How does tokenization work?

Editorial Team

6 min read
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Tokenization is one of the most popular security measures that merchants, payment processors, and banks use to protect sensitive financial and personal information from criminals.

This fraud-prevention technology shares some similarities with data encryption. Both are employed for many of the same reasons — especially in the ongoing fight against:

  • Payment fraud
  • Data breaches
  • Cyberattacks

However, tokenization differs from standard encryption in several key ways. Before weaving this security technology into your payment environment, it is important to understand:

  • What is Credit Card Tokenization
  • How Tokenization Keeps Data Safe
  • The Anatomy of a Tokenized Transaction
  • How Tokenization Differs From Encryption
  • The Main Advantages of Tokenization

Let’s begin.

What Is tokenization?

Simply put — tokenization is a fraud-prevention measure designed to protect sensitive payment credentials, such as:

  • Credit card numbers
  • Cardholder names
  • Expiration dates
  • CVV codes
  • Bank account numbers

Tokenization accomplishes this by substituting all of a user’s payment details with non-specific IDs known as “tokens.” Each of these tokens is randomly generated when a customer supplies his or her payment information at the point of sale (POS). By design, there is no clear relationship between the user’s payment details and the resulting tokens.

For example, a credit card number like 4331-1244-5658-8762 might be converted into a much shorter tokenized value like B7f6%3fhTu.

Only the merchant’s payment gateway can match this token against the customer’s original credit card number. It is unreadable by anyone else (including the merchant). Even if a token is intercepted mid-transit across an unsecured network, criminals cannot reverse-engineer the customer’s payment information. The token is useless to them and cannot be used to make purchases.

Tokenization also allows the merchant to securely store a user’s payment details (in the form of a token) for internal tracking and reporting purposes. Only the randomly generated token remains in the merchant’s payment environment — not the customer’s account number. Again, even if this information falls into the wrong hands, it is unusable by anyone else.

How does tokenization work (in practice)?

We now have a general overview of the tokenization process. That said, it helps to visually see how this fraud-prevention technology works in practice when accepting credit cards or other forms of payment in-person or online.

Below is a sample transaction that walks you through the process — step by step.

Anatomy of a tokenized credit card transaction

  • When a customer provides his or her payment details (either at a POS terminal or through an online checkout form), each data point is substituted with a randomly generated token.
  • In most cases, the merchant’s payment gateway is responsible for creating these random IDs.
  • Next, the tokenized information is encrypted before being sent across the networks to the merchant’s payment processor. The original credit card information is securely stored in the payment gateway’s “token” vault. It is the only component that can map this token back to the underlying payment data.
  • The merchant’s provider encrypts the information again before sending these payment details across the card or ACH networks for verification.
  • If authorization goes through, confirmation of the sale is sent across the card or ACH networks to all relevant parties – including the payment processor, payment gateway, merchant, and the customer.

How is tokenization different from encryption?

Tokenization and encryption are often thought of as similar, partially because they serve the same purpose — i.e., payment data security; however, they are not interchangeable. How they provide this security is different.

Most encryption technologies (like point-to-point encryption) use algorithms to encode sensitive data before sending this information across unsecured networks. The math behind this conversion process is complex. Those who get their hands on the algorithm can decode the original information. In fact, they can reverse-engineer any data that has been encrypted by that specific algorithm. It’s like having a master decoder ring.

By contrast, tokenization creates a randomly generated substitution that bears no resemblance to the original data. This makes it impossible to guess or hack the user’s payment information. Only someone with access to the token vault can map the two values to each other.

Many merchants are confused about which of these technologies offers the most protection — tokenization or encryption — but it’s not really an either/or decision. These two fraud-prevention solutions complement each other, which is why most secure payment environments use both:

  • Tokenization to swap payment details with unique IDs
  • Encryption when sending data across unsecured networks

What are the benefits of tokenization?

Payment tokenization offers several important advantages — with the most obvious being that it keeps customers’ credit card or bank account information out of the wrong hands. Because the payment gateway is the only party that can map tokens to their original values, it is the only component that can ever see your users’ payment details. Using a payment gateway that is owned or affiliated with your payment processor makes it easier to resolve any technical, operational, or billing inquiries you may have with your account, as you only need to contact one company.

This information is invisible and inaccessible — even to you, but there are also other benefits.

For example, tokenization helps to reduce your overall PCI scope. That’s because you aren’t capturing any sensitive details in your payment environment. With no credit card or account numbers to store locally, there’s nothing for criminals to steal. Because you minimize your PCI scope, this makes your annual PCI Self-Assessment Questionnaire (SAQ) much simpler and easier to pass.

Another advantage is that tokenization can protect any type of information. In the U.S., the focus is usually on credit card processing — with merchants using tokenization to safeguard account numbers, cardholder names, and CVV codes.

Though in many parts of the world, privacy laws require that merchants also tokenize the following:

  • Passwords
  • Addresses
  • Patient records
  • Employee files

If you sell internationally (as many online merchants do), tokenizing all of your users’ data makes it easier to comply with these evolving privacy requirements around the globe.

How tokenization gives you peace of mind

Because tokenization isn’t required for PCI compliance, many merchants treat this fraud-prevention technology as an afterthought. Regardless, at a time when data breaches and cyberattacks are on the rise, businesses should use every tool at their disposal to safeguard their users’ information.

Few technologies offer the security and peace of mind that tokenization does.

When harnessed correctly, tokenization eliminates sensitive customer data from your environment. This can be liberating if you lack the in-house IT resources to protect user information 24/7.

The fewer details you store locally, the less data there is for criminals to steal.

If you’d like to learn how tokenization can help protect your customers and shield your business from fraud and abuse, schedule a free consultation with our team of payments experts today.

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