Understanding open-loop payment systems
There’s very little that you can’t do with a credit or debit card. On one Saturday you could shop up a storm in your local shopping mall, pay for parking, fill up your fuel tank, and grab dinner at your favourite Italian restaurant – all before picking up tickets to catch the latest blockbuster on the silver screen. Swiping your card is just a part of what happens in everyday life.
But do you understand what really happens between the time your card is swiped, the PIN code is entered, and the local barista smiles as he hands over the receipt for the Americano order you’ve just placed? Hint: quite a bit. There’s a layer of technology that makes these and many more similar transactions happen across the globe every second. It’s called an open-loop payment system.
The when and why of open-loop payment systems
According to MasterCard, the very first payment card was born in Brooklyn back in 1946. John Biggins, an employee of Flatbush National Bank in New York decided to try an experiment. Biggins wanted to see if the option of credit would appeal to the local community so he created the “Charg-It” card. Community members who were also Flatbush National clients were afforded the opportunity to use credit in local stores and the bank assumed responsibility for collecting the debt from Charg-It cardholders.
The Charg-it card was a success; however, it had two major limitations. For starters, the card was developed to be used by a select few who banked with Flatbush National. The limited reach meant limited revenue growth for this new idea. Secondly, the users of the new card happened to be part of a small community – yet again, limited growth potential. Seeing that people were open to credit and the interest incurred for purchases made with the Charg-It card, banks quickly became aware of the potential revenue stream this new model presented.
In the mid-1960s, the idea to develop a larger network was formed. The concept was to offer a Charg-It-like solution to a much wider audience. Like all growing businesses, rules and policies were put in place to formalise billing processes and limit the amount of fraud inherent to trust-based systems. At the heart of this upgraded and larger system was an organisation called InterBank (now known as MasterCard). But it wasn’t until the 1980s that the very first card transaction which required a PIN took place.
By the 1990s open-loop payment cards existed in different forms in the US, from prepaid to payroll and even food stamp cards. At around the same time popular credit cards had also made their way to South Africa, with ATMs sprouting in more locations across the country.
How open-loop payment systems work
Open-loop payment systems are electronic networks that connect financial institutions to each other. These connections make it possible for consumers and merchants (who bank with the same or different banks) to come together and complete transactions. The open-loop payment system makes it possible for money to pass from your bank account to that of the merchant you transact with after a set of procedures have been followed and certain requirements successfully met.
In the typical open-loop payment system transaction, there are four participants: the consumer, the consumer’s bank (issuing bank), the merchant’s bank (also known as the acquiring bank), and the merchant.
Once the transaction is initiated via an electronic point of sale device or card machine, a series of steps take place for a card transaction to be completed. Here’s what those steps look like:
- You hand your card over to the cashier who swipes it and passes the card machine to you for your PIN code.
- Once your PIN code is entered into the card machine, an electronic request is sent from the card machine to the merchant’s bank. The card machine asks the merchant’s bank if the card presented is a valid card (the authentication step), and if the account associated with the card has enough funds to pay for the transaction (the authorisation step). If the card was not issued by the merchant’s bank, the same authentication and authorisation requests are passed through the open-loop payment network from the merchant’s bank to your bank.
- Once the authentication and authorisation steps have been completed successfully, the merchant accepts the payment and the funds are then transferred electronically from your bank account to the merchant’s bank account.
These steps take place for every card transaction you make at a till.
It’s worth noting that the authentication and authorisation steps are the only ways for banks to know whether you are who you say you are, and that you’re good for the transaction. Card fraud is big business in South Africa and internationally, which is why security measures like entering a PIN code before a transaction exist to combat card theft, and SMS notifications for transactions limit the amount of loss in the event that a card or bank account is compromised.
Open-loop payment systems are large networks that span continents and facilitate an unimaginably large number of transactions occurring across the globe every second. Through the use of authentication and authorisation steps, they give consumers the opportunity to spend electronic cash with merchants. While they’re very rarely the topic of conversation, knowing how open-loop payment systems work should help you find a little more appreciation – and possibly a little more patience – next time you’re at the till waiting to enjoy a coffee.