LAFLIF#2: THE LEGAL AND FINANCIAL ARRANGEMENTS OF CARD PAYMENTS

Last episode, we looked at why Nigerians are unable to pay for international transactions despite having globally accepted cards like Mastercard, Visa, etc. Today we dive deeper.

What do you think happens when you pay for stuff online with your bank card? How does money move from your account in Nigeria to the account of the seller? Take a minute to answer the question. Don’t worry about being right, just say how you think it should work.

Let’s make it less abstract. If I make a purchase for a course for $10 on Coursera. How does the money get into the purse of Coursera in America? Think about it and answer before reading further.

Here is one possible transaction flow:

1. I select the course I want to pay for

2. I am shown the price

3. I input my PIN/FingerPrint/FaceID and confirm the transaction

4. My bank removes the money from my account

5. My bank sends it to the bank account of Coursera

6. Cousera gives me access to the course.

If you think of this kind of transaction flow, you would not be wrong. In essence, you know for certain that money must move from your account to the merchant’s account. You are not entirely wrong.

Law and Finance mimic real life, if you have this at the back of your mind when you are working your way through transactions, it becomes unbelievably easy to understand the legal and financial arrangements, no matter how complex it seems.

Let’s start to unwrap each of these steps to see if the above transaction flow is the most efficient.

Steps 1 through 3 are self-explanatory, there is nothing else that could be done. You select what you need and confirm that you want to make that purchase. Are there things that could make confirming a transaction more efficient or secure? Of course, there are, but at the end of the day, it is still just generally confirming a purchase.

Steps 4 through 5 require our keen analysis. So let us break it down further. We start to see what challenges might pop up. Steps 4 through 5 mean that:

1. Money has to leave my bank account in Nigeria and get into the bank account of Coursera in America.

Now, this is a challenge that may not be quite obvious if you do not know anything about law and finance.

Firstly, the law bit. Banking is heavily regulated meaning that to run a bank, the government of the country where you operate must give you permission generally in the form of a license. Why is this the case? As a bank, you can take deposits (money) from virtually all citizens. If you are allowed to mismanage citizens’ money, then the whole country could wake up penniless. In any case, what it means is that your bank which is licensed in Nigeria may not be licensed in America so it cannot move money into that financial system. Even if it were licensed in America, there is no certainty that Coursera uses that same bank. This is an oversimplification, there are so many considerations, but this is enough for this explainer.

Secondly, the finance bit. Since your bank is not licensed in America, it must look for a partner bank that is licensed in America. What this means is that your bank will take your instruction to pay Coursera $10 dollars and pass it on to the partner bank in America, who will then pay the money to whatever bank account Coursera uses. This partner bank is called a Correspondent Bank. The implication is huge fees. The Correspondent Bank charges your Nigerian Bank a fee for this service, and your Nigerian Bank adds its fee to this fee, and now you have to pay a total of say $15 dollars for a $10 course. Additionally, your bank would need to find a partner bank in every country of the world so you can pay for services from Zambia, South Africa, Germany, etc. That is very expensive and very difficult. Again, this is an oversimplification of the financial challenges, but sufficient to give you a glimpse into the challenges.

What this means is that the current transaction flow that we are analyzing simply cannot work. So what are the solutions to the legal and financial obstacles we have identified? We need a financial institution:

1. That is present and licensed in a lot of countries (legal obstacle);

2. That is willing to charge reasonable fees for this service of settling payments to merchants in the countries where they have a presence (financial obstacle).

This is where Card Schemes come in. Don’t fret yet, it is easy to understand. Mastercard, Visa, Verve, AmEx, do they sound familiar? Yup, the fancy term for them in the world of finance is Card Scheme. Pick up your card right now, look at the bottom right corner. You are most likely looking at the logo for your Card Scheme provider.

What do card schemes do? Card schemes provide a fluid system for payment. That sums it up. So what exactly does this system look like? The card scheme approaches the financial payment regulators in different countries and says “hey look, we are in a global world now and your citizens need to pay for things from other countries. They also need to get paid from other countries. If you license us to operate in your country, then your citizens can pay and get paid globally. We would establish a presence here so that whenever someone abroad buys something from your citizens, we pay for it from our own accounts here. When they need to pay people abroad, we would collect the money here from them and be the one to settle the merchant abroad because we have a presence there too”. They do this across different countries and acquire a license that allows them to settle payments to merchants in those countries.

I would point out that the license generally allows them to operate a payment scheme, not to establish a bank. So although Mastercard, Visa etc are licensed in Nigeria, you cannot open an account with them.

Now that the Card Scheme has permission to move money in and out of various countries, let’s take a look at the financial arrangements. The Card Scheme now needs two things for its payment scheme to actually be a scheme.

1. It needs customers who want to purchase stuff to use its card.

2. It needs merchants who are willing to receive payment through them.

There are a couple of ways to go about it. One option is to create marketing, targeting individuals and businesses asking them to come open an account directly with them and attempting to explain what they do and how they help. However, that is a ridiculous financial adventure, truly unnecessary. Instead, it can embed itself into the existing financial models in the country for better user experience and seamless integration. So, who should the card scheme target? Yup, they target the banks. It is easier to work with the 24 commercial banks in Nigeria which already provide banking services for the majority of the citizens in Nigeria than to target the over 200 million population. You see the prudence in that approach, don’t you?

The Card Scheme says to the bank, “hey look, I established a payment scheme and when people use our cards, they can pay any merchant in all the countries we operate. Your customers want to shop without restrictions. If you partner with us, your customers can use our cards and they would be happy they have an account with you. We just need two things from you. We need you to acquire merchants for us, tell your customers who run businesses to join our community and accept payments from us, and open a merchant account for them where we would pay them. Then you also issue our cards to individuals who want to pay for stuff, tell them that with our cards, they can pay for things in almost all countries.”

If the bank agrees (and meets some legal and financial requirements), it does two things:

1. It issues cards to customers hence the term Issuing Bank

2. It acquires merchants to join the payment scheme hence, Acquiring Bank

Now when you see Issuing Bank, you know that they mean the bank on the side of the customer, and when you see Acquiring Bank, they mean the bank on the side of the merchant/seller. So all banks Issue and Acquire, but they are called either depending on what side of the transaction they fall on. Multiply this process across and you end up with a robust payment network. Mastercard is accepted in 210 countries, UnionPay in 180 countries, Visa in 210 countries, and American Express in 110 countries. On the contrary, it is also the same reason why Verve cards, operated by Interswitch, only worked for local payments, as they did not have such as wide coverage globally. Verve now touts Verve Global, in partnership with Disover, and claim they now work in about 200 countries.

There is an important legal point to note. The Card Scheme would only partner with an entity that holds a license in the country that allows it to acquire merchants and issue cards. This point will become important as we continue this series and get to virtual card providers. So before you become a partner with Mastercard, Visa, etc., you must hold a license in your country that permits the issuing of cards and the acquiring of merchants. It's interesting how the law divides the license categories. Card schemes themselves like Mastercard, and Visa hold a license that permits the operation of a payment network, but not the issuing of cards (opens as PDF). While banks and other financial institutions hold a license that allows them to issue cards and to acquire merchants for the card scheme (opens as PDF).

A crucial financial point to note as well is that the Card Scheme provider requires the partner bank to deposit a sum with it, generally in dollars. This sum is calculated to match the value of transactions the bank customers would make. It is from the deposit that the Card Scheme removes any payment that the bank’s customers make. You will get to understand why this is, in just a moment.

Okay, now that we understand the arrangement, how does money actually move? If I make a purchase for a course for $10 on Coursera with a Mastercard from the United Bank of Africa (UBA), how does the money get into the purse of Coursera in America? This is the transaction flow from this arrangement. Again, there may be technical discrepancies but this transaction flow is what obtains generally:

1. I select the course I want to pay for;

2. I am shown the price;

3. I input my PIN/FingerPrint/FaceID and confirm the transaction;

4. Mastercard receives a notice that I want to make a purchase, asking if the purchase should be approved since Mastercard is the one to give them the money;

5. Mastercard asks UBA, the Issuing Bank, if it should approve the payment since it is the bank that would give them the money;

6. The bank checks my account

   1. If it is a debit account, and I have enough money to cover the amount

   2. If it is a credit account, and I have enough credit limit to cover the purchase;

7. The bank sends a response to approve the transaction, meaning Mastercard can deduct the money from the deposit UBA paid to it;

8. Mastercard sends a response to Coursera to approve the transaction, and credits Coursera’s account with Acquiring Bank;

9. I can now access the course.

I will highlight some things that you may have missed.

1. UBA may deduct the money from my account, but it is not that money that it pays over. The money in your account does not cross borders. The bank only sends a response to approve the transaction. This is why sometimes you don’t get the deduction on your account until a couple of minutes, hours, or even days. Card payments are a feedback loop of “should this purchase be approved?”, not “has this money been paid?”.

2. The Card Scheme pays from its own pocket to merchants in the countries where it has a presence. So the Card Schemes carry a lot of risks and understandably charge a fee for this service.

3. The banks have to deposit a money sum, usually in dollars, to the Card Scheme ahead to cover transactions that customers will make. As customers make transactions, this sum reduces and when it gets to a point, the bank needs to deposit more money.

This third point is important in the context of the payment troubles in Nigeria. UBA has to source dollars to deposit with the Card Schemes so that customers can continue shopping internationally. Being a regulated financial entity, it cannot charge far above the exchange rate stipulated by the Central Bank of Nigeria. Yet, the Central Bank of Nigeria cannot supply sufficient dollar sums to maintain that exchange rate. What is the implication of this?

UBA has to reduce the dollar amount it can deposit to the Card Scheme. This means the total volume of international transactions that all UBA customers can make drops significantly. I do not work with UBA so I do not know how much the Card Schemes allow it to make. However, we do know for certain that UBA did its maths and set a limit of $20 dollars for every UBA card. So now when you make a payment above $20 dollars it is automatically rejected.

Okay, thanks for reading so far. We would continue with this on another episode when we look at the legal and financial arrangements for virtual card providers.