Clearing and settlement in payment card schemes
In 2004 MasterCard and Visa processed more than 45 billion card payments and some $3 trillion was cleared and settled between their member banks. The majority of these payments were made with classic debit or credit cards which work both off-line, where a transaction is not controlled directly by a computer, and on-line, where a card is connected direct from the point of sale (POS) to the card issuer.
To understand how clearing and settlement works in the MasterCard and Visa systems take the example of a payment involving a cardholder from France who has a French bank-issued euro-based card and is visiting the UK, which uses sterling. On Day 1 the cardholder buys an expensive item from a store in the UK, which is above the store’s floor limit set by the merchant acquirer and therefore requires an authorisation from the card issuer in France. The typical processes (in a dual message transaction), the authorisation, clearing and settlement carried out in most MasterCard and Visa payment card transactions, are described below. There is some variation by type of message transaction, card and country, but overall the authorisation, clearing and settlement processes are basically the same.
Mostly payment card transactions are on-line and authorised direct by the card issuer, i.e. the card issuer authorises a specific payment to be made from one of their cardholder’s accounts. The percentage of transactions authorised on-line varies considerably by country, e.g. in France less than 30 per cent of transactions are authorised, in the UK more than 70 per cent and in the USA more than 99 per cent.
Each merchant or retailer in the MasterCard and Visa card schemes has one or more floor limits for transactions at their stores. The details of these floor limits are held either by the merchant or their acquiring bank. The process and the information flows in typical MasterCard and Visa card transactions, which are basically the same for domestic and cross-border transactions, are shown in Figure 1.
With magnetic stripe cards the merchant swipes the card and asks the cardholder to sign a slip. Then the terminal sends an authorisation request containing the card number, transaction amount and currency; transaction time and date; merchant ID, name, location and merchant type; acquirer and issuer IDs; and various card security information to the merchant’s bank which transmits this to MasterCard or Visa who then send it on to the cardholder’s bank requesting authorisation.
The cardholder’s bank approves the purchase and sends the approval to MasterCard or Visa who then pass it on to the merchant’s bank to transmit to the merchant.
The complete authorisation process typically takes one to three seconds. The banks involved can be anywhere in the world. MasterCard and Visa carryout their part in milliseconds, what varies is how long the cardholder’s and merchant’s banks take to process the request.
When the authorisation of the purchase is complete, the cardholder receives a MasterCard or Visa slip and a merchant receipt. After this, the clearing process, i.e. calculating and reconciling who owes what to whom, begins. The flows in the clearing process are shown in Figure 2.
First the merchant’s bank brings together the full payment transaction details which are made up of the basic authorisation data already sent to the issuer bank plus the authorisation code, EMV data, and with commercial T&E cards and purchase cards additional data on the transaction, e.g. car rental data, local tax/VAT details. MasterCard and Visa collect the data from member banks on the morning of Day 2. Their member banks have to make this data available by specified cut-off times which vary by currency, e.g. in Europe there is a cut-off time for the euro and one for other currencies.
MasterCard and Visa then prepare files for delivery to the acquirer and issuer banks. The primary purpose of these processes is to consolidate the debit transactions from different acquirers into one file for each issuer bank and files of chargebacks for the acquirer banks and to calculate the overall net balance due to be, or received, by each member bank. A fully reconciled daily clearing data file is prepared for each member bank. This clearing file is transmitted to each member bank some three to six hours after the initial data collection.
Each member bank chooses which currency or currencies they will settle in, usually the local currency, so in the example above the French bank will settle in euros. The clearing file specifies the net balance in the chosen settlement currencies that each member bank will receive or need to pay.
Both MasterCard and Visa’s volumes of foreign exchange are huge so they get exceptional FX rates from the banks they use. For some currencies both MasterCard and Visa add a very small mark up for currency conversion costs. Visa’s policy on FX rates is as follows: “Visa charges its issuing members a wholesale rate plus 0.84 per cent for currency conversion outside Europe. There is no mark-up within Europe. The member banks can choose to pass that on to the consumer and/or include an additional service fee, which they set. This is a highly competitive market and this is up to each individual Issuer.” But even with a small mark up MasterCard and Visa’s wholesale rates are extremely competitive.
To participate in MasterCard and Visa’s settlement systems member banks must open an account at a specified bank. Both MasterCard and Visa use a small number of major banks to carry out their settlements. The process is shown in Figure 3.
At a specified time and date the member banks are debited or credited at the settlement banks for the net balances outstanding for each of their settlement currencies. Typically euros and US$ are settled on Day 2, i.e. the same day the reconciled data files are received by the member banks, so the French bank in the example above would settle in euros on the same day. Other currencies are typically settled two days later.
When the cardholder’s account is debited and the merchant’s account credited depends on business decisions taken by the member banks, the payment card products used, and the size and type of merchant.
Most card issuing banks, particularly for revolving credit and charge cards, debit the cardholder’s account on Day 1, the date of the purchase, even though they are not debited for the fully cleared transaction until Day 2, the next business day. The mark up on the MasterCard and Visa FX wholesale rates vary by bank. A few issuer banks make no mark up but most charge cardholders between 1.5-3.0 per cent on each FX transaction, so in the example above the French cardholder could be charged up to 3 per cent for his purchase in sterling.
When the merchant acquiring banks credit their merchant’s account depends on many different factors. Most credit the merchant on the day the funds are received from MasterCard or Visa. If the merchant is very large and has considerable bargaining power in certain circumstances, which are tightly negotiated, the acquiring bank will credit the merchant on Day 1, the day the transaction is made, even though they do not get paid by the card issuer bank until Day 2.
A recent development in cross-border, multi-currency payments, as in the example above, is to offer cardholders at the POS (or when making purchases on-line) the option to pay in their local currency, so the French cardholder shopping in the UK could choose to pay in euros, the base currency of his card and know the exact cost of his purchase immediately. This amount is then debited from the cardholder’s account.
MasterCard and Visa provide the two largest global multi-currency clearing and settlement systems in the world. At present they are used primarily for consumer to business transactions but increasingly they are being used for business-to-business transactions because they offer so many advantages over the other payment systems.