How Card-based Merchant Acquiring Really Works
A review of the Payment Services Directive by the European Commission provides an opportunity for Simon Deane-Johns to clarify its scope by reference to how the major card schemes actually work.
The 'Payment Services Directive' (PSD) was intended to carve out the supply of certain 'payment services' from the European banking monopoly and harmonise the applicable regulations throughout the EEA. Those services include the execution of bank transfers, direct debits and money remittance. The expression 'acquiring of payment instruments' was also included, in an attempt to cover 'merchant acquiring' - the service that enables retailers to accept payment by credit cards and debit cards, amongst other payment methods. However, many merchant acquirers believe card acquiring falls outside the scope of the PSD. Uncertainty on the point appears to turn on confusion about how card-based merchant acquiring works, particularly in connection with the major card schemes. The launch of a mandatory review of the PSD by the European Commission has provided an opportunity either to align key provisions with how the major card schemes actually work or to clarify that card-based merchant acquiring is out of scope. While I have my views on the applicability of the PSD, this article merely seeks to ground the debate by setting out the relevant details of how the primary form of card-based acquiring works.
Card payment systems
The primary type of card payment system is the 'four-party' scheme operated by the likes of Visa and MasterCard. It comprises a series of automated processes, messages, transactions, clearing and settlement activities and funds flows enabled by a range of independent parties under separate contracts - as illustrated in Figure 1 (see the download panel opposite for Figure 1). Some variation may arise where multiple functions are performed by the same party, or supported by third party technical service providers who do not handle funds. The various types of contractual relationships may be summarised as follows:
1. the merchant services agreement between the merchant and the merchant acquirer who enables that merchant to accept card payments;
2. the business banking agreement between the merchant and its business bank account provider for the bank account to which the merchant acquirer pays the proceeds of transactions it acquires;
3. the acquiring licence granted by each card scheme operator to each merchant acquirer, which incorporates some provisions of the operator's card scheme rules (discussed below);
4. the merchant acquirer's banking agreement with its business banking service provider (except where these are one and the same entity);
5. the issuing licence granted by each card scheme operator to each credit card or debit card issuer, which incorporates some provisions of the operator's card scheme rules (discussed below);
6. the card issuer's banking agreement with its bank (except where these are one and the same entity);
7. the cardholder agreement between each card issuer and the cardholder, for the issue of a credit card or debit card - in the case of a debit card, the card issuer will also be the cardholder's current account provider;
8. the current account agreement between the cardholder and his or her current account provider (who, in the case of a debit card transaction, would also be the card issuer); and
9. the sale agreement between the cardholder (as purchaser) and the merchant, which governs the sale of goods or services.
In addition, card scheme rules specify the rights and obligations of each card scheme operator, and the merchant acquirer and card issuer respectively. Some of the card scheme rules are incorporated in the acquiring licence and/or the issuing licence. Because there is no direct contractual relationship between the card scheme operator and either the cardholder or merchant, some of the rules seek to control the conduct of cardholders and merchants by placing certain obligations on the card issuer or the merchant acquirer. For example,:
· the merchant acquirer (not the card issuer or the card scheme operator) is obliged to pay the merchant for the transactions that the merchant acquirer acquires from the merchant; and
· the merchant acquirer is obliged to ensure that the merchant follows certain protocols in facilitating the various types of card payment.
When a card is inserted by a cardholder into a merchant's card terminal (or the card details are entered into a payment page displayed via a merchant's web site), certain data flows from the merchant to the merchant acquirer. This data includes the details stored on the card, and usually an authorisation request. This data is passed by the merchant acquirer to the card scheme operator and from the card scheme operator to the card issuer. The purpose of this data flow is to enable the card issuer to make certain checks (eg, whether the card number is valid or is reported as stolen, and whether the cardholder has sufficient funds or credit available). Where the checks are satisfied, the card issuer sends its authorisation to the card scheme operator, who sends it to the merchant acquirer, who sends it to the merchant's terminal or e-commerce system.
If a transaction is authorised by the card issuer via the above process, the merchant confirms acceptance of the card as means of payment and the sale transaction is completed. The authorisation, along with the transaction data, is then passed from the merchant to the merchant acquirer, by the merchant acquirer to the card scheme operator and ultimately by the card scheme operator to the card issuer. However, the relationship between the authorisation and transaction is not always linear. For example:
· a merchant may request many authorisations and process a single transaction, or none (eg below a pre-assigned 'floor limit');
· the merchant usually creates a batch of transactions and sends these to the merchant acquirer, often as part of the 'end of day' processes at the merchant, or at a fixed time.
Settlement, Fund Flows and Timing
On 'Day 0': At multiple points during each day the merchant acquirer gathers all the batches of transactions it receives from its merchants and submits these to the card scheme operator in a single file. Files submitted prior to specific cut-off times are treated as 'same day' on receipt.
On 'Day 1': For domestic transactions, the card scheme operator:
Ø nets-off the amount that the card scheme operator determines is owed by each card issuer to the card scheme operator for all transactions it has cleared, against the amount of interchange fees related to those transactions that the card scheme operator determines that it owes to the card issuer;
Ø nets-off the amount that the card scheme operator determines that it owes to each merchant acquirer for the transactions it submitted, against amounts that the card scheme operator determines is owed to it by the merchant acquirer;
Ø produces and sends to each card issuer a settlement report listing the transaction data, and stating the net amount payable by the card issuer to the card scheme operator (less interchange to be retained by the card issuer);
Ø produces and sends to each merchant acquirer a settlement report stating only the net amount payable by the card scheme operator to the merchant acquirer (less interchange, card scheme fees, assessments, chargebacks and refunds) in relation to the transactions it submitted to the card scheme operator; and
Ø initiates a debit from the bank account of each card issuer for monies it owes to the card scheme operator (the timing varies depending on geography, currency or time zone).
Later on Day 1: On receipt of the card scheme operator's settlement report, the merchant acquirer's own payment systems will generate a payment report showing the amount owed to each merchant in respect of the transactions it submitted to the merchant acquirer. Note that this occurs irrespective of the day on which the card scheme operator is due to actually settle funds to the merchant acquirer. In fact, it is common for merchant acquirers to initiate payment to the merchant ahead of receiving funds from the card scheme operators. That is because the operators settle the net amount due to the merchant acquirer in tranches across Days 1, 2 and 3 depending on geography, currency and time zone. Merchant acquirers initiate payment instructions with their own bank (unless they are one and the same) to pay their merchant's business bank account for the transactions submitted by the merchant depending on merchant type and disbursement method. For example:
Ø to large merchants on Day 1 via CHAPS, for which the merchants may have provided security;
Ø to merchants which bank with certain banks where the merchant acquirer has specific disbursement arrangements for efficiency, on Day 2;
Ø to the remaining merchants via standard payment methods (eg BACS), on Day 3; and
Ø there are other arrangements (eg SWIFT) where merchants hold bank accounts in different countries or currencies.
The merchant acquirer may pay its merchants either gross or net of any amounts that are payable by the merchant to the merchant acquirer. Where gross settlement occurs, the merchant acquirer invoices the merchant on a regular basis for amounts owed to the merchant acquirer. Payment for those amounts is usually made by the merchant to the merchant acquirer's bank account via direct debit (or set-off against later payments due to the merchant from the merchant acquirer).
On 'Day 3': The card scheme operator credits the bank account of the merchant acquirer with the balance of funds owed to it by the card scheme operator for domestic transactions.
The process as described above is consistent with the findings of fact summarised by Rimer LJ in Lancore Services v Barclays Bank plc  1 All ER 763, up to the point of payment. The findings at that stage are inconsistent. On the one hand it is said that: '…the card issuer incurs a debt liability under the Visa or MasterCard rules, which results in a sum equal to the value of the transaction being paid via Visa or MasterCard to the merchant acquirer…' while on the other it is said that 'Typically, the merchant acquirer will receive payment from the card issuer…' (emphasis added). However, the latter could not occur, as the card scheme operator undertakes clearing and settlement centrally – ie the relevant ledger entries (debits and credits) are in the card scheme's settlement system, rather than in the accounts of each issuer and acquirer. It is also worth noting that the description of merchant acquiring in the applicable Joint Money Laundering Steering Group's guidance is consistent with payment by card issuer to card scheme operator, and by card scheme operator to merchant acquirer.
Payment due between each of the parties in the chain described above may be reversed before or after settlement in relation to a specific transaction, either because the transaction is challenged by the cardholder or card issuer as a 'chargeback' under the card scheme rules or because it is refunded by the merchant. Card scheme operators settle to merchant acquirers net of all current chargebacks or refunds, rather than on a case-by-case basis. If a chargeback is successfully challenged by the merchant or merchant acquirer, the cardholder becomes liable to the card issuer for the amount of the original transaction. The card scheme operator then debits the card issuer for that amount, and credits the merchant acquirer in the next net settlement.
There are two fundamental points to be made in conclusion. Firstly, the cardholder never intends to pay the merchant. By using a payment card instead of cash, the cardholder is indicating a desire only to pay his card issuer from his current account, either immediately (when using a debit card) or on the due date for payment on his monthly credit card statement. Secondly, the merchant has no expectation of receiving payment from the cardholder, card issuer or card scheme operator. The merchant only expects to be paid by the merchant acquirer for the transactions submitted to it.
Simon Deane-Johns is a consultant solicitor with Keystone Law, specialising in retail financial services, e-commerce and IT. He advises various non-bank finance platforms and payment service providers, however, the views expressed in this article are his own and not necessarily those of any client(s). Simon is also a member of the SCL's Media Board.
 Directive 2007/64/EC. The PSD is a 'maximum harmonisation' directive that had to be transposed into the law of all EU member states by 1 November 2009. It was transposed into UK law by the Payment Services Regulations 2009.
 Required by no later than 1 November 2012: Art. 87, PSD.
 Others, like American Express, operate a three-party scheme, in which the scheme operator is also the card issuer and the merchant acquirer. The term 'card payment system' does not have the narrow meaning of 'payment system' as defined in the PSD.
 Each card scheme operator may also have contracts with its own bank service provider(s), which are not shown. The card scheme operator may either act as a clearing counterparty or as agent for the direct participants (i.e. the card issuers and merchant acquirers). For the purposes of this article it is assumed that the operator is a clearing counterparty acting as a principal (rather than an agent) in deciding and recording how much each issuer owes to the operator, and how much the operator owes to each acquirer.
 This is also a type of 'consumer credit agreement' under the Consumer Credit Act 1974, defined in s 8 as 'an agreement between an individual ('the debtor') and any other person ('the creditor') by which the creditor provides the debtor with credit of any amount'.
 This forms the basis of the cardholder's rights against the merchant under the law related to the sale of goods and services; and a merchant's breach of the sale agreement, or misrepresentation, also triggers the card issuer's joint and several liability under the Consumer Credit Act 1974, s. 75.
 Generally classified as Card Present Transactions, Mail Order/Telephone Order (MOTO) Transactions, Cardholder Not Present Transactions and eCommerce Transactions
 The need for authorisation may be waived, eg for transactions with a value below a certain 'floor limit'. The authorisation process is usually automated and almost instantaneous, but may be undertaken manually by telephone call from merchant to acquirer, during which the acquirer calls the card issuer and then orally provides the issuer's authorisation code to the waiting merchant.
 These are transactions in EUR/GBP on UK/European bank identification numbers ('BINs') to be settled within UK/Europe.
 The amounts owed by the merchant acquirer to the card scheme operator include interchange fees, card scheme fees, assessments of fines for card scheme rule violations, chargebacks and refunds.
 For example, the merchant acquirer's fees, assessments of fines for card scheme rule violations attributable to the merchant's conduct and chargebacks.
 With respect to most non-domestic (foreign currency) transactions the same set of steps occur, except that, in addition, the merchant acquirer locks in a forward foreign exchange rate to cover the risk of movement between the foreign exchange rates applicable to the currency of its earlier payment to the merchant and the currency in which payment is later received from the card scheme operator. In such cases, the proportion of the total amount that is settled by the card scheme operator to the merchant acquirer on Day 1 or Day 3 may also vary significantly. For some foreign currency card payments both the settlement reports and corresponding funds may be sent by the card scheme operators only on Day 3.
 Ibid, at .
 Paragraph 2.10, Part II (http://www.jmlsg.org.uk/jmlsg-guidance/part-i-part-ii-part-iii-and-treasury-ministerial-approval). Of course, this leaves open the question as to whether the card scheme operator is acting as principal or agent, as discussed in footnote 4.
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