credit card industry
Part one in a series of postings about the workings of the credit card industry.
DEFINITIONS
First some terms, along with the meanings they have in the industry:
- Cardholder - an individual to whom a credit card is issued. Typically, this individual is also responsible for payment of all charges made to that card. Corporate cards are an exception to this rule.
- Card Issuer - an institution that issues credit cards to cardholders. This institution is also responsible for billing the cardholder for charges. Often abbreviated to "Issuer".
- Card Accepter - an individual, organization, or corporation that accepts credit cards as payment for merchandise or services. Often abbreviated "Accepter" or "merchant".
- Acquirer - an organization that collects (acquires) credit authorization requests from Card Accepters and provides guarantees of payment. Normally, this will be by agreement with the Issuer of the card in question.
Many issuers are also acquirers. Some issuers allow other acquirers to provide authorizations for them, under pre-agreed conditions. Other issuers provide all their own authorizations.
TYPES OF CARDS
The industry typically divides up cards by the business of the issuer. So there are bank cards (VISA, Master Card, Discover), Petroleum Cards (SUN Oil, Exxon, etc.), and Travel and Entertainment (T&E) cards (American Express, Diners' Club, Carte Blanche). Other cards are typically lumped together as "Private Label" cards. That would include department store cards, telephone cards, and the like. Most private label cards are only accepted by the issuer. People are starting to divide the telephone cards into a separate class, but it hasn't received widespread acceptance. (This is just a matter of terminology, and doesn't affect anything important.)
Cards are also divided by how they are billed. Thus there are credit cards (VISA, MC, Discover, most department store cards), charge cards (American Express, AT&T, many petroleum cards) and debit cards. Credit cards invoke a loan of money by the issuer to the cardholder under pre-arranged terms and conditions. Charge cards are simply a payment convenience, and their total balance is due when billed. When a debit card is used, the amount is taken directly from the cardholder's account with the issuer. Terminology is loose - often people use "credit card" to encompass credit cards and charge cards.
A recent phenomenon is third-party debit cards. These cards are issued by an organization with which the cardholder has no account relationship. Instead, the cardholder provides the card issuer with the information necessary to debit the cardholder's checking account directly through an Automated Clearing House (ACH), the same way a check would be cleared. This is sort of like direct deposit of paychecks, in reverse. ACHs love third-party debit cards. Banks hate them.
Another recent addition is affinity cards. These cards are valid credit cards from their issuer, but carry the logo of a third party, and the third party benefits from their use. There is an incredible variety of affinity cards, ranging from airlines to colleges to professional sports teams.
HOW THEY MAKE MONEY
Issuers of credit cards make money from cardholder fees and from interest paid on outstanding balances. Not all issuers charge fees. Even those that do, make most of their money on the interest. They really LIKE people who pay the minimum each month.
Issuers of charge cards make money from cardholder fees. Some charge cards actually run at a loss for the company, particularly those that are free. The primary purpose of such cards is to stimulate business.
Issuers of debit cards may make money on transaction fees. Not all debit card transactions have fees. Most debit cards exist to stimulate business for the bank and to offload tellers and back-room departments. To date, third-party debit cards exist solely to stimulate business. Providers of such cards make no direct money from their use.
Acquirers make money from transaction charges and discount fees. Unlike the charges and fees mentioned above, these fees are paid by the accepter, not (directly) by the cardholder. (Technically, it is not legal for the merchants to pass these charges directly to the consumer. Some petroleum stations have gotten away with giving a discount for cash, and it has survived court challenges so far.) Transaction charges are typically in pennies per transaction, and are sensitive to the type of communication used for the authorization. Discount fees are a percentage of the purchase price and are sensitive to volume and compliance to rules. One way to encourage merchants to follow certain procedures or to upgrade to new equipment is to offer a lower discount fee.
Until fairly recently, the only motivation for accepters was to expand their business by accepting cards. Reduction of fraud was enough reason for many merchants to pay authorization fees, but in many cases, it isn't worth the cost. (That is, it is cheaper to pay the fraud than to prevent it.) Recently, electronic settlement has provided merchants with an added benefit by reducing float on charged purchases. Merchants can now get their accounts credited much faster than before, which helps cash flow.
Companies that issue charge cards are real keen on float reduction. The sooner they can bill you, the sooner they get their money. Credit card companies are also interested in float reduction, since the sooner they bill, the sooner they can start charging interest. Debit cards typically involve little or no float.
Affinity cards usually pay a percentage of purchases to the affinity organization. Although it may seem obvious to take this money from the discount fee, this doesn't work since the issuer is not always the acquirer. The money for this usually comes from the interest paid on outstanding balances. Essentially, the bank is giving a share of its profits to an organization in turn for the organization promoting use of its credit card. The affinity organization is free to use its cut any way it wishes. An airline will typically put it into the frequent flyer program (and credit miles to your account). A college may put the money into the general fund or into a scholarship fund. Lord only knows what a sports team does with the money!
THE PLAYERS AND THEIR ROLES
American Express (AMEX) is a charge card issuer and acquirer. (Their other businesses are not important to this discussion.) All AMEX purchases are authorized by AMEX. They make most of their money from the discount fees, which is why they have the highest discount fee in the industry. That's one reason why AMEX isn't accepted in as many places as VISA and MC, and a reason why many merchants will prefer another card to an AMEX card. The control AMEX has over authorization allows them to provide what they consider to be better cardholder ("cardmember" to them) services.
VISA is a non-profit corporation (SURPRISE!) that is best described as a purchasing and marketing coalition of its member banks. VISA issues no credit cards itself - all VISA cards are issued by member banks. VISA does not set terms and conditions for its member banks - the banks can do pretty much as they please in signing cardholders. All VISA charges are ultimately approved by the card issuer, regardless of where the purchase was made. Many smaller banks share their account databases with larger banks, third parties, or VISA itself, so that the bank doesn't have to provide authorization facilities itself.
Master Card (MC) is very much like VISA. There are some differences that are important to those in the industry, but from the consumers standpoint they operate pretty much the same.
Discover cards are issued by a bank owned by Sears. All Discover purchases are authorized by Sears.
Most petroleum cards, if they are even authorized, are authorized by the petroleum company itself. There are exceptions. Fraud on petroleum cards is so low that the main reason for authorization is to achieve the float reduction of electronic settlement.
THE BUSINESS RELATIONSHIPS
Card acceptors generally sign up with a local acquirer for authorization and settlement of all credit cards. This acquirer may or may not be a card issuer, but certainly will not have issued all the cards that the merchant can accept. The accepter does not generally call one place for VISA and a different place for MC, for example. At one time, this was necessary, but more and more acquirers are connected to all networks and are offering a broader range of services.
Acquirers generally are connected to many issuers, and pay transaction charges and discount fees to those issuers for authorizations. Thus, the acquirer is actually making money on the difference between fees paid and fees billed. Most acquirers gather together transactions from many accepters, allowing them to get volume discounts on fees. Since the accepters individually have lower volume and are not eligible for those discounts, there is a markup that the acquirer can get away with. Acquirers also, of course, provide the convenience of a single contact.
Most large banks are issuers and acquirers. Things get real interesting when it's time to settle up. Some small banks are only issuers. There are third parties that are only acquirers.
In future episodes, I'll explain how standards help all this chaos work together, and give details about how the authorization process happens.
Joe Ziegler
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