered to all parties and that the funds are settled

How are credit cards processed?

Transaction processing is split into two events; authorization and settlement. 

Here’s an overview of how card transactions are approved:

  1. The cardholder provides their details. The customer enters their card information through an online payment gateway, or presents it to a physical payment terminal. 
  2. The merchant issues a request. The card and transaction details are captured and sent to the acquiring bank.
  3. The request is routed to the issuing bank. The acquiring bank takes the request and routes it to the issuing bank for approval using the appropriate card network. For instance, Visa cards are routed through Visanet and Mastercard cards are routed through Banknet.
  4. The issuing bank approves or declines the transaction. There are several pieces of information that an issuing bank will use in their approval decision, including, validating that card details and address information match the customer record at their financial institution, ensuring sufficient funds, and confirming that the account is in good standing. 
  5. A response is sent back to the merchant. The issuing bank sends a response code to the acquiring bank and the merchant to let them know if the transaction was approved or denied. If the transaction is approved, it’ll move forward to the settlement phase where the approved funds are deposited into your merchant account. 

The authorization process happens at an average speed of under two seconds. Within 24-48 hours, the authorization becomes a settled transaction.

Card Processing Fees (aka. Discount Rates)

Processing fees, known as merchant discount rates, are the fees paid by a merchant to process card transactions. Merchants with low transaction volumes can expect to pay about 3% plus $0.30 per transaction.  This fee includes interchange paid to the issuing bank, assessment fees collected by the network, as well as fees for using the processors software/hardware.  

Payment processors like Stripe and Square use this simplified pricing model because it is a better reflection of the overall mix of software, services, and transaction processing that the merchant is consuming. It’s also a simpler way for small merchants to buy these services.

Higher volume merchants, that are willing to take more responsibility for fraud, should opt for “cost plus” pricing. Card transactions are processed at different interchange rates depending on the type of transaction (card present vs. card not present) and the type of card (credit vs. debit), and a handful of other factors.  With cost plus pricing, you will be charged the true cost of processing, plus an agreed upon margin.  

Card payments for high-risk merchants

The type of business accepting payments has a significant impact on their processing fees, as well as how fraud losses are handled. Payment processors need to offset the risk of servicing a merchant that has a higher chance of fraud, returns or chargebacks. 

What impacts a merchant’s risk profile

There are several reasons why a payment processor may consider a merchant to be high-risk. Each provider has its own set of criteria, but you can expect these categories of reasons: 

  • New merchant: A merchant with no processing history is higher risk than an established business 
  • International business: A merchant that transacts with customers in certain countries may be considered higher risk
  • High value transactions: Larger transaction sizes mean more risk per transaction
  • High-risk industry: There is a list of industries and business activities that providers consider high-risk, for example cryptocurrency, gambling, and adult content

How do banks identify high-risk merchants?

All card network transactions must include a merchant category code (MCC). The MCC is a four-digit number that helps banks identify the business activity associated with a specific transaction. For example, all transactions involving the sale or exchange of cryptocurrency must be processed using MCC 6051.  MCC 6051 is reserved for Quasi-cash transactions.  It’s the same MCC used for the sale of money orders and travelers checks.

Based on data from our customers, 70% of cryptocurrency purchase attempts with a card fail. 

Some other ways that issuing banks use MCCs: 

  • To offer cashback or reward points for qualified purchases
  • To determine the interchange fee to charge merchants 
  • To identify and restrict transactions from prohibited industries
  • For tax reporting purposes 

There are over 500 different MCC codes and they can differ between card networks, but they are generally similar. Citi provides a good source for a comprehensive list of typical MCC codes.

What additional fees and terms should high-risk merchants expect?

Card processors charge high risk merchants additional processing fees averaging about 1%. In addition to that, you can expect the following: 

  • Long contract terms: For taking on the risk of working with a high-risk merchant, card processors may require longer contract terms of up to three years. 
  • Higher chargeback fees: Some providers may charge high-risk merchants higher chargeback fees to offset the risks. 

Rolling reserve: a percentage, typically 5-10%, of your monthly gross merchant sales could be held in a reserve for a period of time before it becomes available to you as a way for the provider to manage risk. 

Bottom line

Web3 businesses have unique challenges when it comes to payments processing. Card payments fail 70% of the time when users attempt to exchange dollars for cryptocurrency.  

Even in the 30% of cases where card payments succeed, the high cost of card transaction processing does not align with the economics of most Web3 transactions and business models. 

Next up, we’ll look at bank account payments (ie ACH) as an alternative to cards.