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How do debit cards work?

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Consumers love debit cards.

And no wonder. This payment method is convenient and secure, and it allows consumers to “pay as they go and track their spending of ready funds,” says Ed Kadletz, head of debit and prepaid cards at Wells Fargo in Minneapolis.

But what really happens when a consumer makes a purchase with a debit card? Here’s a quick tour through the three-part process.

What happens after the swipe?

Authorization. When someone swipes a debit card through a merchant’s terminal, the terminal reads the magnetic strip on the back of the card and transmits the data to a card-processing network, says Bob Whyte, head of consumer debit products, North America, at Visa Inc.

Visa is a card-processing network as are MasterCard, Pulse, STAR Network, Interlink and Maestro.

The network ensures the pieces of transaction data are correctly formatted. Then, it performs a fraud analysis and forwards the information to the bank that issued the debit card. The issuer then validates that the card hasn’t been reported as stolen or lost, confirms whether funds are available in the cardholder’s account and then notifies the merchant, again through the network, whether the transaction has been approved.

“The vast majority of times, the issuer of the card will authorize the transaction, and it will go back through the process in the blink of an eye,” Whyte says.

The transmitted data typically include the card number, transaction amount and date. The data will also include the merchant’s name and location and a merchant category code, or MCC, that’s used for rewards programs, among other purposes. If the consumer entered a personal identification number, or PIN, that would be encrypted and sent as well, Whyte says.

Clearing. At the end of the day or several times throughout the day, the merchant sends all the authorized transactions back to the network, which splits up and recompiles those transactions and then sends them back to the issuers. In turn, the issuers post the transactions to their customers’ accounts, Whyte says.

Settlement. Finally, the network calculates how much money each issuer owes the network and how much money the network owes each merchant, Whyte says. Payment of the funds to the merchant can happen the same day as the swipe, or the next day, or within a few days.

Kadletz says that rather than connect directly to the network, most merchants contract out their debit card processing chores to large financial companies referred to in this context as “acquirers.”

“An acquirer represents the merchant to the bank and is typically the means by which funds are flowing,” Kadletz says. “When the merchant is paid, it’s typically happening through an acquiring bank.”

Wells Fargo, Bank of America, Chase and other major banks all act as acquirers for merchants.

The volume of transactions processed is staggering. Whyte says the Visa network routed more than 7 billion U.S. debit card transactions in the three-month period that ended June 30. That’s only Visa, only U.S., only debit, only three months — and that’s billion with a “b.”

The debit card

The 16-digit number on the front of the debit card is crucial to the process, says Linda Echard, CEO of ICBA Bancard, an Independent Community Bankers of America subsidiary through which many community banks issue debit cards. Typically, the 16 digits are comprised of a six-digit bank identification number, or BIN, the customer’s bank account number, and a so-called check digit that’s generated by the Luhn test algorithm and is used to verify that the account number is legitimate, Echard says.

The back of the card contains the magnetic strip, or stripe, a security code and signature panel, Kadletz says.

Sometimes, the issuer puts a hold on the consumer’s funds when the transaction is authorized and adjusts the amount when the transaction settles, Echard says. Two examples: An authorization to purchase gasoline up to a certain dollar amount might be adjusted after the fuel is pumped into the tank, and an authorization to pay a certain dollar amount for a meal at a restaurant might be adjusted after the diner adds a tip to the total.

Signature or PIN?

Visa and MasterCard tend to process signature-based transactions, which typically use a so-called two-message process in which authorization and settlement are performed separately. The smaller networks usually handle PIN-based purchases, which occur via a single message that incorporates both authorization and settlement, Kadletz says.

“Signature is a legacy technology, but it has broader acceptance,” he says. “Merchants take MasterCard and Visa all around the world. PIN you’ll find mostly at supermarkets, gas stations and major retailers.”

The line between the two technologies is blurring now that some merchants accept debit card transactions where the card user doesn’t have to sign or use a PIN, Kadletz says.

“Those used to be distinct, but now you have signature (transactions) that don’t have any signature, and you’re starting to see PIN transactions that don’t have a PIN,” he says. “The preference for most merchants as well as cardholders is swipe and go. It’s a fast way to pay.”