Visa Inc and MasterCard Inc: How the Magic of Credit Cards Works

This article is part of a series on the present and future of digital payments. For the full report, click here.

Last year, over $8 trillion of commerce passed over digital payment networks. At the same time, about 60% of total payment volume was still processed with cash.

To say that this ecosystem is large is a laughable understatement. The payments industry is gigantic. It's massive. It's ridiculous. It's the back bone of the entire global economy. And it still has lots of room to grow.

But it's not just large. It's also changing very quickly. Forty years ago payments were processed with cash and checks. Then came the plastic card, imprinted onto carbon paper and processed manually. And then came the Internet and digital processing.

Today, millions of people use those same plastic cards online, "swiping" their cards without any face-to-face interaction. That change is subtle, but it's revolutionary. It's a wholly new phenomena in the history of business. Sure, people were mailing in rent checks back in the 1970s and 1980s, but those checks were eventually opened by a human being, run manually through processing, and then physically stored.

It's possible today to hit a button on your smartphone to pay a cup of coffee. One gentle, tiny tap of one single finger. That's the only human interaction in the entire payment process. That's insane!

For most consumers and many investors, the processes that allow this amazing feat are in the shadows. We take it for granted. It just works.

How does the payment system work?

There are four participants in the typical digital transaction, starting with the consumer.

The consumer, that's you and me, is pretty self-explanatory. We want to buy a good or service, and we're going to use our card to pay for it.

The second participant is, obviously, the merchant. This is the seller of the good or service we want to buy. It's the store. 

The consumer's card is linked to a bank account, which brings us to the third participant into the process, the bank. There are two banks involved, each filling a different but similar role—they're the source of the money.

Source: Visa.com

The consumer's bank is the entity that manages the transfer of the consumer's money to be used for payment. In industry parlance, this bank is known as the issuer. If the consumer is using a debit card, the issuer will use the available money in that account to pay the purchase price. If the card is a credit card, the issuer will use the customer's line of credit linked to that card to fund the transaction.

The issuer doesn't actually pay directly to the retailer. Instead, it reimburses the retailer's bank, known as the merchant bank or acquirer. This can be a bit confusing, so let's use an example.

If you swipe your card to buy a pair of shoes, the merchant bank authorizes the transaction and pays the shoe store for the purchase. The merchant bank then communicates with the consumer's bank (the issuer – the bank where you have your checking account or credit card) and asks to be paid. The consumer's bank then reimburses the merchant bank, closing the transaction.

These banks receive a small percentage fee of each transaction they process. These fees, called "interchange fees", were quite lucrative in the past, but legislation like the Durbin Act have limited that income source for the banks. But don't worry, the banks are also making money on the interest charged for the credit account or the fees on the checking account.

The fourth participant in the process is the glue that holds the whole system together, the payment network. Visa  (NYSE: V  )  and MasterCard  (NYSE: MA  )  are the largest and most dominant of the payment networks.

These companies build and operate the digital pipes that connect the merchant to the acquirer to the issuer. Think of their business model just like a toll road; Visa built a payment network like an interstate highway system, and every transaction (like a car) that passes over the network is charged a fee. These companies make the action behind your transaction possible, and they charge for access to the system.

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To read Jay's full report on digital payments, click here.

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