Bitesize Payments

The Magic of Cards and their 4 corners

• Paul Thomalla • Season 1 • Episode 9

Share episode

Welcome back, dear listeners, to 'Bitesize Payments.' In this podcast, we delve into the fascinating history of payments, exploring how they function, and the key players involved. Today, our focus is on cards. Once considered a status symbol, today nearly everyone possesses one, with many owning multiple cards. While most of us use them in our daily lives, have you ever wondered about their origins, how they function, and who's behind them? 

 

Did you know? There are approximately 24 billion cards in circulation worldwide. With a global population of around 8 billion, including children, it's evident just how much we adore our cards.

 

To shed more light on this topic, I'm thrilled to be joined by one of the most knowledgeable payments experts I know and my good friend, David Godfrey. 

 

Let's dive into the world of our 'flexible friend.' Let's get started 

Send us a text









Payments Industry Insights

History of Payments

Payment System Explained

Corporate Payments Strategy

Payment Regulations Impact

ISO20022 Standard

Digital Payments Evolution

CBDC Advancements

Cryptocurrency in Payments

Financial Technology Education


SPEAKER_01:

Welcome back, dear listeners, to Bite Size Payments. We're looking at the history of payments, how they work, and of course, who does what. Today, we're going to look into cards, the magic of cards. They were once a status symbol. Nearly everyone has one. Some have loads. They're mostly used by you and I as citizens. But where did they come from? How did they work? And who does what? Welcome to our flexible friend, cards. They just work like magic, right? Off we go. So today we have some 24 billion cards in circulation, which given there are only 8 billion people, and that includes children, Well, you can kind of do the maths. We love cards. To understand a little bit more, I am joined by one of the most knowledgeable payments guys I know, David Godfrey. Welcome, David.

SPEAKER_00:

Yeah. Hi, Paul. Thanks very much for inviting me. Looking forward to talking more about cards.

SPEAKER_01:

Brilliant. I'm so pleased that you're here, mate. As I mentioned in the episode on citizens, cars were first used by Diners Club, which used all of 27 restaurants that they were working with in New York. Then American Express in 1958, a year after I was born, I should say, expanded the concept from restaurants to merchants. In 1966, a good year for football. The Bank of Delaware introduced the first debit card and Visa introduced a nationwide debit card in the United States in 1982. And that was called the Visa Check Card, which further popularized the use of debit cards for everyday purchases. Bank of America originally owned Visa and MasterCard was effectively launched to actually compete with them. And that was in 1966. Of course, there are notable others. There is Amex, Discover, JCB, etc. But effectively, Visa and MasterCard have their logos on about 80% of all the cards worldwide. But effectively, Dave, there are three types of cards.

SPEAKER_00:

Yeah, indeed. So we have debit cards, credit cards, and closed-loop cards. I think debit cards and credit cards everybody's familiar with. Those are the ones that we all use. We know how they work. A debit card is linked to our bank account. so that when we use it, the funds are debited from our bank account. A credit card that is linked to a line of credit that the credit card issuer gives us. The closed loop cards, the ones that people are less familiar with and to all intents and purposes probably look and work in the same way, but tend to be used by smaller groups of people, particularly used by businesses, for example.

SPEAKER_01:

Yeah, but the majority of this is around citizens. It's us. It's the retail side of things. But In the early years, it was kind of like the Wild West. I remember those Zip-Zap machines where you put your little card in and then they created electronic devices. And we had different card standards. We had different networks behind them. And I literally can remember going into stores with a card and trying every machine until eventually it worked. And that was horrible for the merchant. It wasn't that great for us either. But we did need to get some kind of standardization going.

SPEAKER_00:

Yeah, I mean, absolutely. Standardization is critical. And that started really with the physical aspects of the card. You know, what's the size of the card and how is the information stored on the card that is going to enable the citizen to make a payment transaction? If we think about the physical side of the cards, people might be surprised to know, but that's been standardized since the 1960s. The International Standards Organization, the ISO, created a standard in 1985, ISO 7810, that very specifically specified what the dimension of the credit card was, 85.6 mil by 53.98 mil, or 3.375 inches by 2.125 inches. Who would have thought it was quite that important to get the size right? But of course, it really is, because the standardization of credit card and debit card sizes was necessary. As you said, we had all these different payment terminals and devices being made all over the world different manufacturers and a key thing with cards of course is interoperability we want to be able to go anywhere and use our card anywhere and not worry if it's going to work so having that standardization making sure that the cards were the same physical dimension so they could fit in the machines made by anybody that's obviously a really key step it might sound obvious but you know that's been a key thing behind the success of these cards um And then we can also look at how the card carries the information that it needs in order to enable a payment to be made. Three ways of doing that, of course. So mag stripe that was used for many years. So that's the black magnetic stripe. Most of our cards still have those. Although if you're anything like me, I can't remember the last time I used my card where the mag stripe was actually swiped. And to be honest, I'd probably be pretty suspicious now if somebody wanted me to swipe my card. Absolutely. And then what we call chip and pin, also more technically known as EMV. So if you're in the UK, I think it was 2005, 2006, we moved away from mag stripe to chip and pin. So putting a smart chip on the card to securely store all of the card data and have a quite sophisticated mechanism that the owner of that card needs to follow in order to authenticate themselves. So typically you type your pin, into the card terminal in order for the card to be used. So all about actually making the use of the cards more secure and giving people more confidence to use their cards securely. And then again, more recently, contactless that is built upon that EMV chip and pin technology. So using technologies like RFID, near field communications, and that allows us to use the card simply by holding it in proximity to a suitable terminal. So what people might call tap and go or something like that

SPEAKER_01:

yeah and you know now of course we can embed effectively the card onto our phones we don't even need to carry cards which is which is kind of crazy but that's the way the way it is but it's It's really important to remember that while we want to talk about cards, we're really talking about the networks that they run over. To all intents and purposes, these are Visa and MasterCard. But we should really discuss the schemes rather than just the network. And the schemes are effectively the rules that go around the brand of the card, say Visa, as opposed to the scheme that covers Amex. But it's not only international schemes, there are local ones too.

SPEAKER_00:

Yes. So, you know, people obviously, as you said, familiar with Visa, MasterCard, Amex, maybe Diners Club. But you're also seeing, for example, union pay from China over the past decade has become far more widely accepted internationally. I think that's just a reflection of the economic growth of China and more Chinese tourists, for example, traveling around the world. So a few years ago, if I went to a hotel or a shop in London, I might have seen a Visa and a MasterCard logo. Not at all uncommon now to see a UnionPay logo and see that they accept those cards as well. You also have something like JCB. That was originally Japan Credit Bureau. They created alliances with a number of organizations in the US in the 2000s and really expanded their footprint. And then I think a really interesting one, RuPay in India. Only created around 10 years ago. And I think as a political imperative, really, by the Indian government, they wanted to see a domestic payment network that was under the control of the Indian government and the Indian payments industry. and businesses and banks and so forth. And if we think China and India is over a third of the global population, it's pretty obvious why those schemes are so important. And they're only going to grow in prominence. We're just going to see more and more of those schemes, just a reflection of the size of those countries.

SPEAKER_01:

Yeah, and I think that the actual control piece inside of the country, we'll come back on to that later on. But least we forget, these schemes mean that when we go on holiday, our cards work there too. It's not just about it being in the UK or in France or in America. When we go away, our cards work. And if you have an issue or a dispute, as it's called, these schemes effectively govern how those issues get resolved.

SPEAKER_00:

Yeah. And I think this is just all part of the magic of card payments, isn't it? Especially if you're Somebody that doesn't understand the intricacies of how this all works, but it just does look like magic, but it is fantastic, the interoperability that has been promoted and created by having these rules that the card networks and the card schemes, as you pointed out, created that dictate to the merchants and actually all of the other parties that are involved in the payment transactions as to how they use the payment network, what are they charged for doing it, under what conditions should they accept or not accept transactions, and as you said, how they might have to deal with refunds or disputes if somebody's card has been used fraudulently, what risks they're taking when they do all these different transactions and so forth. So yeah, that interoperability that has been effectively created by having a very, very strict set of rules that everybody has to follow, I think, is just part of the magic of how cards have developed.

SPEAKER_01:

And I think that's right. At times, cards just do feel like magic. They generally work just about everywhere now. And so the cards themselves, the standardization, the schemes, the regulation, they've been entwined for so long. But let's go on to the next stage of this and talk about how they actually work. The cards world is almost always, as we discussed before, used by citizens and mostly used with merchants either online or in store. However, there are many players in the cards world. While there are many differences between online and in store payments, we're going to treat them as the same for the time being. Clearly, this is not actually true for the merchants, as Paul and I discussed when we talked about merchants. But we have issuers, acquirers, processors, standards organizations, merchants, ped manufacturers, networks. Honestly, there are so many players here. At times, it's really hard to get your brain around them all. So let's start to lay out some of the main players in the process, which was created in the 90s and effectively is called the Four Corner Model.

SPEAKER_00:

Yeah, so four corners refers to a payment processing model that describes the four parties involved in a card transaction. We have cardholder, merchant, the acquiring bank, the issuing bank, and then ultimately they're all interconnected via a party in the middle, which is the card network. So the cardholder, this is the citizen who uses their debit or credit card, puts it into a terminal, taps a terminal to make a purchase at a merchant. That's obviously the bit that everybody is very familiar with because they all do it many, many times a day. The merchant then, of course, they accept that transaction using their terminal or their PED. They submit the transaction to their bank, the acquiring bank, for processing of that transaction. The acquiring bank validates the transaction received from the merchant and sends the request to authorize that transaction to the card network. The card network receives that from the acquiring bank and they will route that request to the issuing bank, who is then going to verify that the cardholder has available funds or is within their credit limit if it's a credit card. And the issuing bank receiving that message, shall we say, from the card network, sends the authorization response once they've checked, do I actually have enough money in my account? Am I within my credit limit? Back to the network. The network routes it back to the acquiring bank. The acquiring bank routes that back to the merchant. And ultimately, that enables the merchant to know, has the transaction been approved or not? And can they accept or decline the payment? Can they give the customer, the consumer, goods. So that is the, I guess, easily understood part of the process, because that's the bit that the consumer sees. And it all happens in the blink of an eye, literally in a second or so, all of that stuff has happened, again, part of the magic of cards. We then have a process that goes on, shall we say, behind the scenes, the settlement process, making sure that that ultimately the money gets moved from the consumer's account and the merchant gets paid for the goods. And that bit doesn't happen quite so quickly. So again, I don't think that's always necessarily obvious to the consumer. They might think, you know, I've tapped my card, and if I look at my bank account, my bank balance has gone down by£10. The merchant must have been paid, but of course it's a little bit more complex than that. So the settlement process sees the acquiring bank settling the transaction by sending the funds to the merchant and making sure that the Cardholders account was of course debited at the issuing bank. So that four-corner model ensures the secure and efficient processing of card transactions, makes sure that cardholders can use their cards to make purchases wherever they like, and it makes sure that merchants know that the consumer is good for the money, they have the funds available, and that they are going to get paid for the goods or services that they just supplied.

SPEAKER_01:

Absolutely. Now, You know, interestingly enough, Amex and Dynas have a closed loop model and effectively they have a three corner model, but the majority of users are using what you've just said, Dave, the four corner model. And one of the focal points of the four corner model was literally who gets paid for what. And this model was called effectively the interchange fee. Now there's more bits, but effectively it's about the interchange fees. And the interchange fee has been the focus of regulators ever ever since it was created. But as we've discussed before, these fees are effectively paid by us, the user, and we don't necessarily see them, but they're embedded in the price that we pay. So while the price may say it's£10, what have you. Inside of there, there is this 2.5%, 3% fee that is used to fund what we call the interchange fee. However, the high cost of this interchange fee has been a source of controversy as merchants and consumers have argued that the fees are too high and increased the cost of the goods and services. It's gone on a long time.

SPEAKER_00:

Yeah, it has. It's a contentious point that always seems to be bubbling around and always seems to be in the news. But I think we should also recognize that interchange fees are an important component of card payments. Ultimately, somebody has to bear the costs. The card networks and the banks are not charities. They have costs running these systems. So ultimately, the interchange fee helps to ensure the secure and efficient processing of these transactions. actions and make sure that everybody involved in the process is rewarded for the investment in all the technology and the services that they have to provide to make this magic card system all work.

SPEAKER_01:

Yeah. EU regulators are focused in on the interchange fee with the interchange fee regulation of 2015. And it really has been a cat and mouse game for some time now. The regulators, they make the regulations, and the networks take those regulations and go, ah, maybe I should change my processes, right?

SPEAKER_00:

Yeah, and I think a good example of how this might not work in the way that people thought it was going to work, what we call the law of unintended consequences, was in Europe several years ago. The regulators try to regulate interchange fees to reduce them with the aim to ultimately reduce the cost of payments, I guess. But then, of course, these fees represent income for things like the issuing banks who get some of the interchange fee. And all of a sudden, they see their income reduced because the regulators have reduced the amount of interchange that could be charged. So they have to mitigate that loss of income. And what did we see? Well, things that were previously, shall we say, free, like issuing a card for you every year, is now charged for. So whereas at one time, maybe my credit card was free and the issuing bank just made their money on the interchange and maybe on charging the interest on the credit if I didn't pay my card every month. Now, of course, it's quite common to see an annual charge for the card. So I think sometimes, as I say, the regulators might have good intentions, but it doesn't necessarily end up in reducing the cost to the consumer.

SPEAKER_01:

No, I genuinely think it's a bit of a cat and mouse game there. Now, It's also true to say that every country has their own protocols for cards in the same way as we talked about for some of the other payment rails. So it's generally quite a complex process, especially for large merchants, when they have to implement in many countries. So perhaps in Europe, in France, Germany, Spain, Belgium, they're all slightly different protocols and slightly different methodologies. So it can be quite complex for large merchants. merchants to do this. It's also true to say, in this particular part of the world, we hear a lot about data. And there is so much data here that it's actually crazy, but it's not so easy to use as you might think. The banks know, for instance, that we've spent money at, say, Tesco's, but not what I actually bought at Tesco's. Tesco's know that somebody with the card number dum-di-dum-di-dum-di-dum bought these gods, but not necessarily Who? So data is not quite as sweet as people think it is in here.

SPEAKER_00:

Yeah, I mean, effectively, you've got all of those different parties that we talked about earlier involved in the transaction. And each one of them knows some of the truth, but they don't know all of the truth. And probably none of them know all of the things that they would ideally like to know. So it's quite obvious that a large retailer would love to know as much as possible about who is buying their products so that they can better promote those products and do other things to optimize their business. And that, of course, is why you see these large retailers wanting you to sign up to their loyalty schemes. So Tesco Club Card in the UK, for example. And that gives them far more insight then into that data and interestingly of course it also opens up the possibility of the retailer once they've got people onboarded onto those loyalty apps and people have got into the habit of using them, especially if it's a, let's say, a smartphone app rather than a physical card, that the retailer can then actually create their own payment capability using things like QR codes to pay using the loyalty app rather than using card transactions. And again, there's a whole bunch of reasons why the retailer might want to do that. But certainly, you know, think of a number of well-known high street retailers in the UK that have done that and been very successful at it.

SPEAKER_01:

Yeah. So one of the things we do need to talk about is the PAN, okay? Now, we're not talking about Peter here. We're talking about your personal account number. And it's a unique 14 to 19-digit number that effectively identifies you under credit card or debit card. And the PAN is effectively embossed It's laser printed at the front end of the card. It's also stored in the mag stripe or the chip. And of course, it's stored on your phone. And the first digits of the PAN identifies your card network. For example, Visa starts with a 4. MasterCard starts with a 5. American Express with a 3. And the remaining digits of the PAN identify the issuing bank, the individual account. But here's the real thing. The card is really the mechanism by which we identify your ID.

SPEAKER_00:

Yes, so the PAN is used to identify the cardholder and to authorise transactions. So when you make a purchase with your credit or debit card, That PAN is part of the data that the merchant, shall we say, extracts from the card and sends to the card network. The card network uses the PAN to route the transaction. So as you explained, Paul, using different parts of that PAN to figure out where that transaction should go to. And then the issuing bank that receives the transaction uses that PAN to figure out which account it is that needs to be checked in order to authorize the transaction. So the PAN is literally the key, the ID that points to the bank account or to the credit card account. So absolutely key part of how cards work. Another interesting thing about this is for the longest time we've been used, as you said, the card, the PAN number was embossed or printed on the front of the card. Starting to see now banks, um not putting pans on cards so chase who started up uh a uk entity for example have made a big thing about their cards don't have a card number in it they might not use the term pan because they obviously know people when and understand what that means but yeah they make a big thing about saying actually the card pan is not on the card and because most people are using it contactless chip and pin so why does that card need to have the pan printed on it And indeed, if you do want to use it online, log into their online facility or use their app, and then you can get access to the PAM there. So an example of the way that the use of cards has evolved over time and how institutions are starting to say, okay, maybe we should evolve the way that we produce our cards to reflect that in order to promote better security.

SPEAKER_01:

Okay, so that's a walkthrough of how cards work. But we need to come back to the Muthoni issue and explore it a bit more about regulation. So I think it's fair to say, Dave, that the regulators have had a keen eye on interchange fees and schemes and the rules that manage their use. They're worldwide. So one level, the great, as we said, when you go global, go on holiday or go abroad. And cards are magic. But it's also true to say that their management is outside, generally, of the regulator's specific control. Regulators are looking to regulate what they can, i.e. fees. And we talked about that cat and mouse thing. But clearly this is different around the world. So you've talked about India and you've talked about China and the US, that's easy. But the truth of the matter is cards keep coming under scrutiny and the EU has tried three times to the best of my knowledge to replace the, let's call them the American schemes and try to come back with something else. It's not really happened though, has it?

SPEAKER_00:

It's not. And I think a big part of that issue is the ubiquity of cards. It's incredibly hard to replace something that everybody already has. For the most part, something that works. And I think it's fair to say most people are happy with the way that cards work, especially the ability to use more smart devices as well now. So that's a huge barrier to replacing those cards. And of course, even if they could decide that they did want to go and do that, the cost to do it would be very, very significant. And ultimately, those costs, regardless of how it gets represented, get paid for by the consumer. So in trying to replace... cards or to come up with an alternative to some of the existing card schemes and saying well actually the reason we want to do this is because we want to reduce costs for the consumer would that actually happen or would you actually end up spending so much money that would have to be amortized then across all the transactions and funded by the consumer so of course what we have seen is the rise of you know payment schemes that ride on top of card payments so things like apple pay and android pay But, of course, the reality, as I said, is they just ride on top of the card networks. They've just dematerialized the physical card into something that could be handled via a smartphone. And the underlying payment transaction is still handled by the card networks using the same model we discussed. I do think the fact that once people increasingly move to using their smart devices instead of using the physical cards... that barrier to replacing the card schemes potentially comes down because actually all people are interested in is how does this transaction work as far as I'm concerned. So if I go and tap my phone on a terminal and it allows me to pay for some goods or services, Do I really care if it actually went through a Visa or MasterCard network behind the scenes, or if it was actually handled via some alternative new digital payment scheme that would be created? So I think there's a lot of barriers that would stop it happening, but I think we're increasingly getting to a point, like I say, because of the emergence of smart devices that might make it more possible. And maybe talking a little while about something like UPI in India, which actually has been a huge success in trying to do that. Yeah,

SPEAKER_01:

and I think one of the things is that, you know, from a regulator's point of view, the scheme owners of Visa and MasterCard are outside of their purview. So all they can do is look at fees and try and touch on the outsides. They would dearly like to bring it inside of their remit, a bit like you talked about in India. And so we're now seeing different types of things happening. I'm seeing different rails potentially vying to displace card networks. So I worked on the digital euro feedback with two different groups, and you can see the use cases they're trying to build in there. But it's also true for immediate payments, right? So there are different ways of doing this.

SPEAKER_00:

Indeed. And I think it will be interesting to see if it ultimately proves possible. I just mentioned, you know, India. There... you've seen the rise of something called UPI, a digital payment scheme that's had tremendous success. And that is truly different in that it is based on an underlying instant payment network. So somewhat similar to how things like faster payments work in the UK, rather than actually working over the card networks. But I think in India, a lot of the success early on with that particular scheme came from replacing cash with rather than replacing card transactions. So I don't think that necessarily replacing card transactions, especially as India had built that domestic repay card network, was necessarily a focus. I think what we could see is the card networks looking to leverage the real-time payment networks, so more and more countries have these real-time payment networks now, as a means of accelerating the settlement part of the card payment process that we talked about, so that The card and the card network remains the means of authorizing the transaction. So from the consumer's perspective, it doesn't really look any different, but the money is moved in real time from the consumer's account to the merchant. So you're accelerating the settlement of the card transaction using these new real-time payment rails. But from the perspective of the consumer, everything looks and works the same. I think you also have people talk about things like crypto or central bank digital currency could they replace cards I'm kind of quite sceptical about that I think there are massive obstacles in terms of not just the ubiquity that we talked about before but you think about the speed at which the card transaction happens like we said from the user's perspective it all seems to happen in a second or two and the volume of payments that are getting processed in order to build something that is going to replace the card schemes it's going to be or it's going to require a tremendous amount of research development investment to build something and the infrastructure that is capable of operating at that sort of scale and then that's even before we've then thought about the interoperability because we talked a lot about the importance of interoperability the fact that we can go all over the world and our cards just work if we start building you know in one particular country something that is going to replace cards it doesn't really solve the problem for people that travel and in fact it makes things worse because then I've got two payment mechanisms I can use something I can use domestically and then when I go abroad I have to take my card with me so I think there's a lot of obstacles to get into a situation where you could use some of these emerging payment technologies to completely replace cards

SPEAKER_01:

I think that's right I think that you know I mean, we talked about cards a lot. And the truth of the matter is they are relatively old ideas. They were designed back in the 50s, 60s. And these immediate payments and CBDCs, they're all digital and what have you. But people forget it's just the sheer central infrastructures that you have to put in place and the ubiquity of everything that needs to be put in place to be able to supplant the magic of cards, as you say. So I think it's... A long way off yet, but it's possible and we'll watch that space, I guess. But Dave, you know, this is a huge topic. I mean, people take cards for granted. We all take cards for granted, but it's a huge topic. Have we missed anything you'd like to add?

SPEAKER_00:

I think the thing I would just reinforce really is, you know, just... remind ourselves again call it the magic of cards how amazing these things really are the fact that it works ubiquitously across the globe and enables us to have the same payment experience whichever country we go to without having to worry about finding physical cash and the fact that it can do it to sustain years and years and years of massive growth you know the volumes of transactions across the globe are just unbelievable um i was just trying to see if i could find a statistic for the global volume of card transactions and the last one i could find was for 2018 and that was for about 400 billion card transactions globally you know obviously we're five years later we know that the pandemic had a massive effect on people moving away from cash to using cards especially contactless so that 400 billion transactions from 2018 will be way way higher now and you know for the most part this stuff just works and it works seamlessly and it you know um in the very, very rare event that some of this stuff stops working, it is truly headline news. You know, I think one of the card schemes in the UK had an outage for a couple of hours back in about 2015 or 2016. And that truly was, you know, in all the newspapers and all over the news websites. So I just think, yeah, people should really... think about just how amazing the technology is behind this the fact that it can work at the scale that it can at the speed that it can and it can continue to grow to sustain this massive growth that's just been going on for years and will continue to go on for years it's a real success story

SPEAKER_01:

i think that's absolutely right and nearly every citizen around the world has been trained how to use a card you couldn't say that for checks anymore as a an example right but Dave as always it's great to catch up with you thanks for your insight and feedback on cards and I think soon we're going to talk about RTGS so I look forward to that session too

SPEAKER_00:

yeah many thanks for having me on today's session Paul and yeah looking forward to doing RTGS in the future cheers

SPEAKER_01:

thanks Dave take care music So there you go. The magic of cards, as Dave says. The truth of the matter is we use cards probably more than any other payment device. We use them in our day-to-day living. We use them online. We use them in store. We've tried to describe a little bit of their history going back to diners and to the setting up a Visa and then MasterCard. We talked about the four corner model and how that works and the multitude of players that are involved. We've also tried to highlight a little bit about the regulations and how that works. And it's, as I say, it's a bit of a cat and mouse game. The truth of the matter is that cards are going to be around for a long time yet. The thing that's really intriguing is that Now that cards have effectively disappeared into our phones, there's no reason that they can't be replaced. And I think over time, we'll start to see that happening. But I think it's a long way away, whether it's immediate payments or CBDCs, who knows. But our flexible friends can be around for a long, long time yet. As ever, thank you for your emails. If you'd like to get in touch, please do get in touch via email. bitesizepayments at gmail.com. And if you could do me a favor, if you've liked the podcast, please recommend it to somebody. That's the way that these things get spread out. And I would really appreciate it. Thanks a lot. Cheers now.