Anatomy of a Payment Transaction

Last decade (and especially the last 5 years) have seen a deluge of innovation from startups and established companies alike. Many fortunes were made, and many more went into abyss after finding how tough this space could be. As payments went from snail paced to real-time, many new flows were designed. But whatever be the payment rail or innovation, the core anatomies of these payment products have still relied on innovating across three key stages: Payment Transaction processing, Settlement and Clearing.

In upcoming editions of this newsletter, I will delve into the fundamental workings of various payment systems (per my understanding), as it traverses these three distinct stages. But before we dip into a specific payment method or system (in future articles), let us look at the most basic questions a Product Manager needs to ask at the outset:

• Whose need is being solved here, which all players are we looking at?
• What are their use cases, why do they need this payment solution and if it is not available then what are their alternatives? This exercise also helps in mapping the “Jobs To Be Done”

Precursor: Why do we need "Payments"?

Let us go to the very start and build this whole Payment flow concept from the first principles. It is a detour, but a worthy one. We will start by defining Payments, and slowly reach those 3 stages I mentioned above. In upcoming articles, we will use these concepts to understand and compare various payment methods. In case you already know about transaction, settlement and clearing, then you can jump directly to the “Anatomy of the modern payment” section below.

Payment definition: A payment is a transfer or an exchange of value.

Even before cash was invented, people used to still exchange valuable goods. A farmer would go to a locksmith to buy tools, and in exchange give the grains. On a silk route in 200BC, a Mongolian merchant could offer a fine-bred horse in lieu of 5 bolts of silk from his Chinese counterpart. This is called a 'barter' and was the most common method of payments for a long time. What essentially we have here is the Deal Agreement, or a Transaction where people are coming together to exchange goods of value.

Barter works well when the needs of each side can be met with the goods/services that other has. But a farmer may not always want to buy goods made by locksmith. Or the farmer may have fresh carrots to sell today, but locksmith may only deliver the farming tools two months later. Such trades can be settled by IOUs (I Owe You notes), but that takes trust, and at times trust could be a luxury. In such cases they needed a better store of value, something that can be transferred easily, can be exchanged in variable units, and does not lose its value easily. Enter the money as a payment instrument.

Aligning upon something as a "money" means a large number of people agree for it to be a store of value, align on what would be a basic unit for accounting (what would be a value of one denomination of this money), and accept it as a medium of exchange. That will allow you to sell something for an equivalent value of "money" and then exchange that money later to similarly buy something of an equivalent value. Fast forward to today's monetary system that allows for payments to be made with (fiat)?currency. Currency, has simplified the means of economic transactions, provides a convenient medium through which payments can be made, and it can also be easily stored.

It is hard to keep the money for all your needs with you, all the time. This led to money holders, banks, IOU managers etc. coming into picture. One could do a business deal, while having the funds to be released/provided by the intermediaries. In some cases, the goods or services being purchased were themselves delivered by these intermediaries. And using these “intermediaries” added an additional step – SETTLEMENT. A settlement happens when the money movement as well as product/service delivery is finally complete – aka settled.

Let’s scale things up one last time. As world trade flourished, and merchants flocked to international trade, they faced the ever-increasing risk of goods being sold but payments not coming through. The trust becomes an important decision point when exchanging valuables, and that hindered the scale of trade. Merchants then started identifying a trusted person, someone who had enough wealth (to mitigate the risk of non-payment) and and then do the trade via them. Philip Burlamachi was one such person who contributed to the next leg of payment systems growth. He became the?financial intermediary?of King?Charles I of England and acted on behalf of the City of London Merchants to collect money from foreign merchants and transfer it to the UK Privy Council. Such an involvement of an intermediary in payments was focused on reducing the risk of an individual firm failing to honor its trade settlement obligations. That is what we call as CLEARING.

In 1636, Philip proposed to set a centralized Clearing house, and London Clearing-House was established in late 1700s as a place where the bankers of the city of London could assemble daily to exchange the cheques (checks) drawn upon and bills payable at their respective houses. Before that, clerks from one bank had to visit every other banker in London. The first automated clearing house was?BACS?in the UK, which started processing payments in April 1968.

But that is not Burlamachi’s only major contribution. He proposed an idea of a national?clearing bank,?the first known proposal for a?central bank, where the word?bank?is first used for "a bank for the payment of all large sums of which shall be negotiated". Based on his proposal, in 1694, the?Bank of England?was first formed to help England rebuild itself, after it lost Battle of Beachy Head to France dearly in 1690. That further changed the power play of payments, and the lenders of last resort (LoR).

While I will go into Clearing details in future article on ACH payments, the concept of clearing is applicable to all modern payments. They essentially provide a “Payment Guarantee”.

The reason I have gone into such historical details is because this theme will repeat across many payment methods - we will continue to see the innovation getting stuck due to many-to-many interactions, and then being solved by a centralized or an automated platform.

Anatomy of a modern Payment:

Coming back to today, in our modern payments the transactions follow these same stages. But also have to deal with facilitating payments between multiple unknown counterparts, where either only one party is present at the time of transaction, or even having no one being present. That makes the deal making a multi-step function as we now have to ensure the payment is being conducted by an authentic owner, and right payment method is being charged. The consent has been digitized too. Each function of the payment flow can now be handled by a different intermediary, and each of that handoff becomes a potential point of failure as well as point of fraud.

The transaction flow, before settlement and clearing, is the one that has changed a lot. To understand the changes, let us do a further breakdown of Transaction stage:

1. Initiation of Payment: Within the overall transaction flow, the payment process begins when a customer initiates a payment for a product or service. In today’s world, this can be done in various ways- through a physical point-of-sale (POS) terminal, an online payment form, a mobile payment app, or even contactless methods like NFC (Near Field Communication) technology. Also based on actual use cases, the payment could be initiated by person who wants to send the payment, as well as someone who wants to receive payment.
2. Authorization: Once the payment is initiated, the receiving intermediary (payment processor) needs to confirm if this payment can indeed go through. For example, a Health Savings (HSA) Card can only be used for medical and health purchases. It will get rejected if it is being used at a restaurant, that transaction is not authorized. To handle these checks and business rules, the processor first communicates with the customer's bank or payment method holder (like card issuer) to request authorization for the transaction. The processor verifies the customer's payment details (such as the credit card number, token number, expiration date, and security code), and checks if the customer has sufficient funds or credit available.
3. Authentication: Once payment processor establishes that the payment can go through, it next checks the owner of that payment method is indeed the one authorizing this transaction. This is done to prevent any fraudulent transactions. This can include asking the customer to provide a one-time password (OTP) received via SMS or using biometric authentication methods like fingerprint or facial recognition. Depending upon the business rules, the transaction may be deemed high risk and hence routed for more stringent checks.
4. Authorization Response: This is a wrap up now. After establishing validity of the payment method, the funds availability and ensuring that owner has indeed authorized the transaction, the customer's financial institution sends an authorization response to the payment processor. This response indicates the decision - whether the transaction is approved or declined based on factors like available funds, account status, and risk assessment. If approved, the response includes an authorization code. (There are over?one billion credit card transactions?processed worldwide every day, and all of them require authorization to be completed!)

This whole set of actions are still within Transaction stage. Once complete, the transactions would move to settlement and then clearing stages to settle the funds based on agreements and risk outcomes.

Settlement: At this stage, the payment has been processed as far as the payee is concerned. But as we discussed in Settlement stage above, the money has still not exchanged the hands. Settlement is when the funds from customer transactions are finally transferred. For card payments, this means the processor aggregating transactions from various merchants and settling the funds periodically (usually daily or weekly) in a batched manner. The settlement process here involves transferring funds between the acquiring bank (merchant's bank) and the issuing bank (customer's bank).

Clearing: After settlement, the payment processor initiates the clearing process. Clearing in these modern systems involves sending transaction details to the appropriate card networks (e.g., Visa, Mastercard, American Express) or payment schemes (e.g., PayPal, Alipay) involved in the transaction. The networks and schemes verify the transactions, ensure proper interchange fees are charged, and facilitate the transfer of funds between the banks involved. While the Settlement stage focused on sending the funds, the Clearing stage is focused on clearing the books or the accounting entries.

Once complete, all intermediaries can generate receipts and invoices, which serves as proof of payment for their customers. This ensures that the transaction details, settlement amounts, and fees charged align correctly. The reconciliation being done in this stage helps in resolving any discrepancies or errors that may have occurred during the payment process.

It's important to note that the specific steps and intricacies of the payment processing may vary depending on factors such as the payment method used (credit card, debit card, mobile wallet, etc.), the involved parties (banks, processors, payment networks), and the industry or country-specific regulations. But overall, this framework will help us explain various payment methods.

TLDR (Too Long, Didn't Read)

A payment is a transfer or exchange of value. For a payment to happen, a transaction must be agreed upon. Any negotiations around what the transaction mean should be discussed before the deal is finalized. This could simply mean ordering coffee from a barista and choosing a payment method to pay for it. This can simply be called the Transaction.

When the barista get's their money (cash/ digital funds), and you get your coffee as ordered - that marks the deal as Settled. The money movement is now complete.

Let’s say you had ordered the coffee from a delivery person, and the exchange happened via them. In that case there are some extra hops - the delivery person would pass you the coffee, and take money from you to pay the funds to the barista. While you settled the payment by paying the delivery person in this case, the actual exchange is only complete when delivery person is done giving coffee to you and the money to barista. This last lap is called the Clearing, and is done when all members are done honoring their trade settlement obligations.

For digital payments, we noted that the transaction stage itself can been split into four sub-stages : Initiation of Payment, Authorization, Authentication and Authorization Response (processing).

Whatever be the payment rail or instrument, they all can be better understood using this three-stage core anatomy of the payment flow. In coming articles, you will see how most new payment innovations have either combined some of these steps in the customer journey, bypassed them or restacked them to make the payment faster or more secure.

Next Edition...

In the next edition we will use the above framework and look at how most card-transactions work.

In future editions we will delve into ACH payments, check (cheque) payments, Open Banking, Real Time Payments (RTP), Wire payments etc.

I hope this article helps shed light on the basics of payment processing for the interested. Comments, opinions, and corrections are much welcomed!