Understanding Technology

Merchant Payment Switches: An Overview

The first credit card transaction was run in 1950. While we have not yet become a cashless society, it is unlikely that 57 years ago anyone could have predicted the increasingly important and complex role that electronic payments now play within the retail environment.
More and more payments are being handled electronically, and new payment types continue to proliferate. Merchants are now using payment acceptance to achieve a variety of objectives, including improved customer loyalty, increased transaction throughput, higher revenues, and payment cost minimization. One way they are doing this is by implementing payment switches and related transaction management software solutions to help them take more control of their payment environments. Merchants have historically relied heavily on proprietary applications at the point of sale, including payment processing applications. According to a May 2006 AMR Research Report (Retail ERP Suites: Investing in the Backbone of a Modern Retailer), more than 50% of deployed enterprise retail applications have been built or maintained internally. However, we are now in the midst of a technology replacement cycle in which proprietary, legacy POS and payment processing applications are being replaced with third-party applications. The Growing Importance And Complexity Of Payments Today, more than half of retail transactions are card based. Checks are in rapid decline, while PIN-based debit acceptance is surging. Interchange continues to trend upward. Contactless payments have been introduced. Biometric authentication has seen some early adoption. Cell phones and PDAs are being used as digital wallets. Alternative online payment options like PayPal, Google Checkout, and Bill Me Later have taken hold. The ACH (automated clearinghouse) network is growing as an alternative

means of accessing consumer bank accounts, especially with the advent of back office conversion. PCI (payment card industry) data security standards have been introduced, complete with comprehensive audit requirements and sanctions for noncompliance. Gift cards are on the upswing, relegating paper-based gift certificates to the dark ages. Companies like Blackhawk Network and InComm have introduced gift card trees, enabling merchants to sell gift cards branded by other merchants. This is just a sampling of the change and complexity in retail payments, all in the name of cashless transactions. Unfortunately, this complexity too often translates into pain for merchants pain that can be addressed by a payment switch. The Payment Value Chain A quick review of the payment value chain is worthwhile at this point, since many of the benefits associated with payment switches come in the form of cost savings. Figure 1 illustrates the basic payment value chain and the various participants. The full cost of payment acceptance, known as the merchant discount, has increased dramatically in recent years. The merchant discount ranges from just under 2% to well over 3% of the total transaction amount. Roughly 10% of the merchant discount is paid to the merchants payment processor in the form of processing or per-item fees. After that, 1% to 2% is paid to the credit card company in the form of access fees and assessments to support association advertising and operating activities. Finally, the largest portion 85% to 90% goes to interchange, a fee paid by merchants to reimburse the credit card issuers (usually banks) for assuming the costs and risks associated with credit cards. The most significant fees in the payment value chain are the processing fees and interchange, and both of these fee types can be reduced using payment switches. The Inception Of Payment Switches Over the years, merchants have had to deal with the unique specifications of each individual merchant processor. In an integrated POS situation, this has traditionally required a custom or proprietary

By John Filby, President and CEO, ISD Corporation

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Understanding Technology

Figure 1: The basic payment value chain and its various participants.

integration between the POS and the selected processor. As a result, changes to the POS are required every time there is a change in that processors specification or whenever a merchant decides to change processors. These traditional one-to-one connections between the POS and a processor have proven to be very high-maintenance. Roughly 20 years ago, this particular pain point led to the birth of payment switches for merchants. Through a single interface to a payment switch, POS transaction messages can be instantaneously translated and reformatted into any processor specification. This creates an inherently one-to-many relationship between the POS and the processing world, thereby insulating the POS from increasingly frequent specification and processor changes. So what is a payment switch? Basically, it is a software application that can interface with any POS system, consolidate all electronic transactions at the enterprise level, and then intelligently route them to one or more payment processors for authorization and settlement. In effect, payment switches enable merchants to bring some of the robust transaction switching capabilities of payment processors into their enterprises. Given the high incidence of cardbased transactions, the steep declines in the cost of enterprise-class servers, and the ubiquity of highspeed WANs, payment switches are now in the mainstream. They have become one of the most value-added applications to run over a merchant WAN, quickly relegating slow, dial-based payment processing to a historical footnote. The Benefits Of Payment Switches The previous section touched on the original impetus for the development of payment switches. Following is an exhaustive summary of the benefits of payment switches. Processing Cost Savings Processor neutrality: Switches are designed to be payment processor neutral, easily interfaced to virtually any payment processor. This processor neutrality, combined with insulation of the POS from payment processor connections, gives merchants maximum flexibility when it comes to evaluating their payment processing relationships. While processors can be changed without a switch, extensive POS programming changes are required, which in many

cases amount to six-digit costs and project durations that exceed processor contract renewal deadlines. Eliminating the middleman: Some merchants use a middleman processor or a payment gateway. These intermediary processing arrangements and related processing costs can be eliminated by using a payment switch to route transactions directly to processing end points. Dial authorizations: Some merchants still use dial authorization to send transactions to their processor at the store level, thereby incurring incremental processing costs of a penny or more per transaction. By consolidating transactions at the enterprise level over a WAN and through a payment switch, merchants can transmit transactions to the processor through a single connection and eliminate these incremental dial processing costs not to mention the cost of dial lines to each store. Batch settlement: Merchants using store-based batch settlement can reduce costs associated with settlement processing by consolidating settlement records into a single settlement file at the payment switch level before transmission to the processor. Consolidating multiple channels: Merchants often use different payment solutions and processors across their transaction channels retail, restaurant, petroleum, e-commerce, catalog, etc. These organizations can enjoy volume discounts by consolidating these channels through a payment switch and sending all transactions to the same processor. In addition, implementing a payment switch across a merchants channels centralizes PCI management and streamlines reconciliation. Direct connections: If transaction volumes justify direct connections to the credit card associations, a payment switch may be used to establish such direct connects, eliminating per-transaction conveyance fees (ranging from 1 to 4 cents) charged by processors to route these transactions. Internal check verification: Merchants using an external check authorization or guarantee service can reduce the associated per-transaction fees by utilizing a payment switch for in-house check authorization. The merchant is able to verify against an internal database before seeking external authorization. Internal gift cards: Merchants using an external gift card service can eliminate the associated pertransaction fees (as much as 10 to 20 cents) by

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utilizing a payment switch for in-house gift card processing and management. The gift card transactions never leave the enterprise IT network. Interchange Savings Intelligent PIN prompting: By using a payment switch to adopt PIN debit with intelligent PIN prompting, merchants can maximize conversion of highinterchange credit/signature debit transactions to lower-interchange PIN debit transactions. Interchange on PIN debit transactions can be up to 50% lower than interchange on credit/signature debit transactions. Merchants can enjoy conversion rates of 40% or more on PIN-capable transactions. Intelligent PIN prompting can also eliminate in-store staff training, since in-lane confusion over PIN debit is minimized through automation. Commercial or corporate purchase cards: Merchants accepting commercial or corporate purchase cards are able to pass sales tax and lineitem detail (Level II and Level III data, respectively) on to the processor, enjoying interchange savings of up to 50 basis points, or up to 25% of the merchant discount. A payment switch makes it easy to capture and pass along Level II and Level III data as part of the settlement file. Specification changes: Processors and card associations make regular changes to their payment processing specifications. In some cases, compliance with these changes puts a merchant in a position to enjoy interchange savings. Payment switches make it easy to comply with specification changes, enabling merchants to quickly take advantage of interchange savings opportunities. POS Programming Cost Savings Insulate the POS from the processor world: As noted earlier, payment switches are designed to insulate the POS system from regular programming modifications necessitated by specification and regulatory changes from the associations and processors. There are literally dozens of these processor specification and regulatory changes across the industry every year. Without a payment switch, compliance with such changes requires costly and time-consuming custom POS programming projects. Adopt new payment types: Payment switches enable merchants to quickly adopt new payment types, since a new tender or processor module is all that is required, as compared with developing custom programming changes to a POS system. Revenue Generation Opportunities Customer choice: Payment switches are typically integrated and certified with multiple processors across numerous tender types and payment products. As previously discussed, this facilitates the easy adoption of new payment products. It also provides the merchant with a broad array of choices, enabling it to easily accommodate the payment preferences of its customers. Some tender types (e.g. Bill Me Later) have been proven to increase the average ticket or attract customers that might not

otherwise be attracted. By adopting such new payment types or message types more quickly, merchants can increase revenue. In addition, by offering switch-supported payment products, such as prepaid phone cards and gift card trees, merchants actually create new revenue streams by merchandising payment products. There is a revenue opportunity cost associated with failing to rapidly adopt such new tender types and payment products. Administrative Efficiencies Centralized reporting: A payment switch enables a merchant to centralize the entire settlement process. This eliminates the burden on in-store staff for batch settlement and the associated reconciliation challenges. In addition, by managing all transaction channels through a payment switch, merchants enjoy a single view into their payment system with one reporting and administrative interface. Integrated POS: Some merchants still operate payment terminals in a stand-beside scenario. Without integration, card information is entered twice at the payment terminal once via a card swipe and then again through a manually keyed entry into the POS system. A payment switch can help integrate payment terminals with POS systems, eliminating the need to double-enter transactions. It also removes the associated back office burden needed to reconcile transaction record differences between the POS system and payment terminal. Enhanced Customer Experience Transaction speed: By running transactions over a WAN through a payment switch and out to the processor merchants speed up transactions to sub-seconds (versus a dial scenario), which improves the customer experience. Multichannel recognition: When a merchant consolidates all transaction channels through a payment switch and accepts all payment types across all channels (to the greatest extent possible), customers appreciate the personalization inherent in such cross-channel tender acceptance. Prompting for PIN debit: As noted above, the use of PIN debit cards is automated through prompting, which reduces in-lane confusion, enhancing the customer experience. Other Savings Chargeback management: If chargebacks are an issue, payment switches with signature capture modules enable merchants to easily store and retrieve electronic receipts and meet the time constraints for chargeback challenges. PIN pad key management: For merchants accepting PIN debit, a payment switch with a host security module (HSM) gives merchants ownership and control over their security keys. Normally, control of such keys resides with the payment processor. An HSM can eliminate the cost of injecting PIN pads with new security keys in the event of a processor change. This cost, including shipping, can be as high as $840 per PIN pad.

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Enterprise Transaction Framework This section will describe the elements of an enterprise transaction framework a collection of software interfaces at the heart of which is an open architecture, Java-based payment switch (see Figure 2). This kind of transaction setup gives merchants more control over their payment systems. Authorization Engine The authorization engine is the core of the payment switch. Its purpose is to route any type of credit, debit, check, private label, stored value, phone card activation, or other electronic payment from any transaction source directly to the processing institution(s) of the merchants choice for subsecond authorization.

prompt customers to enter a PIN if PIN debit truly represents the least-cost option for the merchant. In this manner, higher interchange credit and signature debit transactions can be converted into lower interchange PIN debit transactions. Self-Managed Suite In addition to externally authorized payment types, stored value, house charge, check authorization, and signature capture modules can enable retailers to self-manage their own end-to-end payment solutions in-house, without any third-party dependencies.

Settlement Engine The settlement engine electronically transmits an electronic deposit file, commonly called a settlement file, to a merchants bank or banks (via a settlement interface) for enterprise-wide settlement and reconciliation. Online settlement screens, Figure 2: A sample enterprise transaction framework a collection of software reports, and other system interfaces with a payment switch at the core. features are available through the Web-based user interface, allowing for better tracking of bank Interface Toolkit card rejects or chargebacks, and providing The interface toolkit includes several software merchants with faster funds availability. Settlement development tools that enable merchants to easily options could include host capture, terminal capture, integrate any transaction source with the payment or a hybrid of the two. switch. Authorization Interfaces These interfaces enable the payment switch to send and receive payment messages to and from one or more payment processors for authorization. When an authorization request is received from the authorization engine, these interfaces decrypt the request, translate it into the native format of the target destination, and then transmit the request to the appropriate destination. When a response is received by these interfaces, it is translated back into the authorization engines native format, encrypted, and returned to the authorization engine. Settlement Interfaces Similar in nature to the authorization interfaces, settlement interfaces are responsible for formatting the settlement file according to processor-specific requirements for reconciliation. Transaction Services Additional capabilities may be required within the point of sale environment in order to most effectively process PIN debit transactions. These may include PIN pad device management, host security module functionality, and intelligent PIN prompting. The latter capability can identify PIN debit-capable cards and Conclusion The payment world continues to become increasingly complex, and payments are playing an ever-expanding role in the merchant environment. Merchants need best-in-class software applications to help relieve or eliminate the pain often associated with this inherent complexity. Payment switches are an increasingly important arrow in merchants quivers, in some cases insulating them from the complexity of payment processing, in other cases providing them the flexibility to adapt to change, but in all cases providing them the opportunity to realize meaningful and tangible benefits. About The Author John Filby, president and CEO of ISD Corporation, has more than 17 years of experience in the software industry. In 1999, he founded eCash Technologies, Inc., an electronic payments company and, as CEO, led the effort to raise more than $25 million in venture funding. The business was acquired by InfoSpace, Inc. in 2002. At InfoSpace, Filby served as VP , Merchant Services Division. Prior to founding eCash, John was on the management team of InterTrans Logistics Solutions, an enterprise software company that was acquired by i2 Technologies.

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