Credit cards

EVERYTHING YOU EVER WANTED TO KNOW ABOUT CC' S

Joe Ziegler

EVERYTHING YOU EVER WANTED TO KNOW ABOUT CC'S

This is part one in a series of postings about the workings of the credit card industry.

DEFINITIONS First some terms, along with the meanings they have in the industry:

Cardholder - an individual to whom a credit card is issued. Typically,this individual is also responsible for payment of all charges made to that card. Corporate cards are an exception to this rule.

Card Issuer - an institution that issues credit cards to cardholders.This institution is also responsible for billing the cardholder for charges. Often abbreviated to "Issuer".

Card Accepter - an individual, organization, or corporation that accepts credit cards as payment for merchandise or services. Often abbreviated "Accepter" or "merchant".

Acquirer - an organization that collects (acquires) credit authorization requests from Card Accepters and provides guarantees of payment. Normally, this will be by agreement with the Issuer of the card in question. Many issuers are also acquirers.

Some issuers allow other acquirers to provide authorizations for them, under preagreed conditions. Other issuers provide all their own authorizations.

TYPES OF CARDS The industry typically divides up cards by the business of the issuer. So there are bank cards (VISA, Master Card, Discover), Petroleum Cards (SUN Oil, Exxon, etc.), and Travel and Entertainment (T&E) cards (American Express, Diners' Club, Carte Blanche). Other cards are typically lumped together as "Private Label" cards. That would include department store cards, telephone cards, and the like. Most private label cards are only accepted by the issuer. People are starting to divide the telephone cards into a separate class, but it hasn't received widespread acceptance.

(This is just a matter of terminology, and doesn't affect anything important.)

Cards are also divided by how they are billed. Thus there are credit cards (VISA, MC, Discover, most department store cards), charge cards (American Express, AT&T, many petroleum cards) and debit cards. Credit cards invoke a loan of money by the issuer to the cardholder under pre-arranged terms and conditions. Charge cards are simply a payment convenience, and their total balance is due when billed. When a

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debit card is used, the amount is taken directly from the cardholder's account with the issuer. Terminology is loose - often people use "credit card" to encompass credit cards and charge cards.

A recent phenomenon is third-party debit cards. These cards are issued by an organization with which the cardholder has no account relationship. Instead, the cardholder provides the card issuer with the information necessary to debit the cardholder's checking account directly through an Automated Clearing House (ACH), the same way a check would be cleared. This is sort of like direct deposit of paychecks, in reverse. ACHs love third-party debit cards. Banks hate them.

Another recent addition is affinity cards. These cards are valid credit cards from their issuer, but carry the logo of a third party, and the third party benefits from their use.

There is an incredible variety of affinity cards, ranging from airlines to colleges to professional sports teams.

HOW THEY MAKE MONEY Issuers of credit cards make money from cardholder fees and from interest paid on outstanding balances. Not all issuers charge fees. Even those that do, make most of their money on the interest. They really LIKE people who pay the minimum each month.

Issuers of charge cards make money from cardholder fees. Some charge cards actually run at a loss for the company, particularly those that are free. The primary purpose of such cards is to stimulate business.

Issuers of debit cards may make money on transaction fees. Not all debit card transactions have fees. Most debit cards exist to stimulate business for the bank and to offload tellers and back-room departments. To date, third-party debit cards exist solely to stimulate business. Providers of such cards make no direct money from their use.

Acquirers make money from transaction charges and discount fees. Unlike the charges and fees mentioned above, these fees are paid by the accepter, not (directly) by the cardholder. (Technically, it is not legal for the merchants to pass these charges directly to the consumer. Some petroleum stations have gotten away with giving a discount for cash, and it has survived court challenges so far.) Transaction charges are typically in pennies per transaction, and are sensitive to the type of communication used for the authorization. Discount fees are a percentage of the purchase price and are sensitive to volume and compliance to rules. One way to encourage merchants to follow certain procedures or to upgrade to new equipment is to offer a lower discount fee.

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Until fairly recently, the only motivation for accepters was to expand their business by accepting cards. Reduction of fraud was enough reason for many merchants to pay authorization fees, but in many cases, it isn't worth the cost. (That is, it is cheaper to pay the fraud than to prevent it.) Recently, electronic settlement has provided merchants with an added benefit by reducing float on charged purchases. Merchants can now get their accounts credited much faster than before, which helps cash flow.

Companies that issue charge cards are real keen on float reduction. The sooner they can bill you, the sooner they get their money. Credit card companies are also interested in float reduction, since the sooner they bill, the sooner they can start charging interest. Debit cards typically involve little or no float.

Affinity cards usually pay a percentage of purchases to the affinity organization.

Although it may seem obvious to take this money from the discount fee, this doesn't work since the issuer is not always the acquirer. The money for this usually comes from the interest paid on outstanding balances. Essentially, the bank is giving a share of its profits to an organization in turn for the organization promoting use of its credit card. The affinity organization is free to use its cut any way it wishes. An airline will typically put it into the frequent flyer program (and credit miles to your account). A college may put the money into the general fund or into a scholarship fund. Lord only knows what a sports team does with the money!

THE PLAYERS AND THEIR ROLES

American Express (AMEX) - is a charge card issuer and acquirer. (Their other businesses are not important to this discussion.) All AMEX purchases are authorized

by AMEX. They make most of their money from the discount fees, which is why they have the highest discount fee in the industry. That's one reason why AMEX isn't accepted in as many places as VISA and MC, and a reason why many merchants will prefer another card to an AMEX card. The control AMEX has over authorization allows them to provide what they consider to be better cardholder ("cardmember" to them) services.

VISA- is a non-profit corporation (SURPRISE!) that is best described as a purchasing and marketing coalition of its member banks. VISA issues no credit cards itself - all VISA cards are issued by member banks.

VISA does not set terms and conditions for its member banks - the banks can do pretty much as they please in signing cardholders. All VISA charges are ultimately approved by the card issuer, regardless of where the purchase was made. Many smaller banks share their account databases with larger banks, third parties, or VISA itself, so that the bank doesn't have to provide authorization facilities itself.

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Master Card (MC) - is very much like VISA. There are some differences that are important to those in the industry, but from the consumers standpoint they operate pretty much the same.

Discover-cards are issued by a bank owned by Sears. All Discover purchases are authorized by Sears.

Most petroleum cards, if they are even authorized, are authorized by the petroleum company itself. There are exceptions. Fraud on petroleum cards is so low that the main reason for authorization is to achieve the float reduction of electronic settlement.

THE BUSINESS RELATIONSHIPS Card acceptors generally sign up with a local acquirer for authorization and settlement of all credit cards. This acquirer may or may not be a card issuer, but certainly will not have issued all the cards that the merchant can accept. The accepter does not generally call one place for VISA and a different place for MC, for example.

At one time, this was necessary, but more and more acquirers are connected to all networks and are offering a broader range of services.

Acquirers generally are connected to many issuers, and pay transaction charges and discount fees to those issuers for authorizations. Thus, the acquirer is actually making money on the difference between fees paid and fees billed. Most acquirers gather together transactions from many accepters, allowing them to get volume discounts on fees. Since the accepters individually have lower volume and are not eligible for those discounts, there is a markup that the acquirer can get away with. Acquirers also, of course, provide the convenience of a single contact.

Most large banks are issuers and acquirers. Things get real interesting when it's time to settle up. Some small banks are only issuers. There are third parties that are only acquirers.

This is part two in a planned six-part series about the credit card industry. It would be best if you read part one before reading this part. Enjoy.

DEFINITIONS Some more new terms that are used in this posting.

ABA - American Bankers Association

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ACH - Automated Clearing House - an organization that mechanically and electronically processes checks.

ANSI - American National Standards Institute Embossing - creating raised letters and numbers on the face of the card.

Encoding - recording data on the magnetic stripe on the back of the card.

Imprinting - using the embossed information to make an impression on a charge slip.

Interchange - sending authorization requests from one host (the acquirer) to another (the issuer) for approval.

ISO - International Standards Organization NACHA - National Automated Clearing House Association PAN - Personal Account Number. The account number associated with a credit, debit or charge card. This is usually the same as the number on the card.

PIN - Personal Identification Number. A number associated with the card, that is supposedly know only to the cardholder and the card issuer. This number is used for verification of cardholder identity.

THE ORGANIZATIONS

ISO sets standards for plastic cards and for data interchange, among other things.

ISO standards generally allow for national expansion.

Typically, a national standards organization, like ANSI, will take an ISO standard and develop a national standard from it. National standards are generally subsets of the ISO standard, with extensions as allowed in the original ISO standard. Many credit card standards originated in the United States, and were generalized and adopted by ISO later.

The ANSI committees that deal with credit card standards are sponsored by the ABA. Most members of these committees work for banks and other financial institutions, or for vendors who supply banks and financial institutions. Working committees report to governing committees.

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All standards go through a formal comment and review procedure before they are officially adopted.

PHYSICAL STANDARDS

ANSI X4.13, "American National Standard for Financial Services - Financial Transaction Cards" defines the size, shape, and other physical characteristics of credit cards. Most of it is of interest only to mechanical engineers. It defines the location and size of the magnetic stripe, signature panel, and embossing area. This standard also includes the Luhn formula used to generate the check digit for the PAN, and gives the first cut at identifying card type from the account number. (This part was expanded later in other standards.) Also, this standard identifies the character sets that can be used for embossing a card.

Three character sets are allowed - OCR-A as defined in ANSI X3.17, OCR-B as defined in ANSI X3.49, and Farrington 7B, which is defined in the appendix of ANSI X4.13 itself. Almost all the cards I have use Farrington 7B, but Sears uses OCR-A. (Sears also uses the optional, smaller card size as, allowed in the standard.) These character sets are intended to be used with optical character readers (hence the OCR), and large issuers have some pretty impressive equipment to read those slips.

ENCODING STANDARDS

ANSI X4.16, "American National Standard for Financial Services – Financial Transaction Cards - Magnetic Stripe Encoding" defines the physical, chemical, and magnetic characteristics of the magnetic stripe on the card. The standard defines a minimum and maximum size for the stripe, and the location of the three defined encoding tracks. (Some cards have a fourth, proprietary track.)

Track 1 is encoded at 210 bits per inch, and uses a 6-bit coding of a 64-element character set of numerics, alphabet (one case only), and some special characters.

Track 1 can hold up to 79 characters, six of which are reserved control characters.

Included in these six characters is a Longitudinal Redundancy Check (LRC) character, so that a card reader can detect most read failures. Data encoded on track 1 include PAN, country code, full name, expiration date, and "discretionary data". Discretionary data is anything the issuer wants it to be. Track 1 was originally intended for use by airlines, but many Automatic Teller Machines (ATMs) are now using it to personalize prompts with your name and your language of choice. Some credit authorization applications are starting to use track 1 as well.

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Track 2 is encoded at 75 bits per inch, and uses a 4-bit coding of the ten digits. Three of the remaining characters are reserved as delimiters, two are reserved for device control, and one is left undefined. In practice, the device control characters are never used, either. Track 2 can hold up to 40 characters, including an LRC. Data encoded on track 2 include PAN, country code (optional), expiration date, and discretionary data.

In practice, the country code is hardly ever used by United States issuers. Later revisions of this standard added a qualification code that defines the type of the card (debit, credit, etc.) and limitations on its use. AMEX includes an issue date in the discretionary data. Track 2 was originally intended for credit authorization applications. Nowadays, most ATMs use track 2 as well.

Thus, many ATM cards have a "PIN offset" encoded in the discretionary data. The PIN offset is usually derived by running the PIN through an encryption algorithm (maybe DES, maybe proprietary) with a secret key. This allows ATMs to verify your PIN when the host is offline, generally allowing restricted account access.

Track 3 uses the same density and coding scheme as track 1. The contents of track 3 are defined in ANSI X9.1, "American National Standard - Magnetic Stripe Data Content for Track 3". There is a slight contradiction in this standard, in that it allows up to 107 characters to be encoded on track 3, while X4.16 only gives enough physical room for 105 characters. Actually, there is over a quarter of an inch on each end of the card unused, so there really is room for the data. In practice, nobody ever uses that many characters, anyway. The original intent was for track 3 to be a read/write track (tracks 1 and 2 are intended to be read-only) for use by ATMs. It contains information needed to maintain account balances on the card itself. As far as I know, nobody is actually using track 3 for this purpose anymore, because it is very easy to defraud.

COMMUNICATION STANDARDS Formats for interchange of messages between hosts (acquirer to issuer) is defined by ANSI X9.2, which I helped define. Financial message authentication is described by ANSI X9.9. PIN management and security is described by ANSI X9.8. There is a committee working on formats of messages from accepter to acquirer. ISO has reconvened the international committee on host message interchange (TC68/SC5/WG1), and ANSI may need to re-convene the X9.2 committee after the ISO committee finishes. These standards are still evolving, and are less specific than the older standards mentioned above. This makes them somewhat less useful, but is a natural result of the dramatic progress in the industry.

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ISO maintains a registry of card numbers and the issuers to which they are assigned.

Given a card that follows standards (Not all of them do.) and the register, you can tell who issued the card based on the first six digits (in most cases). This identifies not just VISA, MasterCard, etc., but also which member bank actually issued the card.

DE FACTO INDUSTRY STANDARDS Most ATMs use IBM synchronous protocols, and many networks are migrating toward SNA. There are exceptions, of course. Message formats used for ATMs vary with the manufacturer, but a message set originally defined by Diebold is fairly widely accepted.

Many large department stores and supermarkets (those that take cards) run their credit authorization through their cash register controllers, which communicate using synchronous IBM protocols.

Standalone Point-of-Sale (POS) devices, such as you would find at most smaller stores (i.e. not at department stores), restaurants and hotels use a dial-up asynchronous protocol devised by VISA. There are two generations of this protocol, with the second generation just beginning to get widespread acceptance.

Many petroleum applications use multipoint private lines and a polled asynchronous protocol known as TINET. This protocol was developed by Texas Instruments for a terminal of the same name, the Texas Instruments Network E(something) Terminal.

The private lines reduce response time, but cost a lot more money than dial-up.

NACHA establishes standards for message interchange between ACHs, and between ACHs and banks, for clearing checks. This is important to this discussion due to the emergence of third-party debit cards, as discussed in part 1 of this series. The issuers of third-party debit cards are connecting to ACHs, using the standard messages, and clearing POS purchases as though they were checks. This puts the third parties at an advantage over the banks, because they can achieve the same results as a bank debit card without the federal and state legal restrictions imposed on banks.

In the next installment, I'll describe how an authorization happens, as well as how the settlement process gets the bill to you and your money to the merchant. After that I'll describe various methods of fraud, and how issuers, acquirers, and accepters protect themselves. Stay tuned.

This is part 3 in my six-part series on the credit card industry. This part discusses how authorization and settlement work. This is a long one. It will help if you have read

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parts 1 and 2, since I had to leave out a lot of overlap to keep this from getting ridiculous. Enjoy.

THE ACCEPTER An important fact to note is that a card accepter does not have to get approval for any purchases using credit or charge cards. Of course, a merchant is usually interested in actually getting money, and so must participate in some form of settlement process (see below). Usually, the most acceptable (to a merchant) forms of settlement are tied (by the acquirer) to authorization processes. However, a merchant could simply accept all cards without any validation, any eat any fraud that results.

A merchant typically makes a business arrangement with a local bank or some other acquirer for authorization and settlement services. The acquirer assigns a merchant identifier to that merchant, which will uniquely identify the location of the transaction. (This facilitates compliance with federal regulations requiring that credit card bills identify where each purchase was made.) The acquirer also establishes procedures for the merchant to follow. The procedures will vary by type of the merchant business, geographic location, volume of transactions, and types of cards accepted.

If the merchant follows the procedures given by the acquirer and a transaction is approved, the merchant is guaranteed payment whether the card in question is good or bad. The purpose of authorization is to shift financial liability from the acceptor to the acquirer.

There are two basic tools used - bulletins and online checks. Bulletins may be hardcopy, or may be downloaded into a local controller of some form. Online checks could be done via a voice call, a standalone terminal, or software and/or hardware integrated into the cash register.

A low-volume, high-ticket application (a jewelry store) would probably do all its authorizations with voice calls, or may have a stand-alone terminal. A high-volume, low-ticket application (a fast-food chain) will probably do most of its authorizations locally against a bulletin downloaded into the cash register controller. Applications in between typically merge the two - things below a certain amount (the "floor limit") are locally authorized after a lookup in the bulletin, while things over the floor limit are authorized online.

Usually a lot of effort is taken to use the least expensive tools that are required by the expected risk of fraud. Typically, communication costs for authorizations make up the biggest single item in the overall cost of providing credit cards.

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Large accepters are always a special case. Airlines are usually directly connected, host-to-host, to issuers and/or acquirers, and authorize everything online. Likewise for many petroleum companies and large department stores. Some large chains use different approaches at different locations, either as a result of franchising oddities or due to volume differences between locations. A lot of experimentation is still going on as well - this is not a mature market.

For voice authorizations, the merchant ID, PAN, expiration date, and purchase amount are required for an approval. Some applications also require the name on the card, but this is not strictly necessary. For data authorizations, the merchant ID, PAN, PIN (if collected), expiration date, and purchase amount are required. Typically, the "discretionary data" from track 2 is sent as well, but this is not strictly necessary. In applications that do not transmit the PIN with the authorization, it is the responsibility of the merchant to verify identity. Usually, this should be done by checking the signature on the card against the signature on the form. Merchants don't often follow this procedure, and they take a risk in not doing so.

In most applications, the amount of the purchase is known at the time of the authorization request. For hotels, car rentals, and some petroleum applications, an estimated amount is used for the authorization. After the transaction is complete (e.g. after the gas is pumped or at check-out time), another transaction may be sent to advise of the actual amount of the transaction. More on this later.

THE ACQUIRER The acquirer gathers authorization requests from accepters and returns approvals. If the acquirer is an issuer as well, "on us" transactions will typically be turned around locally. As before, the acquirer does not have to forward any requests on to the actual issuer. However, acquirers are not willing to take the financial risks associated with generating local approvals. Thus most transactions are sent on to the issuers (interchanged). The purpose of interchange is to shift financial liability from the acquirer to the issuer.

Typically, an acquirer connects to many issuers, and negotiates different business arrangements with each one of them. But the acquirer generally provides a uniform interface to the accepter. Thus, the interchange rules are sometimes less stringent than those imposed on the accepter. Also, most issuers will trust acquirers to with responsibilities they would never trust to accepters. The acquirer can therefore perform some front-end screening on the transactions, and turn some of them around locally without going back to the issuer.

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The first screening by the acquirer would be a "sanity" test, for valid merchant ID, valid Luhn check on PAN, expiration date not past, amount field within reason for type of merchant, etc. After that, a floor limit check will be done. Issuers generally give acquirers higher floor limits than acquirers give accepters, and floor limits may vary by type of merchant. Next, a "negative file" check would be done against a file of known bad cards. (This is essentially the same as the bulletin.) Then a "velocity file" check may be done. A velocity file keeps track of card usage, and limits are often imposed on both number of uses and total amount charged within a given time period. Sometimes multiple time periods are used, and it can get fairly complicated.

Transactions that pass all the checks, and are within the authority vested in the acquirer by the issuer, are approved by the acquirer. (Note that, under the business arrangement, financial liability still resides with the issuer.) An "advice" transaction is sometimes sent to the issuer (perhaps at a later time), to tell the issuer that the transaction took place.

Transactions that "fail" one or more checks are denied by the acquirer (if the cause was due to form, such as bad PAN) or sent to the issuer for further checking. (Note that "failure" here can mean that it's beyond the acquirer's authority, not necessarily that the card is bad.) Some systems nowadays will periodically take transactions that would otherwise be approved locally, and send them to the issuer anyway. This serves as a check on the screening software and as a countermeasure against fraudulent users who know the limits.

Transactions that go to the issuer are routed according to the first six digits of the PAN, according to the ISO registry mentioned in an earlier section. Actually, it's a bit more complicated than that, since there can be multiple layers of acquirers, and some issuers or acquirers will "stand in" for other issuers when there are hardware or communication failures, but the general principal is the same at each point.

THE ISSUER An issuer receiving an interchanged transaction will often perform many of the same tests on it that the acquirer performs. Some of the tests may be eliminated if the acquirer is trusted to do them correctly. This is the only point where a velocity file can actually detect all usage of a card. This is also the only point where a "positive file" lookup against the actual account can be done, since only the issuer has the account relationship with the cardholder. If a PIN is used in the transaction, only the issuer can provide true PIN verification - acquirers may be able to do only "PIN offset" checking, as described in a previous section. This is one reason why PINs have not become popular on credit and charge cards.

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An account typically has a credit limit associated with it. An approved authorization request usually places a "hold" against the credit limit. If the sum of outstanding holds plus the actual outstanding balance on the account, plus the amount of the current transaction, is greater than the credit limit, the transaction is (usually) denied.

Often in such a case the issuer will send back a "call me" response to the merchant.

The merchant will then call the issuer's number, and the operator may even want to talk to the cardholder. The credit limit could be extended on the spot, or artificially high holds (from hotels or car rental companies) could be overlooked so that the transaction can be approved.

The difference between the credit limit and the sum of holds and outstanding balance is often referred to as the "open to buy" amount. Once a hold is placed on an account, it is kept there until the actual the transaction in question is settled (see below), in which case the amount goes from a hold to a billed amount, with no impact on the open to buy amount, theoretically. For authorizations of an estimated amount, the actual settled amount will be less than or equal to the approved amount. (If not, the settlement can be denied, and the merchant must initiate a new transaction to get the money.) Theoretically, in such a case, the full hold is removed and the actual amount is added to the outstanding balance, resulting in a possible increase in the open to buy amount.

In practice, older systems were not capable of matching settlements to authorizations, and holds were simply expired based on the time it would take most transactions to clear. Newer systems are starting to get more sophisticated, and can do a reasonable job of matching authorizations for actual amounts with the settlements. Some of them still don't match estimated amounts well, with varying effects. In some cases, the difference between actual and estimated will remain as a hold for some period of time. In other cases, both the authorization and the settlement will go against the account, reducing the open to buy by up to twice the actual amount, until the hold expires. These problems are getting better as the software gets more sophisticated.

Some issuers are also starting to use much more sophisticated usage checks as well.

They will not only detect number of uses and amount over time, but also types of merchandise bought, or other patterns to buying behavior. Most of this stuff is new, and is used for fraud prevention. I expect this to be the biggest effort in authorization software for the next few years.

American Express does things completely differently. There are no credit limits on AMEX cards. Instead, AMEX relies entirely on usage patterns, payment history, and

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financial data about cardmembers to determine whether or not to automatically approve a transaction. AMEX also has a policy that a cardmember will never be denied by a machine.

Thus, if the computer determines that a transaction is too risky, the merchant will receive a "call me" message. The operator will then get details of the transaction from the merchant, and may talk to the cardmember as well, if cardmember identity is in question or a large amount is requested. To verify cardmember identity, the cardmember will be asked about personal information from the original application, or about recent usage history. The questions are not the same each time. If an unusually large amount is requested, the cardmember may be asked for additional financial data, particularly anything relating to a change in financial status (like a new job or a promotion). People who are paranoid about Big Brother and computer databases should not use AMEX cards.

SETTLEMENT So far, no money has changed hands, only financial liability. The purpose of settlement is to shift the financial liability back to the cardholder, and to shift the cardholder's money to the merchant.

Theoretically, all authorization information can be simply discarded once an approval is received by a merchant. Of course, contested charges, chargebacks, merchant credits, and proper processing of holds require that the information stay around. Still, it is important to realize that an authorization transaction has no direct financial consequences. It only establishes who is responsible for the financial consequences to follow.

Traditionally, a merchant would take the charge slips to the bank that was that merchant's acquirer, and "deposit" them into the merchant account. The acquirer would take the slips, sort them by issuer, and send them to the issuing banks, receiving credits by wire once they arrived and were processed. The issuer would receive the slips, microfilm them (to save the transaction information, as required by federal and state laws) charge them against the cardholder's accounts, send credits by wire to the acquirer, and send out the bill to the cardholder. Problem is, this took time. Merchants generally had to wait a couple of weeks for the money to be available in their accounts, and issuers often suffered from float on the billables of about 45 days.

Therefore, nowadays many issuers and acquirers are moving to on-line settlement of transactions. This is often called "draft capture" in the industry. There are two ways this is done - one based on the host and one based on the terminal at the merchant's

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premises. In the host-based case, the terminal generally only keeps counts and totals, while the acquirer host keeps all the transaction details. Periodically, the acquirer host and the terminal communicate, and verify that they both agree on the data. In the terminal-based case, the terminal remembers all the important transaction information, and periodically calls the acquirer host and replays it all for several transactions. In either case, once the settlement is complete the merchant account is credited. The acquirer then sends the settlement information electronically to the issuers, and is credited by wire immediately (or nearly so). The issuer can bill directly to the cardholder account, and float can be reduced to an average of 15 days.

The problem is, what to do with the paper? Current regulations in many states require that it be saved, but there is no need for it to be sent to the issuer. Also, for contested charges, a paper trail is much more likely to stand up in court, and much better to use for fraud investigations. Currently, the paper usually ends up back at the issuer, as before, but it doesn't need to be processed, just microfilmed and stored.

Much of the market still uses paper settlement methods. Online settlement will replace virtually all of this within the next 5 to 10 years, because of its many benefits.

This was pretty long, but there is a lot of information, and I skimmed over a lot of details. Future installments should be shorter. Coming up next is a discussion of fraud and security, and then a special discussion of debit cards. Hang on, we're halfway through this!

This is part four of a planned six-part series on the credit card industry. It will be helpful if you have read parts one through three, as I use a lot of terminology here that was introduced earlier. Enjoy.

WARNING This installment describes various methods of perpetrating fraud against credit and charge card issuers, acquirers, and cardholders. Legal penalties for using these methods to commit fraud are severe. The reason for sharing this information is so that consumers will be aware of the importance of security and be aware of the procedures used by financial institutions to protect against fraud. Neither I nor my employer advocate use of the fraudulent methods described herein.

All the information here is publicly available from other sources. Unnecessary detail is purposely not included, particularly as it applies to detection and prevention of fraud.

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CARDHOLDER FRAUD The most common type of fraud against credit cards is cardholders falsifying applications to get higher credit limits than they can afford to pay, or to get multiple cards that they cannot afford to pay off.

Sometimes this is done with intent to defraud, but most often it is done out of desperation or sheer financial ineptitude. Those who intend to defraud generally use the multiple-card approach. They give false names and financial data on several (sometimes as many as hundreds) of applications. Often, the address of a vacant house that the crook has access to is given, making it difficult to track the crook's real identity. Once cards start showing up, the crook uses them for cash advances or charges merchandise that is easy to sell, like consumer electronics. The crook will run all the cards up to the limit immediately, and will generally move on by the time the bills start arriving. This type of fraud is not applicable to debit cards, since they require an available account balance equal to or greater than any purchases or withdrawals.

Protecting against this type of fraud, either intentional or otherwise, is exactly the purpose of credit bureaus such as TRW. Issuers have become more aware of the need for careful screening of applications, and are using better techniques for detecting similar applications sent to multiple issuers. More sophisticated velocity file screening can also be used to detect possibly fraudulent usage patterns. Since this is a method of fraud that can be used to gain really large amounts of money, it is a high priority with issuers' security departments.

A variant of this scheme is much like check kiting. Can you use your VISA to pay your MasterCard? Well, you might be able to manage it, but if you're doing it with intent to defraud, you can be prosecuted. Kiting schemes typically don't last long, have a low payoff, and are very easy to detect.

Another type of cardholder fraud is simply contesting legitimate charges. Most often, retrieving the documents gives pretty convincing proof. Frequently, a family member will be found to have used the card without the cardholder's permission. Such cases are usually pretty easy to resolve. In the case of an ATM card, cameras are often placed at ATMs (sometimes hidden) to record users of the machine. The camera is usually tied to the ATM, so that a single retrieval stamp can be placed on the film and the ATM log. If a withdrawal is contested, the bank can then retrieve the picture of the person standing at the machine, and conclusively tie that picture to the transaction.

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A type of cardholder fraud that is endemic only to ATMs is making false deposits. You could, theoretically, tell the ATM that you are depositing a large amount of money, and put in an empty envelope. Most banks will not let you withdraw amounts deposited into an ATM until the deposit has been verified, but some will allow part of the deposit to be withdrawn. Typically, you can't get away with much. If you have any money actually in your account, the bank has easy, legal recourse to seize those funds. Most banks have no sense of humor about such things, and will remove ATM card privileges after the first offense.

THIRD-PARTY FRAUD The simplest way for a third party to commit fraud is for them to get their hands on a legitimate card. There is a large black market for credit cards obtained from hold-ups, break-ins and muggings. Perhaps one of the cruelest methods of getting a card is a "Good Samaritan" scam. In such a scam, credit cards are stolen by pick-pockets, purse-snatchers, etc. That same day, someone looks up your number in the phone book and calls you up. "I just found your wallet. All the money is gone, but the credit cards and your driver's license are still here. It just happens that I'll be in your neighborhood next Wednesday and I'll drop it off then." Since the cards are found, you don't report them stolen, and the crooks get until next Wednesday before you're even suspicious. If such a thing happens to you, ask if you can come and pick the cards up immediately. A true good samaritan won't mind, but a crook will stall you. If you can't get your hands on the cards immediately, report them as stolen. Most issuers will be able to get you a new card by next Wednesday, anyway.

Often stolen cards will be used for a time exactly as is. The best tool for preventing this is verification of the signature, but this is ineffective because most merchants don't consistently check signatures and some people don't even sign their cards. (I guess these people figure that all purse snatchers are accomplished forgers as well.)

Many cards will eventually be modified as the various security schemes start catching up.

It is a very easy matter, for example, to re-encode a different number on the magnetic stripe. Since the card still looks fine, a merchant will accept it and run it through the POS terminal, completely ignorant of the fact that the number read off the back is not the same as that on the front. Although the number on the front would fail a negative file check, the number on the back is one that hasn't been reported yet. A card can be re-encoded almost any number of times, as long as you can keep coming up with new valid PANs. To protect against this, some merchants purposely avoid using the magnetic stripe. Others have terminals that display the number read from the stripe, so the cashier can compare it to the number on the

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card. Some issuers are experimenting with special encoding schemes, to make reencoding difficult, but most of these schemes would require replacing the entire embedded base of POS terminals. An interesting approach I've seen (it's probably patented) uses a laser to burn off the parts of the magnetic stripe where zeroes are encoded, leaving only the ones. This severely limits the changes you can make to the card number. Some issuers use the "discretionary data" field to encode data unique to the card, that a crook would not be able to guess, to combat this type of fraud.

Since an ATM doesn't have a human looking at the card, it is especially susceptible to re-encoding fraud. A crook could get a number from a discarded receipt and encode it on a white card blank, which is easy to obtain legally. Many people use PINs that are easy to guess, and the crook has an easy job of it. Most ATMs will not give you your card back if you don't enter a correct PIN, and will only give you a few tries to get it right, to prevent this type of fraud. Velocity file checks are also important in detecting this. You should always take your ATM receipts with you, pick a nonobvious PIN, and make sure that nobody sees you enter it.

One place that a crook can get valid PANs to encode on credit cards is from dumpsters outside of stores and restaurants. The credit slip typically is a multipart form, with one copy for you, one for the merchant, and one for the issuer (ultimately). If carbon paper is used, and the carbons are discarded intact, it's pretty easy to read the numbers off of them. Carbonless paper and forms that either rip the carbons in half or attach them to the cardholder copy automatically are used to prevent this.

There are a lot of scams for getting people to tell their credit card numbers over the phone. Never give your card number to anyone unless you are buying something from them, and make sure that it is a legitimate business you are buying from.

"Incredible deal!! Diamond jewelry at half price!! Call now with your VISA number, and we'll rush you your necklace!!" When you don't get the necklace for four weeks, you might start to wonder. When you get your credit card bill, you'll stop wondering.

There are other, more sophisticated ways to modify a credit card. If you're skillful, you can change the embossing on the card and even the signature on the back. For most purposes, these techniques are more trouble than they're worth, since it's not difficult to come up with a new stolen card, or fake ID to match the existing card.

MERCHANT FRAUD There are many urban rumors of merchants imprinting a card multiple times while the cardholder isn't looking, and then running through a bunch of charges after the cardholder leaves. I don't know of any case where this is an official policy of a

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merchant, but this is certainly one technique a dishonest cashier could use. The cashier can then take home a bunch of merchandise charged to your account.

Although some people are afraid of this happening in a restaurant, where a waiter takes your card away for a while, it's actually less likely there, since there isn't anything the waiter can charge against your card and take home.

A merchant could also make copies of charge slips, to sell the PANs to other crooks.

(See above for use of PANs.) Most credit card investigation departments are sensitive to this possibility, and catch on real fast if it's happening just by looking at usage history of cards with fraudulent charges.

A merchant is also in a position to create many false charges against bogus numbers, to attempt to defraud the acquirer or issuer. These schemes are usually not too effective, since acquirers generally respond very quickly to an unusual number of fraudulent transactions by tightening restrictions on the merchant.

ACQUIRER AND ISSUER FRAUD The place to make really big bucks in fraud is at the acquirer or issuer, since this is where you can get access to large amounts of money. Fortunately, it's also fairly easy to control things here with audit procedures and dual control. People working in the back offices, processing credit slips, bills, etc. have a big opportunity to "lose" things, introduce false things, artificially delay things, and temporarily divert things. Most of the control is standard banking stuff, and has been proven effective for decades, so this isn't a big problem.

A bigger potential problem to the consumer is the possibility of an employee at the issuer or acquirer selling PANs to crooks. This would be very hard to track down, and could compromise a large part of the card base. I know of no cases where this has happened.

Programmers, in particular, are very dangerous because they know where the data is, how to get it, and what to do with it. In most shops, development is done on completely separate facilities from the production system. Certification and installation are done by non-developers, and developers are not allowed any access to the production facilities. Operations and maintenance staff are monitored very carefully as well, since they typically have access to the entire system as part of their jobs.

Another type of fraud that is possible here is diversion of materials, such as printed, but not embossed or encoded, card blanks. Such materials are typically controlled using processes similar to those used at U.S. mints. Since most of the cards issued in

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the United States are actually manufactured by only a handful of companies, it's not too hard to keep things under control.

There are many types of fraud that can be perpetrated by tapping data communication lines, and using protocol analyzers or computers to intercept or introduce data. These types of fraud are not widespread, mainly because of the need for physical access and because sophisticated computer techniques are required.

There are message authentication, encryption, and key management techniques that are available to combat this type of fraud, but currently these techniques are far more costly than the minimal fraud they could prevent. About the only such security technique that is in widespread use is encryption of PINs. The next episode will be devoted to debit cards, and the final episode will talk about the networks that make all this magic happen.

This is part 5 EVOLUTION OF DEBIT CARDS The debit card originated as a method for bank customers to have access to their funds through Automatic Teller Machines (ATMs). This was seen as a way for banks to automate their branches and save money, as well as a benefit for customers. A secondary intent was for the card to be used as a method of identification when dealing with a human teller.

Although that idea never really caught on, it has seen renewed interest from time to time.

One problem with using cards to access bank accounts is that federal regulations required a signature be used for each withdrawal transaction. After much debate, the concept of a Personal Identification Number (PIN) was invented, and federal regulations were modified to allow PINs for use in place of signatures with bank withdrawals. ATMs also faced many other regulatory difficulties. In many states, for example, there are limitations on the number of branches a bank can have. In a conflict that only a lawyer could conceive of, a ruling was required about whether an ATM constitutes a bank branch or not. Since such rulings were made on a state by state basis, it varies across the country. This results in some very odd arrangements in some states, because of requirements placed on bank branches.

In early attempts, the card actually carried account information and balances. The cardholder would bring the card into a branch, and bank personnel would "load" money onto the card, based on the customer's actual account balance. The

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cardholder could then use the card at a stand-alone machine that would update the information on the card as money was withdrawn. The information was stored on track 3 of the magnetic stripe, as mentioned in an earlier installment. This approach had many problems. It was far too susceptible to fraud, it could not reasonably handle multiple accounts, and it could not be used as a vehicle for other services.

Since it was pretty much limited to withdrawals, it didn't even automate much of the bank branch functions.

The online ATM offered a solution to the problems of the early ATM cards. Since the ATM was connected to the bank's host, it was no longer necessary to maintain account balances on the card itself, which removed a major source of fraud. Also, access to multiple accounts became possible, as did additional services, such as bill payment.

Once banks started buying and installing ATMs, they quickly realized that it is very expensive to maintain a large number of machines. Yet customers began demanding more machines, so they could have easier access to their funds. Since many banks in an area would have ATMs, the obvious solution was to somehow cross-connect bank hosts so that customers could use ATMs at other banks, for convenience. The lawyers struck again. Does a shared ATM count as a branch for both banks? Does a transaction at a shared ATM mean that one bank is doing financial transactions for another, which is not allowed? If two banks share ATMs, but refuse to allow a third bank, is that monopolizing or restraint of trade? Strange restrictions on shared ATM transactions resulted.

Soon interchange standards began to evolve, and ATM networks became a competitive tool. Regional and national networks started to emerge. And the lawyers struck again. If a network allows transactions in one state for a bank in another state, isn't that interstate banking, which was at the time forbidden? Should an ATM network that dominates a region become a regulated monopoly? Should an ATM network that gets really big be considered a public utility?

Today, the regional and national networks continue to grow and offer more services and more interconnections. All of the regulatory issues have not been resolved, and this is creating a lot of tension for easing banking restrictions.

An ATM card is just an ATM card, regardless of how many ATMs it works in. Most banks long ago saw an opportunity for the ATM card to be used as a debit card, presumably to replace checks. A tremendous number of checks are used each year, and it costs banks a lot of money to process them. Debit card transactions could cost less to process, given an appropriate infrastructure. Some of the costs could

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potentially be passed on to the merchants or the consumers, who are notoriously reluctant to directly pay the cost of checks. So far there have been many trials of using ATM cards as debit cards at the point of sale, but they have, in general, met with consumer apathy. In some areas, where banks have aggressively promoted debit, things have gone better. Still, general acceptance of debit seems a ways off.

One interesting twist to the debit card story, as mentioned earlier, is the emergence of third party debit cards. Issuers of these cards have no real account relationship with the cardholders. Instead, they obtain permission from the cardholders to debit their checking accounts directly through the Automated Clearing Houses (ACHs), the same way checks are cleared. (Think of it as direct deposit, in reverse.) Oil companies first started experimenting with this a couple of years ago, and it has met with surprising success. Banks dislike this concept, because it competes directly with their debit cards, but isn't subject to the same state and federal regulations. ACHs like this, because it bolsters their business, which otherwise stands to lose a lot by acceptance of debit cards. Merchants generally like this, especially the large retailers, because it allows them to get their payment systems out from under the control of the banks.

THE ATM An ATM is an interesting combination of computer, communication, banking, and security technology all in one box. A typical machine has a microprocessor, usually along the lines of an 8086, a communications module (which may have it's own microprocessor), a security module (also with a microprocessor), and special-purpose controllers for the hardware. The user interface is typically a CRT, a telephone-style keypad, and some soft function keys. Typically there is a lot of memory, but no disk.

The screens and program are usually downloaded from the host at initialization, and are stored in battery-backed RAM indefinitely. The machine typically interacts with the host for every transaction, but it can operate offline if necessary, as dictated by the downloaded program. The downloaded program is often in an industry-standard "states and screens" format that was created by Diebold, a manufacturer of various banking equipment, including ATMs. Most machines can use a few IBM protocols (bisync, SNA, and an outmoded but still used "loop" protocol), Burroughs poll/select, and perhaps some others, depending on which communications module is in place. This allows the manufacturer to make a standard machine, and plug in different communications hardware to suit the customer. The IBM bisync and SNA protocols are most common, with most networks moving toward SNA. The security modules do all encryption for the ATM. They are separate devices that are physically sealed and cannot be opened or tapped without destroying the data

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within them. In a truly secure application, no sensitive data entering or leaving the security module is in cleartext. Arranging this and maintaining it is more complicated than I can go into here.

Most ATMs contain two bill dispensers, a "divert" bin for bills, a "capture" bin for cards, a card reader, receipt printer, journal printer, and envelope receptacle. Some ATMs have more than two bill dispensers, and can even dispense coins.

When an ATM is dispensing money, it counts the appropriate bills out of the bill dispensers, and uses a couple of mechanical and optical checks to make sure it counted correctly. If the checks fail, it shunts the bills into the divert bin and tries again. Typically, this is because two bills were stuck together. I've seen ATMs have sensor faults, and divert the total contents of both bill dispensers the first time a user asks for a withdrawal. "Gee, all I did was ask for $50, and this machine made all kinds of funny whirring noises and shut down." Most banks will put twenty-dollar bills in one of the dispensers and five dollar bills in the other. Some use tens and fives, or tens and twenties. Depending on the denominations of the bills, the size of the dispensers, and the policy of the bank, an ATM can hold tens of thousands of dollars.

The journal printer keeps a running log of every use of the machine, and exactly what the machine is doing, for audit purposes. you can often hear it printing as soon as you put your card in or after your transaction is complete.

When you put an envelope into an ATM, the transaction information is usually printed directly on the envelope, so that verifying the deposit is easier. Bank policies typically require that any deposit envelope be opened and verified by two people. In this, you're actually safer depositing cash at an ATM than giving it to a human teller.

A card will be diverted to the capture bin if it is on the "hot card" list, if the user doesn't enter a correct PIN, or if the user walks away and forgets to take the card.

On some machines, the divert bin, capture bin, envelope receptacle, and bill dispenser bins are all separately locked containers, so that restocking can be done by courier services who simply swap bins and return the whole thing to a central site.

The entire ATM is typically housed in a hardened steel case with alarm circuitry built in. These suckers have been known to survive dynamite explosions. The housing typically has a combination lock on the door, and no single person knows the entire combination. The machine can thus be opened for restocking, maintenance, or repair, only if at least two people are present.

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DEBIT CARD PROCESSING Debit card processing is fairly similar to credit and charge card processing, with a few exceptions. First, in the case of ATMs, the accepter and acquirer are usually the same.

For debit card use at the point of sale, the usual acquirer-accepter relationship holds.

In general, acquirers may do front-end screening on debit cards, but all approvals are generated by the issuer - the floor limit is zero. This makes it possible to eliminate a separate settlement process for debit card transactions, but places additional security and reliability constraints on the "authorization". Often a separate settlement is done anyway.

One problem that has caused difficulties for POS use of debit cards is the use of PINs. Many merchants and cardholders would rather use signature for identity verification.

But most debit systems grew out of ATM systems, and require PINs. This is an ironic reversal of the early ATM card days, when people were trying to avoid requiring signature. Other than the PIN, the information required for a debit transaction is the same as that required for a credit transaction.

One last installment on the networks that tie this all together, and the Credit Card 101 course will be complete. There will be no final exam - you will be graded entirely on classroom participation. Most of you are failing miserably...

This is part 6 ACCESS NETWORKS For most credit card applications, the cost of the access network is the single biggest factor in overall costs, often accounting for over half of the total. For that reason, there are many different solutions, depending on the provider, the application, and geographical constraints.

The simplest form of access network uses 800 service, in one of its many forms.

Terminals at merchant locations across the country dial an 800 number that is terminated on a large hunt group of modems, connected directly to the acquirer's front-end processor (FEP). The FEP is typically a fault-tolerant machine, since an outage here will take out the entire service. A large acquirer will typically have two or more centers for terminating the 800 service. This allows better economy, due to the nature of 800 service tariffs, and allows for disaster recovery in case of a failure of one data center. An advantage of 800 service is that it is quite easy to cover the entire country with it. It also provides the most effective utilization of your FEP resources. (A little queuing theory will show you why.) However, 800 service is quite expensive. It always requires 10 (or 11) digits dialed, and in areas with pulse dialing it

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can take almost three seconds just to dial 1-800. The delay between dialing and connection is longer for 800 calls than many other calls, because of the way the calls get routed. All of this adds to the perceived response time at the merchant location, even though the acquirer has no control over it.

Large acquirers prefer to offer some form of local access service. In this service, terminals at the merchants dial a local telephone number to gain access to the acquirer. Typically, the local number actually connects to a packet network, which then connects to the acquirer. If the packet network is a public network, the terminal must go through a login sequence to get connected across the packet network.

Typically, local calls are much less expensive than 800 service calls, and local calls typically connect faster than 800 calls. The cost of those calls are absorbed by the merchants directly. In those few remaining areas where local calls are still free from a business line, this works out well for the merchant. Otherwise, the merchant can end up spending a lot of money on phone calls. Usually, the acquirer has to offer lower prices to accepters who use local calls, to help offset this. Even so, these networks are generally much less expensive for the acquirers.

Such networks are difficult to maintain, due to the distributed nature of the access network. Since most packet networks are much more likely to experience failures than the phone network is, the merchant's POS terminal is usually programmed to dial an 800 number for fallback if the local number doesn't work. Also, it is generally not cost-effective to cover every free calling area in the entire country with access equipment, so some 800 service is required anyway. There is also an administrative headache associated with keeping track of the different phone numbers that each merchant across the country needs to dial. When you have tens of thousands of terminals to support, this can be formidable.

Acquirers are beginning to experiment with Feature Group B (FGB) access. FGB access was the method of access used to get to alternative long-distance carriers before "equal access" was available. The tariffs are still on the books, and they are favorable for this application. FGB access provides a single number, nationwide, for all merchants to dial in order to gain access to the acquirer. The call has simpler (hence, presumably, faster) routing than 800 service, and the call is charged to the acquirer, not the accepter. FGB access does have to terminate on equipment that is physically located in the Local Access Toll Area (LATA) where the call originated, so there is the problem of having distributed equipment, as above. This also implies that it is not cost-effective to deploy FGB access everywhere, as well. There are also some technical oddities of FGB, due to its original intent, that have made it difficult to implement so far.

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The other big switched access capability that is likely to have an impact in the future is ISDN. So far, this has been inhibited by limited availability and lack of adequate equipment on the merchant end, but it could be very beneficial when these problems are solved.

Private-line networks are pretty straightforward applications of point-to-point and multipoint private lines. Since private lines are quite expensive, engineering of the networks is challenging. Usually, sophisticated software is used to determine the optimum placement of concentrators in order to minimize costs. Since tariffs, real estate prices, and business needs change frequently, maintaining a stable, costeffective network is hard work. A typical asynchronous private line network will have multiplexers at remote sites, with backbone links to companion multiplexers at a central site. Synchronous private line networks may use multiplexers, or remote controllers, or remote FEPs, depending on the application and the availability of real estate.

INTERCHANGE NETWORKS Interchange networks physically consist mostly of point-to-point private lines. In many of the large interchange networks, there is a central "switch" that takes transactions from acquirers (thereby acting as an issuer), and routes them to issuers (thereby acting as an acquirer).

Often the switch provider will actually be an acquirer or issuer as well, but this is not always the case. Usually, the provider of the switch defines standard message formats, protocols, and interchange rules. These formats and protocols usually comply with national and international standards, but sometimes do not. Often the switch will provide translation between different message formats and protocols.

The switch provider is generally very concerned that settlement complete successfully. Failure to settle with one or more large issuers can leave the switch provider with an overnight deficit of a couple million dollars. Even though this is a temporary situation, it has significant financial impact.

In some current networks, authorization and settlement take place on completely separate facilities, with separate hosts in some cases. This is mainly due to the history of the industry in this country. Recall that authorizations were originally done by voice calls, and settlement was done by moving paper around. These two processes were automated at different times, by separate means. Thus VISA has a BASE 1 network for authorization, and a BASE 2 network for settlement.

Likewise, MasterCard has INET and INES, one for authorization and one for settlement. These functions are becoming less and less separated as communication 25

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and computer facilities evolve, and will probably be completely integrated over the next five to ten years.

Interchange networks are probably the most volatile part of the ATM market right now. There is currently a shakeout going on in much of the market, with larger, more aggressive regionals buying out standalone networks and smaller regionals. This causes local banks to change local and national network affiliation from time to time.

So a card may work in a given ATM one day, but fail in that machine the next, which confuses many consumers. Most large regional and national networks have operating regulations requiring labeling of ATMs and cards, so that if you see the same logo on your card and the ATM, you can be pretty sure it will work.

Some regionals are interconnected, and others are not. The two biggest nationals, Cirrus and Plus, have operating regulations that effectively prohibit a member of one network from connecting to the other. But a regional on Cirrus could be connected to a regional on Plus. In that case, whether a machine will take your ATM card depends on the routing algorithm used. In most cases, the acquirer will have a table of issuers that are directly connected, and will send anything else to the regional switch. The regional switch will have a table of each issuer it is directly connected to, and tables of which cards are acceptable to other regionals it interchanges with. Anything else goes to the national switch. The same process happens in reverse from there. Often the order of search in the routing tables is determined by fee scales, not geography, so transactions can be routed in completely non-obvious ways.

So the easiest way to tell if your card will work in a given ATM is to stick the card in and try. I don't know of any machine that will eat a card just because it can't route the transaction - it will generally give some non-specific message about being unable to complete the transaction and spit the card back out. Of course, if the transaction is completed from a machine that you're not sure of, you also aren't sure what the fee is going to be if your bank passes those fees on to you. Sometimes the fee will be printed on the receipt, but usually it isn't. If you do the transaction in a foreign country, you may not know the exchange rate used. (I once couldn't balance my checkbook for a month until I got a statement with the transaction I did at Banc du Canada in Montreal.) But if you need the money and are willing to pay the fee, you have little to lose by trying out just about any ATM.

Joe Ziegler

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