We are nearing the end of our initial excursion into the basic payment methods with what are the most fundamental ones, albeit the least familiar to the average person. ACH and wires are the plumbing behind all the other payment types, as well as their own products. Faster Payments systems are just a refinement, with the most important difference being on the data layer. For other installments in the Payments 101 series, click here.
ACH stands for Automated Clearinghouse, and every country on earth has one, under various names. Usually, it is run by the central bank, but it can also be offered by private companies. In the U.S., there are two operators: Federal Reserve Financial Services, and The Clearing House (TCH). The brand names are FedACH and just plain ACH.
Wires are the earliest electronic payment method, and get their name from their original delivery method, telegraph wires. Again, wire transfers exist in every country, are usually operated by a central bank, and may also be offered by private entities. In the U.S., the same two providers, the Fed and TCH, offer wires under the brand names Fedwire and CHIPS (Clearing House Interbank Payments System).
Faster Payments is a catchall term representing a new generation of payment systems that combine the best of ACH and wire transfers with a modern messaging and data structure. Earlier versions of ACH and wires were limited by the technology available when they were created, and decades of lock-in have made it almost impossible to change them. Hence the need to create a completely new payments platform.
What unifies these products is that they are all primarily interbank payment systems; in other words, they are not customer-facing, unlike the other products we have discussed. Instead, they underlie the customer-facing products. For example, card payments are settled through a combination of ACH and wire transfers. If a consumer or business uses ACH, it will be in the guise of “bill payments,” “person-to-person payments,” or “autodebit.” There are various brand names, such as Zelle, Venmo, PayPal, Square Cash, etc., but all rely on these interbank payment systems to work.
Fundamental Concepts in Interbank Payment Systems
To understand how ACH, wires and faster payments work, it will be necessary to discuss a couple key concepts.
Payment Instruction and Settlement
A payment generally has two separate stages: instruction and settlement. First the payment instruction is created, containing information such as the account numbers of the payor and payee, the date on which the funds transfer is to be received, the amount of the payment, and so forth. Second, the payment is settled by moving the money from one account to the other. Usually, these two stages are invisible to the customer, but you can see them in some cases.
For example, suppose you are paying cash at the corner store. The payment instruction is the clerk telling you how much your order costs. The settlement is you handing over the cash, and the clerk making change. These happen so fast we do not usually think of them as separate stages, but they are.
When you pay a bill online, you authorize the biller to pull the money out of your account using an ACH transaction. Note that the biller tells you when the payment will be credited; usually the next business day, although some billers will credit you the same day. However, the actual money does not move until a day or two later. If you watch your bank account closely, you will see that money is not removed, or debited, until a day or two after you submitted the payment.
The Clearing House provides a helpful diagram of the ACH process, shown below.
In this case, it is a power company who is billing the customer. The first thing you will see is the ACH is bi-directional. Pull payments are called debits, while push payments are called credits. All other payment types are generally one way, mostly debits. The customer provides an card number or check, and the merchant pulls the money out of their account some time later. This does not work so well for business-to-business payments, where the amounts involved, and therefore the risk, are higher. To reduce risk, the merchant or seller provides the account number (which cannot be debited), and the customer or buyer tells their bank to transfer funds out of their account and into the seller’s account. This is what is shown on the right side of the diagram.
Something else to note in the diagram is that the “Debit(Credit) Instruction” is different from the “Settlement Instruction,” as I observed before. The distinction between payment instruction and settlement is crucial to understanding faster payments because faster payments sometimes look faster than they really are. The receiver’s account can be credited in real time using a system like Zelle, but the cash is not received until sometime later, either later that day or even the next day. The receiver’s bank is taking a small amount of risk extending the funds to create the illusion of a real time payment.
With wires, the instruction and settlement go together, and take place immediately. Yet they are still separate processes; the instruction must be validated through a cumbersome process, involving verifying the identity of the person issuing the instruction, verifying that there are sufficient funds in the account, and verifying that the destination account is the correct one. These steps can be automated, but the goal is to reduce risk as low as possible. Therefore, you will often see advanced security measures such as hardware tokens used.
Net and Gross Settlement
Net settlement is a means of saving time and money by bundling a whole bunch of payments into a batch, summing them up, and settling them simultaneously. Take the following chain of transactions:
Obviously in real life you will have more than three participants, but we will keep it simple for purposes of this example. If we look at each participant separately, what is their total amount of money at the end of the chain?
A = -$80,000. A paid B $100,000, but received $20,000 from C, making their final balance $80,000 lower than it was at the beginning.
B = $30,000. B paid C $70,000, but received $100,000 from A, making their final balance $30,000 higher than it was at the beginning.
C = $50,000. C paid A $20,000, but received $70,000 from B, making their final balance $50,000 higher than it was at the beginning.
If we add the three positions together, we get $30,000+$50,000-$80,000 = zero. The three positions net to zero, and the payments are considered cleared. Clearing just means that all the transactions sum to zero. If your transactions do not clear, then you have a problem. The job of clearinghouses is to make sure this does not happen.
We could do these three transactions individually, settling each one in turn. This would be called gross settlement. Each transaction would have a separate cost and be run consecutively. However, each participant would need to have enough money to cover each transaction. For example, A would need to have $100,000 in their account, B would need to have $70,000, and C would need to have $20,000.
With net settlement, the reserves, or amounts held at the start, are the same or less. A only needs $80,000, not $100,000. B and C need zero, not $70,000 or $20,000. Since reserves generally do not earn much interest, this is important at scale, because the unneeded reserves can be lent out at a profit. Net settlement is also safer than gross settlement, because the chances that one of the participants will not have enough money to cover their commitments is less.
However, net settlement comes with a time delay while the clearinghouse accumulates enough transactions to make a batch. In some situations, like making an expensive purchase (a house, car, or boat), this delay is unacceptable. Once the buyer drives away with the car, it is hard to get it back if it turns out the buyer did not actually have enough money in their account, because someone else got to it first. In these cases, it is better to use gross settlement.
However, suppose you could get the time delay for net settlement lower? Instead of taking a whole day, what if it only took an hour? Or a half-hour? At some point, the risk becomes low enough that net settlement can substitute for gross settlement. Modern-day faster payment systems use this principle to get the best of both worlds, net settlement at gross settlement speeds. This is made possible by modern computer systems and telecommunications networks, that operate so quickly that thousands of transactions can be settled near instantaneously. The industry calls this “fast batch,” and it is the “faster” part of “faster payments.” It is not real time, but it is practically indistinguishable.
Messaging and data
Now we come to the third key concept, messaging and data. It is not enough to simply send money hither and yon; you also need to tell the receiver who it is from, and what it is for. This is called remittance data, and it is a lot harder to handle than you might think.
Going back to your bank account, if you try to balance it, you will know how important remittance data is. Suppose you have a line on your bank statement that reads DORNNSLET *PAYPAL. You might not know what this is at first and have to do some research. It would be nice if the line read, instead, DORNIGER’S LETTER SHOP – 3 GREETING CARDS, PAID VIA PAYPAL. Why doesn’t it? Well, the message received by your bank only had a certain number of characters, and it was composed from another message from PayPal that only had a certain number of characters, and some of those characters got cut off by the “*PAYPAL” text.
Also, something got messed up when the merchant acquirer set the merchant up on the system, and an extra N got inserted. There is not a clear rule about what to do when the name is longer than the data field allows, and so the person setting up the account makes their own idiosyncratic decision about what to put in there. Even if there is a rule, the rule for this acquirer is not the same as the rule used by another acquirer. Oh, and maybe the shop changed names, but the change was not reflected in the account. Or maybe Dorniger’s is allowing some other merchant to use its ecommerce account. In that case, you might have to call them.
Now take this problem and scale it up to the level of a company. Businesses have entire departments, called Accounts Receivable, dedicated to figuring this stuff out.
It would be helpful if we were not constrained by the old messaging formats, created at a time when technology resources were scare. Indeed, there are many groups working on new messaging standards at this very moment. However, they are held back by one problem, and we have seen it before.
The Network Effect
Just as with a payments network, a messaging standard must be widely accepted to be worth the trouble of converting existing software to work with it. However, until most companies have done the conversion, it is not worth it, which creates a chicken-and-egg problem. The industry has devised several ways around this problem:
- Government mandate – nobody likes being told what to do by the government, but if you have a regulator with enough authority, you can jumpstart the process. A softer version of this option is for the payment services operated by the national government to be upgraded with the new messaging format, which is what has been done in the European Union.
- Message format conversion – a quick fix is to take whatever the legacy payments system expects to see and write a piece of software to convert that into the new messaging format, and vice versa. The obvious problem with this is that you cannot convert what is not there. If the old format did not have all the fields you need, you must either leave the new fields blank, or fill them with something semi-intelligent. Sometimes, this can be done by inferring values from other fields. However, doing this risk breaking things down the road. A persistent problem in format conversion is programmers using fields for purposes not originally envisioned. For example, one way to deal with the lack of remittance data in older messaging formats was to put a reference number or URL in an unused field, like a memo field. Each company did this differently, however, so there is no standard conversion technique. Internal development teams often run into problems with “dirty data,” where the reason for the work-around has been forgotten, and later programmers must try and figure out what was intended.
- Vertical industry focus – it can be easier to find a vertical industry or industry association where the pain is greatest and get every member of that group to convert to the new standard. However, that only gets you so far. Also, a particular industry often wants fields no other industry wants, so they modify the standard to include them, creating dialects and variants that then render their work of limited utility. It turns out that universal standards are not great solutions for anybody.
The most prominent such format in payments is called ISO 20022, and it has been widely adopted by national and international payments networks, often as an overlay to existing formats. Those who wish to continue using the old formats can do it, while those who want the richer data can switch to ISO 20022. Unfortunately, you still need agreement on what goes into the added fields. Remittance data is formatted differently in different industries; some need a lot more data than others. This is the thing that is holding up ISO 20022 adoption now. However, the newest faster payments networks all use ISO 20022 natively, so as companies and banks start to adopt them, ISO20022 will come along for the ride.
Faster Payments is Really Faster Data
Let us review:
- ACH, wire and faster payments are fundamentally the same. The only difference is the rules, procedures, and legal frameworks surrounding them.
- The main operational difference is between gross settlement and net settlement; gross settlement is faster but more expensive. Faster payments networks take advantage of greater computer power and faster network speeds to make net settlement feasible on an hourly basis, called “fast batch.” This makes faster payments a reliable substitute for wires. Note that you do not actually need a new network; ACH can achieve near real time on its own by using more frequent settlement. Also, existing card networks already operate in real time, and can be extended to offer ad hoc funds transfers.
- The real value of building a new network is not the speed of the payment, but really the expanded data fields, and the ability to transmit those as part of the payment message. Thus, you can think of faster payments as really being “faster data” as well as richer data. This is where the real value will be added.
- Realizing this value will take time, because it depends on wider acceptance of the ISO 20022 messaging format, which depends on adoption of new networks. The early wins are due to speed, but the ultimate reason to adopt faster payments is to get access to the data. This will be a long, complicated process, but it is well underway.