Payments Ecosystem 101

A summary of Payments in the Context of Shopify

The Digital Transaction Process, Players & Shopify’s Role:

Before going into how Shopify creates value in payments, it’s imperative to understand the process, its players and how the firm fits into the full equation.

Checkout begins when a customer finishes filling their online basket and is ready to pay for their selections. The customer can enter in credit/debit card information manually, or can use a payments provider like Shopify Payments to have the data auto-populated once an account has been created. After a payment method is selected and the data is entered, the card and all identifiable account information is encrypted (AKA tokenized) by what’s called a gateway service. Shopify Payments offers a gateway. This can effectively be considered a digital point of sale (POS) system or a high-tech, digital cash register during the checkout process.

• Tokenization definition: Process of anonymizing sensitive card data by converting it to a string of continuously generated numbers called a token. This is very similar to encryption and the two terms are often used interchangeably.

A gateway offers many of the essential software connections to the rest of the landscape. It plugs a merchant’s site into online payment processors, integrates into card networks and connects to digital wallets to power consumer payment optionality. It’s needed for any online sales presence. Gateways also provide payment vaulting databases which serve as encrypted storage systems of consumer information. That’s how shoppers can speed through checkout without entering in card and address data each time.

Post-gateway data collection and encryption, this information is sent to a payment processor. Processors conduct most of the transaction authenticating to ensure its legitimacy and legality. It’s the work horse of the equation and the second required merchant connection -- this time between gateways and the merchant’s bank. A processor moves the transaction funds through its network and back again, facilitates the settlement of funds and authenticates. Shopify Payments offers processing through a partnership with Stripe rather than doing so on its own.

• Payment processor examples: Adyen, Stripe, PayPal, Braintree etc.

Authentication concludes with a request sent from the processor to the customer’s card issuer.

• Card Issuer examples: Bank of America issues a consumer debit card on top of a card network (rail) like MasterCard.

The issuer is the party ultimately responsible for approving the transaction -- it will do so largely based on account balance data. Processors authenticate and issuers authorize all in a few seconds. If approved by the issuer, it will then directly fund the transaction and communicate its decision to the rest of the ecosystem. Issuer funds will be sent through the processing network, back to the gateway and ultimately into a merchant bank’s (or merchant acquirer’s) deposits.

This merchant acquirer maintains and services merchant accounts within their deposit ecosystem. Shopify does not offer traditional merchant acquirer accounts.

Post fund settlement, the acquirer immediately credits the merchant account for the sale amount. Settlement usually takes a day or two, and commonly, the role of merchant acquirer and processor are done by the same entity (such as Wells Fargo). Merchants must have one of these accounts in order to accept online payments through a licensed financial institution.

Finally, to compensate the consumer issuer for its transaction funding role, it directly debits the shopper’s approved account by the amount of the purchase. It’s worth noting that none of this process is visible to the front-end customer, but instead facilitated all through the back-end to ensure a slick, delightful experience. All a shopper sees is a receipt post-approval or a notice of rejection from the gateway.

Fees:

Every party mentioned above that touches the transaction requires a fee for their participation:

• The interchange fee is paid to the customer’s issuing bank as a percentage of every sale. This is usually around 2% of the sale + ~$0.10.

• The assessment fee is paid to the credit card association (card rails such as Visa or AmEx). This is often combined with the interchange fee and quoted as one value, but alone it is typically around 0.1% of the sale + ~$0.10.

• The markup fee is paid to any other party involved in the transaction -- such as the merchant acquirer. This is usually around 0.25% of sales + ~$0.10 on its own.

• The authorization fee is paid to the processor for their services and is generally ~$0.30 per transaction. This is charged for all transactions: sales, declines and returns.

  • This is why a merchant bank/acquirer would ideally like to be the processor for every transaction as well -- they get a higher, margin-accretive fee.

There are various methods for quoting these fees for merchants. Regardless of the method chosen, these costs are inherent in card-based commerce.