Few people would consider the intricacies of the payments settlement system, which ultimately gets the money from the customer to the merchant. After all, as long as the system works, why would we need to understand it?
Understanding settlement processing isn’t something the general public is likely to have a firm grasp upon. However, for those in the finance industry, the process is an important one. This article will look at how funds are authorized for transfer in the clearing and settlement process.
TL;DR
- When a credit card payment is made, the banks communicate instantly via the merchant’s payment gateway. However, the actual funds are not transferred at the same time. This is where the settlement process comes in. It’s an interbank process where obligations are met and funds are ultimately discharged.
- Clearing is the process by which funds are either received or paid out. All transactions that have been made need to be confirmed and either sent off to their respective parties or deposited into the intended accounts. This ensures that all parties have sufficient funds to cover the transaction.
- Liquidity risk is the risk that a party will not be able to pay their dues on time.
What is the settlement process?
Imagine a customer walking into a brick-and-mortar store seeking a few items. Ready to make their payment, the customer pulls out their Visa card, and the merchant rings up the transaction on the till.
The customer inserts their credit card into the terminal, and moments later, both parties are satisfied. The retailer can feel confident they’ve been paid, and the customer knows they’re now the proud owner of the basket full of various items they’ve chosen to purchase.
But what makes both parties confident following this seemingly simple interaction? It’s complete in a matter of seconds but does a funds transfer occur within this minuscule window? Naturally, the reality is a little more complex.
When a credit card payment is made, the banks communicate instantly via the merchant’s payment gateway. However, the actual funds are not transferred at the same time. This is where the settlement process comes in. It’s an interbank process where obligations are met, and funds are ultimately discharged.
The full payments process involves three distinct steps:
- Authorization (the instant approval and hold on funds)
- Clearing (the process of submitting and validating the transaction data), and
- Settlement (the final transfer of funds to the merchant’s account).
How is the settlement process administered?
At the heart of the interbank settlement process, card networks utilize netting. This sums up all transactions between two banks (e.g., acquiring bank and issuing bank), canceling out offsetting obligations. This reduces the total transfer amount, and ultimately, only the net difference is exchanged
Credit card settlement is governed by the rules of the card networks (Visa, Mastercard, Amex). These networks use their own clearing systems to move funds. ACH (automated clearing house) is a separate payment rail, governed by National Automated Clearing House Association (NACHA), used for bank-to-bank transfers (e.g., direct deposit, e-checks), and operates on different settlement cycles.
The settlement process begins when the payment processor (acting on behalf of the acquiring bank) collects all the merchant’s approved transactions from the day and submits them in a batch to the card network. This step officially kicks off the clearing process.
What is meant by “gross” or “net” settlement?
As a merchant, online or with a physical store, you’ll be expecting the funds all your customers have spent with you. The funds are usually deposited at a fixed time each day, but gross or net settlement determines quite how much you’ll be banking.
With a gross settlement, all the funds you’ve taken that day will be deposited as one lump sum. Fees are then debited from your account separately, usually at the end of the month. This money will still be subject to variable fees. The cost is primarily driven by the interchange rate (set by the issuing bank) and card network assessments (set by Visa/Mastercard), which vary based on the type of card (e.g., rewards, business) and how it was accepted.
Visa and Mastercard have very similar fees to remain competitive, whereas some providers might have different fees. American Express (Amex) famously charges a little more to merchants for accepting their credit and charge cards, though, of course, the more Amex cards you’re processing ,the greater the likelihood of that higher rate suddenly becoming negotiable!
With net settlement, you don’t have to worry about a subsequent bill for those fees. The payment will be made net of fees, meaning all processing costs are subtracted before the remaining sum is deposited into your bank account.
What is clearing?
Clearing is the process by which funds are either received or paid out. All transactions that have been made need to be confirmed and either sent off to their respective parties or deposited into the intended accounts. This is done to ensure that all parties have sufficient funds to cover the transaction. As such, clearing is a critical part of the settlement process.
All banks communicate through a payment network, which shares all relevant information with the financial institutions so that they can process the payment instructions as they’re received. Traditionally, this was a lengthy process but with the advent of faster payment networks. This clearing process is sped-up to allow real-time, or at least near real-time, payments to be credited.
In the clearing process, banks’ routing information gets validated to ensure that the receiving bank is within that particular payment network. For online transactions (CNP), the communication during the authorization step verifies cardholder details such as their address, zip code, and AVS (address verification service) data. The CVV is used only for authorization and is not stored or used during the clearing phase.
If anything doesn’t add up during this process, the transaction is not authorized, and the cardholder gets a declined message. However, when all the data is validated, the banks involved (the cardholder’s bank and the bank of the merchant they’re buying from) will have committed to the transaction.
Suppose Bank A accepts a payment process order from Bank B (the card issuing bank of the customer), which has now committed to paying the full amount of that order, while Bank A has itself committed to paying those funds to its customer (the merchant).
What we’re seeing is the banks settling transactions among themselves, relying on being able to debit and credit the accounts of their customers (buyer and merchant) at a later point.
How do Faster Payments work?
The term Faster Payments refers to modern systems like FedNow and RTP (Real-Time Payments) that transfer funds instantly, 24/7/365. This technology operates on a separate rail from the ACH Network, which is still a batch system, although it does offer accelerated settlement.
The key difference with the Faster Payments system is that funds are sent directly from one account to another. This means funds are never actually “re-allocated” through the ACH. It’s for this reason that Faster Payments are often referred to as being real-time.
The process for sending funds via the ACH is actually incredibly simple: A customer requests that a transfer is made to another account holder. The funds are withdrawn from that customer’s account via ACH. The funds are then sent to the intended recipient account via ACH. The recipient will receive the funds almost instantly, as the validation process is completely automated.
How is liquidity risk handled?
Liquidity risk is the risk that a party will not be able to pay their dues on time. To manage this risk, the system relies on collateral being put up by the banks and other parties.
This means that the bank (or other counterparties) is required to put up an equivalent value of either gold or cash to prove that they are capable of meeting their obligations. The system is designed to ensure that the correct funds are exchanged between parties and that no mistakes are made. Many banks are connected to the Federal Reserve via Reserve Banks, of which there are 12 in the US.
The settlement process in summary
Networks can process interbank transactions in a number of ways, depending on the system used. Clearing takes place when financial institutions exchange messages and other data to enable payment transactions between payers and recipients. The discharge of interbank obligations in connection with faster payments is referred to as interbank settlement. Real-time gross settlement and deferred net settlement have risks associated with settlement, particularly liquidity and credit risk. Therefore, financial institutions’ risk management teams should understand how various faster and instant payment networks mitigate risk as a result of their settlement cycle.
The settlement process is just one of the many steps involved in payment processing. Efficient settlement processing is critical because it dictates when you receive your money. Processors like Stax focus on securing next-day funding (funds deposited the next business day) for our merchants, ensuring optimal cash flow.
At Stax, we’re committed to helping businesses accept payments in the most streamlined and cost-effective way possible. Get in touch with us to learn more about how we can help you process payments with ease.
Quick FAQs about settlement process
Q: What is the settlement process in payment processing?
The settlement process in payment processing is an interbank process in which obligations are met and funds are ultimately discharged. When a credit card payment is made, the banks communicate instantly via the merchant’s payment gateway. However, the actual funds are not transferred simultaneously.
Q: How does the settlement process work?
At the core of the settlement process is a procedure called “netting.” At the heart of the interbank settlement process, card networks utilize netting. This sums up all transactions between two banks (e.g., acquiring bank and issuing bank), canceling out offsetting obligations. This reduces the total transfer amount, and ultimately, only the net difference is exchanged.The settlement process is governed by the rules of the automated clearing house (ACH), the largest payment network globally.
Q: What is the difference between gross and net settlement?
With gross settlement, all the funds taken that day are deposited as one lump sum. However, this money will still be subject to card issuer fees. On the other hand, with net settlement, the payment made is net of fees, subtracted so the sum you receive is what you can take home at the end of the business day.
Q: What is the role of the clearing process in settlement processing?
Clearing is a crucial part of the settlement process where funds are either received or paid out. In this process, all transactions that have been made need to be confirmed and either sent to their respective parties or deposited into the intended accounts to ensure that all parties have sufficient funds to cover the transaction.
Q: How do faster payments work in the settlement process?
Faster Payments are a system that enables funds to be transferred almost instantly. This is done by setting up an account with one of the banks part of the ACH. The key difference with the Faster Payments system is that funds are sent directly from one account to another, allowing for real-time transactions.
Q: How is liquidity risk managed in the settlement process?
Liquidity risk, the risk that a party will not be able to pay their dues on time, is managed by acquiring banks and other parties to put up collateral. This collateral could be an equivalent value of gold or cash, proving they are capable of meeting their obligations.
Q: What does “netting” mean in the context of the settlement process?
In the settlement process, “netting” means that all transactions are summed up, and any two parties who have a positive transaction with each other will be canceled out. This process leaves only the net transaction, which is the one actually settled.
Q: What is the Automated Clearing House (ACH)?
The Automated Clearing House (ACH) is a payment system that facilitates the movement of funds from one bank account to another. It is the single largest payment network in the world and governs the rules of the settlement process.
Q: What is the role of the National Automated Clearing House Association (NACHA) in the settlement process?
The National Automated Clearing House Association (NACHA) is the network where each bank that participates in the ACH can exchange transaction data with other banks that are also part of the system. This network runs on a 24-hour cycle and is where the funds are exchanged.
Q: How does the settlement process impact businesses?
The settlement process directly impacts a business’s cash flow. Depending on whether it’s a gross or net settlement, businesses will receive a lump sum each day that may or may not be subject to card issuer fees. The process ensures the smooth operation of transactions, making it easier for businesses to manage their finances.
