What is payment processing?

By: Made possible by Airwallex

Date: 27 November 2024

A woman pays for a coffee using her digital wallet

Online shopping continues to grow steadily: one in every five transactions took place online in 2023, and forecasts estimate that will become one in four by 2027. This is good news for anyone selling goods online.

The success of any online business depends in part on choosing a payment processing solution that supports your operational strategy. This article will help you choose the right solution for your business.

What is payment processing?

Before looking at payment processing solutions, we should explain what payment processing is. Payment processing is what happens when a customer makes an online purchase, transferring funds from a customer’s account to a merchant’s account. Merchants partner with a payment processor to enable this to happen. Sometimes payment processing technology is offered in a bundle together with other services like acquiring.

Online, customers can pay in many ways, including cards and mobile wallets. Services such as Klarna, which allow customers to pay in instalments, can also be used to encourage sales from customers who may not be able to cover the full cost of a purchase up front. Whichever payment method is used, payment processing is what ultimately ensures that the money is transferred, and the transaction is completed.

What are the key elements of payment processing?

To explain how payment processing works, it’s helpful first to clarify some key terms:

Merchant: The business or individual selling goods or services.
Payment gateway: Technology that encrypts and transmits transaction information from the merchant's website to the payment processor.
Payment processor: A company that handles the transaction process, passing information between the merchant, customer’s bank and card network.
Issuing bank: The financial institution that issued the customer’s credit or debit card.
Acquiring bank: The financial institution that holds the merchant’s account and receives the transaction funds.
Card networks: Organisations such as Visa, MasterCard and American Express that facilitate the transaction process between banks and merchants.

How does payment processing work?

Because the payment process is not visible and usually happens very quickly and seamlessly, it can be easy to forget that there’s lots of digital activity happening ‘behind the scenes’. Here is a rough guide to what happens after a customer clicks ‘buy’ during an ecommerce transaction:

The customer provides their payment information. For example, by completing an online form with their card details or scanning their face or fingerprint to complete the purchase using a mobile wallet.
The payment gateway sends the information to the payment processor. The payment processor sends an authorisation request to the card network, which routes it to the issuing bank.
The issuing bank verifies the customer’s identity and checks whether the customer has sufficient funds to approve the transaction. It then sends a response to the payment processor to approve or decline the payment.
If the transaction is approved, the payment processor sends a message to the payment gateway, which informs the merchant. The customer receives a notification that the payment has been approved.
Funds are transferred from the issuing bank to the acquiring bank, minus any relevant transaction fees.

Popular payment methods for online transaction processing

Credit and debit cards: Payment cards are still the default online payment method. Credit cards allow customers to borrow funds while debit cards deduct money from the customer’s account
Digital wallets: Increasingly popular, it’s estimated that these mobile apps including Apple Pay and Google Pay will make up 49% of all global online and instore POS (Points of Sale) transactions by 2027.
Buy Now Pay Later (BNPL): This payment method allows customers to make a purchase and pay later or in a series of instalments. A small down payment is usually required, and subsequent payments can be automatically deducted from the user’s account or card. Klarna is an example of a popular BNPL provider.

The importance of security when processing payments

Security is one of the most important aspects of payment processing. There are many ways the payment process can be tampered with. These include:

Stealing a credit or debit card and using the information to make purchases.
Targeting payment systems to steal sensitive customer data.
Tricking individuals into sharing their payment information through fraudulent ‘phishing’ attacks and using this information to make purchases.
Requesting a refund for fraudulent reasons, such as saying the item was not received.

As well as being aware of these risks, businesses must also ensure that they are compliant with industry regulations and standards, or they may incur penalties. One important standard in this context is the Payment Card Industry Data Security Standard (PCI DSS). It requires businesses to protect their customers by ensuring that their data remains secure and private. Working with the right payment provider and implementing secure payment processing technology can make compliance easier.

Key security technology for payment processing

There are various technologies used during the payment process to ensure that the transaction and customer data remain secure, including:

Encryption: Customer data is scrambled into a meaningless string of characters before it is transmitted to ensure no one else can access it. Encryption tools like SSL (Secure Sockets Layer) and TLS (Transport Layer Security) are used during the payment process.
Tokenisation: Similarly to encryption, tokenisation replaces sensitive card information with a unique identifier or token. When the transaction takes place, a key unlocks the information to complete the payment process.
Biometric authentication: Various methods can be used to check someone is not using stolen card details. Multi-factor authentication – when two methods are used to check the person’s identity – help reduce the risk of fraud. However, this adds friction to the checkout process which can reduce conversion rates. Mobile wallets have popularised biometric authentication – such as fingerprint or face scan - which is secure, quick and easy.
Artificial intelligence and machine learning: AI and ML can be used by payment providers to track unusual transactions to assess the risk of fraud. Any suspicious activity could trigger an additional demand for authentication, for example.

Why do businesses need a payment processing solution?

Some ecommerce platforms offer their own payment processing solutions, but it can be beneficial for businesses to partner with a payment processor if they have an online shop or sell through a marketplace. These providers can optimise the checkout experience and help boost conversions. The software can also be integrated seamlessly with a pre-existing ecommerce store. Here are some of the benefits payment processors can provide:

Multiple payment methods: Offering a range of payment methods helps boost conversions.
Advanced security: Advanced payment processing solutions use encryption, tokenisation and secure communication protocols to protect customers’ payment information. They also help businesses comply with standards such as PCI DSS.
Operational insights: Payment processing solutions help merchants analyse transaction data so they can understand customer behaviour and optimise sales.
Risk management: Payment processors can help manage chargebacks, protecting businesses from fraudulent claims and reducing losses. They also monitor transactions in real time so suspicious activity is flagged and investigated before fraud can take place.
Streamlined record keeping: As well as ensuring that businesses remain compliant with local and international financial regulations, modern payment processors can seamlessly sync with accounting software, streamlining financial reporting and auditing.

Three features to look for in a payment processing solution

Global reach

As well as offering a range of payment methods, a good payment processor will allow customers to see prices and make purchases in their preferred currency. You should also check if it supports digital wallets such as Apple Pay and BNPL methods as these can offer strategic advantages for businesses.

Security and compliance

Security and fraud prevention are essential in protecting both companies and customers. A good payment processing solution will have advanced security measures to deal with evolving threats. Look out for solutions that offer 3DS protocols and pre-chargeback programmes and employ machine-learning-powered checkout optimisation that can enhance payment acceptance rates.

Cost savings

Different payment processors offer different fee structures. Often there’s a monthly or yearly subscription fee as well as transaction fees (either a flat rate, a percentage of the transaction, or a combination of these). Check for “hidden” costs that aren’t immediately obvious, but which can quickly mount. If you’re likely to have a high proportion of international transactions, consider using a payment processor that specialises in cross-border payments.

In summary

The wrong payment solution can lead to a negative checkout experience, costly conversion fees, and an increased risk of fraud. Learn more about the key features to look for in a payment processor here.