Credit Card Systems and their Participants
In order to understand the complexities of the
credit card processing
industry, it is important to appreciate the participants and the systems under which they operate. Credit card programs operate under two distinct models often referred to as “open-loop” and “closed-loop” systems. The most popular system is the open-loop system, which is used by both Visa and MasterCard and represents approximately 87 percent of all card volume
. The following diagram illustrates the players, and their relative positions within this system.
Open-Loop Systems (Visa and MasterCard)
Open-looped Systems: Visa and MasterCard *
In its most basic form there are six distinct players. At the core of the system are the Card Issuing Bank, the Merchant Bank (often referred to as the Acquiring Bank or “Acquirer”), and the Card Associations. The Issuers and Merchant Banks are members of the Associations, and they pay the Associations annual dues and other fees that contribute to the operation of the networks.
As you might expect, the Card Issuing Bank issues credit cards to Buyers who make purchases with the cards, and who are expected to pay for these purchases under specific terms and within expected intervals. The Merchant Bank signs up Merchants to accept the cards, and provides them with physical means for accepting the cards and receiving payment. Merchant Banks also provide the merchant with branding materials to attract Buyers. An important feature of this system is that the buyer and merchant do not contract directly with the Associations. They must work with a card issuer or merchant bank as the case may be.
It should also be noted that it is possible, and not uncommon, for the Merchant Bank and Issuing Bank to be the same for any given transaction. This type of transaction is called an “on-us” transaction, but still passes through the associations.
The Associations provide four major functions:
Develop and maintain the primary physical networks that allow the flow of authorization, settlement and disputed transactions between Merchant Banks and Card Issuers. These networks also manage the movement of cash between the participants. It should be recognized that these networks extend into the Card Issuing and Acquiring Banks.
Governance Responsible for legislating and enforcing rules and regulations governing the players and the networks including the legislation of fees like Interchange and Assessments.*
Branding Responsible for the development, deployment and advancement of their brands. Priceless®!
Shareholder Value When the Associations entered the public equity markets, they also became responsible for financial performance to stakeholders.
Closed-loop Systems: American Express and Discover
Closed-loop systems constitute a much smaller percentage of overall credit card transaction volume, but are decidedly simpler than open-looped systems. The fundamental difference in the closed-loop system is that the Card Issuing Bank and the Merchant Bank are effectively one in the same. With closed-loop systems, we will discard the term Association because there is no independent organization like Visa or MasterCard arbitrating between an issuer and an acquirer. In this case, the simple term Bank will do. In this system, the primary banks in the U.S. are American Express and Discover. The following diagram depicts a closed-loop system operating under two different scenarios:
Closed-Loop Systems (American Express and Discover)
In this model there are only three or four players in this system. In its simplest form, the system includes the Bank, the Buyer and the Merchant. The Bank issues credit cards to Buyers who make purchases with the cards. The Bank also signs up Merchants to accept the cards, and provides them with physical means for accepting the cards and receiving payment. An important aspect of the closed-loop system is that the bank contracts directly with the merchant and cardholder. Merchants are able and encouraged to physically connect directly with the Bank, and many do just that. For reasons of convenience, however, most merchants process their transactions through Payment Processors. In this manner, merchants maintain a sole source for submitting transactions for both the open-loop Associations and closed-loop Banks. This practice also allows the merchant to receive a consolidated payment processing report.