Payment systems part 1

Certificate Program in Payment Systems Domain Competency Academy

Competency V 2.0

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Chapter 1 - Basics of Payments System

1.1 Introduction

This session gives you an idea about how the ancient practice of barter system has

evolved into the present day payment systems. It is interesting to understand the

standards involved and various methods deployed for transferring funds and evolution

of the payment systems over the years.

In this session, we will focus on importance of payment systems and the operations,

roles, and associated risks involved in carrying out payment transactions.

1.2 Learning Objective

After reading this chapter you will get a grasp of:

• How financial transactions have evolved

• What are the various payment systems and their importance in banking

industry

• Associated risks involved in payment systems.

Topics Covered:

Chapter 1 - Basics of Payments System................................................................................................... 3

1.1 Introduction..................................................................................................................................... 3

1.2 Learning Objective ....................................................................................................................... 3

1.3 Introduction..................................................................................................................................... 4

1.4 Payment Systems – A definition ............................................................................................. 5

1.5 Importance of Payment Systems............................................................................................ 7

1.6 Goals of Payment Systems ......................................................................................................10

1.7 Role of Central Banks in Payment Systems ......................................................................11

1.8 Evolution of Payment System in India ...............................................................................13

1.9 A Time line of payment instruments and systems in modern India......................15

1.10 Summary.........................................................................................................................................16


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1.3 Introduction

“There are no free lunches in this world “

-An old Economics adage

We homo-sapiens are essentially consumers, everyday we consume either goods in the

form of food, clothes, soaps, detergents, etc. or services (also be termed as intangible

goods) in the form of banking services, medical & healthcare services, entertainment

services etc. However, goods and services do not come for free and we have to pay for

them. In the manufacturing and delivery of goods & services, producers do incur some

cost , which need to be paid for by the consumers of such goods and services.

In ancient times long before the usage of money as a medium of exchange the “Barter

System” existed. In that system, goods were exchanged for other goods or services. ..

Barter system is referred to as a trade system in societies that do not have any monetary

system .Barter system solely relied on the coincidence and reciprocity of need. For

example:

• If a person X has 3 cows and wants to trade one out of three with a pair of mules

, he would have to wait until some person Y turns up with the exactly reciprocal

need.

• If the same person X has free bushel of grains and wants a person who can

mend his house roof, then again he has to wait until somebody turns up with

the exact reciprocal need.

• Also, if a person X has to exchange one commodity for another, say, cotton for

wheat, he can never have an exact value in cotton in terms of wheat, it all

depends on the needs and wishes of the person involved and not on the value

the commodity is holding. So it creates a fallacy in the system.

Problems associated with the barter system were:

• No proper method of valuation of goods - As there were innumerous goods

and each can’t be valued against the others justifiably.

• Information and Time delays – A full fledged market place with a single mode

of exchange wasn’t available, and hence people generally get delayed

information.

• Dissatisfaction amongst the exchangers (parties)- As one person’s estimate

of the value of certain good may not be acceptable to another and they would

have to compromise eventually as per the urgency of transaction.

• Difficulty in coincidence of wants: The goods or services in possession of two

parties must be useful and needed by each other.


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• Difficulty in contractual payments or future payments under barter system

After the dawn of money as a medium of exchange above-mentioned shortcomings of

the barter system were addressed. Initially, precious metals like gold, silver, copper

which were not abundantly available but have some intrinsic value attached to them

were used as money (in the form of coins). Due to relative abundance of copper vis-à-

vis other precious metals like gold and silver, copper coins of various denomination

were in vogue in Sweden. However, higher denomination coins meant more weight

and this made copper unsuitable for higher denomination coins. During 1661, Sweden

introduced paper currency in lieu of metal coins (especially for higher denomination

currency) which heralded the advent of the Paper Currency as we know today.

With the advent of the banking system, banks became the keeper and issuer of

currency. Banks also perform the function of lending money and money transfer

function from one bank account to another, either in the same bank or to another bank.

As banks take care of all types of monetary transactions (inter-account, inter-bank, intra-

bank, and forex transactions) various payment systems are employed to perform every

specific type of transaction. Worldwide different countries employ different payment

systems but the core phenomenon and the purpose behind all of them is same.

1.4 Payment Systems – A definition

• “A set of instruments, procedures and rules for the transfer of funds among

system participants”.

- (Committee on Payment and Settlement Systems of the

Bank for International Settlements, Basle )

• “A system that enables payment to be effected between a payer and a

beneficiary and includes clearing, settlement or payment service”.

- (Payment System Bill, 2002)

The above definition describes the various components which constitute a payment

system.

a) A Set of Instruments – Every payment system consists of various modes of making

payment. Examples include cheque, credit cards, debit cards, E-money, Demand Drafts,

Banker Cheque, Pay Order, Mail Transfer, Telegraphic Transfer, Traveler’s cheque etc.

The adoption of new payment system depends of incentives the new payment mode

provides to the customer. These instruments instruct the bank on how and where the

funds are to be transferred.


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b) Procedures – After a payment instruction is initiated by the payer the back office

operation of fund transfer starts. The procedures employed for the fund transfer are

known as Clearing and Settlement procedures in which two or more banks

participate to settle the accounts of the payer and payee under a Clearing & Settlement

Agency. Most of the times, the central bank of the country or its authorized

representative bank acts as the clearing & settlement agency.

c) Rules of Fund Transfer –They are the norms or regulations which each party

participating in the payment services/funds transfer should follow. Generally, all fund

transfer take place electronically through the payment system network. The rules

specified are the protocols or the message formats used for various types of fund

transfer.

d) System Participants – The following figure 1.1 gives a basic idea about the

participants in a payment system:

i) Paying bank – The bank where payer has an account and from where the payment is

initiated.

ii) Receiving bank – The bank where payee has an account and receives the money.

iii) Clearing House – A place of book keeping where the accounts of every bank with the

central bank are maintained. It performs the functions of crediting or debiting i.e.

increasing or decreasing the respective banks’ accounts with the central bank.

Figure 1.1 Key players in the payment system

iv) Central Bank – The prime monetary/regulatory authority of the country, issuer of

currency, banker of banks. It formulates, implement and monitors the monetary policy,

maintain price stability and ensure adequate flow of credit to productive sectors,

managing country’s foreign exchange and gold reserve and managing both inflation

and exchange rates

e.g in India, central bank is RBI


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1.5 Importance of Payment Systems

Not more than a couple of years ago, payment systems were not of much significance.

They were considered by banks as just “back-office” functions rather than a contributor

to the economy. However, with the advent of technology-based market integration of

diverse economies and regions on to a common payment platform, payment systems

have gained increased significance as a key driver for economic growth.

Some of the key features of payment systems are enumerated below:

a) Payment Systems as a Revenue Generator – Many of us wonder how banks

make money. Banks primarily make money due to the Interest Spread – which is

simply the difference between the Deposit rate and the Lending rate.

Moreover, due to the advancement in efficient payment systems which obliterate

the need of cash transactions, financial transactions have increased in geometric

progression. This is because of the ease, convenience and secure way of conducting

online transactions (essentially non-cash based).

Did you know?

A research conducted by Federal Reserve of New York in 1997 considering the top 25

bank holdings of US as their sample size shows that payment systems form almost

42.2 % of their total operating profit that is $59.2 billion of total $140.2 billion.


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The table 1.1 below shows the impact of non-cash retail payments as a revenue-

generating force in select G-10 countries.

The table shows ratio:-

Total monetary value of all transactions for a given payment instrument in a G10 country

for a year.

________________________________________________________________

The gross domestic product of that country in the same year

Table1.1: Usage of payment instruments by non-banks

(Source: www.bis.org)

The analyses of the above statistics are astounding and will help us understand the

gravity of the situation. Let us take US and analyze it for the year 2004.

http://www.bis.org


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1. In year 2004 total value of credit transfers was approximately 1.2 times the value of

GDP of US.

2. Total Monetary value of the transactions made through cheques was almost 3.3

times the GDP of US.

From the above statistics we can compute the amount of revenue that would have

been generated by US banks as transaction fees. This factor underlines the

importance of payment systems.

b) Role of Payment Systems in nation’s financial stability – Payment system play a

central role in the financial stability of a nation. Suppose a bank X on account of an

operational crisis or bankruptcy cannot meet its obligations of paying its debts to

another bank at the “settlement time” (when banks transfer funds to each other they do

not pay money every time a transaction is made but just pay the offset of their total

transactions with every other bank in the system at the end of the day, generally known

as settlement time). Due to this failure to pay, other banks that were to receive pending

payments cannot get the same which in turn affects their payment obligations. This

results in a cascading systemic failure to make payments and thereby affects the

clearing and settlements process. This results in a traffic-jam like situation where

everybody gets stuck, technically called as “Grid-Lock”. Due to this cash crunch occurs

which threatens the overall stability of nation’s financial stability. Hence payment

systems and the financial systems of a nation are closely entwined with each other.

c) Role of Payment Systems in the economic efficiency of a nation – An inefficient

payment system would result in cash settlement delays resulting in a cash crunch

scenario thereby affecting / delaying investments and economic growth.

d) Role of Payment Systems in the implementation of monetary policy- Central Bank

of a nation holds the magic stick to control the total liquidity or the cash in the market.

This magic stick is known as short-term interest rate i.e. the rate of interest at which

banks can lend and borrow money from each other in money markets (also known as

Inter-bank borrowing). Hence monetary policy of the central bank revolves around the

short term interest rate.

If the large value payment systems of a nation are not efficient then central bank

cannot control the demand and supply of funds. Moreover, due to delays in the large

value payment systems the banks might not be able to settle their accounts with each

other in a day’s time.

Therefore payment systems have a very important role to play in the implementation of

the monetary policy of central bank also.

e) Payment systems customer support function – Now payment systems have

become full fledged customer support and service providing systems. They not only


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transfer money which is their basic function but also help customers to transfer funds

from one account to another electronically. They provide security-handling services to

corporate and institutional customers such as pension funds, mutual funds and

endowments.

1.6 Goals of Payment Systems

“Anyone can make payments to whomsoever one likes, whenever one likes, in

whatever type of currency one likes, at the cost of a few cents per transaction. There are no

settlement delays or mountains of paperwork and value is received instantaneously. There

are no distinctions in costs or delays between a domestic and a foreign currency transaction.

Interest is computed real-time rather than on a "settlement day", a relic from the ancient

times, when accounting was done manually. Finally, privacy and security are guaranteed.”

(RBI Vision Statement for Payment Systems, 2001)

These are the goals of the payment systems as stated by the RBI Vision 2001 statement.

The above lines are self explanatory and although efforts are being made to achieve the

desired goal, we have a long way to go.

However, in the field of Large Value Payment Systems (LVPS) RBI has implemented Real

Time Gross Settlement System (RTGS) in India. Other countries also have their own

RTGS systems like FedWire in US, CHAPS in UK etc.

The RBI Vision statement encompasses the following tenets for an efficient payment

system. They are referred to as “Triple S+E” by RBI. This acronym stands for Safety,

Security, Soundness and Efficiency.

a) Safety- This addresses to the need of the payment system being secure so that it can

handle system risks. There are many forms of risks which may hamper the credibility of

the payment system. Those are namely:

• Credit Risk – associated with the risk of inability to fulfill a financial obligation.

For example, if a borrowing bank is unable to settle its account with the lending

bank within the specified period of settlement or gets bankrupt, then this is the

Fulfillment or Credit risk faced by the Lender.

• Liquidity Risk – This risk is about the probability that if the party within the

system will be able to meet its financial obligations within settlement time or

not. Though it may have sufficient funds afterwards to pay but not at the time

of settlement.

(Here we should know that in credit risk the party does not meet it’s financial

Obligations at all whereas, in liquidity risk the party does not meet it’s financial

obligations within the time period of settlement.)


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• Operating Risk – This is the risk of malfunction of support systems which could

result in an incomplete payment or the risk that the system operator or core

infrastructure provider to the system is operationally unable to process. For

example the failure of IT infrastructure or the inability of the system to account

for the changes in a particular account do to access problems with certain

banks, etc.. These risks affect the operational efficiency of the system.

• Systemic Risk – Risk arising out of a failure to pay, leading to a cascading effect

of other parties being similarly affected. Earlier in this course we have talked

about the situation of Grid-Lock where every party’s financial obligation is

affected by the other party’s failure to pay.

• Legal Risk- This is the risk of not having appropriate legal framework and

procedures to protect the interests of the system participants and hence

adversely affecting the situations of credit and liquidity risks.

• Business Risk: refers to the risk the payment system or any of its components

e.g any of its infrastructure provider cannot be maintained as a going concern

in face of adverse financial shocks which may disrupt its capacity to deliver

processing services.

b) Security- Confidence and integrity levels for paper-based payment systems are

inculcated after years of continuous efforts. This goal talks about the development of

the same levels of confidence and integrity for the today’s non-cash and paperless

payment systems too. For this the security objectives and policies must be established

during design of the system and reviewed periodically, also the system should be

subject to regular security risk analysis. So security is a major concern when it comes to

get more users for e-payment systems.

c) Soundness- Development of the strong infrastructure is needed for the

implementation of such systems. Due to high volume and frequency of transactions it

is essential to automate the clearing and settlement procedures. Therefore, the

underlying communication backbone and IT infrastructure must work soundly in order

to avoid any systemic disruptions.

d) Efficiency – Being efficient means doing a task in an optimal time at optimal costs.

Hence it is a goal to make payment systems delay-free and free from all the

transactional costs involved.

1.7 Role of Central Banks in Payment Systems

Central bank is often termed as “lender of last resort” i.e. the ultimate provider of the

liquidity in the system. In national interest central bank has the responsibility of


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maintaining both monetary and financial stability. As we read in previous sections that

payment systems are the mode by which central bank can achieve its ultimate goal.

a) Central bank as an operator of the payment systems- Payment systems for large

value payments (LVPs) amongst the banks, payment and settlement systems for the

settlement of securities and forex are often critical to the system, these are termed as

Systemically Important Payment Systems (SIPS). Due to their criticality of operation SIPS

are owned and operated by the central bank of the country. For example Fedwire is

Federal Reserve owned RTGS system for the settlement of LVPs in US. In UK, CHAPS and

BOJNET for Japan do the similar functions.

Credit and Liquidity risks are reduced to miniscule levels if central bank’s money is used

rather than the commercial bank money (i.e. money held in the accounts of private

commercial banks).

Following are some advantages of using central bank money in the settlement process:

• Security – Because there is no credit risk on the central bank.

• Availability –It is readily available to all participants in payment system.

• Efficiency -Since it is secure and can easily be used as a means of payment.

• Neutrality- Central banks do not discriminate participants while lending money

or settling accounts.

• Finality – Central bank money can be used directly as a means of payment.

b) Central Bank as an overseer- This role of central bank has far-reaching

consequences. Central bank acts as a guardian of the interests of all the

participating members of the system as well as the common public. Much

importance is now being assigned to the role of payment systems in the overall

financial stability of the nation. Hence a central bank must work towards the

elimination of settlement risks from the system. Moreover, it is central bank’s task to

regulate and make sure that the international standards of payment systems are

followed while implementation and operations.

c) Central Bank as the provider of the payment services – All the hardware, software,

communication network setup required for the automation of the whole payment

system is provided by central bank.

The central bank should clearly define its payment system objectives and should

publicly disclose its role and major policies with respect to important payment systems.

e.g The objective and role of the Reserve bank in the systematically important payment

systems is published and available in public domain.

The central bank, in promoting the payment system safety and efficiency must co-

operate with other central banks and with relevant foreign or domestic authorities.


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e.g at the international level RBI has been in touch with various multilateral institutions

like world bank, IMF etc.

1.8 Evolution of Payment System in India

India has a rich history in commercial trade since ancient times, as we all know our

country was even known as “The Golden Sparrow”. India has traditionally been a

storehouse of world's gold and it has always had defense systems and attitudes that

can be best compared to that of a sparrow - defensive with strict policy of non-

aggression. Remains of trading centers and payment instruments of ancient times that

we find today suggest that payment instruments like loan deeds, silver and copper

coins were in usage even before 260 B.C. In this section we take a cursory look on how

payment instruments and mechanisms in India have evolved.

Ancient India (Before 260 B.C.) – Loan deed form, used for taking credit was known as

rnapatra or rnalekhya. This form contained the following: Name of the creditor, Name of

the Debtor, Interest rate to be paid, any terms and conditions applicable at the time of

payment. The loan-deed was witnessed by a respectable person of society and

endorsed by a loan-deed writer. In Buddhist period loan-deed forms were known as

inapanna.

Figure 1.2: Coins used in ancient India were either punch-marked or cast in silver or

copper. (Courtesy- Museum cell, RBI)

The Mauryan Period – In this period an instrument named “Adesha” was used. This

instrument corresponds to today’s bank pay order, in which a bank was desired to pay

the written amount to a third party. This instrument was a bill of exchange heavily used by

merchants. Even promissory notes were heavily used during those days.

The Mughal Period – Following were the various instruments used during that era:

• Loan deeds - dastawez-e-indultalab which was payable on demand and

dastawez-e-miadi which was payable after a stipulated time.

• Pay orders – Known as Barattes, these instruments are comparable to today’s

cheques and drafts. These were issued by the Royal Treasury of the state on

district or provincial treasuries.


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During Mughal regime many foreign travelers came to India. From their travel records it

is found that even during those times Indian bankers issued bills of exchange on

foreign countries. These bills of exchange were mainly used for the trade with foreign

countries via sea.

Hundi – A landmark credit instrument in the history of India:

This is the most widely used credit instrument in India. Its usage was on prime in 12th

century and even continued to be used some places in today’s time also.

Its usages include:

ü As remittance instrument, comparable to cheques and demand drafts. Used to

take money from a place to another.

ü As credit instrument, used in borrowing and lending of money.

ü As a bill of exchange, for the transactions.

Hundi’s types:

A) Darshani Hundi – A demand bill of exchange payable on presentation of the

instrument. This has various sub-types described as below.

ü Sah-jog - A hundi transferable by endorsement and delivery but payable only

to a Sah or to his order. A Sah was a respectable and responsible person, a man

of worth and substance who was known in the market.

ü Dhanni-jog - was a demand bill of exchange payable only to the dhanni, i.e. the

payee. This hundi was not negotiable.

ü Firman-jog - Hundis came into existence during the Muslim period. Firman is a

Persian word meaning order and therefore, firman-jog hundis were payable to

the order of the person name. These hundis could be negotiated with simple or

conditional endorsement.

ü Dekhavanhar - hundi was a bearer demand bill of exchange payable to the

person presenting it to the drawee. Thus it corresponded to a bearer cheque.

B) Muddati hundi - This is a bill of exchange which is payable after stipulated time or

on a given date or on a determinable future date or on the happening of a certain

stipulated event. All its subtypes are same as that of Darshani hundi. An important

subtype is Jokhami hundi, the word jokham here means risk. Therefore as the name says this

hundi was used in minimizing the risk as the amount is only payable on the safe arrival of

goods.


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Figure 1.3 Nineteenth century Period Hundi (Source: RBI Museum cell)

1.9 A Time line of payment instruments and systems in modern India.

ü Late 18th century- Private and semi-government banks started issuing paper

money. Earliest issuers were the Bank of Hindustan, the General Bank in Bengal

and Behar, and the Bengal Bank. Later on this task was taken up by 3 presidency

banks.

ü 1827 – Post Bills introduced by British. These were promissory notes issued at a

distant place. Its holder will be paid money after some stipulated time, similarly

to the Muddati hundi.

ü 1833- Cash credit accounts started by bank on Bengal as a credit instrument.

ü 1839 – Buying and selling bills of exchange took the form of a business at Bank

of Bengal.

ü 1861 – Paper currency act made government of India the sole issuer of currency

putting an end to private bank currency issuing.

ü 1881 – Negotiable Instrument Act, India came into force which provided a

necessary legal framework for the non-cash paper based instruments.

ü 1938-40 Various associations like Calcutta Clearing Banks' Association,

Metropolitan Banking Association, and The Bombay Clearing House established

there clearing houses for the non-cash instruments like cheques.


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ü Finally the RBI Act 1935 paved the way for the making of RBI later on, which at

last took the job of clearing and settlement.

Further advances in payment systems due to evolution of digital money and e-

payments should be included in the timeline. (the exact timeline of e-payments and

payments advancement after 1935 in India are not available right now, in search)

1.10 Summary

• “A set of instruments, procedures and rules for the transfer of funds among

system participants” is known as Payment System.

• Clearing House is a place of book keeping where the accounts of every bank

with the central bank are maintained. It performs the functions of crediting or

debiting i.e. increasing or decreasing the respective banks’ accounts with the

central bank.

• Banks primarily earn due to the different interest rate they charge while they

lend money and interest they offer when they keep money - also known as the

Interest Spread

• Moreover due to development of various non-cash methods of payments the

number of banking transactions has increased

• People are willing to pay more transactional fee as Real-Time Non-Cash

transactions full-fill their instant cash requirements

• The Central Bank of a country holds ‘rate of interest’ magic stick to control the

total liquidity or the cash in the market

• In the field of Large Value Payment Systems (LVPS), Real Time Gross Settlement

System (RTGS) has been implemented in India and in many countries

• “Triple S+E”, stands for Safety, Security, Soundness and Efficiency are the goals

aspired to be achieved for payment system by RBI

• Central Banks role is to ensure stability in the economy.

Certificate Program in Payment Systems Competency V 2.0 Domain Competency Academy

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Chapter-2 Core Principles of Systemically

Important Payments Systems

2.1 Introduction

The chapter has detailed discussion of the key characteristics required to be realized by

the task force established by the Apex committee CPSS (Committee on Payment and

Settlement Systems), so that they could be helpful for the various countries including

G-10 countries to improve their payments system. This chapter has been derived

largely from the consultative document on SIPS (Systemically Important Payments

System) published by Bank for International Settlement (BIS).

2.2 Learning Objectives

After reading this chapter you will know-:

• About the apex institution which laid the fundamentals of payment systems.

• The various legal obligations that need to be kept in mind while enforcing a

payment system.

• Various measures and incentives to be kept in mind by the participant to avoid

various types of risk while using the payment systems.

2.3 Topics Covered

Chapter-2 Core Principles of Systemically Important Payments Systems ............................... 3

2.1 Introduction..................................................................................................................................... 3

2.2 Learning Objectives ..................................................................................................................... 3

2.3 Topics Covered............................................................................................................................... 3

2.4 Introduction..................................................................................................................................... 4

2.5 Core Principles of Systemically Important Payment Systems.................................... 5

2.5.1 Legal basis ................................................................................................................................. 5

2.5.2 Rules & Procedures................................................................................................................ 5

2.5.3 Risk Management procedures.......................................................................................... 6

2.5.4 Final settlement process ..................................................................................................... 7

2.5.5 Multilateral netting..............................................................................................................10

2.5.6 Claims as Assets ....................................................................................................................11

2.5.7 Security & Operational reliability...................................................................................12

2.5.8 Efficient payment means ..................................................................................................14

2.5.9 Fair & Open access...............................................................................................................15

2.5.10 Transparency & Accountability .................................................................................16

2.6 Summary.........................................................................................................................................17


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2.4 Introduction

An efficient and reliable payment system is very crucial for orderly operation of a

country’s banking and financial system, to the economy and the reputation of the

Central bank of the country. Numerous international initiatives are taken to keep the

financial stability in the payments systems scenario by strengthening financial

infrastructure. The Committee on Payment and Settlement Systems (CPSS) which

comprises of the central banks of the G10 nations is contributing to this process

through its work on developing core principles for systemically important payment

systems.

A task force was made by CPSS on Payment System Principles and Practices in May

1998 to consider what principles should govern the design and operation of payment

systems in all countries.

The objective of the Task Force was to develop an international consensus on such

principles. the task force was expanded to include representatives not only from the

G10 central banks and the European Central Bank, but also from 11 other national

central banks of countries in different stages of economic development from all over

the world and representatives from the International Monetary Fund and the World

Bank. In developing universal principles, it consulted groups of central banks in Africa,

the Americas, Asia, the Pacific Rim and Europe.

In January 2001 the Bank for International Settlements (BIS)(established in 1930 for

fostering cooperation of central banks and international monetary policy makers)

published a draft of the Core Principles for comment from the wider financial

community. From the responses it was clear that there is strong and widespread

international support for the Core Principles. The Core Principles are expressed

deliberately in a general way to help ensure that they can be useful in all countries and

that they will be durable. They do not represent a blueprint for the design or operation

of any individual system, but suggest the key characteristics that all systemically

important payment systems should satisfy. Hence following are the core principles

published by the BIS in January 2001 which the nations should follow to develop their

payment systems.

By March 2004, India with the help of RBI has made all the SIPS compliant with the Core

Principles. Further, inter-banks clearings at Mumbai and Chennai were achieved by the

end of 2007.


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2.5 Core Principles of Systemically Important Payment Systems

2.5.1 Legal basis

The system should have a well-founded legal basis under all relevant jurisdictions

The first core principle is concerned with minimizing legal risks. According to this

principle .The rules and procedures of a system should be enforceable and their

consequences predictable. A system, which is not legally robust or in which the legal

issues are poorly understood, could endanger its participants. Poor understanding can

give participants a false sense of security, leading them, for example, to underestimate

their credit or liquidity exposures. The jurisdiction under whose law the system’s rules

and procedures are to be interpreted should be specified clearly. In most cases, the

most important legal environment will be the domestic one, although, in particular

where the system involves cross-border elements such as foreign bank participation or

the use of multiple currencies, it will also be necessary to consider whether there are

any material legal risks stemming from other relevant jurisdictions. The implementation

of this principle can involve substantial amount of work by specialists and most

countries can improve the legal robustness of their payment infrastructure.

e.g In UK the implementation of Settlement Finality Directive has made more certain

that British and European courts would enforce a designated system’s rule in event of

insolvency of participant.

A sound legal basis is fundamental to risk management. Careful attention should be

given to the:

• Completeness and reliability of framework legislation;

• Enforceability of laws and of contracts in all relevant circumstances;

• Clarity of timing of final settlement especially when there is an insolvency;

• Legal recognition of netting arrangements;

• Existence of any zero hour or similar rules;

• Enforceability of security interests provided under collateral arrangements and

of any relevant repo agreements;

• A legal framework that would support electronic processing of payments;

• Relevant provisions of banking and central banking law;

• Relevance of laws outside the domestic jurisdiction.

2.5.2 Rules & Procedures

The system’s rules and procedures should enable participants to have a clear

understanding of the system’s impact on each of the financial risks they incur through

participation in it.


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Participants, the system operator, and other involved parties - in some cases including

customers - should understand clearly the financial risks in the system and where they

are borne. An important determinant of where the risks are borne will be the rules and

procedures of the system. These should define clearly the rights and obligations of all

the parties involved and all such parties should be provided with up-to-date

explanatory material. In particular, the relationship between the system rules and the

other components of the legal environment should be clearly understood and

explained. In addition, key rules relating to financial risks should be made publicly

available.

Participants need to understand the financial risks they bear. Operators should,

therefore, have rules and procedures that:

• are clear, comprehensive and up-to-date;

• explain the system design, its timetable and risk management procedures;

• explain the system’s legal basis and roles of the parties;

• are readily available;

• explain where there is discretion and how it is exercised;

• set out decision and notification procedures and timetables for handling

abnormal situations.

2.5.3 Risk Management procedures

The system should have clearly defined procedures for the management of credit risks and

liquidity risks, which specify the respective responsibilities of the system operator and the

participants and which provide appropriate incentives to manage and contain those risks.

The concern behind this principle is that system participants and operators must clearly

understand the financial risks in the system and where they are borne.

The rules and procedures of a systemically important payment system are not only the

basis for establishing where credit and liquidity risks are borne within the system, but

also, for allocating responsibilities for risk management and risk containment. They are,

therefore, an important mechanism for addressing the financial risks, which can arise in

payment systems. Private sector parties, in particular, could have inadequate incentives

to limit or manage these risks. A system’s rules and procedures should, therefore,

ensure that all parties have both the incentives and the capabilities to manage and

contain each of the risks they bear and that limits are placed on the maximum level of

credit exposure that can be produced by each participant. Limits on credit exposure are

likely to be particularly relevant in systems involving netting mechanisms.


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The effective management of financial risks is at the heart of designing safe payment

systems. The appropriate tools and incentives depend on the type of system design,

but techniques include:

Tools for managing credit risks

• Using system designs in which credit risk between participants does not arise

(e.g. in real-time gross settlement system);

• Access criteria (but the system needs also to comply with Core Principle 2.2.9);

• Credit limits (bilateral or multilateral) to cap exposures;

• Loss-sharing arrangements and/or “defaulter pays” arrangements.

Tools for managing liquidity risks

• Management of payment queues;

• Provision of intraday credit (which means credit risk issues for the lender, e.g.

the Central Bank);

• Throughput guidelines;

• Position (receiver or sender) limits;

• Tools described under Core Principle 2.5.5 for systems with deferred net

settlement.

General tools

• Information systems to support the tools for managing credit and liquidity risks;

• Clear, full and timely (ideally real-time) financial information to participants;

• Timely monitoring by the system operator.

Incentives to manage these risks can come from:

• Formula for loss-sharing – for example, if it reflects the scale/nature of

controllable positions with the failed institution;

• Pricing.

2.5.4 Final settlement process

The system should provide prompt final settlement on the day of value, preferably during

the day and at a minimum at the end of the day.

This principle relates to daily settlement in normal circumstances. Between the time

when payments are accepted for settlement by the payment system (including

satisfaction of any relevant risk management tests, such as the application of limits on

exposures or availability of liquidity) and the time when final settlement actually occurs,

participants may still face credit and liquidity risks. These risks are exacerbated or

aggravated if they extend overnight, in part, because a likely time for the relevant

authorities to close insolvent institutions is between business days. Prompt final


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Promptness of final settlement on the day of value entails:

• Clarity in the system rules and procedures that a payment accepted by the

system for settlement cannot be removed from the settlement process;

• A clearly defined and legally effective moment of final settlement;

• Ensuring that the interval between the system’s acceptance of a payment and

the payment’s final settlement at least never lasts overnight and preferably is

much shorter;

• Ensuring that operating hours and the settlement processes are strictly

enforced.

The list below shows countries which have already introduced RTGS (Real Time

Gross Settlement System):

Ø Armenia Malta

Ø Australia Mexico

Ø Austria New Zealand

Ø Bahrain Norway

Ø Belarus Poland

Ø Belgium Portugal

Ø Colombia Saudi Arabia

Ø Czech Republic Singapore

Ø Denmark Slovenia

Ø Finland South Africa

Ø France South Korea

Ø Germany Spain

Ø Greece Sweden

Ø Hong Kong SAR Switzerland

Ø Hungary Thailand

Ø Ireland The Netherlands

Ø Italy The Netherlands Antilles

Ø Japan Turkey

Ø Jordan United Kingdom

Ø Luxembourg United States

Primary source: Fry et al (1999).


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2.5.5 Multilateral netting

A system in which multilateral netting takes place should, at a minimum, be capable of

ensuring the timely completion of daily settlements in the event of an inability to settle by

the participant with the largest single settlement obligation.

Multilateral netting (i.e. offsetting of payables, receivables among number of parties to

a transaction, with each of them making payments for net obligations to others or

receiving net payments due from others) systems with deferred settlement face the risk

that a participant will not be able to meet its settlement obligations, raising the

possibility that other participants will face unexpected credit and liquidity pressures at

the time of settlement. Such systems, therefore, need strong controls to address this

settlement risk. Lamfalussy Standard IV specified that, at a minimum, a netting system

must be able to withstand the failure of the largest single net debtor to the system. This

approach underlies the present arrangements in many payment systems that settle on

a net basis for limiting credit and liquidity risk, and for ensuring access to liquidity in

adverse circumstances. But this approach is developing. Systems which satisfy only this

minimum standard are still exposed to the financial risks of the failure of more than one

institution during the same business day. The circumstances in which one large net

debtor is unable to meet its settlement obligations to the system may well be those in

which other institutions are also under liquidity pressure. Best international practice

now is, therefore, for such systems to be able to withstand the default of more than the

one participant with the largest single settlement obligation. Careful consideration

should be given to this approach and its implications should be evaluated taking into

account the benefits of reduced settlement risk and any other consequences such as for

the management of liquidity. In addition, alternative system designs (such as RTGS or

hybrid systems) are increasingly being adopted to reduce or eliminate settlement risk.

System that combines multilateral net settlement with deferral of settlement needs to

be protected against liquidity risk arising from an inability to settle on the part of one or

more participants.

• This can be achieved by ensuring that additional financial resources are

available to meet this contingency. These usually involve a combination of the

following:

o A pool of collateral (cash or securities), appropriately valued;

o Committed lines of credit.


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• The amount of such additional resources needs to be determined in relation to:

o Maximum individual settlement obligation;

o Whether the system meets or exceeds the minimum standard (i.e. whether

the system is designed to withstand an inability to settle by the participant

with the largest single settlement obligation or to withstand a more

widespread inability to settle).

• Alternatively, the need to control liquidity risk in this context can be avoided by

the use of an alternative system design (e.g. RTGS or some types of hybrid

design) that does not give rise to the concerns addressed by Core Principle

2.5.5.

2.5.6 Claims as Assets

Assets used for settlement should preferably be a claim on the central bank; where other

assets are used, they should carry little or no credit risk.

It states that where a settlement asset other than a claim on central bank is used it should

carry little or no credit risk.

Most systems involve the transfer of an asset among system participants to settle

payment obligations. The most common and preferable form of such an asset is an

account balance at the central bank, representing a claim on the central bank. There

are, however, examples of other forms of settlement asset, representing claims on other

supervised institutions. As all participants in the system must accept the asset, the

system’s safety depends in part on whether the asset leaves the holder with significant

credit risk. If there were more than a negligible risk that the issuer of the asset could fail,

the system could face a crisis of confidence, which would create systemic risk. Balances

at the central bank are generally the most satisfactory asset used for settlement,

because of the lack of credit risk for the holder, and they are typically used in

systemically important payment systems. If settlement is completed using other assets,

such as claims on a commercial bank, those assets must pose little credit risk. In some

payment systems minimal use is made of a transferable asset. For example, they may

settle by offsetting one claim against another. This can be consistent with Principle 2.5.6

provided that there is no inconsistency with the other principles, particularly with

Principle I, which requires the legal basis for the offset process to be sound.

The most satisfactory settlement asset for systemically important payment systems is a

claim on the central bank issuing the relevant currency. If other assets are used,

considerations relevant to whether Core Principle 2.5.6 is met are:

• the creditworthiness of the issuer of the settlement asset;

• how readily the asset can be transferred into other assets;


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• size and duration of involuntary exposures to the issuer;

• Risk controls, if any.

2.5.7 Security & Operational reliability

The system should ensure a high degree of security and operational reliability and should

have contingency arrangements for timely completion of daily processing.

This principle addresses operational risk. For most market participants this is the most

important requirement for a payment system .Market participants rely on payment

systems for settling their financial market transactions. To ensure the accuracy and

integrity of these transactions, the system should incorporate commercially recognized

standards of security appropriate to the transaction values involved. These standards

rise over time with advances in technology. To ensure completion of daily processing,

the system should maintain a high degree of operational resilience. This is not just a

matter of having reliable technology and adequate back up of all hardware, software

and network facilities. It is also necessary to have effective business procedures and

well-trained and competent personnel who can operate the system safely and

efficiently and ensure that the correct procedures are followed. This, together with

good technology, will, for example, help to ensure that payments are correctly and

quickly processed and that risk management procedures, such as limits, are observed.

The degree of security and reliability required for providing adequate safety and efficiency

depends on the degree of systematic importance of the system, as well as any other relevant

factors, such as the availability of alternative arrangements for making payments in

contingency situations.

The designers and operators of payment systems should consider the following issues

in relation to security and operational reliability:

General

• The system should meet the security policies and operational service levels

agreed by the system operator and participants, and relevant legal constraints,

system rules, risk management procedures, business requirements, or

international, national or industry-level standards.

• The system’s security and operational reliability depend on both central system

and participants components; the participants have responsibilities for security

and operational reliability. The system should be formally monitored to ensure

the policies and service levels are being met.

• Security policies and operational service levels should change over time, in

response to market and technological developments; system should be

designed and operated to meet such developments.


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• The system requires adequate numbers of well-trained, competent and

trustworthy personnel to operate it safely and efficiently in both normal and

abnormal situations.

Security

• Security objectives and policies should be established during the design of the

system, and reviewed periodically. They should be appropriate to the payment

system, recognising its particular architecture and ownership.

• A well defined business continuity strategy and an effective monitoring system

endorsed by the board of directors should be maintained.

• System security should conform to commercially reasonable standards, for

example, for confidentiality, integrity, authentication, non-reputability,

availability and audit ability. Security features should be tested regularly.

• The system should be subject to regular security risk analyses. The system

operator should pro-actively monitor technological advances to keep system’s

security risk analysis up-to-date. A crisis management team with a well

structured crisis management procedural setup should be employed and a

better internal/external crisis communication infrastructure should be provided

to them.

Operational reliability

• Threats to operational reliability arise not just from the failure of central system

and participant components, but also from failures of infrastructure services and

natural disasters.

• The system requires comprehensive, rigorous and well-documented

operational and technical procedures.

• Changes to the system should be properly documented, authorised, controlled,

tested and subject to quality assurance.

• The system should be designed with sufficient capacity, which should be

monitored and upgraded in advance of business changes.

Business continuity

Business continuity management is an important purpose of the system to seek to

ensure that the agreed service levels are met, even when the system fails to pursue its

normal settlement business.

• The system operator should carry out a formal business continuity planning

exercise. Simplicity and practicality should be key considerations when

designing contingency arrangements.


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• Business continuity arrangements should be documented and regularly tested.

They should include procedures for crisis management and information

dissemination.

• Business continuity arrangements could include: diversion of payments to

another payment system; a secondary processing site; and/or a “minimum level

service”.

2.5.8 Efficient payment means

The system should provide a means of making payments which is practical for its users and

efficient for the economy.

Operators, users (that is participants, such as banks and their customers) and overseers

of systems, all have an interest in the efficiency of a system. They want to avoid wasting

resources and, other things being equal, would wish to use fewer resources. There will

typically be a trade-off between minimizing resource costs and other objectives, such

as maximizing safety. Within the need to meet these other objectives, the design of the

system, including the technological choices made, should seek to economize on

relevant resource costs by being practical in the specific circumstances of the system,

and by taking account of its effects on the economy as a whole. The costs of providing

payment services will depend on the quality of service and the features demanded by

the users, and on the need for the system to meet the core principles limiting risk in the

system. A system which is consistent with the demands of the markets it serves is likely

to be more heavily used and so will spread more widely the risk-reducing benefits of

satisfying the other principles and the costs of providing the services. Designers and

operators of payment systems need to consider how to provide a given quality of

service, in terms of functionality, safety and efficiency, at minimum resource cost. The

relevant costs are not just those passed on to users through system charges, but those

of the total resources used by the system and its users in providing the payments

services. They will need, for example, to take into account any indirect costs to users,

such as the costs of liquidity and collateral.

The availability of liquidity in a system can be an important element in its smooth

operation. Recipients like to be paid in funds which are immediately reusable and so

value the advantages of systems with intraday settlement. Senders, however, may face

costs in raising liquidity to enable them to pay early in a system. Where systems have

inadequate intraday liquidity mechanisms, they can face a risk of slow turnover or even

gridlock (where participants are each waiting for the others to pay first). In the interests

of efficiency, systems should provide participants with adequate incentives to pay

promptly. For real-time systems the supply of intraday liquidity is particularly


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important. Relevant factors in its supply will include the depth of inter-bank money

markets and the availability of any relevant collateral. With the benefits of smooth

payment flows in mind, the central bank should consider whether and how to provide

intraday liquidity to support a system’s daily functioning.

The technology and operating procedures used to provide payment services should be

consistent with the types of services demanded by users, reflecting the stage of

economic development of the markets served. The design of the payment system

should therefore be appropriate for the country’s geography, its population

distribution other demographic factors and its infrastructure (such as

telecommunications, transportation and banking structure). A particular design or

technological solution which is right for one country may not be right for another.

The design of the payment systems thus can be outlined as:

General

• Define objectives (identifying risk and efficiency factors)

• Identify user needs and constraints

• Identify system choices and benefits

• Determine social and private costs

• Develop decision choices.

Analytical framework

• Identify efficiency requirements (or conversely identify inefficiencies)

• Identify safety requirements

• Evaluate costs (social and private)

• Identify resources (social or private)

• Determine practical constraints (technology, infrastructure)

• Define safety constraints (e.g. applying the Core Principles)

Methods

• Cost-benefit or other structured analysis

• Involvement of participants and/or users in discussions

• Methodology for data collection and analysis

• Identify data sources (archived data, economic data, samples or estimates)

2.5.9 Fair & Open access

The system should have objective and publicly disclosed criteria for participation, which

permit fair and open access.

(i) Access criteria that encourage competition amongst participants promote efficient

and low-cost payment services. This advantage, however, may need to be weighed

against the need to protect systems and their participants from participation in the


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system by institutions that would expose them to excessive legal, financial or

operational risks. Any restrictions on access should be objective and based on

appropriate risk criteria. All access criteria should be stated explicitly and disclosed to

interested parties.

(ii) Exit Criteria: The rules of the system should provide for clearly specified procedures

for orderly withdrawal of a participant from the system, either at the participant’s

request, or following a decision by the system operator that the participant should

withdraw. A central bank’s actions in withdrawing access to payment system facilities,

or to settlement account services, may also lead to the withdrawal of a participant from

a payment system, but it may not be possible for a central bank to specify explicitly in

advance all the circumstances in which it might act in this way.

Access criteria should encourage competition among participants, without

compromising the system’s safety. Criteria that restrict access should be assessed for:

• Justification in terms of safety;

• Justification in terms of efficiency;

• Consideration should be given to adopting forms of risk management which

have the least restrictive impact on competition that circumstances permit.

2.5.10 Transparency & Accountability

The system’s governance arrangements should be effective, accountable and transparent.

Payment system governance arrangements encompass the set of relationships

between the payment system’s management and its governing body (such as a board

of directors), its owners and its other stakeholders. These arrangements provide the

structure through which the system’s overall objectives are set, how they are attained

and how performance is monitored. Because systemically important payment systems

have the potential to affect the wider financial and economic community, there is a

particular need for effective, accountable and transparent governance, whether the

system is owned and operated by the central bank or by the private sector.

Effective governance provides proper incentives for management to pursue objectives

that are in the interests of the system, its participants and the public more generally. It

also ensures that management has the appropriate tools and abilities to achieve the

system’s objectives. Governance arrangements should provide accountability to

owners (for example, to the shareholders of a private sector system) and, because of the

system’s systemic importance, to the wider financial community, so that those served

by the payment system can influence its overall objectives and performance. An

essential aspect of achieving accountability is to ensure that governance arrangements

are transparent, so that all affected parties have access to information about decisions


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affecting the system and how they are taken. The combination of effective, accountable

and transparent governance provides a foundation for compliance with the core

principles as a whole.

In contrast to many of the other Core Principles, it is difficult to advice on the

appropriate structure of governance, because there are so many possible

arrangements. It is, however, possible to suggest indicators that governance

arrangements are effective, accountable and transparent. It is advisable for governance

arrangements to be reviewed regularly against such indicators. The following is not an

exhaustive list of indicators, nor does any one of these factors alone necessarily indicate

whether the system complies with Core Principle 2.5.10:

• Relevant information on the system and its operations is readily available,

complete and up-to-date;

• Major decisions are made after consultation with all interested parties and due

deliberation;

• The high-level decision-making process is prompt and communicated clearly to

the system users;

• The system consistently attains projected financial results and can explain any

differences from those plans;

• The system delivers payment services that satisfy customer needs;

• The system complies with the other nine Core Principles.

2.6 Summary

• The CPSS (Committee on Payment & Settlement Systems) comprises of central

banks of G-10 nations

• The Payment System of any country should have a legal base under all countries

jurisdiction

• Systems rules & procedures should be clearly understood by the people

• Should be practical for the users and efficient for the economy

• All the responsibilities of the management should be clearly defined

• Systems should be capable of prompt settlement

• No time lag should occur during settlement of payments and the system should

have contingency arrangements for timely processing of daily settlements

• Central banks play vital role in settlement and claim of credit risk

• A high degree of security & reliability is the main core feature of Payment

System

• The system should be practical & implemental.


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Chapter-3 Payment Instruments

3.1 Introduction

A sum of money paid or a claim discharged is called payment. This can be done

with the help of various means which we call instruments. For example: currency, debit

cards, credit cards, demand drafts, cheques are all payment instruments. This session

delves in various payment instruments, used worldwide. This is necessary to

understand the whole landscape of payments systems.

3.2 Learning Objectives

After reading this session you will learn

• About various payment Instruments

• Their major categories and subcategories

3.3 Topics Covered

Chapter-3 Payment Instruments................................................................................................................ 3

3.1 Introduction.................................................................................................................................... 3

3.2 Learning Objectives ..................................................................................................................... 3

3.3 Topics Covered............................................................................................................................... 3

3.4 Credit-based and Debit-based Payment Instruments.................................................. 4

3.4.1 Credit based instrument ........................................................................................................... 5

3.4.2 Debit based instrument ............................................................................................................ 5

3.5 Features of Payment Instruments......................................................................................... 5

3.6 Categories of Payment Instruments .................................................................................... 6

3.6.1 Cash.................................................................................................................................................... 6

3.6.2 Negotiable Instruments ............................................................................................................ 7

3.6.2.1 Types of Negotiable Instruments ................................................................................. 8

3.6.3 Cheques .........................................................................................................................................11

3.6.4 Credit Transfers...........................................................................................................................13

3.6.5 Direct debits .................................................................................................................................14

3.6.6 Card based Payment Instruments.......................................................................................15

3.7 Summary.........................................................................................................................................15


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Till now we learned about what basically a payment system means, who are the

participants of the system, its roles, importance etc. For the process of funds transfer

between two parties, instruments are needed. In this section we will look into various

payment instruments that are in vogue.

All payments essentially require a transfer or exchange of money between two parties:

a Payer and a Payee. The way or the mode in which this transfer is made is determined

by the instrument of payment used and the channel through which the parties choose

to make the payment. The transactions thus can be categorized into:

1. Cash transactions

2. Non-cash transactions

For cash payments the payment is finalized at the actual time of payment, when the

instrument of payment, that is to say, banknotes and coins, are exchanged. Here we

have no intermediaries. Money transfers, card payments through debit and credit cards,

cheques and bank money orders are examples of payment instruments that initiate

transfer of funds between two or more accounts held by one or more intermediaries,

usually banks. They are all therefore said to be account based payment instruments.

Such payment instruments can often be used in and via different channels.

The payment channel indicates the route chosen to send the information about the

transaction. For example, a bank card can be used for payments over the counter in the

shop, on internet or even by telephone.

3.4 Credit-based and Debit-based Payment Instruments

The initiation of a payment is the first, and in many ways the most visible, step in the

whole process of transferring funds between the bank accounts of different customers.

The selection of payment instrument for a particular transaction will depend on the

answers to a range of questions:

• What is the cost to the customer of using particular instruments?

• Is the transaction ‘face to face’ (e.g. in a shop) or a ‘remote’ transaction?

• Is it a regular (monthly, quarterly) transaction or a ‘one-off’ transaction?

• Is it urgent (e.g. requiring same-day availability of funds to the receiver) or non-

urgent?

• Is it a high-value or low-value payment?

• Is it a local or long-distance payment?

• Is it domestic or cross-border?

• Is the privacy of the transaction data maintained?

• To what extent the processing is secure and reliable using a particular

instrument?


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The range of payment instruments available in any particular country will necessarily

reflect that country’s historical and social background. However, it is important that the

choice should also as far as possible be a reflection of that country’s developing non-

cash payment requirements.

Credit: A granting of loan and creation of debt it means “to believe”.

Debit: It’s a Latin word meaning “to owe”.

3.4.1 Credit based instrument

When a credit-based instrument is used (for example, a payment order), the sender

gives the instruction directly to his own bank for onward transmission to the receiver’s

bank. So, as can be seen from Fig3.1, for a credit-based transfer, instruction and funds

move in the same direction.

3.4.2 Debit based instrument

When a debit-based instrument is used (such as a cheque), the sender first of all gives

the instruction to the receiver himself, and the receiver then passes the instruction to

his bank, which will in turn pass it to the sender’s bank.

So, as can be seen from Fig 3.2, for a debit-based transfer instruction and funds move in

opposite directions.

3.5 Features of Payment Instruments

(a) Physical form

This is the most obvious categorization of payment instruments. Traditionally, the

physical form of a payment instruction has been paper. For example: cheques or

payment orders.

Figure 3.1 Credit based payment instrument (Source: CCBS)


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Figure 3.2 Debit based payment instruments (Source: CCBS)

Today, it is increasingly likely to be a payment card of some sort; or the sender may

arrange (in person, or by telephone, fax or telex) with his bank for an electronic

instruction to be sent. For example: e-payment, m-payment.

(b) Security features

Closely related to the physical form of the payment instruction are the security features

that it incorporates - the means of checking that the Instruction is genuine, and has not

been fraudulently produced.

Traditionally, this was by means of a person’s signature. Today it may more often be by

means of a personal identification number (PIN) entered by the sender, or in the case of

direct electronic instructions, by the use of a password. So, now it is been protected

through a code which should be matched.

3.6 Categories of Payment Instruments

Payment Instruments can be broadly categorized into following categories

1) Paper based payment instruments:

ü Cash

ü Negotiable instruments

2) Card based instruments.

3) Electronic funds transfer – debit transfer and credit transfer

3.6.1 Cash

“Money is a standardized unit of exchange”. The practical form of money is currency or

cash. Currency varies across countries whereas money remains the same. For example,

in India, the currency is the Indian Rupee (INR) and in the US, it is the US Dollar (USD).

Cash or Currency has been the predominantly used medium of payment across the

globe until the advent of cards. The modern day currency was originally preceded by

drafts and bills, which were the two ancient forms of paper money. The former were

basically receipts for certain value, while the latter were a promise to convert to certain

value at a later date. Cattle and grain were the oldest forms of exchange, as per the


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Barter System. Drafts in the form of metals were used as far as 1 BC in Ptolemaic Egypt.

Paper money came into being to make up for coin shortages.

3.6.2 Negotiable Instruments

Exchange of goods and services is the basis of every business activity. Goods are

bought and sold for cash as well as on credit. All these transactions require flow of cash

either immediately or after a certain time. In modern business, large numbers of

transactions involving huge sums of money take place everyday. It is inconvenient as

well as risky for either party to make and receive payments in cash. Hence, it is a

common practice for businessmen to make use of certain documents as means of

making payment. Some of these documents are called negotiable instruments.

Negotiable Instrument – is defined as: A negotiable Instrument is a “Transferable”

document, which is an integral part of business mechanism and is transferable by delivery

or by endorsement and delivery.

In India Negotiable Instruments are governed by the Negotiable Instrument Act 1888.

Cheques, Bills of Exchange, Promissory Notes, Demand Drafts are some examples of it.

These instruments can be easily converted into cash, hence they are used for business

transaction purposes.

To understand why these instruments are called negotiable instruments we will look at

some common examples:

Example 1: Suppose Ram, a book publisher has sold books to Govind for Rupees

10,000/- on three months credit. To be sure that Govind will pay the money after three

months, Ram may write an order addressed to Govind that he is to pay after three

months, for value of goods received by him, Rs.10,000/- to Ram or anyone holding the

order and presenting it before him (Govind) for payment. This written document has to

be signed by Govind to show his acceptance of the order. Now, Ram can hold the

document with him for three months and on the due date can collect the money from

Govind. He can also use it for meeting different business transactions. For instance,

after a month, if required, he can borrow money from Hari for a period of two months

and pass on this document to Hari. He has to write on the back of the document an

instruction to Govind to pay money to Hari, and sign it. Now Hari becomes the owner of

this document and he can claim money from Govind on the due date. Hari, if required,

can further pass on the document to Arun after instructing and signing on the back of

the document. This passing on process may continue further till the final payment is

made.

Example 2: Ramesh issues a cheque worth Rs. 5,000/ - in favor of Shankar, then Shankar

can claim Rs. 5,000/- from the bank, or he can transfer it to Vishnu to meet any business


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obligation, like paying back a loan that he might have taken from Vishnu. Once he does

it, Vishnu gets a right to Rs. 5,000/- and he can transfer it to Ganesh, if required. Such

transfers may continue till the payment is finally made to somebody.

In the above examples, we find that there are certain documents used for payment in

business transactions and are transferred freely from one person to another. Such

documents are called Negotiable Instruments. Thus, we can say negotiable instrument

is a transferable document, where “negotiable” means transferable and “instrument”

means document.

3.6.2.1 Types of Negotiable Instruments

There are 3 types of payment instruments defined by the Negotiable Instruments Act

1888, i.e. Promissory Notes, Bills of Exchange and Cheques.

a) Promissory Note - Section 4 of the Negotiable Instruments Act, 1881 defines a

promissory note as ‘an instrument in writing (not being a bank note or a currency note)

containing an unconditional undertaking, signed by the maker, to pay a certain sum of

money only to or to the order of a certain person or to the bearer of the instrument’. For

example a Bank note.

Let us take an example to understand better - Suppose Sanjeev takes a loan of Rupees

Five Thousand from your friend Ramesh. Sanjeev can make a document stating that he

will pay the money to Ramesh or the bearer on demand. Or he can mention in the

document that he would like to pay the amount after three months. This document,

once signed by Sanjeev, duly stamped and handed over to Ramesh, becomes a

negotiable instrument. Now Ramesh can personally present it before Sanjeev for

payment or give this document to some other person to collect money on his behalf.

He can endorse it in somebody else’s name who in turn can endorse it further till the

final payment is made by Sanjeev to whosoever presents it before Sanjeev. This type of

a document is called a Promissory Note because a promise is made by the payee to pay

a particular sum after a particular time to the payer.

Parties in a Promissory Note: There are primarily two parties involved in a promissory

note. They are

i) The Maker or Drawer – the person who makes the note and promises to pay the

amount stated therein. In the above specimen, Sanjeev is the maker or drawer.

ii) The Payee – the person to whom the amount is payable. In the above specimen it is

Ramesh.

In course of transfer of a promissory note by payee and others, the parties involved may

be -


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a. The Endorser – the person who endorses the note in favour of another person. In the

Above specimen if Ramesh endorses it in favour of Ranjan and Ranjan also endorses it

in favour of Puneet, then Ramesh and Ranjan both are endorsers.

b. The Endorsee – the person in whose favour the note is negotiated by endorsement.

In the above, it is Ranjan and then Puneet.

Characteristics of a Promissory Note: Following are the main features

• A promissory note must be in writing, duly signed by its maker and properly

stamped as per Indian Stamp Act.

• It must contain an undertaking or promise to pay. Mere acknowledgement of

indebtedness is not enough. For example, if some one writes ‘I owe Rs. 5000/- to

Satya Ramesh’, it is not a promissory note.

• The promise to pay must not be conditional. For example, if it is written ‘I

promise to pay Suresh Rs 5,000/- after my sister’s marriage’, is not a promissory

note.

• It must contain a promise to pay money only. For example, if some one writes ‘I

promise to give Suresh a Maruti car’ then it is not a promissory note.

• The parties to a promissory note, i.e. the maker and the payee must be certain.

• A promissory note may be payable on demand or after a certain date. For

example, if it is written ‘three months after date I promise to pay Satinder or

order a sum of rupees Five Thousand only’ then it is a promissory note.

• The sum payable mentioned must be certain or capable of being made certain.

It means that the sum payable may be in figures or may be such that it can be

calculated. (See specimen below).

Figure 3.4 Specimen of Promissory note

Figure 3.3 Specimen of promissory note

<Place>

Rs.25,000/- <Date>

I, Vijay, s/o Govind of Bangalore, promise to pay Preetum , s/o Krishna of Chennai

or order, on demand a sum of Rs.25,000/- (Rupees Twenty Five thousand only)

with interest @ 9% per annum, for value received.

Signed Preetum

Stamp

To Preetum

Chennai


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b) Bill of Exchange - Section 5 of the Negotiable Instruments Act, 1881 defines a bill of

exchange as ‘an instrument in writing containing an unconditional order, signed by the

maker, directing a certain person to pay a certain sum of money only to or to the order of a

certain person, or to the bearer of the instrument’.

Let us look at the following example for the better understanding, Suppose Rajiv has

given a loan of Rupees Ten Thousand to Sameer, which Sameer has to return. Now,

Rajiv, in turn has borrowed Rupees Ten Thousand from Tarun. In this case, Rajiv can

make a document directing Sameer to make payment up to Rupees Ten Thousand to

Tarun on demand or after expiry of a specified period. This document is called a bill of

exchange, which can be transferred to some other person’s name by Tarun. Following is

a specimen of the bill of exchange.

Figure 3.4 Specimen of bill of exchange

Parties involved in a Bill of Exchange- There are three parties involved in a bill of

exchange. They are

The Drawer– The person who makes the order for making payment. In the above

specimen, Rajiv is the drawer.

The Drawee – The person to whom the order to pay is made. He is generally a debtor of

the drawer. It is Sameer in this case.

The Payee –The person to whom the payment is to be made. In this case it is Tarun.

The drawer can also draw a bill in his own name thereby he himself becomes the payee.

Here the words in the bill would be Pay to us or order. In a bill where a time period is

mentioned, just like the above specimen, is called a Time Bill. But a bill may be made

payable on demand also. This is called a Demand Bill.

Features of a bill of exchange:

• A bill must be in writing, duly signed by its drawer, accepted by its drawee and

properly stamped as per Indian Stamp Act.

<Place>

Rs.25,000/- <Date>

Six months after Date pay Vijay or (to His) order the sum of Rupees Twenty Five

thousand only for value received.

To Accepted Stamp

Sudip Sudip Signed

Address Preetum


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• It must contain an order to pay. Words like ‘please pay Rs 5,000/- on demand

and oblige’ are not used.

• The order must be unconditional.

• The order must be to pay money and money alone.

• The sum payable mentioned must be certain or capable of being made certain.

• The parties to a bill must be certain.

3.6.3 Cheques

The Negotiable Instruments Act, 1881 defines a cheque as “a bill of exchange drawn on a

specified banker and not expressed to be payable otherwise than on demand”. Actually, a

cheque is a debit based instrument in the form of written order by the account holder

of the bank directing his banker to pay on demand, the specified amount, to or to the

order of the person named therein or to the bearer.

Following is a specimen of a check.

Figure 3.5 Specimen of a cheque

<Date>

Pay…………………………………………………………………………..

……………………………………………………………………or Bearer

Rupees………………………………………………………………………

……………………………………………………………...Rs……………

CANARA BANK

Banjara Hills,

Hyderabad

MSBL/99

65303 110002056 10


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Features of a cheque

• A cheque must be in writing and duly signed by the drawer.

• It contains an unconditional order.

• It is issued on a specified bank only.

• The amount specified is always certain and must be clearly mentioned both in

figures and words.

• The payee is always certain.

• It is always payable on demand.

• The cheque must bear a date otherwise it is invalid and shall not be honored by

the bank.

Types of cheques: Broadly cheques can be categorized on the basis of ownership or on

the basis of timing of issue.

On the basis of ownership cheque has following four sub-categories.

a) Open cheque.

b) Crossed cheque.

c) Bearer cheque.

d) Order cheque.

a) Open cheque: A cheque is called ‘Open’ when it is possible to get cash over the counter

at the bank. The holder of an open cheque can do the following:

• Receive its payment over the counter at the bank,

• Deposit the cheque in his own account

• Pass it to some one else by signing on the back of a cheque.

b) Crossed cheque: Since open cheque is subject to risk of theft, it is dangerous to issue

such cheques. This risk can be avoided by issuing another type of cheque called

‘Crossed cheque’. The payment of such cheque is not made over the counter at the

bank. It is only credited to the bank account of the payee. A cheque can be crossed by

drawing two transverse parallel lines across the cheque, with or without the writing

‘Account payee’ or ‘Not Negotiable’.

c) Bearer cheque: A cheque which is payable to any person who presents it for

payment at the bank counter is called ‘Bearer cheque’. A bearer cheque can be

transferred by mere delivery and requires no endorsement.

d) Order cheque: An order cheque is one which is payable to a particular person. In

such a cheque the word ‘bearer’ may be cut out or cancelled and the word ‘order’ may

be written. The payee can transfer an order cheque to someone else by signing his or

her name on the back of it.

On the basis of timing of Issue checks can be put into following subcategories.


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(a) Ante-dated cheques

(b) Stale Cheque

(c) Post-dated Cheque

(a) Ante-dated cheques- Cheque in which the drawer mentions the date earlier to the

date of presenting if for payment. For example, a cheque issued on 20th May 2003 may

bear a date 5th May 2003.

(b) Stale Cheque- A cheque which is issued today must be presented at bank for

payment within a stipulated period, in India the stipulated period is 6 months. After

expiry of that period, no payment will be made and it is then termed as a ‘stale cheque’.

(c) Post-dated Cheque- Cheque on which drawer mentions a date which is subsequent

to the date on which it is presented, is called post-dated cheque. For example, if a

cheque presented on 8th May 2003 bears a date of 25th May 2003, it is a post-dated

cheque. The bank will make payment only on or after 25th May 2003 upto a period ( six

months) after which the cheque becomes “stale”.

3.6.4 Credit Transfers

Credit transfers (or giro payments as they are frequently called) are the traditional

means of non-cash payment in a number of European countries. They can be in paper

or electronic form and can be used for both non-recurring and recurring (e.g. weekly,

monthly, quarterly) payments; they are not, however, suitable for ‘point-of-sale’

transactions.

A particular advantage of credit transfers is that the receiving customer does not have

to worry about the credit-worthiness of the payer since, by definition, a credit transfer

cannot be sent without the approval of the paying customer’s bank, and without the

paying customer’s account having first been debited. (So, as with a pre-paid cheque or

banker’s draft, certainty of payment for the receiving customer is at the expense of the

paying customer in terms of immediate debiting of his account.)

Customers who need to make recurring payments (for example payment of household

mortgages, insurance premiums etc.) can enter into a standing order arrangement with

their bank, which then contracts to carry out the necessary credit transfers on a regular

specified data, to a specified customer and for a specified amount. Corporate customers

can similarly arrange for regular payments to be made (e.g. wages and salaries) under a

direct credit arrangement.

Customers needing to make (or receive) time-critical and/or high-value payments may

use an electronic credit transfer. Not only does it provide greater certainty of payment

for the receiving customer but it may also provide him with funds on the same day that

the payer initiated the transfer. Indeed, in terms of the total value of payments, rather


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than the number of transactions, the dominance of the electronic credit transfer is

readily apparent.

3.6.5 Direct debits

A direct debit is an instrument specifically developed to facilitate recurring customer

payments, and like a standing order, is well-suited to automation. It is becoming of

increasing importance in a number of countries. Direct debit payments are pre-

authorised by the paying customer, who gives permission for his bank to debit his

account upon receipt of instructions initiated by the receiving customer (e.g. a utility

company, or insurance company).

Cheques are popular from the payer’s point of view because of the delay between the

drawing of the cheque and the debiting of the payer’s bank account. Indeed, this feature

can be deliberately used by enterprises to improve their management of cash flow.

However, as with all debit-based instruments, there is the potential problem of the credit-

worthiness of the drawer of the cheque (the person making the payment): what guarantee

does the receiving customer have that the cheque which he has received will represent

good value – i.e. that the payer has funds in his bank account to back the cheque? There are

a number of ways of approaching this problem:

(a) In a number of countries, banks have developed cheque guarantee schemes to improve

the acceptability of cheques. Cheques are supported by a plastic card (a cheque guarantee

card) which is issued by a bank to its customers and which, when presented along with the

cheque, gives assurance to the receiver (usually a shopkeeper) that the cheque will be

honoured (up to a specified amount) by the payer’s bank.

(b) The cheque as a pre-paid instrument Bank customers can be issued with cheques which

they have, in effect, already paid for, by having a specified sum debited to their account in

advance. The travellers’ cheque and the banker’s draft are examples of such pre-paid

cheques. The receiving customer can accept such instruments as payment in the certain

knowledge that they will be honoured (provided the issuing bank is itself sound). However,

the paying customer can no longer benefit from the delay mentioned earlier.

(c) Paying customers may also be discouraged from issuing cheques that will subsequently

be dishonoured, by making such practices illegal - with fines (and even the possibility of a

prison sentence) for offenders. Alternatively, customers could have their cheque books

confiscated and their right to use cheques suspended for a specified period.


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3.6.6 Card based Payment Instruments

It is a term collectively used to refer to different cards used by cardholder for payment,

it include credit card, debit card, charge card or any other card issued by financial

intuition like banks and which help cardholder to make payment for service, product or

to obtain cash.

The basic choice here is between credit cards and debit cards. A credit card indicates

that the holder has been granted a line of credit by the card-issuing bank, enabling the

holder to make purchases up to a prearranged ceiling. Credit thus granted can be

settled in full by the end of a specified period; or can be settled in part, with the balance

taken as extended credit on which interest is charged. Travel and entertainment cards

(charge cards) operate on a similar principle, except that the card holder is not given

the opportunity to have a period of extended credit, the full amount of the outstanding

debt having to be settled at the end of the specified period.

A debit card enables the holder to have his expenditure directly charged to his bank

account. It does not offer a period of free credit to the holder after he has made a

purchase; but it is seen by many as a more convenient alternative to writing a cheque

for a ‘point-of-sale’ purchase.

Nowadays, debit cards are the primary means to carry money in pockets, it is very useful

in terms as it can also be used as an ATM card to carry out bank withdrawals. Thus they

are both convenient and time saving.

Both debit and credit card systems may incorporate authorization procedures, whereby

merchants at the point-of-sale obtain the approval (increasingly by on-line electronic

means) of the card issuer to accept the transaction.

A third kind of payment card that is now being developed is the pre-paid card. This is a

card incorporating a computer chip/integrated circuit on which value is “loaded”, either

from the card-holder’s bank account or in return for cash. Value is then removed from

the card as purchases are made, using special point-of-sale terminals. Single-purpose,

non-reusable prepaid cards have been in existence for a number of years, for use in

telephone kiosks and car parks for example. The new generation of cards will be multi-

purpose, and rechargeable.

Payment cards may also incorporate non-payment functions. Specifically, they may be

used as a cheque guarantee card (as discussed above), or as an ATM/cash dispenser

card.

3.7 Summary

• In a credit based instrument the sender gives instructions to his own bank

for the transmission


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• In a debit based instrument the sender gives instruction to the receiver first

for the transmission

• Payment Instruments are categorized into 1) Paper Based Instruments, and

2) Card Based instruments

• Negotiable Instrument is a transferable instrument document

• Bills of exchange is an instrument in writing containing an unconditional

order signed by the maker

• In open check it is possible to get the cash over the counter of the bank

• In crossed check the amount is credited to the payees account

• Credit card is ‘Buy now & Pay later’.


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9.11.3 Advantages of SWIFT Network 18

9.12 Summary 19

9.4 Preamble

The universal payments landscape, populated by standardised formats and powered by

harmonised systems all talking the same language, is closer to reality largely due to the

development of Internet-based technologies. Today's payments regime is close to

achieving what was, until a couple of years ago, an utopian dream that few believed

could be transformed into a workable proposition.

9.5 Why do we need standards?

The constantly changing nature of business practices and procedures influenced by

changing customer demand, technology changes, economic and regulatory pressures

has forced dynamic changes in the system. Conforming to the standards will thus aid in

embracing these changes easily at a reduced cost.

Standards will help us to streamline our processes so that costs can be minimized.

Moreover, in today’s scenario when IT is sprawling its tentacles to almost every industry,

Businesses will be communicating with each other through their IT infrastructures so

that for different systems to interact with each other we need standards or the common

language. It would help the system to be globally accepted and understood. It is a

positive step towards the integration and ease of compatibility for the systems

worldwide.

Following are some desired characteristics of standards are given in table 6.1:

Table 9.1: Characteristics of Standards

Characteristics Description

Good Life expectancy The company investing in the standards wants reassurance

that its investment will have good life expectancy

Flexible The set of standards should enhance the functionality without

restricting itself to a given business process

Useable Implementation should be a simple process

Supported Standards should be well supported( documentation, user

groups, user committee)

Satisfy User Need Standards should accommodate all business user needs

without sacrifice

Single Standards This will give true global benefits. However this will curtail the

competition and innovation

Adaptable Standards should anticipate and embrace changes, making it


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simpler to adopt to external changes

Global Standards should work alongside and complement other sets

of standards

9.6 A SWIFT Beginning…..

The slow path towards open standards (i.e. a universal framework for sending payments

data between corporate and banks) began almost 30 years ago. A consortium of

bankers came up with the idea of employing the technology of the day to create

standardised inter-bank messages, allowing them to do away with the slow, manual

and insecure telex system. To this end, in 1973, some 239 banks from15 countries

formed a cooperative to 'automate the telex'.

They called it the Society for Worldwide Interbank Financial Telecommunication

(SWIFT) and its goal at the time was simply to transmit a message and ensure its

successful delivery. They hoped one day to achieve a success rate of 300,000 messages

per day. Today, SWIFT exceeds 8 million messages a day. More about SWIFT will be

discussed in chapter 9.7.

9.7 EDIFACT – (Electronic Data Interchange for Administration, Commerce and

Transport)

EDIFACT (Electronic Data Interchange for Administration, Commerce, and Transport) is

the computer-to-computer exchange of business data in standard formats. In EDIFACT,

information is organised according to a specified format set by both receiving and

sending parties, allowing an automated computerised transaction that requires no

human intervention or re-keying at either end. Early developments of EDI were driven

primarily by large buying organizations - supermarkets, chain stores, health services -

which had the financial muscle to influence their trading partners to adopt a standard

method of electronic trading, initially largely to the benefit of the buyer, though

ultimately with benefits for both sides. The information contained in an EDIFACT

message set is the same as on a paper document, and it can support the movement of

large amounts of data within the body of the message. When using automatic data

interchange, a much more rigid discipline needs to be exercised regarding data

presentation and exchange rules than in the care of paper documents.

9.7.1 History of EDIFACT

• The EDIFACT syntax has evolved out of United Nations Guidelines for Trade Data

Interchange (known as TRADECOMS) and American National Standards Institute X12

committee rules for data interchange (ANSI X12).


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• These standards were agreed by ISO committee as an international standard (ISO

9735) in September 1987

• EDIFACT is widely accepted as the international EDI standard adopted by

organizations that have a global presence

• EDIFACT can be seen as international, cross-sector language used for exchanging

electronic messages. Like any other language, it

Ø Uses a dictionary-DIRECTORY

Ø Has grammatical rules- SYNTAX

Ø Uses standard phrases- MESSAGES

EDIFACT standard provides:

• A set of syntax rules to structure data

• An interactive exchange protocol

• Standard messages which allow multi country and multi industry exchange

9.7.2 EDI

Actually EDIFACT is just a standard for electronic data interchange. We should

understand first that what EDI is. EDI (Electronic Data Interchange) is the direct

communication of trading messages between computer systems, using national and

international telecommunications networks. Many libraries and suppliers may currently

use EDI simply for transmitting Orders and receiving Acknowledgements. However, EDI

messages may also be used to transmit other information, for example:

· Invoices

· New title notifications

The main advantage of EDI is its ability to prevent unnecessary human intervention and

manual activity in reviewing, formatting, reading and transmitting information shared by

different businesses by agreeing standards and protocols for data sharing.

Moreover EDI facilitates Straight through Processing (STP) by virtue of its ability to reduce

manual activity in the process.

9.7.3 Nomenclature for EDIFACT

EDIFACT has hierarchal structure, where the top level is referred to as interchange, and

the lower level contain multiple messages which consist of segments which in turn

consist of composites. The final iteration is an element which is derived from United

Nations Trade Data Element Directory (UNTDED) and are normalized through the

EDIFACT standard.

• The EDIFACT message is designed to contain all the functionality and data required

at the international level.


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• The electronic transmission of the EDIFACT consists of one or many interchanges

• Each interchange may comprise one or more Messages

• Each message contains Segment of data relating to the corresponding business

transaction

• A series of enveloping data pairs control the exchange structure at each level

9.7.4 Structure of an EDIFACT Transmission

An interchange may consist of the following segments:

Ø UNA Conditional

Ø UNB Interchange Header Mandatory

Ø UNG Functional Group Header Conditional

Ø UNH Message Header Mandatory

Ø User Data Segments

Ø UNT Message Trailer Mandatory

Ø UNE Functional Group Trailer Conditional

Ø UNZ Interchange trailer Mandatory.

Segments starting with “UN” are called service segments. They constitute the envelope

or the “packing” of the EDIFACT messages.


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A complete interchange can be represented like this:

UNA

UNB UNZ

UNG UNE UNG UNE

UNH UNT UNH UNT UNH UNT UNH UNT

data data data data

• The UNA segment defines the separator characters used in the transmission, if they

are not the default set for the character set defined in the UNB segment.

• The UNB segment identifies the sender and receiver of the transmission, specifies

the character set used, and carries other “housekeeping” data for the transmission.

• The UNG and UNE segments are used only if the transmission carries several groups

of message of different types. For book and serials applications, EDItEUR

recommends that a transmission should be limited to carrying only one group of

messages of a single type. The UNG and UNE segments should not be used.

• The UNA, UNB and UNZ segments will normally be generated in outgoing

transmissions, and processed in incoming transmissions, by a standard EDI software

package. The user application need not be aware of their content. They are not,

therefore, specified in detail in the present document.

Figure 9.1 Structure of the Message,


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• Header section - A segment occurring in this section relates to the entire message.

• Detail section - A segment occurring in this section relates to the detail information

only.

• Summary section - Only segments containing totals or control information may

occur in the summary section, e.g. invoice total amount, number of lines in a

purchase order, etc.

EDIFACT was the corporate's answer to SWIFT. It differed from the SWIFT at a technical

level, but the notion of a universal communications standard is at core. Unlike SWIFT

however, EDIFACT lacks consistency. EDIFACT messages, were open to interpretation

by each corporate and each industry sector, reflecting their own needs. Differences in

interpretation contributed to significant problems in the payments cycle. For example,

references placed in different fields meant that if a corporate was multi-banked, they

may have had to send one version of an EDIFACT message to Bank One, another to

Bank Two and a third to Bank Three.

EDIFACT was an expensive format, and one that small corporate kept away from, which

reduced the benefits for larger firms. Large companies need to have all their suppliers

connected via EDIFACT without which complete view of the business electronically is

impossible. The increased benefits of EDIFACT are therefore constrained to the existing

'connected' supply chain, which is significantly less than the actual number of

companies in the supply chain.

But while its “expensive” and “inconsistent” character did not spell the end for EDIFACT,

but it became clear that a degree of standardisation was needed to make the standard

work. Consequently, the Corporate Reference Group (CRG) was established, setting out

four key objectives:

• To create a platform where information on financial EDIFACT could be

exchanged;

• To co-ordinate the corporate's position towards the banking industry

concerning the exchange of financial UN/EDIFACT messages;

• To encourage the banking industry to invest in and develop the capability to

process financial data in the UN/EDIFACT standard; and

• To have the corporate speak as one voice with respect to financial UN/EDIFACT

messaging.

With the help of the CRG, EDIFACT developed into a standard of sorts, and is likely to

grow as lot of organisations have invested and adopted an EDIFACT-based

infrastructure. Many large corporate have realised the original goals of EDIFACT, i.e. the


Page 10 of 20

reduction of costs and resources by replacing paper with electronic messages. In

Europe, the EDI and EDIFACT standards are competing head-to-head with SWIFT.

EDIFACT is not only a format, it is a security protocol. "XML 'standards' primarily address

only format standardisation issues. That is one of EDIFACT's strengths - the security

around transactions that they had been built into their standard.

EDI has already migrated to the Internet and web-based EDI is also forecast to grow

rapidly. However, the web-enabling of EDI does mean that those larger firms who

employ the standard can maximise its efficiency by integrating EDI with smaller

volume-related applications. But with XML cited by most as the natural avenue to a

truly harmonised payments communication infrastructure, many organisations are

already looking at ways in which to adapt their infrastructure to accommodate the

language.

The key characteristics of EDIFACT which are relevant to the present discussion are

these:

• It is the accepted international standard for electronic transaction messages across

many fields, including, in this context, library book and journal supply.

• It is already implemented, and well understood, by many library systems suppliers

• It is independent of any particular transport medium or protocol - EDIFACT defines

the messages, not how they are carried

• Messages are already defined for many basic transactions, including financial

transactions which are not always adequately considered in library-specific

standards

• The message standards are very flexible in terms of content and coding for specific

applications

• Book and journals applications of EDIFACT are actively developed and supported by

EDItEUR, an agency which represents libraries as well as trade interests, and by

competent national agencies in the UK, the USA and other countries.

To date EDIFACT has supported store-and-forward rather than interactive transactions,

so that although the latest version of EDIFACT syntax also has interactive functionality,

it is probably more realistic to regard it as appropriate to batch, or at least off-line,

applications.

(Source: United Nations Economic Commission for Europe.)

9.8 Extended Mark-up Language [XML]

Following are some of the characteristics of XML

• XML is a Markup Language used for annotating text.

• It is concerned with logical structure to identify sections, titles, section headers,

chapters, paragraphs etc.

• It is a Markup language used for transferring data, it was designed to carry data

and not display data


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• It is concerned with data models to convert between applications –appropriate

and transfer appropriate forms.

• It is produced and used by programs.

• It is a tree-structured document that is a useable transfer mechanism that can

be applied almost on anything.

• XML was designed to describe data and to focus on what data is.

• XML is designed to be self descriptive

9.8.1 History of XML

• XML is a set of rules for designing text formats that helps in structuring the data.

• It describes a class of data objects called XML documents and partially describes

the behavior of computer programs which process them.

• XML was developed by the XML working group in 1996 under the patronage of

World Wide Web Consortium (W3C).

• The specification was married to associated standards ( Unicode ISO/IEC 10646

for characters, internet RFC 1766 for language identification tags, ISO 639 for

language name codes and ISO3166 for country name codes) to form basis of

XML.

9.8.2 Design goals of XML

• XML shall be straightforwardly usable over the internet.

• XML shall support a wide variety of applications.

• XML shall be compatible with SGML (Standard Generalized Markup Language).

• The number of optional features in XML is to be kept to the absolute minimum.

• XML documents should be readable by people as well as by machines with

clarity.

• XML design should be prepared quickly.

• The design shall be formal and concise.

• Ease in creating the XML documents.

• Conciseness in XML markup is of minimal importance.

Advantages of XML:

• It is text based.

• It supports Unicode, allowing almost any information in any written human

language to be communicated.

• It can represent common computer science data structures, records, lists and trees.


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• Its self documenting format describes structure and field names as well as specific

values.

• The strict syntax and parsing requirements make the necessary parsing algorithms

extrememlely simple, efficient and consistent.

• XML is based on international standards and can be updated incrementally.

9.8.3 XML document types

• XML documents are made up of storage units called entities that contain parsed

or unparsed data.

• The parsed data is made up of characters; some of which are character data and

some in the form of Mark up.

• Markup encodes a description of the document’s storage Layout and logical

structure.

• XML provides a mechanism to impose constraints on the storage layout and

logical structure.

9.8.4 XML client server architecture

• Client/Server structure can be looked as the front end: the Client, retrieving and

sending information from/ to a back-end system or database, the Server

• XML functions:

o At the client end

I. Use XML plus XSL (extended Style sheet Language) as the

basis for what user sees on screen.

II. Use XSLinks from a master document to pull together

different sources of information.

o At the server end

I. Use XML as a uniform interface for an data source onto the web

XML is a valuable tool in the development of payments standards because it has been

designed for ease of implementation, and for interoperability with both Standard

Generalised Markup Language (SGML) and Hyper-Text Markup Language (HTML). XML

meet the requirements of large-scale web-content providers for industry-specific

markup. The agility and coding effectiveness garnered by the advent of XML have

produced functionality which has provided a way for an open standard to be created

without the need to regulate all naming conventions and validation routines within the

code itself.

This means that groups like TWIST and Rosetta Net are able to employ XML standards

for 'plug-and-play' interfaces that can significantly reduce implementation costs. In


Page 13 of 20

addition, XML enables a smoother data flow than existing technologies. With truly

effective STP, any piece of information needs to be registered only once throughout the

process, irrespective of the number of systems and organisations involved. This

streamlining is the major advantage of the XML messaging standard.

9.9 Rosetta net

RosettaNet was named after the Rosetta stone - which, carved with the same message

in three languages, led to the understanding of hieroglyphics. RosettaNet is a

consortium of an independent consortium of more than 500 organizations that include

electronic, computer, consumer electronics and telecommunication companies

working to create and implement industry-wide, open e-business process standards. In

simple terms, RosettaNet's Payment Milestone Program (PMP) has used XML-based

technologies to develop a solution that automates the account receivable

reconciliation process. In the PMP solution, the remittance advice travels separately -

across real-time XML servers - from the money flow, which uses legacy bank systems.

And although it is designed for use across the Internet, it can also support non-XML

message formats like EDI or ERP proprietary messaging.

Some of the other features are described below.

• RosettaNet standard is based on XML and defines message guidelines, business

process interface and implementation frameworks for interaction between

companies.

• Rosettanet aims to optimize the supply chain by improving efficiency and

performance through enhanced B2B integration.

• Rosettanet provides a shared communication platform, allowing different

trading partners to both automate that process and to use the internet to

engage in that process.

• Rosettanet has been designed with the bottom-up approach, to include security

aspects and on-demand integration. Thus reducing the processing time of

standard transactions.

9.9.1 Standards

There are Rosettanet standards addressing various areas

a) Partner Interface Processes (PIP): are the business processes which occur in every level

of a supply chain. They act as the foundation for B2B alignment.

PIP can be defined as the composition and message content exchanged with the

trading partners. They capture the business processes by describing format and

structure of business documents, as well as the characteristics of each trading partner


Page 14 of 20

PIP is only the specification and not implementation that aids the trading partner to

utilize PIP themselves or use third party software does.

b) Rosetta net Implementation Framework: This supports implementers of e-business

systems who design and create interoperable software applications that jointly use

Rosettanet PIPs. This ensures seamless integration with others using the same

framework

c) Rosettanet Business and Technical Dictionaries: These define the common

terminologies used for both business and technical processes.

Ø Business Dictionary : defines Business properties, Business Data Entities

and Fundamental Data entities in PIP message guidelines

Ø Technical Dictionary : provides with properties for defining products and

services ensuring trade partners do not need to use different

dictionaries when implementing more that one PIP

9.9.2 Structure of a Rosettanet

Rosetta net defines the complete e-business supply chain for which PIPs are specified

into seven ‘clusters’ and an additional cluster used for the supportive administration.

The clusters are listed below.

Table No. 9.2 PIP Clusters

Rosetta net Support Provides administrative functionality

Partner product and service

review

Allows information collection, maintenance and

distribution for the development of trading-partner

profiles and product information subscriptions

Product information Enables the distribution and periodic update of

product and design information, including product

change notices and detailed technical specifications

Order management Supports the full order-management business, from

pricing to delivery quoting through purchase order

initiation, status reporting and management. Order

invoicing, payment and discrepancy notification are

also managed

Inventory management

Marketing information

management

Enables inventory management, including

collaboration, replenishment, price protection,

reporting and allocation of constrained products.

Marketing information

management

Enables communication of marketing information,

including campaign plans, lead information and design

registration


Page 15 of 20

Service and Support Provides post-sales technical support, service warranty

support and asset management capabilities

Manufacturing Enables the exchange of design, configuration,

process, quality and other manufacturing floor

information to support a virtual manufacturing

environment

Barriers to Rosetta Net implementation:

• Firstly initial cost of RosettaNet is a roadblock to it’s adoption

• Secondly since RosettaNet is a relatively new standard in electronics industry it

faces relatively tough competition from pre existing standards. e.g EDI has

been used in US for over 25 years and in Japan over 90% electronic companies

have EDI.

• Thirdly cultural issues may also be hindering RosettaNet. E.g since the system

lacks human involvement this may be a problem for some

9.9.3 How is Rosetta net different from Electronic Data Interchange (EDI)

• The major difference is in terms of focus, EDI focuses on document transfer where

as Rosetta net concentrates on the processes, and their network integration

• The use of common platform reduces the normal costs associated with EDI

initiatives (design , test and implementation of bespoke solutions, reduced

integration and test time with business partners)

Figure 9.2 Structure of Rosetta net


Page 16 of 20

9.10 Transaction Workflow Innovation Standards Team (TWIST)

• TWIST is a body comprising representatives from different business sectors and

different functions (corporate treasuries, fund managers, trading platforms, market

infrastructures, and professional service firms)

• It aims to deliver non-proprietary XML-based standards in three financial processes:

Ø Wholesale financial market transaction processing

Ø Commercial payments and collections as well as working

capital finance

Ø Cash Management.

9.10.1 Objectives of TWIST

• TWIST is a complementary initiative, it will not compete or replace with the

current standards (SWIFT, FIX FpML) thus resulting in simpler integration and

implementations for the system developers.

• TWIST follows end-to-end process focused approach that allows the organizations

to achieve Straight Through Processing (STP), while developing practical

standards that allow market participants to communicate with each other

directly or via external service providers irrespective of:

Ø How the processes are transacted

Ø Which service providers are involved

Ø The system infrastructure used

TWIST - Treasury Workstation Integration Standards Team - is focused on delivering

standards to support the straight-through processing (STP) of wholesale trade

transactions, working capital management and corporate payments. In co-ordination

with IFX, OAGi, SWIFT, TWIST is delivered standards for electronic funds transfer and

cheque payments (including payment initiation, status updates, credit and debit

advices and bank statements) in Q2 2004. TWIST also published standards for the

following bank-to-corporate and corporate-to-corporate communication types: usage

of bank beneficiary due date, direct debits, card payments (corporate to corporate),

cancellations, remittance advises, investigations and claims, electronic invoices, invoice

dispute management, static data maintenance and working capital financing.

9.10.2 Benefits from TWIST

• TWIST observes a Holistic view- It considers the complete process lifecycle across

all electronic communications, rather than just focusing on message formats.

• Modular Designs - The components can be considered as individual items or

together


Page 17 of 20

• The initiative is beneficial through out the electronic finance industry, as a

combination of common sense, good practice and flexibility, which can be

measured in terms of

Ø Increased operational efficiency

Ø Reduced errors and reworks

Ø Reduced integration and upgrade costs

Ø Facilitation of benchmarking

Ø Identification and dissemination of good practice

Ø Reduce implementation and operational risks of modern technology

(specifically fro banks)

Ø Assist system and trading platform vendors ( by gaining access to

globally relevant, agreed good practices at low costs)

Figure 9.3 represents the message flow in TWIST


Page 18 of 20

9.11 Society for Worldwide Interbank Financial Telecommunication (SWIFT)

S.W.I.F.T. is an acronym for Society for Worldwide Interbank Financial

Telecommunications. It is essentially a non-profit organization owned by financial

industry headquartered at Brussels, supplying secure standardized messaging services

and interfaces software to over 200 countries. SWIFT consists of an international

computer network especially dedicated to handle the financial data communication

and processing services to support the business activities of worldwide financial

institutions for securities, payments, foreign exchange and money markets, as well as

trade finance.

SWIFT network guarantees the rapid, cost-effective, secure and reliable transmission of

financial data using a range of ISO-compliant standardized messages with its users and

industry organizations.

It is designed to eliminate the need for paper-based processes in the financial markets.

S.W.I.F.T. lowered costs, increased productivity and helped in reducing risk in the

securities industry by providing several of the key elements necessary for the

automation of the settlement process, and by providing a reliable and secure network.

9.11.1 Objectives of SWIFT

S.W.I.F.T. offers software and network-compatible interfaces, as well as several

applications that could be worn with the network to reduce outlay and risk. The

objectives of SWIFT are

• To standardize the Fund Transfer instructions among the member participants.

• Immediate delivery of payment instructions and related messages.

• To enhance the security levels of fund transfers.

• To reduce the cost of message transmission.

• To provide service that is worldwide, round the clock and available on all days of

the week.

9.11.2 Benefits of using SWIFT

The benefits offered by SWIFT standard are three-fold and are mentioned below:

• Reduces manual operations

• Helps in avoiding errors and re-work

• improves timeliness and reduces failures

9.11.3 Advantages of SWIFT Network

• No need of other external network.

• Reduction of common carrier and associated cost.

• A single package can support several package of communication.


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• Secure telecommunications network supports messages that need a dated

acknowledgment and a guarantee of delivery.

• SWIFT network provides immediate connectivity to almost all of their potential

counter parties and clearing banks and brokers.

• Ensures accurate accounting.

• Easier and direct communication.

• Managers who have either a DTC or a S.W.I.F.T. connection are able to access

both networks.

9.12 Summary

• XML is A Markup Language used for annotating text for transferring data

Concerned with logical structure to identify sections, titles, section headers,

chapters, paragraphs etc.

• XML documents are made up of storage units called entities

• XML provides a mechanism to impose constraints on the storage layout &

logical structure

• EDIFACT syntax is evolved out of UN Guidelines for Trade data Interchange

called TRADECOMS

• EDIFACT cross sector language is used for exchanging electronic message

• Rosetta net is an independent consortium of more than 500 organizations that

include electronic computer

• Rosetta net aims to optimize the supply chain by improving efficiency

performance through B2B integration

• TWIST is a body comprising representatives from different business sector &

different functions’

• SWIFT is a non-profit organization owned by financial industry

• SWIFT network guarantees the rapid, cost-effective, secure and reliable

transmission of financial data using a range of ISO-compliant standardized

messages with its users and industry organizations.


Page 4 of 25

10.17 Support....................................................................................................................................22

10.18 Benefits of Using SWIFT....................................................................................................22

10.19 Reduction of Risks by using SWIFT ..............................................................................23

10.20 Summary..................................................................................................................................24

List of figures

Error! No table of figures entries found.

List of tables

Error! No table of figures entries found.

10.4 SWIFT- An Introduction

S.W.I.F.T. is an acronym for Society for Worldwide Interbank Financial

Telecommunications. According to Article 3 of its Articles of Association "The object of

the Company is for the collective benefit of the Members of the Company, the study,

creation, utilisation and operation of the means necessary for the telecommunication,

transmission and routing of private, confidential and proprietary financial messages"

The Society's headquarters are situated in La Hulpe, on the outskirts of Brussels.

S.W.I.F.T. also acts as a United Nations’ sanctioned International Standards Body (ISO)

for the creation and maintenance of financial messaging standards.

S.W.I.F.T. was formed when seven major international banks met in 1973 to discuss the

limitations of Telex as a means of secure delivery of payment and confirmation

information, primarily in the Treasury and Correspondent banking areas. Telex suffered

from a number of limitations

• due to its speed (50 Baud or approximately 8 bytes per second),

• its free format (that made automation at the receiving end almost impossible),

• and the lack of security, with Test-keys only being calculated on a subset of the

message content.

The decision was taken at that time to form the society and later in 1977, 230 banks in 5

countries went live.

Over the years message type [MT messages] coverage has been greatly expanded to

cover a much greater range of financial transactions, and new message types are added

to the system once a year between September and November. The original network

was superseded by an X.25 based network in 1990 to cope with the increasing message

volumes. Uniquely, S.W.I.F.T. takes full liability for each message once they have

accepted it, and it is probably this linked to the inbuilt security and robustness of the

network (consistently better than 99.99% up time every year) that has led to S.W.I.F.T.'s

dominant position in the market.


Page 5 of 25

It is essentially a non-profit organization owned by financial industry supplying secure

standardized messaging services and interface software to over 200 countries. SWIFT

consists of an international computer network especially dedicated to handle the

financial data communication and processing services to support the business activities

of worldwide financial institutions for securities, payments, foreign exchange and

money markets, as well as trade finance.

SWIFT network guarantees the rapid, cost-effective, secure and reliable

transmission of financial data using a range of ISO-compliant standardized

messages with its users and industry organizations. It is designed to eliminate

the need for paper-based processes in the financial markets. S.W.I.F.T. lowered

costs, increased productivity and helped in reducing risk in the securities

industry by providing several of the key elements necessary for the automation

of the settlement process, and by providing a reliable and secure network.

10.5 SWIFT Establishment & Time Line

SWIFT was established in 1973 by European bankers who needed a more efficient and

secure system for interbank communications and transfer of funds and securities. Until

then, all interbank communications were through telephone, telex, courier or mail. The

guiding principles of SWIFT is “to offer a common platform of advanced technology and

access to shared solutions to the financial services industry through which each

member can build its competitive edge”. A chronology of events prominent in the

establishment and growth of SWIFT is as follows:

• 1973 – SWIFT is born, forty square metres of office space in the centre of

Brussels, Supported by 239 banks in 15 countries. Mission – 1.Creating a shared

worldwide data processing 2.Communications link 3.Common language

• 1974 — Partnership principles established, Financial institutions planning to use

SWIFT for messages are heavily involved in the development process, ensuring

effectiveness and practicality.

• 1975 — Emphasis on security and reliability, Rules defining responsibility and

liability are written, operational practices put in place. Fundamental principles

behind SWIFT are established at an early stage.

• 1976 — First operating centre opened, Significant progress towards live

operations continues with the opening of the first operating centre. Each has its

own redundant facilities and is capable of backing up the other to ensure high

system availability.


Page 6 of 25

• 1977 — SWIFT goes live. Albert, The Prince of Belgium and now King, sends the

first message. The initial group of members has grown to 518 commercial banks

in 22 countries.

• 1978 — First ten million messages, SWIFT's on-going success is confirmed as the

accumulated total of processed messages passes 10 million after less than 12

months of activity. To maintain contact with the growing user base the first

SIBOS [SWIFT International Banking Operations Seminar] is held in Brussels with

300 participants.

• 1979 — Opening of North American operating centre. The scope of SWIFT

services is constantly under review. Considerable efforts continue to be made in

the Working Groups as they dealt with collections, documentary credits,

reconciliation, securities, standards interpretation, and warning messages.

Source: “SWIFTnet MA-CUGs: A Growing Pathway To Bank Services” Leonard Schwartz, ABN

Amro Working Capital Group, www.gtnews.com

Figure 10.1 Timeline of SWIFT

• 1980 — First Asian countries connect. Hong Kong and Singapore start live

operations.

• 1981 — SWIFT introduces the ST100 interface. Provision of interfaces and

software is now handled through a wholly owned subsidiary, SWIFT Terminal

Services.

• 1983 — Banque Nationale de Belgique becomes the 1,000th member. The

connection of central banks reinforces SWIFT's position as the common link

between all parties in the banking industry.

http://www.gtnews.com


Page 7 of 25

• 1984 — Knowledge for the future, SWIFT upgrades its customer education

services and introduces instructor-led, computer-based and tailor-made courses

• 1985 - Satellite enhances services; SWIFT installs a high-volume satellite link

between its Operating Centres to support traffic growth.

• 1987 — SWIFT goes into securities, SWIFT's members votes to expand the user

base by including broker dealers, exchanges, central depositories and clearing

institutions. The first BIC [Bank Identification Code] directory is issued.

• 1993 — SWIFT brings the benefits of speed, reliability, security and

standardisation to an additional 404 users in 12 new countries. Security and

data integrity are strengthened by introducing smart cards for log-in and

Bilateral Key Exchange (BKE) via the network. A new UNIX-based interface is

launched. SWIFTAlliance [An interface tool] responds to customers’ needs for

multinetwork, single platform processing capabilities.

• 1996 —. SWIFT steps up its straight-through processing (STP) drive with a

dedicated team and solutions. Reducing costs, managing risk, improving

automation

• 1997 — Announcement of SWIFTNet,[A TCP/IP Network] which Increases

connectivity grows FIN traffic, progresses STP, supports market infrastructure

initiatives in clearing and settlement and trade.

Figure 10.2 Announcement of SWIFTNet

• 2000 — SWIFT's 'e' future takes shape, Payments into the business-to-business

domain (SIPN, SWIFTNet Link, SWIFTNet PKI, SWIFTNet Interact deployed) New

XML standards methodology being developed, E-enabling of customer

activities such as ordering and billing. (E-enabling of Knowledge base, Case

manager, Operational status, Download centre, Documentation, Ordering,

Billing information, Contact information)

• 2002 —On 15 August 2002 SWIFTNet Release 4.0 went live, First SWIFTNet FIN

message sent, SWIFT successfully drives ISO 15022 migration

• 2003- SWIFT community reaches 200 countries. ISO 15022 migration completed.

MT 103 migration completed. SWIFT yearly traffic reaches 2 billion FIN message

mark, doubling the volume since 1999.


Page 8 of 25

• 2004- SWIFTnetIP migration completed. SWIFT honoured with “Dream Team

award” World’s second largest pension fund adopts SWIFTNet FileAct. ISO

20022 got published and deployment gets underway.

• 2005- SWIFT focuses industry attention. TARGET2 chooses SWIFTNet. SWIFT cut

prices by 8% and announced new pricing initiatives. Won 2005 ICT trends award

for SWIFTWatch products. SAP announced the company will SWIFT enable its

ERP.

• 2006- SWIFT’s first CEO Carl Reuterskiold died. SWIFTNet Trade Service Utility

enters pilot phase. SWIFT AGM Approves new corporate categories.

10.6 Organization of SWIFT

SWIFT is organized into seven divisions, each led by an executive. The divisions

and their functions are as follows:

o Marketing determines demand and customer requirements for all products

and services. It includes the Standards department, which coordinates with

external standards organizations and develops the requirements for SWIFT

message standards.

o The Banking Industry and Securities Industry divisions manage

commercial relationships with customers and market infrastructures and

promote the SWIFT messaging services and SWIFT Solutions portfolio to

prospective customers.

o IT designs and develops all product and internal technology solutions. It is

also responsible for the security control framework for the SWIFT enterprise.

o Technology Operations manages and monitors the services used by

customers including the running of S.W.I.F.T’s operational centers and

global network.

o Customer Operations is responsible for customer ordering, service

provisioning, global customer support and crisis management.

o Finance and Administration is responsible for financial management,

monitoring company performance, billing, purchasing, logistics and general

administration services.

o Human Resources recruits, develops, retains and rewards talent and

provides the programmes, policies and practices to help achieve business

goals through motivated, high-performing employees.

o An Executive Steering Group (ESG) is formed from the CEO

(presently, Leonard H. Schrank) and the Executive Heads of various

divisions. The ESG is responsible for the preparation, integrity and


Page 9 of 25

objectivity of the consolidated financial statements. The executive

heads report to the CEO.

10.7 The Users of SWIFT

Although originally the network was designed to support the requirements of Treasury

and Correspondent banking operations, S.W.I.F.T has over the years allowed other

institutions to access the services, albeit in some cases only to a limited degree.

Currently the following categories of organisation as shown in figure 7.3 can access the

service:

The Society is owned by its members, and in order to become one the organisation

must hold a banking license. In return members own shares in the society and have

voting rights. There are different categories of SWIFT members

• Shareholder (Member)

An eligible organisation holding a share in S.W.I.F.T. including banks, eligible

securities broker, dealers and regulated investment management institutions.

• Non-Shareholding Members

A Non-Shareholding Member is an organisation which complies with the eligibility

criteria of a “Shareholder (Member)” which either is not chosen or is prevented from

becoming a Shareholder.

• Sub-Member

An organisation more than 50 percent directly or 100 percent indirectly owned by a

shareholder and which meets the criteria set forth in the first paragraph of Article 8

of the Articles of Association (By-laws). A Sub-Member must fall under full

management control of the Shareholder.


Page 10 of 25

Figure 10.3 Users of S.W.I.F.T.

All classes of member pay an initial joining fee and an annual support charge, although

the amount differs for each class. In addition users are charged on a per message basis

by unit lengths of 325 or 1950 characters depending on message type. The charges also

vary depending on volume tier and route with the amounts reducing for high volume

users and those messages passing along the most common routes such as U.K. to U.S.A.

The pricing is calculated to cover all of S.W.I.F.T.'s costs and investments with users then

receiving regular rebates after these are finalised.

Example:

SWIFT Standards develops a comprehensive set of business standards to support end-

to-end payment transactions. The traditional MT messages are complemented by new

MX messages, which enable the completion of the information loop through the

transfer of richer data for end-to-end business transactions.


Page 11 of 25

Source: http://www.swift.com/index.cfm?item_id=60134

10.8 Services Offered by SWIFT

S.W.I.F.T. offers a number of services, [offered by X.25 network, some of which are

available in SWIFTNet] primarily:

o GPA: General Purpose Application, which only allows system messages, i.e.

messages from a user to SWIFT and vice versa, not from one user to another.

o FIN: Financial Application, which is the user to user service comprising:

1. System Messages MT0nn,

2. User to User Messages MT1nn through 9nn and

3. Service Messages such as Acknowledgements.

Where n represent is a number from 0 to 9.

Additionally, S.W.I.F.T. provides a number of services that are charged for over and

above the normal fees. Summarizing these:

o IFT (Inter-bank File Transfer) – For bulk file transfer of messages, for example low

net value, high value retail payments

o ACCORD – A centralized confirmation matching bureau service

o Directory Services – An automated and centralized Standard Settlement

Instruction service for message enrichment that presently, is limited to Treasury

and Payment information.

o RTGS – Mostly used for sending a copy of a message or parts thereof to a third

party, for example the Central Bank.

http://www.swift.com/index.cfm?item_id=60134


Page 12 of 25

o Country Specific (e.g. CREST, CHAPS Euro) – SWIFT is either the carrier of

messages or the supplier of additional network services.

One or more of the above services are provided in three key spaces as shown in

Fig.10.4

1. Bank to bank

2. Market Infrastructures

3. Bank to corporate

Figure 10.4 SWIFT serving three key spaces

10.9 Different Kinds of SWIFT Network

In 1977 when SWIFT went live it was 3270 based network. In 1990 X.25 protocol based

network was adopted to support burgeoning message traffic. In 2004 TCP/IP was

adopted to offer interactive services. Here we will learn about two kinds of network.

They are standard network and TCP/IP network.

1. Standard network: The Standard S.W.I.F.T. network uses a protocol X.25; this

protocol sends information in discrete units called packets (separate

packages of information) and functions over leased or dial-up lines. Packet

switching networks are designed to ensure accurate transmission of

messages and files over lines of differing telecommunication quality in

many emerging countries. S.W.I.F.T. also supports messages and file

transfers through the use of a "Store and Forward" standard, called CCITT

X.400. S.W.I.F.T. processes messages and file transactions with automatic

verification and authentication. Even for cross-border message transfers, if

the sender and the receiver both are on-line, a message transfer typically

takes less than 20 seconds. The automatic verification and authentication


Page 13 of 25

not only fasten the transfer of message but also help in improving the

productivity of the firm. SWIFT s "black box" architecture is a simple way to

connect the firm with each other in a network. This is most guaranteed

network of financial message delivery working 24*7.

2. TCP/IP network: S.W.I.F.T. has built a next generation, TCP/IP-based

communications network, which permit real-time, interactive services

termed as SWIFTNet. These services will be used to facilitate S.W.I.F.T.’s role

in a variety of global market infrastructure projects. These projects include 1.

CLS (Continuous Linked Settlement) in the Foreign Exchange market. 2.

Bolero in the Trade Finance market 3. GSTPA (Global Straight Through

Processing Association) in the securities market

SWIFT Architecture: Provides a centralized store and forward mechanism with some

transaction management. E.g for bank A to send message to bank B with a copy of

authorization with institution C, it formats the message according to standard and

securely sends it to SWIFT. Further SWIFT guarantees reliable and secure delivery to B

after an appropriate action by C.

10.10 Working of SWIFT

The S.W.I.F.T. network has an architecture that supports the requirements for a fully

redundant 24 x 7 secure operation that is also highly scalable.

There are a number of components to this X.25 protocol based packet switched

network.

The System Control Processors are responsible for the operation of the entire system.

This includes:

• Session Management

• Software and database distribution

• Monitoring all S.W.I.F.T. hardware and software

• Failure diagnostics and recovery

• Dynamic allocation of system resources.

These are located at Operating Centres, 2 in the US centre and 2 at the centre in the

Netherlands.

The Slice Processors [SP] are responsible for:

• Routing and safe storage of messages & history

• Safe-storage of acknowledgements to Regional Processors

• Generation of reports

• Delivery and non-delivery messages

• Processing retrievals and system messages


Page 14 of 25

• Archiving, billing and statistics.

All messages are safe-stored on two media. The SP's are located in the operating

centres.

The Regional Processors are the entry and exit point to S.W.I.F.T. and they support

leased line, dial up or public data network connection. The most common method is

primary leased line with dial-up backup. They are usually in same country as the user

and provide sequence number checking and message validation, temporary safe-

storage, generation of Positive and Negative Acknowledgements and verification of

checksums.

A Computer Based Terminal (CBT) that is also referred to as “S.W.I.F.T. interface” is

located at each user site. These terminals support the connectivity to the local regional

processor and facilitate both manual entry of messages and the bridge to originating

applications. Some more detail on the latter facility will be covered in next session.

There are many vendors of these interface devices although S.W.I.F.T. themselves have

by far the largest market share. The list of some of the more common ones is in Table

no. 10.1. The diagram 10.5 shows high-level architecture.

As stated above, access to the network is via the CBT and Smart Card technology is used

to access secure functions. Many functions require dual user and password input.

Initially a User will LOGIN to the GPA service and receive a GPA Acknowledgement. The

user then SELECTS the application or service that they wish to use, for example FIN. The

user can then send FIN messages to other users and the Regional Processor will either

send back a Positive (ACK) or Negative (NAK) acknowledgement for each message after

having safe-stored it.

The session then remains open for sending and receiving messages until the User

QUITS. The FIN service will acknowledge this before the User LOGOUT is selected. It is a

requirement of S.W.I.F.T. that the CBT is logged in to at least receive messages for at

least 7 hours per business day. All of the terms in upper case represent messages.

10.11 The Multi-vendor Network Environment

The most important aspect of the architecture is the co-existence of multiple IP network

providers, called network partners, [SWIFT has adopted a multi-vendor model called as

Network Partners for its secure IP network (SIPN)- like Equants, Infonet, AT & T, Colts]

each with a standard offering of managed IP-VPN [Virtual Private Network] services. See

figure 7.5 for the explanation given below.

Table No. 10.1 Vendors and their CBT

Sr. No Vendors CBT

1 S.W.I.F.T Alliance Access (NT and Unix)


Page 15 of 25

2 S.W.I.F.T Alliance Entry (NT)

3 S.W.I.F.T ST400 (VMS)

4 IBM Merva/ESA (Mainframe)

5 IBM(S.W.I.F.T.) Merva/2 (OS/2)

6 IBM(S.W.I.F.T.) Merva/AIX (AIX)

7 Logica Fastwire (Unix)

8 Logica Bess (Tandem)

9 Netik TurboSWIFT (NT and Unix)

10 Mint Mint

7.12 The Multi-vendor Network Environment

The most important aspect of the architecture is the co-existence of multiple IP network

providers, called network partners, [SWIFT has adopted a multi-vendor model called as

Network Partners for its secure IP network (SIPN)- like Equants, Infonet, AT & T, Colts]

each with a standard offering of managed IP-VPN [Virtual Private Network] services. See

figure 10.5 for the explanation given below.

Customers will be able to connect through one or more of these network partners

[Customers may connect directly or indirectly through a service bureau or have shared

connectivity], who will provide and install one or more M-CPEs (Managed-Customer

Figure 10.5 High level architecture [Irrespective of network protocol]

Premises Equipments) and local loops at the customer premises. The network partners

rout these connections over their IP networks to the Backbone Access Points, which are

under full control and ownership of SWIFT.

These Backbone Access Points are interconnected through the SWIFT-owned and

controlled fully resilient SIPN backbone network.


Page 16 of 25

The Backbone Access Points also serve as secure tunnel aggregators for customer

connections. These “tunnels” guarantee a fully transparent and secure SWIFT-controlled

data path through the IP-VPN networks. Therefore, SWIFT will have a VPN box installed

at the customer site to establish a secure end-to-end tunnel between the customer site

and the Backbone Access Point. By introducing IPsec-based security, SWIFT protects

itself and its customers against a number of possible risks at the network level. The

customer connection options (connectivity packs) contain sufficient flexibility to

address resilience and quality-of-service requirements.

The current SIPN Access Network will serve as one of the possible IP-VPN access

networks, alongside the offerings of the selected network partners.

Figure 10.6 Multi-vendor Network Environment

10.13 SWIFTNet- What is it?

When the SWIFT network was originally designed in the mid 1970's it used the most up

to date technology available at the time to support a secure and robust network

infrastructure. However, in the 1980's it became clear that due to the increased

membership and global presence of the network, the original 3270 based network

would not be able to cope with the volumes and throughput. So, by 1990 a new X.25

based network was brought on line with accompanying altered message formats to

implement enhanced addressing and security. Over the next few years the entire SWIFT

user base migrated onto this new service that at the time was referred to as SWIFT II. As

is always the case in technology and business, time moves quickly and consequently

the industry has, over the last couple of years, increasingly adopted internet

technologies and approaches to data transport and standardisation.


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Thus, SWIFT as a cooperative owned by its membership has implemented a new Secure

IP (Internet Protocol) network with associated services, products and message

standards. This approach has been given the name SWIFTNet Services (formerly known

as SWIFT Next Generation). Initially this architecture was rolled out in order to support

other industry initiatives such as CLS (Continuous Linked Settlement in Foreign

Exchange) and the now defunct GSTPA (Global Straight Through Processing

Association for Cross Border Securities trading). Over the last couple of years this

infrastructure has been adopted by many market infrastructures such as:

• New CHAPS Enquiry Link

• RTGSplus

• Clearstream

• C&S (NYCH)

• Euroclear

• OMGEO

• Reserve Bank of South Africa

SWIFT itself has also implemented Business Solutions that are or will be delivered over

this infrastructure, such as:

• SWIFTNet Accord

• SWIFTNet Affirmations

• SWIFTNet Bulk Payments

• SWIFTNet Cash Reporting

• SWIFTNet CLS Third Party Service

• SWIFTNet Corporate Actions

• SWIFTNet Data Distribution

• SWIFTNet Exceptions and Investigations

• SWIFTNet FIX

• SWIFTNet Funds

• SWIFTNet Trade Services Utility

• SWIFTSolutions for Corporates

• SWIFTSolutions for Payments Clearing

All the users in have migrated their existing X.25 FIN traffic (The ordinary MTnnn

messages) to the new network. This migration is over and was conducted on a country

by country basis with the major trading nations being allocated a number of slots. It is

important to note that the messages themselves have not changed the format, only

their transmission protocol. This is not the same as the messages changing to an XML


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format. During the second half of 2004 users that had not converted were fined up until

the X.25 network is decommissioned at the end of 2004.

Another facility that has been enabled by the introduction of SWIFTNet is support for

MA-CUG’s (Member Administered Closed User Groups). Effectively this allows members

to communicate with their corporate customers in a secure fashion without the

corporates being able to talk to each other, thereby, extending the reach of STP without

disintermediation.

10.14 SWIFTNet Services

SWIFTNet Services is the umbrella term for a range of related services that are available

over SWIFT's new Secure IP Network which allows the bank/financial institutions

transact through bulk movements, online transaction and SWIFT browser. In the X.25

SWIFT there were services such as FIN, GPA and IFT, in the same way the new network

has corresponding services.

SWIFTNet harnesses a new generation of XML-based standards that complement

existing FIN standards in the SWIFT Standards messaging portfolios. These are applied

according to agreed rules within a closed community.

The current release of SWIFTNet offers following services:

10.14.1 SWIFTNet FIN

SWIFTNet FIN is SWIFT’s core messaging service which enables financial institutions to

exchange individual structured financial message securely and reliably. It is used by

more than 7800 financial institutes across different business areas around the globe.

SWIFTNet FIN works on store-n-forward mode, which makes sure that the message is

delivered to all the recipients as soon as they are online. This removes the uncertainty

about whether or not one’s correspondents are online at the time one send the

message. It provides the ideal way to send individual instructions, confirmations and

reports to large number for correspondents, regardless of their geographical location or

time zone.

10.14.2 SWIFTNet FileAct

SWIFTNet FileAct allows secure and reliable transfer of files and is typically used to

exchange batches of structured financial messages and large reports.

It supports tailored solutions for groups and financial institutions. It is particularly

suitable for bulk payments, securities value added information and reporting, central

bank reporting and intra-institution reporting.

SWIFTNet FileAct works on store and forward mode. It provides the PKI security which

offers message authentication and integrity control.


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Each SWIFTNet FileAct file transfer is controlled for compliance with predefined Closed

User Group rules that determine which users can transfer files to which other users.

SWIFTNet FileAct enables you to limit the relative share of your communication

resources used for the transfer of files

10.14.3 SWIFTNet InterAct

SWIFTNet InterAct enables financial institutions to exchange individual structured

financial messages securely and reliably. It provides the ideal way to send individual

instructions, confirmations, and reports to large number for correspondents even in

different time zones. It provides a secure messaging using authentication, encryption

and integrity. Each message is controlled for compliance to closed used groups rules

that determine which users can send messages to which other users.

10.14.4 SWIFTNet Browse

SWIFTNet Browse enables users to browse on financial online portals made available by

financial institutions and market infrastructures on SWIFTNet. It combines the user

friendliness of the web and security of SWIFTNet. Financial institutions and market

infrastructures that make their web portals available on SWIFTNet benefit from a more

convenient and attractive delivery channel to their clients, while reducing costs and

improving the security and reliability of their services.

10.15 How These Services Are Accessed?

In order to access either of the above services there are a number of mandatory and

optional products:

• SWIFTNet Link

• SWIFTNet PKI

• M-CPE (Managed Customer Premises Equipment) or dial up line

• SWIFTAlliance Gateway (Optional)

• SWIFTAlliance Webstation (Optional)

Together these enable what SWIFT describes as the single window of access. Practically

speaking this means that with a single connection to the Secure IP Network an

organization can access not just other SWIFT members but also other market

infrastructures such as ICSD’s and VMU’s. This thereby offers the potential for

significant reduction in complexity of notifying other market participants and therefore

the ability to drive down operation costs.


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Figure 10.6 SWIFTNet Single Window

10.15.1 SWIFTNet Link

This is a mandatory component and is effectively the entry point to the Secure IP

Network (SIPN). It ensures the technical interoperability between sending and receiving

users. It is the consistent access point for all SWIFTNet Services both now and in the

future. It provides a set of API's that can be used to automate the sending/receiving of

messages, authentication and PKI in addition to time and date information. This bridge

ensures that end users or applications do not have to concern themselves with SWIFT

specific protocols or the specifics of load balancing. Applications and third party

vendors can therefore directly access the SWIFTNet Services by utilising the available

API's.

10.15.2 SWIFTNet PKI

This is a mandatory product that is installed with SWIFTNet Link and provides for the

use of digital certificates supporting Authenticity, Integrity, and Non-repudiation in

combination with a strong registration process.

10.15.3 M-CPE or Dial Up

Dial up over ISDN or PSTN is still available at speeds of 64Kbps and 33.6Kbps

respectively from SWIFTNet Link. It is, however, used for fall back purposes. In an M-CPE

(Managed Customer Premises Equipment) environment S.W.I.F.T. themselves are

responsible for the installation and operational management of the equipment (router)

and connection to the SIPN.

This second approach will not only support much higher connection speeds (up to

2Mbps) but also support remote monitoring of equipment by S.W.I.F.T. and the ability

of users to centrally monitor the status of branches and customers.


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10.15.4 SWIFTAlliance Gateway

SWIFTNet Link and SWIFTNet PKI have been fully integrated into the existing

SWIFTAlliance Gateway product. Although this is not a mandatory component it is likely

that many organisations that already have connections to SWIFT will continue to wish

to use this as the primary means of access.

10.15.5 SWIFTAlliance WebStation

This optional component will support direct user to application communication from a

desktop environment, for example, enabling users to interface directly to services such

as ACCORD for matching.

10.16 SWIFTNet Services messages

The introduction of a secure IP based network also had an effect on message standards.

Traditionally, users of S.W.I.F.T. have been restricted to the ISO7775 message set. Over

the past couple of years the industry has looked to implement a more data dictionary

based approach as can been seen by the introduction of the ISO15022 messages. With

SWIFTNet Services this has been taken to the next logical step, which is support for not

just common standards but also specialised standards, for example, within a particular

market. The aim is not just to support the syntactical rules but also to enable

encapsulation of the related processing rules.

Figure 10.7 SWIFTNet XML Standards

The migration to XML based message formats is well under way and the initial

deliveries of these have been in the Business Solutions such as “SWIFTNet Cash

Reporting” and “SWIFTNet Bulk Payments”. These messages are implemented using a

standard approach. There is a Global Message Template and then a number of Explicit

Variants each represented by XML schemas. For example there is a Bulk Credit Transfer

Template that has 4 variants.


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The XML messages also have the concept of explicit versions, i.e. as a message

definition changes it will be given a version number and unlike the current FIN

conventions it will be possible for two versions to be run in parallel for a period of time.

The frequency of new versions will also increase from the current yearly release to a

quarterly release.

The naming conventions will also change in the XML world as follows.

Figure 10.8 FIN and XML message identifier

10.17 Support

Technical support is provided through the centres located in Europe, Hong Kong,

Japan, and United States. SWIFT offers all customers 24 hour support via the Case

manager. Using this tool members can easily report, update and monitor the status of

cases. Technical support is also provided via telephone. Additional information on a

query or technical problem can also be sent via e-mail to [email protected].

10.18 Benefits of Using SWIFT

The benefits offered by SWIFT standard are three-fold and are mentioned below:

Ø Reduces manual operations

Ø Helps in avoiding errors and re-work

Ø Improves timeliness and reduces failures

Whereas the SWIFT network offers the following advantages:

Ø No need of other external network

Ø Reduction of common carrier and associated cost

Ø A single package can support several package of communication

Ø Secure telecommunications network supports messages that need a

dated acknowledgment and a guarantee of delivery

Ø SWIFT network provides immediate connectivity to almost all of their

potential counter parties and clearing banks and brokers

mailto:[email protected].


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Ø Ensures accurate accounting

Ø Easier and direct communication.

10.19 Reduction of Risks by using SWIFT

There are two types of risks that an investment manager of a bank faces–

• Domestic firm risk and

• Cross-broader firm risk.

Domestic firm risks - By using SWIFT, an investment manager can reduce this type of risk

using the following applications:

Ø Improve connectivity: Investment Managers can improve their

processing timeliness and their connectivity with the exchanges, the

clearing agencies and the depositories

Ø Move to interactive processing: Some of the small investors still using

overnight process of transaction, it can be reduce by using SWIFT

application to a single day

Ø Move settlement closer to the trade: By using T+3 settlement processes,

investment managers can reduce 40% of the settlement cycle. To reduce

the settlement process firm has to move settlement closer to trade.

Ø Get it right first time: The settlement process (if it takes longer) reduces

each firm's ability to recover from processing errors and settles routinely

on-time. To compensate this firm has to develop a methodology or

quality program called “Get it right first time”.

Cross-broader firm risks - S.W.I.F.T. can help reduce the risks of the firms by providing

the structure to standardize the communication format for securities, cash

management, and foreign exchange processing. It gives opportunities for automated

exception-based processing, risk control, and cost reduction. Many financial institutions

use SWIFT software application like

Ø Settlement instruction processing

Ø Securities trade confirmation matching

Ø Custodial reconciliation and reporting

Ø Payments and cash management processing

Ø Foreign exchange confirmation matching and netting

These software applications help the transaction process and reduce risks of the

investment manager.


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SWIFTNET Products and Services:

It provides a complete range of end to end SWIFT solutions covering every aspect of

financial services processing. E.g payments and cash management, treasury and

derivatives, pre- settlement, clearing and settlement

10.20 Summary

• S.W.I.F.T. is an acronym for Society for Worldwide Interbank Financial

Telecommunications.

• SWIFT was established in 1973 by European bankers who needed a more

efficient and secure system for interbank communications and transfer of funds

and securities.

• The Society is owned by its members, and in order to become one, the

organization must hold a banking license.

• In 1977 when SWIFT went live it was 3270 based network. In 1990 X.25 protocol

based network was adopted to support burgeoning message traffic. In 2004

TCP/IP was adopted to offer interactive services.

• There are a large number of uses of SWIFT in corporate, banks, government

institutions, settlement systems, clearance systems, payment systems, stock

exchanges etc.

• Services offered by SWIFT: GPA, FIN, IFT, ACCORD, directory services etc.

• SWIFT offers following services in three key spaces

1. Bank to bank

2. Market Infrastructures

3. Bank to corporate

• SWIFTNet Services is the umbrella term for a range of related services that are

available over SWIFT's new Secure IP Network which allows the bank/financial

institutions transact through bulk movements, online transaction and SWIFT

browser.

• It offers important benefits like:

Reducing manual operations, avoid errors and rework, improve timeliness and

reduce failures.


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12.16.3 Regulation E ......................................................................................................................21

12.16.4 Uniform Commercial Code Form UCC-4A (UCC4A) .........................................22

12.17 Summary..................................................................................................................................22

12.4 CHIPS-An Introduction

CHIPS, Clearing House Inter-bank Payments System, are a premier bank-owned

payments system in USA for clearing mainly large value payments. CHIPS are a real-

time, final payments system for U.S. dollars that use bi-lateral and multi-lateral netting

for maximum liquidity efficiency. CHIPS has developed and maintained a reputation of

reliability, efficiency and innovation in the marketplace by processing over 95% of the

USD cross-border payments. CHIPS are a privately operated, real-time, multilateral,

payments system typically used for large dollar payments. CHIPS are owned by financial

institutions, and any banking organization with a regulated U.S. presence may become

an owner and participate in the CHIPS network.

Since January 2001, CHIPS has been a real-time final settlement system that

continuously matches, nets and settles payment orders. This system provides real-time

finality for all payment orders released by CHIPS from the CHIPS queue.

12.5 Types of Payment Transaction Executed through CHIPS

• Large and small payment transactions

• U.S. dollar foreign exchange settlements

• Financial settlements (ex. Loan and interest payments)

• Commercial payments

• Off shore investments.

12.6 Features of CHIPS

12.6.1 Real-time, Multilateral Netting with Payment Finality

As the name suggests CHIPS payment systems provides clearance of large value

transaction in real time without delaying and following the feature of Multilateral

Did you know? CHIPS is the only large value system in the world that has the

capability of carrying extensive remittance information for commercial payments.

CHIPS processes over 320,000 payments a day with a gross value of $1.6 trillion. It is

a premier payments platform serving large banks from around the world,

representing 19 countries world wide.


Page 5 of 23

Payment Finality- a patented process that maximizes the use of liquidity, which reduces

daylight overdraft charges. A single dollar in the CHIPS system is reused many times by

the netting system to clear payments throughout the day.

12.6.2 Global Processing Hours

CHIPS have facilitated global electronic commerce by expanding its processing hours.

CHIPS processes transactions beginning at 9 pm for payments valued for the next

business day. Key benefits of global processing hours include:

• Real-time finality for U.S. dollar payments during the entire Asian business day.

• Better positioned to compete with the local US dollar clearings that have been

established in Asia.

Ø Improving operating efficiency

Ø Improving liquidity management.

• Concentration of USD clearing into CHIPS makes one’s payments clearing more

efficient, more certain and reduces risk for the bank and its customers.

12.6.3 Straight-through Processing Rate

96% of CHIPS payments require no manual intervention by the receiving institution. CHIPS

make automatic posting and funds available immediately. Hence following are the

advantages of having such a low STP rate:

• Operationally efficient

• Reduces expenses

• Ability to offer better customer service

• Saves time

• Corporate customers are confident their payments are accurate

• Faster processing and credit notices.

12.6.4 Eliminates Daylight Overdraft Charges

Unlike Fedwire, CHIPS has no overdraft charges. Daylight overdraft charges are fees a

bank pays as a result of creating overdrafts in its reserve account at the Federal Reserve

Bank. These overdrafts are due to insufficient funds to settle a particular payment or

balance requirement. Since CHIPS is a payments system that does not permit overdrafts

there is no need for a fee. It is estimated that banks pay approximately $36MM annually

in daylight overdraft charges for using Fedwire.

12.6.5 Maximizes Liquidity - $1 turns over 500 times

Each day, CHIPS participants fund the system with balances that facilitate the

processing of the day’s payments. Using CHIPS’ netting process, one only needs to fund


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a fraction of one’s total payments for the day, which frees up bank’s liquidity for other

cash management purposes. In CHIPS, a dollar turns over 500 times per day. With only

$2.8 billion in prefunding, CHIPS is able to process payments worth more than $1.4

trillion each day.

Figure 9.1 Funding requirements of CHIPS

12.6.6 Payments on Demand Capability

This feature gives participants the ability to add funds intraday in order to guarantee

the immediate release of a payment. A significant operational benefit of Payments on

Demand is that it does not require any system changes. Other key benefits include:

• Speed & Control: Payments are released and settled immediately

• No additional cost incurred

• Global access to Payments on Demand via CHIPS Online Management Tools

• Payment flow significantly improved

• Preserves current liquidity efficiency ($1 turns over 500 times per day!).

12.6.7 Remittance Information Delivery

This capability allows the participants of CHIPS to provide their corporate customers

with the remittance details they need - customer numbers, invoice numbers, discounts

taken, and more- together with each electronic payment. (Messages can carry up to an

additional 9,000 characters.) This allows for:

• Speed: Straight-through processing without manual lookup and faster

reconciliation of customers' accounts receivables.

• Security: Keeps information private to help reduce fraud

• Accuracy: Accounts are updated on a daily basis

• Reduction in errors

• Promotion of electronic transactions


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12.6.8 Alternative to Fedwire for Contingency Planning

As a payments utility, CHIPS is dedicated to providing a system that is price

competitive, safe, sound and reliable. As an alternative to Fedwire, CHIPS assures a level

and competitive playing field, which translates into real dollar savings. And with

increasing emphasis on business continuity and resilience, CHIPS has an additional

strategic role as an alternative to Fedwire in the event that a major crisis occurs.

While the resiliency of the CHIPS system has never been stronger, in light of heightened

security concerns facing every business today, CHIPS established a third data site. This

additional site operates as CHIPS' third hot backup site, fully mirroring all transactions

that are processed at the primary data center. This ensures that even if the primary and

secondary sites become unusable, the third site is capable of carrying out the rest of the

day’s transactions and operates as the main data center until operations are restored in

the primary or secondary center.

CHIPS also works with the Fed on industry initiatives:

• Synchronizing quarterly test dates. CHIPS and the Fed now permit banks to

test their backup capabilities simultaneously, thus saving time and money

• Standardizing message formats. This enhances interoperability between the

two systems.

12.6.9 Universal Identification Numbers (UIDs)

This extensive database quickly and accurately verifies and matches corporate

customers with their bank account information. With this unique feature, one only

needs to use the bank and UID number to process any transaction, so one’s corporate

customers can be rest assured that their private account information will stay that way.

• Accurate: Accounts are updated daily to keep information current

• Secure: Keeps account information private to help reduce fraud

• Allows for Straight-through processing without manual lookup.

12.7 Working of CHIPS

Since January 2001, CHIPS has been a real-time final settlement system that

continuously matches, nets and settles payment orders. On a daily basis, the new

system provides real-time finality for all payment orders released by CHIPS from the

CHIPS queue.

To achieve real-time finality, payment orders are settled on the books of CHIPS against

positive positions, simultaneously offset by incoming payment orders, or both. To

facilitate this process, the Federal Reserve Bank of New York established a CHIPS

prefunded balance account (CHIPS account).


Page 8 of 23

Under the real-time finality arrangement, each CHIPS participant has a pre-established

opening position requirement, which, once funded via a Fedwire funds transfer to the

CHIPS account, is used to settle payment orders throughout the day. A participant

cannot send or receive CHIPS payment orders until it transfers its opening position

requirement to the CHIPS account.

Opening position requirements can be transferred into the CHIPS account any time

after the opening of CHIPS and Fedwire at 12.30 am ET; all participants must transfer

their requirement no later than 9 am ET. During the operating day, participants submit

payment orders to a centralized queue maintained by CHIPS.

An optimization algorithm searches the centralized queue for payment orders to settle,

subject to restrictions contained in CHIPS Rule 12. When an opportunity for settlement

involving one, two or more payment orders is found, the optimization algorithm

releases the relevant payment order(s) from the central queue and simultaneously

marks the CHIPS records to reflect the associated debits and credits to the relevant

participants’ positions.

Participants may remove payment orders from the queue at any time prior to the daily

cutoff time for the system (5 pm ET). Debits and credits to the current position are

reflected only in CHIPS records and are not recorded on the books of the Federal

Reserve Bank of New York. Under New York law and CHIPS Rules, payment orders are

finally settled at the time of release from the central CHIPS queue.

At 5 pm ET CHIPS attempts to match, net, set off and release as many of the remaining

payment orders as possible, although no participant is allowed to incur a negative

position. As soon as this process is complete, any unreleased payment orders remaining

in the queue are tallied on a multilateral net basis. The resulting net position for each

participant is provisionally combined with that participant’s current position (which is

always zero or positive) to calculate the participant’s final net position; if that position is

negative, it is the participant’s “final position requirement”.

Each participant with a final position requirement must transfer, via Fedwire, its

requirement to the CHIPS account. These requirements, when delivered, are credited to

participants’ balances. Once all of the Fedwire funds transfers have been received,

CHIPS is able to release and settle all remaining payment orders.

After completion of this process, CHIPS transfers to those participants who have any

balances remaining the full amount of those positions, reducing the amount of funds in

the CHIPS account to zero by the end of the day.

Let’s take an example to understand more about the working of CHIPS.

When Bank A has to pay $500 million to Bank B, and Bank B has to pay $500 million to

Bank A), without any actual movement of funds between CHIPS participants.


Page 9 of 23

Other payments are netted multilaterally. Suppose Bank A must pay $500 million to

Bank B, and Bank A is also expecting to receive $500 million from Bank C. Without

netting, Bank A would send $500 million to Bank B, and it would thus experience a

decline in its available cash while it was awaiting the payment from Bank C.

Using the CHIPS netting system, however, Bank A submits its $500 million payment for

Bank B to a payments queue, where it waits until Bank C’s offsetting payment is

received. The effect of matching and netting these payments is that Bank A’s cash

position is simultaneously reduced by its payment to Bank B and increased by receipt of

its payment from Bank C.

The overall effect on Bank A’s cash position is thus zero.

Let’s look at the Net Settlement Periodic Process at CHIPS.

Scenario: Bank A in Paris instructs its New York branch to pay $1 million to Bank B for

deposit in the account of the software company XYZ Inc. (Refer figures 9.2 below for

diagrammatic representation of the scenario)

Figure 12.2 Working of CHIPS Courtesy: www.chips.org

1. Prefunding: Bank A, NY branch is part of the banks that jointly maintain an account

with FED used for CHIPS settlement. Every day morning before CHIPS operations start,

Bank A needs to send pre-funding to this account. Let’s assume bank A transfers $ 50

million in pre-funding.

(Pre-funding is money a bank needs to transfer to the joint CHIPS settlement account in

order to start clearing using CHIPS network. This is calculated once in a week, based on

http://www.chips.org


Page 10 of 23

transactions done by the bank, average outstanding balance etc. Pre-funding amount has

to be transferred to CHIPS account before 9am EST on every business day.)

2. Bank A Paris branch sends a MT202 (Message Type 202 – special SWIFT message for

financial institution transfers) to its NY branch instructing it to transfer $1 million to

beneficiary XYZ Inc. having account with beneficiary bank B.

3. Payment system at Bank A NY branch receives the MT202 and decides to transfer the

money using CHIPS network.

4. Bank A sends a payment message to CHIPS network

5. Assume that bank A had a net negative position with Bank B of $ 100 million

6. The message is received and is put into CHIPS central queue. The net negative

position is incremented to $101 million.

7. Through the course of the day Bank B sends payment messages to CHIPS in favor of

bank A. The amounts in these messages would go towards reducing the negative

balances in the CHIPS central queue.

8. When payments worth $ 110 million (or any amount => $ 101 million) are received

from bank B in favor of bank A, the CHIPS system releases the relevant payment orders

from the central queue and simultaneously marks the CHIPS records to reflect the

associated debits and credits to the relevant participant’s positions. Debits and credits

to the current position are reflected only in CHIPS records and are not recorded on the

books of the Federal Reserve Bank of New York.

9. Under New York law and CHIPS Rules, payments orders are finally settled at the time

of release from the central CHIPS queue. The figure below (titled: Typical CHIPS transfer)

gives diagrammatic depiction of the scenario discussed above

Consider a variation of this scenario to understand end of the day settlement

better. (Steps 1 through 6 remain the same):

Ø 7a Through the course of the day Bank B sends payments worth $ 60 million to

bank A.

Ø 8a. CHIPS algorithm immediately converts those $ 60 million into final

payments by matching it against $ 60 million that bank A needed to bank B.

Ø 9a. Thus, going into the close of business (5 pm EST), bank A still ended up with

a debit balance of $ 41 million ($101 mil - $ 60 mil).

Ø 10a Soon after 5 pm EST, CHIPS aggregates any unreleased payment orders

remaining in the queue on a multilateral net basis.


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Ø 11a. Assume that on this particular day, Bank A had debit balance with 3 other

banks running into $ 200 million and credit balance with 4 other banks running

into $150 million.

Ø 12a. CHIPS determines the resulting net position for bank A to be $ 91 million

(Dr.) (= $ 41 million + $ 200 million - $ 150 million).

Ø 13a. Assume that Bank B had a net position of $ 100 million (Cr.), bank C has a

net position of $ 400 million (Cr.) and bank D had a net position of $ 409 million

(Dr.)

Ø 14a. CHIPS computes the final net position for bank A to be $ 41 million (= $ 50

million in pre-funding less EOD net position). As this position is negative, it is the

participant’s “final position requirement.”

Ø 15a. Each participant with a final position requirement must transfer, via

Fedwire Funds Service, this second round of pre-funding to the CHIPS account.

Ø 16a. Bank A transfers $ 41 million to CHIPS joint account held at FED.

Ø 17a. Once all of the Fedwire Funds Service funds transfers have been received ($

41 million from bank A and $ 409 million from bank D), CHIPS is able to release

and settle all remaining payment orders.

Ø 18a. CHIPS will thus be able to transfer balance payments to bank B and bank C.

Ø 19a. After completion of this process, the amount of funds in the CHIPS account

will reduce to zero.

Ø 20a. In the event that less than all final position requirements are received,

CHIPS settles as many payments as possible, subject to the positive balance

requirement, and deletes any remaining messages from the queue. Participants

with deleted messages are informed of which messages were not settled, and

may choose, but are in no way required, to settle such messages over Fedwire

Funds Service.


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12.8 The Owner Banks of CHIPS

Figure 12.3 Typical CHIPS transfer

12.9 Facts about CHIPS

• Transfers an average total value of $2 trillion a day, with only $3.5 billion in pre-

funding.

• Clears over 350,000 transactions on an average day.

• 85% of all payments are processed through system by 12 pm each day.

• Handles 95% of all U.S. dollar cross-border payments.


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• Only U.S. real-time payments system with Remittance Information Delivery

capability (This capability allows corporate customers with the remittance

details they need - customer numbers, invoice numbers, discounts taken, and

more- together with each electronic payment)

• 37 years of experience, knowledge and reliability.

• Customers represent 19 countries from around the world.

Figure 12.4 Average Daily Volumes and Value of CHIPS Source: www.chips.org

12.10 Automated Clearing House

The Automated Clearing House (ACH) is a network for electronically exchanging funds

and related information among individuals, businesses, financial institutions, and

government entities. ACH rules and regulations are established by the National

Automated Clearing House Association (NACHA). Private ACH operators and other local

and regional ACH associations provide input into the rules. The payments transferred

over the ACH have represented recurring credit payments intended for the accounts of

the receivers. Typical payments are salaries, consumer and corporate bill payments,

interest and dividends, and Social Security and other entitlement programs originated

by the U.S. Treasury. The ACH has the ability to process large volumes of payments

efficiently and to allow an originator to debit the banking account of the payer because

http://www.chips.org


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of which it is increasingly used for other types of payments, such as insurance

premiums, purchases of stock, and consolidation of corporate cash balances also.

12.11 How the ACH works? (A timeline)

• The Automated Clearing House (in simpler way, known as "Automatic Check

Handling") was in 1972, first established in California, by a joint venture

between banks and the regional Federal Reserve to facilitate checks with

paperless transactions.

• Very soon, more ACH associations were established, with agreements made

between the associations and their corresponding regional Federal Reserve

Banks to operate regional ACH networks.

• The National Automated Clearing House Association was established in 1974 to

coordinate efforts to develop a nationwide ACH network, ultimately succeeding

in 1978, when all ACH networks nationwide were electronically linked.

• In 1980, the ACH Network was changed slightly by the passage of the Monetary

Control Act, which allowed for private sector ACH Operators to compete with

the Federal Reserve Bank. There are now three recognized private sector ACH

Operators: American Clearing House Association, the New York Automated

Clearing House, and VisaNet ACH Services.

• It's expected that more private sector clearing houses will emerge in the near

future.

• Currently, the FED ACH Operator (Federal Reserve) handles more than 85% of

ACH transactions. The ACH Network is what is responsible for allowing such

services as online bill pay, direct deposit, and direct debiting, and has proven to

be a viable, faster and more cost effective alternative to paper check processing.

• It consists of more than 12,000 financial institutions, 650 industry councils, and a

network of regional ACH associations, and is governed by NACHA - The

Electronic Payments Association in Herndon, Virginia.

12.12 The ACH Network

The Federal Reserve is the principal ACH operator, distributing ACH transactions through

Fedline. There are also over 20 private sector operators, such as EastPay, Inc., Mid-

America Payment Exchange, Visa U.S.A., Payment Resources One, and Western

Payments Alliance.

All participants in the network fall into one or more of these six categories:

1. Originator - The Originator is the entity that agrees to initiate ACH entries into the

payment system according to an arrangement with a Receiver. The Originator is usually


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a company directing a transfer of funds to or from a consumer or another company’s

account. In the case of a consumer-initiated entry; however, the Originator may be an

individual initiating funds transfer activity to or from his or her own account.

2. Originating Depository Financial Institution (ODFI) – An institution that receives

the payment instruction from the Originator and forwards the entry to the ACH

operator.

A DFI may participate in the ACH Network as a RDFI (see below) without being an ODFI;

however, if a DFI chooses to originate ACH entries, it must also agree to act as an RDFI.

3. ACH Operator - A central processing facility operated by the Federal Reserve Bank or

other private sector organization. The operator receives electronic entries from ODFIs

and distributes entries to the appropriate RDFIs (see figure 9.5 below), and performs the

settlement functions for the affected financial institutions.

4. Receiving Depository Financial Institution (RDFI) – is a financial institution, which

receives ACH entries from the ACH Operator and posts to the receiver (depositor)

account.

5. Receiver – An individual or organization, which has authorized an Originator to

initiate an ACH entry to the Receiver’s account with the RDFI.

6. Third Party Processor - A third party processor may serve as an agent for an ODFI or

RDFI. The ODFI and RDFI are still responsible for compliance with ACH rules and

regulations.

A Herald News page says:

Western Union is diversifying its portfolio of services beyond consumer-to-consumer

money transfers (which accounted for 80 percent of total money transfer revenues in

2002). Western Union now offers ACH payment services to businesses. Western Union’s

Phone Pay service enables businesses such as utility companies to receive payments

from their customers over the telephone, verify the authenticity of the bank account

information, batch and transmit the transactions to Western Union for processing and

archiving. Western Union sends the ACH information to the Federal Reserve Bank daily.

The Corporate Payments service enables businesses to make domestic and cross-

border payments online via instruments such as ACH, checks, wire transfers and foreign

currency drafts.


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12.13 ACH System Operations

The ACH system supports both credit and debit transactions. In credit transactions, funds

flow from the Originator’s account through the ODFI to an account held by the receiver at

the RDFI. For ACH debit transactions, the funds flow from the receiver’s account at the RDFI

through the ODFI to the account of the Originator.

Examples of ACH Credits Examples of ACH Debits

• Payroll direct deposits • Insurance premium collections

• Social Security payments • Mortgage and loan payments

• Dividend and interest payments • Consumer bill paying

• Corporate bill payments to customers • Corporate cash concentration

ACH data transmissions always flow in the same direction i.e. are unidirectional- from

Originator to the ODFI to the ACH operator to the RDFI. This is true whether the item is

a debit or a credit. For credits, the ODFIs settlement account is debited and the RDFI’s

settlement account is credited. For debits, the ODFIs settlement account is credited and

the RDFI’s settlement account is debited.

Figure 12.5 ACH workflow

The following are the steps for ACH origination:

1. The Originator (individual or business account holder) initiates a payment order to

the ODFI;

2. The ODFI transmits the payment information to the ACH operator;

3. The ACH operator receives data from the ODFI and sorts the entries by routing

number;

4. The entry is transmitted to the RDFI; and

5. The RDFI receives, processes, and posts the ACH data to the receiver account on

settlement day.

ACH return items flow from the RDFI to the ACH Operator to the ODFI. The ODFI must

notify the Originator of return items. Third party processors may become involved at

any step in the process. They may prepare files and send them to the ACH Operator on


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behalf of ODFI or they receive them on behalf of the RDFI. Regardless of the role third

party processors play, the responsibility for rules adherence and liability falls on the

appropriate financial institution using the third party processor.

Did you know?

FedACH International Services FedACH International Services, which is owned and

operated by the Federal Reserve System, currently supports ACH payments from the

U.S. to Canada. The Federal Reserve Bank of Minneapolis and Toronto Dominion Bank

serve as conduits to the U.S. and Canadian payment systems, respectively, and each

country is governed by its own domestic clearing rules and practices. The Federal

Reserve Bank of Minneapolis acts as the Originating Gateway Operator (OGO) for these

U.S. to Canada transactions, and Toronto-Dominion Bank acts as the Receiving Gateway

Operator (RGO).


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12.14 Payment Flow at ACH

Figure 12.6 Workflow of payments through ACH


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Did you know?

The number of ACH payments grew USD 2.9 billion to USD 9.1 billion between 2000

and 2003, for an annual growth rate of 13.4 percent. ACH debits grew faster than ACH

credits. Debits made up 39 percent of all ACH payments in 2000 compared to nearly

half (47 percent) in 2003. The growth in the number of ACH debits is due largely to the

conversion of some check payments to ACH payments.

12.15 ACH Uses

The ACH Network supports a number of different payment applications. A unique

Standard Entry Class (SEC) code identifies each application and the related ACH record

format used to carry the payment and payment-related information. An Originator

initiates entries into the system, authorizes either a debit or credit, which affects either a

consumer or a business account at the RDFI.

Listed below are SEC codes and the different products each code supports. This list is

not all-inclusive since new codes are always being developed and used.

12.15.1 Consumer Applications

1. Pre-arranged Payment and Deposit Entries (PPD) include both Direct Deposits and

Direct Payments, as follows:

a) Direct Deposit is a credit application that transfers funds into a consumer’s

account at the RDFI. These funds represent a variety of products (e.g., payroll, interest,

and pension.); and

b) Direct Payment (Pre-authorized Bill Payment) is a debit application.

Companies with billing operations may participate in the ACH Network through the

electronic transfer (direct debit) of bill payment entries. Through pre-established or

single entry written authorizations, the consumer grants the company authority to

initiate periodic charges to their account. Examples of recurring bills paid by ACH

include insurance premiums, mortgage payments, and installment loan payments. An

example of a non-recurring bill (i.e., the amount varies) paid by ACH is utility payments.

2. Point of Sales Entries and Shared Network Transactions (POS and SHR) are two SEC

codes, which are most often initiated by the consumer via a plastic access card. They

represent point of sale debit applications in either a shared or non-shared environment;

3. Machine Transfer Entries. The Network supports the clearing of transactions from

Automated Teller Machines (ATMs); and

4. Customer Initiated Entries (CIE) are limited to credit applications where the consumer

initiates the transfer of funds to a company for payment of funds owed, typically

through some type of home banking product.


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12.15.2 Corporate Applications

1. Cash Concentration or Disbursement (CCD) can be either a credit or a debit

transaction where funds are either disbursed or collected between corporate entities.

This application can serve as a stand-alone funds transfer or it can support a limited

amount of payment-related data with the funds transfer.

2. Corporate Trade Exchanges (CTX) support the transfer of funds (debit or credit)

within a trading partner relationship in which a full (ANSI ASC X12) message or

payment-related (UN/EDIFACT) information is sent with the funds transfer. Upon

receiver request, the ODFI must provide all payment related information in the

addenda records transmitted with CCD and CTX entries. The information must be

provided by the opening of business on the second banking day following the

settlement date of the entry.

12.16 Applicable Regulations

12.16.1 ACH Rules

NACHA ACH Rules are published annually and incorporate rules approved by the

NACHA board. The NACHA is a self-regulated body, which depends on users’

compliance with ACH rules for the system to operate efficiently. The rules provide

warranties and indemnification requiring entries to be originated, received, and

returned promptly.

ODFIs are responsible for most of the warranties and indemnifications; however, many

responsibilities pass through the ODFI to the Originator. The warranties and

indemnifications reside mostly with the ODFIs and Originators because they have

primary control over the initiation of entries. The passing through of responsibility to

the Originator relies heavily if not exclusively on the agreements between the ODFI and

the Originator.

Responsibilities of ODFIs include:

1. Ensuring entries are properly authorized;

2. Submitting timely entry of transactions into the ACH system;

3. Terminating the origination of entries, when appropriate;

4. Meeting requirements for data security and personal identification numbers in

certain applications;

5. Ensuring the entries contain the appropriate information;

6. Assuring an agreement is in place with Originators and sending points; and

7. Complying with ACH rules.

The ODFI indemnifies the RDFI, ACH operator, and ACH association against loss when

breaching any of these warranties. NACHA may require ODFIs that fail to adhere to the


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ACH rules to reimburse an RDFI or ACH operator for claims, losses, or expenses

(including attorneys’ fees and costs) that result directly or indirectly from breach of

warranty. Thus, a failure to comply with the warranties may result in a loss to an ODFI.

ODFIs assume responsibility for most warranties related to ACH transactions. The RDFI

warrants to each ODFI, ACH operator and ACH association that the law permits it to

receive entries allowed by the ACH rules. RDFI also warrants it is in compliance with the

rules concerning RDFIs and participating DFIs.

Responsibilities of RDFIs:

1. Receiving and validating all ACH entries;

2. Posting to receiver’s accounts;

3. Validating pre-notifications;

4. Returning entries which do not post within proper time frames;

5. Handling remittance data as required by the receiver;

6. Making funds available to the receiver within proper time frames; and

7. Fulfilling responsibilities when a receiving point is used.

Did you know?

According to the Mid-America Payment Exchange, ACH is used for Direct Deposit by

70% of all Social Security benefit recipients, 46% of the U.S. workforce, and 96% of all

Federal Government employees. Direct Deposit saves time and money for both

employers and employees, making it one of the fastest increasing services of the ACH

Network. Some financial institutions will also waive your account fees if you use Direct

Deposit!

12.16.2 Electronic Funds Transfer Act (EFTA)

The EFTA provides for rights and duties of consumers and financial institutions

regarding electronic funds transfers. EFTA covers both private sector and government-

initiated transfers.

12.16.3 Regulation E

Regulation E was issued by the Federal Reserve Board of Governors implementing EFTA

to ensure consumers have a minimum level of protection in disputes arising from

electronic funds transfers.


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12.16.4 Uniform Commercial Code Form UCC-4A (UCC4A)

UCC4A was developed in part for funds transfers, but also applies to wholesale

(institution-to-institution) ACH credit transactions and certain ACH credit transactions

not subject to the EFTA.

12.17 Summary

• CHIPS is a premier bank-owned payments system in USA

• CHIPS payments require no manual intervention by the Receiving institution up

to 96% of the time

• CHIPS has no overdraft charges

• In CHIPS a dollar turns over 500 times per day

• Comparing CHIPS to Fedwire, it assures competitive playing field

• CHIPS requires UID Universal Identification Number for any process of

transaction and hence secure

• ACH is a network for electronically exchanged funds

• Federal Reserves is the principal ACH operator

• ACH system supports both credit and debit transaction.

• The NACHA is a self-regulated body, which depends on users’ compliance with

ACH rules for the system to operate efficiently.

Page 1 of 11

Chapter-19 Mobile Payments

V 2.0, April 2009

for associates

Certification Program in Payment Systems Competency V_2.0


Page 2 of 11

Confidentiality statement

This document should not be carried outside the physical and virtual boundaries of TCS

and its client work locations. The sharing of this document with any person other than

TCSer would tantamount to violation of confidentiality agreement signed by you while

joining TCS.


Page 3 of 11

Chapter-19 Mobile Payments

19.1. Introduction

The payments landscape is full of alternative payment systems. One out of them, which

would capture populace’s eye in near future, is M-payments. M-payments or Mobile

payments are a ubiquitous method of carrying out transactions of different deals and

purchases through a mobile device. This session is focused on the same, i.e. Mobile

payment system.

19.2. Learning Objectives

After completing this session, you will learn

• Nuances of the Mobile or M-payments

• Types of mobile payments

• Process involved in a M-payment cycle

• Various players in the M-payment cycle

• Various technology vendors and their role.

19.3. Topics Covered

Chapter-19 Mobile Payments...................................................................................................................... 3

19.1. Introduction.............................................................................................................................. 3

19.2. Learning Objectives .............................................................................................................. 3

19.3. Topics Covered........................................................................................................................ 3

19.4. Mobile payments [M-payments]...................................................................................... 3

19.5. Macro and Micro Payments in M-payment scenario .............................................. 4

19.6. Types of Mobile Payments ................................................................................................. 4

19.7. Mobile Transaction (Payment) Model ........................................................................... 5

19.8. Mobile Payment Cycle ......................................................................................................... 6

19.9. Requirements for Adopting a Mobile Payment System........................................ 7

19.10. The Payment Process............................................................................................................ 7

19.11. Various Players and their Benefits................................................................................... 8

19.12. Roles of the technology vendors..................................................................................... 9

19.13. Summary..................................................................................................................................10

19.4. Mobile payments [M-payments]

Mobile payment refers to customer paying for goods /services purchased by him using

mobile devices through mobile network. It is done by using mobile device (Cell phone,

PDA etc) that is connected to payment gateway through mobile service provider (like

Airtel, Hutch etc) network. Service provider server is connected to bank server using

which merchants perform authentication and authorization function, and subsequently


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presented with confirmation of the completed transaction. Due to high penetration of

mobile phones, m-payments are expected to grow at high pace. It is similar to e-

payment with the difference being m-payments have limited resources and limited user

interface.

Based on the mode of operation, the infrastructure and the equipment deployed, M-

Payment is seen to encompass three basic components:

• It involves transaction of monetary value

• It involves mobile or wireless communication devices and services

• It involves wireless telecommunication operators.

19.5. Macro and Micro Payments in M-payment scenario

Mobile payments can be divided into micro and macro payments depending on the

amount paid by the customer. Micro payments refer to payment of approximately $10

or less. Generally, this is payment made by customer for downloading mobile contents

like games, videos, ringbones etc. Macro payments refer to larger volume payments

such as online shopping, ticket etc.

Distinction in both type of payment is required because both types of transactions have

different security (authorization) needs. For micro payment, only SIM authentication is

sufficient but a macro payment transaction is done through trusted financial

institutions. Emerging future models for m-payment will lead banks to play a dominant

role. Mobile phones simply provide another way for users to access and transact their

bank accounts.

19.6. Types of Mobile Payments

There are two types of mobile payments

Ø Remote payments

Ø Proximity payments


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As the name depicts, remote payments are those payment applications where payer

and payee are far apart or no point of sale (POS) equipment (like a POS Hardware or

Software is available. While in proximity payments the transaction takes place between

a point of sale equipment and the mobile handset. Remote payments can be initiated

by using any of the modes, SMS or WAP and proximity payments can be triggered by

using RFID (radio frequency identification) tags which can be incorporated into the

mobiles.

19.7. Mobile Transaction (Payment) Model

Mobile transaction payment model can be explained using matrix as shown in figure

19.1. There are four quadrant- Macro payment /micro payment and remote /local.

Figure 19.1- Mobile transaction (payment) model

Four quadrants are explained as follow–

• Micro/Remote Payment Proximity (1st quadrant)– It Starts with the

introduction of Value added services such as cricket score, downloadable ring

tones. This type of payment is growing fast with customized products .The

market has grown to the size of over $1 Billion for this segment.

• Macro/Remote Payment proximity (2nd quadrant)- This type of payment

include top-up of prepaid accounts without using scratch card directly from

customers account using mobile. Example- Physical goods purchasing like

books etc.

• Macro/Local Payment Proximity (3rd quadrant)-Local payment has greater

growth potential because using regular payment system customer has to face a

longer lead time like ticketing system, fast food etc.


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• Micro/Local payment proximity (4th quadrant) - This quadrant represent

customer paying small value payments (generally regular services) using mobile

phone. This include payment such as toll, parking etc

Figure 19.2–Mobile Payment Life Cycle Source: Mobile payment Forum white paper

Local business is high growth emerging segment for the mobile transactions.

19.8. Mobile Payment Cycle

Due to high penetration of mobile phones it provides a very lucrative platform to the

merchants. All over the world the data services growth rate is much higher than the

voice services growth rate. Figure 19.2 shows payment life cycle for the remote micro

payment proximity. In the mobile environment, the transaction dynamics are similar,

although the transaction network is different. Payment life cycle can be divided into

following four steps -

• Set-up and configuration of the payment mechanism

• The initiation of the payment

• Authentication of the user

• Completion of the payment

• First phase in mobile payment life cycle is Setup and configuration. Generally it

is one time process, which may include mobile wallet, new mobile device or

new SIM card. This also include selection of the network by the provider,

whether to go for OTA (open to air) or WAN and also this step includes some

other critical parameters.

• Second step is payment initiation. It involves transferring payment information

over the network or wireless protocol to the merchant. In this step some form

filling standards are created for uniformity. Standardization includes defining a

set of minimum requirements for authenticating the user based on SIM on a

GSM handset whereas two ways messaging involve universal interface for

requests like servers.


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• Authentication is the most important element of any payment transaction. In

mobile payment transaction, two types of authentication processes are

employed-one is two ways messaging and other is SAT (SIM alliance Toolkit).

• Payment completion is the last element of the payment life cycle. This process

takes place once cardholder’s detail has been authenticated and transaction is

authorized. In real term it means the printing receipt for the actual fund transfer.

Benchmarking this entire step assures secure user mobile experience.

19.9. Requirements for Adopting a Mobile Payment System

There are three main requirements for the global adoption of mobile payments that are

being addressed. These are-

• Security – Mobile payment network should be secure and it should fit all

security parameters like

Ø Authentication – It should allow customer to carry out transaction if he

or she is legitimate cardholder

Ø Confidentiality –It ensures that unauthorized parties should not have

access to any confidential information

Ø Data Integrity –It assures that data is not altered after the user agrees for

the transaction.

Ø Non-repudiation- Parties once agree for the transaction can not back off

from the transaction.

Ø Increased security minimizes fraud and therefore reduces the cost of

operating the payment system and it also helps to increase the

confidence of the parties involved in the transaction.

• Interoperability -Interoperability is the ability or capacity of a product or a

system to work with other systems or products without special effort on the

part of the customer. It ensures that any participating payment product can be

used.

• Usability- Research shows that people use that mobile transaction system

which is easy to use. Mobile payment system should be easy to use and it is

challenging task because of limited user interfaces.

19.10. The Payment Process

The following steps are described below and graphically depicted in Fig 19.3 on next

page:

• The consumer initiates a payment transaction by ordering a service.

• The user is then informed about the payment details.


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• To continue the user needs to confirm the payment (optionally depending on

the amount to be paid).

• The payment system keeps track of the transaction details in the background

and makes sure that clearing and settlement takes place at the right moment

for the service.

Figure 19.3 Payment Process

Source: www.paycircle.com

• Provider/merchant and user

• To conclude the transaction, the payment system ensures that the service

provider will receive confirmation of the payment before the actual service is

delivered.

19.11. Various Players and their Benefits

Consumer or user

• One ubiquitous and trusted user interface for payment in all e-services

• Private user data is not visible to any e-service provider – sensitive data

becomes visible only in the relation to the payment

E-service provider

• Easy and flexible way of charging for e-services

• Easy to integrate the payment into the services, the payment capabilities come

as standard with the e-speak package interfaces

• The payment provider takes on the burden of the payment processing

• Now has an incentive to develop more services since payment is immediate.

http://www.paycircle.com


Page 9 of 11

Mobile Payment Service provider

• Deploying e-services provide new business opportunities, they generate

additional payment transactions.

• The payment provider can address a whole community, or ecosystems in one

go.

• Payment can be integrated with an existing pre-paid service; this lowers the

initial investment threshold for a mobile operator to become a payment

provider. Concept of the Payment Service is shown in the figure 19.4 below.

Figure 19.4 Payment Service Source: www.mobilebanking.com

19.12. Roles of the technology vendors

E-service infrastructure provider

• Act as a catalyst for adoption of interoperable frameworks

• Fuel the growth of mobile e-services

• Accelerate the mobile services market

Payment infrastructure provider

• Help create an industry standard payment interface for e-services

• Facilitate payment enabling for e-service community

• Provide the mobile payment provider with access to additional chargeable

services.

The implementation of payment extensions for the e-service communities is technically

feasible with state of the art technologies such as Java, XML (Extensible Mark-up

http://www.mobilebanking.com


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Language), SOAP(Simple Object Access Protocol), UDDI(Universal Description,

Discovery and Integration) within very short timeframes.

A specific implementation of the specified interface enables hundreds of service

providers to obtain with easy-to-implement payment capabilities for their services.

Mobile payment service providers have now a broad range of additional revenue-

generating services

19.13. Summary

• Mobile payment refers to customer paying for goods /services purchased by

him using mobile devices through mobile network

• Mobile payments can be divided into micro and macro payments depending on

the amount paid by the customer. Micro payments refer to payment of

approximately $10 or less

• There are two types of mobile payments Remote payments & Proximity

payments

• Security, Interoperability and usability form the basic requirements for

adoption of mobile payment system

• The Payment Process involves various players like the Consumer, Payment

Service provider, network provider or e-service provider, merchant and

Financial Service provider or Bank.

Page 11 of 11


Page 3 of 18

Chapter-17 PayPal

17.1. Introduction

This session offers clear view of the most popular peer-to-peer (P2P) money transfer

system PayPal, which not only gives benefits to customers but provides safe and secure

service through different modes charging very minimal transaction fees of 3.4% on

private individuals receiving money and an additional per transaction fee. Over the

years PayPal transactions have increased and PayPal is active in more than 35 countries.

Some of the countries where paypal operates are Austin, Texas, US, India, Germany etc


After reading this session you will learn

• What is PayPal?

• How to use PayPal?

• Types of PayPal accounts

• Fee structure of PayPal

• Legal Implications of PayPal

17.3. Topics covered

Chapter-17 PayPal............................................................................................................................................ 3

17.1. Introduction.............................................................................................................................. 3


17.3. Topics covered ........................................................................................................................ 3

17.4. Introduction.............................................................................................................................. 4

17.5. Benefits of Transacting via PayPal................................................................................... 4

17.6. Working of PayPal from User Point of View ................................................................ 6

17.7. Types of Payments in PayPal ............................................................................................. 7

7

17.8. Flow of Payments in PayPal ............................................................................................... 9

17.9. Payment Schemes of PayPal.............................................................................................. 9

17.10. Economics of PayPal ...........................................................................................................10

17.11. Types of Accounts in PayPal ............................................................................................11

17.12. Why PayPal was successful? ............................................................................................12

17.13. PayPal vs. Financial Industry............................................................................................13

17.14. Legal Implications................................................................................................................14

17.15. Summary..................................................................................................................................16


Page 4 of 18

17.4. Introduction

PayPal is an alternate mode for transferring money online, and was founded in

December 1998 by college graduates Max Levchin and hedge fund manager Peter Thiel

under the name ‘Confinity’. This company went through several ideas, including

cryptography software and a service for transmitting money via PDAs, before finding its

niche as a web-based payment system in 1998. The simple idea behind Paypal is ‘using

encryption software to allow people to make financial transfers between computers

and this idea has revolutionized the world of ‘Online payment’. PayPal has often been

called “email money”, and its business model warrants such a name. PayPal went public

in early 2002 and was acquired later that year by eBay for $1.5 billion.

PayPal allows users to pay for goods and services online, without having to key in their

card details for each purchase. The service also hides account details from retailers, for

extra security i.e. PayPal allows one to send money without revealing credit card or

banking information. Both buyers and sellers are protected against fraud, and privacy

and security is ensured. They do this by severely restricting access to personal

information. Because of the fast nature of online purchasing, online payment methods

are more popular than traditional ones, as they allow for the transaction to be

concluded almost immediately, and it has the added benefit that the seller can easily

corroborate payment upon delivery. The buyer also has the advantage of being certain

that the goods will be sent as soon as possible, reducing the waiting time for the goods.

PayPal uses existing financial infrastructure of bank accounts and credit cards, and acts

as the only intermediary between the Buyer and the Seller.

Due to its adaptable model and the ease of user registration, PayPal has become

the most successful online payment system for C2C transactions. The PayPal account

does not provide interest, so PayPal can invest any money left there until the user wants

to spend it. The money lying with PayPal may be withdrawn by various means (see

Figure below) or may be transferred to PayPal Money Market Funds for better returns

for which one needs to apply. PayPal operates by placing a small charge to each online

transaction. For customer accounts, the average sum charged for transactions under

$15USD is $0.30. For UK personal accounts the transaction is free, but the customer

cannot receive credit card payments.

17.5. Benefits of Transacting via PayPal

PayPal uses infrastructure of banks and Credit Card companies. PayPal also takes an

edge over the online payment system in the following ways.

PayPal saves time


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• In PayPal all the financial information are accumulated and are kept under one

category so that it causes no hardship while looking for any reference

• PayPal eases online payments by using different credit cards

• PayPal make payments directly from one’s bank account, and reduces the chances

of any confusion in the bank balance

• No more hassle of typing credit card numbers every time while making a purchase

• PayPal is faster than money orders and checks.

PayPal is trusted worldwide

• PayPal online Payment System has more than 133 million member accounts

• PayPal is used across the world in 103 countries and regions

• It is widely accepted on merchant websites.

PayPal is safe

• In a PayPal transaction, the financial information of the user is never shared

• Sellers do not see credit card or bank account numbers in a PayPal Payment

System

• PayPal Fraud prevention team fights pr-empts fraud occurrence and thus makes the

system more secure.

DID YOU KNOW?

Security

After a series of scams, PayPal formulated a plan to prevent criminals from using

computer programs to open dozens of fraudulent accounts with stolen credit card

numbers. This system, known as the "Gausebeck-Levchin" test, is now widely used by

thousands of Web sites [ref]. It requires new account creators to type in a word found in

a small image file on the account creation page. A script or a bot can't read this word --

only a human can decipher it.

The Gausebeck-Levchin test on PayPal: The sight-impaired (who use text-based Web

browsers) can listen to a recording of the letters instead.

PayPal also uses special programs to detect potentially fraudulent activity. These

programs watch for certain red flags that might be a sign of fraud. These red flags


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include sudden increases in volume or quantity of transfers, denied credit card charges

or invalid IP addresses.

Source: www.paypal.com

PayPal is cost-effective

• All purchases using PayPal is free of charge

• Affordable pricing for all businesses.

17.6. Working of PayPal from User Point of View

PayPal’s core function is to transfer money between private customers expeditiously.

PayPal also offers a debit card affiliated to either Master or Visa card that can be used

for making payments at any physical POS or at an ATM to withdraw money. PayPal

allows members to have one Personal account and one Premier or Business account.

However, each PayPal account must contain unique email address and financial

information.

One can use this debit card to pay for online auctions, purchase goods and services, or

to make donations. One can even use it to send cash to a beneficiary.

A basic PayPal account is provided free of charge. Funds may be sent to a beneficiary

with an e-mail address, irrespective of the beneficiary not having a PayPal account. On

receipt of a PayPal message the beneficiary has to simply access his own account to

make withdrawal. Funds transferred via PayPal reside in a PayPal account until the

holder of the funds retrieves them or utilizes them. If the user has entered and verified

his bank account information, then the funds can be transferred directly into their

account.

Figure 17.1 Working of PayPal

Purchasing made through PayPal

Ø User Selects PayPal on a merchant website or eBay

Ø User funds PayPal purchase with a credit card, bank account, or other source

http://www.paypal.com


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Ø Funds are transferred securely through PayPal and money is deposited into the

seller's PayPal account

Payment made through PayPal

Ø Buyer selects PayPal as a payment option on website or eBay.

Ø Buyer chooses to pay with a credit card, bank account, or other source

Ø Money is deposited into receiver’s PayPal account

Ø Receiver can transfer money from his PayPal account to his bank account, or

spend it online.

17.7. Types of Payments in PayPal

Figure 17.2 Types of PayPal Payments


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Email Payments

To start accepting payments using Email Payments, merchant needs to set up one or

more of the payment processing options. A merchant can select as many additional

features as per his business needs.

Web Accept Based Payments

Accepting payments on a website with PayPal is as simple or as complex as one wants

to make it. At the basic level, though, setting up an e-commerce site with PayPal is very

straightforward and requires only a working knowledge of the website’s HTML code in

order to be successful.


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17.8. Flow of Payments in PayPal

Figure 17.3 Flow of Payments in PayPal

17.9. Payment Schemes of PayPal

Mass Payments

Mass Payment allows anyone with a Premier or Business account to send multiple

payments instantly—saving time, money and the hassle of having to individually send

funds to every payment recipient.

Mass Payment can be used for such things as:

• Affiliate commissions

• Customer rebates

• Pay-to-surf rewards

• Employee benefits

• Lottery prizes

• Survey in.

PayPal Mobile Payments

PayPal Mobile users make payments by sending a text message to PayPal. PayPal calls

the user back to confirm the mobile payment, and then sends the money to the

recipient. In the case of a Text to Buy purchase, after the merchant receives the

payment, the item is shipped to the address already saved in the user's PayPal account.

Every PayPal Mobile payment is PIN-protected and backed by PayPal's fraud prevention

system. With PayPal Mobile, financial information is never shared with the recipient.

Each user's financial information is stored on PayPal's secure servers, not on the mobile

telephone, so even if the telephone is lost or stolen, the user's PayPal account remains

secure.


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17.10. Economics of PayPal

PayPal acts as a middleman and does not fundamentally change the way merchants

interact with banks and credit card companies. Credit and debit card transactions travel

on different networks. When a merchant accepts a charge from a card, the merchant

pays an interchange. The interchange is made up of a variety of small fees paid to all the

different companies that have a part in the transaction -- the merchant's bank, the

credit card association and the company that issued the card. If payment is made by

check, a different network is used, one that costs the merchant less but moves more

slowly.

Both buyer and seller deal with PayPal, having already provided their bank account or

credit card information. PayPal, in turn, handles all the transactions with various banks

and credit card companies, and pays the interchange. They charge back on the fees

they charge for receiving money, as well as the interest they collect on money left in

PayPal accounts.

PayPal touts its presence as an extra layer of security feature, since all information,

including credit card numbers, bank account numbers and address, resides within the

PayPal realm. With other online transactions, this information is transmitted from the

buyer to the merchant and in turn to the credit card processor.

All the money held in PayPal accounts is placed into one or more bank accounts, where

PayPal collects interest which however is not shared with its Account holders.

Fees Structure for PayPal USA

PayPal’s fees range from 1.9 % to 2.9 %, depending on monthly sales volume.

Monthly Sales Transaction Fee

$0-$3,000.00 2.9%

$3,000.01-$10,000.00 2.5%

$10,000.01-$100,000.00 2.2%

>$100,000.00 1.9%

User is also charged a flat $0.30 per transaction, regardless of sales volume. All fees are

deducted from account with every transaction.


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Personal Account Premier/Business Account

Open an Account Free Free

Send Money Free Free

Withdraw Funds

Free for bank accounts in the US.

Fees for other banks

Free for bank accounts in the US.

Fees for other banks

Add Funds Free Free

Receive payments

funded by PayPal

Balance, PayPal Instant

Transfer or PayPal eCheck

Free 1.9% to 2.9% + $0.30 USD

Receive payments

funded by Credit Card,

Debit Card or Buyer

Credit

4.9% + $0.30 USD (limit of 5

transactions per 12 month

period)** for domestic or U.S.

transactions

2% + applicable Fees for cross

border payments.

4.9% plus $0.30 USD for card

payments received using PayPal

on Skype

1.9% to 2.9% + $0.30 USD

Multiple Currency

Transactions

Exchange rate includes a 2.5%

fee**

Fees for cross border payments

Exchange rate includes a 2.5%

fee**

Fees for cross border payments

17.11. Types of Accounts in PayPal

Personal Account- This is a basic account, which is suitable for people who always buy

online or for eBay buyer and not for sellers. One can send and receive payments from

other PayPal account, but debit card or credit cards are not acceptable if one is selling

something on eBay.

Premiere Account-This account has all the features of personal account as well as

additional feature for accepting payments through debit & credit cards. Sellers who sell

goods online under their own name, find this very convenient because it facilitates

credit and debit card acceptance for receiving payments. On receiving payments a

nominal fee is also charged.

Business Account- This account is a multi-access account which comprises the features

of both Personal & Premiere account. This account is suitable for the individual who

does business under a company name. A nominal fee is charged on receiving the

Payment.


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PayPal charges fees only to the sellers and not buyers. PayPal charges fees based on the

total amount of money paid, not on the selling price of the item. That means if a $10

item has a $5 shipping/handling cost, the buyer pays PayPal a total of $15—and PayPal

bases its fee on that $15 payment. Accordingly, PayPal fees would be computed on the

total cost of item price plus shipping costs.

The three PayPal account types differ in some important ways as described earlier in

this Section.

However, all have access to PayPal's core features, which include:

Ø Send Money

Ø Request Money

Ø Auction Tools

Ø Website Payments

Ø Money Market

Ø Virtual Debit Card

Ø Account Insurance

Ø E-mail Customer service.

17.12. Why PayPal was successful?

With the transition of the internet usage from an information publishing medium to a

global transaction platform, newer payment transaction methods were necessitated.

Banks and credit card companies tried to fulfill this requirement by expanding existing

systems or by developing new methods. However, these systems could not match the

success of the PayPal system for the following reasons:

Competing payment systems: Banks tried to compete with their payment systems,

but payment transactions can only be successful when they are widely deployed, which

was not the case with other payment systems.

Lack of ease-of-use and high system complexity: In particular application registration

process often takes several weeks, as a result of this, only a small part of the interested

customers pass through the whole registration process. A trade-off between security

implications and ease-of-use was required. Security is not an end in itself and can hardly

be sold to customers in case the ease-of-use is compromised. Since security cannot be

quantified by the majority of customers the system which is easy to use and fulfils the

subjective security requirements at the same time will always prevail.

Especially for payment transactions a coordination and standardization between

companies is needed. This requires a lot of time. The strength of the banks and credit

card companies, which is the networking of local systems, becomes less important due

to globalization. By using existing infrastructure, it is possible to offer comparable

services faster and cheaper than ever before. Besides providing an opportunity to

reduce costs for banks it also provides a means of “cannibalization” of their existing

services.


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17.13. PayPal vs. Financial Industry

PayPal’s possible global success could result in extensive interference within the

financial industry. These are described in detail in the ensuing paragraph.

Credit Card Companies

For long most credit card companies have set the rules to expand their business on the

internet. Payment possibility at a POS as well as from an ATM is completed with card to

card transactions (P2P payments). Due to high transaction volume, PayPal offers better

terms and conditions than other payment systems. Better terms and feature of Business

Accounts has made PayPal a preferred transaction mode by small merchants. They

prefer accepting credit cards via PayPal than conducting acceptance contracts directly

from the credit card companies. In a way, PayPal offers the credit card companies’

service cheaper than the industry itself using their infrastructure. Considering the credit

card companies’ business model (fees are shared between credit card company, issuer

and acquirer), it won’t be possible to keep predominance in a price-competition.

In case a customer is paying a PayPal merchant with a PayPal card the fees are even

more profitable. Then a merchant receives 1.5 % of the standard PayPal merchant fee as

cash back. For many small merchants it is nearly impossible to obtain an acceptance

contract for internet transactions from the acquirer. Because of risk and liability

considerations, acquirers are not willing to place a contract and even cancel existing

contracts. A realistic scenario would be the displacement of acquirers by PayPal.

(Credit) card issuer

Card issuers are normally banks or big companies who issue credit cards to their

customers. As long as the main part of PayPal transactions are processed via credit

cards which results in increased number of credit card transactions and therefore the

issuers’ revenues. PayPal issues both a MasterCard and a VISA cards.

Banks

PayPal’s product innovations increase pressure on banks. The PayPal fees & tariff

structure is extremely competitive. Dominated by checks and credit card payments the

US doe not offer either bank transfer or debit card payments. Cashless payments

between private customers in the USA are increasingly done via PayPal.

DID YOU KNOW?

The only way for paypal users to make money on their own

funds is to apply for its money market fund. Unlike money

market accounts, money market funds are not insured by

FDIC.


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Credit card acquirer

PayPal does not only occupy a new business area but also challenges the existing credit

card companies’ business. Just 60% of all PayPal transactions are online auction

processing. The remaining 40% are mostly conducted via small shops. A company

which opens a PayPal Business Account indirectly gets the opportunity to accept credit

card payments of VISA, MasterCard, Amex and Discover by signing a single contract.

This complies with a global acceptance contract extending over all credit card

companies and is also shown in the acceptance logo.

European Central Bank (ECB)

PayPal does not necessarily need to open a branch in Europe to do its business. The low

spread in Germany simply means that neither PayPal offers German web pages nor

eBay Germany promotes PayPal. If PayPal continues with its strategy to confine its

business in the USA, it could have a negative impact on the volume of money in

circulation and ECBs minimum reserve policy.

National economy

The effect of globalization based on different national legislation with respect to topics

like money laundering, taxes and fight against fraud would raise fundamentally new

questions: PayPal transactions do not show up in any bank document.

17.14. Legal Implications

There are several interesting legal issues involved with C2C payment systems, and in

particular with the business model presented by PayPal. Notwithstanding the problems

in regards to liability of PayPal as an intermediary system in cases of fraud, money

laundering or the use of the system to pay for illegal or restricted goods and/or services,

the regulatory status of PayPal as per European law is in question.

PayPal functioning is similar to a credit institution as defined by various European

directives and as such Directive 2000/12/EC on credit institutions states that

“‘Credit institution' shall mean an undertaking whose business is to receive deposits or other

repayable funds from the public and to grant credits for its own account” is applicable to

PayPal transactions.

Deposit has been defined by the Directive 94/19/EC as

“A credit balance that results from funds entered into an account and which the credit

institution must pay back”

This is rather straightforward definition of what a deposit is, but differs slightly from the

definition in effect in the UK through the Regulated Activities Order 2001 (RAO), which

defines a deposit in two different ways:


Page 15 of 18

“(a) Money received by way of deposit is lent to others; or (b) any other activity of the person

accepting the deposit is financed wholly, or to a material extent, out of the capital of or

interest on money received by way of deposit.”

The above definitions would seem to indicate that PayPal acts as a deposit-taking

institution, and therefore should be considered as a bank for all regulatory purposes.

However, and contrary to some of the earlier opinions already quoted by people related

to the company, PayPal argues that it does not make any use of the deposits in the user

accounts it holds. In fact, PayPal’s user agreement states that

“PayPal will at all times hold your funds separate from its corporate funds, will not use your

funds for its operating expenses or any other corporate purposes, and will not voluntarily

make funds available to its creditors in the event of bankruptcy or for any other purpose.”

An interesting riddle as PayPal claims not to use the funds in the accounts held by the

customers for operational expenses, a practice that would clearly indicate that they are

indeed a financial institution as defined.

Some agree that PayPal is not a financial institution because the money received in an

account is not deposited by the account holder but by third parties, and because it

does not lend money out and keeps it in separate bank accounts. The first assumption

does not appear to be correct.

After all, large amounts of money that goes into an account holder’s bank accounts are

deposited by third parties, such as employers, and there is no requirement in the

existing legislation that a deposit needs to be made by the account holder to be

considered such. Presently, the Financial Services Authority (FSA) has not made any

pronouncements in this respect.

In the United States, the Federal Deposit Insurance Corporation (FDIC) did not consider

PayPal to be a bank in accordance to US regulations because it did not physically

handle or hold the money placed in the customer’s accounts. The FDIC also ruled that

PayPal should not be considered a bank because it did not have a bank charter, which is

one of the legal requirements in US legislation.

This would seem to be circular reasoning from the American regulators, but regardless

of this the opinion of the FDIC should not bear too much importance in Europe as the

regulatory regimes are dissimilar. Besides, there appears to be a small discrepancy in

the FDIC’s opinion, as they have also held that deposits made to PayPal will be subject

to federal deposit insurance, which is usually given only to banking institutions.

Financial services institutions are heavily regulated and must be authorized to operate

by a governmental body. In the UK this responsibility falls unto the FSA, which is the

only body that can authorize operations of a deposit-taking and credit-giving

institutions. What is more, an institution that undertakes these services will be


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prohibited to operate at all without said authorization. If one considers PayPal to be a

deposit-taking institution as defined by the cited legislation, then it should require

authorization. Because PayPal is now operating in the UK – they have a co.uk domain

name and take deposits from UK bank accounts – then they are operating outside the

regulatory scheme.

The financial implication for PayPal of being considered a bank or not would be

substantial, as they would have to comply with a strict regulatory scheme that includes

restrictions on the initial capital required, the own-funds that it must have at all times,

the solvency ratio and restrictions on holdings in other undertakings. The reason for

this strict regime is the nature of a bank, it acts as a depository of depositors’ money, so

the liabilities and securities that it must provide are higher than to other institutions

because there is a considerable public interest in making sure that only trustworthy

undertakings will be subject to it.

Problems with Paypal:

• One of the biggest criticism of Paypal is that it acts like a Bank but it is not

regulated like one. In other words Paypal offers its customers none of the

protection that real banks offer.

• Paypal holds large amount of customers’ money, makes millions of transactions

and all this is done without any assurance of protection like real banks

• The most common problem experienced by paypal users is sudden freezing of

their accounts

• Once your paypal account is frozen, you cannot add or withdraw any funds

from your account

• This is followed by a tedious and complicated process of verification of your

identity.

• Poor hiring practices have led to a number of scams committed as inside jobs

• Lacks security, despite paypal’s claims that it is a secure way of transacting.

17.15. Summary

• PayPal allows users to pay for goods and services online, without having to key

in their card details for each purchase

• This service also hides account details from retailers, for extra security i.e. PayPal

allows money transfer without revealing one’s credit card or banking

information

• PayPal consumers’ financial information is never shared

http://co.uk


Page 17 of 18

• PayPal is cost-effective since all purchase transactions are free of charge

• PayPal offers two types of payments such as Email based payments & Web

based Payment system

• Mass Payment allows anyone with a Premier or Business account to send

multiple payments instantly—saving time, money and the hassle of having to

individually send funds to every payment recipient

• PayPal Mobile users make payments by sending a text message to PayPal

• PayPal calls the user back to confirm the mobile payment, and then sends the

money to the recipient

• PayPal offers Personal account which is a basic account, which is suitable for

people who always buy online or for an eBay buyer

• Premiere account is one that has all the features of a Personal account as well as

additional feature for accepting payments through debit & credit cards

• Business Account is a multi-access account that consist features of both

Personal & Premiere accounts.


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1.1.6 Security:..........................................................................................................................................23

1.1.7 Customisation:.............................................................................................................................24

1.1.8 Ease of Integration:....................................................................................................................24

1.1.9 Interfaces and Functionalities:..............................................................................................24

1.2 In Terms of Functionalities .............................................................................................................24

1.2.1 Interchange Support –.............................................................................................................24

1.2.2 Security – .......................................................................................................................................24

1.2.3 Host Interfaces – .........................................................................................................................25

1.2.4 Hotlist –...........................................................................................................................................25

1.2.5 Authorisation –............................................................................................................................26

1.2.6 Settlement – .................................................................................................................................26

1.2.7 Administration –.........................................................................................................................27

1.2.7.1 Operator Interface –..........................................................................................................27

1.2.7.2 Database Enquiries –........................................................................................................28

1.2.7.3 Merchant Management –...............................................................................................28

1.2.7.4 Systems Management –..................................................................................................28

1.2.7.5 Reports Generation – .......................................................................................................28

1.2.7.6 Statistics – .............................................................................................................................28

1.2.7 Diagnostic and Test Software –.......................................................................................29

1.3 In Terms of Transactions/Messages............................................................................................30

1.3.1 Various Transactions/Messages in a Payment Gateway............................................30

18.4. Payment Gateway- An Introduction

For e-commerce businesses, a Payment Gateway is the access point to the national

banking network. A Payment Gateway is basically an electronic cash register that

can complete transactions using international credit cards such as VISA or MasterCard,

or even local cards. The result is a web page, where a credit card number and expiration

date can be entered to complete a purchase or other transaction. A user-friendly web-

interface allows the owner of the website to administer the transactions, view statistics

and even reject transactions if they cannot be fulfilled. Automated processes can also

be enabled, making administration even easier.

A Payment Gateway authenticates and routes payment details in an extremely secure

environment between various parties and related banks. To clarify this concept further,

the Payment Gateway functions as an “encrypted” channel, which securely passes

transaction details from the buyer’s PC to banks for authorisation and approval. On

gaining the approval, the Payment Gateway sends back the information to the

merchant thereby completing the “order”, and providing verification. It also facilitates

secure funds transfer from the customer’s bank to the merchant’s account. It uses

enhanced security features such as digital envelopes and content keys (public and

private key encryption systems) so that information being transmitted is inaccessible to

other Internet users. It takes a transaction, certifies it, encrypts, routes it and then


Page 5 of 32

decrypts it. We can therefore, think of the Payment Gateway as a “facilitator” of e-

commerce transactions.

Payment Gateways offer multiple benefits including:

• Secure flow of transaction details among buyers, sellers and financial institutions

• Flexible, powerful real-time reports generation

• Multi-currency settlements, if required

• Facility for customer refund

• Ability to provide value-added services to merchants, acquiring and issuing banks

• Provision for multiple host interfaces

• Comprehensive, simple administrative control

• The obvious 24x7x365 convenience

• Rapid, efficient transaction processing

• Real time authorisation of credit/debit cards

• Access to card “hot-list” to filter out fraudulent deals

• Automatic filtering and routing of authorisation request/response

To maintain the transactional security of payment gateways majority of Payment

Gateways are based on SET (Secure Electronic Transaction). SET is an encryption

technology that helps protect the transfer of payment information over the Internet

and uses advanced security technology, which allows cardholders to make secure

payments to merchants on the Internet

18.4.1 The Process Flow

Whenever a customer buys something from a virtual shopping mall, the Payment

Gateway comes in the picture for the following functions:

• Authorising – Verifying the buyer’s credit/debit card details

• Clearing – Transferring the transaction to merchant’s bank

• Reporting – Recording all transactions

When a buyer presents his credit/debit card for payment through the Payment

Gateway, the same has to be Authorized by the issuing bank. Accordingly, a request for

authorisation is transmitted to the issuer, for which there could be three outcomes:

Accepted Card acceptable, transaction permitted

Rejected Card unacceptable, transaction not permitted

Invalid Data Problems with the offered card details

Then the Payment Gateway sends transaction details to the acquiring bank for the

purpose of processing. This is called “Clearing”. Often, a Payment Gateway creates a

batch of all the transactions in a one day and sends the same to the acquiring bank.

“Accepted” and “Rejected” could be two batches. The batches accepted are displayed


Page 6 of 32

on the bank statement. In case of rejected batches, the payment gateway solves any

problems and resubmits such batches.

The support offered by Payment Gateway by way of recording all transactions so that

they can be seen, printed and even downloaded is known as Reporting.

Now that we have seen the key functions the transaction flow of various situations

in Payment Gateways are described below.

18.4.1.1 E-Cheque Transactions

Where E-cheques are concerned the steps will be as follows:

1 – Consumer visiting a shopping website selects the goods or services and clicks on

the “Buy” button. A message is sent to the website regarding the consumer’s desire to

buy and make payment.

2 - After receiving the message from the buyer the web-store’s server, adds its digital

certificate to identify the mall. This message is now called a “Digital Order” and also

includes the consumer’s IP address and transaction amount. The Digital Order is now

sent to the Payment Gateway over a secure network. Security is ensured by data

encryption.

Figure 18.1 Flow for E-cheque Transaction

3 -, the Payment Gateway authenticates the web store Based on the Digital Certificate

4 - The Payment Gateway offers various payment options on a screen to the buyer.

5 – Buyer selects E-Cheque option, writes, signs, and sends the E-Cheque to seller.

6 – Seller approves and adds deposit information. The seller then signs the E-Cheque

using his/her E-Cheque Book and sends completed document to the bank.


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7 – Bank validates the E-Cheque, verifies contents, certificates and signatures, and

sends the valid information for clearance. The bank then transfers information about

clearance (or bouncing, as the case may be) to the Payment Gateway.

8 – The Payment Gateway issues digital receipts to the seller as well as the buyer

once deposit clearance is confirmed.

18.4.1.2 Credit/Debit Card B2C Transactions

When consumers buy goods or services offline, they generally use cash or credit card to

make payments. If a credit card is used, the shop personnel swipe the card using a

mechanical device and then dial a specific number for the purpose of authorisation. The

basis for authorisation is the credit card validity and credit limit. This is the manual

mode.

In case of non-manual transactions, most transactions are automated using the

merchant’s Point-of-Sale (POS) device. The latter can read all the credit card details and

transfer the same to the acquiring bank, which again transmits the data to the issuing

bank for authorisation. All the transmissions occur over a secure network. The Payment

Gateway tends to replicate this process in the Internet environment as shown in the

figure given below.

Figure 18.2 B2C Transaction


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Steps Involved in a Payment Gateway:

1 – Consumer visits a shopping website and selects the goods or services and clicks on



2 - The Web store’s server, after receiving the message from the buyer, adds its digital




encryption.

3 - Based on the Digital Certificate, the Payment Gateway authenticates the web store.


5 - Buyer chooses the desired payment option, which is transmitted via the secure link

to the Payment Gateway.

6 - The Payment Gateway sends the payment details to the acquiring bank.

7 - The acquiring bank sends the information to the buyer’s issuing bank over a secure

link.

8 - Based on the credit limit and the payment instrument’s validity, the issuing bank

either accepts or rejects the transaction. The confirmation/rejection message is

transmitted to the Payment Gateway.

9 - The Payment Gateway then transmits digital receipts to the shopping site as well as

the buyer.

10 – The web store can ship the goods/services to the buyer.

As opposed to the lengthy offline process, the online version may at the most require

30-40 seconds.

18.4.1.3 B2B EFT Transactions

In the earlier section what we talked about holds true for B2C transactions. But in other

kinds of transactions including B2B, generally electronic funds transfers (EFT) are

involved.

The first five steps are common for both B2C and B2B transactions, with only one

difference and that is with regard to the payment option. Moreover, instead of

“Acquiring Bank” and “Issuing Bank”, the appropriate phrases are “Seller’s Bank” and

“Buyer’s Bank”, respectively.

In B2B transactions, generally electronic funds transfers (EFT) are involved.


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Figure 18.3 B2B Transaction

Steps Involved in B2B Payment Gateway Transaction

1 – Consumer visits a shopping website and selects the goods or services and clicks on



2 - The Web store’s server, after receiving the message from the buyer, adds its digital




encryption.

3 - Based on the Digital Certificate, the Payment Gateway authenticates the web store.


5 - Buyer chooses the desired payment option, which is transmitted via the secure link

to the Payment Gateway.

6 – The Payment Gateway sends the payment information to the buyer’s bank along

with a debit request.

7 – The buyer’s bank checks for the buyer’s limits and transmits the relevant message to

the Payment Gateway (debit confirmation or rejection, as the case may be).

8 – The Payment Gateway sends a message to the seller’s (shopping site) bank about

the payment that has to come from the buyer’s bank (credit request).

9 – The seller’s bank again transmits credit confirmation message to the Payment

Gateway.

10 – The Payment Gateway transfers digital receipts to the seller as well as the buyer.


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11 – The Payment Gateway then acquires the payment from the buyer’s

account.

12 – The Payment Gateway transfers the money thus acquired to the seller’s account.

13 – The seller can then ship the goods/services to the buyer.

18.5. Components of Payment Gateway

At the basic level, a Payment Gateway can be seen as a combination of three systems,

namely

•Payment Server,

•Transaction Database and

•Reporting Server.

Additionally, a Payment Gateway consists of several other components such as

switching networks and two applications including authorisation systems and

settlement systems.

A Payment Gateway has a complex arrangement of firewalls to check intrusion, and

filtration and protection in the networks.

18.5.1 Payment Server

A payment server forms the core, which stores all transaction functions, modules and

applications. A Certification Authority (CA) generally authenticates this Server.

Generally, in most Payment Gateways, the Merchant Server is designed to make

automatic request authorisation on receiving purchase order from the customer.

However, customer authorisation is also permitted. The Merchant Server receives

authorisation from the Payment Gateway by using standard SET protocol messaging in

a SET environment.

Linking between the Payment Gateway and Merchant Server can be achieved by a

range of communication links such as TCP/IP.

The Payment Gateway must be so designed as to function with existing banking

infrastructure so that banks can go online without disrupting the existing environment.

The Payment Server performs the following functions:

• Accepting encrypted transaction data

• Undertaking fraud control

• Sending information to acquiring networks

The actual working of the server is given below:

1. After accepting the encrypted information, the payment server does the

groundwork for using the information within the Payment Gateway.


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2. Next, a series of steps are effected including fraud-filtering routines, rules-

based checking and data scrubbing.

3. The Payment Gateway then detects the intended destination for the

information

4. The Payment Gateway finally transmits information to the appropriate card

network

5. The entire process occurs within 4-5 seconds.

185.5.2 RDBMS (Relational Database Management System)

The core of the System is very high performing, facilitating high-volume, and on-line

transaction throughput. It allows an advanced Man Machine Interface (MMI) that can be

customised for specific needs of the Payment Gateway user. In addition to the easy,

rapid definition of screens, data structures and user access rights, apart from enabling

future changes.

RDBMS stores data in the form of related tables. Relational databases are powerful

because they require few assumptions about how data is related or how it will be

extracted from the database. As a result, the same database can be viewed in many

different ways.

An important feature of relational systems is that a single database can be spread

across several tables. This differs from flat-file databases, in which each database is self-

contained in a single table.

18.5.3 Transaction Database

A transaction database is basically a “storehouse” of all the information critical for

payment processing and reporting. All the transactions are recorded into this database.

There are two cluster based data, namely, Decision Support System (DSS) and Online

Transaction Processing (OLTP). The DSS is used by reporting server for reports

generation, while the payment server uses OLTP for processing payment transactions.

18.5.4 Reporting Server

Reporting Server is one which acquires the tracking of information rapidly and

accurately, this server facilitates the generation of a wide range of reports in real time.

The Payment Gateway’s reporting server is constantly updated with transaction details.

18.5.5 Switching Networks

Switching networks purpose is to transfer information over networks. This is achieved

through intelligent routers and switches.


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18.5.6 Application Software

The Payment Gateway’s application software is generally split into several semi-

autonomous software tasks. Each of these performs a specific function. The Database

Management task is at core of the application software and is employed by all

functional tasks for manipulating the database. There is a single dedicated task, which

manages user interface with the Payment Gateway system. There are several

background tasks, which handle various functional components such as:

• Merchant initiation and update

• Transaction collection

• Transaction decryption and encryption

• Transaction authentication and validation

• Host transaction file creation

• Hot card administration

• Authorisation message routing

• Archive generation and retrieval

• Statistics collection

• Report generation

• System monitoring and control.

18.5.7 Key Modules

The primary modules in the Payment Gateway Architecture include:

• Client Module

• User Registration Module

• Payer/Payee Information Module

• Payment Maintenance Module

• Security Module

• Payment Handler Module

• Communication Module

• Backup & Recovery Module

• Web Interface Module.


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The following table gives a brief description about the function of the modules in

Payment Gateways.

Table 18.1 Key Modules of Payment Gateway

Modules Functions

Client Module

The User Client Module manages the functionality of

writing and signing E-Check, creating signed Funds

Transfer and other such instructions. It allows the Payee

to send payment due notification to the system. The

Bank Client Module facilitates interaction with the

Banking System and also keeps track of the transaction.

User Registration Module

This module enables the user to register with the

Electronic Payment Services. The user must have a

digital certificate from one of the participating banks.

Payment Maintenance Module

This module helps the payee notify the system

regarding the payments due. The module also accepts

payments and maintains payment status.

Security Module

This module undertakes the encryption, decryption and

signing functionalities.

Payment Handler Module

The module manages various payments instruments

and the related validations.

Communication Module

This manages the communication functionality with

other systems.

Backup & Recovery Module

This module archives all the information regularly and

handles the recovery procedures to ensure high

availability; it helps transfer information to another

server.

Web Interface Module

This provides the interface to Web to access electronic

payment services. It also acts as the interface between

the Electronic Payment Services system and banking

applications.

18.5.8 Processing Techniques

While using a Payment Gateway, transactions can be processed online through two key

techniques. These are Shopping Carts and Virtual Terminals.

• Shopping Cart - A Shopping Cart is basically a software program, which is often

combined with a merchant website’s Payment Gateway. This program transfers

information about credit card transactions to the acquiring bank, which

authorises the transaction amount. The customer enters in all the required

information.


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• Virtual Terminal - A Virtual Terminal represents an online transaction terminal. It

is often hosted on the transaction server of the Payment Gateway. To access this

terminal, merchants just require logging in through their web browser. Then,

using their merchant account, they can conduct real time transactions.

The merchant enters transactions manually and the processing is done by the virtual

terminal in real time. Once the information is input into the terminal, it is sent to the

acquiring bank, which authorizes the transaction.

Virtual Terminal Vs Shopping Cart - In contrast to the shopping cart, virtual terminal is

not combined with the merchant’s website – it is separate. However, it enables the

merchants to access their accounts and charge buyers’ credit cards. They do not need

to use a shopping cart. The merchant has to enter data manually into a virtual terminal.

There is no such need with the shopping cart, wherein the customer directly keys in the

required information. This information is automatically sent to the acquiring bank.

18.6. Infrastructure of Payment Gateway in Terms of Security

Payment Gateways need to have a robust security infrastructure. When one talks about

security measures with relation to a Payment Gateway, one that most prominently

comes to mind is a Digital Certificate. Security must start at the basic level and include

all those so-called “routine” activities including the actual physical security (e.g. tamper-

proof storage for cryptographic information), firewalls, intrusion detection, transaction

security, database security, and data centre security.

All the servers used with a Payment Gateway are secure. And despite all the concerns,

transactions involving such servers are as safe as can be…in fact, much safer than

transactions hinging on signatures on paper.

In order to facilitate e-commerce, certain critical security infrastructure is required. This

includes:

Authentication - Authentication is the process involved in verifying an individual or an

organization. This could be in the routine fashion of username and password or more

advanced methods such as smart cards and biometrics.

Digital certificates are electronic means that are used to uniquely identify people and

resources over networks such as the Internet. Digital certificates also enable secure,

confidential communication between two parties. A trusted third party called a

Certification Authority (CA) issues certificates. The role of the CA is to validate the

certificate holders’ identity and to “sign” the certificate so that it cannot be forged or

tampered with. Once a CA has signed a certificate, the holders can present their

certificates to people, Web sites, and network resources to prove their identity and

establish encrypted, confidential communications.


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•With a personal Digital Certificate you can identify yourself to web sites and be

authorized to access private and protected information

•You can use your personal certificate for most low-value commercial transactions

like online purchases and subscriptions and for encrypting

•With an S/MIME (Secure/Multipurpose Internet Mail Extensions) compatible e-mail

reader, you can sign and secure your e-mail

• You can use it for high-value commercial transactions such as electronic banking

and share trading.

Encryption - Through encryption, information can be converted into an unreadable

format, which is termed Cipher (meaning secret message). The message can be read

(decrypted) only by those possessing the corresponding “key”.

Public-key cryptography uses a pair of keys for encryption and decryption. With public-

key cryptography, keys work in pairs of matched “public” and “private” keys. The public

key can be freely distributed without compromising the private key, which must be

kept secret by its owner.

Firewall - Firewall is a secure system that prevents any unauthorised access to

information. This implies that no unauthorised user will be allowed to access the private

networks. The firewall studies each incoming and outgoing message to check their

compliance with certain security criteria. Those messages that fail the examination are

blocked.

The online perspective:

An online Internet payment gateway allows you to process credit card orders from your

website in real time. This way, the customer knows immediately whether or not their

credit card was approved.

A shopping cart is usually used before the payment gateway. This function allows your

customers to pick and choose the various items they want to purchase from your

website, including options such as size, color, etc. At checkout the shopping cart totals

the items, adds tax and shipping and collects the customers shipping and billing

information.

The payment gateway captures the credit card transaction, encrypts the transaction

information, routes it to the credit card processor and then returns either an approval

or a decline notice.


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18.7. Various Transactions/Messages between Merchant and Payment

Gateway

Payment Initialisation – These messages allow the Merchant to send encryption

certificates to the buyer (cardholder).

Purchase Request/Response – Some merchants choose to send Purchase Response

message at various stages of transaction processing. However, certain merchants may

elect to send the message following authorisation and capture responses from the

Acquiring Bank

Enquiry Request/Response – Through this message pair, the buyer can determine the

transaction status.

Authorisation Request/Response – Authorisation is a process whereby a designated

person/institution permits an action on behalf of an organisation. Through this process,

the transaction’s risk is assessed. Moreover, it verifies whether the transaction amount is

within the account holder’s credit limits.

Authorisation processing involves two messages –

• Authorisation request from the merchant to the Payment Gateway

• Response from the Payment Gateway to the merchant.

These messages are employed in authorisation with capture (sale) as well as

authorisation only transactions. This message pair is the tool through which the

merchant obtains purchase authorisation.

Capture Request/Response – This is the message sent on the shipping of goods by the

merchant. The capture message is the starting point for funds transfer from the Issuing

Bank to the Acquiring Bank, and finally to the Merchant’s account

Credit Request/Response – Credit is basically a transaction wherein the Merchant

returns money to the buyer through the Acquiring and Issuing Banks after a valid

capture message has been sent. This is often the case with defective or returned goods.

Credit Reversal Request/Response – Credit Reversal is the message sent when the

information sent in an earlier credit transaction is incorrect or not meant to be sent.

Through this message pair, a previously granted credit can be reversed.

Gateway Certificate Request/Response – Two messages are involved in the Gateway

Certificate request processing. These include:

• Request from the Merchant to Payment Gateway for encryption certificate

• Response from the Payment Gateway to the merchant by way of the requested

certificate

Batch Administration – As with other messages, batch administrating processing also

includes two messages:


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• The Merchant sends a request for batch administration to the Payment Gateway

• The Payment Gateway’s response to this request.

18.8. Existing Payment Gateways Worldwide (Examples)

Table 18.2 Payment Gateways in Use Worldwide

Payment Gateway Description

ISABEL • Interbank Standards Association Belgium (ISABEL).

• A premier multibank electronic banking platform, providing a

joint network, service provider and customer software with

regard to remote banking (EDI) for companies.

• Offers two Payment Gateways - IsaGate and Isabel eInvoice

Server.

• IsaGate is ideal for transferring large volume of electronic

messages. Applications options are eBusiness, eGovernment

and eBanking.

• Isabel e-Invoice Server is designed for large volume invoicing.

NETS • Network for Electronic Transfers (S) Pte Ltd. (NETS)

• Offers a wide array of electronic payment services

• Services include: e-NETS, NETS Cashcard, NETS EFTPOS

• E-NETS Debit represents an online Payment Gateway, which

facilitates payments for products and services, and bills. This is

achieved by debiting the customer’s bank account using his

Internet Banking ID and PIN

Transecute • Transecute allows merchants to accept Credit Card payments

online

• Extensive support to the merchants in the form of

Transecute.com Knowledge Base and Help Desk, and a Fraud

Detection Engine

• Only domestic Payment Gateway to employ sophisticated

Heuristic Fraud Detection and Risk Management modules

http://Transecute.com


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CCAvenue •Provides e-commerce solutions to Indian merchants

•Provides two web interfaces – Variable Amount and Shopping Cart

•A large bouquet of debit options

•Enables payments via Internet banking

•Integrated two separate banks, Citibank and ICICI Bank for

processing credit card transactions - only Payment Gateway

provider in Asia to offer such a feature

• First Payment Gateway worldwide to offer instant SMS order

alerts

18.9. How It Should Interact With Other Payment Gateways?

In the process of its functioning, a Payment Gateway may have to interact with a

number of other Payment Gateways. Take the example of CCAvenue – it has links with

two other Payment Gateways PaySeal and Citibank, exclusively for processing VISA and

Mastercard credit card transactions.

This shows that a Payment Gateway can harness other existing Payment Gateways to

cut down on the work-load and increase efficiency. This will help reduce time lag and

speed up the transactions.

A series of Payment Gateways may be involved for converting payment instructions

from one payment system to another. CCAvenue has included two Payment Gateways

in its platform for credit card processing. However, in future, the Payment Gateway

could require different Payment Gateways to handle different payment instruments.

This could be one scenario. Another scenario could be when the Payment Gateway has

to interact with the Payment Gateway of another financial institution or bank. For

instance, ICICI Bank and HDFC Bank each have their own Payment Gateways. Therefore,

the Payment Gateway will have to interact with such individual Gateways.

The Payment Gateway (PG) sends payment details to the merchant’s acquiring bank,

where the bank’s own Payment Gateway will verify the merchant’s account and

eligibility for such transactions. The Bank’s Payment Gateway then sends this

information over a secured link to the PG of the Issuing Bank, which checks for the

message authenticity, the cardholder’s account and credit limits. The PG then transmits

back the acceptance or rejection to the National Payment Gateway. This kind of

interaction is at the very basic level. At a more micro level, within a bank there can be

several PGs – for instance there could a PG each at the branch level, regional level and

head office level. All of these could be connected to the “main” PG, through which

messages can be routed to respective PGs.


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As payment instruments evolve and the transaction volumes up, the complexity of

interaction will also increase.

Payment Router Router Payment

Gateway Router Gateway

Payment

Gateway

Figure 18.4 Indicative Interactions between Payment Gateways

18.10. Summary

• Payment Gateway is an electronic cash register that can complete transactions

using international credit cards such as VISA, Master Card or even local cards

• To maintain the transactional security of payment gateways majority of

Payment Gateways are based on SET (Secure Electronic Transaction)

• SET is an encryption technology that helps protect the transfer of payment

information over the Internet

• When a buyer presents his credit/debit card for payment through the Payment

Gateway, the same has to be authorized by the issuing bank

• Clearing process involves the Payment Gateway sending transaction details to

the acquiring bank for the purpose of processing

• The support offered by Payment Gateway by way of recording all

transactions so that they can be seen, printed and even downloaded is

known as Reporting

Internet


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• In case of non-manual transactions, most transactions are automated

using the merchant’s Point-of-Sale (POS) device

• In B2B transactions, generally electronic funds transfers (EFT) are involved

• Payment Gateway can be seen as a combination of three systems, namely

Payment Server, Transaction Database and Reporting Server

• While using a Payment Gateway, transactions can be processed online through

two key techniques - These are Shopping Carts and Virtual Terminals

• Payment Gateways need to have a robust security infrastructure

• There are various modes of messages transacted in Payment Gateway

• ISABEL, Transecute NETS, CCAvenue are some examples of the Payment

Gateway being used worldwide.


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Appendix - I What to seek in a Payment Gateways?

A Payment Gateway must support a comprehensive range of features, functionalities

and transactions. In this section, we will outline all these.

1.1 In Terms of Features

Ideally, a Payment Gateway should function as a high-performance financial transaction

gateway with the following features:

1. Facilitate authorisation, settlement and/or funding.

2. Support a wide range of payment instruments including credit/debit cards, ATM

cards, Smart cards, E-cheques, EFT and ECS.

3. Support transaction capture and authorisation routing.

4. Support message routing.

5. Allow comprehensive reporting for Internet transactions.

6. Support settlement at various levels – bank, merchant and network.

7. Support customisation (if required by the merchant).

8. Support various transaction modes and eventualities including sale, reversal,

partial reversal, etc.

9. Comply with SET and SSL standards.

10. Support various communication protocols including TCP/IP, socket connection,

HTTP, FTP.

11. Support various communication channels such as Leased Line, Dial-Up, VSAT,

ISDN and Internet.

12. Provide total end-to-end transactional capability, i.e., ensure once-only

guaranteed message delivery.

13. Offer complete audit trails of the transaction.

14. Support a range of architectures at merchant sites or banks.

15. Ensure message security, confidentiality, and authenticity.

16. Support encryption, decryption, digital signatures and certification.

17. Offer security at operational and transaction level, based on PKI.

18. Offer secure capture, processing and transmission of transaction information

over networks.

19. Use best practices to protect genuine parties in an e-commerce transaction.

20. Ensure adequate measures and tools for fraud detection and mitigation.

21. Enable integration with PKI and Card Management System to offer a

comprehensive solution so as to ensure data integrity.

22. Provide for non-repudiation.


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23. Offer an easy integration process for the sellers.

24. Provide a comprehensive range of merchant interface functionalities.

25. Provide links to issuing and acquiring banks.

26. Ability to function with multiple hardware and OS.

27. Support national and international interchanges.

28. Support site-to-site and remote access virtual private networks (VPNs).

29. Offer extensive customer support in the form of warranty and maintenance.

30. Suit meshed hub-and-spoke and nested networks.

31. Have flexible, scalable network design.

1.1.1 Authorization & Settlement:

Payment authorisation and settlement is obviously the basic and most essential

function of a Payment Gateway. In fact, it’s the very reason for evolution of a Payment

Gateway. As we have discussed earlier, a Payment Gateway routes the transaction

details to the acquiring bank, which transmits the same to issuing bank. The

authorisation status is then sent to the Payment Gateway, which issues the digital

receipts to the buyer and seller, if the transaction is authorised.

1.1.2 Payment Options:

A Payment Gateway should be able to support a wide range of payment options, and

not just credit cards. The idea is to hold onto the consumer – once he comes to the site,

he should not turn back for lack of options. There should be an option for everyone. For

those shy of revealing credit card details, there should be other payment instruments to

choose from.

For instance, CCAvenue.com offers the Internet banking facility, wherein the consumer

can log onto his preferred bank site to make payments. This way, no banking or credit

card details are divulged.

1.1.3 Reporting:

Internet-based transactions have one major limitation – identities of sellers and buyers

are unknown. In the real world, the buyer and seller can see each other and if

something goes wrong, one can always hold the other liable. Such a thing is not

possible on the Net. There are authentication measures, but not everyone is assured.

Perhaps the best way to combat such concerns is for the Payment Gateway to offer a

comprehensive range of reports. For each stage of a transaction, the buyer and seller

should ideally get reports. For example, once transaction details are sent to the

acquiring bank, the seller has to be intimated of this. The buyer has to be intimated

when these details are sent to the issuing bank. The authorisation status should then be

http://CCAvenue.com


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informed to the buyer as well as the seller. Finally, the seller has to be told when the

amount is transferred to his bank, and the buyer has to be informed that the amount

has been debited from his account. There should be a step-by-step information

procedure, helping the participants keep track of the transaction. This should be

separate from the end-of-the-day reports.

1.1.4 Communication Protocols and Channels:

A Payment Gateway is associated with several kinds of users and their respective

systems. Therefore, it should be flexible enough to support a variety of communication

protocols including TCP/IP, socket connection, HTTP, FTP, and a range of channels such

as leased line, VSAT, ISDN, and dial-up. This will ensure that there are no

communication hitches at a later stage.

1.1.5 Transactional Capability:

The Payment Gateway has to have end-to-end transactional capability, implying

guaranteed “once only” message delivery. This will ensure there is no duplication of

messages. Adequate measures have to be built in so that messages are not duplicated.

Moreover, complete audit trails of the transaction have to be given. The Payment

Gateway has to support different modes of transactions, particularly with regard to

credit card transactions. Various kinds of transactions include Sale, Auth-Capture, Partial

Capture, Partial Reverse and Reversal. A Payment Gateway must be able to support all

these modes. Over a period of time, a business will have to deal with most of these

modes.

The Internet has made overseas transactions a reality. Therefore, a Payment Gateway

must be able to support multiple currencies.

1.1.6 Security:

The survival of e-commerce hinges on security. In this context, the Payment Gateway

has a crucial role to perform by ensuring the authenticity, confidentiality and security of

the messages sent. For this purpose, the Payment Gateway must support encryption,

decryption, digital signatures and certification. We have already dealt with security

infrastructure in earlier sections. Apart from this, the Payment Gateway must include

the following measures:

• Fraud detection and prevention tools

• Extensive audit logging

• Alarm condition detection and reporting

• Secure download of software updates

• Performance monitoring


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1.1.7 Customisation:

A merchant may not want to unsettle his customer by redirecting him to a foreign-

looking page. In the Internet world, where the fate of a transaction hinges just on the

click of a button, merchants may not want to alienate their customers. Therefore,

several want the Payments page to blend in with their existing Website. A Payment

Gateway hence, has to be flexible enough to allow customisation as per the merchant’s

requirements. This way, both the merchant and customer will be appeased.

1.1.8 Ease of Integration:

It is critical that a Payment Gateway is easy to integrate with the merchant’s website.

Several Payment Gateways world over, offer readymade integration kits, while some

others offer socket-based APIs. Overall, the solution has to be such that there is

seamless integration with the merchant site; otherwise, the entire effort will become

expensive and time consuming.

1.1.9 Interfaces and Functionalities:

The Payment Gateway has to support various kinds of interfaces such as virtual

terminal and shopping cart. With respect of functionalities as well, the merchant

interface must offer a comprehensive range including reports, withdrawal requests,

interfaces for search, processing refunds, etc.

1.2 In Terms of Functionalities

1.2.1 Interchange Support –

The Payment Gateway must enable interaction with different regional, national as well

as international interchanges. This interchange interface must be designed in a manner

to facilitate expanded transaction sets, changes in message formats, and changes in key

management. It must interface with external networks. The interface needs to support

acquirer and issuer transactions such as purchase, authorisation, cash advance,

mail/phone order, balance enquiry, adjustment, card verification, etc. It must also

provide support for settlement messages and network management. It must also

facilitate reports generation for reconciliation of interchange transaction traffic. Some

of the common interchange supports offered are with relation to VisaNet ISO, BankNet

ISO and Maestro.

1.2.2 Security –

To provide operation security, the following measures are critical:

• Operator access control, restricting users from adding and/or deleting records

• Securing all device connections to the system


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• Verifying all transactions against “hotlists”

• Application of SSL and SET security mechanisms

In order to restrict access to the Payment Gateway system, there has to be a login

procedure with the requisite username/password. Most times, there are two kinds of

access – “Operator” and “System Administrator”. There can be more depending on the

security levels required and the user categories required.

The System Administrator must have the authority to add as well as remove Operators

as also cause the latter to change their passwords.

A Payment Gateway has a database of all active authorised merchant sites, each of

which is uniquely identified by a reference number. In case a merchant site becomes

invalid, the corresponding reference number is deleted from the record and the

merchant’s certificate is revoked.

Data security is ensured by way of public key cryptography for authenticating and

protecting messages. The transaction is allowed to proceed only if the incoming

message is decrypted successfully and validated using the public key of the

merchant/customer. In case the message is invalid, then access is denied and

transaction terminated. The Payment Gateway system does not process transactions in

such a situation.

1.2.3 Host Interfaces –

The host interface’s function is to link the Payment Gateway to Issuing Bank’s host

systems for transaction authorisation and acknowledgment of completion.

• Batch File Transfer – The System gathers all the individual transactions into Batch

Transaction files on a day-to-day basis. This is often one each for the acquiring bank

or issuing bank. Each of these files may be designed differently as per the specific

requirements of the acquirer or issuer.

• Online Host Interfaces – Instead of creating batch files, transactions can be switched

to host interfaces. Based on card types and ranges, can be switched to local host

interfaces or external interchange interfaces.

1.2.4 Hotlist –

The Payment Gateway must have an efficient system for tracking and identifying card

misuse. For this purpose, it must ideally maintain a “hotlist”, which is a record of all

stolen, lost and “abused” cards. Such a list can either be downloaded from the

computer of the Issuing Bank or accessed by interfacing with the local hosts that

maintain a multi-issuer hotlist.


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If any transaction is attempted using a card on the “hotlist”, the system records the

details including the card number, the terminal number and date and time of

attempted use.

1.2.5 Authorisation –

Payment Gateway offers authorisation request validation, filtering and routing. These

requests are verified with the online “hotlist”. On the basis of the results, the request is

then transferred to the local issuer host.

The Payment Gateway can be configured with authorisation floor limits for various

Issuers. Below this limit, it can itself undertake the authorisation. If there is a request

from an invalid card, the Payment Gateway negates it and sends the message to the

Merchant Server. Therefore, the Payment Gateway functions as a switch/router as well

as a filter for authorisation request/response.

• Routing Options – The Payment Gateway system maintains a database of all card

issuers identified by their Issuer Identification Number (IIN). The latter is used for

controlling the authorisation routing of card-based transactions. The Payment

Gateway can send the transaction to a back-end host interface or an

interchange or authorise the transactions locally. Such alternative routing

mechanisms will speed up the response time to authorisation requests.

• Pre-Routing Checks – The Payment Gateway must be able to undertake pre-

routing validations including valid PIN, card status, withdrawal limits, and card

expiration date.

• Blind Authorisation – The Payment Gateway can also offer local authorisation

depending on the card issuer/range within the system defined limits.

• Authorisation Reversal – In case the interchange has authorised a transaction,

but the response cannot be sent to the terminal device, then the system

generates the required reversals automatically.

1.2.6 Settlement –

The Payment Gateway can offer settlement at various levels – bank, merchant and

interchange. The function also facilitates audit and reporting.

• Merchant Site Cut-Over – The Payment Gateway system initiates the online cut-

over at mid-night or at a time required by the merchant. If by that time, the

merchant is not cut-over, then the bank cuts over. The Payment Gateway

system cuts over the merchant to the next day automatically.

• Institution Cut-Over – An institution is any entity that receives transactions.

Through institution cut-over, completion of the settlement process is ensured


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for all the associated merchants. When the cut-over is completed, the Payment

Gateway closes the log files of respective institutions and creates a settlement

summary for each.

• Archiving – The Payment Gateway maintains a daily transaction log for

recording transactions of the day and also those not processed into batches of

previous days. At end of the day, every day, the system runs an archiving task,

which moves the processed transaction records into a daily archive file. The

latter is integrated into the Payment Gateway database from which records can

be accessed when needed. At the end of a specified period, the daily archives

are stored by the System Administrator on a storage device. The Administrator

also takes back-ups of all the data areas on a regular basis.

1.2.7 Administration –

A Payment Gateway should be able to offer a comprehensive range of operator

facilities to enable merchant management and data updates. It also must facilitate the

generation of a wide range of reports indicating statistics, transaction histories and

other information. Various administration activities include:

• Systems management

• Acquiring and Issuing Bank management

• Hotlist management

• Merchant site management

• Transaction collection monitoring

• Authorisation message routing

• Transaction archiving

• Statistics collection

• Statistics reporting

• Telecommunications management and maintenance

1.2.7.1 Operator Interface –

The Payment Gateway must provide a comprehensive operator interface. It must

ideally be organised as Windows-based hierarchical menus and forms. Screen forms

must display data fields, which can be filled in by the operator. The system immediately

checks the input data for integrity. Data collection can be done from multiple records

on the screen. This enables the operator to simultaneously enter, update records or

make queries. The screens can be designed with a number of special effects such as

data validation, default values, field-by-field help messages, etc.


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1.2.7.2 Database Enquiries –

The Payment Gateway needs to offer a comprehensive range of online enquiry features

for operators and administrators. It must be easy to bring up individual database

records.

1.2.7.3 Merchant Management –

It is essential for the Payment Gateway to offer a full range of facilities to enable

maintenance of the merchant site database. Whenever a new merchant is added to this

list, it must be accompanied with the details of card and payment types, which can be

processed and information about the specific acquiring or issuing bank. In addition,

operational and technical information including the public key certificates to use are

also input. The Payment Gateway system allows communication only when the

merchants are so registered and have a public key.

1.2.7.4 Systems Management –

This entails the primary functions of starting and stopping the Payment Gateway

system. The system must operate as a self-contained unit once it is started. It comprises

several independent software tasks so that users can log in and out without impacting

the operation of the system.

It is preferred to display a communications link status so that the communications

process is monitored continuously. Moreover, there must be a facility to allow the

System manager to find out the load on the system. The System Management facilities

must be the sole domain of the Payment Gateway System Administrator.

1.2.7.5 Reports Generation –

The Payment Gateway must have the ability to generate a variety of reports using data

from various tables in the database. This feature is critical when information has to be

provided to merchants and banking institutions customised to their specific needs.

1.2.7.6 Statistics –

The system must have features that facilitate statistics collation regarding the

transactions and merchant connections and sessions. These should include (indicative

list only):

Type of Statistics Example

Merchant-Based Average number and value of payment transactions per merchant, per

day

Card-Based The frequency, number and average value of transactions for specific

cards

Application-Based Average/total value of transactions across specific product groups within


Page 29 of 32

the merchant’s company

A Payment Gateway must be flexible enough to generate a wide range of reports and

screens. Prints of these reports can be taken and offered to clients and

acquiring/issuing banks as an additional service.

1.2.7 Diagnostic and Test Software –

The Payment Gateway’s application software must also comprise diagnostic and test

utilities, which enable detection and diagnosis of system faults. It must be possible to

remotely access the system so that the application can be monitored and diagnostic

tests run without a site visit. This facility will also allow remote software loads.

• Comparison of Payment Gateway Providers in India

Product Features Transecute Citi Bank ICICI Bank

Credit Card Support

Support for All Cards Visa/Master YES YES YES

Branding

Ability to Change the look and feel of the

Payment Pages

easy and fully

brand able

NO

Requires API

calls -

cumbersome

Integration Process

Available Integration Kits

Java (JSP) /

ASP/ PHP/

Perl

Specifications

only

Java / DLL

Method for passing integration parameters

Checksum

based

SSL Socket

based

SSL Socket

based

Level of Integration DifficultyLOW High High

Typical Integration time

Less than 1

hour

Several hours

to days

Several hours to

days

Fraud Prevention and Risk Mitigation *Important*

Instant Fraud Alert Mails for risky TransactionsYES NO NO

Heuristic Fraud Pattern Matching and detection engineYES NO NO

Customisable Alert and Action criteria for Risky

transactions

YES NO NO

Comprehensive daily reports with Risk Scores per

Transaction

YES NO NO

Partial Captures and Refunds YES YES YES

Cost

Set Up Rs 20000/-

Rs 75,000 or

greater

Rs 75,000 or

greater

Transaction Discounting rate

5% per

transaction

5% per

transaction

5% per

transaction


Page 30 of 32

Monthly Rental feeNIL

Rs 5000 to NIL

(volume

dependant)

Rs 5000 to NIL

(volume

dependant)

Initial Reserved Deposit NIL

10% - 30% of

estimated

transaction

volume

10% - 30% of

estimated

transaction

volume

Support

24 x 7 HelpdeskYES NO NO

Comprehensive Online KnowledgebaseYES NO NO

MIS Interface

Compehensive MIS Interface YES YES YES

Online Journal Entries for all Transactions YES NO NO

Facility for online Capture & Reversals YES YES YES

Inital Signup

Approval Time

Immediate to

24 hours

1 week or

greater

1 week or

greater

Transaction Features

Auth & Capture Support YES YES YES

Source: Paymentgateway.org

1.3 In Terms of Transactions/Messages

Given below are the transactions supported by a Payment Gateway.

1.3.1 Various Transactions/Messages in a Payment Gateway

Transaction Mode Description

Purchase Initialisation Request of acquirer and merchant certificates

by customer

Purchase Order Request/Response Sale transaction

Enquiry Request/Response Enquiry regarding the status of an outstanding

purchase order

Gateway Certificate Request/Response Request by merchant for Payment Gateway

certificates

Capture Request/Response Completion of transaction between the

merchant and Payment Gateway

Authorisation Request/Response Verification of buyer’s card account

Capture Reversal Reduction/reversal of an earlier transaction

Authorisation Reversal Reversal of an earlier authorisation

Credit Request/Response Return credit on a transaction captured earlier

Credit Reversal Reversal of an earlier credit transaction

http://Paymentgateway.org


Page 3 of 21

Chapter-20 E-Money

20.1. Introduction

Electronic currency has become a reality in some parts of the world and replaced hard

currency. This has made buying possible without carrying cash. It is suggested that e-

money is likely to lead a new concept of ‘pocket money’, change the way government

payout benefits electronically and revolutionize the way value moves over telephone

lines, internet and airwaves. Electronic money has also almost eliminated risk of

carrying hard currency.


After going through this session you will learn

• About electronic Money

• Process to make payments through E money

• Key features of E Money

• Various kinds of E Money.


Chapter-20 E-Money ....................................................................................................................................... 3

20.1. Introduction.............................................................................................................................. 3


20.3. Topics Covered........................................................................................................................ 3

20.4. E-money- An Introduction.................................................................................................. 3

20.5. Electronic Money – a definition........................................................................................ 4

20.6. Evolution of E-Money ........................................................................................................... 7

20.7. The Key Features of Electronic Money.......................................................................... 9

20.8. Types of Electronic Money payments .........................................................................10

20.9. Models of Electronic Payments ......................................................................................10

20.10. Requirements for the Safe Transaction of Electronic Money............................14

20.11. Legal issues in using and issuing electronic money..............................................15

20.12. Issues of Regulation in E Money ....................................................................................17

20.13. Clearing and Settlement of E-money ..........................................................................18

20.14. Market Players in the E Money landscape .................................................................18

20.15. Summary..................................................................................................................................20

20.4. E-money- An Introduction

What will be your reaction if the currency notes or the change you have in your pocket

is soon going to be a relic of old days and hence will become obsolete?

What will be your reaction if somebody tells you that the jar of coins you now have in

your home in the piggy bank will become a collector's item or a conversation piece;

much like stone beads or gold doubloons are now?


Page 4 of 21

Some strange statements! Even to the extent of being ridiculous and humorous. Isn’t it?

Perhaps not! Electronic cash and the smart cards are the future whether we are ready

for it or not. Some proof? How about the increasing use of credit cards for purchasing

goods and services, the increasing availability and use of long-distance phone cards

that hold a specific value (money and time), the increasing use of student IDs on

campuses for purchasing everything from books to lunch to beer, and the creation of

the debit/credit card? Several European countries are using smart cards on a regular

basis. Companies such as Quicken and CheckFree that allow paying bills and

conducting other transactions electronically are becoming increasingly available.

The Internet is pushing this need/demand for electronic payments. The desire is to have

the safe, secure, and anonymous ability to make purchases online or in a real store as if

using hard currency. Some factors to consider: credit cards leave a paper trail for

marketers to follow (not to mention the interest rates), currency can be stolen and used

by anyone, and paper checks are inefficient. Hence this session of ours concentrate on a

very contemporary and emerging mode of payment which may change the face of the

payments industry and our purchasing habits as well.

Electronic Money!

20.5. Electronic Money – a definition

According to Lawrence H. White a more precise definition of digital money

can be obtained:

“The currency balance information, an encoded string of digits, can be carried

on a “smart” plastic card with an implanted microchip, or kept on a computer

hard drive. Like a travelers’ check, a digital currency balance is a floating

claim on a bank or other financial institution that is not linked to any particular

account. One cardholder can make a payment to another without bank

Involvement, by placing both cards in a “digital wallet” that writes down the

card balance on one card and writes up the balance on the other by the same

amount.” (Source: White, 1996, http://cato.org/moneyconf/14mc-7.html)

The European Central Bank defines the electronic money as follows.

“Electronic money is broadly defined as an electronic store of monetary value on a technical

device that may be widely used for making payments to undertakings other than the issuer

without necessarily involving bank accounts in the transaction, but acting as a prepaid

bearer instrument” - European Central bank.

http://cato.org/moneyconf/14mc


Page 5 of 21

As the definition itself states that for the electronic money it’s not necessary that the

banks are always involved for the fund transfer at the moment of payment, but e-

money can be used as a prepaid payment instrument issued by a payer.

Here it should be considered that the word “technical device" does not essentially mean

physical device. On one hand when the instruments such as smart cards, are physical,

on the other hand it also takes in it purview internet based systems as well. A key

element is that payments must be accepted by entities other than the issuer. Thus,

prepaid phone cards, for example, would not be considered electronic money.

But the above definition may cause confusion to us. Electronic Funds Transfer are

already common in use, when we make payments from our credit cards the amount is

electronically reduced and transferred to the payee’s account from our account. So the

very next question arises is, are we already having electronic money in use in a

widespread manner? And if not, then how is the electronic fund transfer different from

the electronic money?

Different authors have expressed their different views on the questions above.

"Electronic cash" is the digital replacement for banknotes and coins, in other words,

electronic money for small transactions.

"Electronic money" includes electronic cash, as well as the immense torrents of digital

funds that zip through international and national payments networks, such as SWIFT,

Fedwire, and CHIPS." [Bern Kopf, 1996]

However the CPSS Committee of Payment and Settlement Systems make the

differentiation as follows.

"Electronic money products are defined as stored value or prepaid products in which a

record of the funds or value available to the consumer is stored on a device in the

consumer’s possession. This definition includes both prepaid cards (sometimes called

electronic purses) and prepaid software products that use computer networks such as

the internet (sometimes called digital cash). These products differ from so-called access

products that allow consumers to use electronic means of communication to access

otherwise conventional payment services (for example, use of the internet to make a

credit card payment or for general “online banking”)." (CPSS, 2000)


Page 6 of 21

Source: A study in US by Federal Reserve System.

E-money is monetary value electronically stored on a technical device. The value can be

stored on a chip card, a hard disk or other devices like chip in watches or a car body. The

monetary value is like traditional cash in the “hand“ (usually card or pc) of the owner

and not on an account at the banks like book money. It is a digital bearer instrument

and not a deposit. From legal point of view the basic difference to other media of

exchange like cheque, debit or credit card is the claim only against the issuer. The

payee of e-money has no claim against the payer. So e-money is a non-personal and not

account-based claim of the owner against the issuer or a pool of issuers.

The figure below illustrates most common type of electronic transactions as compared

to paper transactions.


Page 7 of 21

20.6. Evolution of E-Money

E-money as prepaid chip-card-related product started in Japan in the second part of the

eighties. Non-banks like telephone companies (e.g. NTT), rail road companies and

retailers started to widen the acceptance of their prepaid cards to other companies.

Since 1987 also joint-ventures between different non-bank companies have been

created to issue a common prepaid card with multi-branch acceptance (so called U-

Card). Some banks joined but without initiator or leader role. The main reasons for non-

banks to issue prepaid cards were cash substitution, customer loyalty and discount

programs. After establishing a committee of inquiry by Japanese ministry of finance

and the Bank of Japan, regulations were introduced in 1990. The new prepaid card law

required supervision of issuers of open e-purses (no regulation for two party- systems

and small sized three-party-systems): registration, regular reporting and reserve

requirements (non-interest bearing) on prepaid e-money balances. To issue e-money a

bank license was not necessary.

In the beginning of the nineties we see the same development in Europe. Non-banks

(like Danmont in Denmark) – and not the banks - started with e-money, based on the

new chip card technology by widening the acceptance points of their prepaid cards.

Not the banks, but the non-banks were the first pioneers of chip card applications and

they still are the forerunners.

In midst of this decade two further basic e-money product innovations pop up. David

Chaum invented the software-based form of e-money called e-cash and his company

Digicash piloted his cyberbucks with world wide around 10,000 internet users.

Anonymous electronic cash created and issued by a non-bank without legal

redeemability into the old-fashioned cash of central banks. The second pioneer Mondex


Page 8 of 21

– a former initiative of some banks in the UK – invented the real electronic purse, e-cash

on chip cards with the possibility to make payments between cardholders without the

necessity of clearing and settlement in old money between the banks. Real e-money

was born.

The early birth of e-money embryos by Digicash and Mondex was directly picked up by

serious monetary reformers and cranks in the nineties and fiercely discussed world wide

in internet chat rooms.

A digital exchange unit could be a basic monetary innovation and the temporary end of

monetary evolution. From historical point of view basic innovation always changed the

monetary order. The invention of banknotes by London's goldsmiths by issuing receipts

for treasuring gold a few centuries ago, for example, marked the beginning of paper

money an ultimately the central bank monopoly in money issuance. It is widely

believed that the emergence of e-money may have similar far-reaching consequences.

The issue of e-money by non-banks based in unregulated off-shore centres poses a

threat to the central bank monopoly. Central banks are equally worried by the prospect

that e-money may be issued that is not denominated in the national unit of account,

like dollar or Euro. That could be the rebirth of private currencies and free banking.

But not just free banking supporters see e-money as a “golden opportunity”. The new

technology is also interesting for proponents of so-called “barter”- schemes.

Decentralisation and privatisation of money could start an innovation process which

could generate improved forms of exchange based on real reciprocity between

economic subjects, so the reformers expect. It is argued that lack of inflation and

interest is a realistic outcome of the competitive evolutionary process and may turn

money from evil to server of mankind. These high expectations were nurtured by the

local money movement called LETS (Local Exchange Trading Systems) and other so

called MFA (Micro Financial Alternatives) based on private currencies. People and small

businesses - often supported by local communities - started to buy and sell services and

commodities in a self-made local currency. It is not a return to archaic barter, but rather

a high sophisticated cashless micro monetary system.

Did you know?

In China, Even when banks issue credit cards to their customers, people use debit

cards to draw directly from their respective bank accounts, very few people are in

the habit to use their credit cards for online payment. Cash-on-delivery is still the

most popular mode of e-commerce payment. Nonetheless, online payment is

gaining popularity because of the emergence of Chinapay and Cyber Beijing, which

offer a city-wide online payment system.


Page 9 of 21

20.7. The Key Features of Electronic Money

1. In E-money, value is stored electronically on an electronic device, although

different products differ in their technical implementation. To store the prepaid

value, card-based schemes involve a specialized and portable computer

hardware device, typically a microprocessor chip embedded in a plastic card,

while software-based schemes use specialized software installed on a standard

personal computer.

2. E-money value is transferred electronically in different ways. Some e-money

schemes allow transfers of electronic balances directly from one consumer to

another without any involvement of a third party such as the issuer of the

electronic value. More usually, the only payments allowed are those from

consumers to merchants, and the merchants in turn have to redeem the value

recorded.

3. Related to transferability is the extent to which transactions are recorded. Most

schemes register some details of transactions between consumers and

merchants in a central database, which could then be monitored. In cases where

direct consumer-to-consumer transactions are allowed, these can only be

recorded on consumers' own storage devices and can be monitored centrally

only when the consumer contacts the e-money scheme operator.

4. The number of participants and parties functionally involved in e-money

transactions tends to be greater than in conventional transactions. Typically,

four types of service provider will be involved in the operation of an e-money

scheme: the issuers of the e-money value, the network operators, the vendors of

specialized hardware and software and the clearers of e-money transactions.

The issuers are the most important providers, while the network operators and

vendors only supply technical services, and clearing institutions are typically

banks or specialized bank-owned companies that provide a service that is no

different from that provided for other cashless payment instruments.

5. Technical hitches and human errors may hinder or prevent the execution of a

transaction to a degree not commonly experienced in relation to paper based

transactions.

Besides all these features ultimately the consumer and business acceptance of e-

money will determine the extent to which it is used. Some of the benefits of e-

money to consumers include:

Ø Faster and more efficient transactions

Ø Loyalty and frequent user plans

Ø Automatic personal financial record keeping


Page 10 of 21

Ø Possible security from threat

Ø More personalized banking services and instruments

The benefits of this technology (e money) to business include:

Ø Instant transactions

Ø Easier collection of marketing information about the customers

Ø Cost saving due to reduction in physical handling of currency

20.8. Types of Electronic Money payments

When we go through the available literature on the electronic money we come to know

the there are two major types of it which are mainly in use. Those are.

Ø Stored value Smart Cards. (Offline Electronic Money)

Ø Internet based electronic cash. (Online Electronic Money)

20.9. Models of Electronic Payments

There are four models of electronic payments specifying how the payments are actually

made in the electronic payments. Mostly these payment models deal with the offline

way of making payments. That is with a smart card.

1. The Merchant Issuer Model - Smart card issuer and seller of goods are the

same. Example: the Creative Star fare card used by riders of the Hong Kong

transit system. In this model first you pay the traditional money to a banking

system from where you get the stored value of money in the form of electronic

cash. Then while you go for a purchase to a merchant then there the stored

value is transferred to a merchant’s account. For example smart cards like

Octopus cards used in Hong Kong transit mechanism are used in this way.

Those cards can be loaded with value then one has to wave the card in front of

the card reader and the particular amount gets deducted from the card’s value.

The new value is stored on the card by the reader after the amount is deduced


Page 11 of 21

Figure 20.1Merchant issuer Model of Electronic Payment

2. The Bank Issuer Model - Merchant and smart card issuer are different parties.

Transactions are cleared through traditional financial systems. Examples:

Banksys’ Proton card in Belgium (now licensed by American Express) and the

Danmont card in Denmark. As stated above the proton card is a smart card

issued by the banksys in the Belgium. Here the card issuer is not the merchant

but the bank itself. This card is mainly used for the very small retail payments

like, newspaper and public telephones. Proton is used for safety reasons on the

trams and buses of the MIVB network in Brussels. Some large schools have a

variant of Proton, namely the Portos payment card for their students. It is only

valid within the school premises: in the canteen for lunch, in confectionery

machines. This gives parents security that their little ones are not secretly

spending their electronic pennies on cigarettes or top-up cards for their mobile

phones.

One can put a maximum of 125 euro on the chip card. They are reloaded at cash

machines, in some stores, in telephone boxes, using a Maestro Smart telephone

or a PC.

3. Non-Bank Issuer Model - Users buy electronic cash from issuers using

traditional money and spend the electronic cash at participating merchants.

Issuer subsequently redeems the electronic cash from the merchant. Example:

Cyber Cash’s electronic coin product.


Page 12 of 21

Figure 20.2 Bank issuer model of Electronic payment

4. Peer-to-Peer Model - Bank or non-bank issued electronic cash is transferable

between users. Only point of contact between the traditional payments system and

electronic cash is the initial purchase of electronic cash from the issuer and

redemption of electronic cash from individuals or merchants. Example: Peer-to-Peer

value transfers through the MONDEX stored value smart card.

Figure 20.3 Non-bank issuer model of Electronic Payment


Page 13 of 21

Figure 20.4 Peer-to-peer model of Electronic Payment

• MONDEX stored value smart cards are a good example of it. Mondex is a part of

the MasterCard Worldwide suite of smart card products. It enables cardholders

to carry, store and spend cash value using a payment card. Mondex was

developed by National Westminister Bank in UK and later sold to Master card

international.

It is faster and safer than dealing with the traditional form of currency. The Mondex

platform allows its use in multiple channels where cash cannot be used including:

Ø Internet

Ø Mobile phones

Ø Interactive television

How does a Mondex Cards works?

Mondex uses public-key cryptography, and digital signatures, to authenticate

transactions. Each card, whether it is a merchant card or a consumer, has an embedded

public key which can be used to digitally "sign" a transaction. This solves the problem of

authentication of the merchant, and repudiation by the consumer.


Page 14 of 21

Figure 20.5 Working of Mondex Card Courtesy: www.mondex.com

Mondex cards contain three logs, to track past transactions, pending transactions, and

transactions which raise exceptions (Mondex, 1998). This gives the card some form of

audit trail, and should allow custom wallet devices to display the last ten transactions.

With a portable reader, Mondex cards could be used to conduct transactions over the

Internet.

Hence above were the basic four models employed for the electronic money issuance

and transactions. More or less players have these basic models which they are following

with some changes to their respective business models.

20.10. Requirements for the Safe Transaction of Electronic Money

1. Encryption - First, as the money is sent over the network it must be unreadable by

unauthorized persons. Therefore, the electronic money must be encrypted. Encryption

is the conversion of data into a form called ciphertext( it means encrypted text) that

cannot be easily understood by unauthorized people.

It can be done using a key for mathematical transformation. Both secret key as well as

public key encryption can be used.

To prevent that somebody else creates similar money we need authentication. The

purpose of digital signatures is to authenticate both the sender and the message; i.e. to

provide proof to the recipient that the message stems from the sender, and that the

message’s contents have not been altered since leaving the signatory. Cryptography

has produced a number of different methods for proving and verifying the authenticity

of electronic documents, messages and transactions using a digital signature.

The sender produces a digital signature by applying certain calculations to a message.

This process is called the signature function. The resulting signature, which looks like

random data, only has meaning when read in conjunction with the message used to

create it.

The recipient of the message checks the digital signature by performing another set of

calculations on the signature and the message. This is called the verification function.

http://www.mondex.com


Page 15 of 21

The result of these calculations reveals whether or not the signature is a genuine

authentication of both sender and message.

To guarantee that the public-key list (used by everyone to verify signatures) has not

been tampered with the public directory entries are digitally signed by a certification

authority trusted by all parties. Using the authority’s public key anyone can verify that

the directory entry is genuine. The signed directory entry is known as a ‘certificate’.

2. Preventing the Problem of Double Counting

Since electronic money is just a bunch of bits, a piece of electronic money is very easy

to duplicate. Obviously, real electronic money systems must be able to prevent or

detect double spending.

On-line electronic money system prevents double spending by requiring merchants to

contact the bank’s computer with every sale. The bank computer maintains a database

of all the spent pieces of electronic money and can easily indicate to the merchant if a

given piece of electronic money is still spend able. If the bank computer says the

electronic money has already been spent, the merchant refuses the sale.

Off-line electronic money systems detect double spending in a different way. A special

smart card containing a tamper-proof chip called an ‘Observer’ or ‘Guardian’ is created.

Both the user and the bank have to trust the observer chip. The observer chip keeps a

mini database of all the pieces of electronic money spent by that smart card. If the

owner of the smart card attempts to copy some electronic money and spend it twice,

the Observer chip would detect the attempt and would not allow the transaction. Since

the Observer chip is tamper-proof, the owner cannot erase the mini-database without

permanently damaging the smart card.

20.11. Legal issues in using and issuing electronic money

1) Security

Security issues are a major source of concern for everyone both inside and outside the

banking industry. E-money increases security risks, potentially exposing hitherto

isolated systems to open and risky environments.

Security breaches could occur at the level of the consumer, the merchant or the issuer,

and could involve attempts to steal consumer or merchant devices, to create fraudulent

devices or messages that are accepted as genuine, to alter data stored on or contained

in messages transmitted between devices, or to alter the software functions of a

product. Security attacks would most likely be for financial gain, but could also aim to

disrupt the system. Security breaches essentially fall into three categories: breaches

with serious criminal intent (e.g. fraud, theft of commercially sensitive or financial

information), breaches by casual hackers (e.g. defacement of web sites or denial of


Page 16 of 21

service- causing web sites to crash), and flaws in systems design and/or set up leading

to security breaches (e.g. genuine users seeing / being able to transact on other users

accounts). All of these threats have potentially serious financial, legal and reputation

implications.

Therefore, it is crucial important to assess whether the institution's proposed system is

sound and the service provided through the Internet will have adequate security. Surely

there no absolute security exists in either the electronic or physical world of banking.

The fundamental objectives that security arrangements of e-money products should try

to achieve are to:

Ø restrict access to the system to those users who are authorized;

Ø authenticate the identity and authority of the parties concerned to ensure

the enforceability of transactions conducted through the internet;

Ø maintain the secrecy of information while it is in passage over the

communications network;

Ø ensure that the data has not been modified either accidentally or

fraudulently while in passage over the network; and

Ø prevent unauthorized access to the bank's central computer system and

database.

There are specific security features available to protect e-money products, which are

perceived to lie in the use of encryption, electronic signatures and, in some cases, in

certificates issued by third parties, known as Trusted Third Parties (TTPs). A key

safeguard for card-based schemes is to make the microchip embedded in the card

tamper-resistant. A critical safeguard for both card-based and software-based schemes

is the encryption technology used to authenticate e-money devices and messages and

to protect data on the devices from unauthorized alteration.

Did you know?

IBM, Netscape, GTE, CyberCash, MasterCard, Microsoft and Visa have cooperatively

developed the Secure Electronic Transactions Protocol (SET) for securing

On-line transactions. This protocol will facilitate credit card transactions on the Internet.

2) Privacy

Sound practice requires the ability to track and verify that the proper exchanges occur

which ensuring that only authenticated parties and payment mechanisms are involved

in the exchange, and that they exchange only those items for which they are

authorized. However, consumers may fear that their financial, credit and spending

information derived from e-money transactions or products could be used without


Page 17 of 21

their knowledge or permission. And these fears will be widespread and strongly held

when e-banking and the use of e-money becomes more widespread. With the growth

of e-money, the spread of crime is likely to accompany the vastly increased storage and

transmission of customer financial information. Therefore, many parties want the

option of anonymous financial transactions. However, it is difficult to be widely

accepted due to security concerns and money laundering. Even so, to achieve

widespread confidence, all participants in the system such as banks, other issuers,

consumers and merchants, must have certain basic information about the rules

governing the use of e-money products. The consumer must be guaranteed that any

information exchanged will be transmitted only to properly authenticated parties and

only to the extent to which they are authorized to receive the information.

3) Legal risks

Legal risk arises from violation of laws, regulations or prescribed practices, such as

money laundering, customer disclosures, privacy protection, etc. Legal risk may also

arise when the legal rights and obligations of parties are not well established. The

contractual and legal relationships between consumers, retailers, issuers and operators

might be complex. Schemes differ as to when payment is final and also as to whether

the consumer or the merchant bears the credit, settlement and other risks until

settlement has occurred. A major concern is whether the rights and obligations of all

the parties involved are certain and transparent. For example, issues could arise

regarding liability in the event of fraud, counterfeiting, accident or the default of one or

more of the participants.

20.12. Issues of Regulation in E Money

1. Effect of E money products on the monetary policy

The most important development in connection with e-money is a reduction in the

demand for cash. As cash circulation is a lever by which central banks can control the

money and credit expansion of private banks and hence provide some more monetary

stability, it is conceivable that a very extensive substitution could complicate the

operating procedures used by central banks to set money market interest rates. As bank

interest rate is an important tool by which the central bank regulates the lending

systems in a nation.

Another big implication could be the rise of inflation. As the electronic money

transactions will be very fast and considerably reduce the money in circulation or in the

process of settlement. So as the money supply increases in the economic system it

could lead to a higher inflation.


Page 18 of 21

The e-money targets to become a substitute for the cash in circulation. Since cash is a

large or the largest component of central bank liabilities in many countries, a very

extensive spread of e-money could shrink central bank balance sheets significantly.

Since banknotes in circulation represent non-interest-bearing central bank liabilities, a

substitution of e-money for cash would lead to a corresponding decline in central bank

asset holdings and the interest earned on these assets that constitutes central bank

seigniorage revenue. And these revenues are large relative to central bank operating

costs, as e-money developing; the revenues could be too small to cover the cost of

central bank operations.

2. Who should issue the e-money?

This issue challenges the supremacy of central banks of a nation. As central banks only

have the right to issue currency in a nation, if private players start issuing their own e

money products and e money itself may threaten the central bank’s position.

20.13. Clearing and Settlement of E-money

Virtually all e-money schemes under development will need inter-institution clearing

and settlement arrangements. Many e-money schemes plan to use existing interbank

arrangements. Those clearing agents usually require each issuer to maintain an

adequate balance between e-money outstanding and the chosen reserve backing.

However, if there is a sudden increase in demand for redemption of e-money, it may be

a serious problem for the issuer. If public perceives liquidity problems there may be a

more widespread withdrawal of deposits or redemption of e-money. Failure to meet

redemption demands in a timely manner could also lead to reputation damage.

Therefore, regulations and monitoring system on clearing and redemption may be

necessary for smooth operation as they provide a safeguard against over-issuance.

20.14. Market Players in the E Money landscape

It is clear that e-money includes both prepaid cards (smart cards, electronic purses) and

prepaid software products that use computer networks such as the Internet (sometimes

referred to as digital cash).

The most common e-money products are card-based products, industry leaders in this

sector being Mondex and VISA Cash. While the Dutch company Digicash first pioneered

the software approach. There have been dozens of other e-money products and

systems introduced to the public, such as CyberCash, Millicent, Proton, PayPal, and

eMoneyMail, BillPoint, Payme.com, PayTrust and Propay.

Mondex - Mondex was initially invented in 1990 and based in London, it is currently

under development in more than 75 countries around the world. It contains a

microprocessor chip that could hold and transfer electronic value. By utilizing bearer

http://Payme.com


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certificates, funds deposited are remotely stored on the users actual card, which is not

linked to any central account. In addition, the electronic wallet that accompanied the

card allows the value on the card to be transferred from person-to-person indefinitely

without any central verification or clearing requirement, making it the closest in

operation to real cash. It also has the additional ability to store the recent payment

history.

Visa-Cash - The Visa Cash is similar to Mondex. However Visa Cash payments are routed

through a central facility and cannot be transferred from card to card with the same

degree of ease. One major point in its favor is its appeal to banks as it allows them to

earn float income; therefore Visa Cash is more attractive from a purely commercial point

of view.

Digi-Cash - The Digicash Company was based in the Netherlands after being

established in 1990 by David Chaum. The e-money product of the company was called

eCash. To use eCash, an account should be established at a DigiCash-licensed bank with

real money. Once established, the customer can withdraw eCash that is stored on the

user computer's hard drive. Using proprietary software, eCash can be spent with an

Internet merchant or with anyone else whose computer is set up to deal in eCash.

However all such transactions must be made through an intermediary bank. One of the

cornerstones of the Digicash system is its insistence on the maintenance of privacy. The

system uses blind signatures as the way for the issuing bank to certify each token it

issues. The actual process requires the customer, not the bank, to generate the eCash

token. The customer creates blank tokens and forwards them (hidden in a digital

envelope) to the bank for certification. The bank stamps its signature on each token,

debit the customers account and sends the token back over the Internet. So the digital

tokens can be registered and verified by the issuer without revealing to whom it was

originally issued. In effect, these digital cash transactions are capable of being as

anonymous as cash. Because the system is software based, it is therefore relatively easy

to duplicate certified eCash tokens. Therefore to guard against this, any eCash

presented for payment is crosschecked with the central registrar to ensure it has not

already been spent. It seems it is impractical for most merchants and customers and

this has limited its application in the market.

Some of the hurdles to implementation of E money include:

• For the operator the cost of installation of technological infrastructure can be

huge amount.

• E money systems will have to be compatible and integrated with current

methods of payment.


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• The risk of losing the card could intimidate the customers.

• Personal information privacy will also be an issue.

20.15. Summary

• Electronic Money is broadly defined as an electronic store of monetary value on

a technical device

• "Electronic cash" is the digital replacement for banknotes and coins, in other

words, electronic money for small transactions.

• "Electronic money" includes electronic cash, as well as the immense torrents of

digital funds that zip through international and national payments networks,

such as SWIFT, Fedwire, and CHIPS."

• The number of participants and parties functionally involved in e-money

transactions tends to be greater than in conventional transactions

• There are four models of electronic payments specifying how the payments are

actually made in the electronic payments

• Mondex is a part of the MasterCard Worldwide suite of smart card products. It

enables cardholders to carry, store and spend cash value using a payment card.

• The purpose of digital signatures is to authenticate both the sender and the

message

• On-line electronic money systems: prevent double spending by requiring

merchants to contact the bank’s computer with every sale

• Off-line electronic money systems: detect double spending in a different way. A

special smart card containing a tamper-proof chip called an ‘Observer’ or

‘Guardian’ is created.

• There have been dozens of other e-money products and systems introduced to

the public, such as CyberCash, Millicent, Proton, PayPal, and eMoneyMail,

BillPoint, Payme.com, PayTrust and Propay.

http://Payme.com


Page 3 of 18

Chapter 21- Risks and Liquidity Issues

21.1. Introduction

This session gives you an insight into various risks faced by the parties during settling

down the payments, and what measures should be taken to avoid them by fixing a limit

to the different risks.


After reading this session you will come to know about

• The risks involved while settling down the payments through net settlement

process and deferred settlement process.

• What measures should be adopted to avoid such risks.

• What are the limits drawn to such risks so as to minimize their effect on the

economy.


Chapter 21- Risks and Liquidity Issues..................................................................................................... 3

21.1. Introduction.............................................................................................................................. 3


21.3. Topics Covered........................................................................................................................ 3

21.4. Introduction.............................................................................................................................. 3

21.5. Risks Associated With Net Settlement Systems ........................................................ 4

21.5.1 The Operational Risk....................................................................................................... 4

21.5.2 Liquidity Risk...................................................................................................................... 4

21.5.3 Credit Risk ........................................................................................................................... 4

21.5.4 The Settlement Risk ........................................................................................................ 5

21.6. Liquidity Requirements in the Net Settlement systems......................................12

21.7. Risks in Real Time Gross Settlement systems...........................................................13

21.7.1 Operational Risk .............................................................................................................13

21.7.2 Credit Risk in RTGS.........................................................................................................16

21.7.3 Liquidity Risk in RTGS...................................................................................................16

21.8. Summary..................................................................................................................................17

21.4. Introduction

In earlier sessions of Clearing and Settlement system, we read about Net Settlement

mechanisms and learnt about Real Time Gross Settlement (RTGS) concepts and their

architecture. In this session we will take a more critical look on the issues related with

these systems, their pros and cons, the trade-offs of having one system and not the

other.

• We will take an in-depth look into the associated risk issues and liquidity

requirements of both these systems. We shall start with Net Settlement systems.


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21.5. Risks Associated With Net Settlement Systems

21.5.1 The Operational Risk

A participant runs an operational risk if there is a risk of financial loss as a consequence

of manual or technical faults, breach of rules or laws, or as a consequence of external

events such as natural disasters, terrorism, etc. In modern payment systems operational

risk mainly relates to IT systems. Operational risk can lead to unexpected exposure that

can amplify credit and liquidity risks. It is caused due to multiple factors ranging from

weak internal control system to natural disaster. Operational risk is caused both by high

probability, low impact events and low probability, high impact events. While the

former are day-to-day events such as data entry error leading to minor losses and are

more predictable, the latter are events such as 9/11 attack and its aftermath,

threatening the very survival and are the most difficult ones to predict. Operational risk

is related to other risks in a very complex manner making it very difficult to decipher.

Measures to limit operational risk include clear procedures and contingency

procedures, including chains of command, to ensure that action is taken without delay

in the event of system failure, etc. In addition, it is customary to establish two separate

operations centers to reduce operational risk in critical system.

For example If a receiving bank makes the proceeds of an incoming payment

instruction available to its customer on the assumption that the sending bank will be

able to meet its net settlement obligation at the end of the day and If the sending bank

defaults, then the receiving bank risks losing the funds it has already paid out to its

customer (who may already have delivered them to somebody else).

21.5.2 Liquidity Risk

This is the risk that if one bank fails, for whatever reason, to meet its net settlement

obligation when due, then the other banks in the system will receive less in the

settlement (or have to pay more) than they had been expecting. The surviving banks

may as a result have to raise additional funds at very short notice in order to cover their

settlement obligations -particularly if, as is likely, they normally manage their

settlement accounts so that balances are kept to a minimum. Failure to secure the

additional late funding which is required may trigger a second round of problems. This

is a state of liquidity crunch because everybody is waiting for their payments to be

made.

21.5.3 Credit Risk

Credit risk is the risk of financial loss as a consequence of counterparty’s inability to

meet its payment obligations, either at the time of settlement or at a later time. The

credit risk is dependent on the size of the counterparty's obligations (exposure), which


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can e.g. be a payment for settlement or an account balance, as well as the

counterparty's creditworthiness. Credit risk increases with the maturity of the exposure.

Credit risk consists of primarily two components:

• Quantity of risk, which is nothing but the outstanding loan balance as on the

date of default, and

• The quality of risk, i.e., the severity of loss defined by both the Probability of

Default as reduced by the recoveries that could be made in the event of

default.

The term credit analysis is used to describe any process for assessing the credit quality

of counterparty. While the term can encompass credit scoring, it is more commonly

used to refer to processes that entail human judgment. One or more people, called

credit analysts, will review information about the counterparty. This might include its

balance sheet, income statement, recent trends in its industry, the current economic

environment, etc. They may also assess the exact nature of an obligation. For example,

senior debt generally has higher credit quality than subordinated debt of the same

issuer. Based upon this analysis, the credit analysts assign the counterparty (or the

specific obligation) a credit rating, which can be used for making credit decisions.

21.5.4 The Settlement Risk

Settlement risk arises because all the Multilateral Net Settlement systems work on the

principle of DNS (Deferred Net Settlement) which means that all the payments are settled

after a delay. That is the actual transfer of payments take place only at the end of the

day. This means that banks without receiving actual payments make payments to other

banks in anticipation of receiving them from the payers. This gives rise to the risk of

settlement; let’s see how the problem may arise.

Suppose Citibank has to pay a net amount of 84 million rupees at the end of the day (i.e. at

the settlement time) to the settlement agent (RBI), as its net obligations. Suppose Citibank

due to unforeseen reasons isn’t in the position to meet its obligations (suppose the reason

could be bankruptcy). Then it will give rise to a disruption which will give birth to a chain

reaction (the ripple effect).

Is paying consideration to settlement risk so important?

The answer is YES. Why? The reason is net settlement is a very convenient way of

organizing settlement in payment systems handling large volumes of low-value

payments. However, in many developed market economies, the principle has also been

adopted for systems handling high-value payments. As a result the liquidity risks and credit

risks in such systems have become very large; but the banks operating in such systems

frequently assume that the central bank would resolve any settlement risk problem at


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the end of the day - in other words, that the central bank would, implicitly if not

explicitly, guarantee the final settlement. Central banks reject any suggestion that they

(and ultimately the taxpayer) should provide such a guarantee - it is not an appropriate

use of public funds.

So what will happen if “The lender of last resort” also denies giving you credit? You can

run your imagination from here.

Interesting facts:

The Bank for International Settlements (BIS) estimated that the average daily turnover

of global currencies in spot, outright forward and foreign exchange swap contracts is

US$1,230 billion. Since each trade could involve two or more payments, daily

settlement flows are likely to amount, in aggregate, to a multiple of this figure

especially on standard expiration dates. Even more frightening, a report prepared by

the Committee on Payment and Settlement Systems (CPSS) of the central banks of the

G-10 countries maintains that a bank's maximum foreign exchange settlement

exposure could equal, or even surpass, the amount receivable for three days' worth of

trades, so that at any point in time, the amount at risk to even a single counterparty

could exceed a bank's capital.

Ways to address settlement risk –

(a) Delay the availability of funds to the final customer –

That is until the inter bank settlement has taken place. In theory, this would have the

effect of removing the credit risk from the system (though it does not address the

liquidity risk problem). However, in practice it is not a very realistic basis for operating

large-value payment systems where, increasingly, customers will demand same-day

value - which, in an end-of-day net settlement system, inevitably means making funds

available before settlement.

(b) Restricting membership of the payment system

That is to those banks who might be least expected to default on a settlement

obligation. The problem here is how to define such a group. Allowance would need to

be made for the factors, such as the amount of capital, or the amount of liquid assets

held. Whatever the criteria, they would need to be publicly disclosed and would

therefore have to be seen as objective and non-discriminatory. However, no form of

restricted membership could entirely guarantee against a default occurring.

(c) Caps/limits on intra-day exposures –

That apply to the payment systems, a technique that banks use to control counterparty

risk in other markets (such as the money or foreign exchange markets). Thus, if a bank


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attempts to send a payment which results in that bank breaching the limits set for it

within the system, then that payment will be rejected, or will join a queue and be

released as and when there is sufficient room within the limits structure. Limits are

basically of two kinds:

Ø Bilateral net receiver limits- These are limits set by each bank in the system on

every other individual bank in the system, and define the maximum intra-day

net credit positions that a bank is prepared to have with respect to those other

banks. The size of each individual limit will reflect the assessment made of the

other bank’s creditworthiness. Thus, if sending Bank A has a payment

rejected/queued because it breaks the receiver limit set by receiving Bank B,

then that payment can only be released once a sufficient payment (or

payments) has passed in the opposition direction (i.e. from B to A), thereby

reducing Bank B’s bilateral net exposure to Bank A.

Ø System-wide net sender debit limits-These are limits set centrally in the

payment system, placing a limit on the aggregate net debit position that a bank

may have with the rest of the members as a whole. It is often related

arithmetically to the bilateral net credit limits - in the illustration in diagram

below each bank’s net sender debit limit is set at 5% of the sum of all the

bilateral credit limits set against it by the other banks in the system.

To operate and police a system of limits requires an electronic transfer system with

real-time (rather than batch) processing of payment instructions. More importantly,

the limitations of any such system should be recognised:

Ø By definition, they leave a certain amount of intra-day exposure in the

system. In the event of a settlement default, can the central bank and the

commercial banks be sure that the limits structure has reduced the problem

to manageable, non-systemic, proportions? One solution here is to have all

exposures fully-covered by collateral, so that in the event of a settlement

default, the defaulting bank’s collateral assets can be quickly used to

generate the necessary ‘missing’ liquidity.

Ø The effectiveness of a limits structure in even containing the settlement risk

problem may tend to be eroded over time. Pressure from customers, who

dislike having their incoming payments delayed, may lead to the setting of

limits at accommodating, rather than prudent, levels. A bank which does not

respond to such pressure may eventually lose customers to its competitors.


Page 8 of 18

Figure 21.1 Buyer Receiver Net Settlement Limits

(d) Liquidity-sharing and loss-sharing agreements.

These methods are applied along with the system of limits, and their aim is to provide

assurance that, if a settlement failure occurs within the limits structure, the necessary

funds will be forthcoming so that the settlement can be completed. All the members

who survive the liquidity crunch will join their hands to protect themselves against the

failure. Following are the methods to do so:

Ø Equal shares amongst the survivors-This is the simplest formula, but is

also the least fair, taking no account of the existence or otherwise of

counterparty relationships between individual surviving banks and the

failed bank.

Lets take an example, in a net settlement system of 4 (A, B, C, D) participating banks

if one bank (A) fails totally to settle its obligation of say 100 crores then, it’s not fare

that the other members share equally 33.3 crores each because its not necessary

that the failed bank A had equal obligations to each of the participant.

Ø Losses shared pro-rata according to the actual bilateral exposures to the

failed bank- This seems fairer - but fails to recognise the

passive/involuntary nature of many payment system exposures: the fact


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that a surviving bank has the largest exposure to the failed bank may simply

reflect a particular pattern of customer payment flows, beyond the control

of either bank. Should that surviving bank therefore be made to bear the

burden of the loss-sharing?

Ø Losses shared proportionately to the bilateral limits each surviving

bank had set against the failed bank-This is probably the most equitable

method of sharing out the loss amongst the surviving banks-according to

their prior individual assessments of the failed member’s creditworthiness.

For example, take a look at the table below:

The bank A has made the default at settlement time; its total obligations at that

time were 2500 crores. The table below shows the bilateral credit limit each

bank has set towards A depending on their assessment of A’s creditworthiness.

Table 21.1

Banks Each bank’s credit cap

towards bank A (all in

crores)

Proportion of loss to be

shared

Actual value borne(in

crores)

B 500 1/6 1/6 * 2500 = 416.67

C 1000 1/3 1/3 * 2500 = 833.34

D 1500 1/2 1/2 * 2500 = 1250.00

However, loss-sharing agreements carry their own risks. First, such schemes are unlikely

to eliminate settlement risk completely, and so may create a sense of undue

complacency amongst the system’s member banks. Second, the additional settlement

obligations which arise for the members when a loss-sharing agreement has been

activated could themselves, if not anticipated or somehow allowed for in advance, lead

to a second round of settlement failures – e.g. if a bank, which had previously only just

enough liquidity to cover its original obligations, was now being called upon to provide

an additional amount of funding in excess of its liquid resources. Continuing from the

above example, if bank B had sufficient money earlier to cover its own obligations but

now has the responsibility to provide with an extra 416.67 crores of rupee which the

bank B may not be able to bear. This may lead to a second round of problems.

Hence the basic assumption for the above method to be successful is that every other

bank in the system has sufficient amount of liquidity with them to bear extra losses.

Ø “Unwind” and recalculation of the net positions- One further method for

resolving a settlement problem, which is practiced in a number of clearing

houses, involves removing the failed bank from the day’s settlement altogether

and re-calculating the net settlement positions excluding payments to and from

that failed bank. However, such a measure - involving the cancellation of all the


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affected payments – could have major repercussions amongst the customers of

both the failed bank and the surviving banks, and could quite possibly trigger

defaults among those customers, creating the sort of financial market instability

and uncertainty that central banks are so keen to avoid. More directly, the

process of excluding one bank from the net settlement calculations can

transform the settlement obligations of the other banks, and create unexpected

liquidity shortfalls for other members which they in turn may not be able to

fund. Tables 21.2 and 21.3 below illustrate how such a domino effect could get

underway through the use of an “unwind” procedure, and show why central

banks have concluded that reliance on this procedure is no longer an

acceptable approach to the management of payment system risk.

In the settlement matrix illustrated in Table 6 three of the six banks in the system have

‘net pay’ positions after the end-of-day calculation, with Bank B unable to cover its

position from available sources of liquidity (such as liquid balances, readily marketable

assets, or lines of credit from other banks).

Table 21.2 Possible effects of an "unwind" mechanism: The original settlement

matrix

Excluding Bank B from the matrix and recalculating the net positions produces the

results shown in Table 21.3.

Following the recalculation, Bank F now has a ‘net pay’ position that it cannot cover

from its available liquid resources. Continuing this procedure, by excluding Bank F and

recalculating, the problem passes to Bank A, and so on. This unravelling of the

settlement matrix is not an inevitable outcome of an “unwind” procedure, as it will

depend on the particular pattern of the payment flows and resulting net positions;


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however, the risk that it might happen makes the use of such a procedure very

unattractive, particularly if the clearing arrangement is handling high value payments.

Table 21.3 Settlement matrix excluding bank B

The legal validity of the netting calculations in net settlement systems:

Quite apart from the credit and liquidity risks that are inherent in payment systems with

net settlement, there is also a risk attached to the netting process itself. While

calculating the net amounts due between the member banks is easy enough,

difficulties may well arise in ensuring that, in the event of one bank defaulting, those

net amounts represent the real – i.e. legal - obligations or claims of the remaining

banks. The danger is that a liquidator, appointed to sort out the bank’s financial affairs

after it has failed, will challenge the netting procedure, claiming that it is the underlying

gross payment flows that are the real obligations. If such a challenge was successful, the

remaining banks in the system would first of all be required to settle with the liquidator

all the gross amounts due to the failed bank, and only later would those banks be

compensated (and not necessarily in full) for the gross amounts that they should have

received from the failed bank. This “unpicking” of the netting calculation could itself

create severe financial pressures amongst the remaining banks, some of whom would

have been expecting to be net recipients in the settlement and would have organised

themselves accordingly but who would now be faced with immediate claims for funds

from the liquidator.

Depending on the particular legal framework that exists in a country, it may be possible

to make laws and regulations that protect netting arrangements in the event of a bank

failure/insolvency. However, this is not always the case, and for many central banks the

uncertainties surrounding the legal validity of netting has been an important additional


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reason why they are now seeking to develop real time gross settlement systems to

handle high-value payments.

21.6. Liquidity Requirements in the Net Settlement systems

We read about how bilateral and multilateral net-positions for each of the participant

are calculated in the previous session. As actual payments are only to be made at the

end of the day (settlement time) which is the resultant of netting of payments made

and received throughout the day by a particular bank.

Hence this reduces the pressure on each bank to keep huge cash reserves with

themselves to settle the payments.

To brush up the concept, let’s take an example:

Bank A has the following payments made and received throughout the day to other

three banks B, C, D.

Table 21.4 Payments Made and Received in a Day

BANK PAYMENT MADE (in crores) PAYMENT RECEIVED (in crores)

B 1000 2000

B 800 750

D 500 650

C 900 400

B 1500 2000

C 100 800

C 500 950

D 700 -

B 600 200

D - 1000

Net Position of Bank A at the end of the day is

Total payments received – Total payments made = 8750 – 6600 = 2150 (in crores of Rupees).

Hence rather than keeping a cash reserve of total Rs. 6600 crores throughout the day

Bank A would have to pay only Rs. 2150 crores at the end of the day. If it has to keep the

entire amount of Rs. 6600 crores the additional Rs. 4450 crores would have been

blocked which it could now invest in other activities and earn a return on it.

This example explains that in net settlement systems participating banks need not to

keep large cash reserves to meet their payment obligations.


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21.7. Risks in Real Time Gross Settlement systems

21.7.1 Operational Risk

The underlying factors in operational risks are same in RTGS as they are in Net

settlement systems. However, the measure of operational risks both systems face is

different due to the nature of their settlement procedures.

In a net settlement system a failure will not delay settlement if the fault is corrected

before clearing and settlement are initiated at the end of day. In an RTGS system, on the

other hand, a failure will delay all the payments which will follow after the system is

down. As all payments are settled in the RTGS systems as soon as they are received, this

means if the system fails the situation will be similar to a traffic jam.

The risk of having a “Grid-Lock” –

This is a profound risk which arises due to the very particular nature of the settlement

process of the Real Time Gross Settlement systems. It’s very difficult for the banks to

manage their cash reserves when they have to settle down their payments on one by

one basis. Take a look at the following example. There are 3 banks operating on a RTGS

system.

Any of the three banks in the above system doesn’t have the requisite amount of the

liquidities with them to make their payments. For example bank A has a cash reserve of

10 crores of rupees whereas it has to pay 25 crores to the bank C. Same is the condition

for the other banks, why this problem has aroused?

Figure 21.2 Gridlock Situations

Because, banks need to make their payments as soon as they receive payment

instructions from the other banks. No bank has sufficient liquidity available to cover the

payment that it wishes to make - and the settlement agent is likely to reject all the

payment requests. The system therefore faces a situation of “gridlock”: for any


Page 14 of 18

individual bank, no outgoing payment can be made because the incoming payment is

also held up.

However, net settlement systems can never face the problem of gridlock as all the

payments will be settled at the settlement time. If in the above example the payments

are settled by multilateral net settlement mechanism then following will be the

settlement matrix for the system at the settlement time.

Table 21.5 Avoiding “Gridlock” using net settlement

As at the time of settlement the bank A and B have their net positions:

For A: 10 (the a/c balance) + 20 (received from B) – 25 (paid to C) = 5

For B: 10 (the a/c balance) + 15 (received from C) – 20 (paid to A) = 5

For C: 5 (the a/c balance) + 25 (received from A) – 15 (paid to B) = 10

So, both Banks A and B have sufficient liquidity to meet their ‘net pay’ obligations, while

Bank C is in a ‘net receive’ position anyway. This ability to economise on settlement

account balances is obviously attractive to commercial banks - given that such balances

do not normally attract any interest.

Gridlock occurs if some participants minimize their liquidity requirement by not

remitting payments until they receive incoming payments. This can lead to a situation

where the participants are awaiting each other's payments and where some

participants cannot settle their payments due to lack of liquidity.

To avoid this RTGS systems employ methods which make their participants to settle

their payments as early as possible. For example some RTGS systems have rules which

make it mandatory for the participants to settle a proportion of their payments till

afternoon. Or they make to settle payments in the afternoon very expensive as

compared in the morning.

Gridlock Resolution by Reordering and Optimization

The following examples attempt to illustrate the essence of how reordering and a type

of optimization mechanism can solve a gridlock. It should be noted that, because the

examples are for illustrative purposes, they abstract from some of the complications

that may accompany gridlocks in practice.


Page 15 of 18

Assumptions

There are three banks, A, B and C, and all have a balance of 100. The following transfers

are being held under FIFO queuing. Note that (Tij) indicates the jth transfer being

processed by Bank i and "A – B 120" means that Bank A will transfer 120 to Bank B. For

simplicity, no central bank credit or other liquid funds are available during the time

under consideration.

Bank A Bank B Bank C

(TA1) A - B 120 (TB1) B - A 180 (TC1) C - A 120

(TA2) A - B 80 (TB2) B – C 120 (TC2) C - B 100

Given the balances (100) and the order in which the payments are queued, none of the

transfers can settle and the system is thus considered to be in gridlock.

Optimization: Assume that the system can activate an optimization mechanism. The

system will select (TA1) and (TA2) and settle them simultaneously with (TB1). Since Bank

B's balance will then become 120 (100 + net transfers from Bank A of 20), transfers (TB2),

(TC1) and (TC2) will subsequently be settled without further intervention.

Alternatively, assume that the system's optimization is based on simulated net balances

i.e. the net balances calculated by subtracting total outgoing payments from total

incoming payments. In this case, the banks' simulated net balances are as follows. Since

simulated net balances are non-negative for all banks (i.e. net intraday liquidity

including potential cover is sufficient to settle outgoing transfers), all transfers will be

settled simultaneously.

Table 21.6

Reordering: Reordering could also solve this gridlock. Suppose that the system centre

switches the order of (TA1) and (TA2). Bank A will now be able to settle (TA2) given its

initial balance of 100. Bank B will then be able to settle (TB1) because its balance has

increased by the incoming transfer from Bank A (i.e. the new balance = the initial

balance of 100 + the incoming transfer from Bank A of 80 = 180).

Subsequently, settlement of all the other queued transfers in the system will become

possible in the following sequence:

Bank A will settle TA1 (120) with the new balance (200 = 20 + 180).


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Bank B will settle TB2 (120) with the new balance (120 = 0 + 120).

Bank C will settle TC1 (120) and TC2 (100) with the new balance (220 = 100 + 120).

21.7.2 Credit Risk in RTGS

In an RTGS system, a payment is usually settled immediately after it has been entered

and accepted in the system. So in principle there is no credit risk on other participants

in the system. This is opposite to the risk factor in the net settlement system because

there the payments are settled at the end of the day.

21.7.3 Liquidity Risk in RTGS

All other things being equal, the individual settlement of payments in RTGS systems

entails a larger liquidity requirement and thereby a greater liquidity risk than settlement

in net settlement systems. Moreover, in RTGS systems gridlocks and deadlocks can arise

which prevent the execution of payments at the agreed time.

Netting Effect –

The netting effect is a measure of the liquidity that the participants save by settling

payments via a net settlement system rather than an RTGS system.

It is calculated as: (TPG-TPN)/TPG

Where TPG = Total payment obligations for all participants on gross settlement.

TPN = Total payment obligations for all participants on net settlement.

An example: The first Table shows three banks that each have six payments for

settlement. Without netting there are 18 payments to be settled, and the participants'

total payment obligations are 865 (=365+230+270)

Table 21.7 Gross Settlement State

If we use Bilateral Net settlement mechanism the liquidity requirement will reduce by

“(TPG-TPN)/TPG” percent. The table below shows the same.

Table 21.8 Net Settlement State


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Chapter-22 Role of Regulatory Bodies

22.1. Introduction

To safeguard the banking and financial systems, legislation and bye-laws need to be

developed to ensure that only authorized organizations are involved in the country’s

payment systems. Such legislation will also enable the regulator to monitor and

supervise the development of e-payment in the country.

It is important for a regulatory body to be assigned oversight of the payment system in

the country. The regulatory body will have to develop and enforce, in consultation with

banks and service providers, rules and standards that will ensure the safe and efficient

operation and development of all the essential components of the payments system.

The primary 4 components of a payment system include:

• Cheques and GIRO transactions

• Stored value e-money

• Real time gross settlement

• Issuance of notes and coins.

In this session you would learn about different regulatory bodies, particularly those

who enact regulation for payment systems.


After completing this chapter you would know more about

• Regulatory bodies in the context of the payments scenario

• And the associated various Regulations.


Chapter-22 Role of Regulatory Bodies..................................................................................................... 3

22.1. Introduction.............................................................................................................................. 3


22.3. Topics Covered........................................................................................................................ 3

22.4. Regulatory Body – An Introduction................................................................................ 4

22.5. Financial Services Authority (FSA)................................................................................... 4

22.2.1 Objectives of FSA....................................................................................................................... 5

22.2.2 Regulatory Regime & Associates......................................................................................... 5

22.2.3 Legal Framework of FSA......................................................................................................... 6

22.2.4 General Body of Law ................................................................................................................ 8

22.2.5 Money Laundering and Terrorist Financing .................................................................. 9

22.6. Association for Payments Clearing Services (APACS)...........................................10

22.7. British Banker’s Association (BBA).................................................................................11

22.8. Euroland Legal and Regulatory regime......................................................................12

22.8.1 PSD [Payment Services directive] ...........................................................................13

22.8.1.1 Subject matter & scope of PSD ...........................................................................14


Page 4 of 22

22.9. Federal Reserve Board of U.S.A ......................................................................................16

22.10. US Regulations ......................................................................................................................16

22.10.1........................................................................................................................................................16

22.10.2 CC 12 CFR 229 (Regulation CC) Availability of Funds and Collection of

Checks 18

22.10.3 E 12 CFR 205 (Regulation E) Electronic Fund Transfers ...............................18

22.11. Different Governing Agencies ........................................................................................19

22.12. Summary..................................................................................................................................20

22.4. Regulatory Body – An Introduction

A Regulatory Body or Regulator is an apex institution which governs the various

activities of organizations in different fields by enforcing rules and regulations,

supervision or oversight, for the benefit of the public at large. Regulatory authorities are

commonly set up to enforce standards and safety measures, to oversee use of public

goods and regulate commercial activities.

The Regulatory process has three fundamentals to guide

Ø Regulated agencies have an effective means to defend themselves against

unauthorized or arbitrary requirements or liabilities,

Ø The wider interest group have a means to have their views considered and

addressed in administrative decisions

Ø It confirms that the activity of regulatory supreme is rule based.

To ensure that it does fulfill its role, a Regulatory Body uses mechanisms such as the

following

Ø Need that the head follows the principles that promote non-arbitrary and

responsive decisions

Ø Arrangements for review of administrative decisions by courts or other bodies

Ø Clarity of information and decision making

Ø Method of advising and participation

Ø Need that administrators give reasons explaining their actions.

22.5. Financial Services Authority (FSA)

In UK, the apex independent Institution for governing the Payment Services is FSA

Financial Services Authority. It is an independent non-governmental body, given

statutory powers by the Financial Services and Markets Act 2000 (FSMA). The FSA is

accountable to Treasury Ministers and through them to Parliament. It is operationally

independent of Government and is funded entirely by the firms it regulates. The FSA

regulates most financial services markets, exchanges and firms. It sets the standards

that they must meet and can take action against firms if they fail to meet these required

standards.


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On 20th

May 1997 creation of new regulation took place in UK. The first stage of the

reform of financial services regulation was completed in June 1998, when responsibility

for banking supervision was transferred to the FSA from the Bank of England. In May

2000 the FSA took over the role of UK Listing Authority from the London Stock

Exchange. The Financial Services and Markets Act, which received royal assent in June

2000 and was implemented on 1 December 2001, transferred to the FSA the

responsibilities of several other organizations:

Ø Building Societies Commission

Ø Friendly Societies Commission

Ø Investment Management Regulatory Organization

Ø Personal Investment Authority

Ø Register of Friendly Societies

Ø Securities and Futures Authority.

22.2.1 Objectives of FSA

The FSA is an open and transparent organization and provides full information for firms,

consumers and others about its objectives, plans, policies and rules. FSMA requires

satisfying the key objectives which are as follows

• Statutory Objectives

• Reduce the scope of financial crime

• Promote understanding of financial services amongst the general people

• Maintain confidence in financial system

• Provide appropriate degree of security in financial services.

22.2.2 Regulatory Regime & Associates

The FSA as being an apex institution covers a wide range of rule making, investigatory &

enforcement powers. FSA has its regulatory regime in the services of

1. Credit institutions- Accepting sums of money paid on terms under which it will

be repaid and which are not referable to the provision (excluding currency) of

property or services or giving of securities. There are specified exclusions like

sums of money received which are immediately exchanged for electronic

money

2. Electronic money Services- Issuing electronic money

Electronic money is defined in the RAO (Regulated Activities Order 2001) as monetary

value, as represented by a claim on the issuer which is:

• Stored on an electronic device

• Issued on receipt of funds


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• Accepted as a means of payment by persons other than issuer

Another regulator after FSA is HMRC (Her Majesty’s Revenue & Customs) which controls

Money Services Business. The associates of FSA are BBA (British Bankers Association) &

APACS (Association for Payment & Clearing Services).

22.2.3 Legal Framework of FSA

The FSMA 2000 requires FSA to meet four statutory objectives and principles of good

regulation. The statutory objectives are:

• Maintain confidence in the financial system

• Secure the appropriate degree of protection for consumers;

• Promote public understanding of the financial system;

• Reduce the scope for financial crime.

Principles of a good regulator which applied to FSA are, as follows:

• Most efficient and economic use of resources;

• Being fair & impartial

• Responsibility of firms’ own management

• Maintaining the UK’s competitive position

• Competition

• Facilitating innovation.

General Prohibition

• FSA prohibits the businesses or the person carrying business which are in

certain aspects known to be as Regulated Activities or which are not within the

legal demarcations of FSA or are termed as unauthorized by FSA

• The entity that has obtained permission (Part IV permission) for one or more

regulated activities are known as authorized person.

Regulated Activities

§ The specified kinds of activity which if carried on by way of business and relate

to an investment of a specified kind as set out in the Financial Services and

Markets Act 2000 (Regulated Activities) Order 2001 (RAO) as amended.

§ The principal regulated activities relevant to payments industry are:

1. Accepting sums of money paid on terms under which it will be repaid and

which are not referable to the provision (excluding currency) of property or

services or giving of securities. There are specified exclusions like sums of

money received which are immediately exchanged for electronic money

2. Electronic money is defined in the RAO as monetary value, as represented by a

claim on the issuer which is:


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- Stored on an electronic device

- Issued on receipt of funds

- Accepted as a means of payment by persons other than issuer

Threshold conditions for authorization

§ The applicant is a corporate constituted under the laws of any part of UK

(England and Wales, Scotland and Northern Ireland but not the Channel Islands,

the Isle of Man or other overseas territories or dependencies), its head office

must be in UK

§ If the applicant has ‘Close links’ with another person the FSA must be satisfied

that those links will not prevent the FSA’s effective supervision of the applicant.

(close links include relationship with any person which is : a parent undertaking

of the applicant; a subsidiary undertaking of the applicant or of a parent

undertaking; or which has a 20% ownership or voting connection with the

applicant)

§ The resources of the applicant must, in the opinion of FSA, be adequate in

relation to the regulated activities that it is seeking to carry on. The FSA may

take into account the applicant’s membership of a group and the effect which

being part of that group may have, and have regard to the potential liabilities

and risk management within the group.

§ The applicant must satisfy the FSA that it is a fit and proper person having

regard to all circumstances including any connection with any other person, the

nature of the regulated activities and the need to ensure that the applicant’s

affairs are conducted soundly and prudently.

Controllers

§ FSA holds the right to approve the ‘Controllers’ of the applicant. A controller is

anyone who holds more than 10% of the shares in, or can exercise 10% or more

of the voting power of, the applicant (or any parent undertaking of the

applicant)

§ FSA should be provided with the complete “Organogram” and the full details of

the controllers of the corporate chain.

Financial Reporting and notification requirements

The reporting and notifications of financial details will require:

• The keeping of accounting records meeting the FSA requirements

• An annual audit, with the auditors reporting to the FSA;

• Periodic financial reporting statements containing information required by the

FSA.


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• Authorized persons have to notify the FSA of, and in some cases to obtain prior

consent to, certain changes and events.

Risk-based regulation: systems and controls

§ The FSA aims to practice risk based regulation. This means that:

o It will seek as part of the application process to assess the risks of the

applicant’s operation, and may impose requirements designed to mitigate

the risk

o Its level of subsequent supervision will be based on its risk assessment.

§ The FSA expects a firm to ‘identify, measure, manage and control’ risks

§ The FSA also expects the firm to take ‘reasonable care to establish and maintain

such systems and controls as are appropriate to its business’. The factors that

needs to be considered are exhibited below

o The organizational structure and reporting lines

o The desirability of a risk assessment function

o The need for the firm’s governing body to have appropriate management

information

o The need for procedures to establish suitability of employees

o Appropriateness of audit function and/or an audit committee.

22.2.4 General Body of Law

§ The legislation pertaining to data protection is the Data Protection Act 1998

(DPA 1998)

§ The data protection principles are the core of the DPA act 1998. The key

attributes are mentioned below:

o Personal data shall be processed fairly and lawfully and shall not be

processed unless :

o At least one of the conditions in the DPA 1998, schedule 2 is met

o In the case of sensitive personal data , at least one of the conditions

in schedule 3 is also met.

o Personal data shall be obtained only for one or more specified and lawful

purposes, and shall not be further processed in any manner incompatible

with that purpose.

o Personal data shall be adequate, relevant and not excessive in relation to

the purpose for which it is processed

o Personal data shall be accurate and, where necessary, kept up to date

o Personal data processed for any purpose shall not be kept longer than the

necessary for purpose


Page 9 of 22

o Personal data shall be processed in accordance with the data subjects’ rights

under the DPA 1998.

o Appropriate technical and organizational measures shall be taken against

the unauthorized or unlawful processing of personal data and against

accidental loss or destruction of, or damage to personal data.

o Personal data shall not transferred to a country or territory outside

European Economic Area unless that country or territory ensures an

adequate level of protection for the rights and freedoms of data subjects in

relation to the processing of personal data.

• With regard to the technological development and the implementation (of

measures) costs, the measures have to ensure a level of security appropriate to:

o the harm that might result from unauthorized or unlawful processing or

accidental loss, destruction or damage as mentioned in the seventh

principle

o The nature of the data to be protected

o The data controller has to take reasonable steps to ensure the reliability of

any employees of his who have access to data

• Where processing of personal data is carried out by a data processor on behalf

of a data controller, the data controller must, to comply with seventh principle:

o choose a data processor providing sufficient guarantees regarding the

technical and organisation security measures for the processing to be

carried out

o Take reasonable steps to ensure compliance with those measures

• Where processing of personal data is carried out by a data processor on behalf

of a data controller, the data controller is not to be regarded as complying with

the seventh principle unless:

o the processing is carried out under the contract in writing under which the

data processor is to act only on instructions from the data controller

o The contract requires the data processor to comply with obligations

equivalent to those imposed on a data controller by the seventh principle.

22.2.5 Money Laundering and Terrorist Financing

Money Laundering: The conversion or transfer of property, knowing that such

property is derived from any [drug trafficking] offense or offenses or from an act of

participation in such offense or offenses, for the purpose of concealing or disguising the

illicit origin of the property or of assisting any person who is involved in the commission

of such an offense or offenses to evade the legal consequences of his actions;


Page 10 of 22

Source: (Definition adopted by the United Nations Convention Against Illicit Traffic in Narcotic

Drugs and Psychotropic Substances (1988) (Vienna Convention)

The Joint Money Laundering Steering Group (JMLSG) comprises the leading UK trade

associations in the financial services industry. JMLSG has been producing money

laundering guidance for the financial sector since 1990, initially in conjunction with

Bank of England (BoE) and lately to provide regularly updated guidance on various

Money Laundering regulations in force.

The key responsibilities of JMLSG are to:

• Promulgate good practice in the countering money laundering and

terrorism financing

• Practical assistance in interpreting the UK Money Laundering

Regulations 2003 and money laundering aspects of the Proceeds of

Crime Act 2002.

The above issues are addressed by publishing the industry guidance.

§ The revised guidance will enable the UK financial services industry to take

sharper, risk-based approach to the international fight against financial crime.

The new guidance reflects the reality that most customers are neither money

launderers nor terrorists.

22.6. Association for Payments Clearing Services (APACS)

Overview

Ø A UK trade association for payments and those institutions that deliver

payment services to customers.

Ø Member strength is 31, whose payment traffic volumes is 97% of the total

UK markets.

Key responsibilities

Ø Payment industry voice on a wide range of topics and the industry’s

representative in Europe

Ø Forecast payment trends, conduct market research,

Ø Conducts lobbying activities,

Ø Develops industry standards and best practices

Ø Coordinates activities to tackle payment related frauds (It contributed

strongly on introduction of chip and PIN cards in UK)

Strategy and vision for the payments industry

Ø To define, articulate and promote a vision and strategy for the UK payments

industry, in the context of domestic, European and international


Page 11 of 22

developments to ensure that end customer requirements can be delivered

in an economically sustainable manner.

Ø To ensure that key strategic issues and stakeholders expectations for the

payments industry are identified, understood and managed.

External communications

Ø To maximize the industry’s effectiveness in managing the external

environment and stakeholders satisfaction

Ø To promote public confidence in, and improve public perception of, the

payments industry

Ø To act as a respected spokesperson foe the payments industry

Ø To be an authoritative source of payment knowledge and promote the

understanding of payments and payments-related issues to interested

stakeholders and general public

Integrity

Ø To protect and enhance the integrity of the payments industry an d to

promote world-class management of payment system risks. (Scope includes

risk management, fraud management pan-scheme settlement risk, security

and business continuity

Ø To facilitate and promote the development of the industry measures to

reduce payment-related fraud and criminal activities in payments

Change Management

Ø To facilitate co-operative innovation between members and manage pan-

scheme industry projects as appropriate

Ø To support and encourage the development of existing payment services

and the establishment of new payment services to better meet members

and stakeholder requirements.

Standards and Interoperability

Ø To promote improvements to interoperability, and error free processing, as

an aid to cost reduction and improved customer service

Ø To develop and promote world-class standards for use in UK payment

services, in the context of European and international developments.

22.7. British Banker’s Association (BBA)

The BBA is the leading association for UK banking and financial services sector, an

association that speaks for 223 banking members from 60 countries on full range of UK

or international banking issues.

Overview


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A principal trade association for banks operating in UK

Member strength is 223; 85% of which provide wholesale banking activities; 75% of

the membership is non-UK origin representing 60 countries; BBA members hold

90% of the UK banks assets.

Key responsibilities

Ø Development production and continuing revision of the Banking Code

(voluntary code that sets the banking industry standard on good practice)

Ø Development of Bankfacts ( a collection of easy-to-understand plain English

guides)

Ø Guidance on Accounting practice

Ø Market pricing benchmarks such as LIBOR rates

Ø Collation and maintenance of data on bank deposits and lending as well as

in areas such as credit cards and operational losses

Ø Shaping European regulation to enable the better provision of financial

services from UCITS (Undertakings for the Collective Investment of

Transferable Securities) to new securities issues on a cross border basis

across EU

Ø Playing key role in promoting the development of the Basel Accord for both

credit and operational risk (providing regulators with carefully evidenced

arguments for change).

22.8. Euroland Legal and Regulatory regime

Overview

The existing EU payments related measures comprise:

Ø The Directive on cross-border credit transfer, Directive 97/5/EC.

Ø The recommendation for customer protection using electronic payments

instruments

Ø The Regulation on cross-border payments in Euro, Regulation 2560/2001

Ø The Payments Service Directive (PSD), which aims at establishing a modern

and harmonized legal framework for integrated payments markets in

Euroland.

The main aim to cast new framework in financial market is, the non-discrimination

between corresponding national and cross-border payments made in Euro on the basis

of price and the requirement on institutions who offer cross-border payment services to

provide customers with readily comprehensible ex-ante information on charges levied

for affected payments. This legal framework 25060/2001 comprises of the regulation for

cross border payments being made.


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The EU regulation is applicable where:

Ø A payment is made within EU

When any transaction is made within the boundaries of its country, this regulation is

followed.

Ø From one member to another

Any two persons being involved in transaction should bear equal profit or equal loss on

account that none of the party is cheated on the behalf of other parties’ profit

Ø In Euro

The transaction payment should be made in the European currency

• Up to € 50000

The limit of the transaction is fixed up to euro 50000 that the risk could be prevented

up to Euro 50000.

The regulation provides three key Articles that changed the EU payments landscape.

They are

Article 3 – Charges for cross-border electronic payment transactions and credit transfers

Article 4 – Transparency of charges

Article 5 – Measures for facilitating cross-border transfers

22.8.1 PSD [Payment Services directive]

The Payments Service Directive (PSD) aims at establishing a modern and harmonized

legal framework for integrated payments markets in Euro land. It provides the legal

foundation for the creation of an EU wide single market for payments. The proposal for

the directive was released on 1 December, 2005 by the European Commission (EC). The

Objectives of the directive are:

Ø to enhance competition by opening markets and creating a level playing field;

Ø to increase market transparency for providers and users;

Ø to standardize rights and obligations of providers and users of payment services

in the EU, with a strong emphasis on a high level of consumer protection

Ø The target is to make cross border payments efficient, faster, easier and secure

as national payments within a member state.

The reason to build a new framework by EC were

Ø Highly fragmented payments market

Ø Incapability of common means of payments (Direct Debit and electronic

payments) to address the usage, difference in the charging structure and

efficiency related issues.


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Ø The divergence and conflict in the national rules (specifically pertaining to

authorization and liability for delayed and defective execution, non-execution

and unauthorized transaction)

22.8.1.1 Subject matter & scope of PSD

PSD covers following

Ø Subject-matter, scope, negative scope and definitions

Ø Article 1: covers its subject-matter, and excludes central banks and public

authorities from the Directive’s scope;

o Article 2: sets out the Directive’s scope, and cross-refers to an Annex that

lists the activities caught by the Directive;

o Article 3: sets out the Directive’s negative scope, listing for clarity those

activities not caught by the Directive

o Article 4: provides the definitions for the Directive.

Ø Authorization regime for payment institutions

o Article 1:

Section 1 sets out the general rules applying to Payment Institutions, covering

the requirements that would need to be met in order for a Payment Institution

to become authorized and limitations on its activities.

Section 2 sets out other requirements applying to Payment Institutions,

particularly in relation to the use of agents by Payment Institutions;

Section 3 sets out provisions relating to competent authorities and supervision,

setting out the controls that may be exercised by supervisors in relation to

Payment Institutions;

Section 4 establishes a waiver regime for certain types of payment service

provider. This would allow smaller firms meeting certain requirements to be

exempted from the requirements set out in the rest of Title 2;

o Article 23: is related to access to and operation of payment systems. This Article

would stop payment systems from imposing any access conditions beyond

those needed to safeguard against risks and protect financial stability.

Ø Transparency of conditions for payment services

Chapter 1 covers single payment transactions, including obligations to provide

information prior to and subsequent to making and receiving a payment,

setting out both the information that needs to be provided and how it should

be communicated to customers;


Page 15 of 22

Chapter 2 covers framework contracts involving multiple payment transactions,

again covering obligations to provide information prior to and subsequent to

making and receiving a payment and setting out both the information that

needs to be provided and how it should be communicated to customers; and

Chapter 3 covers provisions common to both single payment transactions and

framework contract involving multiple payment transactions, including those

related to currency exchange

Ø Rights and Obligations of users and providers of payment services

Chapter 1: sets out rules relating to the authorization of payment transactions.

These establish what constitutes authorization and what happens in the event

of unauthorized payments being made and also establishes provisions for

refunds for certain types of payments. Article 51 provides a specific exemption

for micro-enterprises and electronic money;

Chapter 2:

Section 1 sets out rules relating to payment orders and amounts transferred,

harmonizing the point in time at which a payment is considered to be accepted

by a provider and requiring that providers ensure that the full amount of the

payment transferred is received by the intended recipient;

Section 2 provides for a maximum execution time for payments both initiated

by the payer and initiated by the payee;

Section 3 sets out rules relating to the availability of funds and non or defective

execution of the transactions

Chapter 3: covers data protection

Chapter 4: covers penalties and complaint and redress procedures.

Ø Amendment and updating the directive

Title 5 of the Directive establishes a Payments Committee and provides for

various provisions of the Directive to be updated.

Ø Reinforcing full harmonization, mutual recognition and mandatory nature of

the regulation

Title 6 of the Directive contains the final provisions, including the provision

making the Directive fully harmonizing (with some limited exceptions) and

transposition requirements applying to Member States. It also contains

provisions allowing payment service providers to grant more favorable terms

to payment service users.


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22.9. Federal Reserve Board of U.S.A

In Unites States of America the main regulator of payment services is Federal reserve

Bank. The Federal Reserve Act of 1913 (FRA) established the Federal Reserve as the

central bank of the United States. The Federal Reserve has responsibilities that include

issuing notes, providing payment services, acting as fiscal agent and depository of the

United States, supervising and regulating banking institutions and conducting

monetary policy. The Federal Reserve System includes the 12 regional Federal Reserve

Banks, located throughout the United States, and the Board of Governors, located in

Washington, DC.

The Board of Governors is responsible for the general supervision and oversight of the

Federal Reserve Banks, which are separately, incorporated entities.

Apart from Federal Reserve Board there are many other regulatory bodies in U.S which

directly influence the functioning of the banks and other financial institutions.

Regulatory bodies are

Ø Federal Depository Insurance Corporation (FDIC)

Ø Office of the Comptroller of the Currency (OCC)

Ø Office of Thrift Supervision (OTS)

Ø National Credit Union Administration (NCUA)

Ø Department of Treasury

Ø Federal Financial Institutions Examination Council (FFIEC).

In United States federal statutes, regulations and case law govern the payment system

in the United States.

The relevant legal principles generally depend on the method of payment (paper-based

or electronic) and in some cases the status of parties to a payment, for example

consumer, merchant or financial institution.

Several federal laws, which are discussed further below, apply to payment activities,

particularly in the consumer sector. At the state level, the Uniform Commercial Code

(UCC) establishes a set of model statutes governing certain commercial and financial

activities, including some banking and securities market transactions. Articles of the

UCC pertinent to payment and settlement activities are the services that the Federal

Reserve operates, Federal Reserve regulations and operating circulars specify the terms

and conditions under which the services are provided.

22.10. US Regulations

22.10.1 J 12 CFR 210 (Regulation J) Collection of Checks and Other Items by

Federal Reserve Banks and Funds Transfers through Fedwire


Page 17 of 22

The procedures, duties, and responsibilities among (1) Federal Reserve Banks, (2) the

senders and payers of checks and other items, and (3) the senders and recipients of

Fedwire funds transfers are defined under this framework. Regulation J also directs the

Federal Reserve to issue operating circulars governing details of funds transfer

operations. These circulars, which specify the terms and conditions of the funds transfer

service, cover such matters as operating hours, security, authentication, and fees.

Regulation J also incorporates certain provisions of Uniform Commercial Code (UCC)

Article 4A. This article establishes the rights and obligations of the various participants

in a funds transfer, including the originator, intermediary institutions, and the

beneficiary. Since its approval in 1989, regulation J covers the details of checks under

section 210 as;

Sec. 210.1 - Authority, purpose, and scope.

Sec. 210.2 - Definitions.

Sec. 210.3 - General provisions.

Sec. 210.4 - Sending items to Reserve banks.

Sec. 210.5 - Sender's agreement; recovery by Reserve Bank.

Sec. 210.6 - Status, warranties, and liability of Reserve Bank.

Sec. 210.7 - Presenting items for payment.

Sec. 210.8 - Presenting non cash items for acceptance.

Sec. 210.9 - Settlement and payment.

Sec. 210.10 - Time schedule and availability of credits for cash items and returned

checks.

Sec. 210.11 - Availability of proceeds of non cash items; time schedule.

Sec. 210.12 - Return of cash items and handling of returned checks.

Sec. 210.13 - Unpaid items.

Sec. 210.14 - Extension of time limits.

Sec. 210.15 - Direct presentment of certain warrants.

Subpart B--Funds Transfers Through Fedwire

Sec. 210.25 - Authority, purpose, and scope.


Sec. 210.27 - Reliance on identifying number.

Sec. 210.28 - Agreement of sender.

Sec. 210.29 - Agreement of receiving bank.

Sec. 210.30 - Payment orders.

Sec. 210.31 - Payment by a Federal Reserve Bank to a receiving bank or beneficiary.

Sec. 210.32 - Federal Reserve Bank liability; payment of interest


Page 18 of 22

22.10.2 CC 12 CFR 229 (Regulation CC) Availability of Funds and Collection of Checks

This rule governs the availability of funds deposited in checking accounts and the

collection and return of checks

Fedwire funds transfers are also subject to Regulation CC funds availability provisions

and to Bank Secrecy Act (BSA) relating to record keeping for funds transfers and

transmittals of funds by financial institutions. Bank Secrecy Act was passed by congress

in 1970 as the first laws to fight money laundering in the United States. Records and file

reports that are very usefulness are kept in accordance with BSA. The BSA requires

businesses to maintain criminal, tax, and regulatory matters. The credentials filed by

businesses under the BSA requirements are used by law enforcement agencies, both

domestic and international to identify, detect and deter money laundering whether it is

of a criminal enterprise, terrorism, tax evasion or other unlawful activity. Regulation CC

moreover covers all the obligations for check collection under sec 229

Subpart A--General

Sec. 229.1 - Authority and purpose; organization.


Sec. 229.3 - Administrative enforcement

Subpart B--Availability of Funds and Disclosure of Funds Availability Policies Sec. 229.10 -

Next-day availability.

Sec. 229.11 - [Reserved]

Sec. 229.12 - Availability schedule

Sec. 229.13 - Exceptions.

Sec. 229.14 - Payment of interest.

Sec. 229.15 - General disclosure requirements.

Sec. 229.16 - Specific availability policy disclosure.

Sec. 229.17 - Initial disclosures.

Sec. 229.18 - Additional disclosure requirements.

Sec. 229.19 - Miscellaneous

Sec. 229.20 - Relation to state law.

Sec. 229.21 - Civil liability

Subpart C--Collection of Checks

Sec. 229.30 - Paying bank's responsibility for return of checks.

Sec. 229.31 - Returning bank's responsibility for return of checks.

Sec. 229.32 - Depositary bank's responsibility for returned checks

22.10.3 E 12 CFR 205 (Regulation E) Electronic Fund Transfers

This part carries out the purposes of the Electronic Fund Transfer Act, which guidelines

the basic rights, liabilities, and responsibilities of consumers who use electronic fund


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transfer services and of financial institutions that offer these services The primary

objective of the act and this part is the protection of consumers engaging in electronic

fund transfers. This regulation further defines various obligations under each section.

Sec. 205.1 - Authority and purpose.


Sec. 205.3 - Coverage.

Sec. 205.4 - General disclosure requirements; jointly offered services.

Sec. 205.5 - Issuance of access devices.

Sec. 205.6 - Liability of consumer for unauthorized transfers.

Sec. 205.7 - Initial disclosures.

Sec. 205.8 - Change in terms notice; error resolution notice.

Sec. 205.9 - Receipts at electronic terminals; periodic statements.

Sec. 205.10 - Preauthorized transfers.

Sec. 205.11 - Procedures for resolving errors.

Sec. 205.12 - Relation to other laws.

Sec. 205.13 - Administrative enforcement; record retention.

Sec. 205.14 - Electronic fund transfer service provider not holding consumer's account.

Sec. 205.15 - Electronic fund transfer of government benefits.

Sec. 205.16 - Disclosures at automated teller machines

Sec. 205.17 - Requirements for electronic communication.

Sec. 205.18 - Requirements for Financial Institutions Offering Payroll Card Accounts.

The term electronic fund transfer does not include:

(1) Checks.

(2) Check guarantee or authorization.

(3) Wire or other similar transfers.

(4) Securities and commodities transfers.

(5) Automatic transfers by account-holding institution.

(6) Telephone-initiated transfers..

(7) Small institutions.

22.11. Different Governing Agencies

A number of government agencies have established regulations governing the

issuance of agency securities. The Federal Reserve issues an operating circular to

institutions that participate in the Fedwire securities transfer service that incorporates

the provisions of both Treasury and agency securities regulations.

In addition, financial institutions must comply with the US Department of Treasury's

Office for Foreign Assets Control (OFAC) regulations when processing Fedwire funds


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transfers. OFAC acts under Presidential wartime and national emergency powers, as

well as authority granted by specific legislation, to oblige controls on transactions and

congeal foreign assets under US jurisdiction. The Office of Foreign Assets Control

("OFAC") administers and enforces economic and trade sanctions based on US foreign

policy and national security goals against targeted foreign countries, terrorists,

international narcotics traffickers, and those engaged in activities related to the

proliferation of weapons of mass destruction.

Along with this, depository institutions are also subject to the Federal Reserve Policy

Statement on Payment Risk dated January 4, 1999. Board’s objective to adopt this

policy is to promote the safety and efficiency of payments and securities settlement

systems. These policy objectives are dependent on

(1) The Board’s long-standing objectives to promote the integrity, efficiency, and

accessibility of the payments mechanism;

(2) Industry and supervisory methods for risk management; and

(3) Internationally accepted risk management standards and practices for systemically

important payments and securities settlement systems

The US government securities market is governed by the US Department of Treasury

and the Government Securities Act (GSA) of 1986 and the GSA Amendments of 1993.

The Treasury/Reserve Automated Debt Entry System (TRADES) regulations, issued on

August 23, 1996 by the US Department of Treasury, provide the legal framework

governing treasury securities held on the Fedwire system as well as the subsidiary

holdings of Fedwire participants.

22.12. Summary

• A Regulatory Body or Regulator is an apex institution which governs the various

activities of organizations in different fields by enforcing rules and regulations,

supervision or oversight, for the benefit of the public at large.

• In UK the apex independent Institution for governing the Payment Services is

FSA Financial Services Authority. It is an independent non-governmental body,

given statutory powers by the Financial Services and Markets Act 2000 (FSMA).

• In Unites States of America the main regulator of payment services is Federal

reserve Bank. The Federal Reserve Act of 1913 (FRA) established the Federal

Reserve as the central bank of the United States.

• Fedwire funds transfers are also subject to Regulation CC funds availability

provisions and to Bank Secrecy Act (BSA) relating to record keeping for funds

transfers and transmittals of funds by financial institutions.


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• OFAC acts under Presidential wartime and national emergency powers, as well

as authority granted by specific legislation, to oblige controls on transactions

and congeal foreign assets under US jurisdiction.

Page 1 of 59

Chapter-23 Role of Non-bank Institutions in

Payment systems

V 2.0, April 2009

for associates



Page 2 of 59





joining TCS.


Page 3 of 59

Chapter-23 Role of Non-bank Institutions in Payment systems

23.1. Introduction

Non-bank institutions have always been a key component of the national payments

system, enhancing the efficiency, breadth, and competitiveness of the industry. What is

new is higher visibility and greater prominence of the Non-bank institutions. Whether it

is back-office processing or front-end consumer interaction, Non-bank institutions have

become a major market force. The heightened visibility of such institutions in the

payments system raises several important questions.

In which payment activities are these institutions engaged? What roles do they play in

specific payment types? What types of risk are potentially associated with their

participation? This chapter provides the first step in addressing these questions.

23.2. Learning objectives

After reading this session you will know more

• About Non-bank Institutions & their activities

• Diverse roles played by these institutions in the Payment System

• Detailed insight into the Automated Clearing House (ACH).


Chapter-23 Role of Non-bank Institutions in Payment systems................................................... 3

23.1. Introduction.............................................................................................................................. 3

23.2. Learning objectives............................................................................................................... 3

23.3. Topics Covered........................................................................................................................ 3

23.4. Introduction- Non Bank Payment Activities ............................................................... 4

23.5. Non-bank roles in Traditional Payments Types......................................................... 7

23.5.1 Check..................................................................................................................................... 8

23.5.1.1 Cheque: POS- without Truncation.....................................................................12

23.5.1.2 Cheque: POS- with Truncation............................................................................13

23.5.1.3 Cheque-Lockbox – Bank as processor .............................................................14

23.5.1.4 Cheque-Lockbox – NonBank as processor ....................................................15

23.5.2 ACH ......................................................................................................................................16

23.5.3 Online debit card ...........................................................................................................17

23.5.4 Credit Card & Offline Debit Card .............................................................................19

23.5.4.1 Credit & Offline Debit: Card Present—Visa/MasterCard Networks .....20

23.5.4.2 Credit & Offline Debit: Card Not Present—Visa/MasterCard Networks

21

23.5.5 Retail wire services ........................................................................................................22

23.6 Non-Bank Roles in Emerging Payments Types..............................................................24

23.6.1 Check conversion (Point of sale)...............................................................................25

23.6.1.1 Check Conversion: POS—ACH............................................................................27


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23.6.1.2 Check Conversion: POS—EFT..............................................................................28

23.6.1.3 Check Conversion: POS—Visa (in network)...................................................28

23.6.1.4 Check Conversion: POS—Visa (out of network) ..........................................30

23.6.2 Lockbox..............................................................................................................................31

23.6.2.1 Check Conversion: Lockbox- Bank as processor .........................................32

23.6.2.2 Check Conversion: Lockbox- Non-bank as processor...............................32

23.3.3 Electronic bill presentment and payment ....................................................................33

23.6.3.1 EBPP: Biller Direct......................................................................................................36

23.6.3.2 EBPP: Consolidator...................................................................................................37

23.6.3.3 EBPP: Lockbox............................................................................................................38

23.3.4 Electronic Invoice Presentment and Payment (EIPP) ...............................................39

23.6.5 Stored value .....................................................................................................................40

23.6.5.1 Stored Value: Single Purpose—Sale .................................................................43

23.6.5.2 Stored Value: Single Purpose—Redemption................................................44

23.6.5.3 Stored Value: Multipurpose- ACH Infrastructure/EBT...............................45

23.6.5.4 Stored Value: Multipurpose—Credit Card Infrastructure/Visa Buxx...46

23.6.5.5 Stored Value: Multipurpose—Credit Card Infrastructure/Payroll Card

47

23.6.6 Contactless payments..................................................................................................48

23.6.6.1 Contact- less: Funding and Use ..........................................................................49

23.6.7 Person-to-Person ...........................................................................................................49

23.6.7.1 P2P: PayPal—Sending ............................................................................................51

23.6.7.2 P2P: PayPal—Receiving .........................................................................................52

23.6.7.3 P2P Western Union Moneyzap ...........................................................................53

23. Glossary of Terms ........................................................................................................................54

23.8.1. Summary..................................................................................................................................58

23.4. Introduction- Non Bank Payment Activities

Non-banking institutions are usually not directly involved in settlement activities. Non

banking financial institutions offer financial services that are not appropriate for banks

because of the nature of risks involved (insurance for example). Some evolve to fill in

gaps in market place (development banks). These institutions capitalize on benefits of

specialization in knowledge and information. Also they tend to be less costly and more

efficient. They typically have a relationship with a bank or any other financial institution

for settlement purposes. While they appear to be associated with limited settlement

and systemic risk, they are susceptible to other types of payments system risk,

especially operational risk. Non-bank business relationships with banks and other

participants in the payments system are often highly complex and intertwined. In light

of non bank pervasiveness, complexity, and risk potential, it is essential to track and

better understand non-banks’ roles in the payments system. (The term “non-bank” can

be defined in many ways. Non-bank is any firm that is not a bank, whereas a “bank” is an

institution that accepts demand deposits. Some non-banks, of course, are owned or

governed by banks, with two prominent examples being the Visa and MasterCard credit


Page 5 of 59

card associations. This session encompasses all non-banks but tends to focus on those

without bank ties.)

Non-banks are an integral part of the payments system. They perform functions at all

stages of the payments process. For example, non-banks are actively involved in the

back-office processing of many traditional payments instruments, such as checks and

automated clearing house (ACH) transactions. In other traditional payments types, such

as automated teller machine (ATM) and credit card transactions, non-banks often are at

the forefront, highly visible to the end user. And in the world of emerging payments, for

example, Internet bill payment and online person-to-person transactions, non-banks

are often the trendsetters leading the way.

This section provides an overview of the principal types of non-bank payments

activities.

Among core data processing that is outsourced, three non-bank firms—Fiserv,

Metavante, and Alltel—have largest market share. Among personal identification

number (PIN)-based debit card processors, two non-bank firms—Concord and First

Data/NYCE—have a largest share. And in the online person-to-person market, one non-

bank—PayPal—has an 80 percent market share. While these are just three examples,

they do illustrate the importance of non-bank participation in some key categories.

And non-bank participation is rising overall because banks are increasingly outsourcing

payments activities to third parties and payments system is steadily shifting from

paper-based to electronic transactions.

Table 23.1 shows how extensive the range of non-bank payments activities is. Thirty-

five types of activities are listed and grouped into three broad areas:

Ø authorization,

Ø processing, and

Ø Instrument provision.

For each activity, a brief description is given and examples of non-bank companies are

shown. It is important to note that the degree of non-bank participation varies across

activities. It also should be stressed that while the table highlights non-banks, banks

also are involved in many of these activities, sometimes extensively.

The first set of activities represents authorization activities. Before a transaction can

take place, it needs to be authorized and approved. Examples of such activities include

check authorization, fraud detection, online security systems, certificate authorities, and

authorization independent sales organizations (ISOs).

The second broad group of activities involves processing. This encompasses a wide

range of activities. The first three in some sense are the most basic, providing early-

stage infrastructure: hardware providers, software providers, and core data processors.


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Non-banks have a large presence in all three. Non-banks, for example, dominate the

hardware category (ATM terminals, cash registers, point-of-sale (POS) terminals, plastic

cards, etc.) and are major suppliers of traditional and Internet-related banking software.

And, as noted earlier, non-banks also are important core data processors, especially for

small and medium-sized banks. The large majority of the biggest banks (those with

assets of more than $10 billion), in contrast, keep their core data processing in-house.

The next set of payment activities centers on check processing. Many of these include

non-bank involvement. Activities include check outsourcing, in-house remittance

processing, remittance and lockbox processing, check clearinghouses, and archive

services. Non-bank check outsourcers—firms that perform such tasks as check capture

and encoding—handle from 5 to 10 percent of the total checks processed. The leading

check outsourcer is Fiserv. One reason for writing checks, of course, is to pay bills.

Approximately two-thirds of the 11 to 16 billion remittance checks written are

processed in-house by large non-bank billers, including insurance, utility, and financial

services companies. The remaining one-third is outsourced to lockbox processors,

mainly banks; however, non-banks such as Regulus and Remitco also have a share of

this market.

Regarding the clearing of checks, of the 70 percent that are cleared (30 percent are “on-

us”), approximately 25 percent of these are cleared through private clearing houses

such as WesPay and NYCH/SVPCo. These clearinghouses are non-banks, but most are

owned by banks and other financial institutions. Finally, the majority of check-archiving

services is handled in-house, an exception being services performed by the (partially

bank-owned) non-bank ViewPointe.

Turning to ACH-related payments activities, it is estimated that non-bank payroll service

providers, such as ADP and Ceridian, were involved in the origination of as many as 50

percent of these deposits. Historically, there has been heavy non-bank participation

among ACH outsourcers as well. Large ACH outsourcers, such as Fiserv, EDS, and

Metavante, originate millions of ACH transactions annually.

For example: EDS processed 95 million ACH transactions in 2000. ACH network

operators in contrast are characterized by a dominant bank presence.

The next set of activities centers on credit, debit, and ATM card activities. As with

ACH-related activities, the card networks are largely controlled by banks or bank-owned

non-banks. The many processing activities surrounding card transactions tend to be

dominated by non-banks.

One of the largest card-related activities is card-issuer processing. Two non-banks,

First Data and TSYS, dominate this market. First Data also is the leading non-bank card

merchant processor.


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The two largest credit card networks, Visa and MasterCard, are bank-owned

associations. Conversely, the electronic funds transfer (EFT) networks used for ATM and

online debit card transactions have a large non-bank presence.

Non-banks also are important operators of ATM terminals. Leading firms include

eFunds, E*Trade, and American Express. In addition, non-banks have a presence in

Electronic Benefits Transfer (EBT) service provision, examples being eFunds and

Lockheed Martin.

The remaining activities in the processing group represent an assortment, the common

attribute being a closer connection to the end-user. Some facilitate the exchange of

business-to-business (B2B) information, such as EDI VANs and B2B payment services.

Others facilitate consumer-to-business exchanges, including Web platform hosting and

the provision of electronic bill presentment and payment services. Bottomline, Digital

Insight, CheckFree, and Metavante are some of the principal players in these markets. A

third subcategory is online person-to-person payments, with PayPal the dominant firm.

And a fourth subcategory might be termed “walk-up” services, including retail wire

services (e.g., Western Union and MoneyGram) and check cashing services (e.g., the ACE

Cash Express chain). Non-banks dominate throughout these activities.

The final broad group of payments activities, instrument provision, is what the term

suggests—the provision of actual payments instruments. The first category is general-

purpose credit card issuers. This category includes both bank issuers, operating under

the auspices of the bank-owned Visa and MasterCard card associations, and non-bank

issuers, principally American Express, Discover, and Diners’ Club. The second category is

private-label credit card issuers, e.g., retailers and gas stores. Many of these issuers turn

to other third parties such as GE Capital for processing. Debit card issuers comprise an

important third category. The majority of debit cards are issued by banks belonging to

one or more of the regional or national EFT networks or offline debit card networks, but

some non-banks issue debit cards as well. Storedvalue cards, money orders, and

travelers checks round out the final group. non-banks play a dominant role in all three.

23.5. Non-bank roles in Traditional Payments Types

Traditional retail payments fall into five broad categories: check, ACH, credit card, debit

card, and retail wire services. This section presents and explains the specific steps

involved in these transactions, breaking out, where appropriate, important variants of

the broad payments types. The roles played by non-banks are emphasized throughout

this chapter.

Figure 23.1 shows the ten payments types. As noted, there are four check-related

entries, one ACH entry, three credit card/offline debit card entries (grouped together


Page 8 of 59

because they share a common infrastructure), one online debit card entry, and one

retail wire entry. Each payment type is introduced by a brief discussion, followed by a

detailed schematic.

The schematics in the figures follow a common format. non-banks are shaded in gray; a

nonblank positioned “behind” a bank or a bank positioned behind a non-bank denotes

a possible intervening relationship; and dashed lines signify final settlement. In

addition, when a given payment’s final settlement is implemented through another

payments mechanism, the schematic makes this clear. Two observations become

apparent in surveying these schematics: There is a good deal of gray, that is, significant

non-bank involvement. And dashed lines (final settlement) always flow from bank to

bank.

23.5.1 Check

Traditional processing of checks can entail handling the paper check throughout the

various stages of processing or truncating the check, processing the paper item up to

some point, and then processing the payment electronically through the remaining

“steps.”

Figures 23.2 and 23.3 illustrate how a check presented at the POS might be processed.

In both figures a consumer paying for a purchase at a POS location with a check

initiates the transaction. When the merchant receives the check, it uses vendor-

provided software to verify checking account information against databases and,

presumably, obtains transaction authorization. The merchant then accepts the check as

payment and provides the consumer with a sales receipt. At some point during the

business day, the merchant deposits the checks it received with either its merchant

bank or its bank’s processor. When the check deposit is received by either, the checks

are run through check reader/sorter machines to gather debit/credit information.

In Figure 23.2, either the merchant bank or its processor prepares check cash letters

and presents them to other banks and/or clearinghouses. Credits are passed to the

merchant’s bank, and debits are passed to the consumer’s (drawee) bank. Ultimately,

the merchant’s bank credits the merchant’s account, and the drawee bank debits the

consumer’s demand deposit account (DDA).


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Table 23.1 Activities of Non-bank institutions


Page 10 of 59

In Figure 23.3, the merchant bank or its outsourcer truncates the checks. So, instead of

sending the physical checks to other banks and/or clearinghouses, an electronic file is

sent to the Fed. The credit to the merchant’s account occurs during the merchant bank

Figure 23.1 Roles of Non-Banks in Traditional Payment System

or outsourcer’s magnetic ink character recognition (MICR) capture process. The Fed

debits the drawee bank, and the drawee bank subsequently debits the consumer’s

DDA.


Page 11 of 59

Figures 23.4 and 23.5 outline how a check presented at a lockbox might be processed.

Again, in both figures a consumer making a bill payment with a check and mailing it to

a lockbox initiates the transaction. Once received by the service provider, check

information is verified against the payment stub, both items are encoded, payment

information is posted for the biller, and MICR line capture and check imaging may be

performed. A bank (Figure 23.4) or a remittance/lockbox processor (Figure 23.5) may

perform these functions. If the biller’s service provider is a remittance/lockbox

processor, that processor then forwards the checks to its bank or its bank’s core data

processor.

Once the checks are received by a bank or a core data processor, debit/credit

information is gathered; on-us items may be outsorted and credits made to the biller’s

account; and cash letters may be presented to the Fed, to banks with which there is an

arrangement, and/or to a clearinghouse. After the banks and/or clearinghouse process

the cash letters, settlement may occur via ACH and/or funds transfer. Ultimately, the

biller’s bank credits the biller’s account and the drawee bank debits the consumer’s

DDA.

Alternatives to the traditional methods of processing consumer checks written at the

POS and for remittance purposes do exist. POS checks can be converted to ACH and,

potentially, EFT payments. Remittance checks also can be converted to ACH payments,

or a consumer can use electronic bill presentment and payment (EBPP), which entirely

eliminates consumer-written checks. Discussion of POS alternatives is contained in the

text that accompanies Figures 23.12 through 23.15, while discussion of ACH

conversion of remittance checks can be found in the text that accompanies Figures

23.16 and 23.17. Discussion of EBPP can be found in the text that accompanies Figures

23.18 through 23.20.


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23.5.1.1 Cheque: POS- without Truncation

Figure 23.2 Cheque POS without Truncation

Authorization

1. The consumer writes a check for goods or services at a merchant location.

2. The merchant uses vendor-provided software to verify checking account information

against negative databases and completes transaction authorization.

Processing

3. The merchant accepts the check as payment and provides the customer with a sales

receipt.

4. The merchant forwards its check deposit to its merchant bank (or potentially a

processor for the merchant bank).

5. The merchant bank (or its processor) runs the checks to gather debit/credit

information and may:

• Process on-us items and credit the biller’s account (skip to 7)

• Present a cash letter to the Fed;

• Send cash letters to banks with which it has an arrangement; and/or

• Present a cash letter to a check clearinghouse.

Settlement

6. Any credits due to the merchant’s bank from other banks or the clearinghouse are

passed. The Fed, other banks, and/or the clearinghouse (potentially through the Fed)

debit the drawee bank and credit the merchant bank.


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7. The merchant bank (or potentially its processor) credits the merchant’s account for

the items deposited and collected, and the drawee bank (or its processor) debits the

consumer’s DDA.

23.5.1.2 Cheque: POS- with Truncation

Figure 23.3 Cheque: POS-with Truncation

Authorization


2. The merchant uses vendor-provided check authorization software to verify checking

account information against negative databases and completes transaction

authorization.

Processing

3. The merchant accepts the check as payment and provides the consumer with a sales

receipt.

4. The merchant forwards its check deposit to its merchant bank (or potentially its

merchant bank’s processor).

5. The processor runs the checks to gather debit/credit information, sends an electronic

file to the Fed, and either truncates the checks or sends the physical items.

Settlement

6. The Fed debits the drawee bank and credits the merchant’s bank.

7. The merchant bank (or potentially its processor) credits the merchant’s account for

the items deposited and collected, and the drawee bank (or its processor) debits the

consumer’s DDA.


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23.5.1.3 Cheque-Lockbox – Bank as processor

Figure 23.4 Cheque-Lockbox – Bank as processor

Authorization

1. The consumer mails a check for a bill payment to a lockbox address.

Processing

2. A biller’s bank (or potentially its bank’s processor) collects and processes the checks

by verifying the check against the payment stub, encoding both items, posting

payment information for the biller, and potentially capturing the MICR line and imaging

the check. The biller’s bank then runs the checks to gather debit/credit information and

may:

• Process on-us item and credit the biller’s account (skip to step 4)


• Send cash letters directly to banks with which it has an arrangement; and/or

• Present a cash letter to a clearinghouse.

Settlement

3. The biller’s bank is credited, and the consumer’s (drawee) bank is debited. Settlement

may occur via an ACH and/or funds transfer.

4. The biller’s bank (or potentially its processor) credits the biller’s account, and the

drawee bank (or potentially its processor) debits the consumer’s DDA.


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23.5.1.4 Cheque-Lockbox – NonBank as processor

Figure 23.5 Cheque: Lockbox as Bank non-processor

Authorization

1. The consumer mails a check for a bill payment to a lockbox address.

Processing

2. A remittance/lockbox processor collects and processes the checks by verifying the

check against the payment stub, encoding both items, posting payment information

for the biller, and potentially capturing the MICR line and imaging the check. The

processor then forwards the checks to its bank (or potentially its bank’s processor).

3. The processor’s bank (or its bank’s processor) runs the checks to gather debit/credit

information and may:

• Process on-us items and credit the biller’s bank (or the biller’s account, if it also

is the biller’s bank) (skip to step 5)


• Send cash letters to banks with which it has an arrangement; and/or

• Present a cash letter to a clearinghouse.

Settlement

4. Credits due to the biller’s bank are passed through the processor’s bank (or

potentially the bank’s processor), and the consumer’s (drawee) bank is debited.

Settlement may occur via an ACH, (see figure 23.6 on next page) and/or funds transfer.

5. The biller’s bank (or potentially its processor) credits the biller’s account, and the

drawee bank (or its processor) debits the consumer’s DDA


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23.5.2 ACH

The automated clearinghouse (ACH) is an electronic payments network that allows for

the clearing and settlement of debit and credit transactions among banks. Only banks

may have direct links to the ACH, and, through them, businesses and consumers

originate and receive ACH transactions. The ACH was created in the mid-1970s as part

of the government’s efforts to begin dispersing electronically the burgeoning number

of government payments (such as Social Security). Since then, the ACH has experienced

continued growth. The network is governed by the Operating Rules of the National

Automated Clearinghouse Association (NACHA)—The Electronic Payments Association.

There are currently two ACH operators—the Federal Reserve and Electronic Payments

Network (EPN; formerly the New York Automated Clearinghouse, or NYACH). Though

EPN is a non-bank, it is bank-owned. For transactions sent through the Federal Reserve,

settlement may take place in the Federal Reserve account of each bank or in the Federal

Reserve account of designated correspondents. EPN ultimately relies on the Federal

Reserve for settlement.

In 2001 8 billion transactions with a corresponding value of $14 trillion were sent over

the ACH network. Of those traditional uses of the ACH such as payroll direct deposit,

and automatic bill payment accounted for nearly 6million transactions.

Figure 23.6 Transactions through ACH

Figure 23.6 illustrates a basic ACH transaction. The transaction begins with a party

providing authorization to an originator. That originator passes entries along to the

bank that will serve as the originating depository financial institution (ODFI). The ODFI,

in turn, sends entries to the operator, which edits the entries and distributes them to


Page 17 of 59

the appropriate receiving depository financial institutions (RDFIs), and effects

settlement. The RDFI posts the item(s) to the receiver’s account.

As with other payments system applications, the ACH network allows for the

participation of third-party processors on behalf of banks. There are four situations in

which third-party processors may be participants in the ACH. In the first scenario, a

bank allows a corporate customer to send files directly to the ACH operator. In the

second, a bank allows a consumer bill payment service to collect and then disburse

funds by sending files directly to the ACH operator, using its account at the ODFI as a

pass-through account. The third scenario is one in which the ODFI uses a

correspondent bank for processing and/or settlement. Finally, in the fourth scenario,

the ODFI uses a correspondent bank for processing but not for settlement.

Though the bulk of ACH transactions are generated for traditional payments, the ACH

network also is being used for emerging payments. For example, in 1999 NACHA

implemented rules that allow for the conversion of paper checks to ACH items. Two

such conversion opportunities are paper checks written at the POS and paper checks

received at remittance lockboxes. Discussion of these types of transactions is contained

in the text that accompanies Figure 23.11 and Figure 23.17, respectively.

Authorization

1. The receiver provides the originator with authorization to debit or credit his/her

account.

Processing

2. The originator sends a file of ACH items to the ODFI.

3. The ODFI sends the file to the ACH operator or to a third-party processor (sending

point) who sends the file to the operator.

4. The ACH operator edits the file and distributes the items in output files to RDFIs or

third-party processors (receiving points). The receiving point handles posting of ACH

items to the bank’s DDA accounts, and the bank can notify the receiving point if any

items should be returned or need notifications of change (NOCs).

5. The RDFI posts the item to the receiver’s account.

Settlement

6. The ACH operator performs settlement for transactions between the ODFI and the

RDFI.

23.5.3 Online debit card

An online debit card transaction is one in which a consumer uses a debit card along

with a PIN, allowing the merchant to inquire on the consumer’s account and verify that

the funds are available. These transactions are exchanged through EFT networks.


Page 18 of 59

Figure 23.7 shows an online debit card transaction. This figure represents a simple

form of online debit card transaction—one in which both the merchant’s bank and the

issuing bank belong to the same regional network (a “network on-us” transaction).

Once funds availability is confirmed, the issuing bank automatically deducts those

funds from the consumer’s available balance. Unlike a credit card or offline debit card

transaction, which involves “capturing” the transaction subsequent to approval, all

transaction details are sent in the initial message because the consumer has used a PIN.

Thus, end-of-day processing will complete the transaction between the merchant and

the card issuer.

The settlement process described in Figure 23.7 is “processor-level settlement,” in

which the network calculates the net position for each processor and sends ACH items

to each processor for settlement. After settlement between network and processors,

each processor creates an ACH file for settlement with its customers (card issuing and

merchant banks).

Figure 23.7 Online Debit Card

Though not described in this figure, direct settlement is an alternative.

Potential innovations in the debit card arena include allowing consumers to make PIN-

based debit card payments on the Internet. Another program being explored is

DebitMan, an alternative POS debit network that would pay interchange to merchants

that issue the network’s debit cards.

Authorization

1. A consumer uses a debit card for a purchase at a merchant and enters a PIN.

2. The merchant sends the transaction data to the acquiring processor for authorization.

Note: The merchant acquiring processor may or may not be the same entity as the

merchant’s bank.


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3. The acquiring processor sends the transaction data to the consumer’s (issuing) bank

via an EFT network. Note: To provide a fairly simple view of this process, this schematic

reflects a transaction in which both merchant acquiring processor/merchant’s bank and

issuing bank are members of the same EFT network.

4. The issuing bank verifies the cardholder’s PIN and checks the account balance. If the

funds are available, the issuing bank authorizes the transaction and immediately

deducts those funds from the cardholder’s available balance. If funds are not available,

the issuing bank declines the transaction.

5. The acquiring processor communicates with the merchant that the purchase has

been approved or declined.

Processing

Because funds are immediately debited from the consumer’s account when the

transaction is authorized, end-of-day processing completes the settlement process

between merchant and card issuer. The merchant’s acquiring bank/processor received

all of the debit card transaction information as it was initially routed through the

networks for authorization.

Settlement

6. At the network’s cutoff, the processor creates an ACH file including a net debit to

each card-issuing bank for all of its customers’ online transactions and a net credit to

each merchant’s bank account for all of its transactions. (See Figure 23.6 for full details

of how the ACH process works.)

23.5.4 Credit Card & Offline Debit Card

Credit card networks allow for the clearing and settlement of credit card as well as

offline (signature) debit card transactions among participants. There are several credit

card networks. Two of the largest are Visa and MasterCard, which are both bank-owned

associations.

Figure 23.8 illustrates a credit card or offline debit card transaction in which the card is

present. A merchant uses a card merchant processor (such as FDC), which in turn sends

the transaction details over the Visa or MasterCard network for authorization by the

issuing bank. After the merchant “captures” the transaction, the card merchant

processor originates ACH items to the ACH operator, which then effects settlement

between the issuing and merchant banks.

Figure 23.9 (as shown after two pages) illustrates a credit or offline debit card

transaction in which the card is not present. These transactions are identical to card-

present transactions (illustrated in Figure 23.8 on next page), except that they are

initiated over the Internet or telephone.


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Card-present transactions enable merchants to verify by signature and/or identification

that the person presenting the card for payment is one who is authorized to do so.

When the card is not present, the risk of fraud inherent with card transactions obviously

increases. In many cases, a merchant can minimize this risk by having recurring

customers set up some sort of shared secret, such as a password or PIN, which will help

to authenticate the customer before he or she is allowed to make a payment by credit

card. However, if there is no relationship between the customer and the merchant, the

merchant simply incurs higher risk of fraud and chargeback.

23.5.4.1 Credit & Offline Debit: Card Present—

Visa/MasterCard Networks

Figure 23.8 Card Present—Visa/MasterCard Networks

Authorization

1. A consumer uses a credit card to pay a merchant.

2. The merchant sends the encrypted transaction data to a card merchant processor

(e.g., First Data Merchant Services) for authorization.

3. The card merchant processor sends the transaction data to the consumer’s (issuing)

bank over the Visa or MasterCard network. The issuing bank is a licensed member of

Visa or MasterCard and holds agreements with, and issues cards to, consumers.

4. The issuing bank authorizes the amount and issues an authorization code or declines

the transaction.

5. The card merchant processor notifies the merchant that the transaction either has

been authorized or declined. The merchant requests the consumer’s signature as

authorization for the transaction or notifies the consumer that the transaction has been

declined.

Processing

6. Once authorized, the transaction must be “captured” by the merchant. The capture

uses information from the successful authorization to charge the authorized amount of


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money to the consumer’s credit card. The merchant accumulates captures and credits

into a batch, which then will be settled as a group. The merchant submits the batch to

the card merchant processor to finalize the transactions. (If the consumer returns goods

after a transaction has been captured, a “credit” is generated.)

Settlement

7. The card merchant processor receives the information and settles the batch, then

sends ACH items through the ACH operator to the issuing and merchant banks; (see

fig.23.6 the merchant bank is the ODFI, with the card merchant processor serving as

authorized sending point.) The operator settles transactions between the issuing and

merchant banks. The merchant bank credits the merchant’s account.

(Note: Many merchant banks hire a third party (acquiring processor) for bankcard

processing. The processor provides credit card processing, billing, reporting and

settlement, and operational services to the merchant bank.)

23.5.4.2 Credit & Offline Debit: Card Not Present—

Visa/MasterCard Networks

A credit or offline debit card transaction in which the card is not present. These

transactions are identical to card-present transactions, only differentiating except that

they are initiated over the Internet or telephone. When the card is not present, the risk

of fraud inherent with card transactions obviously increases. In many cases, a merchant

can minimize this risk by having recurring customers set up some sort of shared secret,

such as a password or PIN, which will help to authenticate the customer before he or

she is allowed to make a payment by credit card. However, if there is no relationship

between the customer and the merchant, the merchant simply incurs higher risk of

fraud and chargeback

Figure 23.9 Credit Card or Offline Debit Cad Transaction when Card is not present

Authorization


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1. A consumer uses a credit card to make a purchase from a merchant’s Web site. The

merchant’s e-commerce enabled Web site prompts the consumer for credit card

information and “bill to” and “shipping” addresses.

2. The merchant sends the encrypted transaction data to a merchant acquiring

processor (e.g., First Data Merchant Services) for authorization.

3. The acquiring processor sends the transaction data to the consumer’s (issuing) bank

over the Visa or MasterCard network. The issuing bank is a licensed member of Visa or

MasterCard that holds agreements with and issues cards to consumers.

4. The issuing bank authorizes a certain amount of money and issues an authorization

code or declines the transaction.

5. The acquiring processor communicates with the merchant’s Web site, which notifies

the customer that the transaction is either authorized or declined.

Processing

6. Once the transaction has been authorized, it must be captured. The capture uses

information from the successful authorization to charge the authorized amount of

money to the consumer’s credit card. The merchant accumulates captures and credits

into a batch and settles them as a group. When submitting a batch, the merchant’s

payment enabled

Web server connects with the acquiring processor (e.g., First Data) to finalize the

transactions.

Settlement

7. When the acquiring processor receives the information and settles the batch, it sends

ACH items through the ACH operator to the issuing and merchant banks; the merchant

bank is the ODFI, with the acquiring processor serving as authorized sending point.)

The operator settles these transactions between the issuing and merchant banks. The

merchant bank credits the merchant’s account. (If the consumer returns goods after a

transaction has been captured, a “credit” is generated.)

23.5.5 Retail wire services

Retail wire services are a traditional form of person-to-person payment that enables

consumers to send funds electronically to other individuals. The services often are used

by individuals without traditional banking relationships to send money to their home

country. However, retail wire services also are used by traditional bank customers in

need of emergency money transfer services, by tourists without local bank accounts,

and by U.S. businesses that need rapid wire transfer services. In 2000, 130 million

money transfers were sent; approximately 90 million of those were from United States

to other countries.


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The two major non-bank retail wire service providers are Western Union, a First Data

company, and MoneyGram. Western Union controls about major share of the market,

with MoneyGram and many others accounting for the balance. Western Union’s money

transfer service was introduced in 1871 and today enables customers to use cash to

send money from nearly 170,000 Western Union agent locations in more than 190

countries around the world. MoneyGram was established in 1988 and has an

international network of about 60,000 agent locations in more than 150 countries.

Figure 23.10 (on next page) outlines how a retail wire transfer is conducted via

Western Union. A consumer wishing to send funds to someone through a Western

Union agent location completes a “To Send Money” form. The sender provides the

agent with that form along with cash to cover the amount of the transfer and related

fees. The agent enters information into a computer linked to the Western Union

network. The sender then notifies the recipient that the funds have been sent and

provides the beneficiary with appropriate information. With the information provided

by the Remitter and some personal identification, the recipient (or beneficiary) can

retrieve the funds at any Western Union agent location. The recipient completes a “To

Receive Money” form, provides information given by the sender, and shows proper

identification. The agent then uses that information to reference the Western Union

network. Upon verification, a check is printed, and if the agent has an appropriate

amount of cash on hand, the check is cashed immediately.

Each day, Western Union’s bank will initiate an ACH debit to withdraw funds from

agents that initiated transfers. At the end of each month, Western Union’s bank will pay

agents fees earned for monthly transactions.

Figure 23.10 Retail wire Services

Authorization


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1. At an agent location, a consumer completes a “To Send Money” form and provides it

to a Western Union agent with cash to cover the transaction plus a fee. The consumer

also provides the agent with information about where he/she anticipates the recipient

will pick up the payment.

Processing

2. The Western Union “collecting” agent takes the money and form and enters the

information from the form into a PC that interfaces with a Western Union mainframe.

Approximately 15 minutes later, this information is available to whichever location

becomes the “paying” agent. The collecting agent also provides the consumer with a

tracking number.

3. The consumer provides the tracking number to the recipient.

4. The recipient of the funds goes to any Western Union location, completes a “To

Receive Money” form, and provides it along with proper ID and other required

information.

5. The agent enters the information into a PC that accesses the Western Union

mainframe, and a check is automatically printed.

6. If the agent has enough cash on hand, it also cashes the check for the recipient.

Depending on the amount sent and the location, some payments may be made with

either a combination of cash and check or entirely by check. A sender can send any

amount, but certain security compliance requirements must be met for amounts

exceeding $3,000.

7. At the close of business, Western Union pulls information from its mainframe to

identify how much the collecting agent has received.

8. The next day, Western Union’s bank initiates an ACH debit (See Figure 23.6; Western

Union’s bank is the ODFI, and its agents’ banks are the RDFIs) to withdraw the funds

from the accounts of the collecting agents.

Settlement

9. At the end of the month, Western Union’s bank pays the paying agents fees earned

for monthly transactions.

23.6 Non-Bank Roles in Emerging Payments Types

Emerging payments can be classified into six broad groups

1. check conversion,

2. electronic bill presentment and payment (EBPP),

3. electronic invoice presentment and payment (EIPP),

4. person to-person payments (P2P),

5. stored-value instruments,


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6. Contact less payment.

Figure 23.11 (on next page) shows the 19 emerging payments categories. As noted,

there are six check conversion entries, three EBPP entries, one EIPP entry, three P2P

entries, five stored-value entries, and one contactless payment entry. Each payment

type is introduced by a brief discussion, followed by a detailed schematic.

23.6.1 Check conversion (Point of sale)

Point of sale (POS) check conversion enables merchants to convert checks to electronic

transactions via the ACH, EFT, or Visa networks. The NACHA Rules allowing for POS

check conversion using the ACH network went into effect in September 2000. These

rules allow merchants to use the ACH system to convert consumer check payments to

one-time electronic debits.

Figure 23.11 Non-Bank Roles in Emerging Payment Types

The growth in use of ACH to convert POS checks is expected to continue, especially as

merchants both large and small explore the potential cost savings.

TeleCheck, a subsidiary of FDC, is the most prominent service provider for POS check

conversion via ACH.


Page 26 of 59

Plans also are underway to implement POS check conversion via EFT networks. Using

EFT networks will enable instantaneous direct debits of consumer accounts at the time

of conversion. NYCE Corporation is one of the participating networks. Visa also offers a

POS check conversion product that uses VisaNet. It offers its product to banks that in

turn market it to merchants. Early adopters of the service include US Bank, First National

Bank of Omaha, Provident Bank, and BB&T. Participating banks are allowed to “brand”

the service with their own product name.

Figure 23.12 (on next page) illustrates a POS check conversion via the ACH network. In

this scenario, the consumer presents the merchant with a check, which is used solely as

a source document. The merchant scans the check through a MICR reader to capture

routing/transit, account, and check serial numbers, which are used to originate an ACH

debit to the consumer’s account.

The merchant stamps the consumer’s check with “VOID” and returns the check to the

consumer along with a receipt for the consumer to sign as authorization for processing

the transaction as an ACH item. The merchant (or its processor) submits the items to an

ODFI, which originates them through the ACH network for posting to accounts at RDFIs.

Figure 23.13 (on next page) illustrates a check conversion through an EFT network.

Again, the check presented by the consumer is used solely as a source document. When

the merchant scans the check through a MICR reader, the check information is

converted into an electronic transaction, which is then passed to the merchant’s bank

or its bank’s acquirer. The bank or its acquirer routes the transaction through an EFT

network to the paying bank for verification and authorization. If the funds are available

in the consumer’s account, the consumer’s (drawee) bank sends an approval to the

merchant bank or its acquirer via the EFT network and deducts the funds from the

consumer’s DDA in real time. The merchant is notified that the transaction is

authorized, voids the consumer’s check, and returns it along with a receipt for the

consumer to sign as authorization for processing of the transaction as an EFT item. The

transaction is settled either via the EFT or ACH network.

Figures 23.14 and 23.15 illustrate how POS check conversion occurs through VisaNet.

The consumer presents the merchant with a check. The transaction is authorized using

the credit card network, and if the consumer’s bank is a participant in the service

(Figure 23.14) the transaction takes place in real time. If the consumer’s bank is not a

participant (Figure 23.15), the transaction is sent to a third-party processor that uses

the information captured from the check to originate an ACH debit to the consumer’s

account.


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23.6.1.1 Check Conversion: POS—ACH

Figure 23.12 Check conversion- Point of sale

Authorization


2. The merchant uses vendor-provided check authorization software to capture MICR

information from the check.

3. The vendor software verifies checking account information against negative

databases and completes the transaction authorization. The merchant stores and

batches the MICR information for the transaction.

4. The merchant voids the check and returns it to the consumer along with a two-part

receipt for the consumer’s signature, which authorizes the ACH conversion. (The

merchant retains one copy and the consumer retains the other.)

Processing

5. At the end of the business day or from time to time the merchant forwards its POS

MICR transaction information (see step 3) to its merchant bank, which will serve as the

ODFI for the ACH transaction.

6. The balance of the steps involved in processing these payments as ACH transactions

can be viewed on Figure for ACH beginning with step 3. The merchant is the originator,

and the consumer is the receiver.


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23.6.1.2 Check Conversion: POS—EFT

Figure 23.13 Cheque conversions by EFT

Authorization/Processing

1. The consumer writes a check for goods and/or services at a merchant location.

2. The merchant captures MICR information from the check, which is converted to an

electronic transaction and passes to the merchant’s bank/acquirer.

3. The merchant’s bank/acquirer routes the transaction through an electronic payments

network to the paying bank for verification and authorization.

4. If funds are available, the drawee’s bank sends an approval message back to the

merchant’s bank/acquirer via the EFT network and deducts funds from the consumer’s

DDA in real time.

5. The merchant’s bank/acquirer notifies the merchant that the transaction is

authorized.

6. Upon receiving authorization, the merchant voids the check and returns it along with

a receipt for signature authorizing the conversion to an EFT debit transaction.

Settlement

7. The EFT network initiates settlement of the transaction that night by ACH (see Figure

for ACH), net settlement, or wire transfer. If settlement is initiated by ACH, the drawee’s

bank (or its processor) is debited and the merchant’s bank (or its bank’s processor) is

credited by the ACH operator. The drawee’s bank posts the debit to the consumer’s

(receiver’s) account.

8. The merchant’s bank (or its processor) credits the merchant’s account.

23.6.1.3 Check Conversion: POS—Visa (in network)


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Figure 23.14 POS Cheque conversions through Visa Net

Authorization/Processing


2. The merchant captures MICR information and passes it to its bank or potentially to its

bank’s processor.

Note: (The merchant may have a direct connection to Visa Net, in which case, it passes its

MICR information directly to Visa Net instead of to its bank.)

3. The merchant’s bank or its bank’s processor uses VisaNet to get transaction

authorization.

4. Visa Net validates the transaction by forwarding it to the drawee’s bank or its bank’s

processor.

5. The drawee’s bank or its bank’s processor performs standard authorization and

communicates to VisaNet.

6. VisaNet notifies the merchant’s bank or its bank’s processor that the transaction is

authorized. (Again, if the merchant has a direct connection to VisaNet, VisaNet could

provide the transaction authorization directly to the merchant.)

7. The merchant’s bank or its bank’s processor notifies the merchant.

8. Upon receiving authorization, the merchant voids the consumer’s check and returns

it along with a two-part receipt for signature, which authorizes the conversion of the

payment from check to electronic. (The merchant keeps one copy of the receipt and the

consumer keeps the other.)

Settlement

9. Visa handles settlement by passing net debits and information to the drawee’s bank

(or its bank’s processor) and net credits and information to the merchant’s

bank/acquirer.


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10. The drawee’s bank debits the consumer’s DDA while the merchant’s bank credits

the merchant’s account. If processors are involved in the transaction, then the issuer

processor initiates a debit through the drawee’s bank to the consumer’s DDA while the

merchant processor initiates a credit through the merchant’s bank to the merchant’s

account.

If the consumer’s bank is not a participant, the transaction is sent to a third-party

processor that uses the information captured from the check to originate an ACH debit

to the consumer’s account.

23.6.1.4 Check Conversion: POS—Visa (out of network)

Authorization


2. The merchant captures MICR information from the check and passes it to its bank or

potentially its merchant bank’s processor.

Note: The merchant may have a direct connection to VisaNet, in which case, it would

pass its MICR information directly to VisaNet instead of to its bank.

3. The merchant’s bank or its bank’s processor uses VisaNet to get transaction

authorization.

4. VisaNet validates the transaction by forwarding it to its processor.

5. VisaNet’s processor performs standard authorization and then notifies VisaNet.

Figure 23.15 Cheque conversions –Visa (out of network)


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6. VisaNet notifies the merchant’s bank or the bank’s processor that the transaction is

authorized. (Again, if the merchant has a direct connection to VisaNet, VisaNet could

provide the transaction authorization directly to the merchant.)

7. The merchant’s bank or its bank’s processor notifies the merchant.

8. Upon receiving authorization, the merchant voids the consumer’s check and returns

it to him/her.

Processing

9. VisaNet’s processor passes the transaction information to an ODFI.

10. The ODFI handles on-us items and sends the remaining items to an ACH operator.

(See figure for ACH beginning with step 4) The merchant is the originator. The

consumer is the receiver.)

23.6.2 Lockbox

The ACH is providing new ways of electronifying payments received at remittance

locations. In March 2002, the NACHA Operating Rules were amended to allow

originators to convert checks received from consumers at a lockbox or dropbox

location to ACH items. From March through December 2002, more than 17 million

paper checks had been converted to accounts receivable (ARC) items. Wells Fargo,

Regulus, and American Express are among those converting remittance checks.

Figures 23.16 and 23.17 illustrate the transaction flows of a paper check being

converted to an ARC item by a bank provider of lockbox services and a non-bank

provider, respectively. In both scenarios the biller notifies its customers that checks

received at the biller’s lockbox or dropbox will be converted to ACH items. Upon

receiving customers’ checks, the service provider verifies the check against the

payment stub, encodes both items, and captures MICR and other information. If the

provider is a bank (Figure 23.16), it also handles on-us items and creates an ACH debit

file. If the provider is a nonblank (Figure 23.17), it may create an ACH debit file if it is an

originator. However, if it is not, it transmits the data to an ODFI for processing. The

service provider also truncates the checks, creates an image, and destroys the originals

within 14 days.


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23.6.2.1 Check Conversion: Lockbox- Bank as processor

Figure 23.16 Transaction made through Lockbox

Authorization

In this scenario, the biller already has provided notification to the consumer that checks

received at the biller’s lockbox address will be converted to ACH items.

1. The consumer uses a check to make a bill payment and mails it to a lockbox address.

Processing

2. The biller’s bank, as the lockbox service provider, verifies the check against the

payment stub, encodes both items, captures MICR and other information, handles on-

us items, and creates an ACH debit file. In so doing, the biller’s bank serves as an ODFI

and transmits the ACH file to an ACH operator. The biller’s bank also truncates the

checks, creates images, and destroys the original checks within 14 days.

Then follows the ACH transaction sequence as illustrated under the ACH Transactions

(the consumer is the receiver) beginning with step 4.

23.6.2.2 Check Conversion: Lockbox- Non-bank as processor

If the provider is a non bank institution then it may create an ACH debit file if it is an

originator. However, if it is not, it transmits the data to an ODFI for processing. The

service provider also truncates the checks, creates an image, and destroys the originals


Page 33 of 59

within 14 days.

Figure 23.17 Transaction when the processor is a non-bank institution

Authorization

In this scenario, the biller provides notification on the consumer’s bill that a check

received at the biller’s lockbox address will be converted to an ACH item.

1. The consumer uses a check to make a bill payment and mails it to a lockbox address.

Processing

2. The remittance/lockbox processor verifies the check against the payment stub,

encodes items, captures MICR and other information, creates an ACH debit file, and, if it

is not an originator, transmits the data to an ODFI for processing.

The remittance/lockbox processor truncates the checks, creates an image, and destroys

the original checks within 14 days.

3. The balance of the steps involved in processing these payments as ACH transactions

can be viewed in figure for ACH beginning with step 3.

23.3.3 Electronic bill presentment and payment

Electronic bill presentment and payment (EBPP), the process of delivering a bill to a

consumer via the Internet and allowing the consumer to pay the biller electronically,

provides an alternative to the traditional process of writing checks and sending them to

billers.

With EBPP, convoluted processes not only disappear, the interaction between the

invoice issuer and recipient significantly improves. For example, better communication

makes it easier to deal with payment shortfalls and to provide high-quality customer

service.


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Source: System application and products for data processing.

Non-banks have a strong presence in this market. CheckFree controls about 70 percent

of the EBPP market and Metavante controls about 25 percent.

There are essentially three EBPP models: Biller-Direct, Consolidator, and Lockbox. With

the Biller-Direct method, banks play virtually no role in the process. Rather, billers that

have established electronic payment capability on their Web sites notify participating

customers either by paper or e-mail that a bill is due for payment. By visiting the biller’s

Web site, those customers can view billing information and make payments directly to

the biller using a credit card or DDA.

The Consolidator method of EBPP is based on agreements the consolidator establishes

with a variety of billers to provide presentment and payment capabilities to the billers’

customers. Consolidators may be financial institutions, such as banks and insurance

companies, Internet portals, such as MSN and Yahoo, or other private sector entities,

such as CheckFree, Metavante, or Princeton eCom. Acting as a “service bureau,” the

consolidator collects billing data from billers, delivers the data to customers, and

collects payment instructions from customers online.

The third EBPP method, Consumer Lockbox, provides a means for consumers to receive

all their bills electronically by enrolling with and rerouting their bills to a lockbox

provider such as PayTrust (Metavante). When paper bills are received at the lockbox,

they are scanned and converted to electronic statements. The electronic statements are

then presented to consumers to review. As with the Biller-Direct method, banks play

virtually no role in the process.

The biller’s preferred role in EBPP determines which of the three models it opts to

employ.


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Figure 23.18 outlines how a payment is effected in the Biller-Direct EBPP model. With

this model the biller, perhaps with the assistance of a bill service provider, presents

billing information directly to the customer and enables him/her to make payment

electronically. If the customer makes payment via a credit card, the biller’s bank may

work with a non-bank service provider like MasterCard RPPS or Visa ePay to collect the

funds for the biller. Or, if the customer makes payment via a DDA, the biller’s bank may

work with an ACH operator to collect the funds on the biller’s behalf.

Figure 23.19 outlines how a payment is effected in the Consolidator EBPP model. With

this model, non-banks are more involved. Though a bank may operate the Web site at

which the consumer views and pays bills, the Web site consolidator also could be a

non-bank. In addition, non-banks are often the providers of the software that supports

the consolidator’s Web site and ultimately may be involved in processing the bill

payment information before instructing a bank to initiate payment to the biller. On the

payment side, non-banks again have a presence. Dependent on the consolidator’s

agreement with the biller, a bank may initiate payment to the biller through a non-bank

service provider like MasterCard RPPS or Visa ePay, through an ACH operator, by wire,

or by check (accompanied by a list of consumer payers and amounts).

Figure 23.20 outlines how a payment is effected in the Lockbox EBPP model. non-

banks, specifically lockbox service providers, are present at the point of payment

initiation. The service provider is the actual recipient of the consumer’s paper bill and

presents that bill information at its Web site for the consumer’s review. The service

provider then either works through its bank or a contracted processor to collect the

funds on the biller’s behalf. Again, the method of payment depends on the lockbox

provider’s agreements with its participating billers. A bank may initiate payment to the

biller through a non-bank service provider like MasterCard RPPS or Visa ePay, through

an ACH operator, by wire, or by check (accompanied by a list of consumer payers and

amounts).

A Layman’s view of EBPP working process:


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23.6.3.1 EBPP: Biller Direct

Figure 23.18 Biller Direct

Authorization

1. A consumer visits a biller’s Web site to pay a bill. The biller authenticates the

consumer and obtains appropriate authorization.

Processing

2. The consumer is presented with a payment screen to pay bills. The consumer

completes name, address, and payment type and amount, and account number fields.

(If the consumer has used the biller’s electronic billing function before, the biller may

retain name and address information and may populate some or all of these fields.) The

consumer receives an acknowledgement that the bill has been paid. The biller may

require a consumer to pay a bill before the actual due date (e.g., five days before) to

ensure adequate time for posting.

3. The biller establishes a daily cutoff, after which, the end-of-day cycle is run. The biller

(or the biller’s service provider) sends a data file to its bank.

4. Based on the payment method selected by the consumer, the processor instructs its

bank to initiate payment— through MasterCard RPPS or Visa ePay, or by ACH (See

figure 23.6 for ACH -the BSP’s bank is the ODFI, while the consumer receives an ACH

debit and the biller receives an ACH credit), wire transfer, or check. Billers receive the

payments and an electronic data file with accompanying information. A paper check

and list of payers are created for billers who receive a check payment.

Settlement

Settlement depends on the method(s) by which the biller has chosen to receive

payments. Check, ACH, and wire transfer payments settle as described elsewhere.

5. If the payment is made through MasterCard RPPS or Visa ePay, it is processed

through the respective channels and delivered to the biller.


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23.6.3.2 EBPP: Consolidator

Figure 23.19 Consolidator EBPP Model

Authorization

1. A consumer visits a consolidator’s Web site where all of his/her bills are gathered into

one place for viewing and payment. The consolidator may or may not be a bank. The

consolidator authenticates the consumer and obtains authorization for the payment.

Processing

2. The consumer is presented with a payment screen to pay bills. (The consumer may

not be viewing his/her bill online in this model.) The consumer completes name,

address, payment amount, and account number fields. If the consumer has an existing

relationship with the consolidator, the consolidator may keep name and address

information on file and populate this information for the consumer. The consumer

receives acknowledgment that the bill has been paid. The consolidator may require

consumers to pay bills before the biller’s actual due date given on the bill (e.g., five days

before) to ensure timely posting.

3. The consolidator establishes a daily cutoff, after which, the end-of-day cycle is run.

The consolidator sends a data file to the processor with whom it maintains a contract

(e.g., Princeton eCom, CheckFree).

Note: It is possible that the software vendor also is the EBPP provider, thus step 3 would

take place “internally” through communication between the software and provider.

4. Based on agreements between the processor and the billers who are to receive

payment, the processor instructs its bank to initiate payment through MasterCard RPPS

or Visa ePay, or by ACH (see Figure for ACH), wire transfer, or check. Billers receive the




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Settlement

Settlement is dependent on the method(s) by which the biller has chosen to receive




23.6.3.3 EBPP: Lockbox

Figure 23. 20 EBPP Lockbox Model

Authorization

1. Consumers can reroute paper bills to an electronic bill payment lockbox service

provider such as Pay Trust (Metavante). When paper bills are received at the lockbox,

they are scanned and converted to electronic statements.

These electronic statements then are presented to the consumer for review. The

consumer visits the lockbox service provider’s Web site to review the statements. The

lockbox service provider authenticates the consumer. The consumer provides payment

instructions to the EBPP lockbox service provider. The provider may require consumers

to pay bills before the biller’s actual due date given on the bill (e.g., five days before) to

ensure timely posting.

Processing

2. The consumer receives acknowledgment from the EBPP lockbox service provider that

the bill has been paid.

3. The provider establishes a daily cutoff, after which, the end-of-day cycle is run. The

provider sends a data file to its bank or possibly to a third-party processor with whom it

maintains a contract (e.g., Princeton eCom, CheckFree).

4. Based on agreements between the processor and the billers who are to receive

payment, the processor instructs its bank to initiate payment through MasterCard RPPS

or Visa ePay, by ACH (see Figure for ACH), wire transfer, or check. Billers receive the




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Settlement

Settlement is dependent on the method(s) by which the biller has chosen to receive




23.3.4 Electronic Invoice Presentment and Payment (EIPP)

Just as EBPP provides consumers with the opportunity to view and/or pay bills online,

Electronic Invoice Presentment and Payment (EIPP) provides businesses with the same

opportunity. Thus it also is referred to as B2B (Business-to-Business) EBPP.

There are three models for EIPP—

1. Seller-Direct,

2. Consolidator, and

3. Buyer-Direct.

The Seller-Direct and Buyer-Direct models are straightforward models in which the

buyer and seller have set up some arrangement where invoices are presented and can

be paid online. Some, or even all of the steps in between (reconciling, dispute

resolution, etc.), take place electronically.

In the Consolidator model of EIPP, a non bank participant may provide a Web site

accessible to both the buyer and seller.

The following figure 23.21 (on next page) illustrates the flow of EIPP in the

Consolidator model. The seller can post electronic invoices for buyers using the

consolidator’s Web site. Buyers sign on to reclaim invoices and then review, modify as

needed, and approve them for payment. Typically the buyer controls the timing of the

payment, which may be made via the ACH, credit card, wire transfer, or check.

Authorization

1. Sellers post their invoices to the browser-accessed Web site of a consolidator In the

Consolidator model, where buyers can view them. Any type of authorization scheme in

place would be specific to the systems and/or agreements among these three parties.

Processing

2. The buyer’s personnel view the invoices online, modify them if necessary, and

approve them for payment, all from one integrated system.


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Figure 23.21 Electronic Invoice Presentment and Payment (EIPP)

3. The consolidator, through its ODFI, initiates an ACH debit to the buyer’s account and

a credit to the seller’s account for payment of the invoice. (See Figure for ACH; the

consolidator is the originator, the buyer is the receiver of an ACH debit, and the seller is

the receiver of an ACH credit.) The consolidator also may provide payment capabilities

via credit card, wire transfer, or check.

23.6.5 Stored value

Stored-value cards are access devices used to debit funds from a nonchecking account

and are funded through traditional means such as checking accounts, ACH funds

transfer, credit cards, debit cards, or cash.

Stored-value cards come in many forms, including gift cards, EBT cards, payroll cards,

and prepaid cards and are either single purpose (closed loop) or multipurpose (open

loop). Single-purpose cards, such as gift cards, are good only at a specific retailer. In

contrast, multipurpose cards, like EBT cards, payroll cards, and some prepaid cards, can

be used in multiple locations.

Gift cards are typically offered by retailers as a replacement for paper-based gift

certificates, as well as by some banks.

There are two main categories of stored value cards in the marketplace:

The first prepaid cards made available to the marketplace were single-purpose or

‘closed-loop’ cards. Gift cards, which can only be used to purchase goods at particular

retailers, and prepaid telephone cards, which can only be used to make telephone calls,

are examples of single-purpose cards.

The second type of card to emerge was a multipurpose or ‘open-loop’ card, which can

be used to make debit transactions at a wide variety of retail locations, as well as for

other purposes, such as receiving direct deposits and withdrawing cash from ATMs.

Some multipurpose cards are branded by Visa or MasterCard and can be used wherever

those brands are accepted.


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With gift cards, customers are given a card with a magnetic stripe in exchange for

money received, merchandise returned, or other considerations. The card represents a

money value that the consumer either can use or give to another individual.

The record of the balance on the card is maintained on a centralized stored-value card

database.

EBT cards enable recipients of government benefits to authorize transfer of those

benefits from a Federal government account to a participating retailer account to pay

for products received. The EBT card is similar to a debit card and is issued to a recipient

along with an assigned or chosen PIN. EBT systems typically use magnetic stripe

technology; however, smart card technology is a little-used option. Those systems that

use magnetic stripe technology for online authorizations use the same EFT technology

that many stores use for their debit card payments. Companies like eFunds and

Lockheed Martin has major market share. Prepaid cards like Visa Buxx are another form

of stored-value cards. The Visa Buxx card is typically purchased by one consumer

(usually a parent) on behalf of another (usually a teen) and is accepted at more than 23

million locations worldwide, including online merchants. In addition, a PIN can be

requested when the card is ordered, making ATMs accessible with the Visa Buxx card as

well. When a purchase is made with the Visa Buxx card, the amount is deducted from

the card balance. And, when the balance is low, the card can be reloaded.

Wage earners who lack banking relationship are paid by paper check. Payroll cards are

targeted to un-banked or under-banked workers as a replacement for paper checks.

Payroll cards can be established in either a reloadable card for ongoing payroll

payments or as a single-load, instant-issue card for final pay, payroll adjustments, or

other one-time payments. The re-loadable card typically is a Visa or MasterCard

account, while the single-load card typically is a PIN-based debit card. Both are prepaid

card accounts with the card being assigned to an employee and funded by the

employer through either direct deposit or a standard ACH batch file. The Visa or

Did you know?

According to industry estimates, more than 2,000 stored value programs are

available, with roughly 7 million Visa or MasterCard-branded stored value

cards in the marketplace. There are approximately 20 million users and that

figure is expected to more than double to 49 million users by 2008.


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MasterCard account is personalized with the employee’s name and can be used—up to

the available funds—wherever Visa or MasterCard is accepted worldwide. In addition, a

PIN can be added, which would provide cash-back service at most retailers as well as

ATM access to the available funds.

Figure 23.22 outlines how a consumer might purchase a single-purpose, stored-value

card. Consumers have the option of using a check, credit card, or debit card to make a

gift card purchase. Additionally, it is possible that a consumer’s check can be converted

at the POS to an ACH transaction. Upon successful completion of purchase

authorization, the merchant swipes the gift card through its POS reader to activate it

with its stored-value card issuer. The card issuer also adds the sale of the card to its

information database. This transaction looks like a normal sale but results in a credit to

the merchant’s “gift card” general ledger account.

Figure 23.23 outlines how a consumer redeems a single-purpose, stored-value card. In

this instance, a consumer uses a gift card to make a purchase. When the card is

presented to the merchant, the merchant swipes the card through its POS reader,

through which the transaction details are forwarded to the merchant’s stored-value

card issuer. The issuer searches its database for the card number and sends transaction

authorization to the merchant. From the merchant’s perspective, the redemption of the

card is handled on its books with a debit to the merchant’s general ledger “gift card”

account.

Figure 23.24 outlines how a recipient of Federal benefits uses their EBT card at an

authorized merchant to make a purchase.

The card is swiped through a POS terminal and the cardholder enters his/her PIN. The

transaction information then is forwarded to an EBT provider that verifies the PIN and

the account balance and sends transaction authorization back to the merchant. The EBT

provider ultimately deducts the amount of purchase from the cardholder’s existing

balance, and, if the EBT provider is an ACH originator, it initiates an ACH credit to the

merchant’s account at its bank. If the provider is not an originator, it provides

information to an ODFI, which does so, on the provider’s behalf.

Figure 23.25 outlines how a consumer might fund a Visa Buxx card and, subsequently,

how that card might then be used.

Consumers have the option of using information from a DDA to initiate an ACH

transaction, a credit card, or a debit card to fund a Visa Buxx card purchase. Once the

transaction is approved, a Visa Buxx card is issued in the name requested by the

consumer. The designated user of the Visa Buxx card can use the card to make

purchases at both physical and Internet locations or sites. The merchant processes the

card just as they would any other POS or Internet transaction.


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Figure 23.26 outlines how an employer might fund a payroll card and how its

employee might then use the card. Working with a stored-value card issuer, a bank

markets the payroll card program to employers. Once an employer enrolls, either the

employer or the bank provides the employee with a payroll card. Before the pay date,

the employer transmits an electronic file to the bank indicating how much to credit to

the employee’s payroll card account. If the bank is not the employer’s “primary” bank, it

acts as an ODFI and originates a file to the employer’s bank (the RDFI). When the funds

are available, depending on the type of card issued, the employee may use the payroll

card at physical and/or Internet merchant locations and sites and as either a PIN-based

and/or signature debit card

23.6.5.1 Stored Value: Single Purpose—Sale

Authorization

1. The consumer purchases a gift card at a merchant location.

Processing

2. The sale of the gift card is processed based on the method of payment (check, credit

card, debit card, or POS check conversion) and recorded as a gift card sale (credit) on

the merchant’s general ledger.

3. Upon successful completion of the purchase transaction, the merchant swipes the

gift card through its POS reader, and the transaction travels through the merchant’s

existing internal network or credit card authorization interface to its gift card service

provider.

Figure 23.22 Stored Value: Single Purpose—Sale

4. The service provider adds the sale of the gift card to its information databases, which

both records the sale and activates the card for use.


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Note: The value the service provider adds for the merchant is the ability to issue gift

cards and various reporting features showing sales and redemptions that assist the

merchant with reconciling its gift card transactions on its general ledger. The service

provider is not involved in the actual processing of the payment portion of the

transaction.

23.6.5.2 Stored Value: Single Purpose—Redemption

Figure 23.23 Stored Value: Single Purpose—Redemption

Authorization

1. The consumer makes a purchase and presents a gift card as payment at the POS.

2. The merchant swipes the gift card through its POS reader and the transaction travels

through the merchant’s existing internal network or credit card authorization interface

and is forwarded to the service provider.

3. The service provider searches its databases for the gift card account number and

sends a response (authorization) to the merchant, in that response the amount is also

available on the gift card. (It is possible that the gift card balance is not sufficient for the

entire purchase and that the transaction will require some additional form of payment,

but for simplicity’s sake, this example assumes that the gift card covers the purchase

amount.)

Processing

From the merchant’s perspective, the redemption of the gift card is handled on its

books with a debit to the merchant’s general ledger “gift card” account.

Note: The value the service provider adds for the merchant is assisting with various

reporting features showing sales and redemptions that facilitate the merchant’s

reconcilement process.


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23.6.5.3 Stored Value: Multipurpose- ACH Infrastructure/EBT

Figure 23.24 Multipurpose- ACH Infrastructure/EBT

Authorization

1. Using a plastic card similar to a debit card, the benefits recipient initiates a grocery

purchase by running his/her benefits card though an electronic POS terminal and

entering a PIN number to access his/her food stamp account.

2. The benefits recipient’s information is forwarded to an EBT service provider.

3. The provider verifies the PIN and the account balance and sends an authorization or

denial back to the merchant.

Processing

4. The EBT service provider deducts the amount of the purchase from the benefits

recipient’s existing balance. Either the EBT service provider (if it has ODFI capabilities) or

its ODFI initiates a credit to the merchant’s account at its bank via either the ACH or EFT.

For ACH, see Figure 23.6 beginning with step 3.

Note: Transaction processors typically are responsible for issuing cards in addition

to authorizing transactions and maintaining benefits recipients’ accounts.


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23.6.5.4 Stored Value: Multipurpose—Credit Card

Infrastructure/Visa Buxx

Figure 23.25 Multipurpose—Credit Card Infrastructure/Visa Buxx

Authorization

1. The consumer purchases a Visa Buxx card by going to the Visa Buxx Web site.

Processing

2. The consumer prepays a starting dollar amount by using an ACH transaction, a credit

card, or a debit card. If an ACH transaction is used to fund the card, see Figure 23.6

beginning with step 2. (Visa is the originator of the transaction, and the consumer is the

receiver.) If a credit card or debit card is used to fund the card, see Figure 23.9

beginning with step 3.

3. Once the transaction is approved, a Visa Buxx card is issued to the consumer.

4. The consumer uses a Visa Buxx card to make a purchase at either a physical or

Internet merchant location or site.

5. The merchant processes the card as it would any other credit card transaction. Refer

to Figure 23.8, step 2 if the purchase is a “card-present” transaction; Figure 23.9, step 2

if the purchase is made via the Internet or telephone; or Figure 23.7, step 2 if the

transaction is PIN-based.


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23.6.5.5 Stored Value: Multipurpose—Credit Card

Infrastructure/Payroll Card

Figure 23.26 Multipurpose—Credit Card Infrastructure/Payroll Card

Authorization

1. The service provider works with a bank to establish a payroll card program. The

provider handles things such as card issuing and transaction processing, customer

service, and program administration.

2. The bank then “markets” the payroll card service to its business clients.

3. Once an employer enrolls, either the bank mails the payroll cards to the employees

the business has enrolled or the employer provides the cards directly to its participating

employees.


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Processing

4. Before the pay date, the employer transmits an electronic file to its bank telling it how

much to credit to the employees’ payroll card “accounts.” The employer’s bank serves

as the ODFI and sends an ACH file containing these items to the ACH operator.

Note: The employer’s bank also may serve as the RDFI—or it may use its ODFI and a

separate RDFI that offers the payroll card service. See Figure 23.26.

5. On the pay date, the RDFI posts the funds to the employees’ accounts. The

employees then have access to their funds.

6. The employee/payroll cardholder uses the card to purchase goods or services at a

merchant location.

7. If the card is issued as a Visa or MasterCard account, it can be used anywhere that Visa

or MasterCard are accepted and will be processed like either a credit card or an offline

debit card transaction. If the card is PIN-based, the employee also can use it to make

online, PIN-based, debit purchases.

23.6.6 Contactless payments

Contactless payments are evolving to serve as a substitute for small-ticket cash

purchases and enable the use of card information without having to actually swipe a

card. A variety of technologies can be employed to effect such transactions including

Bluetooth, infrared, and, most recently, radio frequency identification (RFID). Bluetooth

and infrared technologies are experiencing some success overseas. In the United States,

RFID is gaining in appeal partly because of its packaging flexibility.

ExxonMobil is experiencing success with its RFID product, which is a key fob called

Speedpass. In just over five years, more than 6 million consumers have signed up for

Speedpass, which can be used at more than 8,100 Exxon locations nationwide and

more than 400 Chicago-area McDonald’s restaurants. MasterCard has developed a

product called PayPass, which on a pilot basis has been integrated into credit cards

issued by Citibank, J.P. Morgan Chase, and MBNA and into Nokia phones. American

Express is piloting a key-fob product called ExpressPay. And, Timex and Exxon have

partnered to produce a watch with RFID technology.

Payments effected using an RFID device are initiated when a consumer either waves

his/her device over a transponder terminal or, in the case of the Nokia phone, taps the

phone on specially equipped readers at checkout counters. From that interaction, the

card information provided by the consumer at “enrollment” is accessed from a remote

database and used for the payment. While the programs of the various providers of

these products currently are not interoperable, there are some discussions under way

that may facilitate such future interoperability.


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Figure 23.27 outlines a simple transaction in which a consumer uses a contactless

device provided by a card issuer. In this example, the device is linked directly to a card

product offered by the card issuer. When the consumer makes a purchase, he/she

waves the device over a transponder at the checkout counter. Via radio frequency, the

consumer’s card account information is accessed, and, if the account balance is

sufficient, the merchant will be provided with purchase authorization.

The transaction ultimately will be processed through existing payment card networks.

23.6.6.1 Contact- less: Funding and Use

Authorization

1. A consumer enrolls with a card issuer to receive a contactless payment device and

opts to link the device directly to a card offered by that issuer.

2. Upon successful completion of the enrollment process, the issuer provides the

consumer with a payment device.

3. The consumer makes a purchase at a physical retail location. As payment for the

transaction, the consumer waves the device over a transponder located at the checkout

counter. The device communicates via radio frequency to access a remote database.

Figure 23.27 Contact-less Payment

Processing

4. Providing that the transaction is authorized, processing will occur through existing

card networks. See Figure 23.28 beginning with step 2.

23.6.7 Person-to-Person

The origin of person-to-person (P2P) payment services is related to the introduction of

online auction Web sites, such as eBay.com. P2P payment services were pioneered by


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non-banks to provide an expeditious method of “settling” online auction transactions,

and on the surface they looked new. However, as is the case with many types of

emerging payments, they combine newer technologies (Web and e-mail) with

traditional payments infrastructures (bank accounts, debit and credit card networks,

ACH, and potentially EFT networks.)

The most prominent provider of P2P services is a non-bank, PayPal. Established in 1999,

PayPal’s network builds on the existing financial infrastructure of bank accounts and

credit cards. In so doing, PayPal enables consumers to make payments to one another

and to businesses by using a Visa, MasterCard, Discover, or American Express card, a

debit card, a checking account, or funds held in a PayPal stored-value account.

Bank providers of P2P services later emerged (Wells Fargo—Billpoint, BankOne—

eMoneyMail, Citibank—c2it), but they have each ceased offering these services.

Another variant of P2P services is an online check offering from TeleCheck, a First Data

company, called Western Union MoneyZap. The MoneyZap service enables consumers

to use information from their checking accounts to facilitate online purchases.

However, funds cannot be transferred internationally, and transactions must be in U.S.

dollars drawn from U.S.-based banks. While discussed as a P2P service, this service is

consumer-to-business and is aimed at enabling merchants to tap into the buying

power of the U.S. households that do not have credit cards.

A P2P service that uses the EFT network also is on the horizon. The NYCE Corporation

and CertaPay are promoting technology that will let people pay anyone from a

multitude of devices, including the Internet, and provide immediate availability of

funds by settling through the NYCE EFT network infrastructure. This technology

requires that the person making the payment know the ATM or debit card number of

the person receiving the payment, and both people must have accounts at banks that

are members of NYCE. NYCE is currently piloting this technology.

Figure 23.28 outlines how a P2P payment might be initiated through the PayPal

network. Payment initiators have the option of using a checking account, a PayPal

money market account, idle PayPal funds held in an FDIC-insured bank account, or a

Visa, MasterCard, Discover, or American Express card to effect their payment. If the

payment is initiated using a checking account or a PayPal money market account, the

transaction will be processed via ACH. If the payment is initiated via credit card, it will

be processed in a manner consistent with “card not present” transactions (refer to

Figure 23.9).

And, if a payment is initiated by using idle funds, a general ledger account entry results.

Figure 23.29 outlines how the recipient of a PayPal payment may opt to receive funds.

If the recipient has or opens a PayPal Personal Account, several options are available.


Page 51 of 59

The money can be left in the PayPal account to be used for future payments, a PayPal

money market account can be opened and the funds moved to it, the funds can be

deposited in an individual checking account, or a check can be mailed. If the money is

left in a PayPal account, it will immediately be moved to a consumer account at an

FDIC-insured bank. If either the money market option or the deposit option is selected,

the transaction is effected through ACH. With a Premier or Business account, the

recipient has the additional option of accessing the funds at POS locations and ATMs

with the PayPal ATM/debit card. Additionally, the recipient can receive payments

initiated by credit card.

Figure 23.30 outlines a payment made through the Western Union MoneyZap service.

Each of these payments is initiated via information from a checking account and

ultimately is processed as an ACH transaction. Account and personal information are

verified against third-party and proprietary databases. The ultimate payment to the

recipient is effected through ACH.

23.6.7.1 P2P: PayPal—Sending

Figure 23.28 PayPal—Sending

Authorization

1. The consumer uses the Internet or e-mail and checking account information, a credit

card, or PayPal account stored value to initiate payment to a merchant or another

individual via the PayPal service. The PayPal stored value can take one of two forms—

the PayPal money market account or funds the customer has left in his/her PayPal

account, which is held at an FDIC-insured bank.

2. PayPal sends encrypted transaction data either to its bank or its bank’s processor.

Processing

3. The back-office processing of these transactions depends on the method of payment

selected by the consumer.


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• If the payment is being initiated from the consumer’s checking account,

PayPal’s bank or its bank’s processor handles the resulting transaction. See

Figure 23.6 to view the balance of the steps involved in processing the

payment. Pay Pal’s bank acts as the ODFI, and the consumer is the receiver of

the ACH transaction.

• If the payment is being initiated via a consumer’s credit card, PayPal’s bank or its

bank’s core data processor or check outsourcer processes the transaction. See

Figure 23.9 beginning with step 2 to view the balance of the steps involved in

processing the payment.

• If the payment is being initiated via a consumer’s PayPal account stored-value

funds, the funds are swept either from the consumer’s money market fund

account or from an account at an FDIC-insured bank to pay for the purchase.

23.6.7.2 P2P: PayPal—Receiving

Figure 23.29 PayPal—Receiving

Authorization

1. The recipient of the payment receives notification from PayPal that someone has sent

him/her a payment.

Note: Once received by PayPal, the funds are immediately credited to the customer’s

stored-value account, which is either a PayPal money market account or a pooled

account at an FDIC-insured bank.

2. When the recipient chooses, he/she informs PayPal of how he/she would like to

receive the funds.

3. PayPal notifies its bank of the customer’s request.

Processing

4. The processing of the payment transaction depends on the method selected by the

recipient.


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• If the recipient requests a check, PayPal contacts its bank and provides payment

instructions so that a check can be cut and mailed.

• If the recipient requests that the funds be deposited to an individual bank

account, the transaction is handled via an ACH transfer through Wells Fargo.

(Wells Fargo serves as Pay Pal’s ODFI, and the recipient becomes the receiver in

the ACH transaction.)

• If the recipient is a holder of a PayPal/MasterCard debit/ATM card, he/she may

use that card at a POS location or at an Internet vendor. See Figure 23.28 for

offline debit POS transactions, Figure 23.27 for the online debit POS scenario,

or Figure 23.29 for purchases made from Internet vendors.

In addition, the recipients may send payment to other PayPal customers, funded from

their PayPal stored value. They also may make a bill payment, which is processed

through a third-party provider (MasterCard RPPS).

23.6.7.3 P2P Western Union Moneyzap

Figure 23.30 Western Union MoneyZap

Authorization

1. A consumer initiates payment to a merchant by selecting the MoneyZap payment

option during checkout and entering his/her checking account information into a pop-

up window hosted by Western Union.

2. Using the consumer’s personal and financial information, Western Union verifies the

identity of the consumer and the validity of his/her account information through the

use of third-party and proprietary software.

3. If approved, the consumer is presented with an online receipt.

Processing


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4. The merchant submits a request to Western Union to initiate funds movement. These

entries include full and partial claims, full and partial refunds, and recurring payment

transfers for which a merchant has authorization.

5. Western Union instructs its ODFI to initiate an ACH debit from the consumer’s

designated checking account and an ACH credit to the merchant’s account.

6. See Figure 23.26 beginning with step 3.

23. Glossary of Terms

Acquirer: Also referred to as the acquiring bank or merchant bank. A bank that has

entered into an agreement with a merchant to accept deposits generated by bankcard

transactions.

Association: Usually a group of banks that agrees to rules and processes that allow

issuers and acquirers to provide payment services. “The Associations” is usually a

reference to Visa and MasterCard.

Authentication: The process whereby an authorized card user’s identity is verified.

Signature-based products involve a visual signature inspection. PIN-based products

involve an electronic comparison of secret information.

Authorization: The process whereby a card issuing entity determines that the

cardholder’s account has enough funds available to pay for the goods or services.

Automated clearinghouse (ACH) network: A funds transfer system governed by the

rules of the National Automated Clearinghouse Association (NACHA). ACH provides for

the interbank clearing of electronic entries for participating banks.

Automated clearinghouse (ACH) operator: A central clearing facility operated by a

Federal Reserve Bank or a private sector organization in which participating banks

transmit or receive ACH entries.

Batch: A group of records or documents considered as a single unit for the purpose of

data processing.

Biller: A company or organization that sends a bill or statement, usually a request for

payment for a product or service, to a consumer.

Bill service provider (BSP): An agent of the biller that provides an electronic bill

presentment and payment service for the biller.

Capture: Converting the authorization amount into a billable transaction record within

a batch. Transactions cannot be captured unless previously authorized.

Card processor: A third party that provides transaction processing and other services

for a card issuer or acquirer.


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Chargeback: The act of an issuing bank returning a previously authorized transaction

to the merchant bank because of some defect. Common defects include: cardholder

disputes amount, cardholder disputes performing the transaction, cardholder disputes

the merchandise suitability.

Check truncation: Arrangements in which original paper checks are removed from the

collection or return process before reaching either paying or depository banks or their

customers. Currently, under typical check truncation arrangements, electronic

information about the truncated checks, instead of the original paper checks, is

presented to paying banks.

Closed loop: An issuing and acquiring scenario with the same institution on both sides

of a card transaction.

Consolidator: A BSP that consolidates bills from other BSPs or billers and delivers them

for presentment to the CSP.

Consumer service provider (CSP): An agent of the customer that provides an interface

directly to customers, businesses, or others for bill presentment. The CSP enrolls

customers, enables presentment, and provides customer care, among other functions.

Credit: An entry to the record of an account to represent the transfer or placement of

funds into the account.

Credit risk: The risk that a party to a transaction will be unable to meet its financial

obligations either when due or at any time in the future.

Debit entry: An entry to the record of an account to represent the transfer or removal

of funds from the account.

Demand deposit account (DDA): An account holding deposits, which may be

withdrawn at any time without prior written notice to the depository institution. A

checking account is the most common form of demand deposit.

Draft: The instrument whereby the cardholder’s data are captured. These data include

card number, expiration date, amount of sale, signature of cardholder, merchant name,

merchant address, and other information. This is the legal document for a transaction.

Drawee bank: The bank on which an item is drawn and must be presented to prior to

receiving value for that item.

Electronic funds transfer (EFT) networks: ATM and online debit card networks.

Electronic benefits transfer (EBT): A benefit delivery system that provides public

assistance recipients with electronic access to their cash and food stamp benefits.

Electronic bill presentment and payment (EBPP): The process that enables primarily

consumer bills to be created, delivered, and paid over the Internet.


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Electronic data capture: The method by which credit card or debit card information is

electronified at the point of purchase thus eliminating the need for paper drafts to be

stored and transported.

Electronic invoice payment and presentment (EIPP): The process that enables

corporate invoices, primarily, to be created, delivered, and paid electronically.

Encryption: A data security technique used to protect information from unauthorized

inspection or alteration. Information is encoded so that data appear as a meaningless

string of letters and symbols during delivery or transmission. Upon receipt, the

information is decoded using an encryption key.

Inquiry: The technical term used to describe an issuing bank’s request to the merchant-

sponsoring bank for additional information about a previously performed cardholder

transaction.

Interchange: The fee paid by the merchant bank to the card-issuing bank for the

privilege of allowing merchants to obtain funding from the cardholder’s account.

Issuer: The association or network participant that issues cards.

Legal risk: The risk that a poor legal framework or legal uncertainties will cause

financial exposure or losses to payments participants.

Liquidity risk: The risk that a party will have insufficient funds to meet its obligations

when due, although it may be able to do so at some time in the future.

Lockbox: A financial service that facilitates rapid collection and posting of corporate

receivables. Typically, it entails collecting items; sorting, totaling, and recording

payments; and processing items and making bank deposits.

Merchant: A retailer or any other person, firm, or corporation that, according to a

merchant agreement, agrees to accept credit cards, debit cards, or both when properly

presented in exchange for the sale of goods and services.

Merchant bank: See Acquirer.

MICR encoding: The abbreviation for magnetic ink character recognition. MICR

characters are the numbers and symbols that are printed in magnetic ink on checks and

other documents for automated processing.

National Automated Clearinghouse Association (NACHA): The national association

that establishes the rules and procedures governing exchange of ACH payments

among banks.

Operational risk: The risk that hardware or software problems, human error, or fraud

will cause an operational malfunction that will lead to financial exposure and possible

loss.

Originator: A person or entity that has authorized an ODFI to transmit a credit or debit

entry to a receiver’s RDFI.


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Originating depository financial institution (ODFI): A participating bank that

originates entries at the request of and by agreement with its customers in accordance

with the provisions of ACH rules.

Personal identification number (PIN): A sequence of digits used to verify the identity

of a device holder.

Point of sale (POS): The place where a card transaction is executed. Can be a

standalone swipe machine, an integrated cash register, an ATM, a PC application, or a

Web site, as well as a personal telephone call that authorizes and submits transactions

for posting and settlement.

Processor: A generic term used to define a broad set of third-party service providers.

Receiver: An individual, corporation, or other entity that has authorized a company or

an originator to initiate an ACH credit or debit entry to a transaction account held at an

RDFI.

Receiving depository financial institution (RDFI): Any bank qualified to receive debits

or credits through its ACH operator in accordance with ACH rules.

Routing number: A nine-digit number (eight digits and a check number) that identifies

a specific bank. Also referred to as the ABA number.

Settlement: The final, irrevocable transfer of funds between parties in a payments

system.

Settlement date: The date on which an exchange of funds with respect to an entry is

reflected on the books of the Federal Reserve Bank(s).

Settlement risk: The risk that final settlement fails to take place, leading to a financial

loss.

Single entry: A one-time transfer of funds initiated by an originator in accordance with

the receiver’s authorization for a single ACH credit or debit to the receiver’s consumer

account.

Systemic risk: The risk that the failure of one party in a payments system will lead to

the failure of other parties in the system, having a domino effect that may eventually be

transmitted to other parts of the financial system or economy.

System-wide risk: Refers to situations in which, in the event of a shock, the amounts

transferred through a payments system are too small to have repercussions throughout

other parts of the financial system but still could be very disruptive to that particular

system.

Unwinding risk: The unwinding of financial obligations that can occur if there is a

settlement failure in a net settlement system and payments instructions that

accumulated during the day are allowed to be revoked.


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23.8.1. Summary

• Non-banking institutions usually are not directly involved in settlement

activities

• In other traditional payments types, such as automated teller machine (ATM)

and credit card transactions, non banks often are at the forefront, highly visible

to the end user

• The automated clearinghouse (ACH) is an electronic payments network for the

clearing and settlement of debit and credit transactions among banks

• In the Federal Reserve account settlement may take place in each bank or in the

Federal Reserve account of designated correspondents

• EPN (Electronic Payment Network) is a non-bank, owned by a bank. EPN

eventually relies on the Federal Reserve for settlement

• An online debit card transaction is one in which a consumer uses a debit card

along with a PIN, allowing the merchant to inquire on the consumer’s account

and verify that the funds are available

• Credit card networks allow for the clearing and settlement of credit card as well

as offline (signature) debit card transactions among participants

• Retail wire services often are used by individuals without traditional banking

relationships to send money to their home country is known as Retail Wire

Service

• In POS check conversion, the consumer presents the merchant with a check,

which is used exclusively as a source document

• Electronic bill presentment and payment (EBPP), is the process of delivering a

bill to a consumer via the Internet and allowing the consumer to pay the biller

electronically

• Electronic invoice presentment and payment (EIPP) provides businesses with

the same opportunity and is referred to as B2B (Business-to-Business) EBPP

• Stored-value cards come in many forms, including gift cards, EBT cards, payroll

cards, and prepaid cards and are either single purpose (closed loop) or

multipurpose (open loop).

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Page 1 of 21

Chapter-4 Clearing and Settlement System

V 2.0, April 2009

for associates



Page 2 of 21





joining TCS.


Page 3 of 21

Chapter-4 Clearing and Settlement System

4.1 Introduction

This session will give an idea about the clearing and settlement systems of payments in

banks.

The procedure through which an organization while acting as an intermediary

assuming a role of buyer or seller for transaction in order to reconcile orders between

transacting parties is called clearing. It is necessary for matching of the entire buy and

sell orders in the market. It makes the transactions easier and smoother by payments

being made to clearing houses or intermediaries rather than the parties reaching out to

each and every party with which deals are made.

When the payment for a certain transaction is made and is completed through both the

sides getting their part of account debit and credit the settlement is done. Now further

the session discusses deferred and net settlements of payments and system of payment

settlement through RTGS.

4.2 Learning objectives

After going through this session you will learn……

• How payments are settled and cleared within banks

• What system is followed to clear high volume of payments

• To clear the net and deferred payment what steps are taken

• And learn basics of RTGS

4.3 Topics Covered

Chapter-4 Clearing and Settlement System.......................................................................................... 3

4.1 Introduction..................................................................................................................................... 3

4.2 Learning objectives...................................................................................................................... 3

4.3 Topics Covered............................................................................................................................... 3

4.4 Bilateral Correspondent Arrangement – A basic model of settlement................. 4

4.5 Correspondent Bank as Settlement Agent ....................................................................... 6

4.6 The Role of Settlement Agent................................................................................................. 7

4.7 Gross Settlement & Net Settlement ..................................................................................... 7

4.7.1 Net Settlement Mechanism .............................................................................................. 8

4.7.2 Role of clearing houses in Net Settlement ................................................................11

4.7.3 Real Time Gross Settlement.............................................................................................13

4.7.3.1 Objectives of RTGS introduction................................................................................15

4.7.3.2 Features of RTGS ................................................................................................................15

4.7.3.3 Message Flow Structures in RTGS systems.............................................................16

4.8 Summary.........................................................................................................................................20


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Having looked in the previous session (Session 3) at the various means by which a

payment can be initiated, this session examines what happens to that payment

instruction - how it is exchanged between the sending and receiving banks; and how

those banks settle between themselves so that the receiving customer’s account gets

credited.

CLEARING: The process of transmitting, reconciling and in some cases confirming

payment orders or security transfer prior to settlement.

However, for the purpose of this session on Clearing & Settlement we refer to only cash

transactions and exclude securities clearing and settlement from our scope.

SETTLEMENT: refers to the act of transferring “good and final funds” between two

parties.

TYPES OF SETTLEMENT:

1. Designated-time net settlement (DNS): in this running balances are calculated on a

bilateral or multilateral basis for each participant vis a vis the other participants and

only net amounts are settled at pre-specified times during the day

2. Real Time Gross settlement (RTGS): Settlement of funds occurs on a transaction by

transaction basis continuously in real time without netting debits against credits.

4.4 Bilateral Correspondent Arrangement – A basic model of settlement

Here we will start with a basic model of payment settlements through a correspondent

bank. After having gone through this model carefully reader will get equipped with the

basic concept of what exactly settlement means.

Figure 4.1 Bilateral payment arrangements

The above Figure 4.1 shows one of simplest arrangements for settlement of funds

amongst the banks. Assumptions made for this model are:

• There exist only two banks in the whole system of banking.

• Both of these banks hold an account in the name of each other in their

accounting system, i.e. the bank A has an account of bank B in their books and

vice-versa.


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Let us understand the above with an example:

Payer A has to pay a sum of Rupees 10,000 to the Payee B. Both have their accounts

with banks A and B respectively. Now the payer gives the payment instruction of

money transfer, for example typical wire transfer to bank A. Then, since both banks

have Nostro-Vostro (mutual) accounts for each other in their books of accounts. Let us

assume that in A’s accounting books bank B’s account has 10, 00,000 rupees and B’s

books have bank A’s account with 12,00,000 rupees.

On generation of the payment instruction of 10,000 rupees by the payer to payee, one

of the following two procedures can be followed by both banks to transfer the funds.

Bank A increases (credits) the account balance of bank B by 10,000 rupees making it

10,10,000 and passes the information to bank B so the bank B in-lieu decreases (debits)

its own bank balance and credits the account of the payee held in their bank by the

same money.

1) Bank A simply passes the information to the bank B where in turn bank B

decreases the balance of A’s account by 10,000 rupees making it 11, 90,000

rupees and increases the balance of payee’s account by 10,000 rupees.

In a transaction process the creation, validation and transmission of payment is

administered. It involves the following steps:

Did you know? – Such mutual accounts held by banks in the name of other banks

they deal with are known as Nostro-Vostro accounts. Nostro and Vostro are latin

words meaning “your account” and “my account” respectively


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1. ID verification of the involved parties.

2. The validation of the payment instrument.

3. Verification and check over the ability to pay.

4. Authorization of the transfer of funds by the payer and the payer’s financial

institution.

5. Communication of the transaction settlement and clearance proceedings

between the parties.

6. Processing of the transaction.

4.5 Correspondent Bank as Settlement Agent

In the basic model our assumptions were very simple and far from the reality of actual

world. The financial space has numerous banks; it obviously becomes very difficult for

each of the bank to maintain a mutual account with every other bank.

Consider the difficulty if we have N banks, N being a very large number, then every bank

has to have N-1 accounts of other banks with them. Suppose every bank has equal

number of customers M, which will obviously be a large number also. Let x, y be a subset

of M and z be a subset of N-1, then the total number of transactions every day held by each

bank are “xyz”. In the worst case this number can be M*M*(N-1) which would be a big

headache for banks.

As the whole process is described algorithmically above, here in fig 4.2 the

correspondent bank is acting as the settlement agent for both banks. Both banks keep

account with bank C which in turn debits or credits their accounts depending upon the flow

of funds amongst them.

Figure 4.2 Payment Settlements through Correspondent Bank


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4.6 The Role of Settlement Agent

To eradicate the difficulty in settlement we include a settlement agent, which works for

the process of settling each bank’s account with respect to others depending upon the

transactions they make with each other. Let’s see the following figure 4.3

Figure 4.3 Role of Settlement Agent

The settlement agent is the third party which can be another financial institution doing

the task of holding each bank’s account with them and making the adjustments in each

other’s accounts depending upon the transactions they have made with each other.

Generally central bank of the country acts as the settlement agent. So, in terms of the

present example, Bank A’s balances at the central bank are reduced, and Bank B’s

balances are increased.

For example in India RBI acts as a settlement agent and every other bank like ICICI, PNB,

HDFC, SBI etc hold an account with RBI and all the payments amongst them are

accounted for at RBI.

So for example: a person/firm having an account in PNB who needs to pay Rs. 20,000 to

another person/firm having an account in HDFC bank, can pay the amount through an

instrument which is transferred between them and then processed by the RBI in each of

the Banks account, so the changes in the accounts are done by the respective banks,

but the money transfer between the banks is taken care of by the RBI.

Here the Central Bank, RBI acts as the settlement agent.

4.7 Gross Settlement & Net Settlement

In the previous section we considered the simplified model of payment settlement

which we extended with the inclusion of settlement agent. Till then we were concerned


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about how the settlement could be done. In this section we will focus on frequency of

the settlement processes in a day i.e. when the settlement should be done.

Participating banks, can settle their payment balances with the other banks either at

the end of every day or they can settle it after every payment made or received.

Depending upon the frequency of the settlement of the payments, at the end of day or

payment by payment basis there are two methods to settle payments:

• Gross settlement and

• Net settlement

Both of these methods have their own issues and implications.

4.7.1 Net Settlement Mechanism

In the net settlement mechanism the total number of a particular bank’s out payments

are offset against the total number of bank’s in-payments i.e. as soon as the payment is

made or received by a bank no actual transfer of funds takes place between the settling

authority (assume central bank) and the bank instead only the entries are made into the

account of the bank with RBI. At the end of day, i.e. at the settlement time the final

transfer of funds takes place which is equivalent to the net position of the bank.

The process of Net Settlement can be divided into two steps, either of which may form

the basis for producing the entries for posting to settlement accounts:

A. Bilateral Settlement - Let’s take an example of banking system comprising of four

banks. In it every bank deals with every bank bilaterally i.e. payments are offset

between each pair of bank individually.

Figure 4.4 Bilateral Settlement

The diagram above shows the day long actual flow of instructions in between every pair

of bank. Let’s take a look at the flow of funds in a tabular form.

Table 4.1

From/To A B C D

A - 90 40 80


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B 70 - 0 0

C 0 50 - 20

D 10 30 60 -

In table 4.1 The values in the row denote the payments to be made by the bank to the

other banks in the columns. The values in the column denote the payments to be

received by the bank in the column from other banks.

The following diagram shows how the net payment positions are calculated

bilaterally for each bank. Here clearing house comes into the picture. The clearing

house calculate net obligation of each bank by considering all the payments to be

made to other banks individually and total payments to be received from other

banks.

In other words, Bilateral netting involves the offsetting of the bilateral claims and

obligations between each pair of banks. In the four-bank example this means that

each bank will have three separate bilateral positions with respect to the other

members of the system - positions that can be either a ‘net pay’ or a ‘net receive’, or

a zero net obligation (though this last possibility is not included in the example).

Thus in the next diagram, Bank A is a net payer to all three other banks; while Bank

D is a net receiver from A, but a net payer to B and C. These bilateral net positions

may be used instead of the gross figures for the inter-bank settlement.

Figure 4.5 Bilateral Net Settlements

We will show you how it is done by calculating the net positions of Bank A with every

other bank:

Between Banks A&B 90 -70 = 20 (Net Payable)

Between Banks A&C 40 – 0 = 40 (Net Payable)

Between Banks A& D 80 – 10 = 70 (Net Payable)


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For an m*m matrix the general formula to get the bilateral net positions will be

A(i , j) – A( j , i) ; where i

B. Multilateral Net Settlement – When bilateral net positions are calculated, then in

the second step each bank in the system settles its overall net position with respect to

all the other members of the system. There will only be one settlement account entry

for each bank.

Figure 4.6 Multilateral Net Settlement

Under multilateral net settlement, Bank A is a net payer, Banks B and C are net receivers,

while Bank D has a zero net position. This whole process can be presented in tabular

form in a settlement matrix (Table 4.2). This shows all the gross payments between pairs

of banks and how the ultimate multilateral net positions are derived.

As discussed, Payment systems with multilateral net settlement usually operate

through a clearing house, a central location through which the payment instructions

pass and which is responsible for calculating the multilateral net positions of the

member banks and passing them on to the central bank for posting to the members’

settlement accounts.

This leads naturally onto the question of the timing of settlement. A netting operation

requires the collecting together of details of in and out-payments submitted over a

specified time period - often a whole business day, although it may involve shorter,

more frequent periods. There is thus a delay between the initial submission of the

payment instruction and the settlement across the accounts at the central bank.

Indeed, it may be the case that payment instructions pass through the clearing house

and on to the receiving banks before settlement takes place. This has important

implications for the risks in payment systems.

In table 4.2 settlement matrix all the net positions of banks are calculated as below.

For 1st

bank -

For 2nd

bank -

:


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: For Mth bank -

All those payments systems where volume of transactions is greater than the value of

transactions per day use net settlement systems. For example retail payment systems

which deal with settlement of credit cards payments or cheques payments deal employ

net settlement systems to settle their payments.

Table 4.2 Settlement Matrix

4.7.2 Role of clearing houses in Net Settlement

We saw that a lot of calculation is needed to come up to the final net payable or

receivable position of each participant. Question arises that “who on the behalf of every

bank carries out these calculations”, it is the clearing house which determines everybody’s

net funds payable or receivable positions before passing on the result to the central bank.

The thing which is to be kept in mind that it’s not the clearing house which also holds the

accounts of every participating bank with it. This is the task of central bank; clearing house

just passes the information to the bank that how much is to be settled by which bank


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Figure 4.7 Role of Clearing House

Things to be noted here are:

• Payment system clearing houses can take a variety of forms. They may be

owned and operated by the central bank itself, or by the commercial banks, or

by a combination of the two.

• They may be designed to handle either paper or electronic/automated payment

instructions, or both. With electronic payments, the clearing house may process

them in batches, or in real-time as each instruction arrives. The latter alternative

enables the clearing house to monitor banks’ net positions on a continuous

basis - important if there is a structure of limits in place.

• They may be organised to serve the whole country, or on a regional basis within

the country. The latter may be useful in countries with poor communications

and transport infrastructure, or where there are large distances between centers

of population and activity. In such cases, the settlement accounts of the banks

in the regional/local clearing house may be held at the local branch of the

central bank. Clearing houses may be owned and operated by central bank.

The following Figure 4.8 explains the process of net settlement taking the perspective

of the customer and the banker both.

Figure 4.8 Payment Settlements in Net Settlement System


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4.7.3 Real Time Gross Settlement

With gross settlement, each payment instruction is passed from the paying bank to the

central bank and is individually settled across the accounts of the paying and receiving

banks. Thus, there will be a debit and credit entry for each and every payment

instruction settled. The meanings of “real time” and “gross settlement” are as follows:

“Gross Settlement” – An alternative method of settlement of funds other than net

settlement whereby all the payment instructions are settled on transaction-by-transaction

basis

“Real-Time” – All the payments are settled continuously rather than periodically as in the

net settlement system.

Thus RTGS may be defined as a funds transfer mechanism where transfer of money

takes place from one bank to another on a ‘real time’ and ‘gross’ basis. This is the fastest

money transfer system through the banking channel. Settlement in ‘realtime’ means

payment transaction is not subjected to any waiting period. The transactions are settled

as soon as they are processed. ‘ Gross Settlement’ means the transaction is settled on

one to one basis without bunching with any other transaction.

As stated above in the definition of Real Time Gross Settlement (referred as RTGS

hereby), an RTGS system provides continuous finality to the intra-day payments. As

soon as the payer bank generates a payment instruction it gets settled, i.e. funds are

transferred from the payer bank’s account with the central bank into the payee bank’s

account, then and there without any delay. This is just opposite to the net settlement

mechanism where actual transfer of funds takes place at the end of day and till then

only net credit or net debit positions of each bank is calculated.

As detailed earlier, Net Settlement mechanisms are employed generally where the

volume of daily payments is very high as compared to the value of each payment. For

example in retail payments like cheque transactions, credit card and debit card

transactions etc. RTGS cannot be employed because their recurrence is very high and

using continuous settlement mechanisms for them will eventually lead to the severe

congestion problems in the system.

• On the contrary RTGS systems are used for high valued payments. In India the

minimum amount to be remitted through RTGS is Rs1 Lakh. There is no upper

ceiling for RTGS transactions High value payments include mainly inter-bank

transactions, which comprise:

• i.e. High value payments are those where value of each transaction is very high;

these are mainly inter-bank transactions, which comprise:


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• Money market transactions: when banks take intra day loan to settle their

accounts with RBI from various financial institutions like Industrial Development

Bank of India (IDBI), Industrial Finance Corporation of India (IFCI) etc.

• Foreign Exchange Settlement: When banks deal with foreign exchange trading.

• Cash transactions in Securities Trading: When banks make or receive cash

payments in-lieu of trading of huge volumes of securities (i.e. Govt. bonds,

Shares, Debentures Etc.)

Due to these high value transactions in financial markets sometimes the total turnover

for a RTGS system can be equal to 50 times the total GDP of the economy.

Many developed nations and all G10 countries have employed RTGS systems for their

settlement of high value payments. For example Fed-wire (USA), CHAPS (UK), BOJNET

(Japan), KRONOS (Denmark), RTGS+ (Germany) etc.

INTERNATIONAL ACCPETANCE OF RTGS:

List of some of the countries with RTGS system

Denmark ,Finland ,Germany ,Italy, Japan, Netherlands, Sweden, Switzerland, United

States ,Austria, Belgium, China ,France, Greece, Hong Kong, Ireland, Luxembourg, New

Zealand, Norway, Portugal, Saudi Arabia, South Korea, Spain, Thailand, United Kingdom

Payments in RTGS systems are typically credit transactions, i.e. payments are initiated

by the remitter (debtor). Payments in RTGS systems are settled via the participants'

accounts with the settlement bank by simultaneous debiting of the remitter's account

and crediting of the recipient’s account, after which a payment is considered to be final.

In most RTGS systems the settlement bank is the national central bank, which also owns

the system.

The following figure 4.9 explains the process of settling down the payments via RTGS

mechanism

Figure 4.9 Payment Settlements through RTGS System


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All the RTGS transactions are done electronically. A payment message {using SWIFT

standards and SWIFT network, SWIFT-Society for Worldwide Inter-bank Financial

Telecommunication} is generated by the payee bank (i.e. these messages are specific

electronic formats of data transfer wherein every message contains a header in which it

is specified that what type of transaction is it, BIC (Bank identifier Code) of the bank

which generated it and the BIC of the bank which is going to receive it. The payment

message generated is then routed to the receiver bank through the RTGS system

installed at the central bank. RTGS system follows the star-topology with central bank

acting as a hub.

4.7.3.1 Objectives of RTGS introduction

• To widen and strengthen the customer base

• To improve liquidty management of participating Banks

• To reduce settlement risk due to payment default

• To reduce the transaction costs and to explore revenues for generating addition

income for banks

• To increase the speed of transfer

• To increase the system reliability

• To strengthen the payment system and thus the trade and economy.

Fundamental advantages of RTGS:

• Most certain way of eliminating inter-bank settlement risk

• Liquidity problem is easily and immediately detected

• RTGS system prevents settlement risk arising between commercial banks in high

value payments systems

• Provides recipients of high value payments with assurance that payments are

irrevocable in their hands at the time of receipt

4.7.3.2 Features of RTGS

A. Queuing, FIFO, Prioritisation, Cancellation and Rescheduling in the RTGS

systems: Conventionally, a payment instruction is expected to be settled as soon as it is

received, which is a feature of a real time system. However, there exists scope of some

transactions not being capable of immediate settlement. In such cases, the RTGS

system will maintain a payment queue within which the payment transactions will be

held on a FIFO basis. The participants are also provided facilities to view the

transactions held in payment queues, cancel transaction(s) and can change the order of

priority. In view of the confidentiality and security concerns of participants, one can


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view only the other participants in queue or one’s own pending incoming payment

instructions. We will take an example to help the reader appreciate this fact better.

Suppose ICICI bank is a participant of the RTGS system in India and they have to handle

several high value payments due to a large number of transactions. Suppose ICICI bank

does not have enough liquidity with them at that time, they will also be maintaining a

payments queue which will be working on first in first out principle (FIFO). The client

of the RTGS system installed at their side will maintain such a queue for them. Outgoing

payments will be put in the queue along with a function, which will continuously check

the position of bank’s liquidity pool. It’s just like checking the levels of inventory in a

manufacturing firm.

As soon as the liquidity levels become adequate the payment which first entered the

system will be settled first.

Figure 4.10 Conceptual View of the Queue

Now we will discuss various queuing features to handle the payments.

B. Bypass

In RTGS systems participants can select a bypass function that can be used when the

first payment in the liquidity queue cannot be settled due to lack of liquidity. With

bypass, the system will attempt to settle one or more of the subsequent payments,

provided that there is cover in the participant's account. It will then attempt to settle

the first payment at a later time. Using the bypass function prevents a situation where a

large-value payment blocks the settlement of small payments.

C. Optimization Routines

A number of RTGS systems use optimization routines to minimize the number and

value of queued payments. One type of optimization routine typically attempts to settle

a group of payments simultaneously. Another type of optimization routine offsets

outgoing and ingoing payments of the same size.

4.7.3.3 Message Flow Structures in RTGS systems

We read in previous sections that RTGS is a high value fund transfer system, where

funds are transferred electronically. We also read that payments are initiated by


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payment messages. These messages are electronic messages having formats for

different types of payments. For forex transactions and for securities settlements there

are different messages.

To initiate a payment, the message is first transferred to the central bank from where it

gets routed to the beneficiary. This whole setup has to follow some sort of architecture.

In this section we will look at the four topologies of how messages can be transferred

between banks.

1. The V-Shaped Structure –

To initiate a fund transfer, the sending bank dispatches a payment message which

is routed through a Central Bank, to a receiving bank. In this structure, the message

with all necessary information about the payment is passed on to the Central Bank.

For example all the information about the beneficiary, is passed to the central bank.

After the receiving bank settles the transfers with Central Bank, the said information

is passed on to the receiving bank. In this structure, the Central Bank functions as an

arbitrator and a postman. Most of the RTGS systems worldwide use this structure

itself.

Figure 4.11 “V” Structure of RTGS

2. The Y-Shaped Structure –

Those that use the Swift Network follow an alternative structure, which is a ‘Y’

shaped structure. In this case, the payment message is transmitted by the sending

bank to the central processor. The central processor filters the information and

takes a subset of information that is necessary for settlement, from the original

message and passes this subset to the Central Bank. The Central Bank’s processor

retains the original message.

On receipt of the subset, the Central Bank verifies whether the sending bank

has sufficient funds in its account. Then the Central Bank informs the central


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processor the status of the transfer as to whether settled or queued or rejected.

Once settlement takes place, the full message containing all the information

confirming the settlement is rebuilt by the central processor and sent to the

receiving bank. In this structure, the business information that is exchanged

between the sending and receiving banks is not known to the settlement agent viz.

the Central Bank.

Figure 4.12 “Y” Structure of RTGS

e.g. Reserve Bank of India has chosen Y-shaped structure to meet strategic

objectives i.e possibility to hive-off the Inter Bank funds transfer processor (IFTP),

which strips and retains the customer related information and forwards the

payments and settlements particulars to RTGS, to an independent industry service

provider.

3. The L- Shaped Structure –

CHAPS of UK have implemented this structure. It is similar to the Y-shaped

structure in every aspect apart from the little difference that there is a gateway

attached to the sending bank’s processing system which does the same task of central

processor in the previous structure that’s of taking a subset of core information and only

sending it to central bank for settlement. Elaboration is given below.

In this structure, the payment message emanating from the sending bank is held

at a system gateway, which is attached to the sending bank’s internal processing

system. From the gateway a subset of the original message is created and sent to

the Central Bank. If the sending bank has sufficient funds in its account, the

settlement is completed and the Central Bank confirms this, by way of a message to

the sending bank’s gateway. On receipt of this confirmation message, the original


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payment message is automatically relayed from the sending bank’s gateway to the

receiving bank.

Figure 4.13 “L” Structure of RTGS

4. The T-Shaped Structure

The common feature in the previous three structures was that only after full

settlement takes place the message is passed on to the beneficiary. But in the T

structure a copy of the unsettled payment message is also passed to the beneficiary

bank. This may give rise to some complications as the sole purpose of RTGS is to

handle various risks such as credit risks and other settlement risks which is

minimized by not informing the beneficiary until the final settlement. But due to

sending of unsettled messages also to the beneficiary, beneficiary may give credit

to its customers in the anticipation of receipt of funds. Hence this structure is

vulnerable to credit risk exposure. T shaped structure has generally been viewed as

incompatible with the basic principles of RTGS that a funds transfer should be

passed on to a receiving bank , if and only if, it has been settled irrevocably and

unconditionally by central bank. Till now none of the G10 nations have adopted this

RTGS structure type.

Figure 4.14 “T” Structure of RTGS


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4.8 Summary

• The settlement agent is the third party which can be another financial

institution doing the task of holding each bank’s account with them and making

the adjustments in each other’s accounts depending upon the transactions they

have made with each other.

• In the net settlement mechanism the total number of a particular bank’s out

payments is offset against the total number of bank’s in-payments.

• Bilateral netting involves the offsetting of the bilateral claims and obligations

between each pair of banks.

• Payment systems with multilateral net settlement usually operate through a

clearing house, a central location through which the payment instructions pass

and which is responsible for calculating the multilateral net positions of the

member banks and passing them on to the central bank for posting to the

members’ settlement accounts.

• The continuous finality and settlement of transactions is achieved through Real

Time Gross Settlement (RTGS) mainly applicable for high value settlements.

• Type of message flow structures in RTGS: V-shaped, Y-shaped, L-shaped and T-

shaped structure.

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Documents

Payment systems part 1