Credit card 101: Clearing and settlement

I ended the previous article by mentioning that obtaining an authorization is just the first step and in this article I would be explaining the second leg of the Credit card transaction life cycle, that is Clearing and Settlement. Technically, the authorization leg is also called BASE 1 and clearing/settlement leg is called BASE 2.If you haven't read the article on authorization process, I would recommend you to go through that first. Here is the link for the same.

So to start with, clearing and settlement in financial service industry refers to all activities from the time a commitment is made for a transaction until it is settled. So the transactions which has been successfully authorized by Issuing Bank has to be settled before sales can be deposited into the merchant’s bank account. When it comes to Credit card settlement, this is usually being done in three stages:

Stage 1

Transaction submission: Payments made through credit card is not completed until the transaction information is submitted to the processing bank(Acquiring Bank). Generally transactions are submitted electronically and all POS /virtual payment handling systems are modified to naturally do that at pre-characterized stretches. Generally toward the finish of the business day, the vendor terminal makes a batch of the multitude of transactions finished during the day and sends the equivalent to the acquirer.

For Card Not Present transactions(E-com, MO/TO) the transaction date is the shipping date, not the order date, so merchant should not deposit sales before you have shipped the associated items.

Once the Acquiring Bank receives the merchant batch, it performs the reconciliation with their own transaction log for this merchant. If the information is validated, then the Acquiring Bank sends a confirmation message to the merchant.

In case the reconciliation fails which happens due to the difference in transaction counts between merchant and Acquirer batches, then the batch mismatch is conveyed to the merchant. There are primarily two scenarios when the reconciliation fails:

• Transaction count in merchant batch is more than Acquirer batch: This happens when there is an offline transaction sync issue particularly when due to some technical glitch the merchant terminal could not send the authorization request to the acquirer/network and approves the transaction by itself .In this scenario ,Acquirer is going to create a new Acquirer batch which would comprise these additional transactions along with all the matched transactions.
• Transaction count in Acquirer batch is more than the merchant batch: This situation primarily arises when there has been a reversal on the transaction performed and it fails to synchronize on the acquirer side and thereby still appearing in their logs. These additional transactions won't be settled with the merchants.

Once the reconciliation is successful, acquirer credits the merchant's account after adjusting the settlement amount with Merchant Discount Rate(MDR) and submits the transaction to card schemes(VISA, MasterCard etc.).

MDR stand for Merchant Discount Rate which is charged to the Merchant by the Acquiring bank for providing them with the required infrastructure and processing services that enables merchant to accept credit card payments

Stage 2

Clearing: Through this process Issuing Bank exchanges transaction information with the Acquiring Bank. After successful reconciliation with the merchant, Acquiring Bank generates outgoing settlement file for various Card schemes/networks(MasterCard ,Visa etc.).These Card networks then further break these files into clearing files and is sent to different Issuing banks.

Each Issuing Bank then performs the reconciliation where their system initiate the match off process so as to validate the transactions approved by their authorization engine with that of transaction information appearing in Clearing file. After the match off processing, a status is stamped on those transaction. There are three statuses "Clean, Bad and Grey.

• A transaction is declared as Clean transaction once it successfully clears all the validations.
• A transaction is declared as Bad when it does not meet any of the condition specified by the Issuer bank.
• A transaction is declared as Grey when that transaction fails in any of the validations, 

Clean transactions are billed to the customer and gets reflected in the cardholder's monthly statement. All Bad transactions are sent back as chargebacks to the Acquirer bank through the Card schemes.

All Grey transactions are reviewed by the Bank Operations team and then decision is taken whether it has to be charged back to the Acquiring bank or would be billed to the customer.

Stage 3

3)Settlement: Settlement is the exchange of funds between a card issuer and an acquiring bank for all Clean transactions that would be billed to the customer. The cardholder is responsible for repaying his or her issuing bank for the purchases that has been billed on the statement and any accrued interest/associated fees.

Issuing Bank also levies an Interchange fees on the Acquirer and adjust the same while transferring the fund to Acquirer. We have to remember that when it comes to credit card, it's an unsecured line of credit and eventually any bad debt or fraud transaction is going to fall on Issuer's book and Interchange fees helps the Bank in covering those risks.

This conclude the basics of credit card transaction lifecycle comprising authorization, clearing and settlement.