How do PSPs differ from ISOs within the payments ecosystem?

There is a really great article to this Question by Braintree (company) on their Blog on a post called Merchant Account Basics:

Not all service providers are made equal
There are really two types of merchant service providers: processors and resellers (resellers are known in the industry as Independent Sales Organizations (ISO's) and/or Merchant Service Providers (MSP's)). Your first thought is probably that you would rather go with a processor to cut out the middle man, but I'll show you why it's not that clean cut. Before I started Braintree, I worked for a processor and saw first hand some of the limitations they had in providing solutions to merchants. I'll provide more detailed descriptions of both options and then offer an assessment of their differences.

1) Processors - Also known as Acquirers, processors are distinguished by their ability to actually process a transaction. To be a processor, a company must have the technical capability to receive transaction data from a merchant via a telephone line or the internet and then communicate with the appropriate financial institutions to approve or decline transactions. Processors must also be able to settle completed transactions through financial institutions in order to deposit funds into the merchant's bank account.

The processing industry is highly concentrated with the top five processors maintaining over 70% of all transaction volume. Processors can be banks or non-banks. While processors do maintain a direct sales force of their own, they primarily work through ISOs to acquire and maintain their merchant base. A processor's business model is really one of economies of scale. They're volume shops. They essentially outsource the sales function to ISOs. I don't have data on this but I would guess that over 80% of the 7 million U.S. merchants work with an ISO.

Below is simple diagram of the transaction flow. I took the liberty of putting my company in the value chain, but because Braintree is an ISO, there is a processor behind the scenes doing the actual transaction processing. Because most everything is private labeled, it's difficult for most merchants to discern whether their service provider is a processor or an ISO. Be careful not to be improperly influenced by this. Most sales people try to use the 'we are the processor' line to gain additional credibility when in reality it doesn't really matter.

2) ISOs - ISOs resell the products or services of one or multiple processors. They can also develop their own or aggregate other value added products and services. ISO's range from a little sketchy to best in class providers.

There are two types of ISOs:
a. Banks - Banks of all shapes and sizes are ISOs. Wells Fargo, for example, is an ISO of First Data. Your local community and large regional banks are most likely ISOs. Banks entered into the merchant services business because it was a natural fit with their product and service offerings. It's a way to increase revenue per customer. Most, but not all banks, will private label the services so that it's difficult to distinguish whether they are a processor or ISO. The benefit of working with a bank is that you can consolidate your financial services. The drawback is the you usually get out of the box solutions and service.

b. Non-banks - These types of ISOs range from some of the most dynamic and capable providers to firms who don't represent the industry very well.

Industry Dynamics There are a few dynamics that make the industry landscape quite interesting. First, there are very barriers to entry due to the lack of certifications, licenses, and capital requirements. Secondly, there really is no active regulatory body that oversees and enforces acceptable practices. So naturally, with these two market conditions, merchants need to be mindful and thorough in selecting a provider.

Processors versus ISOs In comparing the two, ISOs offer all of the products and services that processors do (because they are reselling) but processors can't always offer the same products and services as ISOs. This is because ISOs can resell for multiple processors and can either develop their own technologies or aggregate solutions from other providers. ISOs have largely been the most successful creators of value-added services while attempts by processors have usually been pretty clunky. ISO's also tend to be smaller, which usually (but not always) leads to better customer service.

Processors are usually a safer bet for newer merchants that are still learning about the industry. Most still maintain what I consider less-than-upfront pricing practices, but with their services it is less common to hear about some of the more serious problems that merchants encounter when they deal with the wrong ISO. As for price, in most cases, there really is very little to no difference. I argue, and fully disclose my vested interest, that in nearly any situation a best in class, non-bank ISO can provide more value than a processor. For some other considerations about what to bear in mind when evaluating different providers, you can read How to choose a merchant service provider.

Source: Merchant Account Basics