Authorization process

What you will learn

  • What the authorization process is
  • What the clearing process is
  • What the settlement process is

What you should read first

The "Fees" article which begins with Interchange (Part 1 of 4)

Full article

This is part 1 of 3 of the authorization and settlement article. Here are links to each part:

Introduction

There are three words that are used repeatedly when describing a transaction. They are: authorization, clearing, and settlement. Clearing and settlement are possibly new terms but you have likely seen the word authorization while using a credit card at a store — POS devices often display a message like “Authorization in progress” during a card transaction.

Trillions of dollars flow through the economy every year via credit and debit cards and every dollar of that volume goes through the processes of authorization, clearing, and settlement.[1] Understanding these three processes will illustrate how the industry works together and how its many entities and fees cooperate.

Authorization process

Authorization request

Similar to its use in plain English, the process of authorization in payment processing is the act of requesting permission for a transaction. A merchant first requests authorization of a transaction, then the cardholder’s issuing bank must approve the transaction before any funds are actually transferred. The cardholder completes their purchase and leaves the store before any money is actually exchanged — that occurs over the next couple days.

Whether the issuing bank grants authorization for a transaction depends on two steps designed to prevent fraud. First, the card’s validity is authenticated. Second, a check is performed for whether the cardholder has sufficient funds or credit in their account. [2]

Authorization response

If the card is valid and the cardholder has sufficient funds for the transaction, the merchant receives an approval response. Otherwise the merchant will receive a decline response if the card is fraudulent or the cardholder does not have enough funds.

The term authorization is sometimes colloquially used to refer both to the process of requesting approval as well as to the response of approval. For clarity, we will use the term authorization only to describe the approval response and describe the request as the authorization process.

Authorization process
The process of verifying whether a card is valid and the cardholder has sufficient funds or credit to preform a transaction. Within a few seconds after the cardholder uses their card, the merchant receives a response of authorized or declined.

Mechanics of the authorization process

In the authorization process, the merchant essentially asks whether a cardholder is able to make a transaction. The issuing bank is the entity that has the authority to grant this permission. To enable this decision, information about the transaction is gathered by the merchant’s POS into an authorization request, which includes data about the purchase size, the card presented, and the merchant.

The authorization request is first sent to the merchant’s processor. The processor then routes this request to the card association (the association whose name is embossed on the card). The card association tests the card’s validity and, if authentic, forwards the request to the cardholder’s issuing bank.

The issuer verifies that the cardholder’s account is in good standing and has sufficient funds or credit. Depending on the results of those tests, the issuer then sends an authorization response back through those entities to the merchant. This whole process is illustrated below.

Authorization process v2.jpg

The process of authorization is essentially the process of assuring the merchant that they will receive payment for the purchase in the future. If the authorization response is a decline, it is because there is reason to believe that the merchant will not be paid in the future — perhaps because the cardholder does not have enough funds in their account.

To help ensure that a merchant will be paid, an authorization hold will be placed on the necessary funds in a cardholder's account, rendering those funds unavailable to the cardholder until a merchant is paid or the hold falls off — essentially expires — which can take up to 30 days, depending on the bank. This guarantees that that money will still be there when it is actually time to pay the merchant.

Authorization Hold
The practice of rendering necessary funds unavailable to be used by a cardholder once a transaction has been authorized. This hold lasts until the merchant is paid or the hold expires, known as falling off.

After the authorization process, the next step is the clearing process during which the amounts owed to the merchant from various purchases are totaled up. The actual transfer of funds occurs lastly in the settlement process.

What you should read next

References

  1. "Credit Card and Debit Card Transaction Volume Statistics," nerdwallet
  2. "Clearing and Settlement of Interbank Card Transactions," Federal Reserve Bank of Philadelphia