What you will learn
- What the authorization process is
- What the clearing process is
- What the settlement process is
What you should read first
- Clearing process (Part 2 of 3)
This is part 3 of 3 of the authorization and settlement article. Here are links to each part:
In the previous two parts, we discussed the authorization and clearing processes, during which checks are performed to determine whether a customer is allowed to perform the current transaction, then processors and card associations subsequently total every transaction performed and calculate the necessary funds that should be transferred.
This part covers the settlement process, the only time in which money is actually transferred between banks.
Debits and credits
Settlement is the process of transferring funds between banks to match the transactions that have previously been authorized. Recall that when a transaction is authorized and cleared, no money has yet been exchanged.
A debit and a credit are created every time a transaction occurs. When a customer makes a purchase at a merchant, for example, the cardholder then owes money to the merchant. This means the cardholder's account with their issuing bank has a pending debit transaction. At the same time, the merchant's acquiring bank has a pending credit transaction because the bank is owed money on the merchant's behalf. This will eventually be settled when the issuing bank transfers funds to the acquiring bank.
For the sake of efficiency, however, it does not make sense to make each of these transfers of funds between banks individually. Instead, banks transfer funds in an aggregate sum — with this sum, each bank accounts for all of the debits that their cardholders and merchants are responsible for.
Imagine, for example, that two cardholders each make a $10 purchase at the same merchant. If they both had an account at the same bank, that bank would transfer a settlement total of $20 once to the merchant's bank.
If, instead, one cardholder made a $10 purchase and the other returned a $4 item and was owed money from the merchant, their bank would instead only transfer $6 to the merchant.
How much each bank owes and is owed is calculated by the card associations, using the draft reports received from banks. The associations also calculate interchange fees and include those in the aggregate sums owed. Interchange is paid from acquiring banks (a debit to them) and paid to issuing banks (credit).
How the funds are transferred
Settlement funds are transferred in stages with the card association acting as an intermediary:
- The card association tells each bank the total funds it needs to transfer or the total funds it will receive.
- A bank that owes money to other banks (a net debit position) transfers its settlement funds to the card association's settlement bank account.
- The card association transfers funds to recipient banks. This will often be acquiring banks who, because of their merchants that are owed money in exchange for purchases, typically have a net credit position.
Enabling these transfers between banks are primarily two networks:
- Fedwire: the wire transfer service of the Federal Reserve Banks
- Automated Clearing House (ACH): an alternate electronic network run by the National Automated Clearing House Assocation (NACHA) and the Federal Reserve
After funds have been transferred between banks, banks then update their cardholder and merchant accounts. For example, a cardholder who has made a purchase will have the authorization hold on those funds dropped and the transaction posted to their account. A merchant that has delivered goods will receive their funds in their deposit account, unless their deposit account is held by a bank separate from their acquiring bank, in which instance their acquiring bank will simply transfer the funds to that institution.
This article should give some insight to the basics of authorization, clearing, and settlement — essential processes that occur every day with billions of dollars. After reading this article it should be clear what occurs when a cardholder makes a transaction and what complex mechanisms are necessary to subsequently transfer money.
- "Clearing and Settlement of Interbank Card Transactions," Federal Reserve Bank of Philadelphia