Money makes the world go round, at least in business. Paying efficiently for goods and services procured and receiving money for sales are critical to business survival. Apart from cash (notes and coins) and virtual currencies, money is paid and received by businesses through bank accounts.
Banks execute payments for their customers through a variety of payment instruments most of which are mediated by clearing systems (collectively known as market infrastructures).
These can be summarised as follows:
Other payment types include:
- Book transfers (payments within one bank need not pass through clearing; some banks offer cross-border book transfers within their own branch network),
- International cheques or drafts (foreign currency),
- Banker's cheques or demand drafts (drawn on bank on behalf of customer to reduce credit risk), and
- Various trade payment instruments covered below.
Cash (notes and coins) remains prevalent in retail businesses globally despite the risks and inconveniences it presents. Cash (notes and coins) still represents 19% of GDP in Japan and 7% in USA while in Scandinavia it is down to below 2%. Cash handling is fraught with risk. This can only partially be mitigated with automation and collection services.
Credit and debit cards are a more secure method for retail collections and also for business procurement. Card systems are essentially interbank netting systems with final settlement across central bank accounts through RTGS.
Cheque usage has practically disappeared in some advanced economies with the advent of fast/instant and mobile payments, but cheques remain stubbornly entrenched in many economies. Cheque usage is artificially buoyed by distortive pricing. For example, free cheques and bank fees for electronic payments. Many governments are nudging their economies away from paper to electronic instruments with little success.
Cheques must be created, delivered, and processed manually. This is a huge cost for economies that are big users of cheques.
Most markets have some kind of cheque clearing system. Many use scanning to 'de-materialise' cheques and speed up clearing. Cheque clearing requires that the beneficiary's bank present the cheque (electronically or in paper) to the payer's bank for payment. Final settlement goes through the central bank via RTGS.
Because of the work involved and the inefficiencies of paper handling, cheque clearing typically ranges from overnight processing to weeks. Cross-border cheques are especially problematic.
ACH is in fact the name of the USA high volume clearing system run by NACHA since 1974, enabling 26 billion payments worth USD 43 trillion per annum. ACH refers to 'Automated Clearing House' and the term has become commonly used to describe the high volume batch oriented payment systems that exist under different names in most markets.
Although high volume payment systems vary in the details, they generally share some common characteristics:
- They are batch oriented rather than real time. Initially the batch frequency was daily with overnight processing (that could go up to three days). More recent systems have, for instance, ten hourly batches per day.
- Final settlement between banks is a net settlement across central bank accounts via RTGS.
The sequence of processing, whether daily or hourly, is somehting like this:
- Payer instructs payer bank to pay
- Payer debits payer account
- Bank submits file of all payments to clearing house
- Clearing house computes net settlement for each bank
- Banks settle net amounts via RTGS
- Clearing house confirms payments to banks
- Beneficiary bank credits beneficiary account
When the batch processing occurs overnight, this means there will be one to three days of float enjoyed by the banks. Float is the time between the date when the payer is debited by their bank (and therefore ceases to earn interest on their funds) until the date when the beneficiary is credited by their bank (and therefore starts to earn interest on their funds).
ACH payments are typically two orders of magnitude cheaper than RTGS payment, indicatively an ACH may cost $0.05 or less whereas an RTGS may cost $5.00 or more. Many banks offer free ACH because the float is more valuable to them than the transaction fees.
Generally, ACH is the cheapest and most effective way for corporates to make domestic payments. In practice, most ACH systems are already or are moving towards same day clearing. In any case, value dating is not commonly practiced for commercial transactions. For most corporates, only treasury transactions such as foreign exchange and money market settlement need to be settled through RTGS.
In some markets, ACH systems limit the maximum value of payments. This may limit the use of ACH for high value commercial payments.
While an ACH credit transfer is initiated by the payer, and ACH debit transfer is initiated by the beneficiary. So ACH credit is a 'push' payment, whereas ACH debit is a 'pull' collection. Such direct debits are commonly used by governments and utilities to collect taxes, phone and electricity bills, credit card bills, etc.
The clearing and settlement of ACH debits is the same as for ACH credits described above, and the same networks and systems are used for both.
ACH debit requires that the payer (normally the beneficiary's customer) sign a direct debit mandate which authorises their bank to pay the stated beneficiary when requested to do so. Such mandates are increasingly becoming electronic.
With the mandate in place, the process is normally something like this:
- On or just before the invoice due date, the beneficiary / seller instructs its bank to request / 'pull'the invoice amount from the payer / buyer's bank account
- The beneficiary / seller's bank routes the pull request to the payer / buyer's bank via the clearing house
- Assuming the payer / buyer has sufficient funds on their account, the payer / buyer's bank debits the payer / buyer's account and updates the clearing house accordingly
- Clearing house computes net settlement for each bank
- Banks settle net amounts via RTGS
- Clearing house confirms payments to banks, and banks credit beneficiary / seller account
This has big advantages for the beneficiary / seller:
- Collection is automated and does not rely on customer action, so the risk of late or non-payment is greatly reduced
- Since the beneficiary / seller initiates the collection, they know what the incoming funds relate to and can automated accounts receivable reconciliation (in contrast ACH credits received are often hard to reconcile)
- ACH debit allows a full STP (straight through processing) reducing time and costs as well as operational risk
Consumer protection laws in many markets require that customers have the right to reverse direct debits for up to 60 days. Although it rarely occurs, this creates a potential liability for the bank and for the beneficiary / seller. To mitigate this risk, the bank will often require collateral or guarantee or credit line allocation for a percentage of the direct debits subject to such laws. This is similar to the risks that exist with card reversals.
Fast / immediate payments
In response to the falling cost of compute power and network bandwidth, and to address the needs and expectations of a digitalised world, many markets have introduced fast or immediate payments. Fast or immediate payments are near real-time, typically within 30 seconds. This is a big difference, when compared to minutes for RTGS (which are not really real-time from an IT perspective) and overnight or at best hours for an ACH.
Fast or immediate payments are generally net settlement systems and are thus comparable with ACH. While ACH uses batch clearing and net settlement between banks, fast or immediate payments use immediate clearing and net settlement between banks. To limit interbank liquidity requirements, net settlement generally happens hourly (or when net obligations exceed defined thresholds).
Notionally, the process goes like this:
- Within 30 seconds:
- Payer instructs bank to pay beneficiary
- Payer bank posts payment to fast clearing
- Fast clearing records payer bank obligation to beneficiary bank and advises beneficiary bank
- Beneficiary bank credits beneficiary account
- Fast clearing advises banks to settle net obligations across central bank accounts via RTGS
Because of the liquidity risk introduced by immediate clearing and later net settlement, many fast or immediate payment systems limit the value of each payment, typically to below $200,000. This makes such fast or immediate payment systems unsuitable for high value commercial payments (which then have to go through ACH or RTGS if same day value is required).
Most fast or immediate payment systems handle both credit and debit transfers, which is similar in functionality to those described for ACH above.
Some new fast or immediate payment systems eschew the net settlement solution in favour of real-time gross settlement across central bank accounts. This reduces the liquidity risk across the system but increases the technical demands on the central bank's systems. Given the reducing costs of compute power and network bandwidth, and increasingly real-time economies, it seems likely that real-time gross settlement across central bank accounts will become the norm in future. When this happens, there will be only one payment system, handling high volumes of all value payments, resulting in no distinction between ACH and RTGS.
In many markets, authorities are keen to build on new fast or immediate clearing systems with application programming interfaces (APIs) that allow third party payment service providers to access the system (with appropriate security and account holder consent). This is expected to allow novel and innovative services to further the digital economy. Banks are also implementing APIs to open their systems to complementary service providers.
Another popular evolution of fast or immediate payment systems is to add the account holder's mobile phone number to their account information. This enables phone-to-phone payment, which is in fact happening across bank accounts. Some people are not comfortable giving out their bank account number, and in any case phone numbers are more familiar and standardised, as well as easier to communicate and remember.
eWallet and mobile banking
eWallets and mobile banking (other than crypto currencies) rely on the payment systems described above. eWallets are essentially de-materialised stored value cards. Some eWallets have a pass through feature linking them to a bank account; this makes them basically mobile banking platforms.
The advantage of stored value eWallets is that the maximum loss is the stored value rather than the full balance of the bank account. The disadvantage of stored value eWallets is that they fragment cash, and generally do not pay interest. eWallets linked to investment products already exist, and e-banking offers limits on different payment types such as RFID payments.
It is likely that the market will rationalise and coalesce with developments around API banking, phone number payments, and single use card numbers to provide solutions that will be helpful to corporates. These might include 'pull' collections from retail customers mediated by immediate one-off mandates, de-materialised procurement cards, better solutions for travel and entertainment expenses, etc.
RTGS means real-time gross settlement. Almost all markets have a RTGS for interbank settlement across central bank accounts. Typically, the process is not real-time as IT would understand it, it takes minutes not milliseconds.
RTGS operates across central bank accounts held by commercial banks. As such, it is normally the system of final settlement for the other payment systems described above, as well as for securities and treasury transactions. RTGS is also the system for final settlement of cross-border payments.
RTGS is designed for low volume, high value transactions. RTGS often have a minimum value. RTGS typically costs two orders of magnitude more than ACH and other high volume systems, RTGS payment might cost $5.00, while an ACH payment might cost $0.05 or less.
The process flow for a RTGS payment is somehting like:
- Payer instructs bank to pay beneficiary
- Bank posts payment on RTGS
- RTGS debits payer bank and credits beneficiary bank accounts with central bank
- Beneficiary bank credits beneficiary
One partial exception to the near universal role of RTGS for final settlement is the CHIPS system in the USA. CHIPS is a hybrid net settlement system used in parallel with FedWire that is designed for high value payments. Like all other USD payment systems, CHIPS final settlement is through the central bank via FedWire (which is the USD RTGS). CHIPS is used extensively for securities settlements.
RTGS is the fundamental building block of all payments, and will always be needed in any financial system. Fiat crypto currencies may mean that RTGS now run by central banks will migrate to blockchains, but the underlying need for a system of interbank settlement will remain.
Like domestic payments, cross-border payments also must settle in the central bank of the currency. (Or a central bank, some markets have a central bank that runs foreign currency RTGS; for example, the Hong Kong Monetary Authority's CHATS handles HKD, CNY, EUR, and USD.)
As an example, a USD payment from Singapore to Hong Kong will be processed as follows:
- Singapore payer instructs bank to pay Hong Kong beneficiary
- Payer bank sends instructions to its USD correspondent in New York
- Payer correspondent pays beneficiary correspondent across central bank accounts via FedWire (RTGS)
- Beneficiary correspondent advises beneficiary bank of incoming funds
- Beneficiary bank credits Hong Kong beneficiary's account
In a sense, the only real payment here is between the two correspondent banks in New York; the rest are accounting entries.
The messaging for cross-border payments almost always uses SWIFT messaging (MT101 or ISO20022 pain messages) over the SWIFT network (which includes approximately 10,000 banks worldwide).
Although this chain of messages takes seconds or minutes, it is not uncommon for banks to delay payments in order to earn float. With the exception of large time zone differences (for example, making NZD payments in European time zone), it is always possible to execute same day cross-border payments with good value. In any case, it is always possible to get good value (i.e. payer's account is debited the same date as beneficiary's account is credited) if the payment instruction is given to the bank one or more days before the intended value date. Not getting good value simply means that one or more of the banks is benefitting from the float.
Lack of customer understanding of this process, combined with the number of players, leads to abuse of float. Unscrupulous banks may charge different fees on their customers or their correspondent's customers, such as lifting fees, commission in lieu of exchange, etc. None of these are acceptable. Cross-border payments should cost between a range of $5 to $25 (whether born by the payer or the beneficiary or shared), and ad valorem (percentage) fees are not acceptable.
Because of these problems, which (as explained above) are purely commercial and not technical, and in response to competition from fintechs, SWIFT introduced a new program to improve bank behavior on cross-border payments called Global Payments Initiative (GPI) in 2015. GPI is primarily a rule book (creating visibility on float and opaque fees) combined with a technical platform that allows customers to track payments near real-time. Payments must be credited on the same day and charges must be clearly disclosed up front.
An interesting alternative to the traditional correspondent banking SWIFT-based cross-border payments is the cross-border ACH. In cross-border ACH, banks leverage their networks (complemented as needed by payment service providers like WorldPay's BankOut) to execute customer's foreign payments via local ACH. This is typically an order of magnitude cheaper than traditional TTs (telegraphic transfers).
Cross-border ACH does have limitations. The bank (or Payment Service Provider) must have access to the beneficiary market. The payment must be in the beneficiary's local currency (because ACHs operate in local currency). Some ACHs have maximum value limits, and this may make cross-border ACH unsuitable for large value commercial payments.
Fintechs are also looking to disrupt cross-border payments. Most fintech solutions currently available are in the retail space and tend to focus on reducing foreign exchange spreads. Ripple is an example of a fintech looking to disrupt correspondent banking for cross-border payments at commercial scale.
Book transfers offer an attractive solution to payer and beneficiary that have accounts at the same bank. Book transfers are usually free (at least domestically) and without loss of float. Most banks will automatically route payment instructions as book transfers when possible, so corporates do not have to adjust their systems to benefit.In other words, corporates can send the same payment instruction format to the bank as for ACH or RTGS, and the bank will treat it as a book transfer when applicable.
Many banks also offer cross-border book transfers within their own network, though these are seldom free. Cross-border book transfers are an attractive solution for intercompany payments.
BitCoin and blockchain
BitCoin and other crypto currencies like Ether and Ripple are much in the news. Although some corporates accept bitcoin for retail collections, this is normally on the basis that the bitcoin will be immediately converted to fiat money.
Most non-fiat crypto currencies are too volatile for corporate use. Furthermore, it is unclear that they will be able to scale to large payment volumes, hence, the famous bitcoin fork dilemma.
Bills of exchange / promissory notes are akin to forward dated cheques and are often used in business transactions, for example in Korea and China, where corporate and bank acceptance drafts are common. Bills of exchange can be issued by corporates or by banks on corporates' behalf to reduce credit risk to the beneficiary. They can be endorsed and are transferable; this means they can be encashed before their due date if needed. In China, bills of exchange are routinely used to pay corporate obligations, and are the basis of China's triangle trade problems.
Letters of credit (L/Cs) are commonly used for cross-border trade. They are normally issued by banks on behalf of buyers, so that payment is guaranteed by the bank (reducing credit risk for the seller) upon meeting the L/C terms (subject to discrepancies). L/Cs can be confirmed to enhance their credit risk, and since they are negotiable instruments, they can also be discounted (sold) to speed up cash flow. Documentary collections execute in the same work flow, without bank payment guarantee.
Since bills of exchange and L/Cs are paper instruments with history going back to the 14th century, there have been efforts to de-materialise them and move to electronic alternatives. In China, the PBOC has mandated the use of ECDS (Electronic Commercial Draft System) to digitise corporate and bank acceptance drafts.
For international trade, SWIFT has introduced TSU (Trade Services Utility) in conjunction with ICC approved BPOs (Bank Payment Obligations) to create a more efficient alternative to L/Cs.
Many payment systems have long histories 'USA's ACH is 45 years old and SWIFT is approaching its half century. SWIFT's MT messages were designed when bandwidth was expensive, in fact, they were designed for manual typing by telex operators. So they tend to carry limited data beyond bank names, account numbers, dates, and amounts.
This means that corporates receiving incoming payments often have difficulty reconciling them to accounts receivable. It may also be unclear who instructed the payment, what it is for, and any deductions will be opaque.
To address this, newer systems use XML to allow more data to be transported with the payment as remittance information. SWIFT's ISO20022 messages have practically unlimited data capabilities. The problem is that the added data may be lost in clearing systems and / or in legacy banking systems.
To mitigate this, SWIFT plans to extend the GPI to cover sending remittance information directly from payer bank to beneficiary bank, so that data does not get lost with the correspondents or in RTGS.
Lowest cost routing
Normally, corporates try to minimise cost of payments. All else being equal, domestic payments will be cheaper than cross-border payments, and this is a driver for IHB and cross-border ACH.
In general, the order of preference for domestic payments is usually:
- RTGS: most expensive
- Cheques: expensive
- Fast/immediate: Cheap
- ACH: Cheapest
Cheques are often free in terms of bank fees, but when corporate handling costs are included they are expensive. Over time, fast or immediate payments will replace ACH, and probably be free.
For cross border payments the order is:
- SWIFT/ Telegraphic transfer: most expensive
- Cross-border ACH: cheaper
- Ripple: Cheapest
Clearing vs settlement
A critical underpinning of all payment instruments, other than cash (notes and coins) and some crypto currencies, is that they all resolve to central bank money. When a bank credits a customer account, that entry is always underpinned, via netting and aggregation and sometimes with different timing, by an interbank entry across the banks' accounts with the central bank.
Cash (notes and coins) is also ultimately central bank money, cash is equivalent to a central bank promissory note, and was historically exchangeable for gold. Only crypto currencies are not backed by central banks, which is a source of many attractions and considerable risks.
Since the end of the gold standard (variously in 1931 and 1971 for the USA), central bank money is what is call fiat money, it has value because the government says it has and because (in most markets) we choose to believe its value. This is why inflation is so feared. Crypto currencies do not have any authority behind them, so their value is purely a matter of market psychology, resulting in volatility.
Understanding that bank entries on customer accounts are always underpinned by entries across banks' accounts with the central bank enables comprehension of the distinction between clearing and settlement. Clearing refers to entries on customer accounts at banks. Settlement refers to entries on banks' accounts at central banks.
In the case of, for example, an RTGS, clearing and settlement happen at roughly the same time, or strictly speaking in sequence: debiting the payer's bank account, then debiting and crediting the two banks' account with the central bank, then crediting the beneficiary's bank account.
In the case of low value payment systems, clearing and settlement often take place at different times. In the old ACH style batch clearing systems, payment information was exchanged between banks (often overnight), net settlement was made between banks' central bank accounts, and clearing by crediting beneficiary bank accounts was done later. This is why the old ACH systems often had overnight up to 3 day clearing cycles.
In the case of the newer fast / immediate payments, clearing by crediting beneficiary bank accounts happens in near real-time (typically within 30 seconds) and settlement between banks across central bank accounts happens later, typically hourly or four times per day. This is why many fast payment systems limit the maximum amount that can be transferred so as to limit credit and liquidity risk to banks.
Taking advantage of the lowering cost of compute power, some recent fast payment systems get around this problem by settling across central bank accounts in near real-time, effectively making them high volume RTGSs. Historical RTGSs would have struggled to deal with high volumes of payments, which is why ACH type low value clearing systems were established.
In Europe, all bank account entries have two dates, the booking date and the value date. The booking date is the date on which the entry was made. The value date is the date from which the entry begins to earn interest (or pay interest if overdraft) and funds can be used to make payments.
Some markets do not follow this practice today. In these markets, there are often more or less obscure practices which equate to value dating without the transparency. Obscurity generally enables banks to extract higher rents from the real economy.
Value dating is practiced in cross-border payments, and where cross-border flows are large, the lack of visibility of value dating can be a problem for cash management.
Consider USD payments between Asian counterparties. USD flows must settle between banks across their accounts with the Federal Reserve Bank via their interbank RTGS called FedWire. FedWire closes at 18:00 New York time, which is 06:00 the next morning in Singapore / Hong Kong / Beijing time. In managing their bank balances with the Fed, it is common for banks to hold customer payments until they have sufficient incoming flows to cover them. In practice, this often means that USD payments for Asian customers are settled (and therefore cleared) after Asian banking hours. From a New York perspective, the funds have moved on the requested value date. But a dishonest Asian bank without value dating transparency might credit the beneficiary account only on the following day. If the value date is a Friday, this results in the customer losing three days' interest (or, worse, paying three days overdraft).
Honest banks provide back valuation on such flows. In other words, the booking date may be the following Monday but the value date will be on the Friday, thereby ensuring that the bank's customer earns the interest they are due (or avoids an unfair overdraft).
Anti-money Laundering (AML)
To combat crime and terrorism, the G7 created the Financial Action Task Force (FATF) in 1989 in Paris. FATF has set out rules for banks that include Know Your Customer (KYC) and other practices to ensure that funds remain within the official (and monitored) economy.
In practice, this means that banks must take steps to know the source of funds and validate beneficiaries. This applies to all payments, but because of the information barriers involved in cross-border flows, it is most onerous in cross-border payments.
USD is the major global trading currency, and the Fed has mandated that all USD SWIFT MT103 payment messages be accompanied by an MT202 cover message which sets out all parties to the payment for sanctions and AML screening.
Bank Identifier Codes (BIC)
BIC codes, also known as SWIFT codes, are 8 or 11 character alphanumeric codes that identify all 11,000 banks and 2,000 corporates in the SWIFT network. The format of BIC codes is:
- Bank code (4 characters)
- ISO country code (2 characters)
- City code (2 characters)
- Optional branch code (3 characters)
For example, DBSSSGSG means DBS Bank at Marina Bay Financial Centre in Singapore.
International Bank Account Number (IBAN)
In the context of the Euro zone, European banks have standardised their customer account numbers in the IBAN format under ISO13616 to facilitate straight through processing. IBANs include the ISO country code, bank code, branch code, and customer account number, as well as a checksum to help with validation.
As IBANs include country, bank, and branch codes, they make BIC codes redundant or implicit where they are used.
In view of its many benefits, IBAN is being adopted by many non-Euro markets around the world. Other markets use separate bank codes, branch codes (such as routing numbers in US and sort codes in GB), and account numbers. Only a few other systems include the country code.
Here are some typical IBANs:
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