Dirty Little Secret: The Merchant Services Industry
The average person has no idea how many different entities are involved for businesses to have the ability to accept credit and debit cards. In a typical transaction, as many as seven entities are involved in a single transaction, and it all happens in seconds or less.
Here is a quick example of the process for a typical transaction:
3. ISO (Independent Sales Organization)
4. Merchant Processor (aka, Merchant Acquirer)
5. Settlement bank (aka, sponsor bank)
6. Issuing bank (bank that provided the card to the cardholder)
7. Card network (e.g., Visa, MasterCard)
Once a card is swiped, the business’ point-of-sale device queries the merchant processor. The merchant processor queries the customer’s card issuer to confirm the customer has credit available to complete the purchase via the network the customer’s card issuing bank utilizes (such as Visa or MasterCard). The issuing bank then sends back an approval — or denial — through the credit card network to the merchant processor. The merchant processor then notifies the business electronically, via their POS device, if the purchase has been approved or declined.
From the perspective of a business owner, you don’t need to become an expert on the payment processing ecosystem. What is important to understand is what rates, fees and charges are hard costs you have to pay and which are negotiable. Fortunately, this is actually very simple when you understand the basics of the system.
Interchange is the universal cost any business must pay in order to accept card payments. Interchange is set by the card networks, and interchange rates are always made public and can be found online. The good news is virtually every business pays the same interchange. In fact, there are only two ways to get a discount:
1. Process over 82 million transactions and over $5 billion in volume annually.
2. Create a class action lawsuit against Visa and MasterCard for excessive fees, like Walmart.
Now that the thought of negotiating interchange is out of mind, let’s explore interchange further. The most confusing thing about interchange is the hundreds of different rates between the various cards networks.
This built-in variability leads to confusion and random and hidden fees to unsuspecting merchants. In order to issue credit cards banks work with associations, most notably Visa and MasterCard. The associations, like Visa, for example, charge an assessment of 0.13%. The assessments are made public by the associations, and you can easily run a Google search for the current rates.
So, if every merchant pays the same fees for interchange and association dues, why are merchant processing fees so different?
The wide variability in merchant processing fees come from the other bank in the mix: the processing bank. Rates charged by processing banks and ISOs vary substantially. Banks, in general, are very good at assessing small fees for their many services, and processing banks charge for everything. Not only do they have many different fees, they assess these fees in many different ways.
To explore further let’s start with the big picture. There are three main ways merchants are typically billed for processing:
2. Flat Rate
3. Interchange/Cost Plus
With tiered pricing, merchants usually pay three different rates for their processing. They pay the lowest rate for Qualified cards, a higher rate for Mid-Qualified cards and the highest rate for Non-Qualified cards. This sounds good, because rather than many different rates, the merchant knows they will only pay three different rates, and they hope most of their customers will use their debit cards, keeping their costs to a minimum.
The problem with this method is merchant processing companies widely advertises the lowest rate, and many merchants skip the fine print disclosure showing the higher Mid and Non-Qualified rates. They mistakenly believe they will pay the low Qualified rate on all their transactions and receive a big sticker shock when they see their first bill. “Teaser rates” are still widely advertised, so buyer beware. Who decides which cards fall into which tier? You got it — the processing bank.
Flat-rate pricing was created to combat the confusion and provide a simple and easy to understand fees structure. Because of the widespread confusion in the industry, coupled with merchants tired of being hit with hidden fees, this pricing style has been wildly successful. Companies like Square and Paypal have built their entire business models around flat-rate pricing, and Square especially owes much if its success in offering flat-rate pricing.
So, what’s the catch? With flat-rate pricing, it’s simple, but simple is not cheap. In fact, it’s pretty expensive. For small businesses or startups not processing very much in card volume, flat-rate pricing is a great solution. However, for most businesses, you’re leaving a lot of money on the table by going with a processor that offers flat-rate pricing.
Big retailers figured out tiered pricing was not a good option for them a long time ago and started working deals with the processing banks. They talked the processing banks into charging Interchange Plus pricing. With this pricing model, the merchant agrees to pay a small percentage (known as discount) and a small per-transaction fee over interchange on each swipe. This way, the merchant does not pay a larger than fair markup on some cards over others. This pricing model used primarily only with big-box merchants and was often called “wholesale” pricing. We now use the terms Interchange Plus, Cost Plus or IC+ for this pricing model.
The Bottom Line
Everyone is in business to make a profit, right? Due to this, really dive deep into each pricing method to find the best fit for your business. And, if you want to check whether you are paying tiered, flat rate or IC+ pricing, take a look at your statement.