Understand the difference between payment gateways, payment processors, and payment service providers and choose the best one for your ecomm business.
As an online seller, when your customer clicks on ‘checkout’ and selects one of the many payment options you offer - Shop Pay, Stripe, Paypal, etc. - you accept, with blind faith, that those funds will somehow end up in your bank account.
You do your job of generating sales, and you trust your payment processor to do theirs.
Despite the crucial role that payment processors play for your ecommerce store, many online sellers don’t know the difference between a payment gateway, payment processor, and payment service provider (hint: they are not all the same). Without this, how can you be sure you have chosen the right provider for your business?
In this blog we’ll cover:
The differences between a payment gateway, payment processor, and payment service provider,
How the money ends up in your bank account, and
How to choose the right providers to optimize your payment offerings, increase your approval rates, and reduce your costs.
The Key Players
It takes about 2 seconds from the time a customer hits the "pay" button until they receive a "transaction approved" notification. During those 2 seconds, a lot is happening behind-the-scenes to ensure the cash successfully goes from your customer’s bank to your business bank account.
Let’s take a second to meet the key players:
Issuing Bank is the bank connected to your customer’s payment card (such as credit or debit card) on your website. This is where the payment funds originate.
Merchant Account is a type of business bank account that allows you to accept and process electronic payment card transactions and is associated with the Payment Processor. This account is a holding place for deposits before being transferred to your business bank account. As a merchant, you generally can’t access the funds in your Merchant Account before the funds hit your business bank account.
Acquiring Bank is the financial institution that holds your Merchant Account and is associated with the Payment Processor.
The Acquiring Bank transfers the payment from the customer’s Issuing Bank, through your Merchant Account, ultimately into your business bank account. The coordination and transmission of the data and transfer of the funds are done by the following payment facilitators:
The Payment Card Networks, such as American Express, Visa, and Mastercard, provide the electronic network that allows consumers, banks, merchants, and payment processors to communicate and conduct transactions.
Payment Gateway is a bridge between your online store and the Payment Processor. The Payment Gateway captures the transaction information on your website and sends it securely to the Payment Processor. Examples include Authorize.net and Payflow (by PayPal).
Payment Processor, sometimes known as an Acquiring Processor or a Merchant Service Provider (MSP), facilitates the transaction information from the Payment Gateway, through the Payment Card Network to the Issuing Bank. This informs the Issuing Bank of the transaction and confirms whether the transaction will be approved (i.e., whether the customer has sufficient funds). The Payment Processor also facilitates the flow of funds from the Issuing Bank to the Acquiring Bank (explained further below). Examples include TSYS, Fiserv, FIS, and Elavon.
Payment Service Provider (PSP) acts as both a Payment Gateway and a Payment Processor. PSPs have become more popular in recent years as a one-stop shop solution for merchants, enabling you to engage with one provider instead of multiple providers. Examples include Stripe, Square, and PayPal.
The Payment Process
The actual payment process usually consists of 2 key phases: (1) authorization and capture, and (2) settlement.
Phase 1: Authorization and Capture
A customer, let’s call him Joe, proceeds to the checkout page on your website and selects from the available payment options.
The Payment Gateway captures Joe’s payment card information and transaction details.
The Payment Gateway transmits the information securely to the Payment Processor.
The Payment Processor routes the transaction information through the Payment Card Network affiliated with the customer's credit or debit card to the Issuing Bank.
The Issuing Bank approves or declines the transaction, based on Joe’s (i.e., the cardholder's) available funds and other factors.
Upon Authorization of the transaction, a "Hold" is placed on Joe’s funds. This hold action is known as Capture.
The Issuing Bank then sends a notification back through the Card Network to the Payment Processor and then to the Payment Gateway and your online store, to inform both you and Joe that the transaction has been approved or declined.
The purpose of the authorization and capture phase is to check whether the customer has sufficient funds, authorize the transaction, and reserve the associated funds for the settlement. This allows you, as the seller, to start shipping the goods, with the comfort of knowing that the payment will eventually be settled.
Phase 2: Settlement
At the end of each business day or other agreed-upon period, the Payment Processor/ Acquiring Bank transmits the approved transaction information to the Issuing Bank, triggering a disbursement of the funds.
The Issuing Bank transfers the funds to the Acquiring bank, i.e., the financial institution or bank associated with the Payment Processor. The Acquiring Bank deposits the amounts to your Merchant Account.
Ultimately, the funds are transferred from the Merchant Account to your business bank account.
The process has been optimized in more recent years. Now, online sellers can simplify the process by using a single entity known as a Payment Service Provider (PSP). When a PSP is involved, steps 2-9 are taken care of by one provider, such as Stripe or Paypal.
A variation of this flow exists if you also offer your customers a buy now, pay later (BNPL) solution.
What is BNPL?
In the past few years, a new set of PSPs has emerged called buy now, pay later (BNPL).
BNPL is a loan offered to your customers when they are ready to checkout of your Shopify or Woocommerce store. It allows them to buy your products on credit. Your customer will have different options to repay the loan, depending on the company used and the amount they borrowed. Popular examples include Shop Pay Installments, Affirm, Afterpay, Klarna, and Sezzle.
The BNPL vendor will charge you, as the seller, a merchant fee which is typically between 2%-8% of the transaction amount. For short term loans, the loan will often be interest-free to your customer. Eventhough you get charged by the BNPL vendor, it can still be very beneficial to you to offer this payment option since increased flexibility for your customers can increase your sales.
Is it better to use a Payment Service Provider instead of a Payment Gateway and Payment Processor?
If your main concern is simplicity, it may be best to use a PSP instead of a separate Payment Processor and Payment Gateway. Dealing with only one provider is generally more simple and more flexible. It can make managing your business, understanding your merchant or transaction fees, and dealing with your ecommerce bookkeeping and admin tasks more straightforward.
In some cases, PSPs also provide merchants fast access to funds, by transferring cash by the next business day after the date of transaction, while receiving the settled amounts from the Acquiring Bank typically 1-2 business days after the transaction.
On the other hand, depending on what you sell, working directly with Payment Gateways and Payment Processors can improve the approval rate for transactions and save costs for high-volume merchants.
Specifically, certain high-risk merchants, such as online sellers of CBD products and adult toys, generally report higher approval rates when working with separate Payment Gateways and Payment Processors rather than using a PSP. They also may have trouble opening accounts with certain PSPs. For example, adult stores generally do not use Paypal but instead may use PaymentCloud or Instabill.
Grasping the basic process of how you get the money from your online sales is important for any DTC brand. It helps you better choose the right provider for your store, understand issues or delays that arise in the process, and find ways to increase approval rates and reduce merchant fees.
For example, in some cases, engaging separately with a Payment Gateway and Payment Processor as opposed to engaging with a Payment Service Provider that offers a one-stop-shop solution, may save you costs and increase the approval rates of transactions.
On the other hand, this might add logistics and coordination complexity, while increasing the complexity of your ecommerce accounting. As a general rule, though, accounting complexities should never be a reason to take or not take a certain business decision. These can always be outsourced or automated by using an automated bookkeeping service, like Finaloop.
We are a technology company providing automated end-to-end accounting service to ecommerce businesses. Our system connects to your apps, syncs all your data, and reconciles your books in real-time, replacing your bookkeeper. We offer reconciled books available 24/7, tax-saving insights, and a single place for all your financial data.
*The information provided on this website does not, and is not intended to, constitute legal advice. All information, content, and materials available on this site are for general informational purposes only. Readers are advised to consult with their attorney or accountant with any questions or concerns.*
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