What Is a Settlement Bank? Definition, Functions, and Process

The settlement bank, often referred to as an “acquiring bank” or the “acquirer”, operates on the merchant’s side to facilitate the process of accepting card payments from the customers and depositing the funds into the merchant’s account. This financial institution engages with more than one card network, acting as an intermediary between the merchant and the bank of the card issuer whenever a card is used.

Definition Of Settlement Bank

After a customer purchases a service or goods, the issuing bank transfers funds to the payment processor employed by the seller. The term “settlement” denotes the number of funds transferred to the merchant from the acquirer, matching the specific sale amount for the approval of the card transaction.

A settlement bank serves as the primary financial institution for merchants, facilitating the receipt of payments and enabling electronic transactions or credit card processing. It is also known as the acquiring bank or the acquirer. Building a positive relationship with a settlement bank is crucial for merchants to ensure prompt and efficient payments for their clients and businesses.

The e-transaction or credit card process involves three key entities— the settlement bank, the cardholder’s bank, and the payment processor. To initiate this process, the merchant is required to establish a merchant account and enter into an agreement with the acquiring bank, outlining the T&Cs and settlement procedures for transactions. These banks typically charge transaction fees for the services provided.

Some of the well-known settlement banks include Citibank, Bank of America, and JPMorgan Chase. These banks hold a significant position in the global financial system and are trusted by both the senders and recipients of wire transfers.

Settlement banks play a crucial role in the transfer process, serving as intermediaries to ensure the security and efficiency of transactions. Understanding the functions of settlement banks and their importance helps ensure that transfers are completed securely and without complications.

Advantages of Settlement Banks

• Facilitate Electronic Transactions: Settlement banks streamline the process for merchants to accept payments from customers. Merchants need to open a merchant account and agree to terms for processing and settling transactions.
• Transparent Fee Structure: Acquiring banks typically charge merchants a per-transaction fee and a monthly service fee. Merchants can assess the costs associated with these fees to make informed decisions.
• Network Relationships: Merchants often choose settlement banks based on their relationships with major processing networks. Some banks can receive payments from multiple processing networks, enhancing the merchant’s reach.
• Processor Fee Considerations: Since processors charge fees for their services, merchants weigh the advantages of paying higher fees to access a broader customer base.
• Credit Card Incentives: The best credit cards often provide incentives to members, such as loyalty points or cash back. These incentives are typically supported by the fees merchants pay for payment processing services.

How Does Settlement Banks Work?

Credit card or electronic transactions involve a three-party interaction among the cardholder’s bank (which is also known as the issuer bank), the settlement bank, and a payment processor, with the settlement bank serving as the primary facilitator for these transactions.

When a customer swipes their card, the settlement bank initiates communication with its network to process the transaction. Simultaneously, the payment processor contacts the cardholder’s bank to verify the availability of funds. Upon successful clearance, the issuer bank deducts the amount from the customer’s account and transfers the funds to the settlement bank on behalf of the merchant.

The timing of fund deposition varies among settlement banks. Some banks credit the merchant’s account immediately, while others settle at the end of the business day or within 24 to 48 hours. The settlement bank communicates confirmation to the merchant once a transaction has cleared, indicating the availability of funds.

Here’s how the process of settlement will work in the case of a credit card transaction issued by JPMorgan. Here’s a breakdown of the steps involved in this transaction:

• You swipe or insert your credit card into the checkout’s card terminal.
• The acquiring or settlement bank receives your credit card information for further processing.
• The settlement bank then forwards your transaction details to the card network, which, in turn, sends it to your card issuer’s bank.
• The bank then reviews the transaction and, if approved, applies the charge to your credit card account. The approved amount is then sent to the settlement bank. If the transaction is declined, you’re promptly notified at the checkout.
• After a successful transaction, the store where you made your purchase receives the funds from your credit card in its merchant bank account. This amount is adjusted for any fees imposed by the card network and settlement bank. The store can then freely transfer or utilize the received funds.
• If you opt to settle your credit card bill later, you can make the payment directly to your credit card company. However, should you choose to initiate a chargeback and it is approved, the corresponding amount may be reversed on your credit card account. During this process, the merchant receives the funds, but with fees deducted from its merchant account.

If you use a Visa debit card for the transaction, your own bank acts as the issuer. The funds are directly withdrawn from your bank account before being routed to the acquiring bank for settlement into the merchant’s account. In this scenario, there is no subsequent charge to settle. Any funds resulting from a successful chargeback would be credited directly to your bank account.

What Are The Associated Charges?

Merchants encounter various fees throughout the transaction-processing stages. The most notable is the interchange fee, paid to a card network to cover the card issuer’s expenses for handling transactions. This fee varies by card network, typically comprising a fixed amount along with a percentage of the transaction value.

In addition to interchange fees, card networks may impose additional charges on merchants based on a percentage of their monthly sales, generally ranging from 2-2.5% of the total transaction. Settlement banks also levy various expenses, including monthly fees, gateway and terminal fees, and processing and reporting fees, among others. Merchants have the flexibility to explore different fee structures.

Upon approval, the merchant establishes a merchant account with the settlement bank for the deposit of authorized payments. The processing time can vary, with some settlement banks completing transactions in as little as a few hours. Once the funds reach the merchant account, the merchant can transfer the money to their business bank account for utilization. However, it’s essential to note that withdrawals from the merchant account may be subject to fees.

What Are The Risks?

Both merchants and settlement banks are susceptible to the risk of chargebacks, occurrences initiated by customers filing complaints with their card companies over purchase issues seeking reimbursement. Consequently, the issuing bank requests the merchant’s settlement bank to refund the funds, placing the merchant in the dilemma of accepting or challenging the claim. This process can lead to significant fees and financial losses for the merchant.

Settlement banks recognize the potential insolvency risk for merchants arising from frequent chargebacks. To mitigate this risk, they impose substantial fees on merchants in addition to the refunded amounts. If chargebacks become a recurrent issue, it may lead the settlement bank to reconsider its business association with the merchant.

What Are The Security Measures Followed By The Settlement Banks?

When it comes to finance, prioritizing security is a priority. Settlement banks, serving as intermediaries in transfers between senders and recipients, play a vital role in ensuring the safety and security of these transactions. To safeguard customers’ assets, settlement banks have implemented various security measures aimed at preventing fraud. These measures are crafted to identify and thwart unauthorized access to accounts, detect suspicious activity, and mitigate risks. This section delves into some of the security measures adopted by settlement banks to ensure secure transfers.

• 2-Factor authentication: Settlement banks mandate customers to provide 2FA before gaining access to their accounts. This may involve a password along with a security token or a fingerprint scan. This dual-layered approach helps thwart unauthorized access, even in cases where a password might be compromised.
• Encryption: Settlement banks employ advanced encryption technology to safeguard customer data during transmission. This ensures that critical information, including account numbers and transaction details, remains impervious to interception or unauthorized access.
• Fraud detection: Settlement banks vigilantly scrutinize transfers for any signs of suspicious activity, such as substantial transfers to unfamiliar accounts or irregular transaction patterns. This proactive approach aids in averting fraudulent actions, thereby shielding customers from potential financial losses.
• Compliance with regulations: Settlement banks adhere to a spectrum of regulations, including Anti-Money Laundering laws and the Bank Secrecy Act. Compliance with these stringent rules acts as a deterrent to criminal activities, such as funding illegal pursuits and money laundering.
• Continuous monitoring: Settlement banks engage in ongoing surveillance of their systems to identify potential security threats. This encompasses monitoring for anomalies like multiple unsuccessful login attempts or efforts to access accounts from atypical locations.

Distinguishing Between Clearing and Settlement

Clearing and settlement, essential components in financial transactions, are different. Clearing determines the commitment of funds, while settlement constitutes the final reconciliation between banks.

Settlement involves the actual exchange of funds between two banks, whereas clearing may conclude without any movement of money between them. During clearing, funds transition between the recipient’s or sender’s bank account and their bank’s reserves. Central banks, operating interbank settlement networks, facilitate money movement between banks during settlement. This process involves debiting the sender’s account and crediting the receiver’s account directly at the central bank.

Timing is another factor setting these processes apart. While wire transfers ensure intraday fund transfers, clearing and settlement operate on different timelines. Clearing occurs swiftly, often within minutes. However, settlement, offering more flexibility, can take place immediately after clearing or at a later time, allowing banks to settle accounts and exchange the wire amount.

The Role of Settlement Banks in Financial Transactions and Clearing Processes

A settlement bank is the ultimate institution to receive and document the completion of a transaction between two parties, often partnering with the entity receiving payment, commonly a merchant. Also known as the acquiring bank or acquirer, it serves as the primary bank for the merchant’s payment reception.

In financial transactions, exchanges concluded on Wednesday may take up to 5 business days to settle trades, allowing necessary paperwork to be processed. In the context of transferable securities, the clearinghouse consolidates trades from its members, netting out transactions for the trading day. By the end of the day, only net payments and securities are exchanged among clearinghouse members.

In banking and finance, clearing encompasses all activities from the commitment to a transaction until its settlement. This process transforms the commitment to payment, such as a cheque or electronic payment request, into the actual transfer of money from one account to another. Clearing houses facilitate such transactions among banks. In times preceding modern financial technologies, securities settlement involved the physical movement of paper instruments, such as certificates and transfer forms.

For cleared derivatives like options and futures, the clearinghouse acts as a counterparty to both the buyer and the seller, ensuring transactions and substantially reducing counterparty risk. The clearinghouse records all member transactions, offering valuable statistics and enabling regulatory oversight. Settlement banks play a pivotal role in the transaction process, facilitating the availability of electronic transaction processing for merchants. However, opting for debt settlement may lead to fees charged by the settlement company, as it necessitates ceasing payments and can adversely impact credit scores due to incomplete debt repayment.

Conclusion

Settlement banks have an integral role in the world of finance. They make sure that transactions happen smoothly by acting as intermediaries, ensuring that money flows seamlessly between merchants and customers when it comes to transactions and credit card processing. The relationship between merchants and settlement banks is vital because it ensures that payments are processed securely and on time. While settlement banks offer benefits like facilitating electronic transactions and transparent fee structures, there are also factors to consider such as associated charges and risks, especially when it comes to chargebacks.

Frequently Asked Questions