Table of Contents
What is Payment Settlement?
The payment settlement is a process in any financial transaction where the issuing bank transfers funds from the cardholder’s account to the acquiring bank through a payment gateway. This is the final step in any financial transaction after authorisation and approval. This process ensures that relevant parties receive correct payments.
How Does Payment Settlement Work?
1. Initiation of Transaction
The customer initiates a payment by presenting their card or payment information to make a purchase. This can occur at a physical point-of-sale (POS) terminal or through an online payment gateway.
2. Authorisation
The merchant’s POS system initiates an authorisation request, which passes through the acquiring bank and card association to reach the customer’s issuing bank. The issuing bank performs several checks on the card’s security details (like expiry date and CVV) and confirms that sufficient funds are available.
3. Clearing
The clearing process starts when merchants batch authorise transactions and send them to their payment processor. The acquiring bank forwards these to card networks, which route them to issuing banks. During this process, card networks calculate interchange fees for processing transactions between banks.
4. Settlement
The settlement involves the actual fund transfer. The issuing bank sends funds to card networks (like Visa or Mastercard), which transfer them to the acquiring bank. The acquiring bank then credits the merchant’s account with the net amount after fees.
Example Payment Settlement
Let us go through the step-by-step process of how payment settlement works during an online purchase of a product that costs ₹5,000.
Step 1: A customer finds a desired product in an online store and decides to purchase it. As they proceed to checkout and enter card details, the online store’s payment gateway transmits this detail to the card network.
Step 2: The card network passes on this information to the customer’s bank – known as the issuing bank.
Step 3: Next, the issuing bank performs a couple of checks: is there enough money in the account? Does this transaction fit the customer’s usual spending pattern? If all is well, the bank sends an approval code to the card network.
Step 4: The payment gateway notifies the online store that the transaction is approved. The customer sees a confirmation page and receives a receipt.
Step 5: As the business day concludes, the online store’s acquiring bank reaches out to the customer’s issuing bank, asking for ₹5,000.
Step 6: The issuing bank transfers the ₹5,000 to the acquiring bank, which then deposits it into the online store’s merchant account.
Payment Settlement in Different Payment Methods
1. Debit Cards
When a customer purchases using a debit card, the merchant’s point-of-sale system sends the transaction information to the card network (e.g., Visa, Mastercard). After validating the card information, the network forwards the data to the customer’s bank. The bank verifies sufficient funds. If approved, the funds are immediately allocated for settlement to the merchant’s account.
2. Credit Cards
Credit card settlement involves a multi-step process that typically takes 1-3 business days. After a transaction is authorised, the merchant submits a batch of approved transactions to their credit card processor at the end of the day. The processor forwards these details to the respective card networks. These networks then coordinate with issuing banks to transfer funds for each transaction to the merchant’s acquiring bank.
3. UPI
UPI settlement is one of the fastest payment methods. When a user initiates a payment using a UPI app, their bank verifies the request and sends it to the National Payments Corporation of India (NPCI). The NPCI then routes the request to the recipient’s bank. Upon receiving this request, the recipient’s bank immediately credits the account.
4. Net Banking
Net banking transfers, which include RTGS (Real Time Gross Settlement) and NEFT (National Electronic Funds Transfer), have different settlement timeframes. RTGS provides real-time settlement, where fund transfer instructions are processed and settled individually as they are received. NEFT, on the other hand, operates on a deferred net settlement basis, with transactions settled in batches every 30 minutes.
5. Mobile Wallets
Mobile wallet settlements vary depending on the specific wallet provider and the type of transaction. For in-store purchases using NFC (Near Field Communication) or MST (Magnetic Secure Transmission) technology, the transaction settlement process is similar to credit or debit card transactions. For peer-to-peer transfers within the same wallet ecosystem, settlements can be instantaneous.
Types of Payment Settlement
1. Issuer Settlement
Issuer settlement is an interbank settlement where the issuing bank (the customer’s bank) transfers the transaction amount to the acquiring bank (the merchant’s bank) via the relevant card network.
2. Merchant Settlement
Merchant settlement occurs when the acquirer transfers the transaction amount to the merchant’s business bank account minus any applicable fees.
3. Scheme Settlement
Scheme settlement refers to the process where the acquirer receives funds from issuers via the card schemes. The entire process is facilitated by card schemes such as Visa or Mastercard, which provide the network and infrastructure for transferring funds from issuers to acquirers.
Components of Payment Settlement
1. Cardholder
The individual who purchases goods or services using a credit or debit card.
2. Merchant (Business)
The entity selling goods or services. They accept payments from customers.
3. Acquiring Bank
Acquiring banks provides merchants with the tools and accounts to accept card payments and communicate with issuing banks.
4. Payment Processors
Third-party companies that manage the transaction flow between merchants, acquiring banks, and card networks.
5. Card Networks (e.g., Visa, Mastercard)
These networks facilitate the electronic transfer of financial information and funds between parties.
6. Issuers (Issuing Banks)
The banks that issue credit or debit cards to customers. They are responsible for paying the acquiring bank on behalf of the cardholder.
Significance of Effective Settlement Practices in Business Operations
Reduction of Financial Risk
By minimising the time between transaction initiation and fund receipt, you can decrease your exposure to various financial risks like fluctuating currency exchange rates, the risk of insolvency of involved parties, and the possibility of fraud.
Improved Cash Flow Management
Timely settlements enable you to accurately forecast cash inflows and outflows. This enhanced visibility into financial resources allows you to make more informed decisions about investments and expenses.
Enhanced Stakeholder Trust
Efficient settlement practices lead to customers experiencing smooth and reliable transactions and your suppliers receiving timely payments.
Reduced Operational Costs
By automating settlement procedures, you can focus on core activities that drive growth and innovation rather than getting stuck in financial administration.
Improved Budget and Timeline Management
Real-time financial data enables precise planning and budgeting. This allows you to allocate resources efficiently and operate responsively.
Challenges in Transaction Settlement Processes
Settlement Delays
Settlement delays happen when there’s a lag between initiating a transaction and the actual transfer of funds. These delays can be caused by technical issues such as system outages, batch processing methods, or regulatory compliance checks. The impact of settlement delays leads to lost sales and damaged customer relationships.
Reconciliation Issues
Reconciliation is the process of ensuring all parties involved in a transaction, have the same view of the data. This process faces challenges such as error-prone manual processes, complex transactions involving multiple parties, and a lack of standardisation in data sharing. Inefficient reconciliation leads to inaccurate financial reporting and difficulty in identifying outstanding payments.
Transaction Data Discrepancies
Mismatches can happen in transaction data recorded by different parties involved in the settlement process. These can arise from multiple data sources with separate databases or timing issues. Data discrepancies lead to inaccurate cash balances and difficulties in detecting fraudulent activities.
Chargebacks
Chargebacks occur when a customer disputes a transaction, which results in a reversal of funds. They present challenges regarding the impact on cash flow and increased operational costs for investigation and resolution.
Fraud Prevention
Fraud prevention measures are implemented to protect against fraudulent transactions, but they can slow down genuine settlements. These measures often involve rigorous verification processes and additional scrutiny for high-risk transactions. Failing to identify fraud promptly can lead to significant financial losses and increase the liability for businesses.
Regulatory Compliance
Regulatory compliance refers to following legal and regulatory requirements. It presents challenges in the form of time-consuming checks and changing regulations that require constant process updates. Compliance requirements can increase settlement times and operational complexity.
Best Practices for Improving Transaction Settlement Processes
Regular Reconciliation and Audit
Regular reconciliation and audit involve implementing robust processes to match transaction records consistently between payers and payees. To implement this, businesses should set up automated daily reconciliation processes, conduct monthly audits to review overall settlement patterns, and use specialised reconciliation software for large transaction volumes.
Adoption of Modern Technology Solutions
Adopting modern technology solutions leads to reduced manual errors, provides robust security measures, enables real-time processing, improves cash flow, and reduces settlement delays. Implementation strategies include investing in secure, encrypted payment gateways and utilising blockchain technology for transparent transaction records.
Understanding and Mitigating Settlement Risks
Understanding and mitigating settlement risks involves identifying potential issues in the settlement process and implementing strategies to address them. To implement this, businesses should conduct regular risk assessments, implement advanced fraud detection systems, and maintain compliance with relevant financial regulations.
Future of Transaction Settlements
Growing Demand for Real-Time Payments
Driven by blockchain innovations, real-time settlements are becoming standard in the global economy. New-age platforms have started to offer instant settlements, and low-cost international payments by eliminating intermediaries, reducing fees, and enhancing transparency.
Rise of Cryptocurrency
Tokenisation and cryptocurrencies are accelerating asset settlements. Central Bank Digital Currencies (CBDCs) provide secure, efficient alternatives to traditional systems for faster cross-border transactions.
Impact of Regulations and Compliance
Regulations like Payment Services Directive 2 (PSD2) mandate Strong Customer Authentication(SCA). This is helping reduce fraud and enhancing consumer trust in digital payments. Businesses must prioritise compliance with global regulations to ensure secure and transparent transactions.
Challenges in Payment Processing and Solutions
Digital payments present challenges such as data breaches and fraud. Regulatory complexities, especially for businesses operating across borders, add to the difficulty. Also, competition from fintech startups pushes traditional financial institutions to innovate quickly to stay relevant.
To address these challenges, processors can offer value-added services like integrating blockchain, AI, and IoT for secure and automated payment processing.
Frequently asked questions
1. How long does transaction settlement take?
Payment for settlement systems have different timelines for different payment methods. For instance, transaction settlement typically takes one to three business days for credit cards.
2. What are the common methods used for payment settlement?
Common transaction settlement methods include cash, cheques, credit cards, debit cards, and bank transfers.
3. Are there any fees associated with transaction settlement?
Yes. Transaction settlement fees are deducted by the merchant’s acquirer before funding the merchant’s account.
4. What are the potential risks involved in payment settlement?
The main risks in payment for settlement are credit risk, where a party can’t meet its obligations, and liquidity risk, which results from delay in transaction settlement.
