Chapter 4 - Payment Instruments and Systems Flashcards
Payment
transfer of monetary value from one party to another whether in cash or non-cash form
cash payment is effected with transfer of notes and /or coin from payer to payee
Payor
party sending the payment
payor’s account is debited for the value of the transaction
Payor’s Bank
processes the value transfer on the payor’s behalf
Payee / Beneficiary
receiver of the payment
payee’s account is credited the value of the transaction
Payee’s Bank
processes the transaction on behalf of the payee and generally holds the value in an account
Other Payment Participants
(1) central banks e.g. the Fed
(2) commercial entities e.g. CHIPS, Visa
(3) transaction facilitators that transmit info but do NOT provide settlement e.g. SWIFT
(4) payment systems that transmit info and provide funds settlement e.g. Fedwire and / or ACH Network
(5) third party processors e.g. payroll processors, check printers, and systems providers
Four Elements in the payment process
(1) payment instructions
(2) payment generation
(3) clearing
(4) settlement
Payment Instruction
instructions from the payor telling the paying bank to transfer value to the payee through the receiving bank
consists of info in an electronic transfer, payment card transaction, or a check
Payment Generation
occurs when the payment instructions are entered into the payment system
Clearing
process in which banks use te payment info to transfer money between themselves on behalf of the payor and the payee
involves the transfer and confirmation of info between payor’s bank and payee’s bank
Settlement
occurs when the payee’s bank account is credited and the payor’s bank account is charged
settlement refers to the movement of funds from payor’s account to payee’s account aka when the payee can use the money
Finality
point in time at which the funds cannot be taken back or retracted by the payor or payor’s bank
settlement transitions to finality when a payment is unconditional and irrevocable
finality is determined by the transfer system’s rules and applicable law
Real Time Gross Settlement Systems (RTGS)
payment systems that offer immediate and irrevocable value (aka wire transfer systems)
Correspondent accounts
two banks can have accounts with each other for the purpose of clearing and settling payments
Check
written instruction form the payor to the payor’s bank to make a payment to the named payee or the bearer (unnamed payee)
Electronic Funds Transfers (EFT)
payments that are cleared and settled electronically
categorized as individual transfer or batch payments
Wire transfers
one of two forms of individual transfer EFTs
processed individually and in real time with immediate and irrevocable settlement
Instant / real-time payments
one of two forms of individual transfer EFTs
lower cost alternative to wires, generally irrevocable, reduces settlement risk associated with batch payments
Low-value electronic batch payments
aka ACH payments
value-dated and processed in batches, and typically takes one to two days to settle
may be recalled under certain conditions
Card payments
settle through on of the large card-processing networks including Visa, Mastercard, UnionPay, Amex
may also settle through an ATM or POS system
Digital payments
include digital or mobile wallets, mobile (phone) payments, person-to-person payments and virtual currencies
(1) digital wallets - use smartphones with near field communication (NFC) chips or bar code
(2) mobile payments allow user to set up account with a cell phone provider and transfer funds via text using a PIN for security - does not require smartphone or bank account, making it a popular method in developing and underbanked countries
(3) P2P payments can be initiated by the payor through a bank or nonbank intermediary (e.g. PayPal)
(4) virtual currencies e.g. cryptocurrencies have limited acceptance and are not seen as stable stores of value
Business-to-Business (B2B)
one business to another, typically for vendor payments
smallest portion of payment volume but represent largest portion of payment value
primarily electronic payments or via card
Business-to-Consumer (B2C)
business to consumers or individuals e.g. payroll
Consumer-to-Business (C2B)
consumer to business, typically for purchases and bill payments
majority are either card payments at point of sale or electronic payments made through a bank
Consumer-to-Consumer (C2C)
person-to-person or peer-to-peer (P2P)
move funds from one individual to another e.g. income payments from babysitting and personal payments such as gifts
Consumer-to-Government (C2G)
taxes and other government fees
Business-to-Government (B2G)
taxes, fines and other government fees
Government-to-Business (G2B)
usually for vendor payments
Government-to-Consumer (G2B)
retirement, social security, tax refunds, welfare payments
majority are electronic or card-based
Payment Characteristics that affect payment method used
(1) urgency and time sensitivity: processing time and when payee will receive value vary by selected instrument and can affect the method chosen
(2) dollar value of payment: max value thresholds for certain payment systems and require payment above that value to be processed via a systemically important EFT system
(3) push vs. pull payments: push are initiated by the payor (e.g. checks, ACH credits, wires) pull are initiated by the payee using authority granted by the payor (one time or recurring)
Cash payment
involves currency and coin and are used to settle small transactions
cash payments are self settling, the physical transfer of cash is the ““clearing network”” that leads to final settlement
many types of companies continue to receive a portion of receipts in cash
cash represents a security risk and must be safeguarded at collection point until it can be transported to a bank for deposit, making it a high-cost payment method for most companies
Check payment
overall check volume is declining but it still remains an important method for B2B payments in the US
funds are usually available to depositor in 1-2 days but finality can take several weeks or longer due to stop payments and overdraft returns
US Check Clearing Process
(1) Check Deposit: payee deposits the check at payee’s bank with the physical check or with image of check via remote capture
(2) Convert to Electronic Image: if not done so already, bank of first deposit images the check and captures the MICR info - check in snow considered truncated
(3) Clearing: checks / images are sorted and sent through a clearing channel as cash letters which includes info such as depositing institution routing #, total dollar amount of deposit, and # of items deposited
(4) Check Exchange: historically settlement occurs after presentment / delivery of physical checks to the paying bank but with check truncation, this bow occurs with exchange of check images
(5) Value Subtracted: value is subtracted from paying bank’s account at time of presentment through central bank, correspondent bank, or other clearing channel and paying bank debits the amount from payor’s account
(6) Paying Bank Review: paying bank has a limited period of time to review check/image and decide to either authorize or refuse the payment (return to bank of first deposit)
- US: banks have ~36 hours; midnight of the business day following the day of receipt of a check
- UK: deadline is business day after check was deposited
On-Us Check Clearing
payee deposits check in an account at the same bank on which the check is drawn
bank simultaneously debits payor and credits payee
typically same day or immediate availability and lower processing fees
On-We Check Clearing
similar to on-us checks but involves a group of banks that use the same third party vendor for check processing, since checks are processed at the same time and place, they are treated as on-us items with same day or immediate availability
Transit Check Clearing
deposited checks are drawn on another bank and require more processing than on-us or on-we items
bank of first deposit must sort checks into cash letters and transmit them to the paying bank for final settlement
Foreign Checks
checks deposited at a bank in one country that are drawn on a bank in another country, can be drawn in foreign currency
normally treated as collection items and processed outside of the normal check clearing systems
depository bank will send check to a correspondent bank in the country where the check is payable
correspondent bank will process the check locally and remit proceeds to depository bank
are subject to both FX costs and extra processing fees so bank of first deposit will not credit the payee’s account until it receives and converts proceeds of the check into its base currency
results in days or weeks for clearing and amount is usually less than the face amount of the check”
Ledger Cutoff Time
time of day when a deposit must be received in order for the amount to be posted to the ledger balance of the payee’s account
items deposited after the ledger cutoff are considered to be received by the bank on the following banking day
ledger balances are granted provisional credit based on anticipated settlement and finality of the item
Deposit Deadline
time within the banking day when an item must be ready for transit at the depository bank’s processing center to qualify for the availability stated in the availability schedule
if deposit deadline is missed, availability is delayed
Availability Schedule
specifies when a bank grants available credit for deposited items or includes them in collected balances
banks set availability schedules based on processing schedules, capabilities, and pricing decisions
availability is assigned using proof-of-deposit method, where availability is assigned to each check as it is processed and is determined based on time/day of deposit and where paying bank is located
availability schedule impacts float balances, so availability schedules offers is typically part of pricing decision
Ledger Balance
reflects all entries to a bank account regardless of if deposited items have been collected
important for account purposes
NOT used for fund availability or bank compensation
negative ledger balance results in an overdraft and is subject to OD charges
Available Balance
amount of funds available for withdrawal from an account
may also include overdraft lines of credit
Deposit Float
deposited items that are listed on the ledger but not available for withdrawal
Collected Balances
ledger balance minus deposit float
Intraday Overdrafts
occurs when banks permit companies to make payments in excess of the available balance and overdraft positions are usually eliminated by funds that arrive later in the day
RDC / Image Capture Impact of Availability
check items that are preprocessed using RDC may receive faster availability, later cutoff, later deposit deadline, and/or lower fees because the customer is performing a labor intensive task for the bank
Check Deposit - Reject Items
check items that are rejected by ta bank’s automated check processing equipment due to physical defects in the MICR line
or MICR line non-compliance with banking industry specifications
items will need to be repaired and reprocessed and will likely miss critical deposit deadlines resulting in delays in availability and additional processing fees”
As-of Adjustments
represents the different between the time the check takes to clear and the initial availability granted by the bank
banks may make as-of adjustments if a check takes longer to clear than expected (e.g. granted one-day availability but it took two days to clear)
additional day(s) of float is added when calculating collected balances which reduces available balances and may increase bank fees
Value Dating
practice of debiting or crediting a transaction on some date other than the processing date
Cashier’s Check
aka official bank check
check is drawn on a bank’s funds
Certified Check
drawn on a depositor’s account, funds are withdrawn at the time of certification to assure payment with a certification / guarantee by the bank
Government Warrants
an order to pay that instructs a treasurer to pay the warrant holder on demand or after a maturity date
deposited warrants are routed to a collecting bank that processes them as collection items
collecting bank presents the warrants to the govt entity’s treasury dept for payment each business day
typically used for payroll, A/P to vendors, tax refunds, or payment of unclaimed monies
Money Order
prepaid instrument issued by banks or third parties (e.g. post office, convenience stores, check cashing agencies)
purchaser of the instrument is the payor and money order is the obligation of the issuer
Payable-through-draft (PTD)
resembles a check and is drawn against the payor instead of the bank
handled like a check through the clearing process
responsibility to pay lies with the payor
typically used when companies want to preserve the right to review the item prior to final payment
e.g. insurance companies often use PTD’s for claim reimbursement to ensure opportunity to verify signatures and endorsements prior to honoring the item
Pre-authorized debits (aka remotely created checks)
used to draw or draft against a payor’s account
check is unsigned and the payee initiates the transaction, not the payor
typically created for one-time payment
since they do not bear a signature and can be created without the knowledge of the payor, RCCs are vulnerable to fraud and banks often refuse to accept them
Sight Draft
usually presented in combination with other documents to verify the terms of a transaction have been met
if all documentation is in order draft is payable upon presentment i.e. on sight
typically used to support international trade
Time Draft
same as a sight draft but is not payable until a specific future date
typically used for transactions that call for delayed payment
primarily used to support international trade
Gross Settlement
occurs when each transaction results in a separate value transfer between the payor and payee
settlement occurs immediately through an RTS system
payments are considered final when processed
Net Settlement
when many transactions are combined and then sorted by sending and receiving banks
net amount either owed by or owed to each bank is determined and only the net amount is actually transferred
at this point - electronic credit transaction are considered final and electronic debits may be reversible under certain circumstances
Systemically Important EFT Systems (RTGS Systems)
most countries have at least one systemically important payment system which is used at a minimum for interbank payments and are usually used by banks to process urgent or time-sensitive client payments
most systemically important systems settle payments individually and in real time using RTGS systems
RTGS systems clear and settle individual transactions continuously throughout the system’s processing day
RTGS systems are used by companies to facilitate major transactions that are time sensitive and where irrevocable receipt is required
Finality for RTGS
Payment is final and irrevocable when either
(1) RTGS processor credits the amount to the receiving bank’s account OR
(2) RTGS processor sends notice to receiving bank
whichever is earlier
TARGET2
is based on a common operating platform developed and operated by Banca Italia, Banque de France, and Deutsche Bundesbank on behalf of the Eurosystem
became operational in Nov, 2007 and was introduced to support eurozone monetary policy and facilitate cross border payments in euros
Clearing House Interbank Payment System (CHIPS)
US-based privately owned wire transfer system, is an RTGS system that provides finality
is one of the main EFT systems for processing international USD funds transfer made among international banks in the US
to access the CHIPS network, a bank must have US presence
EURO1
a privately owned same day net settlement system that settles its transactions via TARGET2
settles payments with high priority, mostly within 30 minutes
Low-Value Transfer Systems (e.g. ACH)
used for the exchange of non-system critical payment instructions between banks
can transfer more payment-related info than can be transmitted via paper instruments or wire transfers
allow transactions to be originated as either credits or debits
- ACH credits are originated by the payor
- ACH debits are originated by the payee
ACH Operators in the US (2)
Fed processes most of the ACH transactions in the US and EPN (private operator) processes the rest
NACHA
is a trade organization responsible for managing the development, administration, and governance of the US ACH system
Instant / Real Time Systems
(1) UK: Faster Payments, since 2008 with max transaction size of 250k GBP
(2) SEPA: Instant Credit Transfer, since Nov. 2017, settles within 10 seconds, max of 100k EUR
(3) US: CHIPS - RTP, since 2017 with max of 100k USD
(4) US: Fed - FedNow, since 2023, 24x7x365 payment settlement system
(5) Singapore: FAST in 2014 and PayNow in 2017, both allow up to 200k SGD
SEPA
ensures that electronic euro-payments within the SEPA region are handled in a standardized and inexpensive manner
cross-border payments within the SEPA boundaries are treated as if they were in country rather than cross border payments
Cross Border ACH (IAT)
accomplished through the use of “gateway” banks or service providers that will receive transactions in one country and then forward them to the ACH system of another country
FedGlobal ACH Payments
Provided by the Fed and allows for cross border ACH transactions to over 30 countries
standard option is account-to-account transfer - distributes cross border payments between deposit accounts
account-to-receiver option allows fund from accounts at a US bank be retrieved by any receiver either at a participating bank location or at a trusted third party provider in certain receiving countries
FedGlobal Transaction Currency Options
(1) fixed-to-variable: USD are converted to destination currency based on exchange rate, settlement occurs in USD between US bank and Fed bank
(2) fixed-to-fixed USD to USD: transferred and received in USD, settlement occurs in USD between US bank and Fed bank
(3) fixed-to-fixed FX to FX: transferred and received in foreign currency, FX rate and settlement managed and processed by US bank and foreign gateway operators via their foreign correspondent banks
Society for Worldwide Interbank Financial Telecommunication (SWIFT)
is an industry owned, cooperative, interbank telecomm network that enables banks, nonbank financial institutions and some corporates to send authenticated, electronic messages in standard formats
contains payment related information but do not actually transfer value
access options include:
(1) direct corporate access via dedicated connection
(2) direct corporate access via online / web-based
(3) indirect access via service bureau or through bank
SWIFT global payments innovation (SWIFT gpi)
improves the speed and traceability of cross border electronic funds transfers
provides transparency for deductions, permits up to 140 characters of remittance info
stop-and-recall option to return tracked payment to originating bank
and initiator generated end-to-end transaction reference # for tracking of payment”
Card Types
(1) credit card - issued against a line of credit
(2) charge card - special type of credit card where outstanding balance must be paid off each month
(3) debit card - issued against a deposit account belonging to the cardholder, also called EFTPOS - EFT at point of sale
(4) prepaid / stored value card - preloaded with value and will only be accepted if sufficient value remains on the card
(5) virtual card - digital card with features of credit, charge, debit, or prepaid card
Purchasing Card
aka procurement cards are used by business for the purchase of supplies, inventory, equipment, etc.
Benefits:
(1) reduces / eliminates time consuming labor intensive paper based process
(2) reduce / eliminate need use of petty cash in an organization
(3) earn rebate based on charge volume
(4) delay payment until end of billing cycle
(5) procure goods and services quickly without complicated PO process
T&E Card
used by businesses for employee travel
Fleet Card
designed for expenditures related to trucks and cars such as fuel and repairs
entitles users to fuel discounts and capture added info such as vehicle mileage and location
Department Card
unnamed card for general use by a department; linked to department instead of an individual
Single-Use Card
generate single use / disposable card numbers
can be used for T&E and / or AP and vendor spend
Stored-Value / Prepaid Card
can be branded open-loop cards or private label closed loop cards
can either reloadable or non-reloadable
e.g. gift cards, payroll cards, FSA/HAS cards
Credit Card Transaction Process
(1) Authorization: (a) card presented to merchant for purchase (b) merchant submits authorization request via gateway (c) issuing bank reviews and if approved, places hold on credit limit (d) authorization response routed back and presented via gateway
(2) Clearing: (a) card transaction si submitted by merchant to merchant acquirer (b) acquirer route info to issuing bank (c) issuing bank receives info and converts hold into a charge on customer’s card
(3) Settlement: funds are transferred from issuing bank to the merchant via the merchant acquirer, settlement typically occurs the next day following submission of the clearing transaction to the network operator; any FX conversion is handled as part of settlement process
Merchant Gross Settlement
merchant receives full transaction value and is periodically invoiced for amount of fees owed to respective parties
Merchant Net Settlement
merchant receives transaction value minus the fees
Merchant Fees
includes (1) interchange due to issuing bank (2) assessment / network fee due to network operator e.g. Visa / MC (3) transaction fees due to merchant acquirer
Payment Card Industry Data Security Standard (PCI DSS)
a worldwide info security standard defined by the Payment Card Industry Security Standards Council
created to help organizations that process card payments prevent card fraud by increasing controls on the data they hold and exchange
failure to comply with standards or breach of security can result in substantial fines and possible termination of acceptance of credit cards
Card Authorization
(1) signature based: customer authorizes the credit / debit transaction by signing receipt at checkout
(2) PIN-based: facilitates consumer authorization and authentication through entry of a PIN at the POS terminal
Smart Cards (EMV Chip Cards)
smart cards include a computer chip that stores info for security / transaction processing
these EMV compliant cards also have a magnetic stripe in addition to the chip
EMV chip transactions are more secure than magnetic stripe transactions as criminals can copy the magnetic stripe data and produce counterfeit cards
EMV chip has dynamic authentication that reduces the possibility of fraud
liability for fraud has shifted to merchants if they do not support chip technology or to issuers if they have not issued a smart card to the user
if a chip card is used at POS but is not processed via EMV (e.g. used magnetic stripe) merchant will not be able to dispute a charge back”
Interchange
largest portion of overall merchant gees, and is paid to the issuing bank for each transaction
fee is intended to cover issuing banks costs to issue cards and process card transactions
interchange varies by acquisition method and card type
(1) acquisition method: interchange is lower for card present transactions where cardholder authorizes the transaction via PIN due to lower risk of fraud / chargebacks and higher for card not present transactions (e.g. online, phone, mail order) where there’s an increased risk of fraud or error
(2) card type can refer to standard vs. reward card and / or credit vs debit card - interchange is typically higher for reward cards and higher for credit cards since regulations cap debit card interchange to ~$0.22 per transaction
Assessment Fee
calculated as a percentage of the transaction amount and are set by the network operators based on method of acceptance and type of industry
fee is intended to reimburse the network operators for their services and for brand management
Processor / Transaction Fee
are set by the individual card processor or merchant acquirer and fees are charged to process the transaction on the merchant’s behalf and is usually based on expected transaction volume
this is the only portion of merchant fees that is negotiable
Electronic Fund Transfer Act (EFTA) 1978
defines the rights and responsibilities of customers using all types EFT services except for wires
limits customer liability for unauthorized bank transactions involving ATMs and POS terminals provided that the customer notifies the bank / institution that issued the card
Depository Institutions Deregulation and Monetary Control Act (DIDMCA) 1980
(1) requires deposit taking institutions to hold reserves at the Fed
(2) makes Fed services (e.g. discount window, check clearing) available to all deposit-taking institutions
(3) mandates that the Fed reduce / price payment system float and reprice previously free Fed services to be in line with the standards of a tax-paying vendor
Electronic Signatures in Global and National Commerce Act (E-Sign Act) 2000
grants digital signatures the same legal status as handwritten ink signatures
establishes the legal certainty of e-commerce transactions
provides a measure of confidence around the enforceability of electronic transactions
Check Clearing for the 21st Century Act (Check 21) 2003
provides the basis for electronic clearing of checks by allowing an image to substitute for the original check document in the clearing process
led to faster clearing of checks and improved efficiency of the payment system
Federal Reserve - Reg E
implements provisions of the Electronic Funds Transfer Act (EFTA)
establishes guidelines for the documentation of electronic transfers
Federal Reserve - Reg J
implements check collection and settlement provision of the Federal Reserve Act of 1913
establishes procedures, duties and responsibilities for check collection and settlement through the Fed
Federal Reserve - Reg Z
for treasury professions, primary impact of reg Z is related to credit cards offered to their customers as it implements the Credit Card Accountability and Disclosure Act of 2009 (Credit CARD Act)
(1) prohibits increase credit card rates during the first year after account opening and prohibits increase to rates that apply to existing credit balances
(2) prohibit creditors from issuing cards to anyone under 21 unless there is a parent or cosigner
(3) Requires creditors to get consent from consumer before charging fees for transactions that exceed the credit limit
(4) limits the high fees associated with sub prime credit cards
(5) bans creditors from using two-cycle billing to impose creidt charges
(6) prohibits creditors from allocating payment in ways that maximize interest charge”
Federal Reserve - Reg CC
implements provisions of the Expedited Funds Availability Act of 1987
establishes rules designed to speed the collection and return of checks and mandates banks to return unpaid checks expeditiously
imposes the same procedures to payable-through-drafts (PTD)
Federal Reserve - Reg II
implements provisions of the Durbin Amendment to the Dodd-Frank Act of 2010
provision limit debit card interchange fees and increases competition in payment processing
UCC - Article 3: Negotiable Instruments
prevents inadvertent accord and satisfaction for paper instruments (e.g. unauthorized signatures on checks) if the payee discovers the error and returns the payment to the payor within 90 days
clarifies that a bank’s failure to examine a forged signature is not a failure to exercise ordinary care if it does not violate bank procedures and if bank procedures do not vary from general banking practices unreasonably
bank customer may be liable if they do not exercise ordinary care related to check issuance and do not notify the bank of any potential discrepancies in a timely manner
UCC - Article 4A: Funds Transfer
outlines the risk, rights and obligations of parties in electronic funds transfers
(1) security procedures: bank must make security procedures available to customer and bank and customer must agree that the procedures are commercially reasonable for verifying payment (e.g. PIN, callback, encryption)
(2) consequential damages: banks are generally NOT responsible for consequential damages (i.e. losses from an action or error made by the bank beyond the actual loss) but bank is still liable for any interest losses from incorrectly executing payment order.
Bank is only liable for consequential damages when it agrees to assume this liability in a written agreement with the customer
EU Payment Services Directives - PSD1
adopted in 2007
is the legislative framework for SEPA focused on two primary concepts
(1) create standard credit and debit payment schemes
(2) create a common payment card framework
EU Payment Services Directives - PSD2
applied since Jan. 2018 in response to growth in mobile / internet payments
includes rules that limit interchange fees on consumer credit and debit card transactions and prohibit the use of surcharging on these transactions
is also the legal basis for open banking in the EU - allows FSP to register as account info service providers (AISPs) or payment initiation service providers (PISPs)
- AISPs are entitled to receive customer account info to provide account aggregation, price comparison, and similar info collation services
- PISPs are entitled to connect to a customer’s bank account to initiate payment on behalf of that customer”
