Words like blockchain and cryptocurrency have made their way back into the boardroom as well as mainstream media. Bitcoin was the first user-facing blockchain technology that came in the form of cryptocurrency. This emerging technology is only ten years old but opened up a world of opportunities when it comes to disrupting the banking and finance industries, especially in terms of the payment settlement process.
To get a better understanding of how cryptocurrency’s use of blockchain technology may be poised to disrupt the payment settlement process, we need to understand how payment settlements are now. In this article, we’ll analyze the current payment settlement processes for debit and credit card transactions, the settlement process for cryptocurrency transactions, and the pros and cons of cryptocurrency adoption.
Batch Payment Processing
Currently, merchants typically use batch processing to settle credit or debit card transactions between their business and a customer. Batch processing is when a business or merchant sends over all of the authorized debit and credit card transactions to their acquiring bank in a batch at the end of each business day. Although a business can send the debit/credit card invoices generated to their acquiring bank directly after every purchase, the acquiring bank charges a fee for each batch of transaction settlements. Therefore, it is typically more cost-effective for businesses to group these transactions and send them over all at once. In other words, to send them over in a batch.
The batch payment process is roughly four steps, yet, the entire payment settlement process can take anywhere from 1-5 days!
Credit and Debit Card Payment Settlement: Key Players
Before we dive deeper into the process, there are a few key players involved in the batch payment process.
Cardholder (Buyer): The cardholder is the one using a credit or debit card to purchase goods and services from a merchant. Typically, cardholders are individual consumers; however, in B2B transactions, the cardholder may be another business.
Merchants (Seller): During this process, merchants refer to any business that accepts debit and credit card payments in exchange for their goods or services.
Payment Processor: The companies that facilitate the transfer of funds from the cardholder’s issuing bank to the merchant’s acquiring bank.
Acquiring Banks: An acquiring bank is also known as a merchant bank. They are a financial institution that processes credit or debit card payments on behalf of a merchant. They act as the middleman in the transaction, adding time to the settlement process, as well as increasing costs due to service fees.
Issuing Banks: An issuing bank is a financial institution that issues the debit and/or credit cards that the cardholder uses. During this process, they are also referred to as the buyer’s bank.
Credit and Debit Card Payment Settlement: The Batch Process
The batch process–also known as the settlement stage of a transaction–starts when a cardholder/buyer uses a credit or debit card to purchase a good or service from a merchant.
- When a buyer makes a purchase, the merchant’s Point of Sale (POS) terminal will first need to authorize the transaction. This means that the POS terminal will verify that the card being used is legitimate, and communicate with the buyer’s issuing bank to make sure they have a sufficient amount of funds in their account to make this purchase.Note: No funds are actually moved from the buyer’s bank account at this point. Instead, a hold is placed on buyer’s funds in the amount of the good or service they purchased. That is why you will sometimes see that a transaction is ‘pending’ on your bank/credit statements.
- At the end of each business day, the merchant then sends all of the approved transactions to their payment processor in a batch.
- The payment processor will forward the authorizations to the buyer’s issuing bank–who has already placed a hold on the buyer’s funds in the amount of the good or service they purchased from the business.
- The buyer’s bank clears the transfer of funds from the buyer’s bank account to the merchant’s bank account. If the buyer used their credit card, funds will typically appear in the merchant’s bank account (and get deducted from the buyer’s account) within 24 hours. If the buyer used their debit card, the funds can take up to 48 hours to transfer. However, if the purchase takes place on a Friday, weekend, or holiday, the clearing and transfer of funds may take additional time.
Although this is the traditional way payments by credit or debit cards are settled, it is a lengthy process that requires several different parties to play a unique role in order to complete a payment. In comparison, cryptocurrency’s blockchain technology would reduce the number of middlemen, as well as reduce the time and transaction fees, thus potentially making the payment settlement process more efficient.
Cryptocurrency’s Blockchain Settlement Process
In comparison to the traditional way credit and debit card transactions are settled, cryptocurrency transactions rely on blockchain technology – a faster and more transparent process.
Blockchain technology gives businesses the ability to transact and accept payments directly instead of working through a middle man. This is just one reason why more and more businesses began to research and develop blockchain solutions for their businesses when cryptocurrencies made their way into mainstream media a few years ago. Because every peer on the network can see what activity took place within the blockchain, utilizing cryptocurrency offered increased security as well as increased transparency throughout the entire payment process.
Blockchain Settlement: Key Players
Before we dive deeper into the process, there are a few key players involved in the blockchain settlement process.
Blocks: A group of recent transactions that took place on the blockchain.
Blockchain: A blockchain is a peer to peer database where every transaction is secured by mathematical proofs that the nodes (peers) within the network must validate and the miners must mathematically verify in order for everyone to agree that the transaction took place. These transactions are grouped in arrangements called blocks before added to the official record of transaction history–the blockchain.
Blockchain Ledger: The entire record of a blockchain’s transaction history.
Nodes: Individuals who keep a copy of the blockchain ledger on their computer and validate whether the transactions that appear within the ledger are legitimate.
Miners: Miners are individuals who allocate their computing power to solving mathematical proofs that place the transactions that occur into blocks. Blocks are subsequently added and linked to one another which forms the blockchain.
Mempool: The mempool is a holding area for transactions waiting to be validated before they are added to blocks.
Sender (Buyer): The sender is the one using cryptocurrency to purchase goods and services from a merchant (the recipient).
Recipient (Merchant): A recipient is an individual who accepts cryptocurrency as payment through a blockchain network.
The Blockchain Settlement Process
While cryptocurrency is meant to be complex in terms of its payment security, the payment settlement process is relatively straightforward. The blockchain settlement process is a three-step process where settlement can happen in as little as a few seconds.
- The buyer initiates a transaction with a business, sending them cryptocurrency at the point-of-sale (instead of using a credit or debit card).
- The transaction is then sent to the mempool where it’ll wait to be validated. Settlement can be as fast as seconds–like on the blockchain network Ripple –or as long as an hour, like on the Bitcoin network. The reason settlement time varies is because different blockchains have different difficulty levels regarding their cryptographic proofs, so miners may need more or less time to solve the proofs.
- Once the transaction has been validated by the nodes (peers) on the network and mathematically verified by the miners, the transaction will be added as a block to the blockchain. The merchant/recipient will then receive the funds from the sender in their cryptocurrency wallet.
The Pros and Cons of Cryptocurrency
Although the payment settlement process for cryptocurrency is more straightforward than batch payment processing, the technology behind cryptocurrency is still being refined. Let’s take a look at some of the main pros and cons of accepting cryptocurrency payments.
Less Expensive: The transaction fee for most cryptocurrencies is relatively low, usually below a dollar per transaction. While miners do take a fee for the work they do to verify and validate your transaction, these fees are far lower than a typical batch transaction fee. For instance, the current transaction fee on Ripple is $.0005 per transaction. However, it varies depending on the size of the transaction and how much data/space it takes up within a block.
Faster: Depending on how many transactions per second a chain can process, and the time it takes for a block to be added to the blockchain, you can settle your payments in as little as a few seconds.
More secure: Nodes and miners add an increased layer of security to the transaction process. Every transaction on a blockchain is cryptographically secured by miners, and the miners and nodes on the network must all agree that the block of transactions is legitimate before payment settlement can occur. For this system to fail, a 51% attack would need to occur where an individual or group of individuals gain control of a majority (51%) of the blockchain. But since the nodes on the network are decentralized, and the computer hardware as well as the electricity it takes to run that hardware are expensive, a 51% attack is both difficult and expensive to pull off if you operate on a chain with an ample number of nodes and computing power dedicated to it.
Limited Adoption: Although blockchain technology and cryptocurrency have gained more attention over the years, it is still an emerging industry, and the technology has not been mass adopted yet. At this point in time, many of your customers will most likely not be familiar with blockchains and cryptocurrency. Thus, using this technology to settle payments directly may make the lives of your customers more complicated than necessary.
Value Volatility: Depending on which blockchain you use to settle your payments, your cryptocurrency value could fluctuate rapidly. Bitcoin has been known to have severe price fluctuations. It is not unusual for the price to fluctuate several hundreds of dollars within a 30-minute timeframe. Thus, accepting cryptocurrency would potentially make your business revenue unstable. You do not want a customer making a $5,000 payment only to learn that the funds are valued at $3,000 an hour later. There are cryptocurrencies pegged to stable assets, but if you do not use one of them or do not have a mechanism to minimize or remove the volatility, settling payments via cryptocurrency can be seen as a high-risk activity that can end up losing your company money.
Will Cryptocurrency Disrupt Payment Settlement?
Despite its drawbacks, cryptocurrency has the architecture and infrastructure to disrupt credit and debit card payment settlement. However, being only ten years old, cryptocurrency and blockchain technology are not yet ready to take over the traditional payment settlement process. Although cryptocurrencies allow businesses to settle payments faster, for cheaper, and in a more secure and transparent way, this technology has not been mass adopted yet. Asking customers to pay via cryptocurrency at this point is thus a much more complicated process than if they paid with their debit or credit card. However, as the industry matures and cryptocurrency use becomes more convenient for consumers, it is possible that we will see blockchain technology play a more significant role in the future of banking and finance.