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Payment Processing 101: What it is and How it Works?

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The world is going digital and so are the modes of trade and transactions. The acceptance of digital payments is rising all around the world. Owing to its numerous benefits, both customers and businesses are accepting this trend. As a result, new online payment methods are evolving every day.

Have you integrated online payments into your business?

If not, it’s high time now. Go ahead with it.

Although most businesses and customers want to adapt to this advanced payment system, its complexity becomes a hindrance sometimes.

So, here we bring a comprehensive guide that takes you through different aspects of payment processing; from definition to its future trends.

Introduction to Payment Processing

When a payment is digitally made to a merchant or a business (in exchange of goods and services), it is known as payment processing. And the payment processor is the platform which manages this whole process. It authorizes, verifies and settles the transactions via electronic payment systems.

The good part of the payment processing system is that a variety of payments, including electronic funds transfers, credit and debit cards, mobile payments, automated clearing houses, cryptocurrencies and digital wallets are acceptable. 

All these online payment processing services work with the combined efforts of different stakeholders, including businesses, financial institutions, banks, payment processors, and technology providers.

Key Components of Payment Processing

Payment processing systems comprise a number of components which combinedly ensure a safe and secure transaction. Let’s know these components in brief.

  • The merchant and the customer: The merchant will receive the payment for the goods and services offered, while the latter makes the payment in return for the goods and services. 
  • The acquirer: The merchant or the business must have an account to receive payments. The financial institution that will hold the account of the merchant is the acquirer. It will receive the payment on the merchant’s behalf, process it and deposit the amount in his account.
  • The issuer: The financial institution that will hold the customer’s account is the issuer. It will initiate the transaction on behalf of the customer and has the right to authorize or decline payments based on the account status.
  • The mode of payment: The method of payment selected by the customer, including debit cards, credit cards, cryptocurrencies and electronic wallets.
  • The POS system: It’s the digital platform where the transaction occurs such as a mobile app, e-commerce website or a retail terminal.
  • The payment processor: It’s the third party that will handle the technical facets of online transactions by connecting the issuing bank, payment gateway and the acquiring bank. The payment processor will validate the payment details, get authorization and initiate fund transfer. Besides, the payment processing platform also ensures the security and safety of the transaction to avoid any fraud.
  • The payment gateway: This is the service that will transmit all payment details from the POS system to the acquiring bank/payment processor, while ensuring security of the data.
  • The card network: The rules and standards of different card organizations for executing transactions with their brands.
  • Payment security: Different technologies, standards and compliances required for the integrity and safety of payment information come under payment security. It includes encryption, tokenization and compliance with different industry standards such as PCI DSS.
  • Settlement: Once the payment processor authorizes and verifies the payment, the settlement starts. During this process, the acquirer transfers funds from the issuer’s account to the merchant’s account.

How Payment Processing Works?

So, by now, you have a basic idea of what payment processing is. But how does it work?

Basically, all the components work collectively to complete the payment processing process. Here is the process that explains the functioning of payment processing.

Transaction initiated by the customer

Firstly, the customer initiates the transaction by providing his payment details to the POS systems (mobile app, e-commerce website or any online platform).

Payment gateway

Now, the customer’s payment information reaches the payment gateway that connects the customer, business and the payment processor. The gateway encrypts the data so that it reaches the payment processor securely.

Authorization of transaction

As the payment processor gets the information from the payment gateway, it will authorize and validate it first. Once done, it is sent to the merchant’s bank. The bank then sends this information to the card company for further authorization.

Issuing bank verification

As the card company receives this information, it will send it to the customer’s bank so that it can verify the status of the customer’s account. After verifying the credit limit of the available balance, the issuing bank may authorize or decline the payment.

Authorization received

Based on the verification done, the issuing bank will send its authorization to the acquiring bank through a card network. The acquiring bank then sends this information to the payment processor. The payment gateway then receives this information from the payment processor and sends it to the merchant’s POS system.

Completion of transaction

As soon as a transaction gets approved, the settlement process starts. The merchant sends the goods or services to the customer and gets payment in this response in his account. On the contrary, for a declined transaction, the merchant may ask the customer for an alternate payment method.

Settlement of the transaction

All the approved transactions are sent to the payment processor for settlement. Now the acquirer’s bank can request funds from the issuer’s bank via card network. The issuing bank transfers the requested funds to the acquirer’s bank, which deposits into the merchant’s account in two-three working days.

Payment reconciliation

Once the payment is there, the merchant or the business will reconcile the payment with its sales. Further, they will analyze extra fees by the bank, payment processor or any other party. After a successful transaction, the customer and the business get the valid receipts, invoices and bank statements.

Types of Payment Processors

Undoubtedly, payment processors have become an integral part of modern trade to facilitate safe and smooth transactions. However, payment processors are of different types and you need to understand them before you make your pick.

1. Merchant account providers

Some payment processors create a dedicated merchant account to accept payments. They set these accounts in the merchants’ banks and offer special personal support such as risk management, fraud prevention, etc., and provide comprehensive solutions.

2. Payment service providers

With a streamlined approach, PSPs allow businesses to accept payments using different methods under a single platform. These PSPs also authorize, clear and settle the transactions on the merchant’s behalf. Unlike merchant account providers, which basically provide customized solutions for their customers, PSPs mainly strive to facilitate transactions smoothly and securely.

3. Industry-specific processors

There are some payment processors which dedicatedly provide services to specific industries/niches. Some offer special hardware options to in-person businesses while some others are good to integrate with accounting software.

Choose the payment processing services depending on your business transaction volume, requirements and preferred features.

Security and Compliance

Is my data secure in payment processing? 

That’s the question that pops into everyone’s mind about online payment methods. But thankfully, payment processors and related institutions take the required measures to ensure payment security. For a business, it is further essential to maintain the customer’s data security to build their trust and confidence. 

 So, let’s find out what security and compliance standards secure payment processing.

  • Encryption is one way to secure sensitive data as it converts it into a protected format. Thus, no unauthorized party can access this data. You can choose either symmetric or asymmetric encryption, depending on the keys for locking and unlocking the data.
  • Another way to secure data is tokenization where sensitive data such as credit card details is converted into specific tokens. If someone even compromises these tokens, they hold no importance.
  • All secure payment gateways need to comply with PCI DSS (Payment Card Industry Data Security Standard) and other similar industry standards. Compliance with such standards helps businesses be free from independent security considerations.
  • Multi-Factor Authentication means you need to prove your identity multiple times before accessing your account. You can add various identification features such as fingerprint, password or SMS code during payment processing for extra security.
  • Businesses must conduct security audits on a regular basis to ensure a secure payment space. It will detect any vulnerabilities so that you can promptly work on it.

Future Trends in Payment Processing

Several trends and technologies are emerging every day and they will surely shape the future of payment processing. With the onset of COVID-19, the idea of contactless payments gained traction and even after covid, the trend is still here. As contactless payment processing offers convenience and security, these are going to grow in the future.

Further, decentralized finance and blockchain technology will surely change the payment structure. As a merchant, you must prepare yourself for this renewed infrastructure to stay in the competition. 

Also, more and more mobile wallets will get linked to bank accounts to facilitate simplified online transactions. Apart from the banks, some non-bankers are also coming up with innovative solutions, expanding global payment solutions. As a result, you are going to witness tough competition and more collaborations among companies. 

With all these growing digital payment systems, the need for secure transactions will also rise. You may need to prove your identity through your biometrics. Also, some AI-supported security features and encryption will make their place in the market.


Hope this guide helps you get a brief idea about payment processing systems. All in all, payment processors prove to be the best payment processing for small businesses and large businesses alike. 

Knowing the intricacies of payment processing systems helps you choose simple, safe and convenient billing options for your customers. Keep yourself updated with the new industry trends and security standards to beat your competitors.


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