Payments 101: Part 3 – Enterprise Systems: Check, ACH and Wires
Updated: Nov 20, 2022
This is part 3 in my Payments 101 series. In this article, I would talk about the payment systems that are typically used by enterprises for moving large sum of customers. While consumers also use checks and ACH credit/debit, most of consumer transactions today occur via credit cards, debit cards or cash. Other articles in this series can be found here:
Payments 101: Part 3 – Enterprise Systems: Check, ACH and Wires
Payments 101: Part 4 – Core Consumer Systems: Credit and Debit cards
A check is a paper instrument (typically signed) that directs the financial institution of a sender to transfer some money from their bank account to the bearer of the check or the person/organization, whose name is written on the check. In the first article in this series, I had mentioned that every payment has 3 components. These components for a check payment system are as follows:
Initiation: A recipient or holder of the check presents the check at a bank
Funding: The amount on the check is funded from the sender’s bank account
Delivery: Once the bank verifies the details on the check (and if sufficient amount exists in the sender’s bank account) then that amount is delivered to the recipient in cash or transferred to the recipient’s bank account
A check transaction is a pull transaction i.e. the payment is initiated when the recipient deposits/presents the check at a bank/financial institution. Therefore, the recipient bears the risk that the amount may not be present in the sender’s bank account (what is referred to as a bounced check).
A check is a negotiable instrument i.e. it can be transferred from one person to the other. Despite the fact that a checking transaction begins with a piece of paper, almost all of today’s check processing is electronic.
Evolution of checks:
Consumers and Businesses of one bank can send checks to consumers/businesses of other banks. Since, these are physical pieces of document, banks had to establish a process to exchange these checks and “clear” them. For e.g. Bank A may have checks drawn on it from 3 different banks – Banks B, C and D – and needed to develop a process that can enable it to easily collect these checks and then transfer the amount of money owed to different banks in “one go” rather than individually (i.e. check by check). Similarly Bank A may have also received checks from banks B and D and may need to collect the money from these banks. Therefore, it was easier for these banks to devise a mutual “clearing” system to “exchange” these checks with each other. This need led to the establishment of clearing houses.
The first check clearing house was established in New York City in 1853. The clearing house was just a hall in which banks, on every banking day, brought checks that were drawn on other banks. The clearing house helped in exchange of these checks and calculated the daily net settlement for each bank after all the checks that were drawn and “owed” to the bank were settled.
Initially, checks were deposited at discount i.e. if a recipient took a check for $100 to his/her bank then the deposit bank will credit the customer only $98 rather than the entire amount. The Federal Reserve Bank system changed that and started requiring all its member banks to accept checks for deposit at par i.e. the full amount was credited to the customer. This helped in the check system becoming a national system.
In the early days, check processing was still a manual task. Furthermore, the time take for check processing led to delays in money transfer from one account to the other. This problem led to the development of MICR – Magnetic Ink character recognition. Key information about the check was encoded in the MICR code and mechanical check sorters were able to scan checks at a much faster rate.
These mechanical check sorters also captured an image of both sides of the check as it flowed through the sorter. At this time, banks still had to manage and store the paper version of the check (and secure it) and sometimes the check had to be also shipped across the country as banks may demand to see the physical check for verification. Since the sorting machines were already capturing the check image, banks and other financial organizations thought that it would be more cost-effective to only transmit images rather than actual physical check. This was codified in law when Check 21 law was passed. This law mandated that a printed copy of the original check is the legal equivalent of the original paper check.
Check Payment Flow:
Check payment is a pull transaction. The check holder (payee/recipient) presents the check to his/her bank (Bank of First Deposit) and this bank starts the pull transaction to move the funds. The check (or the image of the check) moves through the chain and assuming the check is verified and the payer has sufficient funds, the money is transferred from the check writer’s bank to the bank in which the check was deposited (known as the Bank of First Deposit).
If the payer bank account did not have sufficient funds then the check writer’s bank could do one of two things: (1) extend an overdraft to the payer and transfer the fund, (2) reject the check or “bounce” it back to the bank of first deposit. The risk of a bounced check is borne by the payee/check holder. The check holder may have already provided services to the payer and, therefore, may face loss in this case. The costs of this process is quite low when everything is moving as expected. However, the cost of exception handling is very high as manual intervention may be needed. Therefore, there can be additional costs for handling bounced checks and banks will typically charge their customers for such occurrences (either as a flat penalty fee or as high interest rate on the overdraft extended). Banks use the expression “Day 2 Processing” to refer to all activities (returns, adjustments, statement rendering, research, etc.) resulting after acceptance or refusal of an item
Check fraud has a history that is as old as that of check usage itself. Common check fraud consists of forged checks, forged signatures, altered amounts/dates/payees and check kiting. Check fraud is one of the most common fraud vector for banks. Size of attempted check fraud was $15.1 billion in 2018 and successful check fraud made up 47%, or $1.3 billion, of banks’ fraud losses.
Recent trends in check writing:
Checks are becoming a less common payment system in the US and the number of checks written has decreased every year for the last 2 decades as shown below:
Furthermore, the evolution of check deposits have continued. For e.g. we saw how check processing went from paper to image captured by sorting machines. The next logical evolution was to use smartphones to capture check images and use those images for deposit. Therefore, mobile check deposit has become a common feature of mobile banking apps.
It is estimated that consumers deposited more than $40B on mobile via checks in 2017. Mobile check deposits are typically cleared/transferred within 1 business day. This is also a fraud vector and different banks have different limits and rules for check deposits on mobile. For e.g. my Bank of America account allows me to deposit $75K per month while my Chase bank account allows me to deposit only $5K per month.
Checks can also be deposited at ATM machines. Most banks capture the image of the check as it being deposited and then use that initiating the transfer.
ACH stands for Automated Clearing House. It is the only payments system in the U.S. that handles both push and pull payments transactions. ACH credit transfers are payments for which the payer’s depository institution “pushes” funds to the payee’s depository institution, such as direct-deposit payroll payments. ACH debit transfers are payments for which the payee’s depository institution “pulls” funds from the payer’s depository institution, such as an insurance or mortgage payment drawn from an individual’s account on a prearranged basis. ACH system is extensively used by both consumers (for receiving their salary via Direct Deposit, for making large payments like rent) and enterprises (for executing large payments).
Evolution of ACH:
As we discussed above, bankers found it cumbersome to manage and transport physical checks. Therefore, they introduced MICR encoding in checks to expedite the sorting of checks and then started transferring only the image of the check rather than the physical check. And most recently, banks do not even require consumers to present the check at a branch/ATM but allows consumers to take check pictures and deposit via their smartphones.
The ACH system developed in parallel to the above evolution. With the introduction of MICR encoding, bankers realized that they do not need to even collect/manage the physical check but they only needed the MICR data to make a transfer. The network got a kickstart as the US government decided to pay Social Security benefits via ACH and a significant portion of the population (and almost all banks that had social security benefit recipients as their customers) were exposed to the ACH network.
ACH Payment Flow:
An ACH transaction is entered into the ACH payments system by an originator, most typically an enterprise. The originator delivers the transaction to its bank, called the ODFI, or originating depository financial institution. The ODFI credits or debits its customer’s account (depending whether the transaction is “pull” or “push”) and forwards the transaction to its chosen ACH operator. Currently, there are two operators—the Federal Reserve Bank and Electronic Payments Network (EPN), owned by The Clearing House. The role of an ACH operator is somewhat similar to that of Visa/Mastercard in managing card networks (we will discuss this in the next article). The operator passes the transactions on to the RDFI, or receiving depository financial institution. (If the ODFI and the RDFI use different ACH operators then the first operator switches the transaction to the second operator). The RDFI then debits or credits the account of its customer (the recipient), again depending on whether the transaction is “pull” or “push”
A significant portion of checks are actually executed on the ACH network. For e.g. when a payee gives a check to their bank then the bank can convert the transaction into an ACH debit transaction (i.e. a pull transaction) and destroys the check. This payment is now completed over the ACH network.
In the last few decades, ACH WEB transactions have become a significant portion of all ACH transactions. An ACH WEB transaction is authorized by a consumer online. For e.g. a customer can decide to pay for a product by using ACH option (e.g. pay using your bank account). The merchant will then create an ACH debit transaction/payment in order to charge the amount to the customer’s account. The merchant undertake some risk in doing this as the customer may remove the funds from his/her account or may give wrong information at the time of the payment. Many merchants get around this by doing 2 micro transactions to the customer’s account and then asking customers to verify those amounts (so that the merchant can establish that the customer owns that bank account). However, the risk that a customer may not have enough funds in his/her bank account remains. Typically, the transfer process takes only 1-2 days and the merchant ships the product only once the transfer has occurred. However, customers may expect to receive some digital products immediately and if the merchant entitles those products then the merchant will take on “funds not available” risk. For e.g the chart shown below looks at the reason for failure rate for Direct Debit (via SEPA and BACS), which is a common payment method in the EU/UK. ~2.4% of Direct Debit transactions (which are very similar to ACH transactions) fail due to lack of sufficient funds.
Recent trends in ACH:
Same Day ACH was introduced recently. Before this, banks typically cleared their ACH transactions once every day. As part of this program, 2 additional clearing slots were introduced per day. These additional slots led to faster clearing/settlement due to which same day settlement/ACH transfer could be achieved. Same day ACH is an important step forward for the ACH system, but it is equally important to understand what it is not—it is not an “immediate funds transfer” system. Same day ACH relies on the same batch processing protocols that are used in “normal” ACH transactions.
While Same Day ACH is growing fast, it represented only 1.2% of all ACH transactions in Q2 2020.
Wire transfer systems are designed for handling very high-value transactions between businesses. Most of these systems are real-time gross settlement (RTGS) systems vs. net settlement systems (like ACH, check). This is because the wire system is used for transferring billions of dollars everyday and a bank can rack up hundreds of billions of debt in a day if the payments are not settled in real-time and this can bring down the entire financial system.
Wire transfers are fully guaranteed payments. A wire transfer cannot be repudiated, reversed, or charged back without the agreement of the recipient. Consumer payments systems, both paper and electronic, tolerate a certain amount of fraud. The cost of these fraud losses is covered by the revenue (fees, interchange, interest, float) earned on good transactions. But this doesn’t work with wire transfer systems: there is no price a bank can set on a “good” wire transfer that would cover the bank for the loss, for example, on a single fraudulent $500 million transaction.
The US has 2 systems for wire transfers:
FedWire: This is a service that is offered by the Federal Reserve Banks
CHIPS: CHIPS stands for Clearing House Interbank Payments System. It is owned by The Clearing House, which is in turn owned by large banks in the US. The CHIPS system is used by only a small number of very large banks.
FedWire has a ~60% market share compared to CHIPS.
To read the 4th part in my Payments 101 series, please click here: Payments 101: Part 4 – Core Consumer Systems: Credit and Debit cards.