Understanding Settlement Processing How Does the Settlement Process Work in Payment Processing

Making card payments day to day, whether online or in person, 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? Like catching a plane, most passengers are unlikely to have a firm grasp of flight dynamics. Still, if they arrive at their intended destination, they can carry on in blissful ignorance as to the number of mathematical calculations needed to keep that plane in the air!

Understanding settlement processing, just like the science of flight dynamics, 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 left-handed pinking shears. They’re lucky enough to find their chosen product and grab a few other 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.

How is the Settlement Process Administered?

At the heart of the settlement process is a process of “netting.” This means that all transactions are summed up, and any two parties who have a positive transaction with each other will be canceled out. Effectively it’s only the transaction that is left, the net transaction, which is actually settled.

The settlement process is governed by the rules of the Automated Clearing House (ACH). ACH is a payment system that facilitates the movement of funds from one account to another. It is the single largest payment network in the world and has existed since the 1970s.

Each bank that participates in the ACH accesses the network where it can exchange transaction data with other banks that are also part of the system. This network is called the National Automated Clearing House (NACH). The NACH runs on a 24-hour cycle and is where the funds are exchanged. The netting process takes place every night, with funds being exchanged between banks and their customers.

In 2021, the NACH processed transactions worth $72.6 trillion. 

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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 been spending 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. However, this money will still be subject to card issuer fees, and therefore you’d be liable for these fees later. Different card issuers charge additional fees so your card fees bill might vary day to day depending on the different ratios of cards used.

Visa and Mastercard have very similar fees to remain competitive, whereas some providers might have different fees. American Express (AMEX) famously charge 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 card issuer fees. This payment will be made net of fees, all subtracted so the sum you receive is the sum you can take home at the end of the business day (metaphorically, anyway).

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 or those termed cardholder not present (CNP) transactions, the communication within the clearing process would also need to check and verify cardholder details such as their address, zip code, and card security number (technically known as the card verification value or CVV).

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?

Faster Payments are a system that makes it possible for funds to be transferred almost instantly. This is done by setting up an account with one of the banks that are part of the ACH. The system uses the same infrastructure as the ACH, meaning that there is no additional cost incurred by individuals or businesses who withdraw funds via the Faster Payments system.

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 vie Reserve Banks, of which there are 12 in the US.

The Settlement Process in Summary

Faster payment 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. 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

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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”. This means that all transactions are added up, and any two parties who have a positive transaction with each other will be canceled out. In effect, only the net transaction is actually settled. 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 requiring 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 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 (NACH) in the settlement process?

The National Automated Clearing House (NACH) 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.