This book is for payments professionals working for comapnies that enable payments transactrions: banks, processors, payments services, software companies, service providers, risk managers, and others. It provides a comprehensive view of the entire US payments industry, including all its systems and functions. It also examines the economics of each core payment system.

Payments are a big part of our lives, both for people and for businesses. Behind payment transactions are the systems, products, and companies that form the payments industry.

What is a payment? It’s the transfer of value from one end party (sender) to another (receiver).

Three parts in a payments transfer:

1. initiation of the payment
2. funding of the payment by sender
3. delivery of payment to the receiver

There are five core payments systems in the US:

1. Cash
2. Checking system
3. Card system - charge, credit, debit, and prepaid cards
4. ACH (Automated Clearing House) system
5. Wire transfer system

Payment system volumes are measured in two ways:

• count: number of transactions processed
• amount: total dollar value of those transactionsTypeAngle@37Signals

Domains of Payment:

1. Point of Sale
2. Remote commerce
3. Bill payments
4. P2P payment
5. B2B payment
6. Income payment

Regulation: A mix of governmental and private rules regulates payments systems. The primary issuer of payments regulations is the Federal Reserve Board.

Providers make money from payments through direct and indirect sources.

• Direct revenue comes from fees explicitly charged to the end party: transaction fees, loan interest, maintenance fees, exception (overdraft/bounced check/late payment) fees, etc.
• Indirect revenue comes from net interest income on deposit balances, float (value earned from money held over a period of time), and interchange (fee that flows from one bank to another).

Risk Management:

1. Credit risk. The cardholder may simply fail to repay their loan balance.
2. Fraud risk
3. Liquidity risk. A party cannot fulfill its financial obligations to another party.
4. Operational risk. When one party to a transaction either fails to do what’s expected or does something in error.
5. Data security risk. Data is exposed for faudulent use.
6. Reputation risk. End parties lose faith in the integrity of the payments system.

Checking

A check instructs a bank to pay funds out of a checking account and provde those funds to the person or institution named on the check.

A customer who presents, or deposits, a check to his or her bank creates a problem for that bank. The check is a claim on an account—usually at another bank. How does the consumer’s bank collect the funds from the other bank? Historically, this process, known as clearing and settlement, happened bilaterally. The deposit bank would send a messenger to the other bank; the messenger would present the check and receive funds—perhaps in gold, cash, or banknotes—in return.

As the number of banks and the volume of checks grew in the 18th and 19th century, clearing and settlement of checks became more and more cumbersome. Messengers carried bags of checks to other banks, and cash was subject to theft.

The first check clearing house was established in 1853 in New York City.

Banks joined the clearing house and every banking day, deposited checks drawn on other member banks. The clearing house facilitated an orderly exchange of checks among the banks, and calculated the daily net settlement for each bank. Then banks then funded or drew from their settlement accounts.

In the 1950s and 60s, MICR (Magnetic Inc Character Recognition) and sorting enabled high-speed check processing. In the 1980s and 90s, imaging technology enabled banks to reduce the internal costs of storing and retrieving checks, by using cameras in the check sorters, capturing an image of each document as it went through the machine.

In October 2004, the check clearing for the 21st century act took effect. It simply states that a printed copy of the original check is the legal equivalent of the original paper check. By early 2010, 99% of checks were being processed electronically.

ACH

One of the largest payments networks in the US. Started in the 70s by bankers working in check processing automation. In the early days, focus was on high-volume, low-risk, repetitive transactions: payroll checks, social security benefit checks, and insurance premiums.

In the ACH system, an originator delivers transactions to its bank. Each bank in the system chooses an operator. The operator sorts and forwards the transactions to receiving banks or other operators. The flow is exactly the same for both push and pull transactions.

ACH operator is the entity that runs the ACH network infrastructure. Think of it as the traffic controller / bookkeeper for ACH payments.

An ACH operator:

• Receives ACH files from originating banks
• Validates and sorts transactions by receiving bank
• Calculates net positions (who owes whom, and how much)
• stributes transactions to receiving banks
• Facilitates settlement between banks (via accounts at the Federal Reserve)

The operator does not deal with consumers or businesses directly. It only interacts with banks and financial institutions.

There are only two ACH operators in the US. Banks can connect to either or both operators.

1. Fedreal Reserve (runs FedACH service)
2. The Clearing House (operates EPN - Electronic Payments Network)

ACH operators calculate net settlement totals for their banks on a daily basis and submit them to the Fed, which manages the actual settlement process using its National Settlement Service. This results in zero float among the banks and their clients.

ACH is owned by the banks. NACHA is a non-profit that oversees the netwrok. It’s not involved in the processing of payment, however.

Cards

Originated in private department store. Later, Diners club and American Express issued charge cards.

Visa and Mastercard are card networks. They connect issuing and acquiring banks, set rules and standards, and move auth messages and settlement data.

• Bank of America -> BankAmerica Service Corp. -> National BankAmericard -> Visa
• Interbank Card Association -> Master Charge -> Mastercard

After their IPOs in the 2000s, they are mainly technology-based processing companies, earning revenue from their bank clients (no longer owners) for transaction handling, brand management, and other services.

Similar card systems were developed in other countries and linked into Visa and mastercard systems to extend their scope of coverage.

The card payments value chain has two main components, issuing and acquiring.

Card Issuing Bank (Issuer) - Your bank as a cardholder. It gives you a credit or debit card and decides whether you’re allowed to spend money.

• Who they serve: the customer (cardholder)
• What they do: issue cards and pay on the customer’s behalf

Card Acquiring Bank (Acquirer) - The merchant’s bank. It helps a business accept card payments and get the money into their account.

• Who they serve: the merchant (business)
• What they do: accept card payments for merchants

In parallel to the credit cards in the 60s, banks began to introduce ATMs for serving checking account customers. In the 80s, ATM cards and credit cards began increasingly colliding. This led to Visa and Mastercard developing debit products for retail banks.

The Network Business - Running an open loop payment network involves following functions:

1. Transaction switching among participating banks
2. Net settlement among banks on a daily basis, including multi-currency settlement
3. Create, update, maintain, and enforce operating rules
4. Manage network membership and resolve disputes
5. Manage brand and promotion

Cash

Cash is physically produced by the US Treasury’s Bureau of Engraving and Printing (bakn notes) and US Mint (coins).

The only way that cash can get physically inserted into the economy is if a bank that is a Federal Reserve Bank member orders cash from the Fed. Upon receiving the order, the Fed debits the bank’s account at the Fed for the amount ordered, and tells the bank to come and collect the cash.

Wire Transfer

Designed to handle very high value transactions between businesses, and often between financial institutions.

US has two such systems: Fedwire and CHIPS. - Fedwire is a service of the Federal Reserve Banks, available to all banks that hav ean account at one of the Federal Reserve Banks. - CHIPS stands for Clearing House Interbank Payments System. It’s a private sector alternative to Fedwire. It’s owned by The Clearing House, which is owned by the large banks in the US.

An important third system, SWIFT, is not a payment system, but a global financial services messaging system / network. Participating members, e.g. banks and securities firms, can send each other secure, structured messages.

A wire transfer cannot be rejected, reversed, or charged back without the agreement of the recipient.

An enterprise wanting to send a wire transfer sends an electronic message to its bank. Once the bank is satisfied that their customer’s request is legitimate, the bank debits the account and sends a message to Fedwire. The Federal Reserve Bank at which the account is domiciled debits the bank’s account and credits the account of the receiving bank. The receiving bank then credits the account of the receiving company. All of this is done online, in real time.

Banks

In the U.S., to start a bank, you need a charter from a regulatory agency—a state or federal chartering authority. The chartering authority examines the business plan, management competency, and capital adequacy of the proposed bank. The charter, when issued, defines the capabilities of the bank. The key activity is deposit taking: a non-bank can lend money or handle payments, but only a chartered institution can accept consumer deposits into a transaction account.

Banks are audited and examined on an ongoing basis, often by multiple regulatory agencies; these agencies have the power to revoke a bank’s charter, among other actions, if dissatisfied with its performance.

Banks make money by lending money, by holding money (in deposit accounts or investment accounts), and by moving money—moving money means payments. Although all three activities are profitable for banks, the relative profits are highest for lending, and lending activities tend to dominate a bank’s management agenda.

Payment Networks

Companies that provide one or more of the three key functions of an open loop payments systems: rules, brand, and processing. Most payments networks in the U.S. began life as bank-owned consortia. Today, some remain so, while most are, or are owned by, public companies.

Customers don’t want disruption, they want new kinds of value that make life easier for them - Steve Ellis, head of innovation at Wells Fargo